Macroeconomics: How To Think and Reason in

24mm
and reason in
How does the South African economy work? Why do macroeconomic variables change? So what
How to think
if they do? What happens next? How do economic processes and policy institutions really work?
How can we reduce unemployment and maintain low inflation? What about poverty and inequality?
The answers are given in How to think and reason in Macroeconomics – A South African text, a university textbook
with excellent feedback from students, lecturers and practitioners. This fifth edition with updated context and case studies
Macroeconomics
combines practical information with solid economic theory plus a discussion of South African economic issues, processes,
institutions and data. It enables the reader to analyse macroeconomic events and policies in a globalised and development
context, and understand the different perspectives in policy and political-economic debates.
How to think and reason in

This textbook contains:
• Accessible analysis, theory and diagrams, combining intuitive understanding and sophisticated analysis
Macroeconomics
• A choice of learning routes with different levels of difficulty and mathematics
• Real-world economic reasoning, not dry theory
• Online animations that illustrate macroeconomic fluctuations and shocks
• Continuous focus on South Africa as an open economy in an African and global context shaped by China, Trump’s trade
wars and Brexit
• Theoretical and policy analysis of unemployment, inflation, low growth and inclusive growth, and the NDP
A SOUTH AFRICAN TEXT

• Analytical case studies of the global financial crisis, quantitative easing, the Euro crisis and the Eskom crisis
• First-hand, updated insights into how South African policy institutions, processes and instruments work
• Relevant South African data sources, with useful data tips
• An integration of the structural social and economic realities (notably inequality and poverty) of South Africa
• Incorporation of broader considerations, such as sustainable development.
The book covers the main topics for a second-year or MBA course in Macroeconomics or a third-year course on
Macroeconomic Policy. Any manager or practising economist will also find this a lifelong handy reference source on how FIFTH
the economy works. EDITION
ABOUT THE AUTHORS Frederick C v N Fourie Philippe Burger

Frederick Fourie has a PhD in Economics from Harvard University, has been Professor of Economics at the University
of the Free State since 1982, was appointed Distinguished Professor in 1996, and served as Vice-Chancellor there from
2003–2008. In the 1990s he was founding head of the Unit for Fiscal Analysis at the National Treasury and a member of
the first Competition Tribunal. From 2012-2018 he was Research Co-ordinator of the Research Project on Employment,
Income Distribution and Inclusive Growth (REDI3x3), based at the University of Cape Town. He is founding editor of the
online policy forum Econ3x3 and editor and co-author of The South African informal sector: Creating jobs, reducing poverty
Philippe Burger
Frederick C v N Fourie
(2018).
Philippe Burger is Professor of Economics, Vice Dean of the Faculty of Economics and Management Sciences and Pro
Vice-Chancellor: Poverty, Inequality and Economic Development at the University of the Free State. He is a past President
of the Economic Society of South Africa (ESSA) and was a member of the South African Statistics Council. He is a National
Research Foundation rated researcher and has been a research consultant to the OECD and visiting scholar at the IMF. He
is the 2002 recipient of the Founder’s Medal of ESSA for the best PhD thesis at a SA university and was associate editor of
the South African Journal of Economics. He is the author of Getting it right: A new economy for South Africa (2018). FIFTH EDITION
www.juta.co.za
Macroeconomics
How_to_think_BOOK_2019.indb 1 2019/12/17 09:14

Macroeconomics
Frederick C v N Fourie
Philippe Burger

How to think and reason in Macroeconomics
First published 1997

Second edition 2001
Third edition 2009
Fourth edition 2015
Fifth edition 2019
Juta and Company (Pty) Ltd

First floor, Sunclare Building, 21 Dreyer Street, Claremont 7708
PO Box 14373, Lansdowne 7779, Cape Town, South Africa
www.juta.co.za
© 2019 Frederick C v N Fourie, Phillippe Burger and Juta and Company (Pty) Ltd
ISBN 978 1 48513 047 5 (Print)
ISBN 978 1 48513 048 2 (WebPDF)
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electronic or mechanical, including photocopying, recording, or any information storage or retrieval system, without
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electronically supplied publications, a person may engage in fair dealing with a copy of this publication for his or her
personal or private use, or his or her research or private study. See section 12(1)(a) of the Copyright Act 98 of 1978.
Project manager: Seshni Kazadi

Editor: Lilané Putter Joubert
Proofreader: Lilané Putter Joubert
Cover designer: Drag and Drop
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Indexer: Frederick Fourie
Typeset in 11 on 13 pt Photina MT Std
The author and the publisher believe on the strength of due diligence exercised that this work does not contain any
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Table of contents
Preface�� ix
0. Introduction and orientation: macroeconomics in the South African

context�� 1
Part I How does the economy work?

1. Why macroeconomics? An introduction to the issues
1.1 What is macroeconomics?��9
1.2 How can learning to think and reason in macroeconomics help me?��10
1.3 Main macroeconomic problems and policy objectives��11
1.4 The development objective��25
1.5 Intermediate objectives��30
1.6 Conflict between the standard objectives – priorities and trade-offs��30
1.7 Priority choices of the South African government��31
1.8 Main perspectives in the economic debate in South Africa��33
1.9 Analytical questions and exercises��41
2. The basic model I: consumers, producers and government

2.1 The basic framework��46
2.2 The real (or goods) sector ��50
2.3 Analytical questions and exercises��74
3. The basic model II: financial institutions, money and interest rates
3.1 The monetary sector and interest rates��76
3.2 Linkages between the monetary and the real sectors��98
3.3 The IS-LM model as a powerful diagrammatical aid�� 109
3.4 Real-world application: The 2007–08 financial crisis – varying investor
behaviour and impotent monetary policy�� 134
3.5 Analytical questions and exercises�� 138
4. The basic model III: the foreign sector

4.1 Background – why trade internationally?�� 141
4.2 Imports, exports and capital flows�� 142
4.3 The balance of payments and exchange rates�� 156
4.4 The BoP adjustment process�� 171
4.5 The complete model – the BoP, the exchange rate and the domestic economy�� 172
Table of contents v

4.6 Conflict between internal and external considerations�� 186
4.7 The IS-LM-BP model for an open economy�� 188
4.8 Real-world application – the Euro crisis and the impact of confidence
on international capital flows�� 204
5. Understanding sectoral coherence and constraints: how to use

macroeconomic identities
5.1 From equilibrium conditions to identities�� 214
5.2 The interpretation of identities – uses and abuses�� 216
5.3 Expenditure, production and current account deficits�� 219
5.4 The sectoral balance identities�� 219
5.5 The financing of gross capital formation�� 225
5.6 The SNA at a glance – relationships between subaccounts�� 228
5.7 Using the sectoral balance identities for decision making�� 232
Addendum 5.1: National accounting definitions and conventions –
a student’s guide�� 235
6. A model for an inflationary economy: aggregate demand

and supply
6.1 Essentials of the AD-AS model�� 241
6.2 Aggregate demand (AD)�� 243
6.3 Aggregate supply (AS)�� 249
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together�� 272
6.5 Real-world application – the Eskom crisis, GDP and prices�� 294
Addendum 6.1: Labour market changes following demand stimulation�� 300
Addendum 6.2: Labour market details following a domestic supply shock�� 301
Addendum 6.3: A complete example of IS-LM-BP and AD-AS for an increase
in the repo rate�� 302
Addendum 6.4: A complete example of IS-LM-BP and AD-AS for an increase
in the price of imported inputs (e.g. oil)�� 303
7. Extending the model: inflation and policy reactions

7.1 Adjusting the model – inflation-augmented AD and AS curves�� 306
7.2 Managing inflation – policy options and the monetary reaction (MR) function�� 320
8. Macroeconomics in the very long run: growth theory

8.1 The importance of growth�� 329
8.2 Why growth theory?�� 330
8.3 From intuition to formal analysis – from AD-AS to the Solow growth model�� 332
8.4 Rearranging the model – towards income per capita�� 336
Y
8.5 Sources of sustained growth in    – first conclusions�� 338
N
8.6 Is any capital–labour ratio possible? The idea of balanced growth�� 340
8.7 Expanding the model – the expanded balanced growth condition�� 344
vi Table of contents

8.8 Using the model – changes in the balanced growth path due to
changing parameters�� 348
8.9 Convergence between low-and-middle-income and high-income countries?�� 354
8.10 Human capital – the previously missing element�� 355
8.11 Summary and conclusions�� 358
8.12 A last word on growth (for now …) �� 361
Addendum 8.1: The Cobb-Douglas production function�� 363
Addendum 8.2: An illustration of balanced growth – the course of ratios between
key variables�� 365
Part II Macroeconomic policy, unemployment, inflation and growth

in an open economy
9. Monetary policy: the role of the Reserve Bank
9.1 Definition and main instruments�� 371
9.2 Monetary policy design – four important choices�� 376
9.3 Inflation targeting in South Africa�� 380
9.4 The practice of monetary policy�� 383
9.5 Public debt management – the interface between financial markets and
fiscal and monetary policy�� 386
9.6 Exchange rate policy and the problems of monetary policy in an
open economy�� 389
9.7 Real-world application – quantitative easing and ‘creative monetary policy’
in the USA�� 392
9.8 Monetary policy and the ownership of the Reserve Bank�� 394
10. Fiscal policy: the role of government

10.1 State, government and public sector�� 397
10.2 Definition and instruments of fiscal policy�� 397
10.3 The choice of overarching policy objectives�� 402
10.4 Constraints on fiscal policy choices�� 405
10.5 The decision on the main fiscal aggregates�� 411
10.6 Public debt and public debt management�� 431
10.7 Fiscal discipline and fiscal norms�� 436
10.8 Fiscal policy and development – broader criteria�� 451
Addendum 10.1: Measuring aggregate government expenditure�� 454
Addendum 10.2: Measuring government revenue and the deficit�� 459
11. Policy problems: coordination, lags and schools of thought

11.1 Monetary vs. fiscal policy?�� 461
11.2 Policy problems�� 464
11.3 The larger problem – different schools of thought�� 467
Table of contents vii

12. Inflation, unemployment and low growth: causes and remedies
12.1 Inflation�� 481
12.2 Unemployment�� 501
12.3 Low economic growth�� 528
12.4 Inclusive growth and development�� 553
12.5 Policy design in practice – the National Development Plan�� 558
12.6 A final thought – the structural dimension of macroeconomic problems�� 564
Index�� 568
viii Table of contents

Preface
How to think and reason in macroeconomics – a South African text. Why the
complicated title?
First, this textbook purposefully and methodically teaches the reader how to think and
reason about economic behaviour, real-life processes and change in macroeconomics –
not merely how to manipulate a set of theoretical equations or shift a few curves around.
(After all, the economy does not have curves.)
Secondly, the text continually situates the analysis and comprehension of economic
processes in the South African context. Thus the reader will learn extensively about:
❐ relevant data and data sources to underpin understanding;
❐ economic institutions that shape economic processes, including policy institutions and
the political-economic landscape;
❐ policies that could be used (but also misused) in the pursuit of macroeconomic objectives
such as high employment, low inflation and steady growth; as well as
❐ broader considerations such as human development and inclusive growth – with South
Africa being an (upper-) middle-income country relative to peer countries in Africa and
elsewhere, as well as high-income countries.
But what does this really entail?
Combining intuitive understanding and sophisticated analysis

Modern macroeconomics, especially in advanced and postgraduate courses, typically
aims to equip students with the ability to manipulate complex mathematical models of the
economy. Yet one finds graduates with a first or advanced degree in economics who still do
not have the ability to analyse and converse about the basic operation and dynamics of the
economy, for example in response to cyclical or policy effects, or international economic
shocks. Economics graduates often have very limited knowledge of the institutions,
processes and data – and often feel they have to ‘unlearn’ or disregard prior ‘academic’
studies when they start work as practising economists in the private or public sectors.
Our point of departure is that theoretical insights and refinements should always be
rooted in a thorough intuitive understanding of economic behaviour, processes, data and
institutions. Without a solid intuitive understanding, technical wizardry and theoretical
sophistication have limited value in practice.
❐ Therefore, in this text, topics typically evolve from a thorough intuitive understanding
through increasing levels of theoretical sophistication up to the theoretical rigour
found in standard intermediate macroeconomics texts.
Preface ix

In addition, without the ability to situate theoretical insights in the real-life institutional
context, theory becomes almost sterile. The practices of institutions such as the central
bank or national treasury, or ratings agencies and labour unions, often have as large a
bearing on economic processes and outcomes as the behaviour of individuals or businesses.
Also, it is important to have a sense of economic magnitudes: to know when a statistic or
number, mentioned by some commentator or churned out by an analyst, sounds plausible
… or just could not be right.
❐ In this book, pertinent institutional and historical information as well as data tables,
graphs and tips continually reinforce the link between theory (abstraction) and reality.
This also provides a confidence-building experience to students who could easily have a
sense of alienation if confronted with economic theory only.
So what? Let’s reason
To contribute to active learning and a higher knowledge retention rate, the text has been
written in an interactive style. Expositions are interspersed with questions and stimulating
data, or a fascinating institutional backdrop. Students are encouraged to ask questions
about the operation of the economy: Why do things happen? How does the process actually
occur? How do the institutions operate? So what? What happens next? Why does it matter?
Such a habit of thinking and asking questions makes the acquired insights ‘active’ and
ready for application.
In the same way, the policy chapters do not provide recipes to ‘solve’ macroeconomics.
They demonstrate how intelligent economic analysis can help one to think more effectively
and make fewer policy mistakes.
All of this will help to impart to users of the book (both students and practitioners) an
enduring and satisfying understanding of – and the ability to think and reason about –
macroeconomics in South Africa. Exhaustive experience with this approach to lecturing
macroeconomics has shown that students retain significantly more knowledge and
insights, even years afterwards, than with conventional mostly theoretical analysis. They
also feel confident in discussing both theory and its practical aspects – and to think on
their feet.
Learning routes – a choice of difficulty level

A distinguishing characteristic of the book is that the reader can choose to read and engage
with the subject matter, and especially the theory, at different levels of difficulty. Thus it
affords access at different levels of complexity, progressively providing deeper insights and
higher analytical capabilities.
These levels are:
❐ a mainly intuitive route, or level, using chain-reaction arguments in which a sequence of
changes in variables unfold, accompanied by relatively simple theory, basic equations
and basic diagrams; then moving on to
❐ a more theoretical level, where the sequence of changes is depicted and analysed with
more complex equations and diagrammatical aids such as the IS-LM-BP model and the
AD-AS or AD'-PC curves (see below); then, if desired,
❐ a more advanced level, using mathematical derivations and analysis presented in a
parallel series of ‘maths boxes’; these show the relevant mathematical derivations and
manipulations alongside the intuitive, chain-reaction and diagrammatical analyses –
to fully deepen understanding.
x Preface

Learning how macroeconomic changes unfold: from chain reactions to time-paths
and animations
A key objective is for the reader or student to develop a ‘feel’ for the economy: how
macroeconomic changes in fact are dynamic processes that unfold and evolve, rather than
being jumps from one static equilibrium to the next – which is not how people experience
the economy.
The first tool is the extensive use of chain reactions in analysing economic behaviour. Based
on the basic theories of consumption, investment, etc., the reader learns to construct
sequences of likely effects as disturbances spread from one variable to another and one
sector to another. This creates a real sense of how things unfold over the business cycle or
in response to an external shock or a policy intervention.
Building on this, novel time-path diagrams demonstrate the possible course of several
variables unfolding over time, affording a strong real-world feel to examples of the
consequences of macroeconomic disturbances or policy steps. A related feature is
the explicit clarification of the short, medium and long run. This develops the reader’s
understanding of the time dimension of disturbances and various adjustment processes
in the money market, balance of payments and aggregate supply.
The culmination of this is a new online learning aid, animations of key diagrams, ideal for
the video generation. These are vastly effective in giving readers a sense of dynamics and
changes in the economy. The analysis is not limited to comparing equilibrium points, but
can be seen as ‘live’ dynamic shifts of curves that move a point of intersection on the way
to a new equilibrium. These analytical visuals are paired with the time-path diagrams,
showing the corresponding course of the variables over time live – movies of the economy
changing and adapting to cycles, shocks and policies.
Enthusiastic feedback from lecturers and students indicates that the animations add
significantly to one’s understanding of macroeconomic forces and dynamics. These
animations are available online free of charge to students for use on laptops, tablets and
cell phones and can be accessed on the following websites:
❐ www.ufs.ac.za/macroecon
❐ https://jutapassmasters.co.za/learning/search.php?search=how+to+think
PowerPoint slides of all the diagrams in the book, with hyperlinks to the animations,
are available to lecturers. The slides provide a seamless transition from static diagrams
to animations in the lecture room (providing wi-fi is available). These slides can be
downloaded at:
Major features in terms of content
As an integral part of a distinctive approach to teaching macroeconomics and situating
it in the South African context, the book differentiates itself also with regard to content.
Chapter 0 contains some detail on this. Here we only note a few.
Preface xi

An open-economy approach throughout
An important characteristic of this book is the explicit incorporation of the fact that
South Africa has a very open economy, strongly subject to international economic forces.
Whereas many textbooks consider the macroeconomic implications of international trade
and capital flows only in the final chapters, if at all, here they are incorporated throughout
the text, starting in the first chapters. Chapter 4 sets out these intricacies in depth and
provides a level of analysis not often accessible to readers of macroeconomics textbooks.
This should make the reader very comfortable with discussions of, for example, the balance
of payments, exchange rates, the gold price and the impact of events in South Africa’s
main trade partners on the local economy.
The emerging-market, middle-income and African context

The book illuminates the development context of the South Africa economy. From the
first chapter it situates the standard macroeconomic issues and policy objectives in
the circumstance of South Africa as a middle-income country and emerging-market
economy in Africa. A brief overview of the definition, measurement and analysis of
human development is presented, also with reference to the Sustainable Development
Goals (SDGs). Attention is given to development aspects by means of informative boxes
and explicit discussions of, for instance, the link between economic growth and human
and institutional development, as well as HIV and Aids (see chapters 8 and 12). The
first chapter also includes perspectives on the political-economic elements of race, class,
capitalism and apartheid that continue to shape the economic policy and development
debate in South Africa.
Unemployment – and structural unemployment

There is thorough coverage of the labour market and unemployment, particularly
recognising the role of labour-market features such as segmentation and entry barriers,
as well as the informal sector. This neatly complements a key feature of the book, i.e. the
analysis of structural unemployment – something economists and policymakers need to
engage with seriously. Structural unemployment is included in the theory, data and policy
discussion in several chapters. In the theoretical model the treatment of unemployment
and a long-run equilibrium output level is couched in a way that explicitly accommodates
the existence of structural unemployment and a structural rate of unemployment (SRU)
– while retaining easy comparability with texts and theory from abroad. (Such texts
usually have very little to say about structural unemployment in low- and middle-income
countries.)
The final chapter provides a thorough analysis of the causes of voluntary and involuntary
unemployment – and structural unemployment in particular. This includes possible links
to the development trajectory, demography, health and education status, technology
and capital intensity, sectoral factors, labour unions and labour mobility, social welfare,
migrant labour, etc. This informs a critical discussion of possible policy interventions,
including the limitations of conventional macroeconomic policy instruments to address
this problem.
Supply-side analysis quite exhaustive

In standard textbook presentations of the AD-AS model, the aggregate supply side often
gets only cursory treatment. This book presents a more exhaustive treatment of the
xii Preface

aggregate supply side (in chapter 6) to match the depth of the derivation of the aggregate
demand side. The short- and long-run aggregate supply (AS) curves are derived from
behaviour in the labour market, using price-setting and wage-setting relationships in a
context that recognises imperfect competition and institutional rigidities in product and
labour markets. Differences between expected and actual prices explain the difference
between the short-run and long-run AS curves as well as related supply adjustment
processes towards a long-run, or structural, equilibrium. This well-grounded derivation
of the AS curve enables a much better analysis of supply shocks, revealing new nuances
and complexities, also in the policy context.
Inflation integrated from the start

Another distinctive feature is having an intensive and integrated treatment of inflation
and the inflationary context. While a variable price level is only formally introduced in the
AD-AS model in chapter 6 and inflation in chapter 7, the distinction between nominal and
real variables is present in the first theory chapters. This enables the investment function
to be stated as a function of the real rate of interest, and the money demand function as
a function of the nominal interest rate. Secondly, in chapter 7, a theoretical framework
is provided that prepares the reader to analyse macroeconomic shocks and adjustments
in a setting where inflation is a permanent phenomenon. It combines an inflation-
augmented AD curve with inflation-augmented AS curves – the short- and long-run
Phillips (or PC) curves. Also included is a discussion of monetary reaction (MR) functions,
typically associated with inflation-targeting policy regimes. The final chapter then deals
exhaustively with the measurement, causes and remedies of inflation in South Africa.
Economic growth theory – in a way everyone can understand

In many macroeconomics courses, growth theory is often disregarded, or otherwise
experienced by students as murky and somewhat disconnected from macroeconomic
models that focus on the business cycle, unemployment and inflation. The treatment
in this book is a natural extension of the theory of aggregate supply in a time frame
stretching from the short and medium run to the long run and very long run. This
presentation of growth theory (chapter 8) provides a novel, intuitive and insightful grasp
of the idea of balanced growth paths. The exposition starts from a simple Solow model,
but soon broadens to include aspects such as social and economic institutions, thus also
linking growth theory to human capital and human development. Here the animations
are particularly useful in grasping the technicalities of one of the more challenging topics
in macroeconomics.
The section in the final chapter on the measurement, causes and remedies of low growth
in South Africa also considers aspects particularly relevant to many African countries,
e.g. human capital, income inequality, institutions, political barriers, culture, trust,
ethnicity, social division and geography. The relationship between economic growth and
the environment is also discussed.
A window on the real worlds of monetary and fiscal policy making

The text conveys a solid feel for the real world of policy making: the difficult choices
policymakers face and the constraints they have to deal with. In addition, the institutional
dimension is incorporated throughout, revealing the actual policy-making processes in
the National Treasury and the Reserve Bank. For example, in addition to analyses of the
Preface xiii

role and impact of monetary policy steps, chapter 9 explains the key choices in the design
of monetary policy (objectives, instruments, targets, including inflation targeting), as
well as the practice of monetary policy, i.e. monetary monitoring combined with basic
monetary policy making such as the determination of the repo rate by the Monetary
Policy Committee (MPC).
The chapter on fiscal policy is especially rich in this regard, distinguishing this book from
most others. The role and financing of government are central to the intense debates
on service delivery, public sector wages, government expenditure on health or higher
education (or Eskom bail-outs), VAT and income tax, the budget deficit and growing public
debt (and the hazard of ratings downgrades). Chapter 10 provides essential insights and
methods of analysis. It draws extensively on the practical experience of the authors in
either working in or advising the National Treasury, putting across an authentic sense of
how decisions are made in the budget process amidst complex constraints. Also shown is
how to make sense of public finance numbers and use fiscal yardsticks.
Using the national accounting identities as a tool to understand sectoral coherence and
constraints
The national accounts can be a dry subject area, dominated by definitions and accounting
conventions. But one can engage with the topic without doing accounting. Indeed, chapter
5 provides a unique treatment of the national accounting identities: as powerful tools to
bolster logical-intuitive reasoning and analyses of macroeconomic change. It becomes a
tool to understand the accounting-type coherence between sectors of the economy – the
numbers must add up, must balance – as well as underlying constraints on macroeconomic
change and adjustments. Along the way the reader will acquire a working understanding
of the System of National Accounts and important South African data sources.
Extensive case studies and real-world applications

In addition to real-world examples throughout the book, there are several major case
studies with full diagrammatical analysis and animations. These include the 2007–08
international financial crisis, quantitative easing and ‘creative monetary policy’ in the
USA, the Euro-zone public-debt crisis, as well as the ongoing Eskom crisis in South Africa
and its impact on gross domestic product (GDP) growth and inflation.
Changes in the fifth edition

The focus on the South African context, including its status as an upper-middle-income
country in the Southern Africa Development Community (SADC) and Africa, already
was present in the earlier editions. In this edition the quest to integrate the appropriate
context into the analysis has been sharpened and made more explicit, also in data boxes,
applications, examples and exercises.
All policy sections have been freshly updated to incorporate the newest policy approaches
as well as institutional changes in South Africa. Major policy initiatives, such as the
National Development Plan (which appears to be back on the table under president
Ramaphosa), are thoroughly discussed. Also noted are controversies relating to the
mandate and ownership of the Reserve Bank, frequent changes in Ministers of Finance,
the public debt issue, as well as the impact of recent political dynamics. The book retains its
unique, institution-rich treatment of the complex role of government in macroeconomic
relationships, events, policies and official South African data.
xiv Preface

Other updates include the implications of major changes in South Africa’s international
trade patterns, as well as recent international shocks such as Brexit and US president
Donald Trump’s trade war with China. On the development front it includes sections on
the SDGs and the Inclusive Development Index, developed by the World Economic Forum,
to complement the section on the United Nations Development Programme’s (UNDP)
Inclusiveness Index, which measures inclusive growth.
All data tables and graphs have been updated and new internet sources provided.
Numerous new analytical exercises and questions at the end of chapters engage with
recent developments in South Africa and internationally. These include Brexit, China’s
prominence and the possibility of South Africa having to request assistance – a bail-out –
from the International Monetary Fund (IMF).
August 2019
Preface xv

Introduction and orientation: macro-
economics in the South African context
0
The objective of this book is to teach you to think and reason about macroeconomic events
as well as policy issues such as the balance of payments, inflation, unemployment and
economic growth in the South African context.
The book strives to teach an active way of thinking in the particular setting of South Africa
as an upper-middle-income (or ‘developing’1) country and emerging-market economy –
not dry, static theory with no real-world, historical or institutional context, or situated in
a European, British or American context.
Consequently, the subject matter is presented in a particular style that makes it something
between a textbook and a workbook, encouraging you to participate actively in developing
macroeconomic thinking skills – it is a think-and-work textbook. ‘Activity boxes’ challenge
the reader to find information or formulate a viewpoint on an issue, while other boxes
highlight interesting facts and events in the South African economy (including its
institutions and its international economic relations with the Americas, Europe, Asia and
Africa).
To give you a real sense of cycles and other changes in the economy, we provide – on the
internet – animations of key diagrams. Thus the analysis of shocks and policy impacts
is not limited to comparative statics (comparing static equilibrium points) but can be
seen as dynamic shifts of curves that move a point of intersection on a path to a new
equilibrium. These movies also show how the expected paths of variables unfold over
time. Theory becomes live action that embeds a much more intimate understanding of
macroeconomic change and processes. The animations are available free of charge on the
following websites:
❐ www.ufs.ac.za/macroecon
1 A categorisation of countries using the terms ‘developing’ and ‘developed’ – to distinguish poorer and richer countries – has been the
standard internationally. However, we approve of a recent policy change by the World Bank to stop using them. The two terms group
countries that are very dissimilar, do not recognise that development challenges and poverty exist also in the richest countries and that
all countries always are developing; the terms also suggest a patronising attitude. The World Bank distinguishes four groups, based on
Gross National Income (GNI) per capita: low-income countries, lower-middle-income and upper-middle-income countries, and then
high-income countries. South Africa is an upper-middle-income country. [At the moment (2019) the United Nations still uses these
terms (said to be ‘for convenience’), while the International Monetary Fund (IMF) distinguishes between ‘advanced economies’ and
all others as ‘emerging market and developing economies’.]
Chapter 0: Introduction and orientation: macroeconomics in the South African context 1

Part I presents the basic theoretical framework. Chapter 1 sets the scene. After a brief
introduction to macroeconomics as a field and its usefulness to you as a citizen and other
role-players in society, the main macroeconomic problems and issues are described. These
also constitute the main macroeconomic policy objectives, as practised by policymakers in
the fields of, notably, fiscal and monetary policy – within the broader development context
of a middle-income country such as South Africa (within SADC and sub-Saharan Africa).
Unemployment, one of the most severe economic problems in South Africa, receives
prominent attention. A brief overview of the definition, measurement and analysis of
human development is presented, showing South Africa’s human development status
relative to relevant other countries. The chapter also provides a backdrop to understanding
the macroeconomic policy debate in South Africa. This includes a rudimentary outline of
the main schools of thought in economics – from Marxism to the two major mainstream
approaches – as well as an introduction to political-economic views (from the left to the
right) on race, class, capitalism and apartheid that continue to impact the macroeconomic
policy debate in South Africa. This political-economic background traverses the period
from colonial times, the Glen Grey Act of 1894 and the Natives Land Act of 1913 to the
1948 election victory of the National Party, the Freedom Charter of 1955, the ANC’s
armed struggle and the 1994 democratic election and beyond.
The text covers the main topics and components at the level of a second-year course
in macroeconomics or a third-year course in macroeconomic policy. While it generally
assumes prior knowledge of the basic Keynesian model at an introductory economics level,
this is not absolutely essential. In the first theory chapter (chapter 2), on the real sector,
the fundamental topics are reviewed, notably the role of expenditure – consumption,
investment, government expenditure, exports and imports – in determining the level of
output and real income in an economy. (The role of the supply side of the economy is
introduced in chapter 6.) Crucial intuitive insights and analytical abilities are developed,
notably the construction of logical sequences of events, i.e. the use of chain reasoning. This
ability will aid you considerably in thinking and reasoning about real-world economic
events and policy in South Africa and elsewhere, especially disturbances and resulting
short-run fluctuations (i.e. the business cycle), as well as the role of the National Treasury
and the national budget.
Chapter 3 explains the operation of the monetary sector of the economy in a way that
marries theoretical analysis and the everyday operation of money and capital markets in
South Africa. After studying this chapter, you should feel comfortable with discussions
of financial institutions, financial markets, interest rates and the Reserve Bank in the
financial news media, and understand the linkages between the financial world and real
economic activities (consumption, investment, production, employment, exports, imports
and so forth). You will be able to construct more complex chain reactions that link the
monetary and real sectors.
Together, the first two theory chapters provide you with most of the analytical insights
usually found in the so-called IS-LM model, which is a powerful diagrammatic aid and is
standard fare in intermediate macroeconomics textbooks. After an intuitive introduction
to the model and its uses, the more formal aspects of the theory are explained in an
accessible way.
The presentation of the IS-LM model and its mathematics illustrates an important
characteristic of the book. It enables you to read and understand the theory at different
levels, as follows.
2 Chapter 0: Introduction and orientation

(a) A strongly intuitive understanding with the help of chain-reaction arguments and
relatively simple diagrams, enabling you to develop an intuitive and real-world
approach to economic reasoning. This promotes a thorough understanding of
economic processes rather than mechanics – a major benefit.
(b) A more theoretical level with the help of more complex diagrammatical aids such as
the IS-LM model; or
(c) The complete package of intermediate-level models coupled with and aided by
mathematical derivations and analysis in ‘maths boxes’.
The chapter ends with an extensive case study relating to the 2007–08 financial crisis,
which impacted the entire world economy. It is demonstrated how the two-sector IS-
LM model can be used to explain the course of events in the USA – the housing bubble,
quantitative easing and so forth – and how it pushed South Africa into a major recession.
The South African economy is an open economy, strongly subject to international
economic forces. A special characteristic of this book is the strong and explicit focus on
the open economy. Whereas many textbooks consider the macroeconomic implications of
international trade and capital flows only in the final chapters, here they are incorporated
throughout the text, starting in chapters 2 and 3. Chapter 4 sets out these intricacies in
depth and provides a level of analysis not often accessible to students in macroeconomics
textbooks. This should make you very comfortable with discussions of, for example, the
South African balance of payments, exchange rates and the gold price. Chain reactions
here also include external elements and disturbances originating in other countries,
including the balance of payments adjustment process (which could be different for South
Africa than for high-income economies). Also included is the growing role, in South
African imports and exports, of China and other Asian as well as African and SADC
countries – though economic conditions in the USA and Europe continue to influence the
South African economy intensely.
❐ You will encounter all the results of the IS-LM-BP model. After an intuitive introduction
to the model and its uses, the more formal aspects of the theory are explained in an
accessible way.
❐ Again, you can choose the extent to which you want to engage with the formal model.
(As noted before, there are many benefits to mastering the full model.)
This chapter also ends with an extensive real-world application: it explains the Euro crisis
that started in 2010 following a debt crisis in Greece and other countries, the subsequent
attempts of Germany to address this Eurozone problem, international repercussions and
so forth. It provides a fascinating demonstrating of the usefulness of the IS-LM-BP model
in analysing such a complex chain of events, including the impact on South Africa..
Macroeconomics in the real world is intimately involved with numbers. Understanding
and interpreting macroeconomics statistics are essential skills for any economist, business
person or modern citizen. Throughout the text you will encounter relevant quantitative
information on the South African economy. Much of this is to be found in ‘data tip’ boxes,
and in some cases you are prompted to find or calculate certain numbers yourself. You will
also be alerted to the many dangers inherent in analysing economic data. The approach
taken is in line with the view of the great British economist Joan Robinson on the purpose
of studying economics:
The purpose of studying economics is not to acquire a set of ready-made answers to

economic questions, but to learn how to avoid being deceived by economists.
Chapter 0: Introduction and orientation 3

The insights into data provided here, as well as the thinking skills you will acquire
throughout the book, should enable you to evaluate economic arguments and data
interpretation in the news media with a critical eye. Tables and graphs depicting the course
of important macroeconomic variables in South Africa during the last three decades can
be found in most of the chapters, and information regarding the measurement of data in
a specific area of analysis in chapters 5 and 10.
A further dimension of economic numbers is that, in terms of the measured values of the
variables, they must and will remain within an encompassing set of constraints. These
are rooted in an accounting-type coherence between different sectors – the numbers must
add up, must balance. This coherence is captured in special equations, called identities,
involving key variables. These identities are derived from the national accounts, which
have an important role in ‘keeping the books’ of a country. The national accounts can
be a dry subject area, dominated by definitions and accounting conventions. But here we
do not do accounting at all. Indeed, chapter 5 provides a unique treatment. You will see
how these national accounting identities constitute a powerful additional tool of analysis
for the economist – a tool to understand the coherence between sectors of the economy
as well as underlying constraints on macroeconomic change and adjustments. Along the
way you will acquire a working understanding of the System of National Accounts and
important South African data sources. At the same time you will be alerted to the misuse,
by some ‘experts’, of the national accounting relationships.
Though inflation appears to be less of a problem in South Africa and internationally
now, compared to earlier decades, it remains a key factor, and always-present risk,
in macroeconomics. In chapter 6 you will acquire the ability to understand, from
a macroeconomic point of view, the forces acting on the average price level (in an open
economy). This knowledge is the foundation for the in-depth discussion of inflation in
chapters 7 and 12. Chapter 6 shows how the analysis of expenditure, or the aggregate
demand (AD) side of the economy – found in chapters 2 to 4 – must be supplemented with
an analysis of aggregate supply (AS) if the simultaneous determination of real income and
the average price level is to be understood. The theory of aggregate supply is rooted in
economic behaviour in the labour market, where the demand of firms for labour is related
to their price-setting behaviour in product markets, and where unions play an important
role in setting wages, as is the case in South Africa. At the same time, the presence of
structural unemployment, especially in the South African context, is highlighted. An
important element of aggregate supply theory is the existence of both a long-run and a
short-run aggregate supply (AS) curve. This leads to important conclusions on medium-
run adjustments on the supply side following short-run disturbances (whether on the
demand or the supply side). The Eskom capacity crisis and its impact on the South African
economy is the subject of the case study in this chapter. The power of the AD-AS model
in analysing the short- and long-run effects of such a bottleneck on GDP growth and the
price level (and inflation) is demonstrated clearly.
Chapter 7 adapts the AD-AS model, which is designed to explain changes in the average
price level, to a model that explains inflation as such, i.e. sustained increases in the price
level over the years. The adapted AD-PC model has the AS curve renamed as the Phillips
curve (PC-curve). The model strengthens your ability to analyse short-run cycles and
disturbances in the context of an economy where inflation is a permanent phenomenon.
The attention thus shifts to explaining increases or decreases in the rate of inflation rather
than in just the price level. Important lessons for policymakers are derived. The chapter

also provides an analysis of typical anti-inflation policy by central banks, and the kind of
policy reactions one can expect if the Reserve Bank adopts an approach of steering the
economy towards a targeted inflation rate or interval (which indeed is the case).
Chapter 8 takes the analysis of the supply side (or production side) further by focusing on
the very long run, where economic growth (or the lack of it) is the prime concern. While
short-run fluctuations are very important for the well-being of people in a country, their
long-run welfare and standard of living depend much more on the long-run economic
growth trend – specifically, whether it is sufficient to increase income per person (or,
per capita income). Economic growth theory tries to explain the factors that determine
either low or high rates of growth in output (and thus income per capita). The concept
of a ‘balanced growth path’ is important in this context. The role of capital goods and
technology is highlighted, as is the crucial role of human skills, human development and
‘human capital’. You will also see how important the development of social and economic
institutions is to economic growth and development. Chapter 8 also completes part I of
the book, which comprises the basic macroeconomic model for an open, inflationary and
growing economy, as applied to South Africa.
Part II deals with macroeconomic policy and institutions, such as the South African
Reserve Bank and the National Treasury while focusing on the problems of inflation,
unemployment and low economic growth. If you wish to skip the policy and
institutional discussion, you can go directly to chapter 12 – the analysis of inflation,
unemployment and low growth. You should be able to follow most of it, although you
will be less equipped to understand fully the policy debates on these three problems.
Chapters 9 and 10 focus on macroeconomic policy, i.e. monetary policy (including exchange
rate policy) and fiscal policy. The standard analytical insights with regard to policy are
developed, using the logical-intuitive method encountered earlier. In addition, you will get
a feel for the real world of policy making: the difficult choices policymakers face and the
constraints they have to deal with. The institutional dimension – which may often be more
decisive than formal economic knowledge – is incorporated throughout the discussion,
revealing the actual policy-making processes in the National Treasury and the Reserve
Bank.
The chapter on fiscal policy is especially rich in this regard, and is something that
distinguishes this book from most other textbooks that are available. In the current South
African debate, the role of government as revealed in the annual budget is a key and often
divisive issue. It dominates many an economic argument – consider the intense debates
on service delivery, government expenditure on health or higher education or housing,
taxation, the budget deficit or public debt. It is therefore one area that you should be able
to analyse with some comfort. Chapter 10 is designed to give you the necessary insights
and methods of analysis. It pays particular attention to helping you evaluate the fiscal
state of the economy, using various fiscal yardsticks. It draws extensively on the practical
experience of the authors in the fiscal policy field in South Africa.
❐ This is one area where Joan Robinson’s adage (on page 3) is most pertinent. It is also one of
the most exciting areas of macroeconomics, as the frenzy surrounding budget day reveals.
Throughout the text you will be aware of the fact that economics is a science within which
major differences of opinion exist. These are often related to deep-seated philosophical
differences on the functioning of a market economy – consider the debate on capitalism
versus socialism, which is still very much alive behind the scenes in South Africa, despite
appearances to the contrary.
Chapter 0: Introduction and orientation 5

In capitalism, man exploits man. In socialism, it’s exactly the other way around.
Anonymous
The debate on the budget (chapter 10) clearly illustrates these philosophical differences.
As background, chapter 1 has set out three main protagonists: Marxist thought, and
then the two major mainstream macroeconomic protagonists, i.e. the Keynesians/New
Keynesians and the Monetarists/New Classicals. You will not be able really to understand
the high emotions surrounding macroeconomic issues if you do not understand the basic
differences between the latter two mainstream schools of thought, with the Marxist school
of thought always present. This is especially true of the policy debate, where the different
views also present the policymaker with serious problems. Whom should the policymaker
believe? Chapter 11 explains the main differences and policy problems in this regard. (You
will also encounter some other practical problems in executing policy, e.g. policy lags.)
After all the analysis and discussions of chapters 1 to 11, the scene is set for the final
chapter: an in-depth analysis of the three major macroeconomic problems of inflation,
unemployment and low economic growth. The Monetarist/New Classical and New Keynesian
views are analysed and compared. It becomes apparent that conventional macroeconomic
analysis is not sufficient fully to understand the causes or to design appropriate policy
remedies. The severity of these problems appears to derive from more fundamental,
structural dimensions of a market economy, especially in a middle-income country such
as South Africa. This is especially true with regard to unemployment and the prevalence
of structural unemployment, which requires remedies other than macroeconomic policy
measures. Examples include: skills and education policy, competition policy, employment-
intensive industrial policy, the strengthening of the informal sector, and land reform.
Consequently, this last chapter also broadens your understanding to include elements
outside conventional macroeconomics, such as human capital, income inequality,
institutions, culture, trust and social division, geography and the environment. After all,
economic life does not exist in a vacuum – it is part of the larger social fabric, and it has
to be analysed as such. The chapter ends with a discussion of inclusive development and
inclusive growth, concepts in the South African debate that integrate several concerns:
about growth, about unemployment, about poverty and inequality as well as human
development. This is followed by a real-world policy application: an explanation and
critical analysis of the National Development Plan, which may shape macroeconomic and
other important policies for the next 10 years and beyond, depending on whether and how
it is implemented.
So, there it is. Now read – and enjoy thinking and reasoning about macroeconomic events
and policy in complex South Africa!
Legend for icons
! Take note box π Maths box
✍ Activity box Animation available
The data tip box is self-explanatory.

Part I
How does the

economy work?
A basic model for an open,
inflationary economy

Why macroeconomics?
An introduction to the issues 1
After reading this chapter, you should be able to:
■ explain what macroeconomics entails and why it is useful to you and others;
■ interpret the main concerns that typically are the focus of macroeconomics;
■ identify and explain the standard objectives of macroeconomic policy;
■ analyse and assess the complexities involved in defining and pursuing these objectives
in a country such as South Africa, including the potential for conflict between objectives;
and
■ integrate macroeconomic objectives in a broader development context, and evaluate the
relative importance of macroeconomic goals in the broader social context in South Africa.
It goes without saying that the state, health and course of a country’s economy matter a
great deal. The material welfare of every household and individual in South Africa, as in
other countries, depends decisively on the state of affairs in the economy, now and in the
future. It is important to understand whether times are good or bad, so that people can
comprehend what is happening to them and can deal with it to their benefit, or so that
policymakers can take corrective action to try to moderate the turn of events, if required.
To do this, one must gain an understanding of how things work.
1.1 What is macroeconomics?

The economy comprises millions of individuals, workers and families, and thousands of
businesses, as well as labour unions and other organisations, all engaged in millions of
activities and transactions. For many purposes this is too much to make sense of in its
disaggregated multiplicity. What macroeconomics does is to simplify that multiplicity into
a broad, aggregate grasp on the cumulative and summary impact of all those millions of
actions. (Other branches of economics, e.g. microeconomics or labour economics, consider
the detail of small chunks of the economy or specific dimensions of economic behaviour.)
So macroeconomics is about understanding the course and ‘behaviour’ of the economy as
a whole – not just for the fun of it, but because the behaviour of that ‘whole’ influences the
lives and welfare of the millions of individuals and families that make up the economy. These
influences flow from macroeconomic phenomena such as the business cycle (upswings,
downswings, recessions and depressions), unemployment, inflation and economic
growth. In addition, they form the basis for macroeconomic policy steps by a government
that is trying to improve the lives of citizens by ameliorating negative experiences (such
as economic instability, high inflation, high unemployment and poverty) and enhancing
positive processes such as economic growth, employment and development.
1.1 What is macroeconomics? 9

1.2 How can learning to think and reason in macroeconomics
help me?
An individual, a household or a firm cannot control the macroeconomic ebbs and flows of a
country, or the actions of policymakers. But one can understand these things better, learn
better to anticipate events or policy steps using best available information, and prepare
better to weather the storms or to exploit opportunities due to economic disturbances and
changes. At the very least one can feel less bewildered about the waves and storms, the
ups and downs of living in a country that is inevitably part of a global economy beset by a
multitude of forces and dynamics.
More specifically, politicians, civil servants, business people, labour unions, farmers,
mineworkers, families and individuals need to understand the waves and storms that
surround and threaten their efforts to make a dignified and decent livelihood. For instance,
an understanding of macroeconomics will be relevant to the following:
❐ An individual afraid of losing her job due to a recession – a recession that can originate
locally, or in economic events far away in the USA or Japan (such as the ‘subprime’
financial crisis of 2007–08 or the subsequent Eurozone crisis).
❐ Individuals hoping to get a job due to new factories being erected by private companies,
or roads being constructed through public works programmes.
❐ Retired people afraid of having their savings and pensions eroded by inflation. What
will the interest rate on bonds do? What will the stock market do?
❐ Young people concerned about their future income and wealth prospects or being
unable to find jobs despite economic growth, or families concerned about the impact of
their mortgage interest rate on their monthly budget.
❐ Businesses involved in strategic and annual planning of output and entrepreneurial
initiatives and not wanting to be caught unawares – or clueless – by interest rate
changes, exchange rate fluctuations, a slump or upsurge in sales for which they did not
prepare. This is the essence of understanding the business cycle: having some ability
to comprehend the state of the cycle and roughly anticipate prospects for the coming
year or two.
❐ Businesses and farmers facing the danger, in good times, of investing and expanding as
if the good times will never end, likewise the danger, in bad times, of cutting back and
not investing as if the bad times will never end.
❐ Farmers planning major export initiatives for their product, but who are concerned
about possible changes in the exchange rate or in sales prospects abroad.
❐ Farmers or factories concerned about the effect of the international oil price on their
input costs (diesel, etc.).
❐ Voters contemplating which political party’s economic policy is the best – whether it is
budgetary policy, interest rate policy, exchange rate policy, anti-inflation policy, growth
and development policy (such as the National Development Plan), environmental
policy or other policies.
❐ Labour unions needing to understand the state of the business cycle to gauge their
bargaining power in wage negotiations, whether (and how) to incorporate some
expectation of future inflation into their negotiations (including the expected impact
of likely policy steps on inflation expectations), and also how excessive wage claims can
impact on the pursuit of other important national goals such as the containment of
inflation.
❐ NGO or government officials and politicians caring about equity and social justice, or at
least the social consequences of economic shocks and policies.
10 Chapter 1: Why macroeconomics? An introduction to the issues

❐ Anybody who wants to understand why poverty and unemployment remain high
despite economic stimulation and growth, and why so much economic inequality exists
amidst more than a decade of successful global and domestic economic growth (since
the mid-1990s up to 2008).
Whoever you are, at the very least you need to have a minimum level of macroeconomic
literacy: understanding the news, understanding economists, understanding public
debate on economic policy (the Treasury and the budget, the Reserve Bank and the repo
rate); understanding news reports on national and international economic events –
unemployment rates, interest rates, the inflation rate, the exchange rate, the gold price,
the oil price, US interest rates, China’s economic growth, Europe’s debt crisis and struggles
with Brexit, the implications of economic growth or natural disasters in SADC and sub-
Saharan Africa, the effects of climate change on the economy, and so forth.
The macroeconomic dimensions noted above can be summarised as comprising the
following:
❐ The short- to medium-run pattern and trend, notably the business cycle and fluctuations
in aggregate expenditure (or demand), output and employment, and ways possibly to
stabilise them through fiscal or monetary policy (i.e. government budgets, spending and
taxation and the deficit, as well as Reserve Bank steps such as a change in the repo rate);
❐ Ongoing medium-term phenomena such as inflation and adjustments of the productive
capacity (or supply side) of the economy, some of them occurring in reaction to short-
term shocks or policy steps; and
❐ Long-run growth and employment trends and ways to influence them.
All of these occur within the broader context of structural and institutional dimensions
related to the development challenges of a post-colonial, post-apartheid, middle-income
country with deep-seated problems of structural unemployment, poverty and inequality;
development backlogs, skills deficiencies and skills mismatches in the modern economy;
low rates of labour absorption by industry, segmented labour markets and barriers to
entry faced by job seekers; the economic marginalisation of poor people, as well as health-
related issues such as HIV and Aids – and of course the wider issue of sustainability with
regard to the environment and climate change.
In these different contexts, we will also encounter – and come to understand – some of the
puzzles and dilemmas facing the policymaker, and effectively also the voter-citizen. These
include apparent trade-offs and difficult choices between desirable goals such as reducing
unemployment and reducing inflation. Or indications that certain policy steps that may
be good for the economy in the short run may be bad for the economy in the long run, or
vice versa. What appears to be good for economic growth may be bad for the environment
and climate change – or may make no real difference to the situation of the unemployed.
1.3 Main macroeconomic problems and policy objectives

The main problems and issues of concern in macroeconomics are best identified
by considering the main objectives of macroeconomic policy. People often think of
macroeconomic policy as synonymous with stabilisation policy. While the latter is an
important aspect, macroeconomic policy is concerned with much more than the business
cycle. The standard objectives of macroeconomic policy usually include the following:
1. Economic growth and increasing employment (i.e. reducing unemployment)
2. Stability of output and employment levels
3. Stable and low inflation
1.3 Main macroeconomic problems and policy objectives 11

4. Balance of payments
5. Distributional and equity objectives and the reduction of inequality
6. Economic development and poverty reduction.
These constitute the main dimensions by which the overall health of an economy is
measured. A thorough diagnosis of the state of the economy as a whole will have to deal
with these aspects in one way or another.
Traditional macroeconomic textbooks, notably those of American or British origins,
normally will only list the first four or five of these objectives in their assessment of the
macroeconomic performance of a country. However, for South Africa as an upper-middle-
income country and emerging-market economy, macroeconomic events and discussions
of policy objectives can never be severed from the encompassing concerns of economic
and human development as well as deep-rooted poverty and inequality.
For any student in a low- or middle-income country, it is essential to understand the linkages
and broader context of these issues. Section 1.5 gives some background on economic and
human development issues and objectives. We will also encounter development issues in
the chapters on long-term economic growth (chapters 8 and 12).
1.3.1 Economic growth and increasing employment

The pursuit of high economic growth is the objective that usually is accepted as the most
obvious one – often to such an extent that little critical thought is given to the issue.
The basic belief behind such general acceptance is that economic growth will lead to an
improvement in the living standards of the entire population. (As we will see below, the
matter is not so simple.)
Economic growth is defined as a sustained increase, over time, in the level of aggregate
production, i.e. gross domestic product or GDP. (A complementary definition considers the
trend in per capita GDP, i.e. in average GDP per person.)
The focus on the trend in the level of GDP is used in this definition to indicate that cyclical
deviations from the underlying trend in aggregate output are not of concern here.
Economic growth is a long-run policy consideration.
❐ This clearly distinguishes it from short-run or stabilisation objectives that are concerned
with cyclical fluctuations around the long-run trend of real GDP (i.e. the business cycle).
❐ This also means that the focus is on the behaviour of the full-capacity level of output
(GDP) over time (amidst upswings and downswings).
❐ In other words, the long-run growth path is the ‘base line’ or trend line around which
cyclical fluctuations occur. It indicates, and determines, the long-term rate of increase
(or decrease) in the average material standard of living of a population. In the long run
it is much more important for the wealth and welfare of people than fluctuations in GDP.
The simplest measure of aggregate economic growth is the annual growth rate of real
GDP, i.e. the percentage increase in real GDP from one year to the next. The per capita GDP
growth rate is the percentage increase in real per capita GDP from one year to the next.
This way of measuring growth unfortunately does not exclude the cyclical component of
the behaviour of GDP – it mixes cyclical increases and decreases in GDP with the long-run
trend. To see the long-run pattern, one has to smooth the annual growth rates by taking
averages over longer periods, as shown in table 1.1. (See chapter 12 for more details on the
definition and calculation of the GDP growth rate.)

The data in table 1.1 and figure 1.1 Table 1.1 Average economic growth rates in South Africa
clearly show how dramatically the South
Real GDP Per capita real
African growth performance declined growth GDP growth
since the mid-1970s (among cyclical
1971–1975 3.68 1.22
increases and decreases in growth) –
1976–1980 3.10 0.72
with the 1980s and early 1990s being
the worst. It is apparent how economic 1981–1985 1.42 –0.90
growth has recovered after the change in 1986–1990 1.68 –0.48
government in 1994. 1991–1995 0.88 –1.22
However, the period after 2008 again 1996–2000 2.80 0.66
marks a period of sustained decline in 2001–2005 3.84 1.98

the GDP growth rate, with especially 2006–2010 3.14 1.80
the period 2014–18 becoming quite 2011–2015 2.20 0.96
disastrous. 2016–2018 0.87 –0.53
Source: South African Reserve Bank (www.resbank.co.za).
Figure 1.1 Real GDP growth rate and moving average trendline 1960–2018
10
6
Percentage
–2
–4
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
1960
1962
1964
1966
1968
1970
1972
1974
1976
Does economic growth improve living standards? Per capita growth

An important perspective on the real GDP growth rate is provided by the population
growth rate. Only if the real economic growth rate exceeds the population growth rate
will there be an increase in real GDP per capita, i.e. GDP per person.
❐ Up to 1990 the South African population growth rate averaged approximately 2.5%
per annum. Since 1991 the rate of natural increase has fallen steeply to approximately
1.2% in 2017.
❐ Real economic growth was insufficient to compensate for the population growth for
more than a decade after 1980, but in the period after 1993, GDP per person increased
almost continuously, except for brief declines in 1998 and 2008–9 (see figure 1.2).
However, since 2014 per capita GDP has declined (negative growth).

The extent to which sustained growth in GDP contributes to people’s living standards also
depends on the composition of the output. For example, if increased military expenditure
and production are primarily responsible for the GDP growth, it does not have the same
effect on living standards as when the source of growth is expenditure on, and the
production of, basic household goods, housing and medical services.
Figure 1.2 Real GDP per capita (2010 base year) 1960–2018
62 000
57 000
52 000
47 000
42 000
R million
37 000
32 000
27 000
22 000
17 000
12 000
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
!
Even if per capita GDP increases numerically – if there is a positive per capita growth rate, as
was the case in much of the 1960s and 70s and the first two decades after 1993 – it need not be
the case that all (or even the majority) of the population are better off. This depends on the way
in which the benefits of economic growth are distributed among the population, i.e. the extent to
which people share in the growth. This is the issue encapsulated in the inequality objective (listed
previously as number 5 and discussed in section 1.3.5). Unfortunately, it regularly happens that
the benefits of growth largely flow to a relatively small group of already well-off people and do
not ‘trickle down’ to benefit the poor – the poor are not sufficiently part of expanding economic
activities. This phenomenon is likely to have been a contributing factor in the political tension and
mobilisation in South Africa in the 1960s and 70s as well as the dramatic rise in township protests
since 2009. Of course, it is much worse if per capita GDP starts to decline, as has occurred from
2014 onwards.
GDP growth and employment growth

Assuming a direct link between GDP growth and employment, and thus unemployment,
is not necessarily correct in reality. For example, increases in production capacity and
output due to the substitution of capital (i.e. machines) for labour – through the use of
more capital- and technology-intensive methods of production – can cause high growth
accompanied by stagnating or even declining employment. In South Africa this is visible
in the declining employment-intensity of output. Economic growth with low labour
intensity appears to be typical.

Figure 1.3 Indices showing trend in real GDP and formal-sector employment since 1985 (1985=100)
250
200
Real GDP
150
Index
Formal-sector employment
100
50
0
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
Source: South African Reserve Bank employment series, derived from Statistics SA’s Quarterly Employment Series
(QES) and its predecessors; GDP: South African Reserve Bank.
In general employment tends to grow much more slowly than GDP. Figure 1.3 shows the
absolute levels of real GDP and total formal-sector employment since 1985, while figure
1.4 shows the growth rates of real GDP and total formal-sector employment.1
❐ From 1985 to 2018, real GDP has more than doubled, while total formal-sector
employment has increased by only 30% (figure 1.3).
❐ Or, as figure 1.4 shows, from 1985 to 2018 the formal-sector employment growth rate
has persistently been significantly below the GDP growth rate. The average growth rate
for GDP over the entire period was 2.2% per year and that for formal-sector employment
0.8%.
Figure 1.4 Real GDP growth and formal-sector employment growth rates since 1985
6
Real GDP growth
5
2
Percentage
–1
–2
Formal-sector employment growth
–3
–4
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
Source: South African Reserve Bank employment series, derived from Statistics SA’s Quarterly Employment Series
(QES) and its predecessors; GDP: South African Reserve Bank.
1 One should be careful with employment data and related calculations of coefficients. The Quarterly Employment
Series (QES) – which is based on formal-sector enterprises and government – and the more comprehensive Quarterly
Labour Force Survey (QLFS) produce somewhat different results, while the latter has been available for a shorter
historical period. See the Data Tip box in section 12.2.1, chapter 12. (Figures 1.3 and 1.4 with approximations of
longer-term trends, dating back to 1960, can be found in the fourth edition of this book.)

Another way to look at this, is to consider the macroeconomic ‘employment coefficient’. It
expresses the employment growth rate relative to (i.e. as a ratio of) the real GDP growth rate.
❐ For the formal sector alone, the average employment coefficient for 1960–2018 has
been estimated to be 0.52. This confirms a broad pattern from as far back as 1946. For
total employment, data for the period since 2001 suggest an employment coefficient
that is somewhat higher.
❐ Note that these values do not indicate ‘jobless growth’, which occurs when the
employment coefficient is negative. In South Africa this only occurred in an exceptional
few years after the political transition of the mid-1990s and in the major recession of
2008-09.
These numbers mean that formal-sector employment growth in South Africa tends
to occur only at roughly half the rate of GDP growth. If this is coupled with a growing
population and a growing labour force (a characteristic since 1994), this is likely to lead
to increasing unemployment – unless very high GDP growth rates are attained. Growth in
GDP therefore does not necessarily lead to a corresponding long-run increase in formal-
Does the informal sector create employment?

According to the Quarterly Labour Force Survey, formal-sector employment plus employment
in agriculture and private households reached approximately 13.3 million in 2018 (employment
in agriculture was 0.85 million and in private households 1.3 million.) However, about 3 million
people work in the informal sector, of which an estimated 1.4 million are employers plus their
paid employees in enterprises, while 1.4 million work as owner-operators in their own one-
person enterprises. These workers are also affected by macroeconomic cycles and policies, but
macroeconomists and media reports often ignore this part of the economy. That is a weakness in
macroeconomic theory and policy thinking. The informal sector is an important current and potential
source of employment. (See section 12.2 for more on the informal sector and employment.)
sector employment. Formal-sector growth alone is unlikely to absorb enough workers to

significantly reduce unemployment.
Unemployment
Unemployment is one of the most important measures of macroeconomic performance.
It also is the most sensitive variable politically. It is discussed in depth in chapter 12.
Unemployment occurs when a person who is in the labour force, i.e. who is economically
active, does not have a job. Children, students and the elderly, for example, are not
regarded as part of the labour force, and thus are not counted as being unemployed. The
unemployment rate is calculated by expressing the total number of unemployed persons
as a percentage of the total labour force. In practice there are two definitions (see section
12.2 for a more detailed discussion):
❐ In terms of the strict definition, a person must be actively searching for a job to be
counted as unemployed. This is how the official unemployment rate in South Africa is
defined. It is also called the narrow unemployment rate. Table 1.2 and figure 1.5 show
the official unemployment rate in South Africa since 2000. It has been fluctuating
around 25% since 2000, but climbing steadily since 2016.
❐ In terms of the expanded definition, persons who are not actively searching for
work but who want to work and are willing to work – most of whom are so-called

discouraged workers – are also included. It is also Table 1.2 Unemployment rates in South Africa
called the broad unemployment rate. This rate is Narrow Broad
much higher than the narrow unemployment 2000 23.30 30.00
rate. In South Africa it has been approximately
2001 26.20 34.50
8–10% higher than the narrow rate and has been
2002 26.60 34.70
fluctuating around 34% since 2000, increasing
to 38% in 2019. Figure 1.5 shows the persistent 2003 24.80 34.70
gap between the two unemployment rates. 2004 23.00 33.70

2005 23.50 32.80
While the strict rate is the official rate of
2006 22.10 30.90
unemployment in South Africa (in line with
2007 21.00 31.40
international statistical agencies), researchers
often prefer to use the broad rate in the analysis 2008 22.80 29.50
of unemployment. They argue that, given the 2009 24.50 33.80

country’s development and structural challenges, 2010 25.40 36.10
the more than three million discouraged and other 2011 25.00 35.50
non-searching unemployed must be recognised as 2012 25.20 35.60
part of the employment/unemployment problem – 2013 24.50 34.90
that these marginalised workers cannot simply be 2014 25.40 35.80
ruled out of consideration in policy analysis as being 2015 25.50 34.40
‘not economically active’.
2016 27.10 36.60
The long-run level of the rate of unemployment 2017 27.70 36.80
depends partially on the long-run growth 2018 27.50 37.70
performance of GDP, but mostly on structural Source: Statistics SA.
characteristics of the labour market and the
economy. These do not change easily; indeed, a high level of ‘structural’ unemployment
is an ingrained characteristic of the South African economy (see section 12.2.3 for a
thorough discussion).
Figure 1.5 Unemployment rates since 2000

40
35
Broad rate of unemployment
30
25
Narrow rate of unemployment
Percentage
20
15
10
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Source: Statistics SA, QLFS data.

The sustainability of economic growth
The unqualified pursuit of high economic growth is increasingly questioned in the light of
the considerable costs of economic growth. These include the increasing pollution of the
environment (air, water, etc.), the accumulation of waste material (including dangerous
substances such as nuclear waste) and noise pollution. In recent years, the apparent impact
on climate change has become very prominent.
In addition, there are the disadvantages of a modern, industrialised urban life (traffic
congestion, noise, job stress in the rat race, and so forth). The fundamental question is
whether this kind of growth necessarily brings about a real improvement in people’s quality
of life.
Another crucial qualification is the impact of unqualified economic growth on the depletion of
natural resources. Concern exists worldwide that the world may be facing serious shortages
of essential natural resources within decades. One of the most important resources – also
in South Africa – is fresh water. Another is natural energy resources, some of which may be
exhausted or under stress relatively early in this century.
All of these factors impose important constraints on the sustainable rate of growth as well as
on the kind of growth that can and should be pursued. The fact that, in addition, economic
growth does not necessarily reach all sectors of the population, stresses the importance
of not pursuing more and more growth in an unqualified fashion. While an increase in the
general level of economic activity surely is important, especially in a country with development
problems and a growing population, it would be short-sighted to ignore the inherent dangers
in a single-minded growth-at-all-costs approach. (See the discussion of development in
section 1.4 and also chapter 12, section 12.3.6.)
1.3.2 Stability of output and employment

In contrast to a concern with the long-run level and growth of GDP and employment,
this objective relates to cyclical fluctuations in general economic activity, as measured by
changes in GDP (or the GDP growth rate) as well as total employment. Fluctuations in the
rate of unemployment generally are linked to the business cycle, i.e. fluctuations in GDP.
In most Western countries the pursuit or attainment of high (or even ‘full’) employment
is regarded as a responsibility of the government. This can be traced back to the Great
Depression of the early 1930s, the first major and sustained cyclical downturn that
struck the USA and the world (including South Africa) after the First World War. This
led to the acceptance by US President Franklin D Roosevelt of full employment as an
official government objective and responsibility. While there has been some rethinking of
this position in the West in the last couple of decades, few governments can dissociate
themselves from the problems of unemployment, since it is an important political factor
in most democratic elections.
In low- or middle-income countries with significant poverty, such as South Africa,
unemployment has a particular relevance from the point of view of both government and
labour unions. During cyclical downturns in the economy the plight of those losing their
jobs while already being members of poor households becomes acute.

Usually, and especially in simple theoretical models of the economy, it is assumed that
there is a close correlation between the level of employment and the level of real GDP.
Following this, the basic policy assumption also is that cyclical fluctuations in GDP will
cause corresponding changes in total employment.
❐ The standard objective of stabilisation policy, therefore, is to moderate cyclical
fluctuations in GDP and thus simultaneously moderate fluctuations in employment.2
While the link between GDP and employment is weak in the context of long-run growth (figure
1.3), in the short-run or cyclical context a clearer correspondence between GDP fluctuations
and employment fluctuations is apparent – see figure 1.4. Nevertheless, the data in figure 1.4
show that sometimes the direction and often the magnitude of changes in the two variables
differ noticeably. One must realise that cyclical movements in production do not necessarily
cause corresponding changes in employment. In an upswing in production a corresponding
proportional increase in employment will not occur if the extra output is produced using
machines and capital goods which have surplus capacity, or with current employees initially
working below capacity. Likewise, in a downswing, employment can fall less than production
if labour unions use their power to prevent retrenchments; on the other hand, it could also
fall more if employers shift the burden of falling sales and profits disproportionately onto
labour. (In practice both of these effects may be operational at the same time.)
❐ Therefore, policy steps – such as monetary and fiscal policies – aimed at short-run levels
of GDP are not automatically appropriate or sufficient for achieving the employment
stability objective.
The important point is that one can distinguish two components of unemployment: a
cyclical component and a long-run or structural component. Macroeconomic policy can
influence GDP in the short run, bearing in mind that steps to moderate fluctuations in
GDP (or to promote GDP growth) will not automatically be effective to deal with cyclical
unemployment. However, this is even less the case with regard to long-run, or structural,
unemployment, which is largely outside the reach of standard macroeconomic policy
remedies. It is rooted in complex aspects of labour markets, spatial patterns, economic
marginalisation, underdevelopment and so forth.
This means that, given that employment is a legitimate objective of public policy, the
different kinds and components of unemployment require a combination of different
kinds of policy steps, many of them not macroeconomic in nature. Therefore, the design
of macroeconomic policies geared towards (un)employment must fully take account of
the labour-economic and other intricacies of unemployment. The macroeconomic debate
on unemployment of 25% cannot proceed as if it is primarily a low-growth problem or a
downswing-in-GDP problem.
The problem of unemployment is further complicated by the fact that it is also an integral
part of the broader problems of poverty and underdevelopment. This forces one to
consider a much wider set of perspectives, causes and policy options (see section 1.4 and
also chapter 12, section 12.2).
1.3.3 Stable and low inflation

The control of inflation is accepted as a very important macroeconomic policy objective
in most countries. It is discussed in depth in chapters 7 and 12. Table 1.3 displays the five-
2 As we will see later, ‘full’ employment does not actually mean 0% unemployment. It allows for frictional
unemployment and seasonal unemployment (see the box in chapter 6, section 6.3.2).

year averages for inflation in South Africa since the Table 1.3 The rate of inflation in South Africa
1960s. Notice the steep increase in the inflation rate 1961–1965 2.1%
in the 1970s, an increase that was reversed only
1966–1970 3.4%
in the late 1990s – with relatively low rates then
sustained into the 2010s. 1971–1975 9.4%
Inflation is defined as a sustained increase in 1976–1980 12.1%

the general or average price level. One-off or 1981–1985 14.0%
intermittent increases in the average price level do
1986–1990 15.4%
not constitute inflation. Likewise, increases in the
prices of individual products or services are not 1991–1995 11.3%
inflation, but rather a change in relative prices. The 1996–2000 6.7%
average price level is measured by different price 2001–2005 5.1%
indices, the consumer price index (CPI) being the
most important. 2006–2010 6.9%
2011–2015 5.4%
Inflation is measured as the rate of increase of
the average price level during a specified period, 2016–2018 5.5%
normally one year. More specifically, the inflation Source: South African Reserve Bank
rate is the percentage change in the CPI during the (www.resbank.co.za).
chosen period.
The formulation and pursuit of this policy objective is no simple matter. For example, one
must distinguish between the prevention of higher (or increasing) inflation and the actual
reduction of the inflation rate. That the latter is automatically preferred to the former is
not accepted by all.
❐ Also bear in mind that, specifically when inflation is a policy objective, the existence of
various trade-offs will be of utmost importance. The most prominent (and controversial)
of these is the trade-off between inflation and unemployment (see chapters 7 and 12).
Another important link between inflation and other policy objectives derives from the
impact of high domestic inflation on the international competitiveness of a country, and
the subsequent impact on the current account of the balance of payments (objective 4).
If the South African inflation rate is persistently higher than that of its main trading
partners, this will impair exports and encourage import expenditure. This may continually
place the current account of the balance of payments under pressure (see the analysis in
chapter 4).
Inflation also can have important redistributional impacts (objective 5):
❐ People with debt (borrowers) benefit from inflation, since the real value of the debt
decreases gradually due to inflation. Homeowners with mortgage bonds are a good
example of such a group. By the same token, inflation harms lenders, since it reduces
the real purchasing power of debt repayments.
❐ Inflation harms any person with a constant or slow-growing income source. Pensioners
and people dependent on interest income are important examples.
❐ In a progressive income tax system, bracket creep harms income taxpayers: adjustments
to wages and salaries to keep abreast of inflation push people into higher tax brackets,
where they have to pay higher marginal and average tax rates – even though their
income has not increased in real terms. The state is the beneficiary of this redistribution
(unless it takes active steps to prevent bracket creep by regularly adjusting tax brackets
so that they remain constant in real terms).

❐ People who (have to) spend the largest portion of their monthly income – especially
on consumer goods such as food and clothing – may experience a higher inflation rate
than people who spend only a relatively small portion of their income (and save or
invest much of it). This means that low-income households may experience a higher
inflation rate than high-income households.
1.3.4 Balance of payments (BoP)

While the balance of payments does not directly affect the welfare or living standards of
people, it is an important policy consideration, notably in an economy as open as South
Africa’s.
This objective should not be understood to mean that the BoP should always be in
equilibrium. As discussed in chapter 4, a BoP deficit or surplus need not be a problem
– as long as it does not persist indefinitely – and may even be desirable at times. What
one can say is that in the very long run the BoP must be in equilibrium. That means
that the average BoP position over a very long period should be that of equilibrium
(BoP = 0).
One reason why the BoP position is important is that it determines the foreign reserves
of the country, i.e. the stock of foreign currency. The foreign reserves are important,
inter alia, to finance imports (notably of essential inputs), to repay foreign debt, and
to support the currency in foreign exchange markets should it come under pressure
(see chapter 4).
Another reason for keeping an eye on the BoP is that the BoP position can have important
effects on the real economy (via money supply and exchange rate adjustments). It has
an important influence on other objectives of policy (e.g. GDP, growth, employment and
inflation). The BoP also influences the pursuit of these other objectives: policy steps to
attain growth and employment objectives often cause an undesirable impact on the BoP –
and especially on the current account.3
❐ Therefore, the BoP position is often an objective of policy in the sense that it is a
constraint on the extent to which other objectives can be pursued. As a consequence,
situations often arise where the BoP situation has to be corrected before other
objectives can be pursued.
In similar fashion, the individual components of the BoP, e.g. the current account
or the financial account, can also become important policy considerations at times,
requiring corresponding policy steps. In particular, a current account deficit cannot
be endured indefinitely. The financial account surplus necessary to finance it can be
achieved and sustained only with high interest rates (and sufficient foreign confidence
in the domestic economy) to attract foreign investment or loans. High interest rates are
likely to discourage the investment that is necessary for growth and for repaying the
foreign debt. A persistent current account deficit also makes a country vulnerable to
capital outflow problems. This has been the case with South Africa since 1994, when
the current account turned negative.
3 Chapter 4 demonstrates that the different channels of the BoP adjustment process can drastically affect the
effectiveness of, for example, monetary policy.

1.3.5 Distributional and equity objectives and the reduction of inequality
The equity of the distribution of income
and wealth between individual members Equity or equality?
of the population is an important Equity does not mean that everyone should
consideration when evaluating just how have an equal share (or quantity) of income
optimal the overall results of the economic or wealth. This is not what it is all about.
institutions, processes and interactions in Equity is about fairness and justice, which
a country are. The issue is whether each are complex concepts. Equity cannot and
individual or household in society earns should not be reduced to a one-dimensional
or possesses a sufficient, fair or equitable measure such as equality in the quantity of
share of the national income and wealth. income or wealth of persons or households.
It is a characteristic of market economies

(and other types of economies, let it be said) that normal economic processes often lead to a
very unequal distribution of income and wealth. As a result, government has to include the
equitable distribution of wealth in its range of objectives. However, the way and extent to
which this objective must be pursued is very controversial. No consensus exists on what
constitutes a fair and equitable distribution of income and wealth. In particular, there is
little agreement between those who have much and those who have little. Yet, often it is
not too difficult to recognise something as unfair – even though it may be difficult to specify
accurately what would constitute fairness, let alone how to attain such a condition.
How does one measure the inequality of the distribution of income?

One important measure of inequality is the Gini coefficient, which is derived from the Lorenz
curve. When there is absolute equality, the Gini value is zero; a value closer to 1 indicates greater
inequality. Most countries lie between 0.3 (highly equal) and 0.7 (highly unequal). High-income
countries usually have Gini values around 0.40, while middle- and low-income countries have
values between 0.50 and 0.60. For South Africa the Gini value for income was estimated at 0.68
in 1991 – one of the highest in the world. Estimates from Statistics SA show the Gini coefficient
for income at 0.70 in 2000, rising to 0.72 in 2006 and thereafter declining gradually to 0.70 in
2009 and 0.68 in 2015. This slight downward movement is supported by similar estimates based
on the National Income Dynamics Study (NIDS). Income inequality in South Africa is stubbornly
high and persistent, despite significant progress in reducing poverty and deprivation levels.
Although inequality in South Africa has a significant racial pattern, there is also significant
inequality within each population group. The 2015 Gini coefficient for blacks was 0.65 – more
unequal than that for whites, which was at 0.51.
For more information on income inequality in South Africa, visit the website of Statistics SA at
www.statssa.gov.za.
In South Africa the distribution of personal income is exceptionally unequal compared

to other countries – even some Third World countries. South Africa has the ominous
reputation of having the highest degrees of income and expenditure inequality in the
world.
❐ According to the 2005/6 Income and Expenditure Survey of Statistics SA, the richest
10% of the population as a group received 51% of total income, while the poorest 50%
of the population received less than 10% of total income in the country. The Living
Conditions Survey of Statistics SA shows that by 2014/15 the income share of the
richest 10% had declined to 41%, while especially those in the middle gained.

❐ Another way of putting this is to say that 10% of the population receives roughly 40%
of all income, while the remaining 90% receives 60% of all income. The political and
policy relevance of this inequality cannot be underestimated.
❐ Recent studies of the middle class confirm the presence of high inequality. Because
there are so many poor people, those with the occupations, lifestyle and stable income
to put them in ‘the middle class’, are not in the middle of the income distribution at all!
Who falls in the middle class? Households with a per capita income of only R3 800 up
to R12 750 per month in 2019 money terms. But the data show they are in the top
20% to 25% of households (which include the elite – the top 4%), thus up to 80% of
households have a lower standard of living. The share of the middle class has grown
slowly since 1993, but there has been a major demographic transformation, with
Africans constituting two-thirds of the middle class by 2017.
The large disparities between the incomes of individuals/households in South Africa and the
existence of extensive poverty alongside great wealth have exerted tremendous pressure on
the government to address this issue. This state of affairs has serious political implications
and threatens the legitimacy and acceptability of the entire public order – even after the
political transformation has run its course. This threat stems, in particular, from the fact
that the skew distribution of income seems to correspond largely with racial divisions.
❐ Unfortunately, the traditional macroeconomic policy debate, especially in the private
sector, often disregards (or studiously avoids) the distributional objective.
It is true that the South African government has been giving increasing attention to the
inequity of economic conditions. However, narrower macroeconomic issues do tend to
dominate the policy discussion in Pretoria – especially when a factor such as the BoP
becomes problematic and begins to dominate all policy thinking.
Even ‘normal’ macroeconomic policy steps necessarily have distributional effects:
❐ How much government spends and on what it spends, the kinds of taxes levied, and
the level of interest rates – to mention a few examples – do not affect all individuals to
the same extent: some benefit, others are harmed.
❐ Macroeconomic policy steps also affect the welfare levels in different regions of the
country, and the relationships between agriculture and other sectors, between small and
large business enterprises, between homeowners, investors and pensioners, and so forth.
This means that the equity dimension or objective should be kept in mind at all times, even
when contemplating ‘pure’ macroeconomic policy steps.
Likewise, inequality can have important effects on growth and employment (objective
1). Recent international research from the International Monetary Fund (IMF)4 indicates
that a high degree of inequality can be detrimental to economic growth. Inequality
undermines progress in health and education, inhibits full economic participation,
narrows the consumer market and the tax base, and creates deep tensions that undermine
social consensus and investor confidence. Their results show that longer growth spells are
robustly associated with lower inequality in the distribution of income, especially in low-
and middle-income countries. Carefully designed redistributive policies can thus promote
the duration of high growth spells. The contrary, more traditional view is that policies
to reduce inequality (e.g. via taxes and government expenditure) can inhibit economic
growth by discouraging business investment.
4 Berg A, Ostry JD, Tsangarides CG and Yakhshilikov Y (2018). Redistribution, inequality and growth: new evidence,
Journal of Economic Growth.

Redistribution versus growth?
The relationship between economic growth and redistribution has deadlocked the public debate in an
unfruitful squabble since 1990. This often constituted the form in which the economic dimension of the
transition to a new political dispensation was discussed. Different political-economic constituencies
favoured different relationships between these two objectives. In its crudest form, the debate displayed a
split between two opposing viewpoints: Growth through redistribution or Redistribution through growth.
The latter viewpoint was favoured by the business sector and the pre-1994 policy establishment. Their
argument is that economic growth should be pursued first, in order to enlarge the economic ‘cake’. The
increased availability of income and wealth – the benefits of growth – will spread or filter down to all the
people in the country, including the poor, thereby establishing a more equitable distribution of income.
In addition, the growing economic cake will increasingly make it possible to channel more resources
to the satisfaction of basic needs (education, housing and health). Direct steps to attain speedier
redistribution – higher taxes to finance higher government spending on public services, for example – will
be counterproductive since they will simply retard economic growth. As a consequence, there would be
a shrinking pool of income and wealth to redistribute, and the goose that laid the golden eggs would be
strangled. (What would happen is that ‘poverty would be redistributed’.) This viewpoint can be discerned
in the proposals of the business sector.
The first viewpoint was held by representatives of those who were excluded from power in the previous
political dispensation. They argue that the business argument has only one objective: the protection of the
privileges of the rich and of the status quo of income and economic power distribution – and, moreover,
that the trickling down of benefits to the poor is a myth. The goose that lays the golden eggs is not under
threat at all. They argue further that direct government intervention should be used to restructure the
pattern of income and economic power. Increased government expenditure to build the capacity of the
poor and empower them will unleash their potential and lead the country to a new phase of economic
prosperity for all. Social expenditure on housing, schools and hospitals will also provide an economic
injection and new domestic economic opportunities – for all.
❐ This viewpoint was present in the initial policy documents of the ANC, as well as, for example, in the
proposals of Cosatu (the Congress of South African Trade Unions) and labour unions such as Numsa.
Different and subtler variants of these two viewpoints have developed in the past two decades. In the
Reconstruction and Development Programme (RDP) of the ANC, elements of both viewpoints are present.
The redistribution sentiment remains strong, though – perhaps not in its original crude form, but rather
with a strong focus on economic empowerment and capacity building. In pursuing this the government is
accorded a significant responsibility, with certain sections of the ANC pushing for a strong planning role
for the state.
In 1996 the government introduced the Growth, Employment and Redistribution (GEAR) programme.
For the most part, GEAR is a macroeconomic stabilisation policy aimed at setting the scene for a higher
economic growth rate and higher employment. A key component is tight fiscal policy and the reduction of
the budget deficit.
GEAR to a large extent considers a prudent fiscal policy as a prerequisite for growth, with growth then
generating the revenue that will help to finance more development. Therefore, GEAR leans over to the
redistribution through growth viewpoint.
In 2006 the government introduced the Accelerated and Shared Growth Initiative for South Africa
(ASGISA). With its emphasis more on microeconomic policy aspects, ASGISA, more than GEAR,
recognises that, within the constraints of the budget, some human development can and must take place
without waiting for growth.
⇒

⇒
After 2009 two key policy frameworks were adopted. These are the New Growth Path (NGP) of 2010
and the National Development Plan (NDP) of 2012. The NGP focuses on growth via labour-intensive
manufacturing. The NDP is a comprehensive development plan that covers almost all areas of society,
e.g. demography, education, health, social protection, human settlements, spatial legacies, infrastructure,
agriculture and the rural economy, the economy and employment – and a ‘capable and developmental
state’.
Whereas GEAR, ASGISA and the NGP focused largely on economic growth, the NDP has a broader
concern with human capabilities, the inclusivity of growth and the reduction of unemployment and
poverty – also by tackling structural problems. Job creation and the reduction of inequality (and poverty)
are explicit objectives of the NDP. Nevertheless, the NDP has been heavily criticised by Cosatu as being
too free-market oriented, protecting the rich and not being concerned with the plight of poor workers –
especially in its chapter on the economy.
❐ The concept of inclusive growth has the potential to defuse the apparent tension between growth and
redistribution. If properly understood, it combines the increased participation of poor and marginalised
people in growing economic processes – i.e. via employment – with increased sharing in the benefits
of growth via equitable earnings, social expenditure and human capacity-building (see section 12.4 in
chapter 12). This implies that the nature of production and employment processes, and thus the nature
of growth itself, needs to be adapted to attain both objectives simultaneously.
❐ Unfortunately, this concept is prone to distortion. For example, many people in the private sector
appear to restrict the concept of inclusivity to benefit-sharing – and then in the restricted sense of
receiving social grants and social services – after growth has occurred. This would require no change
to current economic practices and simply recasts the old tension between growth and redistribution in
new terminology.
1.4 The development objective

One possible way out of the sterile, polarised debate on redistribution versus growth may
be found in the concept of development.
1.4.1 What is development?

Development is not a particular outcome or event. Development can be understood as a
decisive, comprehensive and integrated process that expands the range of choices that
people have and improves their standards of living. It therefore entails much, much more
than an increase in income or GDP or employment, as explained in the UN’s Human
Development Report 1990:
Human development is a process of enlarging people’s choices. The most critical ones are to lead
a long and healthy life, to be educated and to enjoy a decent standard of living … It is sometimes
suggested that income is a good proxy for all other human choices since access to income permits
exercise of every other option. This is only partly true for a variety of reasons:
❐ Income is a means, not an end. Well-being of a society depends on the uses to which income is
put, not on the level of income itself.
❐ Country experience demonstrates several cases of high levels of human development at modest
income levels and poor levels of human development at fairly high income levels.
❐ Present income of a country may offer little guidance as to its future growth prospects…
❐ Multiplying human problems in many industrial, rich countries show that high income levels, by
themselves, are no guarantee of human progress.
The simple truth is that there is no automatic link between income growth and human progress.
United Nations Human Development Report 1990 (1990: 10)
1.4 The development objective 25

It is not the redistribution or the growth of income as such that is important. What is
critical is the development of people, their potential, their abilities to experience a self-
reliant and humane existence, and to use their increasing power of disposal over economic
means or resources to satisfy their needs. Real development can therefore deliver both
economic growth and the economic empowerment of the poor.
❐ This results in economic growth and redistribution through development. Development
therefore has the potential to dissolve the tension between growth and social
considerations.
What is the difference between economic growth and development?

This question can provoke a never-ending debate. The most important insight is that
development entails (and requires) much more than an increase in the total value of production
(GDP) or income, or even in per capita income. GDP growth is necessary but not sufficient
for human development. While increased household income or purchasing power is a crucial
element in eliminating poverty, alone it is insufficient to achieve development.
The single-minded pursuit of economic growth, narrowly defined, without taking the other
dimensions of human and social development into consideration, cannot but produce
distorted or unbalanced ‘development’ in a country. Human development can be absent in a
society despite fast growth in GDP or per capita incomes unless certain other steps are taken
and other endogenous social and economic processes are activated and empowered.
❐ This has been demonstrated by the failed efforts of the high-income countries, in previous
decades, to solve the poverty and development problems of the low- and middle-income
countries through large capital projects to achieve economic growth. (Also see chapter 12,
sections 12.3 and 12.4.)
1.4.2 How does one measure development?

Development is a complex process, as is the measurement of development. Through the
years different approaches to development have produced different measures. These have
evolved from crude measures that considered only per capita income to sophisticated
indicators that measure several dimensions of basic need satisfaction and of capacity
building and empowerment.
Besides measures of income or purchasing power, they include several ‘social’ indicators
of aspects such as education (level of schooling, literacy), life expectancy, nutrition levels,
health (e.g. infant mortality rates) and housing (persons per room, running water per
household, sanitation, etc.).
Such information can also be summarised in composite development indicators. The best
known of these indicators is the Human Development Index (HDI), which was developed by
the United Nations Development Programme. It provides, in a single number, a composite
measure of the level of development in a country, and of progress with development efforts.
The HDI is constructed from three indicators of the basic dimensions of human development:
❐ ability to lead a long and healthy life (i.e. life expectancy, which implicitly includes
factors such as nutrition, health and shelter);
❐ ability to acquire knowledge (measured by years of schooling, which implicitly includes
adult literacy and school enrolment); and
❐ ability to acquire a decent standard of living (measured by income in terms of
purchasing-power-adjusted real gross national income (GNI) per capita).

1.4.3 The development picture – South Africa and other countries
For South Africa, the development picture as compared with four groups of countries is
shown in table 1.4.
The data show that South Africa compares quite well with other middle- and lower-income
countries in terms of per capita income levels, but relatively poorly in terms of life
expectancy – and also with regard to the overall development index, the HDI. A country
such as Vietnam, for example, has an income level only half of that of South Africa, but
its HDI is similar since its life expectancy is much higher (76.5 years in 2017 in contrast
to 63.4 years for South Africa).
Table 1.4 Development indicators
GNI per
Change Life ex- Mean
capita
Rank Country HDI in HDI pectancy years of
(2011
rank (years) schooling
PPP US$)
Very high human 1990 2000 2010 2015 2017 2012–2017 2017 2017 2017
development
1 Norway 0.85 0.92 0.94 0.95 0.95 – 82.3 12.6 68 012
4 Ireland 0.76 0.86 0.91 0.93 0.94 +13 81.6 12.5 53 754
5 Germany 0.80 0.87 0.92 0.93 0.94 –1 81.2 14.1 46 136
12 Canada 0.85 0.87 0.90 0.92 0.93 – 82.5 13.3 43 433
13 USA 0.86 0.89 0.91 0.92 0.92 –5 79.5 13.4 54 941
19 Japan 0.82 0.86 0.89 0.91 0.91 +1 83.9 12.8 30 660
31 Greece 0.75 0.80 0.86 0.87 0.87 –1 81.4 10.8 24 648
37 Qatar 0.75 0.81 0.83 0.85 0.86 –1 78.3 9.8 116 818
49 Russia 0.73 0.72 0.78 0.81 0.82 +3 71.2 12.0 24 233
High human development
79 Brazil 0.61 0.07 0.73 0.76 0.76 +7 75.7 7.8 13 755
86 China 0.50 0.59 0.71 0.74 0.75 +7 76.4 7.8 15 270
101 Botswana 0.59 0.57 0.66 0.71 0.72 +8 67.6 9.3 15 534
Medium human development
113 South Africa 0.62 0.63 0.65 0.69 0.70 +6 63.4 10.1 11 923
115 Egypt 0.55 0.61 0.66 0.69 0.69 – 71.7 7.2 10 355
129 Namibia 0.58 0.56 0.59 0.64 0.65 – 64.9 6.8 9 387
130 India 0.43 0.49 0.58 0.63 0.64 +2 68.8 6.4 6 353
142 Kenya 0.47 0.45 0.54 0.58 0.59 +3 67.3 6.5 2 961
144 Zambia 0.40 0.43 0.54 0.58 0.59 –3 62.3 7.0 3 557
Low human development
154 Tanzania 0.37 0.40 0.49 0.53 0.54 +3 66.3 5.8 2 655
156 Zimbabwe 0.49 0.44 0.47 0.53 0.54 +2 61.7 8.1 1 683
157 Nigeria – – 0.49 0.53 0.53 –2 53.9 6.2 5 231
159 Lesotho 0.50 0.47 0.49 0.51 0.52 –1 54.6 6.3 3 255
180 Mozambique 0.21 0.30 0.40 0.43 0.44 +1 58.9 3.5 1 093
Source: United Nations Development Programme: Human Development Indicators – Statistical Update 2018.
PPP US$ is a special income measure designed to solve the exchange-rate problem in international comparisons of income.

❐ The spectre of Aids had a marked downward effect on life expectancy in South Africa
and other African countries after 1995: this affected their HDI values negatively.
❐ Life expectancy in South Africa fell from 62.2 years in 1992 to 53.3 in 2012. That
was a quite disturbing decline. However, it was turned around after that, following the
government’s eventual policy decision to provide antiretroviral medicine, as well as a
marked improvement in the efficacy of such medicine.
✍ Income and development

Study table 1.4. Why do you think the relationship between GDP per capita and the HDI values
as well as the relationship between GDP per capita and the components of the HDI values
are not perfect? What does this signify regarding the link between economic growth and
development? (Also see box in chapter 12, section 12.3.4.)
______________________________________________________________________________________
______________________________________________________________________________________
In 2017, Norway had the highest HDI in the world and the Niger the lowest. Qatar had
the highest per capita income in 2017, but it was ranked only number 37 given that some
other high-income countries performed better in terms of life expectancy and education
enrolment. (However, the first 20 countries all have very similar HDI values ranging from
0.91 to 0.95.) For 2017, South Africa ranked number 113 in a list of 189 countries. With
the exception of Papua New Guinea, the Solomon Islands, Yemen and Haiti, all countries
below number 150 are African countries. This demonstrates the enormous developmental
backlog still faced by Africa.
1.4.4 What does macroeconomic policy have to do with development?

The tension between growth and redistribution is often transmitted to the analysis
of the relationship between growth and development. A major reason for this is that
people reason as if development and redistribution are synonymous. Proponents of the
redistribution-through-growth approach then proceed to evaluate development-oriented
steps of government in the same way as they would evaluate redistribution efforts, i.e. as
a threat to growth and other macroeconomic objectives.
❐ This is a mistake. Development is something quite different from redistribution –
although good development, which addresses poverty successfully, should produce
improved income distribution patterns as well as economic growth.
Obviously it is true that the development efforts of a government often have significant
budgetary and fiscal implications. They usually entail government expenditure that has to
be financed. Government expenditure also has macroeconomic implications, as analysed
in the following chapters. Overambitious development-oriented government expenditure
can cause undesirable macroeconomic consequences – through an increasing tax burden,
an excessive budget deficit, crowding-out, inflation or excessive stimulation of the economy.
Therefore unwise development policy can threaten macroeconomic objectives.
On the other hand, a country can achieve good macroeconomic performance in the sense
of a high growth rate of real GDP, but in a way that does not address the problems of
severe poverty and underdevelopment. In particular, excessively conservative fiscal policy

can seriously impair government development activities if funds for these purposes are cut
back. (See the discussion of fiscal policy in chapter 10.) Unwise macroeconomic policy,
therefore, can threaten development objectives.
The Sustainable Development Goals (SDGs) for 2030

The SDGs constitute an internationally adopted blueprint to achieve a better and more
sustainable future for all by 2030. It is a collection of 17 goals for global development, set
by the United Nations General Assembly in 2015. These include: no poverty; zero hunger;
good health and well-being; quality education; gender equality; clean water and sanitation;
affordable and clean energy; decent work and economic growth; infrastructure, new industries
and technologies; reduced inequality; sustainable cities and communities; responsible
consumption and production; climate action; life on land and below water; and peace, justice
and strong institutions. A total of 195 governments, including South Africa, have committed
to translating the goals and associated targets into national legislation and plans of action, to
establish budgets and monitor progress using appropriate indicators. Though non-enforceable,
implementation to tackle all the challenges started worldwide in 2016.
For more information on the SDG project, see: https://www.un.org/sustainabledevelopment
Development problems will not disappear conveniently unless steps are taken to initiate
development processes. Macroeconomic performance as conventionally measured in
itself is not sufficient. Therefore, the important thing is to pursue an appropriate balance
between macroeconomic objectives and development objectives.
❐ Achieving such a balance requires that macroeconomic objectives should not be
regarded as of absolute and sole importance. Their relative importance is to be found
in the fact that, if macroeconomic considerations do not receive sufficient attention in
the pursuit of development objectives, the economy can experience serious problems,
e.g. BoP crises, a drastic depreciation of the currency, runaway inflation, a disastrous
public debt burden and so forth. Correcting such severe macroeconomic errors will
require incisive structural adjustments which can impair development work seriously,
and for many years.
❐ By taking macroeconomic considerations seriously, a government can create room for
good development efforts. Healthy macroeconomic policy makes the pursuit of other
objectives possible. Therefore, macroeconomic objectives should be recognised, in this
wider context, as important constraints on development policy.
Yet this last point still does not mean that macroeconomic objectives should be seen as
being of absolute importance. What is necessary is a balance between the macroeconomic
and other objectives. This means that the discussion on macroeconomic policy must be
broadened expressly to include the development dimensions. Development objectives
should not be regarded as something separate from or opposite to macroeconomics, or as
something that can be addressed afterwards.
Ideally, a development orientation should guide and characterise all policy. For example,
proper development-oriented fiscal (and monetary) policy would also use development
indicators and objectives in the design and monitoring of policy.
In the final instance, development policy – which empowers people and unleashes their
economic and social capacity – can be an important instrument in boosting productivity,

output and employment – the basic macroeconomic indicators. Good development policy
will also serve macroeconomic objectives. Real development can deliver both economic
growth and the economic empowerment of the poor. In such a case, any choice between
growth and development is a false choice.
At the same time, the debate on development policy should, at all times, expressly take the
importance of macroeconomic constraints into account. Development objectives cannot be
pursued uncompromisingly either, especially not if via government expenditure programmes.
It is clear that macroeconomic policy is (or should be) much concerned with development.
However, in practice, the pursuit of development objectives also concerns microeconomic
and public management aspects, as well as budget practices, which takes the discussion
far beyond the normal macroeconomic frame of reference. This is one reason why
macroeconomists so readily disregard development aspects.
1.5 Intermediate objectives

While the list in section 1.3 contains the main objectives of macroeconomic policy, there
is also a set of secondary or intermediate macroeconomic objectives. These are important
because they have crucial implications for the other, main objectives – and are sometimes
important in their own right.
Most notable among these is the rate of interest. Whichever way it moves, it affects certain
groups of people positively and others negatively – homeowners, investors, borrowers,
lenders, farmers, pensioners, etc. These differential effects, and their consequences, can
make the interest rate an important policy objective at times.
Likewise, the exchange rate can harm or benefit people, which can also make it an important
objective at times. In this sense, interest rate and exchange rate levels are also important in
any diagnosis of the economic situation, so they will usually be included in such an exercise.
A last factor sometimes proposed as a policy objective is a balanced budget. However, this is
not generally accepted, mainly because an intentional budget deficit can be an important
Keynesian policy instrument. In more sophisticated fiscal analyses, the preference is
for other fiscal norms (criteria) that are derived from specially defined budget balance
concepts, e.g. the primary deficit (see chapter 10).
1.6 Conflict between the standard objectives – priorities and trade-offs

While it may be simple to understand each objective in relative isolation, the problem in
practice is to pursue or realise all these objectives simultaneously. The fundamental problem
is that, given the way the economy works, several of the objectives are usually in conflict
with each other. The pursuit of one of them frequently has a negative impact on another.
This conflict often occurs in the form of a trade-off, where progress with one objective
is possible only at the expense of another. In such a situation the government is forced
to choose, i.e. it has to give priority to certain objectives over others. This choice is often
the source of serious political differences. The choices, and the disputes, are also strongly
determined by the relative influence and popularity of alternative economic schools of
thought (such as Keynesianism and Monetarism/New Classicism, as well as Marxism) in
policy-making circles.
The most well-known trade-offs are those between (a) employment and the BoP, and (b)
employment and price stability. These are fully discussed in chapters 6, 7 and 12.

Chapter 4 will demonstrate how conflict can arise between BoP and unemployment
considerations. Stimulating the economy to relieve unemployment stimulates imports
and thus causes a deterioration in the current account (and the BoP). Cooling down the
economy to alleviate a current account deficit, on the other hand, is likely to aggravate
unemployment. Increasing interest rates to improve the financial account discourages
investments – which harms the growth and employment objectives.
Moreover, if unemployment and a BoP deficit occur simultaneously, the dilemma is
particularly acute: the economy suffers from two serious problems, but policymakers can
alleviate one only to the detriment of the other. The conventional solution for this policy
dilemma is to fight unemployment with expansionary fiscal policy, while simultaneously
using restrictive monetary policy to increase interest rates sufficiently to rectify the BoP
position (by attracting strong capital inflows). Theoretically, the correct combination of
these two steps can lead to the simultaneous achievement of both objectives. In South Africa
prior to 1994, the low sensitivity of foreign capital to domestic interest rates inhibited the
effectiveness of this policy package – especially since political conditions also discouraged
capital inflow. After 1994 it has become much less of a problem. However, this problem
might return if South Africa loses all three sovereign investor-grade credit ratings (i.e. the
sovereign credit ratings issued by Moody’s, S&P and Fitch rating agencies).
On a deeper level, trade-offs have to be faced when contemplating economic growth and
unemployment together with economic development and poverty reduction. Whereas
it is often assumed that higher economic growth will lead to lower unemployment and
progress with economic development, things are not so straightforward. As we will see
when we discuss the concept of structural unemployment (see box in chapter 6, section
6.3.2), certain kinds of growth can leave structural unemployment unreduced (compare
the concept of jobless growth). Depending on the way it occurs, economic growth can also
be accompanied by increasing inequality among citizens of a country, can make a limited
impact on the level of human development, or can harm the environment.
On the other hand, making economic growth truly inclusive could generate an important
convergence between economic growth, on the one hand, and development, employment
creation and poverty reduction on the other (see ‘Redistribution versus growth’ above).
1.7 Priority choices of the South African government

The South African government is also forced to choose between various policy objectives.
Throughout the years the South African government also did not award the same priority
to all its objectives:
❐ In the first half of the 1970s, economic growth had the highest priority. However, these
also were the last years of the so-called macroeconomic ‘golden age’ that started in
the 1960s in South Africa. The 1973 OPEC oil crisis introduced the period of high
inflation all over the world; price stability became a major policy concern. After the
1976 Soweto student uprising, when international economic pressure on South Africa
(e.g. trade sanctions) began, the BoP demanded increasing attention.
❐ A rather low priority was given to growth and employment in the period 1981–85.
South Africa registered rather good economic growth in 1981 following the boom in
the gold price. However, the large inflow of foreign reserves in 1981 caused a significant
spike in the inflation rate. Therefore, the government and the Reserve Bank came to
associate growth with unwanted inflation. This led to an under-emphasis of growth.
❐ Much changed in 1986. That year’s budget speech was unique in that it expressly gave
the highest priority to the economic conditions for social reform – i.e. the distribution,
1.7 Priority choices of the South African government 31

equity and development objectives, in conjunction with the employment objective. This
was a first for a Minister of Finance (then Barend du Plessis). The political protests
of those years (perhaps partly due to the previous neglect of the employment and
development objectives?) are likely to have been a major factor in this policy shift.
The financial sanctions imposed on South Africa put tremendous pressure on the BoP
though, pushing economic growth to the back burner.
❐ The early 1990s represent a period of major political transition. Economic growth
received a higher priority, but, due to political uncertainty (resulting in low investment)
as well as the international recession, actual growth was at its lowest level since 1960.
During the 1990s the Reserve Bank under governor Chris Stals was very successful in
reducing inflation to below 10%.
❐ After the first democratic election in 1994, the new government came to power with the
Reconstruction and Development Programme (RDP) as its mandate. The RDP emphasised
human development, but acknowledged the need for economic growth. It also acknowledged
the budgetary constraints that government faced. This year marked a significant shift in
government policy towards emphasising development and social spending.
❐ In 1996 the government announced the Growth, Employment and Redistribution
(GEAR) strategy. GEAR was mainly a macroeconomic stabilisation policy that reflected
the basic principles of the so-called Washington consensus. (It is called thus because it
reflects the central ideas propounded by the IMF and the World Bank – both located in
the US capital Washington DC.) These principles include an emphasis on growth, fiscal
prudence and avoiding government dissaving (typically requiring cutting government
expenditure and deficits), monetary prudence (to get low inflation) and privatisation.
With the GEAR emphasis on a 6% growth target, many people – but most notably the
trade unions – accused government of neglecting employment, redistribution and social
spending. Although government succeeded in reducing the budget deficit and public
debt, it was less successful in stimulating investment and economic growth.
❐ After 1999, when Tito Mboweni became governor, the Reserve Bank was able to use
conservative monetary policy to focus on maintaining an inflation rate of 6% on average
– though at times inflation exceeded 10% due to exchange rate or oil price shocks.
❐ With a prudent macroeconomic (i.e. fiscal and monetary) policy in place at the turn of
the century, and the subsequent room created in the budget, the government turned to
the more microeconomic and redistributive aspects of policy. Since 2000 a permanent
expansion of the social welfare system was introduced. Whereas only 5.8 million people
received a type of social grant in 2003, by 2018 about 17.5 million people received
a social grant. The largest increase occurred in child support grants. In 2003 there
were 2.6 million child grants and in 2018 about 12.2 million. Approximately 45% of
households received some type of government grant in 2018.
❐ In 2006, government introduced the Accelerated and Shared Growth Initiative South
Africa (ASGISA). ASGISA was a rather loose collection of initiatives to address the
binding constraints on growth. It included elements of industrial policy, small business
development and infrastructure investment. However, it never really got off the ground.
❐ Government’s New Growth Path (NGP) of 2010 prioritised employment creation and
‘decent’ jobs through investment in massive infrastructure projects (also in rural areas),
reindustrialisation, minerals beneficiation, small business development and public
works programmes – while it also intended to produce equitable and inclusive growth
and decent jobs (via labour rights). With the focus on ‘jobs drivers’, little was said of
social objectives or changing the situation of marginalised people. The NGP was soon
superseded by the more encompassing National Development Plan (NDP) of 2012.

❐ The NDP, which was formally adopted by government, presented plans with 2030 as
the end goal. While it thoroughly addressed many dimensions of society, at its core
the NDP prioritised ‘faster and more inclusive growth: an economy that will create
more jobs’. For GDP growth it mainly proposed increasing exports, linked to a growing
service sector and small business development for employment growth. Extensive
infrastructure expenditure was intended to stimulate growth while public works
programmes would create millions of temporary public-sector jobs in the interim years.
Social expenditure and social protection would be increased to eliminate poverty and
reduce inequality, while also transforming human settlements and the rural economy.
(In the period up to 2018 the implementation of the NDP was slow or absent, though.)
❐ The Minister of Finance up to May 2014, Pravin Gordhan, adopted economic growth
as the key to tackling unemployment and poverty, declaring that a growth rate of 7%
will be required for a generation to reduce unemployment. Since the rate of inflation
had been below 6% for several years, it was not a high priority and the Reserve Bank
(with new governor Gill Marcus and subsequently Lesetja Kganyago) had a low profile.
❐ This policy approach largely continued up to early 2019 (amidst a high rotation of
Ministers of Finance, including Nene, Van Rooyen (literally for a weekend), Gordhan,
Gigaba and Mboweni). At the same time, decisions with huge fiscal implications, such
as the abrupt announcement of free higher education, as well as repeated financial
bail-outs of state-owned enterprises (SOEs) such as Eskom, South African Airways
(SAA) and the SA Broadcasting Corporation (SABC), forced to the fore government
debt and the government’s ability to borrow money internationally (i.e. South Africa’s
sovereign credit rating).
❐ At this stage the NDP objectives had largely faded away, or was not being implemented
at all. However, in June 2019 President Cyril Ramaphosa recommitted the government
to the implementation of the goals of the NDP.
1.8 Main perspectives in the economic debate in South Africa

Any person reading the overview of policy choices and priorities of the South African
government since the 1970s will be struck by the strong undertone of opposing economic and
political philosophies. Moreover, when one considers the economic policy history, embedded
as it is in South Africa’s peculiar political history, one realises that it cannot be separated
from at least two debates: one on economic philosophy, the other political-economic.
1.8.1 Economic schools of thought – Classicism, Marxism and Keynesianism

Since early in the last century, South African policymakers have always been influenced
by the broader international debate between economic schools of thought (or ideologies).
This is discussed in depth in chapter 11 (section 11.3). At this stage it is necessary, though,
to note the broad outlines of the course of mainstream economics since its inception. It
has shaped, and still shapes, our everyday lives.
A very simple, rudimentary outline

This will be a very simple, even crude outline. Its very simplicity implies a high risk of hiding
important nuances. Nevertheless, such a simple outline has an important role: to set out
the very broad parameters of the main streams, or traditions, of thought in economics and
about economic policy. Once these are understood, the refinements of various economists
and schools of thought can be better understood and positioned within the large scope of
things. The biggest divide exists between the following two broad streams:
1.8 Main perspectives in the economic debate in South Africa 33

A. Mainstream economic thought, which B. Marxist thought, which is fundamentally critical of the
accepts and works within the basic capitalist or capitalist model and seeks radically alternative ways of organ-
mixed-economy model. ising economic activity. Some of the political alternatives pro-
posed include socialism and communism (but few proponents
would approve any of the forms observed in former communist
states). Marxist thought is based on a deep criticism of the way
the interaction of private property, private enterprise and the
free market has lead to a high inequality of economic power,
political power and economic welfare among people and na-
tions – while acknowledging that no system has produced eco-
nomic growth and wealth (in the aggregate) like the capitalist
system. The state and politicians are seen as often being in ca-
hoots with the capitalists: the ‘capitalist state’ is no antidote for
the market.
❐ While little formal economic theory (parallel to stand-
ard microeconomic or macroeconomic theory, say) has
been forthcoming from Marxist circles, Marx is one of
those historical and philosophical figures that one can-
not ignore or avoid. Think of a fundamental economic
issue, and Marx has been there (i.e. he probably has said
something profound – whether right or wrong – about
it and it probably has influenced thinking about the is-
sue). Marxist thought tackles issues at a different angle
and level, and rarely fails to provoke an intellectual re-
action from the reader.
❐ Several loosely affiliated strands, ‘radical’ or ‘alternative’
in varying degrees, can be identified. These include
neo-Marxism, post-Keynesianism, Institutionalism and
Evolutionary Economics.
* * *
Mainstream economic thought and related theories are based on the principles of private property, private
enterprise and a significant role for the market, as well as at least a minimum role for government in the economy.
Within the mainstream, the latter element – the role of the state vis-à-vis the market – has been responsible for
an important, major divide between two broad sub-streams.
Mainstream Group 1 – the free market and Mainstream Group 2 – the mixed economy
minimalist state group: This group believes, in group: This group believes, in the core, that markets
the core, in markets as the optimal organisational are very important but that they face and harbour
mechanism for social and economic activity, and intrinsic deficiencies that constrain their ability to
in the smooth and efficient functioning of markets work smoothly and efficiently, thus leading to distort-
in determining equilibrium prices, quantities and ed outcomes – market failures – in terms of prices,
incomes. As a corollary, the role of the state should be quantities and incomes. The only agent that can step
kept to a minimum – which comprises the provision in to rectify these distorted outcomes, is the state (i.e.
of a public legal order and the enforcement of private government), which can and must support, oversee,
property rights and contracts. Anything more than a regulate and complement the activities of the market
minimalist state will be counterproductive and cause and private enterprise. (Within this group, a variety
more problems than benefits. Government failure is of sub-views exist regarding the proper mix of ‘state
a real risk. and market’, as well as the best design of government
interventions and activities in the economy.)

From broad approaches to two seminal models
(1) The Classical model and its articles of faith

Mainstream Group 1 first entered the ring in the middle 1700s, with the works of Adam
Smith, founder of so-called Classical economic thought, and John Locke, the English
philosopher. Both were exponents of Classical liberalism, the philosophy built on the
fundamental belief that individual freedom and liberty are the highest good. The state is
fundamentally distrusted. No artificial restrictions are to be placed on individuals, least
of all by a state. If only individuals could be left alone to pursue their own interests in
complete freedom, a situation of harmony and equilibrium would prevail in society – a
‘natural order’ would emerge ‘as if arranged by an Invisible Hand’.
❐ Adam Smith’s most famous work on economics was An inquiry into the Nature and Causes
of the Wealth of Nations (1776). Its central thesis is that resources for the production of
wealth are best employed under conditions of governmental non-interference or laissez
faire.
The intellectual heirs of Adam Smith, in particular the neo-classical economists, refined
this view into the well-known atomistic model of ‘perfect’ competition. In this model the
unrestricted interaction of demand and supply theoretically leads to an efficient, optimal
equilibrium – as long as the state keeps its hands off. This theoretical model clearly
corresponds closely to the general Classical view.
The main thrust of the Classical approach to macroeconomics is the proposition that,
given unfettered markets, the economy will always tend towards a stable equilibrium at full
employment. The economy is inherently stable. Recessions and periods of unemployment
are only temporary and due to external disturbances; the economy will automatically
Marxist thought – a reaction to Classical views?

Living in London during the Industrial Revolution, Karl Marx (1818–1883) was highly critical
of the way industrialists exploited workers, including women and children, for the benefit of a
few, wealthy capitalists. In an era when Classical views were accepted wisdom, there was little
oversight or regulation of markets by government.
Marx developed a radical critique of the capitalist process of production. His classic book
Das Kapital (1867) highlighted fundamental characteristics, forces and contradictions in
the way a capitalist economy functions. These characteristics laid the foundation for large
inequalities and inequities between workers and the owners of business enterprises, i.e. the
capitalists.
The resultant class conflict, he predicted, would continually place the market system under
stress, leading to a series of crises. He foresaw a cycle of growth, followed by collapse,
followed by growth, etc. In the process, the capitalist class would become richer and the
working class poorer.
In the end, he predicted, the capitalist system would be destroyed by its intrinsic tensions
and crises. (It was to be replaced by socialism, an interim phase on the way to a classless,
stateless society.)
Footnote: The reader might find it interesting that Karl Marx’s sister Louise was married to a Dutch gentleman called
Johann Carel Juta. They moved to South Africa in 1853 and settled in Cape Town, where he built a publishing company
now known as Juta & Company – the publisher of this book. Mr Juta knew Marx well and encouraged him to write articles
for a Cape Town newspaper, De Zuid-Afrikaan.

return to the full employment equilibrium promptly. As a result, unemployment is not a
real problem. No remedial steps are necessary, least of all from government. Protracted
periods of unemployment and recession cannot occur.
The Classical model of the economy was in vogue up to 1930.
(2) The Keynesian model and its articles of faith

Mainstream Group 2 emerged in the 1930s. While the Classical and the neo-classical
models constituted the dominant economic paradigm up to the end of the third decade of
the 20th century, the Great Depression of 1929–33 all but killed the Classical proposition
that unemployment at most is a temporary aberration (disequilibrium) that will disappear
spontaneously.
The Depression was triggered by the US stock market crash of 1929. It quickly spread
to the rest of the Western world. In the USA, hundreds of banks collapsed, bankruptcies
abounded, and employment rose to more than 10 million, which at the time represented a
25% unemployment rate (with similar rates in countries such as the UK). This lasted until
at least 1933. South Africa also experienced the Depression, with severe unemployment
and poverty being aggravated by the great drought of 1933.
From 1933 to 1938, US President Franklin D Roosevelt introduced the New Deal, a set
of economic policies intended to counter the effects of the Great Depression via large
government infrastructural projects and fiscal stimulation.
This was not dissimilar to the policies suggested by the British (Cambridge) economist
John Maynard Keynes (1883–1946). Keynes, one of the most influential people of the
20th century, published his General Theory of Employment, Interest and Money in 1936.
From the late 1920s he already proposed similar policies for the UK. The demise of the
Classical model coincided with the rise of Keynesian theory.
The crux of the Keynesian approach is the acceptance of the inherent instability of the
economy and the intrinsic imperfections and flaws of markets. Keynesian macroeconomic
theory demonstrated that the economy can stabilise (stagnate) at an equilibrium with
unemployment (see chapter 2). This was a radical deviation from Classical thought.
Moreover, Keynesianism prescribed deliberate government action in the form of a fiscal
stimulus as a remedy. In general, it favoured active anti-cyclical fiscal policy, and deficit
spending if necessary, to remedy the flawed dynamics of the unfettered market. The
positive economic impact of wartime government expenditure on the US economy, and of
the Marshall Plan in Europe, boosted this view. Keynesian macroeconomics – later refined
to include the attempted fine-tuning of the business cycle to minimise cyclical instability –
became the dominant policy approach of most Western governments until the mid-1970s.
The end of the business cycle was proclaimed (prematurely, as it turned out).
Ideologies, legacies and disciples

With both these large ideologies having been founded, and each having had a period of
dominance in economic teaching and research as well as policymaking, the stage was set
for a prolonged battle of ideas.
The unfolding of this process involved various comebacks, revisions and refinements.
It was interspersed with – and triggered by – definitive occurrences in the real world.
One example was the sudden high inflation of the late 1970s, which could not be explained
by existing Keynesian theory, and of which the timing and diagnosis fitted the analytical

paradigm of the Classical proponents like a glove. University of Chicago economists such
as Milton Friedman had been working hard, from the 1950s, at rehabilitating Classical
liberal economic thought.
A first ‘reborn Classical’ approach, which came to be known as Monetarism, became very
popular in the high-inflation 1970s – following a decade of intense policy debates with
Keynesians (see chapter 11, sections 11.3.2 and 11.3.5). A central tenet was that policy
to fight unemployment is impotent in the long run and will only lead to permanently
higher inflation.
This was followed by the birth of the so-called New Classical School. This was a younger
and more extreme mutation in the Classical-Monetarist lineage (sometimes also called
Monetarism mark II; see section 11.3.3). It claimed that not only is policy impotent in the
long run (Friedman’s view), but also that it is impotent in the short run. The concept of
rational expectations, introduced by Robert Lucas (also from the University of Chicago), is
central to this approach.
Just as the advent of Keynesian economics in the 1930s did not mean the end of the
Classical tradition, so the resurgence of the Classical tradition in the form of Monetarism
and New Classical economics did not mean the end of the Keynesian approach. (That is
the nature of ideologies: they do not wither and die easily.)
From the late 1980s, Keynesian economists such as Mankiw and Blanchard addressed
the weaknesses of the older Keynesian approach – inter alia that it failed to explain the
high inflation of the 1970s. Their approach became known as New Keynesian economics.
While incorporating rational expectations into their models, they showed that various
wage and price rigidities can explain why an economy experiences unemployment and
instability in the short and medium run – a central tenet of original Keynesianism (see
chapter 6).
Nevertheless, at the turn of the century, New Classical economists appeared to think that
they had won the intellectual battle. The world was in an unprecedented era of economic
growth and prosperity, coinciding with an era of shrinking government involvement –
often in the form of financial and economic deregulation – in major Western economies.
Keynesian theory started to disappear from macroeconomic courses, first at postgraduate
level, and then from undergraduate textbooks.
Then the real world intervened – again. In late 2007, the subprime crisis struck in the USA
and quickly spread to other countries, leading to the greatest financial and economic crisis
in the world economy since the infamous Great Depression of the 1930s. Analysts quickly
pointed fingers to the legacy of Thatcher, Reagan and others: by making deregulation and
unfettered markets the centrepiece of policy in major high-income economies, they opened
the door for excessive risk-taking in financial markets – on a huge scale. Governments had
to respond quickly to prevent a worldwide economic meltdown. After bailing out several
banks and financial institutions, the government of US President Barack Obama launched
a government spending programme, notably on infrastructure, of unprecedented scale.
Several newspapers proclaimed – with a certain sense of irony – that this marked a return,
in the USA at least, to Keynesianism on a huge scale. (It was complemented by a huge
programme of monetary stimulation, until October 2014, called ‘quantitative easing’, run
by the US Federal Reserve – see the case study in section 3.4.) Similar policy shifts occurred
in Europe: although anti-Keynesian ideas did seem to have some purchase there previously,
the experience of the harm caused by fiscal austerity changed many policy minds.

In the USA president Donald Trump enacted large tax cuts and market deregulation
in 2017–18. While these were seen as ‘freeing-up business’ steps that resembled the
‘supply-side’ policy approach of former president Reagan, Trump’s introduction of
protectionist international trade tariffs constitutes the opposite of free-market ideology.
Increased government spending on the military and on infrastructure ‘to get the
economy working again’ also suggests a Keynesian approach. On the whole, though, his
mix of policies appeared to be driven by political opportunism or populism, rather than
any coherent Keynesian (or non-Keynesian) policy framework or economic ideology.
South Africa – always a microcosm?

While most of this ideological battle occurred in the USA and the UK, and also in Europe,
countries such as South Africa have always been affected by the broader currents.
Through the use of foreign textbooks, studying abroad in the USA, UK and Europe,
and through international academic journals, conferences and communication, these
debates spilled over to South Africa quite rapidly. Elements of how this unfolded in South
African policy circles are discussed above (section 1.7) and in chapter 10 (on fiscal policy).
Views representing both main schools of thought are to be found among South African
universities and economists.
1.8.2 Political-economic perspectives – race, class, capitalism and apartheid

A broader South African context is provided by the debate on the constitutional, political
and social framework of the country – going from a colonial and later apartheid past
to a fully democratic, post-1994 present. That political history had a parallel economic
philosophy and policy history.
The interaction between politics and economics in South African history is a complex
and contested topic. Several theories exist on whether race-based legislation and policies
have inhibited economic development, or may have served the interests of business and
especially mining. There are too many to summarise here. Nevertheless, there are many
indications of an intricate symbiosis (or mutual dependence) between, first, the way the
capitalist economy and business sector was organised and managed since before 1900,
and, second, the development of various manifestations of racial supremacy, racial
exploitation, migrant labour, separate development and apartheid. In short: persons and
institutions who wielded political power and economic power were often in agreement
– since at least 1894, when the Glen Grey Act was promulgated – about the need to use
race-based measures and subjugation of especially black workers to further the economic
and political interests of a selected group of people.
The interesting thing to note is the contrasting role played by socialist/communist
thinking during the 20th century. During the mineworker strike of 1922, communist
sympathies and class consciousness among white workers were strong, as they were
united against (English) capitalists. During the 1930s and 1940s, there was a strong
block of support amongst the (at the time very poor) white Afrikaner community
for socialist views of the state and the economy, favouring state interventions and
redress to benefit the poor (white) class. Market-based philosophies were seen as
the other side of the coin of British imperialism and dominance by British capital.
Hence, during the Second World War, some support developed for the philosophy of
National Socialism, then strongly propounded in Nazi Germany. (This philosophy
combined socialist ideals with nationalist ideals regarding the self-determination of
the German people.)

After the war, despite increasing involvement in the international economy, the National
Party government remained sceptical of classical-liberal economic thinking. This might
have been partly due to the association of the latter philosophy with growing criticism,
from overseas, against the system of apartheid and ‘separate development’. Also, the state
was seen to be, and was used as, an important instrument to strengthen the economy,
often for the disproportionate benefit of whites. After 1948 and the election victory of
the National Party, apartheid rapidly changed from a tacit understanding amongst the
powerful to an explicit, formalised and legalised social regulation system. Government
policymakers distrusted the ‘market’ and (English-dominated) business sector, and the
state was a major actor in steering the economy within the context of the capitalist-
apartheid economy.
In the Freedom Charter, adopted at Kliptown in 1955 following the ANC defiance campaign,
principles for a future South Africa were set out. Many of the economic clauses refer to
basic economic freedoms: to work, to be paid equitably, to own land, to be educated. What
raised the ire of the economic and political establishment at the time were clauses that
sounded just too socialist for comfort or raised fears of expropriation, such as:
The People Shall Share in the Country’s Wealth!
The national wealth of our country … shall be restored to the people
The mineral wealth beneath the soil, the Banks and monopoly industry shall be transferred to
the ownership of the people as a whole
All other industry and trade shall be controlled to assist the wellbeing of the people
The Land Shall be Shared Among Those Who Work It!
There Shall be Work and Security!
The Doors of Learning and Culture Shall be Opened!
Education shall be free, compulsory, universal and equal for all children
There Shall be Houses, Security and Comfort!
These yearnings of oppressed people did not find much sympathy in (white) establishment
circles, whether political or economic. The 1960s were an era of high economic growth based
largely on high gold export earnings. To whites there appeared to be little reason to change
political or economic policies. In the ANC the struggle was transformed into an armed struggle
(in 1961).
Only in the mid-1970s did voices in influential Afrikaner circles start to argue for the ‘free
market philosophy’ (notably economists such as Jan Lombard and Nic Wiehahn). By this
time, the National Party government increasingly associated socialism with the communist
threat. In addition, the latter had a very immediate presence in the form of support from
the USSR and China for liberation movements, the armed struggle and the border war.
Moreover, movements such as the ANC, Azapo and the PAC propounded various socialist
solutions for the South African economy and state. Thus, government sympathies started
to shift towards the free market ideology, a move encouraged by good relations with the
conservative UK government of Margaret Thatcher. In the early 1980s, the National Party
government and the business sector openly moved closer together around the free market
theme. Labour market liberalisations led to a new era for labour unions.
By the late 1980s, the first meetings (in Europe) between domestic economists/
businessmen and ANC economists-in-exile revealed a large gap between, respectively, free
market capitalist proponents and pro-state, socialist proponents – with a few outsiders
arguing for a Third Way, but without much success. In the years that followed, intense
lobbying and debate took place behind the scenes. After the 1994 election, the new ANC-
dominated government took a surprisingly conciliatory line with regard to key elements

of the economy, notably property rights and private ownership of the economy (after
propounding nationalisation for many years), central bank independence, monetary and
fiscal discipline, a firm anti-inflationary stance, international trade liberalisation and so
forth. It had already adopted many elements of the Washington consensus, as noted above.
The adoption of the RDP (1994) and the GEAR (1996) policies followed, harbouring
elements of both (a) a state-directed approach to development and redress, and (b) a
market-based, business-oriented approach to economic policy. This was an evolving form
of social democracy, one could say. But it was a highly contested one, squeezed between
players such as, on the one hand, the more socialist Cosatu and the SACP, and, on the
other, the ANC government, often supported by the business sector (by now with a growing
black and black empowerment component).
At the time of the 2009 election, the role of the SACP and Cosatu in the so-called tripartite
alliance appeared to be gaining influence in ANC economic thinking. However, in the
following years the SACP fully submitted to the ANC approach without protest. Then,
in the run-up to the 2014 election, significant internal divisions developed in Cosatu,
particularly with respect to the economic policy component of the National Development
Plan (NDP). Numsa, Cosatu’s largest affiliate, together with a number of smaller Cosatu
affiliates, distanced themselves from the NDP and withdrew their support of the ANC in
the 2014 national election. These unions also broke away from Cosatu and formed the SA
Federation of Trade Unions (SAFTU). In 2018 Numsa established a Socialist Revolutionary
Workers Party (SRWP) as a ‘Marxist-Leninist political party fighting to overthrow the
brutal capitalist system’ – but it did not receive many votes.
Other political breakaways from the ANC were the Economic Freedom Fighters (EFF) as
well as new, non-Cosatu labour formations such as the Association of Mineworkers and
Construction Union (AMCU) (opposing ‘democratic capitalism’ and ANC policies) and
SAFTU (with its proclaimed ‘revolutionary and socialist orientation’). These signalled
a growing split in groupings on the left of the political spectrum – between those with
stronger class-based and socialist (or democratic socialist) views and those with stronger
social democratic views.
Alongside this big debate, parties such as the Democratic Alliance continued to represent
the more business- and market-oriented part of the political-economic spectrum (liberal-
democratic albeit with a social conscience) – but with signs of a growing social-democratic
component since 2015.
These broad political divisions would continue to shape the South African debate, also on
economic policy, in the years to follow.
❐ By developing a political party spectrum that is differentiated mainly on the basis of
economic policy – notably the role of government in the economy – South Africa would
join large parts of the world where economic ideology and policy are the main dividing
factors among political parties in elections.
Left, right or centre – or what?

Sorting out the left and the right in South Africa is not easy. Unlike other countries, we have
always had a left-to-right on politics and another one on economics. And the two have not
necessarily corresponded.
❐ The political left-to-right has always been along race-and-culture views, politics and policies.
❐ The economic left-to-right, as in other countries, is along views on market vis-à-vis state.
⇒

⇒
Politically left and right – a race-based spectrum
Political conservatives, in terms of race-based paradigms, are the political right or far-right.
In the old South Africa, the National Party considered themselves moderate/centre, with the
Conservative Party (later the Freedom Front) on the right wing, the Democratic Party (later
the Democratic Alliance) viewed as ‘left’, and the ANC and PAC far out off the cliff on the
radical left. From the viewpoint of the ANC and PAC, the DP was centrist at best; the rest were
varying degrees of right and far-right. The ANC and its affiliates have always been proudly left.
While racial attitudes and politics still feature resiliently at grassroots level, South African
political parties today are increasingly differentiated according to their view on the economy
rather than on race and identity, as follows:
Economically left and right – a market-state spectrum
The basic positions can be defined as follows:
❐ Economic conservatives = free marketeers = economically on the right wing (several
variants of ‘classical liberals’ and libertarians: US Republican Party; UK Conservative
Party; South Africa: elements of the DA).
❐ Economic liberals = mixed economy moderates = economically centrist (several variants:
US: ‘bleeding heart’ liberals = Democratic Party; UK New Labour Party; European Social
Democratic Parties; South Africa: post-1994 Mandela-Mbeki ANC; centrist wing of the
current ANC; elements of the DA).
❐ Economic radicals = critical of market economies, neo-Marxist = economically leftist (Old
UK Labour Party; European Democratic Socialist Parties; European Communist Parties;
South Africa: pre-1994 ANC; left wing of post-1994 and current ANC, SACP and elements
of Cosatu; Saftu; Numsa and SRWP; EFF; AMCU).
1.9 Analytical questions and exercises

1. Discuss economic growth and price stability as objectives of macroeconomic policy.
Refer to all possible complementarities and/or trade-offs that might exist between
these two objectives, and also discuss the most current trends in the indicators that
are associated with these objectives.
2. The clearest indicator of South Africa’s worsening position globally has been the
sustained fall in the rand since 2011, frequently due to foreign investors selling SA
bonds and equity. In the first six months of 2019 alone, foreign investors withdrew
about R70 billion from South African bond and equity markets. What could this
imply for the pursuit of economic growth and development? Also explain how the
macroeconomic goals of balance of payments stability and price stability are affected.
(In Chapter 4 you will encounter a detailed analysis of the international context.)
3. Discuss price stability as an objective of macroeconomic policy in South Africa. In your
discussion, clearly define what is meant by the objective, and indicate how inflation
affects low-income households and pensioners, as well as borrowers and investors
respectively. Provide most recent values of suitable indicators of the situation.
4. ‘To solve South Africa’s unemployment problem, there is only one solution: the
economic growth rate needs to be increased.’ Critically discuss this statement with
reference to employment trends and various types of unemployment. (In Chapter 12
you will learn much more about employment and unemployment.)

5. Discuss economic growth and the redistribution of income as objectives of
macroeconomic policy. In your discussion, clearly define what is meant by each
objective, and indicate any complementarities and/or trade-offs between these
two objectives. Provide most recent values of suitable indicators to measure these
objectives in South Africa.
6. Explain the possible effect of a higher inflation rate on interest rates and related
impacts on low-income groups and pensioners earning fixed interest income.
7. During the first two quarters of 2018 South Africa experienced consecutive negative
quarterly economic growth rates for the first time in many years – following steady
declines in the GDP growth rate since 2011. Can such a decline have any significant
effects on the country’s economic development? Discuss with reference to the
relationship between economic growth and economic development.

The basic model I:
consumers, producers and government 2
■ construct a basic model of production and income determination;
■ use the model to explain why and how total income in the economy tends to
fluctuate over the course of the ‘business cycle’;
■ compare and explain the behaviour of the main components of expenditure in an open
economy, i.e. consumption, investment, government expenditure, imports and exports;
■ compose chain reactions (or ‘chain reasoning’) to analyse the way changes in
economic variables (taxation, interest rates and so forth) or external disturbances work
dynamically through the economy; and
■ use graphical aids to support and critically evaluate your economic reasoning.
Unemployment, inflation, interest rates, exchange rates, the balance of payments, the
gold price, the budget, public debt, taxation, Reserve Bank policy – these issues are
what macroeconomics is all about. They deeply affect all our lives, whether as student,
household consumer, investor, business manager, employee, labour union member or
government official. News coverage and political-economic debates show the importance
of macroeconomic events and issues in these times, with the added complication of
concurrent development challenges.
As noted in chapters 0 and 1, the objective of this book is to enable you to think and reason
about actual macroeconomic events and policy. It does so by systematically building a
comprehensive framework of analysis (i.e. a theory or model of the macroeconomy) that
you can use to analyse events – in conjunction with a thorough intuitive grasp of the issues
and a concrete feel for South African economic processes, institutions and data.
As a first step towards understanding the operation of the economy, we consider, in this
chapter, the simple Keynesian theory of income determination. This theory was designed
originally to explain recessions and periods of unemployment. It emphasises the nature and
causes of short-run fluctuations in real domestic income and employment.
❐ The short run is a period usually thought to be up to three years. In later chapters
(chapters 6 and 7) we will also encounter adjustments, notably on the supply side of
the economy, that occur in the so-called medium term. This can be thought of as lasting
another three to seven years. The typical average for both processes, allowing for some
overlap, is approximately four to seven years. Short- and medium-term changes and
adjustments are frequently discussed in the context of business cycles with references
to ‘booms’ and ‘busts’, ‘upswings’ and ‘downswings’. Both the short- and medium-term
periods can be distinguished from the very long term, with a time horizon measured in
decades, which is the topic of economic growth (chapter 8).
Chapter 2: The basic model I: consumers, producers and government 43

The simple model focuses on the so-called real sector (or goods sector) of the economy, where
real economic activities such as production, consumption, saving, investment, imports
and exports occur. The theory can, therefore, help us understand the short-run course of
the South African economy, especially the course of gross domestic product (GDP).
❐ You would have encountered this theory in an introductory economics course. This
chapter will, therefore, review this material in a summary fashion. Still, important
intuitive insights and new analytical abilities will be developed.
While the interest rate plays a major role in this chapter, its full explanation is left to
chapter 3, where the monetary sector – the world of financial institutions, money and
interest rates – is added to the framework. Chapter 4 considers matters such as the balance
of payments and exchange rates (the foreign sector).
The price level, which is essential for an analysis of inflation, is a prominent variable
in more modern versions of Keynesian theory. However, for explanatory reasons, this
is brought into the analysis only in chapter 6. (Inflation gets a thorough treatment in
chapters 7 and 12.)
❐ In the simple Keynesian model we assume, for the time being, that the average price
level P remains constant. While obviously unrealistic, it does not affect the initial
results of the analysis materially. And it is helpful to make things clear at the start. We
will relax this assumption in chapter 6. At the end of this book the model will be fully
developed and quite sophisticated.
❐ Nevertheless, throughout the book we will define all concepts and relationships in such
a way that the place of the average price level P (and the inflation rate π where appro-
priate) is evident.
Allowing for changes in the average price level P, and for inflation, brings us to the use of
the term ‘real’ in another context.
❐ This is the difference between so-called nominal values of economic variables (e.g.
nominal GDP) and real values of variables (e.g. real GDP). For example, nominal GDP
is the value of total output measured in terms of the current prices of goods and services.
The presence of inflation can inflate the measured value of a nominal variable artificially.
In real values this artificial inflation has been removed to reveal the true, underlying
change in a variable. Thus real GDP is the value of total output expressed in the prices
of a base year, e.g. 2010. It is also called GDP at constant prices. The significance of this
distinction will become clear as we proceed.
Inflation and the distinction between real and nominal

Working with variables and data in an inflationary context requires an acute awareness of the
difference between nominal and real values. It must be taken into account in the way values
are measured. The following are useful formulae:
Real values (e.g. GDP) = Nominal value (of GDP, say) deflated with a price index, i.e.
divided by a suitable price index
Real GDP growth rate = Nominal growth rate – inflation rate [approximately]
Real interest rate = Nominal interest rate – inflation rate [approximately]
One must also ask whether certain economic behaviours reflect a reaction to a nominal value
or to a real value of a variable. For example, real investment reacts to real interest rates, but
money demand reacts to nominal interest rates (see sections 2.2.2 and 3.1.2).
44 Chapter 2: The basic model I: consumers, producers and government

❐ Except where explicitly indicated otherwise, we will be concerned with real values of
GDP, income, consumption, investment, interest rates and so forth – without always
adding the adjective ‘real’.
In this chapter we focus on the determination of total production and real income in the
short run. This is measured in terms of real GDP. Changes in real GDP are reflected in the
business cycle (short-run fluctuations – i.e. upswings and downswings – in the economy).
Table 2.1 provides pertinent information on the business cycle in South Africa.
Table 2.1 Business cycle upswings and downswings in South Africa since 1968
Upswings Downswings Note the variability in the duration of both upswings and down-
swings, the average duration of each being approximately
Jan 1968 – Dec 1970 Jan 1971 – Aug 1972 30 months, so that a full cycle takes approximately 5 years on
average. The recession of 51 months from March 1989 to May
Sept 1972 – Aug 1974 Sept 1974 – Dec 1977
1993 and the almost decade-long upswing after September 1999
Jan 1978 – Aug 1974 Sept 1981 – March 1983 have been the longest since the second World War. (See graphs in
section 1.3.1.)
April 1983 – June 1984 July 1984 – March 1986 * The official turning points are determined by the Reserve
Bank after a statistical analysis of approximately 230 time
April 1986 – Feb 1989 March 1989 – May 1993
series as well as consideration of economic events in the
June 1993 – Nov 1996 Dec 1996 – Aug 1999 vicinity of a possible turning point. The data requirements
cause a long time lag in the official announcement of a
Sept 1999 – Nov 2007 Dec 2007 – Aug 2009 turning point date.
Sept 2009 – Nov 2013 Dec 2013 –

Source: Key Information. Reserve Bank Quarterly Bulletin.
✍ Approximately how many trillion rand was the GDP of South Africa last year?
_____________________________________________________________________________________
What is the definition of GDP?
_____________________________________________________________________________________
What is the difference between nominal and real GDP? Why is this difference important?
_____________________________________________________________________________________
What was the approximate growth rate in South Africa since 2010? How does it
compare with previous decades? How does one measure the growth rate?
_____________________________________________________________________________________
(Consult the formulae, tables and graphs in chapter 5 and chapter 1, section 1.3.)
Macroeconomic data: which source?

The main source of macroeconomic data in South Africa is the Quarterly Bulletin of
the South African Reserve Bank. It is available from the Bank or from libraries, or at
DATA TIP
www.resbank.co.za
For employment and unemployment data, the main source is the Quarterly Labour Force
Survey (QLFS), published by Statistics South Africa. It is available at www.statssa.gov.za
Tables and graphs depicting the course of the main macroeconomic variables in South
Africa can be found throughout this book.
Chapter 2: The basic model I: consumers, producers and government 45

2.1 The basic framework
The crux of the original Keynesian approach is that the explanation of changes in production
and income, particularly in the short run, is to be found in fluctuations in total expenditure in the
economy. Thus, in the short run, total expenditure in the economy is at the centre of the action.
If that can be explained, the decisions that lead to (or are reflected in) the macroeconomic state
of the economy can be understood. Therefore, the basic Keynesian model is an expenditure-
or demand-determined model. (Later versions of the model also take the supply side into
consideration – see chapters 6 and 7.)
The significance of expenditure is that it induces and determines production decisions.
In the simple model, we more or less assume that the production (or supply) side of the
economy – the decisions of producers to produce – will respond without difficulty or delay
to changes in total expenditure. (This assumption will be relaxed in chapter 6 to make
the model more realistic.) Each level of production implies a corresponding level of real
domestic income. Depending on the methods of production chosen by producers, this is
likely to have some effect on employment.
The idea of an income-expenditure circular flow is very useful to illustrate the Keynesian
approach (see figure 2.3). It shows the circular flow of expenditure and income between
two key groups of role-players in a simple economy: households (consumers) and firms
(producers).
❐ In a more complete diagram, one will also indicate a public sector (state), a monetary
sector and a foreign sector. A complete circular flow diagram can be found at the begin-
ning of chapter 6; also compare the one at the end of this chapter.
What we study on the macroeconomic level is the aggregate of activities taking place on a micro-
economic level. The circular flow is a simplified representation of all transactions in the economy.
To see this, consider the three transactions (or exchanges) portrayed in figure 2.1.
There are three types of transaction:
1. A goods market transaction where Vusi buys vegetables from Vuyelwa’s grocery store.
In exchange for the vegetables, Vuyelwa’s store receives payment in the form of money.
Figure 2.1 Three types of transaction

A goods market transaction
Expenditure on goods
Vuyelwa’s grocery store Vusi and his family
(Firm) Vegetables (Household)
A factor (labour) market transaction

Labour services
Vuyelwa’s grocery store Sylvia
(Firm) Wages (Household)
A factor (capital) market transaction

Capital (funds)
Vuyelwa’s grocery store John
(Firm) Interest (Household)

2. A labour market transaction where Vuyelwa’s store employs Sylvia. In exchange for
her labour services, Sylvia receives a wage/salary from Vuyelwa’s grocery store.
3. A financial (or capital) market transaction where John buys shares in Vuyelwa’s
grocery store, or where John extends a loan to Vuyelwa’s grocery store. In exchange
for the capital funds invested in Vuyelwa’s grocery store, John receives dividends and/
or interest.
The labour and financial markets both are factor markets – labour and capital are factors
of production. Grouping them together, distinct from goods market transactions, and
aggregating all such transactions in the economy, one can represent the two types of
transaction between all firms and all households as follows:
Figure 2.2 All transactions together
Total expenditure
Goods
Firms Households
Factors of production
Factor payments (income)
If we focus only on the flows of income and expenditure between firms and households
(and thus disregard the flows of factors and goods), the circular flow in the entire economy
can be represented as shown in figure 2.3:
Figure 2.3 A basic circular flow
Expenditure flow
(Payments for
goods)
FIRMS HOUSEHOLDS
(Producers) (Consumers)
Income flow
(Factor payments)
Our main concern now is the aggregate amount of real income that ends up in the pockets
of households and individuals in the bottom half of the circle. The volume of real income
flowing in the bottom half of the circular ‘tube’ depends on the volume of expenditure in
the top half. If the flow of total expenditure increases, for example, it is likely to induce
decisions to increase production to meet the increased expenditure. This implies a
corresponding adjusted level of sales and real income Y. The same is true for decreases in
2.1 The basic framework 47

expenditure, which initially lead to unsold products and stock increases, to be followed by
a drop in production, income and employment (i.e. a recession).
This reasoning provides us with the first and basic chain reaction: changes in expenditure
cause adjustments in production and real income. When production has adjusted fully to
a change in total expenditure, a situation of macroeconomic equilibrium occurs. In such
a situation, neither expenditure nor production has any further reason to change, and
therefore income stabilises on a certain level. All demand/expenditure is satisfied, and all
production is sold. At such an equilibrium, the following condition is satisfied:
Total expenditure = Total production
In Keynesian theory, both short-run fluctuations and trends in real domestic income Y
are interpreted as changes in this equilibrium, or at least as movements towards a new
equilibrium point. Therefore, it is an equilibrium approach. Changes in the equilibrium level
of income are caused and explained by changes in total expenditure.
❐ Accordingly, a low level of income and employment – a recession – is caused by a too
low level of aggregate expenditure, i.e. a demand deficiency.
Figure 2.4 The business cycle: fluctuations in real GDP relative to its long-term trend
3 600
3 100
Acute recession
Strong upswing
2 600
R billion
2 100
Severe recession
1 600
Mild recession
1 100
600
1980/01
1981/02
1982/03
1983/04
1985/01
1986/02
1987/03
1988/04
1990/01
1991/02
1992/03
1993/04
1995/01
1996/02
1997/03
1998/04
2000/01
2001/02
2002/03
2003/04
2005/01
2006/02
2007/03
2008/04
2010/01
2011/02
2012/03
2013/04
2015/01
2016/02
2017/03
2018/04
Figure 2.4 shows cyclical fluctuations in real GDP around the long-term real GDP trend (or
potential GDP) of South Africa since 1980. Note the significant fluctuations from 1980 to 1993
and in 2008–09 and the smaller fluctuations around a strong upward trend in between.
A slowdown (or mild recession) occurs when the GDP data line becomes less steep, even
though it may still be increasing. A proper recession occurs when the data line drops below
previous levels of GDP. The ‘technical definition’ of a recession is two (or more) successive
quarters of negative growth in GDP. A generic definition of a recession is: a significant decline in
economic activity spread across the economy, lasting more than a few months, normally visible
in real GDP, real income, employment, industrial production, and wholesale and retail sales.

Is a macroeconomic equilibrium a good thing?
Not necessarily, even though the concept of ‘equilibrium’, especially in the natural sciences but
also in everyday language, has a positive connotation (balance, harmony, etc). One of the main
contributions of Keynes was to show that an equilibrium does not necessarily occur at full
employment and, especially, that an economy can attain equilibrium and stabilise (stagnate) at
levels of high unemployment for considerable periods of time. In this way, he sought to explain
the Great Depression of 1929–33.
❐ This view contrasts strongly with the Classical or pre-Keynesian view that, given unfettered
markets, the economy will always tend towards a stable equilibrium with full employment.
Times of unemployment are temporary aberrations at most, in the Classical view.
❐ Today this view, or variations of it, can be found in the New Classical or Monetarist
approaches, for example (see chapter 11, section 11.3.4 as well as chapter 12, section 12.2.2).
A more complete chain reaction would run as follows:

Suppose total expenditure increases. At existing production levels, production is less than
the new level of expenditure. This will be apparent in a decrease in the stocks of producers,
which is a sign and inducement for producers to adjust their production levels to the new
expenditure levels. When (and if) they decide to do so, total production will increase
(as measured in terms of real GDP) and so will employment. The real income from the
increased sales flows to the different factors of production – managers, workers, land
owners, shareholders, other input suppliers, etc. – and real domestic income Y increases
correspondingly. This increase is bound to continue until production is equal to the new,
higher level of total expenditure – i.e. until a new and higher equilibrium level of real
income Y is reached. An economic upswing occurs.
In brief:
Total expenditure increases ⇒ stocks are depleted ⇒ increased production is induced ⇒
real GDP and real income Y increase
The role of stock adjustments is central in this chain reaction.
The entire Keynesian approach centres on this fundamental chain reaction. It enables
one to identify the likely causes of short-run fluctuations in real income Y, or the likely
consequences of fluctuations in expenditure.
❐ We will see in this chapter and others that there are different types of real expenditure
(e.g. consumption and investment) and that changes in these will cause changes in total
expenditure. Once total expenditure changes, the rest of the chain reaction remains
the same. In this way, one can gain insight into the causes of upswings or downswings
in the economy, or increases or decreases in the real economic growth rate.
The rest of the theory consists of a refined focus on real expenditure. It focuses on two
aspects:
(a) To understand and explain trends and fluctuations in expenditure as such, and
(b) To relate and translate all other disturbances and shocks in the economy – changes
in interest rates, the money supply, taxation, VAT, the gold price, the exchange rate,
the balance of payments (BoP), etc. – into one or another impact on (a component of)
expenditure. If this has been derived, the likely impact on production and real income
Y follows more or less automatically.
2.1 The basic framework 49

The income–expenditure diagram or ‘45° Figure 2.5 Equilibrium income determination
diagram’ shown in figure 2.5, is the basic
graphical aid of the simple Keynesian E
approach. This shows the real sector (or goods 45° line
sector) of the economy, and illustrates the
interaction between total expenditure E and
total production to determine the equilibrium Aggregate
level of real income Y. The graphical indication expenditure
of this level is where the total expenditure
line intersects the 45° line. Only at that level
of Y (i.e. Y0) will total production (measured
horizontally) be equal to total expenditure
(measured vertically). Any other Y level is
a disequilibrium level, since production can
be seen to be either higher or lower than Y0 Income Y
expenditure.
In other words, only at Y0 is the condition for macroeconomic equilibrium satisfied: Total
expenditure = Total production.
Any disturbance of, or fluctuation in, total expenditure is graphically reflected in vertical
shifts in the total expenditure line, with a corresponding change in the equilibrium level
of real income Y.
!
Does an economy have curves? :
The usefulness of a graphical aid for sensible economic thinking and reasoning – our main
purposes – must be understood carefully. Its use is that it can serve:
❐ as a guide or ‘road map’ to indicate where an economic chain of logic (‘chain reasoning’) must
end up, or
❐ as an ‘afterwards test’ to check whether one’s thinking on the expected chain of consequences
of a disturbance has been correct.
Therefore, graphical manipulations and economic reasoning must occur in parallel. One should
always be able to use both of these methods.
The graphical illustration as such has no economic meaning. It is not an explanation of an
economic event to say that this or that line or curve or equilibrium point has shifted. An economy does not
have curves, and curves cannot explain economic events. Graphical depictions have meaning only
if used to support and supplement economic thinking and reasoning. The latter – the economic
explanation of the dynamic path between two equilibrium points – is ultimately what matters.
2.2 The real (or goods) sector

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

Therefore:
Total expenditure = C + I + G + (X – M)
In the explanation of macroeconomic events, these types of expenditure are distinguished
because they are determined and explained by different factors, and flow from the decisions
of different agents with different motives and ways of decision making. For example, real con-
sumption expenditure patterns are determined by other factors compared to real investment
behaviour, while decisions on government expenditure are something quite different. Different
decision-makers with different concerns are at work in each case. Therefore one has to distin-
guish between them and analyse their actions separately to understand events (i.e. if one
wants to develop a theory of expenditure and income).
Expenditure components: which data?

The main source of data on the components of aggregate expenditure is the Quarterly
Bulletin of the Reserve Bank, in particular the national account section.
DATA TIP
❐ The table ‘Expenditure on gross domestic product’ summarises the main expenditure
items of the real sector. Subsequent tables give detailed information on individual
components, e.g. consumption and capital formation (investment). The data are
presented in various formats and also disaggregated in various ways.
❐ The national accounts are explained in chapter 5, section 5.6 which shows the relation
between the different accounts and tables. Chapter 5 also contains many figures with
pertinent data on expenditure components.
The graph in figure 2.6 shows the behaviour of the main domestic expenditure components
for South Africa since 1960: consumption expenditure by households, gross fixed business
capital formation, and total expenditure by general government (all in real terms, constant
2010 prices). Observe the relative magnitudes of these categories of expenditure and
Figure 2.6 The components of aggregate expenditure (in real terms – 2010 prices)
2 000
1 800
Household consumption
1 600
1 400
1 200
R billion
1 000
800
600
Government expenditure
400
Business capital formation

200
0
1960/01
1961/04
1963/03
1965/02
1967/01
1968/04
1970/03
1972/02
1974/01
1975/04
1977/03
1979/02
1981/01
1982/04
1984/03
1986/02
1988/01
1989/04
1991/03
1993/02
1995/01
1996/04
1998/03
2000/02
2002/01
2003/04
2005/03
2007/02
2009/01
2010/04
2012/03
2014/02
2016/01
2017/04
2.2 The real (or goods) sector 51

how they behave in relation to the upswings and downswings in real GDP. Note that both
household consumption and the fixed capital formation cycle broadly correspond with the
GDP cycle, although clearly more complex causalities are at work.
Traditionally, consumption and investment constitute the core of the theory, with other
components added on.
2.2.1 Real consumption

Real consumption C pertains to expenditure by households on consumable items and
services such as clothing, food, sport, movies, transport, medical services, books, pencils,
computers, fridges, lawnmowers and vehicles. Expenditure on imported items is included
in total real consumption expenditure.
❐ Total consumption expenditure is usually a very stable component of aggregate
expenditure.
❐ The national accounts for South Africa, discussed in more detail in chapter 5, section
5.6 (and for which data tables can be obtained from www.resbank.co.za), distinguish
between ‘consumption expenditure by households’ and ‘consumption expenditure by
general government’. This section deals with ‘consumption expenditure by households’,
usually denoted by C, while a later section deals with ‘consumption expenditure by general
government’, usually denoted by, or as part of, G. When discussing ‘consumption’ in this
book, ‘consumption expenditure by households’ is meant.
On what does consumption depend?

If one wishes to explain consumption expenditure, one usually thinks of the purchases
by individuals or consumers. Business enterprises also buy consumable items. In most
economic reasoning we will usually think mainly in terms of individuals or households.
Real consumption C depends on (or, is a function of) real disposable income YD, wealth,
the average price level, expectations, habits, etc.
C = f(real disposable income YD; wealth; expectations; habits;
demographic factors, etc.)
This means that the decisions to spend income on consumption goods largely are
determined (or caused) by these factors. Some of these factors have a positive impact on
consumption expenditure, others a negative impact.
❐ Of all these factors, the most important is the level of real disposable income YD.
Disposable income is the part of income Y that remains after taxation T has been paid
or subtracted (YD = Y – T).
❐ If real disposable income increases, individuals and households are likely to increase
their consumption spending. Decreasing real disposable income will depress total
consumption. Therefore, there is a positive relationship between real disposable income
and consumption.
❐ The part of disposable income that is not spent on consumption is saved. Therefore
saving also depends on disposable income.
❐ The essence of the relationship between real consumption and real disposable income
can be found in the marginal propensity to consume (MPC).
❐ A tax increase will decrease disposable or after-tax income, which should discourage
consumption spending. Here one finds a negative or inverse relationship between taxes
and consumption.

✍ One can distinguish between durable, semi-durable and non-durable consumption, as well as
services. Can you mention examples of each?
_______________________________________________________________________________________
_______________________________________________________________________________________
_______________________________________________________________________________________
Visit www.resbank.co.za and download the annual data series, both at constant and current
prices, for total, durable, semi-durable and non-durable consumption, as well as services for the
period 1990 until the latest year available. Place these on a couple of graphs and describe what
you see. What is the difference between the constant and current prices?
_______________________________________________________________________________________
_______________________________________________________________________________________
Which percentage of gross domestic expenditure (GDE) does consumption C represent in South
Africa (approximately)?
_______________________________________________________________________________________
✍ Define the marginal propensity to consume (MPC). How is it related to the marginal propensity to
save (MPS)?
_____________________________________________________________________________________
_____________________________________________________________________________________
❐ If levels of wealth increase, people are better off, which encourages consumption spend-
ing. It is reasonable to expect a positive relationship between wealth and consumption.
A prominent example is the positive effect of rising stock market prices on wealth and
thus on consumption.
❐ If the average price level increases, the real value of assets will decrease. This decreases
the wealth of people and discourages consumption. In this way, the average price level
can have a negative impact on consumption.
The consumption function
The relationship between real consumption and real income, i.e. the consumption function,
can be expressed in mathematical terms as:
C = a + bY + . . . ...... (2.1)
This function can be depicted graphically on the income-expenditure diagram, as in
figure 2.7. The consumption line shows, for each level of Y (real income), the corres-
ponding level of C (real consumption expenditure in the country), e.g. Y0 and C0 in the
figure. It depicts the overall behaviour of consumers and largely explains the level of
consumption in terms of real income.
The positive slope indicates the positive relationship between real consumption and real
income: as income Y increases, an increase in consumption C is induced. When income
decreases, consumption should decrease. The induced change in consumption expendi-
ture is less than the change in income, therefore 0<b<1.

❐ The slope of the consumption function is Figure 2.7 Keynesian consumption function
directly related to the marginal propensity
C
to consume. (How?)
❐ Graphically, any change in consumption
due to a change in Y is indicated by a
movement on or along the C line.
❐ A change in one of the other factors that C0 C = a + bY
determines consumption implies, graph-
ically, a shift of the C line. If wealth levels a
increase, for example, the C line is shifted
upwards. If taxation is increased, the C
line is shifted down. For simplicity, these
factors are captured by changes in the
intercept a in the consumption equation.
0
Y Income Y
The intercept term, a, thus represents auto-
nomous consumption, i.e. the portion of
consumption that is not sensitive to income levels and would occur irrespective of the level
of income. It can be interpreted, for instance, as a minimum existence level of consumption.
More complex relationships between consumption and income

The above consumption function is known as the ‘Keynesian consumption function’, as John
Maynard Keynes was one of the first major economists to define the relationship set out above
between income and consumption. After Keynes, a number of economists have suggested
more complex relationships between income and consumption. For instance, in his Relative
Income Theory, James Duesenberry has argued that consumption is not so much determined
by the absolute level of income but also by the income of the individual or households relative
to that of friends or neighbours, or relative to higher levels of their own income in an earlier
period. The latter implies that households are reluctant to scale down consumption if income
decreases after a period with higher levels of consumption.
Duesenberry’s Relative Income Theory was an early attempt to refine Keynes’s consump-
tion theory. However, the best-known consumption theories following Keynes are the Per-
manent Income Hypothesis of Milton Friedman and the Life-cycle Hypothesis of Franco
Modigliani.
Permanent income: Friedman argues that a household’s consumption depends not so much
on the current income of a household at a certain time but rather on the level of income
that this household expects to earn normally.
❐ What a household considers as normal depends on what it expects to earn in future.
This level of normal income is called its ‘permanent income’ and is distinguished from
unexpected, ‘transitory income’ – usually measured as the difference between its
actual and permanent income.
❐ When actual income decreases to below its normal or permanent level, households will
borrow or use savings to sustain consumption levels. When actual income increases
above the normal or permanent level, households will rather save than consume more.
This implies an element of stability in consumption patterns, since the consumption
expenditure of households will not react much to temporary or transitory increases or
decreases in income.

Consumption smoothing and life-cycle income
The Keynesian consumption function is altered to become:
Y
  1  (Yt + ∑t +  i 
N
Ct =  
T
   t + i i + At )
(1 + r)
where Ct is current consumption (in period t), Yt is current wage income (in period t), Yt + i is
expected future income in period t + i, r is the discount rate used to arrive at the present value
Yt + i
of the future income, ∑     , At is the present value of wealth (e.g. bonds, shares or property),
(1 + r) i
N is the amount of years that the individual expects to work and T is the amount of years that
the individual expects to live.
❐ Essentially this equation states that individuals sum all their current and expected future
income, add their existing wealth, and then divide it over the amount of years that they
expect to live, so as to establish what amount they can consume per period.
❐ From this equation it can be seen that a R1 change in Yt will cause consumption to only
Y
change by the rand amount __  Tt  
❐ If consumption in a particular period does not match income, individuals can borrow
money at the prevailing interest rate. This introduces a role for the interest rate into the
consumption function. In addition, a higher interest rate will decrease the value of wealth
(i.e. bond and share prices, even house prices), which in turn will cause a decrease in
consumption.
Life-cycle income: According to this theory, households and individuals plan their
expenditure given an expected pattern of income over their entire lifetime. Young people,
who have relatively low earnings, will borrow to support higher levels of consumption
– in expectation of higher earnings later in their careers, when the debt can be repaid.
This later period in their careers, with its higher earnings, is also used to save for old age,
when income is likely to fall below consumption. This also means that consumption does
not only depend on income but also on assets (wealth). All this means that consumption
is likely to be relatively stable over the life cycle, and will in any case vary less than
income – a phenomenon called consumption smoothing. Therefore, this argument
implies an element of stability in this component of expenditure.
The permanent income and life-cycle hypotheses both require an alteration of the Keynesian
consumption function. They imply that consumption becomes a function of income over a
longer time horizon. More specifically, a household’s consumption depends not so much on
current income but on the expected future income stream of the household, plus its wealth.
Thus consumption will be averaged, or smoothed, across periods and will be less volatile than
income when income varies across periods.
❐ Note that consumption in these al ternative theories does not include durable
consumption. The latter is considered as investment from which households derive
a benefit (called an imputed income). The total amount spent on buying a car or a
washing machine, for example, is not included in the consumption of the period in
which it was purchased. Rather, the benefit (consumption) is spread over the life span
of the asset. (This means that the annual depreciation of the asset must be counted as
part of consumption.)

The distribution of income: It is likely that poor, middle-income and rich households have
different marginal propensities to consume. Poor households usually have a higher MPC – they
have little choice but to consume most of their income. A redistribution of income from high-
income to low-income households can, therefore, cause an increase in total consumption.
Poor households are also often constrained in their ability to borrow. Thus, poor households
might not be able to smooth their consumption over time and they are, therefore, much more
exposed to the effects of income fluctuations.
These alternative theories are important if one wants to understand empirical patterns
in income and consumption in depth. For understanding most macroeconomic chain
reactions, they are of lesser importance, though, and it is sufficient to work with the
simple Keynesian consumption function most of the time (although there are a couple of
notable exceptions).
2.2.2 Real investment (capital formation)

Real investment I is the purchase of production or capital goods, for example factories
or machinery – real assets on which a return is expected from the sales of production.
(Expenditure on imported capital goods, e.g. machinery, is included in total investment.)
❐ Typically, real investment is a very unstable element in the economy. It is one of the
main sources of instability in a market economy.
❐ In the national accounts, investment is called ‘capital formation’. These two terms are
synonymous and are used interchangeably in this book.
❐ Study the behaviour of investment (business capital formation) in figure 2.6 to get a
feel for its relative size and its movement over time and over the business cycle.
✍ What is the difference between financial investment and real investment?

Financial investment is the purchase of financial assets, whereas real investment (capital
formation) is the purchase of real assets. The term ‘capital formation’ clearly indicates this.
Financial investment, however, is a form of saving. What is the role of the interest rate in the
case of financial investment, e.g. in deciding to invest in a savings account or certificate, or
another financial asset?
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
Is a purchase of shares real investment (capital formation) or financial
investment?
Does it depend on whether the shares are in a new project or existing shares? Are share
issues usually for specific investment projects or for a general addition to operational capital?
Does an investor usually know this? Does it matter?
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________

More specifically, what is of concern here is fixed investment: gross fixed capital formation
comprises the following components: residential buildings, non-residential buildings,
construction, transport equipment, machinery and other equipment.
The other (non-fixed) part of gross investment is change in inventories (or inventory
investment). This is merely a change in the unplanned and unsold inventory of produced
goods due to an imbalance between total production and total expenditure. It is not
investment in the true sense of the word. The value of change in inventories can also be
negative, i.e. when stocks are depleted in times when production is lower than sales.
Both these categories of real investment can also be divided according to the type of
institution involved – investment by private business enterprises IP, by public corporations
IPC and by general government IG.
Net capital formation differs from gross capital formation due to ‘consumption of fixed capital’,
which, in an accounting sense, can be understood as ‘allowance for depreciation’. Consumption
of fixed capital is supposed to measure that part of gross investment funds that is used for the
replacement of, for example, machinery. Net capital formation indicates the net addition to the
total capital stock.
In practice, it is not actual replacement that is measured, but an estimate of the wear and tear
or depreciation of assets over their normal life span.
The question is which types of investment to include. In macroeconomic reasoning,

one is usually concerned with explaining the investment activities of private business
enterprises. This is because general government investment IG, which is done by
government departments, is driven and explained by a very different set of factors,
mostly social and political. However, the behaviour of government business enterprises
or ‘public corporations’ is not that dissimilar from that of private firms in so far as they
have to avoid losses and must be active in capital markets. Also, investment by public
corporations IPC is not included in the concept of total government expenditure G, which
we will encounter in section 2.2.5, and thus not in the national budget either (the topic
of chapter 10). To ensure alignment with the latter, we will include investment by public
corporations in our definition of aggregate investment as comprising private and public
business fixed investment:
I = IP + IPC
(Of course, some investment, e.g. in houses – i.e. residential investment – is done by
households. However, residential investment is relatively stable. In any case, it is not seen
as a driving force in economic growth or the business cycle in the way business investment
is. Hence the focus here is on understanding and explaining (private and public) business
fixed investment (capital formation).
In the national accounts and in published investment figures in for example the Quarterly
DATA TIP
Bulletin of the Reserve Bank, gross capital formation comprises investment by all three
groups: private firms IP, public corporations IPC and government IG. One must therefore be
very careful when using investment figures for macroeconomic analysis: one must select
the non-government components of gross investment (capital formation).

✍ Approximately what percentage of gross domestic expenditure (GDE) does business investment
constitute in South Africa?
______________________________________________________________________________________
Which factors determine business real investment?

The decisions of private and public business enterprises to invest largely depend on, and
are strongly influenced by, the following factors and variables:
Investment = f (real interest rates; expectations; business confidence;
regulations, etc.)
Real investment and the real
interest rate have an inverse or Sensitivity vs. elasticity
negative relationship: an increase This book refers to parameters in equations such
in the real interest rate is likely as b and h as indicators of sensitivity. As slope
to discourage capital formation, parameters, they denote the absolute change in one
while a decreased real interest variable due to an absolute change in the other, such
rate is likely to stimulate capital ∆x  
as   
∆y
formation. This is so because the Some macroeconomics textbooks incorrectly call
real interest rate is the opportu- these parameters elasticities. An elasticity measures
nity cost of capital formation. the percentage change in one variable due to a
❐ The meaning of the term the percentage change in the other:    %∆x 
 
%∆y
real interest rate was noted
One would only be able to call these parameters
in the introduction, and is
elasticities if, instead of the actual values of
explained in detail in the box say, consumption and income, one uses natural
on the following page. Basically logarithms of both the left- and right-hand variables.
it is the after-inflation rate of
interest. It is very important to
distinguish it from the nominal interest rate. Real investment behaviour is sensitive to the
real interest rate.
What is the meaning of the last statement? The real interest rate represents the return
that one could have earned by buying and holding bonds, and which one now forfeits
by investing in a real asset. Therefore it amounts to a cost item. Given expected rates of
return on planned investment projects, an increase in the interest rate (opportunity cost)
will make some projects, that were projected to be marginally profitable before, unviable
propositions. As a consequence, some projects will not be undertaken, i.e. real investment
is likely to decline.
❐ Note that it is not the real interest rate as such that is of importance, but the comparison
of the real interest rate with the expected real rate of return on the planned investment
project.
More formally, we can represent a very simple relationship between business investment I
and the real interest rate r as follows:
I = Ia  hr …… (2.2)
In this equation Ia is autonomous investment, i.e. the level that investment will be if the
interest rate is 0%. It can be understood to capture all the other elements listed in the
general formulation of the investment relationship above.

Nominal and real interest rates – making sense in an inflationary context
Everyday experience in an inflationary environment can lead to confusion with measurements. This is
particularly true of interest rates.
If there is inflation a distinction should be made between nominal and real interest rates.
❐ Nominal interest rates are the rates usually mentioned when the bank charges a customer, say, the
‘prime rate’, or ‘prime-plus-one’, or when the Reserve Bank announces a change in the repo rate.
❐ Real interest rates are the effective interest rates after the eroding effect of inflation has been
removed.
A lender lending, for example, R1 000 to a borrower for a year would want a large enough amount of
money back after that year, first to provide a real return on the loan, and second to compensate for the
reduced buying power of every rand due to inflation. The real interest rate does the former. The nominal
rate is higher because it must also include compensation for inflation.
What then is the relationship between the nominal interest rate, the real interest rate and inflation, and
how does one calculate the real rate? There is a simple formula for this:
1 + i = (1 + r)(1 + π)
where i is the nominal interest rate, r is Numerical examples
the real interest rate and π is the inflation
rate. The nominal rate thus comprises the Suppose the real rate is 4% and inflation is 10%. Then the
following elements: nominal interest rate is:
i = r + π + rπ Correct formula:
Since the last term of this equation, rπ, i = 0.04  0.1  (0.04)(0.1) = 0.144 (or 14.4%)
usually is negligibly small, one can
Approximate formula:
approximate the nominal interest rate as:
i ≈ 0.04  0.1 = 0.14 (or 14%)
i≈r+π
The approximate formula for the real interest rate is:
r≈i–π
while the precise formula is:
 11 ++ πi   
r = _____ –1
The approximation can only be used when inflation and the real interest rate are fairly low.
The minus in the equation indicates that the relationship between I and r is inverse, i.e.
when the real interest rate increases, investment will decrease. The parameter h indicates
the sensitivity of investment to changes in the real interest rate r. A larger h indicates that
investment is relatively more sensitive to a change in the real interest rate.
Graphically, the investment–interest-rate relationship can be depicted as in figure 2.8. Note that,
uncommonly, the dependent variable I is on the horizontal axis, and the independent variable r
on the vertical axis. Thus the intercept term of the investment function is on the horizontal axis.
The inverse economic relationship between real investment I and the real interest rate
r is reflected graphically in a negative slope. Changes in the interest rate will influence
and determine the level of investment. Graphically, this amounts to a movement along the
investment curve or function.

✍ This negative relationship is true whether one borrows funds for capital formation or whether one
uses one’s own funds. Why?
______________________________________________________________________________________
______________________________________________________________________________________
Is there a positive or a negative relationship between financial investment and interest rates?
Why?
______________________________________________________________________________________
______________________________________________________________________________________
❐ The intercept will change – and the line will shift right or left – if one of the factors
contained in Ia (e.g. business confidence) changes.
Note that business investment (capital formation) in South Africa often does not react
strongly to changes in real interest rates.
Figure 2.8 The investment function
Factors such as tax incentives and depreciation
allowances, or decentralisation incentives, are r
often more important, if not decisive, in the
determination of investment in South Africa.
r0
❐ Graphically, changes in these factors will
shift the investment curve, since they will
be reflected in a change in Ia. (Why?) r 1
In addition, the degree of business confidence

in the long-term prospects of the economy is
of critical importance, since investment is a
long-term decision and commitment. This is of
particular relevance in the post-1994 period,
when the expectations of both domestic and
foreign investors regarding the future of the l0 l1 la l
South African economy – and the economic
policies of the government – have been and
are likely to continue being more decisive Figure 2.9 Investment in the 45° diagram
than interest rates in determining investment
patterns. l
❐ Changes in confidence and expectations will 45° Line
shift the curve in the diagram.
❐ The potent influence of expectations and
psychological factors is one reason why
investment can fluctuate wildly at times.
❐ A factor that often influences expectations is
the exchange rate. (How? Why?) I1
In the income–expenditure diagram (the 45°
l0
diagram, which does not have the interest
rate on one of its axes), investment is depicted
as a horizontal line at the level of investment
determined in the diagram (see figure 2.9). In Income Y

this way we are provided with a channel for interest rates to influence total expenditure in
the 45° diagram.
Any change in the level of real investment, due to either an interest rate change or some
other relevant factor, implies a parallel shift of the I line in the 45° diagram.
2.2.3 Macroeconomic equilibrium: the basic idea

The basic concept of equilibrium between total expenditure and total production, and the
corresponding graphical analysis of equilibrium in the 45° diagram, was explained above.
If one assumes, for a moment, that consumption and investment are the only kinds of
expenditure in the economy, together they constitute total expenditure.
Graphically, the C line and the I line can be added vertically to form the total expenditure
line. Together with the 45° line, the equilibrium level of real income Y is determined.
Investment as such is graphically depicted in the second diagram we encountered. The
two diagrams can be placed alongside each other as in figure 2.10:
Figure 2.10 Basic macroeconomic equilibrium
r E
r0
C + I0
C
l0 l
l0 Investment l Y0 lncome Y
At the equilibrium
Total expenditure = Total production
or, for this simple case with only consumption and investment expenditure,
C + I = Total production
Since production must be identical to income – all revenue from production sold must flow
to some production factor in the form of income – one can also describe the equilibrium as
the point where:
C + I = Y
Inserting the illustrative equations used above, this statement can be refined to:
Y = a + bY + Ia – hr ...... (2.3)
This statement describes the equilibrium for this simple, illustrative case. (See section 2.2.6
for the general case.)
❐ But it is more than that. It is an equilibrium condition – it constitutes the requirement or
prerequisite for equilibrium in the real sector.

2.2.4 Changes in the equilibrium: multipliers
The basic tools to analyse changes in the economy are available to us now. Although
the model still is very simple, one can already construct much more comprehensive
macroeconomic chain reactions. For example:
Suppose real interest rates fall. (The next chapter will explain why that can happen.) This
decreases the opportunity cost of investment. More planned investment projects become
potentially profitable and viable. Therefore, investment is encouraged. If investment does
increase, total expenditure and sales increase. This will cause a decline in inventories, which
is a sign and an incentive for producers to decide to increase production. When (and if) they
do increase production to match the higher level of expenditure, GDP and real income will
increase. The economy experiences an upswing. In brief:
r  ⇒ I  ⇒ total expenditure  ⇒ production  ⇒ Y 
Having gone through the logic of the economic chain reaction, one can now use the diagram
to test whether the above reasoning was correct. One does that by indicating the chain of
events on the two diagrams as in figure 2.11:
Figure 2.11 Changes in the macroeconomic equilibrium
r E
r0
C + I1
r1
C + I0
l1 l1
l0 l0
l0 l1 Investment l Y0 Y1 lncome Y
Was the chain of reasoning above correct or incorrect?
!
It is critically important not to go about these chain reactions or sequences of events in a
mechanical fashion. The various parts and actors in the economy do not fit together like
gears in a machine. People make choices and decisions – wise or unwise, responsible
or irresponsible. Each transition between steps is uncertain and subject to delays. An
expected change will not necessarily occur, or will not occur immediately or when expected.
One reaction may be weak, another strong. At most one should speak of incentives,
encouragements or discouragements. It is best to think of each reaction being likely (at most).
(Perhaps one should indicate this by placing a small question mark above each horizontal
arrow in the chain reactions.)

✍ Repeat the example above for an increase in interest rates. Also show this in a diagram.
✍ If someone were to state that a reduction in interest rates will stimulate the economy and that
this therefore amounts to good news, (a) would you agree with that persons, and (b) would you
know exactly why he or she is right or wrong? Are lower interest rates beneficial for all people in
the economy? Why or why not?
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
(Some more considerations are encountered in chapter 3.)
The expenditure multiplier

The core of the idea of the multiplier is that any change in real expenditure ∆Exp – i.e. any
injection of expenditure into, or withdrawal of expenditure from, the circular flow – will
eventually lead to a change in equilibrium real income ∆Y significantly larger than the
original injection (or withdrawal).
The size of the multiplier K is the ratio between the eventual, cumulative change in Y
(i.e. ∆Y) and the original change in expenditure that caused it, i.e.
∆Y
KE = _____
 ∆Exp   
It can be seen on the 45° diagram in figure 2.12.

The value of the multiplier shows the extent Figure 2.12 The multiplier effect
to which an expenditure injection (or
withdrawal) is amplified or multiplied. E
The multiplier effect can be explained by refer
ence to the existence of a multiplier process. The
crux of the multiplier process is that a number
of rounds of respending follow an initial injection
of expenditure. Each amount that is spent is
received by somebody else, and becomes that E Aggregate
person’s income. Of this, a certain percentage expenditure
will be respent (depending on the marginal
propensity to consume).
This yet again becomes another person’s
income, who spends part of it, and so forth –
Y lncome Y
until the process peters out. The cumulative

change in income, i.e. the sum of each of these individual increases in income – will
therefore be much higher than the initial increase (injection) of expenditure and income.
That is, the initial injection is multiplied or amplified.
How large this cumulative sum of all the respending is will depend on the portion of
spending that is returned to the circular flow in each round, i.e. the percentage respent –
or, the percentage that does not leak from the income–expenditure stream. The larger the
leakage from the domestic expenditure flow in each round – e.g. in the form of savings,
taxation, or spending on imports – the smaller will be the cumulative total, and therefore
the smaller will be the value of the multiplier. In this way, one can see that the value of the
expenditure multiplier will be inversely related to the percentage leakage in each round.
It can be mathematically shown that
1
KE = __________________
  marginal
    
leakage rate
 
Thus the value of the multiplier depends on factors such as the marginal propensity to
save (MPS), the marginal propensity to import and the marginal income tax rate – all
related to forms of leakages from the expenditure–income flow.
We can illustrate this in our simple model with only consumption and investment.
A multiplier can be derived from the equilibrium condition stated above:
Y = C+I
After substitution of the consumption and investment functions, it becomes:
Y = a + bY + Ia – hr
(  1
= ____ )
  1 –  b   (a + Ia – hr) ...... (2.4)
1
where   is the multiplier KE and (1 – b) is the marginal leakage rate given for the above
1 – b  
equations of C and I.
This formula for KE is not generally correct. It recognises only one form of leakage: (1 – b)
is the marginal propensity to save or MPS. It is especially wrong for an open economy with
a significant degree of imports and with taxes.
❐ Remember that at this stage our model is still a simplified one that excludes government
and the foreign sector. These restrictions will be relaxed later.
❐ Calculations of the value of the multiplier with this formula produce unrealistically large
values.
Nevertheless, the formula in terms of the marginal leakage rate can be applied generally,
if one incorporates such leakage rates as the marginal propensity to save, the marginal
propensity to import, and the marginal income tax rate. The exact mathematical formula
for KE will in each case depend on exactly how each function in the macroeconomic model is
formulated mathematically (see maths box in section 2.2.6).
❐ Find out for yourself why the value of the multiplier depends on the size of MPC by
investigating how the multiplier process and the value of KE change if MPC increases
or decreases. Also experiment with some of the other leakages.
❐ In practice, the value of the multiplier is between 1 and 2.
The multiplier effect is valid for any injection (or withdrawal) of expenditure, i.e. any
vertical shift in the total expenditure line due to changes in government spending, taxation,
exports and so forth.

2.2.5 Real government expenditure and taxation
Government expenditure concerns the purchase of goods and services by the general
government. This may vary from pencils to roads to policing services to army tanks. A
large portion of real government spending goes towards the payment of wages and salaries
of public servants.
While the terms ‘government’ and ‘the state’ are used indiscriminately in everyday speech,
here one should be more specific. General government comprises the central government,
provincial governments, as well as local governments (municipalities). It does not include
public corporations.
Warning: Where data and measurement are concerned, the government sector is one of
the most complex (and confusing) areas of economics. Published data, even in tables in
the same publication, are often difficult to reconcile or they may even be contradictory.
This is due to reasons such as the following:
❐ Different definitions of ‘government’ or ‘public sector’ and the inclusion or exclusion of
different public institutions (universities, public corporations, etc.);
❐ Different data systems, e.g. the System of National Accounts (SNA) as against the
Government Finance Statistics (GFS), each with its own interpretations, objectives,
bases, rules and conventions;
DATA TIP
❐ Different institutions that process data for different purposes, e.g. the Reserve Bank
as opposed to the National Treasury, which publishes its own budget figures in a
particular way.
For macroeconomic analysis, national accounts measures are best. You should, however,
always be very careful. (Even in the public debate, government data and concepts are often
used incorrectly.)
❐ Whenever you want to analyse the budget in some detail, national accounts data are not
suitable. See the analysis that is supplied annually in the Budget Review, published by
the National Treasury.
❐ Always be very careful to ascertain where you work with nominal data or real data.
See chapter 10, section 10.1 and addendum 10.1. See also Mohr (2019) Economic
Indicators, Van Schaik, chapter 10.
We define total government expenditure G as the sum of general government consumption

expenditure and general government investment.
❐ Note that many textbooks define G as government consumption expenditure only. One
reason for this is that it corresponds to the practice in the national accounts, the main
source of macroeconomic data, as well as in the national accounting identities (see
chapter 5).
❐ For the sake of consistency throughout this book, we will indicate government
consumption expenditure with the symbol GC.
The graph in figure 2.13 shows the two main components of total government expenditure,
i.e. government consumption expenditure GC as well as investment (capital formation) by
general government IG in South Africa since 1960.

G and government investment
In national accounts data only consumption expenditure by the general government is
indicated separately. Government investment is included in the gross capital formation
DATA TIP
(investment) figure.
❐ Capital formation tables show a breakdown of investment between general
government, government enterprises and public corporations.
Total government expenditure G must thus be calculated as the sum of general
government consumption expenditure and fixed capital formation by general government.
See chapter 10, section 10.5.1 and addendum 10.1. Also see Mohr (2019) Economic Indicators.
✍ What percentage, approximately, of gross domestic expenditure (GDE) does total government
expenditure constitute?
______________________________________________________________________________________
What percentage, approximately, of gross domestic expenditure (GDE) does general government
consumption expenditure constitute?
______________________________________________________________________________________
What portion, approximately, of that is spent on wages and salaries?
______________________________________________________________________________________
Figure 2.13 Components of government expenditure as % of GDP

30
25
Total government expenditure
20
Percentage
Government consumption
15
10
5
Government capital formation
0
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
Note the peak in government consumption expenditure in the late 1980s and early 1990s,
as well as the decline under the new policy regime after 1994. For government capital
formation, the noticeable thing is the significant decline since the mid 1970s – a decline
that has not been reversed, despite a small and transient uptick in 2006–08.

In macroeconomic reasoning we often ignore most of the institutional and definition
problems and broadly treat the general government in terms of total government
expenditure G and total taxation T. While this does not correspond one hundred percent
with budget figures and practices, for the purpose of macroeconomic analysis it is
close enough.
Government expenditure and taxation are the main elements of so-called fiscal policy.
Government borrowing to finance budget deficits is a third important element of fiscal
policy (see chapter 10 for a detailed discussion of fiscal policy).
These are primarily the administrative responsibility of the National Treasury, i.e. the
government department that handles the ‘purse’ of central government. However, in the
final instance, it is the decisions of the national government, more specifically the national
Cabinet, that determine fiscal policy and the national budget.
In macroeconomic reasoning, one usually regards government expenditure and taxation
decisions as exogenous or autonomous, i.e. as political decisions under full control of the
government. These decisions are taken ‘outside’ the economy (therefore exogenous).
Real government expenditure G is a direct component of total real expenditure and
influences it directly and fully.
❐ In the 45° diagram, as shown in figure 2.14, G (just like I) is shown as a horizontal line,
at the level of real government expenditure. It is then simply added, vertically, to the C
and I lines to get the total expenditure line.
❐ Also note that, whereas the equilibrium condition is Y = C + I in the absence of
government, with government it becomes Y = C + I + G.
Figure 2.14 Macroeconomic equilibrium with government expenditure
r E
r0
C + I0 + G0
C + I0
C
G0 G0
l0 l0
l0 Investment l Y0 lncome Y
Any increase in G has the same direct impact as any other direct increase in expenditure.
Graphically the expenditure line is shifted upwards by the exact amount of such
an increase.
❐ The expenditure multiplier KE also applies to changes in G: the eventual change in Y
exceeds the initial change in G by a factor equal to the multiplier.

Taxation has an indirect effect on equilibrium income, i.e. via its impact on disposable
income and, in that way, on consumption. The consumption function must be adapted to
show the introduction of tax:
C = a + b(1  t)Y ...... (2.5)
where t is the tax rate on income. Thus (1 – t)Y is after-tax or disposable income. Note that
we simplify by assuming that all individuals pay the same tax rate, which is usually not
the case. We also ignore other types of taxes. Although this simplification can be relaxed
(e.g. to consider also a progressive tax rate system where individuals with higher income
pay a higher average tax rate), we maintain it to demonstrate the underlying impact of an
income tax on consumption.
❐ Graphically, the consumption function is shifted up or down as a result of tax changes.
❐ Since there is now an additional leakage from the expenditure due to the payment of
tax, the expenditure multiplier will differ from the no-tax case. Whereas the expenditure
1
multiplier was equal to   , with tax (and government expenditure G) we now have:
1 – b  
Y = C+I+G
which becomes:
Y = a + b(1 – t)Y + Ia – hr + G
(  1
=   )
     
1 – b(1 – t)
(a + Ia – hr + G). ...... (2.6)
The marginal leakage rate is larger when there is an income tax in the model. Thus the
expenditure multiplier is smaller.
❐ If the tax rate t is higher, (1 – t) will be smaller; this increases the denominator of the
multiplier, and decreases the value of the multiplier. (Can you see that? The larger is t,
1
the smaller is b(1 – t), the larger is 1 – b(1 – t), and thus the smaller is  , which is
 1 – b(1 – t)  
the expenditure multiplier.)
The tax multiplier

Since a tax increase is partly financed by the individual or households who consume less and
save less – the impact of the higher tax falls only partly on consumption – consumption will
decrease by less (and the C line will shift by less) than any increase in total taxation. However,
that (reduced) decrease in expenditure will experience the normal multiplier process.
❐ Therefore, the tax multiplier KT is smaller than the expenditure multiplier by a factor
equal to the marginal propensity to consume MPC:
KT = MPC × KE
❐ This means that a Rl million increase in government expenditure, for example, will
not have the same impact on equilibrium income Y as a Rl million reduction in total
taxation. The former has a larger impact.
❐ A balanced increase in the budget – equal increases in government expenditure and
taxation – will therefore have a positive net impact on Y. (This is the ‘balanced budget
multiplier’ result. See whether you can establish this by considering an increase in G of
R1 000 that is financed by an increase in T of R1 000.)

✍ Tax reduction ⇒ _______________________________________________________________________
______________________________________________________________________________________
Graphically:
Does your economic reasoning tally with your graphical results?

How would the graphical analysis change if the tax reduction was specified as a cut in the
average tax rate? (See remark 4 below.)
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
Remarks
1. An increase in G and a reduction in T are both examples of expansionary fiscal policy
(and vice versa for restrictive policy).
2. In any discussion of the consequences of a change in government expenditure G,
one should analytically handle them in isolation, i.e. one should not automatically
assume that taxation T will be increased to finance the higher level of spending. Likewise,
a tax change should not be taken automatically to imply a corresponding change in
expenditure. If G and T both do happen to change, analyse first the one and then the
other to finally derive the net impact.
3. In practice, a large portion of taxation is in the form of income taxation. This implies
that the tax revenue of government is a function of total income: if income Y increases
during an upswing, income tax revenue of the Treasury will also increase, even in the
absence of an increase in the tax rate.
4. The graphical analysis of a change in taxation is complicated by the difference
between types of taxation. Only for a very simple kind of tax (a ‘lump sum’ tax where
everybody pays the same amount of tax irrespective of income levels) will a tax
change be depicted, in the 45° diagram, as a parallel shift of the consumption line.
In real life, the most important type of tax is income tax, where the total amount
of tax paid varies with the level of income. If it is a proportional tax (the example
we use here for simplicity), the percentage of tax deducted from income remains
constant, e.g. 25% means T = 0.25Y. Thus, the average tax rate remains unchanged

as income increases. If it is a
progressive tax, the percent Automatic stabilisers
age of tax deducted increases Since income tax payments increase when the
as income increases; the economy is in an upswing phase, total taxation T
average tax rate will increase increases in the process. This has a constraining
as income increases. In both effect on total expenditure, which will hold back
cases the total amount of the upswing. This effect automatically tempers the
tax T paid will be more at upswing. Similarly, in a downswing phase, income
higher levels of GDP than tax payments will automatically decrease, which
stimulates expenditure and restrains the severity of
at lower levels of GDP. In
the downswing. In this way, income tax serves as an
both cases, a decrease in
‘automatic stabiliser’ of the business cycle.
the average income tax ❐ This also implies that income tax is yet another
rate does not produce a factor that effectively decreases the value of the
parallel upward shift in the expenditure multiplier.
consumption function, but
rather rotates the C line up
wards (anticlockwise) from its intercept with the vertical axis: the slope of the C
line increases, without any change in the intercept. Doing the same activity as on
the previous page for the case of a reduction in income tax will thus have a different
graphic result from the simple tax reduction case. (In the latter case, there would
be a parallel upward shift of the C line.) Note, however, that the resultant change in
equilibrium income Y will be in the same direction for both cases.
2.2.6 Real exports and imports (introductory)

The South African economy is ‘open’: a large part of total production is exported, and a large
part of total expenditure is spent on the purchase of imported items. Therefore international
trade affects the pattern of expenditure and production decisively. It is therefore essential to
understand fully the macroeconomic effect of foreign trade transactions.
✍ How ‘open’ is the South African economy? What percentage of South African GDP is exported
annually? _____________________________________________________________________
______________________________________________________________________________
What percentage of South Africa’s gross domestic expenditure (GDE) is spent on imported
items, i.e. effectively ends up in the pockets of foreign producers?
______________________________________________________________________________
The graph in figure 2.15 shows South African imports and exports in real terms since
1985 (at constant 2010 prices). Real exports and imports are elements of ‘expenditure on
gross domestic product’. The gap between the two shows net exports, which is an indication of,
but not equal to, the state (deficit or surplus) of the current account of the balance of payments
(see chapter 4). A close correlation between import fluctuations and GDP fluctuations can be
observed, e.g. during the long upswing since 2000. Also note the significant increase in
both exports and imports, in real terms, since the early 1990s, indicating a significant
increase in external trade.

Figure 2.15 Exports and imports (in real terms – 2010 prices)
1 200
1 000
800
Real imports of goods and services
600
Real exports of goods and services
R billion
400
200
0
Real exports minus real imports
–200
2016/03
2018/01
1994/01
1995/03
1997/01
1998/03
2000/01
2001/03
2003/01
2004/03
2006/01
2007/03
2009/01
2010/03
2012/01
2013/03
2015/01
1985/01
1986/03
1988/01
1989/03
1991/01
1992/03
Chapter 4 discusses these issues in detail. Here it suffices merely to add net exports
(X – M) as a component of total expenditure. To arrive at the total demand that South
African producers experience, one must:
❐ add spending in foreign countries on South African goods to domestic expenditure, and
❐ deduct local spending on imported goods, since this spending merely flows to producers
in other countries.
Gross domestic expenditure is the sum of consumption, business investment and

government expenditure, i.e.
GDE = C + I + G
However, this is not equivalent to the total spending that is effectively felt by domestic producers.
The latter magnitude – the total demand for domestic production – is indicated by the term
expenditure on gross domestic product = C + I + G + (X – M).
❐ In published expenditure data, one also finds a ‘residual’ term. This is an unexplained error
term that is necessary to balance the different totals.
Therefore:
Total expenditure E = C + I + G + (X  M)

For this, the complete open economy case, macroeconomic equilibrium will be at that level
of real income Y where
Total expenditure  Total production
or
C  I  G  (X  M)  Total production
Since production is identical to income, one can equivalently write the equilibrium
condition as:
C  I  G + (X  M)  Y ...... (2.7)
Graphically, one merely adds net exports to the total expenditure line. Any increase in net
exports is treated like any other expenditure injection (and is subject to the same multiplier
process):
(X  M)  ⇒ Total expenditure  ⇒ induces production ⇒ GDP  ⇒ Y 
The expenditure multiplier with exports and imports π

While exports and imports are considered in detail only in chapter 4, it is useful to show
now how equation 2.6 can be expanded to include exports and imports. This then gives the
complete real sector expenditure multiplier.
If X is taken as exogenous, and the import function as M = ma + mY where m is the
marginal propensity to import (see chapter 4, section 4.2.1), then
Y = C + I + G + (X – M) …… (2.7)
becomes equation (2.8):
Y = a  b(1 – t) Y + Ia – hr + G + X – ma – mY
( 
= 
1
  1 – b(1 – t)  
+m)   (a + Ia – hr + G + X – ma ) ...... (2.8)
The import propensity thus adds a marginal leakage rate, which decreases the size of KE.
✍ Complete the following diagram to depict the sequence above:
lncome Y

If one considers the two graphs derived in this chapter, it appears that there is still one
unexplained variable, i.e. the real interest rate (r). What determines the level of real
interest rates? The explanation of interest rate changes can be found in the operation of
the so-called money and capital markets – or the monetary sector of the economy. This is the
subject of the next chapter.
The monetary sector is not a separate part of the economy at all. However, for purposes of
analysis, it is useful to distinguish (but not separate) this component or subsector of the
economy from the real sector.
A more complete circular flow

In section 2.1 the income–expenditure circular flow was developed as an intuitive way to
grasp the basic Keynesian reasoning. The concept of chain reasoning was developed from
this basic idea. At this stage, a more complete depiction of a circular flow can serve to
summarise the main components encountered so far:
Exports
Imports
EXPENDITURE
+ Consumption
I +G )
+
C X–M
(
Government
expenditure Saving
Investment Disposable
income
FIRMS HOUSEHOLDS
(Producers) (Consumers)
Corporate Personal
GOVERNMENT income tax
taxes
REAL INCOME
This is an enhanced version of the simple circular flow of figure 2.3. Given the basic
counter-clockwise flow of expenditure and income between households and firms,
it highlights the different components of expenditure (consumption, investment,
government expenditure and net exports). Government has been added as a major
actor. Various leakages such as saving, import spending and taxes are shown, as are
injections such as investment, export earnings and government expenditure. An
increase or decrease in any of these will either diminish or boost the stream of aggregate
expenditure. The resultant impact on the flow of real income to households can then be
deduced quite readily.

In the following chapters we will progressively fill in the blank spaces in this circular flow,
depicting additional elements of a modern, open economy. At the same time, the circular
flow diagram will serve to remind you of exactly where the topics in a particular chapter
fit into the broader economic picture. The circular flow will be completed at the beginning
of chapter 6.

1. Suppose autonomous consumption increases. Explain, using the appropriate diagram,
what the impact will be on equilibrium income and expenditure.
2. From 2006 to 2008, as part of responses to the international financial crisis, interest
rates were increased from 11% to 15%. What will be the expected impact of an
increase in interest rates on investment and/or consumption, and finally on income?
Explain using the appropriate chain reactions and diagrams.
3. If South Africa develops an increased taste/need for imported products and/or
production inputs, will it lead to higher or lower national income? Explain using (a)
the relevant formula, and (b) the appropriate diagram.
4. How can the government increase output using: (a) government expenditure, and
(b) taxation? Explain, using a relevant diagram. (The budget implications of such
steps will be encountered in chapter 12.)
5. Suppose a simple economy with only consumption, investment and government.
Further suppose Income (Y) 5 R1000, the marginal propensity to consume (b) 5
0.8, autonomous consumption (a) 5 R100, Investment (I) 5 R80, Government
consumption (G) 5 R100 and the tax rate (t) 5 0.1.
a. Calculate the size of the expenditure multiplier.
b. Calculate the size of the tax multiplier.
c. Suppose investment (I) increases by R100, calculate the new income level
following the increase in investment. Also use the appropriate diagram to explain
the effect of the increase in investment on income.
d. Suppose the tax rate on income (t) increases from 0.1 to 0.15, what will be the
value of equilibrium income following the increase in the tax rate? Also use the
appropriate diagram to explain the effect of the increase in the tax rate on income.
6. It appears that, in the period after 2010, private corporations had large amounts of
savings (cash), but were not inclined to use that to invest in new ventures, factories, etc.
(compare figure 2.6 and the period from 1999 to 2008). Looking at the determinants
of private investment, which factor(s) do you think could explain that behaviour?
7. At President Ramaphosa’s Jobs Summit in August 2018, large private-sector
companies announced investment plans amounting to billions of rands. If these
plans were to be implemented, what would be the expected impact on the economy?
Construct a simple chain reaction and diagram.
8. Nine months after the 2018 Jobs Summit, in the second quarter of 2019,
unemployment had risen from 27% to 29%. How does that square with your analysis?
Can you explain what happened?
9. Download the Excel file containing Quarterly Labour Force Trends from the latest
QLFS page of Statistics SA. Use the data to describe what has happened since 2008
to the number of people who are (a) employed, (b) unemployed according to the
official definition of unemployment, and (c) unemployed when including discouraged
job-seekers. Is it possible for the number of employed people to increase while the
unemployment rate also increases? Explain. (You may want to consult chapter 12,
section 12.2.1 in this regard.)

The basic model II: financial
institutions, money and interest rates 3
■ explain the everyday, practical operation of financial markets;
■ explain the way interest rates are determined by money supply and demand;
■ explain movements in nominal and real interest rates and compare the different roles of
nominal and real interest rates in economic behaviour;
■ compose chain reactions that show how monetary disturbances impact on interest rates
and the real economy, and vice versa, and evaluate these with appropriate graphical aids;
and
■ assess the role of monetary policy and the Reserve Bank in the determination of real
income. (Monetary policy is discussed in detail in chapter 9.)
In the discussion of changes and fluctuations in expenditure in the real (or goods) sector
of the economy in chapter 2, the real interest rate featured as an important variable.
However, the theory and logic in that chapter left the interest rate dangling and its
behaviour unexplained. To fill this gap, we turn to an analysis of the monetary sector of the
economy: the world of money and interest rates. The monetary sector comprises various
financial institutions such as commercial banks, merchant banks and the Reserve Bank
(SARB), as well as the financial markets, which is where nominal and real interest rates are
determined.
Financial institutions and markets are integral parts of the economy. Real activities such as
consumption invariably imply financial transactions which involve bank accounts and, often,
bank credit to consumers. Commercial credit is essential for business activities. Investment
and saving imply flows of funds that are channelled via financial institutions. The same is true
for international financial flows deriving from foreign trade or foreign investment.
❐ The monetary sector can be seen to handle the ‘oil’ (money, credit and financial
transactions) necessary for the smooth functioning of the ‘wheels’ of real activities
(production, employment, consumption, investment, etc.) in the real sector. Its
importance largely derives from this facilitating role.
Real sector changes have monetary impacts, and monetary disturbances can have real impacts.
One must be able to analyse these interactions to understand the short-run and medium-run
cyclical behaviour of the economy (as well as the long-term issue of economic growth). This
chapter integrates the analysis of the monetary sector – and especially interest rates – into
your understanding of the real sector and short-run fluctuations in expenditure.
Chapter 3: The basic model II: financial institutions, money and interest rates
75

The location of this topic in
the circular flow diagram
(compare p. 73) FINANCIAL
INSTITUTIONS
Supply of credit
Savings
Interest Monetary
policy RESERVE
rates
BANK
Demand for credit
FIRMS Government C HOUSEHOLDS

ons
borrowing um
dit er c
cre (deficit) redi
m mercial t
Co
GOVERNMENT
✍ How high are interest rates in South Africa currently? Can you indicate the current level of a
particular interest rate?
______________________________________________________________________________________
Monetary sector data: which source?

The main source of monetary data is the Quarterly Bulletin of the Reserve Bank, which
provides an extensive set of banking, financial and monetary data. For macroeconomic
analysis, the following tables in the sections ‘Money and banking’ and ‘Capital market’
DATA TIP
are most relevant:

❐ ‘Monetary aggregates’: money stock figures.
❐ ‘Money market and related interest rates’: short-term interest rates, such as the BA
rate and the prime rate.
❐ ‘Capital market and related interest rates’: long-term interest rates.
On the internet, consult the Quarterly Bulletin at: www.resbank.co.za. Also see Mohr
(2019) Economic Indicators, chapter 9.
3.1 The monetary sector and interest rates

Interest rates are analysed at two levels: first, in terms of the practical, everyday operation
of money markets and, second, more formally in terms of the behavioural relationships that
lie behind and explain this everyday operation – the supply of money MS and the demand
for money MD. In doing this, the distinction between nominal and real interest rates must
be kept in mind. (See the box in chapter 2, section 2.2.2 on the calculation of nominal and
real interest rates.)
❐ Nominal interest rates are the rates usually mentioned when the bank charges a
customer, say, the ‘prime rate’, or the rate earned on a savings account, or when the
Reserve Bank announces a change in the repo rate.
76 Chapter 3: The basic model II: financial institutions, money and interest rates

❐ Real interest rates are the interest rates earned in effect after the eroding effect of
inflation has been removed from the nominal value. An approximate formula for the
real interest rate is: r  i – π.
❐ So, if the inflation rate is 7%, and the nominal interest rate is 12%, the real interest rate
is (approximately) 5%.
3.1.1 The practical determination of nominal interest rates in the

money market
Although one is used to thinking of nominal interest rates in the context of, for example,
savings accounts or, especially, interest rates on loans or on an overdraft, the main interest
rates are those determined in the money market. Other interest rates usually depend largely
on what happens in the money market.
Where are the money and capital markets?

The financial market is arbitrarily divided into the money market and the capital market:
❐ The money market handles instruments/assets with a term or ‘maturity’ of up to one year
(‘short term’). Associated with these are short-term interest rates.
❐ Transactions in financial instruments with a term of more than one year (‘long term’) occur
in the capital market, which is organised in exactly the same fashion as the money markets.
In this market one finds long-term interest rates.
The money and capital markets do not exist in a physical location or building. They are
constituted by a large number of financial institutions, such as commercial and investment
banks, pension funds and long-term insurers that are continually in contact with each other
via telephone, video and computer links. These institutions have ‘dealer rooms’ where dealers
handle large amounts of money, buying and selling in the money market.
Buying and selling transactions occur on behalf of clients who either have surplus funds to invest
in money and capital market assets (‘instruments’), or who require funds on credit/loan for a certain
period. Each transaction establishes a price and a nominal interest rate. These materialise, as you
watch, on computer screens, as the transactions occur (followed by electronic book entries).
When a lot is happening in the market and many opportunities to make profit from buying
and selling present themselves, the adrenalin flows fast, the dealers’ voices are hoarse from
shouting, and their eyes red from staring at video and computer screens. (One must remember
that, even with very small price or interest differentials, significant profit can be made, given
the large amounts that are involved.) Very often dealers do not last long; the stress is too
great. On the other hand, dealers experience tremendous excitement, and some almost
become addicted to it, like one can become addicted to gambling.
❐ Visit the dealer room of a bank to see for yourself how nominal interest rates materialise on
computer screens before your eyes.
Money market dealers trade, on behalf of clients, in short-term financial instruments

or ‘financial paper’. The purpose of the trade is to connect lenders (financial investors)
and borrowers; in other words, the money market channels funds. The financial paper is
merely the proof of a claim (like an IOU). Most of these claims exist for a relatively short
period, normally three months (90 days) at most.
Various kinds of money market paper exist, each with its own nominal interest rate. Each
transaction determines a price for the paper at that moment, which implies a certain
nominal interest rate for that transaction (and type of paper or asset).
3.1 The monetary sector and interest rates 77

For the main types of money market paper this occurs as follows:
(1) Treasury bills (TBs)

Treasury bills are one type of debt instrument issued by the Treasury/government when it
borrows from the private sector during the course of the year to finance the budget deficit.
This occurs regularly, usually every Friday. A TB is issued as proof of the loan, and it entitles
the holder/lender to receive a specified amount (the nominal or face value, e.g. R100 000)
typically after 91 or 182 days. (The Treasury has also issued 273-day TBs.) Alternatively, one
can say that the lender is a financial investor who buys the TB at a certain price.
The interest that the lender/investor receives for the loan to the government (i.e. for the
financial investment in TBs) derives from the fact that she pays less than the R100 000 for
the TB, e.g. R97 000. This discount depends on the interest that the government is willing
to pay, or that it has to pay in order to sell the TBs.
❐ The discount implies that, when the investor claims the full R100 000 after three months,
she has earned a certain percentage nominal rate of return or nominal rate of interest – in
this case, the ‘91-day TB rate’. For this example, the TB rate would amount to:
(  3 000 )( 365 )
  97 000     
   91    × 100 = 12.45%.
What are government bonds
❐ Note: The higher the price the lender (or stock)?
has to pay, the lower the nominal Government bonds are similar to treasury
interest rate, and vice versa. If the bills. Both are debt instruments issued by
price of TB went down to R96 000, the National Treasury to finance the budget
the rate of return would be: deficit. However bonds have a longer term
(or ‘maturity’) attached to them. Treasury

 (  4 000 )( 365 )
  96 000     
  91    × 100 = 16.71%. bills typically have terms of 3, 5, 10, 15 or 20
years. Bonds with terms up to 3 years are
❐ Since TBs are issued/sold on tender, called ‘short-term’ bonds. (Government stock
the initial or issue rate is also called is a synonym for government bonds.)
the ‘tender TB rate’.
❐ Issues of TBs occur in the so-called
primary market.
However, the holder of a bill does not necessarily have to wait the full three months to
get the money back. If the money is needed earlier, the bill can be sold to somebody else
(in the so-called secondary market). Depending on market conditions at that stage – the
supply and demand of TBs – the seller will get a particular price for his TB (still below
the face value).
❐ For instance, suppose that after holding a TB for 30 days, a financial investor decides to
sell his TB. Note that the buyer, should
she decide to hold it till maturity,
will hold it for 61 days. If the seller A free market?
sells it for R98 200, say, then the Although these transactions occur in the
corresponding nominal interest rate money market, where supply and demand are
on the TB will be: of decisive importance, this trade does not
occur in a completely free market. The Reserve
( 

1 800
  98 200     ( 365 )
) 
  61    × 100 = 10.97%. Bank continually monitors the market and
steers it in the direction it desires by intervening
❐ Thus, trade and prices in the secondary in the market in various ways (see the
market determine corresponding nomi- discussion of the money supply that follows).
nal TB interest rates. In this way the

TB rate is determined daily, depending on the buying and selling (demand and supply)
of TBs.
For example, if investors have surplus funds and are eager to invest in TBs, the demand
for financial paper is high and the price increases accordingly, leading to a decrease in the
nominal interest rate.
A shortage of funds in the money market, on the other hand, means a relatively high supply
of financial paper by holders who would rather have cash, which is likely to translate into
a decrease in price and upward pressure on the nominal interest rate.
A similar story can be told for other types of money market paper.
(2) Negotiable certificates of deposit (NCDs)

Negotiable certificates of deposit arise when short-term financial investments are made at
banks. NCDs usually are issued/sold by banks as a way of getting hold of cash when they
experience a liquidity/cash shortage. An NCD is the certificate that is issued as proof of (or
in exchange for) the investment. This type of instrument is in high demand by investors,
and usually carries a relatively high nominal interest rate. An active secondary market
in NCDs also exists. As is the case with TBs, the NCD can be sold to a third person (or
‘third party’) if the investor needs his money before the expiry date. The price the investor
obtains in this instance will always be lower than the nominal value or redemption value;
the difference determines the nominal interest rate.1
(3) Banker’s acceptances (BAs)

Banker’s acceptances are surely the most important short-term money market instrument,
and the BA rate – mentioned daily in the news – is one of the best indicators of short-term
nominal interest rate trends. A BA is a bill of exchange (a credit instrument) that is guaranteed
by a bank. It usually comes into existence in the context of production credit, for example when
a producer requires credit to buy inputs. Instead of buying on account, she pays the seller
with a bill of exchange that is payable, for
instance, three months later. To get the
In layman’s terms, one can describe a BA
seller to accept the bill, the producer asks
as a ‘post-dated, bank-guaranteed cash
her bank to guarantee the bill (by signing cheque’. While this is not 100% correct
on the back, thereby ‘accepting’ it). Such a technically – a BA is an instrument of credit;
banker’s acceptance constitutes a claim on a cheque is not – this does give one a rough
the bank, entitling the holder to receive a idea. As is the case with a post-dated cheque,
certain amount from the bank at a certain the BA gives the holder the right to receive
date in the future. The initial recipient of a certain amount in future. As with a cash
the BA can now sell it in the secondary cheque, it is payable to whoever holds it – in
market; the price – once again, lower than fact, a BA is transferable and can be sold –
the face value – results in a corresponding and it is guaranteed by a bank.
nominal BA rate.
Although these financial instruments come into existence for different reasons and are
issued by different institutions, they (and other financial assets, such as government
bonds) all share the following characteristics:
1 This is as if my savings book shows a certain amount or balance that can be drawn only at a future date. If I want to sell
this savings book to somebody else before that date, he or she will surely only be willing to pay me an amount less than
the balance shown.

❐ There is an inverse relationship between the price and the nominal interest rate.
❐ The price, and thus the nominal rate of interest, is determined by the buying and selling
of the paper, i.e. by the demand for and supply of such instruments.
Even if one understands the money market and how nominal interest rates are determined
every day, one may still not understand why interest rates change. Why does the demand
for financial instruments sometimes increase and sometimes decrease? What determines
the supply of instruments in the market? To understand this, we have to look beyond (or
behind) the visible trade in financial instruments.
❐ The supply of and demand for financial instruments can be understood in terms of the
underlying supply of and demand for cash or money.
❐ Therefore, one must understand the role of money in the economy.
3.1.2 More formally – the supply of and demand for money

Briefly, the process that occurs is the following:
❐ If people or institutions hold more money (e.g. cash) than they really want in their
portfolio – i.e. there is a surplus of money holdings (which also means the supply of
money exceeds the demand for money) – they are likely to buy financial paper (as a
short-term financial investment). An increased demand for such paper is likely to cause
an increase in the price, and a decrease in the nominal interest rate.
❐ If there is a shortage of money (which also means that the demand for money exceeds
the supply) – i.e. people want to improve their cash position – they tend to sell financial
paper. The increased supply of paper on the market causes a decrease in price, and the
nominal interest rate increases.
In other words, nominal interest rates depend on the trade in money market instruments,
and this trade is determined by the supply of and the demand for money. If one understands
fluctuations in these demand and supply relationships, one will be able to understand
nominal (and real) interest rates.
!
Money or income?
When one speaks of ‘money’ in macroeconomics it is important to distinguish it from the everyday
usage of the term. The latter usage – as in ‘Do you have enough money to buy a car?’ – actually
concerns income or wealth rather than money. The decision to buy something or not depends on
whether you have earned or saved enough income with which to buy it.
In macroeconomics, the term ‘money’ very specifically refers to that which is used as a medium
of exchange or as a means of payment to facilitate buying and selling transactions. Everyday
examples of money are cash (coins and banknotes) and money in a cheque account. In the
decision to buy a vehicle, the amount of money in this specific sense plays no decisive role. If,
however, you decide that you do have enough income to buy the car, you must decide whether
you will use money for the transaction. If you wish to use money, you must convert the income
into money form for that purpose. If you do not wish to use money, you may be able to exchange
something else of value, e.g. sheep, for the car. It still is a valid transaction.
Obviously, most transactions in a modern economy are concluded (and, indeed, expedited
immensely) with the aid of money as the medium of exchange or payment. However, that
does not invalidate the formal and very important analytical distinction between money and
income.

The demand for money (MD)
The aggregate demand for money in the economy depends mainly on the amount of
money people require for transactions. Therefore, the total money value, or nominal
value, of transactions (in a year, say) in the country is decisive. This in turn depends on
the total volume of goods that is to be exchanged, i.e. the total volume of goods produced,
as measured by real GDP (or Y).
❐ This means that, if Y increases (the economy is in an upswing and economic activity
increases), the demand for money typically increases. As more goods are produced and
exchanged, more money is required to conclude these transactions.2 There is a direct
or positive relationship between Y and MD.
❐ This suggests that there is an endogenous or built-in effect of the business cycle on the
demand for money, and hence on interest rates. Data show that interest rates typically
start to increase about halfway into an upswing phase, and again start to drop in the
latter part of the downswing phase.
In addition to the volume of (real) production, the nominal value of transactions also
depends on the average price level P [Nominal GDP = P × Y]. Accordingly, an increase in
the average price level (as experienced when inflation occurs) also increases the demand
for money. There is a positive relationship between P and MD.3
A final important factor determining the demand for money is the nominal interest rate i.
The demand for money depends on the amount of money people want to hold at one time
(instead of going to the bank to get money for each transaction). Holding money is not
free of cost, however, since one forfeits interest: the interest rate is the opportunity cost of
holding money/cash.
The higher the nominal rate of interest, the less willing people will be to hold significant
amounts of money/cash. That is, a higher nominal rate of interest will decrease the
demand for money; a lower rate is likely to increase the demand for money. There is an
inverse or negative relationship between i and MD.
Therefore the (nominal) money demand relationship is as follows:
MD = f(i; Y; P)

The signs below the equation indicate the kind of relationship between the left-hand
variable (MD) and the corresponding right-hand variable:  indicates a direct or positive
relationship;  indicates an inverse or negative relationship.
Since we prefer to work in real terms when studying economic relationships and behaviour,
it is preferable to state the money demand relationship in real terms. We will also do so
with money supply MS later on. It will also prepare the ground for later chapters when we
explicitly introduce the price level and inflation into the model.
2 Producers typically also require additional production credit if they want to increase production; since credit creation
also leads to money creation, an increase in production also leads to an increased money supply.
3 Although a higher price level increases the transactions demand for money, it may cause the demand for money
held for precautionary reasons (i.e. holding money in ready form to deal with unexpected (good and bad) events and
opportunities) to decrease. This reduction becomes more likely when a higher level of inflation is not a transitory event,
but a more enduring feature of the economy. When money is held it loses real value due to inflation. As a result, people
and institutions may wish to reduce their money holdings so as to minimise this inflationary loss.

Money demand, investment and their opportunity costs
In chapter 2, when analysing investment behaviour, we argued that the opportunity cost of
investment is the real interest rate. Here, when analysing the demand for money, we argue that
the opportunity cost of holding money is the nominal interest rate. Why the difference?
When deciding to make a real investment in capital goods, the relevant best alternative is buying
a bond with a certain nominal and real yield (interest rate): i = r + π, so there is a real interest rate
r plus compensation for inflation. Funds invested in a capital good will grow for two reasons: the
value of the capital good should rise with inflation and there should be a real return from using the
capital to produce and sell goods.
If inflation is 10%, a machine bought now for R100 should have a value of R110 a year from
now. On top of that it can yield a real return (after allowing for depreciation) for the investor. A
bond bought for R100 now will yield inflation (e.g. 10%) plus a real interest rate (e.g. 5%). The
nominal yield will be R15 (a nominal interest rate of 15%).
In both cases there is compensation for inflation plus a real return. The increase in the price
or value of the capital good and the nominal interest rate on the bond both indemnify the real/
financial investor against inflation. All that is relevant in deciding whether to buy the capital
good is to compare its expected real return with the real interest rate on bonds.
❐ So the opportunity cost of buying a capital good (i.e. investment) is the real interest rate.
When holding money in the form of cash, there is no compensation for inflation and no real
return. A R100 note now is still a R100 note a year from now – and its buying power will have
been eroded by inflation. By not putting that money in a bond, one loses the entire nominal
interest (= R15) that one could have earned.
❐ Therefore, the opportunity cost of holding money is the nominal interest rate.
Formally, the demand for money can be divided into three types:
❐ Transactions demand: the need for money to use in ‘active’ form in transactions. This
depends largely on the value of transactions, i.e. nominal Y.
❐ Precautionary demand: holding money in ‘ready’ form, since one cannot at all times foresee
all transactions. This depends on income Y and the interest rate (opportunity cost), as well
as expectations (pessimistic or optimistic). In times of pessimism, people may want to hold
more cash as a precautionary step.
❐ Speculative demand: money comprises part of a person’s asset portfolio, together with
other financial assets such as bonds. If a person expects the prices of other assets to
increase, he will hold less cash and rather buy other assets, hoping to profit from the
expected price increase. On the other hand, if a decrease in asset prices is expected, a
person is likely to exchange part of her assets (wealth) for cash/money. What does this
decision have to do with interest rates? Recall that the higher the price of financial assets
such as bonds or BAs, the lower the rate of return (interest rate). If interest rates are low, it
is not unreasonable to expect that they may increase at some time in the future (implying
that the prices of bonds may decrease). It may then be wise to rather sell one’s bonds and
hold more cash/money in ‘passive’ form. This means that a low rate of interest creates the
incentive for a greater demand for money (from a speculative point of view). Speculative
demand, therefore, is largely determined by interest rates.
For most macroeconomic reasoning, it is sufficient to use only the transactions and
precautionary motives, with Y and the interest rate as main determinants. For the sake of
convenience, these can be combined into one line of reasoning, as was done above.

❐ Under the standard macroeconomic convention, real sector symbols such as C, I and Y
always indicate real values. Strangely enough, in the monetary sector the convention
is that MS and MD are nominal variables.
❐ To convert them to real values, the convention is to write them as a fraction, i.e. divide
 MP   and  
M
S D
them by the price level P, i.e.  P  . 
❐ We will also work increasingly with the real interest rate r.
The above relationship can be rewritten for the real demand for money:
MD
P    = f(i; Y)
 
We can then express the real money demand mathematically as:
MD
P   = kY – li
  ...... (3.1)
 MP    indicates the real amount of money required in the economy for
D
In this equation 
transactions; the parameter k indicates how responsive real money demand is to changes
in real income, and l indicates how responsive real money demand is to changes in the
nominal interest rate i. P does not appear as a variable on the right-hand side because its
effect is captured on the left-hand side.
M
D
Note that the   P  in the above equation is the
Figure 3.1 Real money demand
demand for real money. The concept of real i
money can be understood as follows. We demand
money mainly to conduct transactions (i.e. to
buy goods and services). If the average price level
increases by a certain percentage (e.g. when
there is inflation), we will require proportionally
more nominal money so that in real terms we will
have the same amount of money to conduct our
transactions of goods and services.
Graphically, the real money demand relation-
ship can be depicted as in figure 3.1. MD
  P  
 
Changes in the rate of interest result in a move
along the curve. Changes in Y and P shift the Real quantity of money
real money demand curve. (How?)
The money supply (MS)

The nominal stock of money is the amount that the monetary system (i.e. the central
banks plus all other financial institutions) is supplying at a particular moment, under the
watchful eye (if not control) of the central bank. Thus, when economists talk about the
money supply, they usually talk about the stock of money. (In standard economic theory,
it is assumed that the central bank is able to control the level of money supplied by the
monetary system.)
The nominal stock of money can be defined as the total amount of money that is present
in the economy at a particular moment. However, there are different definitions of what
constitutes money. In published official data in South Africa, there are four different
definitions of the stock of money or the money supply:

M1A = Sum of coins and banknotes in circulation, plus cheque and transmission
deposits of the domestic private sector at monetary institutions.
M1 = M1A plus other demand deposits held by the domestic private sector at
monetary institutions.
M2 = M1 plus other short-term deposits and all medium-term deposits at monetary
institutions (including savings deposits).
M3 = M2 plus all long-term deposits held by the domestic private sector.
You will note that the definition gets broader and broader, progressively including assets
that are more difficult to convert to, or use as a means of payment. M1 comprises the
immediately ‘liquid’ instruments.
The graph in figure 3.2 shows the value of coins and notes, M1, M2 and M3. Note how small
a proportion coins and notes are of M3 – usually less than 5%. Notice the continual and
strong growth in all these aggregates over time amidst up- and downswings in the economy.
Figure 3.2 The money supply (coins and notes, M1, M2 and M3)
4 000
3 500 M3
3 000
M2
2 500
R billion
2 000
M1
1 500
1 000
500
Coins and notes
0
Jan-90
Oct-96
Jan-99
Oct-05
Jan-08
Oct-14
Jan-17
Apr-92
Apr-01
Apr-10
Jul-94
Jul-03
Jul-12
✍ How large is the money stock in SA currently?

Coins and notes = R ...................... billion
M1A = R ....................... billion
M1 = R ....................... billion
M2 = R ....................... billion
M3 = R ....................... billion
Since the 1980s the Reserve Bank has preferred to use M3 as the most important money
supply indicator. However, there is no general agreement on which definition is best. One
should choose an appropriate measure depending upon what one wants to analyse.

✍ Who creates money in the economy? The government? The Reserve Bank? How is it created?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
What determines the money supply relationship in the economy? This relationship reflects
the money creation process that occurs mainly via (a) lending by the commercial banking
system (in reaction to a demand for credit from within the economy), but is also influenced
by (b) the deliberate actions of the Reserve Bank as part of monetary policy.
❐ One can use the balance sheets of banks and the Reserve Bank to better understand the
money supply and credit creation process (see next subsection).
The nominal quantity of money available at any moment is the result of the credit creation
process and interaction between individuals, firms and banks, and between banks and the
Reserve Bank.
❐ Money creation does not occur via the printing of notes but, rather, via the extension
of credit (loans) by banks.
❐ Banks lend money that has been deposited by clients, e.g. in cheque accounts, to other
persons. This can be a direct loan, such as a mortgage to buy a house, or the provision
of an overdraft. When this facility is used by the borrower to pay for something, the
money typically flows to the bank account of the supplier of the goods or service; that
person or institution’s bank can then, in turn, put out a portion of this deposit on loan,
and so on. Each time this occurs there is an addition to both the total amount of credit
extended and the total amount of bank deposits in the country; and each creation of a
deposit is equivalent to money creation.
❐ There are a number of rounds of lending and relending, with deposits being created
and recreated all the time. Gradually this process peters out. The cumulative result of
this process of relending is the total money stock or supply of money. In this way, an
initial ‘injection’ of a deposit is multiplied, with an eventual effect on the money stock
much greater than the initial injection – it is a credit multiplier process that takes
place.
❐ The extent of the money creation process, i.e. the value of the credit multiplier, depends
on how much is relent in each round. A ceiling is placed on this by the legally prescribed
minimum cash reserve that banks have to hold, implying a forced ‘leakage’ from the
process in each round. Each commercial bank is legally compelled (by the Reserve
Bank) to hold a specified minimum percentage of all deposits at the bank in the form
of cash. Only the remainder may be put out on loan. In 2009 this reserve requirement
was at 2.5% of deposits.
❐ The higher this percentage leakage, the smaller the portion that can be lent in each
round. Therefore the maximum scope of the money creation process is inversely
proportional to the minimum reserve requirement (the leakage rate).
1
❐ This means that the value of the credit multiplier is  R ,  where R = reserve requirement
(e.g. 0.025, meaning 2.5% of deposits). The logic of this is the same as with the
expenditure multiplier outlined in chapter 2: the more that is held back (or that leaks
from the process) in each round, the smaller the cumulative effect of the money creation
process. The credit multiplier can be quite large – it is 40 in the South African case.

It is important to note that the reasoning here concerns the maximum scope of the money
creation process. Banks can choose voluntarily to hold higher-than-required reserves or
so-called excess reserves (see the balance sheet subsection that follows). The holding of
excess reserves restrains the money and credit creation process. Because banks hold an
additional percentage of deposits, the effective value of the credit multiplier will decrease.
❐ For example, should banks choose to hold excess reserves equal to 1% of deposits, while
1
the required reserve requirement is 2.5%, the effective multiplier will be     =
0.025 + 0.01 
1
28.6. Compare this to the value of 
 0.025 = 40 if no excess reserves are held. The formula
    
of the credit multiplier thus indicates a maximum value.
❐ Excess reserves result in an element of uncertainty regarding the extent of any change
in the money stock; they also imply that changes in the money supply do not occur
mechanically.
❐ The proportion of excess reserves that banks hold is very sensitive to the nominal
interest rate they can charge on loans. When the prime rate increases, for instance, the
opportunity cost of holding excess reserves increases – the bank has an incentive to
reduce excess reserves and lend a larger proportion of the deposits that it holds.
✍ What is the value of the credit multiplier if the cash reserve requirement is 2.5% and banks hold
2% excess reserves on average?
__________________________________________________________________________________
The role of the Reserve Bank in the money supply process

Three factors that determine the supply of money have been identified so far: injections of
money into and withdrawals from the banking system, banks voluntarily holding excess
reserves, and changes in the minimum reserve requirement.
The last factor is under the control of the Reserve Bank. Though it has not been used much
in recent years, it is an instrument to control the money supply – it is an instrument of
monetary policy. The Reserve Bank can and does use two other instruments of monetary
policy to influence the money supply:
(1) The repo rate (or ‘repurchase’ rate): This rate – which is not to be confused with the
prime overdraft rate – is the nominal interest rate (i.e. the price) that commercial banks
have to pay when they borrow from the Reserve Bank (have a look at the balance
sheet of the SARB further on). Banks do this when they run low on cash reserves or
borrow with the intent to support their credit creation activities. The former is where
the Reserve Bank functions as ‘lender of last resort’, providing ‘accommodation’ to
commercial banks.
❐ Increases in the repo rate discourage commercial banks from borrowing from the
Reserve Bank and, accordingly, restrain their ability to create credit/money.
❐ The opposite occurs when the Reserve Bank decreases the repo rate. When the
repo rate decreases banks are encouraged to borrow more from the Reserve Bank.
As banks then start lending out the money that they borrowed from the Bank, the
credit multiplier starts to operate. The loans reflect in the bank balances (deposits)
of firms and households in various banks. With a multiplier value of, for example,

40, the cumulative effect can be huge. In this way changes in the repo rate have a
significant impact on the money supply via loans and deposits.4
The repo rate is formally announced by the governor of the SARB after the regularly
scheduled meetings of the Monetary Policy Committee (MPC).
❐ Practically it is made effective via a weekly tender process in which banks express
their need for accommodation (funds). Depending on the total liquidity needs of
banks, the rate is set (in line with the MPC decision) by adjusting the amount of
funds the SARB is willing to provide to banks.5
Bank profit originates from the difference between the nominal interest rate that
banks pay on their liabilities (loans from the SARB and private deposits) and the
nominal interest rate that they earn on their loans and advances to households and
firms. Thus the repo rate at which the banks borrow (the ‘wholesale price of credit’)
will determine the rate that banks will charge (the ‘retail’ price) on the loans that
they extend. This explains why, when the repo rate increases, the prime overdraft rate
charged by banks immediately follows suit.
❐ The margin between the repo rate and the prime overdraft rate typically is 3.5%.
The graph in figure 3.3 shows the consistently parallel way these two rates have
moved over time, and how their cyclical movement relates to the business cycle. (The
repo rate’s predecessor prior to 1997 was known as the bank rate.)
Figure 3.3 The repo (bank) rate and the prime overdraft rate
25
Prime rate
20
Nominal interest rates (%)
15
10
Bank rate/Repo rate
0
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
Source: South African Reserve Bank (www.resbank.co.za) and Quantec.
4 This process will commence with an increase in the ‘loans extended to bank’ on the asset side of the SARB.
Simultaneously, the excess reserves that banks hold with the SARB (appearing on the liability side of the SARB
balance sheet) will also increase. As banks then start lending out the money that they borrowed from the SARB, the
‘loans and advances’ on the asset side and the ‘deposits’ on the liability side of the bank balance sheet start to increase.
Because of the higher levels of deposits and thus the increase in the amount of cash reserves required, the excess
reserves of banks will decrease and be converted into required reserves.
5 Should the repo rate remain constant, it does not mean that the amount of credit extended and deposits created in the economy
will necessarily remain unchanged (indeed, it usually does not remain unchanged). When the level of economic activity
increases, one could also expect that there will be increases in the demand for bank loans and in the demand for deposits held
for transactional purposes. Thus, banks may borrow more reserves from the SARB to finance an increase in their loan book
even when the repo rate remains unchanged (which, in effect, means that the SARB accommodates the additional demand by
allowing the money supply to increase at the prevailing repo and interest rate level). Given a cash reserve requirement of 2.5% and
thus a credit multiplier of 40, relative to their total deposits, banks will not need to borrow that much from the SARB.

Unlike cash reserve requirements (discussed earlier) and open market operations (dis-
cussed later), the repo rate conveys a direct price signal to the financial markets as to
the Reserve Bank view regarding the direction into which the interest rate should be
moving. Cash reserve requirements and open market operations can also influence
the nominal interest rate level in the economy, but the effect is more indirect.
Because of the clarity of its signal, the repo rate is the most important monetary policy
instrument that the SARB uses to conduct monetary policy and to convey its policy
stance to the financial markets. This is the case not only in South Africa but in most
countries with a monetary policy system pursuing a clear goal (usually low inflation).
(2) Open market operations (OMOs): This refers to the Reserve Bank’s buying and selling
of treasury bills or short-term government bonds in order to influence the supply
of money in the economy. Selling of bonds withdraws money from circulation
and decreases the money supply; buying bonds brings money into circulation and
increases the money supply. (Remember that government bonds are originally issued
by the Treasury in the primary market to finance the budget deficit.6 Open market
transactions thus occur in the secondary market, with the role of the Reserve Bank
being that of dominant market participant able to influence the market significantly.)
❐ See sections 3.4 and 9.7 for an explanation of ‘quantitative easing’, a practice in-
troduced in the USA in 2008. It is similar to open market operations but involves
the sale, by a central bank, of long-term government bonds as well as other, private-
sector financial assests such as MBSs (Mortgage-Backed Securities).
Summary: determinants of the money supply

Household, firm and bank actions:
1. Injections of money (deposits, inflows) into and withdrawals (outflows) from the domestic
banking system. This includes international in- or outflows of funds due to a surplus or
deficit on the balance of payments (see chapter 4).
2. Banks voluntarily holding excess reserves or reducing their excess reserves.
3. Banks borrowing more reserves from the SARB to finance an expansion of their loan book
(see footnote 4).
Reserve Bank actions:

4. Changes in the official minimum reserve requirement by the Reserve Bank, which affects
the size of the credit multiplier.
5. Open market operations by the Reserve Bank, which either injects or withdraws money
from circulation.
6. Changes in the repo rate instituted by the Reserve Bank.
✍ What is the prime rate? How high is it at the moment?

____________________________________________________________________________________
____________________________________________________________________________________
6 The matter is complicated by the fact that even primary issues of bonds used to be handled by the Reserve Bank in its
capacity as agent of the Treasury. However, see chapter 9, section 9.5 for current arrangements.

A bank balance sheet approach
To gain a better understanding of how a change in credit leads to a change in the money
supply and what role the central bank (i.e. the Reserve Bank) plays in the process, we can
examine the balance sheets of the central bank and the commercial banks.
❐ We will see linkages between key, corresponding items in the Reserve Bank and com-
mercial bank balance sheets.
❐ In the commercial bank balance sheet we will see the link between deposits (liability
side) and the loans (asset side) so enabled.
Figure 3.4 Balance sheets – SA Reserve Bank and commercial banks
SOUTH AFRICAN RESERVE BANK BALANCE SHEET COMMERCIAL BANK BALANCE SHEET
Assets Liabilities Assets Liabilities
Gold and foreign reserves Notes and coins Central bank money and gold Deposits*
Liquidity provided Deposits Banknotes and coins
Other liabilities to the public
Utilisation of cash reserves Central government Gold coin and bullion
Loans received from SARB
Loans granted to banks Banks and mutual banks Deposits with the SARB
(repurchase agreements)
(repurchase agreements) Required reserve balances and
Loans and advances Other
Advances and investments excess reserves
Mortgage advances Foreign loans
Advances Other
Overdrafts and loans Other loans and advances
Banks Capital and liabilities other than
Instalment debtors, leases Other liabilities to the public
Other notes, coins and deposits
Capital and other liabilities
Investments Foreign currency loans
Government stock (bonds) Other
Other Investments (bonds, shares)
Fixed assets
Other assets Other assets
*Including cash, cheque and transmission accounts, short-, medium- and long-term savings.
The asset side of the balance sheet of the South African Reserve Bank comprises, among
others, gold and foreign reserves as well as loans granted to banks.
❐ The gold and foreign reserves include the dollars, euros, yen and pounds etc. held by
the SARB.
❐ The loans to banks comprise the repurchase agreements into which the SARB enters
with banks, i.e. when banks borrow from the SARB at the ‘repo rate’.
❐ Government bonds that the SARB buys in OMOs appear on the asset side of the balance
sheet of the SARB under ‘government stock’ (under ‘investments’; see below).
The liability side of the SARB balance sheet includes:
❐ Notes and coins circulating in the economy. Just as a treasury bill is an IOU
whereby government promises to pay you the face value of the bill, so a R100
note is an IOU issued by the SARB whereby they promise to pay you R100 if you
offer them your IOU (bank note). (Until the 1990s banknotes had such a promise
written on them).
❐ Deposits made by government (the SARB acts as banker to government) and commercial
banks. The latter includes the required reserves that they need to hold, as well as
additional (excess) reserve deposits at the SARB.

The asset side of the balance sheet of commercial banks includes:
❐ The deposits that they hold at the SARB (the required reserves as well as the excess
reserves), and
❐ Loans and advances that the banks extend to firms and households. These include mortgage
advances, overdrafts and loans, instalment credit and leases. (The asset side of banks may
also include investments in bonds and shares as well as some fixed assets.)
The liability side of the balance sheet of commercial banks includes:
❐ Private deposits (i.e. if you deposit money at the bank, the bank owes you the money).
❐ Loans that the banks receive from the SARB in the form of repurchase agreements, and
on which they pay the repo rate. (Banks may also borrow from other banks, and from
foreign banks and institutions.)
These two liability-side items are the main elements that enable banks to extend loans to
households and firms, i.e. to create credit (which then is reflected on the asset side of their
balance sheets). This is the heart of the money creation process.
❐ If ‘deposits’ increase on the liability side of commercial bank balance sheets, their
conversion into loans to households and firms will be visible in the amount of ‘loans
and advances’ on the asset side.
❐ Observe the mechanism through which changes in the repo rate will affect the liability side
of the balance sheets of commercial banks, and thus the basis of their credit extension
to the private sector, i.e. their money creation. If a repo rate change encourages banks to
borrow from the Reserve Bank, it will reflect first as an increase in ‘loans received from
SARB’ on their liability side, but when it is used to extend loans to households and firms, it
will reflect similarly as an increase in ‘loans and advances’ on the asset side of their balance
sheets.
❐ Likewise, changes in the required reserves (held at the SARB) will impact on the latitude
of commercial banks to extend loans, from deposits, to households and firms.
❐ The asset side reveals how voluntary excess deposits (excess reserves) at the SARB will
reduce the scope for loans that can be extended by commercial banks.
Note how:
❐ Loans from the Reserve Bank to banks are symmetrically reflected as assets for the
Reserve Bank and liabilities for commercial banks.
❐ Required and excess reserves are symmetrically reflected as assets for commercial
banks and liabilities for the Reserve Bank.
It is also possible to compile a consolidated balance sheet for the whole monetary sector
(defined to include, inter alia, the Reserve Bank, commercial banks, the Land Bank, the Post
Bank and the Corporation for Public Deposits). The components of the nominal M3 money
supply and the loans that the monetary sector extends then appear as assets and liabilities
on the sector balance sheet.
Thus an increase in M3 can be traced back, for instance, to an increase in the extension of
credit to the private sector, which in turn can be broken down into increases in mortgage
loans or overdraft facilities, and so forth. Indeed, most of the increase in M3 can be traced
back to changes in the different types of credit extended to the private sector.
One can thus gain insight into money supply conditions and dynamics by studying the
consolidated balance sheets of the monetary sector together with those of the commercial
banks and the Reserve Bank. These balance sheets are published regularly in the Quarterly
Bulletin of the Reserve Bank.

The bank sector balance sheet in numbers
The numbers referring to the above discussed balance sheet can be found in the Quarterly
Bulletin of the South African Reserve Bank. The graphs in figures 3.5 and 3.6 present some
of the salient features of the data. Whereas deposits constitute M3 and thus the liability
Figure 3.5 M3 and its counterparts

4 000
Total credit extended to
the private sector
3 000
M3
2 000
R billion
1 000
Foreign assets
Net credit extended to

0 government
–1 000 Net other assets and

liabilities
–2 000
Jan-90
Jul-91
Jan-93
Jul-94
Jan-96
Jul-97
Jan-99
Jul-00
Jan-02
Jul-03
Jan-05
Jul-06
Jan-08
Jul-09
Jan-11
Jul-12
Jan-14
Jul-15
Jan-17
Jul-18
Figure 3.6 Private credit extension and its main components

4 000
3 500 Total credit

extended to
private sector
3 000
2 500
R billion
2 000
1 500 Other loans and advances

Mortgage advances
1 000
500
Instalment sale credit
0 Leasing finance
Jan-90
Jan-93
Jan-96
Jan-99
Jan-02
Jan-05
Jan-08
Jan-11
Jan-14
Jan-17
Jul-91
Jul-94
Jul-97
Jul-00
Jul-03
Jul-06
Jul-09
Jul-12
Jul-15
Jul-18

side of the banking sector, ‘loans and advances’ constitute the asset-side counterparts to
M3. In figure 3.5, the graph shows M3 and these counterparts. The lines represent the
counterparts to M3 and add up to the value of M3, itself represented by the shaded area.
One of the main components of loans and advances is credit extension to the private sector.
The graph in figure 3.6 shows its main components, of which the category of mortgages
is the largest.
The money supply function

The instruments of monetary policy are the main determinants of the supply of money.
The nominal money supply MS is mainly a function of exogenous policy factors under the control
of the monetary authorities. In simple theory this is as far as one would go. It implies a
vertical money supply curve that is shifted left or right by curtailments or expansions of
the nominal money supply as a consequence of monetary policy steps.
A first refinement that we need to make is to convert the money supply function, and
the diagram, from dealing with the nominal money supply MS to the real money supply,
 MP  .  This parallels the formulation of the money demand function in real terms
S
indicated as 
above. We will also increasingly use the real interest rate r in our analysis.
M S
❐ Henceforth, when we use the term ‘money supply’, we mean the real money supply   P  . 
A further possible refinement would be to include the practice that banks frequently hold
excess reserves. This means that the effective money supply is lower than it would have
been without excess reserves, i.e. when only the exogenous policy factors play a role. Why
would a bank hold excess reserves, and how does that affect the money supply function?
❐ In a period of uncertainty excess reserves provide security.
❐ Excess reserves also provide a ‘buffer’ to protect a bank against unexpected, large
withdrawals of cash by its clients. Especially when the repo rate is high, a bank will want
to ensure that it is not forced to go to the Reserve Bank for assistance (accommodation).
Holding excess reserves is not without cost, however. If a bank holds excess reserves, it
forfeits the interest it could have earned by putting the funds out as loans: the interest rate is
the opportunity cost of holding excess reserves. High interest rates are likely to discourage
the holding of excess reserves and encourage maximum lending. Lower interest rates can
induce banks not to lend to the fullest extent.
This suggests the possibility of a positive relationship between the interest rate and credit/
money creation. Graphically, this is represented as a money supply curve with a positive
slope. The steepness of the curve (the value of the slope) will depend on the interest
responsiveness of the money supply. (How?)
This positive relationship can be valid only up to the point where banks are fully loaned up.
Then money creation in the banking system reaches a ceiling. Exactly where this ceiling
is will depend on the exogenous policy factors analysed above – most importantly, the size
of the cash reserve requirement. Graphically, this means that the money supply curve
becomes vertical at this point.
The money supply can therefore be depicted in two ways, as shown in figure 3.7.
M S
For most macroeconomic chain reactions, it is sufficient to use the simple, vertical  P    
curve. One should, however, always keep the role of excess reserves in mind, as it can be
decisive in some lines of reasoning.

Figure 3.7 Two depictions of the real money supply
i Simple form: MS i Refined form: MS

  P  
    
P
  
Real quantity of money Real quantity of money
Is the money supply exogenous or endogenous?

❐ If a portion of the money supply curve is interest responsive (i.e. non-vertical graphically), then
the money supply is partially endogenous (i.e. dependent on factors within the economy)
and reacts spontaneously to changes in the economy.
❐ If policymakers respond to problems such as unemployment by allowing the money supply
to grow, then this money supply growth is (partially) an endogenous result or symptom of
events in the economy.
In both cases the control of the Reserve Bank over the money supply is not complete, nor
independent. If only the exogenous policy instruments determine the money supply, then it is
exogenous and Reserve Bank control is complete. That is the case with a vertical money supply
curve (graphically).
Supply and demand interaction: equilibrium in the monetary sector?

Graphically (see figure 3.8), it is simple to
indicate that the equilibrium between the Figure 3.8 Money market equilibrium
supply of and demand for money is deter-S
MD M i
  MP  
S
mined by the intersection of the   P  
  and  
P     
curves which determines an equilibrium
interest rate as well as an equilibrium quantity
of money.
Mathematically the equilibrium in the money
market can be expressed as: i0
MS MD
P    =   P   
  
M D
and because  P    = kY – li, the money market
MD
equilibrium condition can be rewritten as:   P  
 
MS Real quantity of money

P   = kY  li
  …… (3.2)

Any shift in either or both of the curves will Figure 3.9 Money market changes
lead to a new interest rate level. An increase i MS
in the money demand (e.g. due to an increase   P  
 
in Y) will lead to a rate increase. Likewise, an
expansion of the money supply should result
in downward pressure on the rate of interest.
However, such a mere diagrammatical or i1
mathematical statement is not sufficient – one
must analyse and understand the economics i0
behind these diagrammatical stories. The
demand for money must be linked to the
demand for financial assets and to money   MP  
 
D
M D
market instruments in particular. Changes in    P    
  MP   , and changes in the equilibrium interest
S
or 
Real quantity of money
rate and quantity (see figure 3.9), can then be
understood and interpreted in terms of the trade in financial instruments.
For example, suppose (due to some change in the economy) the real demand for money were
M D
P  shifts right graphically). The following chain of events would occur in the
to increase ( 
money market:
At the initial interest rate level i0 there will be an excess demand for money. This implies
that the public requires more money (not income) for transactions than they currently
have in their portfolios. One way to get hold of money is to sell some of their financial
instruments/assets. The sale of financial paper implies an increased supply of, for example,
BAs on the money market. This causes downward pressure on the prices of BAs, which is
equivalent to upward pressure on the BA rate. The interest rate moves to i1.
✍ A similar story can be told for an increase in the money supply (MS ). Complete this chain
reaction in the space below:
______________________________________ Graphical test:
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M D
These events explain, practically, why the increase in  P  leads to an increase in the
nominal rate of interest, as shown in the diagram. It thus explains the path between the
two equilibrium points.
M S
P    = kY – li.
❐ At both equilibrium points:  
Remarks
1. In practice, quite a number of different short-term rates of interest exist (compare the
interest rate information in the Quarterly Bulletin of the Reserve Bank). In addition,
there are long-term rates of interest, for example on 20-year Eskom stock or long-term
government stock. Therefore, the single rate of interest shown in the diagram must thus
be understood as being representative of the interest rate spectrum.
✍ How many interest rates?

See how many different rates you can find in the Quarterly Bulletin or in financial weeklies or the
financial pages of newspapers. Can you classify them into groups?
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
2. The relationship between short-term and long-term interest rates is called the
‘term structure of interest rates’ or the ‘yield curve’. It is standard practice to use
the interest rates on government bonds when constructing the yield curve. 7 The
relative height of short-term as against long-term interest rates – the slope of the
yield curve – and their expected relation in future is of great interest to financial
investors and portfolio managers who must decide between investment in short-
or long-term assets.
❐ Usually, when the short-term interest rates are lower than the long-term interest
rates (i.e. there is a positive yield curve), it indicates that there is an expectation in
financial markets that interest rates are likely to increase in future.
❐ If short-term interest rates are higher than long-term interest rates (a negative
yield curve), the expectation is for interest rates to decrease in future.
❐ Close to the peak of a business cycle, when money market conditions become tight
because of the high demand for short-term credit), the yield curve tends to become
negative – short-term rates become higher than long-term rates. A negative yield
curve also means interest rates are relatively high. Hence, there is an expectation
that they will decrease in future. When the economy is close to the trough of the
business cycle (i.e. in recession), money market conditions are not tight, so there
is not much upward pressure on short-term interest rates. The yield curve will be
positive. This implies that interest rates are relatively low. Hence, interest rates are
expected to increase in future.
7 When one compares short-term and long-term interest rates, one should ensure that they are issued by the same
institution. This will ensure that the risk premium included in both the short-term and the long-term interest rate are
the same and that the only difference between the short-term and long-term interest rate is the time to their maturity.
Government is one of few institutions to issue both short-term and long-term bonds.

For portfolio managers, it is very important to know what the interest rate is
expected to do in the future, because, as you may recall from above, there is an
inverse relationship between the interest rate and the price of a financial asset (or
‘security’).
✍ Which are higher – short-term rates or long-term rates?

Find examples of short-term rates and long-term rates for a few years and compare the levels,
also on a graph. Is there any pattern?
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
(Hint: Is there any link to the business cycle? Compare graphs comparing the yield curve to the
economic growth rate.)
3. Note that neither the government nor the Reserve Bank sets interest rates in the sense of
a legal prescription or decree. The Reserve Bank influences, manages or controls inter-
est rates via the money market by influencing the money supply and changing the repo
rate. The Bank indeed has many potent ways to influence the course of interest rates
decisively (these are discussed in depth in chapter 9), but they still do not amount to
‘interest rate fixing’.
4. In the analysis above, we saw
how open market operations Monetary policy and the demand side of the
(OMOs) can change the sup- monetary sector
ply of money in the market, In practice, the repo rate, which constitutes a cost
thereafter leading to a change factor for banks, has an immediate effect on the
in the rate of interest. In prac- lending rates of banks.
tice, the sale of, for example, ❐ This can influence the demand for credit
government stock in OMOs (graphically, a move along the MD curve), which
usually has an immediate ef- can result in a new equilibrium money stock and
fect on interest rates, since interest rate.
each transaction carries a ❐ This is discussed in the analysis of the practice of
certain price and thus a cor- monetary policy in chapter 9.
responding rate of interest. If
the Reserve Bank experiences
difficulties in selling stock, it has to reduce the price sufficiently to attract buyers, i.e.
the rate of interest must be increased sufficiently. To keep one’s economic reasoning
on track, it might be safer, though, to understand the effect of open market transac-
tions as first affecting the money supply, which in turn causes a change in the rate of
interest.
5. The Quarterly Bulletin of the SARB contains information about the weekly money
market accommodation that the SARB provides to banks in the form of, mainly, repo
transactions. The accommodation means that banks are continuously experiencing a
shortage of funds that they are unable to fill by borrowing in the market (by borrowing
from other banks in the so-called ‘interbank market’). Thus they need to borrow from
the SARB. News media sometimes refer to this when they report on the ‘money market
shortage’.

Why always a shortage?
In practice the Reserve Bank prefers the money market always to show a modest shortage. Why?
A shortage means that banks are forced to go to the Reserve Bank for accommodation. This in
turn means that the repo rate is continually activated as a cost factor for banks, which makes
it an effective policy instrument for the Bank (see chapter 9).
❐ The Reserve Bank maintains the necessary shortage by using either open market
operations or changes in the minimum reserve requirement to manipulate the supply side
of the market.
❐ Only when the shortage becomes unusually large can one really expect upward pressure
on interest rates.
❐ In early 2014 the average shortage (amount of accommodation) ranged between
R20 billion and R40 billion. (Is this relatively large or small? What percentage of the money
stock does this constitute? Compare the money supply figures above.)
✍ 1. Commentators may state that an increase in interest rates is a symptom of prosperity and
good times. Why?
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
This effect on interest rates typically occurs in the later stages of an upswing – as the
economic upswing gains momentum, credit bottlenecks start to develop, creating upward
pressure on interest rates. (It is as if the economy heats up and runs a temperature.)
2. If you have to explain why interest rates have declined, what are all the possible causes
(including policy steps)? Make a list. (Hint: Distinguish between demand-side and supply-
side causes, and between endogenous and policy-related causes.)
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
Built-in cycles?
The restraining feedback effect may imply some kind of cyclical tendency in the economy. The
automatic increase in interest rates at the end of an upswing, which dampens expenditure,
may perhaps initiate the start of a downswing phase. Likewise, decreasing interest rates at the
end of a recession may be the beginning of forces that may initiate the next upswing.
In practice, this factor alone cannot explain the cyclical movement in the economy (also
see section 3.2.2). In chapter 4 other factors are identified that may constitute inherent or
endogenous cyclical forces.

3.2 Linkages between the monetary and the real sectors
At this point we can combine the elements of the model encountered so far: the monetary
sector and the real sector. Together the two sectors constitute a coherent model of the
economy (temporarily excluding the external sector variables and the price level). Different
chain reactions can now be linked together to explain most macroeconomic changes in
these two sectors. The three diagrams involved can be juxtaposed to illustrate the linkages
between the two sectors.
The first important linkage is from the monetary sector (or money market) to the real
sector (or goods market).
Working with both nominal and real interest rates in one set of diagrams
Before we demonstrate that, we need to find a way to link the money market diagram
– which has the nominal interest rate i on its vertical axis – with the real investment
diagram, which has the real interest rate r on its vertical axis.
The two diagrams in figure 3.10 show how the money market diagram can be converted
into one with the real interest rate on its vertical axis. Given an inflation rate π, for every
nominal interest rate level i there is an equivalent real interest rate r. So, if a nominal rate
i0 is determined in the money market, in effect a real rate r0 is also determined (given the
inflation rate).
Note how the vertical displacement of the two diagrams is equal to the inflation rate π, as
required by the expression r = i – π, or i = r + π. (See the box in chapter 2, section 2.2.2, for
a discussion of this expression.)
Figure 3.10 The money market with nominal and real interest rates
The money market with a The money market with a

nominal interest rate real interest rate
i r MS
MS
  P  
 
  P  
 
i0 r0
i0 r0
MD MD
  P  
    
P
  


From now on we will use the right-hand version of the money market diagram, with the
real interest rate r on the vertical axis (while keeping in mind that actual money market
behaviour – the buying and selling of financial instruments, and real money demand and
supply – is based on the nominal interest rate).

❐ If the inflation rate is zero, the two diagrams become identical. Since in this chapter we
are still assuming, for the sake of exposition, that the price level P is constant, the new
diagram does not affect our analysis at all. But it does mean that our diagrammatical
apparatus is equipped to deal with the inflationary context when that becomes
necessary (e.g. in chapter 6).
3.2.1 The Keynesian transmission mechanism in the short run

The first important linkage is from the monetary sector (or money market) to the real
sector (or goods market). Changes in the monetary sector cause changes in the rate of interest
that, via the impact on investment (capital formation), influence aggregate expenditure and
consequently real GDP.
This sequence is particularly important in the analysis of the consequences of monetary
policy steps. A more complete example follows.
Suppose the repo rate is increased by the Reserve Bank. This discourages the lending
and money creation capacity of banks. The money supply contracts. This is likely to
cause excess demand in the money market. Sales of money market instruments (to
increase money holdings) cause downward pressure on their prices, and thus upward
pressure on nominal interest rates (towards a new money market equilibrium). In effect
this increases real interest rates with the same amount. The higher real interest rates
discourage investment. (Why?) The likely decrease in investment expenditure I decreases
aggregate expenditure (C + I + G + X – M). Accumulating stocks discourage production.
If and when production decreases, real GDP and thus real income Y decrease. The level
of economic activity declines and the economy experiences a downswing or cooling down
period. In brief:
Repo rate  ⇒ MS  ⇒ upward pressure on r ⇒ I discouraged; if I  ⇒ total
expenditure decreases ⇒ production discouraged ⇒ real GDP and Y decline.
Figure 3.11 Effect of an increase in the repo rate
r r M
MS
  P   G+X–
  C + I0 +
M
G+X–
C + I1 +
I0
I1
M D
  
P
   I
Real quantity of money I Y
The left-hand diagram in figure 3.11 shows what happens in the money market, and with
the interest rate, when the money supply changes due to the repo rate change. The middle
diagram shows what happens to investment due to the change in interest rate. The right-
hand diagram shows what happens to total expenditure E and consequently to the level of
production (GDP) or income Y.
3.2 Linkages between the monetary and the real sectors 99

In this theory or view of the macroeconomy, therefore, the connection between monetary
disturbances and the real sector occurs via the interest rate-investment link. (Note that
the middle diagram has a monetary variable on the vertical axis and a real variable on the
horizontal axis.) This is the so-called Keynesian transmission mechanism: the transmission from
monetary to real variables occurs primarily via interest rates. (The Classical or Monetarist
view differs from this. It is discussed in chapter 11.)
✍ 1. Suppose the reserve requirement is increased ⇒

_____________________________________________________________________________________
_____________________________________________________________________________________
Diagram:
2. Suppose the Reserve Bank sells government stock in open market transactions ⇒
_____________________________________________________________________________________
_____________________________________________________________________________________
Diagram:
To summarise:
1. The implications of money market conditions or events are not limited to the
monetary sector of the economy. They are also transmitted to the real sector. In this
transmission, the link between the real rate of interest and investment is decisive.
2. The main significance of monetary disturbances and events is the consequences they
have for real GDP and employment.

3. The direct causes of, for example, a downswing in the economy can be found in
reductions in one or more of the components of aggregate expenditure (e.g. G or X),
but may actually lie further back in money market conditions. The reverse is true for
an upswing.
Remember that these rather long chain reactions do not come about in a mechanical
fashion. Each step depends on human decision making; uncertainties abound, and delays
or weak reactions often occur. This can significantly influence the speed and extent of the
real impact of a monetary disturbance or policy step. And even though we are working
with short-run changes, these chain reactions can take a year or two to complete.
How strong is the real impact of a change in the money supply?

One specific important factor in these events is the interest rate responsiveness of the
 MP   = kY – li. We have seen that interest rate
D
demand for money MD – the parameter l in 
changes are of critical importance in understanding the real impact of a monetary policy
step in the form of a money supply change: the larger the interest rate change, the larger
the real impact (via investment). However, what determines the extent to which the interest
rate will increase or decrease?
Reconsider the chain reaction in the case of a restrictive monetary policy step such as an
increase in the cash reserve requirement.
❐ What happens in the money market is that the initial decline in the money supply
results in an excess demand situation. This is what causes the upward pressure on the
nominal (and thus real) interest rate.
❐ How far will the interest rate increase? It depends on the extent that the rate needs
to increase in order to dampen or ‘choke’ the excessive money demand sufficiently to
attain balance with the new, reduced supply of money.
❐ Put differently, the interest rate increase must encourage people and institutions to
hold less money/cash and to rather buy financial assets. How far it needs to increase
before demand has been curtailed sufficiently depends on the sensitivity of people and
institutions to the interest rate. If a small interest rate increase is sufficient to curtail all
the excess demand, money market equilibrium will be reached promptly. The interest
rate will increase only minimally and the impact on the real economy will be relatively
mild.
❐ In other words, if money demand reacts strongly and sensitively to nominal interest
rate changes (if the demand for money is highly interest rate responsive, i.e. a large value
MD
P   = kY – li) the real impact of a monetary policy step such as an increase in the
of l in  
money supply on the interest rate will be relatively weak. (In extreme cases monetary
policy can be entirely impotent; in practice this is a rare event, limited to periods
when confidence in the economy is extremely low. The Great Depression in the USA
and many other countries was one such event and the 2008–09 financial crisis was
another.)
❐ Conversely, if money demand is relatively insensitive to nominal interest rate changes
D
M
(i.e. a small value of l in   P   = kY – li) interest rates will change quite a lot during the
chain reaction and a relatively larger real impact can be expected. In such a situation
monetary policy is relatively powerful.
❐ The diagrams in figure 3.12 illustrate the impact of a money supply contraction on the
real interest rate for the contrasting cases of money demand with high and low interest
rate responsiveness (left-hand and right-hand side diagrams respectively).

❐ The left-hand diagram below shows the impact of a money supply contraction on the
equilibrium real interest rate for a money demand relationship with a relatively high
interest rate responsiveness. The right-hand diagram shows a much larger change in
the equilibrium real interest rate for a similar contraction in money supply if the money
demand has a relatively low interest rate responsiveness.
Figure 3.12 The impact of the interest rate responsiveness of money demand
r MS
  P   r MS
  P  
   
r1
r1
r0 r0
MD
  MP     P  
D
   
Real quantity of money Real quantity of money
In addition to factors that determine the extent of the real interest rate change, the rest of
the impact of the monetary policy step will depend on:
❐ How strongly investment reacts to a real interest rate change. A high interest
responsiveness of investment (a high sensitivity to the rate of interest, indicated by a
large h in I = Ia – hr) will strengthen the impact; and
❐ How strongly any change in investment expenditure impacts on production and income.
This depends on the extent of the multiplier process. Therefore, all the determinants
of the value of the expenditure multiplier KE – various leakage rates – are potentially
relevant.
The table summarises the Potency of
potency and impact of a monetary policy
money supply change. Interest responsiveness of money demand: High Lower
Low Higher
Interest responsiveness of investment: High Higher
Low Lower
Expenditure multiplier: Large Higher
Small Lower
The interest rate as a cost factor

Although an interest rate increase due to restrictive monetary policy, for example, has been
analysed primarily as a factor influencing expenditure or demand, interest rates can also be
an important cost consideration for a business enterprise. Thus interest rate changes can also
affect the production or supply side of the economy.

Note that these conclusions about potency apply specifically to monetary policy steps
in the form of money supply changes. If a monetary policy step is defined in terms of
interest rate changes, a very different result emerges. We will return to this issue in
section 3.3.8.
3.2.2 Secondary effects and ‘crowding out’

There is a second linkage between the two sectors. This one operates in the opposite direction,
i.e. from the real to the monetary sector: any change in real income Y has an effect on the
monetary sector (via real money demand). This effect attains prominence with regard to the
expected consequences of increases in government expenditure (although it is present for
any change in total expenditure, even those originating in monetary disturbances). It can be
illustrated by means of an example:
Suppose government tries to stimulate the economy by increasing government
expenditure G. The subsequent chain reaction exhibits two distinct effects:
Primary effect: G  ⇒ total expenditure increases ⇒ production encouraged ⇒ real
GDP and Y increase.
Secondary effect: As and while GDP increases, so does the volume of goods to be
traded ⇒ total value of transactions increases ⇒ transactions demand for money
 MP   shifts right); this puts upward
D
increases, i.e. money demand increases (graphically, 
pressure on (nominal and real) interest rates (why?); increasing real interest rates,
in turn, start to discourage private investment (why?) ⇒ as investment declines, the
rise in total expenditure is held back ⇒ production growth is held back ⇒ real GDP
and Y growth are held back.
Graphically, this secondary effect and the net effect of an increase in government expend-
iture can be represented as shown in figure 3.13.
Figure 3.13 Net effect of an increase in government expenditure
+X–M
Shift in money demand Secondary effect C + I + G1
r due to initial increase in
real income
r
∆I
•
Primary effect
M Net
G0 + X –
C+I+ effect
on
income
MD I
  P  
 
Real quantity of money ∆I I Y
Note that the secondary, feedback effect via the money market runs counter to the initial
increase in Y. Income is pushed up but then starts experiencing a force in the opposite
direction. However, the secondary impact on Y, being a side-effect, is weaker than the
primary impact.

❐ The net impact on Y will still be in the direction of the primary effect (in the example
above there would still be a positive impact on real income Y).
❐ In practice the two effects are not separated in time. It is not an increase in Y followed by
a distinct, smaller decline. It is not a two-step process. As the primary effect gathers
speed, the secondary effect simultaneously becomes operational. This effectively starts
to put a brake on the growth in real income and progressively restrains the net change
in Y. (We will see this even better when we use the IS-LM diagram in section 3.3.6.)
❐ Thus, in reality, there will probably be no zigzag or cyclical movement in the level of
real income Y. What happens is that, in the later stages of the expansion, the increase
in income starts to lose momentum due to the braking effect of the secondary interest
rate increase.
❐ However, the rate of increase or growth rate of Y, i.e. the percentage change in Y per
quarter or per annum, will go through a cycle: it will increase initially, but decline when
the secondary, restraining effect takes effect.
The point is that monetary feedback effects may noticeably reduce the income-boosting effect of an
increase in government expenditure. The growth in real income is gradually restrained or choked
by the rising interest rate.
This secondary counter-effect A term less often heard is the ‘crowding-in’ effect of
is valid for any stimulation of government expenditure. What does this indicate?
GDP and applies to changes in
exports X and the autonomous It indicates the stimulation of private investment
that may result from government investment in,
components of consumption
for example, infrastructure. This is due to the
(the a-term) and investment
opportunities that the stimulation of the economy
(the Ia term). It also applies to creates for private economic activity in general, or
changes in investment due to specifically for the private sector to supply inputs to
monetary policy pressure on the government projects. These backward and forward
real interest rate and changes in linkages with government investment can serve to
consumption due to income tax create more room for private investment, hence the
changes (affecting disposable idea of crowding in.
real income (1 – t)Y).
In the macroeconomic debate, the secondary effect really came to prominence with regard
to the use of government expenditure to stimulate the economy (fiscal expansion). The
expected advantages of increases in government expenditure may be partially offset by the
real sector impact of the upward movement in interest rates.
❐ Since private investment is depressed by the higher interest rates that result from the
increase in government expenditure, the process has been called the ‘crowding out’ of
private investment by government expenditure.
How strong is crowding out? On what does it depend?
The strength of the crowding-out effect is one of the major disputes in the debate on the
potency of fiscal policy. Four factors are relevant. Three of these were encountered in the
discussion of the potency of monetary policy above and are restated only briefly:
❐ The extent of the crowding-out effect depends first on the income responsiveness of the
MD
demand for money – i.e. the k in   P   = kY – li. Recall that the secondary effect is initiated
by an increase in the transactions demand for money due to an increase in production and
 MP   shifts to the right. If this reaction is strong – k is relatively large
D
income. In the diagram 
so that money demand is very income responsive (and shifts a lot) – the secondary effect

will be larger and crowding out will be stronger. If money demand has a low income
responsiveness, i.e. k is relatively small, crowding out will be weaker.
❐ A second factor is the interest
responsiveness of the demand In practice, the initial state of the money market
for money – i.e. the parameter is also relevant in this process. A market with
MD
l in  
P     = kY – li. The increase in surplus liquidity will easily absorb the extra demand
money demand causes excess without significant upward pressure on interest
demand in the money market. rates emerging. However, if the process starts with a
significant money market shortage – a tight market –
If money demand has a high
the upward reaction of interest rates definitely comes
interest rate responsiveness
into play.
– i.e. l is relatively large – the
real interest rate will increase
M D
relatively little before reaching a new equilibrium. The   P   curve will be relatively flat.
A relatively small negative impact on investment and income follows. Crowding out is
relatively weak in this case. If money demand is interest unresponsive, i.e. l is relatively
small, crowding out will be relatively stronger. (Why?)
❐ A third factor is the interest responsiveness of private investment – the h in I = Ia – hr.
A high responsiveness will increase the secondary effect on expenditure and income.
❐ The fourth factor is the size of the expenditure multiplier KE, which determines the ultimate
impact on Y of any change in investment. As before, all the leakage rates are relevant.
The table summarises the potency and impact of fiscal expansion via increased govern-
ment expenditure.
Potency of
In reality, the strength of the fiscal policy
crowding-out effect is an empi
Income responsiveness of money demand: High Lower
rical question. It depends on
the factual conditions and be- Low Higher
havioural patterns in a particu Interest responsiveness of money demand: High Higher
lar country at a particular time.
Low Lower
(For example, in chapter 2 it
was mentioned that investment Interest responsiveness of investment: High Lower
in South Africa appears to be Low Higher
relatively insensitive with regard
Expenditure multiplier: Large Higher
to changes in the interest rate.)
Small Lower
✍ How does the existence of monetary feedback effects affect the size of the expenditure
multiplier?
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
The value of the expenditure multiplier KE mentioned above is still overoptimistic, since the
secondary effect – which reduces the change in Y – is not taken into account.

Which factors determine the income responsiveness of the demand for money?
It depends on the behaviour patterns of economic participants (buyers, sellers, producers,
consumers, workers), as well as institutional factors. For example:
❐ The increasing use of credit cards implies that the direct need for cash reacts less quickly
to increases in transaction volumes.
❐ The accessibility of the money market for firms wishing to expand their activities is also
important. The more easily they can obtain credit via the issue of banker’s acceptances, for
example, the smaller their need for trade credit from commercial banks. This implies that
their demand for money (bank credit in particular) increases relatively slightly.
❐ Workers who receive weekly wages need to hold smaller precautionary balances, whereas
monthly wages create a need to hold more money, either in cash or on deposit at a bank.
Whatever the factors that determine the income responsiveness of money demand, they are
not likely to change rapidly. In general, these elasticities are relatively stable, at least in the
short and medium term.
Different countries can also have very different elasticities, depending on factors such as the
level of development and the nature of their economic and financial institutions.
3.2.3 Financing the budget deficit

Although the budget deficit as an element of fiscal policy is analysed in depth in chapter
10, it is desirable to analyse some interactions of the deficit with the rest of the economy
at this stage. The financing of the budget deficit by the Treasury constitutes a critically
important form of interaction between the real and the monetary sectors. It also provides
further insight into the concept of crowding out.
In the case of a budget deficit – when total tax revenue falls short of total government
expenditure – the shortfall must be financed in some way or another. Since borrowing is
the main form of deficit financing, the deficit is often called the ‘deficit before borrowing’.
There are three main methods of financing a budget deficit: domestic borrowing from
the private non-bank sector, borrowing from the Reserve Bank, and foreign loans. Our
concern here is the different macroeconomic consequences of the three options.
(1) Domestic borrowing from the private non-bank sector

This is the most general and traditional method of deficit financing: the government gets
financing by selling government bonds and TBs in the financial markets to large corporations
(such as pension funds and life
insurers). Treasury bills are usually Crowding out mark II?
sold weekly as part of a running
Since a deficit-induced increase in interest rates
borrowing process.
can also discourage private investment, a form of
❐ We can interpret government crowding out may also exist in this case. However,
borrowing as a component this is not a secondary or indirect monetary effect,
of the demand for credit. De- (which we can denote as ‘crowding out mark I’).
pending on financial market Rather, it concerns the direct financial market effect of
conditions and behaviour, an government borrowing. One should thus distinguish
increase in borrowing is likely this ‘direct’ form of crowding out – crowding out
to cause upward pressure on mark II – from the indirect one analysed above –
interest rates, which is likely to ‘crowding out mark I’.

discourage private investment and is likely eventually to have a contractionary effect
on aggregate expenditure and production.
❐ The standard method of financing is restrictive. If the amount of borrowing is extensive
and places substantial demands on the money market, the contractionary effect on
domestic real income can be significant.
✍ What determines the extent of the impact of government borrowing on interest rates? Can you
explain?
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
(Hint: Consider monetary responsiveness.)
The impact on the actual money market

There is no rule of thumb regarding the size of the deficit that can be financed without putting
inordinate pressure on financial markets (i.e. on interest rates). It depends on economic and
market conditions at a particular time.
In times of monetary tightness (limited liquidity in the market), a relatively stronger interest
reaction can be expected. In an economic downturn, which usually brings about a low
demand for money and credit, a large deficit can be financed domestically without noticeable
upward pressure on interest rates.
Actually, the important question is whether the deficit that is announced in the budget speech
in Parliament comes as a surprise for money and capital market participants. Usually the
markets discount the expected deficit before the national budget is presented – the expected
impact is already largely reflected in the interest rate situation before the budget.
If the budgeted deficit is as expected, there should be no further impact on interest rates. If the
budget deficit is, say, unexpectedly large, interest rates may increase noticeably soon after the
budget speech.
❐ The impact of the budget deficit on interest rates is particularly important in understanding
interest rate patterns in the USA, as well as changes in the dollar exchange rate. As we will see
in chapter 4, US interest rates can be of great importance for the South African economy.
(2) Borrowing from the Reserve Bank

An alternative is for the government to borrow from the Reserve Bank. This can be effected
by selling TBs or government bonds to the Reserve Bank. The payment that the government
receives for the bills constitutes the loan.
❐ Since such transactions constitute an inflow of money from ‘outside’ the economy, they
lead to an injection of money into the system. The resultant money supply expansion
is likely to cause downward pressure on interest rates. Therefore this method of deficit

financing is expansionary.
Because of the credit multiplier, This method is also called financing of the deficit
the ultimate increase in the via money creation. In the media one often notices
the expression ‘financing the deficit with the printing
money supply will in all
press’, as if the government finances the deficit by
likelihood be much larger than
printing money. This is merely a manner of speaking,
the initial injection into the and does not indicate what usually really happens.
money supply resulting from
the government financing its Remember that the government in South Africa does
deficit with ‘new money’. not control the printing or issue of money – only the
Reserve Bank is mandated to do so. Also, actual paper
Since such monetary expansion is notes and coins are not the issue where the money
commonly regarded as inflationary supply is concerned – recall that notes and coins
(see chapters 7 and 12) and has constitute only a fraction of the total M3 money supply.
indeed in reality led to inflationary
and even hyperinflationary episodes – Zimbabwe being a case in point – this is not a popular or
approved form of deficit financing. In practice, governments will only use it in extraordinary
circumstances (see chapter 10).
❐ In contrast, domestic borrowing from the private sector is described as a ‘non-
inflationary method of deficit financing’.
(3) Foreign loans

In this case, the Treasury goes offshore to foreign money and capital markets and sells
(or ‘floats’) bond issues there. The inflow of the borrowed funds from outside implies a
monetary injection, which increases the money supply. The macroeconomic effect is
expansionary.
❐ The so-called ‘Yankee’ and ‘Samurai’ bonds that the South African Treasury issued are
two examples. The ‘Yankee’ bond is a dollar-denominated bond, while the ‘Samurai’
bond is a yen-denominated bond.
Which option?
The choice that government makes between these options will clearly depend on general
economic as well as money market conditions (among other things).
❐ In some situations, government (the Treasury) may expressly want to use an
expansionary method of financing; at other times definitely not. The likely extent of
any crowding out that may occur surely is relevant, as are the private investment level
and prospects.
❐ A further consideration with regard to both domestic and foreign loans is the extent of
annual interest payments, which indeed can become an important expenditure item,
eventually claiming a significant part of the expenditure budget.
❐ As foreign loans are usually denominated in what is called a ‘hard currency’ (i.e. either
dollars, pounds, euros or yen), foreign loans have the additional disadvantage that foreign
exchange is required when they are to be repaid or when interest is paid on them.
❐ This also means that the government faces exchange rate risk. If the exchange rate changes
before the due date, the size of the loan in rand terms can balloon (or shrink, depending on
the case). For example, should the rand depreciate from $1 = R12 to $1 = R18, it means
that for every $1 that the South African government borrowed, it now effectively owes the
lender (maybe a US bank) R6 more in rand terms. This is a 50% increase in the foreign
indebtedness of the government purely due to a depreciation of the rand, i.e. without it
actually having borrowed more.

These considerations are closely linked to the problems of fiscal policy and public debt
management. They are part of a more comprehensive set of considerations and arguments
that are relevant in the policy context, and which are analysed further in chapter 10.
❐ Remember that domestic borrowing from the non-bank private sector is the primary
and predominant method of financing.
The deficit and the balance of payments (BoP)

Although the international aspects of macroeconomics are analysed in chapter 4, it is
desirable to note certain linkages at this stage:
❐ Foreign loans imply an inflow of foreign capital. Therefore they constitute a link between
the budget deficit and the balance of payments deficit or surplus. (How?)
❐ Such a link also results when the budget deficit is financed with domestic loans. The
upward pressure that this places on interest rates can attract foreign capital, which
strengthens the capital account, and thus the balance of payments. (This is of particular
importance in the USA, but also has important implications for South Africa; see below.)
Crowding out mark III?

We have encountered two possible forms of crowding out. Chapter 4 will show that the
financing of a budget deficit via borrowing also can lead to the crowding out of exports – a
possible third form of crowding out linked to the budget deficit or to government expenditure.
(Once again, this has been a major issue in the USA.)
3.3 The IS-LM model as a powerful diagrammatical aid

The diagrammatical exposition encountered so far is straightforward. All the main
components in the chain reactions are individually visible. Each diagram represents
a recognisable component or sector in the overall picture and shows specific economic
behavioural relationships such as consumption or investment. The three diagrams
alongside one another show how disturbances are transmitted from the monetary to the
real sectors via the interest–investment diagram. It also allows for secondary or feedback
effects from the real to the monetary sectors.
Thus, a complete diagrammatical framework has been developed. A sequence of economic
events can be followed clearly through the diagrams. However, working with three
diagrams is cumbersome and imprecise.
3.3.1 Essentials of the IS-LM model

The IS-LM model is an alternative way of depicting these relationships diagrammatically
(see figure 3.14). It is a diagram that summarises these three diagrams into one, somewhat
complex, diagram.
It is a more abstract diagram in that it derives ‘equilibrium curves’ from the various behavioural
relationships. These curves do not permit the direct type of behavioural interpretation
possible in the diagrams encountered so far, e.g. a consumption function that directly shows
consumption behaviour. The IS-LM curves are indirect, derived curves.
3.3 The IS-LM model as a powerful diagrammatical aid 109

On the other hand, the IS-LM diagram provides a concise and powerful graphical (and
mathematical) tool for analysing macroeconomic changes. Still, it does not add much
economic reasoning or content to the analysis. Mostly, it is a diagrammatic tool.
The IS-LM model integrates the real and the monetary sectors and shows their interrelatedness
and interaction in one diagram. It offers a one-diagram summary of the traditional three
diagrams in the simple two-sector Keynesian 45° diagram model. The model depicts the key
macroeconomic relationships in a diagram with real income Y and the real interest rate r on
the two axes. As the name indicates, the IS-LM model comprises two curves: the IS curve and
the LM curve.
The IS curve is a summary curve that depicts the real sector – i.e. the two diagrams shown
in chapter 2, containing the interest rate, investment, consumption, government expenditure,
net exports and aggregate expenditure – in a single diagram.
❐ The IS curve shows combinations of the real interest rate r and real income Y that are consistent
with equilibrium in the real sector.
❐ It is a series of potential equilibrium points, from the point of view of relationships and
behaviour in the real sector. It has a negative slope.
The LM curve is a summary curve Figure 3.14 The IS-LM model
that depicts the monetary sector
r LM curve
– i.e. the demand for money and
the supply of money – on the same
axes as the IS curve.
❐ The LM curve shows combinations
Overall macroeconomic
of the real interest rate r and real
income Y that are consistent with
r1
• equilibrium Y1 and r1:
simultaneous equilibrium in
equilibrium in the money market.
r0
• real and monetary sectors
❐ It is a series of potential
equilibrium points, from the
point of view of relationships
IS curve
and behaviour in the monetary
sector. It has a positive slope.
Y0 Y1 Y
The intersection of the two curves
indicates an overall macroeconomic equilibrium – simultaneous equilibrium in the real
sector and monetary sector (money market). The intersection is the only point among
the two sets of potential equilibrium points denoted by the two curves that produces
equilibrium in both sectors.
The IS-LM diagram can be used to show the impact of macroeconomic disturbances on
the equilibrium levels of real income and real interest. Macroeconomic shocks translate
into a shift in either the IS or the LM curves, or both, resulting in a new intersection point.
This indicates a change in the equilibrium values of r and Y.
For instance, an increase in aggregate expenditure will shift the IS curve right, leading to
both a higher real interest rate and a higher level of real income. The equilibrium point
changes from (r0; Y0) to (r1; Y1).

Which is which?
How does one remember which curve is the IS and which the LM? Try the following association:
❐ IS: Investment, Savings and other real sector variables.
❐ LM: Liquidity, Money and other monetary sector variables.8
3.3.2 Deriving the IS curve

As noted above, the IS curve shows combinations of the interest rate i and real income Y that
are consistent with equilibrium in the real sector. The IS curve is derived directly from the 45°
diagram and the accompanying interest–investment diagram. The derivation is shown in
the set of diagrams in figure 3.15.
The starting point for this derivation is an equilibrium position in the 45° diagram. This shows
a level of Y, which depends on a level of aggregate expenditure – notably a level of investment
I0 – which is consistent with a particular interest rate r0. From this it follows that those levels
– e.g. Y0 and r0 – represent a particular pairing of Y and r that is consistent with the condition
for equilibrium in the real sector, i.e. that aggregate expenditure equals aggregate production.
This pair can be plotted as a point on the income–interest (Y-r) pair of axes.
If the interest rate were at another level, say r1, it would imply a different level of invest-
ment I and of aggregate expenditure, and hence of equilibrium real income – therefore,
another equilibrium pairing, say of r1 and Y1 on the Y-r axes.9 A line connecting these
(and other such) points is the IS curve. It has a negative slope.
In general, each equilibrium level of Y has a specific, corresponding interest rate r as its
counterpart. Stated differently, each point of equilibrium in the real sector has two sides:
a specific level of Y and a corresponding level of r.
❐ In this way one can derive, from the interest-investment diagram and the 45° diagram,
many such pairings of Y and r that satisfy the conditions for equilibrium in the real
sector.
❐ If these (r; Y) pairs are plotted on a diagram with these two variables on the axes, the
result is the IS curve.
Note that the IS curve is a set of points where equilibrium in the real sector may occur
– where the conditions for equilibrium in the real sector are satisfied. Along the IS
curve, the real sector would be in equilibrium. Thus an important interpretation of the
IS curve is as a series of potential equilibrium values of Y and r, given the way economic
actors in the real (or goods) sector – investors, consumers, the government – behave.
When economic shocks and fluctuations have run their course and a new equilibrium
has been attained in the real sector, it will always be one of the points on the IS curve.
8 Formally, the IS label comes from the real sector equilibrium condition I = S, which is an alternative way of stating
Y = C + I + G + (X – M). The LM label derives from the money market equilibrium condition restated as L = M, where
L denotes money demand MD and M the money supply MS.
9 Put differently: any equilibrium level of income other than Y0 would entail a level of the interest rate that differs from
i0 (otherwise there would not be an equilibrium in the real sector).

Figure 3.15 Deriving the IS curve
r E
Equilibrium Equilibrium
pair (r0;Y0 ) pair (r1;Y1 )
r0 –M
+X –M
+G +X
C + I1 +G
r1 C + I0
I1
I0
I0 I1 Investment I Y0 Y1 Income Y
r
Corresponding
pairs of Y and r
denote points that
form the IS curve
r0 (r0;Y0 )
Different interest rates
reappear on vertical
axis of new diagram
r1 (r1;Y1)
Values of Y in 45° IS curve

diagram reappear on
horizontal axis of IS
diagram Y0 Y1 Income Y
❐ Note that, at a point lower down (to the right) on the IS curve, investment I will always
be at a higher level than at any point higher up on the IS curve. (If this is not clear to
you, scrutinise the derivation diagrams of the IS curve again, focusing on the level of
investment I associated with each of the two points on the IS curve: I1 is associated with
point Y1 and r1 on the IS curve.)
❐ The IS curve alone cannot be used to analyse sequences of events in the economy. It
summarises only one part of the economy, i.e. relationships and changes in the real
sector. The addition of the LM curve is necessary to incorporate monetary effects and
to complete the model.
❐ Diagrammatically: to determine the actual equilibrium point and value of Y, a specific
point among the series of potential equilibrium points on the IS curve must be selected.
❐ This will depend on the LM curve (see section 3.3.4).

The IS curve as a summary curve
Economic changes involving r and Y can be summarised in terms of the IS curve. Consider
a simple change in the interest rate. It would lead to a different equilibrium level of income
Y. While this can be depicted using the two diagrams shown in the first part of this chapter,
the IS curve is a handy, concise summary curve that depicts the string of equilibrium
points among which the real economy can settle following such a change in r. Given a
particular change in r, the resultant change in equilibrium Y is shown by the IS curve
(excluding monetary effects).
A formula for the IS curve π

Since the IS curve represents (r; Y) points that satisfy the equilibrium conditions for the real
sector (or goods market), we already have derived its equation in chapter 2 (see equation 2.6):
(  1
Y =  ) (a + Ia + G – hr)
  1 – b (1 – t)    …… (3.3 = 2.6)
= KE(a + Ia + G) – KEhr
 K1h    and its
If this equation is solved for r, one can see that the slope parameter of the IS curve is 
1
__ E
intercept   h (a + Ia + G):
1 1
  h (  a + Ia + G) – 
r =    K h    Y …… (3.4)
E
If exports and imports are included, we have, from chapter 2 (equation 2.8):
Y =  ( 
  1 – b(1 – 
 
t) + m
1
   )
  (a + Ia – hr + G + X – ma ) …... (3.5)
= KE(a  Ia  G  X  ma  hr)
as a formula for the open-economy IS curve.
3.3.3 Properties of the IS curve

The slope of the IS curve
The well-known sequence following a decline in the real interest rate also indicates the
slope of the IS curve. Since a lower interest rate will be associated with a higher equilibrium
income level (other factors being the same), the IS curve has a negative slope, as indicated
in the diagram.
Moving along the IS curve, shifting the IS curve Formal rule for shifting vs. moving
along a curve
The sequence starting with an interest rate
change illustrates an important character- The shifting of the two curves is the most
istic of the IS curve. important aspect of the IS-LM model for
❐ If the interest rate changes, the change rudimentary analysis and reasoning about
in Y from one equilibrium to the next economic events. It is essential to master
is depicted as a move along the IS curve this part of the theory.
❐ A curve shifts if a relevant variable
from one point to another. (Compare the
not on one of the axes of the diagram
first diagram in figure 3.15.)
changes.
A shift in the IS curve would occur if, for ❐ If one of the variables on the axes
some reason, a higher or lower equilibrium changes, there is a move along the
level of Y occurs without the interest rate r curve.
having changed.

The primary reason for such a shift is an exogenous change in expenditure. If exogenous
expenditure is higher, e.g. due to a higher level of government expenditure, it would
imply a higher equilibrium level of Y being paired with the initial level of r.
Since this change does not involve the interest rate, the initial interest rate would now
be paired with a different, higher level of real income Y (to the right in the horizontal
dimension). The whole set of potential equilibrium points – the points (r; Y) that satisfy the
conditions for equilibrium in the goods market – would lie on a different plane.
❐ Diagrammatically, this translates into a Figure 3.16 Shifting the IS curve
shift of the IS curve, horizontally, to the
right (see figure 3.16). r
When we analyse disturbances in an

IS-LM diagram this means that changes New real sector
in any factor other than the interest rate, equilibrium Y1 at
unchanged r0
which impact on aggregate expenditure
and hence on real income Y, will shift the
IS curve. These include exogenous changes
in consumption, investment, government r0
expenditure, taxation (which affects con-
sumption), exports or imports.
❐ Any exogenous change in expenditure Entire IS curve
shifts to the right
that boosts Y would shift the IS curve to
the right. Y0 Y1 Y
❐ Any exogenous change in expenditure
that decreases Y would shift the IS curve to the left. (See the examples in section 3.2.2.)
How far will the IS curve shift?

The extent of the shift in the IS curve following an exogenous change in expenditure depends
on the resultant change in equilibrium Y. Obviously this depends on the magnitude of the
change in expenditure. A small increase in G, for example, would shift the IS curve less than a
large change would.
In addition, it would depend on the relationship between the change in G and the eventual
change in Y that results. This depends, simply, on the size of the expenditure multiplier KE:
❐ If the multiplier is small, IS shifts relatively little (for a given change in G).
❐ If the multiplier is large, IS shifts relatively much (for a given change in G).
To be specific, the IS curve will shift horizontally a distance equal to ∆Expenditure × KE
How steep is the IS curve?

For more sophisticated analysis the factors determining the steepness of the IS curve are
important. The clue to the steepness of the IS curve lies in the reasoning behind the slope
of the curve. The slope of the IS curve will depend on the magnitude of the change in real
income Y, given a certain initial change in the interest rate r. A smaller change in Y would
result in a relatively steep IS curve; a relatively large change in Y gives rise to a relatively
flat IS curve. Diagrammatically, this can be represented as in figure 3.17.

The more important question is: which economic factors or characteristics determine the
slope of the IS curve? Reconsider the example of a drop in interest rates in chapter 2,
section 2.2.4:
r  ⇒ I  ⇒ total expenditure  ⇒ production  ⇒ Y 
How much will Y change? Figure 3.17 The slope of the IS curve
Two factors determine the r
extent of the change in Y: IS steeper
Slope of IS curve depends on how
1. The first is the reaction much Y changes in response to a
of investment to the change in the interest rate
interest rate change.
r0 (r0;Y0 )
The extent of the re-
action depends on the
sensitivity of investors r1
to the interest rate, i.e. IS flatter
the interest responsive-
ness of investment – the
size of h in I = Ia – hr
(or in the formula for Y0 Y1 Y2 Y
IS, see equation 3.5 in
the maths box above). If this sensitivity/responsiveness is high, a given interest rate
change will elicit a strong investment reaction and the eventual change in Y will be
relatively large. This would make the IS curve relatively flat (its slope being   K1h    ). A low
E
interest responsiveness of investment would make the IS curve relatively steeper.
2. The second factor is the reaction of total production to the change in aggregate ex-
penditure. This reaction involves the multiplier process (see section 3.2.1). If the mul-
tiplier KE is large, the change in I in the first step will be amplified considerably and the
eventual, cumulative change in Y would be large. A large multiplier KE would there-
fore make the IS curve flatter (its slope being   K1h    ). A smaller multiplier would make
E
the IS curve steeper. (Remember that the size of the multiplier depends on various
marginal leakage rates. See
Note that the multiplier affects both the slope of the IS
the examples below.)
curve and the extent to which the IS curve would shift
In the diagram above, therefore, following an exogenous change in expenditure.
the slope of the ‘flatter’ IS curve
reflects either a high interest responsiveness of investment or a large multiplier, or both.
The ‘steep’ IS curve reflects either a low interest responsiveness of investment or a small
multiplier, or both.
Examples Effect on slope of IS curve
Investors not very sensitive to interest rates (h) → Steeper
High interest responsiveness of investment (h) → Flatter
Large multiplier KE → Flatter
Small multiplier KE → Steeper
High propensity to consume b → Flatter
High propensity to save (1 – b) → Steeper
High propensity to import m → Steeper
Cut in income tax rates t → Flatter

Points off the IS curve
Since the IS curve is a collection of combinations of Y and r that are consistent with real
sector equilibrium, any point off the IS is a disequilibrium point in the real sector. At
such a point the interest rate is too high or too low to be compatible with the level of real
income. Alternatively, the income level Y is too low or too high to be compatible with that
interest rate (and the resultant investment level). For such a pairing of Y and r, aggregate
expenditure would not be equal to aggregate output, so there would not be real sector
equilibrium.
3.3.4 Deriving the LM curve

In this section we add the second element in the IS-LM model, i.e. the LM curve. Following
that, we can use both curves to analyse economic events and changes.
Whereas the IS curve summarises economic relationships and equilibria in the real sector
of the economy, the LM curve summarises relationships and equilibria in the monetary
sector. More specifically, the LM curve summarises the money market derived in the first
sections of this chapter. It differs from that depiction of the monetary sector in that it
makes explicit the link between monetary relationships and real income Y.
As noted above, the LM curve shows combinations of the real interest rate r and real income Y that
are consistent with equilibrium in the money market. The LM curve is derived directly from the
money market diagram, in conjunction with the 45° diagram (see section 3.2.1).
The essential linkage between the money market and real income lies in the real demand
for money relationship (now written in converted form with the real interest rate r). Recall
that:
MD
P   = f(i; Y)
 
= kY – li
But with i = r  π:
MD
P   = f(r; π; Y)
 
= kY  lπ  lr
The key element to notice is the presence of Y on the right-hand side. It indicates that the
specific position of the real money demand curve in the money market diagram depends
on the prevailing level of real income Y. If Y is relatively high, the money demand curve
would be in a position relatively far to the right. If Y is relatively low, the money demand
curve would be in a position less to the right.
❐ In general, for each level of Y the money demand curve would be in a different position
(other things being the same).
Notice the presence of inflation on the right-hand side. It was mentioned in section 3.1.2
that a higher price level causes the nominal demand for money to increase. This effect
M D
of P was handled by working in terms of   P  
,  the real demand for money. However, the
above equation indicates that inflation (continually increasing P) has an impact on the real
demand for money. The relationship is negative. As shown in section 3.1.2, holding money
means that one is not compensated for the loss of value due to inflation. Therefore, one
would prefer to hold less money when inflation is present. An increase in the inflation rate
will decrease one’s real money demand.

❐ In general, for each level of π the money demand curve would be in a different position
(other things being the same).
Money demand and money supply together determine the equilibrium interest rate in the
M S
M D
moneymarket. For a given real money supply   P  
,  each different money  
P  
  curve would
imply a different equilibrium real interest rate.
❐ For a given money supply (and inflation rate), therefore, each level of Y would imply a
different position for money demand and a different equilibrium interest rate r. Thus
there is a relationship between Y and the equilibrium interest rate r in the money
market. The LM curve depicts this relationship.
Figure 3.18 Deriving the LM curve
For income at the higher level of Y monetary Corresponding pairs of Y

r demands is at a higher level. Hence a higher r and r denote points that
r is necessary for money market equilibrium form the LM curve LM curve
M S
(r1;Y1)
r1 r1
MD for income at Y1 (r0;Y0 )

r0 r0
MD for income at Y0
Quantity of money Y0 Y1 Y
To derive this in the diagram (see figure 3.18), do the following:

❐ The starting point for this derivation is an equilibrium in the money market (left-hand
diagram). For a given money supply (and inflation rate), this shows an equilibrium
interest rate that is compatible with the prevailing position of money demand, which
in turn depends on the prevailing level of Y. Hence that combination of r and Y – e.g.
r0 and Y0 – is consistent with money market equilibrium. This pair can be plotted as a
point on the income–interest (Y-r) pair of axes.
❐ Suppose Y is at a different, higher level. This would imply a higher level of money demand,
or a position more to the right. The equilibrium interest rate would be higher, resulting
in a second equilibrium pairing of, say r1 and Y1 on the income–interest (Y-r) axes. A line
connecting these (and other such) points is the LM curve. It has a positive slope.
In general, each equilibrium level of the interest rate r has a specific, corresponding income
level Y as its counterpart. Stated differently, each point of equilibrium in the monetary
sector has two sides: a specific level of r and a corresponding level of Y.
❐ In this way one can derive, from the money market diagram and the 45° diagram, many
such pairings of Y and r that satisfy the conditions for equilibrium in the money market
(monetary sector).
❐ If these (r; Y) pairs are plotted on a diagram with these two variables on the axes, the
result is the LM curve.

Note that the LM curve is a set of points where equilibrium in the monetary sector may
occur – where the conditions for equilibrium in the money market are satisfied. Along the
LM curve the money market is in equilibrium. Thus an important interpretation of the LM
curve is the following: the LM curve shows a series of potential equilibrium values of Y and
r, given the way economic actors in the monetary sector behave. When economic shocks
and fluctuations have run their course and a new equilibrium has been attained in the
monetary sector, it will always be one of the points on the LM curve.
A formula for the LM curve π

Since the LM curve represents (r; Y) points that satisfy the equilibrium conditions
for the money market, we already have derived its equation above (see equation 3.2).
In real interest format it is:
MS MD
P   =   P   
  
= kY – lπ  lr
If solved to get the interest rate on the left-hand side, it becomes:

k
r =  l  Y –  ( 
1 MS
)
  P  + lπ 
  l     …… (3.6)

 1l    
Thus the slope of the LM curve is  kl  and its intercept is  (  )
  MP    + lπ  .
S
The LM curve as a summary curve

Whereas the money market diagram can be used to analyse the relationship between
the money market and real income, the LM curve is a handy, concise summary curve that
depicts the string of points along which the money market can settle following a change in
real income Y. Given a particular change in Y, the resultant change in equilibrium r – via
a shift of the real money demand curve – is shown by the LM curve (for a given real money
M S
P   and inflation π).

supply  
3.3.5 Properties of the LM curve

The slope of the LM curve
Since a higher level of Y is associated with a higher equilibrium interest rate (for a given
money supply), the LM curve has a positive slope, as indicated in figure 3.19.
Moving along the LM curve, shifting the LM curve

If Y changes, the change in r from one equilibrium to the next is depicted as a move along
the LM curve.
A shift in the LM curve would occur if the equilibrium interest rate were to change for a
reason other than a change in Y.
Three main factors can shift the LM curve: changes in the price level P, an exogenous
 MP  ,  and a change in the real money supply 
 MP  .  In
D S
increase in the real demand for money 
each case the set of points that satisfy the conditions for money market equilibrium, i.e.
the LM curve, moves.
1. At a higher price level, there would be a higher transactions demand for money,
implying a higher interest rate is necessary to yield money market equilibrium

(at the prevailing level of Y). The initial level of Y would then be paired with a different,
higher level of r.
❐ Diagrammatically, this is shown as a horizontal, leftward shift of the LM curve.
2. At a higher level of real demand for money (linked to an exogenous factor, e.g. pessimistic
expectations) there would be a higher precautionary demand for money, implying a
higher equilibrium interest rate (at the prevailing level of Y). The initial level of Y
would now be paired with a different, higher level of r.
❐ Diagrammatically, this is shown as a leftward shift of the LM curve.
3. At a higher level of the real money supply, and at the prevailing level of Y, a new and
lower level of the interest rate would be necessary to attain equilibrium in the money
market. The initial level of Y would now be paired with a different, lower interest
rate r.
❐ Diagrammatically, this is shown as a rightward shift of the LM curve.
When we analyse disturbances in an IS-LM diagram, this means:
❐ If the money supply is increased, it will shift the LM curve right. If the money supply
contracts, it will shift the LM curve left.
❐ If the price level increases, the LM curve shifts left. If the price level decreases, the LM
curve shifts right.
❐ If money demand increases for an exogenous reason, the LM curve shifts left. If it
decreases for some reason, the LM curve shifts right.
The case of a change in the real money supply is very important, especially in analysing
the effects of monetary policy in the IS-LM diagram.
How far will the LM curve shift?

In the case of an expansion in the real money supply, the LM curve will shift right
M S
1
  P   multiplied by  k . 
(horizontally) by a distance equal to the change in 
How steep is the LM curve?

The clue to the steepness of the LM curve lies in the reasoning behind the slope of the curve.
The slope of the LM curve will depend on the magnitude of the change in equilibrium
interest necessary to re-establish equilibrium in the money market, following a particular
change in real income Y. A smaller change in r would imply a relatively flat LM curve; a
relatively large change in r implies a relatively steep LM curve. Diagrammatically, this can
be represented as shown in figure 3.19.
The economic factors or characteristics that determine the slope of the LM curve are
important. Reconsider the example of an increase in real income Y, the resulting increase
in money demand, and the eventual increase in the equilibrium interest rate. How much
will r change? Two factors or sensitivities are relevant:
M D
1. The income responsiveness of the demand for money (which is k in the  P   equation; also
see the LM equation (3.6) in the maths box). This determines the extent to which
monetary demand increases following a given increase in real income Y.
 MP   will
D
❐ If k, the income responsiveness of money demand, is high, money demand 
increase (shift in the money market diagram) relatively a lot following an increase
in Y, and the interest rate will have to be raised relatively a lot higher to restore
equilibrium in the money market. This would make the LM curve relatively steep
(its slope being  kl  ).

Figure 3.19 The slope of the LM curve
r
LM curve steeper
r2
Slope of LM curve depends
on how much r has to in- LM curve flatter
crease to re-establish money
market equilibrium for a
r1
higher level of Y
r0
(r0; Y0)
Y0 Y1 Y
❐ If monetary demand is relatively unresponsive to changes in Y, meaning k is small,

the LM curve will be relatively flat.
 MP   equation;
D
2. The interest rate responsiveness of the demand for money (which is l in the 
also see the LM equation (3.6) in the maths box). Following a given increase in real
money demand (a shift to the right in the money market diagram due to a higher Y),
this responsiveness determines by how much the interest rate would have to increase
to choke off the excess demand for money in the money market (for the existing real
money supply).
❐ If the demand for money reacts strongly to interest rate changes – the interest
responsiveness of money demand l is high – a relatively small interest rate increase
would be sufficient to restore money market equilibrium. As a result, the LM curve
k
would be relatively flat (its slope  l  will be smaller).
❐ If the interest responsiveness of money demand is low, a relatively large interest rate
increase would be necessary to restore money market equilibrium. Consequently,
the LM curve would be relatively steep.
LM a mirror-image of the money demand curve?

In terms of the effect of interest responsiveness the slope of the LM curve is the same as that
of the money demand curve.
M D 
❐ A high interest responsiveness of money demand implies a relatively flat   curve and a
P
relatively flat LM curve.
❐ A low interest responsiveness of money demand implies a relatively steep   MD  curve and a
P
relatively steep LM curve.

To summarise: Effect on slope of LM curve
Low income responsiveness of money demand k → Flatter
High income responsiveness of money demand k → Steeper
Low interest responsiveness of money demand l → Steeper
High interest responsiveness of money demand l → Flatter
Points off the LM curve

Since the LM curve is a collection of pairs of Y and r that are consistent with money market
equilibrium, any point off the LM is a disequilibrium point in the money market. At such a
point, the interest rate is too high or too low to be compatible with the level of real income
(and resultant level of money demand). For such a pairing of Y and r, aggregate monetary
demand would not equal the money supply and there would not be equilibrium in the
money market (or monetary sector).
3.3.6 IS and LM together – simultaneous equilibrium in the real and monetary

sectors
Section 3.3.1 intuitively described the use of the IS and LM curves to determine an overall
equilibrium. Shifts in either curve would lead to a new equilibrium level of GDP and the
interest rate. Graphically, this new equilibrium was to be found at the intersection point
of the two curves.
Why is equilibrium at the intersection?

It was noted that the intersection between the two curves is the only point among the two
sets of potential equilibrium points (denoted by the two curves) that produces equilibrium
in both sectors. This statement needs to be formalised. The question is why the economy
would be at, or would gravitate to, the point of intersection or simultaneous equilibrium.
The reason is that at any point other than the intersection, forces would exist that would push
the economy towards the intersection.
Consider a point such as 1 (see figure 3.20), which is on the IS curve but not on the LM curve.
Being a point on the IS curve, there would be equilibrium in the real sector (goods market),
i.e. between total expenditure and total production. However, that particular pairing of the
interest rate r1 and income Y1 would not Figure 3.20 Equilibrium in the IS-LM model
produce equilibrium in the monetary
r
sector: any point off the LM curve is
one of money market disequilibrium. LM curve
In this case, for that particular interest r2
2
rate and income level, the resultant
r1 1
money demand would be relatively
depressed and would be lower than the
available money supply: there would r0 0
be an excess supply of money. Money
market participants would hold more
cash than desired at that interest rate.
They would then tend to buy money IS curve
market instruments (e.g. BAs), which
would tend to push up the price of these Y1 Y0 Y2 Income Y

Simultaneous equilibrium in the goods and money markets π
We have the formula for the IS curve:
Y = KE(a + Ia + G – hr) ……(3.3)
and the formula for the LM curve:

k
  l  Y –  
r =  
1 MS
(  )
  P  + lπ  ……(3.6)
  l    
Substituting (3.6) into (3.3) produces:
(  k
Y = KE a + Ia + G – h   
l [  1 M
 Y –      
l P ( 
S
    + lπ      )])
Solving for Y and simplifying produces:
Y = 1 (a + Ia + G) + 2  ( 
  P  + lπ  
MS
) ……(3.7)
where
K
  KE hk
1 =    
  El   
1 +   ……(3.7.1)
K Eh
2 =   
l  KEhk
   
Equation 3.7 shows how the equilibrium level of real income Y depends on expenditure
elements as well as real money supply – as captured in the IS and LM curves respectively.
Note that 1, the expenditure multiplier that incorporates secondary effects, is very
different from, and smaller than, KE, which is the expenditure multiplier in the model
without a monetary sector (chapter 2). This demonstrates the constraining impact of the
secondary effect in the money market on changes in Y.
The equilibrium level of the real interest rate can be solved from (3.7) to produce:
  P  + lπ 
r = 1 (a  Ia  G)  2   ( M S
) ……(3.8)
where
kKE
  l  K hk
1 =      
E
……(3.8.1)
  l + K1 hk 
2 =  
E
The equilibrium level of r likewise depends on expenditure elements and the real money supply.
We will return to equation (3.7) in chapter 6 when we derive the aggregate demand (AD) curve.
instruments and push down interest rates. As this happens, investment will increase and
GDP will increase. In the diagram this would push the economy down along the IS curve
towards the intersection. This process will continue until the intersection at point 0 is
reached, because only then would there be no disequilibrium in the monetary sector, and
thus no forces for change.
A similar argument applies to a point such as 2, which is on the LM curve but not on the
IS curve. While the money market would be in equilibrium, the real sector would not be.
While there would be output (production) at the level of Y2, the interest rate r2 at point
2 would be too high for a goods market equilibrium to exist. The interest rate at point 2
is such that investment spending and durable consumption spending would be relatively
low – too low to buy up all the production. There would be an excess supply of goods

and inventories would increase. This would induce producers to cut back on production,
moving the economy towards Y0. As this happens the interest rate would fall to r0. The
process of cutting back will continue until GDP and aggregate expenditure is on par, which
would only be when the economy has moved down the LM curve to meet the IS curve, i.e.
at the intersection point 0.
The point of intersection is the only point where both the real and the monetary sectors are in
equilibrium, implying the absence of excess supply or excess demand in the goods or money
markets that could induce a change in output, expenditure, interest rates or money market
behaviour.
If any disturbance changes conditions, the economy will not be at a simultaneous
equilibrium any more. Graphically the disturbance will be seen in a shift in one or both of
the IS and LM curves, implying a new intersection point. With the initial values of Y and
r the economy would not be at the new intersection point and would be in disequilibrium.
This will put into motion the kind of forces described above, moving the economy towards
a new simultaneous equilibrium and point of rest at the new intersection point. The
particular pairing of r and Y would persist until a new disturbance occurs.
Analysing disturbances: shifting curves

To use the model, one must be able to translate economic disturbances or policy steps into
shifts in the curves:
❐ Shifts in the IS curve: any exogenous change in expenditure – in C, I, G or (X – M) –
that boosts expenditure and thus Y would shift the IS curve towards the right. Any
exogenous decrease in expenditure shifts the IS curve towards the left.
– If G is increased, the IS curve shifts to the right.
– If G declines, the IS curve would shift to the left.
– If exports fall, the IS curve would shift to the left.
– If taxes are reduced, this would lead to an exogenous boost in consumption, and the
IS curve would shift to the right.
– If restrictions are placed on imports, an exogenous drop in imports would result,
(X – M) would increase, and the IS curve would shift to the right.
– If investment falls due to a drop in investor confidence (i.e. at the prevailing interest
rate level), it would shift the IS curve to the left.
❐ Shifts in the LM curve: the primary reason for a shift in the LM curve is an exogenous
or policy change in the money supply (see also discussion below).
– If the money supply expands, the LM curve shifts right.
– If the money supply contracts, the LM curve shifts left.
!
The IS-LM model, in particular, is a case where it is crucial to remember that a purely
diagrammatical analysis – ‘that this or that curve has shifted’ – is no explanation of economic
events. It only provides a way of checking your economic reasoning.
❐ Therefore, always use the diagram in conjunction with the appropriate economic chain
reasoning. Use the three-diagram set outlined in chapters 2 and 3 where necessary.
Examples
1. Suppose there is an increase in government expenditure. This would shift the IS
curve to the right. As the diagram indicates, the equilibrium will change. The new

equilibrium shows a higher level Figure 3.21 Fiscal expansion in the IS-LM model
of real income Y1, coupled with a
r LM curve
higher interest rate r1.
In the context of the 45° diagram
New macroeconomic
(see section 3.2.2), this would be equilibrium point:
depicted as an upward shift of the G r1 Y1 and r1
line and the aggregate expenditure 2
line in the 45° diagram. The subse- r0
1
quent upswing in Y would increase
monetary demand, depicted as a
 MP   curve in
D
rightward shift of the 
the money market diagram. The re- IS curve
sulting increase in the interest rate
would be transmitted to the real
Y0 Y1 Y2 Income Y
sector via reduced investment, im-
plying a secondary, constraining effect on the economic expansion.
The IS-LM diagram in figure 3.21 summarises the simultaneity of these processes. In
response to the increase in aggregate expenditure, income starts increasing. This is
the primary effect. On the diagram this implies a force trying to move Y horizontally
to the right (arrow 1). If nothing else were to change, Y would increase to Y2 (which
would be the full multiplier effect as if there was no monetary sector; see equation 2.6
in chapter 2).
However, as soon as Y starts increasing, the secondary, money-market effect kicks in.
Money demand starts to increase, which causes the interest rate to start rising. The
rising interest rate, in turn, causes investment to decrease. This partially offsets the
expenditure boost due to the initial increase in government expenditure. This implies
a force on Y in the direction of arrow 2.
The net effect of these two forces is the bold blue arrow. Income never gets to Y2.
Income only increases from Y0 to Y1 and the interest rate has increased from r0 to r1.
❐ We see that as the IS curve shifts, the equilibrium point moves along the LM curve.
In terms of the chain reaction, the increase in government expenditure has the
following effects:
G  ⇒ total expenditure  ⇒ production  ⇒ Y 
Primary effect
MD
P    ⇒ r ⇒ I  ⇒ total expenditure  ⇒ production  ⇒ Y 
While Y  ⇒  
Interest rate change + Investment change and expenditure offset

= Concurrent secondary effect
The economics behind the move from the initial to the new equilibrium point in the
IS-LM diagram therefore is the entire sequence of events following an increase in G: the
primary effect on Y (expansionary impact on real sector) plus the concurrent secondary
effect on r and I (upward pressure on the interest rate in the monetary sector).
❐ This example compellingly illustrates ‘crowding out’, explained in section 3.2.2.

Moving up the ramp
This example shows the impact of the secondary or feedback effect via the monetary sector
very graphically. It also provides a telling (if rather mechanical) analogy.
Imagine the equilibrium point being pushed to the right by the forces generated by an increase
in expenditure. However, the equilibrium point cannot move ahead in a horizontal direction. As
it moves to the right, it is forced up a ‘ramp’ formed by the LM curve: the equilibrium point not
only moves to the right, it also has to go up the slope of the LM curve.
The ‘ramp’ exists due to the upward pressure on interest rates generated by the economic
expansion. The eventual ‘horizontal’ change in Y is less than it would have been in the
absence of a ramp (a secondary effect). Going up the slope saps the energy of the expansion.
Which path to the new equilibrium?

The path from one equilibrium to a next need not be exactly along the LM curve, as drawn in
figure 3.21. The path of adjustment of the economy will depend on the speed of adjustment in
each sector or market.
❐ If the interest rate adjusts quickly r
LM curve
relative to the goods market, the
economy will loop, for instance,
from points 1 to 2, and then again New macroeconomic
3
from 2 to 3 (black dotted arrows). equilibrium point
❐ If the money market adjusts
2
more slowly, a bigger loop from
point 1 to 3 can materialise
(blue dotted arrow). 1
❐ To simplify the graphics, we will
normally just indicate the net
effect, i.e. a move along the LM IS curve
curve from point 1 to point 3.
Y
2. Suppose the money supply expands due to an expansionary monetary policy step
such as a cut in the repo rate, which encourages more credit creation by banks. This
would shift the LM curve to the right. As the diagram indicates, the equilibrium would
change to one with a higher level of real income Y1 coupled with a lower interest
rate r1.
In the context of the 45° diagram, this would be depicted as a rightward shift of the
M
S
vertical  
P   curve. This would decrease the interest rate. As intended, this will stimulate
investment and, in turn, output and income Y (see section 3.2.1). However, this is not
the end of the story – there will be a secondary money market effect. The upswing
 MP   curve – resulting in
D
in Y will increase monetary demand – a rightward shift of the 
upward pressure on the interest rate which will, by discouraging investment, imply a
constraining effect on the economic expansion.
The IS-LM diagram in figure 3.22 again captures the complex simultaneity of these
processes. In response to the increase in real money supply, the real interest rate

starts to drop. This is the pri- Figure 3.22 Monetary expansion
mary effect. In the diagram
r LM curve
this implies a force trying
to move r vertically down-
wards (arrow 1). If nothing
else were to change, r would
decrease to r2 to re-establish r0
money market equilibrium New macroeconomic
r1 equilibrium point:
on the new LM curve. 1 Y1 and r1
However, as soon as r starts r2 2
decreasing, investment is
IS curve
stimulated, as is production
and real income. This causes
the secondary, money-market Y0 Y1 Y
effect to be activated. The
demand for money starts to
increase, causing upward pressure on the (still falling) interest rate. This implies a force on
r and Y in the direction of arrow 2.
The net effect of these two forces is the bold blue arrow. The interest rate never drops
as far as r2. Income increases from Y0 to Y1 and the interest rate has decreased from r0
to r1. Investment has increased.
❐ Therefore, we see that as the LM curve shifts, the equilibrium point moves along the
IS curve.
While the main effect may be on the money market (the interest rate change), the trans-
mission mechanism ensures that it also impacts on the real sector (real income Y). This
diagram therefore illustrates the Keynesian transmission mechanism in the case of an
expansionary monetary policy step.
In both cases, the IS-LM mechanics serve as a concise rendition of the many economic
relationships in the real and monetary sectors of the economy, including the interaction
and feedback effects between them. In this sense, the IS-LM model integrates the real and
monetary sectors.
Which path to the new equilibrium?

As before, the actual path from the initial equilibrium
r
to the new one need not be exactly along the IS
curve. The path of adjustment will depend on the
speed of adjustment in each sector. LM curve
❐ If the interest rate drops quickly relative to 1
the growth in investment and income in the
goods market, a big loop from point 1 to 3 can 2
materialise (blue dotted arrow).
❐ If investment reacts rapidly when interest rates 3
start to drop, the economy will have smaller
loops, for instance, from points 1 to 2, and then
again from 2 to 3 (black dotted arrows).
❐ We will normally just indicate the net effect along IS curve
the IS curve from point 1 to point 3.
Y

✍ Suppose taxes are increased ⇒
_______________________________________________________________________________________
_______________________________________________________________________________________
IS-LM diagram:
Suppose the cash reserve requirement is increased ⇒

_______________________________________________________________________________________
_______________________________________________________________________________________
IS-LM diagram:
Suppose exports increase ⇒

_______________________________________________________________________________________
_______________________________________________________________________________________
IS-LM diagram:

The IS-LM is therefore a quick tool for checking one’s economic reasoning, indicating the
basic direction of changes in Y and r. At the same time, however, one loses much of the
diagrammatic richness of the traditional three-diagram model. Hence it is wise to open the
IS-LM ‘black box’ and take out these three diagrams frequently as a way of making absolutely
sure that your economic reasoning is correct. In a way, the very conciseness of the IS-LM
model increases one’s chances of making a mistake.
Of course, while one should never use the three diagrams without giving serious attention
to the relevant economic chain reasoning, this is even truer in the case of the IS-LM model.
The use of the latter model can easily degenerate into pure mechanical manipulation. Do
not fall into this trap.
3.3.7 Different slopes and policy effectiveness

The preceding discussion and examples illustrate the basic application of the IS-LM
mechanics for disturbances originating in either the monetary or the real sector of the
economy.
An interesting dimension of the IS-LM mechanics is the effect of steeper or flatter curves
on the magnitude of the resultant changes in Y and r. These results have an important
implication for the effectiveness of policy. Thus we now reconsider the discussion in
section 3.2 regarding the potency of (a) monetary policy and (b) fiscal policy. Various
responsiveness parameters and multipliers were shown to be relevant. A few examples
suffice to illustrate the basic points.
How potent is monetary policy in affecting real income?

Section 3.2.1 concluded that the potency and impact of a monetary policy step in the form
of a money supply increase will depend on:
❐ the interest responsiveness of money demand l;
❐ the interest responsiveness of investment h, and
❐ the size of the expenditure multiplier KE.
However, these factors also determine the slopes of the IS and LM curves (sections 3.3.3
and 3.3.5). This information can now be combined with the diagrammatical analysis to
answer a question such as the following: what is the effect on real income Y of a one unit
change in the money supply, given different slopes for the LM curve?
❐ For a similar but somewhat surprising analysis regarding the potency of an interest
rate step, see section 3.3.8.
Therefore, consider the impact of a given monetary policy stimulus in the form of a one
unit real money supply increase. It will shift the LM curve to the right by a distance of
 1k   
  MP   . 10 Equilibrium Y will increase, combined with a decline in the real interest rate r.
S
The diagram in figure 3.23 illustrates the influence of the slope of the LM curve on the
change in real income Y (for the same horizontal shift of the LM curve):
❐ If the LM curve is relatively steep, the change in Y is relatively large – monetary policy
is more potent.
❐ If the LM curve is flat, the change in real income Y is smaller – monetary policy is less
potent.
10 Can you see why this is the value? Consider the formula for the LM curve (equation 3.6), but solve this formula for Y
on the left-hand side.

Figure 3.23 Monetary stimulus – influence of LM curve slope
For a similar horizontal shift a

r r LM shifts to
flatter LM produces a smaller
change in both Y and r the right
LM shifts to
the right
r0 r0
r1
r1
IS curve
IS curve
Y0 Y1 Y Y0 Y1 Y
The economic reason for the latter case lies in the interest responsiveness (parameter l) of the
 MP   curve is relatively steep, as is the LM
D
demand for money. If this responsiveness is low – the 
curve – the interest rate will drop much before money market equilibrium is restored (and
all the additional money has been absorbed in portfolios).
The ‘liquidity trap’

An extreme case is that of a completely horizontal LM curve. In such a case, a monetary
stimulus would have no effect whatsoever on income or the interest rate. All extra liquidity
would be absorbed (‘trapped’) in portfolios without any impact on interest rates – there is an
infinite demand for money (a horizontal MD curve). If this situation were to occur, monetary
policy would be entirely impotent.
In the 1940s and 1950s, some economists believed that this condition prevailed at low interest
rates. Although for many years thought to be a theoretical oddity, the liquidity trap drew new
attention first in the late 1990s in Japan when the Bank of Japan decreased its lending rate to
banks to zero per cent, while still failing to stimulate lending.
In 2008 the liquidity trap again drew attention when, in the face of the subprime crisis in the USA,
banks were unwilling to lend to each other as they did not know the extent to which the balance
sheets of borrowing banks were contaminated by bad assets. Effectively this meant that the
interbank market came to a virtual standstill with interbank rates increasing significantly. In an
effort to reignite lending, the major central banks reduced lending rates to banks significantly,
some even providing guarantees for the interbank lending activities. For a time these steps were
not altogether successful, meaning that central banks were unable to spur lending even at much
reduced central bank lending rates. This event appeared to reaffirm the relevance of the liquidity
trap theory. However, its relevance seems to be limited to periods characterised by crises of
confidence. Under normal conditions the liquidity trap theory is not applicable.
The 2007–08 financial crisis in the USA has shown that monetary policy impotence can also
spring from behaviour that is reflected in a very steep IS curve, rather than a very flat LM curve.
(See section 3.4.)
The opposite extreme of the liquidity trap theory is the case of a vertical LM curve. Any
monetary stimulus would have a maximum impact on real income. Therefore, monetary policy
would be very potent in stimulating the economy.
The vertical LM curve is called the Classical case, mainly because it seems to suggest a
preference for monetary policy rather than fiscal policy.

The diagram in figure 3.24 illus Figure 3.24 Monetary stimulus – influence of IS curve slope
trates the influence of the slope r LM0 LM1
of the IS curve on the outcome
(for the same horizontal shift of
the LM curve): If IS curve is
❐ If the IS curve is flat, the flatter, change in
Y is larger and
change in real income is large – change in r smaller
monetary policy is very potent. r0
❐ If the IS curve is relatively
steep, the change in Y is smaller
– monetary policy is less potent. IS curve
‘flat’
The economic reasons for the IS curve
latter case are as follows: ‘steep’
❐ If the interest responsiveness Y0 Y
of investment (h in the invest
ment equation) is high, invest
ment will react strongly to the policy-induced drop in interest rates.
❐ If the expenditure multiplier KE is large, the increase in investment has a strong
multiplier effect on real income Y.
To summarise, the impact on real income of a monetary policy stimulus in the form of an
increase in the money supply is larger if:
❐ the LM curve is relatively steep, and/or
❐ the IS curve is relatively flat.
Similarly, such monetary policy is less potent in affecting real income if the IS curve is
relatively steep and/or if the LM curve is relatively flat. (Similar types of conclusion can be
made regarding the impact of monetary stimulation on the real interest rate.)
These policy examples illustrate that the magnitude of changes in the interest rate or real
income can differ greatly depending on the relative slopes of the two curves. However, this
is a purely mechanical illustration. The question is: why or when would curves be steep or
flat? Which factors determine the slope, and what is the economic interpretation of slopes?
To answer these questions, we have to turn to more formal IS-LM theory.
How potent is fiscal policy in affecting real income? Or, how strong is crowding out?
Section 3.2.2 concluded that the potency and impact of fiscal expansion via increased
government expenditure will depend on:
❐ the income responsiveness of money demand k;
❐ the interest responsiveness of money demand l;
❐ the interest responsiveness of investment h, and
❐ the size of the multiplier KE.
Once again, these factors also determine the slopes of the IS and LM curves, as shown in
sections 3.3.3 and 3.3.5. Combining the information about these discussions with the
diagrammatical analysis, one can answer a question such as: what is the effect on real
income Y of a one unit change in government expenditure (or in taxation), given different
slopes for the IS curve?

Therefore, consider an expansionary fiscal Figure 3.25 Fiscal stimulus – influence of LM curve slope
policy step, e.g. an increase of one unit
If LM curve is steeper change in Y is
(e.g. R1 m) in government expenditure. It r smaller and change in r larger: stronger
would shift the IS curve horizontally to secondary effect (crowding out)
the right. Equilibrium Y will increase, LM curve
combined with an increase in the real ‘steep’
interest rate r. LM curve
The diagram in figure 3.25 illustrates the ‘flat’
influence of a flat or a steep LM curve on
the change in Y: r0
❐ If the LM curve is relatively steep, the
change in Y is relatively small – fiscal
policy is less potent. Crowding out
IS0 IS1
is relatively strong (i.e. the ‘ramp’ is
more steep). Y0 Y
❐ If the LM curve is relatively flat, the
change in Y is relatively large – fiscal
policy is more potent. Crowding out is relatively weak (i.e. the ‘ramp’ is less steep).
The economic reasons for the latter case are as follows:
❐ If the income responsiveness of money demand (k in the money demand equation)
is low, there will be a relatively small increase in the transactions demand for money
when Y increases), and/or
❐ If the interest responsiveness l of money demand is high, a relatively small change in r
will be sufficient to re-establish money market equilibrium.
The Classical case again

If the LM curve were vertical, fiscal expansion (e.g. an increase in G) would have no effect on real
income. Fiscal policy would be totally impotent. Crowding out would be complete, and any increase
in G would be exactly offset by an equal reduction in private spending (investment).
If the LM curve were horizontal – the liquidity trap case – fiscal expansion would be
enormously potent in stimulating real income. There would be absolutely no upward pressure
on interest rates, and no crowding out whatsoever.
Again, while these issues were part of the policy debate decades ago, today they merely serve
to illustrate extreme theoretical cases (and to test your understanding of the theory). In reality,
the IS and LM slopes lie between these two extremes (although they may differ widely from
country to country).
The pair of diagrams in figure 3.26 illustrates the influence of the slope of the IS curve on
the outcome (for the same horizontal shift of the IS curve):
❐ If the IS curve is relatively flat, the change in real income Y is smaller – fiscal policy is
less potent.
❐ If the IS curve is relatively steep, the change in Y is relatively large – fiscal policy is more
potent.
The latter result occurs since:
❐ The interest responsiveness h of investment is low – this reduces the restraining effect
of the secondary interest rate increase on investment.

❐ The expenditure multiplier KE is small – in the secondary phase this limits the restraining
impact of the investment reduction on Y.
However, the role of the multiplier is complex. It also affects the magnitude of the shift in
this IS curve: a larger multiplier implies a bigger shift, the impact of which may outweigh
the contrary effect that occurs via the slope of the IS curve.
Figure 3.26 Fiscal stimulus – influence of IS curve slope
r For a similar horizontal shift, a steeper IS r

produces a larger change in both Y and r
LM curve LM curve
r1
r1
r0 r0
IS shifts IS shifts
to the to the
right right
Y0 Y1 Y Y0 Y1 Y
In summary, the impact of a given fiscal policy stimulus on real income is larger if:
❐ the LM curve is relatively flat (i.e. the ‘ramp’ is less steep, implying limited crowding out),
and/or
❐ the IS curve is relatively steep.
Conversely, fiscal policy is less potent if the IS curve is relatively flat and/or the LM curve
is relatively steep.
A similar analysis can be made regarding the impact on the interest rate following a fiscal
policy step.
3.3.8 The potency of monetary policy when the interest rate is targeted
The above discussion contrasts the result of a steep LM (with money demand not being
interest sensitive), with a flat LM (with money demand being interest sensitive). The
discussion compares the potency, under contrasting behavioural sensitivities, of monetary
policy for equivalent increases in the money supply.
❐ In the money market diagram (see figure 3.8), this comparison relates to equivalent
M S
P   line (measured by its position on

horizontal dimensions of shifts (e.g. rightward) of the  
the horizontal axis).
❐ In the IS-LM diagram, it relates to equivalent horizontal shifts of the LM curve (see
figure 3.23).
The focus on such ‘money supply steps’ was very relevant up to the 1970s and 1980s and
even the 1990s when many countries, including South Africa (from 1986 to 1997) had
money supply targets.

However, these days the focus of many central Figure 3.27 Monetary expansion
banks is to engineer desired interest rate
r
changes. The question then is not the potency
of a given ‘money supply step’, but what the LM0 LM1
potency of a given ‘interest rate step’ will be.
Thus one must compare the potency (for
contrasting behavioural sensitivities) of
monetary policy for equivalent changes in
the interest rate.
❐ In the IS-LM diagram, this is indicated
Horizontal dimension of rightward
by equivalent downward displacements of shift of LM curve
the LM curve (see figure 3.28). Thus it
relates to equivalent vertical dimensions
of right- or leftward shifts of the LM Income Y
curve. (This is measured by the change
in its intercept on the vertical axis.)
Vertical dimension of rightward
shift of LM curve
When the focus is on the comparative
effectiveness of a given interest rate-
based change, the outcome regarding the
potency of monetary policy changes dramatically.
❐ The potency result becomes the opposite of that for equivalent money supply-based
changes.
In figure 3.28, the diagrams contrast the impact on Y, for different LM slopes, of equivalent
interest rate-based steps. (This will usually be effected by equivalent changes in the repo rate,
e.g. a decrease.) This interest rate step is shown as identical vertical drops in the LM curve.
To someone accustomed to equivalent horizontal shifts of the LM curve this may look
completely wrong. But it is not – and it is an important point for graphical analysis.
Figure 3.28 Interest rate-based monetary expansion – influence of LM curve slope on change in real income
r Equal vertical displace- r

ments of the LM curve LM1
LM2
LM1
r0 r0
r1
LM2
r1
IS IS
Y0 Y1 Y Y0 Y1 Y
For equivalent vertical shifts in LM, a flat LM curve – which reflects a more interest-
sensitive money demand – will result in a larger increase in income compared to the case
where the LM is steeper. Compare the changes from Y0 to Y1 in the two cases.

❐ A flat LM curve makes such a monetary policy step more potent in changing Y.
❐ A steep LM curve would make an equivalent monetary policy step less potent in changing Y.
This is the opposite of the conventional result, which was derived based on equivalent changes in
the money supply.
Note that this potency result also applies when measuring potency in terms of changing
the market interest rate (the intersection of IS and LM). Compare the changes from r0 to r1
in the two cases.
❐ A flat LM curve makes such a monetary policy step more potent in changing Y.
❐ A steep LM curve would make an equivalent monetary policy step less potent in
changing Y.
Central bank behaviour that targets the interest rate can be described by a so-called
monetary policy reaction function (see chapter 7). Interest rate-based changes are
usually engineered by a change in the repo rate, but they can also be achieved through
a money supply change: central banks change the money supply and/or the repo rate
with whatever amount necessary to bring about the desired change.
3.4 Real-world application: The 2007–08 financial crisis – varying

investor behaviour and impotent monetary policy
In trying to analyse real-world economic events, an important point to bear in mind is
that the values of the parameters in the behavioural equations such as h, the sensitivity
of investment to changes in the real interest rate, or b, the propensity to consume, are
not cast in stone. The same goes for the autonomous components of consumption and
investment (the constant terms a and Ia in their respective equations). These parameters
describe, or capture, human behaviour, expectations and sensitivities – and human
behaviour can change.
Changes in the behaviour of people would, therefore, change these parameters. Graphically,
that would shift the IS and LM curves and/or change their slopes. This shows that such
changing behaviour can affect the impact and potency of policy. A policy that was potent
five years ago may become less potent now.
An excellent example is how the 2007–08 financial crisis and its multi-year aftermath
played out in the USA. It also illustrates the huge impact that problems in the financial
system can have on the real economy and real people. In the words of Timothy Geithner,
US Treasury Secretary during the Great Recession:
I learned something valuable ... which is how fragile financial systems are, how connected
they are to the economy, how hard it is to separate trauma in a financial system from trauma
in the economy, how hard it is to protect the average person from financial panics.
Time magazine, 26 May 2014, p. 48.
In simplified terms the following occurred.
The run-up: the dot-com bubble and expansionary monetary policy

The financial crisis had a long run-up. Its roots can be found in the reaction of US
monetary policy authorities to the bursting of the so-called dot-com bubble in 2000.
During 1997–2000 share prices on the New York Stock Exchange and the NASDAQ stock
market increased dramatically. Especially the share prices of internet-related companies

rose far above their intrinsic value due to speculative trading and inflated expectations – a
stock price ‘bubble’ developed. When the bubble burst and share prices fell, the NASDAQ
index fell from 5047 in 2000 to 1114 in 2002, losing 78% of its value.
The resulting fall in wealth caused a drop in consumer expenditure and hence a recession
in the USA. To counter this shock, the US Federal Reserve or ‘Fed’ (the US central bank)
lowered the Fed Funds rate (the policy rate in the USA) to push market interest rates down.
The lower interest rates succeeded in restoring investment and economic growth. However,
the lower interest rates also led to the next asset bubble, this time in the housing market.
The housing bubble and the crisis in the financial system

The housing bubble occurred because US banks, in reaction to the lower interest rates,
simultaneously (and somewhat recklessly) lowered their requirements for approving
mortgage loans. This quickly grew a market for so-called subprime borrowers (i.e.
borrowers whose balance sheets are not strong enough to be ‘prime borrowers’). The risk
of a subprime borrower not being able to repay a mortgage loan is significantly higher
than that of a prime borrower.
Banks subsequently repackaged these risky subprime mortgages together with prime
mortgages and sold these mixed-risk packages to other financial institutions as low risk,
prime securities. (Such a package is called a Mortgage-Backed Security, or MBS, and the
repackaging is called securitisation.) Inexplicably, ratings agencies rated these packages
as top-drawer AAA investments; thus, financial institutions were keen to invest in them.
By 2007–08 many financial institutions experienced problems when large numbers of
subprime borrowers defaulted on their mortgages. Institutions saw their balance sheets
weaken to the point that Lehman Brothers went bankrupt in 2008 while most other large
US investment banks only survived because the US government and Federal Reserve, as an
emergency measure, extended very large loans to them at low interest rates.
Despite these measures, the financial stress experienced by these institutions marked
the start of the worldwide financial crisis. Because so many banks and other financial
institutions were affected by MBS holdings, widespread uncertainty and a lack of trust
in the banking and financial system developed. Financial institutions became unwilling
to extend loans. Households and businesses found it difficult to borrow, and consumer
and business expenditure dropped. Households and businesses also preferred to reduce
their debt before investing. Likewise, the uncertainty reduced the willingness of potential
investors to invest. As a result, the US economy entered a recession.
The monetary policy reaction: ‘quantitative easing’ (QE)11

The Fed responded by implementing three waves of quantitative easing from November
2008 to October 2014. In effect the Fed started buying up huge volumes of government
bonds as well as MBSs from financial institutions, thereby injecting trillions of dollars of
money into the financial system. (See section 9.7 for more detail on the nature of this
monetary policy step, which is almost similar to open market transactions.) This monetary
11 In 2008 the US government also implemented the Troubled Asset Relief Program (TARP), in terms of which the
Treasury spent $350 billion to buy MBSs and other financial assets (and later also equity) from troubled financial
institutions such as AIG and Citigroup. The aim of the program was to stabilise these institutions by strengthening
their balance sheets. It amounts to an injection of $350 billion into US financial markets, and thus TARP is
analytically more or less equivalent to QE, as shown in figure 3.29. Hence we do not show TARP separately.
3.4 Real-world application: The 2007–08 financial crisis 135

expansion drove the nominal Fed Funds rate down to 0.25%. With inflation very low,
the real interest rate came close to 0%. To its surprise the Fed found that investment did
not respond and remained flat. The US recession (which infected the rest of the world)
continued for several years.
The question is why QE was so ineffective, if macroeconomic theory tells us that money-
supply expansion, by reducing interest rates, would stimulate investment and consumption
expenditure, and thereby boost GDP growth. For the first round of monetary stimulus
(after the dot-com collapse) the theory appeared to be correct. So what happened with QE?
Understanding the crisis in the IS-LM model: varying slopes and policy impotency
The IS/LM model can be used to understand why the US Federal Reserve failed in its efforts
to stimulate economic activity. The reason is the variable, even fickle, nature of investment
behaviour in particular, which manifested during the financial crisis.
The IS/LM model in figure 3.29 applies to the USA. Suppose that, prior to the financial
crisis, there is equilibrium in both the money market and the goods market at point 0,
where LM0 intersects with IS0. The real interest rate equals r0 and output equals Y0.
Figure 3.29 The financial crisis and quantitative easing in the USA
0 = Initial equilibrium Y0 r0
IS shifts left and rotates LM shifts left initially, then
1 = New equilibrium Y1 r1
clockwise; a reverse rotation right again in the QE phase,
after LM shifts left and
occurs later on and left if QE is phased out
IS shifts and rotates
clockwise. Recession.
r IS1 IS0 IS2 LM1 LM0 LM2 2 = Post-QE equilibrium
Y2 r2 after QE monetary
stimulus: interest rates
collapse, but expendi-
ture is unresponsive.
Monetary policy
impotent. Still recession.
0 3 = Equilibrium Y3 r3 after
r0 fiscal expansion (IS
r1 shifts right to IS2).
r4 1 Recession over.
4 0 = Final equilibrium Y0 r0
if confidence returns
r3 3 and fiscal stimulus with-
drawn (IS rotates and
moves back to IS0) and
QE is reversed
(LM shifts left to LM 0).
4 = Equilibrium Y4 r4 occurs
r2 2 if QE is not phased out.
Risk of further bubbles.
Y1 Y2 Y0 ;Y3 Y4 Y
The impact of the financial crisis

When the financial crisis broke out, two things happened. First, financial institutions
became unwilling to extend and roll over loans. As the quantity of loans extended shrank,
their balance sheets shrank and thus the money supply shrank. In figure 3.29 this is
shown by a leftward shift of the LM curve from LM0 to LM1.
Secondly, households cut back their autonomous consumption a and companies cut
back their autonomous investment Ia. With investors also uncertain about the future,

companies cut back autonomous investment even further. These cutbacks would reflect in
a leftward shift of the IS curve.
But that is not all. The diagram also shows the slope of the IS curve becoming steeper.
Recall that its slope reflects the sensitivity of investment to changes in the interest rate, h,
as well as the marginal propensity to consume, b. When uncertainty increases, investors
become less sensitive to interest rate changes: h falls and the IS curve becomes steeper.
Likewise, when households’ marginal propensity to consume out of income is reduced
(when they decide to rather repay debt), b falls – which also causes IS to become steeper.
Therefore, with the drop in autonomous consumption and investment as well as h and b,
the IS curve shifts and rotates – it changes from IS0 to IS1.
Given these moves of the IS and LM curves, a new equilibrium would settle at point 1, with
the interest rate at r1 and real output much lower at Y1.
The failed policy response: QE and thereafter

To counter this contraction in output, the US Federal Reserve massively expanded the
money supply in three waves of quantitative easing. These steps are shown as a shift of the
LM curve from LM1 to LM2, intersecting IS1 at a new equilibrium point 2. At this point the
real interest rate r2 is close to 0%. However, despite the huge drop in the interest rate, the
steepness of IS1 implies that the output level only increases minimally from Y1 to Y2 – still
far below the pre-crisis level Y0.
Being stuck at Y2 while the interest rate level has collapsed to r2 shows how monetary
policy became impotent due to the changing behaviour of economic agents. Due to fear
and uncertainty they all but stopped responding to a drop in the rate of interest. And,
since nominal interest rates cannot go below 0%, monetary policy could not stimulate the
economy to grow beyond Y2.
The only alternative for the US government was to use expansionary fiscal policy, running
much larger budget deficits. The fiscal stimulus was supposed to shift the IS curve from IS1
to IS2, resulting in the interest rate increasing to r3 and output to Y3, i.e. back to the initial
output level Y0 – but with a much-reduced rate of interest (equilibrium point 3).
(At the time of writing this fiscal policy had not been entirely successful in stimulating the
US economy – implying that the IS curve was still lying somewhere between IS1 and IS2.)
The aftermath: back to normal?

Once confidence returns to the US economy fiscal stimulus can be withdrawn. While the
latter will shift the IS from IS2 towards IS1, the return of confidence will shift and rotate
the IS curve back from IS1 to IS0. Reversing the quantitative easing will shift the LM curve
leftward from LM2 back towards LM0 – possibly reaching equilibrium close to equilibrium
point 0 where it all started.
Were the quantitative easing not to be reversed, an equilibrium would occur at point 4.
While output Y4 would be much higher than the pre-crisis level, the real interest rate r4
would be much lower. This could create a renewed risk of a bubble and excessive borrowing.
To push the interest rate up to a less risky level (such as r0), the quantitative easing would
need to be reversed, at least partially, to get LM to a position such as LM0. (To suppress any
tendency towards excessive borrowing it might even be necessary to push the interest rate
noticeably higher than r0. Graphically this means shifting LM even further left.)
3.4 Real-world application: The 2007–08 financial crisis 137

International repercussions: how did the financial crisis affect South Africa?
Due to limitations of space, the knock-on effects of the financial crisis on South Africa
cannot be analysed here. It suffices to say that the main effects stem from a decline in
GDP in the USA (initially, and later also in Europe) and hence in their imports from other
countries, including South Africa.
The analysis of the impact of these changes on GDP and interest rates in the IS-LM diagram
is left to the reader as an exercise.
But that is not the whole story. The financial crisis also led to foreign investor nervousness
in the USA, Europe and Asia. This can spill over into a wariness to invest in emerging
markets, which could have an impact on capital inflows into South Africa. To understand
these, one has to study the international dimensions of the macroeconomy – the topic of
the next chapter.
* * *
This completes the discussion of the IS-LM model. It will be encountered again in
chapter 4, where it will be analysed in the context of an open economy and expanded
on by the addition of a third curve, the BP (or balance of payments) curve. This curve
will give information regarding the external balance of the economy, and augments the
discussion on the internal balance (as shown by the IS-LM equilibrium).

1. Suppose exports increase, what will be the effect on income and the interest rate if
the income responsiveness of money demand is low compared to when the income
responsiveness of money demand is high?
2. Suppose government expenditure increases, what will be the effect on income and
the interest rate if the income responsiveness of money demand is high compared to
when the income responsiveness of money demand is low?
3. Suppose tax rates increase, what will be the effect on income and the interest rate if
the interest rate responsiveness of investment is low compared to when the interest
rate responsiveness of investment is high?
4. Suppose autonomous investment increases, what will be the effect on income and
the interest rate if the interest rate responsiveness of investment is high compared to
when the interest rate responsiveness of investment is low?
5. Use chain reactions and the IS-LM model to explain and illustrate the impact of an
increase in the repo rate on national income and the interest rate.
6. Use chain reactions and the IS-LM model to explain and illustrate the impact of a
decrease in the cash reserve requirement on national income and the interest rate.
decrease in taxes on national income and the interest rate.
8. In question 6 of chapter 2, the puzzling lack of private investment after 2010 was
noted. Consider your response again, now also noting the level of interest rates in the
period after 2008 compared to earlier periods. Would you change your explanation, or
perhaps add to it? Can interest rate levels explain the observed lacklustre investment
behaviour? Analyse and discuss.
9. Use chain reactions and the IS-LM model to explain and illustrate the impact of the
increase in the gold price on national income and the interest rate.
stimulating fiscal policy on national income and the interest rate.

The basic model III:
the foreign sector 4
■ explain the behaviour of international trade in goods and services (i.e. imports and ex-
ports), and foreign investment and lending (international capital flows);
■ appraise the role and importance of the balance of payments, the current account, the
financial account and foreign reserves;
■ assess and explain movements in exchange rates, including the practical, everyday
determination of these rates in foreign exchange markets;
■ assess the external implications of domestic economic disturbances and fluctuations;
■ compose chain reactions that show how external disturbances impact on domestic
financial markets as well as the real economy, and evaluate these with graphical aids;
■ analyse the role of the balance of payments adjustment mechanism in creating cyclical
forces; and
■ unravel key linkages between foreign interest rates, the gold price, the rand and the dollar.
While the South African economy is relatively strong in the African context, in the world
context it is small. Owing to the openness of the South African economy, it is extremely
vulnerable to external shocks, and foreign factors often dominate the economic news.
Therefore a sound understanding of the linkages between the national economy and
foreign economic relations is essential if we are to grasp events in the South African
economy. The ‘closed’ model of the economy, as introduced in the previous chapters,
must therefore be amended. This chapter presents the main elements of a Keynesian
macroeconomic model (or theory) for an open economy.
✍ What percentage of GDP is exported? Which are the most important products that local
producers export from South Africa? Which countries are our main trading partners?
______________________________________________________________________________________
______________________________________________________________________________________
What percentage of GDE is spent on imported products? Which are the most important
products imported by South Africans? From which countries mainly?
______________________________________________________________________________________
See Mohr (2019) Economic Indicators, sections 7.2 and 7.3.
Chapter 4: The basic model III: the foreign sector 139

The location of this topic in the circular
flow diagram (compare pp. 73, 76) International capital
flows
FOREIGN
COUNTRIES
Ex
po
rts
Ex
ch
a
rat nge
e
Im
po
rts
FINANCIAL
INSTITUTIONS
Disposable
income
FIRMS HOUSEHOLDS
GOVERNMENT
Some preliminary definitions

The balance of payments (BoP) is an accounting record of a country’s involvement in inter-
national trade (exports and imports) and international capital flows. The former category
of transactions is indicated on the current account of the balance of payments and the
latter on the financial account.
The most important international ‘price’ is the exchange rate. This denotes the international
exchange value (or external value) of, for example, the South African rand against another
currency such as the US dollar, e.g. $1 = R10.00 or £1 = R17.00. (The latter represents
the indirect way of quoting the exchange rate. The direct way would be the other way
around, i.e. R1 = $0.10 or R1 = £0.06.)
Another relevant variable is the price ratio between average P
price levels in the home
 P    
country, e.g. South Africa, and those in the rest of the world: 
SA
Foreign
The exchange rate and the price ratio can be combined into one concept, the real effective
exchange rate, denoted by ( the Greek letter theta). (The term ‘effective’ indicates an average
exchange rate; see section 4.3.2 on exchange rate definitions.) It is defined as:1
1 PSA P
 = 
  Average exchange  
  rate  
  = Average exchange rate in direct form  
  P      SA
  P     
Foreign Foreign
1 Note that in many USA and UK textbooks the direct way of expressing the exchange rate is used, also in these
formulas. In general one should always be very careful when working with formulas containing an exchange rate.
140 Chapter 4: The basic model III: the foreign sector

✍ What are the latest figures for the balance on the current account, the financial account and the
BoP?
______________________________________________________________________________________
What is the current exchange rate of the rand against the US dollar, the British pound, the Euro
and the Japanese yen?
______________________________________________________________________________________
Warning: Data on foreign economic transactions are almost as complex as data on the
government sector (also see chapter 2).
❐ Different institutions, e.g. the SA Reserve Bank and the SA Revenue Service (Customs
and Excise division), gather and publish data for different purposes and in various ways.
❐ At least three sets of data are available: national accounts data, balance of payments
data and trade statistics. They may use different terms or may include different
elements or have different frequencies, or may be only in nominal or real terms.
❐ Before June 1999, data on imports and exports in balance of payments tables in the Quarterly
Bulletin of the Reserve Bank differed from data in the national accounts tables. However,
in the revised data system used since June 1999 these figures are exactly the same,
removing the ambiguities in Reserve Bank foreign sector data. The two sets of tables do
use different terms for elements such as labour income flows, though.
❐ The foreign trade statistics of the SA Revenue Service (Customs and Excise division)
pertain to trade in goods only (including gold). They are published monthly.
DATA TIP
For macroeconomic and expenditure analysis, it is usually sufficient to use national accounts
data on imports and exports. If one wishes to analyse the current account of the balance of
payments or capital flows, though, the balance of payments table is more comprehensive.
(See other explanatory boxes that follow.)
Exchange rate data can be found in the section on ‘International economic relations’ in
the Quarterly Bulletin. This section also contains a table ‘Gold and other foreign reserves’.
Data on the balance of payments and exchange rates can be found on the Reserve Bank
website (www.resbank.co.za), while data on trade statistics can be found on the website
of the South African Revenue Service (www.sars.co.za) under ‘Customs and Excise’.
International comparisons of economic data are difficult and can easily lead to absurd
conclusions. Be careful, especially as far as exchange rate conversions of variables such as GDP,
wage levels or petrol prices are concerned. Comparisons of rates of change (GDP growth rate,
inflation rate) and ratios (tax ratio, import ratio) are less risky, although still subject to differences
in definition and calculation. (An interesting website is 'World in Figures' of the Economist
magazine at https://worldinfigures.com or www.economist.com. Also see Mohr (2019)
Economic Indicators, chapter 7.)
4.1 Background – why trade internationally?

One way to study international economic relations is to attempt to understand why
countries engage in international trade and to explain the pattern of imports and
exports. (For example, why does South Africa import clothes pegs – surely they can
be manufactured locally?) Such questions are explored in courses on international
4.1 Background – why trade internationally? 141

economics. In macroeconomics these questions are not considered further. Consequently,
we shall analyse only total import and export levels, ignoring the microeconomic details
of trade patterns.
Who are South Africa’s main trading partners?
South Africa's trade with regions and top 10 partners: shares in 2018 and 1994
Import share 2018 1994 Export share 2018 1994
Asia 45.4% 27.8% Asia 31.3% 26.8%
European Union 28.5% 46.0% Africa 26.5% 13.5%
Africa 11.9% 3.4% European Union 23.5% 31.4%
NAFTA* 7.0% 12.9% SADC 22.8% 11.2%
SADC 6.5% 2.5% NAFTA* 7.3% 11.1%
China 18.3% 1.8% China 9.2% 0.8%
Germany 9.9% 16.6% Germany 7.5% 6.4%
USA 5.9% 11.4% USA 6.7% 10.1%
Saudi Arabia 5.8% 0.1% United Kingdom 5.0% 9.5%
India 4.1% 0.6% Japan 4.8% 8.5%
Nigeria 4.1% 0.0% India 4.7% 0.8%
United Kingdom 3.5% 12.0% Botswana 4.3% 0.0%
Thailand 3.1% 0.8% Namibia 3.8% 0.0%
Japan 3.1% 10.0% Mozambique 3.4% 2.6%
Italy 2.7% 4.0% Netherlands 3.3% 3.3%
Total imports (R) 1.24 trillion 81.8 billion Total exports (R) 1.15 trillion 65.1 billion
Source: Department of Trade and Industry (www.thedti.gov.za).
Note the persistence of some large countries such as the USA, UK, Germany and Japan – but
also the new dominance of China and growing role of India, Saudi Arabia and Nigeria. The
shares of the Asian bloc, Africa and SADC have grown since 1994, while that of the European
Union and North America have shrunk. (NAFTA = USA, Canada and Mexico)
4.2 Imports, exports and capital flows

As indicated in chapter 1, imports and exports are important for the macroeconomy since
they impact directly on total expenditure.
❐ Exports X imply an injection of expenditure (by foreigners) into the domestic expenditure
flow, and imports M imply a leakage from the expenditure flow to the rest of the world.
❐ Net exports (X – M) – i.e. the net injection – constitute a direct component of total
expenditure = C + I + G + (X – M).
Therefore it is essential to understand the behaviour of X and M as well as their conse-
quences for the state of the economy.
International payments relating to imports and exports are recorded in the current account
of the balance of payments (BoP). The gap between real exports and imports is net exports. It
differs from the current account because the current account also includes factor payments
(e.g. dividends, wages) paid across borders. A close correlation between import fluctuations and
GDP fluctuations can be observed.

Figure 4.1 Exports and imports (in real terms – 2010 prices)
1 200
1 000
800
Real imports of goods and services
600
Real exports of goods and services
R billion
400
200
0
Real exports minus real imports
–200
2003/01
2004/03
2006/01
2007/03
2009/01
2010/03
2012/01
2013/03
2015/01
2016/03
2018/01
1985/01
1986/03
1988/01
1989/03
1991/01
1992/03
1994/01
1995/03
1997/01
1998/03
2000/01
2001/03
The graph in figure 4.1 depicts the movements in real imports and exports as well as
net exports since 1980. What is notable from the graph is that for long stretches of time
real imports were less than real exports. This was the case in the period 1985 to 1994.
Since 2003, imports have exceeded exports by a substantial margin, leaving net exports
negative. Also note that, since the early 1990s, both real imports and real exports have
increased significantly.
Which products comprise the main elements of South African imports and
exports?
The main export categories (2018) are precious metals and gems (18%), iron and other ores
(13%), vehicles (11%), mineral fuels (11%), iron, steel and aluminium (9%) and machinery and
equipment (8%).
The main import categories are machinery and equipment (22%), mineral fuels including oil
(18%) and vehicles (8%), and also plastic products, pharmaceuticals, technical and medical
apparatus, and chemical products.
Capital and intermediate goods represent a large portion of imports. Therefore the causal link
between changes in total production and imports is likely to be strong (see below).
4.2.1 Imports (M)

Imports concern the purchase of foreign products (both consumer goods and capital
goods). The major share of South African imports comprises machinery and capital items;
oil is also an important item.
Expenditure on imports by all participants is included: households, business enterprises,
the government sector, government corporations, etc.
4.2 Imports, exports and capital flows 143

Which factors determine imports?
PSA
M = f(YDSA;  ; rand; ...)
  P     
Foreign
+ + +
A part of import expenditure involves the purchase of imported consumer goods.
Therefore, like consumption C, it depends positively on disposable income YD and thus on
total income Y. Furthermore, a very large portion of import expenditure is on production
inputs (machinery and intermediate inputs, often high-tech items). Since increases in
output require more inputs, the demand for imported inputs is strongly influenced by total
production Y (see previous box). In both cases, total income is a crucial determinant.
This suggests the concept of marginal import propensity. (Can you define it?) One can then
write a simple import function as:
M = ma + mY + ... ...... (4.1)
where m is the marginal import propensity. If national income Y increases, imports will
increase. An upswing (or downswing) in the economy frequently causes an increase (or
decrease) in imports. This means that imports behave pro-cyclically: imports increase and
decrease concurrently with the business cycle.
✍ General tax increases will affect import expenditure positively/negatively (choose one
alternative). Why?
______________________________________________________________________________________
______________________________________________________________________________________
Rising imports can be a symptom of (too) good times. Why?
______________________________________________________________________________________
______________________________________________________________________________________
Restrictive policy often causes imports to decline. Why?
______________________________________________________________________________________
______________________________________________________________________________________
A second factor influencing the decision to import is the price of imported goods relative to
the price of locally produced goods. (In the case of essential items that are not produced
in South Africa, such as oil or high-tech machinery, one may have less freedom of choice;
thus, a lower price sensitivity is likely.)
❐ The relevant variable is the price ratio, defined above. The expected relationship is
positive, since a higher price ratio (e.g. due to increasing South African prices) is likely
to encourage imports (and discourage exports, see section 4.2.2).
The exchange rate is a third important factor determining imports. This follows from the
fact that the exchange rate determines the price of an imported product in South African
rands. For example: if the external value of the rand is $1 = R10.50 and an imported video
recorder costs $300, the price in rand is R3 150. Rands have to be exchanged for dollars
to buy the machine; therefore the rate of exchange determines the effective rand price of
the imported item.

✍ How does South Africa’s inflation rate compare with those of our main trade partners? Is this likely to
encourage or discourage imports? What about exports? (Explain your answer.)
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
A higher price ratio will make local producers less/more (choose one alternative) competitive
relative to foreign producers (import competitors).
If the external value of the rand

increases – e.g. when the rand Terms of trade is a concept similar to the price ratio.
strengthens from $1 = R10.50 It is published in the Quarterly Bulletin of the Reserve
Bank and is calculated as the export price index
to $1 = R10.00 – imports are
divided by an import price index, expressed as an
encouraged because the rand
index. A weakening of the terms of trade means that
price of imports effectively de South African export prices have decreased relative
clines. The international purchas to the prices of imported products: the country earns
ing power of the South African less from exports, compared to what it needs to pay
rand has increased. Therefore the for imports.
likely relationship between M and
the rand is positive. See Mohr (2019) Economic Indicators, section 7.4.
❐ Be very careful here. If you
think in terms of the actual
number 10.50 or 10.00,
the relationship is negative: Each international transaction actually comprises a
double transaction: the necessary foreign exchange
a stronger rand means the
or currency is bought first, and then the item is
exchange rate number decreases
bought with that foreign currency. It also means
– which leads to an increase in that the demand for foreign currency is a derived
imports M. demand, i.e. it is derived from the demand for the
The price ratio and the exchange products that importers want to buy.
rate jointly determine the real
effective exchange rate , defined
above. The real effective exchange rate can be thought to impact on m, the marginal
propensity to import. If  increases – due to an increase in the external value of the rand, or
an increase in the price ratio – m will increase, and vice versa. The argument is that changes
in  will affect a country’s willingness to import goods from abroad – i.e. the portion of every
extra R1 of income that will be spent on imported goods and services. So we can write the
marginal propensity to import as being dependent on the value of , i.e. m().
❐ In thinking and reasoning about open economy chain reactions it will often be better
to work P
in terms of the constituent elements of , i.e. the exchange rate and the price
ratio   P    . One must be able to work in both formats.
SA

Foreign
Other factors that can influence imports are trade policy (import taxes, import tariffs or
quotas, etc.), trade sanctions or boycotts.

✍ Depreciation or devaluation?
If the rand weakens, i.e. its external value decreases, it is said that the rand ‘depreciates’. (The
opposite is an ‘appreciation’.) What does devaluation mean? And revaluation? If you do not know,
read section 4.3.2.
A more complete import function thus would be:

M = ma + m()Y ...... (4.2)
In this form, the real effective exchange rate Figure 4.2 The import function
– and thus the price ratio and the exchange E
rate – are built into the import propensity
parameter. (While we will not always write
m as m() in diagrams and mathematical
expressions, its presence must always be
remembered.) M 5 ma 1 mY
❐ An increase in  – due to a strengthening m
a
rand and/or a higher price ratio – will en-
courage imports, i.e. the import propensity
m will be higher.
❐ The import function can be depicted in
the 45° income–expenditure diagram as a
positively sloped line/curve, as in figure 4.2.
If Y increases, the ensuing increase in M will Income Y
be apparent as a move along the M curve.
❐ An increase in  implies a steeper import curve. If any of the elements of the real
effective exchange rate – the price ratio or the exchange rate – changes, the import
function will rotate.
❐ Trade policy steps such as an import tax, tariff or quota or trade sanctions will shift the
import curve up or down.
4.2.2 Exports (X)

Since South African exports are Insufficient domestic production of exports can
actually imports by other countries occur if there are not enough South African goods
from South Africa, the explanation to meet export demand. However, at this stage we
of exports is relatively simple. assume that there are no supply-side restrictions.
(This will change in chapter 6.) However, as a rule,
Accordingly, South African exports
aggregate supply bottlenecks very rarely constitute
are determined by factors similar
a real constraint on export levels – except in the
to those concerning imports. It is case of agricultural products, where a drought can
important to realise, though, that have a disastrous effect on exports. It is quite simple
the export decision is primarily taken to analyse the expected effects of a drought (or a
in another country, i.e. a South miners’ strike) on export performance, and hence on
African producer’s supply of export aggregate economic performance.
goods occurs on demand from
foreigners. It specifically does not
depend on domestic income or production (GDP) to any significant extent.

Which factors determine exports?
Exports depend not only on foreign income levels (YForeign or Yf ), but also on the price ratio
(terms of trade) and the exchange rate. Thus:
PSA
X = f(YForeign;  ; rand; ...)
 P     
Foreign
  
The expected signs (+ or –) of the variables follow from arguments similar to those with
regard to imports. Exports will have a negative relationship with the price ratio – relatively
higher domestic prices will discourage exports. And they will have a negative relationship
with the value of the rand – a weaker rand will make exports cheaper for foreigners.
Similar to our handling of the import function above, the real effective exchange rate can
also be brought into the slope parameter of an export function:
= va + v()Yf + …
X ...... (4.3)
The parameter v is not interpreted as a marginal propensity, but as an indication of the
home country’s share of world trade. A higher value of v will reflect a higher share of
world trade, if Yf represents world income. An increase in  – due to a stronger rand or
a higher price ratio – will discourage exports (imports by foreign countries from South
Africa), and thus reduce our share of world trade v.
Graphically, in the 45° diagram, the X curve is simply a horizontal line (see figure 4.3).
❐ A change in foreign income levels (e.g. upswings or downswings in the economies of
major trading partners) will shift the export curve up or down correspondingly.
❐ A change in the trade share v (due to a change in the real effective exchange rate ) will
also shift the export curve.
✍ What is the impact of relatively high domestic inflation on South African exports?
______________________________________________________________________________________
______________________________________________________________________________________
What does the expression ‘we are pricing ourselves out of world markets’ mean?
______________________________________________________________________________________
______________________________________________________________________________________
Net exports
Putting both the X and the M curves on the 45° diagram enables us also to observe net
exports. Net exports is the numerical difference between imports and exports, i.e. (X – M).
Plotting that difference against income gives us the net exports (X – M) curve. As shown
in figure 4.3, net exports (X – M) is a line with a negative slope.
Observing the difference between the X and M curves relative to income shows why trade
deficits (when the imports of goods exceeds the export of goods) are more prone to occur
at higher levels of income than lower levels of income.

Figure 4.3 Exports and net exports Figure 4.4 A change in net exports
E E
C 1 I 1 G 1 (X 2 M)0
Imports M
C 1 I 1 G 1 (X 2 M)1
Exports X
(X 2 M)
Y
Net exports (X 2 M) Y Income Y
Any change in one or more of the factors that determine X and/or M will imply a change
in (X – M), which – as a direct component of total expenditure – will cause a change in the
real economy (with the usual multiplier effect, as in figure 4.4). For example:
Suppose the rand appreciates ⇒ effective price of imports declines (and the effective price of SA
exports for foreigners increases) ⇒ imports are encouraged and exports discouraged ⇒ (X – M)
declines ⇒ total expenditure declines ⇒ production discouraged ⇒ GDP and Y decline.
✍ Foreign inflation declines ⇒

______________________________________________________________________________________
______________________________________________________________________________________
Upswing in the USA ⇒
______________________________________________________________________________________
______________________________________________________________________________________
What is the difference between ‘Expenditure on Gross Domestic Product’ and ‘Gross Domestic
Expenditure’ in the national accounts? Why is this difference important?
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
If you do not know, read addendum 5.1 (chapter 5).
Remarks
1. Conceptually (X – M) also can be called the trade balance. If X exceeds M there is
a trade surplus; if import payments exceed export earnings, there is a trade deficit.
However, the trade balance includes only imports and exports of goods. Services are
excluded. Therefore the trade balance is also called the goods balance.

2. If trade in services – payments and receipts for services such as international tourism,
transport, financial and insurance services – is included, one gets ‘net exports’.
❐ In our macroeconomic reasoning and chain reactions this is how we interpret
(X – M).
3. Net exports still exclude inflows and outflows of income payments, i.e. compensation
of employees as well as returns on investment (dividends and interest earned abroad).
Income payments thus reflect trade in factors of production – labour and capital. Also
excluded are international transfers.
❐ These excluded items are denoted as ‘invisible trade’.
What is the difference between the trade balance, net exports and the
current account in actual data?
The numerical difference between net exports and the current account can be quite large,
but also quite variable between quarters and years.
The table below shows net exports and the current account in 2018. The two balances
differ markedly. It shows how ‘invisible trade’ can affect the current account significantly,
often negatively. For example, in 2018, the net figure for income receipts and payments
was R97 billion – R251 billion = –R154 billion and for exports (R1 176 + R72 + R210)
billion – (R1 223 – R218) billion = –R17 billion. Income payments always exceed income
receipts by far. Thus the net income outflows aggravated the negative payments balance
before transfers.
Note that in the Quarterly Bulletin BoP data are recorded only in nominal terms, whereas the
Bulletin’s national accounts (SNA) data are published in both nominal and real terms. The
table below is in nominal terms. Note that, if income receipts and payments are excluded
from the balance of payments column, the export and import totals are the same as in the
national accounts column.
DATA TIP
A trade balance (or goods balance) can also be calculated. However, trade balance
figures are also published by the South African Revenue Service (Customs and Excise
Division) on a monthly basis. These say little about macroeconomic trends, since they
fluctuate a lot between months. Second, annual totals also differ from SNA and balance
of payments numbers. For macroeconomic analysis, it is best to use the SNA data.
National accounts 2018 R million Balance of payments 2018 R million
Exports of goods and services 1 457 641 Merchandise exports 1 175 547
Exports of goods 1 247 226 Net gold exports 71 678
Exports of services 210 415 Service receipts 210 415
Less: Imports of goods and services –1 440 883 Income receipts 96 507
Imports of goods –1 222 944 Less: Merchandise imports –1 222 944
Imports of services –217 939 Less: Payment for services –217 939
Exports minus Imports 16 748 Less: Income payments –250 552
Current transfers (net receipts (+)) –35 674
Balance on current account –172 962

4. The current account is the broadest measure: it includes net exports and net income
payments, as well as net current transfers. A positive net inflow of payments for goods
and services implies that the current account is in surplus (and vice versa).
5. A current account deficit means that a country is importing more goods, services and
factors than it exports: total expenditure buys up all domestic production and more.
It is a sign, therefore, that a country is ‘living beyond its means’. Consequently, one
solution is to curb total expenditure.
✍ An economic upswing is likely to strengthen/weaken the current account. (Choose one option
and explain why.)
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
It is often stated that the government cannot stimulate the economy before the current account
is ‘ready’ for it. What does this mean?
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
(Hint: If there is a current account deficit, any stimulation is bound to lead to what?)
6. The extent to which the current account will deteriorate when Y increases will
depend on the marginal propensity to import. A high propensity will cause imports
to react strongly to any increase in GDP, causing the current account to deteriorate
significantly. This can be important if a country is inclined to experience current
account problems. In South Africa, the import propensity is relatively high, especially
since any meaningful expansion of production is dependent on imported inputs. South
African consumer expenditure patterns also contribute to a high marginal propensity
to import. This has important macroeconomic implications (see section 4.5.3).
7. A depreciating rand should stimulate exports and curb imports. The current account
balance is bound to improve after such a depreciation. The appreciation of the
currency is likely to weaken the current account balance.
8. Any positive or negative change in net exports (X – M) has a multiplier effect on
income (via the expenditure multiplier KE).

The peculiar J curve
In practice it often happens that, following a currency depreciation, the current account first deteriorates
and then improves. On a graph with the current account on the vertical axis and time on the horizontal
axis, this produces a curve with a J shape. Why does this happen?
Import and export contracts usually are valid for a relatively long Time of
period of time. In addition, many import contracts are denominated depreciation
in foreign currency such as the dollar. Therefore, if the rand Current account
depreciates suddenly, existing contract volumes will continue to
be imported and exported for some time. Given a weaker rand,
0
payments for the contracted volume of imports will require more Time
rands (since the prices of imports are denominated in foreign
currency). This implies an increase in the outflow of payments for
imports. Export prices are mostly denominated in rands; hence
total receipts for exports will remain constant for some time.
The net effect is that the current account deteriorates initially. Only after some time will contracts
adjust to the new external value of the rand, causing export volumes to increase and import volumes to
decrease. This means that the volume effect on the current account starts to dominate the price effect. Only
then will the current account show an improvement. The diagrammatic result: a J curve.
The Marshall-Lerner condition

The typical existence of a J curve implies that the net effect of a depreciation of the currency is that
the current account (X – M) improves (albeit with some delay). As noted, this is because the effect on
the current account of the change in the volume of imports and exports is stronger than the contrary
effect of the change in the price of imports and exports (in rands). If this is indeed the case, the so-
called Marshall-Lerner condition is satisfied. (The condition is satisfied if the sum of the exchange-
rate elasticities of imports and exports exceeds 1.) If imports and exports have very low elasticity to
exchange rate changes – implying such small changes in the volume of imports and exports that the
current account will deterioriate following a currency depreciation – this condition is not satisfied. In
reality, the Marshall-Lerner condition is satisfied in most cases. So we will continue to assume that a
currency depreciation leads to an improvement in (X – M).
Volumes vs. values

The J curve and Marshall-Lerner condition illustrate an important issue with regard to imports and
exports: one should be extremely careful in analysing volumes versus values. Changes in the exchange
rate influence the rand value of a particular import or export volume dramatically. They can even cause rand
values to increase while volumes decline, and vice versa. In open-economy macroeconomic analysis,
both volumes and rand values are important:
❐ For BoP analysis, the rand values are decisive.
❐ For expenditure and production analysis, it is actually the volumes that are important, since they
indicate the real quantities being imported or exported, or the real expenditure involved.
However, national accounts data do not really reflect real quantities. Real figures are derived simply by
deflating rand values with an estimated price index. The exchange rate effect is not removed from the
data. Therefore patterns in real import and export data (national accounts) will not correspond exactly to
patterns in import and export volumes.

✍ The degree of openness of the economy will influence the size of the multiplier. How and why?
(Hint: Consider the import propensity.)
______________________________________________________________________________________
______________________________________________________________________________________
9. The normal secondary effects (monetary feedback effects) will also follow from any
stimulation of income due to changes in (net) exports. As production and income
are stimulated, interest rates are pushed up by an increased demand for money. This
increasingly acts as a brake on the upswing, thereby restraining the expected upswing
in the economy.
10. One factor that complicates the analysis of the likely consequences of an export surge
is that efforts at export promotion often lead to a subsequent increase in imports. This
is due to the necessary importation of production inputs. In this sense, South African
exports are often import-stimulating. (Normally one would exclude this effect from
the analysis.)
4.2.3 Capital flows

Capital inflows are all inflows of foreign funds for the purpose of fixed investment (in
fixed assets), as well as financial investment (for the purchase of financial assets). Capital
inflows include foreign loans by either the private sector or the public sector (e.g. for
infrastructural projects or for financing a budget deficit).
The flow of capital into and out of the country is recorded in the financial account of
the BoP. Direct and portfolio investment can be distinguished, also in published data. The
former pertains to setting up new companies or foreign subsidiaries, or acquiring shares
in companies with the objective of gaining a meaningful say in management, as well as
investment in real estate. The latter pertains, for example, to purchases or shares or bonds
with the objective of financial returns on the investment, rather than having a say in
management, i.e. there is no longer-term commitment. It also includes the acquisition of
long-term debt and money market instruments.
In figure 4.5, the graph shows quarterly capital movements for the period 1980 to 2018,
as recorded in the financial account of the balance of payments. Three distinct periods can
be observed. In the period between 1985 and 1994, capital movements were rather small.
Real investment, financial investment and the financial account

The important macroeconomic distinction between real investment (capital formation) and
financial investment was explained in chapter 2. In the financial account of the BoP, these
matters are handled differently, which can be confusing. The financial account combines flows of
funds for the sale and purchase of all kinds of assets: residential homes, commercial buildings,
factories, land, companies, shares, government and other stock, even deposits with financial
institutions; it also records loans and loan repayments. However, it does distinguish between
direct investment, portfolio investment and other investment. Compare the balance of payments
table in section 4.3.1.
See also Mohr (2019) Economic Indicators, 131–2.

Figure 4.5 International capital flows – the financial account
100
80
Financial account
60
R billion
40
20
–20
1985/01
1986/03
1988/01
1989/03
1991/01
1992/03
1994/01
1995/03
1997/01
1998/03
2000/01
2001/03
2003/01
2004/03
2006/01
2007/03
2009/01
2010/03
2012/01
2013/03
2015/01
2016/03
2018/01
This was mainly due to the international isolation of, and financial sanctions against,
South Africa in the period prior to 1994. Since 1994, capital movements increased signi-
ficantly. However, notice that capital flows were still rather modest and stable between
1994 and 2003. In the third period, after 2003, capital inflows into South Africa increased
dramatically (albeit with quite some volatility) – and from 2015 with even more volatility.
Also see figure 4.6.
Which factors determine capital inflows?

Capital flows across international borders because capital owners are seeking the highest
possible real rates of return on investments (whether real or financial investments).
Therefore the main factors that determine the inflow of capital into a country are relative
interest rates (on financial investments), relative rates of return (on real investment), the
exchange rate,2 and economic and political expectations. Accordingly:
rSA
K-inflow = f (  ; relative SA rates of return; rand; expectations)
r      Foreign
   ?
Optimism about expected real returns on real investment (i.e. economic growth possibilities)
should attract foreign investors. Furthermore, local interest rates that increase relative to
foreign rates should induce inflows of foreign capital (and strengthen the financial account).
The main effect of the exchange rate is that it determines the effective cost, for a foreign investor,
of the purchase of an asset. A relatively weak rand reduces the prices of South African assets
for foreign investors and encourages foreign investment. This implies an inverse relationship
between the value of the rand and capital inflows. On the other hand, a weak rand reduces the
effective value of dividends to a foreigner – a discouraging factor. Normally this effect is small,
however, and the inverse relationship mentioned above is likely to predominate.
2 Until 1995, South Africa had a special exchange rate for capital flows – the so-called financial rand.

Interest rates and risk premiums in emerging markets
Changes in the interest rate, rather than differences between the levels of interest rates in countries,
are what matters here. Interest rates in South Africa always tend to be higher than in countries such
as the USA or UK. Yet there is no perpetual flow of capital into South Africa. But South Africa will
experience capital outflows when the domestic interest rate level decreases even though domestic
rates still are higher than in other economies.
When searching for investment options across potential target countries, international investors
do not simply decide on the basis of nominal interest rates (or nominal rates of return) in
different countries. They take a broader view.
First, they will take note that high nominal interest rates usually reflect high inflation in a target
country. This implies some risks. An inflation rate that is relatively high is likely to lead to
currency depreciation over the duration of the investment. This will reduce the buying power,
in the investor’s home country, of the nominal return earned in the target country. Moreover,
such depreciation will decrease the value, in home currency, of the capital when it is repatriated
eventually. (The longer the term of the investment, the higher is this risk.) For this reason,
investors will often compare real rates of interest: r ≈ i – π.
Second, investors are sensitive to risks relating to economic and political instability. An investor
investing in, say, a low- or middle-income country or ‘emerging market’, will want some
premium built into the return or interest rate to compensate for the higher risk compared to a
‘safe’ investment in the USA or Germany, for instance. Everything else being equal (including
inflation rates), the typical investor will at least require a real interest rate that is higher by the
amount of the risk premium. Thus:
Required real interest rate in risky country = Real interest rate in safe countries + risk premium
The safe country rate will depend on international capital market conditions, but will not vary
much. The premium will depend on each individual target country.
❐ The risk premium for South Africa, compared to the USA or other OECD countries, may
be in the order of 3%. This can increase dramatically if events occur that signal political
uncertainty and risk.
❐ In a stable situation, the gap between South African nominal rates and average OECD
nominal rates is an approximate indication of the combined exchange rate and political risk
premiums in the eyes of international investors.
Political uncertainty, disturbances and unrest can be potent factors. Such factors have
quite frequently affected South Africa’s external economic relations negatively, with
the Sharpeville incident of 1961 and the Soweto uprising of 1976 as notable examples.
Political instability continues to bedevil many low- and middle-income countries in Africa
and elsewhere (see chapter 12, section 12.3.4).
The perceived high risk of investment in South Africa required a substantial risk premium
in order to induce foreign investors to consider investment here. This was the case, for
instance, in the 1980s and early 1990s when foreign investors watched the political course
of events much more than interest rate or rate of return differentials. Thus, international
capital flows to South Africa were not very sensitive to interest rate differentials (i.e. they
were interest rate inelastic). For these reasons, there was a relatively low flow of capital into
South Africa, especially for direct investment.
The situation improved after 1994. Although there is still a significant risk premium,
capital flows are more sensitive to interest rate changes and rate of return differentials.

This does not mean that politics does not play a role. Rather, the more legitimate and
more stable post-1994 political environment has reduced political uncertainty and the
risk premium. However, since 2009 the risk premium has increased again, mostly because
of weak economic conditions, but also increased political risk. Elections and changes of
party and national leadership, or contentious policy views expressed by presidents or
party officials, regularly cause heightened political concern. Since South Africa is part of
the so-called emerging markets, foreign investors will continue to pay more attention to its
politics than those of democratically mature economies such as the USA, UK and Japan.
Therefore, in contrast to South Africa, there is high international mobility of capital into the
USA. In particular, there is a tremendous international sensitivity to American interest
rates. A small rate increase in the USA can cause a tremendous inflow of foreign capital
into the USA.
❐ This illustrates the fact that one should be careful in applying macroeconomic reasoning
to different countries.
❐ The US example is crucial in understanding movements in the gold price, the dollar and
the rand. (See section 4.5.3.)
Foreign loans by the private sector normally derive from investment plans. The same is true
for large infrastructural projects of the state or of quasi-state institutions (e.g. Eskom,
Telkom and Transnet). Foreign borrowing towards the financing of a budget deficit
depends on the borrowing requirement of the government, the cost and conditions of
such loans compared to domestic loans, and the debt-management policy of the state
(discussed in chapters 9 and 10).
How do foreign capital flows affect the economy?

The analysis of the short-term macroeconomic impact of foreign capital inflows is quite
complex. To understand this, one must clearly distinguish between possible real and
monetary effects.
Not being a direct component of aggregate expenditure, an inflow of foreign capital (e.g. a
foreign loan) as such has no direct impact on aggregate spending, and hence no direct or
immediate effect on real income. (The repayment of foreign loans is simply an outflow, or
a negative inflow, of capital, requiring an analogous analysis.)
To see this, one must distinguish analytically the inflow of funds from their actual use. If
the funds are used to purchase existing shares, there is no new real investment, and hence
no direct real impact. However, even if the funds are used to finance new real investment,
one should rather analyse the effects of the investment expenditure separately – with the
foreign capital simply the method of financing, having no real expenditure effect in itself.
Foreign capital inflows as such therefore have no direct real effect on the economy.
But surely the inflow of funds
must have a monetary impact? It is important to note that in the long run the inflow
This is true – with the crucial of foreign capital is important in the sense that it
qualification that the effect of boosts the domestic pool of funds available to
the financial account cannot finance investment. In this way it is important for
be determined and analysed long-term real economic growth (see chapter 12,
section 12.3).
on its own. Further on we shall
see that the financial account,
together with the current account – i.e. the whole balance of payments – has important

implications for monetary conditions. But one cannot analyse the monetary impact of the
financial account separately – the net balance of the two accounts is what matters here.
To understand this, we first have to consider the exchange rate and the balance of
payments, and the complex two-way interaction between these two. At this stage it is
sufficient to note that a net inflow of funds will expand the domestic money supply. A net
outflow will contract the domestic money supply.
In the following section, the entire network of interrelationships will be traced and
explained. The final and comprehensive picture will materialise.
4.3 The balance of payments and exchange rates

4.3.1 The balance of payments (BoP)
In accounting terms, the balance of payments (BoP) is the sum of the balances on the
current and financial accounts:
BoP = Current account balance + Financial account balance
The graph in figure 4.6 shows historical patterns for annual data on these two elements
for South Africa. Note how, before 1994, the current account was managed (via the
management of GDP growth) to counter financial account imbalances. Specifically, note
the major turnarounds in 1984–85 and again in 1993–94. After 1994, a shortage of
international capital ceased to be a problem, and even more so after 2003. This inflow
enabled the economy to carry a large deficit on the current account – the by-product of
high economic growth – without any problem.
However, in 2007 and 2008, questions were increasingly being asked about the sustain
ability of the current account deficit when it reached levels of 7% and 8% of GDP (compared
to the 3% international rule of thumb that is often cited in the press).
Figure 4.6 The current account and the financial account

300
270
240
Financial account
210
180
150
120
90
60
R billion
30
0
–30
–60
–90
–120
Current account
–150
–180
–210
–240
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018

The unease reached new heights since 2013, when the relatively large current account
deficit, combined with weak GDP growth prospects and a relatively large budget deficit,
caused the South African economy to be seen as rather fragile.
The balance of payments table

The composition and terms of the balance of payments table in the Quarterly Bulletin
of the Reserve Bank is somewhat confusing. The components of the current account
were discussed above. The table below adds the financial account figures to the current
account figures shown on p. 149.
Balance of payments 2018 (R billion)

Current Account:
Merchandise exports 1 175 547
Net gold exports 71 678
Service receipts 210 415
Income receipts 96 507
Less: Merchandise imports –1 222 944
Less: Payment of services –217 939
Less: Income payments –250 552
Current transfers (net receipts (+)) –35 674
Balance on current account –172 962
Capital transfer account (net receipts (+)) 236
Financial Account:
DATA TIP
Net direct investment 10 360

Net portfolio investment 33 224
Net financal derivatives 7 209
Net other investment 102 595
Reserve assets (increase (–)/decrease (+)) –11 337
Balance on the financial account with change in reserves included 142 051
Balance on the financial account (change in reserves excluded) 153 388
Unrecorded transactions 30 675
Balance of Payments with change in reserves included –
Balance of Payments (change in reserves exluded, unrecorded transactions included) 11 337
❐ The capital transfer account item is relatively insignificant in economic analysis.

❐ ‘Other investment’ mainly includes trade credits, and is typically quite large.
❐ Unrecorded transactions denote a capital flow error term, and can be significant.
❐ In the published table in the Quarterly Bulletin the actual number for the ‘Balance
of payments’ is not shown. Due to accounting conventions, its value is shown in
the financial account just above the ‘balance on the financial account’ as ‘Reserve
assets (increase (–)/decrease (+))’. In the tables above and in chapter 5, section 5.6,
we have labelled it ‘Balance of payments (excl. change in reserves, incl. unrecorded
transactions)’. Being equal to the change in reserves, it also equals the sum of
the balances on: the current account, the capital transfer account (very small), the
financial account (change in reserves excluded), and unrecorded transactions.
4.3 The balance of payments and exchange rates 157

What causes an imbalance in the balance of payments (BoP)?
The BoP position depends on all the factors that determine the international flow of goods
and capital: domestic and foreign income levels, interest rates and rates of return, price
levels and exchange rates, as well as expectations, perceptions of risk and so forth. A change
in one or more of these factors – as in the many chain reactions we have encountered –
normally also leads to a concurrent change in imports and exports (and thus the current
account) or capital inflows (the financial account). From these follow a net impact on the
BoP – which is always in the thick of things, as we will see.
We will consider three illustrative examples and elaborate on them throughout this chap-
ter, as well as in chapter 6 (when introducing inflation):
1. A change in the money supply or repo rate (i.e. a disturbance in the money market/
monetary sector). The primary and secondary effects that usually follow a monetary
policy step, e.g. an increase in the repo rate, were explained in chapter 3 (section 3.3.6).
To summarise: The net effect of an increase in the repo rate is an increase in interest
rates and a decrease in real income (through several concurrent processes, the details
of which are not relevant now).
❐ The higher interest rates are likely to attract an inflow of foreign capital, which
affects the financial account of the balance of payments: a financial account
surplus will develop.
❐ The drop in income is likely to lead to a fall in imports, which affect the current
account of the BoP: a current account surplus will develop.
Together these two effects will determine the BoP position, in this case unambiguously
a surplus.
2. A change in aggregate expenditure (i.e. a disturbance in the domestic goods market).
The primary and secondary effects of an increase in government expenditure were
explained in chapter 3 (sections 3.3.2 and 3.3.6).
To summarise
The net effect of an increase in government expenditure is an increase in real income
accompanied by an increase in interest rates.
❐ The higher interest rates are likely to attract an inflow of foreign capital, which
strengthens the financial (or capital) account of the balance of payments.
❐ The upswing in income is likely to lead to a rise in imports, which negatively affect
the current account of the BoP.
The net impact of the two opposing effects will determine the ultimate BoP position.
3. A change in exports (i.e. a disturbance in the foreign sector), for example due to an
economic upswing in the USA. (See chapter 2, section 2.2.6; section 4.5.3 in chapter
4 contains a complete chain reaction.)
In brief: The net effect of an increase in exports is an increase in real income
accompanied by an increase in interest rates.
❐ Increasing exports are directly reflected in an improved current account.
❐ Increased export earnings imply an expenditure injection in the economy, which
causes income Y to increase (see chapter 2, section 2.2.6).
❐ The upswing in income is likely to lead to a rise in imports (why?), which is a
negative impact on the current account.
❐ The increase in Y is likely to lead, via increased money demand, to higher interest
rates. These are likely to attract foreign capital, which strengthens the financial (or
capital) account.

The net impact of these effects will determine the ultimate BoP position. It is likely to
be in a surplus.
✍ What is the effect of the following on the BoP?

Suppose South Africa’s inflation is higher than foreign inflation ⇒
______________________________________________________________________________________
______________________________________________________________________________________
Suppose South Africa’s interest rates are higher than foreign interest rates ⇒
______________________________________________________________________________________
______________________________________________________________________________________
Suppose South Africa has to repay foreign debt ⇒
______________________________________________________________________________________
______________________________________________________________________________________
Suppose the repo rate is reduced ⇒
______________________________________________________________________________________
______________________________________________________________________________________
What are the consequences of a BoP disequilibrium?

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

Since foreign payments to South Africans initially occur in the form of foreign currency, a
surplus on the BoP causes the amount of foreign currency – or ‘foreign reserves’ – in the
country to increase. Likewise, a deficit will cause the foreign reserves to decline, while a BoP
equilibrium will leave reserves unaffected. In this way the state of the foreign reserves is a
good indicator of the BoP situation.
The graph in figure 4.7 shows the balance of payments together with the foreign reserves
since 1985. The balance of payments is a net figure, reflecting the current and financial
accounts. These are nominal values, hence the apparent increase in the magnitude of
the figures. Note how the stock of gold and foreign reserves increased since 1996, with
temporary dips in 2002–03, 2009–10 and 2016–17. The graph indicates that the BoP in
South Africa has improved significantly even though the current account of the balance
of payments has registered a significant and growing deficit. However, 2008, 2013 and
2018 were difficult years.

Figure 4.7 The balance of payments and foreign reserves
780
720
660
Gross gold and foreign reserves
600
540
480
420
R billion
360
300
240
180
120
60
Balance of payments
0
–60
–120
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Net and gross foreign reserves

Technically, foreign reserves also are affected by a number of other international monetary
flows. In published BoP data, the following are distinguished:
❐ Change in net gold and other foreign reserves, and
DATA TIP
❐ Change in gross gold and other foreign reserves.

The differences between these two depend on changes in three factors: (1) the net
monetisation/demonetisation of gold, (2) SDR allocations and calculations (SDR: Standard
Drawing Rights at the IMF) and (3) liabilities related to reserves.3
If one wants to evaluate changes in foreign reserves as such, the gross figure is the relevant one.
However, the net figure is closest to the macroeconomic concept of ‘the balance of payments’.
Foreign reserves are critically important since they are essential in paying for imports.
A country cannot sustain a BoP deficit for an indeterminate period of time: eventually
there will be insufficient foreign currency reserves to pay for imports – especially essential
imports such as oil.
❐ A rule of thumb in this regard is that a country should have sufficient reserves to cover
three months’ imports.
❐ The following table from the Reserve Bank shows the performance of the SA economy
in this regard. During the 1990s the average number of months of imports covered
by foreign reserves was quite low. However, in the 2000s the foreign reserve position
improved. As table 4.1 indicates, the foreign reserve position improved from less
than two months of imports in 2003 to averaging 4.6 months of imports from 2009
onwards. Still, that is not a huge buffer.
3 This concerns foreign loans by the Reserve Bank and the government from foreign banks and governments, but for
specialised purposes other than trade or capital flow. Therefore it falls outside the ambit of the BoP as conventionally
understood, and does not necessarily have any effect on the macroeconomy.

Foreign reserves and the ‘man in the street’
The level of foreign reserves may be one of the most important considerations in Reserve
Bank interest rate policy (in conjunction with other policy goals such as inflation; see chapter
9). As soon as foreign reserves reach relatively low levels, the Reserve Bank may consider
pushing up interest rates (e.g. via a repo rate increase) in order to restrain expenditure and
therefore imports, and perhaps to attract foreign capital.
Therefore, if either the current or the financial account shows a deteriorating trend, and
depending on the state of the other account, one can expect that interest rates may be
increased. Obviously such a step affects the economy and, for example, homeowners,
negatively. Therefore the level of foreign reserves is of great importance for everyone.
❐ On the other hand, low reserves normally are symptomatic of a period of BoP deficits.
This might cause the rand to depreciate, which is negative for import prices and thus
for inflation. Shoring up reserves with a repo rate increase will also serve the inflation
objective.
Foreign reserves also are essential if the Reserve Bank Table 4.1 Foreign reserves
wants to support the rand in foreign exchange markets Imports of goods and services covered
as part of its exchange rate policy (see section 4.3.2). by reserves (average number of months)
If there is a continuous current account deficit, the 2003 1.8

financial account should be in surplus to compensate. 2005 2.8
As long as capital inflows occur continually, a country
2007 3.0
can sustain a current account d eficit without running
into foreign reserve problems. However, if there is a 2009 4.6
sustained capital outflow, current account deficits 2011 4.3
cannot be tolerated for very long. 2013 4.3
2015 4.9
(2) Impact on the money supply
2016 5.4
An important consequence of a BoP deficit or
surplus, referred to above, is that it influences the 2017 4.9
nominal money supply MS. A net inflow of payments 2018 4.7

(even if in foreign currency initially) leads to an Source: South African Reserve Bank, balance
increase in the domestic money supply, as follows: of payments tables (www.resbank.co.za).
Suppose a foreigner wishes to buy an item from a South African producer. She first buys
rands from the Reserve Bank (via her bank), then uses these to pay the export company.
When the funds are deposited in the company’s bank account, the total amount of deposits
in the country (i.e. M3) increases. Alternatively, if the export company is paid in dollars
or other foreign currency, this company has to exchange the foreign currency for rands
(that come from the Reserve Bank, via her bank), which it then deposits in its account.
The impact on the nominal (and real) money supply is identical: the deposit is a monetary
injection, which will be followed by the normal credit multiplier process. In the aggregate
there is an increase in domestic monetary liquidity (nominal and real).
Therefore:
BoP > 0 ⇒ increase in nominal (and real) MS
BoP < 0 ⇒ decrease in nominal (and real) MS

This impact on the money supply will occur as long as there is a BoP disequilibrium. As
soon as a deficit or surplus is eliminated, there will be no further impact on the money
supply from this source.
There are ways for the Reserve Bank to counter the impact of such an inflow of foreign
currency on the nominal money supply. Such a step is called the sterilisation of the foreign
currency inflow. A sterilisation entails that the Reserve Bank conducts an open market
operation where it sells bonds on the domestic capital market equal in value to the rand
value of the foreign reserve inflow.
The BoP constraint

Until 1976 it was usually the case that South Africa experienced significant capital inflows. As
a result, the country could afford to run large current account deficits. But 1976 was a turning
point. (What happened in that year?) The subsequent loss of foreign confidence in South Africa’s
political-economic future – and again in 1985 – drastically changed this situation. A huge and
increasing withdrawal of foreign capital occurred, causing a continuous and large deficit on
the financial account. Hence the current account had to be kept in surplus to earn enough
foreign exchange to finance the financial account deficit. This meant that imports had to be
curtailed at all costs. In turn this implied that the authorities could not allow the economy to
experience too strong an upswing. (Can you explain why not?) Therefore, restrictive policy had
to be used to protect the BoP. Especially in the period between 1985 and 1994, South Africa
was in the ironic position that only weak to moderate upswings could be allowed; anything
better would have caused BoP difficulties.
❐ This analysis shows just how effective financial sanctions – and not the trade sanctions
introduced earlier – were in applying pressure on the former South African government to
change the political system.
❐ Note that in this way the balance of payments position can create a significant constraint
on the economic growth rate that can be sustained. This is what is indicated by the term
‘the balance of payments constraint’.
(3) Impact on the exchange rate

The last important effect of the BoP on the economy concerns the exchange rate. We must
first understand exchange rates before this effect can be explained.
4.3.2 Exchange rates

What is the exchange rate?
As mentioned at the beginning of this chapter, the exchange rate is the price of one
currency in terms of another, e.g. $1 = R10.00 or £1 = R17.00. This is also called the
nominal exchange rate.
The exchange rate of the rand against the dollar, say, determines the ‘outside’ or external
value of the rand, i.e. for a foreign resident who wants to buy rands, or for a South African
wishing to buy foreign currencies with rands. The exchange rate therefore determines the
foreign or international purchasing power of the rand.
The external value of the rand is something completely different from the internal value
or domestic purchasing power of the rand, which is a reflection of the domestic impact of the

!
The way rand–dollar exchange rates are usually written (i.e. $1 = R10.00) may be somewhat
confusing. If the rand depreciates (weakens) against the dollar, the numerical value of the rate of
change actually increases: the exchange rate increases.
Why does a change in the exchange rate from $1 = 10.50 to $1 = R10.20 represent a
strengthening of the rand? Think of the dollar as an item that you buy, just like a can of cola. If the
price of cola decreases, from R10.50 to R10.20, you can buy more cola per rand, i.e. in terms of
buying cola the purchasing power of the rand has increased. The same applies to buying a dollar.
If the price of a dollar decreases from R10.50 to R10.20, then the purchasing power of the rand in
terms of the dollar has increased. The rand has strengthened.
The exchange rate between the rand and some other currencies, such as the Japanese yen, is
expressed the other way around, for example, R1 = ¥10.00.
To prevent confusion and incorrect macroeconomic reasoning, it is safer not to think in terms of
increases or decreases of the exchange rate, but rather of increases or decreases in the value of
the rand (except when a formula requires the exchange rate as such).
inflation rate. (This is true even though there may be important links between these two
concepts of purchasing power.)
If the rand strengthens (the external value of the rand increases), one would say that the
rand has appreciated. Depreciation is the opposite – the rand weakens.
❐ One should therefore use the terms ‘appreciation’ and ‘depreciation’ with care. Only a
currency (the rand or the dollar) can depreciate or appreciate, not the exchange rate.
❐ The terms ‘devaluation’ and ‘revaluation’ have a similar but different meaning. This is
explained later.
In practice, there is no such thing as the exchange rate, but a whole spectrum of rates.
An exchange rate exists between each pair of currencies in the world, i.e. the rate at which
one can be exchanged for the other. The dollar–rand exchange rate is merely the most
prominent one, seen as representative of the value of the rand against other currencies.
The euro–rand exchange rate is also very important.
Special exchange rates

The real exchange rate is an adjusted exchange rate that takes differences between countries’
price levels (and thus inflation rates) into account. The real exchange rate is calculated as
follows using the normal (nominal) exchange rate in its indirect manner of quotation, i.e.
$1 = R10.00. (The real exchange rate is expressed in the direct form.)
1 PSA
Real exchange rate = 
  Exchange
  × 
  rate     P     

Foreign
The effective exchange rate expresses the value of the rand relative to a ‘basket’ of important
foreign currencies, namely those of the main trading partners of the country. It is a
kind of weighted average exchange rate. As such, its value is less sensitive to currency
disturbances in a single country, for example the USA. It is expressed as an index.
By combining these two operations, a real effective exchange rate, indicated with the symbol
, can be calculated (also as an index):
PSA
Real effective exchange rate () = Effective exchange rate × 
  P     
Foreign

Note that by convention the Reserve Bank publishes both these exchange rates in the
direct way (see the introduction to this chapter). Thus a decrease in the external value of
the rand is represented by a decrease in the numerical value of the exchange rate.
Often it is safer to reason in terms of nominal rates rather than real rates, and to handle
the price ratio as a separate variable, as is done in this chapter. Doing so makes the analysis
more transparent and easier to follow.
Figure 4.8 Nominal effective and real effective exchange rates
350
300
250
200
Nominal effective exchange rate of the rand
Index
150
100
50 Real effective exchange rate of the rand
0
1990/01
1991/07
1993/01
1994/07
1996/01
1997/07
1999/01
2000/07
2002/01
2003/07
2005/01
2006/07
2008/01
2009/07
2011/01
2012/07
2014/01
2015/07
2017/01
2018/07
Figure 4.8 depicts both the real and the nominal effective exchange rates. The real effective
exchange rate in South Africa is much more stable than the nominal effective exchange
rate (though it has had a dip in 2001–02). The nominal effective exchange rate displays a
downward trend, especially prior to 2001, which is an indication of the impact of inflation.
After 2006 and especially from 2011 to 2016 there is a discernible downward trend.
Buying and selling rates for currencies

Most often the media report only one exchange rate for, say, the rand/dollar. Currency
dealers such as banks and ‘bureaux de change’ (smaller scale currency dealers in cities or at
international airports) quote two rates, often seen in two columns on electronic boards. The
‘We buy’ column is the exchange rate at which the dealer is willing to buy a foreign currency,
while the ‘We sell’ column is the rate at which a foreign currency is sold. As with any other
commodity or product, a currency dealer wants a profit.
❐ For instance, a currency dealer will buy dollars from you at R10.5112 (it is always quoted
to four places after the decimal point), while they will sell to you at R10.7353. The R0.2241
difference is the profit margin of the dealer.
❐ Exchange rates in the media may be the middle rate between the buy and sell rates, or
alternatively they may quote the sell rate. Therefore, always ensure that you know which
one is quoted.
❐ Rates quoted and published by the SARB are middle rates, calculated as weighted
average daily rates of banks at approximately 10:30.
❐ The difference between the buy and sell rates is called the spread.

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

The forex market, like the money market (see chapter 3), is not a building or a place. A large
number of forex dealers – primarily at banks and the Reserve Bank – are continually in contact
with each other by electronic means. Currencies – rand, dollar, euro, pound, etc. – are bought
and sold on behalf of clients of the banks wishing to conclude international transactions.
Using computers, video monitors and telephones, they make and receive offers, and as deals
are struck and ‘prices’ agreed upon, exchange rates are determined minute by minute. As in
the money market, dealers experience tremendous excitement, especially when things are
happening in forex markets, or if rumours appear about possible important events all over the
world. Speculators can make huge profits (or losses!) from small differentials or movements
in rates. Enormous amounts of funds flow (electronically) across borders due to these
transactions.
Obviously, foreign exchange markets are internationally oriented, and international capital
is extremely mobile. Instant electronic communication and transactions make distance and
international borders irrelevant.
Since the important forex markets are scattered around the globe – New York, London, Zurich,
Hong Kong, Tokyo – forex trade goes on 24 hours a day.
Mostly, foreign exchange markets work as simply as a vegetable market: fundamentally,

the (external) value of the rand is determined by the demand for, and supply of, rand in
forex markets at a particular time. The same is true for any other currency.
❐ If the demand for a currency (e.g. the rand) increases, there is upward pressure on its
external value, and it is likely to appreciate (e.g. the rand–dollar exchange rate will
change from $1 = R10.00 to
$1 = R9.80). If the supply of What are ‘spot’ and ‘forward’ exchange rates?
rands increases, there will be
downward pressure on the The ‘spot exchange rate’ is the conventional rate
rand, and depreciation occurs. that is determined daily for immediate (on the ‘spot’)
trade in foreign currencies.
❐ The supply and demand for
rands can be depicted in a However, importers and exporters often wish
diagram similar to that for to protect themselves against future changes in
any microeconomic market; exchange rates. To reduce uncertainty with regard
a straightforward analysis of to planned future transactions, they then conclude
agreements for foreign exchange transactions to
shifts in either the demand
occur on some date in the future: the price and
or the supply curves can pre-
quantity are agreed upon today for a transaction in
dict the expected results of the future. The agreed-upon exchange rate is the
changing market conditions. ‘forward exchange rate’. Guesses, expectations and
(In fact, the foreign exchange risks regarding the future course of exchange rates
market is one of the few real- are decisive in these cases.
life markets whose operation

and relatively smooth adjustment to equilibrium approximate the theoretical model of
a ‘perfectly competitive’ or atomistic market.)
The basic reason why currencies are bought and sold is to make international
transactions possible. Importers must first exchange their rands for yen, for example,
before they can pay for a Japanese import. Likewise, a foreign importer must exchange
his means of payment, e.g. dollars, for South African rands: the importer must first buy
the South African rands, and then use them to purchase the South African product (the
double transaction). In the first instance, therefore, exchange rates are determined by
the activities of importers, exporters, foreign investors, foreign borrowers, etc.
❐ Of course, policy intervention by the relevant authority (the Reserve Bank in the South
African case) can also play a significant role. This is explained below.
Which factors determine exchange rate movements?

The inflow and outflow of funds – either for import and export payments or for capital
flows – determines the intensity and extent of forex buying and selling transactions, i.e.
the demand and supply for foreign exchange.
❐ Each outflow of funds from the country implies a demand for foreign exchange – which
is mirrored by an exactly equivalent supply of rands.
❐ Each inflow of funds into South Africa implies a demand for rands (i.e. a supply of foreign
currency).
❐ If the inflow exceeds the outflow of funds, there is an excess demand for rands. That
should translate into upward pressure on the external value of the rand.
❐ Likewise, a net outflow of funds leads to an excess supply of rands on forex markets, and
downward pressure on the rand.
At this juncture, the decisive importance of the BoP is unmistakable. A BoP surplus (= net
inflow of funds indicated by rising foreign reserves) implies an excess demand for rands,
and hence upward pressure on the value of the rand, with appreciation the likely outcome.
In brief:
BoP > 0 ⇒ excess demand for rands ⇒ upward pressure on the rand ⇒ rand appreciates
A BoP deficit (= a net outflow of funds and falling reserves) causes downward pressure
on the rand. As long as there is a BoP deficit or surplus, pressure exists on the rand to
depreciate or appreciate. Only when (and if) a BoP deficit or surplus is eradicated would
pressure on the rand to adjust disappear.
❐ Exchange rates often undergo smaller day-to-day fluctuations due to minor influences
on markets: single large transactions, rumours of transactions or policy events (in South
Africa or elsewhere), speculative transactions and so forth. However, the BoP position
remains as the underlying determinant of the direction of change of the exchange rate.
Remember that the value of the rand against the dollar can change simply because
the dollar, as such, has strengthened or weakened on international markets, often due
to factors in the US economic scene unrelated to the rand or South African economic
conditions. In such a case it is preferable to analyse the value of the rand by comparing it
with other currencies, or with a group of other currencies.
❐ This is why (and when) the effective exchange rate is particularly useful, being more
stable and less subject to distortion by foreign country-specific shocks.
The previous analysis focused on short- and medium-term movements in the external
value of the rand. That excludes an important question: which factors determine the long-
term tendency in the exchange rate?

In principle, the analysis of the decisive role of the BoP is valid for the longer term,
ignoring smaller disturbances. Sustained BoP deficits would lead to sustained downward
pressure on the currency (depreciation), while sustained BoP surpluses would augur well
for sustained currency appreciation. (Sustained current account or financial account
tendencies, in turn, explain basic tendencies in the BoP.)
However, the question is: which underlying factors determine or cause sustained BoP
tendencies? Important determinants are discussed below.
Inflation differentials
In some of the examples above it was demonstrated that, if South African inflation is higher
than that in other countries (especially its main trading partners), it would discourage
exports and encourage imports. The current account would deteriorate, which would
weaken the BoP (assuming that the financial account is unaffected), eventually leading to
downward pressure on the external value of the rand.
❐ Therefore, a sustained gap between the inflation rates of South Africa and its trading
partners will cause a long-term, gradual depreciation of the rand.
❐ In practical terms, one can state the argument as follows: the only way in which South
African exporters can remain competitive in world markets while South Africa is
experiencing higher domestic inflation than the rest of the world is if the rand persistently
and gradually depreciates to compensate. Such depreciation will prevent the effective
price for the foreign buyer of the South African product from increasing all the time due
to South African inflation.
❐ One may therefore expect an annual rate of depreciation over the long term that is roughly
equivalent to the difference between the average trading partner inflation rate and the
South African inflation rate.
This is one of the most important underlying explanations of long-term tendencies in
exchange rates.
The theory of purchasing power parity (PPP)

This is a more formal and more theoretical version of this rule of thumb. It is a typical
equilibrium approach, and it posits that exchange rates will tend towards an equilibrium
P
situation where the exchange rate is precisely equal to the price ratio (  ). The exchange rate
Domestic
P
  
Foreign
would change precisely proportionate to changes in the price ratio. While in the short run it never
works like this in practice, inter alia because factors other than prices also play a role, there is
an important element of truth in this theory when viewed over the longer run.
International competitiveness or non-competitiveness

This is another important factor determining trade patterns and therefore the current
account. Competitiveness depends on factors such as productivity, input cost tendencies,
labour force skills, innovative management and marketing, technological developments,
natural resource development, human development and so on.
Political-economic expectations and perceptions

These are important long-term factors, especially on the financial account side. If a
country is regarded as safe, stable and prosperous (e.g. Switzerland), it can experience

significant capital inflows over an extended period of time. This can cause a sustained
appreciation of the currency (depending, of course, on the current account position). The
opposite holds for when a country is considered unsafe and unstable. In the South African
case, perceptions about safety and stability are potentially some of the most important
negative factors in the future (as they have been during the past couple of decades).
What are fixed and floating exchange rates? Exchange rate policy
Exchange rates that are determined by the interaction of demand and supply in a fully
free and smoothly functioning foreign exchange system are called floating exchange rates.
However, this would be an extreme, pure case. Even if the foreign exchange market
operates smoothly, the behaviour of the exchange rate can be influenced significantly by
dominant sellers or buyers of, for example, rands. One such dominant buyer is the Reserve
Bank, which has the responsibility of keeping a watchful eye over the exchange rate. This
is the objective of exchange rate policy, and part of the responsibilities of the Reserve Bank.
By taking part, on a relatively large scale, in purchases or sales of rands in the foreign
exchange market, the Reserve Bank can influence the ‘price’ of the rand. This is the
system that exists in South Africa and in the majority of countries in the world (albeit
in different forms and with different degrees of central bank action). It works in the
following way:
❐ If the Reserve Bank wishes to prevent the rand from depreciating (too much), it can enter
the market and purchase a substantial amount of rands – using foreign currencies as
payment – thereby supporting the value of the rand and preventing a further decline.
❐ The opposite occurs if the Reserve Bank sells large quantities of rands, e.g. by buying
dollars. In this way it can put downward pressure on the value of the rand, thereby
preventing it from appreciating. The need for such a step occurs less frequently, except
to smooth erratic jumps.
Supporting the rand requires dollars or other currencies to pay for the rands that the Bank
is purchasing. Therefore the rand can be supported only as long as the Reserve Bank has
sufficient foreign currency reserves to purchase rands. Because reserves are being used up
as long as support is given, at some point reserves must start reaching critically low levels.
This is one reason why a country’s foreign reserves are so important and are constantly
monitored by policymakers.
❐ In addition to its own foreign reserves, a central bank might also have foreign credit
lines (i.e. loan facilities) on which it can draw at times to obtain foreign reserves (these
loans have to be repaid, of course).
The Bank cannot, therefore, prevent currency depreciation indefinitely. It can at most
prevent unwanted short-term dips, or try to smooth the behaviour of the exchange rate
if transient erratic movements occur, for instance, due to market rumours or speculative
trading.
❐ Therefore the moderation of exchange rate volatility, rather than the sustained
prevention of depreciation (or appreciation), is the main aim of exchange rate policy.
When the Reserve Bank participates (or ‘intervenes’) in the forex market in this way, the
exchange rate is not freely floating in the true sense of the word. It is then appropriate to
speak of a system of ‘dirty floating’.

The Reserve Bank: always there to support the rand?
The limited ability of the Reserve Bank to prevent a depreciation of the rand was clearly
demonstrated in 1998 when the Asian crisis caused significant downward pressure on the
rand. The Reserve Bank attempted to stabilise the value of the rand by selling its foreign
reserves. It even borrowed foreign reserves to then sell in support of the rand. However, these
attempts failed to prevent the depreciation of the rand. The Reserve Bank ended up with what
was known as a net open forward position (also known as the international liquidity position
of the Reserve Bank), that increased from negative $12.7 billion in April 1998 to negative
$23.2 billion in September 1998. After the events of 1998 the Bank decided against such
practices. When the rand again came under pressure in 2001, the Bank did not intervene
in the forex market. The rand depreciated significantly (as it might have done even had the
Reserve Bank intervened). However, after a couple of months foreign investors realised that
the rand was significantly undervalued, and its earlier depreciation was reversed. In January
2019 the international liquidity position of the Reserve Bank was positive $44 billion.
Note: While it is true that the Reserve Bank does not formally fix the exchange rate in
this system, it is as true that its participation or intervention in the market always con-
stitutes a form of policy influence (‘control’) of the exchange rate. The exchange rate is not
determined by market forces alone. However, any intervention cannot continue indefinitely
– ultimately, market forces will be decisive.
A system of fixed exchange rates occurs when this intervention of the Reserve Bank is so
absolutely dominant that it effectively pegs the exchange rate at a particular level (even if
it is technically free to move). This system can be illustrated as follows:
❐ Suppose the Reserve Bank wants to prevent the rand from going above, for example,
$1 = R10.00. All it has to do is to be willing to flood the market with rands at that rate
(price) – i.e. supply any amount of rands at that price, no matter how large the demand
for rands. Then no foreigner would have to pay more than $0.10 for a rand. Whatever
the demand for rands, no upward pressure on the rand can occur. In effect, the rand is
fixed or ‘pegged’ at that rate.
❐ Likewise, if the Reserve Bank wants to prevent the rand from depreciating below $1 =
R10.00, all it has to do is purchase all rands offered to the market at that price. If it is
willing to buy whatever quantity is supplied, no downward pressure on the rand can
develop, and its value cannot fall below that level. In effect, the exchange rate is fixed.
❐ If there is downward pressure on the rand due to substantial selling of rands, and if the
foreign reserves are insufficient to finance further purchases of rands, the Bank will
not be able to counter the downward pressure on the rand. All it can do then is to allow
the rand to fall to a new ‘floor price’. This is what is meant by the term devaluation: an
explicit policy decision to go to a lower floor price for the rand. (Thus devaluation is the
fixed exchange rate equivalent of depreciation.) Conversely, a policy decision to peg the
rate at a higher level is called revaluation.
❐ Note that even fixed exchange rates are not fixed by law. Fixed exchange rates are
similar to any system of floor prices and price ceilings.
From 1946 to 1971 most Western countries had a system of fixed exchange rates – the
outcome of the so-called Bretton Woods Agreement. After 1971, various countries
experimented with freely floating exchange rates and systems of controlled, or dirty, floating.

4.3.3 The BoP and exchange rates: a restatement and summary
The basic linkages between internal economic variables and different external sector
variables are complex but fascinating, and can be summarised as follows.
❐ The exchange rate is determined by the net inflow or outflow of funds. Thus the BoP
position is a decisive factor. In turn the BoP position is determined (caused) by changes
in exports and imports (current account) and in capital inflows (financial account).
❐ The current account (X – M) influences total expenditure (C  I  G  X  M) – and
thus also production GDP and Y – directly.
❐ The financial account on its own has no direct short-term effect on expenditure (see
section 4.2.2).
❐ In other words, the real sector is influenced, in the first instance, by the current account,
since it affects expenditure directly.
❐ The monetary sector is influenced by the current account and financial accounts
together, i.e. by the BoP, and not by the financial account alone. (Of course, this effect
on the monetary sector will subsequently impact on the real sector.)
The current and financial accounts together, i.e. the BoP position, have two important
consequences:
(a) the money supply is influenced, and
(b) the exchange rate is influenced.
Normally one can expect the ef-
fect on the money supply to occur One should therefore take care not to argue the
first. The effect on the exchange seemingly obvious, i.e. that the monetary sector is
rate is likely to become apparent influenced by the financial account (as the expected
somewhat later. Though the effect parallel argument for the influence of the current
account on the real sector). It is incorrect reasoning.
of the balance of payments on the
exchange rate is direct (through
the interaction of the supply and demand for currency), the effect very often is strength-
ened and even triggered when news about the size of the current account deficit (or sur-
plus) is published and discussed in the media and financial circles. These changes in the
money supply and in the exchange rate will then have further effects on the economy (see
below for complete chain reactions).
The main consequences of exchange rate movements are changes in exports and imports,
i.e. in the current account; however, capital inflows can also be affected.
❐ All this means that the exchange rate has an effect on the BoP.
Therefore:
❐ There is an important interaction and two-way causation between the exchange rate
and the BoP (and its components).
❐ In addition, both the exchange rate and the BoP have important links with the rest of
the economy.
At the same time, the real and monetary sectors of the economy also are in continuous
two-way interaction, as analysed in chapter 3. How everything fits together will soon be
demonstrated. First we must con-
sider the so-called BoP adjustment The exchange rate also affects the rand price of
process, which is an important part imported inputs, which can influence production
of the whole picture. costs and inflation. This is analysed in chapter 6.

4.4 The BoP adjustment process
!
Important note to instructors and students
Most textbooks explain the BoP adjustment process under either of two extreme exchange rate
regimes: either fixed rates or fully flexible rates. While it simplifies the analysis, it limits the analysis
to theoretically extreme cases. Most countries have a system of dirty floating exchange rates,
hence the BoP adjustment process will exhibit elements of both pure systems.
The analysis in this book integrates these elements into one chain of events, distinguishing between
an initial and a later, concluding effect. The same approach is followed in the analysis in terms of
the IS-LM and IS-LM-BP models in sections 4.7 and 4.8.
The crux of the idea of a BoP adjustment process is that a BoP disequilibrium activates
forces that tend to eliminate the disequilibrium. These forces operate via the above-
mentioned effects of the BoP on the money supply and the exchange rate. Suppose there is a
BoP surplus (BoP > 0). One can then expect the following two adjustment effects:
1. Initial BoP effect: via the money supply (while the exchange rate is still relatively passive
or rigid).
2. Concluding BoP effect: via the exchange rate (when it starts to adjust).
Both of these effects will operate as long as there is a BoP disequilibrium (BoP  0). On the
whole, what happens is the following complex chain reaction. This constitutes the BoP
adjustment process:
MS
  P     ⇒ i  ⇒ I  ⇒ total expenditure 
BoP > 0 ⇒ (i) inflow of foreign exchange ⇒ 
⇒ Y  ⇒ M  ⇒ current account 
⇒ (ii) inflow of foreign exchange ⇒ excess demand for rands ⇒ rand  ⇒ X 
and M  ⇒ current account 
Both effects will cause the current account to deteriorate. Hence they will reduce the BoP
surplus.
Both these adjustment effects will continue as long as BoP  0, and hence continues to
push the BoP towards equilibrium. When and if BoP equilibrium is reached, the process
stops.
In practice, the process will seldom reach equilibrium so smoothly. Moreover, it rarely
happens that the adjustment process proceeds uninterrupted to the end. New disturbances
may interfere. What is important is the basic direction of the adjustment effects via the money
supply and the exchange rate.
The BoP adjustment is not the end of the story either. The deterioration of the current
account will, in turn, have a cooling-down effect on expenditure and GDP, with the
accompanying secondary downward pressure on interest rates (see section 4.5).
4.4 The BoP adjustment process 171

✍ Suppose BoP < 0 ⇒
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!
Remember that, as with other chain reactions, there continues to be much uncertainty, especially
regarding the speed and smoothness of the adjustment process. At each step people have to
take decisions and make choices. Nothing adjusts automatically or mechanically. Ultimately,
everything that occurs is the result of the (responsible or irresponsible) decisions of human
beings.
4.5 The complete model – the BoP, the exchange rate and the
domestic economy
Our model has been developed sufficiently to analyse the expected consequences of any
internal or external disturbance (as reflected in changes in foreign trade or in capital flows).
It is illustrated with the same three examples introduced in section 4.3.1 – although with
the direction of change reversed – followed by an exposition of a general method.
At the same time we will consider the impact of the exchange rate and BoP adjustment
on the effectiveness of fiscal and monetary policy steps – a recurring theme in all chapters
thus far.
Each of these examples now includes three secondary effects, a concept first introduced in
chapter 3 and its IS-LM analysis (e.g. sections 3.2.2 and 3.3.6).
❐ As mentioned before, in practice the primary and secondary effects are not neatly
separated in time as distinct steps that follow one another – say, as if an increase in Y is
followed by a distinct increase in money demand. The secondary effects concurrently
become operational as the primary effect gathers speed. Different secondary effects
may, though, have different dynamics and time spans. Nevertheless, their typical effect
is to either curb or turn around initial changes in key macroeconomic variables such as
real income Y and the real interest rate r.
❐ In the open economy there are more secondary effects – three – than in the closed
economy, where there is one only. As we will see, the secondary effects flowing from the
balance of payments are likely to commence a while later, but will still unfold parallel
and concurrent to ongoing changes in main variables.

4.5.1 Monetary policy steps – consequences and effectiveness
Example 1: the internal and external effects of a cut in the repo rate
Primary effect:
(1) Lower repo rate ⇒ banks pay less for Reserve Bank accommodation ⇒ banks
encourage credit creation ⇒ money supply expands ⇒ excess supply of money ⇒
increase in acquistion of money market paper ⇒ prices of money market paper rise
⇒ decrease in nominal (and real) interest rates ⇒ capital formation I encouraged ⇒
aggregate demand increases ⇒ production encouraged ⇒ Y increases (= upswing in
the economy).
As Y increases ⇒ imports M increase (why?) ⇒ current account (CA) deficit develops.
The decrease in r causes an outflow of foreign capital, leaving the financial account
(FA) in a deficit. Together these two effects imply that a balance of payments deficit
develops: BoP < 0.
Secondary effects:
(2) Money market effect: As Y increases, it causes the demand for money to increase
concurrently ⇒ upward pressure on interest rates ⇒ initial drop in interest rates
gradually comes to an end ⇒ initial increase in investment is curbed ⇒ initial increase
in aggregate demand arrested ⇒ increase in Y brought to an end ⇒ rise in M arrested
and initial weakening of (X – M) comes to an end.
❐ The main impact of this secondary effect is that the changes in r, I, Y and M will
be smaller than they would have been, had there been no such effect via money
demand. While this secondary effect operates in the opposite direction from the
primary effect, it is a weaker force. The secondary effect does not cancel the primary
effect, it only reduces it.
The net effect of the primary and secondary effects leaves Y higher, r lower and both the
current and financial accounts in deficit. There is a BoP deficit (BoP < 0).
Further secondary effects due to BoP < 0:
(3) Initial BoP effect (foreign reserves adjustment): The BoP deficit causes (i) an outflow
of foreign exchange ⇒ money supply decreases ⇒ upward pressure on interest
rates (which causes the outflow of foreign capital to decrease or reverse and the
financial account deficit to decrease); the increase in the interest rate discourages real
investment I ⇒ aggregate demand/expenditure decreases, causing Y to decrease; as
Y decreases it dampens imports ⇒ (X – M) increases ⇒ prevailing current account
deficit is reduced; the turnaround in the real interest rate will also start to encourage
or reverse capital outflows; thus the financial account is likely to start improving. On
both fronts, the BoP deficit is being reduced.
The contraction in Y implies that the initial upswing has turned around (for now …).
(4) Concluding BoP effect (exchange rate adjustment): The initial BoP deficit also leads to (ii)
an excess supply of rand (excess demand for foreign exchange) ⇒ downward pressure
on the rand ⇒ stimulation of exports and discouragement of imports ⇒ (X – M)
increases ⇒ current account deficit is reduced, and so is the remaining BoP deficit.
The BoP tends towards equilibrium. The process will continue as long as BoP ≠ 0 and
until BoP = 0.
4.5 The complete model – the BoP, the exchange rate and the domestic economy 173

This cumulative increase in (X – M) due to these two BoP effects again boosts aggregate
expenditure, which reverses the short decline in Y – the economic upswing resumes
(Y expands again).
It is likely that the foreign reserves effect (phase 3 above) will come about sooner than the
exchange rate effect (phase 4).
Summary of changes
It is interesting to note the changes that occur in the main macroeconomic variables, i.e.
income Y, interest rate, rand, BoP and exchange rate.
In particular, consider the beha
viour of income Y. Following an In this way the BoP adjustment process may cause
initial upswing in income (held a cyclical movement in Y, or will at least have a
back somewhat by the secondary, restraining effect in the later phases of an upswing
(or downswing). Thus one finds signs of inherent
money market effect), the BoP
sources of cyclical movements in production and
adjustment activates monetary
income in the BoP adjustment process. In practice,
forces in the opposite direction this factor in itself is not sufficient to explain the larger
– via foreign reserves – which cyclical movements in the economy. However, it does
reverse the upswing and pushes contribute to cyclical forces and fluctuations.
Y into the early phases of a
downswing. However, before long
the exchange rate adjustment again places
upward pressure on income – the downswing Figure 4.9 Illustrative time path of key variables due
to a decrease in the repo rate
may be short lived, and an upswing period
may recur. Thus the net effect of all these
processes on Y is likely to be positive.
Interest rates first decrease, only to experience r
repeated upward pressure in later stages. The
net effect should be a rate decline.
The rand depreciates during the latter Time
stages of the BoP adjustment phase (phase
4). This depreciation is the main cause of Y
the final upswing towards the end – mainly
because the depreciation stimulates exports
and discourages imports, thereby boosting
Time
aggregate expenditure.
Rand
The balance of payments goes into deficit,
which is then reversed. The current and
financial accounts change as side-effects of
the primary and secondary effects. Time
BoP
❐ This is in contrast to example 3 that follows
(the case of an export stimulus), where
the primary effect (i.e. initial disturbance)
will directly and immediately influence BoP adjustment
phase
the current account.
The diagram in figure 4.9 is a stylised illus Demand expansion
tration of the course of these main variables op to 3 years

over time during the primary and three secondary effects. Study it carefully and see
whether it conforms to your understanding of the whole chain reaction.
❐ Of course, in reality time paths never are so smooth, and shocks and disturbances occur
simultaneously. Our purpose here is to isolate the basic directional effects encountered
by an open economy following an initial stimulus.
The effectiveness of monetary policy
Note that the basic impact of the monetary policy step on real income is countered by the
foreign reserve, or money supply, effect of the BoP. This effect can take place because, and
as long as, the exchange rate is rigid or slow to adjust. Subsequently, however, the flexible
exchange rate effect does the opposite and boosts the potency of monetary policy. For
practical monetary policy, it is important to ascertain which of these effects will dominate
in practice.
Monetary stimulation in a situation with fixed or very rigid exchange rates has been called
‘sending the money supply overseas’.
Example 1 illustrates how, for a decrease in the repo rate, a BoP deficit develops as a result of
the monetary stimulation. That implies an outflow of funds/money, which contracts the money
supply. That means that the initial monetary stimulus is counteracted or even nullified by the
BoP effect.
When the exchange rate starts to adjust, it speeds up the elimination of the BoP deficit, which
will counter the monetary contraction effect somewhat. In a fully free and quick-adjusting
floating exchange rate system, the exchange rate will adjust so rapidly that the BoP deficit
does not even get the opportunity to emerge. Then there would be no opportunity or reasons
for the money supply outflow to take place. The monetary policy impact will be 100%.
However, if the exchange rate adjusts very slowly or not at all, the money supply effect has
ample opportunity to manifest itself, implying a considerable outflow of money. Then one
can indeed say that the money supply is simply being ‘sent overseas’, with little domestic
monetary impact of the monetary policy step.
This produces the important policy conclusion that rigid exchange rates undermine
the potency of monetary policy, while a quick-adjusting exchange rate enhances the
effectiveness of monetary policy.
❐ In the extreme case of a fixed exchange rate regime, and if capital is perfectly mobile,
the outflow of capital following monetary stimulation would completely offset the
initial stimulation. The rigid exchange rate effect is dominant, and monetary policy
would be entirely ineffective.
❐ In the other extreme of an instantly adjusting floating exchange rate, monetary policy
would be maximally effective: any monetary stimulus is boosted since falling interest
rates weaken the domestic currency, which stimulates net exports (X – M). The flexible
exchange rate effect dominates.

4.5.2 Fiscal policy steps – consequences and effectiveness
Example 2: the internal and external effects of a cutback in government expenditure

Primary effect:
(1) Reduction in government expenditure ⇒ aggregate expenditure decreases ⇒ negative
impact on domestic production ⇒ real income Y decreases.
As Y decreases ⇒ imports M decrease ⇒ a current account surplus develops.
Secondary effects:
(2) Money market effect: As Y decreases, it causes a concurrent decrease in the demand for
money ⇒ downward pressure on interest rates ⇒ encouragement of real investment
I ⇒ increase in aggregate demand, partially countering the impact of the initial
reduction in government expenditure ⇒ curbs the fall in Y ⇒ decline in M curtailed
and initial strengthening of (X – M) comes to an end.
The net effect of the primary effect and the secondary, money market effect leaves Y
lower, r lower and (X – M) > 0, i.e. a current account (CA) surplus.
The decrease in r causes an outflow of foreign capital, causing a deficit on the financial
account (FA). The net effect on the BoP is uncertain: depending on the relative size of the
CA and FA positions, the BoP = CA + FA could be in balance, in a surplus or in a deficit.
Since the state of the BoP is decisive for the further BoP adjustment effects, we must make
some assumptions here. If foreign investors consider the economy well-integrated into the
global economy, international capital flows will be relatively sensitive to domestic interest
rate changes. Therefore, should interest rates decrease as a result of the secondary effect,
there will be a relatively large outflow of foreign capital. Thus, one might expect the deficit
on the FA to exceed the surplus on the CA, in which case BoP < 0. We assume this case to
apply to South Africa at the moment.
❐ If capital flows were not that sensitive to domestic real interest changes, the deficit on
the FA would have been smaller than the surplus on the CA – implying a BoP surplus.
Thus we have further secondary effects due to BoP < 0:
(3) Initial BoP effect (foreign reserves adjustment): The BoP deficit causes (i) an outflow
of foreign exchange ⇒ contraction in money supply ⇒ upward pressure on interest
rates (which causes the outflow of foreign capital to decrease or reverse and the FA
deficit to decrease); the increase in the interest rate also discourages real investment I
⇒ aggregate demand/expenditure decreases, causing Y to decrease; as Y decreases it
dampens imports ⇒ (X – M) increases ⇒ prevailing CA surplus is reduced; however,
the turnaround in the real interest rate will also start to reverse capital outflows; thus
the FA deficit is likely to start being reversed. Assuming a stronger FA effect, the net
effect would be that the BoP deficit is being reduced.
The decrease in Y implies that the initial downswing has been followed by a continuation
of the downswing that exacerbates the decline in Y.
an excess supply of rand (excess demand for foreign exchange) ⇒ downward pressure
on the rand ⇒ stimulation of exports and discouragement of imports ⇒ increase in
(X – M) ⇒ current account surplus increases again. This helps to eliminate the

remaining BoP deficit – the BoP tends towards equilibrium. The process will continue
as long as BoP ≠ 0 and until BoP = 0.
Note how, towards the end, the depreciation of the rand is responsible, via an induced
increase in (X – M), for a stimulation of aggregate expenditure. This reverses the two-
phase contraction of Y – a small recovery begins when Y increases.
Summary of changes
Following an initial contraction of real income Figure 4.10 Illustrative time path of key variables due
Y (held back somewhat by the secondary, to a government expenditure cutback
money market effect), the BoP adjustment
activates monetary forces in the same direction r
– via foreign reserves – which exacerbates the
decline in Y into a deeper recession. Only after
the exchange rate adjustment occurs do we see
the first signs of recovery. Real income would Time
have gone through a business cycle trough –
which is no surprise, given the contractionary Y
fiscal step that initiated everything. Only at the
end is there a small recovery.
Interest rates first decrease, but in the BoP
adjustment stages they experience upward Time
pressure twice. The net effect should still be a Rand
rate decrease, though.
The rand depreciates during the latter
stages of the BoP adjustment phase (phase
Time
4). This depreciation is the main cause of
the final recovery down towards the end BoP
– the depreciation stimulates exports and
discourages imports, thereby boosting aggre BoP adjustment
gate expenditure. phase
The balance of payments goes into deficit,

Demand contraction
which is then reversed. The current and up to 3 years
financial accounts play complex roles in this
process, since they often move in contradictory directions.
The effectiveness of fiscal policy

The basic impact of a fiscal policy step – whether contractionary or expansionary – on real
income is strengthened by the money supply effect of the balance of payments. The flexible
exchange rate effect – depreciation or appreciation – works in the opposite direction.
This produces the important conclusion, as regards South Africa, that a rigid or fixed
exchange rate strengthens the potency of fiscal policy, while a quick-adjusting exchange
rate undermines its effectiveness.

4.5.3 External disturbances
Example 3: the effect of an economic downswing in the USA on the SA economy

Primary effect:
(1) Lower YUSA ⇒ US imports MUSA The importance of diagrammatical aids
decrease ⇒ decreased imports These examples demonstrate that it can become
from abroad, including South quite bewildering to sort out the complexities of
Africa ⇒ XSA decreases ⇒ open-economy chain reactions. This is why it
(X – M) decreases, i.e. cur is so important to master, and use, appropriate
rent account goes into defi diagrammatical aids to guide and check our chain-
cit ⇒ aggregate expenditure reaction thinking.
decreases ⇒ production dis From the initial 45o model we developed the IS-LM
couraged ⇒ Y declines. in chapter 3, which offers a concise and powerful
‘roadmap’ to analyse chain reactions.
(2) As Y decreases, a concurrent
decrease in imports M de Later in this chapter it is expanded by including the
velops ⇒ positive impact on BP curve, which enables us to bring the state of
(X – M), i.e. current account the balance of payments, and the BoP adjustment
process, into the graphical analysis.
(CA) improves a bit.
The net effect on the current
account will still be a substantial deterioration.
Secondary effects:
(3) Money market effect: As real income Y declines, the real demand for money decreases ⇒
downward pressure on real interest rates, which, in turn, causes investment to increase
⇒ upward pressure on aggregate demand ⇒ initial decrease in aggregate demand
countered ⇒ production encouraged ⇒ decrease in Y curbed, downswing comes to an
end; drop in M arrested and deterioration in CA comes to an end; CA in deficit.
The decrease in interest rates should lead to an outflow of foreign capital, which hurts
the financial account (FA) – the FA will be in a deficit.
The net effect of the primary effect and the secondary effect leaves Y lower, r lower and
the current and financial accounts in deficit. Thus the BoP will have a deficit.
Thus we have further secondary effects due to BoP < 0:
(4) Initial BoP effect (foreign reserves adjustment): The BoP deficit causes (i) an outflow of
foreign exchange ⇒ money supply decreases ⇒ upward pressure on interest rates
(which causes the outflow of foreign capital to decrease); higher rates discourage
real investment I ⇒ aggregate demand/expenditure decreases, causing Y to decrease
further; as Y decreases it dampens imports ⇒ (X – M) increases ⇒ prevailing CA deficit
is reduced. The rise in interest rates will encourage capital inflows, so the existing FA
deficit will shrink.
an excess supply of rands (excess demand for foreign exchange) ⇒ downward pressure
on the rand ⇒ stimulation of exports and discouragement of imports ⇒ increases (X
– M) ⇒ CA deficit is reduced.
This depreciation-induced increase in (X – M) boosts aggregate expenditure, which
turns around the sustained downswing. Y will increase, also pulling up interest rates.

The financial account will improve further, and so will the remaining BoP deficit. The
BoP tends towards equilibrium. The process will continue as long as BoP ≠ 0 and until
BoP = 0.
Summary of changes
Figure 4.11 Illustrative time path of key variables due
In contrast to example 1 (internal monetary to a decrease in exports
disturbance), where the current account
changed mainly as part of the BoP r
adjustment phase, in this case the initial
disturbance directly and immediately affects
the current account. As a result, the current
account pattern is somewhat intricate:
❐ The current account deteriorates Time
initially, due to the direct role of exports.
Y
As income decreases due to the export
decline, imports are likely to start
declining. This will restrain the current
account deterioration. On balance the
Time
current account will still deteriorate.
Later, when the balance of payment Rand
adjustment process comes into play, the
current account improves due to changes
in income and the exchange rate.
❐ The financial account is hurt by the Time
secondary, money market impact on BoP
interest rates and goes into deficit, but
later improves during the BoP adjustment
processes. BoP adjustment phase
❐ Income declines due to the export shock
and then again due to the initial BoP Demand contraction
adjustment effect, but then recovers due up to 3 years
to the depreciation of the rand.
❐ The real interest rate first drops, but increases in the BoP adjustment phases.
❐ The rand depreciates in the later stages of the BoP adjustment process, when it is the
main cause of the final recovery at the end.
Theoretically the BoP surplus should be eliminated at the end, since the BoP adjustment
process should continue until BoP = 0. In practice, the process rarely gets to equilibrium
so effortlessly. Nevertheless, the basic nature and direction of the adjustment process is
unchanged.
The export shock example appears similar to the fiscal contraction example. Note the
following differences, though:
❐ In the fiscal contraction example, a CA surplus develops, but it is overshadowed by a
FA deficit, hence a (small) BoP deficit develops. In the export example, a substantial
CA deficit develops immediately, on top of which a FA deficit develops, so that the BoP
deteriorates much quicker and goes into a much larger deficit.
❐ The BoP adjustment process is much longer in the export example.
❐ The rise of r during the BoP adjustment is larger in the export example, due to the
larger BoP deficit and its effects on the money supply.

❐ The downswing in Y is likely
to last longer than in the fiscal In all these examples the change in the exchange
example. rate is, simultaneously, a symptom of one condition,
but also the cause or source of a new phase. More
Note that a rigid exchange rate specifically, one can say that a depreciating rand is
heightens the domestic effects a symptom of a BoP deficit, but also the seed of the
– whether negative or positive – BoP recovery process.
of a change in exports, while a
quickly adjusting exchange rate
puts a damper on export-led economic fluctuations. (This parallels the conclusion about
the positive impact of a slowly adjusting exchange rate on the effectiveness of fiscal policy,
but in this case it makes export-led downswings worse.)
Remark
All these examples are still incomplete, since the effect on the price level is omitted. This
will be rectified in chapter 6.
4.5.4 Analysing internal and external disturbances – a general method

What follows is a general method to analyse the complete, expected consequences of
any internal or external disturbance, as reflected in a change in foreign trade or capital
inflows.
Internal disturbances
1. Derive the primary effect of (i.e. initial impact on) internal variables such as expenditure
components, aggregate expenditure and thus Y. Also derive the endogenous effect on
the current account.
2. Following the primary effect, derive the concurrent secondary internal effect and its
endogenous impact on the current account. Derive the net effect on Y.
3. Summarise the effects of steps 1 and 2 on both the current account and the financial
account (itself the result of the interest rate change occurring in steps 1 and 2).
4. Show the initial BoP adjustment process (rigid exchange rate or foreign reserves effect).
5. Show the concluding BoP adjustment process (flexible exchange rate effect).
Finally, note the impacts of steps 4 and 5 on expenditure and Y (as well as other relevant
variables). Summarise the movements and net effect on different variables.
External disturbances
1. Derive the initial exogenous impact on the current or financial account, and the
ensuing effect on internal variables such as aggregate expenditure and thus Y. Also
identify any concurrent endogenous effect on the current account (and/or financial
account) that is likely to accompany these changes. In this way determine the net,
combined effect on the BoP.
2. Following the primary effect, derive the concurrent secondary internal effect and its
endogenous impact on the current account. Derive the net effect on Y.
3. Summarise the effects of steps 1 and 2 on both the current account and the financial
account (itself the result of the interest rate change occurring in steps 1 and 2).
4. Show the initial BoP adjustment process (rigid exchange rate or money supply effect).
5. Show the concluding BoP adjustment process (flexible exchange rate effect).

Finally, note the impacts of steps 4 and 5 on expenditure and Y (as well as other relevant
variables). Summarise the movements and net effect on different variables.
At each juncture, take the time to ask why something happens, and what the expected
consequences of that occurrence are likely to be as one moves along the chain reaction.
✍ Complete the following:

Suppose taxation is decreased ⇒
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Suppose the rand depreciates strongly ⇒
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4.5.5 Chain reactions in reverse – the likely causes of events

We can use our knowledge of the linkages and interactions between internal and external
variables to uncover the likely causes of observed changes in economic variables. That
is, we return to possible chain reactions, searching for the likely source of changes. For
example, what are the likely causes of the following occurrences?
(a) A depreciation of the rand
Answer: An excess supply of rands on the foreign exchange market, which is likely to be
a reflection of a net outflow of payments via the current and/or financial accounts (i.e. a
BoP deficit). Of course, the likely causes of the latter can also be, for example, a withdrawal
of capital (investment) by foreigners.
(b) Increasing interest rates
Answer: The immediate cause is either an increase in money demand or a decrease in
the money supply, or both. The cause of the former is likely to be an economic upswing

(increase in Y), i.e. some stimulus on the economy, or a large budget deficit that is financed
via domestic borrowing. A money supply contraction can follow from either:
❐ internal causes, the main candidates being one or several restrictive monetary policy
steps; or
❐ an external factor that has resulted in a BoP deficit (which implies a leakage of money
from the domestic economy).
(c) A depreciating rand and increasing interest rates occurring together
Answer: (Complete by eliminating some of the possible causes identified in (a) and (b).
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(d) A current account deterioration
Answer: (Complete)
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The budget deficit and the BoP

It is important to note certain important linkages between the budget deficit and the BoP:
❐ Foreign loans to finance a budget deficit imply an inflow of foreign capital. This links the
budget deficit and the BoP (which may be in deficit or surplus).
❐ Such a linkage also emerges where a budget deficit is financed via domestic borrowing.
The upward pressure that it may put on interest rates can attract foreign capital, which will
strengthen the financial account, and thus the BoP.
The crowding out of exports by a budget deficit
With the exception of the late 1990s and early 2000s, the last linkage has been a major issue
in the USA since the 1980s. It is argued that a budget deficit financed by domestic borrowing
pushes up interest rates. Given the high sensitivity of international capital to US interest rates,
this causes a significant inflow of capital. The subsequent demand for dollars causes the
dollar to appreciate. In turn, this discourages foreign purchases of US goods (as reflected in
a current account deficit). Therefore, US exports are restricted – or ‘crowded out’ – by the
budget deficit. This association between the budget deficit and the current account deficit is
known as the ‘twin deficit phenomenon’.
❐ This effect can only occur in a country with high international capital mobility, and can only
occur in a system of floating (or controlled floating) exchange rates.
❐ This effect decreases the fiscal multiplier, because the restriction of exports counteracts
any fiscal stimulation.
✍ The world financial crisis of October 2007–08: open economy aspects

We introduced this case study in section 3.4 – reread that section. Now try to deduce what
the accompanying open-economy changes would be for the US economy due to the various
changes in the US rate of interest and GDP indicated by the analysis and diagram. Secondly,
what would be the expected effects on South African exports, imports or capital flows – and
hence on internal variables such as GDP?

(e) A financial account improvement
Answer: Possible causes include high interest rates relative to the rest of the world,
new foreign confidence in the growth potential of the South African economy and/or
foreign optimism about the political stability in South Africa.
(f) A shrinking balance of payments deficit
Answer: (Complete.)
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4.5.6 Thirteen open economy puzzles

1. Is a weak rand relative to, for example, the dollar a good thing or a bad thing? And a
strong rand?
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2. Is a balance of payments surplus good and a deficit bad?
Sustained BoP surpluses are not necessarily desirable. Sustained surpluses imply that
the foreign reserves of a country are increasing all the time. If foreign reserves are
in excess of what is required to finance any foreseeable BoP deficit, it amounts to an
unnecessary hoarding of wealth that is not being used to improve living standards in
the country. It would be better to use it to import goods that can improve the standard
of living of the inhabitants of the country.
BoP deficits are a problem when the foreign reserves are near exhaustion and the
financing of the deficit becomes a problem (i.e. the country does not have sufficient
foreign currency reserves to pay for imports). Sustained deficits or continuously
deteriorating deficits especially are a source of anxiety. On the other hand, temporary
or short-term deficits need not be a cause for concern.
3. Why does government have to wait for a considerable current account surplus to be
present before it can institute measures to stimulate the economy?
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4. Is a sustained current account surplus (or current account deficit) a good (or bad)
thing?
A current account deficit need not be a problem if it is accompanied by sufficient capital
inflows (a financial account surplus). However, if a country experiences shortfalls in
capital inflows (as South Africa has at times), a sustained current account deficit can
cause very serious BoP and foreign reserve problems.
Whether a current account deficit is a problem also depends on the phase of the
business cycle at a particular moment. A current account deficit at the beginning of

an upswing phase is particularly undesirable since any growth in economic activity
will stimulate imports, exacerbate the deficit and put the foreign reserves under
pressure. However, at the end of an upswing phase a current account deficit is less of
a problem, being a natural side-effect of the upswing (why?) that is likely to disappear
during the subsequent downswing (why?).
!
For a country with high international capital mobility – meaning that changes in interest rates
would elicit a strong capital flow reaction – current account deficits might be less of a problem.
Together with the deteriorating current account that accompanies an upswing, one would usually
also find upward movement in interest rates (as a secondary effect). If the increase in the interest
rate elicits a strong inflow of foreign capital, it can improve the financial account to such an extent
that any current account deficit is easily financed, without pressure on foreign reserves. In such a
situation, the current account side-effect of an upswing presents no problem at all.
❐ The correct economic reasoning will, therefore, depend on the country concerned and its
particular economic characteristics.
5. What is the likely effect of high South African inflation (relative to its main trading
partners) on the external value of the rand?
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6. How is it possible that gold and platinum mines can show low profits in a period when
the international gold and platinum prices are high (and vice versa)?
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Questions 7 to 11 should be tackled as a group. They are intended to challenge the reader to put
together a number of causal relationships in the international arena. Individually they are not
complex, but when combined they constitute a powerful set of linkages which are essential to
understanding some of the most important interrelationships and transfer of shocks between
South Africa and the global economy.
7. High American interest rates and a strong dollar often occur simultaneously. Why
would that be? (Is the same true for South African interest rates and the rand?)
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8. A strengthening of the US dollar on foreign exchange markets often occurs in concert
with a drop in the gold price. Can you think of a possible explanation or linkage? (Can
there be a similar link between the oil price and the US dollar?)
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9. Therefore, it often happens that, when the gold price increases, the rand simultaneously
appreciates (and vice versa). Why would this be? (Can there be a similar link between
the oil price and the rand?)
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10. Therefore: what is a possible four-way linkage between US interest rates, the dollar,
the rand and the gold price? How does the oil price link up with this foursome?
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11. Finally: can you derive an important linkage between the American budget deficit, the
dollar, the rand and the gold price?
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12. What is the link between the American budget deficit, the American current account
deficit, and the American financial account surplus? (Hint: See the preceding
discussion about the ‘twin deficit phenomenon’ and the crowding out of exports.)
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13. What is a link between the American budget deficit, the American current account
deficit, the Chinese current account surplus and the value of the US dollar relative to
the Chinese yuan?
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4.6 Conflict between internal and external considerations

The previous discussion demonstrates the existence of important linkages between
internal economic variables (e.g. interest rates, GDP, unemployment, the budget deficit)
and external variables (e.g. the exchange rate, the BoP). It is important to note that desirable
changes in internal variables do not necessarily augur well for external variables – and vice
versa. For example, whereas high interest rates may be ‘good’ for the financial account
and foreign reserves, they are detrimental to investment (and homeowners, due to high
bond rates).
An important tension exists between the BoP and unemployment considerations. This
conflict manifests itself in South Africa during the course of each business cycle. During
an upswing, unemployment decreases, but the current account deteriorates. During a
downswing, the external position improves, while unemployment deteriorates.
This tension is less severe if capital flows are relatively sensitive to interest rate changes.
Rising interest rates associated with the secondary effect of an economic upswing will
stimulate capital inflows and cause a financial account surplus that may match or even
exceed the current account deficit. Thus capital inflows provide more than enough cover
for the outflow of payments on the current account.
❐ However, the Reserve Bank might still be concerned about the sustainability of such
capital inflows – particularly when these flows mostly comprise easily reversible
portfolio flows (e.g. financial investments on the JSE and not foreign direct investment).
Therefore, the central bank might still wish to reduce the deficit on the current
account and thereby reduce the risk of a sudden reversal on the financial account for
the economy.
✍ If there is low capital mobility, the combination of a BoP deficit and an overheated economy
is not a policy problem. Why would this be? On the other hand, a BoP surplus combined with
unemployment is not a problem irrespective of capital mobility. Why?
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The tension between a deteriorating current account and a decrease in unemployment

creates a policy dilemma: stimulation of the economy to alleviate unemployment hurts the

current account, with concomitant pressure on foreign reserves. One way to address the
current account deficit is to use policy to constrict income Y. However, that will increase
unemployment. In the South African context this unavoidable tension creates a severe
predicament for policymakers and politicians.
Although inflation – one of the most important dimensions of internal equilibrium – is
discussed in later chapters, it is necessary to note two open-economy linkages concerning
inflation:
❐ To the extent that aggregate expenditure is affected by current account, BoP and
exchange rate changes, aggregate demand in the economy is influenced. This implies a
potential influence on the average price level and, therefore, inflation.
❐ Since the exchange rate directly influences the cost of imported inputs, it has critical
implications for cost-push and supply-side inflation.
All these linkages simultaneously bring a larger number of objectives or considerations
into play, and make the evaluation of any particular internal–external situation that much
more difficult. The ideal may be to attain all internal as well as external objectives. As we
shall see, however, the relationships and causal linkages between economic variables often
make the simultaneous achievement of important policy goals impossible. Situations that
require a complex ‘trade-off ’ – where one objective can be pursued only at the cost of
another – develop quite often.
The preceding remarks on inflation highlight an important aspect: this discussion of open-
economy macroeconomic aspects still is incomplete since the price level and inflation
have not been incorporated. Likewise, any discussion of inflation that excludes external
considerations is, equally, incomplete. Therefore, we shall return to the foreign sector in
chapter 6, when the price level is introduced into the model.
Trade policy
In such difficult situations, the standard fiscal and monetary policy package is not
sufficient, and other policy instruments have to be considered. The instruments of trade
policy, e.g. tariff or import quotas, are important examples in the open economy.
❐ A tariff is a tax on imported items that increases the effective price of those imported
goods. This discourages imports. Quotas are quantitative restrictions on the quantities
of goods that may be imported.
❐ Tariffs and quotas are important since they may be used to restrict imports directly – in
contrast to the indirect restraining of imports by contracting total expenditure.
❐ A government can also pay a subsidy to local producers, allowing them to reduce
their price to below the price of the imported goods. The European Union is very often
accused by low- and middle-income countries that are dependent on agricultural
exports of protecting European farmers with such subsidies. Governments of these
countries have been debating this issue (as well as other trade issues) for years in the
so-called Doha rounds, without reaching a final deal. (Doha is a city in Qatar where the
first round of negotiation took place.)
❐ The desirability of implementing tariffs and quotas has been hotly debated in policy
circles with little indication that consensus will be reached in the foreseeable future.
The way these instruments affect the situation differs from normal fiscal or monetary
policy steps. One side-effect of a direct measure such as tariffs is that it switches domestic
expenditure from imports to domestic production (while aggregate expenditure remains
unchanged). In the domestic economy this implies an expansion of total demand (which
4.6 Conflict between internal and external considerations 187

may be desirable or undesirable at that stage). Since such a stimulation of demand may
be unwanted for other reasons (e.g. inflation), policymakers must keep this expenditure-
switching effect in mind. It may be necessary to add other policy steps to absorb the extra
expenditure and limit the expansionary effect.
❐ Direct import-restricting steps are called a policy of ‘expenditure switching’.
❐ The indirect restraint of imports via a contraction of total expenditure is called a policy
of ‘expenditure reduction’.
✍ What is the WTO? Why is it important for South Africa in these times? How does it affect our
economic prospects?
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What have been the main stumbling blocks in reaching a deal in the Doha rounds?
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4.7 The IS-LM-BP model for an open economy

In chapter 3 the IS-LM diagram was introduced and explained as a diagram that summarises
the basic economic relationships in the monetary and real sectors. In principle, the IS and
LM curves are not different in the open economy, although one should take note of certain
open-economy aspects.
In this section we add a new curve, the BP curve (or BoP curve). We show how this model
can be used to add important open-economy insights, in particular a refined analysis
regarding the BoP position and the ensuing BoP adjustment process.
!
Remember the warning, in chapter 2, that the IS-LM model – and therefore also the extended
IS-LM-BP model – is a mechanical tool that encourages purely mechanical manipulation of curves.
While it is very instructive and powerful, one should always use such diagrammatic manipulation
only as a support system for economic logic and reasoning.

4.7.1 The IS curve in the open economy
For the open-economy IS curve, aggregate expenditure must be defined to include net exports
(X – M). Actually this is how the IS curve was defined and derived in chapter 3.4 Hence
we do not have to add anything to that analysis. However, it is useful to highlight certain
open-economy aspects of the IS curve.
Changes in exports or imports caused by factors other than Y or r – e.g. changes in
exchange rates or foreign economic conditions – would shift the IS curve.
Examples
1. An upswing in the USA that is
How far would IS shift?
likely to increase US imports is
likely to boost South African The size of the expenditure multiplier affects the
exports (including those to distance that the IS curve would shift following an
the USA) and thus aggregate exogenous change in expenditure (chapter 3, section
expenditure. This would be 3.3.3). The higher the import propensity, the smaller
the multiplier, and thus the smaller such a shift.
reflected in a rightward shift
of the IS curve, and a new
equilibrium value of Y and r.
2. A BoP surplus in South Africa is likely to cause upward pressure on the external value
of the rand. Such appreciation is likely to encourage imports and discourage exports.
The net decline in (X – M) and, therefore, aggregate expenditure would be reflected in
a leftward shift of the IS curve, to produce new equilibrium values of Y and r.
The slope of the IS curve

You will recall from chapter 3 (section 3.3.3) that the slope of the IS curve depends, inter alia,
on the multiplier. In turn, the size of the multiplier depends on various ‘marginal leakage rates’.
One of these is the marginal propensity to import.
❐ If the import propensity is high, the total leakage rate would be higher, and the multiplier
smaller. This would make the IS curve steeper. A low import propensity would make the IS
curve flatter. The higher the import propensity, the steeper the IS curve.
❐ Hence, the IS curve for an open economy would be steeper than one for a closed economy
(an economy without any imports).
4.7.2 The LM curve in the open economy

The LM curve was defined and derived in chapter 3 in terms of real money demand and
real money supply in the economy. That derivation allowed for foreign sector influences in
the monetary sphere. It is worth highlighting some of these.
The slope of the LM curve, which depends mainly on the domestic demand for money, is
not markedly different in an open economy.
The position of the LM curve depends decisively on the money supply. International inflows
and outflows of payments strongly influence the supply side of the money market. Such
flows derive mainly from the BoP position.
4 Historically, the IS-LM model was developed primarily to analyse a closed economy. Most textbooks first derive the IS curve
for the closed economy, and then add open-economy elements.
4.7 The IS-LM-BP model for an open economy 189

❐ For example, a BoP surplus implies an inflow of funds, which expands domestic
liquidity. In terms of our analysis, this is equivalent to the effects of an expansionary
monetary policy step in the form of an increase in the real money supply. The LM curve
would therefore be shifted rightward by the money supply effect of a BoP surplus. A BoP
deficit, which implies a net outflow of payments/funds, would shift the LM curve leftward.
These characteristics are particularly important when one analyses the BoP adjustment
process in the IS-LM diagram.
Simultaneous equilibrium in the goods and money markets – the open π

economy case mathematically
We have the formula for the open economy IS curve:
Y = KE(a + Ia – hr + G + X – ma) …… (4.4 = 3.5)
where the multiplier in an open economy equals:
1
KE = 
  1 – b(1 – 
 
t) + m
  
and the formula for the LM curve:

  k  Y – 
1
( M )
S
r =   P    1 l  …… (4.5 = 3.6)
  l     
l
where the nominal money supply in an open economy equals:
MS = D + eF
where D represents domestic deposits, e, the exchange rate defined as the amount of domestic
currency necessary to purchase one unit of foreign currency (e.g. 10 rands per dollar) and F
represents foreign reserves (e.g. dollars, yens, euros). Foreign reserves multiplied by the exchange rate
are added to the domestic money supply because the Reserve Bank and other domestic institutions
that bought the foreign reserves had to pay for them with domestic money, i.e. rands in the South
African case. These rands are now foreign-held deposits that can be used to buy South African goods
priced in rands. In essence, by adding the foreign reserves multiplied by the exchange rate to domestic
deposits, we add the value of foreign-held rand deposits to domestically held rand deposits – the sum
of all deposits then constituting the money supply.
Substituting equation (4.5) into (4.4) produces:
( 
Y = KE (a + Ia + G + X – ma) – h 
  l  Y –  [ k ( 
1 MS
)])
  P  1 lπ     
  l    
Solving for Y and simplifying produces:
MS
Y = 1(a + Ia + G + X – ma) + 2 ( 
P   1 lπ) ...... (4.6)
where
KE
1 =       
1 + K hk/l
E
K Eh ...... (4.6.1)
2 =       
l + K hk
E
Equation 4.6 shows how the equilibrium level of real income Y depends on expenditure elements as
well as the real money supply – as captured in the IS and LM curves respectively.
We will return to equation 4.6 in chapter 6 when we derive the aggregate demand (AD) curve.

4.7.3 The BP curve
The BP curve adds precision and clarity to the analysis of the BoP position and the adjustment
process in an IS-LM framework. Essentially the curve provides a way to read the BoP
condition, following a disturbance, directly off the diagram. In addition, it can be used
to make the analysis of the BoP adjustment process in the diagram more explicit. This is
shown in figure 4.12.
The BP curve is a summary curve that depicts the external sector – imports, exports, capital
flows and the BoP – on the r-Y axes. Like the IS and LM curves, it is a derived curve showing
equilibrium points, in this instance in the external sector.
❐ Points on the curve indicate a state of BoP equilibrium.
❐ Points above the curve indicate a BoP surplus, and points below it indicate a BoP
deficit.
Essentials of the model

This information on the BoP surplus and deficit Figure 4.12 The IS-LM-BP model
areas can be used to characterise the external
r LM curve
dimension of any internal economic equilibrium BoP surplus
indicated by the intersection of the IS and LM area
curves. BP
curve
Thus one would analyse normal shifts in IS or
LM, and get to an equilibrium point such as r0 BoP deficit
(r0; Y0). The diagram in figure 4.12 illustrates area
a point where r and Y (and X and M and capital
inflows) are such that there is a BoP deficit.
(The position of the BP curve as such may also
have been affected by the initial disturbance.)
IS curve
Once the BoP situation at such a point has
been derived, the expected BoP adjustment Y0 Income Y
processes will follow. The BP curve may also
shift due to this adjustment. Nevertheless, the process will take the equilibrium to a point
on the BP curve. BoP equilibrium will have been attained, together with goods market and
money market equilibria. All three sectors will be in simultaneous (short-run) equilibrium.
The formal derivation of the BP curve

The BP curve is defined as follows:
The BP curve shows all combinations of real income Y and the interest rate r that are
consistent with the conditions for BoP equilibrium (i.e. in the external sector).
The BP is a series of points at which the BoP would be in equilibrium, were the economy to
be on the curve. Where the economy is, depends on the location of the internal economic
equilibrium, and consequently on the positions of the IS and LM curves. The BP curve
indicates the BoP characteristics of that equilibrium.
The shape of the BP derives from linkages between the BoP and the two variables on the
axes, i.e. real income and the interest rate:
❐ Real income affects imports, which affect the current account of the BoP.
❐ Interest rates affect capital inflows, which affect the financial account of the BoP.

The BP curve is derived as follows (see Figure 4.13 Deriving the BP curve
figure 4.13): r
❐ Consider a pairing Y0 and r0 in the
diagram which is consistent with balance
of payment equilibrium. For a higher level
(r1;Y1) BP curve
of Y, a higher level of imports would be r1
present. To counter this negative impact
(r0;Y0)
on the BoP and re-establish a point of BoP r0
equilibrium, the real interest rate would
have to be higher to attract the necessary
capital inflows.
❐ Thus a second pairing (Y1 and r1) with
BoP equilibrium would lie above and to
the right of the first point. Any number
of such points can be derived. Connecting Y0 Y1 Income Y
them produces the BP curve.
The slope of the BP curve

The BP curve has a positive slope because, starting from a point with BoP equilibrium, a
higher level of Y would imply higher imports, requiring a higher interest rate to attract
sufficient capital inflows to re-establish BoP equilibrium.
How steep is the BP curve?

The steepness of the BP curve depends on how much the interest rate has to increase,
given a certain increase in real income, to re-establish BoP equilibrium. Hence the relative
steepness or flatness of the BP curve will depend on the following factors:
(1) The income responsiveness of imports. If imports react strongly to a higher level of
real income – the income responsiveness of imports is high – the interest rate would
have to be significantly higher to attract sufficient capital to counter the outflow of
payments on the current account. This would make the BP curve relatively steeper. A
low income responsiveness of imports, on the other hand, would serve to make the BP
curve relatively flatter.
(2) The responsiveness of foreign capital flows to domestic real interest rates. If foreign capital
inflows react strongly to higher domestic real interest rates, only a moderate increase in
interest rates would be sufficient to counter the current account deterioration following
a given increase in income. Therefore the BP curve would be relatively flatter. If foreign
capital is less sensitive to domestic interest rates, the BP curve would be relatively steep.
❐ In everyday terms, this sensitivity can be understood in terms of capital mobility:
low capital mobility to and from a country implies a fairly steep BP curve, and high
capital mobility a fairly flat BP curve.
❐ Countries often differ much with regard to the degree of capital mobility. The
income responsiveness of imports appears to be less decisive (although not
irrelevant). For a country such as the USA, very high capital mobility would
dominate import responsiveness effects. That is why its BP curve is very flat. For
a country such as South Africa prior to 1994 or countries such as Zimbabwe and
Lesotho, a high import propensity as well as relatively low capital mobility work
together to produce a fairly steep BP curve. After 1994, and especially after 2000,
South African capital mobility has increased markedly.

Important: the slope of the BP curve relative to the LM curve
The relative slope of the BP curve decisively affects even a simple diagrammatical analysis.
What is crucial is the slope of the BP curve relative to the slope of the LM curve:
❐ If capital mobility is low, the BP curve must be drawn steeper than the LM curve. This
was the case in South Africa prior to 1994.
❐ If capital mobility is relatively high, the BP curve would be flatter than the LM curve.
This would be the case in the USA, or South Africa in the 2000s.
Since the slope of BP (relative to LM) depends on international capital mobility – which is
so vulnerable to international perceptions, political expectations and risk assessment of the
group of so-called emerging markets – for South Africa it can easily become steeper than the
LM curve again. For many low- or middle-income countries it would be steeper in any case.
In some cases, the relative slopes do not make a large difference to the outcome (e.g. a
monetary stimulation). However, in other cases (e.g. a fiscal stimulation), they do make a
crucial difference.
❐ Where relevant we will present both scenarios: a relatively steep BP and a relatively flat
BP, so that the reader can handle any situation.
Points off the BP curve

Points off the BP curve indicate pairings of Y and r that do not imply BoP equilibrium. The
level of imports or the level of capital inflows would be incorrect, given the level of exports.
The current account and the financial account would therefore not add up to zero.
❐ At points in the area above the BP curve there is a BoP surplus. The interest rate is
too high for equilibrium, attracting more capital than required to match the current
account position.
❐ At points in the area below the BP curve there is a BoP deficit. The interest rate is too low
for equilibrium, causing insufficient capital inflows to match the current account position.
Shifting the BP curve

Shifts in the BP curve are caused by any change (other than Y and r) that affects either the
current account or the financial account:
❐ If the disturbance improves the BoP position, the BP curve shifts to the right.
❐ If the disturbance weakens the BoP position, the BP curve shifts to the left.
Three main factors shift the BP curve – an exogenous change in exports, an exogenous
change in capital flows and the exchange rate:
❐ An increase in exports or capital inflows would shift the BP curve to the right. A drop in
exports or capital flows would shift the curve to the left.
❐ An appreciation of the rand, which stimulates imports and inhibits exports and capital
inflows, would shift the BP curve to the left. Depreciation would shift it to the right.
4.7.4 Using the IS-LM-BP model – the basics

The usefulness of the BP curve can best be seen if one distinguishes three phases – in two
groups – when analysing economic events:
(1) The disturbance phase, when the basic internal effect takes hold, with an accompanying
BoP situation developing.
(2) & (3) The BoP adjustment phases, when the money supply and the exchange rate effects
of a BoP surplus or deficit take hold.

(1) The disturbance phase: the BP curve as an indicator of the BoP position
The first purpose of the BP curve is to indicate the BoP position that accompanies a
particular IS-LM intersection following an economic disturbance.
❐ The IS-LM intersection shows a pairing of Y and r consistent with both real sector and
monetary sector equilibrium – i.e. internal economic equilibrium.5
❐ The BP curve gives additional information about such an internal equilibrium, i.e. the
accompanying BoP position. It therefore shows the external dimensions of the internal
equilibrium determined by the IS-LM curves.
Internal disturbances
Figure 4.14 Monetary stimulus
For internal disturbances such as our two
policy examples the addition of the BP curve r LM0
shows the accompanying BoP position. (The LM1
diagrams below correspond to the first phases
of the chain reactions of these examples.)
BP
Internal real or monetary disturbances
shift the IS and LM curves as usual. The BP r0
curve is not affected by these disturbances r1
BoP in
as such. It remains static, serving mainly
deficit
as a reference point from which to evaluate
the BoP dimension of the new IS-LM
intersection point (internal equilibrium).
❐ If the IS-LM intersection point is below
the BP curve, it indicates that the BoP is in IS
deficit (see figure 4.14). Y0 Y1 Y
❐ A position above the BP curve indicates a
BoP surplus as a by-product of the internal disturbance.
In the case of a monetary stimulus, a BoP deficit develops – irrespective of the relative
slopes of the BP and LM curves. (Check for yourself whether this statement is correct.)
For a fiscal stimulus, the relative slopes make a marked difference. This is illustrated in
figure 4.15. When cross-border capital flows are very interest-sensitive (and thus the BP is
flatter), a BoP surplus develops. Lower capital mobility implies that a BoP deficit develops.
(Why? See the examples.)
External disturbances
For external disturbances, the analysis is a bit more complicated. The BP curve itself is
shifted by external sector shocks or disturbances. Hence one cannot manipulate only
the IS or LM curves – possible shifts in the BP must also be shown. This is the case,
in particular, for exogenous changes in exports or changes in imports induced by the
exchange rate.
Shifts in the BP curve are caused by any change (other than Y and r) that affects either the
current account or the financial account:
5 Once again, this may be a full employment or an unemployment equilibrium.

Figure 4.15 Fiscal stimulus with differing relative slopes
Fiscal stimulus: BP flatter than LM Fiscal stimulus: BP steeper than LM

r LM r
BP
BoP in LM
surplus
r1
r1
BP
BoP in
r0 r0 deficit
IS0 IS1 IS0 IS1

Y0 Y1 Y Y0 Y1 Y
❐ If the disturbance improves the BoP posi- Figure 4.16 An increase in exports – IS and BP shift
tion, the BP curve shifts to the right. For r LM
example, an increase in exports would
shift the BP curve to the right. A drop in BoP in
exports would shift the curve to the left. surplus
❐ If the disturbance weakens the BoP po- r1
BP0
sition, the BP curve shifts to the left. An
r0
appreciation of the rand, which stimu- BP1
lates imports and inhibits exports, would
shift the BP curve to the left. Depreciation
would shift it to the right.
To analyse an external disturbance, the
graphical impact on the IS or LM curves as IS0 IS1
well as on the BP curve must be shown (see Y0 Y1 Y
figure 4.16).
❐ In the disturbance phase, the increase in exports shifts the BP curve to the right (in
addition to the rightward shift of the IS curve).
❐ In the case of a BP that is steeper than LM, the BP curve must be shifted far enough so
that the new IS-LM intersection is above the BP curve, to indicate the BoP surplus that
surely must come about (starting out from BoP equilibrium).
!
In the IS-LM-BP model, the equilibrium values of Y and r – the state of the domestic economy –
are always indicated by the intersection of IS and LM. In this sense, the IS and LM curves are
dominant. The BP curve shows only the external dimension of that equilibrium.
However, as shown below, a certain BoP condition can lead to further changes in either the IS or
LM positions, and hence to a new internal equilibrium with new external characteristics. However, even
then the IS and LM curves always denote the equilibrium levels of Y and r.

(2) & (3) The two BoP adjustment phases: the role of the BP curve in the adjustments
A second, and more complicated, purpose of the BP curve is to indicate impacts on the domestic
economy that may flow from the external dimension of an internal equilibrium. The essence of
such impacts was encountered in the discussion of the BoP adjustment process.
The following are key elements of the BoP adjustment process in terms of all three curves
(starting from an internal equilibrium with a BoP deficit or surplus):
(a) The initial, money supply effect – or rigid exchange rate effect – which shifts the LM
curve.
(b) The concluding, flexible exchange rate effect, which shifts both the IS and the BP
curves (in the same direction).
(c) Whereas the sensitivity of capital flows Figure 4.17 BoP adjustment from a surplus
to interest rate changes may determine r
whether the BoP develops a surplus or
LM
a deficit (compare the two possible out- 1 BoP in
comes of a fiscal stimulus above), it does surplus
not affect the direction in which the LM, 2
BP or IS curves will shift due to a surplus 3
BP
or a deficit on the BoP.
In the case of a BoP surplus (see figure 4.17):
(a) Rigid exchange rate effect: LM shifts right
(due to inflow of funds) in the initial
phase of BoP adjustment. This moves the End: internal
and external IS
equilibrium from point 1 to point 2. equilibrium
(b) Flexible exchange rate effect: both IS
and BP shift to the left (due to currency Y
appreciation) in the concluding BoP
adjustment phase. This moves the Figure 4.18 BoP adjustment from a deficit
equilibrium from point 2 to point 3 in r
the diagram.
In the case of a BoP deficit (see figure 4.18):
(a) Rigid exchange rate effect: LM shifts left 3
End: internal
(due to an outflow of payments/funds) and external
in the initial BoP adjustment phase. This BP equilibrium
moves the equilibrium from point 1 to 2 Start: BoP
point 2. in deficit
(b) Flexible exchange rate effect: both IS and 1

BP shift to the right (due to currency
depreciation) in the concluding BoP
IS
adjustment phase. This moves the
LM
equilibrium from point 2 to point 3.
Y
✍ The above BoP adjustment diagrams have been drawn for a BP that is flatter than the LM.
Repeat the exercise for a BP that is steeper than the LM and show that LM, IS and BP move in
the same direction as in the diagrams above.

Fixed and perfectly flexible exchange rates
❐ If the exchange rate is fixed (not just rigid), only the rigid exchange rate effect and shifts
will occur.
❐ If the exchange rate is perfectly flexible and adjusts instantaneously, only the flexible
exchange rate effect and shifts will occur.
As noted earlier, most textbooks explain the BoP adjustment process in terms of either of
the extreme exchange rate regimes. While it simplifies the analysis considerably, these are
theoretically extreme cases unlikely to be of much practical use. In reality, most countries have
a system of dirty floating exchange rates. Thus both effects are typically present, although not
necessarily at the same time and with the same strength. Unfortunately, reality is quite messy in
this regard – and, of necessity, so must our analysis be.
These shifts in the IS, LM and BP curves can be spliced onto the tail end of any disturbance
of the IS-LM curves that produces a BoP deficit or surplus. Then they actually show the
effect of the BoP adjustment process very clearly.
❐ Theoretically, the BoP adjustment processes, and hence the shifts, would continue until
BoP = 0. That is, the shifts would be such that at the end the IS-LM intersection point
would also be on the BP curve. There would be simultaneous internal and external balance
(equilibrium). (Of course, this excludes the labour market: unemployment can still be
present at such a simultaneous, short-run equilibrium.)
4.7.5 Using the model for an open economy – disturbances and policy
effectiveness
In section 4.5 the consequences of three types of disturbance were analysed: a monetary
policy step, a fiscal policy step, and a change in exports. Chain reactions became quite
complex, indicating the need for diagrammatical support.
We now revisit those examples in terms of the IS-LM-BP model for an open economy, but
with the direction of change reversed.
Figure 4.19 shows the complete set of IS-LM-BP graphics for a particular disturbance
followed by the complete BoP adjustment process. Because so much is compressed into
one diagram, it is very crowded and complicated and should be studied carefully. Also
consult the simpler diagrams (the 45° diagram and supplementary diagrams) in chapters
2 and 3, and remember the economic chain reasoning behind the curves, repeated below.
Ultimately that is what matters.
Example 1: the internal and external effects of an increase in the repo rate
Primary effect:
(1) [The process starts at point 0 on the IS-LM-BP diagram.]
Higher repo rate ⇒ banks pay more for Reserve Bank accommodation ⇒ banks
discourage credit creation ⇒ money supply contracts ⇒ excess demand for money
⇒ increase in sales of money market paper ⇒ prices of money market paper fall ⇒
increase in nominal (and real) interest rates ⇒ capital formation I discouraged ⇒
aggregate demand decreases ⇒ production discouraged ⇒ Y decreases (= downswing
in the economy).

As Y declines, imports M decrease (why?) ⇒ current account (CA) surplus develops.
The increase in r causes an inflow of foreign capital, leaving the financial account (FA)
in a surplus.
Secondary effects:
(2) Money market effect: As Y decreases, it causes the demand for money to decrease
concurrently ⇒ downward pressure on interest rates ⇒ initial rise in interest rates
gradually comes to an end ⇒ initial fall in investment is curbed ⇒ initial fall in
aggregate demand arrested ⇒ fall in Y brought to an end ⇒ drop in M arrested and
initial strengthening of (X – M) comes to an end.
❐ The main impact of this secondary effect is that the changes in r, I, Y and M will
be smaller than what they would have been had there been no such effect via
money demand. While this secondary effect operates in the opposite direction from
the primary effect, it is a weaker force. The secondary effect does not cancel the
primary effect, it only reduces it.
The net effect of the primary and secondary effects leaves Y lower, r higher and both the
current and financial accounts in surplus. There is a BoP surplus (BoP > 0).
[The economy is at point 1 on the diagram. The increase in the repo rate causes the LM curve to
move from LM0 to LM1 and the economy is now at point 1 on the diagram. This point lies above
the BP curve and thus indicates the presence of a surplus in the BoP. This corresponds with our
economic reasoning thus far.]
Further secondary effects due to BoP > 0:
(3) Initial BoP effect (foreign reserves adjustment): The BoP surplus causes (i) an inflow of
foreign exchange ⇒ MS increases ⇒ downward pressure on interest rates (which causes
the inflow of foreign capital to decrease or reverse and the FA surplus to decrease) ⇒
the decrease in the interest rate encourages real investment I ⇒ aggregate demand/
expenditure increases, causing Y to increase; as Y increases it stimulates imports ⇒
(X – M) decreases ⇒ prevailing CA surplus is reduced; the turnaround in the real
Figure 4.19 Increase in repo rate
r
LM shifts left initially, and right
again in the initial BoP adjustment
LM1 phase
LM2
LM0 0 5 Initial equilibrium
r1 1 Y0r0 with BoP equilibrium
1 5 New equilibrium
BP1 Y1r1 with BoP surplus
3 2 (point is above BP0 curve)
r3 2 5 Temporary equilibrium
Y2r2 after initial BoP adjustment
0 BP0
r0 phase (foreign reserves effect).
Still BoP surplus
3 5 Final equilibrium
Y3r3 after concluding BoP adjust-
IS0 ment phase (flexible exchange rate
IS1 effect). Both internal and external
equilibrium.
IS and BP shift left due to the

Y1 Y3 Y0 Y concluding BoP adjustment phase

interest rate will also start to discourage or reverse capital inflows; thus the FA is likely
to start deteriorating. On both fronts the BoP surplus is being reduced.
The increase in Y implies that the initial downswing has turned around (at least for
now … ).
[The economy is at point 2 on the diagram.]
(4) Concluding BoP effect (exchange rate adjustment): The initial BoP surplus (now already
slightly reduced) also leads to (ii) an excess demand for rands (excess supply of
foreign exchange) ⇒ upward pressure on the rand ⇒ stimulation of imports and
discouragement of exports ⇒ decreases (X – M) ⇒ CA surplus is reduced, and so is the
remaining BoP surplus. The BoP tends towards equilibrium. The process will continue
as long as BoP ≠ 0 and until BoP = 0.
This cumulative decrease in (X – M) due to these two BoP effects again reduces
aggregate expenditure, which reverses the short recovery of Y – a further economic
downswing occurs (Y declines again).
[The economy ends up at point 3 on the IS-LM-BP diagram.]
It appears likely that the foreign reserves effect (phase 3 above) will come about sooner
than the exchange rate effect (phase 4).
Summary of changes
Note the changes that occur in the main macro Figure 4.20 Illustrative time path of key
economic variables, i.e. income Y, interest rate, variables – increase in the repo rate
rand, BoP and exchange rate. As far as r and Y
are concerned their cyclical movements can be r
checked against their up-and-down changes on
the axes of the IS-LM-BP diagram.
The time-path diagram (figure 4.20)
illustrates the stylised course of these main Time
variables over time during the primary and
three secondary effects of the example above. Y
❐ As noted before, in reality time paths are
never so smooth, and multiple shocks and
disturbances occur on top of one another.
Our purpose here is to isolate the basic Time
directional effects encountered by an open
economy following an initial stimulus. Rand
Policy effectiveness again BoP

This analysis confirms the conclusions regard-
ing policy effectiveness: the effectiveness of
Time
monetary policy is undermined by a rigid or
slowly adjusting exchange rate (which allows
BoP adjustment
the money supply effect time to take hold), and phase
enhanced by a quickly adjusting exchange rate.
❐ If the exchange rate is completely flexible Demand contraction
and adjusts rapidly, the downward shift of up to 3 years

the LM curve – the money supply or rigid exchange rate effect – would not occur at all.
All that remains is the flexible exchange rate effect, which boosts the effectiveness of
monetary policy.
❐ If the exchange rate is fixed, the IS curve would not adjust at all, and the downward
shift in the LM curve would be decisive and substantial. Indeed, this shift in the LM
curve would cancel the initial, policy-induced upward shift in the LM curve. Monetary
policy would have no net impact on real income.
Example 2: the internal and external effects of an increase in government expenditure
Primary effect:
(1) [The process starts at point 0 on the IS-LM-BP diagram (see figure 4.21).]
Increase in government expenditure ⇒ aggregate expenditure increases ⇒ positive
impact on domestic production ⇒ real income Y increases.
As Y increases ⇒ imports M increase ⇒ a current account (CA) deficit develops.
Secondary effects:
(2) Money market effect: As Y increases, it causes a concurrent increase in the demand for
money ⇒ upward pressure on interest rates ⇒ discouragement of real investment ⇒
decrease in aggregate demand, partially countering the impact of the initial increase
in government expenditure ⇒ curbs the upturn in Y ⇒ growth in M curtailed and
initial weakening of (X – M) comes to an end.
The net effect of the primary effect and the secondary, money market effect leaves Y
higher, r higher and (X – M) < 0, i.e. a CA deficit.
The increase in r causes an inflow of foreign capital, causing a surplus in the financial
account (FA). The net effect on the BoP is uncertain: depending on the relative size of the
CA and FA positions, the BoP = CA + FA could be in balance, in a surplus or in a deficit.
As we did in section 4.5.2, we assume international capital flows to be relatively
sensitive to domestic interest rate changes. Therefore, should interest rates increase as
a result of the secondary effect, there will be a relatively large inflow of foreign capital.
Thus, one might expect the surplus on the FA to exceed the deficit on the CA, in which
case BoP > 0.
❐ If capital flows were not that sensitive to domestic real interest changes, the surplus
on the FA would have been smaller than the deficit on the CA – implying a balance of
payments deficit. (We leave this case to the reader as an exercise.)

Thus we have further secondary effects due to BoP > 0:
foreign exchange ⇒ expansion of money supply ⇒ downward pressure on interest
rates (which causes the inflow of foreign capital to decrease or reverse and the FA
surplus to decrease); the decrease in the interest rate also encourages real investment
I ⇒ aggregate demand/expenditure increases, causing Y to increase; as Y increases
it swells imports ⇒ (X – M) decreases ⇒ prevailing CA deficit is reduced; however,
the turnaround in the real interest rate will also start to reverse capital inflows; thus
the FA surplus is likely to start being reversed. Assuming a stronger FA effect, the net
effect would be that the BoP surplus is being reduced.

Figure 4.21 Increase in government expenditure
r
LM shifts right initially in the first
LM0 BoP adjustment phase
LM1 BP shifts left in the concluding BoP

adjustment phase
r1 1 BP1
0 5 Initial equilibrium
2 BP0 Y0r0 with BoP equilibrium
r3 3 1 5 New equilibrium
Y1r1 with BoP surplus
r0 0 (point is above BP0 curve)
2 5 Temporary equilibrium
Y2r2 after first BoP adjustment
phase. Still BoP surplus
Y3r3 after entire BoP adjustment
process. Simultaneous internal and
IS2 IS1 external equilibrium
IS0
IS shifts right initially, then left in the
Y0 Y3 Y concluding BoP adjustment phase
The increase in Y implies that the initial upswing has been followed by another upswing.
(4) Concluding BoP effect (exchange rate adjust
ment): The initial BoP surplus also leads Figure 4.22 Illustrative time path of key
variables – increase in government expenditure
to (ii) an excess demand of rands (excess
supply of foreign exchange) ⇒ upward
pressure on the rand ⇒ stimulation of
imports and discouragement of exports r
⇒ decrease in (X – M) ⇒ current account
deficit increases again. This helps to
eliminate the remaining BoP surplus – Time
the BoP tends towards equilibrium. The
process will continue as long as BoP ≠ 0 Y
and until BoP = 0.
Note how, towards the end, the
appreciation of the rand is responsible,
Time
via an induced decrease in (X – M), for
a contraction of aggregate expenditure. Rand
This partially reverses the two-phase
expansion of Y.
[The economy ends up at point 3 on the IS-LM-BP BoP
diagram.]
Time
Summary of changes
BoP adjustment
The time-path diagram (see figure 4.22)
phase
illustrates the stylised course of these main
variables over time during the primary and Demand expansion
three secondary effects of the example above. up to 3 years

Example 3: the probable effect of an economic upswing in the USA on the
South African economy
Primary effect:
(1) [The process starts at point 0 on the IS-LM-BP diagram (see figure 4.23).]
Higher YUSA ⇒ US imports MUSA increase ⇒ increased imports from abroad, including
South Africa ⇒ XSA increases ⇒ (X – M) increases, i.e. current account (CA) goes into
surplus ⇒ aggregate expenditure increases ⇒ production encouraged ⇒ Y increases.
(2) As Y increases, a concurrent increase in imports M develops ⇒ negative impact on
(X – M), i.e. current account deteriorates a bit.
The net effect on the current account will still be a substantial improvement.
Secondary effects:
(3) Money market effect: As real income Y increases, the real demand for money increases
⇒ upward pressure on real interest rates, which, in turn, causes investment to decrease
⇒ downward pressure on aggregate demand ⇒ initial increase in aggregate demand
countered ⇒ production discouraged ⇒ increase in Y curbed, upswing comes to an
end; increase in M arrested and improvement in CA comes to an end; CA in surplus.
The increase in interest rate should attract an inflow of foreign capital, which improves
the financial account (FA) – the FA will be in a surplus.
The net effect of the primary effect and the secondary effect leaves Y higher, r higher
and the current and financial accounts in surplus. Thus the BoP will have a surplus.
Thus we have further secondary effects due to BoP > 0:
foreign exchange ⇒ money supply increases ⇒ downward pressure on interest rates
(which causes the inflow of foreign capital to decrease) ⇒ encourages real investment
I ⇒ aggregate demand/expenditure increases, causing Y to increase further; as
Figure 4.23 Increase in exports
r
LM shifts right in the initial BoP
adjustment phase
LM0
BP shifts right initially, then left in
the concluding BoP adjustment
LM1 phase
1 0 5 Initial equilibrium
r1 BP0
Y0r0 with BoP equilibrium
2 BP2 1 5 New equilibrium
3 BP1 Y1r1 with BoP surplus
r3 (point is above BP0 curve)
r0 0 2 5 Temporary equilibrium
Y2r2 after first BoP adjustment
phase. Still BoP surplus
Y3r3 after entire BoP adjustment
process. Simultaneous internal and
IS1 external equilibrium
IS0 IS2
IS shifts right initially, then left in the
Y0 Y1 Y3 Y concluding BoP adjustment phase

Y increases it stimulates imports ⇒ (X – M) decreases ⇒ prevailing CA surplus is
reduced. The drop in interest rates will discourage capital inflows, so the existing FA
surplus will shrink.
(5) Concluding BoP effect (exchange rate adjustment): The initial BoP surplus also leads to (ii)
an excess demand for rands (excess supply of foreign exchange) ⇒ upward pressure
on the rand ⇒ stimulation of imports and discouragement of exports ⇒ decreases
(X – M) ⇒ CA surplus is reduced.
This appreciation-induced decrease in (X – M) contracts aggregate expenditure,
which turns around the sustained upswing. Y will decrease, also dragging interest
rates down further. The FA will shrink further, and so will the remaining BoP surplus.
The BoP tends towards equilibrium. The process will continue as long as BoP ≠ 0 and
until BoP = 0.
[The economy ends up at point 3 on the IS-LM-BP diagram.]
Summary of changes
Figure 4.24 shows that, in contrast to example 1 above (internal monetary disturbance),
where the current account changed mainly as part of the BoP adjustment phase, in this
case the initial disturbance directly and immediately affects the current account.
The export stimulation example appears Figure 4.24 Illustrative time path of key
similar to the fiscal stimulation example. variables – increase in exports
Note the following differences, though:
❐ In the fiscal expansion example, a CA defi-
cit develops, but it is overshadowed by a r
FA surplus, hence a (small) BoP surplus
develops. In the export example, a sub-
stantial CA surplus develops immediately,
Time
on top of which a FA surplus develops, so
that the BoP improves much quicker and
goes into a much larger surplus. Y
❐ The BoP adjustment process is much
longer in the export example.
❐ The decline of r during the BoP adjustment
Time
is larger in the export example, due to the
larger BoP surplus and its effects on the Rand
money supply.
❐ The upswing in Y is likely to last longer
than in the fiscal example. BoP
Note that a rigid exchange rate enhances the

beneficial domestic effects of exports, while a Time
quickly adjusting exchange rate puts a brake
on the export-led economic upswing. This BoP adjustment
parallels the conclusion about the positive phase
impact of a slowly adjusting exchange rate
on the effectiveness of fiscal policy. Demand contraction
up to 3 years

Conclusion
Theoretically, the BoP surplus should be eliminated at the end, since the BoP adjustment
process should continue until BoP = 0. In practice, the process rarely gets to equilibrium
so effortlessly. Nevertheless, the basic nature and direction of the adjustment process is
unchanged.
However, this neat outcome is a
theoretical result. In practice it Internal equilibrium and unemployment?
rarely happens that the adjustment Remember that internal equilibrium need not be
process proceeds to the end – it is accompanied by full employment. This is the
likely to be interrupted by new central theme of the Keynesian approach. Even if
economic disturbances. What is the BoP adjustment process pushes the economy
important is the basic direction of towards a point of simultaneous internal and
the adjustment effects via the money external equilibrium, there could still be substantial
supply and the exchange rate. unemployment. These issues are discussed in
chapter 6.
Finally, as noted earlier, all these
examples are incomplete since the
effect on the price level still is absent. This will be rectified in chapter 6.
Important: While these diagrams are quite powerful, they have intrinsic limitations. In
diagrams such as these one can indicate only the direction and the approximate magnitude
of shifts in the curves – and hence the resultant changes in Y and r. Depending on how
far each curve shifts, and on the different slopes of the curves, the net impact on Y and r
can vary.
❐ The diagrams are not intended to produce accurate ‘forecasts’ of changes in Y and r,
and any attempt to do so goes beyond the limits of diagrammatical analysis.
❐ To get more specific forecasts, one has to use much more sophisticated mathematical
analysis and empirical econometric estimates of the various parameters and multipliers.
❐ Even then there will always be imprecision and substantial uncertainty. As noted earlier
in this book, the economy is not a machine, and changes do not happen mechanically.
Therefore the quantitative results of sequences of events cannot be forecast with
mechanical precision.
✍ The world financial crisis of 2007–08 – using the IS-LM-BP model

We introduced this case study in section 3.4 and earlier in this chapter.
Now is the time to redo that analysis using the IS-LM-BP model, and apply that to both the
USA and South Africa.
4.8 Real-world application – the Euro crisis and the impact of

confidence on international capital flows
The European Union is a monetary union comprising (in 2014) 28 European countries.
Since 1 January 2002, 18 of these countries have used a single currency called the Euro
(€), therefore no foreign exchange transactions are necessary (or possible) between these
countries. (The 18 countries are Austria, Belgium, Cyprus, Estonia, Finland, France,
Germany, Greece, Ireland, Italy, Latvia, Luxembourg, Malta, the Netherlands, Portugal,
Slovakia, Slovenia and Spain.)

The Euro is managed by the European Central Bank (ECB). The single currency also
means that none of the 18 countries using the Euro can pursue an independent,
nationally-managed monetary policy: any policy-induced change in domestic interest
rates will be reversed by capital flows (see ‘sending the money supply overseas’ in
section 4.5.1). However, each country’s government retains control over its own
fiscal policy.
The Euro crisis: a brief overview

The Euro crisis started in 2010, peaked between 2010 and 2012 and was mostly resolved by
2014 (although Greece received assistance until 2018). It appears to have resulted from a
failure to harmonise fiscal policy (especially budget deficits), which – as we shall see below –
is necessary for a monetary union to be a success. A serious lack of fiscal discipline tends to
lead to a loss of confidence and, in turn, destabilising flows of funds among countries.
The protagonists in this crisis are Germany, on the one hand, and Portugal, Italy, Greece
and Spain (also called the PIGS countries, an acronym based on their initials) on the other.
Germany started the 2000s with a large budget deficit and relatively high labour cost. To
address these problems, it implemented what today is called an austerity policy – a policy
of fiscal and general economic contraction, intended to drive down the budget deficit (and
labour cost).
The PIGS countries did the opposite – presumably to obtain or sustain political support
for their governments. Fiscal expansions in the PIGS countries increased GDP growth and
led to current account deficits, which in turn required high levels of capital inflows from
financial investors outside their countries to finance these deficits.
The scale of fiscal expansions was such that the governments of Greece and Italy in
particular ran large budget deficits, driving up their public debt/GDP ratios to well above
100% (in the case of Greece to 130%). In Greece some creative public-sector accounting
also hid the actual size of the deficits and public debt for a number of years. Unaware of
the real nature of the deficits, German banks had gladly financed much of the Greek public
debt, contributing much to the capital inflows.
However, in 2010 the full extent of the debt problems facing the PIGS countries became
clear. Foreign investors lost confidence in the government bonds issued by these countries
and many withdrew their funds. As a result, governments such as those of Greece and
Italy had to offer much higher interest rates to attract foreign capital. In many cases
they were not fully successful in attracting investors. The IMF (in partnership with the
ECB) had to extend and facilitate very large loans to assist Greece in particular. The
country’s fiscal predicament worsened and the spectre of default on Greek government
bonds arose.
Although all the PIGS countries were supposed to arrest their fast-increasing public
debt/GDP ratios by implementing cutbacks in government expenditure and deficits,
they were at first reluctant to do so. In the case of Greece the situation became dire.
Default on government bonds was in the air. To avoid such a crisis, the IMF and ECB
facilitated negotiations with foreign banks that led to ‘write-downs’ of existing Greek
debt. These meant that foreign creditors would agree to extending a new loan of, say,
70c (€0.70) to fully replace every €1 of an old loan. In effect the creditor would lose
30c for each €1 of the loan – thus ‘taking a haircut’ rather than risking total default
on the loan.
4.8 Real-world application – the Euro crisis 205

The impact on the Greek economy was huge. Banks took a hit and general economic
confidence evaporated; the crisis intensified. After several months of dithering, the Greek
government was forced – also as part of the ongoing international write-down deal – to
implement large cutbacks in government expenditure to get the deficit under control and
reduce public debt levels. These cutbacks meant, for example, that Greek civil servants
were forced to accept salary reductions, leading to street protests in Athens and other
Greek cities – and a deep political crisis.
In contrast, confidence in the German economy increased significantly as many investors
saw it as a paragon of good economic management and good financial investment
opportunities.
Using the IS-LM-BP framework to explain the Euro crisis

With some adjustments, example 2 in section 4.7.5 above can be used to explain the Euro
crisis. In example 2 an exchange rate adjustment occurs after a fiscal stimulus as the
second component of the BoP adjustment process; this helps to take the economy back to
equilibrium. In contrast, since a single currency is used by all eighteen Euro countries, an
exchange rate adjustment is not possible. The situation among these countries is similar
to having a fixed exchange rate. In a fixed exchange rate system, there can be no exchange
rate adjustment process – only a foreign reserves adjustment.
However, in a single currency system the foreign reserves adjustment of the BoP has
a peculiarity. Since no exchange of domestic currencies is necessary to buy or sell
goods or government bonds, foreign reserves are not involved in transactions between
Eurozone countries. Thus, any buying of Greek bonds by a Eurozone-based financial
investor would see Euros flow directly into the seller’s Greek bank account. Thus it has
a direct impact on the Greek money supply – not via a foreign exchange transaction, as
is normally the case. This implies that the normal BoP adjustment via foreign reserves
reduces to a direct money supply adjustment. The end result is the same, but it is much
more direct and rapid.
Figure 4.25a is an IS-LM-BP model for Greece (or any other PIGS country), while figure
4.25b is an IS-LM-BP model for Germany.
Analysing events in Greece

The analysis starts at equilibrium point 0 where IS0, LM0 and BP0 intersect, with output
for Greece at Y0 and the interest rate at r0. The Greek government then enters a period of
fiscal expansion that would eventually lead to the crisis.
Graphically the fiscal stimulus is portrayed by the IS curve shifting right from IS0 to IS1.
Output expands and an internal equilibrium is reached at point 1, with the interest rate
higher at r1.
This point 1 is above the BP0 curve, indicating that the balance of payments (BoP) has
gone into a surplus: although the primary effect of the fiscal stimulus causes a current
account (CA) deficit, international capital flows are relatively sensitive to an increase in
the interest rate; this leads to an inflow on the financial account (a FA surplus) which
exceeds the deficit on the CA. As a result there is a net surplus on the BoP – exactly as in
example 2.
❐ These inflows mostly comprised financial investments by German banks that were
buying Greek government bonds. (For simplicity we ignore inflows from outside the
Euro zone.)

Figure 4.25a Fiscal stimulus and the confidence crisis in the Greek economy
IS shifts right in initial fiscal LM shifts right in the first 0 = Initial equilibrium Y0 r0
stimulus and left in later BoP adjustment, then left in 1 = New equilibrium Y1 r1
fiscal contraction second BoP adjustment after IS shifts right (due
to fiscal stimulus). BoP
IS1 LM1
r IS0 BP1 LM2 LM0 surplus.
2 = Equilibrium Y2 r2
after BoP adjustment
(equivalent to monetary
expansion).
Confidence crisis
occurs – BoP shifts up and
rotates anticlockwise. Capital
r1
1 outflow and BoP deficit
develops.
r3 3 3 = Equilibrium Y3 r3 after
BP0
BoP adjustment as well
r2 2 as fiscal contraction.
Major recession.
r0 0 = Possible final equilib-
0 rium Y0 r0 if confidence
returns and capital
BP shifts up and rotates inflows resume. BP
anticlockwise rotates and moves back
to BP0. BoP surplus
develops, followed
by BoP adjustment
Y3 Y0 Y1 Y2 Y (equivalent to monetary
expansion): LM shifts
back to LM0.
As explained above, the BoP surplus implies an inflow of Euros into Greece that causes a
direct increase in the Greek money supply (the ‘initial’ BoP adjustment effect). As a result,
the LM curve shifts right from LM0 to LM1. A new internal and external equilibrium is
established at point 2, with the interest rate dropping to r2 and output increasing to Y2 –
again, exactly as in example 2.
Note that, since the Euro regime implies that the exchange rate cannot adjust, there will
be no ‘concluding’ BoP effect via an exchange rate adjustment.
However, the Greek story does not end at point 2. There is a confidence problem that is not
apparent from the IS-LM-BP diagram. The Greek government ran large budget deficits and
sold the government bonds to foreign investors. As the stimulus continued for a number
of years, the Greek public debt/GDP ratio increased sharply, reaching 130%. The Greek
government was supposed to cut back on its expenditure, but they refused.
In 2010 this led to a crisis of confidence. Wary foreign investors started demanding much
higher interest rates on Greek government bonds. Graphically, this investor reluctance
(or: increased risk aversion) means that the BP curve shifts up. The Greek government
found it almost impossible to finance its budget deficit and had to offer very high interest
rates on their government bonds to attract investors. However, even these rates were
not enough. Investors started withdrawing their funds in large amounts, causing major
capital outflows.
Simultaneously, investors’ behaviour regarding risk-taking changed. Foreign capital inflows
became much less sensitive to Greek interest rates than prior to the crisis. This lower interest-
rate sensitivity of foreign financial investors makes the BP curve much steeper.

These two effects mean that, in figure 4.25a, the BP shifts and rotates from BP0 to BP1.
This is critical: whereas BP0 is flatter than the LM curves, the new BP1 is steeper than the
LM curves. This changes the whole situation. Point 2 now lies well below BP1, reflecting
that a large BoP deficit has developed. This is largely due to the large outflow of Euros from
Greece (a deficit on the FA) that, together with the CA situation, implies a BoP deficit.
Now the BoP adjustment process kicks in, in the form of a contraction in the money supply,
moving the LM curve from LM1 towards LM2. The internal equilibrium starts moving up
the IS1 curve. At about this time, given the severity of the crisis and international pressure,
the Greek government was eventually forced to implement a severe austerity package,
cutting government expenditure sharply. In the diagram, the IS curve is forced from IS1
back to IS0.
The combined shifts of LM and IS culminate in a new internal and external equilibrium
being established at point 3 (roughly along the path indicated by the dashed blue arrow).
The new equilibrium interest rate is at r3 and output at Y3. Graphically one can see that
this new equilibrium at point 3 results from the new position and, especially, new slope of
the BP1 curve.
Note that Y3 is much lower than Y2 or even Y0. This indicates the huge price that Greece
eventually had to pay – in terms of a deep recession and a large drop in employment –
for previous years of excess and unwillingness to cut budget deficits and manage public
debt timeously.
Should Greece maintain a prudent fiscal policy for a number of years and the Greek public
debt/GDP ratio decline to sustainable and manageable levels, confidence in the Greek
economy may return and foreign capital inflows might resume. In the diagram the BP
curve will shift and rotate back to BP0; point 3 will then come to lie above BP0 due to
a BoP surplus having developed. The subsequent inflow of funds (which constitute the
BoP adjustment process) will increase the Greek money supply. The LM curve will shift
back from LM2 to LM0, with equilibrium returning to a point such as point 0 – implying a
recovery of GDP and employment. Greece will have recovered from the crisis.
Analysing changes in Germany

In Germany almost the opposite happened to what happened in Greece. In the early 2000s
the German government ran a large budget deficit. In figure 4.25b this is indicated as
equilibrium point 0. The German government subsequently decided to rein in the budget
deficit by cutting government expenditure. Graphically this shifts the IS curve left from
IS0 to IS1. At the new internal equilibrium (point 1), coupled with a decline in income to
Y1, there is a deficit on the balance of payments. (This is the primary effect: the decline in
income reduces imports, creating a surplus on the CA of the BoP. However, the drop in
the interest rate towards point 1 causes a capital outflow, causing a deficit on the FA that
exceeds the CA surplus. Hence, at point 1 the German BoP is in a deficit.)
Note: The outflow of Euros from Germany and the inflow of Euros into the PIGS countries
were largely two sides of the same coin. Euros flowing out of Germany often willingly
found their way to countries such as Greece and Italy.

Figure 4.25b Fiscal austerity and the German economy
LM shifts right in the first 0 = Initial equilibrium

BoP adjustment, then left in Y0 r0
second BoP adjustment 1 = New equilibrium
IS0 Y1 r1 after IS shifts
r IS1 LM1 LM0 LM2 left (due to fiscal
contraction). Major
recession. BoP
deficit.
BP0 2 = Equilibrium Y2 r2
after BoP adjust-
ment (equivalent to
0 monetary contrac-
r0
tion). Recession
worsens.
r2 2 Greek crisis causes
investors to have
stronger confidence in
r1 Germany. BoP shifts
1 BP1 down. Capital inflow
and BoP surplus
develops.
3 3 = Equilibrium Y3 r3
r3 after BoP adjust-
ment. Upswing, but
ends well below
starting point Yo.
Y2 Y1 Y3 Y0 Y
The outflow of funds due to the BoP deficit reduced the money supply in Germany. This
shifts the LM left from LM0 towards LM1, with a new internal and external equilibrium
likely to be established at point 2. The BoP deficit shrinks, moving towards BoP = 0. (This
is the initial BoP effect, operating through direct changes in the money supply – with no
exchange rate effect occurring.)
However, now something changes. Simultaneous to the loss of confidence in Greece and
the other PIGS countries, confidence in Germany increased. Investors became willing to
accept lower interest rates on German bonds. As a result the BP curve moves downwards.
The BP curve moves from BP0 to BP1.
With the BP curve moving to BP1, point 2 now lies above BP1, reflecting that a surplus has
developed on the BoP due to the capital inflow (FA surplus).
❐ If an increase in investors’ sensitivity to German interest rates also occurs, the BP
curve would become flatter. (This is not shown in the diagram.) In the German case the
change in slope does not change the basic result – the BP is flatter than the LM curve
in any case.
As a result, a BoP adjustment occurs for a second time. The LM curve shifts from LM1 to
LM2. A final equilibrium is reached at point 3, with output (GDP) higher at Y3 and the
interest rate having declined to r3.
This indicates that, after having gone through an austerity phase, Germany eventually
benefited from the subsequent increase in international investor confidence in the German
government and economy. Of course, the German people also paid a heavy price – a
dramatic drop in GDP and employment – but in their case it was early in the process. Still,
their final equilibrium GDP is much below the starting point.

Implications: the need for harmonised fiscal discipline in the Euro zone
The PIGS crisis demonstrates that the behaviour of foreign investors depends greatly on
the confidence that they have in an economy or government, notably its fiscal policies.
Furthermore, a loss of international confidence can have severe implications for a national
economy. In the context of the Euro zone, such a national crisis can affect other member states
badly and threaten the sustainability of the Euro single currency area as such. Therefore,
such a single currency model, which already implies coordinated/unified monetary policy,
needs measures to keep budget deficits and public debt in line with each other.
Following the PIGS crisis, Euro zone members have signed a compact (the Treaty on
Stability, Coordination, and Governance in the Economic and Monetary Union) to try to
ensure fiscal discipline amongst member states. The goal is to get national governments
to maintain structurally balanced budgets – i.e. the budget balance excluding cyclical
effects on expenditure and revenue should not be in a deficit – and to eventually reduce
all national debt levels to below 60%. The compact, pushed by Germany, requires member
countries to introduce laws strictly limiting their structural government budget deficits
to less than 0.5% of GDP (or a more lenient 1% if their debt/GDP ratio is significantly
below 60%).
The compact also foresees that the European Commission would have the power to
review the national budgets of member states to avoid repeating past excesses. Such
supra-national control over fiscal policy is essential for the Euro single-currency
area to function efficiently and without disruptive confidence crises. The question is
whether voters in the different countries – who are at very different stages of economic
development and levels of wealth – would be willing to accept their government budgets
being prescribed by an external body (in effect, the all but dominant Germany). (See
chapter 10 for more on fiscal policy issues as well as the definition and application of the
concept of a structural budget balance.)
International repercussions: how does the Euro crisis affect South Africa?
Due to limitations of space the knock-on effects of the Euro crisis on other countries, such
as South Africa, cannot be analysed here. It suffices to say that the main effects stem from a
decline in GDP in Europe, and hence in their imports from other countries, including South
Africa. At the same time, foreign investor nervousness may spill over into a wariness to invest
in emerging markets, which could have an impact on capital inflows into South Africa.
The analysis of the impact of these changes on GDP, interest rates and the exchange rate
in the IS-LM-BP diagram for South Africa is left to the reader as an exercise.

1. Explain fully why international investors include a risk premium in their decision to
invest in South Africa. In your discussion you must clearly indicate what is meant by
the risk premium.
2. Use chain reactions and diagrams to explain and illustrate the internal and external
impact of an increase in economic growth in the European Union on the level of
national income, the interest rate and the exchange rate of South Africa. Assume that
the degree of international capital mobility is low for South Africa, that the European
and Chinese propensity to import is high and that the exchange rate is floating. Clearly
show the balance of payments adjustment process.

3. In 2018–19, US President Trump initiated a ‘trade war’ with China, introducing high
tariffs on Chinese goods imported into the USA. This resulted in lower growth being
forecast for China. (a) How important is China as a trade partner for South Africa?
(b) Analyse and explain what would be the likely effect on the South African economy.
Assume that the degree of international capital mobility is low for South Africa, that
the Chinese propensity to import is high and that the exchange rate is floating. Clearly
show the balance of payments adjustment process.
4. Suppose the cash reserve requirement is increased. Use the Keynesian transmission
mechanism’s chain reactions to show the primary, secondary and net effects on
total expenditure, total income and the interest rate. Indicate clearly the balance of
payments adjustment process. Assume a floating exchange rate and the capital flows
are not interest rate sensitive.
5. The violence, shootings and deaths at the Marikana platinum mine in August 2012
triggered a sell-off of domestic bonds by foreign investors. (a) Use the Keynesian
transmission mechanism’s chain reactions to show the effect of this event on South
Africa’s income level, interest rate and exchange rate. Clearly indicate the balance of
payments adjustment process. Assume a floating exchange rate and capital flows that
are interest rate sensitive. (b) How would the outcomes have differed if capital flows
were not sensitive to interest rates?
6. In March 2019 the Minister of Finance’s budget speech indicated that the budget
deficit will increase markedly in 2019/20, partly due to bail-outs of Eskom. Use the
Keynesian transmission mechanism’s chain reactions to show the effect on South
Africa’s income level, interest rate and exchange rate. Indicate clearly the balance of
payments adjustment process. Assume a floating exchange rate and capital flows that
are interest rate sensitive.
7. Suppose the rating agency Moody’s reduces South Africa’s rating as a country, which
means that, compared to previous years, South Africa is considered a higher investment
risk. South Africa depends on the inflow of portfolio investments. Use the Keynesian
transmission mechanism’s chain reactions to show the likely effect on the inflow of
portfolio investments due to a lower rating by Moody’s. Then show how the changed
inflow of portfolio investments affects South Africa’s income level, interest rate and
exchange rate. Indicate clearly the balance of payments adjustment process. Assume
a floating exchange rate. (Hint: Assume that prior to the rating adjustment the slope
of the BP curve was flatter than the slope of the LM curve, while after the adjustment
the BP curve is the steeper of the two curves – i.e. the BP curve swivels anticlockwise
due to the ratings decrease. Thus, assume that the interest-rate sensitivity of capital
flows decreases.)
8. The Business Confidence Index decreased markedly in 2018–2019. Use the
Keynesian transmission mechanism’s chain reactions and appropriate diagrams
to explain and show the likely impact of lower levels of business confidence on
South Africa’s income level, interest rate and exchange rate. Indicate clearly the
balance of payments adjustment process. First, assume a fixed exchange rate and
that capital flows are not interest rate sensitive. Then assume a floating exchange
rate and capital flows that are interest-rate sensitive.
9. Growth has been sluggish since 2013, and especially bad in the first quarter of 2019.
In July 2019 the Reserve Bank reduced the repo rate by 0.25%. Describe the likely
impact on economic behaviour and macroeconomic outcomes in a chain reaction and
with the IS-LM-BP model, if capital inflows are sensitive to changes in the interest rate
and the exchange rate is allowed to float freely.
4.9 Analytical questions and exercises 211

10. Use chain reactions and the IS-LM-BP model to explain and illustrate the internal
and external impact of a decrease in taxes on national income and the interest rate.
Assume the degree of international capital mobility is low and the exchange rate is
fixed. Assume further that both the real and monetary sectors are highly responsive
to interest rates.
and external impact of a major increase in the gold and platinum prices on national
income and the interest rate. Assume the degree of international capital mobility is
high and the exchange rate is floating.
and external impact a stimulating fiscal policy will have on national income and
the interest rate. Assume the degree of international capital mobility is low and the
exchange rate is floating.
13. Explain (by using a chain reaction) the relationship between a budget deficit in the
USA, a strengthening US dollar, a weaker rand and South Africa’s export and imports.
14. ‘Foreign investors are becoming risk-averse and selling their shares on the JSE, due to
uncertainty in the South African mining and political sectors.’ Explain the relationship
between the foreign investors selling their shares on the JSE, the effect on the financial
account and the implications for the balance of payments.
15. Explain the ‘twin deficit’ phenomenon by referring to the budget deficit and the
components of the balance of payments.
16. When a country develops an extraordinarily large current account or balance of
payments deficit, it may be forced ‘to get an IMF bail-out’. Consult internet sources
(including factsheets at https://www.imf.org/en/about) to answer the following questions:
a. What is the role and purpose of the IMF in assisting countries in such a case?
b. What kind of ‘assistance’ could it provide for a middle-income country such as
South Africa in the situation described above? (What specific instruments can the
IMF make available?)
c. What is typical IMF ‘conditionality’ in the case of such IMF assistance?
d. Analyse the likely impact on a country such as South Africa of implementing IMF
conditions (use suitable diagrams).
17. In the run-up to Brexit, the British pound lost a lot of value in international currency
markets. Discuss the likely effect of this on different sectors of the British economy
and on the economy as a whole.
18. In the United Kingdom, 2019 was the year of the prospect of leaving the European
Union (EU), of which it had been a member since 1973. At the time of writing (August
2019), it appeared that the ‘divorce’ could happen without an agreement on future
trade between the UK and the EU – i.e. a ‘no-deal Brexit’. The governor of the Bank
of England (the central bank) warned that such an exit would likely cause the UK
economy to shrink (have negative growth) in 2020.
a. Explain, with diagrams, why this could happen, taking domestic and international
aspects into account (and making appropriate assumptions about capital mobility
in the UK and EU).
b. What could be the effect on South Africa and why? Analyse and explain, given
that South Africa has a floating exchange rate and that capital flows are interest
rate sensitive.
c. What did eventually happen with Brexit and what was the impact on the UK
economy in the first couple of years? (Consult the internet.) Analyse and explain
how these outcomes differed, or not, from the prediction of the Bank of England.

Understanding sectoral
coherence and constraints: how to
use macroeconomic identities 5
■ analyse and interpret the different macroeconomic identities that are derived from the
national accounts;
■ use the identities as an analytical tool to understand the coherence between sectors and
evaluate the functioning of an economy;
■ integrate the constraints implied by these identities into macroeconomic analysis;
■ recognise the misuse of the national accounts relationships to derive invalid conclusions
regarding cause-and-effect relationships; and
■ explain the basic structure of the System of National Accounts (SNA) and the
relationships between the different subaccounts.
In chapters 2 to 4 most of the main macroeconomic variables were encountered. These

reflect different types of economic behaviour such as consumption, savings and investment,
by different economic actors such as households (consumers), domestic and foreign
business enterprises, and the government. These behaviours (and variables) influence
each other or are collectively influenced by domestic or international events. The assembly
and analysis of chain reactions have revealed how shocks or policy measures impact
behaviour throughout the economy, as reflected in changes in the magnitude of
macroeconomic variables. Various graphs have shown South African macroeconomic
data that reflect the course of these variables over time. The South African Reserve Bank
publishes much of these data regularly.
The theory in the previous chapters provides a framework for making sense of observed
patterns of economic behaviour – and understanding the likely linkages between variables.
It uses such linkages to explain channels through which disturbances or policy steps are
transmitted through the economy, moving the economy from one state to another. (The
theory explains these transitions as moves from one equilibrium point to another.)
A further dimension of all these interactions and transitions is that, in terms of the
measured values of the variables, they must, and will, at all times remain within an
encompassing set of constraints. These are rooted in an accounting-type coherence
between different sectors – the numbers must add up, must balance. For example, a change
in the measured balance (surplus or deficit) in one sector – for example, a current account
deficit in the external sector – must and will be reflected in the measured balance (surplus
or deficit) in another sector for that year or quarter – either the government-sector budget
balance or the country’s savings-investment balance, or both.
Such crosscutting coherence between sectors (or groups of economic activity) is valuable
to unravel interrelated changes in the data on key macroeconomic components. The
coherence is captured in several identities involving C, I, G, X and M and so forth. These
Chapter 5: Understanding sectoral coherence and constraints: how to use macroeconomic identities 213

identities are derived from the national accounts. The System of National Accounts (SNA)
has an important role in ‘keeping the books’ of a country.
❐ Fortunately, here we do not have to do accounting at all. But, we will see how these
national accounting identities constitute a powerful additional tool of analysis for the
economist.
The System of National Accounts (or SNA) is the primary data system in macroeconomics. It was
developed by the United Nations to promote and standardise systematic economic measurement.
The system prescribes the correct methods to collect, measure and process the data.
❐ It offers a complete set of definitions of macroeconomic variables such as consumption,
investment, imports and exports – the well-known variables of macroeconomic theory. The
definitions are crucial once one starts working with published data.
❐ It offers an accounting framework for all the numbers to ensure a consistent set of data. Section
5.6 offers a bird’s eye view. The SNA is illustrated using the classification of the numbers as in
the Quarterly Bulletin of the Reserve Bank. It is, therefore, a handy reference section. (You can
answer many of the questions in boxes in previous chapters using these data.) It also is an
introduction to the complexities of the data tables and the need to take utmost care when
working with such data. The Addendum offers a ‘student’s guide’ to the national accounts.
The analytical use of the identities is discussed in sections 5.1 to 5.5, while section 5.7
analyses how the sectoral balance identities can be used in decision making. Section 5.6
shows the interaction and links between different subaccounts, how the identities actually
operate, and the way economic changes are reflected in the real numbers.
5.1 From equilibrium conditions to identities

In all the chain reactions, the importance of unplanned changes in inventories were
highlighted. If planned expenditure is less than aggregate production, inventories will
increase. If planned expenditure exceeds aggregate production, inventories will be used up.
So what is the actual position in a non-equilibrium situation? While the economy is
moving towards the equilibrium level of income, there is an imbalance between aggregate
planned expenditure and production – which is reflected in either an increase or a decrease
in inventories (involuntary inventory investment).
Aggregate planned expenditure > production ⇒ Change in inventories is negative
(inventories decrease)
i.e. C + IT + GC + (X – M) > Y ⇒ Inventory investment figure is negative
OR C + IT + GC + (X – M) < Y ⇒ Inventory investment figure is positive
where IT is total fixed investment and GC is government consumption expenditure (see the
shaded box below on the definition of these symbols).
Both these inequalities can be changed into equalities by adding inventory investment II to
the left-hand side of the expression:
C + IT + GC + (X – M) + II = Y OR C + (IT + II ) + GC + (X – M) = Y
OR C + I* + GC + (X – M)  Y ...... (5.1)
where I* denotes investment redefined to include unplanned inventory investment:

I* = IT + II. Thus I* constitutes gross domestic investment (fixed and non-fixed).
214 Chapter 5: Understanding sectoral coherence and constraints: how to use macroeconomic identities

Important: G and GC, I and IT
In chapter 2 (section 2.2.5) we defined G, total general government expenditure, as follows:
G = government consumption expenditure plus government investment = GC + IG. However, as
noted in section 2.2.5, published national accounts data do not do this, since IG is not a part of
‘G’ in the national accounts. That is why we have adopted the practice, throughout this book,
of using the symbol GC to denote government consumption.
In chapter 2 we adopted the practice of defining I as business real fixed investment:
I = IP + IPC, where the former is investment by private firms and the latter is investment by
public corporations. However, in the national accounts, government fixed investment IG is
included in the concept of total fixed investment:
❐ To avoid confusion, we introduce the symbol IT to denote total fixed investment in this all-
inclusive sense: IT = I + IG = IP + IPC + IG.
It should also be noted that the definition of GC as used in the sectoral balance identities in
section 5.4 (and in the ‘Production, distribution and accumulation accounts’ in the Reserve
Bank Quarterly Bulletin) is slightly broader and more comprehensive than general government
consumption in other contexts.
❐ The more comprehensive concept – called general government current expenditure – also
includes interest payments, subsidies and transfers to households and the rest of the
world. These items can be quite large (see table 10.1 in chapter 10).
❐ They are not included in the narrower definition of GC because interest on government debt,
though being current expenditure, does not represent consumption. It is a factor payment.
Subsidies represent a negative tax, while transfers represent a redistribution of income.
❐ Government current expenditure is relevant when calculating saving by general
government (see section 5.4).
The equality in equation 5.1 has the special attribute that it is always true, regardless of
whether the economy is in macroeconomic equilibrium or not. This follows from the fact
that the amount of any gap (excess or shortfall) between aggregate planned expenditure and
aggregate production (which then causes unplanned inventory investment) is automatically
included in the gross investment figure.1 This establishes and continuously maintains the
numerical equality between the left-hand and right-hand sides of the equation.
An expression such as equation 5.1, which is always true by definition, is called an identity. This
characteristic is indicated by using the ‘’ symbol rather than the normal ‘=’ symbol.
❐ This particular identity is called the national income identity.
!
The national income identity closely resembles the equilibrium condition for macroeconomic
equilibrium (see chapter 2, section 2.2.6). However, they are completely different kinds of
expression, as are their interpretations.
❐ The identity is always true, while the equilibrium condition is true only on the infrequent
occasion when the economy actually is in macroeconomic equilibrium.
❐ The major substantial difference lies in the way in which the investment term is put together to
include any excess or shortfall – which then actually creates the identity.
❐ When using either of these in macroeconomic analysis, these differences must be kept in mind
at all times.
1 In the case of equilibrium, planned expenditure and production will be equal, with unplanned inventory investment
being zero.
5.1 From equilibrium conditions to identities 215

Figure 5.1 Nominal domestic expenditure and production
6 000
5 000 GDP
4 000
3 000 C
R billion
2 000
GC
1 000
I*
0
X-M
–1 000
1985/01
1986/03
1988/01
1989/03
1991/01
1992/03
1994/01
1995/03
1997/01
1998/03
2000/01
2001/03
2003/01
2004/03
2006/01
2007/03
2009/01
2010/03
2012/01
2013/03
2015/01
2016/03
2018/01
A more complete version of the national income identity, which corresponds to published
tables, also shows ‘net current transfers received from the rest of the world’ TR:
C + I* + GC + (X + TR – M)  Y + TR ...... (5.1a)

The graph in figure 5.1 shows the course of the variables in the national income identity
since 1985 (R million in nominal terms).2
At all times, despite all kinds of fluctuation, these variables conform to the national income
identity. How to interpret these changes is discussed next.
5.2 The interpretation of identities – uses and abuses

The national income identity can be interpreted in several important ways. With some
simple mathematical manipulation it can also be converted into different formats, which
provide yet more insights.
Broadly speaking, the meaning of these identities is that they indicate certain accounting
constraints on macroeconomic variables – as defined and measured in the system of national
accounts. All changes in variables that occur in the course of a macroeconomic chain
reaction must and always will ‘obey’ these identities.
This follows from the basic accounting coherence built into the system of national
accounts. As with the accounting practice of a private business, the numbers must add
up, must balance (with shortfalls or surpluses added in).
2 The data are taken from the table ‘National income and production account of South Africa’ in the Quarterly Bulletin
of the Reserve Bank. It would be worth your while to scrutinise this table.

While the linkages between variables produce important insights, unfortunately it can say
absolutely nothing about causes, consequences or chain reactions.
❐ Hence it reveals nothing of the causality between economic variables and events. It
merely constitutes the accounting outlines within which economic chain reactions can
run their course. (Indeed, an incalculable number of permutations are possible within
these constraints.)
Example: the South African economy, 1985–2018
The graph in figure 5.2 shows the main variables from the national income identity from
1985. It differs from figure 5.1 in that all data are in real terms.
The components of aggregate expenditure show a number of important trends:
❐ Real GDP increased every year from 1993 to 2018 (following ‘negative growth’ between
1989 and 1992) with the exception of the steep recession of 2008–09.
❐ During 2008–09 gross capital formation by (private and public) businesses slumped
notably, whereafter it recovered before losing steam again since 2014.
❐ After being relatively stable for more than a decade, government consumption
expenditure increased markedly after 1999, before slowing down from 2010 onwards.
❐ Net exports (in real terms) grew gradually up to 2001, whereafter it declined steadily
and developed a persistent deficit since 2011.
❐ Household consumption expenditure increased steadily, but was stable as a ratio of
GDP (similarly showing a large dip during 2008–09).
The data patterns in figure 5.2 are open to various interpretations.
❐ For example, in the period of stagnation between 1988 and 1992, it could appear
that the increase in GC was the cause of the decline in investment I – i.e. excessive
government consumption expenditure GC was crowding out private economic activities
in general – and private investment in particular.
Figure 5.2 Real domestic expenditure and production (2010 prices)
3 500
GDP
3 000
2 500
2 000
C
R billion
1 500
1 000
GC
500 I*
0 X-M
–500
1985/01
1986/03
1988/01
1989/03
1991/01
1992/03
1994/01
1995/03
1997/01
1998/03
2000/01
2001/03
2003/01
2004/03
2006/01
2007/03
2009/01
2010/03
2012/01
2013/03
2015/01
2016/03
2018/01
5.2 The interpretation of identities – uses and abuses 217

❐ To take another example, it might be argued that the sharp decline and eventual deficits
in net exports from 2001 are the result of increasing imports that, in turn, flow from
the sharp increase in private consumption.
Is it valid to derive such conclusions about cause and effect from the identity? It is not, since
an identity can give no indication of causality. Even if the explanation were correct, it would
still be scientifically invalid to deduce it from the identity. It is unwarranted because a number
of other explanations are possible for the same pattern. Consider the two examples again:
❐ The decline in investment between 1988 and 1992 could just as easily have been due
to political-economic uncertainty and a lack of investor confidence (as occurred since
2014). And the increase in GC after 1988 may have prevented the downswing from
being much more serious than it would have been, had GC not increased – rather than
being a cause of the recession.
❐ Regarding the decline in net exports, it is equally possible to argue that, due to prom-
ising returns on investment, foreign investors invested significantly in South Africa
in the high-growth period after 2003. This significant inflow of funds would have in-
creased the external demand for rands, and the rand would have appreciated, which
would have discouraged exports
and encouraged imports. Two versions of the identities
Is this view of the sequence of events The national accounting identities can be expressed
more correct? The answer remains in terms of either GDP or GNDI (i.e. gross national
disposable income). The major difference between
that one cannot deduce anything
GDP and GNDI is net ‘primary’ income from the rest
about causes and consequences
of the world (payments to migrant labour from other
merely by inspecting the identity. countries, and so forth), as well as current transfers.
Either of the two explanations – or Each version is characterised by the way exports and
another one – may be correct. The imports are defined and measured:
identity cannot help one in this ❐ If GDP is used, (X – M) is net exports, and only
regard at all. The danger of the includes foreign trade in goods and services.
identities lies in their simplicity, in ❐ If GNDI is used, net primary income receipts and
how ‘obvious’ apparently related current transfers are included in (X – M).
changes look. The actual relation- (Also see the data tip in chapter 4, section 4.2.1.)
ships and cause-and-effect relations It is immaterial which option is chosen. They are
in economic reality usually are equivalent, since the same element is added to both
more complicated. To understand sides of the definition.
the latter, one has to use logical
One reason to work with GNDI is that it allows a
analysis, theoretical frameworks direct link-up with the current account data in the
and empirical research. balance of payments table (which always includes
❐ The identities do not describe international income flows). It also provides a direct
behaviour. Rather, they record link-up with the important table called ‘The financing
a numerical balance in the of gross capital formation’ (see section 5.5).
outcomes of several behavioural ❐ Hence the data and diagrams that follow are
variables in a specific, accounting shown in terms of gross national disposable
way. Economic theory, such as income. This means that the expression
the theory and chain reactions (X + TR – M) encountered in the equations is
contained in chapters 2 to 4, identical to the current account.
❐ Since balance of payments data are only
describe behaviour and can be
published in nominal terms (i.e. in current prices),
used to explain how change in
the rest of this chapter will mostly work in
one variable may lead to changes nominal terms.
in other variables.

Nevertheless, the identities provide important insights into the way components and sectors
of the macroeconomy cohere. In addition, they give some indication of the quantitative
range of possible macroeconomic changes as well as constraints on such changes. As
long as one is very careful not to use them incorrectly, identities can be valuable (see
section 5.7).
5.3 Expenditure, production and current account deficits

One can rewrite the complete, open economy national income identity as
(X + TR – M)  Y + TR – (C + I* + GC) ...... (5.2)
This form of the identity has a very powerful interpretation. It shows that the extent to
which aggregate domestic expenditure3 (GDE = C + I* + GC) exceeds aggregate national
disposable income GNDI is directly and identically reflected in net exports, and therefore
in the current account (X + TR – M). Leaving aside the complication of net international
transfers TR, one can state the following:
❐ A current account surplus means that GDE is less than gross national disposable
income or GNDI.
❐ A current account deficit means that GDE exceeds gross national disposable income or
GNDI.
OR
❐ If GDE is less than gross national disposable income or GNDI, it implies a current
account surplus.
❐ If GDE exceeds gross national disposable income or GNDI, it implies a current account
deficit.
Therefore an external disequilibrium (current account deficit or surplus) always has an
internal macroeconomic counterpart (production is < or > expenditure). Therefore, the
removal of a current account disequilibrium must always include the restoration of
internal balance between expenditure and production (income). Likewise, restoring internal
equilibrium between expenditure and production (income) always will and must reflect in
the establishment of external (current account) equilibrium.
5.4 The sectoral balance identities

For these identities, we redefine some government sector variables slightly. Let T = current
revenue of government, i.e. taxes and other current revenue, and let GC = current expenditure
of government, i.e. government consumption expenditure and other current expenditure
(interest payments, subsidies and transfers to households and the rest of the world; see the
data tip in section 5.1).
If one adds and immediately subtracts T on the right-hand side of equation 5.2, it
produces:
(X + TR – M)  (Y + TR – T) – (C + I*+ GC – T) ...... (5.3)
3 Take note of the difference between gross domestic expenditure (GDE), expenditure on gross domestic product, and
aggregate demand. This is explained in the addendum to this chapter.
5.4 The sectoral balance identities 219

Moving terms around produces:
(Y + TR – T)  C + I* + (GC – T) + (X + TR – M) ...... (5.4)
Since Y + TR – T is the disposable income (YD) of residents, the following can be derived
with some substitution of terms:
YD  C + I* + (GC – T) + (X + TR – M) ...... (5.5)
Furthermore, saving is that part of disposable income that is not spent on consumption:
S = YD – C, hence YD = S + C. Substituting this in equation 5.5, while collecting terms,
produces:
(S – I*) + (T – GC)  (X + TR – M) ...... (5.6)

This form of the identity is called the sectoral balance identity. It is extremely important, and
can be interpreted in various ways. It shows a fundamental linkage between key balances
in the private sector (households and business enterprises), the government sector and the
foreign sector. Each element (or balance) indicates the relationship between inflows and
outflows of a particular sector:
S – I* = The excess of the total private saving (saving of households and businesses) over
capital formation by both the businesses and government.4 We will call this the
private saving balance.5
❐ Remember that government capital formation is included in I*. While this is not
entirely correct in terms of macroeconomic reasoning, convention is followed
here so that the form of the identities matches published South African data
tables.
❐ Should the consumption of fixed capital (also known as provision for deprecia-
tion) be included in both S and I*, the term S – I* will represent the gross private
saving balance. Otherwise it is net private saving.
❐ Keep in mind that unplanned inventory investment is included in the investment
term I* in all these identities. This element can be negative or positive.
Data for the components of total private saving S can be found in the following tables in
the Quarterly Bulletin:
DATA TIP
❐ Production, distribution and accumulation accounts of South Africa

❐ Current income and saving.
The relevant data are also summarised in the table ‘Financing of gross capital formation’.
The latter table also shows the gross figure for I*, of which more details can be found in the
expenditure and capital formation tables.
4 This element shows the overall (gross and net) investment–saving balance. Investments and loans between firms or
between households and firms do not affect the (gross and net) balance, since these are internal to this component.
5 This terminology is not quite correct, given our comprehensive definition of I* to include government investment IG.
Most textbooks, indeed, show the identities with I as private sector investment, and government investment as a part
of G. Then (S – I) is the private sector balance proper, and (T – G) is the overall fiscal deficit (not only the current deficit,
as in South Africa). However, it does not change the analysis fundamentally – except that government saving or
dissaving is not highlighted so explicitly. The South African debate may have been distorted somewhat by the fact that
the data and the identities highlight government dissaving rather than the overall fiscal deficit.

T – GC =
The current government deficit or surplus (current income less current
expenditure, i.e. gross and net government saving). This term is often negative,
indicating general government ‘dissaving’.
❐ This is not the overall, conventional budget balance. Government capital
expenditure (and revenue) is not included. It only shows current expenditure
and revenue.
❐ Remember that in these sectoral identities GC is current government expenditure,
which comprises more than government consumption expenditure (previously
also indicated with the letter GC). The current expenditure of general government
comprises government consumption expenditure plus interest on public debt,
subsidies and transfers to households and the rest of the world.
❐ If one chooses to define current expenditure to include consumption of fixed
capital by government, T – GC represents gross saving by government. Otherwise
it is net saving by government.
❐ Remember that on the revenue side T includes, in addition to the tax revenue
of the general government, revenue from property, as well as transfers received
from households, business enterprises and the rest of the world.
❐ This element concerns the general government (national government plus
provincial governments plus local governments). The budget presented
annually by the Minister of Finance mostly concerns the national government.
X + TR – M = The external surplus or deficit, i.e. the current account of the BoP. (Net
current transfers from the rest of the world, and net primary income from
the rest of the world, are included.)
Detailed data on (T – GC) can be found in the Quarterly Bulletin table ‘Production,
DATA TIP
distribution and accumulation accounts for South Africa (General Government)’. It also is
summarised in the table ‘Financing of gross capital formation’.
The (X + TR – M) data can be found in the ‘Balance of payments’ table in the Quarterly
Bulletin.
Table 5.1 shows the sectoral balances for the South African economy for 2018 (in nominal
terms). Consider the first line of the table first. The observed values reflect the outcomes, in
a particular year, of numerous intertwined macroeconomic chain reactions, due inter alia
to external disturbances, inherent instability and policy steps. Amidst all the changes, the
figures remain within the constraints of the identity. The numbers always add up; always
balance (given the SNA definitions). While the identity allows an innumerable number of
combinations of values of economic variables such as C, I*, GC, X, M and T, there are limits
within which these values must stay (or add up).
Table 5.1 also demonstrates that the sectoral balances can be calculated either on a gross
saving (first line) or net saving (third line) basis, the latter being gross saving minus the
‘consumption of fixed capital’ (i.e. the provision for depreciation). (Recall that for gross
saving by government GC includes consumption of fixed capital, otherwise known as
provision for depreciation.)
❐ The first three columns show the gross and net private saving of businesses (financial-
and non-financial corporations) and households. This is denoted by S.
❐ Column four shows the gross and net saving by government, denoted by the current deficit
(T – GC).

Table 5.1 The sectoral balances for 2018 (R million, current prices)
House- Non–fin Financial General
Domestic economy Foreign sector
holds corp corp govt
S (T – Gc) S + (T – Gc) I* (S – I*) (S – I*) + (T – Gc) = (X + TR – M)
Gross saving/
67 099 518 640 116 818 –1 124 701 433 874 396 –171 839 –172 963 –172 963
investment
Consumption of
–70 138 –491 447 –21 141 –93 761 –676 487 –676 487 93 761
fixed capital
Net saving/
–3 039 27 193 95 677 –94 885 24 946 197 909 –78 078 –172 963 –172 963
investment
❐ These add up to net or gross domestic saving (S + T – GC), with the difference between
gross and net saving again being the consumption of fixed capital.
❐ Subtracting I* from S yields (S – I*), the private saving balance, while subtracting I* from
[S + (T – GC)] yields excess domestic saving = (S – I*) + (T – GC), which equals the current
account (X + TR – M).
Figure 5.4 shows these basic elements for the South African economy since 1995 (in
nominal terms). Note the change with regard to the current account position after 2002,
and how it is linked to corresponding changes in the other variables.
The identity shows, at each point in time, a ‘snapshot’ of the limits, at a particular moment,
within which the values of variables must stay at all times.
By switching terms around, the sectoral balance identity (equation 5.6) can be written in
different forms, each of which provides different interpretations and insights.
5.4.1 Interpretation 1 – external imbalances
(X + TR – M)  (S – I*) + (T – GC)
 [S + (T – GC)] – I* ...... (5.6a)
Together, the two terms on the right-hand side amount to the overall domestic saving–
investment position:
❐ (T – GC) plus S is gross domestic saving (by government and businesses – i.e. private firms
and government corporations – and households).
❐ I* is gross capital formation (by government and businesses, with inventory investment
included).
The left-hand side is the current account of the BoP – the external (im)balance.
In this form of the identity one can deduce that, if there is an external, current account
surplus (net inflow of funds), the funds have to be, and are being, absorbed somewhere:
either the domestic private sector must save more than it invests, or the government sector
must collect taxes in excess of its current expenditure – or both. That is, any external
imbalance must be matched by corresponding internal sectoral imbalances.
❐ Still, there can and should be no explicit or implicit suggestion of causality in this
interpretation. That is the function of theory and ‘chain reasoning’.

Conversely, if the government sector shows a current fiscal deficit (T < GC) and domestic
investment is in excess of domestic saving (S < I*) – in both cases more is spent than the
funds that are available – it will be matched by an external imbalance (current account
deficit) of corresponding size.
❐ This parallels the conclusion in section 5.3: a trade or current account deficit means
that domestic expenditure is in excess of available domestic production. And, once
again, these deficits or imbalances can have their origins/causes in any of the sectoral
balances, or in variables elsewhere in the economy.
In South Africa it was the case, until 1993, that T < GC (government dissaving) while
S > I* (private saving surplus). The positive (S – I*) figure exceeded the negative (T – GC)
figure in absolute terms, implying a net positive figure. Therefore it was matched by a
current account surplus in each year. (See section 5.5 for a further interpretation of this
situation.)
❐ After 1994 this situation reversed: (S – I*) was still positive, but in absolute terms it was
less than (T – GC). Hence the domestic saving–investment [(S + (T – GC)) – I*] situation was
matched by a parallel deficit on the current account.
The relationship over time between the different elements of the identity is shown in figure
5.3. The consumption of capital is included in saving and investment, so we are dealing
with gross saving concepts. The graph clearly shows how, when the gap between gross
domestic saving and gross domestic investment increased after 2002, the current account
deficit widened correspondingly.
Figure 5.3 Gross domestic saving and the current account

1 000
(S – I*) + (T – GC) I*
800
600
S + (T – GC)
400
R billion
200
X + TR – M
–200
–400
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018

5.4.2 Interpretation 2 – saving and investment imbalances
(S  I*)  (GC  T)  (X  TR  M) ...... (5.6b)
A domestic imbalance between saving and investment (i.e. between inflows and outflows)
is mirrored in either the current government balance or the external balance.
If the private sector as a whole saves more than is being invested domestically, the resultant
surplus funds are being absorbed somewhere: either as loans to the government (to finance a
current government deficit (GC – T) or loans to the external sector (to foreign countries that
need the funds to finance their trade deficit with South Africa) or other forms of capital
outflow. Of course, both can occur simultaneously.
In South Africa, capital outflows absorbed the greater part of these surplus funds for many
years (in addition to those being absorbed by the fiscal deficit). Indeed, the capital outflows
were the major reason why a current account surplus had to be maintained – sufficient
foreign exchange reserves had to be generated from trade to finance the capital outflows.
(Capital flows cannot be seen explicitly in this identity. Section 5.5 shows a form of the
identity in which they are explicit.)
The relationship between the different elements of the identity is shown in figure 5.4
(again with consumption of capital included). It clearly shows how, when the gap between
gross domestic saving and gross domestic investment increased after 2002, the current
account deficit widened correspondingly.
❐ In 1994, and thereafter, the situation changed significantly, bringing about a positive inflow
of capital from other countries. For the first time in more than a decade, South Africa could
afford a current account deficit – the capital inflows brought sufficient foreign reserves to
finance the growing current account deficit (X + TR – M) (see figure 5.4 and table 5.2).
❐ This current account deficit was largely reflected in an increasing negative gross private
saving–investment gap (S – I*), while gross saving by government (T – GC) turned
Figure 5.4 Gross private saving, government saving and the current account
1 200
1 000
I*
800
S
600
R billion
T
400
GC
200
0
X + TR – M
–200
–400
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018

positive in 2004. This means that government eliminated gross dissaving in 2004 (in
national accounting terms).
❐ However, what is not shown on this graph is that net saving by government (i.e. gross
saving minus the consumption of fixed capital) only turned positive for 2006 and 2007.
Since net saving is the relevant concept when analysing dissaving by government, this is
an important aspect to remember (see chapter 10, section 10.7.3 for data on net saving).
5.4.3 Interpretation 3 – current fiscal deficits
(T – GC)  (I* – S) + (X + TR – M) ...... (5.6c)
If government has a current fiscal deficit, it must borrow from a sector that has surplus
funds: either the domestic private sector (households and/or business enterprises) that
saves in excess of total domestic investment, or the foreign sector, which has earned net
surplus funds from trade with South Africa – or both.
❐ Should the current account happen to be in equilibrium, the current fiscal deficit can
be reflected in only one place: an internal imbalance between I* and S.
❐ Likewise, if government finances show a current balance, then the domestic S-I
imbalance must precisely match the external sector (current account) imbalance.
In South Africa, capital outflows occurred for a long period between the early 1980s and
1994; therefore a current account surplus had to be maintained. Domestic expenditure
had to be kept below total production. In other words, the domestic private saving–
investment balance had to generate sufficient surplus funds to finance both the current
fiscal deficit and the capital outflows.
❐ Increased political stability following the political change in 1994 put a stop to the
drainage of domestic saving to other countries. This left more room for gross fixed
capital formation, which could – for the first time in a decade – be allowed to exceed
domestic saving.
Despite the richness of the insights that can be derived from the different forms of the
sectoral balance identity, they still do not reveal any causal relationships. All three of
the balances are determined simultaneously by the entire complex of macroeconomic
relationships, processes and reactions.
5.5 The financing of gross capital formation

Table 5.2, reproduced from the Quarterly Bulletin of the Reserve Bank, provides very useful
additional insights in the constraints implied by the sectoral balance identities. It is closely
related to equation 5.6a, i.e. interpretation 1 of the identity.
The top four lines yield: S + (T – GC) = gross domestic saving.
The last line is: I* = gross capital formation.
Lines 7 and 8 may be more difficult to understand. They derive from the following identity
for the external sector (BoP):
Change in gold and other foreign reserves
= BoP + change in liabilities related to reserves
= Current account + financial account + change in liabilities related to reserves
= Current account + ‘net capital inflow from the rest of the world’.
5.5 The financing of gross capital formation 225

Table 5.2 Financing of gross capital formation (R millions, current prices)
2013 2014 2015 2016 2017 2018
1. Saving by households a
–48 311 –45 553 –19 930 –23 214 5 595 –3 038
2. Corporate savingsa 171 749 184 126 165 602 167 545 193 360 122 870
3. Saving by general governmenta –62 083 –76 770 –45 941 –52 164 –80 809 –94 884
4. Consumption of fixed capital b

482 989 525 308 560 416 617 969 638 782 676 486
5. Gross savingsc 544 344 587 111 660 147 710 136 756 928 701 434
6. Foreign investment 204 841 192 966 187 006 125 102 118 234 172 962
7. Net capital inflow from the rest of the world 209 468 208 100 172 991 164 624 143 759 184 299
8. Change in gold and other foreign reserves d

–4 627 –15 134 14 015 –39 522 –25 525 –11 337
9. Gross capital formation 749 185 780 077 847 153 835 238 875 162 874 396
a. After consumption of fixed capital and after inventory valuation adjustment.

b. At replacement value. (This term used to be called ‘provision for depreciation’.)
c. After inventory valuation adjustment.
d. Increase –; decrease +.
Source: SARB.
The change in liabilities related to reserves usually occurs due to short-term foreign loans
by the national government or the Reserve Bank from foreign banks and governments.
Thus it is a form of capital inflow, but for very specific reasons unrelated to international
trade and investment. It allows for changes in reserves for reasons other than normal BoP
transactions.
Moving terms around in this last equation produces:
Current account (CA) = Change in gold and other foreign reserves
+ net capital inflow from the rest of the world
This expression is particularly useful since it shows how changes in the current account
will be matched by changes in capital flows and especially foreign reserves:
❐ A current account deficit, for example, must be financed by either capital inflow or the
use of foreign reserves (or both). Hence a current account deficit will cause and require
an equivalent change in the sum of the latter two sources of financing.
❐ Conversely, a current account surplus must be reflected in an addition to reserves or an
outflow of capital (or both). The portion of the net current account inflow that does not
go into reserves must have flown out of the country.
Hence, the sum of lines 7 and 8 indicates the current account position. The current account
position is indicated in line 6, where it is called foreign investment. This may sound strange,
but it reflects the fact that a current account deficit needs to be financed, and matched, by
capital inflows. (Note that in this table a positive sign indicates a current account deficit.)
It can now be seen that the structure of the table simply reflects the sectoral balance
identity in a somewhat different form:
[S + (T – GC)] – CA  I*
Therefore, table 5.2 provides an extension of the set of identities above in that it makes explicit
the linkages between (a) the current account (CA) and (b) capital flows and changes in foreign
reserves.

Interpretation 1 above therefore can be restated as follows: if gross domestic saving exceeds
gross domestic investment, it must be matched by a current account surplus – which
must, in turn, be matched by either a capital outflow or an increase in foreign reserves (or
both). This was the case in South Africa after 1986. Only in 1994 did things turn around,
showing current account deficits from 1995 onwards.
Another interpretation, which clearly illustrates the South African economic crisis of the
decade 1983–93, is as follows:
❐ If there is a continual capital outflow (net capital inflow is negative), and if reserves are
insufficient to finance this outflow fully, then the current account has to be kept in a
surplus.
❐ Given the sectoral links revealed by the identities, this can be achieved only by getting
gross capital formation (domestic investment) to a level lower than gross domestic
saving – and keeping it there.
❐ If the level of domestic saving is high, there is no problem. However, if total saving
already is relatively low, it implies a low ceiling below which investment must be
squeezed. Hence investment cannot be allowed to be ‘high’ (relative to domestic saving).
Such a ‘saving ceiling’ makes the problem of capital outflows much worse.
❐ If the contribution of the general government to domestic saving is negative (i.e.
government dissaving, a current fiscal deficit) – as had progressively been the case in
South Africa – it becomes increasingly difficult to generate enough net domestic saving
(from the only remaining source, private households and businesses). The pressure to
put a lid on investment (and expenditure in general) escalates.
❐ In other words, in such a situation a current fiscal deficit – which need not necessarily
be a problem in a general fiscal context6 – suddenly constitutes a major problem, placing
severe pressure on the fiscus.
This analysis reveals the severe ‘straitjacket’ that substantial capital outflows imply for
a country such as South Africa – given the intrinsic constraints, as revealed by the different
identities. In such a situation significant economic growth is not allowed, because:
❐ Private consumption C may not be stimulated, since that may depress personal saving.
❐ Government consumption expenditure GC may not be used for stimulation, since that
would increase government dissaving.
❐ Tax cuts may not be used to stimulate growth, since that also increases government
dissaving.
❐ Capital formation may not be stimulated, since it has to be kept far enough below total
saving to generate a large enough current account surplus (to finance the capital
outflow).
❐ GDP may not increase, since it will stimulate imports, aggravating the problem of sus-
taining a current account surplus.
The turnaround of this situation after 1994 signalled a great relief for South Africa from
the stranglehold, shown in the identities, which prevailed before that. With capital inflows
occurring again, government dissaving suddenly is less of a problem (and something that can
now be evaluated in fiscal terms rather than in the ‘financing of investment’ context; see
chapter 10).
Although the relief after 1994 has been quite significant (aided by capital inflows and gov-
ernment dissaving that decreased significantly), the low saving rate still creates problems
6 This is discussed in chapter 10.
5.5 The financing of gross capital formation 227

for the economy. More specifically, I* exceeds S by a substantial margin because of the low
rate of domestic saving, particularly by households (see table 5.1).
5.6 The SNA at a glance – relationships between subaccounts7

The composite SNA table on the
following pages shows the basic If you have trouble understanding the concepts and
structure and coherence of the variables in the tables, consult the addendum to this
national accounts at a glance. chapter, which provides a simple explanation of the
main definitions.
Study it carefully and thoroughly.
Nine different accounts are shown.
These correspond with the SNA tables in the Quarterly Bulletin of the Reserve Bank (which
also provide a more detailed breakdown of the tables.)
The SNA accounts organise macroeconomic data in terms of:
❐ the main domestic economic activities (production, income, expenditure and saving);
❐ the main domestic sectors (incorporated business enterprises, general government, and
the household or personal sector), and
❐ the external sector, which is represented in a separate account (no. 5), and indirectly in
the expenditure account (no. 3).
Account name SARB table
BLOCK A
Account 1 Production Gross value added by kind of economic activity

Account 2 Income National income and production accounts
Account 3 Expenditure Expenditure on gross domestic product
BLOCK B
Account 4 Saving and investment Financing of gross domestic capital formation; Gross and net capital formation by
type of organisation
Account 5 External account Balance of payments
In this table X and M are defined to include income payments to, and receipts
from, the rest of the world (as is the practice in the balance of payments table)8
BLOCK C
Accounts 6–9 Net sectoral saving Production, distribution and accumulation

(One table for each sector, the sectors being financial corporations, non-financial
corporations, general government and households)
For all three sectors, capital expenditure – i.e. investment – is not shown here. All the investment components feature indirectly in account 4,
where together they constitute gross capital formation I* (= GCF or GDI).
7 This section can be omitted without loss of continuity.

8 Formally, the special capital flows are called Changes in liabilities related to reserves. These are short-term
foreign loans by the Reserve Bank and the government from foreign banks and governments. SDR allocations and
valuation adjustments are excluded from the Change in gross reserves item, since these fall outside the conventional
macroeconomic framework.

Block A illustrates the three methods of calculating aggregate output noted above, and
the intrinsic equivalence of the three methods:
❐ Account 1 shows how total production is made up from production (value added)
in three sectors: the primary sector (agriculture, mining, etc.), the secondary sector
(manufacturing, electricity, construction) and the tertiary or services sector (wholesale
and retail trade, transport and communication services, financial services, and
community and social services).
❐ Account 2 calculates aggregate output from the income side of the circular flow, i.e.
from the income earned by different production factors.
❐ Account 3 works from the expenditure side, using the income-expenditure identity
Y = C + I* + GC + (X – M) (+ residual).
More detailed tables in the Quarterly Bulletin show the breakdown of expenditure within
each of the main categories, e.g. household consumption expenditure and capital
formation.
Block A also shows how indirect taxes and subsidies must be taken into account (compare
the market price vs. basic price vs. factor cost methods). The difference between GDP and
GNI is apparent, as is the equivalence of GDP and ‘Expenditure on GDP’.
Block B shows the relationship between domestic saving and investment (capital forma-
tion), as well as the external account (BoP).
❐ Account 5 shows the relationship between the current account, the capital account
and the BoP, as well as the foreign reserves. More specifically:
– Changes in either trade or capital flows are reflected in the BoP.
– Changes in the BoP are necessarily mirrored in changes in reserves.
– When observing the actual data for these variables (see Quarterly Bulletin), one can
see how the current account deficit in 2018 is financed by capital inflows. Since these
exceeded the CA deficit (outflow of payments), the reserves showed an increase. If
capital flows were less than the CA deficit, reserves would necessarily have been used
to finance the current account (the change in gross reserves figure would have been
negative).
❐ Account 4 is basically the ‘Financing of Gross Capital Formation’ (GCF) table discussed
in section 5.5. It is placed in Block B together with the external account to illustrate
the very important sectoral balance identity, discussed extensively above. In essence, any
gap between gross (or net) capital formation and gross (or net) domestic saving – a
saving deficiency – is reflected in a current account deficit. Excess domestic saving will
be matched by a current account surplus.
Block C shows the sectoral breakdown of production, distribution and accumulation. Note
that these sectoral tables are incomplete in the sense that investment (capital expenditure)
is not shown. Yet the tables are important in that they show how sectoral production,
income and expenditure behaviour, as reflected in saving, becomes an input in account 4,
where total saving is instrumental in financing total capital formation (which, in turn, is
composed of sectoral capital formation).
Of course, sectoral behaviour, in turn, is the endogenous result of changes occurring in
other accounts – as explained in the theory of chapters 2 to 4.
The SNA accounts constitute a complete and consistent system. As in business accounting,
identities and equalities govern the coherence between the different accounts and
subaccounts.
5.6 The SNA at a glance – relationships between subaccounts 229

THE NATIONAL INCOME AND PRODUCTION ACCOUNTS AT A GLANCE (2018, R billion, current prices)1
(Please note that at the time of publication these figures were still subject to revision – so by e.g. 2022 some of the 2018 numbers will have changed after revision.)
230
A) NATIONAL PRODUCTION, INCOME AND EXPENDITURE: Y = C + I* + GC + (X – M )
1. Production 2. Income 3. Expenditure

Primary sector 456.9 Compensation of employees 2 320.2 Final consumption expenditure by households 2 921.0 C
How_to_think_BOOK_2019.indb 230
Secondary sector 909.2 Net operating surplus 1 249.2 Final consumption expenditure by government 1 037.3 GC2
Tertiary sector 2 975.2 Consumption of fixed captital 676.5 Gross fixed captital formation 886.4
I*
Gross value added at factor cost 4 245.9 Change in inventories –12.0

+ Other taxes on production 101.9 Residual 24.5
– Other subsidies on production 6.5
Gross value added at basic prices 4 341.3  Gross value added at basic prices 4 341.3 Gross domestic expenditure (GDE) 4 857.1 C + I* + GC
+ Taxes on products 545.6 + Exports 1 457.6 X
– Subsidies on products 13.0 – Imports 1 440.9 M
Y GDP at market prices 4 873.9  Expenditure on GDP 4 873.49 C + I* + GC + X – M
Net primary income from the rest of the world –154.1

Total production equals total expenditure GNI @ market prices 4 719.9
Net current transfers from the rest of the world –35.7 Difference between GDE and GNDI equals
(on the right-hand side of the table)
GNDI @ market prices 4 684.2 the balance on the current account
B) SECTORAL BALANCE IDENTITIES: (S – I*) + (T – GC) = X + TR – M
4. Saving and investment 5. External account

Net Gross Merchandise exports 1 175.6
Saving by households –3.0 67.1 Net gold exports 71.7
Total corporate saving 122.9 635.5 Service receipts 210.4
S Total private saving 119.9 702.6 Income receipts 96.5
(T – GC)1 Saving by genl government –94.9 –1.1 – Merchandise imports –1 222.9
(S + T – GC )1 Total savings 25.0 701.4 – Payment for services –217.9
I* – Total capital formation –197.9 –874.4 – Income payments –250.6
Net current transfers –35.7

(S – I* + T – G ) SAVING–INVESTMENT BALANCE –173.0  CURRENT ACCOUNT –173.0 (X + TR – M)3
C
Capital transfer account* 0.2

FINANCIAL ACCOUNT
Total capital flows (marked with *) Direct investment 10.4
match the difference between sav- Portfolio investment 33.2
ing and capital formation – and thus Financial derivatives 7.2
also equals the current account. Other investment 102.6
[Reserve assest* (increase (–)] –11.3 (‘Change in reserves’)
FINANCIAL ACCOUNT* 153.4
(excluding change in reserves,
including unrecorded transactions)* 30.7
Chapter 5: Understanding sectoral coherence and constraints: how to use macroeconomic identities
BALANCE OF PAYMENTS 11.3
(change in reserves excluded,
unrecorded transactions included)
2019/12/17 09:15
C) SECTORAL PRODUCTION, DISTRIBUTION AND ACCUMULATION ACCOUNTS
6. Financial corporations 7. Non-financial corporations 8. General government 9. Households
How_to_think_BOOK_2019.indb 231
Gross value added 373.7 Gross value added 2 317.7 Gross value added 836.7 Gross value added 813.2
– Compensation of employees 208.8 – Compensation of employees 1 232.3 – Compensation of employees 719.0 – Compensation of employees 160.1
– Other taxes on production 5.3 – Other taxes on production 54.5 – Other taxes on production 9.6 – Other taxes on production 32.5
Other subsidies on production 0.0 Other subsidies on production 5.9 Other subsidies on production 0.4 Other subsidies on production 0.2
Gross operating surplus 159.6 Gross operating surplus 1 036.7 Gross operating surplus 108.6 Gross operating surplus 620.8
Taxes on products 545.6 Compensation of employees 2 317.9
Other taxes on production 101.9
– Subsidies on products 13.0
– Other subsidies on production 6.5
Net property income 22.8 Net property income –281.6 Net property income –179.1 Net property income 286.1
Gross balance of primary income 182.4 Gross balance of primary income 755.2 Gross balance of primary income 557.5 Gross balance of primary income 3 224.8
Current taxes on income and wealth 752.4
Social contributions received 274.8 Social contributions received 25.3 Social benefits received 434.0
Other current transfers received 223.7 Other current transfers received 40.4 Other current transfers received 12.1 Other current transfers received 251.0
– Current taxes on income and wealth 53.1 – Current taxes on income and wealth 196.3 – Social benefits paid 223.1 – Current taxes on income and wealth 502.9
– Social benefits paid 210.9 – Social benefits paid 19.0 – Social benefits paid 281.1
– Other current transfers paid 233.5 – Other current transfers paid 45.6 – Other current transfers paid 88.0 – Other current transfers paid 195.9
Gross disposable income 183.3 Gross disposable income 534.8 Gross disposable income 1 036.1 Gross disposable income 2 929.9
– Adj for change in net equity of house- 63.9 + Adj for change in net equity of house-
holds in pension reserves holds in pension reserves 63.9
– Residual 2.6 – Residual 16.2 – Residual 5.7
Total household resources 2 988.1
– Final consumption expenditure 1 037.3 – Final consumption expenditure 2 921.0
Gross saving 116.8 Gross saving 518.6 Gross saving –1.1 Gross saving 67.1
– Consumption of fixed capital 21.1 – Consumption of fixed capital 491.5 – Consumption of fixed capital 93.8 – Consumption of fixed capital 70.1
Net saving 95.7 Net saving 65.1 Net saving –136.6 Net saving –3.0
Gross saving 116.8 Gross saving 518.6 Gross saving –1.1 Gross saving 67.1
Capital transfers (net) 0.0 Capital transfers (net) 2.2 Capital transfers (net) –17.1 Capital transfers (net) 15.1
– Change in assets (net) 23.3 – Change in assets (net) 607.3 – Change in assets (net) 145.8 – Change in assets (net) 98.0
Net lending (+)/Net borrowing (–) 93.5 Net lending (+)/Net borrowing (–) –86.5 Net lending (+)/Net borrowing (–) –164.0 Net lending (+)/Net borrowing (–) –15.9
Sectoral saving produces total saving
5.6 The SNA at a glance – relationships between subaccounts

1) Due to rounding of numbers small discrepancies may appear in some totals.
2) GC in Block B4 is government current expenditure, where as in Block A3 it is government consumption expenditure – see section 5.4.
231
3) In this line X and M are defined to include income payments to, and receipts from, the rest of the world (as is the practice in the balance of payments table).
2019/12/17 09:15
Items that appear in more than one place must match. For example:
❐ Government consumption expenditure and household consumption in sector sub-
accounts 8 and 9 also appear in the expenditure account 3, in the familiar C + I +
GC + (X – M) context.
❐ Direct taxes of financial and non-financial corporations and households (accounts 6, 7
and 9) add up to the direct tax receipts of general government in account 8.
❐ Indirect taxes and subsidies, in account 2, match the indirect tax revenue received and
subsidies paid by general government in account 8.
❐ Gross capital formation in account 3 matches that in account 4.
❐ The different sectors’ saving, derived in accounts 6 to 9, reappear as components of
domestic saving in account 4.
❐ The X and M figures in account 5 match those in the C + I + GC + (X – M) table
(account 3).
Identities must always be true. A change in one place will and must be reflected in other
accounts (without saying anything about the direction of causality, as explained above). The
system must balance in an accounting sense.
❐ Any discrepancy between total domestic expenditure GDE and total production GNDI
(in account 3) will be reflected in a current account deficit (in account 5) – a sign of
domestic overspending. (This imbalance could have originated either internally or
externally, e.g. a drop in exports.)
❐ Because of the coherence between the accounts, this will necessarily have its mirror
image in a discrepancy between gross domestic saving GDS and gross capital formation
GCF (account 4).
❐ Any gap between GCF and gross domestic saving GDS – a domestic saving deficiency
– is reflected in the current account, but likewise requires financing by foreign capital
inflows or the use of reserves to finance that part of the investment not financed by
domestic saving. Or, equivalently, the current account deficit must be financed; thus
it will reflect in the financial account of the BoP and/or the reserves. (Excess domestic
saving is mirrored by capital outflows or reserves increasing, matched by a current
account surplus.)
Changes in the economy, as discussed in the various chain reactions in chapters 2 to 4,
will be reflected in the national accounts. For example:
❐ If the economy experiences a recession, production, income and expenditure on GDP
will all be at a lower level. The external account is likely to show changes, at least in
imports. In accounts 1 to 3 some or all components will have to be different (depending
on how, why and where exactly in the economy the recession started and spread through
the economy). Of necessity, some or all sectoral activities will also reflect this (without
revealing which of the changes were causes and which were effects in the various chain
reactions). All the elements in the sectoral balance identity are likely to have different
values – while the identity will remain true at all times (it will always balance).
5.7 Using the sectoral balance identities for decision making

It has been stated repeatedly that all the identities do not show any causal relationships
between sectors and variables. All the sectoral balances are simultaneously determined by
macroeconomic processes and reactions. So, what is the use of the identities for decision
making and analysis (over and above the insights already gained above)?

Anticipating the possible causes of disturbances or policy steps
If one of the elements, e.g. in the sectoral balances, is disturbed by a policy step or some
other event, it will lead – via the normal economic channels and chain reactions – to a new
situation that will be reflected ex post in the identities and balances in an accounting sense.
If government is contemplating a change to (GC – T) with policy, the identity tells it
beforehand that changes in one or both of the other sectoral balances will result (via
the normal chain reactions indicated in chapters 2 to 4). However, since both sectoral
balances can be affected, and to different extents, this knowledge is of limited value only.
Also, GC and T may be affected by changes in the economy. On the basis of the identities
alone, one cannot even predict where the largest impact will be – unless one has other
information on the likely behaviour of sectoral variables (e.g. policy variables under the
control of policy authorities).
❐ Acceptable predictions require estimates of the different elasticities, sensitivities and
time lags involved in economic relationships. Empirical estimates of these can be made
using techniques such as regression analysis or econometric model building, based on
economic theory. These may then be used to generate quantitative estimates of changes
in economic variables following a disturbance.
Following such a disturbance or policy step, and with the prior knowledge of the origin
of a sequence of changes, one can follow the reflection of this sequence in the national
accounts, and interpret the accounting changes in that context. (One should bear in mind
that other events may also have impacted the sequence of events as they took their course.
An economy is continually subject to multiple influences.)
❐ Such an analysis of causes and effects does not flow from the identities themselves, but
from prior knowledge and theoretical insights in economic relationships and causality.
The identities can therefore be useful instruments, in conjunction with others, in better
anticipating and understanding the future course of events.
Diagnostic analysis or problem solving?

Where the cause of a sequence of events is not known, the identities are of less use. If one
were only to observe, ex post facto, changes in the sector balances, it would not be possible
to make a deduction regarding the sequence of events or the cause-and-effect relations
that might have been occurring. Observed changes in the balances cannot indicate where
changes originated; cannot indicate ‘guilty’ or ‘not guilty’ sectors or variables.
Where the identities can be an aid is in checking whether a possible explanation of an event
or problem or the use of economic theory is consistent with the identities. By checking whether
proposed explanations are consistent with the constraints revealed by the identities, invalid
explanations can be disqualified and the potential validity of others ascertained. However,
it would not be possible to designate a ‘winner’.
But is it not possible to identify likely problem areas, or a sector where one should start
to solve certain macroeconomic problems? To some extent this may be possible – first, the
identities do indicate sectors or balances where the economy is experiencing pressure or
tightness, and, second, one knows how the sectors are linked and has a good (theoretical) idea of
how chain reactions spread through the economy. It may therefore be possible to target certain
areas for remedial action.
5.7 Using the sectoral balance identities for decision making 233

❐ This still does not mean that the targeted sector has been identified as ‘guilty’. An
undesirable balance in one or more sectors may have been caused by a disturbance or
policy step elsewhere in the economy.
❐ Without theoretical insights and reasoning, any identification of problem areas is a very
dangerous, mechanical exercise that bases decisions on a ‘black box’.
And so we come to a general and crucial insight regarding the national accounting identities: they
are very useful, but can easily be used improperly.

1. Suppose that the government is running a budget surplus. Use the relevant sectoral
balance identity to indicate how this surplus could have originated.
2. Suppose that domestic investment exceeds domestic saving. Use the relevant sectoral
balance identity to indicate how this saving shortfall could have originated.
3. In 2019 several huge amounts (up to R70 billion) were given to Eskom by the National
Treasury as bail-outs to keep it running and to service its debt. At the same time, said
the Treasury, ‘growth is not coming through and tax revenues are not there: we are
in trouble’. Discuss the sectoral balance identity, the budget identity and fixed budgetary
commitments as constraints on the fiscal policy choices that the National Treasury faces.
4. Consider the current account position in South Africa at the moment and use the
relevant sectoral balance identity to indicate how this position can be absorbed in
the economy.
5. The current account recorded a deficit of R173 billion in 2018. Use the relevant
sectoral balance identity to show how this external imbalance could be absorbed in
the economy.

Addendum 5.1: National accounting definitions and conventions –
a student’s guide
The intricacies of national accounting match those of accounting for a private business
enterprise. As the name indicates, the System of National Accounts is an accounting
framework for the national economy. It is a complete accounting system, organised in a
number of separate accounts that are linked together and which must balance. The most
important accounts and concepts, for macroeconomic purposes, concern expenditure,
saving, production and income. All these take both the domestic economy and external
linkages into account.9
An important element of the SNA, and of the linkages, is the definitions of variables.
These definitions, which can be quite complicated, are governed by a number of national
accounting conventions. For the purposes of basic macroeconomic analysis, the following
distinctions are most important.
1. Measurement at ‘market prices’, ‘basic prices’ and ‘factor cost’, as in GDP at market
prices, GDP at basic prices and GDP at factor cost
This distinction relates to the way in which GDP is actually calculated, and the different
sets of prices used. Three sets are used in the national accounts: market prices, basic prices
and factor cost.
The first refers to a calculation looking at the market value or prices of the goods and
services produced, the second considers the effective price received by a seller, and the
third considers the income earned by production factors in the process (i.e. the cost of the
factors of production such as labour, capital and land).
Conceptually, these three appear to be the same. However, in practice, the presence of
different types of indirect taxes and subsidies implies wedges between market price,
effective (or basic) price and factor income (or factor cost). Therefore the SNA distinguishes
between (a) taxes ‘on products’, e.g. VAT or import duties payable on products as such,
and (b) other taxes and subsidies ‘on production’; the latter relate to taxes payable in the
production process, e.g. payroll taxes or licence fees.
For example, the presence of VAT means that the market price of bread is higher than the
price effectively received by the seller of bread. The indirect tax VAT must be subtracted from
the market price figure to get the ‘basic price’ value of the bread. However, the presence of
a payroll tax, for example, means that this basic price still is higher than the income those
involved in producing the bread (production factors such as labour, capital and land) will
really receive as gross income (i.e. before paying income tax). When this type of indirect
tax is deducted, one gets the value of production ‘at factor cost’. Similar arguments apply
to subsidies on products or production.
Therefore the total value of the production of bread calculated on the basis of market
prices will not equal the total value of bread production calculated on the basis of basic
prices or the income earned by bread producers. The difference is made up by the net tax/
subsidy figure.
9 See the relevant section in Mohr (2019) Economic Indicators for a more complete explanation.
Addendum 5.1: National accounting definitions and conventions: a student’s guide 235

The same principle applies to calculations of aggregate production in a country. Therefore:
GDP at market prices — taxes on products  subsidies on products  GDP (also known as
Gross value added) at basic prices
AND THEN
GDP at basic prices — taxes on production  subsidies on production  GDP (also known as
Gross value added) at factor cost
If GDP at market prices > GDP at factor cost, all the indirect taxes together (on products and
production) exceed total subsidies. In South Africa this is consistently the case, especially
with indirect taxes such as VAT and the fuel levy having become such important elements in
the national budget. In 2018, for example, GDP at market prices was R4 874 billion while
GDP at factor cost was R4 246 billion. GDP at basic prices was somewhere in the middle
of these two, at R4 341 billion.
What is ‘value added’?

Conceptually, value added simply is the total value of production. Gross value added
and gross domestic product (GDP) are therefore exactly the same concepts. In the national
accounts, whenever measurement of total value of production is made at either factor cost
or basic prices, the convention is to use the term gross value added rather than GDP. However,
this is only a terminological convention. It is perfectly proper to think of GDP at factor cost or
GDP at basic prices (compare the SNA table in section 5.6). Therefore:
GDP at market prices — taxes on products  subsidies on products  Gross value added (or
GDP) at basic prices
AND THEN
Gross value added (or GDP) at basic prices — taxes on production  subsidies on production
 Gross value added (or GDP) at factor cost
2. Domestic vs. national measures, e.g. as in gross domestic product (GDP) and gross
national income (GNI)
This relates to the geographic as against the citizenship basis of calculations:
❐ ‘Domestic’ refers to the gross production within the geographic borders of the country,
irrespective of whether South African citizens or foreigners (including migrant labour)
undertook the activity.
❐ ‘National’ refers to aggregate production by South African citizens, irrespective of
where in the world they do that. The production of foreigners within the country must
be subtracted, and the production of South African citizens working in other countries
added. The net figure is called ‘net primary income payments to the rest of the world’,
and constitutes the difference between GDP and GNI.
GDP at market prices — net income payments  GNI at market prices

If GDP > GNI ⇒ Net primary income payments to the rest of the world are positive
⇒ Foreign workers and companies in South Africa produce and earn more here than
South African residents and companies earn in other countries.
In South Africa, GDP is consistently higher than GNI. This is mainly due to large numbers of
migrant labourers from neighbouring countries, and large numbers of foreign companies
doing business here. In 2018, GDP was R4 874 billion while GNI was R4 684 billion (both
at market prices).
What is gross national income (GNI)?

Gross national income (GNI) is exactly equivalent to gross national product (GNP). GNP is a
well-established term in macroeconomics. However, the new System of National Accounts
prefers GNI. Both are proper whenever GDP is being adjusted for net primary income flows
across national borders (compare the SNA table in section 5.6).
GDP at market prices — primary income from the rest of the world  primary income to the
rest of the world = GNI at market prices
The equivalence of production, income and expenditure

The equivalence of aggregate expenditure, aggregate production and aggregate income is
a most fundamental principle in the national accounts. There are also three corresponding
methods to calculate the total value of aggregate output in an economy.
1. Via production: calculate the aggregate value added, in the production of goods and services,
by private enterprises, government and households.
2. Via income: calculate the aggregate income, before taxes, of all the factors of production
(= remuneration of employees plus operating surpluses of producing units).
3. Via expenditure: calculate the aggregate final expenditure on goods and services, i.e.
C + l* + GC + (X – M), where investment includes unplanned inventory investment.
In principle these should be equivalent. In macroeconomic theory, notably in explaining
the circular flow of expenditure and income, one of the basic insights is that the value of
aggregate production must equal the value of income received by the factors of production.
Therefore the terms ‘product’ and ‘income’ are treated as synonyms. In national accounts data
there is one complication, introduced by indirect taxes and subsidies (see above). This affects
the distinction between product and income. Hence indirect taxes and subsidies must be
factored into the equation (see 1 above).
3. Gross domestic expenditure (GDE) or expenditure on gross domestic product?

It is crucial to understand the difference between these similar-sounding terms.
Gross domestic expenditure (GDE) at market prices is the value of aggregate spending on final
goods and services by households, business entities and the government in the country in
a particular year or quarter. Both fixed capital formation and inventory investment are
included. GDE includes spending on imported goods (but excludes exports, i.e. spending by
Addendum 5.1: National accounting definitions and conventions: a student’s guide 237

foreigners on South African goods and services). Note that the residual term is included in
published estimates of GDE.10
GDE  C  I*  GC ( residual)
This is to be used when speaking of ‘total expenditure’ taking place in the country (despite
the fact that some of the expenditure will end up in the pockets of foreign producers). An
example is the relationship between the demand for money and total expenditure (total
transactions) in the country.
Expenditure on gross domestic product indicates the aggregate expenditure felt by domestic
producers. Expenditure leakages to other countries (imports) are subtracted from GDE,
and injections from other countries (exports) added.
By definition, expenditure on gross domestic product is identical to GDP (at market prices).
This reflects the expenditure method of calculating the value of gross output:
Expenditure on GDP  C  I*  GC  X  M ( residual)  GDP
Therefore this variable offers another way to read GDP from the SARB tables.
If one wishes to measure aggregate demand, in the sense of comparing it with aggregate
supply, only planned expenditure must be included. Inventory investment therefore must
be excluded in this case11 and the appropriate compilation is:
Aggregate demand  C  I  GC  X  M ( residual)
This is to be used when comparing ‘aggregate demand’ with present levels of domestic
production GDP.
10 See Mohr (2019) for an explanation of the residual term.

11 Of course, some inventory investment may be planned. Unfortunately there is no way of identifying the
planned portion.

A model for an inflationary economy:
aggregate demand and supply 6
■ use the aggregate demand (AD) and aggregate supply (AS) model to explain both
fluctuations in real GDP and changes in the average price level;
■ explain how the interaction between wage-setting and price-setting relationships
determines both a short-run and a long-run aggregate supply relationship;
■ analyse and assess the importance of the short-run supply adjustment process towards a
long-run, structural equilibrium and a long-run AS curve;
■ assess the importance of structural unemployment in determining the position and nature of
this long-run equilibrium, especially in a low- or middle-income country; and
■ compose complex chain reactions for an open economy which include effects on the price
level together with real GDP, and evaluate these chain reactions with appropriate graphical
aids.
As mentioned at the beginning of chapter 2, the original and relatively simple Keynesian
model paid scant attention to the average price level and inflation – the price level was
assumed to remain constant. The focus was on real income and unemployment.
The reason for this is that Keynesian theory (and macroeconomic theory as such) was
developed in response to high and sustained unemployment during the Great Depression.
While there were periods of inflation after that, they were never serious (at least until
the early 1970s). Therefore the basic Keynesian theory paid only limited attention to the
question of inflation, and only in a very circumscribed way. Below the full employment level
of Y the model shows unemployment, but no upward pressure on prices. If expenditure
is so high that the point of equilibrium is pushed beyond the full employment level of Y
– on the 45° diagram, the equilibrium is to the right of the full employment level of Y –
then there is no unemployment, but upward pressure on prices (inflation). Therefore, in
the simple Keynesian model there can be either unemployment or inflation – respectively
explained by deficient or excessive aggregate expenditure – but not both.
The stagflation experience of the 1970s, with high or rising inflation occurring simultan
eously with high or rising unemployment, placed a serious question mark over the tradit
ional Keynesian theory. As a result, it was adapted in order to try to find an explanation for
the phenomenon of stagflation.
Our objective in this chapter is to incorporate the average price level P into the various
interlinking relationships analysed so far. This is the purpose of the aggregate demand
(AD) and aggregate supply (AS) framework.
The derivation of the AD curve is the culmination of the expenditure theory of chapters
2 to 4, also utilising the IS-LM model. As a parallel to this, the aggregate supply (AS)
Chapter 6: A model for an inflationary economy: aggregate demand and supply 239

relationship will be developed in some depth by focusing on the labour market behaviour
of workers and businesses (firms) together with the aggregate production function. Both
a short-run and a long-run AS relationship will be identified. AD and AS through their
interaction determine the aggregate level of output and the average price level. (Inflation
will be discussed in depth in chapters 7 and 12.)
A complete circular flow (compare pp. 73; 76; 140)

The circular flow diagram has been progressively completed in the chapters so far. With
the concepts of aggregate supply and demand now introduced, as well as the average price
level as an explicit variable, a complete circular flow diagram can now be presented. Study
it carefully.
❐ The price level is indicated in the lower left-hand corner of the diagram. It is shown as
a leakage, in the sense that an increase in the price level implies a leakage (or dilution)
of real income: the larger a price increase, the less the quantity of real income left.
International
capital FOREIGN
flows COUNTRIES
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Ex
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EXPENDITURE e
Aggregate demand for goods and services Im
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+ Consumption
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+
C (X – INSTITUTIONS s
Government Saving
Supply of credit
expenditure
Investment Disposable
Interest Monetary RESERVE
rates income
policy BANK
Demand for credit
FIRMS
(Producers) HOUSEHOLDS
Aggregate supply of Government C
on (Consumers)
borrowing sum
goods and services
cre dit er c
rcial (deficit) redit
Comme
T
VA
or ,
ax
C
po GOVERNMENT
ra te t (Budget and fiscal et
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Changes in
average price level
REAL INCOME
Remarks
1. In chapters 2 and 3 you were introduced to the distinction between nominal and real
values. This distinction becomes particularly important the moment the price level is
recognised and used as a variable. Expenditure and income aggregates (and data) can
240 Chapter 6: A model for an inflationary economy: aggregate demand and supply

be expressed in terms of their present monetary value, i.e. at current prices. Then we
speak of nominal GDP, C, I, Y, etc. If these aggregates are adjusted to eliminate the
effect of inflation, then we are working with real GDP, C and so forth, i.e. at constant
prices.
2. One way to eliminate the effect of inflation is to divide nominal values by a suitable price
index (this is known as ‘deflating’). Another method is to express all amounts in terms
of a base year, for example 2010 rands.
3. As far as interest rates are concerned, the rate normally quoted by banks is the nominal
rate i. The real interest rate r can be calculated (approximately) by subtracting the rate
of inflation from the nominal rate of interest (see the introduction to chapter 2 on the
relationship between real and nominal values, as well as chapter 2, section 2.2.2 for
details on the calculation of the real interest rate).
4. The difference between real and nominal values is extremely important and must be
borne in mind at all times, otherwise incorrect conclusions and arguments may follow.
This distinction is especially important when working with published data.
5. Normally the symbols (Y, C, etc.) indicate real values. The only exception is the money
MS
supply, where the real money supply is denoted by   P   . The real money supply will be a
very important variable in this analysis.
Real and nominal data and price indices

❐ The national accounts section in the Quarterly Bulletin shows all expenditure
DATA TIP
components, income and product (GDP) in both real and nominal terms.
❐ Price indices (CPI, PPI) can be found in the section ‘General economic indicators’,
while inflation rates are shown in the section ‘Key information’.
❐ Real interest rates and real money supply data are not published by the Reserve Bank.
❐ Balance of payments data also are only available in nominal terms.
6.1 Essentials of the AD-AS model

You will recall that the traditional Keynesian model was a demand-determined model (see
chapter 2). It focused on explaining short-run fluctuations in real domestic income Y and
employment by considering fluctuations in aggregate expenditure (or aggregate demand).
❐ Recall that we defined the short-run as a period of usually up to three years. In section
6.3.3 we will encounter adjustments on the supply side of the economy that occur
in the so-called medium term. This can be thought of as lasting a further three to
seven years. The average for both processes, allowing for some overlap, typically is
approximately four to seven years. Short- and medium-term changes and adjustments
are frequently discussed in the context of business cycles with reference to ‘booms’ and
‘busts’, ‘upswings’ and ‘downswings’.
❐ Both the short- and medium-term periods can be distinguished from the very long
run, with a time horizon measured in decades, which is the topic of economic growth
(chapter 8).
Throughout the unfolding exposition of the Keynesian model – both for the closed and the
open economy – it was assumed that the supply side of the economy would respond effortlessly
to any change in demand. Also, the price level was assumed to be constant. We must now relax
these two assumptions.
6.1 Essentials of the AD-AS model 241

The AD-AS model is a powerful analytical tool to focus on the price level, while retaining the
important focus on real income Y. The basic purpose of the aggregate demand-and-supply
model is to recast the analysis of the real and monetary sectors (encountered in chapters 2
to 4) in one diagram that explicitly isolates the average price level P as a variable on one axis.
Real income Y appears on the other axis (see figure 6.1).
The AD-AS model therefore summarises the traditional theory in one diagram. However,
it also expands that theory to incorporate the systematic explanation of the behaviour
of firms and workers on the production, or supply, side of the economy. The supply and
demand sides of the economy together then determine the average price level P. In this way,
the AD-AS model overcomes two of the major weaknesses of the traditional Keynesian
model in an inflationary context.
In essence, the entire analysis of the Figure 6.1 Simultaneous determination of real income
and the price level
traditional ‘demand-side’ model – the
45° diagram threesome as well as the P
ASLR ASSR
IS-LM and IS-LM-BP diagrams – is
collapsed into one curve, the aggregate
demand (AD) curve. The AD curve has Short-run
a negative slope, as shown in figure 6.1. equilibrium
after
The aggregate supply (AS) curve is 1 demand
P1
stimulation
then added to represent the supply side 0
P0
(or producer side) of the economy and
allows for disturbances and chain re
actions to originate on the supply side, AD0 AD1
or for supply-side factors to modify the
anticipated consequences of demand-
side occurrences. To explain short-run YS Y1 Y
fluctuations we will use the short-run
AS or ASSR curve. It has a positive slope, as shown in the diagram in figure 6.1.
Together the ASSR and AD curves simultaneously determine the short-run equilibrium levels
of real income Y and the average price level P. This equilibrium is at the intersection of the two
curves (see figure 6.1).
❐ Any disturbance will shift one or both of the curves, leading to a new intersection and
a new equilibrium level of Y and P.
❐ For instance, diagrammatically, an increase in government expenditure will be reflected
in a rightward shift of the AD curve. The diagram shows the result to be both an increase
in Y (i.e. real GDP) and an increase in the average price level P: the equilibrium moves
from point 0 to point 1.
In this way the model provides a diagrammatical explanation of short-run changes in the
price level together with short-run changes in the level of real GDP.
❐ However, the model also shows a new category of change: adjustments on the supply
side of the economy that occur over a somewhat longer time span, which we call the
medium term.
❐ To understand these supply adjustments, we will develop a second AS curve, i.e. the
so-called long-run AS curve, or ASLR. In the medium term the long-run AS relationship
has a strong influence: the short-run equilibrium will be pulled towards the ASLR curve
through adjustments of the ASSR curve.

All this will become clear in this chapter. The derivation of the AD and both AS curves
is explained below. As always, we will stress that the economic chain reactions and reasoning
are more important than the diagrammatical analysis. However, given the complexity of
these curves, substantial energy will go into explaining the derivation and properties of
the curves. This is followed by an extensive demonstration of the use of these curves to
support reasoning about economic events and policy.
6.2 Aggregate demand (AD)

6.2.1 What is the aggregate demand relationship? How is it derived?
One definition of the aggregate Figure 6.2 Deriving the AD curve from the 45° diagram
demand relationship is simply that
it shows, for each price level, the E
Equilibrium points
aggregate quantity of goods and for different price
levels
services demanded in the economy.
While this is a useful interpretation,
it is not entirely correct. This is
(C + I + G + X – M)P0
apparent from the way the aggregate
demand relationship is derived (C + I + G + X – M)P1
directly from the Keynesian expend-
iture model and the 45° diagram, as
described below (and in figure 6.2).
You will recall that a particular
45° diagram is drawn for a given,
Y
constant price level, and shows a
particular equilibrium level of real P
income. Suppose that initially the
economy is at equilibrium income
level Y0, with the associated price
level being P0. This can be depicted Points on the
aggregate
as point 0 in the P-Y plane. demand curve
Suppose the price is at a higher
level P1. For several reasons (ex
1
plained in section 6.2.3) a higher P1
average price level implies a lower P 0
0
level of aggregate expendi ture
(C + I + G + X – M). Allowing for the AD
secondary, money market effect of a Y1 Y0 Y
change in expenditure and income
(see chapter 3, section 3.2.2), the
net effect would be that the aggregate expenditure line now lies below the initial line, and
the equilibrium level of real income would also be lower at Y1 (showing the net effect on
Y). This produces point 1 in the P-Y plane.
❐ A similar analysis follows for a lower price level.
❐ Connecting these and other such points yields the AD curve.
6.2 Aggregate demand (AD) 243

The aggregate demand curve there fore shows, for various average price levels, the
corresponding equilibrium level of expenditure/income – under the assumption that supply
would respond automatically to meet changes in expenditure.
Formally, the AD curve can be defined as follows:
The AD curve shows all combinations of real income Y and the average price level P at which
there would be simultaneous equilibrium in the real and monetary sectors.
Another important way of under
Essentially, each point on the AD curve is a little ‘black
standing the aggregate demand
box’ containing a 45° diagram with its own price level
curve is to see it as a collection of
and levels of expenditure and hence equilibrium real
points of potential equilibrium, each income Y. A different level of Y implies a different 45°
at a different price level, under the diagram with a different equilibrium Y – and therefore a
assumption that no supply-side different point on the AD curve.
constraints are present.
❐ In the discussion that follows
we will show that supply considerations actually limit the choice between these po
tential equilibrium points. (This interpretation will become clearer once the aggregate
supply curve has been discussed.)
6.2.2 What determines the slope of the aggregate demand curve?

As noted above, the expected slope of the AD curve is negative. Several reasons can be
given why an increase in P can be expected to lead to a decrease in aggregate expenditure,
i.e. why a negative relationship can be expected to exist between aggregate demand and
the average price level P.
1. The interest rate effect: An increase in the average price level P contracts the real money
  MP   ; this forces interest rates upwards, which is likely to depress expenditure.1
S
supply 
2. The wealth effect: A higher average price level diminishes the real value of assets;
people become less affluent and expenditure is discouraged.
3. The foreign trade effect: A higher domestic price level discourages export expenditure
(and encourages imports), so that aggregate expenditure decreases.
4. The tax effect: When personal income increases in periods of increases in the average
price level (i.e. inflation), taxpayers are pushed into higher personal income tax
brackets (so-called bracket creep). This curbs disposable income and thus expenditure.2
The real income effect is often cited as an additional factor: a higher average price level
lowers the real value (real purchasing power) of people’s income and thus their capacity
to spend. There is no agreement on
the validity of this argument. It is
Recall the formal rule for shifting vs. moving along
applicable only if the ‘price level’ a curve. A curve shifts if a relevant variable not on
is understood not to include the one of the axes of the diagram changes. If one of the
price of labour and other factors of variables on the axes changes, there is a move along
production, i.e. only prices of final the curve.
goods and services are included
1 Equivalently, one can consider the money market in nominal terms. In this case, an increase in the average price level
increases the nominal value of transactions. This increases the nominal demand for money. For a given nominal money
supply, an increase in the price level is likely to put upward pressure on interest rates. See chapter 3, section 3.2.
2 This is true only in countries where progressive income tax systems are used, which is the case in most Western
countries. See chapter 10.

(as is done in the calculation of the Figure 6.3 Deriving the AD curve from the IS-LM diagram
consumer price index). It may be safer not r
to use this argument. Equilibrium points for
different price levels
Graphically, any change in P, or any
LMP1 LMP0
change in expenditure that is exclusively
brought about by a change in P, leads to
a movement along the AD curve. Usually 1
such a change in P is the endogenous
0
result of a shift in the AD or AS curves.
6.2.3 Deriving the AD curve from the

IS-LM model IS
The derivation of the AD curve can also

Y
be shown in the context of the IS-LM
model. This has the benefit that it clearly
P
shows the secondary, money market
effects associated with changes in the
IS-LM diagram.
Recall that the LM curve is always drawn Points on the aggregate
for a particular (constant) price level. demand curve
Either of two arguments can be used to
show the impact of a different price level
1
on the internal economic equilibrium P1
shown by the intersection of the IS and 0
P0
LM curves. The first is couched in real
terms, the second in nominal terms: AD
1. A higher price level implies a lower Y1 Y0
MS
real money supply   P   
, which shifts
the LM curve left; or
2. A higher price level implies a higher nominal value of transactions. This increases the
nominal (transactions) demand for money MD, for a given nominal money supply. This
shifts the LM curve to the left (see figure 6.3).
Suppose that initially the economy is at equilibrium income level Y0, with the associate
price level P0. This can be depicted as point 0 on the P-Y axes.
Suppose the price level is at a higher level P1. This implies a lower real money supply
S
M
 
1
P    . Expressed diagrammatically, this is a leftward shift of the LM curve from the initial LM
curve. The result is a different equilibrium with a higher interest rate and a lower level of
real income Y1. This produces point 1 in the P-Y plane.
❐ Connecting these and other such points yields the AD curve.
This derivation can be supplemented with an analysis of the wealth, foreign trade and tax
effects of a higher price level. These reduce expenditure, and are reflected in a shift to the
left of the IS curve, in addition to the leftward shift of the LM curve already shown in the
diagram. The combined effect would be a (larger) decline in the equilibrium level of real in
come Y. The addition of the IS curve to the analysis therefore confirms the diagrammatic
conclusion regarding the slope of the AD curve. (The IS effect is not shown in the diagram.)

6.2.4 How steep is the AD curve?
The steepness of the AD curve can best be understood by considering the first reason for
its negative slope in section 6.2.2, i.e. the fact that an increase in the average price level P
 MP   . Since this is analytically equivalent to a contractionary
S
decreases the real money supply 
monetary policy step, the analysis in chapter 3 (section 3.2.1) relating to the factors
affecting the potency of monetary policy is relevant here. These were the interest sensitivity
of money demand, the interest sensitivity of investment (capital formation), and the size
of the expenditure multiplier.
The reasoning can be applied as follows:
❐ If the interest sensitivity of money demand is low, monetary contraction will have
a large impact on the real economy. In the derivation of the AD curve, for a given
M S
increase in P (and thus a decrease in  P  )
  , Y will decline a lot. Hence the AD curve will
be relatively flat.
❐ If the interest sensitivity of investment is high, monetary contraction will have a large
 MP   ), Y will
S
impact on the real economy. Therefore, for a given change in P (and thus in 
decline a lot. As a result, the AD curve will be relatively flat.
❐ If the expenditure multiplier is large, the drop in investment (capital formation) caused
by monetary contraction (via interest rate increases) will have a large impact on the
M S
real economy. For a given change in P (and thus in   P  )
  therefore, Y will decline a lot.
Consequently, the AD curve will be relatively flat.
Conversely, the AD curve will be steep if one or more of the following is true:
❐ the interest sensitivity of money demand is high;
❐ the interest sensitivity of investment is low; or
❐ the expenditure multiplier is small.
Deriving the AD relationship mathematically π

Recall from chapter 3 that when we substituted the LM relationship into the IS relationship,
we found an equation for the level of real income Y at which both the goods and money
markets will be in equilibrium. Chapter 4 then added the foreign sector. More formally we
had:
Y  1(a  Ia  G  X – ma)  2 __ ( M
S
)
  P   + l  ...... (4.6)
where: K
1  ________
 1 + K Ehk/l
   
 
E
......(4.6.1)
  KEh    
2  ______
l + KEhk
It now transpires that this equation for the equilibrium level of Y is nothing but the equation
for the AD curve, given the equations in our model as derived in the last several chapters –
where P now is a variable (having been treated as constant in the equations of chapters 3 and
4). It shows an inverse relationship between P and Y, hence the negatively sloping AD curve.
A higher price level P implies a smaller real money supply and therefore a smaller level
of Y.
❐ The slope parameter 2 contains several responsiveness parameters and multipliers
(k, l, h, KE).
❐ The position of AD depends on several autonomous expenditure components
(a, Ia, X and ma) and exogenously determined policy variables (G and MS).

In a more complete and more Figure 6.4 Shifts of AD originate in IS-LM changes
complex analysis, it can also r
be demonstrated that the
AD curve will be flatter if
the income sensitivity of the LM1 LM2 LM0
demand for money is lower. 1
r1
Another factor flows from BP1
the open economy context. If
2
exports and imports are very r3 3 BP0
sensitive to domestic price 0
r0
level changes, the AD curve
will be relatively flat. This
implies that the AD curve
will be flatter for an economy
that is relatively more open. IS1 IS0
6.2.5 Which factors shift Y1 Y3 Y2 Y0 Y

the AD curve? How far
does AD shift?
P
Any factor other than P (or Changes in Y (due
Y) which affects aggregate to shifts of IS and
expenditure will lead to a LM) translate into
equivalent horizontal
shift in the AD curve. shifts of AD, at every
❐ Any stimulating factor price level.
would increase aggregate
demand (and vice versa
for a contractionary
factor). In the diagram, P0
any non-price stimulation
of expenditure would
cause the AD curve to
shift to the right. Factors
that contract expenditure
would shift the AD curve Y
to the left.
❐ All the internal factors (real and monetary) and external factors that influence ag
gregate expenditure also influence aggregate demand. These include monetary and
fiscal policy measures, expectations, external shocks, interest rates, exchange rates,
etc. Changes in any of these factors would therefore shift the AD curve.
❐ The three illustrative examples analysed in chapter 4 (section 4.5) are all relevant here.
Both expansionary fiscal policy and expansionary monetary policy would be reflected
in the diagram as a rightward shift of the AD curve. Contractionary policy would shift
the AD curve left. A surge in exports would shift the AD curve right.
❐ More specifically, any change in the equilibrium level of Y (due to real, monetary or
external disturbances or adjustments) – except due to a change in the average price
level P – will shift the AD curve by exactly the same amount.
The diagram in figure 6.4 copies the IS-LM-BP dynamics of an increase in the repo rate
from chapter 4, section 4.7.5.

The fluctuating short-run equi-
librium values of Y (on the Note the typical pattern generated by the two BoP
horizontal axis of the IS-LM- effects following a BoP surplus: first the LM and AD
curves shift right (money supply effect), then the IS,
BP diagram) show the different
BP and AD curves shift left (exchange rate effect).
phases and impacts of the repo
❐ The AD curve shifts right then left. The final, net
change (from point 0 to point 1, effect of the two BoP effects on the position of
which include the money market the AD curve often appears to be relatively minor.
secondary effect) plus the two
secondary BoP adjustment effects For a BoP deficit a contrasting typical pattern is
generated. First the LM and AD curves shift left
(from point 1 to 2 and again to 3),
(money supply effect), then the IS, BP and AD curves
on the equilibrium value of Y –
shift right (exchange rate effect).
all in an exclusively demand-side ❐ The AD curve shifts left then right.
model.
When this result is transferred to
the P-Y axes, it reflects as corresponding horizontal shifts in the AD curve – still under the
assumption of a constant average price level P. The net shift in AD is indicated by the blue
curve.
When the aggregate supply curves are added to the AD curve in section 6.3, we will see
changes in Y resulting. These will impact on the final, net change in equilibrium real income
Y (together with Y).
Policy potency
The analysis of policy potency can also be transferred to explain the magnitude of any
shift in the AD curve:
❐ If fiscal policy is very potent, the AD curve will shift relatively far if an expansionary
fiscal step occurs.
❐ Likewise, if monetary policy is potent, the AD curve will shift relatively far when mon
etary expansion occurs.
Again, the analysis in chapter 3 (section 3.3.7) can be applied. It identified underlying
characteristics of an economy that determine the potency of fiscal and monetary policy steps.
These were the interest sensitivity of money demand, the income sensitivity of money
demand, the interest sensitivity of investment, and the size of the expenditure multiplier.
Any of these that make fiscal or monetary policy potent would lead to the AD curve shifting
further (for a given real or monetary expansion).
For example, any of the following will cause the AD curve to shift relatively far if fiscal
expansion occurs:
❐ a high interest sensitivity of money demand;
❐ a low income sensitivity of money demand;
❐ a high interest sensitivity of investment, or
❐ a large expenditure multiplier.
Similar results can be derived for the magnitude of the shift in AD due to monetary
expansion.

6.3 Aggregate supply (AS)
The explicit introduction of an aggregate supply relationship is aimed at correcting a
previous simplifying assumption, namely that supply (or production) automatically and
effortlessly reacts to all fluctuations in expenditure. Problems on the supply side often
prevent, hamper or modify the anticipated impact of changes in expenditure on Y. Also,
macroeconomic disturbances and problems can originate on the supply side.
❐ The supply side of the macroeconomy implies a constraint on the role of expenditure
(i.e. demand) in determining the equilibrium level of real income Y, and allows for
independent supply-side factors to impact on the economy.
❐ Therefore, before the expected consequences of changes in expenditure can be spelt
out, one must consider the quantity of aggregate production which producers in the
economy (a) are prepared to, and (b) are able to deliver, given supply-related circumstances
and behaviour.
These considerations are represented by the aggregate supply (AS) curve, which can be
defined formally as follows:
The AS curve shows, for each price level P, the aggregate level of real output Y that producers
are willing or able to supply.
As will be explained below, the AS curve can be interpreted as a set of attainable
combinations of P and Y, given supply-side conditions.
Which factors determine aggregate supply?

The main factors that determine, in the aggregate, the ability and/or willingness of firms to
produce output are the following:
❐ size of the labour force (and thus also population growth);
❐ productivity of labour;
❐ labour skills levels (and thus education and training);
❐ cost of labour (wages);
❐ availability of raw materials;
❐ cost of raw materials;
❐ availability of capital goods (and thus investment);
❐ cost of capital goods;
❐ technology (which increases the productivity of labour and capital goods);
❐ cost of financial capital, i.e. interest rates;
❐ exchange rates (which affect the cost of imported inputs), and
❐ actual and expected prices.
Some of these factors impact on supply in the short run (i.e. in the cyclical context), while
others only take effect in the medium to very long run (i.e. the economic growth context).
The long run and the short run

Although this general definition of aggregate supply is true in general, the discussion of
aggregate supply needs to distinguish between aggregate supply in the short run and in
the long run. The difference is defined by the introduction of expected prices (and expected
real wages). In particular (a) that there could be, at times, a difference between expected
prices and actual prices, but (b) over time such a difference should disappear – it will not be
sustained in the long run. In other words, expected prices will be assumed to equal actual
prices in the long run, but in the short run there can and often will be a deviation.
6.3 Aggregate supply (AS) 249

In fact, this is how we will define long run and short run for purposes of the AS curve:
❐ The long run is when, following some disturbance, sufficient time has elapsed for any
mistaken price expectation to have corrected itself so that the expected average price level
P e is the same as the actual average price level: P = P e.
❐ The short run is when this has not yet happened: the expected average price level is not
equal to the actual average price level: P ≠ P e.
This distinction will be critical in understanding aggregate supply behaviour, as the
discussion below will show:
❐ Aggregate supply in the long run indicates combinations of P and Y where the actual
average price and wage equal the expected average price and wage.
❐ When, due to some economic factor or disturbance, the actual average price and real
wage deviate from the expected average price and real wage, other combinations and
levels of P and Y can and will occur. This is aggregate supply in the short run.
(Note that, for ease of exposition,
we will from here on just talk of How long is the short run? And the long run?
‘prices’ and ‘wages’ to indicate It is risky to specify hard time frames for such
the ‘average price level’ and the indications of time periods, since economic
‘average wage level’.) behaviour and macroeconomic reactions vary across
Both the long-run and short-run time and countries. Nevertheless, it is helpful to
adopt some approximations, as follows:
aggregate supply curves show
1. The short run is normally assumed to cover a
levels of output that producers are
period of up to three years.
willing to supply. The difference 2. The period necessary for price expectations
between the relationships is that to adjust fully so that the ‘long-run’ position is
in the short run producers can reached is normally assumed to be a further
and probably will supply more (or period of between three and seven years.
less) than the long-run level of
The typical average for both processes, allowing for
output. They will do so if actual
some overlap, is approximately four to seven years.
prices and wages for a certain
period allow for higher (or lower)
profits, since such higher (or lower) profits create an incentive to supply more (or less).
However, as will also be shown below, these deviations are likely to persist only for a limited
period of time (which could be several years), since expectations will catch up – and ag-
gregate supply will eventually return to the long-run level.
As will be seen in section 6.3.3, explanations of the reasons for actual prices to deviate
from expected prices – i.e. reasons why expectations turn out to be mistaken – are central
to understanding the short-run aggregate supply pattern in the economy. Imperfectly
anticipated economic events, disturbances and shocks can be seen to translate into
sometimes prolonged deviations between actual and expected prices. Aggregate supply will
accordingly deviate substantively
from the long-run level of output The maths of aggregate supply
for considerable periods of time –
The derivation of the aggregate supply relationships
depending, as we will see, also on
and curves requires more mathematics than was the
the state of aggregate demand at case with aggregate demand. In the exposition that
the time (see section 6.4). follows, basic equations will be shown in the text,
❐ We will also see that even but more advanced equations and derivations will be
the long-run level of output shown in maths boxes.
as such can also vary due to

economic factors, implying that the graphical position of the ‘long-run’ aggregate
supply curve is not stationary or permanent (even before we consider the impact of
economic growth, which is considered in chapter 8).
Preview
The core of the theory of aggregate supply can be summarised as follows:
❐ At the beginning of a period, firms decide/plan what amount they will supply at the price
level that they expect. Workers do the same in terms of the amount of labour services that
they are contracted to supply to the firm in exchange for the wage rate that they expect.
Should their price and wage expectations turn out to be correct, all parties will supply what
they wanted to supply, and hence no party desires to adjust its supply of goods or labour
services in that period.
❐ If, however, actual prices in the period exceed expected prices, real wages (and real wage
costs of the firm) will in effect fall short of expected real wages and costs. Because the
lower real wage costs increase profits, firms are willing and keen to supply more goods,
and will do so. However, once wage negotiations occur at the beginning of the next period,
real wages can and are likely to adjust, thereby eradicating some or all of the increase in
profit and hence causing the firm partially or fully to reverse the increase in the supply of
goods. (Analogous but reverse changes occur when actual prices fall short of expected
prices.)
❐ Thus, the changes in supply that result from actual prices falling short of, or exceeding,
expected prices are only short-run, temporary changes – arising from ‘temporary mistaken
expectations’ regarding prices (and thus real wages).
❐ In the longer run, after expected prices and wages have had time to catch up with actual
prices and wages, output will eventually return to the level where actual prices and wages
equal expected prices and wages. Expectations are assumed to be self-correcting in the
long run and thus there are no mistaken expectations in the end.
❐ This level of output to which supply tends to return in the long run – amidst short-run
fluctuations and deviations – will be called the long-run level of output, or long-run supply.
It is denoted graphically as the long-run aggregate supply curve (ASLR ).
❐ The pattern of output resulting when supply diverges from the long-run output level is the
short-run aggregate supply curve (ASSR ).
6.3.1 Deriving aggregate supply – the labour market

What determines the level of output that producers are willing to supply, either in the
‘short run’ or in the ‘long run’? The answer lies in the link between profit, output prices
and input prices. Producers of goods pursue profit, i.e. they want the difference between
the price per unit and the cost per unit that they produce to be sufficiently large, or even
as large as possible. Thus, how much producers supply will depend on the relationship
between the prices that they can charge and their cost of production, and how these vary
over time.
The price-setting (PS) relationship

A more formal way to state the link between prices and cost is to consider the price-setting
(PS) and wage-setting (WS) relationships. The PS relationship indicates how producers set
their prices, taking wages (labour cost) as the most important cost. The PS relationship
assumes that prices are set as a mark-up over wage cost, i.e. a producer determines her wage
cost and then adds a mark-up (margin) to set the price of the goods. The mark-up includes

provision for profits but also for the cost of other (non-labour) inputs and also taxes.
Changes in non-labour costs and taxes would thus impact on the size of the mark-up.
❐ One could alternatively define the mark-up as a pure profit mark-up (i.e. to exclude taxes
and the cost of other inputs) over all costs (i.e. expenditure on all inputs as well as taxes).
However, this would complicate the discussion below without adding additional insight.
Labour cost (i.e. wage cost) is chosen as the base for the mark-up because it is usually the
largest running expenditure item of firms.
❐ Note that the PS relationship assumes that producers are price setters and not price
takers in goods markets. That is, goods markets are assumed to be not completely
competitive, so that sellers have market power to set prices.
Formally, the PS relationship can be stated as:
W
P = (1  μ) ____
    
Q(N)
...... (6.1)
where P is the price level, μ is the mark-up (denoted as a fraction) over labour cost, W is the
nominal wage level and Q is an indicator of labour productivity (which can be measured
as the volume of output that a worker produces on average). Thus, __
W
 Q  is a measure of
the labour cost per unit of output. Q is written as a function of N since the marginal
productivity of labour declines as employment N increases (see the discussion of the total
production function below).
❐ Equation 6.1 can represent the behaviour of a single business or that of all firms in
the economy together. It is in the latter, aggregate sense that we will use it in this book.
Thus the mark-up, for instance, will be interpreted as the average mark-up in the entire
economy.
Equation 6.1 can be interpreted as follows. (A graphical representation of the PS relation
ship will be shown later.)
❐ A higher nominal wage W implies a higher cost per unit produced, and should lead to
a higher price P being set.
❐ Higher labour productivity Q implies a lower cost per unit produced – and should cause
the price P that a producer will charge to be lower. Because, in general, the marginal
productivity of labour decreases as a firm employs additional labour, Q (which can be
defined as the average product per worker) will be lower at higher levels of employment
N. (Labour productivity also depends on factors such as the managerial skills of the
producer and the skills and capacity of the workers, as well as the capital goods,
technology and enabling economic institutions available to workers.)
❐ The mark-up is likely to be higher if producers have more market power. If a producer
is a monopolist, or if a group of producers band together in a cartel, they have more
market power compared to producers in a competitive market.
❐ The mark-up is likely to be higher if non-labour input costs (including the cost of raw
material, energy, the depreciation of capital and so forth) are higher.
❐ The mark-up is also likely to be higher if taxes such as corporate taxes and VAT are
higher.
However, this leaves unanswered what determines the wage. For that, we need to consider
wage-setting behaviour in the economy in the aggregate.
The wage-setting (WS) relationship

The wage-setting (WS) relationship indicates how, on an aggregate level, nominal wages
are set – or contracted – by workers or worker organisations in their interaction with

employers/firms. It is assumed that wages are not set in a competitive labour market, but
in a typical modern labour market characterised by collective bargaining, labour unions,
monopolistic and monopsonistic behaviour, minimum wage legislation and so forth.
Such contracts typically determine wages and other employment conditions for one to
three years.
❐ This is quite important, because it can cause fixed nominal wage contracts to be based
on an expected price level (and expected cost of living) that becomes outdated if and
when the actual price level changes unexpectedly due to an economic disturbance.
Unexpected price movements have major implications for the production decisions and
thus supply behaviour of firms, as will be shown in the discussion that follows.
Several factors are relevant to understanding wage-setting behaviour:
❐ The expected price level P e , which is an indicator of the expected cost of living in
the upcoming contract period, is a key determinant of wage-setting behaviour. If
increases in the cost of living are anticipated, workers will want a higher nominal wage
to compensate for the higher price level P (and in effect leave their future real wage
unchanged).
❐ General labour market conditions in terms of the rate of unemployment U are also
relevant. This is a reflection of the aggregate level of employment N relative to the labour
force LF. Lower levels of employment (which imply higher rates of unemployment U)
are likely to cause downward pressure on wages. Lower rates of unemployment are
likely to cause upward pressure on wages.
❐ A third causal factor comprises the various institutional aspects of labour markets,
mostly pertaining to the level and nature of unionisation, government labour institu
tions and legislation, unemployment and other benefits, and so forth.
Formally, the WS relationship can be formulated as:
W = P e  f(N; Z) ...... (6.2)
where W is the nominal wage and P e is the expected price level, N is the employment level
and Z captures institutional factors in the labour market (to be discussed later).
❐ The employment level N and the unemployment rate U are inversely related, as follows.
The unemployment rate U is defined as the difference between the total labour force
LF and N, the number of the employed, expressed as a fraction of the labour force:
(LF – N)
U =  LF    .
 
Equation 6.2 indicates that, for a given expected price level, a higher employment level N
causes a higher nominal wage W:
❐ For a given labour force, a higher level of employment N will mean a lower rate of
unemployment. A higher level of employment will reduce rivalry among the unemployed
(i.e. workers become more scarce and their bargaining power is strengthened), and thus
put upward pressure on the wage level. Therefore, higher levels of employment are
associated with higher levels of the nominal wage W. There is a positive relationship
between N and W.
❐ Conversely, the higher the unemployment rate U, the lower is the employment level and
thus the number of people employed. More of the unemployed are competing for the
number of available job vacancies and their bargaining power is weaker. This will put
downward pressure on wages. Again, there is a positive relationship between N and W.
❐ If the labour force LF as such grows, this will also put downward pressure on wages.

As far as the institutional factors in the labour market (indicated by Z) are concerned, one
can note the following:
1. Labour unions: In many labour markets there are labour unions that negotiate on
behalf of all or a substantial proportion of the workers. Such workers do not compete
with each other in their negotiations with employers. Rather, they band together
(like a cartel) to negotiate through their labour union. Such a labour union may then
exploit their market power and strong bargaining position to act as a monopolistic
seller of labour services. This is likely to cause the wage to be higher than it would be
in the absence of the unions (i.e. in a more competitive labour market).
❐ Of course, although employers may have to pay the higher wages, they may decide
to employ fewer workers.
2. Employer organisations: Employers in an industry can band together in an industry
association or employer’s organisation to be the sole buyer of labour services. (A sole
buyer is called a monopsonist.) The market power and strong bargaining position of
employers may result in workers being paid a lower wage than it would have been in a
more competitive market. If there are organised unions it implies bargaining between
two powerful organisations.
3. Efficiency wages: Efficiency wages are wages that are higher than the wages that
would otherwise be paid in a competitive labour market. Employers may choose to
pay such a premium in order to elicit higher levels of efficiency and productivity
from workers. Although this increases the unit cost of labour, the higher output
per worker implies that fewer workers are required.
4. Unemployment and other benefits: Many governments pay unemployment benefits and
other benefits such as disability grants. These could serve as a disincentive to seek
employment, since the unemployed will not accept employment at a wage below the
monthly unemployment benefit they could receive from government. Thus the benefit
implies a floor below which the wage cannot go. Higher unemployment benefits imply
a higher wage floor (and that more people may choose to remain unemployed or
outside the labour force).
❐ Social security and income grants may have similar disincentive effects. In addition,
both employees and employers may have to contribute to the fiscus or to social
security funds to finance these benefits, thereby increasing the effective cost per
worker.
5. Minimum wage legislation: Labour legislation may stipulate a minimum wage, some
times for specific sectors. This wage may be higher than the wage rate would have
been in the absence of the labour legislation, thereby increasing the effective cost per
worker. It could also reduce the number of people employed by employers.
Generally, the nominal wage W will be set higher the larger the effect of unionisation, the
smaller the effect of employer organisations, the more prevalent the payment of efficiency
wages, the higher the level of unemployment benefits, and the higher the minimum wage.
While the combined effect of these institutional factors can be quite complex, they all
impact – together with the unemployment situation and the expected price level – on the
nominal wage that will be set for those employed.
Diagrammatical depictions of the price-setting and wage-setting relationships

To show these two relationships on one diagram requires some manipulation of the
equations (without changing their real meaning). Equation 6.2 can be rearranged as

W
equation 6.3, which shows the expected real wage,  P    (because P is the ‘expected’ price
e
e
level) as a function of employment N and the institutional factors Z:

__W
  P   = f(N; Z) ...... (6.3) [Indirect WS relationship]
e
Figure 6.5 is a diagrammatical representa Figure 6.5 The wage-setting and labour supply curves
tion of equation 6.3, with the expected real
wage on the y-axis and employment on   W
  P
   WS
the x-axis. Given the positive relationship
between N and W discussed above, the WS
curve will have a positive slope.
❐ It must be understood that wage
negotiations and wage setting occur LS once a
in terms of a nominal wage, not the nominal wage
implied real wage. However, whether or has been set
not workers explicitly factor in their cost

of living or expected changes in the cost
of living, in effect an expected real wage
is being set – and an actual real wage
will be determined as P is established by N
price setting in the future.
❐ WS as written in equation 6.3 can be viewed as analogous to a labour supply
relationship, but one must remember that the context of the WS relationship is one of
wage setting through collective bargaining by workers and unions and not ‘competitive’
or ‘atomistic’ labour markets that clear, as usually assumed in labour supply theory.
❐ In addition, since wages are not determined by supply and demand continually and
recurrently, once the nominal wage has been contractually set, the WS relationship
becomes dormant until the next round of wage bargaining. The wage-setting
relationship thus is ‘active’ only at the time of bargaining and wage setting, since it
captures the underlying desired wage-and-work pattern of workers.
❐ The set nominal wage W becomes the price of employable labour for the duration of the
contract period, e.g. one to three years.
❐ This implies that the post-bargaining labour supply curve (LS) effectively is horizontal at the
level of the contracted implied real wage. (We will return to the LS curve when we analyse
the labour market and aggregate supply in the short run in section 6.3.3 below.)
Earlier we noted that the volume of output supplied by producers depends on the
relationship between the prices that they can charge and their cost of production,
especially labour costs. To see how price setting relates to wage setting, we need to relate
equations 6.1 and 6.3. We rewrite equation 6.1 so that its left-hand variable is similar
to the left-hand side of equation 6.3:
__W 1
  P  = ____ Q(N)
 1 + μ   ...... (6.4) [Indirect PS relationship]
Although equation 6.4 has the real wage on its left-hand side, it is just an indirect form of
the price-setting (PS) relationship – it still captures price-setting behaviour by firms. For
a specific nominal wage W there is a price P derived as a mark-up over the nominal wage
W
cost W (see equation 6.1). Every W implies a matching P and thus a real wage   P   that firms
in effect are willing to pay as a function of labour productivity Q and the mark-up μ.
❐ Thus, PS as written in equation 6.4 can be viewed as analogous to a demand for
labour relationship, but always remembering that the PS relationship reflects price-
setting behaviour of firms in non-competitive market structures (rather than atomistic,

competitive product markets where firms are price takers, as is usually assumed in
labour demand theory).3
W Figure 6.6 The price-setting curve
Equation 6.4 shows that the real wage   P    
that firms in effect are willing to pay (given
  W
    
their chosen price-setting behaviour) will be P
lower, the higher the mark-up and the lower

average labour productivity Q. Because the
marginal productivity of labour de creases
as a factory employs additional labour, Q is
inversely related to the levels of employment
N. Thus higher levels of employment N will
be associated with lower levels of the implied
W
P   that firms are willing to pay (i.e.
real wage  
as implied by the prices P set by firms).
PS
When depicting the price-setting relationship
diagrammatically as a set of combinations of N
the real wage and employment, as is done in
figure 6.6, the PS curve will have a negative slope.
Note that the faster the marginal product of labour declines, the faster Q (the average
product of labour) in equation 6.1 will decline and the steeper the PS curve will be. If the
marginal productivity of labour does not decline as output grows, Q will remain constant
and the PS curve will be horizontal, its position (i.e. how high above the horizontal axis it
is drawn) depending on the nominal wage W and the mark-up.
Equilibrium and the determination of wage and employment levels

Having derived both the PS and WS curves, we can now put them on the same diagram,
which is done in figure 6.7. It then seems simple to say that, graphically, the equilibrium
W
P   and employment N are determined by the intersection of the PS
levels of the real wage  
and WS curves.
Figure 6.7 Equilibrium in the labour market
Equilibrium implies that the real wage
implicitly desired by workers during nominal W
  P  
 
wage setting must be equal to the real wage WS
that firms are willing to pay (implied by the
price setting of firms). The equilibrium can be
derived by setting PS = WS using equations
6.3 and 6.4. This produces the following: W0
W __ W   P   
 
 __
P   =   P e  ...... (6.5) 0
This equation is not very revealing, though.

At this stage it becomes necessary to dis
tinguish between the labour market situation PS
and the resultant aggregate supply in the
long run and in the short run. N0 N
3 It can be shown that the WS curve lies above the competitive market labour supply curve, and the PS curve below the
competitive market labour demand curve. The PS-WS equilibrium level of N will be below that of a competitive market
model.

6.3.2 The labour market and aggregate supply in the long run (ASLR)
Having defined the long run as a state when sufficient time has elapsed for any mistaken
price expectation to have corrected itself so that expected prices are the same as actual
prices, we assume now that P = P e. From equations 6.3 and 6.4:
__W W 1
  P   =  __
P e  or ______ Q(N) = f(N; Z)
 (1 + μ)  
The equilibrium can be under
stood as follows. Recall that
equilibrium implies that the real
A formula for the PS-WS equilibrium π
Instead of equation 6.5 one can insert
wage, implicitly desired by work
equation 6.2 into equation 6.1:
ers during wage setting, must be
equal to the willingly-paid real
P e · (1 + μ) · f(N; Z)
P = _____________
   
  ...... (6.6)
wage implied by the price set Q 
ting of firms. Because workers This equation describes the equilibrium between PS
in effect set their labour supply and WS (for a given nominal wage W). We will return
to it below.
on the basis of their expected
real wage, when the actual real
wage equals the expected real wage (as is assumed now), workers supply the amount of
labour services that they want to supply in exchange for the real wage that they expected.
Likewise, firms supply their chosen output level at their preferred price level, given the
nominal wage previously contracted with workers.
❐ Therefore, excluding mistakes in price and wage expectations for the moment, no party
will desire to adjust its supply of goods or of labour services. Therefore, the actual real
wage will equal the expected real wage and both employers and workers will be satisfied
with their position. There can be said to be an equilibrium.
As long as the underlying fac
tors that determine the position A formula for the long-run equilibrium π
of the price-setting and wage-
With P = P e equation 6.6 becomes:
setting relationships remain
P  (1  μ)  f(N; Z)
unchanged (and as long as the P = _____________
    Q   
actual price equals the expected
or
price), labour supply and em
(1  μ)  f(N; Z)
1 = ___________
     
...... (6.7)
ployment – and thus output Q 
– will remain at the levels de If a formula is specified for f(N,Z) the equation can be
fined by the equilibrium of the solved for N, the long-run equilibrium level of output,
price-setting and wage-setting as a function of Q, μ and Z.
❐ An important insight is that the long-run equilibrium
relationships. Graphically, the
level of output is independent of the price level P. We
location of this equilibrium is will return to equation 6.7.
where PS intersects WS.
❐ The concept and existence of
a long-run equilibrium in the
labour market does not imply that there is full employment, nor that there is no invol
untary unemployment, at the long-run equilibrium. This is explained further in the
box on employment concepts below.
Note that many of the factors underlying the price-setting and wage-setting relationships,
and thus the positions of the PS and WS curves, are of a structural nature and, therefore,
usually change very slowly over time. Labour market institutional factors such as unions or
labour legislation or unemployment benefits do not frequently change materially. Product
market structure and the power of firms to set mark-ups and prices also change slowly.

Thus, the equilibrium defined by the intersection of PS and WS can be defined as a long-
run equilibrium whose location is largely determined by structural characteristics of the
economy. This equilibrium can also be denoted as a structural equilibrium (in contrast to a
cyclical equilibrium). The employment level of the structural equilibrium can be indicated
as NS and the corresponding output level as YS.
Nevertheless, the position of the long-run or structural equilibrium is not permanent or
invariable, and shifts in the PS and WS curves can occur should any of the factors that
determine the position of these curves change (also see section 6.4). Some of these shifts
can occur less frequently or slower than others (see below).
A shift of the PS curve: Equation 6.4 shows that an increase in the mark-up μ will cause the
W
P    that producers in effect
price level to increase which, in turn, will cause the real wage  
are willing to pay at any employment level (i.e. at a given nominal wage) to decrease.
As figure 6.8 demonstrates, the PS curve will Figure 6.8 A shift in the PS curve
shift downwards and a new ‘long-run’ or
structural equilibrium will be established at a   W
  P
  
lower real wage and a lower level of employ WS

ment NS1. (Similar reasoning applies to a
decrease in the mark-up.) W
  P   
0
 
❐ An increase in taxes and non-labour input 0
costs may cause the mark-up to increase, W

  P   
0
leading to a new ‘long-run’ equilibrium   1
at a lower real wage and a lower level of PS0

employment NS. Supply shocks such as an
oil price shock are important examples of
such negative impacts on the structural PS1
equilibrium level of employment (as seen
in a downward shift in the PS curve due to NS1 NS0 N
a compensatory increase in the mark-up).
❐ An increase in economic concentration and the degree of product market power in the
economy may thus cause the mark-up to increase; hence real wages and the structural
equilibrium employment level NS will be at lower levels. While the mark-up in the first
instance needs to be large enough to cover the costs of non-labour inputs and taxes, the
extent to which a producer can pass on an increase in input costs to its clients depends
on its market power.
❐ An increase in import competition can also affect the structural equilibrium. If high
levels of economic concentration or monopolism characterise a relatively closed
economy, opening up the economy to foreign competition means that domestic
businesses may lose market power. The loss of market power may cause them to reduce
their mark-up and thus their prices, leading to the structural equilibrium being at a
higher real wage and employment level NS.
Likewise an increase, for example, in labour productivity implies a decrease in labour cost
per unit of output, enabling firms to reduce the price level P at every level of employment.
This amounts to an increase in the implied real wage at every level of employment. PS
shifts up. The structural equilibrium level of employment NS will be at a higher point.
In contrast, a drop in worker productivity will shift the PS curve down; the structural
equilibrium level of employment NS will be at a lower point.

❐ Labour productivity, in turn, depends for example on the capital goods available to
workers, levels of technology and the skills levels of workers. An increase in capital
stock K (due to private sector or government real investment), or an improvement in
technology, or improved skill levels would all shift the PS curve up and yield a higher
structural equilibrium level of employment NS. (This is a longer-term effect, especially
relevant in the context of economic growth; see chapter 12.)
A shift of the WS curve: The WS curve will shift if any of the institutional factors that affect
its position change. The power of labour unions and employer organisations, the payment
of efficiency wages, and unemployment and other benefits may all influence the nominal
(and implied real) wage level that workers are willing to work for.
❐ When union power or the unemployment Figure 6.9 A shift in the WS curve
benefits that government pays increase,
there will be upward pressure on the real WS1
  W
  P
  
expected wage that workers are willing
to work for. There will also be upward
WS0
pressure on the expected real wage if
businesses become willing to pay a higher (    W    )1
P
efficiency premium to workers, or if the
(  
P )0
W   
ability of employer organisations to depress
wages diminishes. In the diagram this will
shift the WS curve vertically upwards, as
in figure 6.9. This change will cause the
equilibrium real wage to be at a higher
PS
level, while the long-run (or structural)
equilibrium level of employment NS will be NS1 NS0 N
at a lower level than before.
❐ Note that structural market character
istics that constrain competition either
between firms in the goods market or Staggered contracts?
between workers in the labour market In reality it is not the case that all contracts
tend to lower the long-run equilibrium are simultaneously revised every year
level of employment NS. (or every three years). Such negotiations
occur in any month throughout the year,
It is important to note that the existence of for the next year or more. Certain months
labour contracts that fix nominal wages for may see a higher frequency of contract
a period of one to three years implies that renegotiations than others, so the spread
the WS curve can shift only at the time of of renegotiations is not even.
new wage bargaining. (Recall that the WS ❐ Nevertheless, staggered contracts
curve is activated only at the time of wage mean that instead of jumping every
bargaining; once the nominal wage is set year with a big amount, the LS (and
the curve becomes dormant until the next WS) moves every month with a
round of wage bargaining.) fraction of where it needs to go.
❐ This means the WS curve is institution ❐ In the analysis, however, we will
assume one move per period and
ally rigid. Thus changes in the location of
not, say, 12 small moves spread
the long-run equilibrium due to changes
across a period.
in the underlying determinants of the
wage-setting relationship will be slow.

❐ Recall that this also implies that the effective labour supply curve post-bargaining –
indicated as LS – is horiz ontal. We will return to this when we consider the labour
market and aggregate supply in the short run (section 6.3.3).
If the labour force (LF) increases due to an increase in the labour force participation rate or
through normal population growth, the additional workers will put downward pressure
on wages, creating an incentive for producers to employ more workers. WS shifts down
and the equilibrium output level YS would be at a higher level.
Structural unemployment, the ‘natural’ unemployment rate and types of unemployment

Earlier in this chapter the long-run equilibrium was also denoted as a structural equilibrium with a
corresponding structural unemployment rate (SRU). It is important to realise that, at this ‘long run’ or
structural employment level, there may still be substantial involuntary unemployment. Employment may
still be below what would amount to genuine ‘full’ employment.
Types of unemployment
Four different types of unemployment can be distinguished:
1. Seasonal unemployment occurs due to seasonal patterns of increased or decreased activity in certain
sectors of the economy, for instance the building industry or the agricultural sector. This is not of great
importance and is often ignored from a macroeconomic perspective.
2. Frictional (or search) unemployment – which is always present – exists because there is always a certain
number of people who are in the process of searching for new jobs or busy changing jobs or careers. The
extent of this type of unemployment is relatively limited and it is not really a macroeconomic problem.
3. Cyclical unemployment exists because of short-run cyclical downswings in the level of macroeconomic
activity Y: as the level of Y fluctuates, so employment fluctuates. Usually this kind of unemployment
is the main focus of macroeconomic theory and policy. We will return to this below when combining
aggregate demand AD and aggregate supply AS.
4. Structural unemployment is especially important in the South African context. It refers to a form of
unemployment that occurs regardless of the cyclical state of the economy. This type of unemployment
can be of substantial proportions and is the most problematic, being very difficult to address with normal
macroeconomic policy instruments (see section 12.2.3 in chapter 12 for further analysis).
❐ Structural unemployment is involuntary unemployment and arises, first, from the nature, location and
pattern of employment opportunities (i.e. the demand side of the labour market). The types of product
that are selected for production and the production technology that is used to determine what kinds of,
and how much, labour can be employed. Technology largely determines the employment intensity of the
production process; most new production technologies are labour-saving. Another factor is mismatches
between the (increasing) skills requirements of jobs and the skills of workers.
❐ On the supply side of the labour market, many job seekers face a variety of constraints and entry barriers
with regard to entering labour markets. These include weak education backgrounds, low skill levels,
limited information on job opportunities, long distances from urban labour markets, being marginalised,
disempowered and trapped in poverty.
❐ Entry barriers are related to market segmentation. The South African labour market is not a single market
– in effect it comprises several submarkets. Labour mobility between these market segments is often
limited. An example is the informal and formal sectors – small numbers of workers succeed in entering
the formal sector from the informal sectors. Entry barriers also apply to (especially informal) small, labour-
intensive businesses wishing to enter markets that are dominated by large corporations.
❐ More generally, structural unemployment can be ascribed to structural rigidities, entry barriers,
distortions and imperfections in markets and in the manner in which the economy is organised.
Institutional factors and economic power relations play an important role.
❐ Given a certain pattern of production and employment, the labour market can absorb only a portion
of the labour force. The rest is excluded from the operation (and advantages) of the market.
⇒

⇒
The existence of structural employment effectively implies an intrinsic ceiling on employment in the normal
labour market, given the structure of the economy at a certain stage. Despite being considerably below full
employment in South Africa, this level of employment is the maximum that the normal interaction of producers
and other decision-makers can deliver in input and labour markets, amidst short-run or cyclical fluctuations.
❐ The structurally unemployed thus remain without jobs ‘in the long run’, being more or less excluded
from the labour market proper.
❐ Cyclical fluctuations in production and employment occur around this level of employment and
production, denoted as YS . Upswings can push the economy above YS for considerable periods of
time, but not permanently. In downswings, real income Y will fall below YS.
The structural rate of unemployment (SRU) is the level of unemployment corresponding to YS. The
levels of genuinely full employment (FE) and structural equilibrium employment (at YS ) can be indicated
graphically in terms of real GDP or Y as in the following diagram – where FE only allows for those that are
frictionally unemployed.
At YS , which reflects the intersection of PS and WS, there is equilibrium employment in the labour
market. But the important point is that it is accompanied by structural unemployment – without any
downward (or upward) pressure on wages in the market. Labour markets are ‘saturated’ at YS.
❐ Below YS there is cyclical unemployment in the labour P
ASLR
market, leading to downward pressure on wages.
❐ Above YS cyclical ‘over’-employment occurs, which is Area of cyclical
Area of
likely to imply upward pressure on wages. The latter unemployment
cyclical ‘over’-
may happen amidst and despite the existence of employment
substantial structural unemployment. Downward
pressure on
Upward
Such upward (or downward) pressure on wages and input wages
pressure on
prices in short-run positions above or below YS is important wages
Structural
when the short-run supply curve ASSR is considered in unemployment
Structural
relation to YS (section 6.3.3). ever present unemployment
❐ One must also remember that the position of ASLR and YS still present
can vary over time. Structural
equilibrium
Full employment and the natural rate of
unemployment (NRU) YS YFE Y
In much economic literature, the long-run unemployment rate is called the natural unemployment rate
(NRU). The use of the word ‘natural’ derives from the idea that NRU is a level of unemployment created
by the natural forces of supply and demand in the labour market. It usually also implies the NRU
corresponds to a situation of ‘full’ employment in which there is no involuntary unemployment. Those
who are unemployed would be voluntarily so, choosing not to be part of the labour force at that moment.
The only unemployment would be frictional or seasonal.
Our analysis of the labour market, and the derivation of the PS and WS curves, explicitly incorporated
non-competitive labour and product markets, characterised by market power, price and wage setting,
monopolies, monopsonies and so forth. This was done to recognise the reality of labour and product
markets in most countries, including South Africa.
The NRU approach usually assumes competitive market structures where the forces of supply and
demand can freely interact, clear the market, and produce competitive equilibria with, for labour markets,
no involuntary unemployment. This approach excludes recognition that structural factors in the economy
can preclude the ‘natural’ or automatic attainment of full employment and can cause workers to be
involuntarily unemployed for long periods, despite being willing and eager to work.
❐ Some theoreticians who adopt the NRU approach would argue that the economy returns to
long-run equilibrium so quickly and efficiently that even cyclical unemployment can be ignored
macroeconomically.

⇒
To use the term ‘full employment’, as some textbooks do, to characterise equilibrium in the
labour market, is clearly misleading as well, since it suggest the absence of an unemployment
problem – which is not true at the long-run equilibrium at all. At the latter equilibrium the full
extent of structural unemployment is still present.
Thus it is more suitable to use the term structural rate of unemployment (SRU) to reflect the
true nature of the long-run (or structural) equilibrium in the labour market. In any case, in a
country such as South Africa where the official unemployment rate is close to 25% (and the
unemployment rate according to the expanded definition close to 35%), calling the long-term
unemployment rate natural is a bit misplaced.
Relating PS, WS and total production

The aggregate output produced by the number of workers employed in the ‘long-run’
equilibrium – graphically indicated by the intersection of the price-setting and wage-
setting relationships – represents the total amount of goods that producers in the economy
can supply in the ‘long run’ (i.e. amidst short-run fluctuations and mistaken expectations).
This level of output represents the long-run aggregate supply of the economy (where long-
run has the very specific meaning defined in the preceding discussion).
The relationship between the level of employment and the level of aggregate output can
be depicted by the total production function for the economy. Total production is a function
of the quantity of labour employed N, capital K and technology A. A basic production
function would look as follows:
Y = f(N; K; A)
A more sophisticated production function would also include human capital as well as
social and economic institutions. We will do this when we consider economic growth in
chapter 8.
The total production function – the TP curve in figure 6.10 – shows, for a given amount of
capital (i.e. keeping capital K constant), the relationship between the level of employment
N (on the x-axis) and the level of aggregate output Y (on the y-axis).
Since the employment of more workers will lead to an increase in output, the TP curve
has a positive slope. If capital usage increases, the TP curve rotates upwards: compared
to the original TP curve, the same number
of workers can now produce more output. Figure 6.10 The total production curve
Changes in the usage of new technology will Y
TP
also rotate the TP curve correspondingly.
❐ In a very simple case the production function
can be assumed to be linear, e.g. Y = N Y2
(meaning that if one additional unit of labour Y1
is employed, one additional unit of output
will be produced). While acceptable for some Y0
simple mathematical manipulations (see box
below), this would be too unrealistic.
❐ Note in the diagram (figure 6.10) that,
although TP has a positive slope, the slope
becomes flatter at higher levels of employment:
as employment increases, output in creases
10 11 12 N
but at a decreasing rate. This re flects the

decreasing marginal productivity of labour (an economic phenomenon which also explained
the negative slope of the PS curve). As employment increases, every extra worker added will
produce less additional output than the previous worker added.
❐ This is illustrated in figure 6.10 where the additional output (from Y1 to Y2) produced
by the 12th worker is less than the additional output (from Y0 to Y1) produced by the
11th worker.
❐ Because the effect of decreasing marginal productivity of labour becomes more
pronounced as output reaches higher levels, at some point the TP curve flattens out
and reaches a maximum. It means that even if more workers are employed, aggregate
output will not increase (for a given capital stock).
Deriving long-run aggregate supply ASLR

At the beginning of this section we stated that aggregate supply in the long run, as defined,
indicates combinations of P and Y in a situation where actual prices and wages equal
expected prices and wages.
To determine graphically what total level of output firms will supply in the long run, the
long-run equilibrium level of employment NS established by the PS and WS relationships
(bottom, left-hand panel of figure 6.11) is extended to the top left-hand panel of figure 6.11.
The level of output that corresponds, on the TP curve, to that long-run level of employment,
Figure 6.11 Deriving the ASLR curve
Y Y 45° line
TP
YS
NS N YS Y
W
  P  
  P
ASLR
WS
W0
  P   
  P0
0
PS
NS N YS Y

is the level of output YS that
producers in the aggregate are The formula for ASLR π
able and willing to supply ‘in the The formula for the ASLR relationship can be derived
long run’. from equation 6.8, which describes the long-run
This output level YS can also be equilibrium intersection of PS and WS:
shown on the P-Y plane, which (1 + μ)  f(N; Z)
1 = ___________
    Q 
  ...... (6.8)
is the bottom right-hand panel
of figure 6.11. Note that in this To translate this equilibrium level of employment N
panel total output Y is measured into aggregate output (for a given capital stock), we
on the horizontal axis. (This need the production function. To simplify matters,
assume for the moment that the production function
switch of axis is made possible
is a simple linear function Y = N. Then equation 6.8
by the mirror graph with its 45° becomes:
line in the top right-hand panel of
(1 + μ)  f(Y; Z)
figure 6.11.) 1 = ___________
    Q 
  ..... (6.9)
The bottom, right-hand panel of This equation describes the ASLR curve. If an equation
figure 6.11 finally shows ‘long- is specified for f(N, Z) and for the production function
run’ aggregate supply ASLR. Y = f(N, K, A), the ASLR equation can be solved for Y
❐ Note that graphically ASLR so that Y is expressed as a function of Q, μ, Z factors,
is a vertical line, indicating N, K and A factors.
that output in the ‘long run’ ❐ Since P does not appear in this equation, ASLR is a
is independent of the price vertical line in the P-Y plane.
level P.
❐ This might seem surprising,
given the role that the price level plays in the PS and WS relationships. However, since
the long-run PS-WS equilibrium is defined in real terms, changes in the price level do not
affect the equilibrium. (Also see the graphical interpretation of equation 6.8 in the box.)
Shifts in the ASLR curve

As noted before, the position of the ASLR curve is not constant or permanent. Changes in
the ‘structural’ and other factors identified above that underlie the position of the PS and
WS curves will influence the position of the ASLR curve.
❐ The diagrammatical position of ASLR, like the ‘long-run’ or structural level of aggregate
output, is variable over time.
❐ Any factor that reduces the equilibrium level of output in the PS-WS diagram will be
reflected as a leftward shift of the ASLR curve, and conversely for a rightward shift. (Also
see the AD-AS discussion in section 6.4.1.)
❐ Changes from the price-setting side can change the position of the ASLR curve at any
time, while changes from the wage-setting side occur only at wage bargaining time (i.e.
the reason for the rigidity of the WS curve).
Example: changes from the price-setting side and PS

A change in labour productivity Q, e.g. an increase in labour productivity, firstly causes
the PS curve in figure 6.12 to shift upwards from PS0 to PS1. A new equilibrium is estab
lished at the intersection of PS1 and
W
WS0. It is a characteristic of the new equilibrium
W
that
its real wage would be higher (at  P    ) than that of the initial equilibrium (i.e. 
 P   )  . Likewise,
1 0
0 0
its long-run employment level would be at the higher level of NS1 compared to NS0 initially.
Secondly, the increased labour productivity rotates the TP curve upwards from TP0 to TP1.

Figure 6.12 Shifts in the ASLR curve
Y TP1 Y 45° line
TP0
YS1
YS0
NS0 NS1 N YS0 YS1 Y
  W
     P
P
ASLR0 ASLR1
WS0
W1
  P   
  P0
0
W
  
P
0
   PS1
0
PS0
NS0 NS1 N YS0 YS1 Y
Transferring this to the P-Y plane shows that ASLR shifts to the right from ASLR0 to ASLR1.
Thus the new structural equilibrium output level would be at YS1, which is higher than the
initial YS0.
❐ An increase in the capital stock K (due to private sector or government real investment),
or an improvement in technology (due to investment in research and development),
or improved skills levels (e.g. due to better education and training) would all improve
labour productivity over time. This yields a higher structural equilibrium level of
employment NS. Graphically, ASLR would shift to the right. (Bear in mind that some of
the changes can take some time to effect.)
Changes in the mark-up: As deduced earlier, an increase in the mark-up will shift the PS
W
curve downwards – the higher price level will decrease the real wage   P    at every level of
employment – which results in a drop in the structural employment level. ASLR shifts to the
left, i.e. the structural equilibrium output YS would be at a lower level. (Note: In this case
TP does not rotate or shift.)
❐ This is an important case, since it is also the avenue through which changes in non-
labour input costs will impact on the structural equilibrium and on the position of
ASLR. A supply shock such as a large change in the oil price will push the structural
equilibrium point left, i.e. to a point with a lower output level YS than before the shock.
Graphically, ASLR will shift to the left.
❐ Increases in monopoly power that increase the mark-up will shift ASLR to the left.

Example: changes from the wage-setting side and WS
Increases in union power or the unemployment benefits that government pays will put
upward pressure on the real expected wage that workers are willing to work for. Graphically,
the WS curve shifts vertically upwards, reducing the long-run or structural equilibrium
level of employment NS and thus output YS . This means ASLR shifts to the left.
A similar shift in ASLR will result if firms become willing to pay a higher efficiency wage
premium to workers, or if the ability of employer organisations to depress wages diminishes.
However, due to the rigidity of the WS curve for the duration of labour contract periods,
these shifts – or ‘jumps’, rather – can only occur infrequently.
If the labour force increases through normal population growth or due to an increase in
the labour force participation rate, the additional workers will put downward pressure
on wages (when wages are renegotiated), creating an incentive for producers to employ
more workers. WS will then shift down and the equilibrium output level YS will be at
progressively higher levels.
❐ A scourge such as HIV/Aids can dramatically reduce the life expectancy of the popula
tion and decrease population growth or even shrink the labour force over time. This
would inhibit any rightward shift of YS to higher levels of equilibrium output.
Long-term economic growth and investment

In most countries the level of technology continuously improves in the long run, while the population and
thus the labour force also continually expand; capital stock also grows due to investment (capital formation).
Such continual improvements in productive capacity will be discussed in section 6.4.4, as well as in
chapter 8 on long-term economic growth. A continually growing labour force and capital stock, as well as
continually improving technology, implies that the ASLR curve will steadily shift to the right.
Such improvements in the factors of production depend to a large extent on real investment. One can
distinguish between (a) private sector real investment in, for example, factories and new machinery
and equipment, and (b) government real investment (capital formation) in infrastructure, education and
training facilities, health facilities, etc. (To the private sector in this context can also be added public
corporations and government enterprises; see chapter 2.) Another important form of investment is
investment in research and development (R&D), which produces new technology.
Government expenditure and shifts of ASLR
When analysing the macroeconomic impact of government spending G, one must distinguish between
government consumption expenditure GC and government capital formation IG.
GC impacts primarily on AD, while IG impacts on both AD (in the short run) and ASLR (in the medium to long
run). It can even be argued (see chapter 8, section 8.10), that a significant portion of GC goes towards the
provision of education and health services, which build human capacity and thus human capital – a key
element in generating economic growth and economic development. In an HIV- and Aids-affected society,
health spending can be particularly important. Thus GC partially could also impact on ASLR in the medium to
long run – an important point regarding the relationship between macroeconomic and development policy.
6.3.3 The labour market and aggregate supply in the short run (ASSR )
An important element of understanding the determination of the price and output
levels, and notably cyclical fluctuations and changes in these variables, is the behaviour
of aggregate supply in the short run. This section demonstrates that, in the short run,
producers can willingly deviate from the long-run output level.

Deriving the short-run aggregate supply curve ASSR
Like the ASLR curve, the ASSR curve shows, for each price level P, the aggregate level
of real output that producers are willing or able to supply. The difference between the
relationships is that in the short run producers can and probably will supply more (or
less) than the long-run equilibrium level of output if actual prices and wages for a certain
period allow for higher (or lower) profits, since such higher (or lower) profits create an
incentive to supply more (or less). Such opportunities occur when the actual prices (and
thus actual real wages), set by producers, deviate from expected prices (and thus expected
real wages) due to some economic factor or disturbance.
❐ The corresponding deviations in output from YS yield aggregate supply in the short run.
Recall that, in the long-run equilibrium, the actual price P equals the expected price P e,
W W
and the actual real wage   P   equals the expected real wage  
e
P  .  But how will producers and
workers behave when the labour market is not in this long-run equilibrium, i.e. when P
W W
does not equal Pe, and  
P   therefore does not equal   P   ? Figure 6.13, and specifically the PS
e
curve, together with the LS curve, help to answer that question.
Figure 6.13 Deriving the ASSR curve
Y
TP
Y 45° line
Y1
YS
NS N1 N YS Y1 Y
W
  P  
  P
WS when ASLR ASSR
nominal
wage was P1
set at W0
W0
P0
  P   
  LS0
0
W
  P 0  
  LS1
1
PS
NS N1 N YS Y1 Y

W0
In figure 6.13 the actual wage and expected real wage are initially equal at  P   ,  with
0
W0 having been set contractually through the interaction of WS and PS behaviour.

Employment is at the long-run equilibrium level NS, long-run output is at YS, and actual
price P equals the expected price P e at P0.
W0
At a price that is higher than P e (= P0), say P1, the actual real wage will be lower at  P   . 
1
The ‘post-bargaining’ labour supply curve will in effect shift down from LS0 to LS1. At the
lower real wage, employers will, on the PS curve, be willing to employ more workers N1
and produce higher output Y1. On the price-output schedule (bottom right-hand panel of
figure 6.13), the combination of price P1 and output Y1 lies to the right and above the long-
run equilibrium combination of P0 and YS. Firms will be willing to employ more workers
to produce more because, at the contracted wage of W0, a higher price implies a higher
mark-up, and thus higher profit.
Likewise (not shown in the diagram), at a price lower than P e (= P0), say P2, employment
will be N2. N2 workers will produce output Y2. The combination of price P2 and output Y2
can again be plotted on the price-output schedule, which indicates that this combination
lies to the left and below the equilibrium combination of P0 and YS.
This exercise can be repeated for any price below or above the price that equals the expected
price. If the coordinates are then connected, the resulting curve is the short-run AS curve.
It is derived in the bottom right-hand panel of figure 6.13. It shows, for each price level,
the level of output Y that producers are willing to supply in the ‘short run’ – if, when and
as long as the price level deviates from the expected price level, i.e. as long as the price
expectation is incorrect or is lagging behind due to rigidity.
The ASSR curve shows the pattern of supply behaviour that results when firms willingly
deviate from the long-run level of output as a result of profit opportunities due to unan
ticipated increases in the price level coupled with wages being contractually fixed for a
period – wages are rigid for a period of time. (A corresponding explanation applies to un
anticipated declines of the price level.) Any ASSR curve is thus drawn for a given nominal
wage and expected price.
What is the probable slope and shape of the ASSR curve?

The slope of the ASSR curve is positive: an increase in output is caused by an opportunity
for producers, the price setters, to increase the price level above its ‘long-run’ position
(at which point it equalled the expected price Figure 6.14 The shape of the ASSR curve
level), and to increase output to realise new
P
profit opportunities. Likewise, a drop in the
price level leads to a drop in output.
The shape of the ASSR curve is explained
graphically by the shape of the TP curve in
figure 6.14. The shape of the ASSR curve is a
perfect mirror image of the curvature of the Bottleneck
area
total production (TP) curve. Both reflect the
decreasing marginal productivity of labour.
As production is increased, the average out ASSR
put per worker decreases, while the nominal
wage remains the same (by contract). Thus
the labour cost per unit of output (i.e. the total Y

The formula for ASSR π
The formula for the ASSR relationship can be derived by inserting equation 6.2
into equation 6.1, and inserting a production function. Assuming for simplicity,
as earlier, that Y = N, this produces the following illustrative equation for ASSR:
P e  (1 + μ)  f(Y; Z)
P = _____________
    Q   
...... (6.10)
Thus aggregate supply in the short run is positively related to the output level Y, the expected
price level P e and the mark-up μ; for Z it depends on each factor. Via the production function,
it is also related to capital stock K and the use of other inputs and technology A. Aggregate
supply in the short run is inversely related to labour productivity Q.
But P ≠ P e is a condition for its existence in the first place.
The intercept of the ASSR curve on the vertical ASLR curve is at the level of Pe. The ASSR curve
will shift up or down if there are changes in the expected price level Pe.
The ASSR curve will shift right or left (in lock-step with the ASLR curve) if there are changes
in the mark-up μ (which includes non-labour input costs and taxes), labour productivity
Q, a Z factor, or in capital stock K, the use of other inputs and technology A, or the labour
force LF.
Remember that the equation above is the same one that we used to derive the long-run AS
curve, except that now P ≠ P e and thus they are not eliminated from the equation. If it is
assumed that P = P e, i.e. that we are in the long run, this equation reduces to the equation for
the ASLR curve (see box in section 6.3.2).
wage bill divided by the units of output) increases as more workers are added. Producers
will be willing to produce more only if the price per unit of output, i.e. the price level P,
increases (and increases by an increasing amount – i.e. the rate at which it increases is itself
increasing). Graphically, ASSR curves become steeper at higher levels of output.
❐ If the production function is assumed to be linear, ASSR will also be linear.
The total production function will ultimately flatten out, as noted above, as marginal
productivity converges towards zero. Correspondingly, ASSR ultimately becomes vertical.
Even if prices increase and more workers are employed, output can and will not increase
beyond this level.
❐ The area on the short-run supply curve when it becomes very steep, just before it
reaches its vertical point, is called the bottleneck area. It reflects the increasing dif
ficulty and even futility of trying to increase output by adding additional labour to a
production process that operates with a fixed amount of capital (machinery, etc.) in
the short run. The economy is reaching short-run full capacity (i.e. unless additional
capital is added).
❐ This vertical portion of ASSR is not on the ASLR curve, nor is it on the YFE line indicated
in the box on page 261. It is somewhere in the middle, between them.
What shifts the ASSR curve?
Analysing shifts in the ASSR curve is relatively complicated. The ASSR curve can shift either
on its own or in lock-step (or in tandem) together with the vertical ASLR curve when the
latter shifts.

❐ When the ASSR curve shifts on its Figure 6.15 Two types of shift in the ASSR curve
own, its intercept on the vertical P
ASLR line changes: it shifts up or ASLR1 ASLR0
Vertical shift
ASSR2
down. In the diagram, for example,
of ASSR alone: ASSR1 ASSR0
the intercept on the vertical ASLR1 intercept on
line changes from P0 to P1 (the blue ASLR changes
arrows in figure 6.15).
❐ When ASSR shifts in lock-step P1
with ASLR the intercept on the P0
vertical ASLR line does not change Lock-step
– it remains at P0 in the diagram – horizontal shift
and it shifts right or left (the black of both ASSR
and ASLR
arrows in the diagram).
An increase in the expected price Y
P e will shift the ASSR curve up – it
changes the inter cept of the ASSR
curve on ASLR. In economic terms, this upward shift is a reflection of a higher nominal
wage being contracted (during a new round of negotiations) to match the increase in the
expected price level. (This is discussed again in the next section.)
❐ This shift thus only occurs if and when such negotiations occur.
❐ This is the only case when the ASSR curve shifts on its own.
The other shifts in the ASSR curve are
lock-step changes that occur when Changes in the nominal wage
ASLR shifts due to its underlying
In the text it is stated that ‘any ASSR curve is
causal factors. Both of these curves
drawn for a given nominal wage’. What does this
thus shift left or right for the same
mean for shifts in the ASSR curve? The nominal
distance due to the same factors. wage is the vehicle through which the expected
Thus the ASSR curve will shift right or price manifests itself.
left – together (in lock-step) with the ❐ If it changes due to a change in P e it implies a
ASLR curve – if there are changes in vertical shift of the ASSR curve.
the mark-up μ (which includes non- ❐ If it changes for a reason unrelated to
labour input costs and taxes), labour expected price, e.g. the exercise of labour
productivity Q, a Z factor, or in capital union power, it is analysed as a change in
stock K, the use of other inputs and that particular causal factor, which implies a
technology A, or the labour force LF. lock-step shift of ASSR together with ASLR. In
❐ For example, an increase in labour such cases, an increase in the nominal wage
has the same effect as an increase in the
productivity shifts ASSR and ASLR to
price of a non-labour input, e.g. oil.
the right in lock-step.
❐ Supply shocks, e.g. a large oil price
increase, will shift the ASSR curve to the left in lock-step with the ASLR curve.
As discussed earlier, except for changes in the average price (cost) of non-labour inputs,
most of these shifts in ASSR (and ASLR) are likely to occur relatively infrequently. They are
more of a medium- or long-run nature. This is especially true of those that originate in the
wage-setting context, whose WS curve is rigid.
Adapting expectations and the adaptive nature of the ASSR curve

Shifts in the ASSR curve due to a change in the expected price level Pe explain an important
pattern that usually follows a disturbance that places the economy at a point off the long-

run or structural equilibrium, i.e. a point off the ASLR curve. (As noted in section 6.1, such
a point can occur due to a change/shift in the aggregate demand (AD) relationship; see
section 6.4.1 for further analysis.)
The key point of this section is that any equilibrium point on ASSR curve that is off the ASLR curve
is unlikely to be sustained for an indefinite period. An adjustment process will kick in that will
push the equilibrium back, over time, to the structural equilibrium output level YS (i.e. to the ASLR
curve). Adjustments in the expected price level P e are central to this process.
Recall that the short-run supply relationship – and the ASSR curve – was explained by
periods when the price level diverged from the expected price level. For example, firms will
willingly increase output beyond the structural equilibrium level of output YS – along the
ASSR curve – as a result of profit opportunities due to unanticipated increases in the price
level (coupled with wages being contractually rigid for a period of, for example, one to
three years).
However, after some time, people’s expectations will catch up with reality – a discrepancy
between the actual price level and the expected price level cannot be maintained in the
longer run. For example, if the actual price level has been higher than the expected price
level at the time of contracting, expectations will gradually adjust and the expected price
will move towards the actual price. Once wage renegotiations occur, real wages will
probably adjust to reflect this, causing an increase in labour costs and thereby eroding any
opportunistic profit opportunity and any incentive to produce more than the structural
output level YS. Output will decline.
❐ Theoretically the process should continue until P = P e and end when output has
returned to the long-run, structural equilibrium level YS. Exactly how, and in how
many phases, the economy moves back to the long-run level will become clear when
we combine aggregate demand and aggregate supply in the next section.
❐ Every output level above or below the long-run output level (and thus every point on
ASSR) is the result of mistaken price expectations or ‘price surprises’ (due to some kind
of economic disturbance). At every point on ASSR (except the price at ASLR) the actual
price either exceeds or falls short of the price expected at the time of contracting. Since
this is unlikely to be sustained over time, levels of output above or below the long-run
level of output cannot be sustained indefinitely.
❐ The only aggregate supply level that is sustainable in the long run – in the sense of
being free of expectations-driven pressure to change – is the level where P = P e, which is
also the output level YS corresponding to the ASLR curve. Only when P = P e will workers
have no reason to want to renegotiate their contracted wage to reflect a changed price
level and cost of living (assuming that the factors underlying the price-setting and
wage-setting relationships remain unchanged).
The fact that points along the ASSR curve are ‘temporary’ or ‘short-run’ in a specific
technical sense does not render them unimportant at all. The corresponding fluctuations
in aggregate output are the essence of the business cycle and one of the main ‘problems’
of macroeconomic analysis and policy. In reality, economic disturbances and related
dynamics (for instance, balance of payments or interest rate adjustments) push the
economy off the long-run ASLR curve most of the time.
❐ Moreover, because changes in price expectations have to be reflected in renegotiated
labour contracts before having an impact on labour costs and the position of the ASSR
curve, the shift in ASSR occurs relatively slowly. As we will see, it is also not completed in
one step, because the renegotiated wages usually do not catch up in one round.

6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD)
together
6.4.1 Macroeconomic equilibrium in the ‘short’ and ‘long’ run
As noted in the brief overview in section 6.1, and using the analogy of standard micro
economic theory, the essence of the AD-AS model of explaining, graphically, the state of
the economy is twofold:
❐ First, the actual, ‘month-to-month’, Figure 6.16 AD-AS equilibrium
short-run equilibrium levels of out
P
put and real income Y and the price ASLR
level P are determined by the inter ASSR
section of the AD and ASSR curves.
❐ Second, the presence of a structural Structural
equilibrium with its output level YS equilibrium
(and price level PS) and a vertical PS Short-run
‘long-run’ or structural ASLR curve P1 equilibrium
exerts a ‘gravitational pull’ so that,
if the actual, short-run equilibrium
output level of the economy is not
AD
at YS, the intersection of the AD
and ASSR curves will over time move
towards ASLR through a dynamic YS Y1 YFE Y
process involving ad justments in
price expectations. Following this process, the intersection of the AD and ASSR is likely
to end up exactly on the ASLR curve (see examples below). The long-run or structural
equilibrium point – which can be thought of as exerting the gravitational pull – is thus
at the intersection of the AD and ASLR curves.
The economic interpretation of the long-
run point of equilibrium is somewhat The full-employment level of output YFE is
different from how it is understood in indicated on the horizontal axis throughout
micro economics. We saw above that the rest of this chapter to serve as a
the AD curve is a collection of potential reminder that the long-run, or structural,
equilibrium points – each for a different equilibrium level of output YS is not a full-
employment level and still leaves structural
price level. However, all these points
unemployment untouched.
of equilibrium are not attainable at
all times, because producers are not
necessarily willing or able to produce the quantity of output that is demanded at certain
price levels. (Remember that the points on the AD curve are derived using the assumption
that production readily responds to expenditure.) The points that can be attained are
indicated by the ASSR curve.
❐ In this sense, the short-run aggregate supply curve is a kind of ‘production possibility
frontier’ – points on (and to the left of) the curve are attainable, but points to the right
are not.
❐ The point of intersection is the short-run equilibrium point with the highest attainable
level of income Y, given supply and demand conditions.
This leads to the conclusion that the actual, short-run level of real income Y and the price
level P are simultaneously determined by the interaction between aggregate demand and
short-run aggregate supply, graphically illustrated by their intersection, e.g. Y1 and P1 in

figure 6.16. Shifts of the
short-run supply curve The AD-AS equilibrium mathematically π
would change the set Having derived an equation for the AD curve in
of attainable points of section 6.2 of this chapter:
equilibrium. In the same
( 
Y = 1(a + Ia + G + X – ma) + 2 __ )
 MP   + lπ 
S
way, shifts of the de …… (4.6)

mand curve change the and an equation for the ASSR curve in section 6.3.3 above
point of equilibrium. (based on equilibrium in the labour market):
❐ Given the way AD P e  (1  )  f(Y; Z)
P =   ______________
  
  …… (6.10)
Q 
was constructed from
the goods and money these two relations simultaneously determine the equilibrium
markets (i.e. the real level of Y and P ‘in the short run’. They can be solved to obtain
equilibrium values of Y and P.
and monetary sectors
❐ For the long-run equilibrium, one simply substitutes P for
and the IS and LM P e in the equations.
curves), any point
on the AD represents
equilibrium in the goods and money markets.
❐ Likewise, given the way ASSR was constructed from the labour market (and the inter-
action of the PS and the post-bargaining LS curves), the labour market is in an interim,
between-bargaining equilibrium.
❐ Thus all three of these markets or sectors are simultaneously in equilibrium at the
intersection point of AD and ASSR. Both pairs LS-PS and IS-LM intersect at the same
equilibrium output level.
❐ Note that in a longer-term sense there is no labour market equilibrium, since we are
not at the intersection of WS and PS. Thus workers are not working for the real wage
at which they would have wanted to work at wage-setting and -bargaining time (which
is on the WS curve).
There is no reason why the AD-ASSR equilibrium should be on the ASLR curve, i.e. why
equilibrium output should be at the long-run, structural level YS. Depending on the position
of the AD curve (and thus values of investment, consumption, exports, imports, government
expenditure, taxes and monetary aggregates) and the position of the ASSR curve (and thus
the expected price level Pe and other supply-side factors) the equilibrium of P and Y can be
anywhere on the P-Y plane. (At all but one of these, P will not equal P e.)
❐ Whether the economy can remain at such a point indefinitely is another matter, as ar
gued above. It is analysed again below.
A number of typical patterns are often found in P and Y. One can distinguish patterns
originating in demand-side changes/disturbances, or in supply-side changes/disturbances.
Combinations can also occur. In each case, the initial effect of the disturbance is followed
by an adjustment back towards the long-run level of YS.
6.4.2 Demand-side disturbances leading to points off the ASLR curve

Demand expansion followed by supply adjustment
Suppose that aggregate demand increases (AD shifts to the right in figure 6.17), starting from
an equilibrium income level at YS with the price level at P0 and with P e = P0.
❐ Such a change can be caused by expenditure-stimulating events such as an increase in
government expenditure, a tax cut, an exogenous increase in exports, a drop in imports
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together 273

due to a depreciation of the rand or, Figure 6.17 Initial impact of demand expansion
on the monetary side, a decrease in P ASLR
the repo rate (see complete examples
and chain reactions below). ASSR0
The increased demand alerts firms to Short-run

new possibilities to increase output, P2 equilibrium
which can be sold at a price premium P1 after demand
stimulation
– remembering that they are price
setters. Moreover, increased output P0
also requires a higher price because
of increased costs. As employment AD0 AD1
increases to produce the higher output
demanded, the marginal product
of labour decreases; at the existing YS Y1 YFE Y
nom-inal wage rate the unit cost of
production increases. Producers will
be willing to employ these additional workers only if there is a higher price level (which
will allow the real wage rate to fall and producers to recover the higher unit cost of
production). This places upward pressure on the price level: the price level increases from
P0 to P1 in the diagram. At the given nominal wage, the higher price level creates new
profit opportunities, which induce businesses to increase aggregate production.
Thus, the price increase leads to an increase in output and income Y along the ASSR curve.
Short-run equilibrium output and income increase from the long-run level YS to Y1. The
economy experiences a short-run or cyclical upswing.
❐ Graphically, this is a shift in the AD curve from an equilibrium point on the YS line to
the right, with the new intersection of AD with ASSR being to the right of YS.
❐ In the product and money markets, changes indicated by a rightward shift in IS and/
or LM would have occurred, depending on whether a real or a monetary change was
behind the shift in AD. (See section 6.2.5 and examples 1 and 2 further on.)
❐ In the labour market a downward shift of the LS curve occurs, as shown in figure 6.13 in
section 6.3.3. Equilibrium occurs at the intersection of the PS and LS curves. (Details of
changes in the PS and LS curves are shown in the graphical examples in addendum 6.1.)
W
❐ Workers experience a drop in living standards due to a drop in their real wage   P    since P
has increased. However, there is nothing they can do about it until the next round of wage
negotiations. But at the initially contracted nominal wage W0 (based on P e = P0) there are
more employment opportunities available than before. So at least there is an increase in
employment along the horizontal labour supply curve LS1, as in figure 6.13.
❐ The structural equilibrium, meanwhile, has relocated to the intersection of AD1 with
the long-run supply curve ASLR at point (YS; P2).
❐ This kind of expansion typically takes one to three years to play out through changes in
interest rates, prices, expenditure decisions, production decisions, etc.
At the new short-run equilibrium, output is above the structural equilibrium employment
level YS and the actual price (at P1) is higher than the initial expected price (P e0 = P0). As
noted above, such a position cannot be sustained indefinitely, since adapting expectations
would start to impact on the labour market. Workers are likely to realise that the average
price level P has been increasing. Their price expectation P e would adjust towards the
actual price P1. In due course, labour contracts are likely to adjust to the higher average
price level P1. As a result, nominal wages start to increase.

❐ Graphically, as shown in figure Figure 6.18 Demand expansion followed by supply adjustment
6.18, this is indicated by the P ASLR ASSR2 ASSR1
ASSR curve starting to shift up,
ASSR0
say to position ASSR1, which
intercepts ASLR where the new Equilibrium after
expected price level P e1 = P1. supply adjustments
P2
The increase in the nominal wage P1 Equilibrium after
increases production costs, which demand stimulation
constrains the ability of produ- P0

cers to produce. Aggregate output AD0 AD1
contracts. The equilibrium moves
up and to the left. There is new
upward pressure on the average
price level, accompanied by a drop YS Y1 YFE Y
in total production and income
Y – we have an increasing price
level combined with an economic contraction.
The new output level is still above YS. And, the new price level is yet again above the
recently adjusted expected price level P e1, leading to further changes in the expected price
and resultant wage contract adjustments when the next round of negotiations comes
around. These processes where ASSR shifts up are likely to continue as long as Y is above
YS. The process pushes Y towards YS and ends when the equilibrium level of Y stabilises on
YS and the price level (as well as the expected price level P e) is at P2. In the diagram above
(figure 6.18), this is when ASSR
and AD intersect on the YS line. The neutrality of money?
The economy has reached the
When the demand stimulation is due to an expansion
long-run, structural equilibrium
in the money supply, this example demonstrates
point (YS; P2). what is meant by the term ‘neutrality of money’.
❐ We see here the ‘upward Since the long-run effect of the monetary expansion
elbow’, the typical pattern of on output is eventually zero, it has no long-term
the ASSR adjustment process benefit regarding output or employment. The price
following stimulation of aggre level P will eventually increase exactly in proportion
gate demand AD that pushed Y to the increase in the money supply M – the only
above YS. long-run change.
❐ Remember that the move of the ❐ This does not mean that monetary policy cannot
equilibrium point up along the be used to counter a recession. But output
AD curve is founded in corres- cannot be sustained beyond YS indefinitely by
money supply growth.
ponding changes in the IS and
❐ The neutrality result depends on the ASLR curve
LM curves. Similarly, changes
being stationary. If the drop in interest rates due
on the supply side are founded to the money supply expansion stimulates real
in changes in the WS, LS and investment, it will shift ASLR to the right, producing
PS curves. a long-term real positive impact on YS (see the
❐ Since the ASSR adjustment pro combination patterns below).
cess requires successive rounds
The neutrality of money was an important issue in the
of wage renegotiations, the debate between Keynesians and Monetarists on the
adjustment process can take use of monetary policy to stimulate economic growth
several years to complete. The (see chapter 11).
entire process of stimulation

followed by supply adjustment can easily take five years or more, allowing for some
overlap and concurrency.
What if policymakers try to keep the economy at Y1, above the long-run, structural
equilibrium level of Y? They would again and again have to counter the supply
adjustment process and accompanying contraction by further expansionary policy
to push the economy towards Y1 again. Supply adjustment would occur yet again,
requiring yet further expansionary policy. And so on, and so on. The result would be
continual increases in the price level. As people start to expect these policy reactions,
price expectations would adjust much quicker and be incorporated into wage contracts
proactively. ASSR would start adjusting upwards much quicker, requiring stronger and
stronger expansionary policy. In the end, P would increase faster and faster – i.e. we
would get inflation (more specifically, increasing inflation). The output level Y1 simply
cannot be sustained indefinitely with a given capital stock, labour force and technology.
(We will examine this result better in the next chapter when the model is expanded to
deal with an inflationary environment.)
Demand contraction followed by supply adjustment

For a decrease in aggregate demand Figure 6.19 A demand contraction sequence
AD (figure 6.19), a similar pattern
emerges. In this case Y drops P ASLR ASSR0
ASSR1
below YS. The adjustment process
ASSR2
entails a downward adjustment in
the average price level P, this being Equilibrium after
part of the process of moving back P0 demand decrease
towards YS. P1 Equilibrium after

❐ Such a change can be caused supply adjustments
by a decrease in government PS
expenditure (e.g. to reduce a
large budget deficit), or a drop
in exports due to a recession
AD0 AD1
in the economies of our major
trading partners. Y1 YS YFE Y
❐ The details of the economic
analysis are similar to that
of the expansion example above, but in the opposite direction. Such an example is
presented below. Remember that the move of the equilibrium point down along the AD
curve is founded in corresponding changes in the IS and LM (and BP) curves. Similarly,
changes on the supply side are founded upon changes in the WS, LS and PS curves.
❐ As shown in figure 6.19 this is the ‘downward elbow’, the typical pattern of the ASSR
adjustment process after a decline in AD which decreases Y to a level below YS. The
adjustment returns the economy to YS.
❐ This adjustment can take many, many years, notably since actual prices and nominal
wages have to adjust downwards – not an easy thing in any economy.
Key perspectives on the complete chain reactions

Any of the open-economy chain reactions which in previous chapters led to changes in
aggregate expenditure, now lead to a change in Y as well as in P. The change in P can
also have a feedback effect on the components of expenditure (e.g. investment, imports

and exports). Depending on the position of the equilibrium relative to YS, there could then
also be a supply adjustment process.
❐ Thus any chain reaction leading to an equilibrium income level above or below YS is
unlikely to stop there. The ASSR adjustment process will lead to further changes in Y
and P (and other variables).
❐ As mentioned in chapters 3 and 4, in practice the primary and secondary effects
are not neatly separated in time as distinct steps that follow one another – say, as if
an increase in Y is followed by a distinct increase in money demand. The secondary
effects concurrently become operational as the primary effect gathers speed. Different
secondary effects may, though, have different dynamics and time spans. The secondary
effects flowing from the balance of payments are likely to commence a while later than
the money market secondary effect, but will still unfold parallel and concurrent to
ongoing changes in main variables.
❐ We must now also distinguish between short-run and medium-run secondary effects.
The secondary effects in the money market, and thereafter the two BoP adjustment
effects, pertain to the short run, i.e. a period of up to three years following the initial
stimulus. (Note that these effects were all demand-side adjustments.) The supply-side
adjustment process, which we add now, takes place in the medium term, and can take
several years, typically from three to seven years.
❐ The supply adjustment (a medium-run secondary effect) similarly is not neatly separated
in time from the short-run primary and secondary effects of a change in demand, as the
above theory might suggest. There is likely to be overlap, with the supply adjustment
process starting and gathering speed already in the later stages of the short-term effects.
Such concurrency implies that, on average, an entire macroeconomic chain reaction
can take from four to seven years to complete. Time path diagrams will demonstrate
this in the discussion that follows.
❐ These only are indicative time frames. In reality, an economy never changes in neat,
mechanical fashion – as noted several times before. Moreover, long before this particular
complete chain reaction has played itself out, other shocks will occur on top of it and
start new stimulus-plus-adjustment processes.
❐ Like others, the supply adjustment process – the theoretically predicted move to the
long-run structural equilibrium – is unlikely to occur quite as quickly or smoothly as
the preceding discussion may suggest. Nevertheless, the existence of such adjustment
forces is clear.
❐ During the supply adjustment process, there will also be concurrent impacts on demand-
side elements such as the interest rate and balance of payments components. However,
in this phase their role becomes of minor importance. In the medium term, if any of the
other adjustments causes price or quantity changes contrary to the price and quantity
changes brought about by the supply-adjustment process, the latter will dominate –
the ‘gravitational pull’ of ASLR is persistent and will be as long as the economy is not at
ASLR. Thus expected price will continue to adjust to actual prices until they are equal.
The first two examples in chapter 4, section 4.7.5 will now be spelt out fully, while the third
is left to the reader as an activity. Additions are in italics. The IS-LM-BP dynamics in those
examples explain shifts of the AD curve. These shifts of the AD curve constitute the first
part of the complete chain reactions that follow. This will then be followed by a description
of the economic events that constitute the adjustment of the ASSR curve towards the long-
run, structural equilibrium level of real income, i.e. a point of rest on ASLR.

Example 1: The short- and medium-run internal and external effects of an
increase in the repo rate
Primary effect (demand side)

(1) [The process starts at point 0 on the AD-AS diagram (figure 6.20).]
Higher repo rate ⇒ money supply contracts ⇒ increase in interest rates ⇒ aggregate
demand decreases ⇒ downward pressure on prices and production ⇒ Y decreases
(= downswing in the economy) and P starts to decline. As Y and P decline, imports
decrease ⇒ current account (CA) surplus develops; increase in r ⇒ capital inflows ⇒
financial account (FA) goes into surplus.
Short-run secondary effects (demand side):

(2) Money market effect: As Y decreases, it causes the demand for money to decrease
concurrently ⇒ downward pressure on interest rates ⇒ initial fall in Y arrested ⇒
drop in M arrested, initial strengthening of (X – M) starting to end.
The net effect of the primary and money Figure 6.20 AD-AS and an increase in the repo rate
market secondary effects is that aggregate
AD0
demand and output falls, but that this fall P AD1 AD3 AD2
ASLR ASSR0
is restrained by (a) a concurrent drop
in M , which holds back (but does not
D
ASSR1
reverse) the repo-initiated rise in r and the
consequent drop in I and Y. Moreover, (b) 0
P
the simultaneous decline in the average price P0 3 2
  MP   . This
S
3
level P implies upward pressure on  1
acts as a further restraining force on the P4
increase in r and the decline in I and Y 4
(and M).
❐ Note that, now that P is not assumed
to be constant any more, P changes
and has feedback effects on compo
Y1 Y3 Y2 YS YFE Y
nents of expenditure (investment
and imports).
❐ If (a) didn’t happen, it would mean that the IS curve is flat. AD would shift left further.
If (b) didn’t happen, it would mean that the ASSR curve is flat. The decline in Y would
be larger.
The net effect of the primary and money market secondary effect can be depicted on the
P-Y plane, using the AD-AS framework. The demand/expenditure contraction causes the
AD curve to shift left. The first horizontal shift from AD0 to AD1 captures the combined
primary and money market secondary effects.
❐ The intersection of the shifting AD curve and the (stationary) ASSR curve determines the
short-run equilibrium of P and Y. The short-run equilibrium moves along ASSR0 from
point 0 to point 1.
❐ This move along the ASSR curve captures the restraining effect of the declining P on
aggregate expenditure.
The net effect of the primary and money market secondary effects leaves Y and P lower, r higher
and both the current and financial accounts in surplus. There is a BoP surplus (BoP > 0).

Further secondary effects due to BoP > 0:
(3) Initial BoP effect (foreign reserves adjustment): BoP surplus ⇒ inflow of foreign exchange
⇒ MS increases and downward pressure on interest rates (which decreases the inflow
of foreign capital and the FA surplus) ⇒ aggregate demand increases, causing Y and
P to increase; as Y and P increase it stimulates imports ⇒ prevailing current account
surplus is reduced; the turnaround in the real interest rate starts to discourage or
reverse capital inflows. The BoP surplus is being reduced.
The increase in Y implies that the initial downswing has turned around (at least for
now …). The decline in P is also reversed slightly.
In the diagram, AD shifts a bit to the right to AD2 (or, the initial leftward shift is restrained
– depending on the speed of the MS effect, which is assumed to happen quicker than the
exchange rate effect).
(4) Concluding BoP effect (exchange
rate adjustment): The initial Note the typical AD pattern generated by the two
BoP surplus (now already BoP effects following a BoP surplus: first the AD
slightly reduced) also leads curve shifts right (money supply effect), then the AD
to appreciation of the rand curve shifts left (exchange rate effect).
⇒ current account surplus ❐ The AD curve shifts right then left.
is reduced, and so is the ❐ The net effect of the two BoP effects on the
position of the AD curve and on equilibrium Y
remaining BoP surplus. The
appears to be relatively minor. Nevertheless,
process will continue until BoP
Y went through a noticeable up-down cycle in
= 0. This cumulative decrease the process.
in (X – M) again reduces
aggregate expenditure, which See chapter 4, section 4.7.4 for the initial analysis of
reverses the short recovery of these BoP-related shifts. Addendum 6.3 provides a
complete illustration of the IS-LM-BP changes that
Y and P – a further economic
underlie the movements of and along the AD curve in
downswing occurs (Y and P
this example.
decline again).
In the diagram, AD shifts a bit left
again to AD3. The short-run equilibrium moves to point (P3;Y3).
Depending on the timing of the BoP effects, there can be either a zig-zag in Y and P or one
will only notice the net effect, i.e. the net shift of AD from AD0 to AD3 and the net move of
the equilibrium along ASSR from point 0 to point 3 (blue arrow). Y declines from YS to Y3
and P from P0 to P3.
❐ Working with the net shift of AD simplifies AD-AS analysis. We will do so in the rest of
this and the next example.
The net effect of the primary and money market and BoP secondary effects leaves Y and P
lower, r higher and the BoP = 0. More specifically, and crucial for the supply adjustment that
will follow: real income Y is below YS, the structural equilibrium level of Y, and the actual
price level P is below the expected price level P e, since at this moment P e = P0. That is:
Y < YS and P < P e
These will lead to further economic adjustment processes.

Medium-run secondary effects (supply side):
(5) Supply adjustment: Y < YS and P < P e ⇒ downward pressure on expected prices. These
should lead to reduced wages in the next rounds of labour negotiations. As these come
into effect they reduce production costs and boost the ability of firms to produce ⇒
reduction in price level P and increase in sales and production Y. After several such
(annual) rounds of wage negotiation, the output level will gradually approach YS and
the price level P declines until a point on ASLR is reached and P = P e.
In figure 6.20 this is reflected as a downward move of the ASSR until it intersects AD3 at a
point that is on ASLR (which is where P = P e). The short-run equilibrium moves along the
AD3 curve from point 3 to point 4. Y increases from Y3 to YS and P declines from P3 to P4.
M S
The decline in P also increases the real money supply  P  ,  which puts downward pressure
on interest rates and increases aggregate demand (along the IS and AD curves). Thus the
FA should also go into deficit. The (cost- and interest-rate induced) increase in income Y
also leads to an increase in imports, so that the current account CA should go into deficit.
A BoP deficit develops.
The normal BoP adjustment processes will play out (during which r should increase some
what and the rand should depreciate; the impact of a declining P on X and M will assist these
processes). All these will then take the BoP back to a position of balance – perhaps causing
minor fluctuations in Y on its path along AD3 towards its final resting point at YS.
These processes continue until the short- Figure 6.21 Illustrative time path of key variables –
run equilibrium is at YS and BoP = 0, i.e. increase in the repo rate
with both internal (real, monetary and
labour market) and external equilibrium.
[This is at point 4 in the diagram.] r
Summary of final, net effects Time

1. The price level ends up significantly Y
lower than at its starting level. The
contractionary monetary policy step
followed by the AS adjustment has
Time
unequivocally reduced the average
price level. P
2. Real income is back where it started, af
ter a deep cyclical downswing, with the
recovery – punctuated by a dip on the Time
Rand
way – lasting several years.
3. Cyclical unemployment increases for
BoP
several years, but decreases during the
Time
AS adjustment phase.
4. The balance of payments goes through
two cycles of surplus and deficit, but
Demand contraction Supply adjustment
ends up in balance. phase phase
5. The real interest rate goes through up to 3 years 3–7 years
a strong upward phase initially, but
declines during the BoP as well as AS
Overall (with overlap): 4–7 years
adjustment phases. It will probably end
up roughly where it started.

6. The external value of the rand increases during the second BoP effect of the demand
contraction phase, and will likewise decline again at the end of the supply adjustment
phase.
Example 2: the short- and medium-run internal and external consequences of an increase
in government expenditure
Primary effect and short-run, demand-side secondary effects:

The net impact of higher government expenditure, via its primary and money market secondary
effects, can be summarised as follows. (See chapter 4, section 4.7.5 for detailed steps.)
[The process starts at point 0 on the AD-AS diagram (figure 6.22).]
(1) & (2): Aggregate demand and output Y as well as P rises (as does M), but this increase
is restrained by (a) a concurrent rise in interest rates, which dampens expenditure, as
M S
P  .  This
well as (b) the simultaneous increase in the average price level P, which contracts  
acts as a further restraining force on the increase in Y (and M).
This phase leaves Y and P higher, r higher and the CA < 0. The increase in r leaves the
FA > 0. Assuming mobile international capital flows, the net effect will be a BoP > 0. As a
result, further secondary effects follow. These continue until BoP = 0.
(3) The initial, money supply effect of the BoP reduces interest rates, which stimulates
expenditure, Y and P to increase. This reduces the current account deficit, while the FA
surplus is also reduced by the drop in interest rates. The initial upswing in Y has been
followed by another upswing.
(4) The concluding, exchange rate effect of the BoP leads to an appreciation of the rand ⇒
current account deficit increases again. This helps to eliminate the remaining BoP surplus.
The appreciation of the rand is responsible for a contraction of aggregate expenditure and
Y towards the end.
In the diagram the entire set Figure 6.22 AD-AS and an increase in government expenditure
of demand-side primary and
secondary effects is summarised in ASLR ASSR2
P ASSR1
the net rightward shift of AD from
AD0 to AD1. (If shown in detail, the ASSR0
AD curve will display the typical Equilibrium after
right-then-left shift pattern, 2 supply adjustments
P2
associated with phases 3 and 4 for Equilibrium after
P1 1
a BoP surplus, before reaching the all demand-side
AD1 position.) 0 secondary effects
P0
The short-run equilibrium has AD1
moved from (P0; YS) to point (P1; Y1).
[The economy is at point 1 on the AD0
diagram.]
YS Y1 YFE Y
The net effect of the primary,
money market and BoP secondary
effects leaves Y and P higher, r higher and the BoP = 0. More specifically, and crucial for the
supply adjustment that will follow:
Y > YS and P > P e

since at this point in the process P e = P0. These will now lead to further economic adjustment
processes.
Medium-run secondary effect:

(5) Supply adjustment: Y > YS and P > P e ⇒ upward pressure on expected prices. These
should lead to increased wages in the next rounds of labour negotiations. As these come
into effect they increase production costs and restrict the ability of firms to produce ⇒
increase in price level P coupled with a decrease in sales and production Y.
This process will repeat itself. After several such (annual) rounds of wage negotiation,
the output level will continue to decline and gradually approach YS.
In the diagram, the short-run AS curve shifts upwards to, say, position ASSR1. It shows
a downswing in Y together with an increase in the average price level P – not a happy
combination for a country. Further such adjustments are portrayed as a continual upward
move of the ASSR until it intersects the AD and the ASLR, i.e. at point 2.
M S
The increase in P also decreases the real money supply  
P  ,  which puts upward pressure on
interest rates and dampens demand (moving up along the AD curve). Thus the FA should
also go into surplus. The (cost- and interest-rate induced) decrease in income Y also leads
to a decrease in imports, so that the CA should go into surplus. A BoP surplus develops.
The normal BoP adjustment processes will play out (during which r should decrease some
what and the rand should appreciate; the Figure 6.23 Illustrative time path of key variables –
impact of an increasing P on X and M will increase in government expenditure
assist these processes). All these will then
take the BoP back to a position of balance –
perhaps causing minor fluctuations in Y on
its path along AD3 towards its final resting r
point at YS.
Time
These processes continue until the short-
run equilibrium reaches YS and BoP = 0, Y
i.e. with both internal (real, monetary and
labour market) and external equilibrium.
Time
[The economy ends up at point 2 on the AD-AS
diagram.]
Summary of final, net effects P
1. The price level ends up significantly
Time
higher than at its starting level, follow
Rand
ing interrupted years of increase. The
expansionary fiscal policy step followed
by the AS adjustment has unequivo BoP
cally increased the average price level. Time
2. Real income goes through a substantial
cyclical upswing, followed by a down Demand contraction Supply adjustment
swing lasting several years (the whole phase phase
process lasting perhaps four to seven up to 3 years 3–7 years
years on average). In the end, output and
income are back where they started, and Overall (with overlap): 4–7 years
YS below YFE.

3. Unemployment decreases below long-run levels for several years, but increases again
during the downswing of the AS adjustment phase. It ends up at the same level as
when the process started – the structural rate of unemployment (and still below full
employment).
4. The balance of payments goes through two successive cycles of surplus, and ends up
in balance.
5. The real interest rate goes through two cycles of increase followed by a weaker decline
– one each in both the expansion and contraction phases. It should end up higher
compared to where it started.
6. The rand appreciates during the second BoP effect of the demand contraction phase,
and does so again at the end of the supply adjustment phase. At the end, the rand is
much stronger than it was initially.
✍ The two examples of the impact of monetary and fiscal policy changes built on the IS-LM-BP
analysis of chapter 4. Sections 4.5.3 and 4.7.5 in chapter 4 also presented a third demand-
side example, i.e. an increase in exports (an external disturbance). Complete that example by
incorporating price and supply behaviour. Draw an appropriate AD-AS diagram.
6.4.3 Supply-side disturbances leading to points off the ASLR curve

The analysis of a supply-side disturbance is complex since it affects both the long-run and
the short-run aggregate supply relationships (and curves). A decrease in aggregate supply
– a so-called supply shock – causes both ASSR and ASLR to shift to the left in tandem, and
results in a decrease in Y (a downswing), which is accompanied by an increase in P (see
figure 6.24).
❐ Such a change can be caused by output-restricting or cost-raising events such as a
drought, or increases in the cost of non-labour inputs, e.g. an increase in the oil
price, the price of electricity or an increase in the price of imported inputs due to a
depreciation of the rand, for instance.
❐ On the wage-setting side, such a change can result from an increase in union power
that is used to secure higher nominal wages during a wage bargaining round, or an
increase in the legislatively determined minimum wage.
The whole process plays out in two phases. Since the long-run supply curve also shifts to
the left, the structural equilibrium point relocates to the point (YS2; P2). Simultaneously,

the ASSR curve shifts left an Figure 6.24 Supply shock followed by supply adjustment
equal distance. The short-run ASLR1
P ASSR2
equilibrium point slides up and
ASSR1
to the left along the AD curve. ASSR0
Because of the slide along the Phase 1:
AD curve, this new short-run Supply shock
P2
equilibrium is not on ASLR – shifts both
P ASSR and ASLR
output would be at Y1, which is 1
left
P0
to the right of YS2. Thus it is not
Phase 2:
a long-run or sustainable equi AD Supply
librium because the expected adjustment
price level P e still is at P0, while process shifts
ASSR up
the actual price is already high
er than that; thus P ≠ P . The e
normal ASSR supply adjustment YS2 Y1 YS0 YFE Y

process in such a situation will
be activated – the second phase of the process. Thus ASSR starts shifting up through an
upwardly adjusting expected price P e and a renegotiated nominal wage W, as described
in the case of a demand-led expansion above. The short-run equilibrium moves further
up and to the left along AD through an upwardly shifting ASSR. This process depresses Y
further, combined with a further increase in the price level P. It should continue until the
short-run equilibrium reaches ASLR1 at actual price level P2 and income level YS2.
❐ Recall that the second phase in the diagram, where the ASSR curve shifts due to the
supply-adjustment process, will be relatively slow (i.e. not instantaneous – it may take
approximately three to seven years). This is because it requires the next round of wage
setting/bargaining to take place. Only then can the supply adjustment process start, to
be followed by yet further rounds of wage setting to complete the adjustment process.
❐ It could thus be several years before the new structural equilibrium point on ASLR1 is
reached. A prolonged economic contraction is likely.
❐ Remember that the move of the equilibrium point down along the AD curve is founded
in corresponding changes in the IS and LM curves. Similarly, changes on the supply
side are founded in changes in the WS, LS and PS curves. (Details of changes in the
PS and LS curves are shown in the graphical example in addendum 6.2; also compare
addendum 6.4.)
❐ Note that in this case the situation regarding both key variables, income and prices,
worsens (and does so in both phases). In the case of demand-side disturbances, the
position regarding one variable would worsen while the other would improve ‘in
exchange’ (see the preceding graphical examples). A negative supply shock is quite
disagreeable for society.
Example 3: the short- and medium-run internal and external impacts of an increase in the
price of imported inputs (e.g. oil)
Primary effect and short-run, demand-side secondary effects:
Two simultaneous impacts:
(1) Demand-side impact: Higher imported input prices ⇒ if price elasticity of the demand
for the product is low (as is the case with oil) ⇒ M increases ⇒ (X – M) decreases ⇒
total domestic expenditure decreases (and the CA into deficit) and output Y as well

as P decreases. As Y decreases, Figure 6.25 AD, ASSR, ASLR and an increase in the oil price
interest rates decline as a sec AD1 AD0 ASSR2
P ASSR0
ondary money-market effect,
ASSR1
causing an outflow of foreign
capital (FA into deficit). Supply shock
❐ The development of a large 3 shifts both
P3
initial current account ASSR and ASLR
P2 2 left. Then sup-
deficit is an important ply adjustment
characteristic of this case P0 0 process shifts
P1 1
(in contrast to a domestic ASSR up
supply shock). Rise in import
bill decreases
In the diagram (figure 6.25), AD domestic
shifts leftward from AD0 to AD1. A ASLR1 ASLR0 expenditure
new (P; Y) short-run equilibrium YS1 Y2 Y1 YS0 YFE Y
results.
[The economy has moved from point 0 to point 1 on the AS-AD diagram.]
(2) Supply-side impact: Higher imported input prices (e.g. oil and petrol) ⇒ increase in costs
of production, constrains ability of firms to produce at current price levels ⇒ upward
pressure on the average price level P; this simultaneously decreases the real money
M
S
P   , which increases the interest rate and causes investment and thus aggregate
supply  
expenditure to decline ⇒ output Y starts declining. Thus P starts to increase while Y
declines (and thus also M).
Without an IS-LM-BP diagram, one cannot deduce the net effect on the interest rate.
It would have increased in phase 2 above, but may still be below the starting point.
(Addendum 6.4 contains a complete example that shows the IS-LM-BP curves as well.)
While the FA will have recovered, it is still likely to be in a deficit or a small surplus. The CA
should have improved somewhat due to the decline in Y (and thus M). Nevertheless, the
magnitude of the initial CA deterioration should still dominate, given the relative size of
the oil bill (and bearing in mind that the increase in P would curb any CA improvement).
Thus we can assume that the BoP is still in deficit when the economy reaches point 2.
Graphically, there is a leftward shift of (a) ASSR from ASSR0 to ASSR1 and (b) ASLR from ASLR0
to ASLR1 (see section 6.3.3 if this is not clear). This shows the following things:
(a) Through the interaction between ASSR1 and AD1 a temporary equilibrium (P2; Y2) is
reached on the AD-AS diagram.
(b) The structural equilibrium level of output YS has shifted to a lower level YS1.
(c) The average price level P is higher than at the starting point: P2 > P0.
[The economy is in the vicinity of point 2 in the diagram.]
The expected price level that is embodied in wage contracts is still at its initial level:
P e = P0. And Y is lower than before the supply shock occurred. Yet, because YS has shifted
to a lower level, we have:
Y > YS and P > P e
But first there is a BoP deficit that will have short-run effects:
(3) Initial BoP effect (foreign reserves adjustment): The BoP deficit and outflow of foreign ex
change ⇒ money supply decreases ⇒ upward pressure on interest rates ⇒ aggregate
demand and expenditure decreases.

(4) Concluding BoP effect (exchange rate adjustment): The initial BoP deficit also leads to a
depreciation of the rand ⇒ discouragement of imports and stimulation of exports ⇒
aggregate expenditure stimulated.
These two effects will return the BoP to a position of balance. Within the AD-AS model it
suffices to note the typical AD patterns generated by the two BoP effects following a BoP
deficit. First the AD curve shifts left (due to the money supply effect), then the AD curve
shifts right (due to the exchange rate effect).
❐ The AD curve zig-zags left then right. Y would decline a bit, then rise again. P would
decline a bit, then rise again.
❐ The net effect of the two BoP effects on the position of the AD curve and on equilibrium
Y and P appears to be relatively minor. They are less relevant in the medium-term
context of this example.
❐ Whatever the magnitude of the two BoP effects, we draw the curve AD1 to show the net
effect after both BoP adjustment processes.
[The internal equilibrium of the economy has moved to point 2 in the diagram.]
After the BoP adjustment effects, at short-run equilibrium point 2, we still have:
Y > YS1 and P > P e = P0
The economy still operates at an output level that exceeds the structural, long-run
equilibrium, and there is a discrepancy between the expected price level (in wage contracts)
and the actual price level. This is not a stable, sustainable equilibrium. A medium-run supply
adjustment process must follow.
Medium-run secondary effect:

(1) Supply adjustment: Because Y > YS and P > P e ⇒ upward pressure on expected prices.
These should lead to increased wages in the next rounds of labour negotiations. As
these come into effect they increase production costs ⇒ an increase in price level P
and a decrease in sales and production Y. Gradually the output level will approach YS.
Graphically this is portrayed by an upward shift of ASSR until it intersects the AD curve
and ASLR.
 MP  ,  which puts upward pressure
S
The increase in P also decreases the real money supply 
on interest rates and dampens demand.
The internal equilibrium moves along the IS and AD curves towards point 3. With
interest rates increasing again, now clearly above the starting levels, the FA should go
into surplus.
The further, cost- and interest-rate induced decrease in income Y (from point 2 to 3)
also leads to a decrease in imports, so that the current account should go into surplus.
A BoP surplus develops.
The normal BoP adjustment processes will play out (during which r should decrease
somewhat and the rand should appreciate; the impact of an increasing P on X and
M will assist these processes). All these will then take the BoP back to a position of
balance – perhaps causing minor fluctuations in Y on its path towards its final resting
point at YS.

Graphically, AD is likely to shift right then Figure 6.26 Illustrative time path of key variables –
left, so we retain AD1 as the likely net increase in the oil price
position of aggregate demand.
These processes continue until the
equilibrium is at YS and BoP = 0, i.e. with r
both internal (real, monetary and labour
market) and external equilibrium. This is Time
point 3 on the AD-AS diagram.
[The final equilibrium of the economy is at Y
point 3.]
Time
Summary of final, net effects:
1. The large initial increase in the import P
bill implies a substitution of imported
goods for domestic goods. This reduces
Time
domestic expen diture, putting down
ward pressure on prices initially. Yet Rand
the price level soon starts to increase
due to the cost shock. The contraction
ary effect of the outflow of reserves BoP Time
temporarily brakes the upward mo
mentum of P, before it resumes a Contraction due to Supply
sustained increase. supply shock phase adjustment phase
up to 3 years 3–7 years
2. Real income (and together with it employ
ment) decreases significantly. Except for
a brief upturn due to the first exchange Overall (with overlap): 4–7 years
rate effect of the BoP, it decreases to a new,
lower long-run equilibrium level.
✍ Example 3 above analyses the impact of a change in the oil price – a supply-side disturbance (or
shock) in the external sector. Supply-side disturbances can also originate within the domestic
economy. Examples include unexpected, large changes in labour cost or the price of important
other inputs such as electricity. Redo the analysis of example 3 for an internal cost disturbance
such as a sudden increase in the price of electricity. Illustrate this on an AD-AS diagram. (Also
see the case study in section 6.5.)

3. The balance of payments first deteriorates due to the increase in the oil import bill.
However, later, as part of the medium-run AS effect, it goes into a surplus before
adjusting to final equilibrium.
4. The real interest rate first decreases, before it increases significantly. Much later, as
part of the last BoP adjustments within the medium-run AS adjustment, it decreases
slightly – but still ends up higher than before the shock.
5. The rand first depreciates, before it appreciates later, as part of the BoP-adjustment
dimensions of the medium-run AS adjustment.
6.4.4 Combination patterns

A supply shock followed by policy stimulation
Combinations of patterns can also be found. A pattern that occurs frequently is a ‘left-hand
upward zig-zag’ due to a supply shock (ASSR and ASLR shift to the left) followed by expansionary
fiscal or monetary policy (AD shifts to the right) to counteract the contraction. This is shown in
figure 6.27.
As shown in figure 6.24, the initial shock, followed by a supply adjustment, takes the
economy to a new equilibrium at YS2 with the price level at P2. Note that the long-run
aggre gate supply curve has Figure 6.27 Supply shock followed by accommodation
moved left to ASLR1 due to the
initial shock. The expansionary P ASLR1 ASLR0 ASSR3
demand policy then pushes ASSR2 ASSR1
the economy to a point to the ASSR0
right which again is off ASLR1
(combined with an increase in P4
the price level to P3, say). A new Adjustment
P3
round of supply adjustment – process then
P2 shifts ASSR up
which increases the price level
again
yet again (eventually to P4) P
0
together with a reversal of the AD0 AD1 Policy
policy-led expansion to YS2 – is stimulation
shifts AD right
likely.
❐ The reason for the frequent YS2 YS0 YFE Y
occurrence of the latter zig-
zag pattern is that, as indi
cated earlier, a supply shock Understanding the structural equilibrium level
leaves the economy with twin The level of structural employment, i.e. YS, can
problems: more unemploy now unambiguously be understood as the level
ment plus an increasing price around which cyclical disturbances, fluctuations and
level. Political pressure and/or adjustments in Y occur (see box on unemployment
socio-economic considerations on page 260). It is the output level (together with its
often persuade a government price level PS ) from which the ‘gravitational pull’ that
to adopt unemployment as the we have been speaking about is exerted. In other
first priority of policy, and to words, YS is the cyclically neutral level of income (and
stimulate aggregate expendi employment).
ture. Nevertheless, its own position is not permanent, since
❐ This is called the ‘accom- it can also be shifted around due to economic factors
modation’ of the supply shock. and forces.

The problem with such accommodation is that, in exchange for what turns out to
be only temporary higher GDP and employment, the country has to endure a further
increase in the price level – followed by yet another downswing-plus-price-increase
phase due to the fact that the long-run structural equilibrium has relocated to a lower
level. (This policy dilemma is discussed again in chapter 12, section 12.1.)
Government or business investment leading to supply expansion

It was noted above that real Figure 6.28 Supply expansion due to investment
investment expenditure, either
P ASLR0 ASLR1
by government, public corpora
Equilibrium
tions and government entities after supply
or the private sector, has two ASSR2 growth and
effects. It increases aggregate supply
ASSR0 adjustment
demand in the short run (and
P2 ASSR1
thus shifts the AD curve to the P1 Equilibrium
after demand
right); and it boosts produc stimulation
P0
tive capacity in the medium
to long run. As shown in the
diagram (figure 6.28) it thus AD0 AD1
shifts the ASLR curve to gether
with the ASSR curve to the right.
YS Y2 Y1 YFE Y
Thus there is a com bination
of a positive supply shock and
a demand stimulation. Depending on the speed and magnitude of the relative shifts of
the AD and AS curves, the new short-run equilibrium may be on, to the left of, or to the
right of the new ASLR1 curve (shown in figure 6.28). If it is off the ASLR curve, it may
be followed by supply-adjustment processes until the short-run equilibrium settles on the
new, augmented ASLR1 2 at point (P2; Y2).
❐ It is important to note that – compared to a standard non-investment aggregate demand
stimulation (see example 2 above) – the price level increases by less and that there is a
net increase in the long-run, structural equilibrium output to Y2.
❐ This will be important when discussing the determinants of economic growth, which
is graphically equivalent to a steadily outward shifting ASLR curve and a steadily
increasing structural equilibrium output YS.
❐ This example also relates to the discussion of the Phillips curve in chapter 7 and the
pros and cons of government expenditure to stimulate growth in chapter 10.
❐ Expenditure on new technology and human capital would have similar effects to those
shown above.
❐ This example also alerts one to the importance of supply-directed policies of a structural
nature – rather than anti-cyclical demand policy – to effect outward shifts in the long-
run output level and thus achieve sustained reductions in structural unemployment.

YS and the rate of unemployment in a growing economy
The preceeding diagrams show how the long-run, structural equilibrium level of real income
YS shifts right or left over time due to different economic factors. A YS that continually shifts to
the right implies steady economic growth. It is important to understand how that relates to the
rate of unemployment.
An increase in the structural equilibrium level of output implies higher levels of employment N.
However, the rate of unemployment U will depend on what has been happening with the labour
force (LF) (as well as technology and labour intensity/productivity) over time. Recall that:
(LF – N)
U =  _______
    
LF
A growing YS and growing employment N does not necessarily imply that the rate of
unemployment is declining over time. With a growing population and labour force, a growing
YS is necessary to absorb new entrants into the labour market to prevent the unemployment
rate from rising. However, the absorption of labour also depends on the extent to which the
growth in YS is due to productivity-enhancing technological progress.
❐ If YS grows steadily at the same rate as the labour force, but a major cause of this
growth is productivity-enhancing technological progress, the long-run or structural rate
of unemployment (SRU) could actually increase. A YS that grows at the same rate as the
labour force would produce an unchanging long-run or structural unemployment rate (SRU)
only if technology is not augmenting labour productivity.
❐ If YS grows at a rate higher than the growth in the labour force, but this relatively higher rate
is not primarily due to improved technology (i.e. higher labour productivity), it would mean
that the output growth is the result of increased employment or labour absorption. Thus
the long-run or structural rate of unemployment (SRU) would decline.
❐ The structural dimensions of unemployment imply that changes in YS on their own are not
sufficient.
For more on this, see section 12.2 in chapter 12.
✍ The world financial crisis of 2007–08: aggregate supply and price level effects
We introduced this case study at the end of chapter 3 and followed up in chapter 4.
Recall the context briefly. The world economy was shattered by the so-called subprime
credit crisis in the USA that came to a head in September–October 2008. It led to the failure
of several banks in the USA (and other countries), and a serious credit shortage ensued.
Economic confidence disappeared, durable consumer expenditure and residential (and
other) investment dropped. The US economy hit a recession, and many businesses, e.g. the
Big Three motor companies in the USA, faced serious financial ruin. (These recessionary
conditions spread to the UK, Europe and Japan, for example.)
In reaction to this, the US government increased government expenditure (including national
infrastructure investment) to restore confidence, create jobs and rebuild the economy,
and fend off the threat of deflation. The Federal Reserve also backed up the banking
sector, reduced the bank rate to stimulate credit creation and introduced several rounds of
quantitative easing.
Now analyse these fiscal and monetary policy steps with the additional analytical tools and
insights acquired in this chapter. Focus especially on the aggregate demand and aggregate
supply effects, and thus the joint impact on GDP as well as the average price level.
⇒

⇒ Hint: First consider the initial shock in the AD-AS model and then the policy response. Also
consider whether any supply adjustment processes take place or can be expected to take place.
Second, go back and try to analyse the underlying developments in the real and monetary sectors
(or use the IS-LM-BP diagram). Third, try to analyse events in the labour market (the WS-PS
framework).
✍ What are probable or possible explanations for:

❐ increasing prices?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
❐ decreasing prices?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
❐ increasing prices combined with an upswing?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
❐ increasing prices combined with a downswing?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
❐ increasing prices with a constant level of Y?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
6.4.5 Can this theory explain the course of the South African economy?
The Keynesian framework developed in these chapters can be used to try to explain different
observed patterns in the macroeconomy. While this largely constitutes ‘enlightened
guesswork’ in hindsight, one can attempt to explain the course of the average price level P
and real GDP Y in the South African economy over the last decades.

Figure 6.29 Output fluctuations and the price level in South Africa
2018
2009
2008
2003
1997
Average price level (log scale)
1993
1989
1986
1981
1977
1974
–5 –4 –3 –2 –1 0 1 2 3 4 5 6
Real GDP (% deviation from long-run AS)

Source: South African Reserve Bank (www.resbank.co.za), and authors’ own calculations.
Consider the graph in figure 6.29 representing data on the South African economy since
1970. The graph plots the (log of the) CPI index against the deviation of output from its
long-run trend. Thus it is comparable to the AD-AS framework with P and Y on the axes.
The graph period includes the major recession that followed the substantial increase in oil
prices by the OPEC oil cartel in 1973. It also shows the recession after 1981 and 1989.
The economy reached a trough in 1993, whereafter output increased and exceeded trend
output. However, also note that, after the Asian crisis in 1998 and the rather severe
depreciation of the rand in 2001, output fell slightly below the trend. After the latter
deterioration it improved for several years, reaching a peak in 2007–08. However, in 2009
the economy experienced a deep recession following the fall-out from the global financial
crisis. At the time of writing (2019), the South African economy was stuck in a long period
of very low economic growth.
The question is: can shifts in AD and AS, and related adjustment processes that result
in changes in the equilibrium level of Y and P, map out a path that approximates the
behaviour of the real South African economy? Or, can the latter path be explained by
finding appropriate shifts in AD and AS that can be traced back to actual policy steps or
other disturbances?

We will not provide such a comprehensive explanation now. It is left to the reader. What
one can and must do is to identify periods such as the following:
(1) demand pull;
(2) cost push;
(3) cost push followed by accommodation (stimulation);
(4) demand stimulation followed by supply adjustment towards long-run supply; and
(5) simultaneous demand pull and cost push.
Can you identify such periods in the graph? Once that is done, one can search – among the
determinants of AD and AS – for those potential determinants that were active at specific points
in time. Doing so would identify the likely causes of the changes in AD and AS, and thus of
Y and P. This would constitute a probable explanation of the course of the South African
economy during the past two decades.
6.4.6 A comprehensive explanation of the consequences of economic

disturbances
The entire modern Keynesian macroeconomic theoretical model is now almost complete.
This is apparent from the complete circular flow diagram earlier in this chapter. We have
considered the role of, and linkages between, all the major macroeconomic variables.
We have considered their behaviour and complex interrelationships in the short and
the medium term. The likely causes or consequences of changes in these variables can be
indicated with a reasonable degree of certainty. The model can be used to predict, albeit
only roughly, the expected consequences of any real or monetary, internal or external
disturbance, including adjustment towards the long-run supply curve.
Graphically, the model has been set out in a series of diagrams (see figure 6.30). It started
with the 45° model and its link to the monetary sector. This was then summarised in the
IS-LM model, or the IS-LM-BP model in the open-economy context. Finally, we derived the
AD-AS model, which summarised the initial three-diagram model and the IS-LM dynamics
in the AD curve, and added two AS curves.
Together, these diagrams enable one to trace the consequence of a real, monetary, internal
or external disturbance through the (open) economy. We can see how it impacts on interest
rates and exchange rates and several real and monetary economic variables along the way,
often initiating complex adjustment processes – until it ends with a final impact on the
price level and output/income.
Note that in many cases the Truth or theory?
supply-adjustment process will Remember that this is still only a theory of the way
appear to be inoperative. This is the economy works. While it is sophisticated, and
because of the length of time it the product of the work of highly regarded theorists
takes – from three to seven years and economic scientists, including Nobel Prize
– and the frequent occurrence of winners, it should never be regarded as the absolute
Truth (with a capital T). No theory or science can ever
new disturbances or policy steps
be that. Human knowledge and insight are and always
that override the adjustment.
will be limited, should be regarded as provisional, and
Therefore one often focuses on should be used unpretentiously and in full awareness
the initial impact on the AD-AS of their fallibility.
diagram, largely leaving the sup
ply adjustment process out of consideration – especially in cases where the BoP adjustment
process is of greater importance. Nevertheless, one should always be aware of the underlying
forces of the AS adjustment process.

Figure 6.30 The whole model – monetary and real sectors, aggregate demand and aggregate supply
Monetary sector Real sector
Transmission
mechanism
r M
  
S
   r E P ASLR ASSR
P
C+I+Gc+X–M
MD
  P  
  I AD
Money I Y Y
Feedback
mechanism
NOTE
• Monetary changes are transmitted to the real sector via the interest-investment link (a left-to-right causality).
• Real sector changes include aggregate income (Y) as well as the average price level (P).
• Changes in the real sector (Y, P) have secondary, feedback effects on the monetary sector via the demand for
money (a right to left, indirect causality).
• The first impact of monetary policy is in the monetary sector, while the first impact of fiscal policy is in the real
sector.
This model enables one to consider and analyse specific problem areas of macroeconomics.
The first of these is macroeconomic policy; the second, the problems of inflation, unem
ployment and low growth. These will be discussed in chapters 9 to 12.
However, the above model, though rather extensive, still needs one bit of upgrading to
represent a complete model for the modern era: it needs to be adapted for a world where
inflation is a permanent feature. Whereas this chapter introduced the aggregate price level
and changes in the price level, the next chapter extends the model to situate it in a world
where price increases are not one-off occurrences, but a permanent feature.
6.5 Real-world application – the Eskom crisis, GDP and prices

Section 6.4.4 describes how investment by government and the private sector expands
the long-run capacity of the economy. Graphically this expansion was represented by a
rightward shift of both the long-run and short-run AS curves. In the period after 2008,
South Africa had a striking experience of this kind – although it was in the reverse direction
and a bad experience!
The run-up: Eskom shocks the country with blackouts (or ‘load shedding’)
State-owned electricity producer Eskom, which declared its fourth power emergency of
the 2013/14 summer maintenance season on Thursday morning, began implementing load
shedding from 9:00, causing shops to shut, disrupting cellular networks and raising fresh
concerns about the constraint being placed on South Africa’s already poor growth outlook
by the country’s electricity shortages.
Mining Weekly, 6 March 2014

In 2007 Eskom suddenly announced that, with electricity reserves running lower than 8%
in some areas, they would need to implement a blackout schedule – euphemistically called
‘load shedding’ – from 2008 onward to prevent crashing the entire national electricity
grid. They also announced that, following years of underfunding by the government, they
faced a huge longer-term generation capacity problem and would need to build several
new power stations – but that it could take several years (and cost billions of rands).
To ‘solve’ the problem in the interim, Eskom put pressure on mines, aluminium smelters
and large factories to cut back on their electricity usage. To achieve the desired 10%
reduction in electricity consumption, many had to cut back on production. Retail and
other businesses suffered losses and many had to buy diesel generators to carry them
through blackout periods. Planned – and often unplanned – maintenance on ageing
power stations and other equipment contributed to a bad period for the economy with
regard to a vital input. The disruptions had a very negative effect on business confidence
and appear to have discouraged foreign direct investment in South Africa. The year 2008
alone is estimated to have cost the economy R50 billion in lost production.
In 2012, Eskom once again warned that rolling blackouts may happen. This pattern
continued on and off until the time of writing (2019), despite the fact that Kusile and
Medupi, two coal power stations being built in Mpumalanga and Limpopo respectively, were
supposed to be on stream by 2017. (The fact that the construction of these power stations
had again fallen behind schedule and suffered from construction faults that prevented them
from operating at full capacity, further increased business and consumer anxiety.)
Moreover, to help fund its capital expenses, Eskom started to increase electricity tariffs
significantly. Having had average annual price increases of just above 5% since 2000,
from 2008 tariffs were increased by, on average, 27% per year for four years. After
that it was restricted by Nersa (the official regulator) to 16% and then 8% per year. By
2019 electricity tariffs had increased by more than 300% within ten years. By 2019
Eskom also accumulated debt of almost half a trillion rand, equal to almost 10% of
GDP, imposing a heavy interest burden on the company and necessitating continual
government bail-outs.
On a macroeconomic level, as shown in the diagrams in chapter 1, the period under
discussion is characterised by upward pressure on the average price level since 2010
(i.e. several increases in the inflation rate) plus a decline in the GDP growth rate since
2011. While many factors have probably contributed to this course of events – e.g.
increases in the dollar price of oil from 2009 to 2014, coupled with a decline in the real
effective exchange rate of the rand since early 2011 – the Eskom problems appear to have
had a noticeable impact on both the GDP rate of growth and the rate of inflation. At the
very least Eskom is a substantial part of the explanation of events.
Understanding the slowdown in GDP growth and upward pressure on the average price level
since 2008
The AD-AS model can be used to get a clear analytical grasp of how this could have
occurred.
There are two blows stemming from Eskom:
1. A bottleneck in electricity output (i.e. in the flow of electricity), which repeatedly
causes cost increases in production processes (lost production, damage to machinery,
workers and machines being unproductive during blackouts, switch-on costs of
factories after blackouts, having to install diesel generators and so forth), as well as
major increases in electricity tariffs.
6.5 Real-world application – the Eskom crisis, GDP and prices 295

2. A backlog in Eskom’s long-term electricity generation capacity. This delays and
discourages private investment in productive capacity (factories, mines, infrastructure,
etc.), thereby constraining the growth in the country’s overall capital stock and
productive capacity in the medium to long run. (If Eskom’s construction of expensive
new power stations is delayed, that in itself would constitute an additional reduction
in real investment.)
Both of these are considered in the following discussion in the context of a situation with
a steadily growing GDP. This enables us to see the medium- to long-term effects of the two
Eskom-related problems. Figure 6.32 shows their combined impact on output Y and the
price level P over several years.
❐ The bottom diagram shows a base run with steadily growing output and income levels due
to steadily growing aggregate demand and aggregate supply – i.e. a steadily increasing
structural equilibrium output YS resulting from a steadily outward-shifting AD together
with ASLR (with ASST tagging along). The equilibrium price level P remains constant.
❐ The top diagram shows how the course of equilibrium Y and P is affected by Eskom’s
output and capacity constraints: Y expands less per year and the price level P increases.
The top path in figure 6.32 is a combination of the following:
❐ a supply, or cost, shock (see figure 6.24), and
❐ the supply (and demand) effects of a decline in investment (compare figure 6.28).
This path will be explained by first analysing changes in a single year and then inserting
that analysis into a longer-term, steady-growth situation.
Unpacking the Eskom effects for a single year

As a first step, figure 6.31 zooms in on an interval between two points in time, i.e. the
year 0 (when the Eskom problems start, approximately 2008) and year 1, when the
impact is felt. Nevertheless, we keep the context of a steadily outward-shifting AD and
ASLR in mind.
In figure 6.31 we start in year 0 at point 0 where AD0 and ASLR0 intersect. In the absence
of any Eskom problems, AD and ASLR would have shifted to AD1* and ASLR1* and generated
equilibrium point a with income at Y1* and the price level constant at P0.
However, the supply shock of load shedding (which causes cost increases and production
cutbacks) and higher tariffs implies that the expansion of aggregate supply is being
constrained. There is a negative supply shock on both long-term and short-term aggregate
supply: ASLR and ASSR shift left (in tandem) relative to where they would have been in the
absence of the shock.
Secondly, the discouragement of investment has two effects. First, it holds back aggregate
demand (AD) growth – AD only shifts to AD1 (indicated by the dotted blue arrow) and not
all the way to AD1*. Secondly, and importantly, it causes a negative impact on the growth of
the capital stock and the expansion of productive capacity. This causes a negative impact
on the expansion of aggregate supply (ASLR).
The combined negative supply-side effects imply that the long-term aggregate supply curve
actually shifts only from ASLR0 to ASLR1 (as indicated by the solid blue arrow). (In other
words, compared to where it would have been without the Eskom supply shock, ASLR ends up
in a more leftward position – it has ‘shifted’ left in relative terms, as has ASSR). Combined
with a constrained AD shifting rightwards only to AD1 it means that the economy would
converge on point b.

Figure 6.31 The impact of Eskom bottlenecks on GDP growth and prices: decomposing the changes of a single year
ASLR0 ASLR1 ASLR1*

P
Equilibrium after supply

ASSR1 constriction, the drop in
investment (demand) and
the ASSR adjustment
ASSR0
ASSR1*
P1 1 Equilibrium after supply

constriction and a drop in
b
investment – but before
P0 a ASSR adjustment
0
Equilibrium if no
Eskom problems
AD0 AD1 AD1*
YS0 Y1 Y1* Y
However, since this point is not on the vertical ASLR1, it would not be an equilibrium point.
Price expectations will come into play and cause ASSR to adjust, shifting ASSR upwards to
ASSR1 and taking the economy to an equilibrium at point 1, with income at Y1 and the
price level having increased to P1.
The net effect is that the increase in equilibrium income (from YS0 to Y1) in that year ends
up being smaller than it would have been, were it not for the Eskom problems – and the
price level P ends up being higher. The economy has moved from point 0 to point 1 (see the
curved blue arrow) instead of point a.
Repeated Eskom problems leading to ongoing growth and inflation problems

Since these Eskom problems have recurred in the subsequent years, this pattern has
repeated itself several times. Figure 6.32 shows the cumulative effect of a series of years
such as that of figure 6.31 (without showing the smaller annual adjustments) compared
to a base run where no Eskom problems occur. Key to this sequence is that, following the
Eskom shocks in year 0, from year 1 onward the net annual rightward shifts of ASLR and
AD are smaller than before.
The result is a series of smaller annual steps in Y (i.e. a drop in the GDP growth rate) and
continued upward movements in the average price level P (i.e. a higher rate of inflation).
6.5 Real-world application – the Eskom crisis, GDP and prices 297

Growth is being choked, coupled with upward pressure on prices, on a path indicated by
the curved row of equilibrium dots (upper half of figure 6.32).
If the cost shocks come to an end, the increases in P should level off within a few years, for
example by year 7 or 8 (i.e. the rate of inflation will decline again).
❐ Note that, for example by year 8 (i.e. 2016/7 in reality), Y would be much lower than
in the base run – i.e. much lower than it would have been, had the Eskom shocks and
backlogs not occurred. The Eskom problems would have had a large, permanent impact
on the level of GDP.
❐ If Eskom’s capacity problem remains, growth of GDP would continue steadily from
there on, but at the lower rate.
❐ If Eskom resolves the problem, the rate of growth could return to higher levels.
❐ If new problems recur, a pattern of still slower growth and a yet further increasing
price level would repeat itself.
While the diagram is only a stylised depiction of the post-2008 experience with Eskom,
it provides a powerful analysis and explanation of the performance of the South African
economy in this period – even though it is not the only explanation.
Figure 6.32 The impact of Eskom bottlenecks on GDP growth and prices (medium- to long-term effects)
ASLR-2 ASLR-1 ASLR1

P
ASLR0 ASLR2
AD-2 AD-1 AD0 AD1 AD2
ASSR-2 AS AS
SR-1 SR0
ASSR2 In years 1 and 2 the annual shift

of ASLR to the right gets smaller.
P8 Thus the annual increase in
? YS declines. Growth is being
P4 choked, coupled with upward
P0 pressure on costs and prices.
• By year 8, Y is much lower
than in the base run (below).
• Growth in Y will continue at
the lower rate until Eskom
solves the capacity problem.
Y-2 Y-1 Y0 Y1 Y2 Y3 Y8 Y
ASLR-2 ASLR-1 ASLR1 ASLR2

P
ASLR0 In this base run, the annual increase in
AD-2 AD-1 AD0 AD1 AD2 YS is constant. Growth is steady and
ASSR-2 ASSR-1 AS ASSR1 AS there is no upward pressure on costs
SR0 SR2 and prices.
• By year 8, Y is much higher than in
the Eskom-constrained run.
P1
Y-2 Y-1 Y0 Y1 Y2 Y3 Y8 Y

1. It is often argued that the introduction of the Labour Relations Act has restricted the
ability of businesses to lay off employees, making it more difficult for firms to reduce
their labour costs in order to stay profitable. Use the price-setting (PS) and wage-
setting (WS) relations to explain and illustrate how such a restriction can impact the
long-run (or structural) rate of unemployment.
2. Suppose the productivity of South African workers increases due to better skills
development. Use the price-setting (PS) and wage-setting (WS) relations to explain and
illustrate the impact of higher productivity on the long-run rate of unemployment.
3. Use the AS-AD model to explain and illustrate the short-run and long-run impact, on
the aggregate price level and the level of national income, of the overall change in the
repo rate since 2007.
4. Turmoil in the Middle East, especially tension between the USA and Iran, has raised
the spectre of major increases in the price of oil again (following such a period in
2008–09). Use the AS-AD model to explain and illustrate the expected impact on the
economy of an oil-dependent country such as South Africa.
5. US President Trump signed large cuts in corporate tax into law in December 2017.
He has also put pressure on the US Federal Reserve to reduce interest rates further.
Use the AS-AD model to explain and illustrate the expected short-run and long-run
impact on the aggregate price level and the level of national income of South Africa
due to these policy steps in the USA.
6. ‘The flight from risk, by investors, has led to the depreciation of emerging countries’
currencies. South Africa’s rand depreciated due to the sale of shares and bonds by
foreigners – almost R70 billion in the first six months of 2019. The weak rand is likely
to result in an increase in the petrol price.’ Use the price-setting (PS) and wage-setting
(WS) relations to explain and also illustrate, in a diagram, the impact of an increase
in the petrol price. Clearly indicate the impact on the long-run rate of unemployment
and the aggregate price level. Also indicate diagrammatically how this will shift the
ASLR curve.
7. Suppose the annual rise in the consumer price index (CPI) increases to well outside the
3–6% official range targeted by the Reserve Bank, with direct implications for decisions
on the repo rate. There would be good reasons for the Bank to apply a restrictive policy.
Use the AS-AD model to explain and illustrate the short-run and long-run impact on the
aggregate price level and the level of national income if the Reserve Bank implemented
such a restrictive monetary policy.
8. Use the price-setting (PS) and wage-setting (WS) relations to explain and illustrate the
impact of more stringent labour laws on the South African economy. Clearly indicate
the expected impact on the unemployment rate. Also indicate diagrammatically how
this will shift the ASLR curve.
9. In 2014 the government introduced a youth wage subsidy, also known as the
Employment Tax Incentive Act (ETI), to encourage companies to employ more young
employees. Use the price-setting (PS) and wage-setting (WS) relations to explain and
illustrate the likely impact of the implementation of such a subsidy. Clearly indicate
the expected impact on employment and the unemployment rate. Also indicate
diagrammatically how this will shift the ASLR curve. What is the evidence regarding
the success of this subsidy in increasing youth employment? (Consult the internet as
necessary.)

Addendum 6.1: Labour market changes following demand stimulation
This is an extension of the example of demand stimulation followed by aggregate supply adjustment
in section 6.4.2. It should be read together with that text, plus the following to explain events in the
labour market.
❐ In the expansion phase, the LS curveWshifts down to LS1. WS remains stationary because P e has
not changed. The real wage drops to     P   because of the increase in actual price to P1; employment
0
increases to N1.
❐ As the ASSR adjustment starts, Pe and the renegotiated nominal wage increases (to W1) to match W
up with price P1. However, the actual price has already risen above P1 to P2. The new real wage     P   
2
1
is still lower than the starting real wage. But the real wage has recovered some of the ground
lost due to the demand stimulus and unanticipated price level increase. Employment drops due
to the adjustment of ASSR, but not yet as far back as its starting value NS. LS would have shifted
back to LS2, reflecting effective labour supply at fixed nominal wage W1 for the duration of the
renegotiated labour contract.
❐ Since the equilibrium is not yet on ASLR the adjustment continues. In the end, when ASLR is
reached, the nominal wage will be at W3 to match up with the final price level P3. The final
expected price P e will equal the final actual price P3, but obviously
W W
at a higher level than initially.
The real wage would have recovered all the way so that     P   =  
3
3
  P   . Employment drops yet further,
0
0
back to its starting level at NS, the structural equilibrium level of employment.
Y TP Y 45° line
Y1
YS
NS N1 N YS Y1 Y
P ASLR ASSR2
  W
  P
  
WS
2 ASSR1
P3
0;2
W3
 
W
  P    =  
  P 0   LS0;3 ASSR0
3 0 P2
P1 1
W1
  P   
  LS2
2
W0
  P    LS1 0
  P0
1
1 AD1
PS
AD0
NS N1 N YS Y1 Y

Addendum 6.2: Labour market details following a domestic supply shock
This is an extension of the example of domestic supply shock followed by aggregate supply
adjustment in section 6.4.3. It should be read together with that text, plus the following to explain
what happens in the labour market.
❐ As the supply shock occurs, the PS curve shifts down due to an increase in the mark-up to
compensate for the increased non-labour input costs. Because the price level P increases (to W
P1) to reflect the higher input costs, the LS curve shifts down to LS1. The real wage drops to     P    0
because of the increase in actual price to P1 while the initially contracted nominal wage W0
is still in place. The new short-run equilibrium is at employment level N1, reflecting a drop in
employment due to the supply shock as such.
❐ As the ASSR adjustment starts, P e and the renegotiated nominal wage increases (to W1) to match W
up with price P1. However, the actual price W
has already risen above P1 to P2. The new real wage    P    1
is still lower than the starting real wage     P   . But the real wage has recovered some of the ground
0
0
lost due to the supply shock and unanticipated price level increase. Employment drops further
below N1 due to the ASSR adjustment, but it is not yet at the long-run level NS. LS would have
shifted back to LS2, reflecting effective labour supply at fixed nominal wage W1 for the duration
of the renegotiated labour contract.
❐ Since the equilibrium is not yet on ASLR the adjustment continues. In the end, when ASLR is
reached, the nominal wage will be at W3 to match up with the final price level P3. The final
expected price P e will equal the final actual price P3, but obviously at a higher level than initially.
Through the Wincreases in the levels at W
which W is set and P is set, the real wage would have
recovered to     P    which is lower than  
3
3
  P   . Employment drops yet further, back to the new, post-
0
0
shock structural equilibrium level at N2.
Y TP Y 45° line
N2 N1 N0 N YS2 Y1 YS0 Y
W
  P  
  Y
ASLR1 ASLR0 ASSR2
PS0
WS ASSR1 AS
SR0
PS1
P3
Phase 1: Supply
W0
LS0 P2
 
    shock shifts
P0
P1 both ASSR and
W3 P0 ASLR left
  P   
 
LS3
3
W1 Phase 2:
  
P
  
LS2 AD Supply adjust-
2
W0 ment process
  
P
   LS1 shifts ASSR up
1
NS N1 N0 N YS2 Y1 YS0 Y
Addendum 6.2: Labour market details following a domestic supply shock 301

Addendum 6.3: A complete example of IS-LM-BP and AD-AS for an
increase in the repo rate
r
The case of a repo rate increase LM1
has been explained several times. LM2
❐ In chapter 4 (section 4.7.5) LM0
LM3
the IS-LM-BP analysis was LM4
r1 1
shown, still under the as BP1
sumption of a constant price
2 BP0
level P, to produce equilib
rium values of r and Y. r3
3 0 BP2
❐ In section 6.2.5 the diagram r0
of section 4.7.5 was used 4
to show how the AD curve
would shift in line with the
change in the IS-LM equilib
rium point. IS0
IS1
❐ Section 6.4.2 finally showed IS2
that same, shifting AD curve Y
together with AS curves,
generating changing equi
librium values of P and Y. AD1 AD3 AD2 AD0 ASLR
P
ASSR0
The direct correspondence be
tween changes in the IS-LM-BP
model and the AD-AS model are
shown alongside in one set of ASSR1
diagrams.
❐ Note how the short-run
equilibrium points 1 to 3 in 0
P0
the IS-LM-BP diagram have 2
P3
their exact counterparts in 3
1
the AD-AS diagram.
P4 4
❐ Thus one can see, together
with the changes in Y and
P, what happens to the real
interest rate r as well as the
balance of payments (BoP).
One important thing to notice is Y1 Y3 Y2 Y0 YFE Y
that the shifts of the LM curve
are NOT the same as the original shifts in section 4.7.5 or in 6.2.5.
This is because the move of the equilibrium along the ASSR curve – from point 0 to 1 and back to 2
and 3 – implies changes in the price level P. This impacts correspondingly on the real money supply
  MP  , which affects the position of the LM curve.
S
 
❐ The leftward shift from LM0 to LM1 is restrained by the decrease of P from P0 to P1. Thus LM1
shows the net shift in LM. Likewise, the shift from LM1 to LM2 is restrained by the increase of P
to P2. LM2 shows the net shift in LM.
❐ The LM shifts to position LM3 when P declines from P2 to P3. (Points 2 and 3 are not on the same
LM curve.)
MS
When P declines from point 3 to point 4, it increases    P  , which shifts the LM curve right. Due to a
BoP deficit that develops, the BP and IS curves will also shift to the right. This takes the economy to
point 4 on both diagrams.

Addendum 6.4: A complete example of IS-LM-BP and AD-AS for an
increase in the price of imported inputs (e.g. oil)
The analysis of an oil price r
increase was provided in LM4 LM5 LM3 LM2 LM0
LM1
section 6.4.3. The purpose
here is to show the corres BP1&3
ponding changes in the IS- r5
5 BP2
LM-BP diagram, notably 6
r7
BP0
its power in showing the 7 4
rather complex behaviour r0 0
r2 3
of the BoP and its con 2
stituent components, the r1
CA and FA. Thus we con 1
IS0
centrate on the graphical
analysis – which is quite IS2
complex and requires care IS1&3
ful scrutiny.
Y
From point 0 to point 1:
P AD3&5 ASSR2
The decrease in domestic AD ASSR1 ASSR0
AD2 AD1&4 0
expenditure causes the IS
and BP curves to shift left
from IS0 to IS1 and BP0 to
BP1, while the LM curve P7 7
momentarily shifts right to
LM1 due to the decline in
M S
P4 2
P   ). The
P (and increase in   P0 3 4 1 0
IS-LM intersection moves P1
left, and AD shifts the
same horizontal distance
left from AD0 to AD1. The
equilibrium moves from
point 0 to point 1 on both ASLR1 ASLR0
the IS-LM-BP and AD- YS1 Y3 Y4 Y1 YS0 YFE Y
AS diagrams. This point
is below the BP1 curve,
indicating that a BoP deficit has developed (CA and FA in deficit).
From point 1 to point 2:

 MP    decreases. LM starts shifting
S
As supply contracts, Y decreases while P increases; thus 
left. Given the slopes of IS and LM, the net effect on the interest rate from the starting
point is still negative: r2 < r0. While the FA should recover, it is still likely in a deficit. CA
should have improved due to the decline in Y, but the magnitude of the initial CA deficit
still dominates, given size of oil bill (and bearing in mind that the increase in P would curb
any CA improvement). The BoP is still in deficit.
There has been a leftward shift of (a) ASSR from ASSR0 to ASSR1 and (b) ASLR from ASLR0 to
ASLR1. This shows the following things:
Addendum 6.4: A complete example for an increase in the price of oil 303

(a) Through the interaction between ASSR1 and AD1 a temporary equilibrium (P2; Y2) is
reached at point 2 on the AD-AS diagram.
(b) The structural equilibrium level of output YS has shifted to a lower level.
(c) The average price level P is higher than at the starting point: P2 > P0.
From point 2 to points 3 and 4:

Initial BoP effect (foreign reserves adjustment): Graphically, the net decrease in the money
supply will reflect as a shift in LM to the left from LM2 to LM3 (partly restrained by a decrease
in P from P2 to P3). Internal equilibrium moves to point 3. AD shifts left to AD2.
Concluding BoP effect (exchange rate adjustment): IS and BP move to the right from IS1 to IS2
and BP1 to BP2. An internal and external short-run equilibrium will be reached at point 4.
In the AS-AD diagram, AD will shift to the right from AD2 to AD3 with the equilibrium also
reaching point 4.
At short-run equilibrium point 4, we still have:
Y > YS and P > P e
A medium-run supply adjustment process follows.
From point 4 to point 5 (only shown on IS-LM-BP diagram):

Supply adjustment: Graphically, ASSR shifts upward until it intersects the AD curve and
ASLR.
MS
The increase in P decreases  
P   and LM shifts left to LM4. The equilibrium moves up along
IS and AD towards points 5 and 7 respectively. With r now above starting levels, FA moves
into a surplus. The cost- and interest-rate induced decrease in income Y from point 4 to 5
also decreases M, so CA moves into surplus. BoP surplus develops.
From point 5 to point 6 (only shown on IS-LM-BP diagram) and 7:

Normal BoP adjustment processes, during which r decreases and the rand appreciates;
(impact of increasing P on X and M will assist BoP processes). BoP back to position of
balance.
The money supply effect will see LM and AD shift right to LM5 and AD4 (almost at the
position of AD1). After that IS, BP and AD will shift left to IS3 (almost at the position of IS1),
BP3 (almost at the position of BP1) and AD5 (almost back at the position of AD3). On the
IS-LM-BP diagram the equilibrium moves from 5 to 6 to 7. (For visual ease, we draw these
closely positioned lines superimposed.)
On the AD-AS diagram only the net effect is shown. While all the shifts are not shown, the
typical right-then-left shift of AD will be present in the BoP adjustment phases of the final
stages of the ASSR adjustment. AD3 as shown must thus be understood as the final position
of AD. P and Y ends at (P7; YS1), following perhaps minor fluctuations in Y on its path
towards its final resting point on ASLR.
The process ends at point 7 where there is both internal (real, monetary and labour
market) and external (BoP) equilibrium.

Extending the model: inflation
and policy reactions 7
■ demonstrate how an adapted AD-AS framework can be used to show how the rate of
inflation is determined together with real GDP, i.e. to analyse economic fluctuations in an
inflationary environment;
■ use the Phillips (or PC) curve to assess and analyse possible short-run and long-run
relationships between inflation and GDP;
■ evaluate the relevance of the Phillips-curve debate for anti-inflation policy, and assess
arguments on whether policies can or cannot be used to manage inflation; and
■ analyse and compare typical central bank policy reactions to steer the inflation rate to a
target value, including the costs and benefits of a radical, as opposed to a gradualist,
approach to reducing inflation.
The previous chapter showed various cases of demand and supply disturbances
impacting on the average price level and output. Such disturbances tend to be followed
by supply adjustment processes that eventually return the economy to a long-run or
structural equilibrium level of output and a new, stable price level. In some of these
cases, the price level adjusts downwards before reaching the stability of the structural
equilibrium.
Both a stable price level and a downward-moving price level may seem strange, given that in
most economies inflation is a more
or less permanent phenomenon Do you want to know more about inflation?
– the average price level is always
More information on and discussions of inflation
increasing, even in recessionary
in South Africa and other countries, including the
times or when the central bank or probable causes of inflation, can be found in chapter
government is pursuing a contrac- 12, section 12.1.
tionary policy. Does this make the
model irrelevant? The answer is
no, but it requires a slight adjust-
ment to the model to set it in an in- AS by a different name? The Phillips curve
flationary context.
An essential part of analysing the inflationary context,
An inflationary context means an and policy in that context, is a name that will crop up
economic envi ronment where it in all textbooks: the Phillips curve. For reasons that
has become normal for prices and are explained below, the aggregate supply curves in
wages to increase year by year and this context are frequently called Phillips curves, and
where, indeed, prices and wages indicated as PCSR and PCLR in diagrams. We will also
do so in the discussion that follows.
are expected to increase continually.
Chapter 7: Extending the model: inflation and policy reactions 305

Defining inflation
Inflation is defined as a sustained increase in the average price level. One-off or intermittent
increases in the average price level do not constitute inflation.
The inflation rate, usually denoted by the symbol π, is the rate of increase of the average price
level during a specific period, normally one year. More specifically, the inflation rate is the
percentage increase in the price level during the chosen period:
Pt – Pt–1
  P    
π =    100
t–1
Statistically, it is measured using price indices such as the consumer price index (CPI). Various
ways of measuring the inflation rate exist in practice. This, and other aspects of inflation,
including historical data for South Africa, is discussed in chapter 12.
Improvements in quality
One complexity in measuring changes in the price level is that prices often increase due to
improvements in goods, i.e. higher quality. Or nominal prices remain roughly the same despite
significant increases in quality, e.g. cell phones or PCs since the 1990s. Separating quality
changes from pure price changes is very difficult.
Some economists have argued that, as a rule of thumb, a 2% inflation rate merely reflects the
increase in the price level that results from the general improvement in quality of all goods.
Thus an inflation rate of approximately 2% would be normal and, actually, negligible.
The rate of inflation may vary, but inflation is always there.

❐ Note that this regular increase in the price level may not be high, and might be as low
as 2% per annum in some countries. No central bank would be overly concerned with
an inflation rate of 2%. In some countries Figure 7.1 AD-AS and a continually increasing
a higher rate of inflation is considered price level
normal, and the central bank may be
happy with a rate between 3% and 6% P ASLR
(e.g. South Africa; see chapters 9 and 12).
7.1 Adjusting the model – inflation- P4

augmented AD and AS curves
ASSR2
7.1.1 A state of steady inflation P3
Consider an economy with a steady rate of

ASSR1
inflation at x%, and assume that it is steady P2
at the structural equilibrium output level YS.
This means that the price level P increases by ASSR0
x% every year, while the economy remains P1
on ASLR. If we illustrate this ‘steady inflation AD2
state’ graphically on the P-Y plane, using the
AD-AS curves, it would show a repeatedly P0
upward-moving AD-AS cross, pushing the AD1
equilibrium point up repeatedly along the
vertical ASLR line (see figure 7.1). The price
level increases from P0 to P1 to P2 and so forth AD0
without end. This process would soon push
YS Y
the AD-AS curves off the page!
306 Chapter 7: Extending the model: inflation and policy reactions

To prevent this, we can redefine the vertical axis: instead of the price level, we plot the
rate of change (%∆) in the price level (i.e. inflation, denoted as π) on the y-axis. Output Y
appears on the x-axis, as in the normal AD-AS framework. This is shown in the diagram
in figure 7.2.
❐ The thus redefined aggregate demand and aggregate supply relationships can be termed
inflation-augmented or quasi-AD and quasi-ASSR curves, indicated as AD and ASSR.
A quasi-ASLR curve can also be plotted (it will remain vertical).
❐ Alternatively, the supply curves can be indicated as PCSR or PCLR, as noted above.
The main characteristic of AD and Figure 7.2 A state of steady inflation
ASSR is that, in a state of steady in-
flation, they remain stationary in the π
ASLR (or PCLR )
new π-Y plane – while AD-AS would
soon drop off the top edge of the page
ASSR (or PCSR )
in the P-Y plane.
As we will see below, disturbances
would once again lead to short-run Steady inflation
equilibrium points off the ASLR curve, structural
π equilibrium
followed by supply-side adjustments.
But we will see impacts on the inflation
rate π rather than on the price level P. AD
Note the following important points

regarding the steady inflation case:
YS Y
❐ At every equilibrium point in both
diagrams (figures 7.1 and 7.2), the
expected price equals the actual price. Thus ∆P e = ∆P and thus also %∆P e = %∆P. The
latter means that the expected rate of inflation is equal to the actual rate of inflation (in
the steady state described): πe = π. The short-run equilibrium of AD and ASSR is on ASLR
all the time.
❐ In the labour market, the nominal wage would increase every year by exactly the same
rate as the price level P, i.e. its percentage rate of increase would equal the inflation rate
π. Thus the real wage remains constant. PS and WS would remain stationary. Producers
and workers expected inflation to be at π and inflation is at π. No one is surprised by
the normal price level increase. When wages are negotiated at the beginning of the
contract period, nominal wages are adjusted in anticipation of the expected normal
inflation in that period. The same is true for the prices set by firms.
❐ Likewise, the steady AD curve means that aggregate expenditure, comprising the
components of expenditure C, I, G and (X – M), remains constant in real terms (as does
The causes of inflation?

We are not analysing the causes of inflation now. That will be done in chapter 12, section 12.1.
We merely create the analytical tools to enable us to analyse economic fluctuations, shocks in
supply and demand, and policy steps in an environment where there always is inflation. Thus
we simply work in terms of the inflation rate π rather than the price level P.
What will be required in due course is an economic explanation of how and why the AD and
ASSR curves started shifting up and how and why this shift came to be perpetuated as a
permanent phenomenon.
7.1 Adjusting the model – inflation-augmented AD and AS curves 307

 MP  )  . In other words, the nominal value of aggregate expenditure
S
the real money supply 
increases by the same percentage π in every year (as does the nominal money
supply MS).
7.1.2 Disturbances in the π-Y plane

Disturbances due to demand or supply Figure 7.3 Higher expenditure growth in the P-Y plane
shocks can now be analysed in parallel
P ASLR
fashion to the original analysis in the
AS-AD diagram. However, some results ASSR2
are particularly forceful in the new dia-
gram with π on the vertical axis.
ASSR1
Disturbances and shocks will register as P2
e
unexpected shifts in the ASSR and AD that P2  
take place over and above the expected, AD2
continual shifts shown in figure 7.1 or, ASSR0
P1
equivalently, in figure 7.2.
A demand expansion example P0

Suppose expected inflation is steady at
AD1
π e = 4% and has been so for some time.
❐ In the P-Y plane (figure 7.3), both
ASSR and AD will have been shifting
AD0
upwards steadily by 4%. Suppose they
YS Y1 Y
have now reached the point of shifting
from AD0 to AD1 and ASSR0 to ASSR1.
The price level increases the normal 4% from P0 to P1. Output is steady at YS.
❐ In the π-Y plane (figure 7.4), both AD and ASSR (i.e. PCSR – the short-run Phillips
curve) will be stationary and intersect at π0 = 4%. Expected inflation also is at π e = 4%.
Output is steady at YS.
However, suppose in the next period nominal government expenditure or investment
(due to an interest rate decrease, for instance) increases more than normal and causes
aggregate expenditure growth to go up to, for example, 6%.
❐ In the P-Y plane this will cause AD to Figure 7.4 Higher expenditure growth in the π-Y plane
shift upwards and to the right (to AD2) π
faster than ASSR (since the expected ASLR (or PCLR )
e
price P 2   is now lagging behind).
This involves shifting in excess of its ASSR0;1 (or PCSR )
‘normal’ (and expected) upward shift
of 4%. Therefore, a larger increase Equilibrium
after demand
in the price level will occur (from P1 π
1
stimulation
to P2), in excess of the normal 4%, π
0
together with an increase in output
beyond long-run output (output will AD2
AD0;1
climb to Y1).
❐ In the π-Y plane, the AD curve
shifts up and to the right, while PCSR
YS Y1 Y

(i.e. ASSR) remains stationary since its intercept with PCLR (i.e. ASLR ) is at π0 (and the
expected inflation rate π e = π0). The short-run equilibrium shifts along the ASSR curve
to the right of ASLR, registering an increase in the output level to Y1. The inflation rate
rises to π1.
Similar but opposite shifts in AD would occur for a decrease in the growth rate of
expenditure to below the expected inflation rate. It would cause a decrease in the output
level to below YS, and the inflation rate would drop to a value below π0.
❐ If AD shifts so far down that the short-run equilibrium inflation level is below zero, it
means that the economy is in negative inflation or deflation territory, i.e. prices decline
year after year.
7.1.3 The AS-adjustment process in the π-Y plane with AD and PCSR
As we know by now, points off the ASLR curve (i.e. PCLR) will not be sustained indefinitely
due to intrinsic economic dynamics. The expected aggregate supply adjustment process
also occurs in the inflationary context, and thus in the AD-AS model.
Demand expansion or contraction

Let us take up the example of demand Figure 7.5 Complete effect of higher growth in expenditure
stimulation shown above. Once π
inflation has increased from π0 to π1 PCLR PCSR2
(figure 7.5), inflation expectations PCSR1
are sure to adjust upwards and there
PCSR0
will be upward pressure on nominal π Equilibrium
wages. Once wages are renegotiated 2 after supply
adjustments
upwards, this will shift the ASSR, π 1
now renamed the short-run Phillips π Equilibrium
0 after demand
curve (PCSR), to shift upwards from stimulation
PCSR0 to PCSR1. Prices, real wages
AD1
and employment will adjust (as in AD0
the AD-AS model), and inflation will
increase together with a decrease in
output. The actual inflation rate will, YS Y1 Y
however, yet again be higher than
the expected inflation rate (which would now be at π e = π 1). Thus, during a next cycle of
wage negotiations, another upward adjustment of wages is sure to follow, shifting PCSR up
again. And so on and so on (just like the process in the AD-AS model).
❐ The process is likely to continue until the short-run equilibrium settles on PCLR, the
long-run supply curve, at the structural equilibrium level of output YS and with the
inflation rate at π2.
❐ As the economy is back at a structural equilibrium point, π2 is now also the new
expected inflation rate πe. From now on, workers and firms will expect prices to increase
annually at rate π2 and not π0. There has been a lasting increase in the inflation rate
(and the expected inflation rate).
❐ Using the illustrative numbers of expenditure growth of the example above, the annual
inflation rate will have increased from 4% to 6%.
❐ As noted in the AD-AS context, the whole process of expansion followed by supply
adjustment (in this case a con traction combined with an in crease in inflation,

i.e. stagflation) could take
between four and seven years, What is stagflation?
requiring successive rounds of The short-run Phillips curve associates higher output
wage renegotiations. and employment with higher inflation. This is typically
when inflation is what is called an ‘excess demand
Nevertheless, even though the phenomenon’, i.e. when the aggregate quantity
government or the central bank demanded exceeds long-run levels of output. This
was able to stimulate output (and corresponds to the expansion phase in the example
employment) in the short run for above.
a number of years, in the long run
In contrast, stagflation occurs when higher inflation
output is likely to return to YS (and occurs together with economic stagnation. Typically,
employment will correspondingly stagflation occurs after a supply shock or supply
decline again over time). The adjustment that shifts the ASSR (or PCSR) upwards
short-run, and thus temporary, and to the left. The adjustment phase in the example
gain in output and employment above is an illustration, although a pure supply shock
came at the cost of a permanently would be a better one.
higher inflation rate.
❐ The main implication for pol-
icy is that a sustained stimulation of aggregate demand growth will eventually only
translate, after all the short-term supply adjustments, into a higher rate of inflation
(even though this may take several years). The structural equilibrium level of output
will not change.
❐ This does not mean that monetary or fiscal policy cannot be used to counter a recession,
i.e. from a point below the structural equilibrium output level YS. But output cannot be
pushed beyond YS for a significant period of time without paying an inflation penalty
later.
❐ Of course, if the increased demand expenditure led to a permanent boost of the pro-
ductive capacity of the economy (e.g. through infrastructure investment), the new YS
would indeed be higher than before, and any inflation rate increase would be moderated.
The more realistic policy lesson thus is less severe than the one stated in the previous
paragraph, as long as the focus of any increased expenditure is the creation of new
productive capacity (see section 7.1.6).
One-off vs. sustained demand changes

If the higher nominal growth rate (e.g. at 6%) of aggregate expenditure is sustained year
after year, the AD curve will remain in its higher position at AD1, followed by the supply
adjustment as shown.
However, if the increased growth rate of aggregate expenditure is one-off, so that it returns
to the normal 4% in the next year, the AD curve will shift down again to its original
position. The conclusion of the one-off demand stimulation will be back at the starting
point. Output will have declined back to YS after the brief upswing. Inflation will have
increased briefly, but it will be back at π0 (say 4%, as in the numerical example). There is
no permanent increase in the inflation rate.
Yet there may still be some social costs to this process. As long as inflation expectations
are slow to adjust and be reflected in wage contracts – which is not unlikely in practice
– the PCSR curve will remain stationary and the return to the original equilibrium will
be straightforward. The AD curve will simply shift down again to its original position
before any supply adjustment starts taking place. If, however, inflation expectations and

renegotiated nominal wages go up rapidly, the PCSR curve will indeed shift up noticeably.
The drop in the AD curve will then generate a more roundabout route for the short-
run equilibrium point, involving a drop in output below YS before settling back, through
supply adjustment, at YS. (This phase shares elements of the case of a decrease in demand;
compare chapter 6, section 6.4.2. The details are left to the reader as an exercise.)
✍ Do the complete graphical analysis for a one-off increase in the growth rate of expenditure,
allowing for rapidly adjusting inflation expectations and wage contracts.
Supply shocks in the AD-PCSR model

A supply shock in the context of a steady inflation state will provide the following, as
shown in figure 7.6. The supply shock will shift both PCSR and PCLR an equal distance
to the left. The rate of inflation increases from π0 to π1, and output contracts from YS0 to
Y1. (Compare the supply shock analysis in the AD-AS model in chapter 6, sections 6.4.3
and 6.4.4.)
As higher inflation expectations are built into new rounds of wage negotiations, the PCSR
curve will start shifting up as part of the supply adjustment process. The inflation rate
increases further, eventually to π2, while output drops further to YS2, reaching the new
structural equilibrium output level. The equilibrium point ends up on the relocated PCLR
line, the long-run supply curve. The
net result of a contraction in output Figure 7.6 A supply shock in the π-Y plane
and employment combined with an
π PCLR1 PCLR0
increase in the inflation rate is classic
stagflation. π3 PCSR2
❐ The structural rate of unemploy-
PCSR0
ment SRU would have increased –
more involuntary unemployment Equilibrium
after supply
would be present. Involuntary π2 shock
unemployment, whether cyclical π1
or structural, can be understood π0 AD2
as the difference between actual
unemployment and what it would AD0
have been with market clearing in
labour and product markets.
If policymakers come under political YS2 Y1 YS0 Y
pressure to counter the contraction
in output and employment, they may try to stimulate demand (to AD2) to reverse these
effects. They will be successful, but only for a while, and at the price of still higher inflation.
As we saw above, any short-run equilibrium point to the right of the PCLR line (which has
now been relocated) is not sustainable without higher inflation. The supply adjustment
process will eventually push output back to the relocated PCLR line, with yet another
increase in the inflation rate to π3. There appears to be no way to avoid the permanent
contractionary effect of a supply shock on output and employment, and neither can the
permanent upward effect of a supply shock on inflation be avoided.

7.1.4 A permanent increase in output above YS? The augmented Phillips curve
policy lesson
The main implication for policy thus far has been that a sustained stimulation of aggregate
demand growth will eventually only translate, after all the short-term supply adjustments,
into a higher rate of inflation. Output will contract to the structural equilibrium level YS
after the initial upswing to Y1.
Our next conclusion is very important in the Figure 7.7 Continually increasing inflation
context of the ‘augmented’ Phillips curve π
debate (see below). It is the following: should PCSR4
PCLR
the government or the central bank wish PCSR3
to increase output to Y1 and keep it there
PCSR2
permanently, it will only be possible through
PCSR1
repeated increases in the growth rate of
aggregate demand, which will translate into π3 PCSR0
a continually increasing inflation rate. Thus, π2 AD4
not only will the average price level increase AD3
from period to period, it will increase at an π1
π0 AD2
increasing rate.
AD1
Consider the process following an increase
in the aggregate expenditure growth rate AD0
from, for example, 4% to 6% with the aim of YS Y1 Y
increasing output to Y1.
In year 1, the expansionary policy shifts the AD curve from AD0 to AD1, causing output
to increase from YS to Y1. The short-run equilibrium inflation rate increases to π1 (e.g. 5%).
In year 2, nominal wage increases will be renegotiated to match the new inflation rate of
π1 = 5%. This would shift the short-run Phillips curve upward from PCSR0 to PCSR1 (whose
intercept with PCLR is at π1).
Output would start to contract along AD1 – unless the supply adjustment is countered by
pushing AD up further to AD2 by increasing the growth rate of expenditure further. This
would keep output at Y1, but the inflation rate would increase to π2 = 6%, say. In year 3,
supply adjustment would again kick in via renegotiated nominal wage increases to match
the new, higher inflation rate of π2 = 6%. If output is to be kept at Y1, government will
need to counter the effect of higher wage increases and the upward shift of PCSR1 to PCSR2
(whose intercept with PCLR is at π2). It will need to stimulate aggregate expenditure growth
again, this time shifting AD2 to AD3. Though output will then remain at Y1, inflation will
increase yet again to π3 = 7%, say. And so on and so on.
The picture of a ‘vicious cycle’ is clear. Keeping output at Y1 requires repeated increases in the
growth rate of aggregate demand. Inflation will increase continually year after year. In short,
output can only be kept at Y1 at the price of a continually increasing inflation rate. This is not
just a higher inflation rate – it is an increasing rate. This is clearly not a sustainable policy
as no country can live with an ever-increasing inflation rate. It would also not be possible to
increase expenditure growth indefinitely.
❐ In other words, the only output level where inflation is not increasing in the long run is
when the economy is at the structural equilibrium level of output YS.
❐ A contrasting result can be derived for keeping output levels below YS, in which case the
inflation rate would continually decline. The only output level where inflation would
not be declining in the long run is at the structural equilibrium level of output YS.

The first bullet in the previous paragraph is the narrow augmented Phillips curve policy
result. As before, we must qualify this conclusion, since it assumes a permanently
stationary structural equilibrium output level YS (as in figure 7.7). Any positive impact of
the growing expenditure on productive capacity (i.e. on capital stock, technology, labour
skills and so forth) will shift the PCLR line to the right. This may significantly moderate the
harshness of the process previously described, since the inflation rate will increase less or
not at all, depending on the growth in YS.
❐ Thus one must rather say that the output level Y1 simply cannot be sustained indefinitely
with a given, unchanged capital stock, labour force, labour force skills and technology.
❐ More generally: even when YS is understood to be growing over time (inter alia due to
appropriate policies), output can only be sustained at a level above YS at the price of a
continually increasing inflation rate.
Alternatively, it can be expressed in terms of inflation and unemployment (rather than
output). Being at YS (be it stationary or growing) implies that the economy is at the
structural rate of unemployment (SRU). Thus the general augmented Phillips curve result
can be restated in terms of inflation and unemployment as follows: unemployment can
be sustained permanently below the SRU only at the price of a continually increasing inflation
rate.
❐ This also reminds us of a point made in chapter 6: structural unemployment cannot
be reduced through standard macroeconomic or demand-management policies. It
requires structural policies.
Therefore, over time (and amidst cyclical disturbances), actual output growth must match
the growth of the structural equilibrium level of output YS. The economy cannot be
pushed continually to grow beyond its long-term potential output growth (as determined
by the growth of its productive capacity). Such a strategy would only lead to increasing
inflation without the benefit of a sustained positive impact on output and employment.
Thus, a ‘tolerable’ amount of higher inflation cannot be exchanged for output growth
beyond YS (i.e. unemployment lower than the SRU). There would be increasing inflation,
not just higher inflation.
❐ Thus, in the long run there is no trade-off between inflation and unemployment (or
‘excess output’). The vertical PCLR line (whether stationary or growing) illustrates the
absence of a trade-off in the long run.
❐ In the short run, by contrast, there is a trade-off, but between unemployment (or ‘excess
output’) and rising inflation. The sloping PCSR curve provides the parameters for this
policy trade-off.
If policy stimulation beyond YS occurs only for a very limited period (i.e. a short enough time
before expectations and wages can adjust much) the inflation rate may not rise by much.
But there may always be a price to be paid. Using this trade-off to reduce unemployment
below the SRU for a few years, say, is likely to lead, at the very least, to higher inflation
and is likely to lead to increasing inflation. However, if in the same period PCLR is growing
concurrently due to expanding productive capacity, the inflation penalty may be small.
Such are the complex considerations that policymakers have to weigh in thinking about
policy options.
Reducing the inflation rate may also be a policy goal (from a high-inflation equilibrium
point on PCLR, say). Doing this through contractionary policy that reduces the growth
rate of aggregate expenditure will indeed lead to a lower rate of inflation. Graphically, AD

would shift left/down, producing a new equilibrium point with a lower rate of inflation.
However, as demonstrated with the ‘downward elbow’ case in chapter 6 (section 6.4.2), it
will imply a relatively long period of higher unemployment. Graphically, this is when the
equilibrium point initially slides down along the PCSR curve – the short-term trade-off at
work again – followed by expansionary supply adjustment back to PCLR.
❐ As we will see in section 7.2, policy authorities such as a central bank (the monetary
policy authority) also have the option of fine-tuning or steering the process so that a
different, more preferable path is followed towards the final equilibrium, notably in the
supply adjustment phase.
7.1.5 The short-run and long-run Phillips curves (PCSR and PCLR) – history and
insight
As noted above, in economic literature the inflation-augmented AS or quasi-AS (denoted
ASSR) curve has come to be denoted as the short-run Phillips curve (denoted PCSR). This
was the final (and somewhat ironic) outcome of a long and roundabout theoretical and
policy discourse since the first proposition of the Phillips curve in 1958.
The curve was named thus after AWH Phillips, who plotted a curve in 1958 on the basis
of an observed pattern in empirical data of the UK economy. It suggested an inverse
correlation between the rate of unemployment and the rate of wage increases for the
period 1861 to 1957.
Figure 7.8 The original Phillips curve
In its popular form, the Phillips curve refers
Inflation
to an inverse correlation between the rate rate
of unemployment and the (price) inflation (%)
rate. In many countries it was found that,
over long periods, observations of these
two variables tended to show the stable
pattern shown in the diagram (figure 7.8).
The general proposition was that a stable
relationship exists between inflation and
unemployment. In the 1960s this was
interpreted as a menu of policy options
– combinations of unemployment and
inflation – from which policymakers
could choose at will. They could choose Unemployment rate (%)
low unemployment, but paired with high
inflation. Or, they could choose to have low inflation as long as they were willing to accept
high unemployment in the country. At the time, it was understood that the choice to have
and keep an economy in such a position could be a lasting one.
This is the idea of a trade-off between inflation and unemployment. Given a particular
selection from the menu, the necessary policy stimulation or contraction could then be
used to push the economy to the desired equilibrium (point on the curve).
In contrast to the economists and policymakers who wanted to exploit the supposed trade-
off between inflation and unemployment, Friedman and Phelps argued already in the 1960s
that the trade-off between inflation and unemployment only exists in the short run. They
agreed that in the short run it is possible for government or the central bank to stimulate
the economy, an action that will result in higher inflation as well as higher output and

How many Phillips curves?
One must be aware of possibly three forms of the short-run Phillips curve.
1. The original version depicted the Phillips curve as a relationship between nominal wage
inflation πW and unemployment U. This is the diagram on the left-hand side below.
2. The later, popular version depicts a relationship between price inflation π and
unemployment U. This is the centre diagram below.
3. The most recent version, in the form of the quasi-ASSR or PCSR curve, depicts a relationship
between price inflation π and aggregate output Y.
Graphically, the three versions capture the same relationship in almost equivalent ways:
πw π π PCSR
PCoriginal PCpopular
U U Y
employment. However, they also Figure 7.9 A disintegrating Phillips curve?

argued that in the long run output
Inflation
returns to its long-run level, leav- rate
ing the economy only with higher (%)
inflation. Changing inflation ex-
pectations was key to this process.
Thus, according to Friedman and
Phelps, in the long run the Phillips
curve is vertical: whatever the rate
of inflation, output will return to
its long-run level. Observations
in the 1970s
Their warnings at first were left
unheeded, inter alia because it was
part of the ideological struggle be-
tween Monetarists and Keynesians Unemployment rate (%)
(see box below). However, during
the 1970s data points started to
appear on the diagram that suggested a positive correlation between unemployment and
inflation, or at least the absence of any correlation or pattern. This was the arrival of stag-
flation (a combination of high inflation and economic stagnation) on the world stage. This
experience seemed to suggest that the Phillips curve had broken down.
These experiences induced the development of the modern Keynesian AD-AS framework
with the average price level as an explicit variable. It transpired that the expanded Keynesian
theory of aggregate demand and supply could indeed provide a solid explanation for the
original Phillips relationship as well as the ‘aberrant’ observations of the 1970s.
Shifts in the aggregate demand curve produce an equilibrium that shifts up and down the
short-run aggregate supply curve – i.e. a series of equilibria on the ASSR curve. The price

level and unemployment move Figure 7.10 A shifting Phillips curve
in opposite directions – an
inverse relationship between
Inflation
inflation and unemployment. rate
This is precisely the original (%)
Phillips pattern, which can
be seen to be a reflection of
the short-run equilibrium
sliding along the ASSR curve.
The Phillips curve simply is a
mirror-image of the short-run
supply curve ASSR.
Second, the observations of the
1970s indicated not a disin
tegrating curve but a shifting
Phillips curve. Theoretically Unemployment rate (%)
this is explained by shifts in
the short-run AS curve. For
example, shifts of ASSR due to supply shocks or inflationary expectations produce episodes
of price increases coupled with a drop in real income (i.e. stagflation). For that particular
period it generates a positive correlation between inflation and unemployment. The data
points of the 1970s thus lie on different, parallel Phillips curves.
This implies that the Phillips curve is not dead. When and if the short-run supply curve
shifts, the trade-off shifts to another plane. From a policy point of view, a usable trade-off
relationship still exists. However, this is in a more complex context of a shifting supply
relationship which implies that inflation will increase if output is above the long-run level,
even if for a limited period. The trade-off menu is very different from what it was before
(see illustrative Phillips curve data below).
Today the Phillips curve is an essential part of the analytical apparatus and vocabulary of
macroeconomic policy analysis. After a period of rather obscure existence, it has returned
to centre stage of the policy, and especially monetary policy, debate.
The empirical data pattern that Phillips observed generally is accepted as a manifestation
of economic relationships captured by the ASSR relationship relative to the ASLR curve.
❐ For many decades, the data reflected a more or less stationary ASSR relationship with
small variations around it. This was the era before inflation had become embedded in
price expectations. Whatever inflation existed was largely ignored in price and wage
setting.
❐ Since the 1970s, the data reflected a shifting ASSR due to various supply shocks, starting
with the oil price shock of 1973 and followed by the impact of increasingly ingrained
inflationary expectations. High inflation could not be ignored, and people wizened up
to the phenomenon of inflation. Inflation expectations came to be embedded in price
and wage setting.
❐ This means that the quasi-ASSR curve is identical to the original Phillips curve (in
its shifting form). This is why we adopted the practice of denoting it as PCSR in this
chapter.
Modern AD-AS theory also shows that in the long run – after the ASSR adjustment process
has run its course – output returns to the vertical ASLR curve. After any disturbances,

shocks and cycles have played out, perhaps over several years, the only long-run impact is
on the inflation rate. In the long run there is no trade-off curve.
❐ This result is especially clear in the inflation-augmented AD-PC version of the
theory.
❐ This means that the ASLR curve is identical to the long-run Phillips curve of Friedman
and Phelps. This is why we adopted the practice of denoting it as PCLR in this chapter.
❐ The theory put forward by Friedman and Phelps is known as the expectations-augmented
Phillips curve theory. Their use of the theory of expectations injected an important
long-run dimension into the analysis of the original Phillips curve and the aggregate
supply relationship.
The fact that the modern expecta Figure 7.11 The expectations-augmented Phillips curve
tions-augmented Phillips curve trade-
off means that inflation will increase 
when output is above YS means that Typical data points
generated by ‘new’
higher output (i.e. lower unemploy- 6 expectations-
ment, below SRU) will be associated augmented Phillips
with an increase (positive change) in relationship
4
the inflation rate π. Likewise, higher
2
unemployment (above SRU) will be
associated with a decline (negative 0
change) in the inflation rate. Unemployment
–2
This implies an inverse, or negative,
correlation between unemployment –4 SRU
and changes in the inflation rate (i.e.
∆π and not the inflation rate π, as was the case with the original Phillips relationship)
(figure 7.11). Thus it appears that the post-1970s era of (a) lively and energetic infla-
tion expectations and thus (b) shifting the expectations-augmented Phillips curves has
generated a new inverse relationship that differs significantly from the original Phillips
relationship.
❐ The implied trade-off for an expansionary policy stance is thus between lower un-
employment and rising inflation.
❐ If this theory is correct, it should also be displayed in real-world economic data. In the
case of the USA, this is indeed the case.
7.1.6 Summary: some Phillips curve lessons for policymakers

Starting from a position of long-run equilibrium on the PCLR line and with unemployment
at SRU:
1. A short and one-off demand stimulation, reversed after one period, is unlikely to cause
higher inflation. There will be a short upswing followed by a downswing back to the
starting level. Not much gain, not much pain.
2. An increase in the rate of expenditure growth that is sustained at the higher rate will
eventually lead to higher inflation. There will be an initial upswing in output, but
a downswing back to the original output level will follow (even though it may take
several years).
3. A continual, repeated increase in expenditure growth rates to keep output at a higher
level will lead to increasing inflation. The higher level of output is not sustainable
for long.

4. A permanent reduction in the rate of unemployment below the structural rate
of unemployment (via expenditure growth) can be obtained only at the cost of a
continually increasing inflation rate (not just a higher level of inflation). A ‘tolerable’
amount of higher inflation cannot be exchanged for unemployment permanently
lower than the SRU.
5. Trying to counter the negative impact of a supply shock on output and employment
by stimulating demand will only lead eventually to further increases in inflation. The
pain of a supply shock cannot be avoided.
Is there a Phillips curve relationship in South Africa?

There is some debate on whether or not there is a Phillips curve relationship in South Africa.
Some of the evidence indicates that there is either no relationship between the output gap and
inflation or, if there is, the impact of the output gap on inflation is not that large. A small impact
is an indication of a rather flat PCSR.
As such, one might be under the impression that output can be stimulated beyond its long-run
equilibrium value without putting too much upward pressure on inflation. However, that would
be a mistake, because research also indicates that inflationary expectations in South Africa
adjust fairly quickly, wiping out any output gain in a rather short span of time and leaving the
economy with a permanent increase in inflation.
❐ This means that the South African Phillips curve may be relatively flat, but that it is quite
mobile and shifts up very quickly following inflationary stimulation.
The quick adjustment of expectations – and mobility of the PC curve – also provides benefits,
though. It means that if the economy is hit by a transitory external supply or demand shock
that causes a sudden, unexpected increase in the inflation rate, monetary policy can return
inflation to lower levels fairly quickly. (By fairly quickly is meant a period from 24 to 36 months
– around the lower end of the three-to-seven year interval mentioned earlier. This is the
minimum time it appears to take for interest rate changes to change the behaviour of private
economic agents via impacts on their balance sheets and income statements.)
❐ Examples include a sudden weakening of the rand as in 2001, or an unexpected increase in
the oil price as in 2007–08. In both cases, the inflation rate decreased fairly quickly after 2002
and 2008 following periods of significant inflationary pressure due to a supply shock.
6. If expenditure-raising policy is carefully designed so that it expands the productive

capacity of the economy effectively, the inflation penalty of expansionary policy will
be less severe or even negligible. Such policy can include government investment, or
expenditure on skills development, or incentivised taxes.
7. However, government should be very careful with more broad-range fiscal or monetary
policy steps such as general tax reductions or interest rate reductions. While such
broad-range steps may also stimulate investment and thus productive capacity, they
will in all likelihood lead to a significant expansion of consumption expenditure.
Unless the economy is below YS, this will put upward pressure on inflation. Hence, if
they are not to be inflationary, expenditure-raising policy steps must be very carefully
designed to focus on stimulating the supply side and not so much the demand side.
More generally:
8. If output falls below the structural equilibrium level due to a demand shock or cyclical
downturn, a countercyclical stimulation of expenditure (demand) to get the economy
back to the structural equilibrium output level (but not further) is appropriate.

The mathematics of the Phillips curve π
The augmented Phillips curve is typically written in one of two forms: either with reference
to output level Y and the structural equilibrium YS, or with reference to the unemployment
rate U and the SRU, or US:
e
 = t  + (Yt – YS ) + x where  > 0 ...... (7.1)
or
e
 = t  + (Ut – US) + x where  < 0 ...... (7.2)
Both equations state that inflation in period t, πt, will equal expected inflation π et plus the
unanticipated change in the inflation rate brought about by policy or an autonomous
shock that pushes output away from YS, or unemployment away from US. In addition, both
equations include x, which represents supply shocks such as increases in import prices,
wages, and other inputs such as oil.  and  are slope parameters when π is graphed relative
to (Y – YS), while  is a parameter measuring the response of π to a change in x.
❐ Graphically, this implies that the intercept of the augmented Phillips curve with the
vertical YS line (thus with PCLR) is at the level of πe. (This mirrors the intercept result that
we derived for the short-run supply curve in chapter 6, section 6.3.3.)
❐ These are linear curves for illustrative purposes. More complex mathematical functions
would provide the curvature associated with the short aggregate supply curve ASSR and
PCSR which reflect the curvature of the production function (compare chapter 6).
❐ (Yt – YS) is the so-called output gap, i.e. the gap between actual and long-run output.
Such a gap typically emerges from changes in either aggregate expenditure or aggregate
supply and, through that, actual output Y. One reason for such changes would be policy
steps.
❐ These equations do not actually model economic behaviour, as was done by the supply
relationships in chapter 6. They show a simple mathematical approximation of an
observed pattern in economic data using the concept of an output gap. (A behavioural
equation can be derived from appropriate aggregate supply equations.)
(For the link between the two versions of the Phillips curve, i.e. equations 7.1 and 7.2,
see the box on Okun’s Law in section 12.2.2.)
This can be either monetary or fiscal policy, although normally monetary policy may
be more appropriate as countercyclical medication (but see section 12.3.3). A weaker
exchange rate (weaker rand) will also help by stimulating net exports.
9. Do not try to push the economy faster than the expansion of its productive capacity.
Spend policy energy and resources on boosting human and physical capital,
technology and so forth. That is: pursue complementarity between macroeconomic
policy and development policy.
10. It is inappropriate, ineffective and, indeed, counterproductive to try to use macro-
economic demand stimulation (e.g. a weaker exchange rate, or a low interest rate
strategy to boost consumer demand) to address the underlying problems of long-run,
structural unemployment. Structural unemployment must be recognised for what
it is and addressed with appropriate structural policies. Rather use special targeted
policy measures in product and labour markets to reduce structural unemployment
(see chapter 12, section 12.2).
The Phillips curve discussion has taken us towards the analysis of policy options, trade-offs
and constraints. An interesting issue is whether this theory can help us understand the
behaviour of policymakers (or can guide policymakers in their decisions). An important
case study is the modelling of monetary policy, or central bank policy behaviour.

7.2 Managing inflation – policy options and the monetary reaction
(MR) function
We have seen that higher or increasing inflation can result from several sources, mainly
(a) excessive expenditure growth plus (b) the supply adjustment process following such
excessive growth, or (c) a supply shock (exacerbated by its supply adjustment process) or
(d) accommodating policy to counter the supply shock. These were depicted graphically in
section 7.1.3 above.
The question is what policymakers are set to do if, for any of these reasons, the inflation
rate is at an unacceptably high level. How can it be reduced? How can we analyse the
options using our model and diagrams?
7.2.1 Basic effects of anti-inflationary policy

The basic answer is simple. It was Figure 7.12 Demand contraction to reduce inflation
illustrated in our examples of the π
‘downward elbow’ in chapter 6 PCLR PCSR0
(section 6.4.2). Let us start from PCSR1
a high inflation equilibrium point
PCSR2
on PCLR with inflation at π2 (figure π2
7.12). A reduction in the growth rate Equilibrium
π3 after demand
of nominal aggregate expenditure decrease
below the current rate (which will π4 AD1
equal the rate of inflation in the
AD2 Equilibrium
equilibrium) will cool the economy
after supply
down, reduce production and push adjustment
output below the long-run, structural
level YS to point (π3; Y3). The inflation
rate will drop to π3. Since the latter Y3 YS Y
is below the expected inflation rate
(which still is equal to π2), expectations will adjust downwards and be reflected in the next
round of wage negotiations. Lower nominal wages will reduce costs and output will start
to expand. In this, the supply adjustment phase, the short-run equilibrium will slide along
the new AD2 curve, through several rounds of wage renegotiations, until it reaches PCLR.
At this new equilibrium the final inflation rate will be still lower at π4, while output will be
back at YS. An inflation reduction would have been achieved, but at the cost of a fairly long
period of lower output and higher unemployment. (Output and income will experience a
cyclical downswing followed by a recovery.)
❐ By appropriately choosing the position of the new AD2 curve, the policymaker can
steer the economy towards a desired, target inflation rate such as π4 (assuming rather
precise demand control abilities; see below).
If the unacceptably high inflation rate was the result of preceding excessive demand
growth (plus supply adjustment), the equilibrium would have followed an anticlockwise
diamond-shaped (or roughly circular) route (figure 7.13). There would be four segments
as AD moved to the right (segment 1) and moved left again later (segment 3). The PCSR
curve would have shifted up (segment 2) and down later (segment 4).
❐ The inflation rate and the output level would have fluctuated accordingly.
❐ The final, target inflation rate (indicated as π4 in the diagram) need not be the same

as the initial inflation Figure 7.13 Demand contraction to counter demand inflation
rate π0, as was shown in
π
this illustration. It could PCLR PCSR1
be either higher or lower.
That would dictate the
appropriate position of the PCSR0;2 Equilibrium after
π2 demand increase
final AD curve. 3 2 plus supply
π3
adjustment
7.2.2 Steering the process – 4
π0;4 1
more activist AD1 Initial equilibrium
AND equilibrium
policy strategies after demand
AD0;2 decrease plus
Policy authorities may want supply
to intervene to change the adjustment
route of the short-run equilib- Y3 YS Y1 Y
rium. Remember that the only
thing that they can affect with
demand policy (fiscal or monetary), is to effect and affect the downward shift of the AD
curve. They can manage the timing, speed and magnitude of this shift.
❐ In reality, policy authorities do not have the information and mechanisms to control
aggregate demand as readily and accurately as may be suggested by these theoretical
manipulations. As noted several times in this book, the economy does not behave
mechanically. In addition, there are problems concerning policy control, including policy
lags. These are discussed in chapter 11.
Different paths, different options Figure 7.14 Different policy paths to counter demand inflation
Consider the second example above,
π PCLR Baseline path to
i.e. of excessive demand growth (figure
eradicate excess
7.13). Let us regard its graphical de- demand inflation
piction as a baseline path (represented
by the solid blue arrow curve in figure
7.14). If this path is not acceptable,
policymakers could act pre-emptively
and start contracting expenditure before
the first supply adjustment process gets πT
very far and before inflation reaches its More graduated
anti-inflation policy
peak on PCLR. path
This would create a flatter circular route

back to the target inflation rate (rep- YS Y
resented by the dashed arrow curve).
Inflation would not rise as much, and output would have to dip less below YS. The pre-
emptive and more moderated path seems to be less costly in terms of both inflation and
unemployment.
The first example above (figure 7.12) is particularly important for understanding typical
monetary policy management. It starts from a high-inflation point on the PCLR line, due to
either supply shocks or excess demand growth or both. Again, different paths are possible.
Consider the basic graphical depiction in figure 7.12 as the baseline path. (In figure 7.15
it is shown as the bold blue arrow curve.)
7.2 Managing inflation – policy options and the monetary reaction (MR) function 321

The contraction in aggregate expenditure Figure 7.15 Different policy paths to reduce inflation
can be managed so that the AD curve π
shifts down slower, giving the ag gregate PCLR PCSR
supply and wage adjustment process more
time to kick in. This would produce a less
roundabout route to the target equilibrium More gradualist
point (and target inflation rate) (represented anti-inflation
policy path
by the finely dashed arrow curve to the
right of the baseline arrow curve). The More reactionist
anti-inflation
drop in output that is necessary to squeeze policy path
the unwanted inflation out of the system is πT
less in this case. However, the process will
take longer since the successive downward
adjustments in expectations and thus in
nominal wages will be in smaller steps. It is YS Y
a more gradualist process.
❐ This strategy implies that the minimisation of the contraction carries relatively more
weight than the speedy reduction of inflation.
If, by contrast, the reduction of inflation is top priority, demand can be pushed down more
quickly and further to force a quick drop in the inflation rate. The supply adjustment process
combined with some demand revitalisation can then be used to steer the equilibrium
point to the target inflation rate. This will produce the third path shown in the diagram
(represented by the dashed arrow curve to the left of the baseline arrow curve). Output and
employment will fall a great deal, but inflation will be squeezed out much more quickly.
This is a more severe, reactionist approach.
The strategy chosen by the policy authorities will depend on their preferences regarding
the urgency of lower inflation as against the unavoidable temporary drop in output and
employment (the core elements in the Phillips curve trade-off, essentially).
The monetary reaction function

One way to think about different strategies is in terms of a so-called policy reaction function.
This concept has been developed in recent years, primarily in the context of monetary
policy and central bank actions. So let us confine our attention to the monetary reaction
(MR) function. However, it can clearly be applied to other kinds of policy as well.
Chapter 3 introduced the basic analysis of monetary policy. It demonstrated how the
central bank can manage the money supply process to set the interest rate at a desired
level to pursue a chosen policy goal. What was not explained is how the desired interest
rate level will be determined. The MR function describes how a central bank decides what
should be its policy strategy, normally via interest rate setting, to steer the economy to a
target equilibrium point.
As chapter 9 will discuss in more detail, the SARB has had an official policy of inflation
targeting since 2000. For most of the time, the SARB wanted to contain the inflation rate
within a target range of 3% to 6%. Its main policy lever to achieve this was management of
the repo rate in reaction to the actual and anticipated inflation rate. An undesired increase
in the inflation rate is typically met by an increase in the repo rate to dampen demand.

❐ The idea of a reaction function is not restricted to an inflation targeting regime. It can
apply to different monetary policy regimes (inflation targeting or others) and via either
interest rate setting or money supply manipulation (both most often via the repo rate).
The MR function is a way to describe the Figure 7.16 The MR curve
likely reaction of the central bank should
the inflation rate increase above the target π
PCLR
value or target range. It can be interpreted
as the imposition of an enforced path for the
journey of the short-run equilibrium point
towards its target.
The reaction function, MR, of the central bank
can be plotted in the Phillips curve space, as
in figure 7.16. The MR curve intersects the
long-run Phillips curve at the target inflation πT
rate πT.
MR curve
The MR line shows the desired path of the
short-run equilibrium point (π; Y) on its way YS Y
towards the target equilib rium point (with
the target inflation rate πT) on the PCLR line.
Thus it is a series of desired levels of Y for inflation rates that still are above (or below) the
target inflation rate. Should the inflation rate exceed the target, the central bank would
try to push the economy to the MR line. Thereafter, the central bank will manage further
demand contractions (or expansions, as necessary) alongside the supply adjustment pro-
cess to steer the equilibrium along the MR line towards the targeted level of inflation πT
(together with its matching output level YS).
❐ The MR curve has a negative slope, indicating the extent to which the central bank
needs to keep output below its long-run, structural equilibrium level to put downward
pressure on inflation.
As noted above, the central bank has a spectrum of options in terms of how gradually or
rapidly it wants to guide inflation back to its target level. It can adopt a gradualist approach
or a stronger, reactionist approach.
❐ Graphically, the differences in
approach are reflected in differ- Figure 7.17 A gradualist MR curve
ent MR slopes.
π
❐ The difference between these PCLR PCSR0
approaches will be evident in the PCSR1
extent to which the central bank
PCSR2
chooses to increase interest rates
π0 Path forced by MR
via a repo rate increase.
function – stepwise
The gradualist MR curve is decrease in AD
curve
illustrated in the diagram in figure πT
7.17. It shows how the fall in
output is moderated by decreasing
AD0
aggregate demand gradually, in AD2
Baseline path
stepwise fashion, until it reaches MR curve
AD2, allowing the supply adjust
YS Y1
ment process to kick in and take the

The Taylor ‘rule’
The most well-known monetary reaction function is known as the Taylor rule. In 1993 Taylor presented the
following equation as a simple model and description of monetary policy behaviour in the USA:
i = rLR + π + h(π – πT) + g(Y –YS )

where i is the nominal short-term interest rate, rLR is the long-term or ‘normal’ real interest rate, π is
the actual inflation rate, πT is the inflation target, and (Y – YS) is the output gap (i.e. the percentage gap
between actual output Y and long-term output YS ).
❐ The real interest rate is given by r = i – π. (It should not be confused with the long-term interest rate rLR.)
The rule means that two ‘gap-elements’ exert an influence on the central bank to change the real interest
rate. (They do so by changing the short-term nominal interest rate i as shown by the formula.)
❐ Inflation gap: If and while inflation is above the target value, there is pressure to increase the real
interest rate above the ‘normal’ value. [Consider the term h(π – πT).]
❐ Output gap: If and while output is above the long-run level YS , there is pressure to increase the real
interest rate above the ‘normal’ value. [Consider the term g(Y – YS).]
❐ If both inflation and output are below the target values, there is twofold pressure to reduce the real
(and nominal) interest rate.
❐ If inflation is above the target value, but output is below YS, there are opposing forces: the inflation
gap-related pressure to increase the real interest rate will be moderated by the output gap-related
pressure to reduce rates.
A central bank that behaves like this will in effect steer the economy along one of the reaction paths
shown in the diagrams above. Interest rate setting will change during the route to reflect the changing
influence of the two evolving gaps along the path.
As a description of interest rate policy, the Taylor rule highlights that a central bank fights inflation not so
much by increasing the nominal interest rate, but by increasing the real interest rate – it is when interest
cost in real terms increases that people cut back their expenditure and borrowing.
Note that the inflation target is not necessarily an officially announced target. It could also be the implicit,
unannounced target that the central bank pursues.
The parameters h and g indicate the importance that the central bank attaches to fighting inflation versus
keeping output and employment as close as possible to its long-run, structural value.
❐ For the USA, Taylor found that setting h = 0.5 and g = 0.5 provides a good description of monetary
policy behaviour.
A higher value of h implies that the central bank attaches more importance to fighting inflation.
❐ For instance, suppose rLR = 2% and that h = 0.2. If inflation is at 6% while its target value is 4%,
h(π – πT) will amount to 0.2(6% – 4%) = 0.4%. Assuming for a moment that (Y – YS) = 0, the short-term
nominal interest rate will be set at 8.4%. Thus the real interest rate r equals 2.4% = 8.4% minus 6%.
❐ However, if h = 0.5, h(π – πT) will amount to 1%, which translates into a short-term nominal interest rate
of 9%. The real interest rate r equals 3% = 9% minus 6%.
❐ A higher value of h thus implies a more stringent interest rate policy when inflation is above the target
value: the central bank attaches more weight to inflation than unemployment.
Similarly, the value of g shows how much emphasis the central bank places on getting output and
employment back to their long-run, structural values.
❐ A larger g will imply relatively greater output gap-related pressure to change the interest rate.
The parameters h and g should always exceed zero. A value below zero would imply that the central bank
perversely lowers interest rates when faced by higher inflation or an economic upswing, or vice versa.

economy towards the long-run equilibrium output level. The fall in output (which is less
than in the basic example in figure 7.12) is indicated as the ‘baseline path’. As noted,
this path will take longer than the baseline example to reach the target level of inflation
πT. Unemployment will increase less, but those unemployed will remain unemployed for
longer.
❐ An MR curve that is relatively steep indicates a political or policy preference that favours
the protection of employment over inflation, even though the inflation reduction is the
agreed end goal.
❐ Interest rates will be pushed up less in this case.
The reactionist approach is illustrated in the next diagram (figure 7.18). The path from
π0 to πT is very different from that seen in the gradualist approach. Demand is contracted
further than AD2. The drop in short-run equilibrium output (and employment) is severe,
so much so that demand has to be revitalised in the later stages, otherwise it would be
overkill and the inflation rate would end up below πT. However, the rate of inflation de
clines much more quickly than in the baseline example, and obviously also more quickly
than in the gradualist case. The recovery of output and employment may not be so quick,
though.
❐ An MR curve that is relatively flat indicates a political or policy preference that favours
low inflation over low unemployment, with a more or less single-minded focus on the
reduction of inflation.
Figure 7.18 A reactionist MR curve
❐ The necessary increase in interest
rates will be much larger in this case. π
PCLR PCSR0
An extreme example of the reactionist PCSR1
approach is the so-called cold-turkey ap-
proach. It aims to eradicate excessive
inflation in one decisive move and in π0 Baseline path
one period by increasing the repo rate
drastically.
❐ Graphically, the cold-turkey approach πT AD0
is indicated by a horizontal MR func-
MR curve
tion, indicating an uncompromising Path forced by MR AD2
function – severe initial
anti-inflationary stance by the cen- decrease in AD curve,
tral bank. then gradual recovery
❐ The cold-turkey approach has the YS Y1

benefit that inflation returns to its low
level within one period. However, the drastic increase in unemployment that it entails
may render it politically difficult to implement. Few, if any, central banks follow a cold-
turkey approach (because the turkey may end up dead ...?).
How should the interest rate be set by the central bank? The appropriate interest rate path
in each case can be determined if one considers the IS-LM diagram corresponding to this
AD-PC diagram.
❐ In some textbooks, you will find a so-called IS-PC-MR three-equation model. This is like
figure 7.18, but it is trimmed to show only the essential curves from the point of view of
a central bank that sets/controls/pegs interest rates through open-market operations
and so forth. Typically, they will not show the AD curve, preferring to analyse demand
with the IS curve. The preferred equilibrium path is deduced from PC and MR only.
Then, on the accompanying IS-LM plane, they will not show the LM curve, and focus

only on deriving, from the IS
curve, the target interest rate Which policy objective?
to produce the desired fall in At the moment most central banks consider price
output. stability to be their main objective. This is a broad
❐ This ‘underplaying’ of the LM current consensus in central bank and monetary
curve is not purely innocuous. policy circles. The South African Reserve Bank
It reflects a particular way of (SARB) is no exception.
thinking about what central ❐ Usually, price stability does not mean zero
banks should do, underpinned inflation, but rather an inflation rate low and
stable enough so that people cease to take
by the growing influence of a
inflation into account in their economic decisions.
particular doctrine – in United
States economic policy circles, In other eras (and countries), objectives such as
for example – that monetary employment creation have had similar prominence.
policymakers should interfere In the USA the Federal Reserve has to consider both
as little as possible in markets, inflation and economic growth. In South Africa, an
influential labour federation such as Cosatu feels that
that markets clear efficiently,
the Reserve Bank should consider employment and
and so forth.
poverty alleviation as policy objectives, or at least
❐ A more generally useful model that inflation should not be the only consideration
that can aid understanding of of monetary policy. See chapter 12 for a fuller
different countries and eras discussion of these issues.
keeps the LM intact, since it
can be used to analyse several
approaches to monetary policy.
❐ In any case, the world financial crisis of 2007–08, and the political reactions to it,
reminds one that different eras may also make different approaches appropriate. One’s
analytical apparatus should not be constrained by a single approach that is currently
in vogue.
✍ Analysing the world financial crisis of October 2007–08: inflation effects

We have considered this case study several times since chapter 3. You should have gained
many insights into a complex situation.
The analysis culminated in chapter 6, using the AD-AS model. The last step is to take your
analysis of chapter 6 and transfer it to the AD-PC model.
What additional insights does this model add, relative to the AD-AS model?
7.2.3 Conclusion
This concludes the exposition of the expanded AD-AS theory, in the form of the AD-PC
model, to be used to analyse macroeconomic behaviour, fluctuations, shocks and policy in
an inflationary context.
❐ Nevertheless, it appears that most of the analytical conclusions from the AD-AS chapter
regarding shocks and disturbances and their graphical reflection in diagrams, can
be transferred, with a few modifications, to the inflation context. Therefore, insights
from the standard AD-AS model remain relevant, in most respects, for the inflationary
context.

In terms of the time frame concerned, we have now dealt, first, with short-term fluctuations
due to demand and supply shocks. These can be thought to occur over a time horizon of up
to approximately three years.
We have also considered medium-term adjustments of the supply side of the economy to-
wards the ‘long run’ (sic) or structural equilibrium level of output and employment. Such
adjustments can involve a period of a further three to seven years approximately (within
which short-term disturbances and fluctuations can recur, of course). The average for both
short- and medium-run processes, allowing for some overlap, is typically approximately four to
seven years.
Now is the time to consider the context of output and employment in the very long run,
with a time horizon measured in decades – the topic of economic growth.

1. There was a steady reduction in the repo rate of the Reserve Bank between 2007
and 2013. Use the expectations-augmented Phillips curve to analyse (explain and
illustrate) the short-run and long-run impact of this reduction on the inflation rate,
as well as on the unemployment rate.
2. Use the expectations-augmented Phillips curve to analyse (explain and illustrate) the
short-run and long-run impact of negative supply shocks on the inflation rate, as well
as on the unemployment rate.
3. Following from the previous question, suppose the government wants to restore the
output level that existed prior to the occurrence of the shock, explain the effect such
steps will have on the inflation rate.
4. ‘Manufacturers will appeal to the National Energy Regulator of SA (NERSA) for relief
on Eskom's planned, steep electricity tariff increases, which they say will force many
companies out of business.’ Use the expectations-augmented Phillips curve to analyse
(explain and illustrate) the short-run and long-run impact of an increase in Eskom's
electricity tariffs on the inflation rate, as well as the unemployment rate.
5. During 2016 South Africa experienced the highest inflation rate in seven years. What
can policymakers do to reduce inflation? Which policy institution(s) is (are) best
geared to do that? Use the AS-AD model to illustrate and explain your answer.
6. Suppose the inflation rate is 12% and the Reserve Bank wants to reduce it to 6%,
explain the difference between the options that the Reserve Bank has in terms of the
speed by which it reduces the inflation rate and factors that may slow down such a
reduction.
7. In 2019 pressure increased to expand the mandate of the South African Reserve Bank
so that it does not only target inflation, but also economic growth. Use the AS-AD
model to discuss the merit of targeting growth and inflation. Can the South African
Reserve Bank ensure a higher economic growth rate in the longer term? Discuss. (You
can also consult chapter 9 in this regard.)

Macroeconomics in the very long run:
growth theory 8
■ understand how the analysis of aggregate supply, and the production function in
particular, provides the key to explaining economic growth;
■ analyse and evaluate how the concept of balanced growth helps to explain the long-run
growth path of economies;
■ analyse the main sources of sustained growth in per capita GDP, and compare how
changes in economic behaviour and structure can impact on per capita growth;
■ evaluate the potent roles of technology, institutions and human capital in economic
growth;
■ evaluate how policy measures can and cannot be used to increase the long-term growth
prospects and performance of an economy; and
■ appreciate the importance of a wider social and human development context in under-
standing and promoting economic growth.
The foregoing chapters of this book have dealt with short-term fluctuations due to demand
and supply shocks (e.g. a time horizon of up to three years) and also medium-term
adjustments of the supply side of the economy (a further three to seven years) towards
the ‘long-run’ or structural equilibrium level of output and employment. We have also ex
panded our analysis of changes in the price level P to include the ‘continually increasing’
context of P and thus inflation.
Now is the time to consider the context of continually growing output Y in the very long
run, with a time horizon measured in decades. That brings us to the topic of economic
growth and theories of economic growth.
8.1 The importance of growth

While short- and medium-term fluctuations of an economy are crucial for the inhabitants
of a country, the long-term economic health of an economy is a very important topic.
Within the broader context of development and poverty alleviation in a country such
as South Africa, increasing the standard of living of people in the long term is a major
political objective. The struggle in South Africa to reach a targeted 6% GDP growth rate
calls for a better understanding of the determinants of growth.
Table 1.1 in chapter 1 shows average economic growth rates for South Africa since the
1960s. Economic growth was strong up to the mid-1970s, with economic growth rates
peaking at 6% per annum in the 1960s. However, in the mid-1970s, economic growth in
South Africa weakened significantly, with per capita growth turning negative in the period
8.1 The importance of growth 329

1981 to 1993. Since then the economic growth rate, both in aggregate and per capita
terms, has improved significantly.
Measuring economic growth

The simplest measure of economic growth is the annual growth rate of real GDP, i.e. the
percentage increase in real GDP from one year to the next.
GDP – GDP Yt – Yt–1
Real GDP growth rate =  
t
GDP
t–1
     
× 100 or  
Y
× 100
 
   
t–1 t–1
It can also be measured in terms of per capita GDP (i.e. average GDP per person). The formula
is the same except that aggregate GDP is replaced by real per capita GDP.
When studying long-term trends in economic growth, the focus of attention is per capita GDP.
Warning: economic growth theory is not about ‘economic growth’…

1. Popular discussions by economists, business people and politicians about economic
growth usually proceed in terms of the growth rate of GDP, not GDP per capita. Only rarely
will they relate the GDP growth rate to the population growth rate.
2. The annual change in GDP comprises both a short-run or cyclical component and a long-run
or trend (i.e. growth) component. However, this distinction is very often not made when either
cyclical or growth trend issues are discussed. Thus, when the business cycle is discussed
(for instance in the media), the growth rate is used indiscriminately by commentators who
forget that part of the growth rate represents trend or long-term growth. Strictly speaking,
the cyclical component should be removed from the actual growth rate to obtain the trend or
long-term growth rate. (Also see chapter 12, section 12.3.1.)
These averages, and particularly the dramatic drop in per capita GDP growth rates after
1981, clearly show the importance of long-term growth relative to the business cycle,
which involves short-run fluctuations.
❐ Graphs in chapter 12, section 12.3.2 show per capita GDP together with the long-term
trend in per capita GDP for South Africa and the USA. Deviations from the growth path
indicate the business cycle. It appears that, over the very long run, deviations from the
long-term growth path are dwarfed by the long-term trends of the macroeconomy.
8.2 Why growth theory?

While the harsh reality of recessions and depressions when people lose their jobs cannot
be denied, sustained economic growth can play a powerful role in lifting aggregate, as well
as per capita, production and income in a country.
In terms of the AD-AS framework, sustained growth in GDP implies that the structural
equilibrium output level continually shifts to the right at a sustained rate of growth. The
ASLR (or PCLR) curve obviously moves in tandem.
Note that in growth theory the focus is exclusively on the supply side of the economy. This
is a pattern: the theoretical analysis of short-run fluctuations focuses on expenditure and
demand, with some attention to the supply side; the analysis of medium-term adjustments
focuses largely on supply with some attention to the demand side. Very long-term analysis
focuses exclusively on the supply side, since it is all about the expansion of productive
330 Chapter 8: Macroeconomics in the very long run: growth theory

potential in the very long term,
and the adjustment of the eco- Does economic growth help everyone?
nomy towards that potential A major argument for economic growth is that the
growth path. economic pie must grow if the slices that people
get are to get bigger. Better living standards require
In our analysis of the aggregate
economic growth.
supply curve, we encountered
the aggregate production func- However, per capita GDP is an average. Despite an
tion (TP), which captures the way increase in per capita GDP, some people may not be
aggregate output Y depends on better off. Or, the living standards of some people
may increase much faster than those of others.
the quantities of labour N, capi-
It depends on how the growing income flows to
tal K and technology A that are
different households and individuals are apportioned.
employed in the multitude of pro- ❐ South Africa has one of the highest degrees of
duction processes in an economy. income inequality in the world (see chapter 1,
For a more rounded analysis, we section 1.3.5 and chapter 12, section 12.3.2).
expand this function somewhat in
this chapter. First, the A factor is
expanded to include the role of progress with regard to social and economic institutions
and practices that impact on the productive potential of an economy. These can be
legal (e.g. property rights, constitutional framework, company law framework, labour
law, competition law and policy, etc.), managerial (management techniques, style of
doing business, work ethic, motivational make-up, etc.) or organisational (new ways of
organisation and management) and so forth. These aspects do not change the analysis of
earlier chapters materially, but we embed a much richer analysis of social development
over time in that variable. This will
appear to be quite important (also
Why does demand not matter for growth?
see chapter 12, section 12.3.4.)
Short-run and medium-run fluctuations are largely
Second, we add another vari-
explained by shocks and disturbances that initially
able H. This represents so-called cause output (supply) and expenditure (demand) to
human capital. In its narrow- diverge from each other. The adjustment in economic
est sense, human capital can be behaviour that brings output and expenditure back
defined as the skills of individu- into balance takes the economy to a new equilibrium
als that allow them be more ef- point. Moving equilibrium points are the substance
ficient. Such skills are accumu- of the business cycle and medium-term patterns in
lated over a lifetime, notably output and employment.
through schooling and post- In the very long run, our interest is the long-run
school training and education. trend in aggregate income. Thus we intentionally
Expenditure in education that ignore short-term and medium-term deviations
increases the amount or years of from the trend. To exclude that element, we regard
schooling of individuals can be expenditure and output as being in equilibrium in
seen as an investment in human the long run. This means we can only focus on the
capital, i.e. the ability of people behaviour of output (and thus income) in the long
to be productive. Other forms of run, since expenditure will behave concurrently.
knowledge, such as workplace Obviously the economy will not be on the long-run
experience, on the job training, growth path at all times, as we will see, and will
life skills, etc., improve labour regularly be busy, over time, adjusting back to the
efficiency as well. A broader in- long-run trend. Nevertheless, to see this we first
terpretation would also allow need the long-run trend.
for the development of human
8.2 Why growth theory? 331

ability/capacity due to reasons other than education, e.g. improved health care. This
additional variable is included in our expanded production function, allowing one to
analyse the impact of changes in all these variables on aggregate supply. (See section
8.10 for a fuller discussion.)
It seems rather obvious that economic growth depends on things like labour, capital, skills,
technology and social and economic institutions. And it seems quite straightforward to
deduce how changes in the components of N, K, A or H will impact positively or negatively
on aggregate productive potential and actual output. For example, an increase in the skills
levels of the workforce will improve output and increase aggregate supply. If this happens
continually, aggregate output will grow continually. To be a bit sarcastic: what else is new
in growth theory?
Three aspects deserve attention:
❐ First, not all factors of production can necessarily contribute to economic growth in the
long term in the same way or with the same forcefulness. Some are more potent than
others (in a specific sense to be explained) and some are more constrained than others.
❐ Second, not all long-term growth paths are equally accessible for an economy. Some
growth paths can suffer from imbalances and run into constraints. But at least there
are some economic forces at work that help an economy to get to the balanced growth
path.
❐ Third, policymakers (and voters/citizens) can improve the conditions and prospects
for balanced growth if they are well informed and can implement a few appropriate
changes in economic behaviour and parameters in a country.
This chapter mainly presents the Solow growth model, named after Robert Solow, the
American economist who developed this theory (for which he received the Nobel Prize in
Economics in 1987). However, the chapter also highlights issues that the standard model
does not cover but that need to be considered when thinking about growth (and policies
to support growth) in a low- or middle income country. Thus, we try to fashion a bit of a
bridge between growth theory and development theory, without going into the detail of
the latter. (In chapter 12, section 12.3, we will see that this bridge may be very important.)
8.3 From intuition to formal analysis – from AD-AS to the Solow

growth model
Consider the production function and TP curve in chapter 6 (section 6.3.2), and let us add
the variable H on the right hand side:
Y = f(N; K; H; A) ...... (8.1)
where
N = Labour usage (employment) in production;
K = Physical capital stock in productive use;
H = Human capital stock (the skills levels of workers); and
A = An index of technological and institutional progress.
We will pay limited attention to H for a while, to simplify the initial analysis. However, it
is quite an important variable, particularly in a low- and middle-income countries, where
skills deficiencies often hamper productivity and economic growth. We will also see that the
role of human capital H in economic growth is thought to be very similar to that of physical
capital K, but that some kinds of human capital play a role similar to that of technology.

So the analysis of both physical
capital K and labour efficiency What about natural resources as a source
A can be largely replicated, with of growth?
some adjustments, for the analysis Countries rich in natural resources such as oil
of H (see section 8.10). reserves or mineral deposits (e.g. gold, platinum,
iron ore) clearly have a major economic advantage.
So, for the moment we proceed
How would you accommodate that in the production
with the simpler production function and growth model?
function: ❐ See the box in section 8.5.
Y = f(K; N; A) ...... (8.1a)
This is the form used originally by Solow. Constant returns to scale are assumed, as well as
diminishing marginal returns to both labour and capital.
(a) The former means that if each of the factors of production is increased by a given
percentage, e.g. 10%, total output will also increase by 10%.
(b) The latter means that if only one production factor, e.g. labour, is repeatedly increased
by a particular percentage, e.g. 10%, while the other factors remain constant, total
production Y will successively increase not by the same percentage (10%), but
by a shrinking percentage, e.g. 8%, and then 7%, and then 6%, and so forth. Each
successive increment in the production factor is met by a shrinking increment in
output. Eventually, if theoretically, this growth in output will approach zero.
❐ Graphically diminishing marginal returns are seen in a curved TP function that
gradually flattens out as the variable on the horizontal axis increases (given
that the other factors remain constant). Figure 8.1 shows diminishing marginal
returns to labour.
Factor A is very different in this
regard. Non-diminishing marginal The maths of production functions – the π
Cobb-Douglas function
returns are assumed with regard
to A. Technological and institu- This is one of the most popular production
tional progress is thought to be functions in economics. Despite its simplicity, it
unconstrained by diminishing can be used to generate a variety of production
marginal returns in the long run. relations that approximate real-world situations
quite well. It looks as follows:
New technological or institutional
innovations and refinements that  1–
Yt = AtKt  Nt  where 0 <  < 1
add proportionally (or more) to
output growth always appear to The parameters  and 1–  represent the share
be possible. This characteristic of of capital K and labour N in income Y. For more
details, see addendum 8.1.
A, as against the others, will prove
to be very important in the analy-
sis and conclusions that follow.
❐ The absence of diminishing marginal returns means that there are either constant
marginal returns for that factor, or increasing marginal returns.
❐ For illustrative purposes we will assume, in the rest of this chapter, that A is subject to
constant marginal returns (as against the other option, i.e. increasing marginal returns).
So we assume that an increase (i.e. growth) in A always leads to the same proportional
increase (i.e. growth) in Y: if A increases by 5% it will cause a 5% increase in Y.
Graphically, sustained increases in Y must come from either of two sources (or both): a
sustained move along TP due to increasing N, or a sustained upward shift/rotation of TP due
to increased K or improved technology and social and economic institutions A.
8.3 From intuition to formal analysis – from AD-AS to the Solow growth model 333

Figure 8.1 TP and growth in long-run real income due to changing K or A
Y Y 45° line
TP1
TP0
Y1 Y1
YS YS
NS0 NS1 N YS0 YS1 Y
 W  
__ P ASSR
P
WS
PS
NS0 NS1 N YS Y1 Y
1. Changes in K and A will increase labour productivity; thus TP rotates up and, in the
PS-WS diagram, PS shifts up – see figure 8.1.
❐ New technology lifts but also extends/elongates the TP curve to the right – there
is a new technical relationship, so that the flattening area (diminishing marginal
returns area) is shifted out to the right.
❐ Increasing K produces purely a proportional upward shift/rotation in TP, and the
hazard of diminishing marginal returns to labour setting in is not forestalled. There
is no change in the technical relationships inherent in TP.
2. Changes in the labour force (LF) will shift WS in the WS-PS diagram, but TP will not
rotate. That is, there is a move along a stationary TP, and no change in the technical
relationships inherent in TP.
3. For a similar change in the employment level N, the resultant change in YS (and ASLR)
will be larger when it is combined with changes in A and K (that shift/rotate TP).
What one sees here is that sustained increases in Y (i.e. GDP), and thus economic
growth in the very long run, will depend positively on investment (capital formation:
infrastructure, machinery and equipment, etc.), labour force growth, and progress in

terms of new technology and the development of social and economic institutions and
processes. (Growth of human capital can be added to this list to be more complete; see
section 8.10.)
However, growth in Y is not without constraints and limitations.
❐ Regarding N (as a proxy for the labour force LF): First, it is constrained by natural limits on
the population growth rate. Moreover, increasing employment N is subject to diminishing
returns, so increasing N out of line with K is less productive in the long run.
❐ Regarding K: Capital expansion is subject to diminishing returns (if it is increased out
of line with N), which means that the rotation of TP will be stifled more and more.
Second, capital formation (investment) has to be financed from aggregate saving –
which depends, in turn, on Y (and the saving rate). Also, the capital stock does not
necessarily remain constant. A fraction of the capital stock is depleted annually – i.e.
there is depreciation – due to wear and tear, or machinery becoming obsolete and
having to be replaced regularly through investment.
❐ Regarding A: With growth due to improving technology and institutions not being subject
to diminishing returns, a given percentage growth in technology and institutions (as
measured by growth in A) leads to the same percentage growth in Y.
The amplifying impact of technology and institutions on labour efficiency means that by
improving technology and institutions one can overcome the ultimately choking effects,
on output growth, of diminishing returns to labour.
❐ This is seen in the way TP is rotated and elongated by improving technology and
institutions without the rotation being stifled by diminishing marginal returns: a given
improvement in A leads to an equi-proportional improvement in Y.
Note, with reference to figure 8.2, that in the Figure 8.2 The impact of technology and institutions
initial graphical depiction of the production on TP
function shown in figure 8.1 we have chosen
Y TP1
to place employment N on the horizontal axis.
Thus, changes in K, which is not on either of TP0
the axes, will shift the TP curve. The same
applies to changes in A. By contrast, changes Y1
in N result in moves along the TP curve. Y0
One can, alternatively, choose to show TP with

the capital stock K on the horizontal axis as in
figure 8.2. Changes in A would still shift/rotate
the TP curve, as from TP0 to TP1. A change in
K now is seen as a move along a particular
curve, e.g. TP0, as indicated. Changes in N
will shift the TP curve. Nevertheless, in terms K0 K1 K
of analysis, the diagram will produce results
identical to those for figure 8.1 and its version of TP. The resultant changes in Y will, as
before, reflect as a shift of the vertical ASLR line.
❐ As before, the curvature shows diminishing marginal returns, in this case diminishing
marginal returns to capital.
From now on we will only work with the TP diagram and dispense with the ASLR diagram.
We know that any vertical change in Y in the TP diagram is equivalent, in the AD-AS
plane, to a rightward shift of ASLR and an increase in YS.
❐ For reasons that will immediately become clear, our further development of the TP
relationship will build on figure 8.2, with K on the horizontal axis.
8.3 From intuition to formal analysis – from AD-AS to the Solow growth model 335

8.4 Rearranging the model – towards income per capita
A major limitation of the analysis above is that it works in terms of the growth of aggregate
output and income Y (i.e. GDP). What is important for growth theory, but actually for the
population of a country, is GDP growth relative to population growth. This would determine
what is happening with GDP (or Y) per capita, which indicates what is happening with the
material living standards of individuals in the population.
Thus we have to evaluate and analyse growth in Y relative to the population growth rate
n. Changes in (if not levels of) the latter ratio can be approximated by changes in  NY ,  i.e.
output per worker or income per worker.
Although not precisely equivalent, for the purposes of this chapter we shall use the terms
Y
  N ,  output per worker, income per worker, and income (or GDP) per capita interchangeably.

8.4.1 Recasting the production function

Thus it becomes convenient to recast our analysis with  NY   as the key variable. This can
be done by rewriting the production function TP in so-called intense form with  NY   as the
dependent variable, and thus the variable on the vertical axis of the TP diagram.
❐ This also has the benefit of avoiding a situation where a shifting and rotating TP will
rapidly disappear off the top of the page (similar to when we studied the AD-AS model
in an inflationary context).
Thus the standard production function
Y = f(K; N; A)
can be rewritten in the following form, which we will still indicate as TP:
 __
Y
( K )
__
N  = f   N ; A  ...... (8.2)
where
 NY   = output–labour ratio, i.e. output per worker (also: average labour productivity);
K
 
N   = capital–labour ratio, i.e. capital stock per worker;
A = an index of labour efficiency. Since A in the first production function above is an
index of technological and institutional progress (and something that broadly
speaking is available to everybody), it need not be divided by N.
One could also simply think, in this form of the production function, of A as a measure, or
an index, of labour efficiency due to improved technology, social and economic institutions
and practices. This is the approach we adopt in this chapter.
❐ The growth rate of A (which is denoted as a) thus indicates the growth rate of labour
efficiency due to technological progress and social and economic institutional
development.
Note:
K
❐ Increasing  N  is called capital deepening. Its opposite is capital widening.
❐ Another relevant ratio is  KY  , the capital–output ratio, which is called the capital intensity
of an economy.
From this function we can derive a model that explains fairly robustly how sustained
increases in  NY  – and thus economic growth that increases the standard of living over time
(in the very long run) – will depend on:

(a) saving and investment (i.e. capital formation and accumulation, which improves
capital intensity);
(b) labour force growth;
(c) progress in terms of new technology and the development of social and economic
institutions and processes (which improves labour efficiency); and also
(d) improvements in human capital – which we will not analyse for the moment (see
section 8.10).
This function enables us to generate a diagram with  NY   on the vertical axis and 
 NK  on the
horizontal axis (see figure 8.3).
❐ The benefit of this diagram is that any movement of the economy to a point on TP that
shows an increase in  NY  implies that Y has not only grown, but has grown more than the
labour force or population growth in that period.
Economic growth in the sense of a
sustained annual increase in GDP Working in terms of ratios such as    NY   and   
K
N
 is
Y somewhat confusing at first, so be careful when
per capita, as approximated by   N   
thinking about changes in variables. We will
in the Solow model, implies (and
initially present the analysis in some detail to aid
requires) a sustained increase in understanding. Addendum 8.2 provides a helpful
the  NY   ratio on the vertical axis. illustrative numerical example. It is worth studying
A higher value of  NY  is beneficial it carefully.
for the population, but it does
not constitute growth (just as
an increase in the price level does not constitute inflation). Economic growth is about
sustained, recurring annual increases in   NY   over time.
 NY -   NK  plane has the same general shape as in the Y-K plane, for the same
The TP curve in the 
reason: diminishing marginal returns. It will thus also flatten out at higher levels of   NK . 
8.4.2 Moving along TP, shifting TP

As noted above, increasing one factor of production while keeping the others constant will
increase output Y, but at a decreasing rate. This has complex implications for the change
in  NY  , as follows: K
❐ If K is increased (for constant N),  NK  increases to   1
0
N   . Graphically, there is a move to the
right along TP0. Output Y will increase due
to the Y
additional capital and  NY  will increase Figure 8.3 Changes in TP
(to  
1
N   ). Since it involves diminishing re- TP2

0
turns to capital (graphically, the move is Y/N

along the curvature of TP0),  NY   increases
proportionally less than the increase Y2 /N0 TP0
in   NK   (and K increases proportionally less Y1/N0
than Y). Y0 /N0
❐ If only N is increased (for constant K),
there is a move to the left along TP0 (not
Y
shown).   N    will decline.
❐ Note that the variable N (or LF) has
Y
an unexpected effect on    N .  Increasing
employment N increases output Y, yes,
but since the growth in Y is subject K0 /N0 K1/N0 K/N
to diminishing marginal returns, the
8.4 Rearranging the model – towards income per capita 337

higher value of N implies that output per worker (or per capita income) decreases. Put
differently, because the unchanging capital stock must be spread over more workers,
diminishing marginal returns set in, and Y does not expand proportionally to match
the increase in N. Output per worker actually declines.
If both K and N are increased and in the same proportion,   NY  remains constant though, as
K
does  N  (of course).
❐ Flowing from our assumption, for the production function, of constant returns to scale
for in-tandem increases in N and K, total output Y will increase in proportion to the
  NY  will remain constant. The economy
change in N and K. This means output per worker 
remains at the same point on the TP curve.
Once again, an improvement in technology or in social and economic institutions gives
strikingly different results. Improvements that improve labour efficiency A will increase
output Y as well as output per worker  NY  without any change in K or N or 
 NK  being required.
Graphically, such an increase in A will rotate the TP curve and lengthen
Y
it up and towards
the right (from TP0 to TP2, say). Income per worker increases to   N .

   
2
Y
8.5 Sources of sustained growth in   
N
 – first conclusions
Economic growth in the sense of a sustained increase in GDP per capita, or rather  NY , 
 NY  ratio on the vertical axis.
graphically implies (and requires) a sustained increase in the 
An important question is the sources for such growth, and whether all apparent sources
of growth can deliver such an outcome – or whether they can deliver it in the same
way or with the same potency. We can examine this by repeating the analysis above in
a ‘continually growing’ context: deducing how and whether each factor can deliver the
 NY . 
required sustained increase in 
Growing labour force and employment

Sustained growth in the labour force and employment can cause growth in aggregate
output and income Y, but income will grow slower than N and in such a way (being choked
increasingly by diminishing marginal returns) that it actually leads to a decline in  NY  or per
capita income. The average material standard of living of people will decline.
❐ So N alone cannot produce sustained growth in Y or   NY . 
Growing capital stock

Growth in the capital stock K (with constant N) will lead to growth in aggregate output
Y
and income Y. Since the labour force remains constant,   N    
(output per worker) will
increase/grow, suggesting that income per capita grows correspondingly. Graphically, the
production point moves to the right along the TP curve. This demonstrates the unhappy
truth that the growth in  NY  is constrained and ultimately capped by the slope of the TP
curve, which reflects diminishing marginal returns to capital for increasing capital–labour
ratios.  NY   can grow, but it cannot grow indefinitely. In fact, it will increase from one level to
a higher one, and will then remain there. (Its growth rate will be positive only during this
transition.)
Y
❐ Thus, sustained growth in K alone cannot produce sustained growth in   N  .
❐ In addition, as we will see below, the move along TP is constrained by being dependent
on capital formation (investment) that has to be financed from savings (which comes
out of GDP, i.e. Y). Forces will be at work to guide the  NK  ratio to a stable rest point.

Expanding human capital
What about natural resources as a source
Although we will only discuss
of growth?
human capital H later, it is worth
noting here that the impact of Countries rich in natural resources such as oil re-
growing human capital on   NY   and serves or mineral deposits (e.g. gold, platinum, iron
per capita income is an important ore) clearly have a major economic advantage. The
part of our eventual analysis. question is how to accommodate that in the produc-
tion function and growth model.
As we have noted, the impact of
human capital on  NY  is thought to The basic answer is that natural resources form the
be similar to that of either physical resource base upon which K, N and A are applied
capital K or labour efficiency A. in order to produce output Y. They do not have a
(See the analysis in section 8.10.) separate effect on output, which depends on the
utilisation of K, N and A. Therefore:
❐ In a growth model, their main impact is on the
Growing labour and capital together level of GDP (or the level of the GDP growth
Synchronised sustained growth in path).
the labour force and the cap-ital ❐ Since the extraction of such resources involves
stock will increase aggregate output huge capital expenditure, there is also a capital
in the same proportion (in terms of effect – but also only on the level of GDP.
the assumption of constant return ❐ However, natural resources do not determine the
Y
to scale). 
K
 N  remains constant. This growth rate of Y (or  
 N ).
means, however, that output per ❐ The infusion of new technology into mineral
worker,  NY  , remains constant in the extraction and mining will, however, affect the
growth rate of GDP.
long term. This is explained by the
fact that the benefit of the growth
in Y, caused by the growth in K, is
partly negated by the growth in N, which reduces the per capita benefit.
❐ Thus, sustained growth in N and K together can also not produce sustained growth
in  NY . 
Technological and social institutions/labour efficiency

Growth in labour efficiency due to progress in technology and/or social and economic
institutions will improve the productive performance of an economy and increase Y.
Moreover, since decreasing marginal returns to one of the main factors K and N are not
involved, growth in   NY  due to policy growth in A will always remain equal to the growth
rate of A, unlike the case with capital and labour growth. Graphically, TP can rotate and
be elongated upwards and to the right over time without constraint.
❐ This produces one of the most important results of the Solow growth model: sustained growth
  NY  , i.e. per capita GDP, can only be produced by sustained growth in labour efficiency resulting
in 
from sustained progress in technology and institutions. (But also see section 8.10.)
Historically, this factor, much more than capital accumulation, is understood to explain
the most important eras of sustained growth in living standard in the USA and other
countries, e.g. the post World War II period up to the middle 1970s.
Y 339
8.5 Sources of sustained growth in   
  – first conclusions
N

8.6 Is any capital–labour ratio possible? The idea of balanced growth
A second set of results from the Solow growth model relates to the following key question
for society and government: can a society choose to be at any point on a given TP curve?
Can it move, or be pushed, as far right on the TP curve as it wishes?
Preview: key points of this section

1. The only economic growth path that can be maintained for a very long period is one where a
balance between output and the various factors of production is maintained.
2. Any other course will be subject to economic forces that gradually push the economy
towards the balanced growth path.
8.6.1 The concept of balanced growth

Assume for the moment that there is no growth in A, i.e. labour efficiency remains constant.
 NY  and  NK .  We will relax this assumption in section 8.7.
This will enable us to focus on 
The first question amounts to asking whether or not there is an optimal value of K relative
 NK  ratio (the capital–labour or capital per worker ratio).
to N, i.e. an optimal value of the 
Solow’s approach was the typical economist’s approach: he asked whether the course of
the economy (the growth path and growth rate of Y) is unconstrained and unbounded,
or whether there are either constraints or forces that push it towards rest values or, in
favoured economic parlance, equilibrium values. An important result of Solow’s model is
that there are indeed such rest points or balance points.
❐ In Solow’s model these are captured in the concept of balanced growth points, or steady-
state growth points.
One can thus study economic growth by analysing the pattern and behaviour of ‘stable points’
over time and analysing how the economy moves towards such stable points over time if it is not
at such a point.
We can now give our first definition of the concept of balanced growth. This is in terms
of balanced growth in aggregate GDP (or Y). It will prepare the way for a more general
definition, in section 8.7 below, in terms of balanced growth in per capita GDP.
Balanced growth (in aggregate Y) is defined as a growing-economy situation in which the
K Y
N    and  
ratios   N  remain constant. Y is growing in line with N, and K is growing in line with
N. No variable is getting out of line with regard to any of the others. But there is sustained
growth in aggregate output Y (equal to the growth rate in N and K). This means that both
output and capital stock expand precisely in line with population growth.
K
❐ In such a balanced growth situation,   Y    (capital intensity) remains constant.
❐ The striking thing about a balanced growth situation is that, when the economy is
in such a state of growth, all these ratios remain constant while the many different
variables in the economy change, vary and grow over time.
❐ Note that this particular definition is for balanced growth in aggregate Y, i.e. it is only
for a situation where the aggregate growth (in Y) is such that there is no per capita
Y
growth (in   N  ). As we will see later, this is a situation where the factor A has no growth.
For the more or less normal situation where A has positive growth, the definition will
have to be broadened (section 8.7).

Defining such a point of balanced aggregate growth is not very interesting in itself. But
Solow’s next conclusions are very interesting.
(a) For a given set of conditions and parameters, there is only one balanced growth
point.
(b) Any point on TP off the balanced growth point cannot be kept going in the very
long run. There are ‘gravitational’ forces at work, in the very long run, that pull the
economy towards the balanced growth point.
Let’s consider these in turn.
8.6.2 Conditions for a balanced growth point – a first version

To pin down the concept of balanced growth, the question is: are there specific conditions
under which   NY   and  NK   will be constant and stable, i.e. when an economy would remain
stationary at a point on TP? Alternatively, under which conditions can an economy not
remain stationary at a particular point on TP?
A stationary point on TP means, given a population and workforce growing at rate n,
 NY  is constant. Moreover, it must imply that 
that Y also grows at rate n, so that   NK  remains
constant. Thus the capital stock K must also grow at rate n to match the growth rate of N
(and the population).
The conditions for such a situation can be derived by looking at the behaviour of the
 NK . 
capital stock K, or rather capital stock per worker 
1. If the capital stock K must grow at the same rate as the workforce N, it means that
each additional worker must get the average amount of capital per worker, i.e.  NK .  If the
workforce grows by n, the additional capital needed will be = n × K. (For example, if the
workforce N grows by 2.5%, the additional capital needed for K to keep up with N will
also be 2.5% of the current level of K.)
2. However, before additional capital stock can be made available to workers, the normal
depletion of the capital stock due to depreciation and wear and tear must be restored.
Thus one first needs sufficient investment to replace normal capital depreciation.
The amount of capital written off and that needs to be replaced can be taken to be
a constant fraction (e.g. 0.05) of the capital stock, say Kt, where  is the rate of
depreciation.
So the required investment per worker for capital stock K to keep up with the growth in N is
It Kt Kt
 __ __ __
Nt   =    Nt + n   Nt 
Kt
= ( + n) __
N   t
 NK ,  the required investment per worker to keep the 

This equation shows, for all values of   NK   
 NY  stable.
ratio and 
However, not all these values may be feasible, since there may be insufficient investment
forthcoming in the economy. This is because investment needs to be financed from
savings available in the economy. Saving is the portion of total income that is not spent
on consumption. Saving typically constitutes a more or less stable fraction (e.g. 0.10) of
aggregate income (GDP). So total saving in year t is
St = sYt
where s is the average saving rate.
8.6 Is any capital–labour ratio possible? The idea of balanced growth 341

Whence saving? The saving rate and identities
In terms of the sectoral balances of the national accounting identities (chapter 5, section 5.4),
(S – I*) + (T – GC ) + (X – M) = 0
where I includes unplanned inventory investment. In the long-run growth context, one can
ignore inventory investment, since it is a cyclical phenomenon. Rearranging:
I = S + (T – GC ) + (X – M)
where
S = private (household and business) saving;
T – GC = government saving (the budget balance); and
X – M = foreign saving (the current account balance).
The right-hand side is total saving, and it comprises private saving, government saving and
foreign saving. (Note that the symbol S in the text is used to denote total saving, not private
saving as in the identities.)
We assume for the moment that the total saving rate s is stable on average in the very long run.
The situation where the saving rate can change is analysed in section 8.8.1.
In terms of the national accounting sectoral balances, all saving has to end up in one form
or another of investment, i.e. I = S (see box). In other words, total actual investment will
simply equal total saving.
Thus the actual, available investment is given by
It = sYt
or, in per worker terms:
It Yt
 __ __
Nt   = s   Nt 
In a stable or equilibrium situation, the actual investment per worker will precisely match
the required investment per worker. Using the two expressions derived above, it is a condi-
tion for the stable situation that:
Actual investment per worker = Required investment per worker
i.e.
Yt Kt
s __
 N   = ( + n) __
  N   ...... (8.3)
t t
This is the condition for the balanced growth point on the TP curve (given our temporary
assumption of zero growth in A).
If this condition is not met, there will be either an increase or a decrease in capital per
worker  NK ,  and the economy will not be stationary on TP.
❐ For instance, if more investment is forthcoming in a particular year than is required to
cover depreciation and the capital needs of a growing workforce, the amount of capital
per worker will increase; as a result  NY  will also increase, in line with the production
function. So the economy is not stationary on TP.

Graphically, the expressions on the left-hand and right-hand sides of the balanced growth
condition can be depicted as shown in the diagram (figure 8.4).
❐ The actual investment rela- Figure 8.4 Deriving a balanced aggregate growth point
tionship simply is a fraction
(= s) of the TP relationship; Y/N Required investment
per worker
thus it proportionally fol- and K
5 ( 1 n)     
t
lows the curvature of TP. I/N N t
❐ The required investment TP 5 f(K/N; A)

I K
relationship   = ( + n)  is
t t
 
N   
  
N  
 
t t
a straight line through the

Y0 /N0 Actual investment
origin of the diagram. Its per worker
5 s·f(K/N; A)
slope is equal to  + n.
K0
The stable value of  N   is at the
0
intersection of the two curves.

The corresponding stable or
balanced growth level of   NY  can
Y
be read off the TP curve as   N  . 
0
K0 /N0 K/N
0
Note that, when the economy

is at this point, there is substantive growth in aggregate output Y. The growth rate of Y at
that point is exactly n (i.e. precisely equal to the population growth rate). But there is no
growth in per capita GDP, or in   NY   to be more precise. Nevertheless, the level of 
 NY  at least is
being sustained despite and in the midst of population growth.
Another interpretation of the balanced growth point is the following. At that point Y is
such that just enough is being saved and invested (given s) to exactly replace depreciation
(given ) and equip the growing workforce (given n).
❐ Put differently, given Y, capital stock grows at just the right rate to absorb all the saving
and investment in the form of replacement investment and equipping the growing
workforce with capital goods.
❐ Or, given s and  and n, K grows at exactly the right rate relative to Y, i.e.  KY  is exactly at
the right value so that it is able to remain stable – a key element of balanced growth.
❐ Y grows at a constant rate n, enabled by steadily growing capital stock K, which also
grows at rate n.
  NY  and  NK  are constant. Thus  KY  also remains constant.
❐ 
8.6.3 Automatic adjustments towards the balanced growth point

Solow’s second conclusion was noted above, i.e. that any points with  NK   higher or lower
than the balanced growth value (i.e. points on TP to the left or right of the balanced growth
point) are not sustainable in the very long run. There are ‘gravitational’ forces at work,
in the very long run, which tend to pull the economy towards the balanced growth point.
❐ In figure 8.5 this is indicated by arrows that represent the forces pushing the economy
K Y
N   and  
towards the indicated stable points at   N  . 
0 0
0 0
K0
This can be explained as follows. For   NK   less than  
0
N  ,  investment per worker will exceed
depreciation per worker and the absorption of capital by a growing workforce:
Y K K
N   > ( +n) 
s  N  .  Thus  
N  , or capital per worker, increases.
t t
t t
8.6 Is any capital–labour ratio possible? The idea of balanced growth 343

❐ Y will also rise to a higher Figure 8.5 Adjustment towards a balanced growth point
level due to the increased  NK    Y/N Required
ratio (rightwards in the and investment
Y per worker
diagram); thus  N  
  also I/N K
5 ( 1 n)  t
  
increases. N t
TP 5 f(K/N; A)
Opposite conclusions apply for
Y
values of  N 
   above the stable
growth point, i.e. for   NK   larger Y0 /N0
K Actual
than   N   . If investment per work-
0
0 investment
er is less than the absorption of per worker
5 s·f(K/N; A)
capi tal by depreciation Y
and a
growing workforce, s  < ( +
t
 N  
 
K t
n)  N   . Thus the change in capital

t

t
per worker is negative.  NK  , or cap-

ital per worker, decreases.
K0 /N0 K/N
❐ Y will also decrease due to
the decrease in  NK   (leftwards
in the diagram); thus  NY  also decreases.
This means that over time, in the very long run, the economy will experience forces that
push it towards, or back to, the balanced growth value of the capital–output ratio  NK  – given
current technology and institutions, and current values of s, n and the other parameters.
Correspondingly, output per worker will be pushed towards, or back to, the balanced
growth value of   NY . 
❐ At the balanced growth point there will be positive economic growth in aggregate
output Y, but no growth in income per worker   NY  (or GDP per capita for the population).
❐ However, on the way towards this point there will be positive (or negative) growth in  NY   
for the transition period.
❐ This particular ‘rest’ point prevails while there are no changes in the various para-
meters, and as long as there is no effect of changing technology and institutions on the
production function.
8.7 Expanding the model – the expanded balanced growth condition

8.7.1 Technology and institutions – conditions for a balanced growth path
We have already noted (section 8.4) the main conclusion regarding the potent effect of
improving technology and institutions on the rate of economic growth. What is left to
do is to expand the condition for
a balanced growth point to ca-
From balanced growth in aggregate Y to
ter for the presence of improving balanced growth in per capita Y
technology and institutions, i.e.
we must deal with factor A, which Up to now in this chapter, balanced growth referred
increases and grows. (As we will to steady growth in aggregate Y and the conditions
to get K and N to remain in a stable relationship to Y.
see, this produces conditions for Y
  N
   remained constant. From now on, balanced growth
a series of growth points, or a Y
refers to steady growth in      (= per capita income).
growth path.) N
So, to get K and N to remain in stable relationships
K Y
An important characteristic of to Y, we must get   
N
 to grow at the same rate as  
 N .
such a presence is that the analysis

must now allow for a sustained positive growth rate in  NY   – and not just sustained growth
in aggregate Y – which will be due to steady and sustained growth in A (labour efficiency).
❐ Graphically, TP rotates up and elongates to the right continually, and   NY   grows
continually (whereas it remained constant in a balanced growth situation before).
In these circumstances, balanced growth (in    NY ,  not Y) is defined as a situation in which 
  NY  and 
  NK  
grow at equal rates. Both Y and K are growing faster than N, but in such a way that the
relationship between   NY  and  NK  remains constant.
❐ Another way to understand this is to recall, and repeat, that balanced growth implies
that the capital–output ratio  KY  remains constant. Since  NY  is growing (due to growth
in A),  KY  will remain constant only if   NK  grows at the same rate as  NY . 
To get the appropriate conditions for balanced growth in  NY ,  we must reconsider how the
required investment relationship is constituted. The condition must allow for a state of
steady positive growth in  NY  (as opposed to the previous one where   NY  remained constant).
Y K
Balanced growth still requires correspondence between   N   and  N  . However, in the new
context they must not be constant. They must grow at equal rates.
We saw earlier that, for a given growth in Y, capital stock must be augmented at just the
right rate to absorb all the saving and investment in the form of (a) replacement investment
and (b) equipping the growing workforce with capital goods. This meant that K must grow
at a rate of  + n. Whereas the required investment for capital stock K to keep up with the
growth in N thus was
It Kt
 __ __
N    = ( + n)   N  
t t
it must now be expanded so that investment also ensures that the capital stock grows
enough to keep up with the growth rate a of factor A, the efficiency of labour. So the
required investment for  NK  and  NY  to grow at stable, equal rates becomes:
It Kt
 __ __
N    = (+ n + a)  N   ...... (8.4)
t t
From here, the balanced growth condition (initially equation 8.3) in a growing __
Y
 N   context
now becomes:
Yt Kt
s __ __
N   = ( + n + a)  N   ...... (8.5)
t t
The diagram does not change materially (see figure 8.6), except that the slope of the
required investment line now also incorporates parameter a.
❐ Compared to the case without growth in A, this line will be steeper.
❐ An increase in the parameter a will increase the slope of the required investment line,
and vice versa (see section 8.8.3 for a complete analysis of such a change).
Remember that when there is sustained growth in A (i.e. a > 0), the TP curve will also be
rotating up (and elongating) continually. The diagram in figure 8.7 shows one of those
rotations in some detail. It shows the upward rotation of TP and of the actual investment
curve.
❐ Remember that the actual investment relationship is a fraction (= s) of the TP rela-
tionship. Thus it will always rotate together with TP. (Also see section 8.7.2.) Balanced
growth implies, and requires, that both curves rotate concurrently, so as to maintain
Y K
equality between the rates of growth of  N  and  N  over time.
8.7 Expanding the model – the expanded balanced growth condition 345

The two balanced growth points Figure 8.6 A balanced per capita growth point
on the rotating TP curve in Required
Y/N
the diagram are two points on and
investment
per worker
the balanced growth path of I/N 5 ( 1 n 1 a) __
K
  Nt   
 NY  , of the
per capita income, or  t
economy. More such points can

TP 5 f(K/N; A)
be derived. Let’s consider that
further. Actual investment
Y0 /N0
per worker
5 s·f(K/N; A)
8.7.2 The balanced per capita
growth path over time
As the TP curve rotates upwards
continually due to sustained
growth in A (i.e. its growth rate
a > 0), a series of such balanced K0 /N0 K/N
growth points will be generated.
In a different terminology: the
balanced growth path over time is a series of steady-state points.
The question is how the path is generated by the interaction of the various relationships we
have analysed. This can be deduced from a simple rearrangement of the balanced growth
condition. From equation 8.5 above:
sYt = ( + n + a)Kt ...... (8.6)
The balanced growth condition can also be stated (after some rearrangement) as:
Kt s
 __ ________
Y   =   ( + n +a)  
...... (8.7)
t
This means the balanced growth values of  NY  are those where, for any position of TP,  KY  is
constant. Thus the balanced growth path is generated by the intersection points of the
rotating TP with the stationary  KY  line, as in the diagram in figure 8.8.
In the diagram this path is a
Figure 8.7 Deriving a second balanced per capita growth point
straight line through the origin
with slope Y/N
Required invest-
Yt/Nt Yt (  n  a) TP1
 ____
K /N    = __
 K   = _________
  s   
 
ment per worker
K
  Nt   
5 ( 1 n 1 a) 
t t t
Y1/N
t
TP0
which is simply the inverse of
the balanced growth  KY  ratio.
The  KY  ratio line can be interpret- Y0 /N
Actual invest-
ed as a collection of potential or ment per worker
5 s·f(K/N; A)
available balanced growth points.
The actual point where an eco-
nomy will be at a particular
point in time will depend on the
position of TP. At any time the
intersection between TP and the
K0 /N K1/N K/N
potential balanced growth line

( YK 
  line) indicates the pre- Figure 8.8 Deriving the balanced per capita growth path
vailing long-term balanced Y/N Potential balanced
growth point (or steady state growth points
 1 n 1 a Kt
growth point). 5
s Nt
❐ Intersection points along TP3
the potential balanced
growth line trace the bal- TP2
anced per capita growth TP1
path of the economy in this
diagram. TP0
❐ So the balanced growth Y0 /N0
Y K
path of  N   and  N  will climb
over time as the economy
slides up the line of poten-
tial balanced growth points
(for given parameters).
K0 /N0 K/N
Note that, when the economy
is on this balanced per capi-
ta growth path, there is sub All these ratios …? A numerical example
stantive growth in aggregate
output Y. The growth rate of It can be confusing to understand how some of these
ratios involving Y, K, N etc. can grow at equal rates while
Y when on that path is exactly
others remain constant. Addendum 8.2 contains an
n + a (i.e. the population
example which illustrates how Y, K and N change over
growth rate plus the growth time on a balanced growth path in such a way that    NY  
rate of labour efficiency) – K
and    K
 grow at the same rate, while  
 Y remains constant.
N
the growth in Y is precisely It is worth studying the table showing all the numbers to
sufficient to keep up with the get a feel for the various ratios.
growth in N as well as the
growth in labour efficiency.
AND THUS:
In contrast to the case without growth in A (section 8.6.2), there is sustained growth in
Y
per capita GDP, or in   N  to be more precise. The growth rate of Y (= n + a) is more than the
growth in N (= n), and thus the average material standard of living increases. The growth
rate of  NY   is exactly equal to a (the growth rate of labour efficiency).
It is worth examining an earlier statement, i.e. that in the presence of a growing A factor,   NK  
does not remain constant when on the long-term balanced per capita growth path. It
grows at a constant rate, and at the same rate as   NY . 
❐ While  NK   increases on this path, the increase in capital does not meet such strong diminishing
marginal returns as before. This is because the increase in A rotates and lengthens the TP
curve out to the right. This largely overrides the choking effect of diminishing marginal
returns to capital as long as K doesn’t increase out of line with Y.
❐ We see thus that A in partnership with K constitutes quite a powerful combination as
sources of sustained growth in per capita income   NY . 
One can plot the series of balanced growth points, traced out by TP in figure 8.8, on a graph
with log  NY   on the vertical axis and time on the horizontal axis. For a steadily growing A
(and thus steadily rotating TP), this produces a series of points on a straight line, as shown
in figure 8.9.
8.7 Expanding the model – the expanded balanced growth condition 347

❐ This line is the balanced growth path Figure 8.9 The per capita growth path over time
of  NY  over time.
Y/N
❐ The slope of the line reflects the steady (log
growth rate of  NY  , and is equal to a. scale)
❐ Note that this implies the steady growth
rate of aggregate Y is equal to n + a.
Growth path of Y/N
The actual, historical path of  NY  of a particu- at growth rate a
lar country over time, such as the graph in

figure 1.1 (chapter 1), must be understood
as long-term movements and deviations
around the long-term balanced growth
path. If the economy is off the path due to
‘inappropriate’ values of parameters, K or t1 t2 t3 t4 Time
N or shocks or whatever, it should gradu-
ally and over decades move towards the
balanced growth path. (Also see the activity box in section 8.11: ‘How to understand
growth paths and observed data patterns’.)
The development context

An important benefit of this analysis derives from the fact that factor A provides a way to include
institutional development in growth theory. An important part of human, social and economic
development relates to the development of social and economic institutions, capacities, processes
and practices. As noted in section 8.2, these can be legal, cultural, organisational and so forth.
This is precisely how A has been defined. See chapter 12, section 12.3, for a full discussion.
8.8 Using the model – changes in the balanced growth path due to
changing parameters
Having analysed the balanced growth condition and balanced growth path in a situation
where per capita GDP is growing, we can now consider how the expanded model can be
used to analyse changes and shocks.
The position of balanced growth points and the balanced growth path depends on, in
particular, the saving rate, the population growth rate, and changes in technology and
institutions: s, n and a all impact on the  NK   level where the balanced growth condition
is satisfied. All three of these can change due to changes in the social and economic
environment – or be changed through deliberate policy steps.
8.8.1 Changing the saving rate s

Policy steps to increase the domestic saving rate are often advocated as a remedy for
unsatisfactory growth performance. Let us consider what the impact of such an increase
will be on the balanced growth point(s) and path.
Consider the diagram in figure 8.10. Suppose the saving rate is increased permanently
through, for example, tax incentives. An increase in s would mean an increase in total
saving sY, and thus in investment. This will increase the capital/labour ratio   NK .  The
economy will move along the TP curve to a new balanced growth point with a higher
value of  NY  to match the higher 
 NK  .
❐ Graphically, an increase in s will rotate the actual investment curve upwards, leading
to a new balanced growth or steady-state point.

Such an increase in the saving rate Figure 8.10 Impact of change in s on balanced growth point
will increase the level of  NY   and per Y/N Required invest-
capita income in the long term. and ment per worker
K
However, this will be a one-off I/N   Nt  
5 ( 1 n 1 a) 
t
impact on the level of   NY  – albeit

TP 5 f(K/N; A)
spread over a number of years – but Y1/N0
not sustained growth in  NY .  Investment
Y0 /N0 per worker
Sustained growth in   NY  would require 5 s1·f(K/N; A)
the saving rate to be increased Investment

per worker
continually. Logically, this would 5 s0·f(K/N; A)
require that a country devotes a
larger and larger portion of its
resources to capital formation year
after year. At some point there would
be no output left for consumption,
K
 N  must stabilise,
which is impossible.  K0 /N K1/N K/N
and thus also investment and the
saving rate.
❐ Thus an increase in the saving Figure 8.11 Impact of change in s on series of balanced
growth points
rate cannot be used to obtain
sustained growth in per capita Y/N Potential balanced
growth points
income. 5
 1 n 1 a Kt
❐ Only during the transition from s Nt
one balanced growth point to TP3

another will there be a positive
Y TP2
impact on growth in  N .  This
 
impact will fade away once the TP1
new balanced growth point is TP0
reached.
Y0 /N0
Consider the situation if the increase
in s occurs in the context of a con-
tinually rotating TP curve due to a
constantly growing A. Thus we start
with per capita GDP growing steadily
at rate a due to continual growth in K0 /N0 K/N
labour efficiency (due to continual
technological and institutional pro
gress). When the saving rate increases, the potential balanced growth line rotates and be
+n+a
comes flatter (as its slope   decreases). The balanced growth points cross over to the
 
s   
new potential balanced growth line, and then continue along that line. On the TP diagram,
we get a growth path such as the one generated in figure 8.11.
This can also be illustrated in a graph showing   NY  over time, i.e. the semilog time graph of
Y
 N  . The graph in figure 8.12 shows how the economy starts on a specific balanced growth
path, associated with the initial saving rate s0, and with a certain growth rate of  NY  equal
to a (which is the slope of the balanced growth path, given the log scale). In year t0, the
saving rate increases from s0 to s1. This shifts the balanced growth path of the economy up.
As the economy slowly adjusts to this new reality,  NY  will gradually increase and approach
the new balanced growth path.
8.8 Using the model – changes in the balanced growth path due to changing parameters 349

❐ The higher slope of  NY  during Figure 8.12 Impact of change in s on balanced growth path
the transition shows an in- Y/N
creased rate of growth in  NY    (log Growth path of Y/N
at growth rate a
for that period (which can be scale) with higher savings
several decades). rate s 1
❐ However, when the upper

Growth path of Y/N
growth path is reached, the at growth rate a with
Y initial savings rate s
rate of growth in   N   again 0
stabilises back at the initial

rate, i.e. a.
Thus, after sufficient time has Actual path of Y/N
elapsed for the necessary adjust shows higher growth
Y
ments, per capita income (or  N ) 
 rate in transition to
higher trajectory
goes onto a permanently higher
growth trajectory due to the
increase in the saving rate. t0 Time
During the decades of transition,
the average material standard of
living of the population increases faster than before. And, after the transition, the standard of
living is higher than before the increase in the saving rate.
BUT – and this is an important insight – the post-transition rate of growth of  NY  on the
higher trajectory is the same as its earlier value on the lower trajectory. (The two growth
paths have the same slope.) There is no lasting impact on the growth rate of   NY . 
Y
❐ To repeat: in this model the growth rate of  N  depends solely on the growth rate in A, i.e.
labour efficiency, due to progress in technology and institutions.
K
An optimal saving rate and the golden rule level of s and  
 N 
We noted above that the saving rate (and thus capital accumulation) can be ‘too high’, leaving
too little for consumption by the citizens of a country – too much output is absorbed by just
keeping the capital stock intact. Likewise, ‘too little’ saving can shift the growth path so low
that income and consumption stutter around at low levels. So is there an optimum level of s
K
and   
N
 ?
This is a complex question, since it involves a choice between the consumption levels of the
current generation and future generations. Increasing saving now (and reducing consumption
now), will increase income levels and consumption levels for future generations – but the current
generation pays the price of reduced consumption. Thus there are complex politics involved,
since the expected increase in living standards may only materialise in a generation or more.
A more mundane question is where the consumption of the current generation will be
Y
maximised. In the diagrams, consumption per worker is the vertical distance between    N  (on
S
TP) and saving per worker   N (on the actual investment curve). Maximum consumption per
Y
worker is at the point on the TP curve where the vertical distance between    N and the actual
investment line is the largest. If s can be set so that the actual investment per worker line
K
crosses the required investment per worker line at that level of    N , current consumption per
K
worker will be maximised. (This is called the ‘golden rule’ level of    N .)
❐ Graphically, the golden rule point on TP is where its slope is exactly parallel to the required
K
investment line. The corresponding    N  and s can be determined accordingly.

Remember that the saving rate s does not depend only on domestic saving behaviour.
It also depends on foreign saving and the budget deficit. Thus it is not really constant.
However, the latter two influences tend to fluctuate over the business cycle, and can be
assumed to be more or less constant on average over the long run. However, something
like a sustained change in foreign capital inflows (foreign saving) due to a permanent
change in the foreign investment profile of an economy, for instance, can be analysed as a
sustained change in s.
8.8.2 A change in the population growth rate n

We have noted, in section 8.4.2, Figure 8.13 Impact of change in n on balanced growth point
the somewhat surprising result Required investment
Y/N
re
garding a change in the and
per worker
K
5 ( 1 n0 1 a)     
population growth rate (or the
t
I/N N t
labour force, or N in the model). ( 1 n1 1 a)  

N
t
K
  
t
While an increase in N will TP

increase output Y, diminishing Y1/N1
marginal returns to labour will Y0 /N0 Actual investment
cause Y to increase less than N. per worker
Y 5 s·f(K/N; A)
Thus  N  , and thus income per
worker, will decline. The higher
population growth is a clear
drag on per capita economic
growth.
Conversely, a decline in the K/N0 K/N1 K/N
population growth rate n will
result, according to the model,
 NY  will increase. The
in an increase in per capita income. Y will drop, but less than N; thus 
average standard of living will increase.
❐ In the diagram (figure 8.13), this is seen as a clockwise rotation of the required
investment line, since its slope decreases if n decreases.
❐ Once again, these changes involve long-term adjustments by the economy to a new
balanced growth point. These are not short-term changes in living standards.
In the context of  NY  growing continually due to growing A, a decline in n will produce a
diagram very similar to the one shown above for an increase in the saving rate. Plotting
the growth path of the log of  NY  over time will produce a graph similar to the one for an
increase in the saving rate. The de
crease in n will shift the balanced
growth path up, and over time the The South African case – a sea change
economy will converge to the new ❐ From 1950 to 1990 the average population
growth path. growth rate in South Africa was 2.5% per annum.
❐ Note that the direction of the ❐ After 1990 it started to drop precariously,
shift of the growth path line averaging only 1% for the period 1991–2004.
in this diagram (figure 8.14) ❐ From 2000 it dropped below 1% to as low as
0.1% in 2003. It is likely that HIV/Aids, which
is the opposite of the direction
has reduced the average life expectancy of
of rotation of the potential
South Africans dramatically, has contributed
balanced growth points line in significantly to these lower numbers.
Y K
the  N  -  N  diagram.

Thus a decrease in the popu Figure 8.14 Impact of change in n on balanced growth path
lation growth rate has two Y/N
seemingly contradictory effects. (log Growth path of Y/N
at growth rate a with
❐ Output per worker  NY  rises to scale) lower population
a higher level (and higher growth rate n1
growth path, where it again
Growth path of Y/N
grows at rate a). at growth rate a with
❐ Aggregate output Y will, initial population
growth rate n0
after the adjustment, grow
at a lower rate (= n1 + a).
For a permanent increase in n Actual path of
there will be an opposite effect, Y/N shows higher
growth rate in
i.e. the increase in n will shift transition to higher
the balanced growth path trajectory
down. The growth rate of   NY   
will fall in the transition until it t0 Time
once again settles at the initial
growth rate a. And, after the
transition, the average standard of living will be lower than before the increase in the
population growth rate.
In the context of a low- or middle-income country, the results regarding population growth
may seem puzzling, since a lack of skilled workers is widely recognised as a constraint on
growth in per capita income. However, this must be explained with reference to a lack of
human capital, i.e. people with the necessary skills to make them productive. This negative
Y
impact on the growth of   N  must be differentiated from the pure impact of smaller or larger
numbers of workers.
So, if the workforce growth rate declines and the country also loses the scarce productive
skills that are embedded in at least some of the workers, it must perhaps be analysed as
a combination of a decline in N (which increases  NY )  and a depletion of human capital H
(which impacts negatively on  NY  ). What matters ultimately is the net effect of these two
influences.
✍ HIV/Aids and economic growth

Assess the impact of HIV/Aids on economic growth by discussing the following two
statements:
Y
1. The fact that there is a loss of skilled people (human capital loss/‘depreciation’), hurts  
 N 
(‘it is bad for the growth rate in per capita income’).
Y
2. The fact that the population growth (i.e. n) declines as life expectancy declines, benefits    N 
(‘it increases the growth rate in per capita income’).
Do you agree with these statements?
8.8.3 A change in a (the growth rate of A, the labour efficiency index)

Increases in labour efficiency depend on progress in technology and also social and eco-
nomic institutions and processes. Such changes can be the result of specific economic
policy measures (e.g. investment in research and development, or technology transfer

and implementation). They Figure 8.15 Impact of change in a on balanced growth point
can also flow from other so-
Y/N
cial and institutional policies Required investment
that change business and TP1 per worker
K
workplace practices, create 5 ( 1 n 1 a1)  
N
t
  
t
new legislative frameworks Y1 N ( 1 n 1 a0)  

N
t
K
  
t
for new organisational forms TP0

and management practices,
and so forth. Broader cultural Y0 /N
Actual investment
change may result from in- per worker
5 s·f(K/N; H/N; A)
trinsic societal developments
and/or influences from oth-
er countries, especially in an
era of increased global com-
mun-ication and information
flows (television, the internet,
etc.). K0 /N K1/N K/N
What remains is to consid-

er the impact of a permanent Figure 8.16 Impact of change in a on balanced growth path
change in a, the growth rate Growth path of Y/N
of labour efficiency. Consider Y/N Increase in a at growth rate a1 after
(log increases slope the increase in a
the case of a one-off but per- scale) of growth path
man-ent increase in a.
Section 8.7.1 (figure 8.7) Growth path of Y/N
showed a rotation of TP when at growth rate a 0
before the increase
there is sustained growth in in a
A (i.e. a > 0). However, if the
parameter a increases to a new
level, the diagram is different
in two important respects.
The required investment line
also rotates up once – a higher
a implies a steeper slope. Note
that after the one-off but per- t0 Time
manent increase in a, the rate
of rotation (and elongation) of
the TP and actual investment curves becomes higher permanently. Hence, in every peri-
od (e.g. a year or decade), the rotation-elongation will be more than when a was lower.
The diagram in figure 8.15 shows one of those rotations in some detail. It is quite dense,
but worth studying. (Hint: there are two sets of three related curves/lines.)
Y
In the semilog graph in figure 8.16 showing the growth path of log  N  over time, this is
reflected in a rotation of the growth path. The slope changes (whereas there were parallel
shifts with the changes in s and n).
❐ This means that a permanently higher growth rate of A causes a permanently higher
growth rate of  NY  .
This finally substantiates our repeated remarks on how different the role of factor A is
in understanding the economic growth phenomenon. It appears to be perhaps the only

factor with the real ability to
What about the environment and climate
bring about a sustained increase
change?
in  NY  and thus a positive growth
rate in per capita income. The theoretical result that technological and institutional
❐ This means the growth path progress can deliver unlimited growth does not take
in the semilog graph has a account of constraints that can flow from natural
resource depletion, the effects of global growth on the
positive slope.
environment and climate change.
❐ Moreover, it can even rotate the
growth path line in the semilog It is unlikely that the environment can sustain
graph and put the economy on global economic growth at the rates attained by rich
Y countries in the past, where both the population
a steeper growth path of  N   over
time. The average standard of and the utilisation of natural resources were growing
exponentially, accompanied by increasing pollution
living will increase faster.
and stress on global climate systems. (See chapter 12,
We must bear in mind, though, section 12.3.6.)
that these conclusions flow from a
particular theoretical model of economic growth. In particular, we have assumed that A is
the only factor that is not subject to diminishing marginal returns. So perhaps it is not so
surprising that we find that factor A is the only one that can bring about a positive growth
rate in per capita income. New developments in growth theory have indeed suggested that
other factors, notably human capital, may also exhibit such a character.
❐ Thus the general point may be the following: the less a factor is subject to diminishing
marginal returns, the greater will be its ability to contribute to sustained growth in
per capita income. Technological and institutional progress (via labour efficiency) is a
relatively pure example of such a factor.
8.9 Convergence between low-and-middle-income and high-income

countries?
To a large extent, the lower level of income in poorer relative to that of high-income
countries can be explained by the relatively lower level of capital per worker in the low-
and middle-income countries. Thus it is likely that low- and middle-income countries can
shift their growth path to a higher level – and one closer to those of high-income countries
– by increasing their capital per worker. This will require an increase in the saving rate and
total saving per worker in low- and middle-income countries to levels comparable to those
of high-income countries, as illustrated in section 8.7.2.
The increase in the saving rate will cause low- and middle-income countries to move
gradually from a balanced growth path with low output per worker to a balanced growth
path with higher output per worker that is comparable to that of high-income countries.
As noted above, while a (low- and middle-income) country is moving to the higher
balanced growth path, its economic growth rate will exceed the rate a to which per capita
GDP growth is limited in balanced growth situations.
✍ Is catching up always good?

This kind of analysis implies that the low- and middle-income countries should unquestionably
adopt the technologies of the high-income countries. Given the implications of such technology,
not only for skills and organisational requirements, capital and infrastructure, but also for pollu-
tion, environmental impact and climate change, is it necessarily the most appropriate thing for
poor countries to do? What do you think?

Most low- and middle-income countries strive to close the technological gap between
themselves and high-income countries. Often this is not in the form of new technology
development, but transfer and adoption of existing technology from high-income countries
– also called technological ‘catch-up’.
❐ This means that the rate at which domestic technology improves (which impacts a)
actually climbs higher than that in the high-income countries. While they are catching
up, the economic growth rate in low- and middle-income countries can thus be temporar
ily higher than in high-income countries.
However, this can only last until the technology gap has been closed (if that does indeed
happen). If and when that happens, the rate at which their technology improves will
converge with those of the high-income countries. The technology-related component of
rate a will decrease to the level at which technology improves in high-income countries.
❐ As a result, their economic growth rate will also decrease and converge with those of
high-income countries.
❐ Note that this can be part of an explanation why countries such as China and India are
growing at such high rates compared to countries such as the USA or UK – they are
catching up. By contrast, many other low- and middle-income countries simply are not
catching up technologically and institutionally.
✍ Rich country, poor country

Can you mention ten countries that you think are among the richest in terms of having the
highest per capita GDP in the world?
Can you mention ten countries that you think are among the poorest in terms of having the
lowest per capita GDP in the world?
If you need information, consult the following website:
https://www.imf.org/external/datamapper
Note that, with the exception of China, India and a few other countries, convergence is
not really what is happening in the world in general. It appears that the gap between poor
countries and rich countries in terms of per capita GDP has been increasing rather than
decreasing in the previous century. While individuals in relatively poor countries or regions
are often materially better off than their predecessors, the gap between their standard of
living and those in high-income countries has grown significantly. (In this context, South
Africa actually is a relatively rich country, even in per capita terms, compared to many
very poor countries in Africa, Eastern Europe and the East.)
❐ Where some convergence has occurred is among the richer countries (the so-called G7
or OECD countries) themselves.
8.10 Human capital – the previously missing element

We can now return to the more comprehensive production function and TP curve with
human capital (H) as a variable on the right-hand side:
Y = f(N; K; H; A) ...... (8.1)

or
 __
Y
( K
__ __ H
)
N  = f   N ;    N ; A  ...... (8.1.1)
8.10 Human capital – the previously missing element 355

This is not a pure Solow growth model any more. The original Solow model did not
include human capital. While development economists have pointed out the importance
of developing human capacity and skills if poverty is to be addressed, mainstream
economics did not take this aboard for many years. Some convergence appeared in the
1990s when empirical studies by economists such as Barro, Lucas, Mankiw and Romer
indicated that higher levels of ‘human capital’ have made important contributions to
economic growth.
What is human capital? In its narrowest sense, human capital can be defined as the skills
of individuals that allow them be more productive. Such skills are accumulated over a
lifetime, notably through schooling and post-school training and education. Therefore it is
seen as a stock of ‘capital’ that grows due to time and resources being invested in human
skills development.
❐ Expenditure on education that increases the years of schooling of individuals can
be seen as an investment in human capital, i.e. the ability of people to be productive.
Various educational indices exist in the area of development economics, e.g. literacy
rates, years of schooling, per capita government expenditure on primary or secondary
education, and so forth.
❐ Other forms of knowledge that improve productivity, e.g. workplace experience, on-
the-job training, life skills, organisational know-how, etc. are more difficult to measure.
A broader interpretation would also allow for the development of human ability/capacity
for reasons other than education. For example, improved health care that improves and
extends the productive life of individuals also creates additional human capital.
❐ This can be measured by indicators such as life expectancy or per capita government
expenditure on health.
More generally, an indicator such as the human development index (HDI), which is a
composite index of various dimensions of human development such as literacy and life
expectancy, can aid understanding of the concept of human capital.
We have noted the problem in low-
and middle-income countries of Aspects of human development in growth theory
skills deficiencies (amidst an often Note that we are encountering several issues in
growing population and labour macroeconomics that present – and require – a link to
force). There usually are enough development economics and the problems of human
people who want to work, but many development and poverty alleviation. So far we have
are not skilled enough, or skilled encountered:
correctly, for modern production pro- ❐ Human capital and human skills development (H),
cesses and technology. In the growth and
model, this can be interpreted as a ❐ The development of social and economic
institutions, capacities and processes (via
human capital deficiency. If human
factor A).
skills levels are improved, for
example due to increasing resources While such aspects used to be rare in mainstream
for secondary or higher education, macroeconomics, it is possible to augment and refine
it can be interpreted as an increase the analysis to make provision for what clearly are
in human capital. By contrast, a important aspects of human economic activities. In
a middle-income country such as South Africa, it is
sustained drop in life expectancy
imperative not to forget these aspects (see chapter 12,
can be interpreted, in the economic
section 12.3).
growth model, as a depletion of
human capital.

While the added benefits are huge in the initial stages of increasing schooling and education
in the population, after some point the additional benefits of additional schooling and
education can realistically be expected to decline. Thus economists assume that expanding
output through increasing human capital is subject to diminishing marginal returns.
However, some economists argue that not all increases in human capital are necessarily
subject to diminishing marginal returns. In that sense, human capital would be similar to
technology, not physical capital. Some kinds of education and learning may indeed create
the basis for further learning, more sophisticated skills, innovation and new knowledge
creation – and thus do not run into diminishing returns.
It appears that human capital is such a complex thing that its role in economic growth
cannot be captured as easily as that of physical capital or technological progress. Perhaps
some types of human capital are like physical capital, and others like technology.
Another possibility is that better human capital (a better skilled and educated workforce)
may in itself lead to progress in technology and institutions. In this way, human capital
development causes innovation and/or technological and institutional progress, which in
turn produce sustained growth in productivity and in per capita income. (Otherwise one
has to assume that new technology falls from heaven!) This can mean that we must allow
for cross-causalities between human capital and other production factors.
Thus it is quite difficult to introduce human capital into the mechanics of the growth
model and the analysis of balanced growth conditions and growth paths in the model. For
the purposes of this discussion, the following conclusions will have to suffice:
H
❐ Increasing  N  , the level of human capital per person, will increase aggregate output and
output per worker   NY . 
❐ For growth in some types of human capital (say type HK, or ‘capital-type H’) this is
likely to be subject toH a degree of diminishing marginal returns. Thus   NY  increases less
than the increase in  K
 N  . 
  NY  can grow due to growth in HK, but sustained growth in these types of human capital
❐ 
alone cannot produce sustained growth in   NY .   
Y
N    will increase from one level to a higher
one, and will then remain there. (Its growth rate will be positive only during this
transition.)
❐ Thus there are limits to the contribution that increases in HK on their own can make to
producing growth in Y and  NY . 
❐ This type of human capital HK can thus be analogous to physical capital K. It also
implies that, similar to saving for investment in physical capital, a certain fraction of
GDP must be allocated to growing the human capital stock HK.
❐ On the other hand, for growth in other types of human capital (say type HA, or
‘technology-type H’) there need not be diminishing marginal returns. Thus, such
growth in HA on its own can contribute to sustained positive growth in   NY .  Alternatively,
it can do so together with technological and institutional progress. Whatever the case,
it can be analysed analogous to A and its growth rate a (specifically, with non-decreasing
marginal returns).
❐ Thus, in the different growth path diagrams, one can analyse increases in either HK or
HA in ways analogous to either K or A.
Nevertheless, what is true for both types of human capital is that A in partnership with K
and H constitute a powerful combination as sources of sustained growth in per capita income.
8.10 Human capital – the previously missing element 357

✍ HIV/Aids and economic growth again
statements:
Y
 N 
(‘it is bad for the growth rate in per capita income’).
Y
2. The fact that the population growth (i.e. n) declines as life expectancy declines, benefits    N 
(‘it increases the growth rate in per capita income’).
Do you now have a different view on these statements than before?
8.11 Summary and conclusions

8.11.1 Main conclusions from growth theory
1. While variables change as the economy grows over its growth trajectory over time
(ignoring cyclical changes), their relative trajectories/paths are governed and
explained by certain key ratios between Y, K and N, as well as A and H.
2. The only economic growth path that can be maintained for a very long period is
one where a certain balance between output and the various factors of production is
maintained.
3. Any course other than the balanced growth path will be subject to economic forces
that gradually push the economy towards the balanced growth path, although such a
convergence may take decades.
4. Where the balanced growth path lies depends on a number of key behavioural and
structural parameters. Policies or other social processes that change these parameters
can open up a better growth path for an economy.
5. Excessive population and labour force growth can be a serious drag on economic
growth.
6. A high saving rate is important because it determines the financing available for invest-
ment and capital accumulation. But it alone cannot produce a sustained positive per
capita growth rate.
7. Production factors that are not subject to diminishing marginal returns, such as labour
efficiency due to progress in technology and institutions, or certain kinds of human
capital, are most potent in creating a positive growth rate of per capita income over
time. This result will largely prevail even if there is a very low degree of diminishing
marginal returns.
8. Production factors that are subject to (significant) diminishing marginal returns,
such as physical capital, on their own cannot produce a sustained positive per capita
growth rate. However, they can lift the levels of income, and play an important
complementary role in sustaining a positive per capita growth rate in the presence of
technological and institutional progress (as in sections 8.7 and 8.8.3).
9. Technological and institutional progress may be one of the most potent engines of
sustained per capita growth. The rate of such progress directly determines the growth
rate of per capita income in the long run. Consequently, if, for example, effective
institutions conducive to entrepreneurship, investment and efficient markets do not
develop or develop slowly, it may retard economic growth significantly.
10. Human capital, in its various forms, is an important developmental element of
economic growth. A low rate of human capital development, e.g. due to ineffective

educational systems and policies or weak skills development processes, will retard
economic growth.
11. HIV/Aids can severely limit economic growth through its depletion of human capital
and a skilled labour force.
12. A steeper and more favourable balanced growth path, where per capita GDP climbs
more quickly, is thus most likely the result of continually improving labour efficiency
(due to continually improving technology and institutions) and the growth of certain
types of human capital.
13. Very rarely will an economy be exactly on its balanced growth path. Its long-term
course will probably reflect long adjustment periods – periods of convergence – since
the economy is almost always in transition from one balanced growth trajectory to
another, hopefully higher one (due to changes in parameters or other shocks).
14. Small changes in the long-term rate of per capita growth can make a dramatic
cumulative impact on per capita income levels and standards of living over time.
15. It is unlikely that the environment can sustain global economic growth at the rates
attained by rich countries in the past, where both the population and the utilisation of
natural resources were growing exponentially, accompanied by increasing pollution
and stress being placed on global climate systems.
Summary table: the effects of changes in parameters on key variables and ratios
When there is an increase in The following will happen on the balanced growth path with:
parameter:
Balanced Level of Y   NY 
Level of   Permanent Permanent Permanent
  KY 
growth   growth rate growth growth rate
Y K
of Y rate of   
N
  of   
N
 
Saving rate s Increases Increases Increases No change No change No change
Population growth rate n Decreases Increases Decreases Increases No change No change
Capital depreciation rate  Decreases Decreases Decreases No change No change No change
Labour efficiency growth rate a Decreases Increases Increases Increases Increases Increases
Human capital HK growth rate hK Increases Increases Increases No change No change No change
Human capital HA growth rate hA Decreases Increases Increases Increases Increases Increases
8.11.2 Possible complications and new theoretical developments

The model presented above contains many important insights into the factors that pro-
duce economic growth as well as the complex and sometimes surprising dynamics of an
expanding productive process in a country.
By and large, the model isolates the growth-enhancing effects of different production factors.
Capital accumulation has a certain ‘own’ effect, notably when the  NK  ratio increases. Progress
in technology and institutions has its own effect when its growth rate a is positive. And, while
the addition of human capital to the model has augmented it significantly, human capital simi-
larly has its own, distinguishable effects on long-term per capita growth. (Growth in the labour
force, as we have seen, has a negative effect on per capita income.)
Recent developments in growth theory have pointed out that more complex interactions
between the growth-enhancing production factors are probably at play in explaining eco-
nomic growth. Whereas technological progress was largely assumed to ‘fall from the sky’ in
8.11 Summary and conclusions 359

the Solow model, technological progress is usually the result of investment in research and
development (R&D). Moreover, it often comes embedded in new physical capital equipment.
Thus, technological progress can be the outcome of R&D investment and of physical capital
accumulation – rather than an autonomous factor.
❐ If capital formation produces the technological progress that is the engine of sustained
per capita income growth, at least some types of physical capital may be much less
subject to diminishing marginal returns than one may have thought.
Also note that the importation of physical capital goods usually implies that the embedded
technology, which is the result of perhaps decades of R&D and technological development
in another country, directly boosts the level of the country’s technological know-how. This
is especially important for low- and middle-income countries.
❐ This is one reason why foreign direct investment (FDI) is seen as important to increasing
growth in low- and middle-income countries: it brings with it advanced capital goods
that are carriers of new technology.
As far as human capital is concerned, it is often learning by doing of workers that leads
to new technological innovations. Thus, human capital also can produce growth in
technology, which also makes it more potent.
It appears obvious that progress in terms of social and economic institutions is also the re
sult of human capital, e.g. more efficient economic institutions and processes are created as
a result of relevant new knowledge flowing from investment in education and/or learning
by doing of educated and experienced workers.
It is also true that technology usually cannot be implemented without complementary
increases in the skills of workers, i.e. further development of human capital, and/or
without new machinery and equipment (new capital goods). New capital as such usually
also requires the development of new worker skills – but it is likely that businesses normally
do not include improvements in workers’ skills and productivity in the way they calculate
their returns on an investment.
Thus we see several important likely cross-influences between the growth-enhancing
variables. This means, inter alia, that the hard conclusions regarding the zero impact of
physical capital growth and growth
in certain types of human capital on
the sustainable growth rate of per Exogenous and endogenous growth
capita GDP have to be moderated. ❐ The earlier growth theory is called models of
Their role in creating a positive per ‘exogenous growth’ due to the way technology is
capita growth rate may be much treated as if it falls from the sky.
more complex, but also more ❐ The newer insights that stress that technology is
potent and less constrained, than the result of the development of physical and/or
implied by the Solow model. The human capital, as well as other linkages, are called
exact mechanics and dynamics of models of ‘endogenous growth’. While the details
of these models are beyond the scope of this
these roles are still being sorted
textbook, it is important to be aware of some of the
out by economists. The precise
main implications of these theories noted here – so
impact for a certain country that you treat the conclusions of the exogenous
will also have to be ascertained growth model with some circumspection.
through empirical research.

✍ How to understand growth paths and observed data patterns
Consider the graph of South African real per capita GDP again (figure 1.2), and focus your attention
on the turn it took after 1975, and then another one in the early 1990s.
1. Was there a break, shift or rotation in the balanced growth path?
2. What might have caused such a rotation or shift? A drop in the domestic saving rate? A drop in
foreign saving due to sanctions? A drop in capital formation (infrastructure, etc.)? Slow growth
in long-term foreign saving post-1994 due to our ‘emerging economy’ profile? Slow technology
adoption? Loss of human capital and skills through emigration or affirmative action (and/or
early retirement)? Slow growth in human capital due to a still-deficient education system? High
population growth due to an influx of people from SADC and other African countries?
3. Are we on a new growth path (perhaps with a lower growth rate) or will South Africa adjust
back to the original balanced growth path? (Compare the dashed and dotted curves indicating
alternative scenarios, i.e. moving towards alternative growth paths …)
Alternative
scenarios
25 000
22 500
20 000
17 500
15 000
12 500
Actual real GDP per capita

Long-run real GDP per capita
10 000
50 55 60 65 70 75 80 85 90 95 00 05
Years
8.12 A last word on growth (for now …)

The explanation of growth, and of different growth patterns across countries, remains
elusive. It appears impossible to separate increases in economic activity and income from
the complex textures of societies that go through periods of development, crisis, war,
prosperity and poverty. These textures include cultural habits, religious norms, social
institutions, government institutions, constitutional and legal frameworks, political
regimes, physical infrastructure, social infrastructure, health and education systems,
technology development and adoption, and so forth.
8.12 A last word on growth (for now …) 361

Such complexity cannot be captured in a stylised economic model comprising a few relatively
simple equations. At the very least, it means that economic growth must be embedded in a
larger understanding of human development as well as social and economic development.
In short: the major divergence in living standards and growth rates between countries
cannot be explained by economic factors such as saving and investment, or technology,
alone. The human element – comprising social, cultural and institutional dimensions,
human capital (skills deficiencies) and human development in general – must be
internalised into growth theory if it is to succeed. Growth theory needs the bridge to
development theory.
This also has major implications for policy directed towards enhancing the long-term per
capita growth performance of an economy. As we will see in chapter 12, views on growth
policy diverge broadly in terms of the relative weight given to ‘purely’ macroeconomic
variables such as the saving rate, tax rates, capital accumulation and innovation, as
against broader variables such as human capital, human development and institutional
development.

1. Using the Solow growth model, explain why an increase in the saving rate and the
resultant increase in the capital/output ratio only leads to a temporary increase in the
economic growth rate.
2. Again using the Solow growth model, explain why an improvement in technology will
lead to a permanent increase in the economic growth rate.
3. Will an economic growth rate of 1.5% improve average living standards if the
population grows at 2%? Explain.
4. Discuss how a decrease in the population growth rate will affect (a) output per capita
and (b) the economic growth rate.
5. Explain, using a production function, why emerging markets such as India and China,
in the process of technological catch-up, can be expected to grow faster than an
advanced country such as the USA, which operates at the technological frontier.
6. Due to the worldwide economic crisis in 2008, consumers all over the world increased
their savings. The savings rate in South Africa also increased. Analyse and indicate
the impact of this increase in the savings rate on the steady state capital-labour ratio
K
N  ) by means of the Solow
( 
Y
diagram. Also indicate what the effect of this change will
be on output per worker (  N  , living standard) in the South African economy.
7. Suppose that general labour efficiency (productivity) in the South African
economy decreases due to strikes in a wide range of sectors. Use the Solow diagram
to illustrate the effect of this on the balanced-growth/steady-state level of capital per
K Y
worker level (  N   ). Also explain the effect that it has on output per worker ( 
N  )  .
t t
t t
8. It is generally accepted that the South African education system is largely dysfunctional,
producing many learners who have limited literacy and numerical skills:
‘Approximately 40% of all Grade 1 learners never make it to Grade 12, with most
dropping out between Grades 10 and 12. Only about 40 out of hundred that start
school, pass matric; only 12 gain access to university and only four complete a
degree. Large-scale international tests among learners in Grades 4 and 8 show
the failure of the South African school system.’
Use an appropriate analytical diagram (such as the Solow diagram) and analysis to
explain how investment in a better school system would change the growth prospects
of South Africa.

Addendum 8.1: The Cobb-Douglas production function
One of the most popular production functions in economic literature is the Cobb-Douglas
production function. Despite its simplicity, it can be used to generate a variety of production
relations that approximate real-world situations quite well. The Cobb-Douglas function
looks as follows:
 1–
Yt = AtKt  N
t 
where the parameter  is a number between zero and one. The fractions  and 1 – 
represent the share of capital K and labour N in income Y. The variable A represents the
state of technology and institutions. In many countries the share of capital and labour is
approximately 33% and 67%, meaning that  = 0.33 and 1 –  = 0.67.
1. The Cobb-Douglas production function is a constant returns to scale production
function: if both the capital and labour inputs double, output will double too. This is
due to the fact that, by design, the sum of the two parameters equals one.
2. If the state of technology and institutional capacity increases by a particular rate,
output will increase at that same rate.
3. The Cobb-Douglas production function, by design, imposes diminishing marginal
returns for the factors K and N. This is because  and 1 –  are smaller than one. The
value of  shows the rate at which diminishing returns to capital K will set in, and
likewise for 1 –  and N.
We will demonstrate these three characteristics in turn.
Constant returns to scale

With the Cobb-Douglas function, it is straightforward to demonstrate how changes in capital
K and labour N translate into changes in output. To see that, we express the function in
terms of natural logs. This has the benefit that the difference between the natural log of
any two numbers gives the percentage difference between them. Thus, the simple arithmetic
difference between the natural log of output in years t and t–1 gives you the economic
growth rate of output from year t–1 to year t.
The natural log of the Cobb-Douglas function is the following:
 1–
log Yt = log At + log Kt  + log Nt  ...... (A8.1)
which becomes:
log Yt = log At +  log Kt + (1 – ) log Nt ...... (A8.2)
This is the production function in logarithmic form for period t.
For the previous period, t–1, it is:
log Yt–1 = log At–1 +  log Kt–1 + (1 – ) log Nt–1 ...... (A8.3)
Subtracting A8.3 from A8.2, and using the letter d to indicate
the arithmetic difference, gives us:
d log Yt = d log At + d log Kt + (1 – )d log Nt ...... (A8.4)
The left-hand variable is the percentage change in output. This is the growth rate in Y,
which is what we are after. It is equal to the percentage change in the state of technology
and institutional capacity A plus the weighted average of the percentage changes in capital
Addendum 8.1: The Cobb-Douglas production function 363

K and labour N. The weights are determined by the share of capital and labour in income,
i.e. by  and 1– .
For example, let A be constant. If  = 0.33 then 1 –  = 0.67. Assuming 2% growth in
both the labour force and capital stock, output will also grow by 2%, as follows:
d log Yt = d log Kt + (1 – )d log Nt = 0.33(0.02) + 0.67(0.02) = 0.02
If only capital increases (by 2%), output will increase but by less than 2%:
d log Yt = d log Kt + (1 – )d log Nt = 0.33(0.02) + 0.67(0.00) = 0.0067
i.e. 0.67%. The same is true for an increase in labour that occurs without a concomitant
increase in capital.
No diminishing returns for the state of technology and institutional capacity

However, note that if A, the state of technology and institutional capacity, improves by
2% per year (while labour and capital remain unchanged), it causes Y to grow by 2% per
annum as well. This means technology does not have a diminishing marginal product in
this production function:
d log Yt = d log At = 0.02
Let’s combine our examples. Let A, the state of technology and institutional capacity,
improve at 2% per year, while labour and capital both grow at 2% per year:
d log Yt = d log At + d log Kt + (1 – )d log Nt = 0.02 + 0.33(0.02) + 0.67(0.02)

= 0.04
The economy will grow at 4% per year.
Diminishing marginal productivity of labour and capital

Suppose we have a staff of 10 workers and R2 000 of capital, while the state of technology
and institutional capacity is an index set equal to 1 in the period in which we are
working.
Output then will be:
 1–
Yt = AtKt   N
t  = 1(2000)0.33 (10)0.67 = (1)(12.28)(4.68) = 57.44
Should we now increase the employment of labour by one worker, output Y becomes:
 1–
Yt = AtKt  N
t  = 1(2000)0.33(11)0.67 = (1)(12.28)(4.99) = 61.23
The additional employment of one worker has increased output Y with 3.79 units.
If we repeat the exercise by adding yet another worker so that the total number of workers
increases to 12, output Y becomes:
 1–
Yt = AtKt   N
t   = 1(2000)0.33(12)0.67 = (1)(12.28)(5.29) = 64.9
This time the additional employment of one worker has increased output Y by 3.67 units.
This is a smaller increase than when the number of workers increased from 10 to 11. This
demonstrates the diminishing marginal product of labour.
A similar demonstration of diminishing marginal product can be done for capital.

Addendum 8.2: An illustration of balanced growth – the course of ratios
between key variables
This addendum illustrates the behaviour of key macroeconomic variables in an imaginary
economy with an initial population of 2 000 that grows at 2% per annum. It shows
illustrative numbers of Y, K and N for this economy on a balanced growth path. Initially
GDP is growing at 4% per year, and GDP per capita at 2%. The purpose of the tables and
diagrams is twofold.
1. To make the reader at ease with the puzzling but mesmerising behaviour of ratios in
a state of balanced growth, notably that some ratios stay constant while others grow at
equal rates.
2. To demonstrate the effect of a change in one parameter, i.e. the growth rate a of labour
efficiency A, on key growth rates.
Table A8.1 shows a base run with the initial labour efficiency growth rate a = 2% per
annum. The numbers show a balanced growth situation with a saving rate s of 15%, a
depreciation rate  of 2%, and a population growth rate n of 2%. Initially GDP is growing
at approximately 4% per year (≈ n + a)1. The bottom row of numbers in bold shows the
(constant) growth rates of the variables and ratios – in a ‘steady state’ or ‘balanced growth
situation’ over this period.
Scrutinise the data in table A8.1 and satisfy yourself that the behaviour of the ratios can
in fact be true. Note the following characteristics of the balanced growth base run:
❐ N grows at a constant rate n (by assumption).
❐ K and Y grow steadily at equal rates (4.04% = n + a).
❐ The two ratios  NK  and 
  NY  grow at constant but equal rates (= a).
K
❐ The ratio  Y  stays constant at 2.5 throughout the eight-year period.
Table A8.2 shows an alternative run: the effect of a change in one parameter, i.e. the
growth rate a of labour efficiency A. The first four periods of table A8.2 replicate the first
four periods of the base run. But then, in period 5, a is increased to 2.25% and then to
2.5% in period 6 and thereafter.
Note the following characteristics of the balanced growth alternative run in the final
period 8 (i.e. after the transition):
❐ N still grows at a constant rate n (by assumption).
❐ K and Y again grow steadily at equal rates, but the rate has increased (to 4.55%
= n + a).
❐  NK   and  NY  again grow at constant but equal rates, but the rate has increased (to 2.5%
= a).
❐  KY  decreases from one constant level to another, at a lower value of 2.31. At all times  KY  is
s
equal to   . (The decrease in  KY  , which mirrors an increase in  YK  , is due to an increase in
    
+n+a
labour efficiency capital following increased growth in technological and institutional
innovation; thus a unit of capital can produce more output.)
1 The precise growth rate is calculated as (1 + n)(1 + a) = n + a + an (see tables A8.1 and 8.2). Since the term an
usually is insignificantly small, (n + a) is often used as an approximation.
Addendum 8.2: An illustration of balanced growth – the course of ratios between key variables 365

The diagrams show the results with regard to Y, K and N and their ratios. The base runs
are the lower, straight trajectories. The alternative run provides the upper trajectories after
the ‘fork’.
❐ Figure A8.1 shows the base and alternative runs for aggregate Y and K (together
with N).
❐ Figure A8.2 shows the base and alternative runs for per capita income  NY ,  plotted
against  NK  . It matches the theoretical diagram in figure 8.15 in this chapter.
❐ Figure A8.3 shows the base and alternative runs as time paths, and matches the time
path graph in figure 8.16 in the chapter.
Note:
 NY  (per capita income) go onto a steeper trajectory after the increase in a. At
1. Y as well as 
all times there is positive per capita GDP growth as well as growth in aggregate GDP.
2. The dramatic ‘fork’ in the middle diagram (figure A8.2) that plots   NY   against  NK .  This
diagram reflects the axes we used in our analysis of the production function and the
line of ‘potential balanced growth points’ (e.g. compare the fifth and sixth points in the
middle diagram with points in figure 8.15). The numbers of this imaginary economy
clearly trace out an upward rotation in the line of potential balanced growth points
(against the base run). The economy takes on a different, higher balanced growth path
after the change in a. Still, Y eventually settles down to a constant growth rate equal to
n + a.
3. In the third diagram (figure A8.3), the fork in the per capita income line is similar to
that in the time path diagram of figure 8.16.
4. In the end, GDP is growing at 4.5% per annum (≈ n + a). During the transition, in periods
5 and 6, per capita GDP grows at a quite high rate temporarily. The same is true for
aggregate GDP.

Parameters Savings rate Depreciation Population Initial value of a = 2.00%
s = 15.00% rate  = 2.00% growth rate Interim value of a = 2.25%
n = 2.00% Final value of a = 2.50%
Table A8.1 Base run for initial value of a

Variables Y %∆ K %∆ N %∆ K Y K A %∆
  
N
  %∆  N 
  %∆   
Y
 
Year 1 8 000.00 20 000.00 2 000.00 10.00 2.00% 4.00 2.50 100.00
Year 2 8 323.20 4.04% 20 808. 00 4.04% 2 040.00 2.00% 10.20 2.00% 4.08 2.00% 2.50 102.00 2.00%
Year 3 8 659.46 4.04% 21 548.64 4.04% 2 080.54 2.00% 10.40 2.00% 4.16 2.00% 2.50 104.04 2.00%
Year 4 9 009.30 4.04% 22 523.25 4.04% 2 122.42 2.00% 10.61 2.00% 4.24 2.00% 2.50 106.12 2.00%
Year 5 9 373.28 4.04% 23 433.19 4.04% 2 164.86 2.00% 10.62 2.00% 4.33 2.00% 2.50 108.24 2.00%
Year 6 9 751.96 4.04% 24 379.89 4.04% 2 208.16 2.00% 11.04 2.00% 4.42 2.00% 2.50 110.41 2.00%
Year 7 10 145.93 4.04% 25 364.84 4.04% 2 252.32 2.00% 11.26 2.00% 4.50 2.00% 2.50 112.62 2.00%
Year 8 10 555.83 4.04% 26 389.58 4.04% 2 297.37 2.00% 11.49 2.00% 4.59 2.00% 2.50 114.87 2.00%
Growth rates 4.04% 4.04% 2.00% 2.00% 2.00% 0.00% 2.00%

s
Growth at Growth at Growth at Growth at Growth at =   +n+a
      Growth at rate a
rate n + a* rate n + a rate n rate a rate a**
* Calculated as (1 + n )(1 + a )
** = per capita growth rate
Table A8.2 Alternative run for an increasing value of a

Variables Y %∆ K %∆ N %∆ K Y K A %∆
  
N
  %∆   N 
  %∆   Y 
 
Year 1 8 000.00 20 000.00 2 000.00 10.00 4.00 2.50 100.00
Year 2 8 323.20 4.04% 20 808.00 4.04% 2 040.00 2.00% 10.20 2.00% 4.08 2.00% 2.50 102.00 2.00%
Year 3 8 659.46 4.04% 21 648.64 4.04% 2 080.80 2.00% 10.40 2.00% 4.16 2.00% 2.50 104.04 2.00%
Year 4 9 009.30 4.04% 22 523.25 4.04% 2 122.42 2.00% 10.61 2.00% 4.24 2.00% 2.50 106.12 2.00%
Year 5 9 787.76 8.64% 23 490.62 4.30% 2 164.86 2.00% 10.85 2.25% 4.52 6.50% 2.40 108.51 2.25%
Year 6 10 642.43 8.73% 24 559.45 4.55% 2 208.16 2.00% 11.12 2.50% 4.82 6.60% 2.31 111.22 2.50%
Year 7 11 126.66 4.55% 25 676.91 4.55% 2 252.32 2.00% 11.40 2.50% 4.94 2.50% 2.31 114.00 2.50%
Year 8 11 632.92 4.55% 26 845.20 4.55% 2 297.37 2.00% 11.69 2.50% 5.06 2.50% 2.31 116.85 2.50%
End growth rate 4.55% 4.55% 2.00% 2.50% 2.50% 2.31% 2.50%
s
= Per capita =      
 +n + a
growth rate
Addendum 8.2: An illustration of balanced growth – the course of ratios between key variables 367

Figure A8.1
30 000
Balanced growth time
Capital stock K high a
paths: aggregate
Y, K and N 25 000
Capital stock K low a
20 000
Upper trajectory
is for higher a
Rand
15 000
Income Y
10 000 Income Y low a
5 000
Population N
0
1 2 3 4 5 6 7 8
Years
Figure A8.2 5.20
Balanced growth Balanced growth path of _
 NY  and _ NK  high a
paths:  _NY  against _ NK 
5.00
 NY  
Per capita income _
4.80
Balanced growth path
of _
 NY  and _ NK  low a
4.60
4.40
4.20
4.00
10.0 10.50 11.00 11.50 12.00
Capital per worker _
 NK  
Figure A8.3 5.25
Per capita income _

Balanced growth time
paths:  _NY against time  NY  high a
5.00 Upper trajectory
is for higher a
4.75
Ratios
4.50
4.25
Per capita income _
 NY  low a
The labour efficiency 4.00
growth rate is assumed
to start at 0.02, then
3.75
increase to 0.0225 in 1 2 3 4 5 6 7 8
period 5, and finally to
0.025 in period 6. Years

Part II
Macroeconomic
policy,
unemployment,
inflation and
growth in an open
economy
Addendum8.2:Anillustrationofbalancedgrowth–thecourseofratiosbetweenkeyvariablesAlastwordongrowth(fornow…) 369

Monetary policy: the role of the
Reserve Bank 9
■ appraise the main instruments of monetary policy, and demonstrate their impact on the
economy;
■ assess the policy and other choices that the Reserve Bank has to make in conducting
monetary policy, including the daily practice of monetary policy;
■ analyse and evaluate the role of the Reserve Bank with regard to public debt, including its
impact on fiscal policy; and
■ value the complexity of monetary policy in an open economy, particularly for a small and
emerging-market economy such as that of South Africa.
Monetary policy and fiscal policy

Monetary policy information on the internet
are the two main components
of macroeconomic policy. This Updated money and capital market information,
chapter considers the main Reserve Bank policy statements, and other pertinent
features of monetary policy from information can be found on the internet homepage of
a macroeconomic perspective. the Reserve Bank at: http://www.resbank.co.za
Monetary events and variables
(especially interest rates) are critically important for the business sector and for the state of the
economy. In particular, it is essential to understand, and to be able to evaluate, the policy steps
of the monetary authority (the Reserve Bank). Consult the graphs in chapter 3 for relevant
South African data.
9.1 Definition and main instruments

Formally, monetary policy can be defined as:
All deliberate steps of the monetary authority to affect the money supply, the availability of
credit, and interest rates in order to influence monetary demand, expenditure, production,
income, the inflation rate, the exchange rate and the balance of payments.
Monetary policy is the responsibility of the central bank, which in South Africa is called
the Reserve Bank, and is the ‘monetary authority’. The Reserve Bank is also responsible for
exchange rate policy. Exchange rates are so closely interwoven with interest rates and mone
tary conditions that this area is seen and managed as an integral part of monetary policy.
Formally, the Reserve Bank is independent and not a part of government. However, close
cooperation usually exists between the Reserve Bank and the fiscal authorities. The
Constitution stipulates that the Reserve Bank ‘must perform its functions independently
9.1 Definition and main instruments 371

The location of this topic in the circular flow
diagram (compare pp. 76, 140, 240)
FOREIGN
COUNTRIES
Ex
ch
a
rat nge
e
FINANCIAL
INSTITUTIONS s
Saving
Supply of credit
Interest Monetary RESERVE

rates
policy BANK
Demand for credit
FIRMS Government C HOUSEHOLDS

on
borrowing sum
dit
l cre er c
ercia (deficit) redi t
Comm
GOVERNMENT
and without fear, favour or prejudice, but there must be regular consultation between the
Bank and the Cabinet member responsible for national financial matters’ (i.e. the Minister
of Finance).1
❐ In principle, policy is intrinsically a government function. Therefore, in the last instance,
the government is also responsible for monetary policy. In this sense, the Reserve Bank
is the trustee of the monetary sphere. Any independence that the Reserve Bank enjoys
is always relative and provisional. If things really go awry, the government will have no
choice but to intervene and assert its ultimate authority.
❐ There are also two types of independence: (a) Goal independence refers to the ability
of a central bank to define the ultimate goals that it pursues, where these goals are
defined in terms of aggregate demand, production, income, inflation, the exchange
rate and the balance of payments. (As will be discussed below, a central bank usually
cannot pursue all these goals simultaneously.) (b) Instrument independence refers to the
freedom that a central bank has to change the money supply, the availability of credit,
and interest rates in the pursuit of its goals. A central bank can have both goal and
instrument independence, or only instrument independence (when the government
tells the central bank its goal).
❐ The latter is the case in South Africa, with the important difference that the goal is
determined in the Constitution and not by government. The object (or mandate) given
to the Reserve Bank in the Constitution is ‘to protect the value of the currency in the
1 See section 9.8 on the ownership of the Reserve Bank and the selection and role of its board of directors.
372 Chapter 9: Monetary policy: the role of the Reserve Bank

interest of balanced and sustainable growth in the Republic’. This is interpreted as a
focus on price stability (see section 9.2.1). The mandate can (only) be changed through
a constitutional amendment approved by a two-thirds majority in Parliament.
A complementary mandate for the Reserve Bank

Until the financial crisis in 2007–08 the Reserve Bank (SARB) had a single explicit mandate:
it had to ensure price stability. Price stability is a macroeconomic objective and one of the
topics dealt with in this chapter. However, since 2010 the SARB has been given a second
objective, i.e. the stability of financial markets. While this book focuses on the macroeconomic
objectives of the SARB, one should be aware that increasingly the SARB is pursuing the
equally important objective of maintaining financial market stability. This box explains the
nature and place of this second objective of the Bank.
In the years after the Asian Crisis (1997–8) the SARB increasingly had to take responsibility for
the stability of the banking system. In so-called microprudential regulation, its Bank Supervision
Department was responsible for overseeing the financial soundness of individual South African
banks. Microprudential regulation focuses on the so-called CAMELS: Capital adequacy, Assets,
Management capacity, Earnings, Liquidity (asset and liability management), and Sensitivity (of
banks to market and interest rate risk).
However, over the years it became clear that the financial soundness of individual banks
does not necessarily ensure the soundness of the overall financial system. Banks are highly
interconnected through various financial linkages. They are also, more than any other sector or
industry, highly connected to the entire economy. These interconnections mean that instability
in one institution or one sector of the real economy can very quickly spread to several financial
institutions. Banks that look financially sound today may become financially unsound very
quickly.
Therefore, a broader focus than the financial soundness of individual financial institutions is
required. There is a need to consider the overall systemic risk, i.e. risk that affects the financial
system and not just an individual financial institution. The financial system comprises financial
markets, the financial institutions (banks, insurance companies and investment firms) that
operate in the financial markets and the financial instruments (such as bonds and shares)
traded in the financial markets by the financial institutions. Therefore, systemic risk affects
many institutions in the system, the prices and quantities of instruments sold, as well as the
liquidity of the financial markets.
In the aftermath of the 2007–08 international financial crisis, itself due to the realisation of
massive systemic risk in the USA in particular, the South African government recognised that
financial stability is as important as price stability. In October 2010 the Minister of Finance
announced that the Reserve Bank ‘now has a revised mandate that includes particular
responsibility for financial stability’. This means the Bank has a dual mandate: It is responsible
for both price stability and the stability of the financial system. (The latter implies that the
SARB’s prudential regulation has been expanded to include both micro- and macroprudential
regulation.)
Whereas price stability is a very clear and measurable goal, and while a high degree of
consensus exists on the most effective instruments to pursue that goal, there is little clarity
and consensus among local and international policymakers and analysts with regard to
financial stability. It will take a number of years to establish such clarity and consensus.
The Financial Sector Regulation Act of 2017 establishes the Financial Stability Oversight
Committee (FSOC), chaired by the Governor of the SARB. The FSOC continuously monitors
the financial system for risks and initiates any action necessary to mitigate or remedy a risk.
⇒

⇒
Note: The Financial Sector Regulation Act also created two new institutions, which started
operating in 2018. The Prudential Authority (within the SARB) promotes and enhances the
safety and soundness of financial institutions (including banks, insurers and retirement funds)
and market infrastructures. The Financial Sector Conduct Authority (outside the SARB)
enhances and supports the efficiency and integrity of financial markets, protects financial
customers by promoting their fair treatment by financial institutions, and provides financial
education and literacy programmes.
The basic monetary policy instruments are:

❐ the cash reserve requirement (as well as liquid asset requirements).
❐ the repo rate (as part of the Reserve Bank’s accommodation function).
❐ open market transactions, and
❐ direct measures, such as credit and interest rate ceilings.
At times, the Reserve Bank uses ‘moral persuasion’ to prompt banks and financial
institutions to assist it in attaining monetary objectives. While such a step may have limited
direct impact, in certain circumstances it can contribute to the smooth functioning of the
monetary sector.
The macroeconomic impact of monetary policy instruments (summary)

The theoretical analysis of the chain reactions following various monetary policy actions
constitutes the core of the theory of monetary policy (originally seen primarily as a tool
of stabilisation policy). These monetary policy steps have been encountered throughout
chapters 3, 4, 6 and 7, and need not be repeated here. It suffices to summarise the basic
macroeconomic impact of monetary policy steps.
(1) The cash reserve requirement

An increase in the reserve requirement constrains the ability of commercial banks to extend
credit to their clients. This constrains the money supply, which is likely to put upward pressure
on interest rates. Higher interest rates could discourage private investment and durable
consumption expenditure, which is likely to constrain aggregate expenditure, production
and output. Hence the effect of an increase in the reserve requirement is contractionary. A
decrease in the requirement would amount to monetary stimulation of the economy.
(2) The repo rate

The repo rate (see chapter 3, section 3.1.2) is an essential element of the Reserve Bank’s
accommodation policy. Increases in the repo rate discourage commercial banks from
borrowing from the Reserve Bank, encourage banks to hold larger excess reserves as a
buffer, and accordingly restrain their ability to create credit/money. Therefore, a repo
rate increase curtails the money supply. Since this is likely to push up interest rates and
discourage investment, the impact on real income is likely to be contractionary. Likewise,
a cut in the repo rate is an expansionary monetary policy step.
❐ Remember that the Reserve Bank primarily uses the repo rate as a signal to market
participants regarding the Bank’s wishes and intentions. The psychological effect of
such a signal can significantly influence interest rates.

!
Review the analysis of the basic effects of expansionary or contractionary monetary policy steps
on interest rates, aggregate expenditure, output and the price level (chapters 3, 4, 6 and 7). Give
particular attention to the discussion of the factors influencing the potency of monetary policy
with regard to its influence on real income.
Chapter 3 The basic instruments of monetary policy and the role of the Reserve Bank in
section 3.1.2 influencing the money supply process.
Chapter 3 The transmission of a change in the repo rate to the real sector (via interest
section 3.2.1 rates) in 45° diagram context. This includes the factors (sensitivities and multi-
pliers) that affect the magnitude of the impact of such a monetary policy step.
Chapter 3 The impact of monetary expansion or contraction in the IS-LM diagram.
section 3.3.6
Chapter 3 Factors that affect the potency of monetary policy in terms of the slopes of
sections 3.3.7/8 the IS and LM curves.
Chapter 4 The impact of the BoP adjustment process on the chain reaction following a
section 4.5.1 monetary policy step.
Chapter 4 The BoP adjustment process following a monetary policy step in IS-LM-BP
sections 4.7.4/5 context.
Chapter 6 The impact of monetary contraction on real income and the average price
section 6.4.2 level in the AD-AS model.
Chapter 7 Demand expansion and contraction in the inflationary context, and important
section 7.1 Phillips-curve lessons for policymakers.
Chapter 7 The monetary reaction (MR) function and gradualist versus reactionist anti-
section 7.2.2 inflation policy paths.
❐ In sections 9.2.3 to 9.2.5. you will see that in South Africa the Reserve Bank’s use of
the repo rate appears to be primarily directed towards influencing the demand side of
the money market (MD), rather than the money supply (MS) – compare the basic theory
in chapter 3. The repo rate is used to influence interest rates directly. When interest
rates are thus affected, it affects the demand for credit – which subsequently affects the
amount of money created. (The actual order of events may, therefore, be somewhat
different from that in the basic theory.)
(3) Open market transactions

If the Reserve Bank buys up government bonds in the market, it serves to expand holdings
of money in the private sector (as former bondholders receive cash payments from the
Bank). Such a stimulation of the money supply is likely to depress interest rates and
hence stimulate real economic activity. Likewise, if the Bank sells government bonds, it
withdraws money from circulation, which amounts to a contractionary policy step.
Given an understanding of the likely chain reactions, these seem to be powerful
instruments in the hands of the Reserve Bank as monetary authority. If the Reserve Bank
has a reasonable indication of the strength, speed and extent of these different impacts
– including the sizes of the different multipliers and elasticity values – it is possible, in
theory, to plan and calibrate policy steps to bring about desired changes in macroeconomic
variables.

❐ However, in practice there are so many uncertainties and gaps in our understanding of
these matters – aggravated by the fundamental truth that the economy does not work
in a mechanically predictable way – that monetary policy can seldom be applied so
neatly and successfully.
❐ In this sense, macroeconomic theory is misleading, because it tends to create the
impression that chosen objectives can be achieved quite easily by using policy to ‘shift
a few curves’ to attain certain equilibrium points. This impression is fundamentally at
odds with reality. One should not overrate the ability of the Reserve Bank to influence
the economy in an accurate and predictable manner.
The following discussion will illustrate the complexities of practical monetary policy in a
modern economy, given an environment where South African money and capital markets
are continually subjected to domestic disturbances and, especially, international forces
and financial flows.
9.2 Monetary policy design – four important choices

9.2.1 Overarching policy objectives or mission
A first choice is the mission of monetary policy. This can specify a broad notion of
macroeconomic stability, or distinguish specific elements. The objective (or mandate)
given to the Reserve Bank in the Constitution and the Reserve Bank Act is ‘to protect the
value of the currency in the interest of balanced and sustainable growth in the Republic’.
This phrase could be interpreted to mean either the internal value or the external value
(exchange rate) of the domestic currency, or both, Up to 2000, the Reserve Bank actually
interpreted it as both. Since 2000, the Reserve Bank has interpreted its mission as signifying
that price stability (and thus inflation) – the internal value of the currency – is the primary
objective of monetary policy (in the interest of balanced and sustainable growth).
Other macroeconomic variables such as production, income, employment and the
exchange rate are accorded less explicit weight (while also recognising that they often
constitute constraints on the Bank in its efforts to protect the internal value of the
currency). This means that the chosen approach of the South African Reserve Bank
differs from the broader general definition given above, which stipulates general economic
performance or stability as its objective.
❐ In particular, the Reserve Bank does not have a formal responsibility for macroeconomic
stabilisation policy. But the Bank recognises the role of monetary policy and interest
rates in the context of weak annual growth and smoothing output fluctuations over
the business cycle.
❐ Similarly, long-term economic growth is an explicit part of the analytical framework
used by the Reserve Bank in its consideration of monetary policy measures.2
❐ The Bank also takes into account that its policy on interest rates can have a detrimental
impact on the cost of public debt and thus harm the pursuit of fiscal policy objectives
(see chapter 10, section 10.6.4 and chapter 11, section 11.1).
This choice of mission is not without controversy. Critics claim that the Reserve Bank
should be more concerned with unemployment and cannot ignore that dimension,
especially in South Africa.
2 The Bank’s view is that South Africa’s potential growth (i.e. its long-term growth) is mostly held back by structural
problems in the real economy and not factors such as interest rates (see chapter 12, section 12.3).

The Reserve Bank motivates its choice of mission by pointing to the immense harm
done to the South African economy over almost 25 years of double-digit inflation and
financial instability in the period from 1970 onwards, as well as the experience in other
countries. The Reserve Bank is convinced that South Africa will not have sustainable long-
term economic growth at the desired rate if it does not contain inflation. In its view, price
instability and inflation sooner or later depress living standards, investment, international
competitiveness, job creation and economic growth and lead to unemployment. (This
policy issue is discussed again in chapter 12.)
9.2.2 Intermediate or final policy targets?

Given a certain mission and ultimate policy objective such as inflation, a second decision
in operational policy making is whether to target inflation itself or, alternatively, to
work with intermediate policy targets relating to, for example, the interest rate or the
money stock.
(a) In the first case, the central bank would announce specific inflation rate targets, often
in the form of a numerical interval within which it would want to contain the rate of
inflation. Policy measures relating to interest rates or the money stock are then put in
place to pursue this goal. This is a case of a final policy target.
(b) In the second case, the Bank would not announce specific targets for the inflation rate
as such, but rather announce specific targets or target intervals for either interest
rates or the money supply. This is a case of intermediate policy targets. The ultimate
intention is still to influence the inflation rate, but the latter objective is not specified
in terms of specific numbers.
Between 1986 and 2000, the Reserve Bank had an approach of official money supply
targets (or guidelines). At the end of each year it announced minimum and maximum
growth rates for growth in the money stock (nominal M3) for the coming year. Monetary
policy steps were then introduced from time to time in an attempt to keep the nominal M3
growth rate within this guideline interval.
In February 2000, the Minister of Finance during the 2000/01 budget speech introduced
an approach of official inflation targeting, as well as an inflation target range for inflation
between 3% and 6%. In the South African inflation targeting system the Minister of
Finance (in consultation with the Reserve Bank) from time to time specifies an interval
within which it wants to contain the inflation rate. Policy measures then need to be
implemented to pursue this goal.
Of course, a central bank can choose not to work in terms of specific numerical targets, but
rather in terms of a direction in which it desires a chosen policy variable to move. However,
it would still have to decide between nominating intermediate policy variables, such as the
money stock or interest rates, or nominating a final policy variable such as the inflation rate.
9.2.3 Which intermediate policy variable – interest rates or the money stock?
Having chosen an overall mission objective, and having specified either an intermediate
or a final policy target, for operational reasons the Reserve Bank must still decide which
intermediate monetary variable it wishes to manage with its monetary policy instruments.
What should it manage: the money stock or interest rates (both as means to attaining the
mission objective)?
9.2 Monetary policy design – four important choices 377

The way the money market functions implies that the monetary authority cannot fix
the quantity of money and the interest rate independently of each other. With a given
demand for money, the monetary authority can try to stabilise or control the quantity of
money supplied at a certain level – but must then leave the determination of the ‘price’,
i.e. the interest rate, to the interaction between demanders and suppliers. Alternatively,
the authority can attempt to fix the ‘price’ at a desired level by manipulating the money
supply until the interaction between suppliers and demanders produces the correct
interest rate. A desired level of either the price or the quantity in the money market can
therefore be attained, but not both. The way the money market works does not allow the
latter option.
Any attempts to fix both will lead to substantial deviations from money market equilibrium
levels. This is likely to cause a black market or ‘grey market’ in credit – where borrowers
and lenders transact directly without the intermediation of banks or other financial
institutions. This practice is called disintermediation. If that happens, the Reserve Bank
loses control over these transactions and the interest rates involved.
Therefore, in the practical execution of policy, the Reserve Bank must choose between the
interest rate and the money stock as the operational focus of policy, i.e. whether it pursues
a desired quantity of money (or rate of money growth) or a desired interest rate level. In
1997 the Reserve Bank stopped targeting the money supply and adopted an interest rate
focus. This means that the Reserve Bank continuously has to manipulate the quantity
of money so that the desired level of interest rates is realised in the money market. One
difficulty with such an approach is selecting one interest rate among the many that
exist, and deciding whether the nominal or the real interest rate is to be targeted. In an
environment of high inflation, the latter can be quite difficult. The Reserve Bank has
selected the nominal repo rate as the intermediate target of policy.
The introduction of inflation targeting in 2000 implies that the target variable of
monetary policy is the inflation rate as such, i.e. there is an interval within which the
Reserve Bank must keep the inflation rate. However, in principle, the focus of the system
is to manipulate the demand side of the money market through the Reserve Bank’s
influence over interest rates. The idea is to manipulate (a) the demand for money and
credit, and through that (b) the level of aggregate demand for goods and services in
the economy, and thus ultimately (c) the nature and level of pressure on the average
price level and the rate of inflation. Should the Reserve Bank detect undesired upward
pressure on the price level, it can counter it by limiting aggregate demand through an
appropriately set repo rate. (Remember that it is the interaction of aggregate demand
and aggregate supply that determines the price level and inflation rate in the economy;
see chapters 6 and 7.)
Note that the inflation rate is the ultimate objective or target of policy, while the operational
focus is to set the interest rate at a level that would contain inflation within the target
interval (via the influence on aggregate demand).

The development of monetary policy and anti-inflation policy since 1994
Monetary policy in South Africa went through several changes since 1994. Two sub-periods
coincide with the tenure of three Reserve Bank governors, i.e. Chris Stals in the 1990s
and Tito Mboweni and Gill Marcus after 2000. This period is also marked by the significant
increase in financial market activities (‘market deepening’).
❐ A stronger and more consistent anti-inflationary stance was implemented under Chris
Stals. Coinciding with the reintegration of the South African economy into the world
economy in the mid-1990s as well as financial market innovations, any presumed
stable relationship between money supply growth and inflation disappeared. M3 was
growing at rates close to 20%, while inflation fell to single-digit numbers. The Reserve
Bank recognised this and in 1997 abandoned the system of money supply targets that
it had implemented in 1986. This signalled a change in approach. Having started out in
Monetarist vein, the Reserve Bank started to follow what governor Stals called an ‘eclectic
approach’ – looking not only at M3 but at many other indicators of inflationary pressure. On
average, real interest rates were very high (above 7%) from 1994 to 2000. Inflation came
down sharply (see figure 12.1 in chapter 12).
❐ A system of official inflation targets was implemented in February 2000, with the first
target range set for 2002. With governors Mboweni (1999–2009), Marcus (2009–2014) and
Kganyago (since 2014) at the helm, the Bank has followed a relatively non-ideological,
pragmatic approach to anti-inflation policy. The downward trend in inflation continued, albeit
with some hiccups, notably in 2008. From 2002 to 2007, average real interest rates were
approximately 3% before going negative again in 2008. Under Marcus and Kganyago the
Reserve Bank also implemented a so-called dual mandate approach, focusing both on price
stability and financial market stability.
A monetary reaction function for the Reserve Bank?

The concept of a monetary reaction (MR) function was introduced in chapter 7, section 7.2, in
the context of inflation targeting via interest rate setting.
It appears that the behaviour of the South African Reserve Bank can be approximated with
a monetary reaction function that relates the short-term interest rate to the extent to which
inflation deviates from a target value (the ‘inflation gap’).
To the extent that the Reserve Bank also considers the deviation between actual output and
long-run output, the reaction function should also include the ‘output gap’. (This would then
be a Phillips curve element in the function.)
❐ From statements of the Monetary Policy Committee it appears that the MPC definitely
considers the output gap in its decisions, on the repo rate and monetary stance, in steering
the economy along a particular path to the target range for the inflation rate (see section
7.2.2).
❐ This also means that one might be able to describe the behaviour of the Reserve Bank with
a Taylor ‘rule’ (as discussed in section 7.2.2 of chapter 7).
9.2.4 Which specific target values?

The fourth important policy choice is that of specific quantitative targets or guidelines for
the chosen variable. How this is done depends on the variable chosen.
Under the inflation targeting approach adopted in 2000, the task is relatively simple.
The target interval is determined with reference to the inflation rates of the main trading
9.2 Monetary policy design – four important choices 379

partners of a country. In South Africa, the target interval has been set slightly higher than
the average inflation rate of its main trading partners, i.e. 3% to 6%. Table 9.1 shows the
inflation rates of some of the main trading partners of South Africa (and a few others for
reference).
Table 9.1 Inflation rates in selected countries – 2012 and 2018
2012 2018 2012 2018
China 2.6 2.1 Botswana 7.5 3.2

Germany 2.2 1.9 Namibia 6.7 4.3
United States 2.1 2.4 Brazil 5.4 3.7
United Kingdom 2.8 2.5 Mexico 4.1 4.9
Japan –0.1 1.0 Chile 3.0 2.3
India 10.0 3.5 Venezuela 21.1 930 000
Italy 3.3 1.2 South Africa 5.6 4.6
World 4.1 3.6 Sub-Saharan Africa 10.2 10.3
Advanced economies 2.0 2.0 Emerging market and developing 5.8 4.8
economies
Source: IMF DataMapper (https://www.imf.org/external/datamapper).
9.3 Inflation targeting in South Africa

The main objective of a system of inflation targeting is to provide a stable ‘anchor’ for price
and wage adjustments in the economy, thereby stabilising and containing the inflation
rate. The system provides a stable inflation rate interval on which market participants
can base their inflation expectations and economic behaviour. If it succeeds, it also builds
the credibility of the idea of a stable price environment and of monetary stability (and
monetary policy).
In practice, inflation targeting means that the Minister of Finance (together with the
Reserve Bank) specifies an interval (and sometimes also a time horizon) within which the
Bank must contain the average annual inflation rate. Except for a brief period in which
the target interval was 3% to 5%, it has remained at 3% to 6% since 2002. (Though
the 3% to 6% target was announced in 2000, it had to be reached only in 2002.) Policy
measures are then put in place to attain this goal.
Central banks typically specify the inflation target for two years hence. This is because
measures to control inflation have a considerable time lag (from 18 to 24 months) to
have an impact on the underlying inflation rate. (For more on policy lags, see chapter
11, section 11.2.1.)
The Reserve Bank has also stressed that inflation targeting provides a framework and not
a rigid rule. It does not remove policy discretion from the policymaker, which still has
the onus to monitor economic conditions and react prudently to unusual and unforeseen
circumstances. Serious supply shocks such as an oil price increase would be an example of
such a case. However, the inherent discipline of inflation targeting should not be foregone
by applying discretion. That would undermine the credibility of the approach and forfeit
many of the potential benefits.

❐ In a sense, inflation targeting links the domestic policy stance to the policies of the trading
partners. Given that the main trading partners of South Africa usually pursue consistent
anti-inflation policy to contain their inflation rates. South Africa will also have to pursue
such a policy for its inflation rate to remain in line with its main trading partners. In this
way, it implies a constraint on the policy discretion of the Reserve Bank.
One key advantage of inflation targeting is that the central bank has policy responsibility
only for a single objective. If a central bank has two or more objectives – e.g. to maintain a
stable price level as well as full employment – there may be conflict between the objectives,
particularly over the short term. (Can you explain why?) This would complicate policy
decisions. With a single, clearly focused objective. Parliament can more effectively hold the
central bank, as ‘trustee’ of the monetary sphere, accountable for the way its policies affect
the economy. With a single objective, a central bank cannot justify policy failures by saying
that it has failed to reach one objective because it has been pursuing another.
❐ Of course, the fact that the central bank has adopted only one official objective does not
remove the conflict problem. Pursuing the inflation objective can still impact negatively
on other policy considerations, even if the central bank is not officially held responsible
for those areas. And central banks regularly face political pressure to take on other, or
broader, objectives such as the reduction of unemployment (also see chapter 12).
Formulating monetary policy in terms of the inflation rate also provides a system that is
relatively easy to understand and transparent, also for the lay person. Because monetary
policy is solely focused on inflation, it is clear, credible, unambiguous and predictable,
making planning in the private and public sectors easier. Market participants can form their
expectations on future inflation rate and interest rate movements with more confidence.
For example, they would know that, were there to be upward pressure on the inflation rate,
the central bank would probably step in to put upward pressure on interest rates.
Inflation targeting is not without practical problems. The central bank must select an
appropriate price index to use as indicator. Some of the prices used in calculating an index
such as the CPI (consumer price index) cannot be affected by monetary policy. (Can you
think of some prices that the Reserve Bank cannot influence?) If some of these prices
increase by more than the stated target rate, it cannot be ascribed to policy failure. Therefore
it is reasonable for the central bank to want to exclude from the index those prices that it
cannot control.
❐ There can be a problem if the items left out of the index constitute a large percentage of
consumer or producer expenditure, in which case the inflation rate targeted by the central
bank may differ significantly from the inflation rate actually experienced by consumers
and producers. This is one reason why the so-called core inflation rate was not chosen
initially as a basis for setting the inflation targets. (The core inflation rate excludes the
prices of certain food products, interest rates on mortgage bonds, value-added tax and
property taxes. The excluded products include meat, fish, vegetables and fruit).
❐ Up to 2008, the Reserve Bank excluded only one ‘price’, i.e. interest rates on mortgage
bonds, from the CPI for the purposes of inflation targeting. It calls the adjusted index
the CPIX. This was justified as follows: a standard way for the Reserve Bank to combat
inflation is to put upward pressure on interest rates (in order to slow down spending).
However, if the interest rate on mortgages is included in the price index, this step would
technically increase the rate of inflation, causing the policy step to appear inflationary
while in fact it is deflationary.
9.3 Inflation targeting in South Africa 381

❐ The CPI has been calculated differently since 2009. Instead of including mortgage
payments as an indicator of housing cost, the CPI includes imputed rent. If one lives in
one’s own house, the CPI includes an amount equal to the rent that you forego by not
renting your house to someone else, i.e. it includes the opportunity cost of living in your
own house. This change has been done in line with international best practice. Because
rent is not that sensitive to changes in the interest rate, the Reserve Bank stopped using
CPIX in 2009, and instead defines its inflation target in terms of the overall CPI calculated
for urban areas (and therefore not exclude anything from the index used for targeting).
A contentious issue in determining the target interval is: who sets the targets? Is it the
Reserve Bank or the government, and who is responsible and accountable? As mentioned
in the introduction to the chapter, in South Africa the Minister of Finance sets the
inflation target in consultation with the Governor of the Reserve Bank. This also means
that the Reserve Bank does not have goal independence. However, the Reserve Bank has
instrument independence, and it is free to use the instruments at its disposal as it sees fit
to achieve the inflation target set by the Minister of Finance. However, the question is not
only whether or not government or the central bank should decide on the inflation target,
but also whether or not other stakeholders such as labour unions or organised business
must have a say. Given that such stakeholders may have markedly different views of the
appropriate inflation target in the light of, for example, the state of the business cycle
or unemployment, this could become a serious political problem for an inflation
targeting system.
Another drawback is that the future course of inflation (and other economic variables) is
subject to unforeseeable exogenous shocks on the economy. If changing international and
domestic economic conditions cause the inflation rate to deviate from the path projected
initially, the central bank may fail to get the inflation rate within the target interval – not
because its policy steps were flawed as such, but primarily because of unforeseen events.
However, in the eyes of the public, this can discredit inflation targeting as a policy approach
and impede monetary policy.
❐ Consider the difficulty the Reserve Bank in South Africa has had in containing inflation
within the specified target range of 3% to 6% largely because of the occurrence of
external shocks such as exchange rate crises and oil price increases. The rate of inflation
exceeded its 6% upper bound in 74 (= 36%) of the 205 months between January 2002
and January 2019.
❐ However, this record has improved in the last half of this period: between January 2010
and January 2019 the rate of inflation exceeded the 6% upper bound only in 24% of the
months. Inflation rates and inflation expectations definitely have declined since the mid-
1990s (see table 1.3, chapter 1).
From time to time, opponents of the inflation targeting system have called for its
abandonment, citing possible negative impacts on employment due to a too restrictive
monetary policy stance. Proponents of inflation targeting argue that inflation targeting is
merely a framework and does not require that the inflation rate must be within the interval
at all times. If the inflation rate falls outside the interval, proponents argue, the Governor
of the Reserve Bank can invoke an ‘explanation clause’, whereby he or she explains why
the inflation rate exceeds the target interval and why the Reserve Bank could not prevent
this from happening. In addition, the Governor must also explain how the Reserve Bank
plans to return the inflation rate to the interval within a reasonable time (e.g. 12, 18 or
24 months).

This policy dilemma of the Reserve Bank is part of a wider problem: that the behaviour
and reactions of economic actors (such as money market participants, producers and
consumers) are difficult to anticipate, while reaction lags complicate matters further.
The economic behaviour of people and organisations in markets – and of economic
growth and employment in particular – remains only partially understood, and the
future is difficult to predict. Reserve Bank officials are making decisions on the basis
of necessarily imperfect information, analyses, interpretations and projections – and
must often implement those decisions under subtle or open public pressure. Monetary
policy, like all policy, is an imperfect art. Neither the policymaker nor politicians,
business persons, workers or consumers should have excessive expectations of what
monetary policy can do to improve economic conditions and standards of living.
Obviously all these problems are also present in an inflation targeting approach.
9.4 The practice of monetary policy
9.4.1 Monitoring the monetary policy environment

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

The Reserve Bank monitors and evaluates, on a daily, weekly and monthly basis, conditions
in the monetary sector – levels and trends in money and capital market interest rates,
liquidity (specifically the money market shortage) and accommodation (bank credit at the
Reserve Bank), the volume of bank credit extended to the private sector, coin and notes
in circulation, private deposits at commercial banks, government deposits at banks, and
so forth. The borrowing requirements of the government and the public sector are also
monitored. This information is the basis of policy decisions to influence money market
liquidity (e.g. with open market operations). This is often done to neutralise short-term
inflows or outflows, thereby eliminating undesirable fluctuations in interest rates due, for
example, to sudden large international flows of funds.
In such cases, the Reserve Bank can sell bills or other money market instruments, even for
a few days, to absorb the surplus funds and neutralise temporary fluctuations in liquidity.
In money market jargon, the Bank is said to tap the market. In considering such steps, the
Bank’s principal barometer is the money market shortage. If it is too small for the Bank’s
liking, it will use tap issues to increase it.
The Reserve Bank can also use open market transactions to pursue medium- or long-term
monetary objectives. Sometimes these are announced openly, or they may be undertaken
on the quiet. Conventionally the Reserve Bank traded in government bonds. (Note that
in these cases the sale of government bonds in the market occurred specifically with
monetary aims in mind, and not as a method to finance government expenditure.)
9.4 The practice of monetary policy 383

Changes in the two other monetary instruments, the repo rate and the cash reserve
requirement, are normally not considered on a daily or a weekly basis. Traditionally, these
are deemed to be medium-term policy instruments mostly relevant in affecting the growth
trend in the money aggregates (ignoring smaller weekly or even monthly fluctuations).
Monitoring external sector variables

The exchange rate is an important external policy concern, and its behaviour and trends are
monitored closely. Being a key determinant of the exchange rate, the balance of payments
is one of the most important considerations of the Reserve Bank. Therefore the Reserve
Bank monitors, on a monthly and quarterly basis, various international trade statistics
and the balance of payments (the current and financial accounts together and separately),
as well as the gold and other foreign reserves. In addition, the Reserve Bank keeps watch
over international flows of funds, foreign exchange transactions and foreign assets. On the
basis of this information, the Reserve Bank can decide to intervene in the foreign exchange
market, to support the rand or to prevent it from appreciating too much. It can also act to
protect the foreign reserves, e.g. by attempting to constrain imports by pushing up interest
rates (which would cool down the economy). Both short-run fluctuations and more lasting
tendencies are monitored and influenced – sometimes openly; sometimes discreetly.
❐ The adoption of inflation targeting may seem to indicate that external considerations,
and especially the exchange rate, have been accorded a lower priority in monetary policy
design. However, it is clear that a certain degree of conflict can arise. Although the
Reserve Bank can decide to focus on inflation and leave the external value of the rand
to be determined by supply and demand in foreign exchange markets, any significant
instability would probably force the Bank to attend to it. A significant depreciation,
which could introduce inflationary pressures, would require attention in particular as
it affects the primary objective of the Reserve Bank.
In general, the Reserve Bank keeps a watchful eye on foreign economic events, especially
foreign policy steps and foreign interest rate patterns, notably in the USA and Euroland.
Although international capital flows are relatively insensitive to South African interest
rate levels, an excessive gap between South African and foreign interest rates can cause
capital flow disturbances. These can impact severely on the foreign reserves and hence
on domestic liquidity and monetary conditions. As a result, even seemingly far-removed
events such as the US budget speech and the announcement about the US budget deficit
are monitored closely (as noted in chapter 4, section 4.5.6). Another closely watched
event is the monthly announcement of the Federal Funds rate3 by the US Federal Reserve,
which could impact on relative interest rates and international capital flows.
Monitoring the inflation rate

The Reserve Bank monitors the inflation rate, as principal policy concern, on a monthly
and quarterly basis. Sophisticated analyses of the different price indices are done to
distinguish underlying trends from passing changes or fluctuations that can be ascribed to
statistical disturbances in measurements (so-called technical factors). It is important for
the Reserve Bank to base its policy reaction not on irregular or transient changes, but only
on the underlying trend in inflation. If the Reserve Bank is convinced that an observed
change in the rate of inflation (i.e. in the relevant price indices) is large and lasting enough
3 This is the rate at which banks in the USA lend to each other, and it is also the rate that the US Federal Reserve targets.

to indicate a significant underlying tendency, it can decide on policy steps to counter that
tendency. (A thorough analysis of macroeconomic conditions and trends is essential for
this evaluation.)
❐ In an inflation-targeting approach, the monitoring of the inflation rate has a much
higher significance and public profile, since it forms the basis of market expectations of
future monetary policy steps and interest rate movements. Therefore such an approach
implies a reprioritisation of the variables under monetary policy scrutiny.
❐ However, Reserve Bank policy statements clearly reveal that the Bank still monitors
domestic real economic developments, domestic monetary and financial conditions and
markets, public sector borrowing requirements, the balance of payments and the foreign
exchange market, and overall financial sector stability. These remain the basic elements of
any monetary policy environment, irrespective of changes in policy approaches over the
years. More specifically, the Reserve Bank argues that it monitors these variables because
they may all influence where inflation might be moving in the next 18 to 24 months. Thus,
should the Reserve Bank observe that the growth in credit is increasing significantly, it
might decide to increase the repo rate, not primarily to curb the high growth in credit,
but because the growth in credit (and the associated increase in aggregate expenditure)
might result in inflation in the following 18 to 24 months.
9.4.2 The operational procedures of the Reserve Bank

As stated in section 9.2.3, the Reserve Bank pursues its objectives through the demand
side of the money market. The way the Reserve Bank does this constitutes the operational
procedures of monetary policy. The application of an inflation targeting policy framework
does not directly affect these operational procedures. As in the past, the Bank’s operations
are aimed at influencing the overall lending policies of banks and the demand for money
and credit in the economy.
These activities revolve around the repo rate as the key instrument to regulate liquidity
in the market. This instrument can be complemented by open market transactions and
changing cash reserve requirements, if and when these are required to fine-tune liquidity
and interest rate movements.4
The repo rate is announced by the Governor of the Reserve Bank after Monetary Policy
Committee (MPC) meetings. The MPC decides on the appropriate repo rate after considering
submissions and analyses by Reserve Bank research staff about the state of the economy
and the inflation trend.
The repo rate is the interest rate that commercial banks pay to borrow from the Reserve
Bank when they experience a short-term shortage of funds/liquidity. Although the MPC sets
the rate in accordance with its wishes and intentions, in practice the rate is established, on
a weekly basis, via a tender process in which banks express their need for accommodation
(funds) in a seven-day repurchase transaction. (A daily tender is also available for banks
to fine tune their liquidity needs.)
In a repurchase transaction, the bank sells a financial instrument (e.g. a treasury bill) to
the Reserve Bank and undertakes to repurchase it at a higher price seven days later from
the Reserve Bank. The difference between the buying and selling prices is expressed as an
interest rate on the purchase amount. This is the actual repo rate.
4 Read the box ‘Why always a shortage?’ in chapter 3, section 3.1.2.
9.4 The practice of monetary policy 385

Depending on the total demand for liquidity from banks, the Reserve Bank supplies funds
to the banking sector at such a level that the supply and demand for funds match at the
repo rate set by the MPC meeting. This means that the Reserve Bank will supply whatever
liquidity is needed to keep the repo rate at the desired level. Though the liquidity decision
is taken by the Reserve Bank on a weekly basis, the MPC meetings at which the repo rate
decision is taken occur less frequently. Normally these meetings are scheduled bi-monthly,
The MPC can also hold unscheduled meetings or change the frequency as required by
circumstances.
9.5 Public debt management – the interface between financial

markets and fiscal and monetary policy
Public debt, or government borrowing, is a complex policy area with both monetary
and fiscal dimensions. The thorny issues concerning the total debt are discussed in the
context of fiscal policy (chapter 10, section 10.6). Here we consider only the monetary
impact of public debt. This derives from the impact of the borrowing activities of
government on the financial markets. As noted in chapter 3, government’s demand for
credit is a substantial component of the demand for credit (and indirectly the demand
for money).
Public debt management can be defined as follows:
The decisions and actions of the monetary and fiscal authorities to attain certain objectives
with regard to the magnitude, composition (according to type of debt instrument), term
structure and ownership structure of public debt.
Public debt management has
important interactions with Bond issues – a monetary or a fiscal step?
monetary policy (even though If the Treasury issues new government bonds specifically
the Reserve Bank does not to finance government spending, it does not have a net
have the responsibility for monetary effect. At most there may be a momentary
debt management anymore). monetary effect. The funds are borrowed because the
Traditionally, the Reserve state wants to spend that money forthwith; they therefore
Bank acted as the agent of the promptly flow back into the economy and the money stock.
fiscal authority in marketing ❐ A bond issue is a pure monetary policy step only
government bonds, and thus when extra (‘unnecessary’) funds are borrowed, i.e.
in the management of the the funds are not turned over to the state to spend
but are kept in reserve. Traditionally, the Reserve
public debt. In 1998, the
Bank has had the authority to issue government
Treasury (then called the
bonds for pure monetary reasons, i.e. to absorb
Department of Finance) took money market liquidity. Changes in the late 1990s
the marketing function out of have curtailed this authority of the Reserve Bank.
the hands of the Reserve Bank.
The move of the Treasury to play a more active role in public debt management was
related to an intrinsic tension between fiscal, monetary and refinancing considerations in
the marketing of government bonds. These are:
(1) A fiscal consideration
The cost to the Treasury of borrowing must be minimised. Both the term of loans and
the timing and extent of bond sales throughout the fiscal year must be planned with this
consideration in mind.

❐ For example, at times it may be cheaper to use short-term financing (less than three
years in the case of government bonds) rather than long-term financing (long-term
bonds). The different interest rates for bonds with different terms – the so-called yield
curve – must be watched carefully (see chapter 3).
❐ The expected future course of interest rates is crucial. If interest rates are likely to
increase, it would be prudent for government to borrow sooner rather than later, and
for as long a term as possible. (Why?)
(2) A monetary consideration
From the Reserve Bank point of view, there is a concern to handle the sales of government
bonds in such a manner that financial markets are not disturbed and monetary policy not
disrupted. (Indeed, if possible, these activities must support the attainment of monetary
policy objectives.)
❐ For example, large bond issues (large additions to the demand for credit) should be
avoided in a period when there is a significant shortage of liquidity in the market, or
when a reduction in interest rates is desired – such issues would cause substantial
upward pressure on interest rates.
❐ The term of bonds (and the rate of interest at which they are issued, the so-called
coupon rate) must be chosen so as not to disrupt the concerned subsegment of the
market. (Each term category – 3 years, 5 years, 10 years, 20 years, etc. – constitutes a
subsegment of the market with its own ‘product’ and ‘price’.)
❐ The ‘term structure’ of government debt (i.e. the mix of short-, medium- and long-
term debt) also has practical implications: if a lot of short-term debt is used, there is a
high frequency of bonds maturing and having to be reissued (‘rolled over’). This would
require a very active and effective monitoring and management capacity. Long-term
debt is much simpler to manage administratively.
❐ Note that the monetary consideration is only relevant in relatively illiquid markets. In a
liquid market, the addition of new securities constitutes a small part of the total supply.
Therefore the impact of government on interest rates is relatively small.
(3) A refinancing consideration
The refinancing consideration concerns the ability of government to roll over its debt.
If ‘too much’ debt must be rolled over and financial investors do not want to reinvest in
government securities, the unbalanced demand and supply situation could cause cash-
flow problems and an increase in the cost of public debt. To prevent an imbalance between
supply and demand in the market, the maturity structure of debt (i.e. the amounts of debt
that mature every year) has to be spread out evenly over time.
❐ Note that, in a stable economic and political environment, government should not
encounter difficulties in rolling-over its debt. The importance of the refinancing
consideration diminishes in a stable environment.
In the traditional system, these considerations posed a dilemma for the Reserve Bank in
that the fiscal and monetary considerations may have been in conflict at times.
❐ At times, monetary stability required that more had to be borrowed (more bonds had to
be sold in open-market operations) than was necessary to fulfil the borrowing needs of
the state at that stage. This caused an unnecessary interest burden on the fiscus for the
sake of monetary objectives.
9.5 Public debt management 387

❐ The monetary consideration not to disturb financial markets could have implied
that borrowing did not always occur at minimum cost. This can happen, notably at
a juncture when interest rates are expected to decline. This problem is related to the
preference of the state to issue long-term bonds.
Illustration: an expected drop in interest rates and the cost of public debt
The potential conflict between monetary and refinancing considerations on the one hand and
fiscal considerations on the other can be quite complex. Inherently, it derives from the different
motives of lenders and borrowers. If interest rates are expected to decline in the near future,
the following characterises the bond market:
❐ Lenders would prefer to ‘lend long’, i.e. a long-term loan which would secure a fixed, high
interest for a long period of time. They would therefore prefer to purchase long-term bonds.
❐ Borrowers, on the other hand, would prefer short-term loans (‘to borrow short’), so that
new and cheaper loans can be negotiated once interest rates reach a lower level. They
would therefore prefer to issue short-term bonds (sell bonds in the short-term market).
The question is, given the expected decline in interest rates, should the Treasury borrow in the
short-term or the long-term market?
❐ In the short-term market, the attitude of private-sector borrowers already implies an increased
supply of bonds – which imparts some upward pressure on short-term interest rates. If the
Treasury launches a large issue of bonds in this market segment, it could push up interest rates
markedly. This could destabilise this market segment, thereby impairing the monetary policy
objective of market stability. Because the buyers of securities prefer long-term securities, an
offer of short-term securities by government may cause it to have difficulty in rolling-over its
debt. Thus, such a course of action by government would impair the refinancing objective.
However, the Treasury would have been acting like any borrower in seeking to minimise its
interest cost in a time of declining interest rates – a fiscally prudent attitude.
❐ In the long-term market, the situation is different. The eagerness of lenders to buy long-
term bonds (and their willingness to pay high prices for them) implies downward pressure
on long-term interest rates. If the Treasury were to sell bonds in this market segment, it
would satisfy this demand, and serve to moderate the drop in rates. Thus, government
would improve its ability to roll over its debt. Such a step would, therefore, stabilise interest
rates in this market segment – favouring the monetary policy objective. However, this
would bind the Treasury to current, relatively high interest rates for a long period.5 The state
would not benefit from the eventual decline in interest rates.
Therefore, if the Treasury pursues the fiscal objective of minimum cost, it would borrow in the
short-term market, which could impair the monetary and refinancing objectives. If it pursues
the monetary or refinancing objectives, it would borrow in the long-term market and avoid the
short-term market. This would impair the fiscal objective of minimum cost.6
This situation illustrates the potential for substantial conflict between the monetary consideration
and the fiscal consideration in debt management. For both the monetary policy authority (the
Reserve Bank) and the fiscal authority (the Treasury) this creates a difficult situation.
❐ This potential for conflict exists both in a system where the Reserve Bank markets
government bonds on behalf of the state (the traditional system) and where the Treasury
itself markets government bonds (the current system in South Africa).
5 Given an expected decline in interest rates, current rates must be high in relative terms.
6 If bonds are issued in sufficiently small amounts so that the short-term segment is not disturbed, the total amount
borrowed will be insufficient, and the Treasury would have to go to more expensive segments of the market. This
implies that the loans do not occur at minimum cost.

The dilemma of the Reserve Bank in
its agency function was exacerbated by Primary vs. secondary bond market
the fact that its pure monetary policy When government bonds are issued for the
steps (especially repo rate changes) first time, this occurs in the so-called primary
could affect the cost of government bond market. When existing bonds are traded,
borrowing considerably. In practice, this is said to occur in the secondary market.
the Reserve Bank gave preference to the In marketing its securities to the primary
monetary consideration. dealers, government faces the same
considerations as the Reserve Bank faced.
In the current public debt management Currently, government gives primacy to the
dispensation, the Reserve Bank and its refinancing consideration.
monetary policy decisions are institu
tionally separate from the marketing of
government bonds. Since 1 April 1998, the government (i.e. the Treasury) has marketed
its securities (stocks and bonds) through a system of primary dealers. There are nine
dealers.7 The primary dealers buy government securities on a tender basis directly from
the government. The transactions between the government and the primary dealers
constitute the primary market for government securities. The dealers are then responsible
for creating a secondary market in these securities. They do this by quoting buying and
selling prices at which they trade the securities with other market participants.
Another decision concerns the choice between domestic loans and foreign loans. Monetary
considerations that are relevant in this decision include:
❐ The financing options in domestic financial markets (for example, whether markets are
tight or may be disrupted), and
❐ The implications of an international capital inflow for domestic monetary liquidity
as well as for the balance of payments and the exchange rate. Excessive increases in
domestic monetary liquidity can also boost inflationary pressures (see chapter 12).
9.6 Exchange rate policy and the problems of monetary policy in an

open economy
The first and most important choice concerning exchange rate policy is the exchange rate
system to be followed. As explained in chapter 4 (section 4.3.2), the current system is one
of dirty (or controlled) floating.
However, there are different degrees of dirty floating. With the system of inflation
targeting, the Reserve Bank currently focuses on the internal value of the domestic
currency (i.e. it focuses on inflation) and not, as prior to inflation targeting, on both the
internal and external value of the domestic currency. Unlike 1998 – when the Reserve
Bank (unsuccessfully) intervened significantly in the foreign exchange market to
prevent the rand from depreciating, it did not do so to any noticeable extent since the
implementation of inflation targeting. (An example of a significant currency crisis where
it did not intervene would be the currency crises of 2001.) While there might have been
some unrecorded small interventions (that render a system of dirty floating), the rand has
mostly floated freely since 2000, when inflation targeting was implemented.
7 ABSA, Citi Bank, Deutsche Morgan Grenfell, HSBC, Investec Bank, JP Morgan, Nedcor Investment Bank, Rand
Merchant Bank, and Standard Corporate and Merchant Bank.
9.6 Exchange rate policy 389

❐ A dirty floating system entails that the Reserve Bank intervenes in the forex market to
stabilise the external value of the rand – especially to moderate undesirable short-run
fluctuations. The Reserve Bank cannot contain a depreciation tendency indefinitely.
(Why not? See chapter 4.)
❐ Specific exchange rate targets are not used. Nevertheless, dirty floating implies
that the Reserve Bank must continually take a view on the most desirable level of
the rand, and act accordingly. Given that the Bank is no longer intervening in the
market that often, South Africa can be said to have a significantly watered-down
dirty float.
Is the rand over- or undervalued?

There are many views on this question, often depending on the way that appreciation or
depreciation would affect certain interests.
❐ Exporters are likely to argue that the rand is overvalued, while importers often proclaim
undervaluation. (Why?)
❐ The fact that a strong currency confers a measure of status on a country complicates the
matter. No monetary authority would like to witness a strong depreciation of the currency –
right or wrong, it is regarded as a sign of policy failure and a weakening economy.
However, no universally accepted scientific way of determining the ‘correct’ level exists.
Indeed, scientific economic journals often contain articles setting out approaches to calculate
the correct exchange rate (often called the real equilibrium exchange rate [REER]). However,
a survey of these papers indicates little consensus on how to calculate the correct rate. The
best-known approach is the purchasing power parity theory (see chapter 4). In practice,
however, this theory often proves unsuitable for this purpose as it helps to explain long-term
movements in the exchange rate, but not short- and medium-term movements.
❐ When deciding whether or not a domestic currency is over- or undervalued, the option that
is frequently chosen is to say that the matter should be left to ‘the market’. However, this is
no real solution. In itself, the adoption of a system of dirty floating is an admission that ‘the
market’ does not necessarily ‘decide’ correctly.
❐ Ultimately, the Reserve Bank must rely on its own analysis, judgement and gut feeling in its
management of the exchange rate.
The exchange rate decision is complex in itself. However, it is vastly complicated by the fact
that an open economy comprises a very complex and intricate set of interrelationships
between many variables. This also implies that monetary policy decisions in an open
economy are considerably more complex than in a closed economy. A number of factors
leading to this assertion can be listed.
First, the linkages between domestic monetary liquidity, interest rates and exchange rates
imply that these variables cannot be determined or manipulated independently. Their
levels must be compatible.
❐ A particular decision on interest rates and money supply growth necessarily implies a
corresponding impact on, for example, capital inflows, which will affect the exchange
rate. The monetary policy decision determines the exchange rate possibilities. (As
suggested in the box above, undesirably large depreciations of the currency are often
ascribed to bad [monetary] policy.)

❐ On the other hand, if a particular exchange rate level is to be sustained, it implies a
constraint on the interest rate and money supply levels that can be maintained. The
exchange rate decision effectively determines monetary policy’s room for manoeuvre.
Balancing these interrelated elements –
amid both internal and external shocks The sectoral balance identities (see chapter
and influences – is one of the biggest 5) show the interaction between internal
difficulties of monetary and exchange monetary elements and the external sector
in another way. If monetary policy influences
rate policy.
domestic investment via interest rates – (S – I)
changes – it must be reflected in the other
Second, in an open economy, the
sectoral balances, in this case probably only
effectiveness and independence of mon
in the current account term (X + TR – M), as
etary policy decisions are encumbered mirror image of the change in capital inflow.
by external side-effects and flows of
funds. As explained earlier (chapter 4,
sections 4.5.1 and 4.7.5). the basic impact of a monetary policy step on aggregate
expenditure is weakened by the money supply effect of the associated BoP disequilibrium.
On the other hand, the policy impact is boosted by the exchange rate effect, when (and if)
it happens later on.
❐ This implies that a rigid or fixed exchange rate weakens the effectiveness of monetary
policy, while a promptly adjusting exchange rate strengthens monetary policy.
❐ This same link is the source of the phenomenon that a stimulated money supply
effectively flows out of the country if (and as long as) the exchange rate is rigid (i.e. via
the money supply effect of the BoP; see chapter 4).
❐ In other words, a rigid exchange rate makes independent monetary policy impossible.
This is one reason why monetary authorities often favour a system of floating exchange
rates (even if that has to be dirty floating).
Third, BoP fluctuations can cause serious swings in the money supply ‘from the outside’
– the inflows and outflows of payments affect monetary liquidity directly. This factor
obviously constrains the extent to which the Reserve Bank has control over the monetary
aggregates, and consequently hampers monetary policy. Specifically, large inflows or
outflows of capital – which tend to be more capricious than trade flows – can severely
disrupt monetary policy. This is a particular danger in a small economy.
Last, a fixed or rigid exchange rate makes output and employment levels in the domestic
economy more vulnerable to external shocks. If the exchange rate is flexible, the impact
on output and income of large changes in the international flow of funds (as reflected in
BoP disequilibria) is moderated by the subsequent exchange rate adjustment (which tends
to reverse the initial BoP disequilibrium; see the examples in chapter 4). If exchange rate
rigidity prevents or delays this process, it places immense pressures on the monetary (and
fiscal) policymakers to limit the damage to the economy.
However, the flexible exchange rate case is not beneficial with regard to the price level and
inflation. If a significant outflow of funds causes the currency to depreciate, the price of
imports (including oil) in the domestic currency increases. This supply shock may then
put upward pressure on domestic prices. This may, in turn, require the Reserve Bank to
tighten monetary policy to contain inflation and inflation expectations.
9.6 Exchange rate policy 391

Low domestic savings and the risk of capital flight
It has been remarked in the financial press that the effect on inflation of an outflow of funds from
South Africa – and the subsequent need for a tighter monetary policy – is a symptom of the low
domestic saving rate and the country’s resultant dependence on foreign capital to finance fixed
investment.
This point can be understood by comparing two countries that have the same investment to
GDP ratio (e.g. 25%). Suppose that investment in one country is predominantly financed by
domestic saving – there is a small savings gap – and in the other predominantly by foreign
capital inflows (which may take the form of both foreign direct investment and portfolio flows).
In the latter case, there is a relatively large flow of capital that could be reversed if adverse
events occurred. The country with the large savings (or S – I*) gap can potentially experience a
larger outflow of capital and resultant downward pressure on the value of its domestic currency.
Such depreciation is likely to be inflationary due to more expensive imports such as oil.
The more upward pressure there is on inflation, the more restrictive monetary policy might have
to become to contain the inflation. Therefore, it is argued, a low saving rate renders an economy
more vulnerable to the inflationary effects of capital flight, making recurring restrictive monetary
policy steps all the more likely.
While this may be true, it simply reflects the reality of many emerging market economies. Such
economies have to import equipment and technology, and as such can be expected to run
current account deficits that require financing. They also have inadequate levels of income
to generate enough domestic saving to finance all investment. As such, it would be normal
for emerging market economies to depend on foreign capital inflows, even though such
dependence increases their vulnerability to capital outflows.
9.7 Real-world application – quantitative easing and ‘creative

monetary policy’ in the USA
Since the advent of the international financial crisis in the USA in 2008–09 a new term
has entered economic vocabulary: quantitative easing (or ‘QE’). The US Federal Reserve
(the US central bank) launched three rounds of quantitative easing, known as QE1,
QE2 and QE3 in 2008, 2010 and 2012 respectively. The quantitative easing – which
amounts to monetary easing or expansion – occurred when the central bank purchased
financial assets from institutions such as banks, in exchange for money. The central
bank did this in an effort to encourage banks to extend more credit by lending out the
new money (thus expanding the money supply). So how does quantitative easing differ
from open market transactions?
Both involve the central bank buying securities, but they differ in two respects. First, in
normal open market transactions the central bank buys short-term instruments such as 91-
day treasury bills. With quantitative easing, the central bank buys longer-term securities
such as 10-year government bonds (called Treasury Bonds) and Mortgage-Backed Securities
(MBSs) (see section 3.4 for an explanation of an MBS and its role in the financial crisis).
Secondly, quantitative easing was instituted as a measure of last resort. For instance, the US
Federal Reserve first reduced the Fed Funds rate (its equivalent of the repo rate) to 0.25%,
which is rock bottom (since interest rates cannot go below 0%) and conducted normal open
market transactions as far as it could, all to stimulate the economy. Only when, given the
extraordinary circumstances that developed during the 2007–08 financial crisis, these
normal measures did not work, did the Fed resort to quantitative easing: buying longer-

term securities to pump more money into the financial system to stimulate investment and
durable consumption spending.
The scale of these transactions was astounding. The balance sheet of the US Federal Reserve
expanded dramatically following the implementation of QE1, QE2 and QE3 – as did its
composition. The total value of all US treasury bills and bonds (with bonds being long-term
securities) held by the Federal Reserve in July 2008 – before the crisis struck – equalled $480
billion (or $0.48 trillion). By 2012 the value of US treasury bills and bonds increased to $1.7
trillion and by early 2014 to $2.4 trillion. The Fed’s holdings of MBSs increased from zero in
2009 to $1 trillion by end 2010 and $1.7 trillion by early 2014. (The combined holding of
MBSs and US treasury bills and bonds of $4.1 trillion at the beginning of 2014 was about
fifteen times the South African GDP, calculated at the average exchange rate of $1 = R11 at
the time. The total balance sheet was valued at $4.4 trillion, thus 16 times the South African
GDP at the time.) Figure 9.1 shows the extent of the QE bulge in the USA:
Figure 9.1 Assets of the US Federal Reserve during quantitative easing 2008–14
4 500 000
4 000 000
3 500 000
3 000 000
2 500 000
Other
Mortgage Backed
R million
2 000 000 Securities (MBS)
1 500 000
1 000 000
500 000
Treasury bills
and bonds
0
2002-12-18
2003-05-17
2003-10-14
2004-03-12
2004-08-09
2005-01-06
2005-06-05
2005-11-02
2006-04-01
2006-08-29
2007-01-26
2007-06-25
2007-11-22
2008-04-20
2008-09-17
2009-02-14
2009-07-14
2009-12-11
2010-05-10
2010-10-07
2011-03-06
2011-08-03
2011-12-31
2012-05-29
2012-10-26
2013-03-25
2013-08-22
2014-01-19
Source: Federal Reserve of St Louis.
As noted in the full case study in section 3.4. investment did not respond much to all
the waves of QE, mainly due to fear, uncertainty and a lack of confidence. But the huge
amount of money thus created had to go somewhere. What happened is that a significant
amount of the liquidity that was injected into US banks and other financial institutions
found its way – through portfolio investments – into international financial markets,
including those of South Africa. These short-term capital inflows caused the South
African rand to appreciate until 2011. However, soon thereafter, with growing fears that
the Federal Reserve would start to reverse its quantitative easing (i.e. sell its holdings of
treasury bills, bonds and MBSs), the rand and several other emerging market currencies
started depreciating again in 2012. This depreciation gained momentum in 2013 when
the Federal Reserve indeed announced that it would start to slow quantitative easing,
albeit at a very moderate rate, QE was terminated at the end of October 2014.
9.7 Real-world application – quantitative easing 393

9.8 Monetary policy and the ownership of the Reserve Bank
The independence of the Reserve Bank is discussed in sections 9.1 and 9.2.1. Despite being
an institution that is integral to government policy, the Reserve Bank actually has owners.
Moreover, the South African Reserve Bank is one of only eight central banks globally whose
shareholders are private individuals or companies (Belgium, Greece, Italy, Japan, Switzerland,
Turkey and the US are the other). There are approximately 650 shareholders. No single
shareholder may own more than 10 000 shares (out of a total of two million issued shares).
The private shareholders elect seven of the 15 directors of the Reserve Bank, while
the remainder (the majority, which includes the governor and deputy governors) are
appointed by the government. The board of directors is only responsible for overseeing
corporate governance and the approval of rules and internal policies that ensure the good
administration and functioning of the Reserve Bank.
The board of directors is not involved in, or responsible for, monetary policy at all. For
example, in the system of inflation targeting, the government (i.e. the Minister of Finance)
sets the inflation target in consultation with the Governor, while the Reserve Bank (in fact
its Monetary Policy Committee) then sets the repo rate to achieve that target.
In 2019 President Ramaphosa announced the intention of the government to nationalise
the Reserve Bank, though he also at a later stage said that the government cannot
afford to do so immediately. Given the circumscribed role of the owners, the fact that
the independence and mandate (i.e. objective) of the Reserve Bank are specified in the
Constitution, while the government already sets the inflation target, nationalisation will
not, and should not, affect monetary policy. (The first central bank to be nationalised was
that of New Zealand in 1935. Incidentally, New Zealand was also the first central bank to
introduce inflation targeting in the early 1990s.)

1. Explain two monetary policy options other than interest rate policy that the SARB can
use to restrict economic activity. Also analyse and illustrate how effective these policy
steps will be if the demand for money and investment is not sensitive to changes in the
interest rate.
2. Use chain reactions to discuss and illustrate the effect of the three different methods
of financing a budget deficit on interest rates.
3. How do inflation expectations affect the task of the Reserve Bank to contain inflation?
To what extent, and how, can it manage inflation expectations?
4. In July 2019 the Reserve Bank reduced the repo rate by 0.25%. Given the mediocre
growth performance of the economy in 2018 and 2019, commentators asked why
the Bank did not reduce the repo rate further, to get a larger response? Or what was
their objective with this cut in the repo rate? Why were they willing to cut it? Discuss,
also with reference to press releases as well as the Bank’s constitutional mandate.
5. What is the Reserve Bank’s view of the potency and the appropriateness of using interest
rate policy to address high unemployment, given the nature of the unemployment
problem in South Africa? Discuss and explain. (Consult their website if you need more
information.)
6. ‘The Reserve Bank can and should create money on a large scale and transfer that
to state-owned enterprises and municipalities so that they can repay all their debt.’
Analyse, with the appropriate diagrams such as the IS-LM-BP and AS-AD curves, how
such a policy programme would impact key macroeconomic variables.

Fiscal policy:
the role of government 10
■ describe the main instruments of fiscal policy, and assess their macroeconomic impact;
■ describe and discuss the practice of fiscal policy and the budgetary cycle, including
institutional dimensions;
■ analyse and assess the policy choices that the National Treasury has to make in
conducting fiscal policy and in drawing up the annual government budget;
■ assess the constraints on choices regarding main budget aggregates;
■ analyse and evaluate the key issues regarding the budget deficit and its financing;
■ assess public debt issues, including the interaction between debt cost and monetary
policy;
■ evaluate the applicability of different deficit measures as fiscal criteria, including the key
norm of fiscal sustainability;
■ value the complexity of fiscal policy in a middle-income economy such as that of South
Africa, notably its high unemployment, poverty and inequality; and
■ assess and select the appropriate data to measure government in the macroeconomic
and budgetary context, and to avoid being misled by other economists in this regard.
This chapter considers various dimensions of fiscal policy from a macroeconomic perspective.
(Courses on public finance deal with microeconomic aspects of fiscal policy and the budget.)
The main budget of the national government, usually presented in February, is one of the
main dates on the calendar of every
economist, business person and Fiscal policy information on the internet
taxpayer. The budget is the principal The National Treasury site contains budget
policy document in which the fiscal documents of national and provincial governments,
plans and objectives of the national as well as links to other relevant sites such as
government are set out. It is of the Financial and Fiscal Commission, or various
major macroeconomic significance government departments.
and essential to understanding the This site is at: http://www.treasury.gov.za
policy steps of the fiscal authority
(the National Treasury).
A major problem in analysing fiscal policy and the budget is that it is not really possible
to consider the macroeconomic dimension in isolation – at least not in practice – for the
following reasons:
❐ Budgetary policy – notably expenditure and taxation – directly affects people at the
micro level. It has decisive micro-financial or public finance ramifications that can be
exceedingly complex. A variety of criteria and considerations are at issue, including
efficiency and equity.
Chapter 10: Fiscal policy: the role of government

395

Location of this topic in the circular flow diagram
(compare p. 240)
FOREIGN
COUNTRIES
Government
expenditure FINANCIAL
INSTITUTIONS
Government HOUSEHOLDS
FIRMS
borrowing
(deficit)
GOVERNMENT
(Budget and
fiscal policy)
Corporate taxes; Personal income
VAT tax; VAT
❐ The budget also has important political implications. People want to know: who pays?
Who gets what?
❐ These issues are also closely related to the problems of poverty and underdevelopment,
and government expenditure is regarded as an important (but perhaps overrated?) way
to address these problems.
❐ Finally, the analysis of these issues is complicated by the strong emotional and ideological
overtones of the debate on the role of government (see section 1.8 of chapter 1).
Therefore the analyst rarely has the luxury of considering only the macroeconomic aspects
of the budget. A well-considered and balanced handling of all these aspects is required.
Nevertheless, we will concentrate here, as far as possible, on the broad macroeconomic
questions concerning the budget and the fiscal role of the state in the economy. The main
instruments, choices, practical processes and macroeconomic impacts of the budget will
be analysed, with reference to the South African experience.
An important theme is the search for appropriate and usable fiscal criteria (norms) for sound
fiscal and budgetary policy. Given the history of fiscal crises in countries with considerable
developmental challenges, it is imperative to get clarity on this issue in South Africa.
This chapter will also pay intensive attention to data. The government sector is most
important in macroeconomic policy analysis. At the same time, it is one of the most difficult
396 Chapter 10: Fiscal policy: the role of government

areas of measurement. Any analyst must, therefore, be well acquainted with the pitfalls in
measuring government. These aspects are addressed in various explanatory boxes, as well
as in a rather extensive addendum. You are advised to pay serious attention to these issues.
10.1 State, government and public sector

In everyday language, people tend to use the terms state, government or public sector
interchangeably. However, greater analytical precision is necessary here. Fiscal policy
concerns the government, i.e. the state authority. (The state as such comprises the state
government and the state citizenry.) In practice, different institutional arrangements and
classifications encumber any fiscal analysis considerably.
❐ In discussions about macroeconomic issues one usually works with the general
government. This combines central government, provincial governments and local
governments.
❐ For more detailed analyses of public finances, it is usually necessary to distinguish
the various components. This is crucial in analysing budget statistics, since the main
budget does not cover all levels of government, but only the national government.
On the other hand, some arguments occur in terms of the entire public sector. This
frequently happens when the discussion does not concern fiscal policy in particular, but
the broader ideological debate on the role of the state or government in the economy.
Then, more aggregated measures and statistics are relevant.
State and public sector – key definitions

National government departments
+ Social security funds
= National government (main budget)
+ Extrabudgetary institutions (e.g. SABS)
+ Universities and universities of technology
= Central government
+ Provincial governments
+ Local governments (municipalities)
= General government
+ Public business enterprises and corporations (e.g. Transnet and Eskom)
= Public sector
10.2 Definition and instruments of fiscal policy

In the context of the normal macroeconomic framework, fiscal policy can be defined as
follows:
All deliberate efforts of government to use changes in government expenditure, taxation
(including transfers) and government borrowing to influence aggregate expenditure in order
to influence production, income, inflation and the balance of payments.
10.2 Definition and instruments of fiscal policy 397

Measuring government
Published statistics on the government sector, even different tables in one publication,
often appear difficult to reconcile. This is due to reasons such as the following:
❐ The different definitions of ‘government’ or ‘public sector’ and the inclusion or
exclusion of various institutions (universities, public corporations, etc.).
❐ Different institutions that compile data for different purposes, e.g. the Reserve Bank
as against the National Treasury, where the latter uses and publishes budget statistics
in a particular way.
❐ Different data systems, e.g. the System of National Accounts (SNA) as against the
Government Finance Statistics (GFS), each with its own definitions, interpretation,
aims, rules and conventions.
❐ SNA measures activities with regard to expenditure, production and income that
occur in a particular period, regardless of whether or when payments or cash flows
DATA TIP
occur (i.e. SNA is on an accrual basis).

❐ The GFS system will ultimately be an accruals-based system with a cash flow
statement, but in South Africa currently only contains the cash flow statement.
❐ For macroeconomic and fiscal policy analysis, the national accounts (SNA) data, as
published in the Quarterly Bulletin of the Reserve Bank, are most appropriate. At all times
one should exercise extreme caution, though, in drawing conclusions from such data.
❐ Whenever the budget is to be analysed in any detail, SNA statistics are not suitable.
❐ Rather consult the analyses presented annually in the Budget Review of the Treasury.
The ‘Public Finance’ section of the Quarterly Bulletin also provides some statistics in
GFS format.
❐ When using data provided by the National Treasury, as reported in the Budget Review,
also note that some data refer to budgeted figures (i.e. what government planned
to spend), while other data refer to the actual figures. With regard to the latter, it is
also important to remember that the data for the most recent years are recorded as
preliminary outcomes and estimates and subject to revision as the data are updated.
Addendum 10.1 and 10.2 provide more details. Study these carefully. This is an important
area for macroeconomic analysis.
This is deliberately a relatively narrow definition that excludes the broader social and
development responsibilities of the fiscal authority. A more correct and broader definition
would include social and development objectives, but would take the discussion beyond
the more-or-less restricted scope of macroeconomics. As noted above, here we consider
the budget and fiscal policy only in terms of the main fiscal aggregates: total spending and
revenue, and the total budget deficit or surplus.
❐ This does not mean that it can be done in this way in practice, no matter how much
one wishes to keep things simple. Budgetary practice and policy are necessarily
concerned with all the dimensions and details of government finances and budgetary
politics, which include various microeconomic, social, developmental and political
considerations (see section 10.8).
Formally, fiscal policy is the responsibility of the Minister of Finance. However, in the
final instance, the decisions are made by the national Cabinet. Therefore fiscal policy is
determined by the government of the day, and is basically the result of political decisions.
The relevant government department is the National Treasury.

The basic instruments of fiscal
policy are: The budget – national or general
❐ Government expenditure – both government?
the aggregate level and the Note that the main budget, which is traditionally the
composition of spending (e.g. focus of fiscal analysis, relates only to the national
current vs. capital expenditure, government, not the general government. In fiscal
or spending on economic analysis, one often has to try to draw a link between
services vs. social services). main budget figures and the parallel course of general
❐ All the kinds of direct and government figures. Often this is not altogether possible.
Still, the two levels of analysis often produce comparable
indirect tax, such as personal
results, especially if one considers broad trends.
income tax, corporate taxation,
value-added tax (VAT) and What renders the analysis more difficult in the South
excise duties. (There also are African case is that the transfer of the ‘equitable
different forms of transfers, e.g. shares’ of provinces and municipalities appears as an
pension payments, which can expenditure item in the national budget. Provinces in
South Africa do not collect their own taxes (barring
be analysed as negative taxes.)
a few exceptions), and depend for more than 90%
❐ Government borrowing, which is
of their revenue on the equitable share transfer from
a part of public debt management national government. Thus, even though the national
(see also chapter 9, section 9.5). budget does not focus on provincial expenditure, it
Proposed changes to these fiscal does include as an expenditure most of the funds that
instruments constitute the core of provinces will spend.
the annual budget of the national
government, as presented in Parliament by the Minister of Finance. The main activities
of Parliament (and parliamentary standing committees) comprise the consideration and
approval of the different budget votes, i.e. the expenditure plans of government departments
and ministries for the coming fiscal year (which starts on 1 April every year).
The macroeconomic impact of fiscal policy instruments (summary)

The theoretical analysis of the chain reactions following fiscal policy actions constitutes
the core of the theory of fiscal policy (originally seen primarily as a tool of stabilisation
policy). These have been encountered in chapters 2 to 7, and need not be repeated here. It
suffices to summarise the basic macroeconomic impact of fiscal policy steps.
(1) Government expenditure

In the Keynesian model, the primary effect of an increase in government expenditure on
the economy is expansionary (stimulating): aggregate expenditure is increased, which
induces higher production and hence income. This process materialises in a multiplier
effect, which also stimulates private expenditure. Interest rates may be pushed up as a
secondary effect, which can discourage private investment and durable consumption
expenditure (‘crowding out’). The net short-run effect on income will still be positive (see
chapter 3). For a decrease in government expenditure, the opposite process occurs.
Below we will encounter views that government expenditure can also have a negative
impact. The intellectual heritage of these views is the Classical-Monetarist tradition (see
chapter 11). The general contention is that too large a government sector progressively
decreases the scope for the private sector, thereby depriving the economy of its lifeblood
– ‘crowding out’ in a broader sense. An element of this is the negative effects, on private
economic endeavour, of the increasing tax burden that is necessary to finance a growing
government sector.

!
Review the analysis of the basic effects of government spending, taxation and borrowing on
aggregate expenditure, production, the price level and rate of inflation (chapters 2, 3, 4, 6 and 7).
Give particular attention to the discussion of the factors influencing the potency of fiscal policy
with regard to its influence on real income.
Chapter 2 Government expenditure and taxation in the 45° diagram, including the
section 2.2.5 expenditure, tax and balanced budget multipliers.
Chapter 3 The crowding-out effect of government expenditure, and the factors that
section 3.2.2 determine the extent of crowding out, in the 45° diagram.
Chapter 3 The macroeconomic impact of the three different methods of financing the
section 3.2.3 budget deficit.
Chapter 3 The impact of fiscal expansion or contraction in the IS-LM diagram.
section 3.3.6
Chapter 3 Factors that affect the potency of fiscal policy (or the strength of the crowding-
section 3.3.7 out effect) in terms of the slopes of the IS and LM curves.
Chapter 4 he impact of the balance of payments adjustment process on the chain
T
section 4.5.2 reaction following a fiscal policy step.
Chapter 4 The balance of payments adjustment process following a fiscal policy step in
section 4.7.5 IS-LM-BP context.
Chapter 6 The impact of fiscal expansion on real income and the average price level in
section 6.4.2 the AD-AS model.
Chapter 7 emand expansion and contraction in the inflationary context, and important
D
section 7.1 Phillips-curve lessons for policymakers.
(2) Taxation
In the simple Keynesian model, the main effect of taxation is on the demand side:
taxation decreases the disposable income of households (and after-tax profits of business
enterprises); this restricts aggregate expenditure and consequently constrains production,
income and employment creation. One important result is that, while new taxes to finance
increases in government expenditure will inhibit the initial stimulation of aggregate
demand, they will not cancel the stimulation (the initial rightward shift of the AD curve is
only partially reversed).
The more sophisticated Keynesian model acknowledges that taxation can also have cost or
supply effects. These relate mainly to cost and price consequences of tax increases.
❐ Targeted tax relief or subsidies that reduce the cost of production affect the supply
side positively (the AS curve shifts right). This can relieve inflationary pressures, and
stimulate output.
❐ Income tax increases can be an important source of recurrent demands for wage
increases. Therefore such tax increases cannot summarily be regarded as anti-
inflationary – the negative supply-side effect (upward pressure on costs and hence
prices) can be stronger than the demand-constraining effect (downward pressure on
prices).
❐ Indirect taxes such as excise duties on cigarettes or liquor or luxury items, and especially
the fuel levy, are regarded by most consumers and vendors as a direct cost.1 Hence these
can also cause upward pressure on prices.
1 The manner in which the inflation rate is calculated, using the consumer price index, will in any case introduce a
definite inflationary effect if the fuel levy is increased, for example.

(3) Government borrowing
The macroeconomic effects of government borrowing to finance a budget deficit depend
on the manner in which the deficit is financed:
❐ Domestic loans from the private non-banking sector ⇒ an addition to the demand for
money ⇒ upward pressure on interest rates ⇒ contractionary impact.
❐ Domestic loans from the Reserve Bank ⇒ monetary injection ⇒ money stock increased
⇒ downward pressure on interest rates ⇒ expansionary impact.
❐ Foreign loans ⇒ inflow of funds ⇒ monetary expansion ⇒ downward pressure on
interest rates ⇒ expansionary impact.
Given an understanding of these consequences and likely chain reactions, these seem to be
powerful instruments in the hands of the fiscal authority. If government has a reasonable
indication of the strength, speed and extent of these different impacts – including the
sizes of the different multipliers and elasticity values – it is possible, in theory, to plan and
calibrate policy steps to bring about desired changes in macroeconomic variables.
However, in practice, there are so many uncertainties and gaps in our understanding of
these matters – aggravated by the fundamental truth that the economy does not work in
a mechanically predictable way – that fiscal policy can seldom be applied so neatly and
successfully. In this sense, macroeconomic theory is misleading, because it tends to create
the impression that chosen objectives can be achieved quite easily simply by using policy
to ‘shift a few curves’ to attain certain equilibrium points. Today there is much doubt as
to whether it is possible or desirable to use, or attempt to use, fiscal policy in this way. At
the very least, one should not overrate the ability of the fiscal authority to fine-tune the
economy in an accurate and predictable manner. (These limitations are analysed further
in chapter 11.)
Nevertheless, fiscal expansion can provide an important stimulus for a stagnating
economy, and an overly restrictive fiscal stance can significantly inhibit economic growth.
Moreover, it is always true that, whether it was the intention of the government or not,
budgetary decisions are likely to have a significant impact on macroeconomic conditions.
Therefore a minimum requirement is that the fiscal authority must explicitly consider the
likely consequences of its policy steps. Accordingly, the theory of fiscal policy continues to
be important, despite the various uncertainties and limitations.
Digression: who really determines fiscal policy?

Despite the formal position of the Minister of Finance in budgetary affairs, it is not so simple to
determine who really determines fiscal policy in practice. It depends on a complex interaction between
different personalities, as well as institutional complexities.
❐ The influence of a Minister of Finance in the Cabinet depends on seniority in the Cabinet, personal
stature, seniority and position in the political party, background in economics and public finance,
even age and gender. The person appointed as Minister often has little or no background in fiscal
affairs.
❐ The Minister’s effectiveness also depends on his or her stature in the policy arena in Pretoria, where
the Minister must make his or her influence felt between economic heavyweights at institutions such
as the Reserve Bank (each with its own agenda and ambitions).
❐ Of similar importance is stature in the business world and the financial news media, which can
sometimes make or break a Minister of Finance.
⇒

⇒
Other important role-players include:
❐ Voters, who increasingly demand a direct say in the affairs of government.
❐ Parliament, which must formally approve the budget but which has had only limited powers to
actually amend the budget until 2009 (see section 10.5.4).
❐ Parliamentary standing committees such as the standing committee on public accounts, the standing
committee on finance and the standing committee on appropriations.
❐ The Financial and Fiscal Commission, which has the task of designing and overseeing the system
of intergovernmental fiscal relations and making recommendations on fiscal policy matters to all
tiers of government.
Two important pressure groups are the business sector and the labour unions. Representative business
organisations such as Business Unity South Africa (BUSA), and even well-connected individuals can
significantly influence a Minister of Finance. Likewise, the organised labour union movement (e.g.
Cosatu) can be very assertive and influential in this regard.
❐ This will depend a lot on a Minister’s background and the group with which he or she feels at home
intellectually, be it business or labour unions or university academics. (It can even depend on the
Minister’s golf partner over the weekend!)
Other important role-players are international organisations such as the International Monetary Fund
(IMF), the World Bank, and international financial and business interests.
❐ The IMF releases, for each member country (thus, also for South Africa), an annual Article IV Staff
Report. This report deals with the economic conditions in a country and focuses on issues such as
fiscal and monetary policy.
❐ International credit rating agencies such as Standard and Poor’s, Moody’s and Fitch also issue
reports and award the country a sovereign credit rating. A sovereign credit rating refers to the ability
of government to repay its loans. A low rating means that the government and possibly also private
borrowers will pay higher interest rates on their international loans.
❐ In addition to these formal reports by the IMF and credit rating agencies, the influence of international
role-players also occurs in the form of informal influence.
❐ If a country has to get financing from the IMF, for example, the conditions of the loan can have a
significant impact on fiscal policy and the budget and can severely circumscribe policy options.
10.3 The choice of overarching policy objectives

In contrast to the Reserve Bank, the fiscal authority does not have an official mission
statement in which its objectives are formulated explicitly and clearly. At most, one can
only attempt to deduce its approach from recent budget documents.
It is not easy to reduce the objectives of the fiscal authority to a few aims, since the
budget displays a large spectrum of dimensions. Typically this includes typically
macroeconomic aspects as well as all the complexities of government services, economic
infrastructure, social conditions, poverty and the development situation. In addition,
the budget constitutes the financial manifestation of the plans of the political authority
for the coming year. Therefore it concerns a variety of political objectives. (In this sense
monetary policy is actually fairly simple: it concerns a clearly defined area of responsibility
and clearly specified objectives and instruments. However, there is disagreement on the
extent to which the Reserve Bank can or should distance itself from social and political
considerations.)

Some people might expect something like ‘the pursuit of high employment levels’ as a
more-or-less obvious formulation to parallel the Reserve Bank focus on inflation. However,
if one is to formulate a mission for the fiscal authority, it would have to include broader
social, economic and development objectives, something like ‘the improvement of the
well-being of all the people in the country’ (though such a statement might be a bit fuzzy
and as a result quickly become devoid of real meaning).
❐ In his budget speech of 2014, the Minister of Finance indicated such sentiments when
he stated: ‘Our plans for the period ahead are focused on the transformation imperatives
that will accelerate growth, create work opportunities and build a more equal society.
This Budget lays the foundation for the structural reforms envisaged. … It is time to move
South Africa forward to the next stage of our historic journey to more rapid growth, jobs
and development – time to leave behind poverty, joblessness and inequality!’
❐ However, by the 2019 budget speech the severe deterioration of the economy had
narrowed the Minister’s options, and focus, to a very succinct set of objectives. He
stated that ‘this Budget is built on six fundamental prescripts: achieving a higher rate
of economic growth; increasing tax collection; reasonable, affordable expenditure;
stabilising and reducing debt; reconfiguring state-owned enterprises; and managing
the public sector wage bill. It will not be easy. There are no quick fixes. But our nation is
ready for renewal. We are ready to plant the seeds of our future’.
❐ These formulations suggest a realisation of the complex coherence, but also trade-
offs, between broader socio-economic objectives and macroeconomic considerations
or constraints (compare chapter 1). The meaningful realisation of this coherence in
practice is one of the greatest challenges facing the fiscal authority in South Africa.
What does the acceptance of such a mission imply for the macroeconomic responsibilities
of the fiscal authority? Throughout the 1990s and early 2000s, the National Treasury
appeared to have accepted the international shift away from adopting active short-run
stabilisation goals to a focus on long-run structural balance in the economy. Yet, while
the fiscal authority may not take explicit responsibility for short-run macroeconomic goals
(stabilisation), the underpinning of sustainable, long-run growth and employment creation
always features prominently.
However, the onset of the international financial and banking crisis in 2008 led to a
move by several industrial-country governments, including the USA, UK and Germany,
to announce some of the largest short-run stabilisation packages in economic history –
introducing a new focus on short-run stabilisation goals. The public debt/GDP ratio of most
high-income economies increased significantly; fiscal crises in Portugal, Italy, Greece and
Spain (the so-called PIGS countries) were at the heart of the Euro crisis of 2011–12 (read
the case study in section 4.8). To reduce their budget deficits and growth in public debt/
GDP ratios, they had to implement tax increases as well as severe expenditure cutbacks, as
did countries such as the UK and USA.
Fiscally, South Africa withstood the international financial crisis quite well. The budget
balance went into deficit and the public debt/GDP ratio increased – but it was still far from
crisis levels (and even below levels in the 1990s – see table 10.4). However, a combination
of low economic growth that constrained tax collections and an unwillingness to cut
expenditure to match revenue, led to large budget deficits. This caused the public debt/
GDP ratio to increase unceasingly from 26.5% in 2008 to 56.7% in 2018. The public debt/
GDP ratio more than doubled within a decade to a level not seen in 60 years.
10.3 The choice of overarching policy objectives 403

The development of fiscal policy
Prior to the Great Depression of the 1930s, fiscal policy was largely concerned with the administrative
and accounting aspects of budgeting. Macroeconomic objectives and concerns were not part of the
vocabulary of budget officials. (Of course, this also was before macroeconomics as a discipline had really
come into existence.)
The ‘New Deal’ policy in the United States and the Keynesian era changed all this thoroughly and
forever. Attempting to attain macroeconomic balance, or adopting employment as a budgetary policy
objective, became commonplace. The budget came to be viewed as a functional instrument to manage
the macroeconomy (especially in an anti-cyclical or stabilisation sense). Concurrently, the extent of
government expenditure increased markedly in most countries.
❐ In South Africa, the macroeconomic implications of the budget began receiving explicit attention from
the middle of the 1950s. Functional or anti-cyclical policy gained general acceptance during the 1960s
and early 1970s.
After the OPEC oil crisis of 1973 and subsequent periods of severe stagflation (recession plus inflation
due to supply shocks), the Keynesian policy approach was amended. A rather unsatisfactory policy record
as well as a growing realisation that the management of the economy is fraught with practical difficulties
contributed to a more modest approach to stabilisation policy. Also, the possible negative impact of
excessive government expenditure and taxation came to be recognised. A general decline in the growth
trend also brought about a shift in focus to longer-term, non-cyclical considerations.
❐ In South Africa, the focus shifted to inflation and economic growth (with the BoP as added concern),
while fiscal discipline appeared on the fiscal agenda. (This was partly due to the increasing influence of
Monetarist thinking, which sees no role for anti-cyclical fiscal policy, and sees government intervention
in the economy as the main cause of both inflation and the poor growth performance.)
❐ After 1983, socio-economic considerations started to play a larger role in fiscal policy (especially in the
era of Minister Barend du Plessis). However, when anti-apartheid financial sanctions were instituted
against South Africa in the second half of the 1980s, BoP problems demanded priority treatment.
Fiscal discipline became difficult to maintain and social considerations declined in prominence. In
the early 1990s it was again given centre stage in the form of a deficit reduction target (with socio-
economic and development objectives secondary). This was the approach of Derek Keys, who
was retained as Minister of Finance by President Mandela in 1994, as well as his successor, Chris
Liebenberg.
❐ Trevor Manuel, Minister of Finance from 1996 to 2009, continued the theme of fiscal discipline in
recognition of the restraints placed on countries by international financial markets, especially countries
in political transition or with a history of fiscal problems. (Excessive budget deficits tend to be
‘punished’ by currency depreciation.)
❐ In 1996, the government introduced the Growth, Employment and Redistribution (GEAR) programme.
For the most part, GEAR is a mainstream macroeconomic stabilisation policy aimed at setting the
scene for a higher economic growth rate and higher employment. A key component is the reduction of
the budget deficit. The aim was to reduce the deficit to 3% of GDP and the tax burden to 25% of GDP
by 2000. Broadly speaking, these objectives were realised by government.2
❐ In GEAR, socio-economic and development objectives are said to have been of secondary
importance. However, the share of social expenditure in total government expenditure increased
steadily (within the budget constraints set by GEAR). In this way the government sought to reconcile
the socio-economic and development objectives of the Reconstruction and Development Programme
(RDP) with the principles of sound public finance. However, some commentators (particularly from the
labour unions) still accused government of abandoning the RDP in favour of GEAR.
⇒
2 With regard to the other objectives of GEAR, e.g. higher economic growth, employment and investment, the policy
has been less successful. These variables, unlike the deficit and the tax burden, are not under the direct control of
government and essentially depend on private sector activities, given a policy environment. Government cannot bear
the sole responsibility for the lacklustre growth, employment and investment performance of the economy.

⇒ ❐ Given the success of GEAR in reducing the budget deficit and the public debt burden, the interest cost
of government as share of the total government expenditure decreased sharply. This, combined with
rising tax revenues due to more efficient tax collections by SARS as well as the high economic growth
rates of the Manuel era, left government much more scope to increase social spending, for example
on social grants and benefits.
❐ The expansion of social grants and related entitlements indicated an important new phase,
characterised by a more explicit pro-poor focus. In 2003, approximately 7 million South Africans were
receiving some kind of government grant. By 2018 this number had risen to 17.5 million. While playing
a crucial role to alleviate the burden of those in poverty, such entitlements have major long-term
implications for the fiscal balancing act required of a Minister of Finance (such as Pravin Gordhan,
appointed in 2009, and his successors).
❐ Since 2009 there have been two key policy frameworks: the New Growth Path (NGP) of 2010 and the
National Development Plan (NDP) of 2012. Whereas the NGP focuses on the generation of labour-
intensive growth and industrial policy, the NDP displays a broad concern with the development of human
capabilities, the inclusivity of growth and the reduction of unemployment and poverty. Public sector
investment, particularly in infrastructure, is a key component of the NDP, which projects the creation of an
additional 11 million jobs by 2030. (See section 12.5 for a discussion of the NGP and NDP.)
❐ After the 2007–08 international financial crisis and the worldwide recession that followed, the South
African economy never fully recuperated – and government’s fiscal position deteriorated for several
years. Given concurrent expectations that the government would play a major role in the pursuit of
NDP goals, coupled with ambitious plans for a multibillion rand National Health Insurance system and
free higher education, the fiscus would have difficult choices in funding efforts to stimulate growth,
development, employment and poverty reduction. Minister of Finance Nhlanhla Nene, appointed in
May 2014, would face a daunting task.
❐ Growing fears about policy inconsistency (e.g. whether the NDP was still being implemented),
corruption and the mismanagement of both the broad economy and state-owned enterprises in
particular, led to low levels of investor, business and consumer confidence. The alarming hiring and
firing by president Zuma of several Ministers of Finance (Van Rooyen, Gordan, Gigaba) within a
relatively short period of time contributed hugely to this, inhibiting investment and even consumer
expenditure, and thus aggregate demand. As a result, from 2014 to 2018 economic growth sputtered
below 2% and even 1% per year. While the low economic growth significantly depressed tax revenue,
government failed to cut its expenditure correspondingly, causing the budget deficit, and thus public
debt, to grow markedly relative to GDP.
❐ In addition, the rapidly imploding financial position of state-owned enterprises (SOEs) pushed up
government expenditure as the government paid billions of rands over to SOEs to stave off insolvency.
Also, by 2018 government guarantees to SOEs (excluding other contingent liabilities) increased to well
over 10% of GDP, with the probability of these guarantees being called up, increasing.
❐ A degree of confidence was only restored with the reappointment by president Ramaphosa of
Nhlanhla Nene in February 2018 and especially Tito Mboweni as Minister of Finance in October 2018.
In June 2019 the NDP was also reaffirmed as the framework for prioritising fiscal and other policies.
❐ However, by October 2019 the government’s medium-term budget policy statement showed that the
public debt/GDP ratio was set to increase to 80% by 2027/28, including bail-out support for Eskom.
Also contributing was much lower projected economic growth, and thus tax revenue, than expected
previously. Drastic decisions by government would be required to avoid this scenario.
10.4 Constraints on fiscal policy choices

As noted above, fiscal theory may give an inaccurate impression of the ease (or otherwise)
with which the economy can be manipulated to achieve specific objectives. In practice, the
fiscal authority faces many constraints. Some of these derive from institutional rigidities;
others from fixed financial commitments or from the inherent nature of economic
relationships and behaviour.
10.4 Constraints on fiscal policy choices 405

First, the institutional context in which the budget is drawn up and approved, eventually,
does not promote quick and flexible policy behaviour. The entire process of the long budget
cycle, including the lengthy approval procedures in Parliament, implies that it is quite
difficult to turn the fiscal ship.
Second, the nature of, for example, government expenditure implies a limited ability to
change fiscal variables in the short run. Even if the fiscal authority wishes to pursue short-
run stabilisation objectives, it will face problems such as the following:
❐ Government expenditure items are usually of such a nature – expenditure on wages
and salaries, on schools, hospitals, roads, etc. – that they cannot be increased or
decreased readily in the short run without severely disrupting the activities concerned
or running up against contractual commitments and legal obligations. Any desired
changes to overall expenditure levels (and even the composition of spending) may take
several years to accomplish.
❐ By contrast, taxation can be adjusted much more easily to pursue anti-cyclical or other
short-run objectives. However, as we will see below, such decisions can never be taken
in isolation, which implies another set of constraints.
❐ The manner in which the budget deficit is financed can be used, at least to some extent,
to address cyclical concerns, i.e. by using contractionary or expansionary methods of
financing. These options are constrained by the role of monetary considerations in the
management of public debt (see chapter 9).
The most binding constraints flow from certain fixed linkages between economic and
fiscal variables.
10.4.1 The sectoral balance identities

The sectoral balances discussed in chapter 5 reveal macroeconomic constraints on fiscal
policy that derive from an important coherence between the private sector, the government
sector and the foreign sector. Consider the following form of the identity (interpretation 3,
chapter 5, section 5.4.3):
T – GC = (I* – S) + (X + TR – M)
where GC is current expenditure and T is current revenue of general government. Important
elements of the revenue and expenditure of the general government are present, i.e. the
current fiscal deficit (T– GC) and general government investment, also called ‘fixed capital
formation by government’ (which is included in I*).
In planning government current expenditure and current revenue (especially taxation), the
government must realise that its decisions will necessarily reflect in either the investment–
saving gap or the current account of the BoP (or both). Depending on the position in each
of these sectors, the fiscal authority may be constrained in its policy options.
❐ For example, if a current account deficit cannot be tolerated, a current budget deficit
is possible only if domestic saving exceeds domestic investment by a significant
margin. This was the position in South Africa at the end of the 1980s, when financial
sanctions caused severe capital outflows and a current account surplus had to be
maintained to finance the capital outflow. Therefore policy (especially monetary
policy) had to be used to depress capital formation (and thus GDP) sufficiently below
domestic saving – given a current fiscal deficit (government dissaving) and low levels
of private saving.

❐ However, if capital inflows are sufficient so that (X + TR – M) can be allowed to be
negative (the case since 1994), a current budget deficit ceases to be much of a problem.
In such conditions, the fiscal authorities have much more room to manoeuvre.
Capital inflows also give the government more room to increase its own capital expenditure
(government investment). Such an inflow expands the domestic funds available to finance
gross domestic capital formation. Consequently, the government can claim a larger share
of the domestic funds pool without any danger of crowding out private capital formation
due to a shortage of funds (savings).
In determining fiscal policy and the budget, therefore, the fiscal authority must be keenly
aware of the sectoral impact of a current deficit/surplus and of its capital expenditure, as
well as the constraints on fiscal options that may derive from the situation in the external
sector at the time.
❐ One must bear in mind, however, that the main budget and the deficit are concerned
only with the national government and not the general government (which is the
relevant entity in the case of the sectoral balance identities).
10.4.2 The budget identity

Important constraints on fiscal choice derive from the intrinsic coherence between the
three main instruments of fiscal policy: expenditure, revenue and the deficit (or surplus).
This coherence can be seen in the budget identity:
Budget deficit = Total government expenditure – total government revenue
This identity implies that the three elements cannot be manipulated independently of one
another. If values for two are chosen, the third is determined automatically. Therefore
decisions on each element can never occur in isolation:
❐ If a smaller deficit is desired, it will require either expenditure cuts or increases in
revenue (taxation), or both.
❐ If tax relief is a goal, one
must be willing to accept Current vs. capital expenditure
either a larger deficit or a cut
❐ Current expenditure mainly comprises the wages
in government expenditure,
of government employees, interest on public
or both. debt, subsidies, and transfers to households
As a result, specific numerical (mostly social pensions). The wage bill and
targets cannot be determined interest are the dominant components of
independently. For example, if current expenditure. Government consumption
the deficit is to be kept at 3% of expenditure is a subset of its current expenditure.
(See addendum 10.1.)
GDP and total tax revenue not
❐ Capital expenditure includes the acquisition
higher than 25% of GDP (the
of fixed capital assets, land, stock and other
GEAR targets), then aggregate intangible assets, and capital transfers to
government expenditure may businesses and households. Government
not exceed 28% of GDP. investment is a subset of this, and pertains only
A similar restriction applies to capital formation (new capital assets, e.g.
construction of roads). (See addendum 10.1.)
when one considers the sub-
components of each of these
three elements. An important instance concerns the distinction between the current
and the capital expenditure of government (or, between gov ernment consumption

expenditure and government investment). This is called the economic classification of
government expenditure.3
These two expenditure components cannot be manipulated independently of each other
or of the main elements of the budget identity.4 If the fiscal authority intends to increase
government capital formation, for example, it must implement a decrease in current
expenditure, unless it is willing to accept an increase in total expenditure (current plus
capital expenditure). Obviously, the latter option requires either a tax increase or a larger
deficit, as noted above.
An additional problem, in making the decision between current and capital expenditure,
is that the latter usually has future current expenditure implications: roads that are
built require maintenance later (current expenditure); buildings must be painted and
cleaned periodically; if schools or hospitals are built, annual provision must be made for
considerable current expenditure on staff, equipment and consumable items.
This distinction between current and capital expenditure is important to the extent that
investment (i.e. capital formation) is thought to be more potent as a source of economic
growth than current expenditure (which is largely consumption expenditure). However,
this is yet another source of controversy.
10.4.3 Fixed budgetary commitments

There are three important areas in which government has a fixed commitment to
expenditure: payment of interest on government loans, transfers to households, and the
remuneration of government employees.
An important constraint on fiscal policy choices derives from the interest obligations of
government with regard to prior government loans, i.e. the cost of existing public debt.
The government is contractually bound to the payment of this interest. Therefore this
component has a first claim on government funds. As such, it reduces the flexibility and
leeway on the expenditure side of the budget.
❐ Since public debt is the result of the accumulated budget deficits in the past, this
serves to highlight the fact that the current decision on the deficit also has important
implications for the government’s fiscal room for manoeuvre in years to come.
Some forms of government expenditure also derive from the legal entitlements of
individuals. If the law entitles people to receive certain state pensions, for example, the
fiscal authority is compelled to provide funds for the necessary expenditure. Thus there
is an expenditure category called transfers to households, where the fiscal authority has
almost no discretionary power.
❐ The level of this spending category depends on demographic trends as well as poverty
patterns. This is one reason why steps to address poverty and underdevelopment should
be an important part of the overall policy package. Otherwise these social entitlements
may simply continue to grow, eventually causing severe fiscal stress.
3 Another classification is the so-called functional classification of government expenditure. This shows the allocation between
functions such as general government services, defence, education, health, welfare, housing, agriculture and mining.
4 A similar distinction can be made between the current and the capital revenue of government. However, this is less
important as capital revenue usually constitutes a very small share of total revenue.

✍ What promotes growth – government consumption spending or capital
spending?
From a conventional economic point of view, it appears that capital expenditure is best by
far. Investment in, for example, infrastructure forms the foundation of expanding economic
activities, especially in the private sector. Government consumption expenditure, by contrast,
appears to use resources for the satisfaction of immediate needs, which contribute little to
long-run growth.
However, from a broader development perspective, it is argued that investment in human
capital is just as important as physical capital, or perhaps even more important. This implies
that a significant portion of the current expenditure that goes towards education and medical
services – which builds human capacity and develops individual human potential – can be a
powerful source of progress, development and economic growth. This implies, further, that it is
wrong to regard current expenditure on human capital formation as inferior or as expenditure
that has no return. (In addition, not all physical capital necessarily contributes significantly to
economic growth.)
This is one of the most important issues facing a government, especially in a country with
underdevelopment problems. What is your view on this?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
The determinants of growth, including human capital, are discussed in chapter 8 (on growth
theory) and chapter 12, section 12.3. Also see the discussion of the different budget balance
concepts in sections 10.5.3 and 10.7.3, where this distinction also features.
❐ As mentioned in chapter 1, in the 2018/19 fiscal year more than 17 million South
Africans received some form of a grant. This number constitutes almost a third of
the South African population. Though some of these grants are small, they make a
significant contribution to alleviate poverty among the poorest 40% of households.
Because unemployment levels are very high, these grants often constitute the only
source of income for poor households.
A final threat to fiscal discretion is the item compensation of employees. This constitutes
approximately 33.1% of expenditure by consolidated national and provincial governments
and social security funds in the 2018/19 budget (see table 5 of the 2019 Budget Review).
Between 2008 and 2018 the general government’s salary bill as a percentage of GDP
increased from approximately 11% to 14%. After adjusting for inflation, the average
government wage rose by 66% in 10 years. Since it is difficult to reduce staff numbers in
the public service, a growing salary and wage bill due to above-inflation wage increases,
built-in remuneration and seniority growth, or growing government employment
numbers can put severe constraints on the fiscal authority. Once a general wage increase
has been decided or negotiated, the largest single component of government expenditure
has been fixed.

Components of government expenditure5
Total expenditure = Capital expenditure + Current expenditure
= Capital expenditure + [Current payments + Transfers and subsidies]
= Capital expenditure + [Interest and rent + Non-interest (and non-rent) current payments] +
Transfers and subsidies
= Capital expenditure + Interest and rent + [Compensation of employees + Expenditure on
goods and services + Financial transactions in assets and liabilities] + Transfers and subsidies
The last terms in italics in the box above, i.e. ‘compensation of employees’ plus ‘expenditure
on goods and services’, constitute government consumption expenditure (GC).
❐ ‘Interest’ is primarily interest paid on public debt.
❐ ‘Transfers’ include social pensions and other government grants to households, e.g.
child grants and disability grants.
Table 10.1 presents the 2018/19 breakdown of the above categories for general
government (excluding municipalities). (This breakdown is only reported in the Budget
Review and not in the national accounts, so the totals may not be strictly comparable to
SNA data). Notice that current expenditure constitutes 96.8% of government expenditure.
The single largest component of this is subsidies and transfers, followed by compensation
of employees. Interest payments constitute 11.5% of general government expenditure. In
the mid-1990s this component was approximately 20%.
Table 10.1 Components of expenditure and total consolidated expenditure of
general government (2018/9 fiscal year)
R million %
Current Expenditure 1 526 163 95.9
Current payments 901 907 56.7
Compensation of employees 527 047 33.1
Goods and services 192 192 12.1
Interest and rent on land 182 668 11.5
Transfers and subsidies 624 257 39.2
Social benefits 60 629 3.8
Other transfers and subsidies 563 628 35.4
Payments for capital assets 50 543 3.2
Total consolidated expenditure 1 590 727 100
Source: Budget Review 2019, table 5.
It is important to realise that many of these components cannot be changed readily,

especially in the short or medium term. After the interest component, salaries and wages,
and pensions have been determined, there is little room left to change expenditure. Many
of these constraints derive from previous budgetary policy decisions. These, as well as
5 According to Table 5, Budget Review (2009). Also see addendum 10.1.

institutional constraints, severely hamper the government in its efforts to cut the overall
level of expenditure. As a result, government expenditure tends to have an upward bias.
This explains the concern about fiscal discipline.
10.5 The decision on the main fiscal aggregates

In a macroeconomic sense, the main focus is on the main fiscal aggregates – aggregate
expenditure, aggregate revenue and the budget balances.
10.5.1 Aggregate government expenditure

The decision on the overall level of government expenditure is one of the most contentious
issues in the fiscal policy debate.
One view is that government in South Africa claims too large a portion of the total
economy, it crowds out private economic activity, and in this way saps the vitality of the
private sector – ‘the engine of economic growth’. This is aggravated by the numerous
government regulations on private economic activity. This is largely the view of the
organised business sector.
Another view is that the normal operation of the market has so many gaps and flaws
that the government has no choice: it has to act and vigorously pursue employment,
distribution and development objectives. This is the view largely found in the political and
trade union establishment.
One should also remember the general Keynesian result, summarised in section 10.2
above, that an increase in government expenditure is likely to stimulate economic activity,
GDP and employment, albeit with possible crowding-out (and other adverse) effects.
The historical and political-economic background of the current situation, including
the extent of poverty and discrepancies in living standards, puts immense pressure
on government expenditure. Population growth, the further extension of democracy,
increasing urbanisation, the pursuit of equal educational opportunities and so forth, are
likely to increase the demand for government-provided services in future. Therefore the level
of government expenditure will continue to be critically important in the fiscal debate.
Table 10.2 presents selected data on general government expenditure as a percentage of
GDP since 1960. The data are SNA data on government consumption and investment.
Note that many items
Table 10.2 Government consumption and investment as a ratio of GDP (SNA data)
of government cur
rent expenditure, not Government Government Total government
ably transfers to house consumption investment expenditure
holds, are not included 1960 9.3 7.0 16.3
in these numbers. (This 1970 11.9 8.7 20.6
explains why the govern
ment expenditure ratio is 1980 13.0 7.9 20.9
significantly lower than 1990 18.6 5.3 23.9

in main budget data – 2000 18.4 2.7 21.1
see addendum 10.1.)
2010 20.2 2.8 23.0
In a macroeconomic
sense this may not be 2018 21.3 3.0 24.3
inappropriate, though. If Source: South African Reserve Bank, national accounts (www.resbank.co.za).
10.5 The decision on the main fiscal aggregates 411

what matters is the flow of real expenditure through the actions of government, the SNA
total is the correct one.6
The total figure for general government expenditure indicates that amid the fluctuations
there is a clear increase, from 1960, in the government expenditure ratio. The graph in
figure 10.1 shows the course of total government expenditure since 1960. There was
a significant increase from approximately 16.5% in 1960 to a (brief) peak of 26.5% in
1976. After that a decline set in, reaching a lowest point of 20.7% in 1995, followed by a
slow increase – and a much stronger increase from 2008 onwards. Still, for 30 years since
1978 the government expenditure to GDP ratio has stayed inside a channel between 22%
and 25% (in terms of SNA figures; see box on measurement below).
How reliable are the official budgets?

In the 1980s, the government regularly exceeded budgeted expenditure levels by between
5% and 9%. This lack of fiscal control seriously undermined the credibility of official
budgeted expenditure figures. Between the late 1990s and the late 2000s several government
departments (both on national and provincial levels) spent less than the amount budgeted for
them, while tax collections by the South African Revenue Service (SARS) often exceeded the
planned amount of taxes, as projected in national budget. Since 2010 the reverse happened,
with departments overspending and revenue falling short of budgetary projections. The latter
in particular contributed significantly to actual deficits turning out to be much larger than
budgeted for.
❐ This highlights the point that the budget provides only budgeted figures, i.e. planned
expenditure and revenue, given conditions at that stage. Changing circumstances and
changes in policy due to pressure groups, as well as improved efficiency in revenue
collection, can significantly influence the outcome of the fiscal process.
❐ Also note that tax revenue or certain categories of government expenditure such as
unemployment benefits can also diverge considerably from initial projections if the
economy stagnates or grows unexpectedly.
The government expenditure ratio – which data?

DATA TIP
Earlier in this chapter the difficulties in measuring government were noted. These
are most important when measuring government expenditure. In policy analysis, the
importance of government expenditure lies in two contexts: macroeconomic and public
financial. Each requires different usage of data and data sources. These are explained in
an addendum to this chapter. It suffices here to note the following:
⇒
6 Care should be taken in interpreting the ‘total government expenditure’ figure in the national accounts and in
table 10.2 – as against main budget data in the Budget Review. It shows the sum of the government consumption
and investment figures, and would therefore exclude many components such as grants and transfers, as well as
interest payments usually included in budgetary (but not SNA) data. However, subsidies represent negative taxes
(i.e. government pays rather than receives), transfers and grants represent redistributions of income, and interest
represents a factor payment. Thus, these components are not seen as true expenditure components in the national
accounts system, i.e. they are not seen as expenditure on goods and services. (In terms of the circular flow presented
in chapter 2, subsidies, grants and transfers, as well as interest, belong to the bottom half of the circular flow, while
government consumption and investment belongs to the top half). For more, see addendum 10.1.

⇒
Context 1: The net addition of government expenditure to aggregate expenditure,
production and income – i.e. in the context of the macroeconomic circular flow of
income and expenditure, [C + I* + GC + (X – M)]. In this case, the national accounts
data (‘expenditure on gross domestic product’ tables) on government consumption
expenditure and government capital formation are relevant. These data refer to the
general government, and are available for calendar years.
Context 2: The funds that flow through the expenditure side of the national budget (i.e.
the public finance context). The budget data are supplied by the Treasury in the Budget
Review. These pertain only to the national government, and exclude portions of provincial
expenditure (as reflected in the equitable share transfer recorded in the national budget)
and all local government expenditure. They also pertain to fiscal years, i.e. from 1 April
to 31 March of the next year. The budget data distinguish between current and capital
expenditure. In both cases, there are significant differences as compared to the national
accounts figures.
❐ On the current expenditure side, the budget figures include – in addition to
government consumption expenditure – budgetary expenditure on interest payments,
subsidies, and transfers to households (mainly pensions). These are relevant for the
public finances in that they have to be financed by taxation or borrowing. However,
DATA TIP (continued)
since the funds will eventually be spent by households and business enterprises, their
impact on aggregate macroeconomic expenditure and GDP will be captured in the C, I
and M components of domestic expenditure in the national accounts.
❐ On the capital expenditure side, the budget figures include – in addition to
government investment in the creation of new real assets – government expenditure
on the acquisition of existing real assets. This does not constitute new investment
(capital formation) but merely a transfer of existing physical assets. Hence it is no net
addition to total real expenditure in the economy. Capital expenditure also includes
capital transfers.
Hence the budget figures overstate real government expenditure in the macroeconomic
expenditure sense. Using the budget figures of total government expenditure rather than
the national accounts figures of general government expenditure will give significantly
different impressions of the scope of government expenditure.
❐ According to the 2019 Budget Review, total consolidated government expenditure in
South Africa for the fiscal year 2018/19 was 29.8% of GDP.
❐ According to the national accounts, total expenditure for general government for the
calendar year 2018 was 24.3%.
Addendum 10.1 provides a detailed analysis of different data sources for measuring total
government expenditure, also illustrating the widely differing values obtained.
For a macroeconomic analysis of expenditure, production and income, the national
accounts (SNA) figure is the correct one to use. This is shown in table 10.2.
❐ Still, the budget figures are important in that they show the total amount of funds that
flow through the hands of the national government in a fiscal year.
❐ If one wishes to compare a government expenditure ratio to a tax ratio to compute the
budget deficit as a percentage of GDP (see below), the budget figure must be used.

Is there an optimal level of aggregate government expenditure? Should the fiscal authority
target a specific level or ratio?
This is one of the chief issues in fiscal economics, to a large extent due to it being linked
to the ideological battle over the role of government relative to the role of the market –
the stereotyped and sometimes sterile ‘free market vs. socialism’ debate. Extreme free
marketeers (often called Libertarians), Monetarists and New Classical economists,
Keynesians and Social Democrats, and Democratic Socialists and extreme Socialists all
have different views on this general issue (compare chapter 1, section 1.8.1).
❐ Free marketeers often designate 25% of GDP (at most) as a golden rule for government
expenditure. Keynesians and social democrats would be at ease with a figure of between
25% and 35%. As one moves closer to the extreme socialist pole of the debate, a higher
percentage becomes acceptable.
❐ None of these figures has a solid theoretical grounding. Economic theory has not
been able to give unequivocal indications of an optimal ratio. This does not stop
commentators from presenting certain ratios as if they were incontrovertible ‘sacred
truths’. The ambiguities in measuring the government expenditure ratio do not bother
them either.
One should also remember that government expenditure in low- and middle-income
and emerging-market countries often constitutes a smaller percentage of GDP than in
industrialised countries. However, this does not mean that the role of government in
the economy in low- or middle-income countries is necessarily smaller. Because of low
income levels, the tax base of low- or middle-income countries is limited. This limits the
extent to which government can spend – hence the lower expenditure to GDP ratio in
such countries. However, the more a government is limited by a small tax base, the more it
may want to achieve through legislation and regulation. For instance, instead of making
medicine affordable through a state subsidy (i.e. expenditure that is financed by taxation),
a government could try to control the price of medicine through legislation. (Legislation
that specifically attempts to affect the price of goods and services without increasing taxes
and government expenditure constitutes a quasi-fiscal measure. High-income countries
also engage in quasi-fiscal measures, but to a lesser extent because they have a larger tax
base and a smaller need for them.) This means care must be taken when comparing ratios
of government expenditure to GDP.
The debate about the appropriate role of government in the economy is often conducted
in terms of the relationship between aggregate government expenditure and economic
growth: does higher government expenditure promote or obstruct growth?
❐ International comparative studies suggest that there is no direct causal relationship
to be found between the government expenditure ratio and economic growth. In
some countries, high (or low) growth or per capita income has coincided with a large
government sector, while in others it happened together with a small or shrinking
government expenditure level. Country experiences differ too much to make rigorous
generalisations possible. No simple lessons are to be learnt – not from Korea, Taiwan or
Singapore, nor from Sweden, to name a few favourite cases.
❐ In South Africa, it is just as difficult to interpret the factual evidence unambiguously.
(See chapter 12.3 for an in-depth discussion of growth issues.)

Government and private sector – a zero-sum game?
The debate on aggregate government expenditure often proceeds on the implicit assumption
that the relationship between the government sector and private sector is a ‘zero-sum game’.
This assumption means that one sector can have an expanded role only if the other assumes a
shrinking role (i.e. the sum of the changes must be zero), or that there is a ‘trade-off’ between
public expenditure and private expenditure: more of the one requires, or causes, less of the other.
This way of reasoning can be seriously misleading. It narrows the debate significantly, and limits
one’s insights in this regard. For example, it excludes the possibility that government action and
private economic activity can be complementary. An instance of the latter is the phenomenon
of ‘crowding in’ (see chapter 3, section 3.2.2), where government capital formation creates a
platform for private capital formation and employment-creating business activity.
In addition, it limits the debate to the numerical level of government expenditure. This ignores
questions relating to the kind of government expenditure (and the kind of private investment)
that is conducive to growth or development. Simply spending more on a problem (e.g. illiteracy)
does not guarantee a solution: it depends on how the money is spent, how the delivery of
services is managed. Likewise, a reduction in government expenditure does not guarantee
more dynamic private sector growth. If the wrong services are cut back, or services curtailed in
an inappropriate manner, it could seriously impede private economic activity and development.
❐ Simply put, the question whether higher government expenditure promotes or obstructs
economic growth is much too simplistic.
The sensible view is that the economy of a country can generate (or not generate) economic
growth in numerous ways. These forces are understood imperfectly. Various factors, private
and public, can account for the absence or presence of growth. The impact of government
on the economy and on economic growth can take on many forms. Ultimately, it is a question
of judgement, given the characteristics and conditions in a country in a particular phase
of its development. An optimal ratio in one phase may become less optimal in another. An
optimal ratio in one country may be non-optimal in another. Various economic and fiscal
criteria must be incorporated in making this judgement. Therefore, the fiscal authority
cannot rely on incontrovertible truths on this issue. There is serious doubt whether the
level of government expenditure (relative to GDP) can provide a solid and dependable
general fiscal guideline. Such guidelines have to be sought elsewhere (see section 10.7).
Moreover, and most important, one must look beyond the level or ratio of expenditure.
Of particular importance is the kind of expenditure, on what it is spent, and how it is
spent (and managed). Different choices will serve the different macroeconomic and social
objectives differently.
Nevertheless, in the first years of this century there was a significant consensus – among
decision-makers in Pretoria as well as in the influential policy institutions in Washington
(e.g. the IMF and the World Bank and their ‘Washington consensus’) – that aggregate
government expenditure in South Africa should not be allowed to increase further.
Preferably, it should decrease relative to real GDP.
A parallel development in the 1990s and 2000s has been a ‘Pretoria consensus’ – with
strong support and influence from the business sector (the ‘Johannesburg consensus’).
This consensus focused on the level of government current expenditure or consumption
expenditure. [Aggregate expenditure = current expenditure + capital expenditure.]

One reason for such a focus is the historical pattern of consumption expenditure vs.
investment of the general government. The graph in figure 10.1 shows the extent to which
the period since 1975 has been characterised by a sustained increase in consumption
expenditure by general government up to the mid-1990s, whereafter it stabilised somewhat
before growing again from 2010 onwards. At the same time there was a dramatic, and
worrying, drop in government investment in physical capital (such as infrastructure)
that was halted only in the mid-1990s at an extremely low level of between 2% and 3%
of GDP, where it has remained ever since. What did increase since 2008, is public sector
investment – reflecting an increase in the investment projects undertaken by public sector
corporations such as Transnet and Eskom, but mainly the construction of the Medupi and
Kusile power plants. As a result, public sector investment increased from about 4.4% of
GDP in 2005 to 7.3% of GDP in 2015 (before dropping to 5.7% in 2018). The NDP wants
this number to increase to 10% of GDP.
Many people tend to make the inference that the drop in per capita GDP between 1975
and the late 1990s was caused, to a significant extent, by the drop in government
investment expenditure. However, once again there is no unequivocal basis in economic
theory for this conclusion. Several other explanations are possible. Various conceptual
and definitional issues complicate
the matter, and in any case a line Which aggregate measure?
of causation cannot be derived
One problem, if a fiscal authority wants to commit
by simply observing a pattern
itself to a specific government expenditure ratio
(compare section 5.2). As before, as fiscal target, is that different statistical systems
one should be careful in drawing and definitions of ‘government’ can produce quite
simple conclusions. (We shall different figures (see the addendum to this chapter).
take up the debate on government This can make the use of a simple aggregate fiscal
dissaving and fiscal balances in target all but impossible in practice.
section 10.7.)
Figure 10.1 General government expenditure relative to GDP

30
25
Total government expenditure
20
Percentage
Government consumption
15
10
5
Government capital formation
0
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
Source: South African Reserve Bank, national accounts (www.reservebank.co.za).

One must conclude that attempts to derive guidelines for sound fiscal policy, based on
simple rules in terms of aggregate levels or ratios, are fraught with dangers. The same
applies to suggestions that government should target specific levels or ratios of government
expenditure.
Since all government expenditure has to be financed in some way, the careful analysis of
taxation and government borrowing (public debt) may provide a useful avenue in which
to develop fiscal criteria. This is discussed next.
10.5.2 The aggregate level of taxation (tax burden)

The debate on the aggregate tax level, or the tax burden – defined as the ratio between
aggregate taxation and GDP – is largely a mirror image of the debate on government
expenditure. Although different arguments are encountered, the debate reflects the same
political, ideological and economic points of view:
❐ Those who are in favour of a shrinking government focus on the potential disincentive
effects of high taxation on the initiative and work effort of taxpayers – and thus on
economic growth.
❐ Those who favour a significant role for government argue that the dangers of disincentive
effects are exaggerated; that people would be inclined to work harder to uphold their
standard of living (after-tax income levels) when taxes are increased; moreover, that
the benefits of the government expenditure and government services financed by the
taxation exceed any possible negative impact of taxation on work effort.
Measuring total taxation – which data?

Tax data are available in at least three contexts: the national accounts figures (taxation as
part of the current revenue of general government), government finance statistics and the
DATA TIP
Budget Review figures. The first pertains to the general government, and the second to the
public sector and its components, while the third is limited to the national government.7
Since the national government collects more than 90% of all taxes, the use of either data
set to analyse tax levels and trends does not provide markedly different results.
❐ If the tax ratio is to be compared to an expenditure ratio to compute a deficit ratio for
the national government (see below), budget figures must be used.
Figure 10.2 shows that total taxation of general government in South Africa in 2018
amounted to approximately 29% of GDP (using SNA data – see addendum 10.2). In 1970,
this figure was approximately 18%, having been 14.2% in 1960. Without doubt, the level
of taxation has increased significantly – as a counterpart of the aggregate expenditure
trend shown above.
Taxation, growth and equity

Typically, a macroeconomic analysis of taxation would concentrate on the impact of
taxation on economic growth, or inflation. However, by definition such an analysis is
relatively narrow, since taxation has important other dimensions, notably concerning
equity, income distribution and efficiency.
7 The three data sets also apply different data systems and conventions.

Figure 10.2 Taxes relative to GDP
35
30
Total tax ratio

25
Percentage of GDP
20
Taxes on income and wealth

15
10
Taxes on production and imports

5
0
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
Source: South African Reserve Bank, national accounts (www.resbank.co.za).
❐ An important equity principle is that people who have the same ability to pay should
pay the same taxation (this is called horizontal equity), while people with different
abilities to pay should not pay the same taxation (vertical equity).
❐ An important tax principle in the development context is that taxation should not
make the poor poorer.
❐ Taxation can disturb or distort the economic decisions of people, or direct activity
in certain directions, simply because people want to avoid paying tax. An important
efficiency principle is that the extent to which such distortions and inefficiencies occur
should be minimised. (Minimising inefficiencies would also have a positive impact on
economic growth.)
In practice, all these considerations must be brought into balance simultaneously – one
of the most difficult assignments in tax design. What is important to realise, however, is
that the key issues in taxation primarily relate to the microeconomic details of taxation
rather than macroeconomic or aggregate dimensions such as the overall tax level or the
tax-to-GDP ratio.
Significantly, even the impact of taxation on a key macroeconomic variable such as GDP
growth does not depend much on the total tax level or ratio, but on the extent to which the
microeconomic dimensions of taxation (e.g. marginal tax rates) affect initiative and work
effort. The composition of taxation and the structure of different average and marginal
tax rates are more important than the aggregate level of taxation or the overall tax ratio.
Indeed, the theoretical analysis of the effects of the aggregate tax level on economic
growth is quite thin. As regards the interpretation of empirical evidence from South Africa
and other countries, one encounters similar ambiguities as in the case of government
expenditure. Therefore, the aggregate tax level or tax ratio provides a very limited foundation for
a solid and reliable fiscal guideline.

Tax composition refers to the composition of total taxation, which comprises taxation on
income and wealth (personal income tax and corporate taxation) and taxes on production and
imports (VAT, customs and excise duties, etc.). Taxation on income and wealth is also known
as direct taxes, while taxes on production and imports are also known as indirect taxes. Both
growth and equity considerations are at issue.
One argument is that so-called direct taxation, i.e. taxes on income and wealth, in particular
has a strong disincentive effect, since the tax that individuals and corporations have to pay is
directly linked to work effort and output.
❐ All over the world personal income tax has a progressive structure. This means that the tax rate
increases as taxable income increases.8 This is a result of the application of the vertical equity
principle. The argument is that, since each amount of extra taxable income is taxed at a higher
rate than existing income, people are discouraged from working harder and earning more.
❐ A tax such as VAT (value-added tax) does not have such a disincentive effect, since it is
a flat rate irrespective of income levels. In any case VAT is a tax on consumption, and not
on productive or income-generating activities. Therefore a shift to taxes on production and
imports (so-called indirect taxation) will promote work effort and economic growth.
❐ On the other hand, VAT is regressive. Because the poor usually consume a larger part of
their incomes compared to the non-poor, VAT places a relatively higher burden on the poor
and low-income households than on high-income households. This goes against the equity
objective, and is very sensitive politically.
❐ VAT zero-rating on items such as basic foodstuffs, which is intended to address this
regressivity, is only partially successful in doing so, since it also benefits those with high
incomes (who spend high amounts). It also causes a significant revenue loss for the fiscus.
Taxation and the business cycle

Various links and interactions can be noted in this regard.
Chapter 2 explained the automatic stabiliser effect of taxation: as people earn and spend
more during an economic upswing, payments of ‘direct taxes’ (current taxes on income
and wealth) and ‘indirect taxes’ (taxes on production and imports) increase. This ‘leakage’
serves to constrain expenditure growth and gradually slows the upswing. During a
downswing, a similar process occurs, in which case the downswing is moderated by the
stabilising effect of taxation. Taxation therefore tends to have a built-in anti-cyclical effect.
In practice, tax levels are usually not determined in order to influence the business cycle.
Nevertheless, the impact of tax decisions on the business cycle is a reality, even if such
impacts are not the intention of policymakers. Therefore, the standard analysis of the
impact of tax changes on aggregate expenditure, for instance, continues to be relevant.
Surprising links between taxation and the business cycle can derive from the nature of
the budgeting process. During this process, all planning is based on projected tax revenue
for the coming fiscal year (which largely depends on the expected economic growth rate).
If the projected tax revenue is regarded as unnecessarily high, government can decide to
give tax relief. If a strong upswing is expected, tax rates can be cut for this reason. (This
occurred in 1981, when a very high growth rate and high gold price produced a large
revenue bonus for the state. Income tax rates were accordingly reduced.) Likewise, it can
8 This applies to both marginal and average tax rates. However, the degree of progressivity relates formally to the
average tax rate structure. Marginal tax rates are used in practice to achieve a certain average tax rate structure.

Bracket creep and fiscal drag
This is an important phenomenon that occurs especially when inflation is present.
At the microeconomic level, the following happens: pure inflation adjustments to salaries push
individual income taxpayers into higher marginal tax brackets (which are set in nominal terms).
Even though their real income may not be increasing, they will be paying higher and higher
average and marginal tax rates. This creates many inequities and distorts the structure of
income tax. Taxes increase, even though there has been no such announcement.
❐ Bracket creep can be avoided by regularly adjusting tax brackets for inflation, so that the
tax brackets remain unchanged in real terms.
At the macroeconomic level, the importance of this phenomenon is that the real tax burden
increases. This would have the same constraining effect as an openly announced tax increase.
❐ The effect of bracket creep, also called fiscal drag, can be detrimental if it constrains a
much-needed upswing. On the other hand, it can serve to contain inflationary pressure in a
time of excessive expenditure.
❐ It should be clear that this inflation-related effect is similar to that which occurs with
automatic stabilisers.
In practice, the fiscal authority tends to allow bracket creep, not because of its potential
macroeconomic impact but for other reasons. Bracket creep results in a very convenient windfall
for the Minister of Finance. The fiscus automatically collects more revenue without the Minister
having to take the politically unpopular decision of a tax increase. Alternatively, the Minister can
return part of the windfall revenue via a bogus ‘tax cut’ and get political credit for it.
❐ This is a great temptation for any Minister of Finance, one that is often not resisted,
especially when there are strong demands for increased government expenditure, or for
selected tax reductions. Therefore bracket creep is often not eliminated in the budget.
One must realise, however, that bracket creep has serious disadvantages that warrant its
regular elimination by the fiscal authority.
❐ First, it constitutes a dangerous licence for uncontrolled growth in government expenditure.
❐ Moreover, the question is whether it is fiscally ethical and democratic to increase taxation
in such an unannounced and non-transparent manner.
❐ The problem is exacerbated by the fact that the extra tax burden due to bracket creep falls
on the personal income taxpayer only (and not on the corporate and mining sectors). This
distorts the structure of taxation.
❐ In addition, the extra burden usually falls more heavily on low- and middle-income
households than on high-income households. Bracket creep therefore distorts the vertical
equity dimension of taxation and can cause severe inequities.
happen that falling tax collection during a recession induces the government to increase
tax rates to finance its expenditure and to avoid a large budget deficit.
❐ Both of these can lead to the upswing, or a downswing, being amplified. This is not a
cyclically neutral policy. In effect, it is pro-cyclical policy: it aggravates the cycle.
Whether this outcome will occur will depend on the way taxation is determined in the
budget process. If tax rates are decided simply on the basis of the financing demands
of government expenditure, pro-cyclical policy is bound to result. To avoid this, the tax
decision must be based on a systematic analysis of the macroeconomic impact of tax
changes (and the related budget deficit position).

❐ One option is to allow the budget deficit to grow during a recession and not to prevent
a drop in tax revenue at all costs. Similarly, during a strong upswing, a budget surplus
(or very small deficit) should be tolerated, rather than adjusting tax rates downward.
The important point is that the fiscal authority cannot simply ignore the business cycle,
even if long-run considerations are uppermost.
10.5.3 The budget deficit and the borrowing requirement

Chapter 3 explained the financing of the budget deficit, being an important element of
interaction between the real and the monetary sectors of the economy. We also encountered
the idea of crowding out. In this section we consider the deficit as a general fiscal policy
issue. (Section 10.7 will provide further perspectives on the deficit.)
Definition and interpretation

The relationship between total government expenditure and total revenue determines the
budget balance (deficit or surplus). If total planned expenditure exceeds projected total
revenue, a deficit is budgeted for.
There may be good reasons for a
government not to plan a balanced Do not confuse the budget deficit or surplus and the
budget. BoP deficit or surplus. This is a danger especially when
❐ If it pursues an anti-cyclical pol we discuss the current budget deficit, which sounds
icy, the desired macroeconomic similar to the current account deficit (of the BoP).
effects usually require a budget
that is deliberately in deficit or surplus, as the case may be. As mentioned above, an
increasing budget surplus (or smaller deficit) means that the net effect of the budget on
aggregate expenditure is contractionary, while an increasing budget deficit (or smaller
surplus) is expansionary.
❐ Even if no active anti-cyclical policy is pursued, during a period of stagnation – which
would cause a natural drop in tax revenues – one has to budget for a deficit. The
alternative would be to increase tax rates or reduce government expenditure to avoid
a deficit. These steps would further contract the economy and exacerbate the recession.
❐ Deficit spending, i.e. spending financed by borrowing, is also warranted where
government investment that serves to underpin future economic growth is concerned.
(The tax revenue from the future growth in national income due to investment in
physical and human capital can then be used to repay the debt.)
❐ Historically, in many countries extraordinary circumstances such as wars were
addressed with deficit spending. Peacetime prosperity normally allows debt reduction.
A number of different budget balances (deficits or surpluses) can be defined. The basic
definition is the conventional or overall deficit (or surplus). Other important fiscal deficit
measures offer specific insights by excluding selected elements of expenditure or revenue:
❐ Conventional deficit = Aggregate expenditure – aggregate revenue
❐ Current deficit = Current expenditure – current revenue
❐ Primary deficit = Non-interest expenditure – aggregate revenue
❐ Cyclically adjusted deficit
or
Structural deficit = Cyclically corrected expenditure – cyclically corrected revenue

Measuring the deficit – which data and which levels?
In policy analysis, the importance of the deficit lies in two contexts. Each requires
different usage of data and data sources.
Context 1: The net expansionary or contractionary impact of government expenditure
and taxation on aggregate expenditure, production and income – i.e. in the context of
the circular flow of income and expenditure. In this case the national accounts data on
government consumption expenditure, government investment and total taxation are
relevant. These data refer to the general government.
DATA TIP
Context 2: The state of the public finances, the financing of the deficit, its effects on the
monetary sector as well as the total government debt. In this case one must not use the
national accounting (SNA) data, but rather the budget data supplied by the Treasury in
the Budget Review as well as the government finance statistics (GFS) data supplied by
the Reserve Bank in the Quarterly Bulletin. These pertain only to the national government,
and exclude provincial and local government borrowing.
❐ In debating the deficit, the Budget Review and GFS figures are used most of the t
ime.9
SNA data for government refers to general government (i.e. central government plus
provinces and local authorities). GFS data are available for all levels of government. Main
budget data usually refer to the national government (see box in section 10.1). However,
keep in mind that the national budget also contains transfers to lower levels
of government.
Cyclical adjustment can also be applied to the current and primary deficits. In the
remainder of the chapter the interpretation and use of each of these budget balances will
become clear.
How large is the conventional deficit in South Africa?

In our first look at the deficit we consider the national government level, using main budget
data. These are the figures most often reported in public discussions of the public finances.
Deficits for the general government will be considered in section 10.7.
Table 10.3 shows the conventional budget deficit at national government level since the
1980/81 fiscal year as a percentage of GDP. It also shows the non-financial public sector
borrowing requirement (the PSBR) since 1992, the first year for which data are available.
The PSBR is discussed below.
Since 1980 the conventional deficit, on average, was 3% of GDP, reaching peaks during
the mid-1980s and the early 1990s – when the deficit exceeded 7% of GDP. From the
mid to late 1990s, public finances improved significantly, with the budget even reaching
a surplus in the 2006/07 and 2007/08 fiscal years. However, following the international
financial crisis of 2007–08 and the resultant recession also in South Africa, the budget
balance deteriorated again, reaching 5.3% in 2012/13 before improving somewhat to
4.5% in 2017/18.
9 Other deficit data sources are the tables in the ‘Public Finance’ section of the Reserve Bank Quarterly Bulletin.
The interpretation of these is complex and beyond the scope of this textbook. However, see addendum 10.2 for an
illustration.

Table 10.3 National government budget balance and the PSBR as % of GDP (fiscal years
ending 31 March of the year listed)
Fiscal year Budget PSBR Fiscal year Budget PSBR

ending 31 balance ending 31 balance
March of: March of:
1980 3.1 – 2005 1.4 1.4
1985 3.3 – 2006 –0.3 –0.7
1990 1.4 – 2007 –0.7 –0.3
1994 5.4 6.8 2008 –0.9 0.2
1995 4.5 3.1 2009 0.7 3.3
1996 5.0 3.4 2010 5.1 7.1
1997 4.8 4.1 2011 4.0 5.3
1998 3.6 3.7 2012 4.8 5.3
1999 2.7 3.1 2013 5.3 5.5
2000 2.1 0.8 2014 4.6 5.0
2001 1.9 0.3 2015 4.5 4.1
2002 1.4 –1.1 2016 4.2 4.2
2003 1.0 0.3 2017 3.9 3.3
2004 2.2 1.4 2018 4.5 4.4
Note: Deficit (+) / Surplus (–)
The deficit and the borrowing requirement

The macroeconomic and monetary impact of a fiscal deficit depends on the total amount
that is borrowed. Normally this amount is significantly higher than the formal national
budget deficit, for the following reasons.
❐ National government debt that matures in a particular year can either be repaid
or rolled over. It is all but standing practice to roll over debt, i.e. to reissue debt that
matures. This implies a significant addition to the annual financing requirement of the
national government. (In budget figures these loan redemptions are not shown as part
of the deficit, but as a ‘below the line’ item.)
❐ It is not only the national government that borrows. Though their ability is often
limited by law, all the institutions in the public sector can borrow, e.g. municipalities,
provinces, government enterprises and public corporations (such as Eskom). Of course,
they can also repay their debt. If the net figure is added to the national government
financing requirement, it produces the total non-financial public sector borrowing
requirement or non-financial PSBR (see table 10.3). Note that financial corporations
owned by government are excluded from the PSBR. Usually the PSBR is higher than
the budget deficit; however, there is no constant relationship or ratio. Extrabudgetary
institutions often repay very large amounts of debt.

To the extent that a part of the financing requirement is met by foreign borrowing, the
net claim on the domestic financial markets is reduced. Subtracting foreign loans from
the PSBR yields the actual domestic borrowing requirement of the public sector.10 This
is the relevant figure if one wishes to analyse the potential effect on monetary demand
and interest rates (bearing in mind that foreign loans do impact on the domestic money
supply).
Is a budget surplus a good thing?

There is no straightforward answer to this question. A surplus (or deficit) is not intrinsically bad
or good. The answer depends on issues such as the social and physical infrastructure needs
of the country, the interest rates that government pays on debt, whether debt is domestic
or foreign denominated (which introduces the exchange rate as a consideration) and the
capacity of the economy to generate enough tax revenue to pay for both current and capital
expenditure.
With the implementation of the Growth, Employment and Redistribution (GEAR) strategy of
government in 1996, the South African government consistently reduced the deficit until it
turned into a surplus in the 2006/07 and 2007/08 fiscal years. The government argued that
the reduction in the deficit will place less pressure on financial markets, leading to lower
interest rates that will stimulate investment and economic growth. However, many critics of
government, including Cosatu, argued that government can sustain a higher deficit and that it is
not appropriate for a middle-income country to run a budget surplus – particularly when it faces
large backlogs in service delivery and infrastructure such as its capacity to generate electricity
or to transport goods and oil through rail and pipelines. (At any rate, the surplus didn’t last long –
the budget again went into a deficit from 2008/09 onwards, making that issue moot.)
The cyclical element of the deficit

In considering this conventional deficit pattern, one should appreciate the cyclical element.
The cyclical state of the economy directly affects actual expenditure and tax revenue. An
economic downswing necessarily leads to a drop in personal income tax and company
tax collections, while increased expenditure on welfare and, for example, public works
programmes is likely.
The graph in figure 10.3 shows the conventional deficit in conjunction with the GDP
gap, i.e. the extent (%) to which GDP deviates from potential GDP (or, in AD-AS diagram
context, the deviation of Y from the long-run supply curve). A significant drop below
potential GDP indicates periods of slack (recession).
Many factors influence the deficit. First, note how cyclical movements in the GDP are often
mirrored in a cyclical change in the budget deficit: as income levels fall, tax revenue declines.
Individuals and firms pay less income tax, corporate tax and VAT. Second, it is clear that
the persistent deterioration of the growth performance of the economy in the late 1980s
and early 1990s contributed significantly to the deteriorating deficit position in this period
(interrupted by occasional upswings that each time reduced the deficit somewhat). After
1994, improved GDP growth performance assisted the reduction of the deficit. The graph
shows that this pattern continued until 2007, whereafter the deterioration of economic
growth saw the budget revert to a persistent large deficit.
10 A last matter is that there may be unspent funds available from the previous fiscal year, or a previous deficit not yet
fully financed. Thus the opening balance must also be taken into account.

Figure 10.3 The national government budget deficit and the cyclical course of the GDP gap
6
Budget deficit
4
Percentage of GDP
–2
GDP deviation from potential GDP (= GDP gap)
–4
–6
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Source: South African Reserve Bank, public finance table (www.resbank.co.za), as well as authors’ own calculations.
The important point is that, in evaluating the seriousness of the budget deficit, the
cyclical stance of the economy must be taken into account. A large deficit during a severe
recession does not necessarily indicate an underlying or structural fiscal problem, and
does not necessarily require corrective actions. However, if the weakness in the economy
has lasted for a relatively long time and resulted in a debt/GDP ratio that has increased to
a level considered unacceptably high by buyers of government bonds, corrective actions
would become imperative. (The level considered unacceptably high would depend on
circumstances.) In normal conditions, though, a high cyclical deficit is likely to improve
automatically when the downswing turns around.
❐ However, this does not change the fact that such a large deficit must still be financed,
and still adds to public debt and future public debt cost. Also, what matters ultimately, in
macroeconomic terms, is not the budgeted (planned) figures but the actual expenditure
and tax levels that are realised eventually.
If one wishes to gauge the fiscal policy stance – i.e. the intentions of the fiscal authority
in a particular year – these endogenous effects of the business cycle on expenditure and
revenue must be disregarded or removed from the relevant data. It is possible to adjust
expenditure and revenue figures to remove the estimated cyclical element. This produces
the cyclically adjusted or cyclically neutral or structural deficit.
The financing of the budget deficit

The financing of the budget deficit (or: the deficit before borrowing) is a crucial element
of fiscal policy. Different financing options markedly influence the eventual impact of a
particular budget.
The basic methods were discussed in chapter 3. Here it suffices to note the following:
❐ Domestic loans from the private non-banking sector are the main and preferred form
of deficit financing. This occurs through the sale of government bonds or treasury
bills in the financial markets. (The buyers can be either domestic or foreign investors/

institutions – see box on foreign loans below.) In some circumstances, this could have a
restrictive macroeconomic impact.
❐ Borrowing from the Reserve Bank is regarded as an expansionary and, especially,
inflationary form of financing. As a rule it is used only in exceptional or crisis
circumstances. Since this form of deficit financing constitutes money creation
with the sanction of the Reserve Bank, such a step is described as mixed fiscal and
monetary policy.
❐ Foreign loans are readily used if available. Doing so has the disadvantage that the
country builds up a net debt obligation to other countries. As noted in chapter 3 (section
3.2.3), foreign loans occur through the sale, by the Treasury, of government bonds
that are denominated in a foreign currency (e.g. dollar) to foreign investors or foreign
financial institutions. (The two best-known foreign-currency-denominated bonds of
the South African government are called the Yankee bonds and the Samurai bonds –
the former being US dollar-denominated, the latter yen-denominated.)
Foreign loans and private sector capital formation

Foreign loans also have the objective to create a market in foreign-currency-denominated
South African government bonds, thereby helping to determine the interest rate at which
private South African companies can raise offshore finance. Private loans raised offshore are
usually priced at an interest rate higher than that which government pays. If there is an active
and liquid market in foreign-denominated SA government bonds, it provides a ‘benchmark’
interest rate (to which a private sector risk margin is added to arrive at the interest rate that a
private South African company would pay). Therefore, the existence of foreign-denominated
SA government bonds eases the way for private companies and institutions to attract foreign
investment (which is sorely needed, given the prevalence of current account deficits since the
mid-1990s and the lack of domestic capital formation).
The choice of the fiscal authority between these options will depend on various consider
ations, including general economic as well as money market conditions.
❐ In some circumstances an expansionary form of financing is desirable; in others not.
❐ The potential extent of crowding out is an important consideration, given the existing
investment level and trend. This also has to be evaluated in the context of existing
money market conditions and interest rate trends.
❐ A further consideration, with regard to both domestic and foreign loans, is that annual
interest commitments can become an expenditure problem. If unchecked, they can
absorb a large portion of the annual budgeted expenditure.
❐ The relative cost of domestic and foreign loans obviously is relevant.
❐ Foreign loans have the added disadvantage that foreign exchange is required for
repayment. The BoP implications of both the initial capital inflow and the debt
repayment are further complications that have to be considered. For instance, if the
rand depreciates against the dollar it means that in rand terms the foreign debt of the
South African government has increased.
All these considerations relate to the problems of public debt management (see
section 10.6).

The budget deficit and the BoP
Foreign loans to finance the budget deficit lead to an inflow of foreign capital. This creates a
direct link between the budget deficit and the BoP deficit or surplus.
❐ An indirect link exists in the case where the budget deficit is financed with domestic loans. Any
upward pressure on interest rates due to domestic borrowing can attract an inflow of foreign
capital, which impacts on the capital account of the BoP, and thus strengthens the BoP.
❐ The inflow of payments is likely to lead to an appreciation of the domestic currency. This, in
turn, discourages exports and stimulates imports, which causes the current account of the
BoP to deteriorate.
❐ In the USA, this link between the budget deficit and the current account deficit is often
discussed as the ‘twin deficit problem’ (see box in section 4.5.5).
How much deficit financing is obtained through foreign loans?

Since the 1970s, the extent of foreign financing (i.e. through the sale of South African
government bonds denominated in a foreign currency) was, at most, approximately 15%
of the total financing requirement of the central government. After 1984/85, in the era of
financial sanctions against South Africa, the extent to which the South African government
had access to foreign loans declined dramatically. From the mid-1980s to 2000, foreign
loans never constituted more than 6% of total government debt. Only since 2000 have
foreign loans become somewhat more important. Still, at the end of the 2018/19 fiscal year
they constituted only approximately 11.2% of total government debt (equivalent to 6% of
GDP). Clearly, by far the largest portion of financing occurs in domestic financial markets,
via government bond issues.
Foreign loans compared to domestic bond sales to foreigners

Foreign loans – sales of SA bonds denominated in foreign currencies such as US dollar and yen
and sourced from foreign financial institutions – should be distinguished from domestic, rand-
denominated bonds bought by foreigners. Foreign investors can buy and hold both types of bonds
freely. However, the exchange rate risk faced by the government and the buyers of the two types
of bonds differs. Unlike rand-denominated government bonds, the South African government
faces an exchange rate risk when issuing foreign-currency-denominated bonds. If the rand
depreciates during the life of a dollar-denominated bond (loan), for example, the rand value of this
foreign loan would increase without the government actually having received, or borrowed, an
extra dollar or rand. So, when the government wants to repay the loan, it will have to pay much
more in rands to obtain the amount of dollars that it needs to redeem the loan (compared to what it
would have been without the depreciation). The SA government would suffer a loss.
In the case of rand-denominated bonds that are held by foreign investors the South African
government does not face an exchange rate risk. However, the foreign investor does. To buy a
South African government bond in rands (e.g. for R1 billion), the investor first exchanges a certain
amount of dollars for the required amount of rands to pay for the bond. Should the rand depreciate
while she is holding the bond, the R1 billion that she gets when she eventually redeems the bond
would buy her fewer dollars compared to what she paid initially. The investor would suffer a loss.
This means that, if investors expect the rand to depreciate, they will become less willing to
buy rand-denominated bonds (unless the government is willing to pay a higher interest rate to
compensate the investor for the expected loss).

Of course, foreigners can also buy rand-denominated government bonds in our financial
markets. Foreign holdings of domestic (rand-denominated) government bonds increased
significantly from 12.8% to 37.7% of total domestic bonds (excluding treasury bills)
between 2009 and 2018. This means that foreign holdings of domestic government
bonds (exclusive of treasury bills) increased from roughly 2% of GDP to 14.6%. If we
include foreign currency-denominated government bonds, approximately 34% of the
increase in long-term government debt (thus excluding treasury bills) was financed
through borrowing from foreign investors.
Since the government does not carry an exchange rate risk when foreign investors buy
rand-denominated debt, it is of lesser concern than debt issued in foreign currencies such
as the dollar or yen.
❐ Borrowing freely offshore in this way was fine during the period 2009 to 2013 mainly
because foreign investors had surplus funds due to the quantitative easing implemented
by the US Federal Reserve. However, in the era after quantitative easing a question has
arisen as to the willingness of foreign investors to keep on financing large South African
budget deficits in this way. This willingness might be further undermined by the sharp
depreciation of the rand from roughly $1 = R7.00 in 2011 to around $1 = R14.50 in
2019, which has hurt many foreign holders of our bonds.
10.5.4 The sequence of decisions – the budget process

The budget is compiled by the National Treasury in a complex process in which both the
expenditure side and the revenue side have to be determined, while taking the deficit
into account.
To improve budgeting in the public sector, government introduced the Medium Term
Expenditure Framework (MTEF) in 1997. According to this framework, government
departments must plan their expenditure each year for the following three years.
In October each year, the Treasury releases the Medium Term Budget Policy Statement,
which sets out a broad framework for the budget and the spending estimates for the next
three years.
When the budget is tabled by the Minister of Finance in Parliament early the following
year, the detailed expenditure plans for the first year are reflected in the Appropriation Bill
to be approved by Parliament and detailed projections for all three years are published in
the Estimates of National Expenditure.
The estimates for the second and third years serve as baseline numbers for the next budget
planning cycle. Because three-year expenditure plans are compiled each year, rolling three-
year plans arise. This ensures continuity and better planning in the budgeting process.
The heart of expenditure determination is the annual programme of consultations
between the national and provincial treasuries and other departments, in which proposals
for changes in spending allocations are examined. Changes in government priorities,
public service delivery trends and evidence of the effectiveness and efficiency of spending
programmes come under scrutiny. This process is characterised by the following:
❐ Under the MTEF framework, national departments and provinces (which receive the
bulk of their revenue in the form of a transfer from central government) must submit
their three-year plans to government in the first part of each year. Towards the end
of September of each year, the Medium Term Expenditure Committee scrutinises the
departmental budgets (with a similar process occurring in provinces). Of importance

here are the priorities of government as stated in its various policies and the relation
between inputs (expenditure) and outputs (service levels).
❐ By this time, another process has determined, at the macroeconomic level, aggregate
expenditure guidelines, the so-called upper limit. This may occur within the context
of a macroeconomic framework, also incorporating current and projected economic
conditions and objectives. These guidelines are eventually subject to Cabinet approval,
but other public sector role-players can be influential in the process.
❐ The proposed departmental expenditure regularly exceeds the upper limit. In terms of
the budget management system in place at the time, these plans then have to be scaled
down to fit below the expenditure ceiling. This process has various stages and involves
various committees, including Cabinet committees and Parliamentary portfolio or
standing committees. Parliamentary committees examine departmental strategic plans
during the process of reviewing the Appropriation Bill each year. Such committees
also play an oversight role in reviewing departmental annual reports at the end of the
financial year, when performance is assessed against plans and targets published at the
time of the budget. In this phase, ministers may have to fight to defend expenditure for
their departments. Here they realise that ‘to govern is to budget’ and ‘to budget is to
govern’. Some of the most difficult political decisions have to be taken here, inter alia
on the advice of expert policy analysis – but also with much political gamesmanship
and horse-trading.
A draft expenditure budget is usually prepared during October. It includes both
departmental and provincial expenditure plans and serves as a framework within which
government then makes final adjustments. Various committees involving national
ministers and/or provincial MECs play a role in considering and consolidating new
spending proposals and are responsible for finalising recommendations that go to
Cabinet. Normally the final expenditure is agreed upon before the end of the year. By that
time, barring small adjustments or some crisis (e.g. a drought, disaster or public service
strike), expenditure is largely determined – ready to be captured in the Appropriation
Bill.
In 2009, Parliament passed new legislation that provides for the amendment of money
bills. Taking effect from the 2010 Budget, this legislation made it possible for Parliament
to change the spending proposals tabled by the Minister of Finance. The legislation
does provide the Minister with an opportunity to respond to any changes proposed by
Parliamentary committees. This provision recognises the importance of a sound and
sustainable balance between spending, revenue and the annual borrowing requirement.
However, up to 2019 Parliament has not acted to change or overrule the proposals of the
Minister.
On the revenue side, the first estimates of revenue are made almost a year before Budget Day.
❐ This entails revenue projections drawing on the latest trends in revenue collections
by the SA Revenue Service as well as macroeconomic projections of trends in eco-
nomic output, spending, employment and incomes. The projections are done by the
National Treasury, in conjunction with the Reserve Bank and other public-sector
role-players. Econometric models and forecasting constitute an important support base
for this process.

❐ Information on the first revenue
Bracket creep and inflation tax
projections forms part of the
decision that fixes the expenditure It is at this point that the revenue bonus due to
upper limit. It occurs within inflation wedges into decisions and becomes rooted in
a macro economic framework budgetary planning. Because these initial projections
within which projected tax are based on existing tax rates, using the projected
nominal GDP of the coming fiscal year, they already
revenue and a projected budget
include the extra tax revenue due to bracket creep.
deficit are accounted for. The
Hence, when the Cabinet considers the ‘no change’
revenue implications of changes projections, the unannounced tax increase is already
in tax policy and tax structure firmly embedded.
must also be incorporated. ❐ To remove this extra tax at a later stage, with the
Information on projected money Cabinet and the Minister having gone through
market conditions and the the agonising experience of cutting expenditure
amount of government loans to match the projected revenue and produce an
that can be absorbed in the acceptable deficit, is all but impossible.
market without disturbing it is
an important input in this decision.
❐ The upshot is that expenditure, revenue and the deficit are ultimately decided simultaneously.
Still, at this point the government must decide which element is to receive first priority
and which second. Given the coherence revealed by the budget identity, the third
element is determined by the first two. For instance, if the government is firm on the
level of expenditure and wishes to place the deficit on a particular course, it has to
accept a corresponding tax level. (These decisions may also concern sub-components
of expenditure, e.g. capital expenditure or non-interest current expenditure.)
❐ This is a difficult balancing act with many a trade-off and a weighing of various
considerations in attempting to realise the political and fiscal strategies of the
government. As noted earlier in this chapter, various role-players and committees may
influence this process.
Fiscal policy and the provinces

A constitutional system in which provinces have considerable fiscal powers – fiscal devolution
or fiscal federalism – can severely complicate fiscal policy. Depending on how many powers
are devolved to provinces, as well as the economic impact of larger provinces, budget
decisions at a provincial level can frustrate the attainment of national fiscal objectives.
❐ If a situation is reached where the budget of the central government constitutes only a
relatively small part of the consolidated general government, centrally managed fiscal
policy can become extremely difficult.
❐ Provinces covet their budgetary independence – provincial governments have to answer
to their own voters for the success of provincial expenditure programmes. Provinces may
therefore resist central control over their budgets.
❐ Party-political factors can intensify this conflict, especially if different parties control the
national government and individual provinces.
Currently, provinces – and to a smaller extent also local authorities (municipalities) – share
in the revenue that the central government collects. To ensure that the division of revenue
between the provinces and between local authorities occurs on an equitable basis,
government uses revenue-sharing formulas called the Equitable Share Formulas. There is one
for provinces and another for local authorities. These formulas and changes to them reflect
the economic, social and developmental needs of the provinces and local authorities, and are
based on the research and subsequent advice of the Financial and Fiscal Commission.

With expenditure having been fixed by December, the projection of revenue is repeated
regularly up to the time of the budget speech in February.
❐ About two months before Budget Day, the Minister of Finance seriously starts
considering possible changes to taxes – given the most recent revenue projections and
planned changes in tax structure and policy.
❐ The main consideration at this stage is the size of the deficit that is deemed acceptable.
This can lead to proposals to amend taxes. Tax changes can be contemplated right up to
the last days before the budget is presented to Parliament.
10.6 Public debt and public debt management

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

The public debt is the cumulative result of the borrowing activities of the state in the past.
Each budget deficit leads to an equivalent addition to the stock of public debt. Moreover,
while loans that are redeemed or repaid reduce the public debt, debt that is rolled over – the
normal practice – leaves the amount of public debt unchanged. Consequently, the public
debt continually increases in nominal terms. In 1946, for example, the total public debt
was R1.2 billion, and at the end of the 2018/19 fiscal year it was R2.8 trillion. However,
an increasing debt level is not necessarily a problem if the national income from which this
debt needs to be serviced (by paying of interest) is also be growing. Nevertheless, the debt
becomes a problem if it grows at higher rates than GDP for long periods of time.
Thus, the best way to gauge the level of public debt is to measure it relative to the size of
the economy, i.e. GDP.
Table 10.4 summarises and figure 10.4 illustrates the Table 10.4 Total national government
historical path of the public debt/GDP ratio in South debt as % of GDP (calender years)
Africa. In 1946 the ratio was approximately 70%,
1965 41.1 2008 26.5
mainly due to debt incurred during the Second World
War. The ratio then declined steadily until the 1980s, 1970 40.8 2009 30.1
whereafter it started to increase. In the early 1990s 1975 35.8 2010 34.7
the ratio increased significantly, r eaching a peak of
1980 30.9 2011 38.2
50.4% in 1995. This upward trend in the public debt/
GDP ratio was not sustainable, and the government 1985 29.3 2012 41.0
took steps in the mid-1990s to reduce the debt burden. 1990 30.5 2013 44.1
Following the financial crisis of 2007/08 and the
1995 48.2 2014 47.0
subsequent recession in South Africa, the debt burden
increased again – and quite rapidly. 2000 42.3 2015 49.3
2005 33.2 2016 51.5

Also notice that from 1960 up to 2015 the ratio never
exceeded 50%. Thus, every year since 2016 the public 2006 31.4 2017 53.0
debt/GDP ratio has been higher than at any time in the 2007 27.1 2018 56.7
preceding six decades – and has continued to rise. Still, Source: South African Reserve Bank,
the graph in figure 10.4 also demonstrates that it is Quarterly Bulletin.
10.6 Public debt and public debt management 431

possible to reverse a high public debt situation. If economic growth is relatively high (as it
was in the 30 years after the Second World War, as well as since 2003), it is relatively easy to
keep the debt ratio under control – economic growth increases the denominator of the debt/
GDP ratio.
Therefore, not only budgetary policy but also the relatively poor growth performance
since 1989, explain the increasing debt ratio in South Africa in the early 1990s. This is
a reflection of the pattern we observed with regard to the budget deficit: if the economy
stagnates, tax revenue drops and the budget deficit increases. The same happened during
the recession that followed the international financial crisis of 2007/08, with the debt/
GDP ratio increasing from 26% in 2008/09 to about 56% by the end of 2018/19, and
projected to increase even further.
Figure 10.4 Public debt as a percentage of GDP
60
50
Public debt ratio
Percentage of GDP
40
30
20
10
0
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
Source: South African Reserve Bank, public finance table (www.resbank.co.za).
A further threat to the public debt/GDP ratio in the coming years is the contingent (or
conditional) liabilities of government. These comprise financial guarantees to state-owned
enterprises (SOEs) such as Eskom and SAA that issue their own debt, plus ‘other contingent
liabilities’, most notably those of the Road Accident Fund. To secure lower interest rates on
SOE debt – and in recent years just to get willing buyers for SOE bonds – the government
often has to issue a guarantee. This means that, should Eskom or SAA fail to repay their
loan (which is the contingency), the government undertakes to repay their debt. At the
end of the 2008/09 fiscal year such government guarantees stood at R63 billion (which
included no guarantee to Eskom). By the end of the 2018/19 fiscal year, these guarantees
increased to R529 billion (with guarantees to Eskom of R295 billion and a further R147
billion to independent power producers). By this time the contingent liability of the Road
Accident Fund had also increased from R43 billion to R216 billion. The total contingent
liabilities of government rose from 8.1% of GDP at the end of the 2008/09 fiscal year
to 17.4% of GDP in 2018/19 (of which guarantees to Eskom constituted 5.8% of GDP).
Moreover, the entrenched management troubles at SOEs also increased the probability
that the guarantees would be called up (i.e. that government will have to repay SOE debt).
This could affect South Africa’s sovereign credit rating negatively. Indeed, in 2019 the
ratings agency Moody’s stated that in future they will fully include such guarantees in
assessments of the country’s total public debt burden.

The stabilisation of the debt/GDP ratio after 1994 was not easy to attain, given the low
economic growth rate of the preceding years and continued high interest rate levels
throughout the 1990s, combined with increasing demands on the fiscus for higher social
expenditure. The success of government in stabilising the debt/GDP ratio in that era can
be ascribed to its commitment to fiscal discipline as set out in the GEAR policy.
Note: The interest rate level is a third important determinant of the growth in the public
debt. This is discussed in sections 10.6.3 and 10.7.4.
10.6.2 How does SA’s public debt compare internationally?

Table 10.5 shows the international context of the SA debt position. These debt ratios vary
dramatically. Compared to the public debt/GDP ratios of high-income countries such as
Japan, Belgium, Italy, Japan and Portugal, Ireland and even the USA, South Africa still has
a much lower public debt/GDP ratio.
Also note that South Africa was not alone in experiencing a rather significant increase in
the public debt/GDP ratio in the period since 2008, when the public debt/GDP ratios of
South Africa and many other countries increased significantly – mostly as a result of the
global recession. Notably, the debt ratio of countries such as Spain, Portugal, Ireland and
even the USA increased dramatically, much more than that of South Africa.
Table 10.5 Public debt as % of GDP - some international comparisons
Australia Belgium Canada Chile France Germany

1995 57.3 140.4 124.0 67.3 54.1
2000 41.1 120.5 105.1 72.4 59.5
2005 30.0 108.3 93.9 16.3 82.1 70.1
2010 41.8 108.0 105.0 15.3 101.0 84.5
2017 65.6 122.3 108.8 29.6 124.2 71.5
Greece Italy Japan Netherlands Norway Poland
1995 97.8 121.2 94.7 84.8 37.3 50.4
2000 111.7 119.0 142.6 61.1 32.2 45.0
2005 115.8 117.4 175.9 58.3 46.9 54.7
2010 129.0 124.9 207.2 68.6 48.4 60.9
2017 188.7 152.4 234.3 69.8 42.8 68.1
Portugal Spain Sweden Turkey UK USA
1995 67.5 67.5 76.5 48.8 93.7
2000 62.0 65.2 63.0 44.9 72.1
2005 80.0 50.0 64.1 48.8 88.6
2010 104.1 66.6 52.6 49.2 86.6 125.9
2017 145.3 114.6 58.5 35.2 116.3 135.8
Source: OECD (www.oecd.org).
All governments need to ask regularly whether or not their current fiscal policy – and
possible changes planned, such as an expansion of entitlements – may render fiscal policy
unsustainable now or in the future. This is discussed in the context of fiscal norms in
section 10.7.4.

10.6.3 Budget implications of the interest on public debt
While total public debt in South Africa may not be exceptionally high by international
comparison, this does not imply that the interest obligations of this debt (public debt cost)
are not a budget problem.
❐ Interest on public debt constitutes a legal obligation. Therefore it is a compulsory
expenditure item, an expenditure category over which government has no discretionary
power.
❐ Interest payments on public debt, or the public debt cost, have increased from approx
imately 6% of aggregate government expenditure in 1975 to 19.8% in the 1999/2000
budget of the national government. (As a percentage of GDP, the latter figure was
approximately 6%.)
❐ At this level, interest expenditure was the second largest expenditure item on the budget
– only education expenditure was larger. The severe increase particularly during the
early 1990s reflects the significant increase in the public debt ratio after 1990 as well
as very high domestic interest rates (see figure 3.3).
❐ However, in the early 2000s the interest burden started to decrease significantly, a
reflection both of the lower public debt/GDP ratio and of the lower interest rates at
which government incurred debt. By 2009/10 interest cost still constituted a mere
7.6% of total national government expenditure (or 2.2% of GDP).
❐ After 2009/10 the interest burden started to increase again due to the growing public
debt/GDP ratio. By 2018/19 interest cost had grown to 12.1% of national government
expenditure (3.6% of GDP).
The interest component is crucial in that it determines the latitude and discretion of the
fiscal authority. Unless a steadily increasing level of aggregate expenditure is acceptable,
a growing interest component necessarily means that fewer funds are available for other
current expenditure as well as capital expenditure. Therefore, the interest cost can create
serious problems for the fiscal authority, especially in times of increasing claims on the
public purse.
10.6.4 The Reserve Bank, monetary policy and public debt

In analysing the causes of high public debt or a high debt ratio, the budget deficit is obviously
at the centre of attention. The GDP growth rate is a second important determinant of the
debt/GDP ratio.
Interest rates constitute a third important determinant of the public debt. This points to
an important interaction between monetary policy and public debt, which derives from the
impact of monetary policy on interest rates.
❐ If interest rates are high, it pushes up the cost of government borrowing. This increases
the interest item on the budget, which in turn increases the deficit (assuming that other
expenditure and tax items are unchanged). This leads to a larger addition to public debt,
and a higher public debt level than would have been the case with lower interest rates.
❐ The effect does not stop there. It carries through to future years, when the interest
item (and thus future deficits and public debt) is likely to remain on a higher tack than
it would have been had interest rates been lower initially. (The relatively larger deficit
could push up interest rates, which would further aggravate this vicious cycle.)
❐ Even a one-off period of high interest rates can have a considerable impact, since the
government can be locked into the high-cost debt issued at that juncture for a period
as long as 20 years. (Government bonds typically have a term or maturity longer than
10 years.)

In the South African case, one cannot fail to recall the scary period after 1984/85 – in the
De Kock era, when in some months the real prime interest rate went as high as 12%, with
nominal rates above 25%. This period contributed dramatically to the growth in both the
budget deficit and the total public debt in years to follow. The extent of this impact has
been estimated as follows:11
❐ If real interest rates had remained at the 1973 level of 3.75%, both the budget deficit
and the public debt in 1993 would have been approximately 50% lower than was the case.
❐ That may be an extreme, hypothetical case. However, if interest rates had remained
more or less stable at the 1973–93 average of 9% – instead of fluctuating rather severely
– the deficit in 1993 would have been 25% smaller and the public debt approximately
12.5% lower.
Monetary policy is one of the chief determinants of interest rates, given market forces.
This would suggest that the monetary authority has a significant co-responsibility for the
growth in the budget deficit and in the public debt.
This assertion does not lead to the rather simplistic conclusion that the growth in the
public debt is the fault of the Reserve Bank. In the first instance, it is the fiscal authority
that determines expenditure and taxation, and therefore the deficit. Nevertheless, both
the level of interest rates and fluctuations in rates are decisively influenced by monetary
policy. Unless the fiscal authority compensates by cutting back expenditure or increasing
tax rates sufficiently, a persistently high (real) interest rate policy by the Reserve Bank
cannot but have a significant negative impact on budget deficits, and hence public debt
levels (also see chapter 9, section 9.5).
❐ Therefore the public debt is co-determined by the actions of the fiscal and the monetary
authorities – against a backdrop of domestic political and economic events as well as
external shocks and constraints.
The co-responsibility of the Reserve Bank does not end there, though. Public debt
management, in which the Bank had a central role up to 1997, is pivotal in the long-run
dynamics of deficits and public debt.
❐ To the extent that public debt management succeeds in keeping the effective cost of (or
interest on) public debt at a minimum, it helps to steer deficits and the public debt on a
lower trajectory.
❐ However, we have seen (in chapter 9) that the traditional practice of public debt
management did not necessarily ensure financing at minimum cost. This derived from
the conflict between fiscal, monetary and refinancing considerations in the marketing
of government bonds, with monetary and refinancing considerations often dominant.
In particular, this often meant that the state did not get the benefits of a decline in
interest rates. Given the sometimes very high real interest rates in the 1990s, this factor
was extremely consequential.
❐ The conflict between these considerations was largely resolved with the introduction
of the primary dealers (see chapter 9, footnote 9, for a list) in government bonds in
1998. Prior to that, the Reserve Bank was responsible for the marketing of government
bonds. Conflict was prevented by erecting a ‘Chinese wall’ between, on the one hand,
the money and capital market division of the Reserve Bank and, on the other hand,
the monetary policy decision-making process. Nevertheless, the 1998 step created an
unambiguous institutional separation. It moved the marketing function of government
11 R P Harber (1995) South Africa’s Public Debt (USAID unpublished report), p. 13.

bonds outside the Bank to the primary dealers and required the Reserve Bank to
acquisre any government bonds needed to conduct monetary policy (i.e. open market
operations) in the market and not from government.
One can conclude that public debt management is likely to have contributed to the growth
in both the budget deficit and the total public debt in the 1980s and early 1990s. However,
improvements in public debt management in the late 1990s, and in particular an
increased emphasis by the National Treasury on proper asset and liability management,
have contributed to the significant drop in the public debt burden from the late 1990s to
the 2000s.
This entire analysis highlights the importance of economic conditions in which relatively
stable interest rate levels and manageable budget deficits can be maintained. Both the
fiscal and the monetary authorities must contribute to achieving this.
10.7 Fiscal discipline and fiscal norms

Fiscal discipline has been a persistent theme in the policy debate during the past decade.
At face value, it would seem to be a proper principle. However, its meaning in practice, and
how it should be measured and monitored, is not so simple.
As was the case with regard to the evaluation of aggregate government expenditure and
total taxation, this matter is also confounded by ideological factors, specifically where
people are willing to resort to any argument or measure to justify either an expanding or
a shrinking role for government. It is therefore crucial to consider this issue in a balanced
and sober way.
Fiscal discipline and overspending

An obvious element of fiscal discipline is that government should not readily spend more
than it has budgeted for. To do so would imply blatant indiscipline, which goes against all
budgetary, fiscal and democratic principles.
In the 1980s government frequently overspent, in one case by as much as 9% of budgeted
expenditure. While fiscal discipline was preached, it was not practised. This did much damage
to the integrity and credibility of the national budget. (If excessive expenditure occurs due
to unforeseen cyclical factors or, for example, due to a drought or natural disaster, it is more
acceptable.)
The period since 2008/09 again saw overspending on occasion, with the government
breaching the expenditure ceilings it imposed on itself. Contributing to this overspending were
so-called bail-outs, or large transfers to state-owned enterprises that experienced financial
difficulties.
However, precisely because the undesirability of overspending is so obvious, it is not the real
issue where fiscal discipline is concerned. The discussion below assumes the absence of
expenditure not budgeted for.
Broadly speaking, the objective is to find criteria or norms that indicate sound, healthy
fiscal policy. In the past decade, several criteria have been suggested as part of a gradual
movement towards more sophisticated fiscal measures. Typically, these criteria are closely
related to different definitions of budget balances (deficits or surpluses), often in relation
to the size of GDP.

10.7.1 A variety of fiscal balances
Earlier in this chapter (section 10.5.3) a number of different fiscal balances (fiscal deficits
or surpluses) were defined, inter alia: the conventional budget balance, the current budget
balance and the primary budget balance. They require further scrutiny. Whereas the
earlier deficit graphs and tables referred to the national government level (constructed
with main budget data), we now consider budget balances at the general government
level, using both GFS and SNA data.
Which deficit data? More specific guidelines

Data on the different deficit measures are available from both the SNA and the GFS data
systems. The question is which data source to use. As mentioned earlier, it depends on the
purpose of the analysis. The following should be noted:
❐ There is a significant similarity in size between the GFS and SNA measures on the
conventional deficit. The same similarity can also be observed for the primary deficits.
❐ For the current deficit there is a systematic disparity, with the GFS value consistently
one to two percentage points lower than the SNA value. (The difference can probably
be ascribed to broader current expenditure and revenue definitions in GFS.)
❐ Changes in the GFS deficit lag approximately one year behind changes in SNA deficits.
This is because the SNA is an accruals-based accounting system, while the GFS data
available are cash based. Thus, for instance, a tax liability incurred in 2018 accrues
to 2018 and therefore will be recorded as a 2018 transaction in the SNA data set.
However, because the tax is very often only paid in the next year, the GFS data will only
DATA TIP
record it when the cash payment of the tax actually flows in 2019, in our example.
❐ When the focus is on the health and sustainability of government finances, the most
appropriate measures are the conventional and primary deficits calculated with GFS
data, because they show all the kinds of expenditure and revenue that flow through
government. (However, the SNA versions are not a bad second choice, but they have to
be constructed from various data series.)
❐ For discussions of saving within a macroeconomic context, the most appropriate is the
current deficit measured with SNA data (see section 10.7.3). This measure provides
(gross or net) saving by general government, which can then be compared to the saving
of the other sectors of the economy that are covered in the SNA. But since the SNA
does not count transfers and subsidies, its current deficit (which is available as ‘net
saving’ by general government) is never a good indicator of the state of the budget.
❐ The GFS current deficit measure can be used when considering the financing of capital
vs. current expenditure, given a view that current expenditure should be financed with
current revenue and not with loans, while capital expenditure can be financed with loans.
❐ When, in a broader context, the fiscal and financial sustainability of different sectors
of the economy (of which the government sector is but one) are discussed, the most
appropriate data would be the primary deficit calculated with SNA data. This is because
one can also calculate primary deficits for the other sectors.
The first graph in figure 10.5 shows the three different budget balance measures as
calculated with GFS, while the second graph shows three current balance measures using
GFS and SNA data. Cyclical elements have not been removed from the data.
After being very large in the early 1990s, a significant improvement occurred in the
conventional deficit up to 2007/08. After 2007/08 the deficit position deteriorated
markedly for two years, after which it improved somewhat. The question is to what extent
these balances can be used to monitor and evaluate fiscal policy. This will be discussed in
the next subsections.
10.7 Fiscal discipline and fiscal norms 437

Figure 10.5 Different fiscal balances as a percentage of GDP (GFS and SNA data)
4
Conventional deficit (GFS)
Percentage of GDP
2
0
Zero-deficit line
–2
Current deficit (GFS)

–4
Primary deficit (GFS)

–6
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
6
4
Current deficit (net) (SNA)
Percentage of GDP
0 Zero-deficit line
–2
Current deficit (GFS)

–4
Current deficit (gross) (SNA)

–6
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
All values are for general government. Positive values indicate a deficit; negative values indicate a surplus.
Source: South African Reserve Bank (www.resbank.co.za). GFS tables and authors’ own calculations
from SNA data.
10.7.2 The conventional deficit as fiscal norm?

At the beginning of the 1990s, the budget deficit suddenly came to prominence. This
was related to the impending political transformation and competing efforts to influence
the policies of the new government. At issue was the role and size of government, and
the amount of discretion to be given to government to pursue economic and especially
social objectives.
In this time, the so-called 3% rule appeared. The idea was that a long-run rule for healthy
fiscal policy could be found in the prescription that the conventional deficit should not
exceed 3% of GDP. While supporting arguments highlighted the dangers of crowding out
due to excessive government borrowing, the broader argument was against too large a

government presence in the economy – the crowding out of private economic activity in a
more general sense. (It is still unclear where this prescription originated. At one stage it was
believed to be prescribed by the IMF. However, such a rule has never been the official IMF
viewpoint (although a general disposition in favour of smaller rather than larger deficits is
to be found in IMF circles). A 3% deficit norm was also part of the entry requirements for
the European monetary union (i.e. in the Maastricht treaty).
Such a fiscal rule would rigidly constrain the ability of government to pursue discretionary
macroeconomic policy. While there is much consensus that active countercyclical fiscal
policy – as propounded by early Keynesian theory – is undesirable today, there is still a
strong case for discretionary powers to be available in certain circumstances.
❐ OECD countries such as Germany and France, which have been subject to a 3% deficit
rule that originated in the Maastricht criteria and was reinforced by the Stability and
Growth Pact (SGP) of the EU, often cite economic conditions as perfectly valid reasons
why they break the rule and apply some discretion by allowing the deficit to exceed
3%. (Ironically, they were not so forgiving when, during the Euro crisis of 2011–12,
several, mostly southern European, countries developed deficits that exceeded the 3%
norm by huge margins, saw their public debt/GDP ratios balloon and got to the brink
of defaulting on their public debt – see the case study in section 4.8.)
❐ In practice, the use of such a fixed rule is severely limited by the cyclical elements of
the deficit. Cyclical influences can cause the planned, budgeted deficit and the actual,
realised deficit to diverge significantly. Rigid adherence to a fixed deficit rule can severely
exacerbate recessions (and economic upswings), resulting in pro-cyclical policy. If a rule
is to be used, it would have to apply to the cyclically adjusted deficit. However, the budget
process requires expenditure and revenue plans to be drawn up for the coming fiscal year.
Since the fiscal authority cannot know with any certainty what the cyclical component
is likely to be in the coming fiscal year, pre-emptively limiting the non-cyclical component
of the eventual deficit to a prescribed percentage of GDP is all but impossible.
❐ Unavoidable social and developmental crises can also impact on the sustainability of a
fiscal rule.
If the size of government, or the extent of government involvement in the economy, is one’s
concern, another complication is that a specified deficit level such as 3% can exist in both a
‘high expenditure, high tax’ situation and a ‘low expenditure, low tax’ situation. As such,
the size of the deficit would not have much meaning regarding the size of government
expenditure.
There is also little clear empirical evidence for the validity of a 3% guideline. From the
implementation of GEAR in the late 1990s until 2008, the South African government
succeeded in maintaining the deficit below 3% of GDP. After 2008 the deficits exceeded
3% by a significant margin, reaching 5% in 2012/13 and remaining above 3.8% since.
Internationally, and as demonstrated by the international financial crisis and its
aftermath, deficits in excess of 3% of GDP are common in both small-government and
large-government countries. Unfortunately, there are no simple lessons in this regard.
It would appear that a simple 3% ceiling (or any other fixed percentage of GDP) for the
conventional budget deficit does not have a solid foundation.
❐ This does not mean that ‘anything goes’ as far as the size of the deficit is concerned.
Typically, a fiscal crisis or fiscal indiscipline will be mirrored in a budget deficit that is
‘too large’ in some sense.

❐ The point is that a fixed-percentage fiscal rule is too crude and inflexible to serve as a
solid fiscal norm. More refined measures and considerations have to be applied if a wise
fiscal policy path is to be charted.
For decades, proponents and opponents of rules could not find common ground in the so-
called ‘rules-vs.-discretion’ policy debate – probably because much of it could be related
to the broader debate between Keynesians and Monetarists. However, in recent years, the
literature on fiscal rules increasingly reflects a realisation that the issue is not so much
discretion as bounded flexibility (or constrained discretion). As was the case in Germany
and France – and also other countries where rather rigid fiscal rules were implemented – it
became clear that a rigid rule (such as a balanced budget rule or a rule that caps the deficit
at 3%) will not stop a government that wants to, or must, break it. So the rule would lose
its credibility.
As an alternative economists such as JB Taylor – in analogy to his monetary policy rule
(see box below) have developed more flexible fiscal rules. These allow the deficit to fluctuate
with the business cycle in a manner specified by the rule. When averaged over the business
cycle, it maintains a sustainable low level. Although no country has yet implemented such
a rule explicitly, Taylor has demonstrated that the rule mimics the actual behaviour of a
fiscally responsible government. So it will not be too difficult to implement if a government
wants to run a sustainable fiscal policy that also allows it some discretion.
Ironically, in the wake of the deficit problems of many EU countries that gave rise to
the Euro crisis, Germany passed a law that will prevent its government from running
a cyclically-adjusted (or structural) deficit of more than 0.35% from 2016; its Länder
(provinces) will not be allowed to run any structural deficit from 2020 (save for large
natural disasters or serious economic crises). This experiment has been watched carefully
by macroeconomists. The German government has actually managed to run a balanced
budget since 2014, reducing its public debt/GDP burden significantly (see table 10.5).
Fiscal and monetary rules?

The idea of a 3% fiscal rule reminds one of a similar proposal, from the Monetarist school,
for monetary policy. The idea of the monetary rule is that the monetary authority must
be compelled to control the money supply to grow at a fixed rate.12 This would preclude
discretionary monetary policy. It is not unexpected that support for the 3% fiscal rule comes
primarily from those with a Monetarist orientation.However, as was the case with a rigid
3% fiscal rule, it became clear in the 1970s and 1980s that few, if any, central banks were
willing to commit to a money supply target – even when a central bank was staunchly anti-
inflationary. JB Taylor proposed what has become known as the Taylor rule in monetary policy:
where the central bank changes the short-term interest rate in a ‘programmed reaction’ to
movements in inflation and the business cycle (see chapter 7, section 7.2.2). Again, no country
explicitly implements a Taylor rule; yet data reveal that countries that combat inflation closely
mimic the behaviour described by the Taylor rule – a case of following the rule implicitly. Of
course, for a central bank jealously guarding its independence, that is a completely different
matter from a rigid rule.
12 The monetary rule is discussed briefly in chapter 9.

A balanced budget norm?
The idea of a balanced budget norm is an extreme form of the idea of a fiscal rule – it would prescribe
the deficit to be 0% of GDP.
❐ This idea is quite alive in the USA. It has been proposed at various times in conservative Republican
Party circles, especially during the Reagan era and by Republican-controlled Congresses during
the Clinton and Obama eras (with both presidents Clinton and Obama being Democrats). Especially
during the Obama era the so-called Tea Party faction of the Republican Party were quite vocal in their
support for a balanced budget rule.
❐ In the USA the debate is driven, particularly, by the deep ideological differences between the
Republicans and the Democrats regarding the role of government in the economy. Republicans
typically prefer a smaller rather than larger role for government.
❐ Notwithstanding the ideologically inspired preference of the Republicans in the USA for balanced
budgets, the Republican administrations under Presidents Reagan, Bush Sr, Bush Jr and Trump ran the
largest peacetime deficits in US history, while the Democratic administration under President Clinton
ran a budget surplus and reduced the public debt burden significantly by the time he left office. The
fiscal stimulus package announced in 2009 in the first months of the Obama presidency produced
truly huge deficits and growth in public debt in the following couple of years – to the irritation of
Republicans.
❐ All the remarks above concerning the 3% rule apply to this proposal.
Inflation, deficits and debt – the operational deficit

The measurement and interpretation of deficits and debt are complicated by inflation.
Inflation increases nominal interest rates, and therefore the nominal cost of public debt. (The inflation rate
constitutes the gap between the real and the nominal interest rates.) As a result, the interest component
of government expenditure in the budget is inflated. This implies a squeeze on the funds available for
other purposes.
An important insight is that the inflationary component of the interest paid to bondholders amounts to a
partial repayment of the outstanding loan.
❐ The real interest rate is the real reward that holders of government bonds require to hold the bonds.
❐ After an inflationary period, the real value of bonds will be less than when they were issued – inflation
reduces the real value of public debt.
❐ But the bondholders do not really lose the amount with which the real value of bonds decreases – as
long as the nominal interest rate adjusts on a one-to-one basis with inflation (i.e. for every percentage
point increase in the inflation rate, the nominal interest rate also increases by a percentage point.
They are compensated by the inflation component of the interest they receive. The inflation
component amounts to a partial repayment of the loan (or, in general, of public debt). (Government
has no choice but to resort to such payments by paying the nominal interest due. If not, it would not
find willing bondholders to finance deficits.)
Therefore, the inflationary element of nominal interest on public debt is not a pure interest element, and
should be identified as such in the budget. (Debt roll-over is not shown as an expenditure item, although
it does form part of the overall government borrowing requirement; see section 10.5.3.) Consequently,
the conventional budget deficit overstates the magnitude of the fiscal imbalance in the presence of
inflation. As an alternative, the operational deficit is defined to exclude the implicit ‘debt redemption’
from aggregate expenditure:
Operational deficit = [Aggregate expenditure – inflationary part of interest payments]
 aggregate revenue
In assessing the magnitude of the fiscal deficit relative to GDP, for instance, the operational deficit would
give a less distorted view of the fiscal stance (in the presence of inflation). Unfortunately, it is quite
complicated to calculate the operational budget in practice.

10.7.3 The current deficit as fiscal norm?
A current budget deficit means that
the government’s current (= non- Do not confuse the current budget balance and the
capital) expenditure exceeds its current account of the BoP.
current revenue. When this occurs,
government is said to be ‘dissaving’.
(A current budget surplus would indicate that government is saving.)
❐ A current deficit implies that a portion of the funds borrowed by government is used to
finance current expenditure: the loans cover all capital expenditure, but also a portion
of current expenditures.
❐ A current surplus means that all current expenditure and some capital expenditure
are financed by current revenue. Borrowing is less than capital expenditure, and
government is saving.
❐ Put differently, a current deficit means that the conventional deficit exceeds the
amount of capital expenditure by government. In the case of a current surplus the
conventional deficit (i.e. the amount borrowed) is less than the capital expenditure.
If the current balance is zero, the amount borrowed exactly matches the amount of
capital expenditure.
Figure 10.6 depicts the current budget balance for three basic cases: (1) a current deficit,
(2) a current surplus, and (3) a current surplus coupled with an overall, conventional
budget surplus.
Figure 10.6 The current budget balance – different cases
Aggregate government expenditure
Current expenditure Capital expenditure
Tax revenue Overall deficit

1
Current
deficit
(dissaving) Overall deficit
Tax revenue
2
Current Overall
surplus surplus
Tax revenue (saving)
3
Current surplus
(saving)
Figure 10.7 shows (using SNA data) that in gross terms the government incurred signifi
cant current deficits (dissaving) from the 1980s to mid-1990s (the blue line is above the
zero-deficit line). This contrasts with the period between 1946 and 1981, when the (gross)
current budget balance always displayed a surplus (the blue line is below the zero-deficit
line). From the mid-1990s to 2008 dissaving decreased significantly, with government
even being a net saver in 2006 and 2007. After 2008 dissaving increased again, with the
(gross) current deficit between 1% and 2%.
Since 2008 the net current balance has been in a surplus of between 0% and 1% of GDP.
When this measure is in a deficit (i.e. above the zero line), it means the government is not

even saving enough to replace existing capital, as in the early 1990s. A surplus shows
how much government is saving beyond the amount required for capital replacement.
(For more on net saving/dissaving of government, see section 5.4, chapter 5.)
Figure 10.7 The current balance: gross and net government saving as a percentage of GDP (SNA data)
8
Gross saving
4
2
Percentage of GDP
Zero-deficit line
0
–2
Net saving
–4
–6
–8
–10
1946
1948
1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
Positive values indicate a deficit; negative values a surplus.
The question is how to evaluate current budget deficits (or surpluses). Does this fiscal
measure provide a sound basis for deriving a fiscal norm for budgetary policy?
It is regularly argued that it is an unhealthy budgetary practice to borrow in order to
finance current expenditure. Indeed, until 1975 the budget was divided into a current
budget (called the budget for the ‘Revenue Account’) and a capital budget (called a budget
for the ‘Loan Account’). Loans were allowed only in the capital budget, and were therefore
limited to the financing of capital projects.13
The argument is that loans should be used only for projects (assets) that will provide a return
in future, enabling repayment of the debt, and not for non-productive purposes that simply
consume resources without creating assets or a stream of future returns. This is a principle
often applied in business decisions and one that clearly makes sense in that context.
However, it is not clear that it can be applied in unamended form to the government. The
state is not a profit-making institution, and its typical nature requires a different perspective
on what constitutes assets, productivity and returns. The practical application of such a
principle to government is severely complicated by the problematic distinction between
current and capital items. This relates to the problem of physical vs. human capital. In
standard budgetary accounting, government expenditure on human capital formation
(e.g. education or health) is classified as non-productive consumption expenditure. Yet
such expenditure clearly has an important role in economic growth (see section 10.4.2,
chapter 8 and chapter 12, section 12.3).
13 The Revenue Account usually registered a surplus, which was then used to finance capital expenditure on the Loan
Account (i.e. the Revenue Account surplus was transferred to the Loan Account, thereby leaving only a portion of
capital expenditure to be financed by loans).

Is low aggregate saving a cause of low economic growth?
Does government dissaving contribute to a smaller pool of savings and hence to low capital
formation and low growth?
There is little theoretical or empirical evidence that the low capital formation of the past two
decades has been caused by a shortage of saving in the economy – something to which
government dissaving could have contributed (also see chapter 12, section 12.3.3). Unlike the USA
where companies frequently go to the bond market to raise new capital (and therefore use prior
savings), in emerging-market countries capital formation projects are typically financed not by prior
savings but by bank credit (long-term bank loans). The income stream from such projects is then
used to generate savings to repay the loans. In all likelihood, low aggregate saving is a symptom of
low growth (and low income levels) rather than a cause of it. The low levels of capital formation are
probably due to factors such as political and economic uncertainty.
❐ This means that growth cannot be stimulated by enlarging the savings pool as long as
there is a hesitancy to invest.
❐ Government dissaving is therefore not a decisive factor in either the explanation or the
redress of poor growth performance.
However, Classical-Monetarist, New Classical and supply-side economists have a different
view of this issue: they do see a shortage of saving as a cause of low growth.
What can be agreed is that, if stronger economic growth does develop, at some stage a
shortage of investable funds may occur. In such a situation, government dissaving could be a
contributing factor to the shortage.
Alternatively, government could save and thereby add to the pool of investable funds.
❐ However, even though such saving by government adds to the saving pool, it should also
be kept in mind that, to ensure that it runs a current surplus at a time when it is not doing
so, government needs either to increase taxes or reduce current expenditure – both steps
reduce aggregate expenditure and hence cause output to contract.
❐ Thus, one needs to look at the balance of effects, i.e. the balance between the stimulating
effect of higher investment (financed by government saving) and the contractionary effect
of higher taxes and lower government expenditure. The complex interaction of these
effects again serves as a warning to be very cautious when considering the national
account sectoral identities set out in chapter 5.
The question is whether this classification is solid enough to provide a basis for a fiscal
guideline that can be implemented with confidence. While the idea that consumption
spending should not be financed by borrowing may be valid, there are too many problems
– conceptually and in practice – to use this as a solid fiscal guideline. Therefore the current
budget balance does not offer a reliable fiscal norm.
Nevertheless, it would appear wise not to ignore this dimension. While there may be a
large grey area in the distinction between current and capital expenditure, excessive
current imbalances must be regarded with concern.
❐ The ideal would be to devise a redefined measure of capital expenditure that appropriately
incorporates investment in human capital, and calculate a redefined current deficit.
However, the practical problems involved are substantial.
Another perspective is provided by the place of the current deficit in the context of the
sectoral balance identities (see section 10.4.1). The current deficit (or dissaving) of the
general government, indicated as (T – GC), appears in an important relation to the current

account of the BoP and the domestic investment–saving balance.14 Does this relationship
provide a basis for deriving a fiscal norm?
❐ If a country experiences a significant outflow of capital, the existence of a general
government current budget deficit (dissaving) does pose a problem. One can say that
in such circumstances the contribution of government to general government dissaving
should be monitored. (Review the discussion in chapter 5, section 5.5.)
❐ However, a concern about aggregate domestic saving does not provide a basis for
deriving a generally applicable fiscal guideline with regard to the current deficit. (Also
remember the dangers of drawing any conclusions regarding cause and effect from
these identities. Beware especially the simple conclusion designating government
dissaving as the cause of other sectoral imbalances.)
Concern over the current deficit can also be seen in a focus on constraining the current
or consumption expenditure of the government, favouring capital expenditure and
capital formation by government. This is related to a particular view concerning the
possible advantages of capital as against current expenditure with regard to the growth
objective. However, essentially the targeting of government consumption is just another
manifestation of the concern over dissaving and aggregate saving, which has been
discussed above.
10.7.4 The primary balance and sustainability

Recall the definition of the primary balance:
Primary balance  Total non-interest expenditure – aggregate revenue
Whereas the concept of a current balance is built on the distinction between the current
expenditure and capital expenditure of government, the primary balance uses the
distinction between interest payments and non-interest expenditure of government.
It focuses on the gap between non-interest expenditures and revenue (taxation). A
primary deficit means that the government’s non-interest expenditure exceeds its revenue
(taxation). A primary surplus means that revenue exceeds non-interest expenditure.
❐ A primary deficit indicates that none of the interest payments on the stock of debt is
financed by revenue (taxation). All of the interest payments are financed by borrowing. A
primary surplus means that some or all of the interest payments are financed by taxation.
❐ Equivalently, a primary deficit means that the conventional deficit – the amount
borrowed – exceeds the amount of interest payments. A primary surplus means that
the conventional deficit (borrowing) was less than the interest payments. Only in
the case of a conventional budget surplus does no borrowing go towards financing
interest payments.
Figure 10.8 depicts the primary budget balance for three basic cases: (1) a primary deficit,
(2) a primary surplus, and (3) a primary surplus coupled with an overall, conventional
budget surplus.
14 Remember that the South African data for this identity is peculiar in that GC is defined to exclude government
investment. Therefore T – GC is the current budget deficit. In the international context and in standard textbooks,
T – GC usually denotes the conventional or overall budget deficit. It is worth considering to what extent the sometimes
distortive attention given to government dissaving might have been brought about by the fact that the data and the
identities highlight dissaving rather than the overall budget deficit.

Figure 10.8 The primary budget balance – different cases
Aggregate government expenditure
Non-interest expenditure Interest payments
Tax revenue Overall deficit

1
Primary
deficit
Overall deficit
Tax revenue
2
Primary Overall
surplus surplus
Tax revenue
3
Primary surplus
A last and very useful interpretation of the primary balance is the following: given that
interest payments are a reflection of past deficits (the ‘sins of the past’), the primary
balance can also be interpreted as that part of the overall deficit that derives from the
present provision of goods and services of the government, i.e. from the actual expenditure
on defence, housing, health, etc. and tax revenue during the present fiscal year. That is, it
shows the impact of the present budgetary policy of the government – actual budgetary
activities (excluding debt servicing) – on public debt.
❐ In this context, a primary deficit means that the present level of provision of government
services is not being financed wholly by tax revenue; a primary surplus means that all
present government services are being financed by tax revenue, with some residual tax
revenue left to pay part of the interest on the stock of debt.
What is the ‘debt trap’?

The so-called debt trap can be described in various ways. It has technical as well as political-
economic dimensions.
One definition is that of a situation in which the debt ratio increases indefinitely and
uncontrollably (with government being unable to do anything to modify its budgetary
situation). This means that trends in government expenditure and taxation are such that the
government is powerless to control the debt growth rate.
❐ This is not only a technical definition. In particular, it also implies that the government does
not have the political support to limit expenditure growth and/or to increase tax revenue.
❐ As long as it does have such support, a debt trap situation is unlikely.
Alternatively, a country is in a debt trap if it can prevent the debt ratio from increasing only
by resorting to money creation as a financing method. That means that the government is
powerless to avoid the ‘monetisation of the debt’.
❐ In such a situation, the fiscal position is not sustainable and the government is heading
for a fiscal crisis in which it cannot service the interest on the debt, let alone repay the
debt. As a result, it is likely to find it impossible to borrow in financial markets, either
domestically or internationally. The budgetary process would collapse.

Using the primary deficit as a fiscal norm
The primary deficit provides one of the most important foundations for developing a fiscal
norm – in conjunction with public debt considerations. At the centre of attention is the
idea of fiscal sustainability:
A sustainable fiscal strategy is one in which the public debt stabilises at a certain, desired level
or, more specifically, does not increase continually.
This approach does not try to designate some ideal public debt level or ratio. Rather, it has
a non-explosive – and therefore sustainable – public debt pattern as its goal. From this goal,
a number of useful fiscal norms can be derived that relate to the determinants of the public
debt ratio.
Which factors determine the public debt ratio?

Consider the formula for the public debt ratio:
D Debt
Y   =   GDP  
   
Fiscal sustainability indicates a situation where the numerator (the total public debt) does
not persistently grow faster than the denominator (GDP). Fiscal sustainability will therefore
depend on factors determining the terms above and below the line. The first important
factor is therefore the growth in real GDP: the higher the GDP growth rate, the better the
prospects for the debt ratio. The second important factor is the growth in total public debt,
and increases in debt occur according to the following identity:
Increase in debt = Conventional deficit – money creation
= Interest payments + primary deficit – money creation
= (Existing debt × interest rate) + primary deficit – money creation
It is clear that the interest rate on public debt (= an automatic addition to debt) and the
primary deficit (= net budgetary addition to debt) are decisive in determining increases
in the total public debt. A complicating factor is the extent to which a budget deficit is
financed by money creation. If money creation is used to finance part of the deficit, the
total debt increases only by the remaining portion of the deficit.
The following equation shows a key relationship between these factors and changes in the
public debt ratio:
∆D (r – g)D + F – ∆H
Y    =   
    Y 
  
where:
Y = GDP;
D = public debt at the end of the previous fiscal year (i.e. existing debt);
r = real interest rate on public debt;
g = growth rate of real GDP;
F = primary deficit (note: a surplus would be a negative value); and
H = high-powered money (i.e. money reserves created by the central bank).
The third term on the right-hand side, ΔH, indicates that, if money creation is used fully
to finance a deficit, public debt does not increase at all. The first and second terms derive
from that part of the overall deficit that is not financed by money creation. Each of these
two terms has the following impact on the debt ratio:
❐ If the real interest rate exceeds the real GDP growth rate, interest payments will cause
the debt ratio to increase (first term on the right-hand side).

❐ A primary deficit will cause the debt ratio to increase (second term). The net impact
would depend on the relative sizes of these influences.
The following approximate rules can be derived:
❐ If there is a primary deficit, an increase in the debt ratio can be avoided only if the real
economic growth rate exceeds the real interest rate (g > r) by a significant margin;
if r > g the debt ratio will increase.
❐ If the real rate of interest is higher than the real economic growth rate (r > g), the debt
ratio can be kept in check only if a large enough primary surplus is attained (barring
money creation) (see box below).
❐ If there is a primary surplus that is large enough, a situation with r > g will rarely
present a problem.
How large must the primary surplus be to stabilise the debt ratio?
From the debt ratio formula above, one can deduce a formula for calculating the minimum
required primary surplus F to keep the debt ratio constant (assuming money creation is not
used to finance deficits):
F (r – g)D
Y   =   Y   
   
Given a debt ratio of approximately 50%, each percentage point gap between r and g requires
a primary surplus of 0.5% of GDP. In the late 1990s, this gap was approximately 5.5% in
South Africa. This implied a minimum required primary surplus of approximately 2.8% of GDP
to stabilise the debt ratio.
In the late 1990s, the actual primary surplus in South Africa averaged 2.5% and it increased
thereafter. The 2.5% was roughly in line with the required value, and explains the stabilisation
of the debt ratio in this period, while the larger values later explain why the public debt/GDP
ratio decreased significantly to 26.5% by 2008/09.
Similarly, the maximum allowed conventional deficit (to stabilise the debt ratio) is equal to:
– gD
 
Y   
which (given an average GDP growth rate of 2.5% for the late 1990s) translates to a maximum
conventional deficit of approximately 1.2% of GDP.
❐ In the late 1990s, the actual conventional deficit in South Africa averaged 3.5%, still above
the allowed maximum figure (from a debt stabilisation point of view). However, in the
2000s the conventional deficit became very small and even turned into a modest surplus
(the economy was growing at a higher rate) in the 2006/07 and 2007/08 fiscal years. This
explains, once again, the significant decrease in the public debt/GDP ratio in that period.
However, following the international financial crisis and the subsequent recession, a
conventional deficit reappeared in 2008/09, running in excess of 4% for a number of years.
Both calculations show the importance of a higher GDP growth rate and lower real interest
rates to make fiscal sustainability attainable.
Which interest rate?
Strictly speaking, the interest rate used in these calculations should be the effective interest
rate on public debt (calculated as the ratio of interest expenditure divided by public debt) and
not the current market rate on government bonds. (The former derives from the interest rate
of the bonds at the time of issue.) Nevertheless, to assess the difference between the real
interest rate and the real economic growth rate, we very often merely compare the current
market rate at which bonds trade with the growth rate (as is done in figure 10.9).

The dynamic behaviour of the public debt ratio is very sensitive to the relative levels of
the real interest rate and the real economic growth rate. This produces the following
guidelines for sustainable budgetary policy:
❐ If the real economic growth rate exceeds the real interest rate for a considerable period
of time, a primary deficit (which is a net addition to aggregate debt) does not constitute
a problem. One factor (the primary deficit) would serve to increase the debt ratio, the
other (the interest rate–growth rate differential) to decrease it. However, in practice
in South Africa it is unlikely that the real economic growth rate will be able to remain
higher than the real interest rate for long. (Recall the secondary effect of an increase
in GDP: high growth is likely to put upward pressure on interest rates, which would
depress the growth rate of the economy.) It is worth noting that, after the financial
crisis of 2008/09, the USA and some other high-income economies entered a phase
where the real economic growth rate consistently exceeded the real interest rate. This
contributed to their ability to stabilise their public debt/GDP ratios.
❐ If the real economic growth rate is less than the real interest rate for a considerable
period of time, a primary deficit (a net addition to aggregate debt) constitutes a very
serious problem: two forces that increase the debt ratio would be operative. Even if
there is a primary budget balance (a zero primary deficit), the situation would still
produce a continually increasing debt ratio. Only a sufficiently large primary surplus
can reverse the situation and restore sustainability (unless lower interest rates and/or
higher growth can be achieved).
Of course, at any time an increase in the debt ratio can be prevented if the government
resorts to money creation to finance the deficit. If this is (or has to be) done continually
to control the debt ratio, it already indicates that the government has lost control of the
fiscal situation – it is already in a debt trap. Moreover, the likely inflationary consequences
of such money creation are very damaging – probably more damaging than the steps that
might be necessary to get the budget deficit under control.
The primary deficit therefore offers a powerful fiscal norm, in conjunction with the real
interest rate and growth rate. Given projections of the likely course of these two rates, it
is possible to calculate what the primary deficit or surplus would have to be to ensure that
the debt ratio does not increase. As these rates change over time, the required primary
deficit will change correspondingly.
❐ In practice, one would want to use the cyclically adjusted primary deficit and medium- or
long-term projections of the interest rate and the growth rate.
Alternatively, the likely effect on the debt ratio of provisional budget plans can be
calculated. Remember that one does not necessarily want to stabilise the debt ratio at the
existing level – the existing level of debt may be too low or too high. Unfortunately there is
little guidance on what the ideal level should be (see section 10.6). Nevertheless, if there is
a policy consensus that in a given situation the debt ratio should not be allowed to increase
further, this fiscal norm provides clear guidelines for the budget.
Sustainability analysis clearly shows why something like the 3% rule or a balanced
budget prescription with regard to the conventional deficit is a very crude fiscal norm.
The same applies to a norm based on the current deficit. Budgetary planning using
these unsophisticated norms can lead to expenditure and taxation being pitched at
inappropriate levels.

Is the South African fiscal position sustainable?
The graph in figure 10.9 shows that from 1960 to 1982 the economic growth rate
persistently exceeded the real interest rate on government stock. The real interest rate was
negative from 1973 to 1982, and again in 1986. The negative interest rates of the 1980s
coincided with a period of variable, low and often negative economic growth (see section
10.6.4). Since 1990, real interest rates turned positive again and consistently exceeded
the real economic growth rate until 2002. With the exception of 2004, the real interest
rate was lower than the growth rate, with the real interest rate even turning negative
again in 2008. In 2010 it recovered, but only barely – in the period 2010–14 it has only
been more or less equal to the real economic growth rate. Regrettably, with weakening
economic growth the real interest rate has exceeded the real growth rate since 2015.
Figure 10.9 Real interest and the economic growth rate
10
Real GDP growth rate

8
4
Percentage of GDP
–2
Real interest rate
–4
–6
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
Clearly, the fiscal path from 1990 to 1995 was not sustainable. A primary deficit occurred
together with a real economic growth rate that was below the real interest on public debt.
The outcome of this unfortunate combination is reflected in the dramatic increase in the
public debt ratio during the early 1990s (see figure 10.4).
Since the late 1990s, government succeeded first in stabilising the debt/GDP ratio and
thereafter in reducing it from its high of almost 50% to below 26% in 2008. It did this
mostly by reducing the primary deficit and even running primary surpluses (see figure
10.5). The higher economic growth rate from 2002 to 2008 also contributed significantly
to this reduction. However, the significant primary deficits registered since 2008/09
resulted in the debt/GDP ratio rising to over 56% in 2018.
A higher economic growth rate and lower interest rates together with a sufficient
primary surplus can ensure the continued sustainability of fiscal policy for the
foreseeable future. However, if a higher economic growth and a lower interest rate
level do not realise over the long run, government may find it increasingly difficult
to maintain a sustainable fiscal policy in the face of immense socio-economic and
developmental needs.

10.8 Fiscal policy and development – broader criteria
Judging the sustainability of the deficit position is a key element in the macroeconomic
evaluation of the budget. In addition, the impact on major macroeconomic variables – GDP,
inflation, interest rates, the BoP, unemployment, etc. – is crucial. Yet these macro-economic
dimensions may not be the only, or most important, ones in evaluating fiscal policy. The
discussion of policy objectives in chapter 1 (section 1.4) suggests that the broader socio-
economic and hence political import of the budget – the impact on distributional, equity
and development objectives, the provision of infrastructure, education, medical and other
government services to different social groups – is at least equally important.
Not only fiscal policy is relevant in this context. For example, the point is often made that anti-
inflationary monetary policy – with a tendency to err rather on the high interest side when
pursuing low inflation – can be detrimental to development and economic empowerment to
the extent that high interest rates can hurt small businesses or new homeowners. However,
development considerations are more at issue in budgetary policy, where both government
expenditure and taxation can have decisive implications for development.
Taxation potentially has a large impact on the ability of individuals and business
enterprises to acquire and dispose of economic resources, goods, services and assets. This
directly affects economic empowerment.
While this negative impact on the command of resources is inevitable with any tax system,
the distribution of this impact among different individuals and groups – the equity of the
tax system – is crucial. The equity of the tax system decisively depends on the structure
of personal income taxation, but also of corporate taxation, and indirect taxation (such
as VAT).
If the personal income tax structure has a high degree of progressivity at relatively
low levels of income, it can constrain the ability of low-income households to become
economically self-reliant and afford their own house, for instance. If inflation is present,
the sapping effect of bracket creep on buying power can seriously hamper the economic
progress of low-income households. (On the other hand, high tax rates can have a strong
disincentive effect on high-income households especially, thereby discouraging work
effort and initiative.) In the 1990s, the South African personal income tax system became
increasingly progressive at low- to middle-income levels. This was primarily due to the
failure of government to address bracket creep. (However, significant personal income tax
relief after the late 1990s represented a rolling back of bracket creep that took place in
the 1990s.) In the late 2010s bracket creep was allowed to manifest again. Nevertheless,
its impact was largely limited to middle-income earners as a result of adjustments to the
bottom brackets that reduced the impact of bracket creep on low-income earners.
Various tax allowances (popularly known as tax loopholes), particularly on non-salary
income, also existed for individuals. Individuals who could arrange to receive significant
parts of their income in non-salary form (such as capital gains and some types of fringe
benefit) benefited. Since these are usually higher-income individuals, many of the tax
allowances decreased the progressivity of the tax system. Such allowances can negatively
affect both the vertical and the horizontal equity of the tax system: two individuals who
earned the same income paid different taxes if one earned it all as a salary and the other in
a form such as capital gains. Since the 1990s, government introduced several tax reforms
to reduce or eliminate these tax allowances, and introduced a capital gains tax. These
reforms greatly improved the equity of the tax system.
10.8 Fiscal policy and development – broader criteria 451

A corporate tax system with various tax allowances can create opportunities for companies
also to arrange their affairs to pay much lower effective rates of taxation. It is often the
larger corporations that succeed in doing this. Such allowances can harm small businesses
and frustrate the ability of new entrepreneurs to attain a secure competitive footing against
large, established corporations. This affects the process of economic empowerment and
development negatively.
A general perception of unfairness in the tax system creates incentives for increasing tax
evasion. Tax evasion is illegal and should be distinguished from tax avoidance, which is
legal and entails the use of allowances and ‘tax loopholes’). If it occurs on a big enough
scale, tax evasion can destroy the integrity and functioning of the entire tax system and can
threaten the functioning of government, including its development-oriented functions.
On the expenditure side of the budget, government functions aimed at development are
crucial. This especially concerns so-called social expenditure such as housing, education,
welfare and health. Expenditure on economic infrastructure (e.g. roads, electricity,
communication and transport) can be just as important in supporting and enabling
economic development and growth. It is therefore important for the government to supply
these services in a prudent and efficient manner, and to allocate sufficient funds for them.
However, a lack of timely planning and effective implementation, or insufficient
infrastructure investment or maintenance, can have serious repercussions for economic
welfare and development. As noted in chapter 8, even moderate economic growth rates
can require a doubling of infrastructure within a generation and 5% growth a doubling
within 14 years (roughly speaking). Efficient planning and execution are essential for
government investment to have the desired impact on growth and development.
It is not only the magnitude of expenditure on these categories that is important. True
development support does not imply that government must simply provide everything,
e.g. houses for everybody. While this is not affordable in any case, it can also lead to
an increasing dependence on government, which is the antithesis of development and
economic empowerment. Government must certainly support, and in certain cases
provide, certain key services such as education and health. But in general, government
must concentrate on playing an enabling role.
The key issue is not the amounts allocated, but how they are spent. The question is: do people
acquire skills, do they learn how to sustain their own livelihood, do they learn how to
sustain their own development, is there economic capacity building, are they truly
empowered? Are houses simply dished out to people, or do they take part in building and
financing their houses, thereby acquiring skills?
These are the critical questions regarding development-oriented government expenditure
that have to be asked when evaluating budgets. One must look beyond the absolute
amounts allocated to government functions. Indeed, an excessive focus on the absolute
monetary amounts allocated in the budget can lead to large-scale wastage of funds.

1. List and explain factors that will influence the effectiveness of fiscal policy.
2. Explain what is meant by fiscal policy as an automatic stabiliser. (You may use chain
reactions.)

3. Explain the difference between the situation where a government runs a conventional
and a current deficit, but a primary surplus, on its budget as opposed to a situation
where government runs a conventional, current and primary deficit.
4. Explain how a depreciation of the rand will affect foreign currency-denominated
public debt.
5. In the 2014 Budget Review the government set out plans to reduce the budget deficit in
future years. Compare these plans with actual budget numbers for subsequent years
and describe deviations. What are probably the main reasons for the outcomes that
you observe? To what extent are these under the control of the National Treasury?
6. Obtain data for the public debt/GDP ratio (from the website of the Reserve Bank)
and compare the data to the real GDP growth rate. Does the debt/GDP ratio tend to
increase (decrease) in years with low (high) economic growth? Explain how such a
negative correlation can occur.
7. Who bears the burden of public debt? Discuss.
8. What has been the main reason(s) for the steep increase in the public debt/GDP ratio
since 2008 (compare figure 10.4)? Consider economic and/or political or other factors
and analyse how they could have contributed to rising public debt.
9. Consider the following statement: ‘Growth is not coming through and tax revenues
are not there. We are in trouble. Government needs to reduce spending.’ (The Director
General of the National Treasury, quoted in City Press, July 2019). With SA’s fiscus
in crisis, exacerbated by the R59 billion aid package to Eskom, Treasury needs R120
billion. The best way to plug the gaping hole in the fiscus may be for all state employees
to take a 10% cut in salaries and wages.
Why should the government’s total wage bill be reduced? Analyse the impact of steadily
growing government wage costs on the national budget in terms of the fiscal room
available for infrastructure and the non-labour components of government services, as
well as the pressure on the budget deficit and thus sustainable public debt levels.
10. The sudden announcement of free higher education by president Zuma in December
2017 implied large increases in higher education spending, thus putting the national
budget under severe pressure. In the March 2018 budget, the Minister of Finance
announced the following:
a. All first-year students with a family income of below R350 000 per year will be
funded for the full cost of study. This will be rolled out in future years until all
years of study are covered.
b. The reallocation of resources towards higher education will amount to an
additional R57 billion to fund the phasing in of fee-free tertiary education. This is
in addition to the R10 billion provisionally allocated in the 2017 budget.
c. To find R57 billion to fund free tertiary education, government has committed to
raising VAT (from 14% to 15%) and also hold back on some of its capital projects
and reduce spending on goods and services.
Analyse and discuss the different considerations, pros and cons, and trade-offs,
necessary in coming to such a decision about free higher education.
11. In 2019 the Fitch Ratings Agency changed the outlook on SA’s credit rating from
‘stable’ to ‘negative’. Analyse the different impacts on the economy of such a ratings
downgrade (e.g. international issues, fiscal issues, etc.).

Addendum 10.1: Measuring aggregate government expenditure
Three data sources on government expenditure and revenue are available:
1. The national accounting (SNA) framework, which is designed to measure real
expenditure, production and income flows that occur in a particular period (e.g. a
year), regardless of whether or when payment occurs (i.e. on an accrual basis). It
highlights the net addition of government expenditure to real aggregate expenditure
in the economy. The SNA figures are published in the Reserve Bank Quarterly Bulletin
(National Accounts section).
2. The Government Finance Statistics (GFS) framework. The 2001 GFS system is also
an accruals-based system that contains a balance sheet and income statement for
government with a cash flow statement attached to it. However, few governments
have been able to develop a fully-fledged system with balance sheets, income and
cash flow statements, and South Africa is no exception. Given that the previous GFS
was just cash based, the GFS section of the Quarterly Bulletin contains only a cash
flow statement. Therefore, GFS data in South Africa currently measure only financial
transactions (i.e. only when payment actually occurs, on a cash flow basis), and
regardless of whether the transaction causes a net addition of real expenditure. A
major reason for differences between GFS and SNA figures is time gaps between real
economic activity and the corresponding financial transactions. (Other definitional
differences also exist.) GFS data are published in the Reserve Bank Quarterly Bulletin
(Public Finance section).
3. The budget framework, which shows the flow of funds through the expenditure side
of the budget of the national government. A major reason for differences between
the budget figures and the GFS or SNA figures is that the budget figures pertain only
to the national government. Budget figures, therefore, exclude provincial and local
government expenditure, as well as extrabudgetary institutions and social security
funds. (However, see the important footnote 1 of chapter 10.) It is also necessary
to distinguish between budgeted figures and actual figures published in the budget
framework. The former refers to budget plans, i.e. what government plans or budgets to
spend as well as to raise in taxes. The actual figures published in the budget framework
are the outcomes of the plans, i.e. what government actually spent and raised in taxes.
The context below, when referring to budget data, refers to the actual amounts spent
or raised. All these figures are published in the Budget Review.
Thus:
❐ The budget and GFS data are similar in terms of their focus on financial flows, but differ
in institutional coverage (national government vs. general government).
❐ The budget and SNA data differ with regard to their basis (financial flows vs. real
expenditure) and their institutional coverage. Hence there are larger differences in
amounts.
The SNA figures are normally for calendar years (or quarters), while GFS and budget figures
are for fiscal years (starting on April 1 of each year, i.e. the second quarter). However, both
SNA and GFS figures are also reported on an annual basis, which means that both can be
reported for calendar years (as indeed is done below with the GFS data).
Another major difference between government expenditure in, on the one hand, the SNA
data and, on the other hand, the GFS and the budget data, is the kind of expenditure
included. Total government expenditure in the SNA’s ‘expenditure on gross domestic
product’ tables and in the GFS and budget systems differs as follows:

SNA GFS & Budget15
Final consumption Government consumption expenditure
Current expenditure
expenditure by government plus
Interest on public debt
plus
Subsidies
plus
Current transfers to households
(mainly pensions)
PLUS PLUS
Capital expenditure
Fixed capital formation Government capital formation
by government plus
Acquisition of existing capital assets
plus
Capital transfers
These differences imply very different figures on total government expenditure.

❐ By including or excluding specific items, a variety of measures can be constructed.
❐ As shown below, it is possible to construct an SNA figure that approximates the GFS or
budget figures in terms of these additional elements.
Below is a list of several definitions and measures of total government expenditure. Each
must be handled with care.
Definitions of total government expenditure Nominal amount Percentage of
2018 or 2018/19 GDP 16 2018 or
(R million) 2018/19
National accounts (SNA) context (2018): (Reserve Bank Quarterly Bulletin)
The most straightforward SNA measure is:
Definition 1 (SNA): Final consumption expenditure by 1 316 104 27.0%
general government plus gross fixed capital formation
by public authorities.
This figure for capital formation (investment) is broader
than general government, and also includes investment by
government corporations such as Telkom and Transnet.
The most accurate SNA measure of general government
expenditure is:
Definition 2 (SNA): Final consumption expenditure by 1 182 905 24.3%
general government plus gross fixed capital formation
by general government.
These two measures are most appropriate for
macroeconomic analysis. ⇒
15 The SNA table ‘Current income and expenditure of general government’ does show the current expenditure items
shown in the GFS/Budget column. However, they do not constitute net additions to real expenditure (see the SNA table
‘Expenditure on gross domestic product’) but flows/transfers of funds via government.
16 Nominal GDP calendar 2018 = R4 873 899 million. Nominal GDP fiscal 2018/19 = R5 059 106 million. The former
can be obtained from the Quarterly Bulletin, while the latter originates from the Budget Review.
Addendum 10.1: Measuring aggregate government expenditure 455

⇒ A national accounting equivalent of the expenditure
figures found in the GFS system or budget figures
must also include current expenditure other than
consumption expenditure. ‘Current expenditure of the
general government’ also includes subsidies, transfers to
households (e.g. pension payments), transfers to the rest of
the world, and, notably, interest on public debt.17 However,
because it is cash based, and unlike the SNA system that
is accrual based, the cash flow statement of the GFS does
not contain a consumption of fixed capital (i.e. depreciation)
component. Thus, it is excluded from the SNA figure.
Definition 3 (SNA): Current expenditure plus gross fixed 1 711 134 35.1%
capital formation by general government (excluding
consumption of fixed capital).
This is the closest one can get, in the SNA context, to the
budget figures on total government expenditure. Major
differences remaining include the following:
❐ This figure is for general government, while the budget
figure is only for the national government.
❐ In the budget data, capital expenditure comprises
more than capital formation (investment).
While interest payments do constitute a claim on the
budget, they do not reflect current budget plans but
the legacy of past deficits. In budget analysis, this
item is often excluded, producing ‘non-interest current
expenditure of general government’. Therefore:
Definition 4 (SNA): Non-interest current expenditure plus 1 493 965 30.7%
gross fixed capital formation by general government
(excluding consumption of fixed capital).
Government Finance Statistics (GFS) context (2018): (Reserve Bank Quarterly Bulletin)
In GFS context, the easiest and most comprehensive

measure of total government expenditure is the following:
Definition 5 (GFS): Total cash payments for operating 1 888 698 38.8%
activities (current expenditure) plus net cash flow
from investments in non-financial assets (total capital
expenditure) of the consolidated general government.
⇒
17 Consumption expenditure comprises wages and salaries and expenditure on goods and services of a non-capital
nature. Other items are from the table ‘Income, distribution and accumulation account’ of general government.

⇒ As is the case with budget figures, these include flows
of funds through the expenditure side of government
budgets that do not constitute real expenditure in the
macroeconomic sense, but merely transfers of funds via
the budget conduit.
❐ Hence this figure severely overstates the net
contribution of government to aggregate expenditure
in the economy.
❐ Yet it does show the full amount of funds/resources
that flow through the hands of general government in a
fiscal year.
❐ These figures are for general government.
To approximate the SNA definitions 1 or 2, one would
have to exclude interest, subsidies, grants, social benefits
and other expenses. Thus, one would merely add
compensation of employees, purchases of goods and
services and non-cash flows from investments in non-
financial assets:
Definition 6 (GFS): Total non-interest current expenditure 1 707 168 35.0%
(excluding subsidies, etc.) plus total capital expenditure
of consolidated general government.
Note that GFS definition 6 produces a figure roughly
similar to SNA definition 2.
❐ The important thing to notice, though, is the large
gap between GFS definition 6 and GFS definition 5.
The latter is not a good indication of the extent of
real economic activity provided for by government
expenditure.
Definition 6 would be best for macroeconomic analysis if
one wishes to use GFS figures.
National budget figures (2018/19): (Budget Review, National Treasury)

The Budget Review figures are central to the budgetary
and fiscal policy debate. Tendencies in these figures
always are important, despite their being limited to
the national government. In budget context, the most
comprehensive measure of total expenditure by the
national government is:
Definition 7 (Budget): Total current plus capital expendi- 1 509 858 29.8%
ture of the national government.
As before, one can exclude interest payments to show
present expenditure plans only:
Definition 8 (Budget): Total non-interest current plus capital 1 327 640 26.2%
expenditure of the national government.
The last definition is still not quite usable for macro-
economic analysis, since subsidies and capital transfers
are still included. Also remember that this figure is only for
the national government.
Addendum 10.1: Measuring aggregate government expenditure 457

Which of these definitions and figures is the correct one?
There is no single correct figure or definition. It depends on the objective of one’s analysis.
All this serves as a warning to analysts to be most careful when analysing government
expenditure data.
❐ If the macroeconomic impact of government expenditure is at issue, one should
preferably use SNA definitions 1 or 2. If one has to use GFS figures, use definition 6.
❐ If the financial position of general government or the financing of fiscal deficits is of
concern, GFS definition 5 is best, or Budget definition 7 for the national government.
These are also the appropriate measures if one wishes to compare the expenditure ratio
with a tax ratio to derive a deficit ratio.
❐ To imitate the budget in SNA context, use definitions 3 or 4.
❐ The impact of interest payments (the cost of public debt) can be highlighted by
considering the divergence between certain definitions, i.e. 3 and 4, or 5 and 6, or 7
and 8.
❐ The most difficult choice is when the ‘total size of government’ is the focus of analysis.
No unequivocal choice is possible, and the answer can vary between approximately 24%
and 36%. The basic choice is between measures that reflect (a) the extent of actual real
expenditure initiated by government, and (b) the total amount of funds and resources
that pass through the hands of government institutions – where much of that consists of
transfers between non-government economic actors. Unfortunately, analysts often appear
to choose a definition to suit a favoured judgement on the size of government. One should
thus be very careful in phrasing the question at issue, and in selecting the appropriate
measure. Also, be careful in making international comparisons, since statistical practices
regarding ‘total government expenditure’ in different countries may make any conclusion
risky.
❐ Since the new constitutional dispensation in South Africa unfolded and came to be
reflected in intergovernmental fiscal relations, the revenue-sharing grants, also known
as equitable shares, have been indicated as a separate item in national government
figures.

Addendum 10.2: Measuring government revenue and the deficit
The measurement of the revenue side is much less complex than the expenditure side. The
main differences relate to the fact that:
❐ The SNA does not provide sufficient information on both the expenditure and revenue
sides to easily calculate a deficit; it also records non-tax revenue differently.
❐ The SNA is on accrual basis. The 2001 GFS is also supposed to be an accruals-based
system, with a cash flow statement attached to it. However, given that the previous
GFS was a cash flow based system, the only component of the new 2001 GFS that is
currently available is the cash flow statement published in the Quarterly Bulletin.
❐ The SNA and GFS data are for general government, and the budget data only for the
national government.
The table below illustrates the different data systems and sources. All figures are for 2018
(in the case of the SNA and GFS data) or the 2018/19 fiscal year (in the case of the budget
data), and show the nominal amounts in R million, as well as percentages of GDP.
SNA % of GFS % of Budget % of
(2018) GDP (2018) GDP (2018/19) GDP
Tax revenue 1 380 403 28.3 1 410 895 28.9 1 302 201 25.7
Less: SACU revenue –48 289
Non-tax revenue 406 236 17 508
Total current revenue 1 443 762 29.6 1 817 131 37.3 1 271 421 25.1
Financial transactions in assets and liabilities 13 845
Sales of capital assets 120
Total revenue 1 443 762 29.6 1 817 131 37.3 1 285 386 25.4
Total expenditure 1 711 134 35.1 1 888 698 38.8 1 509 858 29.8
Balance (Deficit (–)/Surplus (+)) –267 372 –5.5 –71 567 –1.5 –224 471 –4.4
* Total expenditure by general government for the SNA category comprises current expenditure by general government
as calculated from the ‘Income, distribution and accumulation accounts’, plus gross fixed capital formation by general
government (excluding consumption of fixed capital). The SNA deficit component can also be calculated as government
gross saving plus fixed capital formation plus change in inventory investment by government.
As far as tax revenue, and thus the tax ratio or tax burden, is concerned, the SNA and GFS
figures provide very similar results. The GFS figure is the most comprehensive measure.
The Budget figures are somewhat lower, mainly due to the exclusion of provincial own
revenue and local government finances (as well as extrabudgetary institutions and social
security funds).
To calculate the (conventional) deficit, use either GFS or Budget figures, keeping the
different institutional coverage in mind. The GFS deficit measure is normally somewhat
higher than the Budget figure (because other levels of government can also borrow).
❐ Normally the SNA system is not used to calculate a budget deficit. However, using
expenditure definition 3 (see addendum 10.1), one can calculate an approximate deficit.
It tends to overstate the deficit, inter alia because capital revenue is not recorded, and
non-tax receipts are not treated adequately. It is best not to use this measure in serious
budget analysis. However, this broader government deficit concept is appropriate in the
context of the sectoral balance identities (chapter 5) where it is denoted as T – GC (albeit
with some complications; see footnote 14 in this chapter).
Addendum 10.2: Measuring government revenue and the deficit 459

Policy problems: coordination, lags
and schools of thought 11
■ understand and formulate the differences and interaction between fiscal policy and
monetary policy, and between the National Treasury and the Reserve Bank;
■ appraise the problems relating to time lags and uncertainties in practical policy
formulation and implementation; and
■ value the problems posed by the existence of different schools of thought with diverse
views on economic theory and policy; in particular, thoroughly assess the essential
differences between the Keynesians and New Classical/Monetarist economists, as this is
crucial for understanding the debate on unemployment and inflation.
In chapter 1 it was noted that, conceptually, the policy process starts with a decision
on the relative priorities to be accorded to the various policy objectives. Thereafter, one
requires knowledge of the operation and impact of the main policy instruments (i.e.
monetary and fiscal policy), as reviewed in chapters 9 and 10. A last step concerns
the actual design and implementation of a policy package from among these options.
Unfortunately, this is not a simple matter at all. Various problems face policymakers,
the first of which is the choice between using fiscal or monetary policy in determining
the proper policy mix.
11.1 Monetary vs. fiscal policy?

In contemplating policy steps to affect the standard macroeconomic variables, a basic
consideration is the different macroeconomic impacts and side-effects of monetary and
fiscal policy. A comparison of the basic macroeconomic effects of fiscal and monetary
policy yields contrasts such as the following.
❐ Fiscal expansion via government expenditure can enlarge the share of the public sector
in the economy relative to that of the private sector, especially if crowding out occurs.
Expansionist monetary policy as such does not affect the relative shares of these sectors,
even if it does imply an increase in the role of government, broadly understood. (Fiscal
expansion via tax cuts does not affect the relative shares either.)
❐ Expansionist monetary policy has a net downward effect on interest rates, which is
likely to stimulate capital formation (investment). Expansionist fiscal policy is likely
to cause some upward pressure on interest rates, via the monetary feedback effect.
This could discourage capital formation. In this way, the fiscal option may constrain
production capacity growth in the long run, while the monetary policy option may
be more growth promoting. (This comparison ignores any indirect negative effects
11.1 Monetary vs. fiscal policy? 461

of monetary expansion on growth via the consequences of inflation and the higher
interest rates to which such higher inflation may lead. See chapter 12.)
In designing a policy package, macroeconomic policymakers have to balance these con-
siderations carefully, taking prevailing conditions and forces in the economy into account.
In practice, the real choice is not between using either the one or the other type of policy:
both fiscal policy and monetary policy are applied regularly. This raises the issue of the
policy mix and of the coordination between the two kinds of policy – especially since two
different institutions are responsible. In general, it is desirable that the two types of policy
should be complementary.
One example is when the Reserve Bank accompanies expansionary fiscal policy with mon-
etary stimulation. The monetary stimulation complements the fiscal policy in the sense
that it counters the major disadvantage of expansionary fiscal policy, i.e. the upward (sec-
ondary) effect on interest rates. This ensures that the full intended impact of the fiscal
stimulation on GDP is felt, and that any potential crowding out is forestalled.
❐ Monetary policy that supports fiscal policy directions is called accommodating monetary
policy.
Another instance would be if the monetary authority were willing to finance a budget
deficit (implying money creation). This would boost the real impact of the fiscal stimulation
and avoid crowding out (but might stimulate inflation; see chapter 12).
However, cooperation does not always occur in practice. At times, the two authorities may
work in different or even opposing directions.
A timeworn point of dispute is whether policy should have an anti-cyclical orientation
or a cyclically neutral, long-run focus. (This relates to the problems of anti-cyclical
policy, which are discussed below.) If fiscal and monetary policymakers adopt different
approaches, their policy steps could conflict.
A particularly severe conflict can occur, for example, if the fiscal authority (the Treasury)
is pursuing a fight against unemployment (using expansionary policy) and the monetary
authority fights inflation (with restrictive policy). The net impact on real GDP may be zero.
However, both of these policies will serve to push up interest rates, which would discourage
private capital formation and constrain the long-run growth in productive capacity (a
negative supply-side effect).
Some types of conflict between fiscal and monetary policy are intrinsic and unavoidable.
The interaction between budget deficits and interest rates presents a particularly vexing
source of conflict.
❐ As explained in chapter 3, section 3.2.3, high budget deficits can lead to upward pres-
sure on interest rates. This is due to the demand for credit exerted by government in
money markets. Alternatively, a government may resort to money creation as a method
of financing the deficit. Both of these could impact on, or interfere with, the pursuit
of monetary policy objectives. Money creation is especially frowned upon by the mon-
etary authorities, given its likely inflationary impact.
❐ On the other hand, high interest rates due to restrictive monetary policy increase the
cost of public debt, which then claims a larger share of government expenditure. This
either crowds out non-interest expenditure, or leads to a higher budget deficit. The
cumulative effect of higher budget deficits (due to high interest rates) is that the public
debt is placed on a higher trajectory than it would have been had interest rates been
lower (chapter 10, section 10.6.4). Higher public debt levels are carried forward into
462 Chapter 11: Policy problems: coordination, lags and schools of thought

permanently higher debt cost components in future budgets. (It was also noted that an
unstable interest rate pattern contributes to an increasing level of public debt. This also
depends on monetary policy.)
❐ High interest rates due to restrictive monetary policy can severely affect the sustain
ability of fiscal policy. It was noted earlier (chapter 10, section 10.7.4) that fiscal
sustainability depends crucially on the relative levels of interest rates and the economic
growth rate. If restrictive monetary policy keeps real interest rates significantly
above attainable economic growth rates for long periods of time, it might preclude a
sustainable fiscal path unless there are significant cutbacks in government expenditure
and/or major tax increases. This is aggravated by the automatic negative impact of
high interest rates on both the budget deficit and the economic growth rate.
This conflict can cause a vicious cycle: high interest rates increase the budget deficit and
depress economic growth, which reduces tax revenue and increases the budget deficit
further. (Any upward pressure on interest rates due to increased government borrowing
only aggravates the situation.) In so far as the Reserve Bank sees high budget deficits
as sufficient reason to sustain high real interest rates (owing to presumed inflationary
consequences of deficits; see chapter 12), this could be a recipe for severe fiscal stress.
✍ Which of the two types of policy – monetary or fiscal – has the primary responsibility for
macroeconomic balance? Which policy authority is in ultimate command of macroeconomic
policy? Which one should ‘run the show’?
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Another source of conflict arises when each of the two institutions has its own diagnosis
of a problem situation. This can be related to different interpretations of data, as well
as different theoretical frameworks. A more serious potential source of conflict is if the
Treasury and the Reserve Bank adhere to different ideological orientations and schools of
thought. Given that the ambit of fiscal policy is the traditional stronghold of Keynesian
ideas, while New Classical/Monetarist ideas seem to be more popular in monetary and
central banking circles, such a conflict is not uncommon. Such differences have decisive
implications for many aspects of policy, e.g. on the desired degree of government action or
‘intervention’, the choice of priorities and instruments, and so forth. (This is discussed in
section 11.3.)
Policymakers can also differ on the style of policy. An important dispute concerns the
issue of rules vs. discretion. The question is whether policymakers should have discretion
over the application and control of policy instruments, or be partially or even fully bound
by fixed rules (determined by a parliament, say). For example, a monetary rule would force
the monetary authority to keep money supply growth at a predetermined rate, rather than
11.1 Monetary vs. fiscal policy? 463

allowing it discretionary control over monetary expansion and contraction. An example
of a fiscal rule would be a prescribed budget deficit or a balanced budget rule (see chapter
10, section 10.7). Economists and policymakers differ on this issue, often depending on
their ideological orientation, but also on their understanding of the practical problems
with both discretionary and rule-bound policy making.
11.2 Policy problems

The theory of macroeconomic policy – showing the impact of fiscal and monetary policy
measures on important macroeconomic variables such as Y, P and so forth – seems to be
clear-cut. However, the effective manipulation/control/management of these variables in
practice is not simple at all. The recurring economic crises of the world attest to this.
Policymakers face a number of quite fundamental problems. While both fiscal and monetary
policy are problematic, the issue is complicated by the fact that the nature and extent of their
respective problems differ. In particular, they encounter difficulties in two areas:
(1) policy lags (observation, as well as internal and external lags), and
(2) uncertainty about the precise effect of policy measures.
11.2.1 Policy lags

As noted in chapter 9, policy decisions and implementation are subject to a number of
lags. Various factors cause lags in the policy process. These seriously complicate policy
making, particularly as far as timing is concerned.
Uncertainty regarding the permanence of disturbances and shocks

A major problem is how and when to decide that an observed disturbance is temporary
or permanent. If a disturbance is only temporary, it may be best to do nothing – at most,
only transitory disturbances of income and employment levels may occur. If a disturbance
is rather more lasting, a speedy policy response would seem appropriate. However, such
action leads to a further problem.
Observation lags
Various factors delay the implementation, execution and effect of policy. One such set
of factors causes a passage of time between the occurrence of a disturbance and its
observation. This passage of time is called the observation lag, i.e. the interval between
the occurrence of a disturbance and the moment when policymakers observe and realise
that it has occurred and that steps are necessary. It takes considerable time to collect
the statistical information that is necessary for a diagnosis. Collection can take several
months, following which the data have to be checked, entered, processed, analysed and
interpreted.
❐ The observation lag is likely to be of similar duration for both fiscal and monetary
policy.
Internal policy lags

Another set of factors causes a delay between the observation of an occurrence and the
initiation of a policy step to address it. This is the so-called internal lag of policy. The internal
lag comprises two components. The first is the decision lag, i.e. the time that passes before
the policymaker is convinced that policy action is necessary, and before the necessary

decisions are taken. The second component is the administration lag. This is the time taken
to effect a policy decision (i.e. to implement it – to translate it into changes in the policy
instruments).
❐ In the case of monetary policy, the Reserve Bank can take a decision to act independently
and speedily. Only a small number of top executives have to meet. In addition, the most
important monetary policy steps, e.g. open market operations or changes in the repo
rate, can be effected almost instantly. The decision and administration lags are likely to
be very short.
❐ In the case of fiscal policy, the decision-making process involves the preparation of
legislation and parliamentary approval. The main budget is presented only once a
year, and parliamentary approval of the budget votes takes at least three months. The
administrative procedures for implementation can also take quite a long time. New tax
forms or PAYE tables have to be drawn up, new projects put out to tender, contracts
negotiated and so forth. Both the decision and the administration lags are likely to be
quite protracted. (Tax changes tend to have a shorter lag than expenditure changes. In
addition, the Minister of Finance is empowered to effect certain changes, e.g. in indirect
taxation, without parliamentary approval.)
External policy lags

The external or implementation lag refers to the length of time between the taking of a policy
step and the ultimate impact on the economy. It concerns the interval from the time a policy
instrument (e.g. the repo rate) is changed until it affects the intended macroeconomic
variable, e.g. the price level or GDP (via aggregate expenditure and production).
The lag derives from the number of steps and phases involved, as well as the fact that the
transition, in a chain reaction from one event to the next, is dependent on human decisions
and behaviour. The non-mechanical nature of economic chain reactions also causes the
duration of the whole process to be anything but constant or predictable. Moreover, the
impact of a policy change often involves a distributed lag process: after some initial impact,
the rest of the effect is spread over a considerable period encompassing several months or
years.
❐ Since monetary policy affects the level of economic activity indirectly via changes in
interest rates, it tends to have a long external lag (subsequent to a short internal lag).
Being indirect, the strength of the effect is also uncertain.
❐ The more direct operation of fiscal policy usually implies a much shorter external lag
(following a relatively long internal lag). This is especially true of tax changes.
These internal and external lags cause much uncertainty as to the time when a policy
step can be expected to have had its eventual or full effect. This can be quite disastrous: by
the time the effects of policy are felt, the conditions that originally necessitated the steps
might have changed significantly, and the policy may be wholly inappropriate in those
new conditions. This is particularly true in the case of cyclical problems, i.e. a recession or
an overheated economy. Uncertainty regarding the policy lag can even lead to stabilisation
policy having perverse (i.e. unintended contrary) effects and actually being destabilising.
For example, contractionary policy that was intended to cool down an overheated economy
in a strong upswing may take effect only after automatic or built-in cyclical forces have
taken the economy beyond the peak of the cycle. As a result, the policy then acts as a
contractionary force that aggravates an already existing downswing. Similar perverse effects can
happen in the case of expansionary policy.
11.2 Policy problems 465

It is clear that questions of timing severely complicate macroeconomic policy – especially
stabilisation policy, which is based on having a specific impact at a specific point in the
business cycle. This applies to both fiscal and monetary policy, though in different ways.
11.2.2 Forecasting and theoretical uncertainty

In chapters 9 and 10 (sections 9.1 and 10.2), a warning was sounded that macroeconomic
theory can be misleading in that it may create the impression that policy objectives can
be attained quite easily by manipulating economic variables (or ‘shifting a few curves’)
in a rather mechanical and predictable way. The broader context of this danger is the
fundamental uncertainty that policymakers face regarding the precise effect of policy
measures.
First, there is uncertainty regarding the reaction of people to changes in policy instruments
and other economic variables. A policy measure implemented on the assumption that
consumers or investors will react in a particular way may go completely awry if these
economic actors react differently. A decisive factor is the way in which expectations are
formed, as well as the way expectations affect human behaviour and decision making.
This is particularly relevant, for example, in the case of long-term investment, which is
based on difficult-to-fathom expectations regarding the future. Even worse, the way that
expectations matter can be affected by the policy step itself. Economic actors may, also,
react purposefully to counter the intended effect of policy rather than ‘behave’ dutifully.
A second source of uncertainty is the fallibility of economic forecasting, of the implicit or
explicit foundation of any policy step. Forecasting can be done with a formal, quantified
econometric policy model, or with a less formalised, more intuitive analysis. Whatever the
case may be, any attempt to use policy instruments to attain chosen goals is designed on
the basis of a projected course of target variables such as GDP, the balance of payments
or the inflation rate. First, a projection is made on the basis of the current values of policy
instruments. This is called a ‘base run’. Then a projection is made on the basis of planned
values of policy instruments, e.g. a higher repo rate. This is called the ‘alternative run’.
The policy change can then be calibrated to attain the desired change in a target variable
such as GDP – or so it appears.
The problem is that various factors lead to serious difficulties in predicting the likely
consequences of policy steps with reasonable certainty. The most basic of these is that the
economy does not work in a constant, unchangeable, almost mechanical manner. If the
course of both the base run and the alternative policy run is uncertain, it becomes very
difficult to design and implement a policy to attain very specific goals, e.g. a specific growth
rate or inflation rate. As a result, any policy step occurs in the dark, so to speak. One may
be able to predict the general direction of economic chain reactions following a policy step,
and an experienced policy analyst may develop a rough idea of the magnitude of possible
changes in economic variables. Nevertheless, there are severe limits to the certainty and
precision with which policy projections can be made.
A third and fundamental source of uncertainty concerns the correct ‘model’ of the
economy. Despite very advanced theories, there is much uncertainty regarding the
linkages between variables, the sensitivities (elasticities) involved in relationships, the
size of coefficients and multipliers, the speed of adjustments, the nature of transmission
mechanisms and adjustment processes, and so forth. There are no simple cause-and-effect
relationships: bi- and multidirectional causalities between variables are often involved. To

be honest, economists do not fully understand ‘how the economy works’. As a result, any
analytical reasoning on policy diagnosis and policy remedies is fundamentally shrouded
in uncertainty and constrained by the limits of human knowledge and understanding.
❐ The first two types of uncertainty are rooted in the third, which is the ultimate source
of uncertainty.
11.3 The larger problem – different schools of thought

The uncertainty regarding the operation of the economy is part of a wider problem that
finds expression in an intense debate between different schools of thought on economic
theory and policy. A broad introduction to these was provided in chapter 1 (section 1.8.1).
As noted there, two main schools of thought can be found within mainstream economics.
These are the broadly Keynesian school – which you know well by now – and the
Monetarist/New Classical school, which is explained in some detail in the next sections. If
one wishes to understand the public policy debate in South Africa and many parts of the
world, it is essential to grasp the essential differences between these two main approaches.
Other approaches are only touched upon below.
11.3.1 Background – the Classical model and the Quantity Theory of Money
The Monetarist/New Classical approach is the antithesis of the Keynesian approach.
The Monetarist/New Classical viewpoint cannot be understood without a thorough
understanding of the Classical model, in which the roots of the Monetarist/New Classical
approach are to be found.
The Classical intellectual framework

The Classical analytical framework can be traced to the works of John Locke, the English
philosopher, and Adam Smith, the Scottish economist. Both were exponents of Classical
liberalism, the philosophy built on the fundamental belief that individual freedom and
liberty are the highest good, and which fundamentally distrusts the state.
Classical liberalism developed in an era when the natural sciences (Galileo, Newton) created
a strong impression of spontan-
eous order and harmony in na-
Classical liberalism
ture. The basic Classical idea is
that a similar order and harmony Early or Classical liberalism developed from the
can be achieved in inter-human middle of the 17th century to the middle of the 19th
social relations if all things are left century.
alone to go their ‘natural’ ways. ❐ John Locke’s most famous political book was
Two Treatises on Civil Government (1690), which
With the individual being regard-
established him as the leading philosopher of
ed as the ‘atom’ of society, this
individual freedom, proponent of private property
‘natural’ outcome can be achieved rights, and opponent of the ideas of the divine right of
only if individuals are allowed max- kings and state sovereignty.
imum, unrestricted freedom to act ❐ Adam Smith’s most famous work on economics
and interact. was An inquiry into the Nature and Causes of the
Wealth of Nations (1776). Its central thesis is that
This requires that no artificial re-
resources are best employed for the production
strictions are placed on individu-
of wealth under conditions of governmental non-
als. If only individuals could be left interference or laissez faire.
alone to pursue their own interests
11.3 The larger problem – different schools of thought 467

in complete freedom, a situation of harmony and equilibrium would prevail in society – a
‘natural order’ would emerge ‘as if arranged by an invisible hand’. Such freedom can be
ensured only if the role of the state is as limited as possible – barring the minimal functions
of the establishment of law and order, the protection of property rights and the enforcement
of contracts. The state is the biggest threat to the individual, and should be fundamentally
distrusted.
❐ This latter element of Classical liberalism is also described as state nihilism = ‘do-not-
believe-in-the-state’.
The Classical economics framework

The economic dimension of this harmonious picture – which emerged in an era when the
economy primarily comprised a large number of one-person and small family enterprises
(bakers, grocers, carpenters, blacksmiths, etc.) – was that the unfettered interaction
between demanders and suppliers in free markets would lead spontaneously to economic
equilibrium. A key condition for this harmonious and presumably optimal outcome was that
the state was not to interfere in the economy – the idea of laissez faire (French: ‘allow to do’,
or ‘let them do (as they please)’).
The intellectual heirs of Adam Smith, in particular the neo-classical economists, refined
this image into the well-known atomistic model of ‘perfect’ competition. In this model, the
unrestricted interaction of demand and supply theoretically leads to an optimal equilibrium.
This theoretical model clearly corresponds closely to the general Classical view.
Classical macroeconomic theory

At a macroeconomic level, the idea that the free market, as a smoothly adjusting mechanism,
will automatically lead to order and harmony found expression in the Classical approach
to macroeconomics. Broadly speaking, the main thrust of this approach is the proposition
that, given unfettered markets, the economy will always tend towards a stable equilibrium
at full employment. Recessions and periods of unemployment are only temporary and due
to external disturbances; the economy will automatically and promptly return to the full
employment equilibrium. In the Classical macroeconomic view, the economy is inherently
stable. As a result, unemployment is not a real problem. No remedial steps are necessary
to ensure full employment, least of all from government. It will materialise spontaneously.
Protracted periods of unemployment and recession are impossible.
More formally, the Classical model of the economy – in vogue up to 1930 or thereabouts
– comprises four main components, built on the fundamental assumption of a world of
perfect competition:
(1) Equilibrium in the labour market

Given government abstention, smoothly adjusting wages will continually ensure equi-
librium between the demand and supply of labour. Everyone who wishes to work at
the equilibrium wage determined by the market is employed. Therefore there is no
unemployment – barring those people who choose not to work at the equilibrium wage, and
hence are ‘voluntarily unemployed’. To all intents and purposes there is full employment.
(2) Say’s Law

The output level that corresponds to the quantity of labour employed at the labour
market equilibrium automatically results in a corresponding level of income (purchasing

power) and therefore a demand
that is just enough to buy up all Contrast this with the Keynesian model where
production – ‘supply creates its own a lack of aggregate expenditure (a demand
deficiency) can lead to an equilibrium level of output
demand’. Expenditure (demand)
Y that is below the full-employment level. At the
can never be insufficient to
latter macroeconomic equilibrium there is labour
purchase all output (supply) at the market disequilibrium, i.e. unemployment. This
full employment level; therefore unemployment is decidedly involuntary.
production (GDP) has no reason to
deviate from the full employment
level, and will remain there.
Say’s Law can be true only if there is no net leakage from the income-expenditure circular
flow – all income must materialise as demand. In this Classical model, this is ensured by
the following:
(3) A real interest theory

In the capital market, the interest rate is determined by the interaction of two real activities,
i.e. saving and investment. Saving = the supply of funds; investment = a demand for funds.
The smooth and automatic adjustment of interest rates will ensure that this demand and
supply reach and stay at equilibrium. When saving equals investment at equilibrium, there
is no net leakage. Say’s Law therefore remains valid.
Note that there is no mention of money thus far, and specifically not in the determination
of interest rates. In the Classical view, money is only a medium of exchange, acting as
lubrication for the real economy, and with no real effect of its own. (Contrast this with the
Keynesian theory of interest rates, which is a monetary theory: money supply and money
demand determine interest rates.)
Money is relevant only in one context, i.e. in the determination of the general price level.
(4) The quantity theory of money

This theory, which is a key element in the Classical model, can be written in symbol form
as follows:
MV  PY
where
M = the nominal money supply MS;
V = the velocity of circulation of money (the number of times a year that a unit of currency
(e.g. R1 or $1) is used for transactions);
P = the average price level; and
Y = real national income.
Inspection shows that the above equation is true by definition. The left-hand side is the
total value of all money transactions, and the right-hand side is nominal income (nominal
GDP). They must be equal at all times – it is an identity (indicated by ).
However, in the Classical model this identity becomes a theory because a direction of causality
is assumed to exist from the left-hand side to the right-hand side: if MV changes, it causes
a corresponding change in PY. Moreover, it is assumed that the velocity of money is stable
(determined by habit). Given that real income Y is also stable (at the full employment level),
the money supply affects only the price level: if MS changes, it causes a corresponding

change in P. Money has no real
effect. It determines only the price This separation between money and the real
level – merely the price stickers of economy is called the Classical dichotomy: the real
and monetary sectors are seen as separate and
the real goods and services. In this
unconnected.
way, money is said to be neutral.
Note that the Classical model,
though very different from the Keynesian approach, is logically complete in the sense that
all the key macroeconomic variables are accounted for. Of vital importance is the inherent
stability assumption, the full employment result and the neutrality of money (including
the one-to-one linkage between money and the price level).
The Great Depression – the Classical model goes into hibernation

While the Classical and the neo-classical models constituted the dominant economics
paradigm up to the end of the third decade of the 20th century, the Great Depression
of 1929 to 1933 all but killed any Classical thought that unemployment is at most a
temporary aberration (disequilibrium) that will disappear spontaneously.
The Great Depression started in the USA, triggered by the stock market crash of 1929. It
quickly spread to the rest of the Western world. In the USA hundreds of banks collapsed,
bankruptcies abounded, and unemployment rose to more than 10 million, which at the time
represented a 25% unemployment rate in the USA (with similar rates in countries such as the
UK). This lasted until at least 1933.
❐ From 1933 to 1938, US President Franklin D Roosevelt introduced the New Deal, a set
of economic policies intended to counter the effects of the Great Depression via large
government projects and fiscal stimulation. This was not dissimilar to the policies
suggested by Keynes, who published his General Theory in 1936, and who from the late
1920s proposed similar policies for the UK.
❐ South Africa also experienced the Depression, with severe unemployment and poverty
being aggravated by the great drought of 1933.
The demise of the Classical model coincided with the rise of Keynesian theory, the crux
of which is the acceptance of the inherent instability of the economy and the intrinsic
imperfections and flaws of markets. The Keynesian approach demonstrated that the
economy can stabilise (stagnate) at an equilibrium with unemployment (see chapter 2). It
prescribed deliberate government action (in the form of fiscal stimulus) as a remedy, and
in general favoured active anti-cyclical fiscal policy.
However, the Classical ideas did not disappear completely. In particular, University
of Chicago economists such as Milton Friedman worked hard, from the 1950s, at
rehabilitating Classical liberal economic thought. This ‘reborn Classical’ approach, which
became very popular in the high-inflation 1970s, is called Monetarism.
11.3.2 Monetarism and the transmission mechanism

Monetarism emphasises the inherent stability of the economy in the longer run. It
acknowledges that monetary and fiscal policy could have an impact on the economy, but
such impact would probably be an adverse one and be limited to the short term. Moreover,
the short term is much shorter than supposed by Keynesian economists, with the long run
not that far off in time. In the longer run, no stabilisation policy or large-scale government
involvement in the economy is necessary because the economy is self-stabilising.

Classical roots
The Monetarist approach quite clearly and openly is built on Classical foundations.
❐ The market is regarded as the optimal regulator of society, and the minimum level of
government action (seen as ‘interference’) is urged.
❐ Much stress is placed on the intrinsic flexibility of prices and wages, which ensures
the smooth operation of the market mechanism and the spontaneous attainment of
equilibrium. This is also true of the labour market.
❐ The most fundamental belief is in the inherent stability of the economy. This applies,
specifically, to the different components of private expenditure (C and I) as well as the
demand for money MD. Any observed instability is not intrinsic, but the result of some
external disturbance.
❐ As a corollary, it is asserted that the economy will tend, in a self-equilibrating way, to
a full employment equilibrium with full capacity utilisation. The only condition is that
the state must leave the economy alone.
❐ In such an equilibrium there would be no involuntary unemployment.
❐ Given the inherent stability of the economy, cyclical fluctuations will be small and
transient, and will occur around full employment (or what is called the natural rate
of unemployment, which allows for frictional unemployment). The return to the full
employment level of output Y will be prompt and smooth.
Furthermore, the Monetarist approach largely centres on the Quantity Theory of Money:
MV = PY. However, it does not, like Classical theory, assume that monetary velocity V is
constant. (Friedman argued that as income increases, velocity may display a downward
trend over time.) Yet its view is that velocity may still display stable behaviour. Stable
behaviour renders velocity predictable, which in turn means that one can also predict the
relationship between M and P in MV = PY. (Y is assumed to grow at trend and remain
more or less stable around that trend.) By allowing for differences in the short- and long-
term behaviour of economic agents, the Monetarist view is somewhat different from, and
less extreme than, the Classical model.
The demand side of the economy

The Quantity Theory is used to provide a basic explanation of the demand-side behaviour
of the economy. Recall that MV is the total extent of nominal spending (i.e. in money
terms) in the economy. With V moving on a predictable trend, the money supply is the chief
determinant of aggregate expenditure, and therefore also of nominal income P × Y.
❐ Fluctuations in aggregate expenditure are therefore largely explained by fluctuations
in the nominal money supply. (In the absence of monetary fluctuations, the inherent
stability of private expenditure will prevail.)
The linkage between the nominal money supply and aggregate expenditure is regarded
as robust and direct. This, say the Monetarists, is due to the nature of the transmission
mechanism, which derives from the way private consumption decisions are understood
as being made. These occur on the basis of the composition of a consumer’s portfolio,
which is defined to include not only money and financial assets but also real assets and
goods. The consumer will continually optimise his or her portfolio by swopping money and
goods. If people have more money in their portfolio than they consider to be optimal, they
will exchange the money for goods – that is, they will spend money on goods. What this
means in the aggregate is that any non-optimality or imbalance between the total money
in portfolios (i.e. the money stock) and goods possessed will lead directly to expenditure.

This also means that the interest rate channel – as encountered in the Keynesian view of
the transmission mechanism between the monetary and real sectors – is not particularly
important, and in any case is not the sole transmission channel. By and large, the
transmission from a monetary imbalance to nominal expenditure is quite direct, and not
via interest rates.
The supply side – the real economy

Although the money supply is a key determinant of nominal expenditure, in the Monetarist
view the real level of economic activity is not decisively determined by money. Fluctuations
in MS can cause short-run fluctuations in Y – and are the main cause of such fluctuations.
However, the main determinant of the equilibrium level of production and income in the
longer run is the labour market. In any case, Y is stable in the long run.
In terms of the AD-AS framework, this implies that ASSR is very steep and, moreover,
that the short-run AS relationship is relatively unimportant: while changes in aggregate
expenditure (AD) can cause temporary fluctuations in production and employment (along
ASSR), the supply adjustment process occurs quickly – wages adjust rapidly – and the
economy speedily returns to full employment equilibrium. (Policy steps to speed up the
movement towards full employment are uncalled for and probably harmful.)
This long-run result is the one that really matters. Likewise, the long-run aggregate supply
relationship ASLR is the most important one in determining macroeconomic outcomes (in
conjunction with aggregate demand AD).
Ultimately, after transient dis
turbances have dissipated, the The Keynesian view is that the ASSR curve is
equilibrium level of real pro relatively horizontal at times; that the AS adjustment
duction depends on the supply process occurs slowly (especially downwards)
side, i.e. on what happens in the and therefore implies a high cost in terms of
unemployment and human suffering. Therefore, the
labour market.
short-run results are very important, and the long-
In the final outcome, money has run return to equilibrium is of theoretical interest
no real effect; money is neutral only. As Keynes put it: ‘In the long run we are all
in the long run. In the long run, dead’. Countercyclical policy is therefore necessary
therefore, Monetarists also assert to expedite the return to full employment levels and
the separation between money reduce human suffering.
and the real economy – the Clas-
sical dichotomy. Less extreme
than the Classicals in this respect, Monetarists accept that in the short run money may
well have real effects – but these would only be temporary. As will be discussed below, New
Classicals returned to the Classical view that maintains that even in the short run money
may have no real effects.
The price level

The last and key element is the determination of the average price level. Two dimensions
are relevant.
❐ Consider the Quantity Theory again. With Y stable at full employment in the long run,
while V is changing at a predictable rate, the long-run effect of the money supply is
exclusively on the price level: ΔM ⇒ ΔP.

❐ At the same time, money is the
only (or at least the dominant) This is a therefore a pure monetary theory of the
determinant of the price level. price level. Contrast the Keynesian approach, which
is a real theory of the price level: real aggregate
Put differently, without an
demand and real supply interact to determine the
increase in the money stock,
average price level.
there can be no increase in the
The Monetarist diagnosis of inflation follows automatically: excessive money creation is the
main cause of an explanation for increasing prices. Inflation is a pure monetary phenomenon
where ‘too much money chases too few goods’. (The significance of the latter proposition
will become clear in the discussion of inflation in chapter 12.)
11.3.3 The New Classical school

The New Classical school is a younger and more extreme mutation in the Classical–
Monetarist lineage. Sometimes it is also called Monetarism mark II.
During the 1970s, economists such as Robert Lucas, also from the University of Chicago, and
Robert Barro added to the Classical rebirth (i.e. Monetarism) by claiming not only that policy
is impotent in the long run (Friedman’s view) but also that it is impotent in the short run.
Introducing the concept of rational expectations, the Lucas approach became known as the
New Classical school (see discussion below). Lucas argues that, whereas Friedman claimed the
long term back for the Classical tradition, he has claimed back the short run too.
The basic New Classical argument is that people, as rational beings, use all available
information in making economic decisions. They do not act in ignorance, but learn from
experience exactly how the economy works. Their expectations of the impact of policy steps
incorporate this knowledge. So-called rational expectations are defined as expectations
that accord with the predictions of standard economic theory (specifically theory in the
Classical lineage).
If people do have rational expectations – and that is the core assumption of this approach
– they can correctly foresee the eventual impact of systematic policy steps. Since their
expectations are correct, the aggregate supply adjustment process effectively occurs
instantaneously. (Remember that this process entails initially incorrect price expectations
being rectified gradually, allowing price expectations to catch up with the real price level.)
In the New Classical view, the economy immediately returns to the long-run AS curve (in
effect, the adjustment is so swift that the equilibrium barely moves off the curve). As such,
there is no short run to speak of.
As the New Classical school views the world, any effort to use policy to move the
economy below the natural rate
of unemployment (i.e. beyond
In contrast, according to Monetarists, the supply
the long-run aggregate supply
adjustment does occur fairly quickly, but not
curve) would immediately be
instantaneously. According to Keynesians it occurs
neutralised by the behaviour of slowly. So-called post-Keynesians assert that a
rationally expecting individuals view true to Keynes’s original thinking would argue
who correctly anticipate this that the adjustment may never reach equilibrium,
policy step and pre-emptively act i.e. that the economy can indefinitely remain at a
to counter its effects. The long- disequilibrium, unemployment level.
run result of the AD-AS model –

the return to equilibrium at the long-run aggregate supply level – is also realised in the
short run. This implies that systematic policy steps are incapable of having any real impact on
the economy. This is the chief assertion of this school of thought.
❐ Formally, this result applies only to systematic policy steps, i.e. steps that can be anticip-
ated or that occur in accordance with normal policy practices. Unexpected policy sur-
prises can have effects on the real economy (though these would still be temporary).
New Classical economists also state the Philips curve differently. Recall from chapter 7,
section 7.1.6 that the conventional Phillips curve is formulated as:1
e
πt = πt  + (Ut – US ) where  < 0
This specification shows that inflation π increases whenever actual unemployment U
decreases below structural unemployment US. In addition, very often the simplifying
assumption is made that expected inflation π e equals the inflation rate of the previous
period πt-1.
In contrast, New Classical economists argue that the correct form of the Phillips curve is:
e
Ut – UN = b(πt – πt  ) where b < 0
They argue that actual unemployment will only be lower than natural unemployment if
actual inflation is higher than expected inflation.
❐ Note that the belief that the economy is self-equilibrating means that they do not accept
the concept of structural unemployment but rather use the term natural unemployment
or the ‘non-accelerating inflation rate of unemployment’ (NAIRU).
However, New Classical economists do not make the simplifying assumption that expected
inflation π e equals the inflation rate of the previous period πt-1. They argue that economic
agents (i.e. people and companies) know the true model of the economy. If they do not,
they listen to economists, writing in the press and elsewhere, who do know. Therefore,
these agents will know that an expansionary monetary policy does not represent an
actual expansion of the productive (supply) capacity of the economy. These agents know
that such ‘expansionary policy’ will only result in inflation and that its output effect is
not sustainable over the longer run. Thus, they will not employ additional workers and
produce more.
Therefore, in terms of the New Classical Phillips curve, actions intended to stimulate
the economy will increase not only actual inflation π but also expected inflation π e. In
terms of the equation above, this means that the difference between π and π e remains
unchanged, which also means that actual unemployment U will not decrease below
natural unemployment UN.
The only way policy can reduce the unemployment rate below its natural rate is to
create surprise inflation, so that π e does not change while π increases. A surprise increase
in the money supply can cause such surprise inflation (through the Quantity Equation
relationship). The problem with such an approach is that it cannot be repeated. Once
surprised, twice shy. One can surprise people once with a 10% increase in the money
supply, but doing it again the next year and the year after will not surprise anybody.
People will simply adapt their expectations to the new ‘unsurprising’ behaviour of the
central bank. As a result, repeated increases in the money supply will cause both actual
1 For reasons of exposition the version quoted here excludes the shock variable x.

and expected inflation to increase continually, leaving monetary policy entirely unable to
affect the unemployment rate.
It is apparent that New Classical theory is a restatement of the basic Classical–Monetarist
theme: that the inherent and automatic operation of a market economy is superior in
providing stable levels of production and employment to the efforts of fiscal and monetary
policymakers. Government must therefore adopt a hands-off approach to the economy.
The question is how valid this theory is. Events in the USA and Britain since 1980 provide
strong evidence against the validity of this theory. It appears that, generally speaking, the
more extreme assertions of the New Classical school are not taken seriously any more by
economists. Yet these assertions still surface in the public policy debate in some form or
another from time to time, even in South Africa.
Despite this, one undeniable effect of the New Classical school has been a greater
awareness, also among Keynesian economists, of the importance of expectations and the
reactions of decision-makers to policy steps. Most mainstream economists would accept
the more moderate view that the intended effects of policy steps may be countered to some
extent if these effects are anticipated by individuals and institutions. This should be taken
into account in policy design.
11.3.4 New Keynesian economics

Just as the advent of Keynesian economics in the 1930s did not mean the end of the
Classical tradition, so the resurgence of the Classical tradition in the form of Monetarism
and New Classical economics did not mean the end of the Keynesian approach.
From the late 1980s, Keynesian economists such as Gregory Mankiw and Olivier Blanchard
addressed the weaknesses of the older Keynesian approach. Their approach became known
as New Keynesian economics. Unlike the older Keynesians, they incorporated rational
expectations into their models. However, they also introduced various wage and price
rigidities, as well as concepts such as asymmetric information, to explain why an economy
may experience unemployment and instability in the short run. Unlike earlier Keynesians,
they agree with the New Classical economists that in the longer run the economy returns
to a long-run equilibrium.
Like many developments in economic thinking, the New Keynesian approach came about
due to real events that challenged strongly held views.
One of the more controversial implications of the New Classical theory is that it should be
possible for a central bank in a high-inflation economy to reduce inflation without a loss in
employment. Just as it is possible for inflation to increase without affecting unemployment, so
too it should be possible to reduce it without affecting unemployment. Therefore, should the
economy experience a high inflation rate, the central bank merely needs to announce that
in future the money supply will grow at a slower rate. Both inflation π and π e will decrease,
leaving the difference between them unchanged. Using the New Classical Phillips curve
relationship set out above, the implication is that actual unemployment will not increase.
The validity of this view was severely brought into question in the early 1980s when both
USA and UK monetary authorities announced and implemented a strong anti-inflationary
stance. Should the New Classical theory have been right, this strong anti-inflationary
policy would not have led to an increase in the unemployment rates in the USA and UK.
However, both countries, as well as many other counties, experienced a severe recession

with a significant increase in unemployment accompanying the reduction in inflation.
❐ New Classical economists attempted to explain the significant increase in unemploy-
ment by arguing that, even though the monetary authorities announced the anti-
inflationary stance, the authorities lacked credibility – i.e. people and companies did
not believe they would follow through on their anti-inflationary stance. When they
actually did follow through, it came as a surprise – hence actual inflation decreased
while expected inflation remained high, the result being an increase in the unemploy-
ment rate according to the New Classical Phillips curve.
However, many economists did not accept this defence by New Classical economists
against the strong challenge levelled against their theory. Many economists believed that
the tendency of the economy towards stability is not as strong as the New Classical school
holds it to be. However, these economists also did not want to revert back to the older
Keynesian theory that failed to explain the high inflation of the 1970s.
What they did was to accept the concept of rational expectations, as well as the idea that
the economy will return to a long-run equilibrium. However, they then argue that in
the short to medium run there are structural rigidities that prevent the economy from
adjusting instantaneously or rapidly to the long-run equilibrium. Therefore, even if people
and companies are endowed with rational expectations, and even if they know what the
eventual effect of a policy step will be, there are rigidities in the economy that prevent
them from acting on their expectations in the short run.
These rigidities may cause (nominal and real) wages to be slow to change in the short
run. For instance, wage contracts are concluded for one to three years (recall the theory
of short-run aggregate supply in chapter 6). Should the central bank announce an
expansionary monetary policy after the labour contract has been concluded, workers
will probably know that inflation will increase. However, being locked into their contract,
they cannot act upon the change in expectation. Only when the contract comes up for
renegotiation can they adjust their wage demands to get them in line with the change in
their expectations. Thus, in the short and medium run, the economy can deviate from its
long-run equilbrium path.
New Keynesians formulated a host of other theories to explain short-run unemployment
and deviations from long-run equilibrium. These include the so-called menu-cost and
input-output arguments.
❐ According to the menu-cost argument, prices cannot adjust quickly in the face of
higher input cost because of the cost of adjusting prices. For instance, it is expensive to
print new menus (hence the name of the theory).
❐ The input-output argument states that, even though a producer might know that a
policy step will be inflationary, the complexity of the input-output chains in a modern
industry means that the producer does not know how precisely the policy step will
impact on his costs and therefore his prices. Hence the producer will wait until the
higher costs are passed through to him through the input-output chain before he
adjusts his prices.
In addition to these theories, there are several labour market theories that are used to
explain unemployment on a macroeconomic level. These include insider–outsider models
and efficiency wage models.
❐ Insider–outsider models argue that those who are employed (the ‘insiders’) are able
to erect barriers of entry to new entrants to the labour market (the ‘outsiders’). This
means outsiders cannot compete with insiders by offering their labour services at a

competitive wage. As such, the insiders are able to negotiate higher wages, which in
turn means that companies will employ fewer workers.
❐ The efficiency wage models argue that employers are willing to pay workers a higher
wage if this will cause these workers to become more efficient. Employers will then need
fewer workers to produce the same output.
Not all these New Keynesian theories need to hold in every context and every country.
However, they do give the economist a menu of possible short- and medium-run deviations
of employment and output from their long-term trend.
Structural unemployment and the African context

Note that neither the New Classical nor the New Keynesian theories provide explanations,
or policy prescriptions, for the high levels of structural unemployment in a country such as
South Africa. Both theories assume that in the longer run the economy returns to a long-run
equilibrium. But both implicitly assume that such a long-run equilibrium is a good position for
any economy to be in.
Neither approach considers the possibility that such a long-run equilibrium may still be
characterised by high structural unemployment, high levels of poverty and underdevelopment,
and significant inequalities in income and wealth.
In a sense, neither approach presents a theory that quite captures the subtleties and
complexities of production, employment and inflation in the context of low- and middle-
income countries. Given their origins in high-income countries, the theories are based on
several hidden institutional assumptions about the functioning of a ‘modern’ economy. The
assumption of the rapid dissemination of the ‘wisdom’ of economists among economic
decision-makers is one example. The question is to what extent the assumptions are essential
to the validity of the theory.
It is incumbent upon economists and policymakers in Africa and elsewhere to reflect critically
on these questions, and to adapt these theories as necessary to account for the reality of the
low- and middle-income countries.
❐ One essential step is the full inclusion of the concept of structural unemployment into the
theory, as has been done throughout this book.
❐ Linking growth theory to human development theory and to cultural and institutional
development, as introduced in chapter 8 and chapter 12, section 12.3, is another.
❐ The deeper analysis of structural unemployment, its link to development backlogs, and the
relevance or irrelevance of conventional macroeconomic policy instruments to address this
problem are other essential elements. These issues are addressed in chapter 12.
11.3.5 The policy debate between Monetarists/New Classicals and

New Keynesians
The Monetarist/New Classical policy approach flows directly from the basic theoretical
framework outlined above, as well as the deep distrust of government found in the
Monetarist/New Classical philosophy. It is also instructive to contrast it with the New
Keynesian viewpoint.
An important preliminary point is that the time horizon under consideration in Monetarist/
New Classical thinking is significantly longer than with New Keynesians. Monetarists/
New Classicals stress the medium- and especially the longer-term result of their model,
while New Keynesians stress short-run results and problems in an economy. (Monetarists/

New Classicals even see ‘the long run’ as occurring within a period as short as two to five
years.) This difference in approach has important implications for the choice of priorities.
Below, the Monetarist/New Classical policy approach is explained in some detail. Blank
space is left on the right for the reader to derive the expected New Keynesian response in
each case.
Monetarists/New Classicals New Keynesians (to be completed)
General approach
_________________________________________
❐ Given that the economy is inherently stable,
stabilisation is unnecessary and uncalled for. _________________________________________
❐ The problems of anti-cyclical policy (discussed _________________________________________
in section 11.2) and the possibility that policy
can be destabilising are insurmountable and _________________________________________
make sensible stabilisation policy impossible. _________________________________________
❐ Since government cannot be trusted, any policy
intervention and especially anti-cyclical ‘fine- _________________________________________
tuning’ must be rejected most strongly. Such _________________________________________
intervention does more harm than good.
❐ Indeed, the main cause of observed economic _________________________________________
instability is policy mistakes and blundering by _________________________________________
the authorities (notably the monetary authority).
❐ In any case, having a passive government
_________________________________________
secures the additional benefit that individual _________________________________________
freedom and the smooth operation of free
_________________________________________
markets are maximised, and the role of
government in the economy minimised. Such an _________________________________________
approach therefore advances the liberal ideal.
_________________________________________
Monetary vs. fiscal policy
_________________________________________
❐ Owing to too-strong crowding-out effects,
fiscal policy is ineffective in affecting GDP – in _________________________________________
both the short and the long run. Fiscal policy _________________________________________
is therefore unimportant and impotent, and
merely serves to crowd out the private sector _________________________________________
and cause the public sector to be excessively _________________________________________
large. The fiscal authority must be passive, not
activist. (Government expenditure has a positive _________________________________________
effect on nominal GDP only when it is financed _________________________________________
by money creation. But then it is not the fiscal
action as such that stimulates the economy but _________________________________________
rather the monetary element. It will also cause _________________________________________
inflation.)
_________________________________________
⇒

⇒ _________________________________________
❐ Monetarists would argue that, since monetary
policy affects the money supply, which in turn _________________________________________
is the direct and chief determinant of aggregate _________________________________________
expenditure, monetary policy is exceptionally
potent in influencing expenditure and GDP (in _________________________________________
the short run). In this sense, monetary policy _________________________________________
is the more important type of policy. (In the
long run even monetary policy has no real _________________________________________
effect, since in the long run money is neutral.) _________________________________________
New Classicals differ from Monetarists,
arguing that, even in the short term, monetary _________________________________________
policy is neutral and cannot affect output and _________________________________________
employment.
❐ Even though Monetarists argue that monetary
_________________________________________
policy is potent in the short run, this does not _________________________________________
mean that monetary policy should be used
_________________________________________
actively. Indeed, precisely because it is so
potent, it is crucial to take control of the money _________________________________________
supply out of the hands of the government – i.e.
_________________________________________
monetary policy is dangerous.
❐ The control of the money supply should _________________________________________
therefore occur via a fixed monetary rule that
_________________________________________
pins down the growth rate of the nominal money
supply at a specified percentage (in accord with _________________________________________
the long-run growth rate of the economy). The
_________________________________________
monetary authority should have no discretionary
control over the money supply. _________________________________________
❐ In the long run, the only variable that can really _________________________________________
be affected by monetary policy is the average
price level. For this variable, stable growth in the _________________________________________
money supply is also the best medicine. In the _________________________________________
long run, regular monetary stimulation results in
only one thing: continual increases in the price _________________________________________
level. This is all the more reason for imposing a _________________________________________
monetary rule on monetary growth.
Priorities of policy
_________________________________________
❐ Since fiscal policy is impotent, and since
monetary policy has no long-run effect on the _________________________________________
real economy, policy cannot be used to fight _________________________________________
unemployment. In any case, it is unnecessary
since there is no involuntary unemployment _________________________________________
(when the economy is in equilibrium, which is _________________________________________
the case most of the time).
❐ However, policy can influence the price level, so _________________________________________
policy must focus on inflation as its first priority _________________________________________
(and not on unemployment at all). That is, an
anti-inflation policy is to be favoured above an _________________________________________
anti-recessionary policy. _________________________________________
⇒

⇒ _________________________________________
❐ The monetary discipline that is required to
fight inflation may cause a drop in GDP and _________________________________________
employment in the short run. However, this is _________________________________________
only temporary, not very serious, and a small
price to pay for the long-run benefit of low _________________________________________
inflation. (The different policy approaches to _________________________________________
inflation and unemployment are analysed in
depth in chapter 10.) _________________________________________
Exchange rate policy
_________________________________________
❐ Given their belief in the market, Monetarists
generally favour a freely floating exchange rate, _________________________________________
i.e. no intervention by the monetary authority in _________________________________________
foreign exchange markets.
_________________________________________

Inflation, unemployment and low
growth: causes and remedies 12
■ define, measure and calculate the rates of inflation, unemployment and growth, and quote
key South African statistics in this regard;
■ assess and compare the Monetarist/New Classical and Keynesian explanations of infla-
tion and unemployment;
■ evaluate the structural dimensions of inflation and unemployment;
■ evaluate the role of policy, both as a remedial step and as a potential factor contributing
to the inflation process;
■ value the complexities of economic growth and growth-oriented policy; and
■ compare differences between the relatively narrow conventional and newer, broader un-
derstandings of the causes and remedies of low growth; and appreciate the limitations of
standard macroeconomic theory in understanding these three phenomena.
Inflation, unemployment and low economic growth are generally regarded as the three
most important macroeconomic problems. While there may be differences of opinion
regarding their importance compared to other economic and social ills, these three issues
clearly dominate the conventional macroeconomic policy debate.
This chapter analyses the definition, measurement, causes and possible solutions of these
three problems, including the complexities of remedial policies. The differences between
the main schools of thought in economics will be a recurring theme, as will the importance
of the structural and developmental dimensions of these phenomena, notably in South
Africa. This also reminds one of limitations of standard macroeconomic theory.
12.1 Inflation
12.1.1 Definition and measurement

The definition of inflation is not a matter of dispute. Inflation is defined as a sustained
increase in the general or average price level. One-off or intermittent increases in the
average price level do not constitute inflation. Likewise, increases in the prices of individual
products or services are not inflation but rather a change in relative prices.
The average price level is measured by different price indices, the consumer price index
(CPI) being the most important.1 The CPI measures the cost of a pre-determined basket
1 Other important indices are the producer price index (PPI) and the GDP deflator.
12.1 Inflation 481

of consumer goods. The contents
of this basket correspond to the One person, one inflation rate?
average consumption patterns of One should remember that the inflation rate measures
consumers (especially in urban the trend in the national average price level.
areas). This cost is measured on ❐ In specific areas or cities a different trend from
the basis of monthly surveys the average price level can occur. For this reason,
of prices. The amount is then Stats SA also publishes separate inflation rates for
expressed as an index with a base certain cities.
year/month value of 100. For ❐ Specific groups of individuals, with an expenditure
pattern that deviates markedly from the average
example, the cost of the basket
– e.g. the rich or the poor, young people or the
in December 2016 is taken as
elderly – can each experience a different inflation
100 (indicated as 2016/12 = rate. Stats SA also publishes such inflation rates.
100). The cost of the basket in ❐ In fact, each individual or household experiences
other periods is then expressed its own average price level and own inflation rate.
relative to this base value. The This depends on the individual’s or the household’s
CPI is calculated and published by particular expenditure pattern, e.g. expenditure on
Statistics South Africa (Stats SA) food relative to transport relative to housing.
each month.
Despite the fact that Stats SA uses internationally standardised methods, interest groups
that stand to benefit from an inflation rate other than the official one – e.g. labour unions
that could use a higher inflation rate to negotiate higher wage increases – sometimes
question the methods of Stats SA.
Inflation is measured as the rate of increase of the average price level during a specified
period, normally one year. More specifically, the inflation rate is the percentage change
in the CPI during the chosen period. Two main methods of calculation exist. Both are
expressed as an annual rate, but they differ somewhat.
(a) Method l: As described above, Stats SA publishes a CPI value each month. To get the
average inflation rate for a whole calendar year, one calculates the average of the 12
monthly CPI values for a particular year, e.g. 2019, and compares it to the average CPI
for the previous calendar year (i.e. 2018). Calculating the difference as a percentage
change produces the inflation rate for 2019. This is how the South African Reserve
Bank calculates its published annual inflation rate. It also publishes annual CPI
values, allowing the easy calculation of annual inflation rates from these.
(b) Method 2: The CPI value for a specific month, e.g. July 2019, is compared with the CPI
value for the corresponding month 12 months earlier (July 2018). This is called the year-
on-year (or YoY) method. Expressed as a percentage change, this produces an inflation
rate ‘for July 2019’ – in fact, for the 12 months up to July 2019. This method produces
12-month inflation results every month. These are also published by the Reserve Bank.
❐ Unfortunately, the YoY monthly results are subject to short-run fluctuations as
well as purely statistical or so-called technical disturbances. Accordingly, they
should be used with circumspection. For example, if a large jump in the YoY-based
inflation rate occurs, a thorough investigation is needed to establish whether it is
a one-off jump or indeed the sign of an underlying shift in the average price level.
❐ Note that the annual inflation rate as calculated by method 1 is equivalent to the
average of 12 monthly YoY inflation rates for a calendar year calculated with
method 2.
482 Chapter 12: Inflation, unemployment and low growth

Another monthly measure of changes in the average price level is to calculate the
percentage change between July 2019 and June 2019 and express that at an annual rate.
As a measure of inflation this can be very misleading and confusing: dealing with such a
short period, the results are very volatile. This method should be avoided.
Table 12.1 The rate of inflation in South Africa since 1961
Inflation in South Africa
Table 12.1 summarises the inflation 1961–65 2.1 2007 7.1
history of South Africa since 1961. (See 1966–70 3.4 2008 11.5
chapter 9, section 9.2.4 for an inter 1971–75 9.4 2009 7.1
national comparison of inflation rates.) 1976–80 12.1 2010 4.3
The data in table 12.1 and figure 12.1 1981–85 14.0 2011 5.0
clearly show the extent to which the 1986–90 15.4 2012 5.6
inflation rate in South Africa has increased 1991–95 11.3 2013 5.7
since 1973, with the mid-1980s the worst 1996–2000 6.7 2014 6.1
period. It has shown a decline since 1992,
2001–05 5.1 2015 4.6
but with significant peaks in 2002 and
2006–10 6.9 2016 6.4
2008 (albeit of shorter duration).
2011–15 5.4 2017 5.3
South Africa (and other Western coun 2016–18 5.5 2018 4.7
tries) also experienced inflation in the
period between 1946 and 1970, but
this was at a very low level – below 4%. Without doubt, the period after 1970 represents a
structural shift in the inflation pattern. South Africa experienced difficulty in getting the
inflation rate below 10%. However, since the late 1990s the inflation rate has stayed below
10% most of the time, and below 6% for most years since 2010. This is very important,
considering that inflation rates of below 3% typically exist in countries that constitute
South Africa’s main trading partners. (Refer to the discussion of the impact of inflation on
Figure 12.1 Annual inflation rate in South Africa 1960–2018

20
18
16
Inflation rate
14
12
Percentage
10
0
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
12.1 Inflation 483

international trade, the current account and the exchange rate in chapter 4. Also see the
discussion of inflation targeting in chapter 9, section 9.3.) The lower inflation rates have
also helped to reduce the level of expected inflation among the general public as well as wage
and price setters. People have to come to believe that inflation rates can indeed come down,
and can remain at lower levels (allowing for spikes due to external shocks from time to time).
If one compares the often dreadful inflation experiences of low- and middle-income (or
'developing')2 countries, and of a neighbour such as Zimbabwe (see box in section 12.1.3),
it is encouraging that the South African inflation rate has never increased above 20%, has
not fluctuated wildly, and now seems to be under control in the range between 4% and 6%.
As is the case with unemployment (see chapter 12, section 12.2), the theoretical explana
tions of inflation – and the proposed solutions – diverge along the lines of the differences
between the broad theoretical and ideological convictions in economics.
12.1.2 The Monetarist/New Classical explanation of inflation

The Monetarist/New Classical view of price determination and of changes in the price
level was explained in chapter 11 (section 11.3.1). Central to this view is the Quantity
Theory of Money:
MV  PY
with V (the velocity of circulation of money) assumed to move according to a predictable
trend, and Y assumed to be stable at the full employment level. (The symbol M denotes the
nominal money supply, previously denoted as MS.) This means that:
❐ The nominal money supply t is the principal determinant of the average price level:
ΔM ⇒ ΔP.
❐ The only long-run effect of money is on the average price level (i.e. money is neutral).
Without an increase in the money supply, the price level cannot increase.
The causes of inflation
A diagnosis of the causes of inflation follows from the above.
❐ First: without growth in the nominal money supply, a sustained increase in the average
price level cannot occur. ‘Inflation is always and everywhere a monetary phenomenon’,
in the famous words of Milton Friedman.
❐ Second: excessive money creation is the principal explanation and cause of a sustained
increase in the average price level. Any monetary expansion in excess of what is
necessary to facilitate the (growing) volume of transactions in a (growing) economy
will merely be reflected in increasing prices. From the quantity theory equation one can
derive the following approximate ‘rule’:
%ΔP = %ΔM – %ΔY – %ΔV
That is, if the growth rate of real GDP is 3% per annum, velocity decreases by 2% per
annum and the nominal money stock grows by 20%, the inflation rate will be 15%.
2 A categorisation of countries using the terms ‘developing’ and ‘developed’ has been standard internationally.
However, we approve of a recent decision by the World Bank to stop using it. These two terms group countries that are
very dissimilar, do not recognise that development challenges and poverty exist also in the richest countries and that
all countries always are developing; the terms also suggest a patronising attitude. The World Bank distinguishes four
groups, based on Gross National Income (GNI) per capita: low-income countries, lower-middle-income and upper-
middle-income countries, and then high-income countries. South Africa is an upper-middle-income country. The
International Monetary Fund (IMF) distinguishes between ‘advanced economies’ and all others as ‘emerging market
and developing economies’.

Thus it is a pure monetary theory of inflation. Inflation is largely explained in isolation from
any real economic variables, and Y in particular. This characteristic of the Monetarist/
New Classical theory of inflation is a clear outcome of the acceptance of the Classical
dichotomy. (Compare the Keynesian view of inflation in section 12.1.3.)
In terms of the AD-AS framework, the Figure 12.2 Money supply growth and increases
Monetarist/New Classical view is shown in in the price level
figure 12.2. While increases in the money stock
P ASLR
can shift the AD curve to the right in the short
run, resulting in an equilibrium off (and to the
right of) the long-run vertical supply curve
ASLR, the supply adjustment process always P4
occurs quickly (or even instantaneously,
as maintained by the New Classicals in ASSR2
particular). The quick (or instantaneous) P3
adjustment promptly takes the economy back
to the intersection of the AD curve and the ASSR1
long-run supply curve ASLR. This implies that P2
the short-run ASSR curve exists only for a very
brief period of time (if at all). It can therefore ASSR0
P1
be disregarded for most purposes.
In this way, a sustained growth in the nominal
money stock simply means that the AD curve P0
continually shifts up along the ASLR curve. AD1
The only effect is a continual increase in the
Continually upward shifting AD (and ASSR) AD0
curves due to sustained growth in MS thus YS Y
result in a continually increasing price level
(i.e. inflation). Conversely, without a sustained growth in MS, such a sustained upward
shift in AD (and sustained increase in P, i.e. inflation) cannot occur. Case concluded,
according to the Monetarists/New Classicals.
❐ The principal supporting evidence was data from the USA which showed a strong
correlation between Ml growth
Figure 12.3 Money supply growth and inflation
rates and the inflation rate.
 ASLR (or PCLR )
This situation can also be depicted
effectively with the AD-PCLR-PCSR
model introduced in chapter 7, ASSR (or PCSR )
where we renamed the AS curves
as Phillips curves (or PC) – as in
figure 12.3. On the vertical axis, it Steady growth in
money supply causes
has the percentage change in the a steady-inflation
0
price level, i.e. the inflation rate structural equilibrium
π. Accordingly, in this diagram,
steadily upward shifting AD and
ASSR curves are represented by AD
stationary AD and ASSR (i.e. PCSR)
curves. The intersection of AD YS
12.1 Inflation 485

with the vertical ASLR (i.e. PCLR) line gives the equilibrium inflation rate π0 = 15% in the
numerical example above. (This percentage also is the rate per annum at which the AD
curve is shifting up in figure 12.2.)
Policy prescription
The policy prescription of the Monetarists/New Classicals follows logically from this
reasoning: the growth in the money stock must be fixed according to a monetary rule that
lets the money stock grow at a specified rate equal to the long-run growth rate in real GDP.
Given the formula above, the result should be the absence of any inflation.
Issues in the debate

Critics point to various factors that seriously limit the Monetarist/New Classical explanation
and render it a partial explanation of inflation, at best.
❐ The general argument is that the Monetarist/New Classical model is oversimplified and
simplistic, especially since it disregards the impact of the real side of the economy on
the price level. (Compare the Keynesian view of price determination.)
❐ The proposition that an increase in the money supply is necessary for inflation is
obvious but trivial and weak logic. It is like saying that (excessive) water is a necessary
condition for drowning. That inflation cannot occur in a world without money does not
necessarily imply that money creation is the only and original cause of inflation. (Surely
water in itself is not the primary cause of drowning, nor does more water cause more
drowning, nor will a reduction in the water supply reduce drowning ...)
❐ In South Africa, as in most other countries, the velocity of circulation of money
V is anything but stable. It is also not changing at a stable rate. Hence, it is rather
unpredictable, which renders the relationship between money supply and inflation un
predictable. This became particularly clear in the 1990s (see the box on the development
of monetary policy in South Africa, chapter 9, section 9.2.3).
❐ In the long run, the economy clearly does not operate at full employment in South
Africa. As noted in chapter 11 (section 11.3.4), the Monetarist/New Classical model
does not allow for a phenomenon such as structural unemployment.
❐ The idea that money is neutral, with no ultimate impact on the real sector, is strongly
questioned.
❐ The degree of control of the monetary authorities over the money supply is not adequate
to enforce a fixed monetary growth rate. The money stock also grows due to internal
changes in the economy, e.g. when people make increasing use of credit facilities. (In
other words, in reality the money supply is not completely exogenous.)
❐ Thus, any observed correlation between the money supply growth rate and the inflation
rate may merely reflect the fact that the transactions demand for credit and money
is significantly influenced by the average price level (remember that MD is a function
of P, among other things). If P increases, the nominal demand for money increases,
and therefore the extent of credit creation. This process will also produce the observed
correlation between monetary growth and inflation. In any case, merely finding a
statistical correlation between MS and P data does not prove the presence of any cause-
and-effect relationship from the one to the other.

12.1.3 A broadly Keynesian explanation and policy approach3
Demand inflation and cost inflation

In contrast to the Monetarist/New Classical theory, a broadly Keynesian view can be
characterised as a real theory of inflation. In addition, the price level (and inflation) and
Y (GDP) are determined simultaneously and inseparably – there is no dichotomy between
monetary and real processes.
The essence of a Keynesian approach is the distinction between demand inflation and cost
inflation (or, demand-pull and cost-push inflation). The basic analytical and graphical
apparatus to understand this view is found in the interaction between the aggregate
demand and aggregate supply – or, graphically, between the AD, ASLR and ASSR curves of
chapter 6, alternatively the AD, PCSR and PCLR curves encountered in chapter 7.
The context of this discussion is not the original cause of the first inflation ever, but rather
the cause of higher (or lower) inflation, starting from a particular steady inflation base
(which could even be close to zero). Thus we are in the context of a permanent inflation
situation. Therefore we will use the AD-PC model.
❐ Nevertheless, the reader can also follow the analysis of demand and cost forces in terms
of the basic AD-AS model, as analysed in section 6.4 of chapter 6, while keeping in
mind that the outcomes must be applied in the context of continually upward-shifting
AD and ASSR curves.
Consider a situation with steady inflation. Graphically, this means that AD is stationary,
intersecting the vertical PCLR line at the prevailing inflation rate π0. The two types of
‘Keynesian’ inflation are then defined as follows:
❐ The basic idea of ‘demand-pull’ is that excessive aggregate demand or expenditure leads
to an increase in the inflation rate. An increase in aggregate demand (AD shifts to the
right) causes, through the interaction with aggregate supply, upward pressure on the
inflation rate (accompanied by an increase in Y). The short-run equilibrium moves up, to
the right, along the PCSR curve.
❐ The basic idea of ‘cost-push’ is that aggregate supply or cost pressure can lead to higher
inflation. A decrease in aggregate supply (PCSR shifts to the left) causes, in interaction
with aggregate demand, upward pressure on the average price level (accompanied by
a simultaneous drop in Y). The short-run equilibrium moves up, to the left, along the
AD curve.
Note that both of these scenarios explicitly accept and integrate the existence of the short-
run aggregate supply, or PCSR, curve. While it is accepted that a supply adjustment process
will eventually shift the PCSR curve, moving the equilibrium back to PCLR, this process is
not instantaneous and it may take some years for the whole process to work itself out
(three to seven years, but a rough average is approximately five years).
3 The model presented here is a somewhat modified version of the traditional Keynesian approach, which is largely
limited to the distinction between demand-pull and cost-push inflation. This section incorporates the concepts
of initiating and propagating factors. They are not explicitly covered in much of Keynesian or New Keynesian
literature, but are not at odds with the basic spirit of the Keynesian framework. It is also called ‘broadly Keynesian’
because the New Keynesian school, discussed in chapter 11, contains so many strands of thought – not necessarily
complementary – dealing with theories of price and wage rigidities. These are intended to explain prolonged
deviations of the economy from its long-run equilibrium, within the context of the Phillips curve debate (see the box
on the Phillips curve and New Keynesians in section 12.2.2).
12.1 Inflation 487

This is the ‘medium term’ (as defined in chapter 2). For the most part, the speed of the
adjustment process depends on the speed with which wage contracts are renegotiated
(and reflects the extent to which the expected inflation rate has caught up with the
actual inflation rate). For a considerable time, the PCSR curve exists and is instrumental in
determining both Y and P, or rather π. In the short and medium run it is PCSR that, together
with AD, is decisive in determining the state of the economy (Y and π).
❐ Note the strong contrast with the Monetarist/New Classical view of rapid or even
instantaneous adjustment of PCSR, as detailed above.
The analysis so far explains only the occurrence of increases in the average price level.
In the AD-PC model, this would appear as a one-off increase in the equilibrium inflation
rate, whereafter it will return to the initial level. Depending on the case, either AD or PCSR
will simply drop back to their initial position and the inflation rate will return to π0.
What is necessary to explain higher inflation is an explanation of a permanent increase in
the inflation rate. Graphically, this requires that both AD and PCSR must shift to a higher
level permanently, with a higher equilibrium inflation rate π1 as the outcome.
Such an explanation is provided by the further distinction between so-called initiating and
propagating factors on both the demand and the supply sides of the economy.4
Initiating and propagating factors

Initiating factors are the immediate causes of an inflation episode, factors that give
inflation a ‘kick start’.
On the demand side, such factors include substantial exogenous increases in any of the
components of aggregate expenditure (C, I, G, X – M) or in the money supply (MS). On
the supply side, the factors include exogenous shocks from any of the determinants of
aggregate supply, notably wage hikes, increases in the cost of imported inputs (following
an increase in their price in foreign currency or a depreciation of the domestic currency),
a shortage of inputs (especially imported inputs), a drought that curbs agricultural
production and so forth.
❐ In graphical terms, changes in any of these factors can activate an initial upward shift
of either the AD or PCSR curves (or both). This initiates an upward movement in the
inflation rate as the short-run equilibrium moves higher.
While any of these factors can be a cause of an upward shift of AD and/or PCSR, this is
unlikely to be sufficient to keep them at their new positions (and therefore to ensure that
the new higher rate at which the price level increases is sustained, i.e. that a higher rate
of inflation is maintained). Something is necessary to propagate the initial stimulus so that
the price level P will continue to increase faster than before.
❐ In AD-AS terms: These – or other – factors must cause recurring larger upward shifts
of AD and ASSR.
❐ In the AD -PC diagram, this would mean that something causes AD and PCSR to remain in
higher positions. The diagrams in figures 12.4 and 12.5 show the two curves in such higher
positions (respectively AD 1 and PCSR2, marked in blue).
This points to a second category of potential causes of inflation: factors that propagate
any already initiated increase in the rate of inflation (even if these causal factors
may not be able to initiate the process of faster price increases in the first place).
4 This distinction has been borrowed from the structuralist approach to inflation, which is discussed below.

Propagating factors are determinants Figure 12.4 Demand-pull inflation
of both the demand and the supply

sides that can lead to permanent PCLR PCSR1
upward shifts in AD and PCSR.
On the demand side, most of the Equilibrium with
higher inflation due
components or determinants of 1 to ‘demand pull’ (via
aggregate expenditure are disqualified, some supply adjust-
since in reality most are unlikely or ment process)
unable to undergo sustained, long- 0

run real growth faster than GDP. This,
AD1
notably, is also true of government
expenditure, the sustained real AD0
growth of which, relative to GDP,
would soon absorb all real GDP. The
YS Y1 Y
latter is logically impossible. While
real growth in G for a number of years
Figure 12.5 Cost-push inflation
can play a propagating role for that
period, it is disqualified as a long-run  Equilibrium
PCLR PCLR
propagating factor. with higher
inflation due to PCSR2
A demand-side factor that does qualify ‘cost push’ (via
– and that is likely to be the most some supply PCSR1 PC
adjustment SR0
important demand-side propagating process)
factor – is nominal money supply 1
growth. Such growth, if sustained,
can easily lead to a sustained upward 0
shift of the AD curve to AD1,
and hence to higher inflation. The
Keynesian view therefore agrees with AD0
the Monetarist/New Classical view
that money supply growth is a crucial YS2 YS0 Y
factor in the inflation process, i.e. that
inflation is a monetary phenomenon.
The important difference is that monetary growth is not regarded as the only, original,
underlying or initiating cause of inflation. It is one among many causes and different types of
cause.
❐ The obvious question is: why would the money supply grow, or be allowed to grow, and
have this undesirable consequence? Below it is demonstrated why the nominal money
supply often grows for particular non-monetary reasons, and also that by doing so it
nevertheless translates an upward shock on prices into higher inflation.
On the supply side, the normal cost shocks do not qualify as propagating factors. Droughts,
OPEC collusion to increase the oil price, strikes and such factors are essentially short-run
phenomena (even in cases where they endure for a year or two). They can shift the PCSR
upward, but only for a short period. Something else must be present for a permanently
higher PCSR curve to materialise and be maintained.
The most important supply factor that qualifies as a propagating factor is inflation
expectations. If workers come to expect continual price increases and incorporate these
expectations in their negotiations on wage setting, that will lead to the PCSR curve
12.1 Inflation 489

permanently shifting to a higher position (graphically). Such a higher position would be
reached only after a supply adjustment process has taken its course (as normally follows
a demand or supply shock; see chapter 7, section 7.1.3). This supply adjustment process
has upwardly adjusting inflation expectations at its core. This would most surely ingrain
higher annual wage and price increases and, therefore, higher inflation. (See the further
discussion on policy options below.)
Such expectations of higher inflation can easily start following a period of faster price
increases, the source of which could be initiating factors on either the demand or the
supply side.
❐ Note that a demand-side propagating factor such as money supply growth may (or may
not) play a complementary role in propagating initial shocks.
External factors can also play a role in causing inflationary expectations. These are
discussed below.
The role of policy – remedy or cause?

The last element of the Keynesian inflation model is the role of policy. In addition to the
obvious anti-inflationary role of policy, it would appear that policy can also be an integral
part of the inflation process.
Standard macroeconomic policy, i.e. fiscal and monetary policy, primarily affects the
demand side of the economy.5 The direct anti-inflationary role of such policy is limited to
steps to contract aggregate demand (AD is shifted to the left), thereby effecting downward
pressure on the average price level or inflation. Different policy strategies and different
paths – whether more gradualist or more reactionist – to reach a target inflation rate were
analysed in chapter 7 (section 7.2.2).
On the other hand, policy can cause upward pressure on prices and inflation (AD is shifted
to the right). If anti-cyclical stimulation is taken too far, strong upward pressure on prices
and inflation can be inflicted (especially if the economy approaches full capacity).
It would appear that policy can be both a remedial step and – perhaps surprisingly – a
contributing factor in the inflation process. Regarding the latter role, an absolutely crucial
insight is that policy often constitutes some kind of accommodation by the authorities,
which could be:
(1) the accommodation of people’s demands;
(2) the accommodation of a supply shock; or
(3) the accommodation of inflationary expectations.
(1) The accommodation of people’s demands
The first form of accommodation concerns the demands of citizens for a higher standard
of living, lower unemployment, reduction of poverty, increased government provision of
goods and services and so forth. If a government, in an effort to satisfy these demands,
increases government expenditure or expands the money supply, it is bound to cause an
increase in inflation – especially when the economy approaches or is pushed beyond the
long-run AS or PCLR curve (i.e. the structural equilibrium level YS). In the latter case, the
economy enters the bottleneck area noted in chapter 6, section 6.3.3.6
5 Certain taxes can serve to constrain supply.

6 Of course, this upward pressure would have to be propagated to cause permanently higher inflation.

If this policy stimulation takes Figure 12.6 Demand-pull inflation and policy accommodation
the economy beyond YS (and 
graphically to the right of PCLR), PCLR PCSR1
two options face government:
PCSR0
first, to do nothing; second, to do
2 Equilibrium after
something, using policy measures. 2 supply adjust-
Figure 12.6 shows these options ments via PC shift
1 1
starting from point 1 (the short- Equilibrium after
run equilibrium after the initial 0 initial demand
stimulation
demand stimulation). Inflation is 3 AD  1
higher than the initial level of π0, Equilibrium after
and so is Y. AD0 AD shift due to
(a) If nothing further is done, the contractionary
policy
supply adjustment process is
likely to commence at some YS Y1 Y
time, pushing the economy
back to YS via an upward shift of PCSR until it intersects PCLR and AD1 at point 2, with
inflation at π2. This adjustment propagates the initial demand-pull inflation for some
time. (As argued in chapters 6 and 7, this process can take several years during which
several rounds of wage contract negotiations embed higher inflation in expectations.)
The end result is that the initial benefit with regard to income Y is wiped out – but
the inflation rate would have increased further.7 And, since inflation expectations as
a propagating factor have come into action (causing the upward shift in PCSR), the
inflation process will have been boosted.
(b) Alternatively, contractionary policy can be used to constrain aggregate demand (AD
shifts back, to the left) and fight the upward pressure on inflation. The inflationary
pressure would be eased, but at the cost of a drop in the level of income back to YS
(returning to PCLR, but at a lower inflation rate). The initial purpose of the expansionary
policy will be defeated.
Often the latter option is politically difficult to implement, given the likely direct impact
on employment levels. Thus the first option is more likely to materialise, in which case
the accommodation of (political?) demands to push the economy beyond YS has become a
cause of permanently higher inflation.
Unfortunately, the first option still involves political risk, since the supply adjustment
process does lead to a drop in aggregate income and increase in unemployment. Therefore,
a government may face substantial pressure to prevent this drop in income. This brings us
to a very dangerous but very likely source of higher or increasing inflation, i.e. attempts by
the authorities to push the economy beyond PCLR and keep it there. The theoretical analysis
of this case, including a detailed diagram, can be found in chapter 7 (section 7.1.4) and
will not be repeated here. What happens is the following:
❐ As the supply adjustment process starts to take Y back towards PCLR (accompanied
by an increase in the inflation rate), additional demand stimulation will have to be
instituted to prevent the fall in Y and employment.
❐ However, this additional demand pressure will again be followed by supply adjustment.
This pushes the economy back to PCLR and a yet higher rate of inflation.
7 The adjustment period displays a drop in Y in conjunction with an increase in the inflation rate π. Therefore this
constitutes stagflation.
12.1 Inflation 491

❐ If this cycle occurs over and over, the outcome is not higher, but increasing inflation.
Keeping Y above YS requires repeated increases in aggregate demand, and inflation
will increase continually year after year. If this occurs, the policy of repeated demand
stimulation becomes the prime cause of increasing inflation.
❐ In the worst of cases, the rate at which inflation increases will itself be increasing, which
leads to so-called hyperinflation (or runaway inflation). Zimbabwe in the recent past
has been an unfortunate example of this occurrence, where inflation rates eventually
reached 98% per day! (See box below.)
This interaction between supply adjustment and ‘corrective’ demand stimulation over
time, given excessive political demands for expansionary policy, can be a very powerful
propagating process. If inflationary price expectations are generated by this process,
ingrained high and even increasing inflation may result. Every effort should therefore be
made to resist such political pressures.
At the same time, this scenario highlights the importance of the proper recognition of the
existence of structural unemployment and of the long-run aggregate supply relationship
being at a level of income Y which is below the truly full employment level YFE – i.e. at the
level indicated as YS.
❐ As noted in chapter 11 (section 11.3.4), the New Keynesian model – like the Monetarist/
New Classical model – does not recognise or allow for a phenomenon such as structural
Hyperinflation and Zimbabwe since 2008

Hyperinflation is a situation where inflation is spiralling out of control with no tendency towards
some kind of stable equilibrium. It is usually characterised by, if not exclusively caused by,
uncontrolled and eventually massive growth in the nominal money supply. The internal value of the
currency falls rapidly, and people start to avoid holding money.
Hyperinflation is generally defined to occur when monthly inflation rates exceed 50%. At a monthly
rate of 50%, a product that costs one unit of domestic currency (e.g. $1) on a particular date,
will cost 130 units (i.e. $130) one year later – thus an annual inflation rate of 13 000%. The most
famous period of hyperinflation was Germany in 1923, when the daily inflation rate reached 20.9%.
Zimbabwe was the first country in the 21st century to develop hyperinflation. It entered the
hyperinflation zone early in 2007, when the monthly inflation rate climbed from 13.7% in January
to 77.6% in February. A year later the monthly inflation rate was 259%. In July 2008 the annual
inflation rate reached approximately 250 million %, and by the middle of October 2008 it is
estimated to have skyrocketed to 300 billion %. This implied that prices doubled every two days.
Practically, the Zimbabwe dollar had ceased to exist. (Earlier, the Zimbabwean central bank had to
print banknotes in increasingly large denominations, eventually releasing a 100 trillion Zimbabwean
dollar banknote in January 2009.)
This inflation appeared to have been stopped in its tracks in January 2009 when the government
officially allowed the use of foreign currencies in commercial transactions. Later the government
abolished the Zimbabwean dollar, leaving the US dollar and South African rand as the main
currencies in circulation.
In 2016 the Zimbabwean government introduced ‘bond notes’ supposedly fully backed by US
dollars, while transactions in foreign currency were outlawed, followed in early 2019 by Real Time
Gross Transfer (RTGS) dollars (a combination of bond notes and coins and electronic balances). By
June 2019 the government declared that existing bond notes and RTGS dollars will henceforth be
known as new Zimbabwean dollars, while transactions in foreign currency were outlawed again.
Whether Zimbabweans would comply with this was uncertain given a likely lack of trust in the new
Zimbabwean dollar. The official rate of inflation reached 98% in July 2019.

unemployment. One must adapt the model by defining the long-run equilibrium level
of Y as the structural equilibrium level YS, with a concomitant structural rate of
unemployment (rather than a ‘natural’ rate of unemployment).
Given the nature and causes of structural unemployment, efforts to use standard macro-
economic policy to get and keep the unemployment rate permanently below the structural
unemployment rate (i.e. to keep Y above YS), are misguided and even dangerous. Indeed,
efforts to do that could result in very high and even continually increasing inflation (and
in the worst case, hyper- or runaway inflation).
That is a very high price to pay for wanting to use macroeconomic policy to address structural
unemployment, rather than appropriate policy steps (as discussed elsewhere in this chapter).
Unfortunately, for various reasons, macroeconomic analysts and even policymakers tend
to be hesitant to recognise the existence and extent of structural unemployment. That
increases the possibility that macroeconomic policy will be used to fight high (structural)
unemployment, thereby actually contributing to, and propagating, inflation.
A trade-off
Note that any policy-induced shift in aggregate demand AD causes unemployment and the
price level to move in opposite directions. Restrictive policy decreases the price level and
inflation, but increases unemployment. Expansionary policy decreases unemployment, but
pushes up the price level and inflation. This is the important trade-off between inflation and
unemployment. Either of these two objectives can be pursued only at the expense of the
other. However, this trade-off is only temporary. As chapter 7 shows, after several years the
economy is likely to have returned to YS and the impact on unemployment would have been
reversed – though the impact on inflation will remain.
❐ This problem is associated with any demand policy and cannot be escaped.
❐ See chapter 7, section 7.1.5 and the box in section 12.2.2 on the Phillips curve
controversy.
(2) The accommodation of a supply shock

A second and important form of accommodation is the accommodation of a supply shock.
Examples are a drastic hike in the oil price, economic sanctions, sharply increasing prices
of imported inputs (perhaps due to exchange rate movements), or a drought. Such events
constrain the general ability or willingness to produce, thereby constraining the supply
side. Graphically, both the PCLR and the PCSR curves shift to the left, i.e. to PCLR1 and PCSR1
in figure 12.7. The economy is at point 1. The contraction of supply leads to an increase
in the inflation rate to π1 in conjunction with a recession – real income has fallen to Y1.
❐ This is stagflation – the typical manifestation of supply-side inflation.
Note that this case presents two simultaneous problems: higher inflation (i.e. faster price
increases) and higher unemployment (i.e. lower output). What is to be done? What may
be the role of policy? Policymakers face three options: passively absorb all aspects of the
shock, actively combat the inflation shock, or actively combat the output shock.
First, they can sit back and let the economy absorb the shock. It means that the economy
will go through a supply adjustment process (see chapter 7, section 7.1.3). Upward pressure
on wages will cause PCSR to shift up to PCSR2. This will result in still higher inflation π2,
while output will settle at a new, lower YS2 (which coincides with the position of the new
PCLR1).
12.1 Inflation 493

The long-run, structural unemployment Figure 12.7 Supply-shock inflation and policy
level will increase. The country is poorer as accommodation
a result of the supply shock. 
PCLR1 PCLR0
❐ Note that the supply adjustment
PCSR2
process, although of a different nature
than the supply shock as such – PCSR 3 3 PCSR1
shifts for a different reason, and up PCSR0
rather than left – its impacts on Y and π 2 2
are similar. It aggravates and prolongs 1 1
the stagflation effect of a supply shock. 0
❐ Such a supply adjustment process can AD2
take approximately three to seven years. AD0
AD1
Second, they can attempt to combat the
inflation by introducing a contractionary
monetary policy (thereby shifting AD left YS2 Y1 YS0 Y
to AD1). As with option 1, real income
will decrease and settle at YS2 on the new PCLR1– the country is poorer, but inflation will
have decreased. So there is a short-run trade-off between lower inflation and higher
unemployment. (As was the case with category (1) above, the return to the target value of
π0 will not be quite as direct as shown in figure 12.7 but via a particular policy path. This
can take several years, as indicated before.)
Third, they can attempt to stimulate output and employment so as to again reach the
starting level of real income, i.e. at YS0. This will shift AD right to AD2 (point 2). However,
output at the former level YS0 is not a long-run structural equilibrium level any more. Due to the
supply shock, PCLR is not in that position any more but is now in position PCLR1. Thus there
will be upward pressure on wages and prices that might introduce a wage–price spiral. As
inflation expectations adjust, the PCSR curve will shift up. The economy is likely to end up
at point 3 with inflation equal to π3 and real income at YS2 despite all the effort not to end
up there.
❐ As noted in chapter 7, on average the entire process can be thought to take approximately
four to seven years, involving successive rounds of wage renegotiations.
If the third option is chosen, government is said to accommodate the supply shock. While
the policy counters the recession, price and inflation increases are aggravated and carried
further. Therefore such accommodating policy contributes to the propagation of the
impact of the supply shock on the inflation rate. In this way the policy is an integral part of
the inflation process.
If such an accommodating policy occurs via monetary stimulation – which is very
common – the growth in the money supply contributes to the inflation process. In this
way, money creation becomes a propagating factor in the inflation process. What is also
clear, though, is that in such a case the increase in the money supply is not an original or
true cause of the inflation at all.
❐ This highlights the key difference between Keynesian and Monetarist/New Classical
views on the role of money in inflation. Monetarists/New Classicals focus exclusively
on money as principal cause of inflation, while a Keynesian view would see monetary
growth as being part of a more complex process in which it is a contributing, a
propagating or an accommodating factor – and where the original source of a bout of
increasing inflation may be something quite different from money.

Why would a government choose the accommodation option if it contributes to inflation?
Again, political pressures to ‘do something’ are likely to build up following a supply
shock, and in the shorter run unemployment is more likely to be a political hot potato
than inflation.
(3) The accommodation of inflationary expectations

Above, inflationary price expectations were identified as one of the main propagating
factors on the supply side – given that a prior initiating phase had already instilled such
expectations. All the possible policy reactions encountered in (1) and (2) above, except the
demand contraction options, are typical examples of such initiating phases.
When inflationary price expectations start taking effect – shifting the PCSR curve to a
higher level – they continually place the authorities almost in the same dilemma as an
ordinary supply shock (except that the long-run PCLR line does not shift left as well). If
aggregate demand does not continue to grow at a rate equal to the expected inflation
rate, the economy will go into a recession. (Graphically, AD will shift down and Y will
decline.) Consequently accommodation often occurs, in the last instance in the form of
monetary growth, to sustain the growth in aggregate demand. The continued sanctioning
or ratification of the higher inflation rate confirms the expectations of higher inflation,
and secures their continuation. The higher inflation becomes permanent.
❐ Once again, it can happen that growth in the money supply (partly) ‘causes’ the
higher inflation. However, this happens as the reluctant but perhaps unavoidable
accommodation of the continual changes on the supply side, which in turn have their
origin in other (non-monetary) factors or disturbances.
Neither of the two ultimate propagating factors – price expectations and monetary
expansion – is a true or original cause of higher inflation. Nevertheless their interaction is
very effective in maintaining (‘causing’) the higher inflation. The interaction between the
two main propagating factors – money on the demand side, expectations on the supply side
– can, therefore, deeply ingrain inflation. Indeed, together they constitute the worst possible
combination. Unfortunately the presence of such circumstances is not uncommon.
❐ The factual presence of this process in a particular country or situation makes any
debate on the original causes all but irrelevant. The relevant question becomes ‘how to
stop this vicious cycle’.
Of course, non-accommodation is a theoretical option. It would imply that the growth
rate of aggregate demand is held back so that it stays below the present expected rate
of inflation. After several years, and following a deep enough recession to help reduce
inflationary expectations (compare section 7.2 of chapter 7), this would reduce the
inflation rate to a desired level. However, during the period of adjustment the cost of this
option in real economic terms is likely to be quite high. The South African Reserve Bank
pursued such a restrictive policy in the 1990s, and again in 2008–09 when it combated
high or increasing inflation. It pursued such a policy even though many commentators
argued that, with severe development and poverty problems as well as high structural
unemployment, such a policy may not be politically and socio-economically desirable.
So, in a sense the solution for inflation – even ingrained inflation – is very simple: implement
a restrictive monetary policy that will wring the inflation and inflationary expectations
out of the system. Chapter 7 showed that this can be done to various degrees of severity –
the AD curve can be shifted down slower or faster. The monetary authority can use either
a gradualist or a more severe, reactionist approach.
12.1 Inflation 495

❐ Of course there is a spectrum of degrees of being gradualist or reactionist. In chapter
7 it was shown that the degree to which a policy is gradualist or reactionist can be
understood as the slope of a monetary reaction (MR) function.
❐ In the case of a gradualist approach, the monetary authority reduces inflation and
inflationary expectations gradually in comparison with the reactionist approach. The
economy would have to be kept in tight rein, though only in a moderate recessionary
state, for the entire period. (AD is shifted down relatively slowly.) While this would
increase interest rates and constrain economic growth and employment creation
for many years, it may eventually liberate the economy from the grip of inflationary
expectations. And this is the drawback: although the gradualist approach results in a
less severe contraction of output, it takes longer to reduce the inflation rate.
❐ The reactionist approach wrings out inflation quicker – AD is shifted down relatively
fast – but it results in much higher unemployment during a period of severe economic
contraction. To illustrate: while a reactionist approach may increase unemployment
by, say, five percentage points for one year to deal with a given inflation problem, a
gradualist approach may increase unemployment by one percentage point for five
years.
❐ The chosen degree of gradualism or reactionism will depend on the seriousness of
the inflation problem as against the prevailing unemployment problem, as well as the
prevailing political acceptability of a more severe anti-inflationary policy stance. It
may depend on the orientation of the policy authorities, in particular the central bank,
in terms of the various schools of thought (see chapter 11).
Perspectives on South African anti-inflation policy

The pre-2000 Reserve Bank policy of monetary growth guidelines was a variant of the
gradualist option. While the use of a guideline interval for monetary growth allowed a
degree of flexibility, the gradual lowering of the level at which the interval was set indicated
a long-run anti-inflationary stance. It also implied a high interest rate policy. And while
the historical record shows that the Reserve Bank had severe difficulty containing money
supply growth within the stated guideline intervals, inflation rates did decline in the latter
half of the 1990s, as did inflationary expectations.
The current inflation targeting approach is more explicitly designed to reduce inflationary
expectations. Using a variable that is more intuitive to understand than money supply
growth enables any person to understand the policy stance and debate on inflation. The
main objective of a system of inflation targeting is to provide a stable ‘anchor’ for price and
wage expectations, thereby stabilising actual price and wage adjustments and containing
the inflation rate. The system provides a stable inflation rate interval on which market
participants can base their inflation expectations and economic behaviour. Because
monetary policy is solely focused on inflation, it is clear, credible, unambiguous and
predictable, so that participants can form their expectations on future inflation rate (and
interest rate) movements with more confidence.
In pursuing its inflation target, the South African Reserve Bank still uses a gradualist
approach. Whenever the inflation rate has exceeded the upper bound of the target range
(which was set, for most of the period since its implementation in 2000, at 3% to 6%),
the Reserve Bank has never attempted to return to the target range immediately. Rather,
the Reserve Bank has invoked an ‘explanation clause’ (initially called an ‘escape clause’),
meaning that it would explain the extraordinary reasons why inflation exceeded its target

range. Then the Reserve Bank would explain how it would attempt to return inflation to
the target range, usually within 24 months.
❐ It followed this approach both in 2001 (following the severe, but temporary depreciation
of the rand) and in 2008–09 (following the effects of the severe, but temporary increase
in the international oil price that lasted until mid-2008). Since both of these were
temporary price shocks rather than underlying inflationary forces, it seemed justified.
External and BoP complications

The dilemma of ingrained inflation is aggravated by the external implications of the
different policy options. External considerations imply certain constraints on the options
available.
If nothing is done to combat the inflation, rising domestic prices relative to world prices
may ‘price South Africa out of world markets’ (unless a continual depreciation of the rand
counters this price differential effect). Given the dependence of South African economic
growth on exports, this is highly undesirable. Imports will also be encouraged. As a result,
a deteriorating current account and balance of payments may place downward pressure
on the rand. While this may counter the price differential effect, it implies an additional
supply shock via imported input prices. If this shock is either absorbed or accommodated,
even higher inflation will result, yet again causing current account deterioration, further
depreciation, and so forth. This can be depicted as a vicious circle of inflation-depreciation-
inflation- …
❐ Note that this particular interaction between internal and external factors constitutes
a very effective propagating factor in the inflation process.
The risk of this outcome was a major consideration in the decision of the Reserve Bank,
in the early 1980s, to opt for a rather strong anti-inflationary stance, i.e. very restrictive
monetary policy. The high social and political costs of this option soon made the policy
unsustainable and it was abandoned in its strong form, to be replaced by a more gradualist
strategy – some would say too gradualist, as inflation did not start to decrease until the
early 1990s.
There appears to be an underlying conflict between external and socio-political con
siderations. The former argue in favour of anti-inflationary steps – non-accommodation or
non-absorption of supply shocks or inflationary expectations. The latter argue in favour of
anti-recessionary accommodation (stimulation). How this difficult choice is to be handled
is one of the biggest difficulties of macroeconomic policy aimed against inflation. Standard
policy measures appear to be largely incapable of resolving the dilemma.
One argument is that macroeconomics policymakers in South Africa should not attempt to
achieve the permanent elimination of inflation. Given the above conflict, the best outcome
would be to prevent inflation from increasing. This is an achievable objective, and one
that, so it seems, enables the policymaker to pursue other, perhaps more important, social
and equity objectives. The chosen inflation target range seems to reflect this view to a
certain extent. However, policymakers should still be aware of false trade-offs between
higher inflation and lower levels of unemployment. Moreover, higher inflation would still
leave the problem of international inflation rate differentials.
12.1 Inflation 497

Summary: potential causes of inflation (in the broadly Keynesian approach)
Demand side Supply side
Initiating factors Exogenous increases in C, I, G, X – M Exogenous changes in cost of inputs (wages, import
Exogenous increase in the money supply prices, depreciation of rand)
Expansionary fiscal policy Exogenous shortages of inputs (supply bottlenecks,
droughts, international unavailability)
Propagating Money supply growth Price and inflation expectations

factors Accommodating fiscal policy
Accommodating monetary policy (money supply
growth)
Do budget deficits cause inflation?

It has become a familiar refrain that (large) budget deficits are an important cause of inflation, both
in South Africa in the 1980s and 1990s and internationally in many other countries. This has been an
important element in the twin prescriptions that the deficit has to be reduced and that interest rates have
to be kept high to combat inflation as long as the deficit is ‘large’. What are the theoretical grounds for
this view? Major disagreement exists, which reflects philosophical differences between the main schools
of thought.
In Keynesian analysis, high budget deficits can be part of an inflation process mainly if they occur in an
economy approaching full capacity (the bottleneck case of chapter 6). By creating excess demand at or
near ‘full’ employment, significant upward pressure on prices can transpire, which can be an initiating
inflationary factor or boost an already inflationary process.
❐ However, when the economy is not operating close to full capacity, its effect on prices is unlikely to
be significant.
❐ In contrast, in a Monetarist/New Classical view of the world a completely different conclusion is
reached. In this view the economy is perpetually at or close to full employment, so that increased
aggregate demand due to deficit spending can only translate into upward pressure on prices.
A second dimension may be the way the deficit is financed. If a deficit is financed by borrowing,
any resulting upward pressure on interest rates would restrict aggregate demand and hence reduce
inflationary pressures. A clear instance of when a budget deficit can be inflationary (also as an initiating
factor) is if it is financed by money creation. If any resulting upward pressure on prices is propagated by
other factors, or if this money creation occurs regularly, inflation can result.
❐ In a Monetarist/New Classical viewpoint, money creation would be highlighted as a major danger of
large budget deficits even if they are not financed by money creation initially. The argument seems
to be that it is all but inevitable that, eventually, large deficits will force the government regularly to
resort to money creation.
❐ However, this is an extreme and surely not inevitable outcome. It also does not explain inflationary
pressure at a time when there is no reason to resort to money creation (unless inflationary
expectations are generated by rhetoric on the inevitability of the ‘monetisation’ of budget deficits).
In a Keynesian approach, it is accepted that, to the extent that large budget deficits cause upward
pressure on interest rates, they may inhibit private capital formation (investment spending). As
investment is held back, it restricts the growth of the productive capacity of the economy in the long run.
This could gradually create inflationary pressures from the supply side – a ‘supply shock’ spread out over
several years.
⇒

⇒
❐ Empirically, the extent of the upward pressure on interest rates due to budget deficits is unclear.
Therefore the potency of this supply-side effect is uncertain. It also has to be balanced against the
growth-promoting effects of deficit spending on government capital formation, say.
An entirely different line of argument comes from the Classical-Monetarist approach. It was noted earlier
that very often economists see a deficiency of saving as a major cause of low economic growth. A
small savings pool is said to restrict investment and hence productive capacity. Budget deficits – and
government dissaving in particular – are seen as a drain on the available pool of savings. Therefore
budget deficits tend to cause a supply-side restriction and have a long-term detrimental effect on
inflation, in this view.
❐ As noted in chapter 10, there is little evidence that the low investment and low growth in South Africa
during the 1980s and 90s have been caused by a shortage of saving in the economy. Rather, low
saving has been a symptom of low economic growth, a sign that the private sector did not undertake
investment and hence did not need to save to pay off any loans to finance investment. Political
uncertainty and pessimistic expectations were the main culprits (in addition to relatively high real
interest rates at times).
It appears that, despite its frequent repetition, one has to question the proposition that high budget
deficits are a major cause of inflation (as long as they are not continually financed by money creation or
occur repeatedly while the economy is at full capacity). Empirical evidence also provides grounds for
scepticism regarding this proposition. However, it is a complex issue on which consensus is unlikely.
12.1.4 Structuralist and conflict views of inflation

Alternative approaches to the inflation problem, as well as possible new policy options,
can be found in the so-called structuralist and conflict views of inflation.
The structuralist approach

The structuralist approach introduces a richer view of initiating and propagating factors,
adding several nuances. The structuralist approach begins by identifying a (third) set of
inflation factors, i.e. underlying factors that cause an underlying susceptibility to inflation in
the economy. These include a wide range of non-economic (social, political and historical)
dimensions, for example:
❐ the traditions and values of a society (selfishness, individualism, care for others,
communalism, commitment to hard work and being productive, inclination to reap
without sowing, and so forth);
❐ the degree of materialism or greed in society, as visible in sustained efforts to wring the
maximum material or monetary benefit from every activity;
❐ the degree of conflict between groups, given limited resources;
❐ the extent to which people look to government for support and demand such support,
rather than fostering self-reliance and independence;
❐ the degree of competition in product markets as well as labour markets;
❐ the political and negotiating power of labour unions;
❐ the extent to which prices are downwardly rigid;
❐ the extent to which prices are controlled;
❐ the official commitment to a policy of full employment, or political pressures for such
a commitment;
12.1 Inflation 499

❐ the size of the public sector and of government employment (which implies political
wage setting), and
❐ the openness of the economy.
Factors such as these may contribute to making an economy susceptible to, or disposed to,
inflation – inflation is easily initiated, easily propagated and easily entrenched.
The structuralist view of initiating factors is similar to that listed under the Keynesian
approach above (which uses some structuralist insights). Therefore both demand-pull
and cost-push elements are acknowledged. What would be added here is something like
an increase in indirect taxes (e.g. VAT) or administered prices, which could initiate an
inflationary process.
In this view, propagating factors include a wider spectrum of factors, including aspects of
the microeconomic interaction between wages, prices and profits. Different price–wage
and wage–price spirals are identified. Prices that are determined on a cost-plus basis, for
example, ensure that cost or wage increases are automatically passed on in the form of price
increases. In this way, wage increases in one sector of the economy almost automatically
lead to wage demands in other sectors. In all these processes, the structure of markets – i.e.
the concentration of economic power – is of central importance.
In essence, the structuralist approach probes much deeper and more microeconomically
to uncover the real structure and interaction of decision making in the economy, and the
institutional and dynamic elements of the way people really act, also incorporating non-
economic elements. It is a pluralist or eclectic model that integrates a variety of elements.
In this sense, it differs fundamentally from the ‘pure’ macroeconomic approaches that
appear, in comparison, to be relatively narrow and limited in analytical substance.
The policy implication of the structuralist approach is that inflation can be curbed effectively
only via a broad, coordinated strategy that targets all three groups of contributing factors
in the inflation process. Neither restrictive monetary policy nor restrictive fiscal policy nor
price or wage controls can, in themselves, make a significant contribution to stopping the
inflation process. Indeed, trying to fight inflation only with monetary policy (high interest rates)
and/or fiscal policy can be counterproductive. A much more probing analysis and modification
of the structure and texture of economic processes will have to be undertaken. In this, the
role of economic power will have to be a central concern.
The conflict approach

This approach does not concern itself with the particulars of the inflation process but
rather with the fundamental causes or sources of inflation. These, it is maintained, lie in
a continual imbalance between (a) the aggregate needs, claims and demands of various
interest groups and (b) the aggregate production capacity of the economy. Interest groups
use their economic and political power to give effect to these claims and demands. Given
the efforts of groups, mostly materialistically inclined, to increase and maximise their
share of the total ‘economic cake’, no mechanism exists to coordinate and constrain these
demands to match the real size of the cake. As a result, the aggregate demands usually
exceed the total real capacity of the economy.
One way to bridge the gap between aggregate demands and aggregate capacity is to
supplement domestic production with imports. However, BoP considerations preclude
this from being done indefinitely (especially if a country experiences problems with
international capital inflows).

Only one possibility remains: the ‘cake’ must be ‘inflated’ so that each slice can appear to be
larger. This is what occurs when the average price level increases to produce an increase in
the nominal value of aggregate production – even though the real content of the cake (real
GDP) remains unchanged. (To extend the metaphor: the cake is filled with air bubbles to
appear larger, but the dough content remains unchanged.) In this way, inflation develops
as a symptom of the unreconciled demands of groups in society.
For many decades, South Africa has been characterised by a particularly high degree of
conflict between interest groups. Since the 1970s there have been significant increases in the
demands on the public sector and of employee organisations and labour unions, high profits
required by the private sector, as well as high demands from foreign countries (primarily
oil-producing countries). At a deeper level, one can point to the conflict between labour and
capital, between race groups, between the haves and have-nots, and between those with
political power and those without it, as fundamental causes of the high inflation since 1973.
The policy implications of this argument are that the competing demands have to be
reconciled in some way or another. One possibility is a voluntary or compulsory agreement
in terms of which the demands of different groups are limited – e.g. a price and wage
freeze. However, such a remedy would require an earnest national consensus between
all groups on the necessity for such a step. Internationally such strategies in the form of
price and wage freezes have dismal records. Despite an apparent initial sense of national
unity and reconciliation in South Africa following the democratic election of 1994, it
is not clear that such a consensus actually exists. Steeply growing demands in recent
years may actually have increased the underlying conflict and pressure on the economy
– as evidenced in political tensions between the ANC and its alliance partners, frequent
labour unrest strikes, unions breaking away from Cosatu, heavyweight battles between
rival factions in the ANC, and the phenomenon of state capture. Symptoms of underlying
discord could be seen in widespread service-delivery protests as well as intense social and
political contestations around land redistribution and calls for the expropriation of land
without compensation.
In principle, a more equal distribution of income and wealth should eventually contribute
to a reduction in some areas of conflict. This shows the importance of the distributional
objective (see chapter 1). Economic and political restructuring may also, eventually,
contribute to a reduction in conflict. However, unless (or until) the desired changes
are brought about in appropriate ways – for example, without harming the underlying
productive capacity of the economy – the government may be left with the disagreeable
choice between restrictive demand policy or continued high inflation.
12.2 Unemployment
In chapter 6 (see box in section 6.3.2) an introductory discussion of different kinds of
unemployment was provided. With that as background, this section considers the problem
of unemployment in more depth.
12.2.1 Definition and measurement

At a conceptual level, it appears quite straightforward to describe or define unemployment.
Unemployment arises when someone who wishes to work cannot find employment
(obviously excluding children, students and the retired). The total unemployment rate can
then be calculated by expressing the total number of unemployed persons as a percentage
of the total labour force (or economically active population).
12.2 Unemployment 501

✍ What is the total population in South Africa approximately?
How large is the labour force in South Africa approximately?
__________ million
__________ million
What is the SA unemployment rate approximately? __________ %
What is the unemployment rate in a country such as the USA? __________ %
Can one compare the employment rates in SA and the USA?
___________________________________________________________________________________
___________________________________________________________________________________
Hint: you can find the information about unemployment in South Africa in the Quarterly Labour
Force Survey (QLFS), conducted by Statistics SA. The QLFS can be downloaded from:
www.statssa.gov.za.
Conceptual issues and problems

In practice, the formal definition and measurement of unemployment is not so easy. The
basic problem is to decide (a) whom to include in the labour force, and (b) what is meant by
being unemployed. Various definitions exist, and hence it is important to be clear on which
definition is being used in a particular analysis or debate. We first consider these issues on
a conceptual level. (In the next section we describe the definitions used by Statistics SA.)
For the purposes of defining unemployment the population of the country is divided
into two parts, i.e. the economically active population and the not economically active
population.
1. The economically active population (the ‘labour force’) consists of employees in both
the formal and the informal sectors, plus all unemployed people. These are all the
working-age people who either work or want to work.
2. The not economically active population includes children, students, retired persons and
all other persons who cannot be classified as either employees or unemployed persons;
that is, these are people who do not work and do not desire to work, regardless of their
age. They are not included when counting the unemployed.
The unemployed thus are a subgroup of the economically active population.
Given these definitions of two populations, there is a strict (or narrow) definition, and an
expanded (or broad) definition of unemployment.
1. Strict definition of unemployment: The unemployed are only those who actively looked
for employment in the preceding few weeks.
2. Expanded definition of unemployment: The unemployed are those who actively looked
for employment in the preceding few weeks plus unemployed people who say they
want to work, but did not look for work in that period. These include the so-called
discouraged workers.

The different population, labour force and unemployment concepts can be illustrated as
follows:
Figure 12.8 Unemployment concepts
Not economically active
Unemployed who did not look

for a job, but are willing to work
C
Unemployed who actively
search for work
B
Workers/employees
Economically active Not counted as Economically active

population (strict unemployed in strict population
definition) definition (expanded definition)
Calculation of the unemployment rate:
  B   
Strict definition:  
A+B
  B + C  
Expanded definition:  
A+B+C
Note that choosing the strict or the expanded definition of unemployment implies a
corresponding narrower or broader definition of the economically active population.
Should one choose to include discouraged work seekers in the unemployed, then one
should also include them in the economically active population.
In addition to these definitions of unemployment there is the concept of underutilised
labour. It is increasingly being used internationally to measure labour market conditions,
but its exact definition and implementation has not been finalised yet. Conceptually it
includes ‘time-related unemployment’, which involves people who work occasionally or
who work part time – less than 35 hours per week, say – but who would like to work more
hours. While such persons are not entirely unemployed, they are not employed in the full
sense of the word either. Yet in a standard labour force survey they will be counted as
being employed.
❐ Underutilised labour then comprises the narrowly unemployed, all non-searching but
willing-to-work unemployed persons plus those in ‘time-related underemployment’,
i.e. people who work for less than 35 hours per week, for example.
❐ Underemployment is an element of the structural unemployment problem.

How are ‘the employed’ and ‘the unemployed’ defined in South Africa?
In the QLFS, employed persons are those aged 15–64 years who, during the week of
the survey, did any work for at least one hour (or were temporarily absent from a job or
business). This clearly is a very low threshold that potentially allows a high degree of
‘time-related underemployment’ to slip through as ‘being employed’.
The official unemployment figure, published by Statistics SA, is based on the strict
definition of unemployment.
Officially the unemployed in South Africa are people, between the ages of 15 and 64 years,
who:
(a) were not employed in the week of the survey, and
(b) actively looked for work or tried to start a business in the four weeks preceding the
survey interview, and
(c) were available for work, i.e. would have been able to start work or a business in the
week of the interview (or had a job or business due to start at a definite date in the
future).
In essence, to be counted as officially unemployed, an unemployed person needs to have
taken definite steps to search for work. Simply having had the desire to work is not sufficient.
❐ The official unemployment rate is calculated as the proportion of the labour force that
is unemployed, as defined.
The broad unemployment rate adds the following two categories of unemployed people:
(a) Discouraged workers: unemployed persons who say they wanted to work, but did not
actively look for work provided that the main reason given for not seeking work was
any of the following: no jobs available in the area, unable to find work requiring his/
her skills, or lost hope of finding any kind of work.
(b) Other unemployed persons who say they wanted to work, but did not actively look for
work for reasons other than those specified for discouraged workers.
The broad, or expanded, rate of unemployment is also published in the QLFS (see table
12.2). As noted in chapter 1, researchers frequently prefer to use the broad rate of
unemployment in the analysis of unemployment. Given the country’s development and
structural challenges, the more than three million discouraged and other non-searching
unemployed persons must be acknowledged as an integral part of the unemployment and
labour-market problems.
Note that, in its QLFS official (strict) definition of the economically active population,
Statistics SA classifies as ‘not economically active’ those working-age people engaged
in so-called ‘non-market production activities’ and who do not actively search for a
job. Non-market production activities includes subsistence farming for own household
consumption (i.e. not to sell in markets), which involve approximately 2.1 million people
in 2019.8 This classification practice of Statistics SA thus excludes unemployed people
who fall back on subsistence farming when they are unsuccessful at finding a job from
being counted as ‘discouraged or other non-searchers’; therefore it reduces the broad rate
of unemployment from what it would have been otherwise. At the same time they also are
excluded from official employent numbers.
8 This is contrary to international guidelines that such a classification should be done only if those activities make only
an insubstantial contribution to household consumption.

Which data?
The main source of official labour market data is the Quarterly Labour Force Survey (QLFS),
published by Statistics SA since August 2008. (It can be downloaded from: www.statssa.gov.
za.) It is based on a quarterly survey of households and provides extensive information on
changes in:
❐ the working-age population and labour force
❐ the employed, distinguishing between employment in the formal sector (non-agricultural),
the informal sector (non-agricultural), agriculture, and private households (i.e. domestic
workers).
❐ the not economically active and the discouraged job-seekers
❐ both the narrow and broad (expanded) unemployment rates
❐ the absorption rate (= the employment/working-age population ratio) and the labour force
participation rate (= the labour force/working-age population ratio)
❐ time-related underemployment and involvement in non-market production activities.
The QLFS was preceded, from 2000 to 2008, by the biannual Labour Force Survey (LFS).
Stats SA has revised the LFS data so that the older data correspond with the newer
DATA TIP
definitions of the QLFS. Between 1995 and 1999 the unemployment counting survey was
done once a year, during the so-called October Household Survey (OHS) of Stats SA. Linking
data from the OHS with those from the LFS is more problematic.
Employment data is also published in the Quarterly Employment Survey (QES) of Statistics
SA. It is based on the payroll of VAT-registered businesses. QES employment numbers can be
misleading, because the survey covers only formal sector businesses and excludes informal
enterprises as well as all agriculture and private households (domestic work). Therefore it
reports employment numbers that are consistently lower than those in the QLFS. The QES
also shows smaller cyclical fluctuations in employment than the more comprehensive QLFS.
❐ The employment numbers and indices that are reported by the SA Reserve Bank in its
Quarterly Bulletin are from the QES and thus understate total employment as well as
employment fluctuations in South Africa.
One should be very careful when comparing employment and unemployment data obtained
from different surveys. Frequently, the definition of who is to be included or excluded from a
particular category differs between surveys. In many cases the numbers cannot be compared.
One should also refrain from attaching too much importance to individual quarterly changes
in employment or in the rate of unemployment. While the media eagerly report them, often
they are too small to be statistically significant or simply reflect smaller disturbances rather
than a significant trend or cyclical movement. They also do not affect the long-run, or
structural, level of unemployment.
How high are unemployment and underutilisation of labour in South Africa?

Given the complexities of definition and measurement – combined with the social and political
sensitivity of unemployment – it is not surprising that Statistics SA is regularly taken to task
for its published figures, even though they are based on international labour measurement
standards. As is the case with inflation, different interest groups (e.g. business, unions and
government) also have an interest in either a higher or a lower official unemployment rate.
Thus scepticism is always a part of the unemployment statistics debate.
Table 12.2 presents a breakdown of the unemployment situation in South Africa in the first
quarter of 2019. It shows that the official unemployment rate, using the strict definition, was
27.6%, the total number of unemployed persons being 6.2 million. According to the expanded
definition, 10 million were unemployed and the ‘broad’ unemployment rate was 38%.

❐ Note that the expanded definition adds discouraged and other non-searching persons
both to the numerator and the denominator of the ratio.
Table 12.2 Unemployment in South Africa – 1st quarter 2019 (QLFS data)
Total employed in formal sector (A1) 11.220 million

Total employment in informal sector (non-agric) (A2) 2.933 million
Other employed (A3) 2.138 million
Total employed (A = A1 + A2 + A3) 16.291 million
Total unemployed (official/strict definition) (B) 6.201 million
Labour force = A + B 22.492 million
Total not economically active 15.791 million
Total population 15 to 64 years 38.283 million
6.201
  B   
Official unemployed rate (strict definition) =    22.492
    
x 100 = 27.6%
A+B
Discouraged job-seekers (C ) 2.997 million
Other non-searching but want to work (D) 0.796 million
Total unemployed (expanded definition) (E = B + C + D) 9.994 million
Expanded labour force = A + B + C + D 26.286 million
E  9.994
Unemployment rate (expanded definition) =  
     
26.286
   
x 100 = 38.0%
(A + B + C + D)
Total RSA population (mid-2018) 57.7 million
Source: Statistics SA.
The QLFS also publishes figures for time-related underemployment. In the first quarter
of 2019, this was estimated at 786 000 persons – which amounts to 4.8% of the 16.3
million employed.
Table 12.3 presents the components of underutilised labour. Underutilised labour takes all
the unemployed in terms of the expanded definition and adds those among the employed
(i.e. within category A in table 12.2) who are time-related underemployed. Denoting the
latter as AU, underutilised labour F = AU + B + C + D. This formula indicates that there
were 10.8 million underutilised workers in South Africa in the first quarter of 2019,
which was 41% of the expanded labour force. This percentage is called the rate of labour
underutilisation.
Table 12.3 Underutilised labour in South Africa – 1st quarter 2019 (QLFS data)
Time-related underemployment (Au) 0.786 million

Total unemployed (expanded definition) (E) 9.994 million
Underutilised labour ( F = E + Au) 10.780 million

Time-related underemployment as % of expanded labour force = 2.99%
F  10.780
Rate of labour underutilisation =   
 x 100 =  
26.286
  x 100 = 41.0%
(A + B + C + D)
Whatever definition of unemployment (or underutilisation of labour) is adopted, the

careful consideration of the relevant data and concepts is important.
❐ It can be argued that the broad definition, which includes the discouraged workers
in the unemployed, overstates the unemployment problem since some persons who
are too lazy to work or look for work are counted as unemployed. On the other hand,

discouraged and other non-searching unemployed people is a real and significant
labour-market phenomenon that undoubtedly is part of the unemployment and
development challenges facing South Africa.
❐ A significant portion of the employed is in the informal sector. For instance, the QLFS
reported that, in the first quarter of 2019, of the total of 16.3 million people employed,
2.9 million were employed in the informal sector (excluding informal agriculture).
They should not be excluded from macroeconomic analysis. Informal sector enterprises
and workers are an integral part of the economy and thus are equally (or even more)
vulnerable to macroeconomic cycles and policies. (At times informal sector appears to
absorb, if only temporarily, a portion of the people who lose their jobs in the formal sector
during cyclical downswings in the economy.)
How serious is unemployment in South Africa?

Figure 12.9 shows the official unemployment rate from 1970 to 2018. Unemployment in
South Africa has been relatively high (around 10%) at least since the 1970s. However, the
period of faltering growth and sanctions against South Africa since the early 1980s led
to a major increase in the rate of unemployment. This continued in the 1990s, peaking
at almost 27% in 2002, whereafter a significant decline set in – until the recession hit
the country in 2008–09 after the international financial crisis of 2007–08. Despite an
international recovery, South Africa saw regular further increases in the unemployment
rate, peaking at 27.7% in 2017 – the highest in 50 years (with the broad unemployment
rate typically being roughly 10 percentage points higher).
The graph in figure 12.9 comes with a warning. Covering such a long period, it had to be
compiled from different sources of data that are not always fully comparable. Changing
classifications and definitions, also influenced by different political eras, indicate the need
to be careful in interpreting the data. Though the overall unemployment trend in the data
is probably correct, one should perhaps not attach too much value to unemployment
rates of earlier periods – especially the 1970s and 1980s, the years for which published
rates most probably represent a significant underestimation. In those years the proper
measurement of unemployment figures for blacks was not a high priority. (See the box
below on unemployment measurement during the apartheid era.)
Figure 12.9 The official unemployment rate in South Africa 1970–2018
30
25
Unemployment rate
20
Percentage
15
10
0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
Source: Quantec and Statistics SA.

Figure 12.10 shows more recent unemployment rates, both strict and broad (see
table 1.2 for the actual rates).
Figure 12.10 Narrow and broad unemployment rates since 2000
40
35
Broad rate of unemployment
30
25
Narrow rate of unemployment
Percentage
20
15
10
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
International comparisons of unemployment rates are risky, given different definitions

and measurement practices in different countries. This is especially so in the case of low-
and middle-income countries. High-income countries generally use the strict definition of
unemployment. If one wishes to compare South Africa with high-income countries, one
should use their official rate that also is based on the strict definition. Table 12.4 shows
unemployment rates of some other countries.
Table 12.4 International comparisons of unemployment rates
2012 2018 2012 2018

Australia 5.2 5.4 Korea 3.2 3.8
Brazil 7.2 12.5 Mexico 4.9 3.3
Canada 7.3 5.9 Namibia 16.7 23.1
Chile 6.7 7.2 New Zealand 6.9 4.5
China 4.6 4.4 Norway 3.2 3.9
Cyprus 11.8 8.1 Russia 5.4 4.7
Egypt 12.6 11.4 South Africa 24.7 27.0
Euro Area 11.4 9.1* Spain 24.8 15.5
France 9.4 9.2 Sweden 8.0 6.4
Germany 5.4 3.4 Thailand 0.6 0.7
Greece 24.4 19.2 Turkey 8.2 10.9
Ireland 15.5 5.7 UK 7.9 4.0
Italy 10.7 10.2 USA 8.1 3.9
Japan 4.3 2.4 Venezuela 7.8 35.0
Note: * 2017
Source: DataMapper.

For many years the official South African unemployment rate (approximately 27% in 2018)
has been significantly higher than those of most other countries, be they industrialised,
emerging market or low-income countries. Most sources consistently place South Africa
in the worst ten countries. In a list of about 200 countries for which the World Bank
has data for 2018, only one (West Bank and Gaza) had an unemployment rate higher
than that of South Africa. In addition, in only about 15 of the other did unemployment
exceed 15% – these include Botswana, Lesotho, Eswatini and Namibia. While a traumatic
event such as the post-2010 Euro crisis has seen countries such as Greece and Spain treble
their 2012 unemployment rates to 25% and many other Eurozone countries with rates
above 10%, these were linked to a specific and acute crisis, not a sustained structural
unemployment situation. The same applies to Venezuela, which experienced rapidly rising
unemployment and hyperinflation since 2016. Therefore, these figures indicate that South
Africa undoubtedly has a serious, entrenched unemployment problem.
Apart from the economic cost in terms of unused productive capacity, the cost in terms of
human suffering and disappointment is immense. And millions of people are concerned.
While this may be part of a wider development problem, it does not detract from the fact
that these conditions can lead to serious social problems – and also political problems
for the South African government, especially given the huge expectations created by the
political transformation.
Unfortunately, the prospects for a dramatic improvement in the situation are not good. As
noted in section 1.3.1, the employment coefficient in South Africa is just above 0.5, implying
that formal employment generally only grows at half the GDP growth rate (see figure 1.4).
Therefore, it is estimated that, to prevent the rate of unemployment from increasing further,
real GDP would have to grow at 4% annually (given population growth rates) – and at up to
7% to significantly decrease unemployment. However, since 1970 – and more recently, since
2007 – economic growth has regularly fallen far short of even the 4% target (see figure 1.1
in chapter 1 and section 12.3.2 below). Economic growth alone will therefore not solve the
problem – although it has an important contribution to make.
The limited impact of economic growth on employment is evident in table 12.5. Both
formal sector employment growth and total employment growth are frequently, and on
average, much lower than GDP growth (also see figure 1.4 in chapter 1). This illustrates
the low employment coefficient in South Africa. Table 12.5 also shows the decline in the
economic (GDP) growth rate after 2011.
Table 12.5 Annual growth rates of GDP and employment
GDP (%) Formal Employment (%) Total Employment (%)

2009 –1.54 –3.2 –4.9
2010 3.04 –3.1 –1.3
2011 3.28 5.5 3.4
2012 2.21 3.1 3.1
2013 2.49 3.9 3.3
2014 1.85 1.3 0.5
2015 1.19 0.8 4.7
2016 0.40 0.9 0.0
2017 1.41 3.2 2.3
2018 0.79 –1.1 1.2
Average 2009–18 1.84 1.11 1.23
Source: SA Reserve Bank and Statistics SA (QLFS).

Measurement complexities – unemployment, poverty and underdevelopment
With its high unemployment rate, South Africa seems to be out of line with both high-
income and low- and middle-income countries – including SADC and African countries.
One may be surprised by African countries – many with high levels of deprivation and
illiteracy – having much lower official unemployment rates than South Africa. Does
everybody measure and interpret ‘work’ and ‘unemployment’ in the same way?
Historically, starting in the 19th century, the concepts and definitions of employment and
unemployment were formulated within the context of high-income wage economies with
the vast majority of people having jobs with formal employers in business (mines, factories,
retailers, etc.) or government organisations. This is where the concepts of having a job,
and of being unemployed, were born – and made sense.
In many low- and middle-income economies large numbers of people find themselves in
some form of subsistence activities, often in traditional rural agriculture, but also in peri-
urban agriculture (in addition to a variety of informal livelihood activities). It is not clear
that the concepts of a formal ‘job’, an ‘employer’ and ‘unemployment’ are fully applicable.
❐ In this regard, the International Labour Organisation (ILO) in 2013 proposed the
introduction of refined measures of unemployment and underutilisation of labour,
particularly to recognise discouragement properly, to rate ‘production for own use’ to its
true value and also to avoid misleadingly low official unemployment rates in countries
where a significant proportion of the population is engaged in subsistence agriculture.
The South African economy is not a typical advanced, high-income economy with only
a modern, formal sector. But as a middle-income country it also has distinctive economic
conditions – an economy historically centred around mining, a legacy of male migrant
workers sourced from ‘homelands’, a dualist economy with highly unequal economic
development, crowded townships originally shaped by being labour pools for mines
and factories, etc. – and much marginalisation and economic disempowerment. The
possibilities of traditional agrarian livelihoods have strongly diminished and townships
have not developed normal business and employment sectors.
It is likely that these conditions may influence the interpretation of terms in answering
survey questions – for example, whether a person regards herself as employed, self-
employed or looking for work? Is self-employment (e.g. as the owner of a spaza shop) seen
as employment? Are subsistence activities seen as (self-)employment? Is working at an
informal hairdresser shop or a car repair shop reported as having a job? Or is a job primarily
the employment found in a typical formal-sector mine or factory, or in government, with
regularly-paid weekly or monthly wages?
If the latter perspective predominantly shapes work expectations, it could be that –
especially compared to another country where traditional agrarian livelihoods still are
an established part of the economy – South African surveys would reflect much higher
levels of self-reported unemployment. What may be reported as part of the ‘traditional
subsistence economy’ in another country may be reported as ‘unemployment’ in South
Africa where there is an ingrained expectation of getting jobs in the modern, formal sector
(mines, factories, etc. or in government).
❐ On the other hand, there is a risk in South Africa that significant elements of under
development and marginalisation will be characterised merely as unemployment
– rather than as more complex, structural economic phenomena with particular
historical, political and developmental roots.

❐ As a result, unemployment should not be treated mainly as a macroeconomic or
economic growth problem. There is a real danger of perverting the problem and
prescribing macroeconomic policy remedies that are inappropriate.
Unemployment in the apartheid era

In the period before 1994, the unemployment rate was a very controversial issue in South
Africa. The reliability and credibility of official unemployment figures were questioned regularly.
Black unemployment was either seriously undercounted or ‘hidden in the homelands’.
Before 1983, blacks were excluded from the official measurement of registered unemployment
(i.e. persons who registered at a government labour bureau as being unemployed). Even
after that the so-called independent homelands were not included in official calculations.
Also, for many years, only the ‘registered’ unemployment figure was acknowledged. Only
from 1977 onward was this figure supplemented with estimates obtained from so-called
Current Population Surveys. And only since the 1990s were comprehensive labour force and
household surveys introduced that included the entire population in their scope.
12.2.2 Causes and remedies – conventional views

The theoretical explanations of unemployment follow from the essential thinking of the
different schools of thought. Many of these have been encountered in this and earlier
chapters. It suffices to summarise the main viewpoints. In addition, we need to situate the
unemployment debate within the theoretical context of macroeconomic models.
Where does unemployment fit into our macroeconomic model?

Unemployment has been in our theoretical focus since chapter 1 and especially chapter
2, where the basic Keynesian 45° model was introduced. The origins of this model lie in
the high unemployment of the Great Depression of 1929 to 1933. The original Keynesian
model, as expanded with the addition of a monetary sector and an external sector (see
chapters 3 and 4), emphasises the nature and causes of short-run fluctuations in both real
domestic income and employment. It shows how fluctuations in aggregate expenditure
(demand), and particularly a deficiency in aggregate demand, are the main cause of a
short-run macroeconomic equilibrium where significant unemployment is present.
Okun’s Law … and the mathematics of the Phillips curve

π
While the Keynesian model predicts that income and employment would fluctuate together,
it does not provide any indication of the magnitude of changes in Y (GDP) and changes in
total employment or, more specifically, unemployment.
A useful rule of thumb can be found in Okun’s Law, suggested in 1962 by US economist
Arthur Okun (1928–1980). From an analysis of USA business cycle data, Okun noticed
that as output increases, cyclical unemployment indeed decreases, as the theory predicts.
However – and this was his important observation – this does not occur in a one-to-one
relationship. When the level of output increases by, for example, 2% above its normal,
or long-run, trajectory, the unemployment rate will not decrease (cyclically) by an equal
number of percentage points, but by fewer. This happens because, as the economy starts to
grow faster, companies also make workers work harder and become more productive. Thus,
some of the increase in output, say 1%, comes from employing new workers, while the other
1% comes from getting workers to be more productive. ⇒

⇒ As a rule of thumb, Okun’s Law holds that a 2% increase in output is associated with a
1 percentage point cyclical decline in the rate of unemployment – or that, to get a
1 percentage point decrease in the unemployment rate, the GDP growth rate has to rise
by 2 percentage points. Therefore:
Change in unemployment rate = 0.5 x change in GDP growth rate
This is the regularity that Okun observed in US data. The rule works in the opposite direction
too, i.e. for a decline in the level of GDP. Okun’s law, seen as a rule of thumb, is regarded as
one of the more useful approximate regularities in macroeconomics – even though the Okun
coefficient can vary across countries and applies only as a rough average.
❐ While the parameter value of –0.5 is based on an empirical observation of US data, it
is remarkably robust in terms of its continued applicability to the USA and many other
countries.
❐ The Okun coefficient for South Africa has been estimated at between –0.2 and –0.7, thus
–0.5 could be a rough average for South Africa as well.
More formally Okun’s Law can also be stated as follows:
(Ut – US) = d(Yt – YS) where –1 < d < 0 and (Yt – YS) is expressed as a percentage.
This relates changes in the unemployment gap (Ut – US) to changes in the output gap (Yt – YS),
where Us is the structural rate of unemployment and Ys the structural/long-term equilibrium
level of output. In terms of the percentages noted above, d would equal –0.5. (This is called
the gap version of Okun’s Law.)
Note that the Okun equation has another useful role. It enables the expectations-augmented
Phillips curve equation to be written in terms of either output or unemployment. These two
versions were shown in the box on the mathematics of the Phillips curve in section 7.1.6.
It is now possible to show the derivation from equation 7.2 to equation 7.1, using the Okun
equation. Consider equation 7.2, which is written in terms of the rate of unemployment U:
p = pct  + a(Ut – US) + x where a < 0 …… (7.2)
Using Okun’s Law, substitute d(Yt – YS) for (Ut – US):
p = pct  + ad(Yt – YS) + x where a < 0 and d < 0
Then define b = ad:
p = pct  + b(Yt – YS) + x where  > 0
which is equation 7.1, written in terms of the output level Y.
(If d = 0.5 then the two Phillips-curve coefficients are correspondingly related: b in
equation 7.1 would be exactly half the size of a in equation 7.2; alternatively, a = 2b.)
In the form of the complete IS-LM-BP model, we have seen how various monetary, real or
external disturbances can lead – via expenditure effects, secondary effects and balance of
payments adjustments – to fluctuations in output and employment. In this way, the model
explains short-run increases (or decreases) in unemployment by way of fluctuations in
aggregate expenditure (aggregate demand).
The AD-AS model takes this approach further (see chapter 6; also chapter 7). Still in the
Keynesian vein, it adds the supply side of the economy to the model. It shows, first, that
short-run levels and fluctuations of income and employment are determined not only by
aggregate demand but also by the aggregate supply behaviour of firms. (This, in turn, is
largely dependent on behaviour and wage setting in labour markets.) Second, not only

output and employment but also the price level (and inflation) are determined by aggregate
supply and demand together. Supply shocks and disturbances can thus also contribute to
fluctuations in output and employment.
An important element of the AD-AS model is the introduction of the concept of a long-
run or structural level of output (and employment), denoted by the long-run AS curve
(ASLR), plus the proposition that the supply side is responsible for another adjustment
or fluctuation in the economy: a medium-term adjustment. The model shows that if, for
instance, a demand disturbance leaves the economy at a point where output is below or
above its long-run or structural level, supply-side forces will make it gravitate back to the
long-run, structural levels of output and employment.
Within this context, a lot of energy has been expended between economists arguing about
the speed of the medium-term adjustment, and whether it means that a trade-off exists
between inflation and unemployment. Most mainstream economists today agree that some
trade-off exists in the short or medium run, but not in the long run. They do not agree on
the duration of the short and medium run, and on the necessity or usefulness of policy steps
to address unemployment. This is discussed below. Nevertheless, they broadly agree that, in
the long run, output and employment will always return to the long-run level. Attempts to
avoid this outcome forever are misguided and are likely to lead merely to higher inflation.
The short-run and involuntary unemployment

In the long-run equilibrium, most mainstream economists would agree, there is no
involuntary unemployment and no real unemployment problem. (As we will see below,
such a view ignores the existence of structural unemployment, which implies that
involuntary unemployment exists even in a long-run equilibrium. Also see the box on
structural unemployment in section 6.3.2.)
Keynesians and New Keynesians would, though, argue that involuntary unemployment is a
real problem in the short and medium term. Since this can last for several (up to seven or
more) years, it is a problem that requires attention from policymakers. Appropriate policy
can speed up the recovery from a recession or shock and can better manage the return and
adjustment back to the long-run equilibrium.
❐ The preferred form of policy is expansionary fiscal and monetary policy, i.e. demand
policy to stimulate output and move the equilibrium back to the long-run supply curve.
In the fiscal sphere, public investment is seen as a powerful cure with long-term growth-
enhancing benefits.
❐ Options such as targeted tax cuts to create incentives for production and capacity-
creating activities (such as investment) can be used as complementary steps to boost
the supply side and growth potential of the economy.
A key element in the modern Keynesian approach is that unemployment policy cannot
be contemplated in isolation from inflation policy (especially in the short to medium run).
Since aggregate output (Y or GDP), the average price level P and inflation π are determined
simultaneously by the interaction of aggregate demand and supply, any policy step would
affect both Y and P (and π).
❐ Hence policy steps should be designed with the complex dynamic interaction between
prices/inflation and production/unemployment in mind.
❐ In such policy design, the insights gained from the Phillips curve experiences (see
chapter 7 and the box on the next page) should be foremost.

The Monetarist/New Classical approach reflects the view that the economy is inherently stable
and self-stabilising, and would spontaneously and speedily return to a full-employment
equilibrium following any disturbance. Therefore, fluctuations in employment would
be small and temporary. The normal operation of market forces would soon eliminate
unemployment.
❐ In the AD-AS framework, this means that the supply adjustment process occurs rapidly.
Actually, only the long-run supply relationship matters – the movement back to full
employment equilibrium is assured and decisive. Therefore, in the Monetarist/New
Classical view the ‘long run’ occurs very soon.
❐ Therefore this approach would not accept that unemployment is a problem even in the
short or medium term. As far as supporters of this view are concerned, employment
and wages are determined by an equilibrium between supply and demand in the labour
market. All observed ‘unemployment’ is nothing but voluntary unemployment: an
unemployed person is someone who chooses not to work at the wage that is available in
the market. The unemployed are persons who have priced themselves out of the labour
market. In this view there is no real unemployment problem. Unemployment figures
indicate a false ‘problem’. No policy steps are necessary.
Therefore, if large and sustained deviations from full employment do occur, they can
have only one cause: government intervention. Such intervention could perhaps stem
from well-meant but inherently faulty (Keynesian?) thinking and doomed efforts at
‘stabilisation’ policy. Government is the likely cause of, and not the solution for, sustained
unemployment. In reality, government action does not stabilise, it destabilises.
❐ Rather than pursuing ‘stabilisation’ policy, government should practise fiscal abstinence.
If this is complemented by a monetary ‘policy’ that constrains money supply growth
to a fixed growth rate – a monetary rule – the problems of prolonged unemployment,
recession and depression (together with the threat of higher inflation) will disappear.
The Phillips curve brawl

The history of the Phillips curve provides a fascinating view of the historical course of the policy
debate between the Keynesians and the Monetarists, and later between the New Keynesians and
New Classicals. (See chapter 7, section 7.1. for theoretical background on the Philips curve.)
While in the 1960s there was no apparent theoretical explanation for the existence of such a
‘trade-off’ relationship – at that stage Keynesian theory was still limited to the simple two-
sector 45° or IS-LM model – the empirically observed ‘relationship’ constituted the foundation
of macroeconomic policy, especially in the USA and UK, for some time. It formed the basis of
activist policy – what can be described, roughly, as Keynesian policy.
Those of a Monetarist conviction never approved of the idea and use of the Phillips curve,
especially given its activist undertones. Hence their delight when data in the 1970s started to
deviate significantly from the typical Phillips pattern. It appeared that the alleged policy menu
had disintegrated. Indeed, the apparent death of the Phillips relationship – which was without
theoretical explanation in any case – was met with elation by Monetarists and kindred New
Classical or free-market spirits.
Thus they promptly buried the idea of a trade-off between inflation and unemployment,
maintaining that there is no usable trade-off for policy, and no place for policy activism. This
served to complement the Monetarist argument that the economy, always and promptly, will
return to full employment and that policy is superfluous and/or dangerous.
⇒

⇒ However, Keynesians did not accept this obituary and burial readily, and refined their theory
into the AD-AS model. New Keynesians (successors to the earlier Keynesians) today concede
readily that there is no trade-off between unemployment and inflation in the long run. However,
say New Keynesians, from a political and policy point of view the short run is important, and
there the trade-off does exist (even though it must be managed with due care for the inflation
risks involved) and can be used to understand and manage the increase in unemployment
during recessions. (Keynes made his famous statement in this regard: ‘In the long run we are
all dead’, meaning that the short run is what matters to people.)
Today the Phillips curve is an integral part of the vocabulary of macroeconomic policy –
although it is used with more circumspection and sophistication, and with a distinction
between short-run and long-run Phillips curves. Those of a New Classical persuasion
(successors to the earlier Monetarists) continue to frown heavily on the idea of using the short-
run Phillips curve as a rationale for active countercyclical policy.
As Robert Lucas, father of New Classical economics and 1995 Nobel Prize winner in
Economics proclaimed in his 2003 presidential address to the American Economic
Association: ‘… the central problem of depression-prevention has been solved for all
practical purposes.’
❐ The elimination of unemployment should therefore not be an active policy objective,
in this view.
❐ While sounding embarrassingly naïve from beyond the 2007–08 financial crisis
and resultant worldwide Great Recession, Lucas’s view has not been abandoned by
adherents of New Classical economics.
Note that, although the two broad viewpoints above differ fundamentally, both still appear
to view unemployment as a relatively unimportant and passing problem. In the long run
– which could arrive either sooner (in the Monetarist/New Classical view) or later (in the
Keynesian view) – unemployment should disappear by itself. Or, it can be eliminated by
policy quite easily (the Keynesian view).
❐ The limited effectiveness, or slowness, of Keynesian-type policies to counter the
worldwide Great Recession after the 2007–08 financial crisis has not left Keynesian
policies unscathed either. Much longer and much more difficult adjustments and
the unpredictable or changed behaviour of economic agents had to be factored into
theories. (See the case study in section 3.4.)
Natural unemployment? Structural unemployment? A revisit

As noted above (also see section 11.3.4) both Keynesian and New Classical theories
assume that the economy eventually returns to a long-run equilibrium that is regarded, in
essence, as a good position for any economy to be in.
It is important to realise that neither approach considers the possibility that such a
long-run equilibrium may still be characterised by high structural unemployment
and, accompanying that, high levels of poverty and underdevelopment and significant
inequalities in income and wealth.
❐ The existence of structural unemployment means that the long-run equilibrium may
still be significantly below what could be called a full-employment level (as defined in
chapter 6, i.e. a level that involves only frictional and search unemployment, which are
fairly harmless).

In reality, unemployment is a
serious and intractable problem Missing the point? The crux of the unemployment
for low-income to high-income debate between the two main schools of thought
is about the speed at which a short-run equilibrium
countries. Neither the New Clas
point that is not on ASLR (such as 1 and 2) will return
sical nor the Keynesian theories
to ASLR and thus output level YS. The existence of
provide explanations, or policy a possibly large gap between unemployment at
prescriptions, for the high levels YS versus at a ‘full’ employment output level YFE –
of structural unemployment in however conceived – is ignored.
a country such as South Africa.
P
And unemployment persists all ASLR
over the world, also in the USA
and Europe, despite many policy
ASSR
efforts. This suggests that the
conventional macroeconomic ex
planations (and remedies) may 1
not have fathomed the true nature
of the problem of unemployment.
One must probe deeper, especial 2 AD
ly in a low- or middle-income
country.
Short-run equilibrium with
Accordingly, when the long-run cyclical unemployment AD
aggregate supply relationship
was developed in chapter 6, YS YFE Y
care was taken to define the
Structural unemployment gap
conception of a long-run equili-
brium such that it could cap-
ture the reality that such an equilibrium could still exhibit high levels of structural
unemployment. Accordingly, we called the long-run output level YS and denoted the long-
run equilibrium as the structural equilibrium level of output and employment.
✍ Read the box in chapter 6, section 6.3.2 on the different types of unemployment, including
‘structural’ and ‘natural’ unemployment.
In chapter 6 it was mentioned that the structural unemployment rate is often called the
‘natural unemployment rate’. This concept is difficult to reconcile with unemployment
rates in excess of 20% in South Africa and some other low- or middle-income countries,
but perhaps less so in most high-income countries where the unemployment rate rarely
exceeds 10%. (Of course even such ‘low’ unemployment still causes serious policy and
personal concerns for the governments, firms and individuals involved.)
New Keynesian and Monetarist/New Classical economists will agree on the measured
long-run employment figure. They might agree on the measured unemployment figure, but
not necessarily. And, while both New Keynesian and Monetarist/New Classical economists
work with the concept of a natural rate of unemployment (NRU), they differ on the type,
nature and extent of the unemployment that should be included.
❐ New Keynesians argue that the NRU comprises both those who are voluntarily and
involuntarily unemployed. In essence, the voluntary unemployed are those who are

between jobs – i.e. frictional or search unemployment. The involuntary unemployed are
those who are out of a job, but not because of their own choice. They are also looking
for a job, but cannot find one. In addition, when the involuntary unemployed have been
unemployed for, say, a year or more, they may become ‘unemployable’ to some extent
– their skills become outdated and their ability to adjust to a working environment
declines. They need to be retrained or reskilled to make them employable again. This
may lead to a phenomenon called hysteresis, where the natural unemployment rate
increases because those who are unemployed become unemployable. In addition, New
Keynesians will argue that many are unemployed because of the non-competitive
structures of labour and goods markets. New Keynesians place considerable emphasis
on these involuntary unemployed.
❐ Monetarist/New Classical economists argue that all long-run unemployment is
voluntary and is restricted to frictional unemployment. They largely deny the existence
of involuntary unemployment – everyone who wishes to work can work if they accept
the market wage. If someone cannot find a job because of union power or the payment
of efficiency wages (see chapter 6), that person can always employ him- or herself.
Cyclical unemployment may occur because people voluntarily prefer to work less during
the recession and more during the boom (because real wages are lower in a recession).
Therefore, the New Keynesian conception of natural unemployment is broader than the
Monetarist/New Classical conception (even when they refer to the same numbers).
❐ The New Classical approach would include only very limited forms of unemployment,
and no involuntary unemployment, in the concept of NRU. They would expect the true
NRU to be very low under normal circumstances.
❐ The New Keynesian approach would include selected forms of involuntary
unemployment into its conception of the NRU. This would include cyclical as well as
some forms of ‘structural’ unemployment, e.g. due to hysteresis or non-competitive
markets. They would recognise the NRU to be somewhat higher than the New Classical
school.
While New Keynesian and Monetarist/New Classical economists will disagree on what
to count into the natural rate of unemployment (NRU), they would probably concur in
disagreeing with the content given to a long-run level of equilibrium unemployment
under the rubric of structural unemployment. As noted in the box in section 11.3.4
of chapter 11, neither of these approaches provides an explanation for high structural
unemployment.
The structural unemployment rate discussed below, and in earlier chapters, accords with
a much broader social and institutional understanding of involuntary unemployment.
It is argued that the largest part of unemployment in a middle-income country such
as South Africa comprises people who are involuntarily unemployed because of deeper
structural characteristics and rigidities than those recognised by the New Keynesians.
These are discussed in section 12.2.3 (as well as in chapter 6, section 6.3.2). Their deep
nature and intransigence warrant the use of the term ‘structural rate of unemployment’
and the practice of indicating the long-run equilibrium output level as YS rather than
YN. It also warrants, and requires, studious attention to be given to understanding, and
addressing, the large employment gap between YS and YFE (see the diagram in the box
above).

Actual economic growth and the required economic growth rate
The extent to which the actual economic growth rate fell short of absorbing new entrants into the labour
market can be gauged by comparing it to the so-called ‘required economic growth rate’.
The rate at which labour is absorbed into the economy depends on two factors. First, the rate of labour
force growth. Second, the rate of labour productivity growth.
❐ If there is no labour productivity improvement, the level of economic activity simply needs to expand at
the same rate as the labour force to get employment to grow at the same rate as the economy. Should
the level of economic activity increase at a rate slower than the labour force, not all new entrants to the
labour market will find a job.
❐ If labour productivity improves by, say, 2% it means that the same quantity of labour produces 2% more
output, resulting in a 2% economic growth rate. This 2% economic growth will not lead to a higher number
of people being employed. Only growth in excess of 2% will translate into higher employment.
Therefore, to ensure that all new entrants to the labour market are employed, the economic growth rate
needs to exceed the labour productivity growth by a rate equal to the growth rate in the labour force.
In other words, the sum of the labour force growth rate and the growth rate of labour productivity is the
minimum economic growth rate needed just to ensure that the unemployment rate does not increase.
This minimum is called the ‘required economic growth rate’. Any higher rate will lead to a decrease in
unemployment.
7
6
Required real GDP growth rate
5
4
Percentage
–1
Real GDP growth rate
–2
Change in unemployment rate
–3
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Source: South African Reserve Bank (www.resbank.co.za) and authors’ own calculations.
The graph shows the ‘required economic growth rate’ for South Africa together with the actual economic
growth rate (both in real terms). Since the late 1980s, the actual growth rate fell short of the required growth
rate. As indicated by the bar graph, this shortfall caused the official unemployment rate to increase. Only for a
few years after 2003 has the actual growth rate exceeded the required growth rate, leading to a corresponding
drop in the unemployment rate (i.e. a negative change in the unemployment rate). From 2008 and especially
2011 the actual GDP growth rate has regularly fallen short of the required growth rate.

12.2.3 Structural unemployment
Unemployment data show a sustained and, indeed, increasing unemployment rate in
South Africa since 1975 – in spite of business cycle upswings in the periods 1978–81,
1983–84, 1986–89 and 1993–96. After 1999, the unemployment rate seems not to
have changed much even though the economy was in an upswing for a whole decade. In
September 2000 (the first year for which revised Labour Force Survey data are available),
the official (narrow) unemployment rate stood at 23.3%. After that it actually increased
to 26.6% in September 2002, before decreasing for about five years in a row – but only
to 21% (in September 2007). After that it rose again, fluctuated along around 25% for
several years, before rising again to above 27% from 2016 to 2019 (see figure 12.9).
Note that, although the unemployment rate kept on increasing during the 1980s and
1990s, South Africa did not really experience ‘jobless growth’. Total employment kept on
increasing (except briefly in the late 1990s). However, employment opportunities grew
slower than the labour force. The growth rate was too low to absorb all new entrants into
the labour market – or, the growth was not sufficiently employment-intensive. Either way,
the increase in employment was too low to produce a drop in the unemployment rate.
The relatively small reaction of the unemployment rate to the economic upswing that
occurred from 1999 to 2007 and its propensity to be stuck in a band around 25% indicate
that the major part of South African unemployment does not react much to cyclical
changes in the level of economic activity (as measured in real GDP).
❐ In other words, the major part of South African unemployment is of a permanent
nature. The largest part of unemployment in South Africa is structural unemployment.
❐ Cyclical fluctuations in production and employment – explained in the AD-AS framework
– actually amount to waves upon a sea of underlying, enduring unemployment.
❐ These fluctuations occur around a permanently high level of unemployment –
previously indicated as the structural rate of unemployment (SRU), which corresponds
to the structural equilibrium output level YS. As noted in chapters 6 and 7, it means
that the long-run supply curve ASLR is located at a level significantly below the truly full
employment level of output.
Since standard macroeconomic theory – Keynesian as well as Monetarist/New Classical –
mainly offers explanations for fluctuations around the long-run (underlying, structural)
unemployment rate, or at most for non-permanent unemployment, one has to look beyond
standard macroeconomic theory if one wishes to understand the causes of structural
unemployment in South Africa (and elsewhere).
The existence of structural unemployment means that the employment opportunities
brought about by the normal operation of the labour market are always less than the total
labour force (widely interpreted). Only a limited portion of the labour force is absorbed
into the market. The rest of the labour force is excluded from the operation, influence and
benefits of the labour market.
Earlier (see chapter 6, section 6.3.2) this phenomenon was ascribed to ‘structural rigidities,
entry barriers, distortions and imperfections in markets and in the manner in which the
economy as a whole is organised’. Structural employment is involuntary unemployment
that arises, firstly, from the nature, location and pattern of employment opportunities (i.e.
the demand side of the labour market). The types of product that are selected for production,
the kinds of input used and especially the way in which they are combined in production
(including production technology) determine labour demand in terms of what kinds of,
and how much, labour can be employed. It also determines the employment intensity of

the production process: most new production technologies are labour-saving in intent and
effect. A major portion of structural unemployment is also due to intrinsic mismatches
between the (increasing) skill requirements of available jobs and the skills of available
workers. All in all, given a certain pattern or structure of production and employment, the
so-called labour market can absorb only a portion of the total labour force.
Secondly, on the supply side of the South African labour market, many job seekers face a
variety of constraints and entry barriers with regard to entering labour markets. These
include the cost of travelling long distances from rural areas or informal settlements to
search for a job in urban labour markets, limited information on job opportunities, a lack
of social networks and other links to friends or family who already have jobs, weak school
backgrounds, low skills levels, limited prior work experience, racial discrimination and so
forth. These barriers are especially high for people who are trapped in a condition of severe
poverty and want to find work – or retain employment – given costly commuting to work
within metro areas, for example. Poor people, especially, are all but excluded from entering
all but the weakest labour markets.
In broad terms, these demand- and supply-side conditions imply that ‘the labour market’
does not work as smoothly as suggested by the standard theory of the market – especially
neo-classical labour market theory. Supply and demand do not readily bring about an
optimal equilibrium wage-and-employment combination for the working-age population.
The labour market may remain in disequilibrium for long periods. Or, whatever apparent
‘equilibrium’ may come about does not entail full employment by any means: large
numbers of unemployed people simply remain outside the reach and benefits of the
labour market. In such structural unemployment one meets the intrinsic limitations and
handicaps of the labour market in full force.
Causes of structural unemployment

Being a complex phenomenon, the possible causes of structural unemployment cover a
wide spectrum of factors. Some of these are common to all market economies; others are
specific to the South African economic and political order. The following is a list of possible
causes often noted:
Warning: The reader will realise that this is a sensitive area, being closely linked to political-
economic issues. Different political viewpoints and, notably, different interpretations of South
African history, can be decisive in people’s identification and assessment of causes. The list below
contains a range of possible causes, drawn from several perspectives. A much more incisive
analysis would be necessary to reach a well-considered conclusion. This is left to the reader.
1. The labour market is not a single market. In reality it is a segmented market, comprising
a number of relatively isolated submarkets. Labour mobility between these market
segments is often limited. Workers who become redundant in one segment of the
market will not necessarily find employment in another segment – even if there is a
labour shortage in that segment, and even if the person is willing to work at a lower
wage. This so because these segments differ in terms of the required level of training,
specialised skills and so forth. A simple example is the market for agricultural labour
versus the one for industrial labour. In so-called white-collar jobs one can find severe
barriers to mobility between sectors or segments, largely due to skills differences.
Labour is simply not homogeneous, and the demand for labour can be very skill- and
experience-specific.

2. A notable form of segmentation is between the informal sector and the formal sector,
indicated by substantial differences in earnings that are not narrowed by workers
flowing from the informal to the formal sector (even though average earnings rates
in the latter are approximately twice those in the informal sector). Small numbers
of workers enter the formal sector from the informal sector: the latter is not a strong
springboard for entering the formal sector. Entry into the informal sector itself is not
easy either. It is not a sector where a person who loses her job in the formal sector, say,
can easily find another job. There also appears to be barriers to mobility even between
informal activities. Employment in the informal sector often is insecure – many people
end up as unemployed. Informal enterprises receive little or zero policy support and
often suffer harassment from local government or police.9 Perhaps all these factors help
explain a major puzzle: why don’t more of the many millions of unemployed people
enter the informal sector in South Africa (which is small compared to that in other low-
and middle-income countries)?
3. Demographic factors are very important. In South Africa, the very high rate of
population growth of the past caused the labour force to grow faster than the
normal labour absorption of the market. This can be seen, for instance, in the very
high unemployment rate of those in their late teens and early twenties. Migration
patterns (and migrant labour) in South Africa contribute to this problem, and hence
also population growth in neighbouring countries. Changes in the composition of
the economically active population, e.g. the proportion that are young or very old, or
the gender or racial composition of the labour force, also contribute to the absorption
problem. For example, in the late 1990s a sudden inflow of women into the labour
force contributed a great deal to the increase in unemployment.
4. Changes in the health status of the population can also play a significant role. For
instance, the HIV and Aids pandemic mostly affects the economically active population
of the country, especially those under the age of 35. Illness and incapacitation
undercut a person’s ability to participate in the labour market. Both patients and
their families (or care-givers) may be affected – the loss of a breadwinner income may
inhibit job search by family members who need to care for children. In addition, a
higher mortality rate among skilled and semi-skilled people such as teachers, nurses,
accountants, engineers and artisans may create a shortage of such skills in the
economy.
5. Changes in the pattern of demand and output affect labour absorption in certain
market segments. Over the past 50 years, the pattern of economic activity in the South
African economy has changed markedly. This was part of a development process that
has stimulated employment in the industrial sector while depressing employment in
mining and agriculture. More recently, employment in manufacturing has also started
to decline (particularly the employment of low-skilled workers), while growth has been
occurring in the services and high-technology sectors. All these changes have implied a
changing mix of the labour-market skills required in the modern economy. Workers not
trained for skilled jobs will find it increasingly difficult to get employed. In addition, trends
in world commodity prices, such as the gold and platinum prices (which dramatically
affect the mining sector), have played an important role in permanently depressing or
boosting employment in certain segments of the economy. If the labour force does not
adapt to such changes quickly enough, structural unemployment occurs.
9 For wide-ranging information on the role and potential of the informal sector in job creation (and appropriate
policies), see Fourie FCvN (ed) (2018) The South African informal sector: Creating jobs, reducing poverty. HSRC Press,
downloadable.

A bad school report: education and unemployment
Human capital forms an increasingly important input in the production function of a country and directly
reflects in the demand for labour. Unfortunately, South Africa is at present seriously underperforming in
preparing its youth for the future world of work.
Approximately 40% of all Grade 1 learners never make it to Grade 12, with most dropping out between
Grades 10 and 12. Only about 40 out of 100 that start school, pass matric; only 12 gain access to university
and only four complete a degree. Not having matric significantly reduces the probability of being employed;
not having a degree has an even larger negative impact.
Large-scale international tests among learners in Grade 4 and Grade 8 show the failure of the South
African school system. In the 2016 Progress in Reading Literacy Study (PIRLS), conducted among Grade 4
learners, South Africa came last of 50 countries.
With the so-called 4th Industrial Revolution underway, in future there will be an increased demand for
people with skills in STEM (Science, Technology, Engineering and Mathematics). In the 2015 Trends in
Mathematics and Science Study (TIMSS), of the 48 and 39 countries that wrote the Grade 4 and Grade 8
mathematics tests, South Africa came in second last in both cases. (What aggravates the finding is that
South Africa in fact applied the test to its Grade 5 and Grade 9 rather than Grade 4 and Grade 8 learners.)
In the case of the Grade 8 science test, South Africa came in last of 39 countries. Note that South Africa
was not the only emerging market economy included in these studies. They also included, among others,
Turkey, Malaysia, Chile, Botswana and Egypt.
More information available in: Burger P (2018) Getting it right: A new economy for South Africa. KMMR
Press, part IV.
6. A related factor is the apparent long-term decline in the growth performance of the
South African economy in the period between 1982 and 1992 and again after 2007
(see chapter 1, figure 1.1, as well as the discussion of growth below). Various factors
may have contributed to this in different periods: the post-war boom in international
trade and commodity exports slowed down; the gold price stagnated after 1980 while
trade and financial sanctions, disinvestment and political turmoil hampered economic
growth; BoP constraints put a ceiling on the growth rate that could be sustained;
development backlogs limited the availability of suitable people to feed/drive growth
in the modern sector of the economy. In the 2000s continued weaknesses in the
education system amidst growing demand for higher-skilled workers appear to have
depressed growth, as has resource constraints due to the unreliable supply and
escalating price of electricity.
7. The high capital intensity of production methods in South Africa is part of a broader
pattern in the use of capital and labour that is typical of Western market economies.
This pattern causes low growth in the demand for labour, even in periods of economic
upswing or high growth. In South Africa, numerous possible causes of excessive
capital intensity have been identified.
❐ Tax incentives, e.g. the accelerated write-off of capital goods for tax purposes, in
the past encouraged the use of capital goods and machinery. Over the years, the
South African tax system has spawned a plethora of such incentives, supposedly
to promote economic growth. Many of these incentives have been rolled back since
the late 1990s, but there is always lobbying to have new ones introduced.
❐ The unqualified admiration of, and importation of, production methods and
‘high’ technology from industrialised countries – designed for an entirely different
production environment with a shortage of unskilled labour. The latter tendency
has been aggravated by the dominant role of foreign corporations in the investment
decisions of local subsidiaries.

❐ Capital intensity is also increased by an unqualified acceptance of ‘high productivity
methods of production’, which usually amounts to the ability to produce high
output with fewer labourers.
❐ The pressure from international competition, which appears to force South African
producers to adopt low-cost production methods similar to foreign countries, e.g. in
Asia – even though our pattern of natural and human resources may be quite different.
❐ A shortage of appropriately skilled
workers, i.e. workers equipped for Unemployment created by the increased use of
the employment opportunities labour-saving production methods is sometimes
offered by a modern economy, called technological unemployment.
also contributes to higher capital
intensity. While this is part of the
development context, this problem is often ascribed to a discriminating education
system that, in the past, did not provide education and training of the same standard
for all. The earlier practice of job reservation also limited skills development among
sections of the population.
❐ The growth and belligerence of labour unions that forcefully claim a larger share
of the ‘economic cake’ for workers. In their ongoing struggle to counter income
inequality in the country, labour union action regularly leads to strikes. Employers
tend to find the push for ‘living wages’ and/or a minimum wage a puzzle in the
midst of mass unemployment – they point, in a manner of speaking, to the ‘queue
of work seekers at the gate’ who are willing to work for a lower wage. Given these
conflicting perspectives on ‘fair wages’ and the resultant work stoppages – in early
2014, strikes in the platinum mines went on for many months, costing the mines
(and the workers) billions of rands in lost income – employers are likely to look for a
solution in increased mechanisation. (This also occurred in the agricultural sector
in 2013, when minimum wages were increased by law.)
❐ The increasing development of consumer preferences that can be satisfied only
with relatively capital-intensive production methods. This often occurs in imitation
of overseas trends and fads.
❐ The market domination of large, capital-intensive corporations, which curbs the
opportunities for growth of small labour-using businesses – or forces them to
mechanise too.
High minimum wages and non-wage costs (employee benefits) may also make employers reluctant
to expand their workforce in good times. Cumbersome dismissal procedures contribute to this. Hence
employers may prefer to pay existing workers for overtime rather than take on new workers, since
the former step can easily be reversed in bad times. This may explain part of the phenomenon of low
employment growth when the economy turns around after a downswing, i.e. when the economy (or GDP) is
growing again – as has occurred both in South Africa and in, for example, the European Union.
High minimum wages may also prevent the creation of large numbers of low-level, low-skill service jobs
in, for example, the hotel, retail, recreation, health care and service industries. Particularly the clothing
and textile industry – one of the last really labour-intensive manufacturing industries in South Africa –
has shed large numbers of jobs following the extension, by the sector bargaining council, of metro-area
level minimum wages to small factories in certain rural areas (amidst intense competition from low-cost
manufacturers in China).
A national minimum wage was enacted in South Africa in January 2019. Empirical research on its impact on
unemployment is sure to appear within a few years – to be eagerly watched by proponents and opponents.

8. Restrictions on labour mobility, i.e. on the geographical or occupational mobility of
people, is another important cause of structural unemployment.
❐ As noted above in the explanation of structural unemployment, the distances
between many people’s homes in rural areas (including former homelands) and
jobs, which mostly are in urban areas, create a major obstacle to the geographical
mobility of job-seekers and workers.
❐ Earlier decades saw measures such as influx control, group areas, labour prefer-
ence areas and job reservation. Institutional and bureaucratic obstacles facing
small business, and blacks especially, were also a significant factor.
❐ In the 1990s, affirmative action and the transformation of institutions have led to
restrictions on the occupational mobility of especially white males, though judging
from official unemployment figures it did not contribute to higher unemployment
among them.
Communal land and unemployment

The structural nature of unemployment becomes more evident when we consider that the unemployed are
not uniformly distributed across the country. There is a strong spatial dimension to unemployment, with the
unemployment rate in rural areas being much higher than in urban areas.
Especially affected are communal land areas under the authority of traditional leaders. South Africa’s
communal land areas largely coincide with the land that made up the apartheid-era homelands (the former
bantustans). The last National Census, conducted in 2011, found that 32% of South Africa’s population still
lived on communal land.
The unemployment rate in communal land areas is much higher than in urban areas. According to the 2011
census the unemployment rate in urban areas was 27.1%, while the unemployment rate in communal land
areas was 47.2%.
Not only was the unemployment rate much higher than in urban areas, the labour absorption rate (i.e. the
percentage of working-age individuals that are employed) was much lower. The 2011 census reported a 45.7%
absorption rate for urban areas, but a mere 18.9% for communal land areas. (Note that the latter rate excludes
subsistence farmers, who do not generate a monetary income from sales in markets, but nevertheless create
livelihoods. If they are added to the employed, the absorption rate in communal land areas is roughly 30%, still
much lower than in urban areas.)
One pertinent factor highlighted by researchers is the tenure insecurity – not having ownership rights with
regard to land – of the more than 16 million people living on communal land. Traditional leaders effectively
control all communal land, with community members having little say in the allocation and use of land.
Community members do have use rights to land, but these rights are not enshrined in law. This limits the
power of people living in these areas to use their own land to generate income and livelihoods. In particular, a
lack of enforceable use rights (alternatively, title deeds) undermines their ability to use them as collateral to get
loans from financial institutions for livestock or crops, for instance, or to invest in another type of business. As
a result, employment creation and development is impeded, increasing the developmental gap between urban
and traditional areas.
For a full discussion, see: Burger P (2018) Getting it right: A new economy for South Africa. KMMR Press, part IV.
9. In Europe a high social welfare ‘safety net’ (social security system) appears to restrict
labour mobility in another sense: in many cases jobless persons are not interested in
job offers, because they can live relatively comfortably on welfare. With the dramatic
expansion of social grants (notably child grants) in South Africa since 1996 and
especially from 2003, it is alleged that the increased receipt of pension and child
grant income by poor households may act as a disincentive to work or search for

work. On the other hand, the additional cash may enable other household members
to go off and search for jobs by covering travel costs, say. Child-support grants may
cover childcare, enabling mothers to enter the labour force. (From available empirical
evidence it appears that the effect of social grants on labour force participation is
ambiguous and dependent on a number of factors.10)
10. Employment in commercial agriculture has grown at a snail’s pace. Since 1960 the
growth rate of employment in agriculture actually was negative. The increasing
implementation of large-scale mechanised farming methods – for reasons similar to
those listed above – has made a significant contribution to this trend.
11. Agriculture is also involved in another political-economic cause of structural
unemployment. This is found in the historical interdependence (or symbiosis) of the
state and, notably, the mining sector in South Africa. Not surprisingly this is a sensitive
area, with several interpretations being offered. One of these is the following:
At the turn of the 20th century the mining sector (but also manufacturing and commerce) had a
large need for cheap labour. The state, in its turn heavily dependent on tax revenue from mining
(the goose that lays the golden eggs), was all too willing to introduce legislation to secure a
stable supply of cheap (black) labour to the mines. The state and the private sector were in
agreement on what had to be done. Taxation and legislation affecting the possession of land
(e.g. the Land Act of 1913) effectively terminated the right of blacks to farm in large parts of the
country. This forced blacks to seek wage jobs in the mines and cities which, in turn, caused
a structural labour surplus that could not be absorbed in the mining or other non-agricultural
sectors. (Until the 1990s, land restrictions all but prevented black households from making an
independent living from farming.)
This means that black farmers were forced off their farms to go and work in the mines
and factories as migrant workers. As a result, farming skills among blacks were lost,
black farmer role models disappeared – and hence there is very limited interest in
farming among the black youth. This means that the agricultural sector, notably in
fertile former homeland areas, has not grown to be a substantial employer – so-called
de-agrarianisation has taken place in these areas. In addition, this also means that
subsistence agriculture has not been absorbing a large proportion of the unemployed.
This interpretation also shows the extent to which the problem of unemployment
is embedded in the complex political-economic history of South Africa during this
century. The macroeconomic policymaker cannot ignore this.
Policy against structural unemployment
In South Africa it has been accepted – albeit only recently – that, while economic growth
is vital in increasing employment, it is not sufficient to reduce or even stabilise the
unemployment rate. Thus growth is a necessary but not a sufficient condition for lower
unemployment. Structural unemployment implies a perennial gap between the long-run
levels of ‘equilibrium’ employment and genuine full employment (and hence between
YS and YFE since ASLR is below genuine full employment). It is clear that it is a complex
phenomenon that cannot be remedied or reduced by means of monetary or fiscal policy
steps. Other measures are required to reduce the gap.
10 Leibbrandt M, Lilenstein K, Shenker C and Woolard I (2013) The influence of social transfers on labour supply: a South
African and international review. SALDRU working paper 122, University of Cape Town.

Alternative policy measures that have already been proposed or instituted include:
❐ The drastic upgrading of the education system to better equip the working population,
and especially young people, to find jobs in an economy where there is a growing
demand for highly-skilled workers and a dwindling demand for low-skilled workers.
❐ Training and retraining programmes for the unemployed to equip them with suitable skills
and/or enable them to adjust to patterns of decline and growth in specific sectors. The
state can do this, and/or tax incentives or training subsidies may induce the private
sector to do it.
❐ Reorienting industrial policy to promote and support employment-intensive manufacturing
rather than heavy, capital-intensive industry. This would require changes in the tax
and subsidy structure to eliminate or reduce the massive and long-standing system of
incentives to mechanise and increase capital intensity – and at the same time institute
incentives (subsidies) for labour use. Levelling the playing field in this regard could
potentially halt the trend of declining employment-intensity in industry.
✍ Affirmative action and broad-based black economic empowerment (BBBEE)

These measures have been introduced in South Africa as mechanisms to redress the legacy of
discrimination and earlier political-economic constraints on workers’ skills development and
occupational and business possibilities.
❐ What is the impact of affirmative action and BBBEE on the labour market?
❐ Is a policy of affirmative action and BBBEE a solution to, or a new cause of, structural
unemployment?
❐ If affirmative action and BBBEE imply that workers and business associates of a certain
race, culture, language, gender or age group are not ‘acceptable’ to employers, in spite of
skills or qualifications, what are their consequences in terms of structural unemployment?
❐ Wage and employment subsidies could encourage labour use. Regional development
incentives that encourage labour use may make a contribution in particular regions/
provinces with a large oversupply of labour (even though the net national effect may be
zero). Another example of an employment subsidy is the so-called youth wage subsidy
that the South African government implemented in 2014 in the form of a tax incentive
to employers.
❐ Restrictions on labour union power and/or a new co-governance model between organised
business, organised labour and government that leads to the harmonious co-
determination of wages and profits can remove incentives for employers to move away
from ‘labour trouble’.
❐ A reduction in minimum wages, or at least more regional and subsectoral flexibility in the
determination of minimum wages to take account of local circumstances could go a
long way towards reducing incentives to reduce the use of the input (labour), which is
becoming relatively expensive due to high wage and non-wage costs (employee benefits).
That would make employers more willing to employ new workers in good times.
❐ The promotion of small business via active support to overcome the various constraints that
they face, including the review of regulations that tend to inhibit small business growth.
❐ The strengthening of the informal sector, which tends to be highly labour intensive,
by both government and the private sector. Government should not unnecessarily
harass unregistered activities. Land-use and regulatory restrictions, especially at
local government level, on informal business should be reviewed. Urban planning
should engage with the typical spatial distribution of informal enterprises in township
residential areas, rather than trying to impose the orthodox city model of restricting
business activities to the ‘mainstreet’. The informal sector should be supported by the

provision of infrastructure, manufacturing hubs, business facilities and related services
(electricity, water, internet), banking services, professional advice, better security and
so forth – and by both government and the private sector. Developing backward and
forward linkages between the informal sector and the formal sector (government and
private sector) can make a major difference. Policy should be used to support informal
retail enterprises that have to compete with established national retail chains in
township areas, notably due to the mushrooming of shopping malls.
❐ The restructuring of agriculture and land use can help this sector to make a larger
contribution to employment creation. Agriculture should be able to absorb large
numbers of workers in a relatively short period. The creation of jobs in agriculture is
much cheaper per job than in industry. The development of large numbers of smaller
farms with effective labour-intensive production methods may be crucial, combined
with appropriate forms of land reform. Collective or community farming (such as
the Israeli kibbutz system) has the potential to be productive as well as labour-using.
Effective agricultural extension services for emerging farmers are essential.
❐ Reforms of land ownership and tenure in communal land areas (mainly the former homelands)
that will provide people with at least registered use rights (if not title deeds) for their
land could unleash entrepreneurial initiatives in either agriculture or business. This
could reduce a major structural barrier to employment and development in these rural
areas.
❐ Public works programmes – in which the government initiates special public construction
projects in labour-intensive ways – can make a significant contribution to absorbing the
structurally unemployed, especially if they contain training and literacy programmes.
Such special projects could include the construction of roads, sewerage systems,
housing, community centres, schools and hospitals.
❐ Direct employment by the state. This method was used in the 1930s and 1940s – together
with public works programmes – to address the so-called poor white problem.
None of these proposals can be a panacea. The causes and nature of structural
unemployment are still imperfectly understood, and they are interwoven with complex
social, economic and political factors. Complex problems and difficult trade-offs face
policymakers in this area. Many of these relate to fiscal constraints and hence also to
macroeconomic considerations. It will suffice to mention a few counter-considerations:
❐ Tax incentives, subsidies and increased government expenditure on training can
have serious implications for the national budget and the deficit – especially since
programmes tend to grow over time and create vested interests.
❐ Tax incentives and subsidies may not be effective in reaching the intended goal. They may
be abused, or only benefit employers or those already established in business. Indeed, the
history of tax incentives and subsidies in South Africa is not encouraging.
❐ Some regulations actually benefit small business. Unqualified deregulation can merely
create unrestrained opportunities for large, capital-intensive corporations to enter
and dominate markets even more. Indiscriminate deregulation can also have a serious
impact on the environment or lead to unsafe working conditions for workers.
❐ Affirmative action and BBBEE programmes may create new forms of restriction on
occupational mobility and employment opportunities for certain groups, thereby
‘redistributing structural unemployment’.
❐ Land reform may be traumatic for existing farmers, distort the whole sector and actually
reduce total agricultural output and employment – without building a new generation
of emerging farmers. This may affect the food security of the country.
❐ Public works programmes, or special employment programmes, are difficult to design
and manage effectively. A number of such programmes in the past have not always had

the desired capacity-building effects. The scope and life span must also be controlled,
lest they become an uncontrolled drain on government expenditure.
❐ Significant increases in government employment can be disastrous from a budgetary point
of view – especially if government comes to be seen as ‘employer of the last resort’. Already
the wage bill of government claims a very high and growing share of total expenditure, and
acts as a straitjacket on efforts to improve the fiscal situation and avoid a public debt crisis.
It also limits efforts to redirect spending to education, health and housing.
12.2.4 Shortcomings of the policy debate on unemployment

The analysis of the measurement, extent, causes and problems of structural unemployment
indicates that the unemployment problem goes much deeper than macroeconomic
fluctuations. Short- to medium-term fluctuations in production and employment –
as explained in the AD-AS framework – relate only to waves upon a sea of underlying,
perennial unemployment.
This is particularly important in South Africa. The standard macroeconomic debate on
the causes and policy solutions for unemployment – focusing on cyclical stabilisation
and the promotion of long-term growth – does not address the essence of the problem,
being concerned mainly with cyclical, non-permanent unemployment. While the latter is
important, in the long run any restriction of the (policy) debate to cyclical unemployment
is extremely narrow and short-sighted. Unfortunately, such narrowness is a characteristic
of many a macroeconomic policy debate.
This reflects a broader problem in the unemployment debate. It tends to be split into
several separate debates, defined by different disciplines and perspectives. Labour econo
mists, development analysts and macroeconomists all talk about and do research on
unemployment. However, they tend to inhabit different worlds of thinking, use different
terminologies and analytical frameworks, and rarely talk or listen to each other. With such
fragmentation, it is unlikely that a constructive, consolidated attack on unemployment will
materialise. To achieve the latter, a more integrated approach that combines insights from
all three worlds – as has been demonstrated in this chapter and this textbook – is necessary.11
12.3 Low economic growth

Chapter 8 presented theories of economic growth. Some background data were provided
in chapter 1, section 1.3.1. This section considers the problem of low economic growth
in more depth. When reading this section, it is important to remember that the topic of
economic growth is about understanding and influencing the growth performance of
aggregate output, income and living standards in an economy in the very long run. The
time horizon is measured in decades, not years or months.
As noted at the end of chapter 8, views on the causes and remedies for low growth broadly
diverge in terms of the relative weight given to ‘purely’ macroeconomic variables such as
the saving rate, tax rates, capital accumulation and innovation as against including broader
variables such as human capital, human development and institutional development.
Despite its simplicity, the growth theory presented in chapter 8 is quite useful in showing
the potential impact of all these dimensions in its small set of variables. Nevertheless, the
real issue is the content (and weight) given to those variables.
11 For a concise discussion, see Fourie FCvN (2012) The unemployment debate is too fragmented to address the problem,
Econ3x3.org, November 2012. For an in-depth analysis, see: Fourie FCvN (2011) The South African unemployment
debate: three worlds, three discourses. SALDRU Working Paper 63, University of Cape Town.

12.3.1 The definition and measurement of economic growth
Economic growth is defined as sustained, recurring annual increases in real GDP per
Y
N  or at least in real GDP (Y) over time. Three elements are critical. First, it is all
capita  
about real GDP, not increases in nominal GDP caused purely by inflation. Second, it must be
sustained and recurring increases. A one-off increase in GDP, or per capita GDP, is beneficial
for the population of a country, but it does not constitute economic growth – just as a one-
off increase in the price level does not constitute inflation. Third, one must decide whether
to consider aggregate GDP or per capita GDP (i.e. average GDP per person).
The simplest measure of economic growth is the annual growth rate of real GDP, i.e. the
percentage increase in real GDP from one year to the next (see chapter 1, section 1.3.1).
t
GDP – GDP
t–1
Yt – Yt–1
Real GDP growth rate = 
  GDP      
100 or   Y    
  100
t–1 t–1
It can also be measured in terms of per capita GDP (i.e. average GDP per person). When
studying long-term trends in economic growth, the focus of attention is per capita GDP –
it is about the long-term increase or decrease in average material living standards. Thus
we focus on long-term trends in per capita GDP.
In South Africa, annual data from 1946 onwards on nominal and real GDP as well as real
per capita GDP are available on the Reserve Bank website (www.resbank.co.za). Quarterly
data are available from 1960 onward.
The annual growth rate is normally measured in either of two main ways:
(a) Method 1: As the percentage change in GDP between two years, e.g. between the
annual GDP values for the years 2019 and 2018; or
(b) Method 2: As the percentage change between two corresponding quarters, e.g. between the
GDP values for the second quarter of 2019 and the corresponding second quarter of 2018.
This method, also called the year-on-year (or YoY) method, provides a year-based (four-
quarter) growth rate that is calculated every quarter and not only once a year. (Note that
one should always use seasonally adjusted annualised GDP data for such calculations.)
❐ The Reserve Bank uses this method to compute the official growth rate each quarter.
A third method, rather to be avoided, is to calculate the annualised percentage change
between two successive quarters, e.g. between the GDP values for the second quarter of
2019 and the first quarter of 2019. This means the quarterly (three-month) percentage
change is taken and expressed on an annual basis, as if that growth rate has prevailed for
four quarters. (This converts the rate to a familiar magnitude.)
❐ One should be very careful when interpreting such annualised measurements of the
quarterly GDP growth rate because transitory movements and shocks in GDP can
register as large changes, attracting undue excitement or concern in the media or
among commentators. (One must at least use seasonally adjusted GDP data.)
The second and the third methods are frequently confused, with both called the growth rate
‘for the second quarter’. For the third method that may be the correct expression. However,
for the second method it is not quite correct, since that method produces the year-on-year
(YoY) growth rate in the second quarter (for the preceding four quarters together).
As noted in chapters 1 and 8, no matter which of the methods outlined above is used,
unfortunately none of the GDP growth rates excludes the cyclical component of the
behaviour of GDP. The annual change in GDP comprises both a short-run or cyclical
component and a long-run or trend (i.e. growth) component. Thus the calculated
growth rate mixes cyclical changes in GDP with the long-run growth trend in GDP.
12.3 Low economic growth 529

When discussing long-term growth, the cyclical component should be removed from the
actual growth rate data to obtain the trend or long-term growth rate. This can be done
using statistical smoothing methods to reveal the underlying growth trend or growth path
(see figure 12.13). Alternatively, one can smooth the growth rates by taking averages over
longer periods, as shown in table 12.7.
Real and nominal growth rates

The presence of inflation causes the growth rate in nominal GDP (or the nominal growth rate)
to be higher than the growth rate in real GDP (the real growth rate). Inflation artificially inflates
nominal GDP figures (and other macroeconomic expenditure aggregates).
Usually one can calculate the growth rate of real GDP directly from real GDP data. In the
absence of real GDP data, one can calculate the real growth rate using nominal GDP data and a
price index. The appropriate price index is the GDP deflator and not the CPI, although the latter
will produce approximate figures.
There are three ways to calculate the real growth rate from nominal GDP and price index data.
Method 1: Real growth rate = Nominal growth rate – inflation rate
This is only approximately correct. The second and accurate calculation is:
[ ( 1 + 1nominal
Method 2: Real growth rate =  
 
  
growth rate
      – 1  × 100
+ inflation rate ) ]
Example: Let Nominal growth rate = 0.15 (15%)
Inflation rate = 0.10 (10%)
Method 1: Real growth rate = (0.15 – 0.10) × 100 = 5%
[ ( 1 + 0.10 ) ]
  1 + 0.15  
Method 2: Real growth rate =     – 1  × 100 = [1.045 – 1] × 100 = 4.5%
These formulae can also be used to change a real GDP growth rate into a nominal GDP growth
rate – or to calculate the inflation rate from real and nominal GDP growth rates.
A third way to calculate real growth is first to deflate nominal GDP to obtain real GDP – using the
GDP deflator – and then to use these figures to calculate the growth rate in real GDP directly.
(This form of these formulae assumes that both the growth rate and the rate of inflation are
expressed as decimal values. If they are expressed as a percentage, e.g. 15% rather than 0.15,
the 1 in the formula must be replaced by 100.)
12.3.2 The growth experience over the ages – a global overview

While short- and medium-term fluctuations of the economy are crucial for the inhabitants
of a country, the long-term economic health of an economy is a very important topic.
Within the broader context of development and poverty alleviation in a country such
as South Africa, increasing the standard of living of people in the long term is a major
political objective. The examples of countries such as the USA, Germany and Japan since
World War II, and China and some Asian countries in recent decades, in elevating the
material prosperity of their citizens are eagerly eyed by South Africa and other low- and
middle-income countries.
While contemplating this ideal, it is worth remembering that, in the history of humankind,
sustained economic growth and increasing standards of living are a recent phenomenon.
The following three graphs show the global growth experience since – yes – the year
1000. The data on growth for the middle ages obviously were not recorded in those days.

These are estimates from pioneering work of economist Angus Maddison,12 based on a
sophisticated analysis of the available facts of economic history in various countries. In
later centuries the measurement of economic activity developed considerably, notably in
the 20th century. While they are estimates, these numbers do offer a fascinating glimpse
of the probable course of economic growth and living standards over the ages and in
different regions of the world.
Figure 12.11 Per capita GDP over the ages – the year 1000 to 1820
2 000
Per capita GDP in international dollars
1 500
1 000
500
0
1000 1500 1600 1700 1820
Western Europe 400 771 890 998 1 204

USA 400 400 527 1 257
Latin America 400 416 438 527 692
Asia (excl. Japan) 450 572 575 571 577
Africa 425 414 422 421 420
Source: Maddison, 2003.

Figure 12.12 Per capita GDP over the ages – 1820 to 2001
30 000
Per capita GDP in international dollars
25 000
20 000
15 000
10 000
5 000
0
1820 1870 1913 1950 1973 2001
Western Europe 1 204 1 960 3 458 4 579 11 416 19 256

USA 1 257 2 445 5 301 9 561 16 689 27 948
Latin America 692 681 1 481 2 506 4 504 5 811
Asia (excl. Japan) 577 550 658 634 1 226 3 256
Africa 420 500 637 894 1 410 1 489
12 Maddison A (2003) The World Economy: Historical Statistics, Development Centre Studies, OECD, Paris.
Maddison A (2005) Measuring and interpreting world economic performance 1500–2001. Review of Income and
Wealth, 51(1), 1–35.

The first two graphs (figures 12.11 and 12.12) show the estimates of per capita GDP in
several regions for the period 1000 to 1820 AD and then for 1820 to 2001. The graph in
figure 12.13 shows growth rates in per capita GDP for 1820 to 2001. Note that for the
period 1000 to 1820 some increases in per capita GDP (notably for Europe and later the
USA) appear significant, but that they shrink into insignificance when compared to
the period from 1820 onward. The significant jump in per capita GDP in the USA during
the 1700s set the stage for its growth dominance after 1820.
Figure 12.13 Per capita growth rates – 1820 to 2001
4.5
Average percentage annual growth
4 Western Europe
Latin America
3.5
Asia (excl. Japan)
3
Africa
2.5
World
2
1.5
1
0.5
0
1820–1870 1870–1913 1913–1950 1950–1973 1973–2001
–0.5
Periods
Little is known about measured economic growth in Africa in earlier centuries, but it is
estimated by Maddison to have been approximately 0% up to the beginning of the 1800s
– despite the presence of centres of trade and intellectual development such as Timbuktu.
In Europe, there was very little growth in output in the 500 years up to the year 1500.
Most people were in subsistence agriculture and expected it to continue over generations.
From 1500 to approximately 1700, there might have been a slight, approximately 0.1%
growth in per capita output per year, as some inventions started to influence productivity.
In the 1700s this may have increased to 0.2% growth. During and after the Industrial
Revolution, which probably had its full impact only in the 1800s, growth rates did go
up to 1% or more due to inventions and technology – but this is less than one might
have expected as a result for the Industrial Revolution. After averaging around 1% for
approximately 120 years more, the growth rate suddenly shot up in the years following
World War II.
In the USA, growth of per capita GDP from 1820 to World War II was approximately 1.5%.
Only after 1950 did it experience annual growth rates of approximately 2.5%. This led to
dramatic increases in the standard of living. By 2000, the average standard of living of US
citizens was approximately three times as high as in 1950. Other high-income countries
have had similar experiences, as seen in the graphs of the Maddison data.
It was in the period after 1950 that growth spread to low- and middle-income countries
in Asia, Latin America and parts of Africa to a significant extent for the first time. Yet the
most distinguishing feature of this period is the failure of many low-income countries
to experience economic growth vaguely similar to that of the advanced economies.
Except for the period 1950 to 1973, when the country average for per capita growth
in Africa was 2%, it has been significantly below 1% most of the time, and below
0.2% in the last quarter of the 20th century. Latin America had a similar pattern

The US experience
This graph shows more detailed per capita GDP data for the US for the period 1790 to 2018, as
well as a line indicating the underlying trend. Note the steeper average slope of the trend line
after 1960, indicating a higher average growth rate of GDP per capita than the period from 1790
to the 1920s. (This is a semilog graph – see the box below on ‘Logarithmic scales in graphs’.)
US real GDP per capita since 1790 (in 2009 US dollar)

$55 471 (2018)
$45 146 (2000)
$49 501 (2009 – after

US $ (logarithmic scale)
$16 641 (1945 – end of WWII) Great Recession)
$9 103 (1929 – start of Great Depression)

$15 094 (1950)
$6 256 (1900)
$6 503 (1933 – end of

Great Depression)
$1 585 (1800)
Trend real GDP per capita (USA 2012 dollars)
$2 393 (1850) Real GDP per capita (USA 2012 dollars)
1790
1800
1810
1820
1830
1840
1850
1860
1870
1880
1890
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
2020
Source: www.measuringworth.org/usgdp
but at somewhat higher rates of per capita growth. Asian countries, including India and
China, were the worst performers until 1950 and even had negative per capita growth
rates in the first half of the 20th century. But it was followed by a significant increase to
3% and higher after that, with the overall growth rates in India and China approaching
8% and 10% respectively after 2000 (though with some decline after 2011). This changed
their standards of living markedly, leaving only Africa trapped on a very low per capita
GDP trajectory.
Africa recorded an average GDP growth rate of approximately 5% for 2001 to 2005.
Table 12.6 shows growth rates since 1986 for some individual SADC and other African
countries (also showing China and India for comparison).
Table 12.6 Average GDP growth rates for some African countries
1991–2000 2001–2010 2011–2017 1991–2000 2001–2010 2011–2018

Algeria 1.8 3.9 2.9 Madagascar 1.8 2.8 3.3
Angola 1.8 8.9 2.3 Mozambique 7.8 8.2 5.8
Botswana 4.2 4.2 4.5 Namibia 3.8 4.0 3.5
Cameroon 1.4 4.0 4.7 Nigeria 2.1 8.9 3.1
DR Congo –6.1 4.7 6.1 Zambia 0.9 7.5 4.6
Egypt 4.4 4.9 3.6 Zimbabwe –2.7 –3.4 5.7
Ethiopia 3.5 8.6 9.6
Kenya 1.7 4.2 5.6 China 10.4 10.5 7.4
South Africa 1.9 3.5 1.7 India 5.6 7.6 7.1
Source: IMF (DataMapper).

Economic growth in South Africa
Since 1994 the South African government has Table 12.7 Economic growth rates in South Africa
launched four major policy initiatives with a Real GDP Real GDP per
focus on growth. The first, launched in 1996, growth capita growth
is the Growth, Employment and Redistribution 1961–1965 6.3 3.4
programme, better known under the acronym 1966–1970 5.1 2.3
GEAR, while the second, launched in 2006, is the 1971–1975 3.7 1.2
Accelerated and Shared Growth Initiative South 1976–1980 3.1 0.7
Africa, or ASGISA. The third is the New Growth 1981–1985 1.4 –0.9
Path (NGP), launched in 2010, while the fourth
1986–1990 1.7 –0.5
is the National Development Plan (NDP). In
1991–1995 0.9 –1.2
addition to these major policy initiatives that are
1996–2000 2.8 0.7
all broad-based, the government also announced
the National Infrastructure Plan in 2012. As 2001–2005 3.8 2.0
noted earlier, for the most part GEAR was a 2006–2010 3.1 1.8
mainstream macroeconomic stabilisation policy 2011–2015 2.2 1.0
aimed at ‘getting the basics right’ – through fiscal 2016–2018 0.9 –0.5
and monetary prudence – to lay the foundation Source: South African Reserve Bank
for a higher economic growth rate and higher (www.reservebank.co.za).
employment (together with lower inflation). ASGISA identified what government called
‘binding constraints’ on economic growth such as the lack of skills, the volatility of the
rand and the cost, efficiency and capacity of the national logistics system. It then proposed
selective interventions aimed at addressing these constraints. These interventions were to
focus on infrastructure, sector strategies, education and skills, and public administration.
(For more on the NGP, NDP and the National Infrastructure Plan, see section 12.5.)
Figure 12.14 shows South African real GDP per capita data for the period 1946 to 2018
(semi-log graph), while table 12.7 provides average growth rates. Due to industrialisation
Figure 12.14 The trend in real GDP per capita in South Africa
R50 939 (2009 – Great Recession)

Rand (logarithmic scale)
R43 656 (1985 – Rubicon speech)

R54 634 (2018)
R43 521 (1976 – Soweto uprising) R40 368 (2000)
R39 589 (1994 – First democratic election)
Trend real GDP per capita (SA 2010 rands)

R25 453 (1950) Real GDP per capita (SA 2010 rands)
1946
1948
1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
Values on y-axis are in constant 2010 prices – logarithmic scale.


and rich natural resources, economic growth was strong up to the mid-1970s, with
economic growth rates peaking at 6% per annum in the 1960s. However, due to the oil
crisis of the mid-1970s as well as the political turmoil that started at the same time and
which then worsened in the struggle-and-sanctions era of the 1980s, economic growth in
South Africa weakened significantly. Per capita growth turned negative in the period 1981
to 1995. Since then real economic growth, both in aggregate and per capita terms, has
improved significantly (see table 12.7). However, in 2009 per capita GDP growth dipped
due to the recession, whereafter it recovered but then stalled after 2011, even declining
in 2018.
What is most important – cyclical stability or growth?

One can gauge the importance of long-term growth relative to the business cycle by
considering the actual annual real per capita GDP levels relative to the long-term trend
or growth path in GDP per capita. Deviations from the growth path indicate the business
cycle, e.g. periods of recession.
❐ It appears that deviations from the long-term growth path are ultimately, over the very
long run, dwarfed by the long-term movement of the economy.
❐ Indeed, in the case of the USA (see graph in box on ‘The US experience’ above) even the
Great Depression of the early 1930s becomes dwarfed by the long-term movement of
the economy.
The 1995 Nobel laureate economist Robert Lucas once said: ‘The consequences for human
welfare involved in (the differential growth performance of countries) are simply staggering.
Once you start thinking about economic growth, it is hard to think about anything else.’
Although Lucas happens to be of the New Classical school of economists who downplay
short-term economic fluctuations and oppose anti-cyclical demand policy (and government
‘interference’ in general), the importance for the poor of successful policies for long-term
increases in living standards – as against successful stabilisation policy – is undeniable.
This does not negate the harsh reality of recessions and depressions when people lose their
jobs. And something like the Great Depression can erase many years of growth and wealth
creation. But it does highlight the powerful role that sustained economic growth can play in
lifting aggregate, as well as per capita, production and income in a country.
Logarithmic scales in graphs

The graphs of per capita GDP growth are semi-logarithmic graphs. The vertical axis is expressed in
natural log scale. These graphs are called semi-logarithmic graphs (‘semi’ because only one of the two
axes is expressed in log scale).
The cumulative, compound effect of growth on a variable over time can be huge. A variable that grows at 3%
per year will double in about 24 years, and will grow about 20 times larger in 100 years. On a normal graph,
a variable that grows at a constant rate will rapidly disappear off the page as it ‘grows to the heavens’ in
absolute terms. Using such a graph to read off changes and analyse growth becomes impossible.
But growth theory is all about the long-term growth of variables such as GDP over time. To have
meaningful graphs, the solution is to express the particular variable in logarithmic form against time on
the horizontal axis.
❐ A variable that grows at a constant rate will then trace out a straight line with a slope equal to the
growth rate.
❐ So, if per capita GDP fluctuates around a straight trend line, it means that the underlying long-run
growth rate is constant and equal to the slope of the trend line.
⇒

⇒
A semilog graph is easily recognisable from the ‘bunching’ of values higher up on the vertical axis – the
distance between values becomes smaller as the numbers get larger. Put differently, a particular vertical
distance comprises larger and larger absolute differences as you move up the vertical axis.
❐ On a normal graph, the vertical distance on the axis between 10 000 and 12 500 is the same as the distance
between 20 000 and 22 500, representing a change of 2 500. Thus a particular distance between two points
represents the same absolute difference in value, no matter where those two points are on the axis.
❐ On a logarithmic axis, the distance between 10 000 and 12 500 will be equal to the distance between
20 000 and 25 000, because in both cases a move from the lower to the higher value is a 25%
change. That is, a particular distance on the axis represents the same percentage change. (Check
this for yourself on the graphs.)
Another very important feature of a semilog graph is that the slope of a curve gives the growth rate of
the variable at that point in time, and not just the rate of change between two successive points. So a
change in slope, or the difference between the slopes of two lines, can be directly interpreted in terms of
changes or differences in growth rates of the variables involved.
❐ A steeper area on a curve on a semilog graph implies a higher growth rate at that point in time.
❐ Check whether you can read off approximate growth rates – or at least periods of positive and
negative per capita growth – from the South African trend line, and compare that with the SA growth
rate table provided (table 12.7).
What is so good about economic growth? The devil of income distribution

A major argument for economic growth is that the economic pie must grow if the slices that people get
are to get bigger. Better living standards require economic growth.
But there is a catch – and it is a big one in reality. The size of the average slice doesn’t tell us much. A
major concern is the differing size of slices, and about who gets which slices.
❐ This is the problem of the unequal distribution of income. South Africa has one of the highest degrees
of income inequality in the world (also see chapter 1, section 1.3.5).
Despite an increase in per capita GDP, some people may not be better off. Indeed, even a steadily
growing per capita GDP does not mean poverty is reduced or eradicated.
If there is an increase in per capita GDP, some people surely will be better off. But not all people may
be better off. Or, the living standards of some people may increase much faster than those of others.
Indeed, even a steadily growing per capita GDP does not mean poverty is reduced or eradicated. It
depends on how the proceeds of growth flow, through the political and economic system, to different
households and individuals.
The basis on which income and the growth in income is divided often depends on the institutional
characteristics of a country and its economy. These might include power relations in the economy, the
political structure and foreign interests. Sometimes some groups are explicitly or implicitly excluded
from power and decision making, and from the benefits of participating in a growing economy. Race,
language, ethnicity and gender may also play a harmful role in this regard.
❐ The South African economy under apartheid was one, rather extreme, example of this. An example is
that the real wage a black mineworker received in 1970 was not much higher than the real wage of a
black mineworker in 1950. In contrast, the real wage of a white mineworker increased by about 60%
in the same period. During the 1950s and 1960s the real wage of black mineworkers did not increase
materially even though the South African economy on average grew at rates of 4% to 6% per annum.
❐ However, various forms of economic exclusion and unfair disadvantage – or unfair patronage and
benefiting from growth – continue to exist in the South African economy. Indeed, the inequality of
income (and of wealth) has not decreased in the 25 years since 1994 (see chapter 1, section 1.3.5).
⇒

⇒
So, while sustained long-term growth might be considered as a necessary condition for sustained
improvements in living standards, growth by itself does not guarantee a broad-based improvement in
living standards. It depends on the kind of growth, and on how the income is distributed by markets,
systems and institutions.
❐ This brings one to the larger debate on what economists call ‘inclusive growth’, which is about how
the economy and people’s livelihoods can or should be improved to provide a more equitable pattern
of living standards by increasing participation in economic activity (through employment) as well as
the sharing in the benefits of growth (through equitable earnings, social services and other benefits).
See section 12.4 on inclusive growth.
12.3.3 Low growth: causes and remedies – conventional views

The different experiences of countries, and the struggle in South Africa to reach a targeted
6% GDP growth rate, call for a closer look at the determinants of economic growth. A
better understanding of such determinants can also help policymakers in this regard.
As noted at the end of chapter 8, views on the causes and remedies for low growth broadly
diverge in terms of the relative weight given to ‘purely’ macroeconomic variables, such as
the saving rate, tax rates, capital accumulation and innovation, as against including broader
variables such as human capital, human development and institutional development in
growth policy design. We first consider the conventional macroeconomic approach.
In the mainstream growth literature, the study of the causes of low growth has been
approached not so much as a single-country issue but as efforts to explain the large
variance in growth rates between countries.
On a single-country level, much effort has gone into explaining, for instance, the lower
growth performance of the US economy since the 1970s (where a productivity growth
slowdown has been identified as a probable cause). However, much of the attention since
the 1990s has gone into understanding and explaining the huge differences in growth
performance between the low- and middle-income and the high-income countries. Of
particular relevance for us is the failure of Africa, especially since 1950, to show significant
growth performance as compared to the North American and European as well as Asian
and Latin American countries. Since 1950, Africa has consistently shown the worst
average per capita growth – and it appears to be falling behind faster. As a result, some of
the poorest countries and poorest people continue to be found on this continent – with not
many signs of significant changes to be expected in the near future.
❐ Of course there are exceptions, of which South Africa is an important one, as the data
above show. Still, in terms of per capita GDP growth and poverty levels, South Africa
still lags behind many comparable countries, and below the expectations of the people
of the country regarding employment growth and poverty reduction.
The big question for us is: why does Africa grow so slowly? What can explain persistent
patterns of low growth in so many countries? (We will consider the South African case
later.)
Conventional views have tended to derive straight from the implications of the Solow-
type growth model, as well as earlier, so-called Harrod-Domar growth models. The
latter stressed the importance of the capital stock (and thus saving and investment) in
explaining and determining economic growth. It also became the central message of
development planning by Western agencies like the World Bank, particularly in the 1960s

and 1970s. Solow took his model further to show the limits of capital-based growth, and
the potency of technology-driven growth. Some ‘lessons for growth’ also derive from the
standard Keynesian macroeconomic model that we have encountered in this book, as well
as (sometimes opposing) Monetarist/New Classical views.
Following these theoretical points of departure, conventional explanations not
unexpectedly point to the following basic causes of low growth, in high-income countries
as well as in low- and middle-income countries. Not all these are undisputed, so the
following list should be seen against the background of the existence of the different
schools of thought in economics (see chapter 11).
1. Insufficient capital formation and investment. While the Solow model seems to suggest
that capital is not so potent, the model’s message should not be misunderstood. While,
theoretically, capital alone perhaps cannot permanently increase the long- run per
capita rate of growth, its ability to lift the growth path to a higher level is remarkable
– especially in conjunction with progress in technology and institutions. Through
post-Solow-model thinking (‘endogenous growth theories’ of Romer and others),
economists have come to recognise that capital formation usually also implies the
embeddedness, incorporation or importation of new technology (see chapter 8, section
8.11.2). Therefore generic investment in machinery and equipment tends to have a
significant impact on GDP growth, especially in low- and middle-income countries.
And increasing capital equipment remains a cornerstone of modern economic growth
built around industrialisation and mechanisation that includes electronics and
advanced technology, and likewise in mining and agriculture. Therefore, a low rate
of capital accumulation (investment) is seen as a major cause of a low growth path
in low- and middle-income countries. Low government investment in infrastructure
would aggravate this problem.
2. Undeveloped or ‘thin’ financial (money and capital) markets. Economic literature suggests
a possible two-way relationship between financial market development and economic
growth. First, economic growth can enhance financial market development. As an
economy starts to grow the demand for financial services usually increases, leading
to the development of the financial markets. However, causality can also run in
the other direction. As financial markets develop they allow for more sophisticated
financial transactions, which, in turn, allow economic activities that would not be
possible otherwise. An example is the development of a stock exchange that allows for
the listing of public companies. Higher levels of economic activity that are enabled by
the more sophisticated financial transactions may stimulate a higher growth rate. The
other side of this coin is that, if growth occurs while financial markets are not well
developed, investors may prefer to take their savings out of the country – which might
then inhibit the development of the domestic financial markets.
3. Insufficient domestic saving – a so-called saving gap – which is seen as the main cause
of insufficient investment. This relates, first, to both (a) insufficient household and
corporate saving, and (b) in the face of insufficient household and corporate saving,
also insufficient foreign saving and foreign investment to fill the saving gap. Both of
these are often ascribed to high personal tax and especially corporate tax rates in low-
and middle-income countries (although some of the highest rates occur in some of
the richest countries).
❐ Foreign saving and investment may also be deterred due to risks associated with
emerging market or low- and middle-income country status, exchange rate risks,
and restrictions on international financial flows.

4. A second saving concern relates to excessive government dissaving when there are
recurring large government (current) deficits due to excessive government expenditure.
Government dissaving shrinks the pool of non-governmental saving available for
investment. (It can also lead to unsustainable levels of domestic debt and foreign debt.
Repaying of foreign loans can cause foreign dissaving.)
❐ Remember that government dissaving occurs only when there is a current
budget deficit, i.e. when a conventional budget deficit exceeds government
capital expenditure. Unfortunately the dissaving debate often proceeds as if any
conventional budget deficit implies dissaving, which is erroneous.
5. In addition, insufficient investment is ascribed to the crowding-out of private investment
by excessive government expenditure that pushes up interest rates. This concern
originated in the Monetarist approach. This issue was part of the earlier debate between
Keynesians and Monetarists on the effectiveness of expansionary fiscal policy. High
government borrowing (as distinguished from high government expenditure, which
can also be financed from taxes and not just borrowing) can also push up interest
rates and thus discourage private investment. While crowding out is not seen as the
demon it used to be in the 1960s and 1970s, in certain tight financial market contexts
and certain risk situations it can be an impediment to private investment. The harm
of crowding out will be much worse when the investments being crowded out are
investments in research and development (see below).
6. Low rates of technology transfer
and technology adoption. Given Are all technologies good to imitate and
the thrust of the Solow growth adopt?
model, it is not surprising that A drawback of most developing countries is that,
the conventional approach given limited own potential and resources to
has an intense focus on ‘tech- develop new technologies, they are dependent
nological backwardness’ and on importing, adopting or imitating technologies
slow technological ‘catch- from leading, developed countries. While this is
up’ as a cause of low growth cheaper and faster, there is a question whether all
in low- and middle-income these technologies are appropriate for developing
countries. This can be linked, countries in terms of a technology’s skills
first, to insufficient investment requirements, its labour usage, capital intensity,
in capital (which often car- input needs, scale requirements, environmental
implications, market requirements, social impact
ries embedded technology).
and so forth, given the stage of development of a
Second, low rates of foreign
particular country.
direct investment can imply
low rates of technology trans-
fer and technology adoption. This restricts the importation of embedded technology
in machinery and equipment.
7. Low rates of innovation. These are linked, primarily, to low rates of investment
in research and development (R&D). One of the main contributions from the
‘endogenous’ growth theories of Romer and others is that investment in R&D can
have major benefits for productivity and output growth. A lack of dynamic R&D
activity and continual R&D investment will cause a low rate of growth of domestic,
‘own’ technology and leave a country dependent on imported technologies, such
as those discussed above. Therefore, the importation of technologies cannot
necessarily sustain a positive growth rate in technology in a country. (Insufficient
human capital development to enable and sustain technology growth can also be
a contributing drag on growth; see section 12.3.4.)

8. Restriction on free international trade has been a favourite culprit identified by
conventional economists for many decades, arguing that more open economies grow
faster than closed ones. In the Solow-type model, trade liberalisation and a strong
export sector – whether originating in agriculture or manufacturing or mining –
can lift the level of output, but not the rate of growth. Little evidence exists that the
reduction of trade barriers like tariffs have impacted significantly on economic growth.
The main direct impact of a more open economy probably is that it provides access to
imported capital equipment, with embedded technology, as noted above. Generally,
openness implies higher exposure to new ideas and technologies from other countries,
which is likely to boost R&D activities – even if through imitation initially – as well as
efficiency-enhancing organisational reforms (see below).
9. On a different tack: a prominent low- and middle-income country factor that impacts
negatively on per capita GDP growth rates is excessive population growth. Due to many
factors, including increased access to health services, mortality rates in low- and
middle-income countries fell during the 20th century, leading to significant increases
in population growth rates. (This does not mean that mortality rates in many countries
are not still too high, only that they are lower than a hundred years ago.) As noted in
chapter 8, this reduces per capita GDP growth rates.
❐ The great irony of economic growth and development in low- and middle-income
countries (or in any country that starts from a low standard of living) is that initial
development successes – notably regarding health and life expectancy – initially
lead to increases in population growth, which constrains per capita GDP growth.
However, as income levels start to increase and families get drawn into the modern
economy, birth rates tend to start a slow decline.
❐ Note that HIV and Aids have turned around the drop in mortality rates since the
1990s. Life expectancy fell dramatically, notably in southern Africa. However,
anti-retroviral medicines have started to reverse the decline.
10. Persistent macroeconomic instability and high or unstable inflation, which increase the
risk of investment and international capital flows to finance investment. The same
applies to frequent policy reversals and policy uncertainty linked to political instability.
11. A lack of competition throughout the economy.
Growth in South Africa explained – a conventional view13
As the preceding discussion indicated, economic growth in South Africa picked up since
the mid-1990s and especially since 2000, although it slowed down again after 2009,
following the global financial crisis, and especially since 2011. The per capita GDP growth
rate is still a bit higher than in the late 1980s and early 1990s, though. What is the
standard explanation for this growth? Is it an increase in labour, or in capital, or did it
result from improved technology and institutional progress?
Unemployment in the late 1990s increased, and, as the discussion above indicates,
decreased moderately after 2003, before increasing again since 2009. Research also
indicates that growth did not so much result from capital deepening. Rather, evidence
indicates that to a large extent the increased growth rate can be ascribed to higher levels of
productivity (due to technological and institutional progress, as measured by variable A in
the production function of chapter 8). This again indicates the importance of technological
and institutional progress for sustained higher growth rates in the longer run.
13 For more on this, see Arora V and Bhundia A (2003) Potential output and total factor productivity growth in post-
Apartheid South Africa. IMF Working Paper. WP/03/178; Eyraud L (2009) Why isn’t South Africa growing faster? A
comparative study. IMF Working Paper. WP/09/25. A more recent source is: Burger P (2018) Getting it right: A new
economy for South Africa. KMMR Press.

Even though economic growth in South Africa has picked up since the mid-1990s, the
growth rate is still lower than the growth rates registered in some other emerging market
countries. The question is, why?
Recent research confirms earlier suspicions that the growth rate is lower because of limited
growth in productivity. Even though productivity explains the improvement in the growth
performance, it also explains why the improvement was rather limited, especially when
compared to other emerging-market countries.
The main reason, though, why growth is lower seems to be too little investment; this, in
turn, is explained by too little domestic saving. The low saving rate is also reflected in a
high cost of capital. Because the supply of loanable funds through the stock and bond
exchange is low, companies have to offer higher interest rates and rates of return to attract
capital. The higher cost of capital renders fewer projects viable, leading to lower levels of
investment and hence growth. (However, recall that higher levels of investment represent
capital deepening, and will therefore lead to temporary, and not permanent, increases in
the growth rate as the economy moves from one growth path to the next. Nevertheless,
‘temporary’ in this context may comprise many years.)
Do all these explanations work?

All these explanations and counter-explanations remain largely within the ambit of
conventional macroeconomic and growth theory. Not many surprises there. But the upshot
of many decades of research is that the conventional explanations do not really succeed in
explaining the great divergence between the rich countries and the poor countries.
Moreover, policies derived from conventional theories have not really been successful. The
world is and has been becoming a more unequal place, and standard theory cannot explain
it nor prescribe successful policies to counter this trend. While many people in many low-
and middle-income countries do have higher standards of living than their predecessors,
their material position relative to those in high-income countries has weakened steadily
during the last century. And despite many efforts and billions of dollars of expenditure, also
from international institutions such as the World Bank and the United Nations Development
Programme (UNDP), growth in Africa, for example, has remained low and stuttering.
This realisation has led to the upsurge in growth theory since the 1980s. This comprised,
inter alia, the broadening of the theoretical framework to include more complex linkages
between factors, as well as broader and non-economic factors, in the analysis of the
causes and remedies of low economic growth. Some of these were introduced in chapter 8
(sections 8.10 to 8.12). We will return to them in the discussion that follows.
✍ HIV/Aids and low economic growth

statements:
Y 
N
(‘it causes the growth rate in per capita income to decrease’).
Y 
2. The fact that the population growth (i.e. n) declines as life expectancy declines, benefits  
N
(‘it causes the growth rate in per capita income to increase’).
Do you agree with these statements? Do you now have a different view on these statements
than before (chapter 8)?

The role of policy
Since the conventional policy implications follow more-or-less automatically from the
identification of a cause of low growth, we will not discuss them separately. It suffices to
make a few general comments on the effectiveness of growth-oriented policies.
The first issue is how much economic policy should focus on growth and how much
on cyclical stabilisation. This is disputed territory. Somebody like Lucas, from the New
Classical School, will lay great stress on the benefits of improving growth performance as
against cyclical stability and urge governments not to intervene in cyclical ‘disequilibria’.
Others will agree that growth is very important, but will point out that major cyclical
downturns such as a depression can wipe out the benefits of many years or decades of
growth, and cause great human suffering for significant periods of time.
A sensible view probably is that growth-oriented policies should have great clarity of
focus and great consistency and not confuse short-term or stability-enhancing steps
with growth-enhancing steps. The focus of a growth-orientated policy should not be on
increasing the annual growth rate per se but rather on increasing the sustainable, long-
term growth rate – the long-run growth trend.
❐ Policymakers should also be aware of perhaps unintended counter-productive effects
of stabilisation-policy steps and other economic policies on the growth path, and vice
versa for growth-enhancing policies.
❐ There should also be clarity on whether all types of policy are equally potent regarding
growth promotion.
Expansionary monetary and fiscal policy (dealt with elsewhere in this book) can increase the
economic growth rate. However, such increases may very often only be temporary and will
not lift the long-run growth path. This follows from the presence of the supply adjustment
process (explained in chapter 6). Thus, straightforward expansionary monetary and fiscal
policy is usually not the right way to increase the long-term growth rate.
❐ As the analysis of the aggregate supply (AS) and Phillips curves demonstrated (chapter
7), the result of an expansionary monetary policy might be a permanent increase in
inflation, while the aggregate GDP growth rate increases only temporarily – a heavy price
to pay for a short-term benefit with no change to the long-term per capita growth path.
❐ In the long run, deficits that are large enough to imply dissaving reduce national saving
and the saving rate (and probably crowd out investment), reduce capital formation and
R&D investment, and thus shift the economy onto a lower, less favourable balanced
growth path. Thus, a shift to reduce dissaving (properly defined in terms of the current
budget balance) is an important growth-enhancing strategy.
However, those elements of the government budget that comprise government investment
expenditure on infrastructure (i.e. capital accumulation) can lift the economy onto a higher
growth path. In a low- and middle-income country this may be absolutely essential if the
private sector is still too small or has limited access to financing, or if domestic capital
markets are insufficiently developed. This may also be true for a portion of government
consumption expenditure on human capital growth, e.g. properly targeted education and
health expenditure (see section 12.3.4).
As far as tax policy is concerned, most growth models produce a strong case for reducing
taxation on capital, i.e. profits tax or corporate tax, in order to promote new investment in
all categories, i.e. infrastructure, capital equipment, R&D and human capital (see below).
Such tax policies can also be instrumental in increasing foreign direct investment (FDI).

International aid and financial inflows to fill the saving gap were once seen as a
potentially potent policy measure, and this was the standard development aid policy of
many international institutions. However, it appeared that foreign aid inflows often did
not go directly into investment and did not necessarily boost the domestic saving pool.
Various explanations include a drop in domestic saving as well as a decline in investment
productivity due to perverse incentives created by the ‘free aid’.
As far as trade policy is concerned, one can deduce that inward-looking trade policies and
strategies that lead to barriers to trade are likely to constrain the transmission of ideas,
knowledge and technologies. However, globalisation and export promotion are no easy
road to economic growth and economic development. If domestic capacity, investment,
human and physical capital and institutions are not developed, there can be no sustainable
growth path. But external exposure and linkages can be a potent complementary strategy
to enhance and boost a growth process built on the real determinants of a robust, growing
economy.
Obviously a major issue is how government policies support investment in R&D or impact
on the rate of technological development, adoption and imitation. This takes one outside
the realm of macroeconomic policies (except perhaps tax policy) and into innovation policy,
intellectual property rights, innovation support programmes, science and technology
policy frameworks and so forth. Generally, one can say that economic growth will benefit
greatly from sound government policies that also provide consistent support for R&D
activities and innovation in both the private and public sectors, including universities.
12.3.4 Newer views – the deeper dimensions of growth14

The conclusion to chapter 8 noted that, when analysing growth, it is impossible to separate
something like increases in production and income from the complex textures of societies
that go through periods of development, crisis, war, prosperity and poverty. These textures
include cultural habits, norms, institutions, and legal frameworks, political regimes,
infrastructure, health and education systems and so forth. Such complexity cannot be
captured in a stylised economic model comprising a few relatively simple equations.
At the very least it means that economic growth must be embedded in a larger understanding of
human, social and economic development. Some of the most important recent contributions in
the growth debate relate to such issues. They may be particularly relevant in understanding
and addressing low growth and development in low- and middle-income countries.
The role of human capital

The introduction of human capital into the conventional growth model has opened the
door to many new insights. A first is that the development of people and of worker skills
at all levels is crucial for enhancing growth performance. This can be education (whether
primary, secondary or higher), training, technical skills transfer, on-the-job-training to
improve the use of modern technologies and equipment, learning-by-doing which leads
to improved ways of organising the production process, and so forth. All these can have
major benefits in enhancing the economy’s productivity level and productivity growth.
14 This section draws on Snowdon B and Vane HR (2005) Modern Macroeconomics, Edward Elgar, chapters 10 and 11.

Growth and human development – HDI vs. per capita income
In thinking about economic growth and human development, it is important to know that growth in per
capita income is an imperfect indicator of human development. The following table shows correlation
coefficients between the HDI and gross national income (GNI) per capita, itself a component of the HDI,
and two other components of the HDI (see chapter 1, section 1.4.3).
Correlation coefficients between the 2017 HDI, GNI per capita and HDI components
Life expectancy Mean years of

GNI per capita
at birth schooling
HDI 0.91 0.91 0.75
GNI per capita 0.65 0.61 1.0
The correlation between the HDI and per capita GNI is 0.75, which is fairly high, but much lower than the
correlations between HDI and the two developmental components (life expectancy and schooling), both
at 0.91. These two would constitute better single indicators of human development than GNI per capita
(if we accept the HDI as a good indicator of human development).
The correlation coefficients between GNI per capita and the other components of the HDI are even lower,
at 0.61 and 0.65. Although these are not weak correlations, they are not very strong either.
These moderate correlations indicate that people living in countries with a higher GNI per capita will
probably but not necessarily also have a higher average life expectancy and more years of schooling.
❐ There are several exceptions where GNI per capita is not a good indicator of the level of human
development – where a relatively high per capita GNI is associated with relatively lower levels of all
or some of the other human development indicators (as is the case in South Africa, Namibia and
Botswana).
❐ Likewise, in some countries a relatively low GNI per capita is associated with relatively higher levels
of all or some of the other indicators (for example, Tonga and Jamaica).
Therefore, when using per capita income to evaluate human development, one must do so in conjunction
with several other variables, such as education and life expectancy.
*GNI is identical to GNP. Note that ‘national’ refers to aggregate production by a country’s citizens, irrespective
of where in the world they do that – and ‘domestic’ to aggregate production within the geographic borders of the
country, whether by citizens or non-citizens. See addendum 5.1 in chapter 5.
A second insight relates to the integrated nature of the growth process in which physical
capital, human capital and new knowledge creation through research and development
interact in a multitude of complex but integrated ways. A resultant new belief is that
‘broad’ capital accumulation (physical and human capital combined with R&D and
embedded technology) may not experience diminishing returns. If capital in this broader
and integrated sense has at least constant returns to scale, it changes the analysis of the
causes of and remedies for low growth dramatically. International evidence appears to
indicate that this type of theory is much better at explaining the extraordinary per capita
growth trajectories in some countries.
Both of these insights imply that deficiencies in these areas can be a major impediment
to higher economic growth. Therefore, policies to address human capital development
effectively and efficiently are essential to put a country on a better growth trajectory.
Effective education policy and service delivery regarding schools, training strategies and
universities are crucial. Furthermore, there must be a policy environment that encourages
training and learning and the processes of how new technologies are adopted and

implemented – and used to develop yet further new technologies. In a broader context,
appropriate health infrastructure and policies that ensure a strong and healthy workforce
with a reasonable life expectancy can make a key contribution to economic growth and
human development.
Income inequality and growth

Chapter 1 noted that a perceived trade-off between redistribution and growth has
been prominent in the policy debate in South Africa for a long time. Some, mainly in
the business sector, argue that redistributive policies financed by higher taxes will be
counterproductive and will retard economic growth, shrinking the economic pie. Others
argue that the benefits of economic growth will not automatically reach the poor – that
the trickle-down effect is a myth – and that redistributive government expenditure to
build the capacity of the poor will unleash additional human potential and lead to higher
growth and prosperity for all. The tension between these viewpoints continues to impact
political and policy debates regularly.
In the growth literature, much attention has been given to the link between inequality
and per capita GDP growth. This is part of research on the political economy of income
redistribution.
The old view, which originated in the 1960s and 1970s, was that inequality is necessary
to generate the necessary high saving to enable the capital accumulation that is the key
to growth (the Harrod-Domar growth model, as noted above). The rich have a higher
propensity to save; thus income inequality and concentration of wealth is conducive to
saving and thus investment and growth. Therefore, a poor country must accept a trade- off
between equity and growth: it must accept inequality to get more economic growth (and
not worry too much about who gets to share in that growth, since it will trickle down to all).
This means that redistributive policies to reduce inequality are bad for economic growth.
A related theory is the so-called Kuznets hypothesis, which suggests that inequality must
first increase to enable growth before it can eventually decrease when a country reaches
the later stages of development.
Newer views, derived from the documenting of several country case studies where some
countries achieved high growth without inequality (the so-called Asian tigers) or failed to
grow despite inequality (Latin America), have caused a rethink. Now there is emphasis on
the potentially adverse impact of inequality on economic growth. Several channels can
explain such a relationship:
1. Poor people have no access to credit markets, thus have limited access to finance and
cannot invest in human capital formation (e.g. education). Reducing inequality will
enable human capital formation to spread across a broader section of the population
and unlock human skills potential.
2. Inequality creates political pressure for redistributive policies, but the higher taxes
required to finance redistribution are a disincentive for potential investors, which is
likely to reduce growth.
3. High inequality leads to much energy being channelled into ways to benefit from crime
and corruption. This can be true for both poor people and a rich elite – even though
corruption tends to hurt the poor more than the rich. The poor may commit crime
because of poverty and because inequality undermines the legitimacy of the existing
social structures, while a rich elite may commit crime and corruption in efforts to
serve and entrench their privileged positions. Subversion of institutions and the rule

of law to serve a corrupt elite threatens property rights and thus the incentive to
invest. A decline in good governance, law and order and political stability discourages
investment, especially foreign investment.
4. High income inequality implies large numbers of people with low incomes. This
suppresses domestic demand growth, especially for manufactured goods, and thus
inhibits the development of mass markets which may be a precondition for successful
manufacturing growth and industrialisation.
5. Inequality promotes social and political unrest, which reduces growth-enhancing
activities. While there may be some tolerance for inequality in the early stages
of development, if the benefits of observable economic growth do not reach the
poor before long, this tolerance will start to evaporate. Persistent and/or growing
inequality is likely to create growing political pressures for change and may even lead
to instability, violence and a political crisis.
✍ The South African case after 1994

To what extent is South Africa an example of the effect described in point 5? What happened
to the degree of inequality among the majority who previously were excluded from political
and economic power? To what extent were there signs of emerging political impatience with
the governing elite?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
Recent evidence published by the IMF indicates that a high degree of inequality can be
detrimental to economic growth – specifically, the duration of high growth spells.15 The
researchers point out that igniting growth is much less challenging than sustaining growth.
In low- and middle-income countries in particular, periods of high growth typically are
interspersed with periods of stagnating growth. Their results show that longer growth
spells are consistently associated with lower inequality in the distribution of income. They
attribute this to the fact that inequality undermines progress in health and education,
inhibits full economic participation, narrows the consumer market and the tax base, and
creates deep tensions that undermine social consensus and investor confidence.
While the implication seems to be that redistributive policies are desirable from a growth
point of view, it may also be that redistributive policies (e.g. taxes and social transfers)
undermine business and work incentives and thus reduce growth. However, using a new
cross-country dataset, these IMF authors16 show that there is no statistical difference
in the growth performance of countries that implemented more equality-enhancing
policies using taxes and transfers and those that implemented fewer or no such policies.
The redistributive policies of the former group did not hurt their growth performance.
Specifically, the authors found that:
❐ More unequal societies tend to redistribute more.
❐ But, redistribution as such does not seem to impact growth negatively, except in extreme
cases.
15 Ostry JD and Berg A (2011) Inequality and unsustainable growth: two sides of the same coin? IMF Staff Discussion Note.
16 Berg A, Ostry JD, Tsangarides CG and Yakhshilikov Y (2018) Redistribution, inequality, and growth: new evidence.
Journal of Economic Growth, 23(3).

❐ Indeed, lower net inequality (resulting from redistribution steps) is consistently
correlated with faster and more durable growth. (Net inequality is inequality after
taxes and transfers.)
Therefore, there appear to be no empirical grounds to assume that there is a big trade-
off between redistribution and growth, i.e. that one of these can only be pursued at the
cost of losing out on the other. In the end, a country must find a balance between the
potential disincentive costs of high taxation and the growth-related and other social
benefits due to redistribution. If not, the negative effects of excessive inequality on
economic growth will be felt.
The role of institutions

In the analysis of growth theory in chapter 8, the factor A was included in the production
function to represent, besides technological progress, advances in social and economic
institutions. While some economists narrow down factor A to technological progress, it will be
apparent that factor A must be broadened to include institutional progress and development.
Differences in natural resources and factor endowments alone cannot explain the low
growth performance of low- and middle-income countries. This brings us to the deeper
social and economic determinants of economic growth, including non-economic aspects.
These deeper aspects require careful analysis of the peculiar history and context of
individual countries to extract conclusions or ‘lessons’ which, by their nature, are not as
generalised as persons accustomed to neat economic models would prefer.
Why is it that, despite injections of financial capital, huge amounts of foreign aid, huge
capital infrastructure projects (often sponsored by foreign donors), the general availability
of new technology, and significant investments in education and health, some countries
just remain poor and stuck on a low growth path? The list of factors mentioned section
12.3.3 may just be the ones that are visible and on the surface. Are there deeper social and
economic factors that explain the puzzle of low growth in some countries – and that can
be the key to successful growth and development strategies?
Snowdon and Vane (2005:596; see footnote 12 above) distinguish between proximate (close;
nearby) and fundamental or deep sources of growth. The latter determine a country’s
ability, capacity and readiness to be part of a process of capital accumulation, human capital
development, organisational utilisation proficiency, technology harnessing and knowledge
development.
On one level, one can identify issues such as the following:
❐ The size and capacity of government to support economic activity and growth in a
complex, competitive, globalised world economy.
❐ The ability and clout of a central bank to provide a stable and secure monetary, financial
and banking environment.
❐ The size, capacity and sophistication of private and public sector financial institutions
to facilitate and support the financing of both large investment projects and innovation-
oriented, entrepreneurial investments.
❐ The depth of experience and business know-how in the private sector (including
manufacturing, mining and commercial agriculture) to be competitive in a globalised
context. This includes the prevalence of an ‘entrepreneurial attitude’.
This leads one to a yet deeper level, to the institutional framework and foundations of a
society and an economy. The term ‘institution’ must be broadly understood to go beyond
‘organisations’ to include aspects such as the following:

❐ Formal legal aspects: the constitutional framework, the rule of law, property rights,
patent and intellectual property laws, enforcement of contracts, tax law and
administration, the company law framework, labour law, competition law and policy,
general law and order and so forth.
❐ Managerial and organisational aspects: dominant traditions of organisation and
management, effectiveness of government service delivery, administrative competence
of government, management techniques, typical style of doing business, work ethic,
motivational make-up, etc.
❐ Governance: how ‘good’ governance is understood and practised in the public and
private sectors; the extent to which private sector company directors are accountable to
shareholders, or public sector company directors and politicians accountable to voters.
❐ Political traditions: how ‘good’ government is understood; the extent to which there is
government in the general interest or government by and for a particular ruling party
or a ruling elite; the extent to which presidents and politicians are accountable and/or
responsive to the electorate and so forth.
Institutional failures frequently prevent a country from adopting the most productive
technologies and increasing its growth and development performance. This can be in both
the public and private sectors. Accordingly, the development of effective institutions can be
crucial. This includes the differentiation of specialised institutions to facilitate economic
interaction and activity in a market-based economy.
❐ If a country exhibits a so-called dual economy, it carries some benefits. Although there
may be widespread underdevelopment and poverty, in the economic core there is likely
to be a strong, modern set of institutions that ‘work’ and do not have to be developed
from scratch.
❐ Institutional progress can flow from social and institutional policies that change business
and workplace practices, create new legislative frameworks for new organisational
forms and management practices, and so forth.
Culture
Social scientists argue that culture can be a very important factor explaining the growth
experience of countries. All across the world, from north to south and east to west, economic
actors are individuals shaped, in their social and economic thinking and behaviour, by the
culture, social and religious customs, taboos, norms and practices of a particular society.
For instance, and broadly speaking, countries in Scandinavia have very different ‘economic
cultures’ from those in Western Europe, and the latter again different from those in Eastern
Europe, and again different from South American or African or Asian countries.
These can be seen, for example, in the role of work and employment, or whether the focus
in the workplace is on individuals or groups (where Japan is an oft-quoted example of the
latter). In many countries there is a more communal approach to social and economic
issues. This includes a more caring attitude towards the community and the vulnerable.
One also finds cultural attitudes that are more attuned to sustaining the basis of subsistence
(i.e. the environment) rather than exploiting it, and so forth. This implies differences with
regard to economic behaviour, incentives and work – which are reflected in the approach
to individual wealth accumulation, how economic prosperity and growth is pursued and
the kind of growth that results – including how institutions evolve (see previous section).
❐ In an era of increased global communication and information flows (television, the
internet, cell phones, social media, etc.), cultural change and changing economic
aspirations and behaviour may increasingly result from influences from other countries.
This may affect growth outcomes and patterns.

Political barriers to economic growth
At issue here is whether democracy is good for economic growth. Although an older view
held that democracy was a luxury that poor countries could not afford, the view that a stable
democracy is good for sustained growth is receiving increasing support. This includes
the effective protection of property rights and being shielded from autocratic rule and
dispossession (which would make fixed investment a high-risk activity).
Some economists have made interesting contributions on the potential role of political
distortions as barriers to progress. Factors such as the following may be present:
❐ A negative attitude to change in hierarchical societies. Politicians may block the adoption
of institutions and policies that would help eliminate economic backwardness because that
may reduce the political power (and wealth) of the elite.
❐ The absence of strong institutions allows autocratic rulers to adopt political strategies that
are highly effective at defusing opposition. As a result, economic growth and development
stagnate.
❐ Countries persist with inefficient institutions and bad policies because new ones may lead
to the emergence of new rich and powerful groups that threaten the political and economic
power of the current elite.
❐ Why do kleptocrats who control assets and expropriate wealth endure? Longevity is often
the result of weak institutional capacities that allow divide-and-rule strategies, with the
help of bribes if necessary. Such strategies are more likely to be successful in the presence
of significant ethnic diversity.
Because high-income countries do not have a typical ‘development problem’ at the moment,
little attention is given to the effect of such behaviour on growth in these countries, now or in
the past. Hence views are aired that almost seem to reflect a patronising attitude towards the
low- and middle-income countries – as if such kinds of behaviour are unique to 'developing'
(i.e. low- and middle-income) countries.. However, the history of Western countries contains
many stories of ‘robber barons’ who became rich through exploitation, abusing the lack
of regulations and legislative control in earlier times, only to go on to influential positions
in politics. One also continues to find more subtle modern forms of kleptocracy in these
countries, e.g. government officials and politicians in high-income countries who come from
‘big business’ or ‘big oil’ and go into government and promote policies that benefit those
sectors.
Trust, ethnicity and social division

Trust among economic actors and policymakers is a key element of successful market
transactions as well as investment. A higher degree of trust reduces the cost – in terms
of time, administrative actions and legal processes – of economic transactions. Where
there is a low level of trust, it appears that the rate of investment and economic growth is
likely to be lower than in high-trust societies. Trust depends in part on the extent to which
there are common norms of proper behaviour and clear social or criminal penalties for
nonconforming behaviour, e.g. cheating or corruption.
❐ Trust appears to be lower when there is a high degree of heterogeneity or ethnic diversity
in the population. Evidence shows that this may be a significant factor in explaining
lower economic growth in Africa and other places. The post-colonial period often
saw ethnic divisions and struggles for political and economic dominance in emerging
countries. Such a situation makes it more difficult for diverse groups to come to an
agreement on the sharing of resources and the fruits of the economy, as well as the
exercise of political control over public resources. The resultant instability and political

risk can be a major disincentive for domestic as well as foreign investors. Such divisions
can however be overcome. Very diverse societies such as India, Malaysia and Singapore
have registered high economic growth for long periods of time. Some of these societies
even mobilised their diversity in support of growth – Singapore would be an example.
❐ If major social or class divisions exist in a society, this can also engender mistrust,
which can inhibit optimal economic activity and investment. Such divisions can persist
in many post-colonial situations, of which South Africa is a very prominent example.
Geography
Climate, water and other natural resources, topography and geographical position in
the global context can impact on many aspects of economic growth and development.
Aspects such as agricultural yield, mining productivity and transport costs are all relevant
in determining regional development patterns and national economic performance.
❐ An abundance of natural resources such as oil or diamonds can be a boon for economic
growth, if properly managed. However, it can also be a cause of political struggle and
civil strife. Excessive reliance on a natural resource such as gold can also inhibit the
incentive to develop a manufacturing sector or other natural resources.
❐ Distance from the major global markets significantly increases transport costs, worsens
the terms of trade for exporters, and inhibits integration with the world economy.
❐ The perceptual distance between some low- and middle-income countries and
economically advanced countries inhibits intellectual contact and transfer of
knowledge and technology. African countries, for example, are not prominent on the
‘radar screens’ of decision-makers, entrepreneurs and researchers in high-income
countries in the northern hemisphere. (The development of the internet has shrunk this
perceptual distance considerably, though, once initial contact has been established.)
❐ Countries near the equator – with higher temperatures, more rainfall and the prevalence
of tropical diseases – have lower per capita incomes than colder countries. This is true
for many countries in sub-Saharan Africa.
❐ Climate and soil conditions are decisive for agricultural output and development. The
arid and semi-arid conditions in many parts of southern Africa make commercial
agriculture a high-risk enterprise.
While not much can be done about many of these factors, they do imply barriers to growth
that must be overcome through effective institutions, good governance and policies, and
special human effort to place a country on a prosperous growth path.
12.3.5 Economic growth and the environment

The 19th-century Thomas Malthus was the first economist to express concern about the
ability of the environment to supply enough food for human consumption. According
to Malthus the population grows geometrically, while food production grows linearly.
Population would soon outrun food production, leading to famine. However, Malthus was
proven wrong. International food production was able to keep up with population growth,
even though the unequal spatial availability of food causes famine in certain areas.
In 1972 a think tank called the Club of Rome published a report called Limits to Growth.
Using sophisticated simulation techniques, it contained scenarios of economic growth
and natural resource availability. Limits to Growth predicted that the world would run out
of natural resources – especially oil – towards the end of the 20th century. Initially, this
report was embraced, given the oil crises of 1973 and 1979. However, the predictions

of the Club of Rome were not realised. First, oil reserves proved to be not as limited as
once thought. Second, technological progress and product redesign led to higher energy
efficiency – lighter and more fuel-efficient cars, for instance. By the 1980s and 1990s,
many considered the views of the Club of Rome as Neo-Malthusian scaremongering. The
pursuit of economic growth continued unabated, with low- and middle-income nations
joining eagerly.
Although overly pessimistic, the Club of Rome was not wrong about the intrinsic nature
of the threat. Environmental concerns increased. In 1987 the United Nations World
Commission on Environment and Development published Our Common Future. This report
coined the term sustainable development, defined as ‘development that meets the needs
of the present without compromising the ability of future generations to meet their own
needs’. The report argued that current development and use of natural resources should
recognise that future generations will also need natural resources to develop. In essence,
the report argued that we cannot use our resources up today and send the bill to our
children.
In 1997 the Kyoto Protocol, originally launched at the 1992 Earth Summit in Rio de Janeiro,
was adopted. According to this protocol, which came into force in 2005, industrialised
countries agreed to reduce their emissions of greenhouse gases by 5.2% below 1990
levels. Most countries signed and ratified the protocol – with the prominent exception of
the USA, the largest emitter per capita of carbon dioxide (a result of burning fossil fuels
such as petrol and coal) in the world. The US Congress argued, inter alia, that it would not
ratify a protocol that would harm US economic growth.
However, the tide has been turning against an unqualified pursuit of traditional forms of
economic growth. The environment suddenly is high on the social and political agenda,
even in the USA. This followed the Stern Report (a UK government report), former US vice-
president Al Gore’s documentary An Inconvenient Truth, and the various reports of the
Intergovernmental Panel on Climate Change (IPCC).
Their collective assessments and predictions are quite dire. Higher temperatures are likely
to start melting the Arctic ice cap, leading to regular flooding of low-lying coastal areas.
Large fluctuations in temperature and precipitation are likely. If no action is taken to cut back
greenhouse gas emissions, by 2035 the quantity of these gases in the atmosphere could be
double what it was prior to industrialisation. Average temperature is expected to increase
by 2°C or more, with huge implications. What is required is a 25% decrease in carbon
emissions by 2050 compared to levels in 2006 to stabilise the amount of CO2 equivalent in
the atmosphere. An important step to achieve this is the Paris Agreement of 2015, signed by
196 countries. It charts a new course to limit the rise in global temperature to below 2% and
preferably attain 1.5%. Each country must determine, plan, and regularly report on steps
that it undertakes. South Africa has signed and ratified the Agreement.
In 2018 the UN Environment Programme released a comprehensive report, the sixth
Global Environment Outlook (GEO-6), on how rising global temperatures will negatively
impact all aspects of human life, including health, economic development and poverty –
and the importance of enacting the changes necessary to limit the temperature increase
to 1.5%.17
17 For more on the IPCC and the Stern Report, go to www.sternreview.org.uk or www.hm-treasury,gov/sternreview_
index or www.ipcc.ch. An Inconvenient Truth is available in video stores. The UN report can be found at https://www.
un.org/en/climatechange/reports.shtml

Addressing climate change will cost about 1% of GDP per year. But not addressing it could
cost anything between 5% and 20% of GDP. Economic growth will be suffocated by its own
excesses and emissions. We cannot 'grow now and clean up later'.
12.3.6 Reflections on the standard approach to economic growth

Economic growth is indeed a complex topic. In the modern era the concept evokes all the
dreams of people, all over the world, for a better life for them and their children. It also
carries all the ghosts of ideologies, paradigms and politics that have driven the history
of human development, human conquest and the pursuit of power. In the last 60 years,
the pursuit of economic growth and the idea of a right to growing prosperity have almost
become unquestioned articles of faith – a ‘world religion’ of sorts.
Standard theories of economic growth appeared to have shown the way – pointing to the
typical modern pattern of industrialisation as the key to growing prosperity. Yet, it has
become absolutely clear that these theories and associated policy approaches are coming
up against some major complexities.
The first is that the ‘recipe for growth’ may not be as simple as presumed before, and
that low growth is a persistent problem in most low- or middle-income countries. The
preceding discussion has highlighted that, in analysing the causes of low growth it simply
is impossible to separate something like increases in production and income from cultural
habits, religious norms, social and government institutions, constitutional and legal
frameworks, political regimes, physical infrastructure, social infrastructure, health and
education systems, technology adoption, and so forth.
The second is that economic growth, as witnessed in the high-income countries, especially
since the Second World War, has enormous implications and costs with regard to
workplace stress and health, urban congestion and traffic, pollution and climate change,
environmental degradation, energy scarcity and natural resource depletion – including,
increasingly, a scarcity of water to feed the thirst of the industrial economies of the world.
In addition, it has sustained persistent inequalities in the economic and political power
relations between the low- or middle-income and high-income countries. Some argue
that the high rates of growth experienced by the latter in the previous century are not
sustainable for the whole world (though consensus does not exist on this point).
These are difficult and emotional issues, as evidenced in discussions of the impact of
slavery, colonialism and racism on economic development in Africa and low- and middle-
income countries elsewhere. Yet they absolutely demand careful consideration and a
willingness to probe beyond the scope of conventional economics and its stylised economic
models. At the very least, it means that economic growth must be embedded in a larger
understanding of human development as well as social and economic development,
embedded in an integrated understanding of the problems of sustainable growth and
development of a global economy (see section 12.4).
It is fortunate that there is a definite movement of scholars, broadly accepted by the
mainstream, into these new areas and aspects of growth and development. (The issue
also reaches beyond economics to other social sciences and the natural sciences.) An
important outcome of this movement is the concept of inclusive growth, which has also
gained prominence in South African policy debates and in policy documents such as the
National Development Plan (see section 12.5). Another is the international adoption of
the concept of inclusive development (see section 12.4.3).

12.4 Inclusive growth and development
It was noted in chapter 1 that the concept of inclusive growth has the potential to defuse
the apparent tension between growth and redistribution. In fact it can do more: it can
integrate considerations of unemployment, poverty and inequality with the idea of
economic growth. Furthermore, the concept of inclusive development can provide an even
more encompassing grasp of the challenges facing low- and middle-income countries.
12.4.1 Defining inclusive growth

The development of this concept was preceded by several attempts to achieve such an
integration. Terms such as pro-poor growth, or broad-based growth, or shared growth,
were the result.
❐ Pro-poor growth typically focuses on the outcomes of growth with regard to its impact
on the incomes of poor people in particular. This impact can be measures in terms of
relative poverty (i.e. whether the incomes of the poor have improved relative to those of
the non-poor) or absolute poverty (i.e. whether the number of people under the poverty
line has declined). The nature of the production and employment processes that lead to
the poverty-reducing result – e.g. who are employed in the growth process – is not an
integral part of the concept.
❐ Broad-based growth involves increasing the number of poor and disadvantaged people
who participate in the growth process, i.e. who take part, through work/employment,
in the process of producing goods and services. How and how much the outcomes of
such growth benefit poor (and other) people in terms of income or similar benefits, is
not part of the concept.
The concept of inclusive growth has been developed as a response to these different
concepts. Essentially it tries to integrate the concerns found in pro-poor growth and broad-
based growth, with a few specific refinements added. A basic definition has been proposed
by Ramos et al.18 of the International Policy Centre for Inclusive Growth of the United
Nations Development Programme. It can be stated as follows:
Inclusive growth is both an outcome and a process. On the one hand, it ensures that everyone
can participate in the growth process, both in terms of decision making for organising the
growth progression as well as in participating in the growth itself (and earning income).
On the other hand, it goes some way towards ensuring that everyone equitably shares the
benefits of growth. Inclusive growth implies participation and benefit sharing. Participation
without benefit sharing will make growth unjust and sharing benefits without participation
will make it a welfare outcome.
Thus defined, inclusive growth combines the increased participation of poor and
marginalised people in growing economic processes (via employment) with increased
sharing in the benefits of growth (via rising incomes, well-being and benefits from social
expenditure, including human capacity building).19
In further refinements of the concept, it is argued that for the growth process to be inclusive
it needs to be expressly non-discriminatory, while the benefit-sharing outcome needs to be
18 Ramos RA, Ranieri R and Lammens J (2013) Mapping inclusive growth. International Policy Centre for Inclusive
Growth Working paper 105.
19 It could be argued that shared growth could mean sharing both participation and benefits, in which case it would
be similar to inclusive growth. However, in South Africa it is often taken to mean that growth must happen first,
whereafter the fruits of growth can be distributed to, or used for the benefit of, the poor (‘sharing the benefits’). Then it
is a narrow, mostly redistributive concept and does not reflect whether the poor have been part of the growth process.
12.4 Inclusive growth and development 553

expressly disadvantage-reducing.20 Thus, no one should be excluded (particularly the poor
and the disadvantaged) and disadvantaged people should see a faster rise in their well-
being than other groups – reducing disparities. (Note that the UNDP definition’s phrase
on the growth process also includes participation in decision making on the nature of
productive processes as well as the sharing of benefits.)
In implementing this definition of inclusive growth, an Inclusiveness Index has been
developed at the International Policy Centre for Inclusive Growth. It contains three
equally-weighted components: two outcomes-based, or benefit-sharing measures, i.e. a
measure of poverty and a measure of income inequality; and one process-based measure,
i.e. a measure of employment participation. The indicators are:
❐ For benefit sharing: the poverty headcount ratio (H) and the Gini coefficient (G); and
❐ For participation: the employment-to-population ratio (EPR), i.e. the absorption rate.
The index is constructed on a 0 to 1 scale. A higher index value implies a worse performance
in terms of the inclusiveness of the economy. Countries with a poverty rate of more than 65%
are summarily classified as non-inclusive and given the highest index value possible, i.e. 1.
For economic growth as such to be considered inclusive, it must either lead to an improvement
in all three indicators of inclusivity, or at least an improvement in one or two indicators
but with the other indicator(s) not deteriorating.21
12.4.2 Inclusive growth in South Africa

Figure 12.15 shows the index values for a number of low- and middle-income countries
for 2006. It is clear that the South African economy has a very high index value, i.e. it has
a very low degree of inclusiveness, compared to other low- and middle-income countries.
The countries with an index value of 1 have calculated values around 0.5 or 0.6 (below
that of South Africa) – but they have very high poverty rates (above 65%).
In terms of this measure, South Africa’s inclusivity has declined since 1996: amidst high
GDP growth rates, the index has climbed from 0.74 in 1996 to 0.77 in 2006. In this
period the only positive element in the SA index was the declining poverty ratio. It was
overshadowed by growing inequality and a declining employment-to-population ratio.
Thus, South African economic growth has not been inclusive in this period. Looking at the
period since 2006, one may note that the Gini coefficient has started to decline since 2006
(see chapter 1) and that the poverty headcount ratio has continued to decline between 2006
and 2018. On the other hand, the important employment-to-population ratio has declined
further from 2006 to 2018. Thus South African growth still has not become inclusive.22
Getting to economic growth that is inclusive will obviously involve much more than stimulating
the economy (‘priming the pump’) or ‘increasing social spending. It requires a much deeper
and integrated look at (a) the nature of production and employment processes, notably
structural and other factors that marginalise and exclude poor and disadvantaged people from
participation in employment and work in both the formal and the informal sectors, and (b) on
the benefit-sharing side, aspects such as the earnings of workers, the inequality of income, the
prevalence of poverty, non-monetary dimensions of well-being, the receipt of benefits from
social expenditure, progress in terms of human development, and so forth.
20 Klasen S (2010) Measuring and monitoring inclusive growth: Multiple definitions, open questions, and some constructive
proposals. Sustainable Development Working Paper 12, Asian Development Bank.
21 These cases would respectively constitute the strong and weak definitions of inclusive growth.
22 Ramos (2017) Inclusive growth: innovation in development thinking but not in countries’ realities? (Presentation, HTW
Berlin) indeed estimates that South Africa’s Inclusive Growth index has increased from 2000 to 2014.

Figure 12.15 The UNDP Inclusiveness Index for 2006
1.0
Kenya
Bangladesh
Ethiopia
India
Madagascar
Unganda
0.8
SOUTH AFRICA
0.6
Pakistan
Honduras
Philippines
Armenia
Moldova
Colombia
Jordan
Indonesia
Georgia
Bolivia
Panama
Dominican Rep.
Chile
Turkey
Tunisia
0.4
Peru
Ei Salvador
Paraguay
Ecuador
Brazil
Argentina
Mexico
Costa Rica
Uruguary
China
Russia
Albania
Poland
Latvia
Bulgaria
Malaysia
Belarus
Ukraine
Kazaknstan
0.2
Slovak Rep.
0.0
Source: Ramos RA, Ranieri R & Lammens J 2013. Mapping inclusive growth. International Policy Centre for Inclusive Growth
Working paper 105, p. 30.
12.4.3 From inclusive growth to inclusive development

Going a step further beyond inclusive growth, the World Economic Forum (WEF) has
recently developed an Inclusive Development Index (IDI). This is part of a new worldwide
movement (also involving the World Bank, the IMF and the OECD, as well as the Stiglitz
Commission Report23) towards utilising more comprehensive measures of economic
performance, progress and living standards than growth in GDP or per capita GDP – thus
providing a better guide for policies.
In addition to distributional as well as participative, or process, aspects (as with inclusive
growth), the WEF’s idea is to incorporate broader developmental measures of well-being.
These comprise social and quality-of-life aspects as well as environmental considerations
and sustainability across generations. In addition, institutions matter. Therefore, the
development of effective social and economic institutions is seen as integral to such a
development trajectory in which there is a sustained, broad-based advancement of living
standards globally.
To assist policymakers in implementing the necessary structural reforms to pursue such
objectives, the WEF has developed a set of twelve National Key Performance Indicators in
three areas:
❐ Growth and Development, which includes per capita GDP but also the employment-to-
population ratio, labour productivity and life expectancy;
23 Stiglitz JE, Sen A and Fitoussi J-P, Report by the Commission on the Measurement of Economic Performance and Social
Progress. https://ec.europa.eu/eurostat/documents/118025/118123/Fitoussi+Commission+report

❐ Inclusion, which includes the poverty rate and median household income, plus Gini
coefficients for income and wealth inequality; and
❐ Intergenerational Equity and Sustainability, which includes public debt as a percentage
of GDP, the dependency ratio,24 the carbon intensity of GDP, and a fine-tuned measure
of net national savings (adding spending on education but subtracting the depletion of
natural resources as well as the damage caused by pollution).
By distilling changes in the twelve indicators in these three areas into one number, the
WEF has created an Inclusive Development Index (IDI). The WEF publishes data on the
index as well as individual performance indicators for more than 100 countries.
Note the presence, in the first two of these areas, of the three indicators used in the UNDP’s
Inclusiveness Index, discussed above. But the WEF goes beyond these to include a larger set
of aspects – gaining breadth and depth (but perhaps losing some focus).
12.4.4 Inclusive development in South Africa?

Figure 12.16 shows the Inclusive Development Index for 2011 and 2016 for South Africa
and several ‘emerging’ economies, as well as a few ‘advanced’ countries for comparison.
Thus one can also see improvements and deteriorations in inclusivity in these countries,
bearing in mind that a period of five years is short in terms of developmental changes. The
index can range from 0 to 7 (the ‘best’). Norway has the highest value in the world, i.e. 6.1
(2016 value).
Figure 12.16 The WEF Inclusive Development Index (IDI) for 2011 and 2016
7.00
6.00
5.00
4.00
Index value
3.00
2.00
1.00
0.00
Mozambique
Lesotho
Egypt
Zimbabwe
Zambia
Nigeria
India
Namibia
Tanzania
Brazil
China
Russia
Greece
New Zealand
Ireland
Norway
SOUTH AFRICA
2011 2016
24 The dependency ratio is the ratio between ‘dependents’ (people younger than 15 or older than 64) and the working-
age population, i.e. ages 15–64, expressed as the proportion of dependents per 100 working-age population. In South
Africa it has declined from 85.4 in 1966 to 53.8 in 2011 to 52.4 in 2016.

South Africa lies low globally. The first 30 in the ranking are grouped as ‘advanced’
economies. Next, 77 ‘emerging economies’ are ranked. Within the latter group, South
Africa ranked only 69th out of the 77 in 2016 (and shows only a small improvement in
its index value since 2011). South Africa’s IDI value is lower than that of SADC countries
such as Tanzania and Namibia, while most of our BRICS partners – Russia (19), China
(26), Brazil (37) and India (62) – have significantly higher rankings. The WEF summarises
the reasons for South Africa’s low ranking as follows:
Despite South Africa’s economy being more advanced than that of most emerging economies,
its low employment levels, subpar health conditions (notably low life expectancy) and high
inequality drive its low overall IDI. At the same time almost 36% of the population is poor.
In addition, South Africa’s economy is also relatively carbon intensive. On a more positive
note, South Africa is more productive than the average emerging country, has better control
of public finance (debt is roughly 50% of GDP), and has a good balance between elder and
younger populations, with a dependency ratio of 52.4. South Africa has yet to develop a
more inclusive growth model, providing better employment opportunities to a larger share of
its population (WEF, 2018: 10).25
It is instructive to compare the ranking based on per capita GDP with the ranking using the
more comprehensive IDI. Compared to being 69th in the latter, South Africa ranks 20th
among emerging economies based on per capita GDP.26 This demonstrates two things:
first, that South Africa has not measurably translated its economic growth into social and
economic inclusion; second, the limited value of GDP as a measure of inclusive growth
and development – and, especially, as the predominant goal for economic policymakers.
It was noted above that inclusive growth requires policy measures that go beyond
macroeconomic stimulation or increased social spending. Likewise, it is clear that pursuing
inclusive development needs to go beyond the two areas most commonly featured in
discussions of inequality and inclusiveness, i.e. education and redistribution. The pursuit
of inclusive development must involve a comprehensive combination of structural and
institutional aspects of economic policy. Countries need coordinated policies, policy
incentives and effective institutions in several social and economic areas (as expounded
in the WEF policy framework) while pursuing sound macroeconomic policies over time.
It is for this reason that the WEF claims that its framework represents an alternative way
of thinking about ‘structural economic reform’ – one that is ‘both pro-labour and pro-
business’ and mixes demand- and supply-side measures to boost living standards while
reinforcing the resilience of growth, rather than merely restructuring fiscal balances or
improving market efficiencies. (The latter approach usually has a dampening effect on
living standards in the short term.) The WEF index and underlying policy framework are
intended to guide governments in broad-based, development-oriented policy analyses and
practices.
25 World Economic Forum (WEF) 2018: The Inclusive Development Index 2018. Available at: http://reports.weforum.org/
the-inclusive-development-index-2018. The WEF policy framework that underpins this index is set out in WEF 2017:
The Inclusive Growth and Development Report. Available at: https://www.weforum.org/reports/the-inclusive-growth-
and-development-report-2017
26 One can also compare the IDI index or ranking with that of the Human Development Index (HDI), discussed in
chapter 1, section 1.4. Countries like Zambia, Tanzania and India have HDI values significantly weaker than that of
South Africa, but their IDI values are better than that of South Africa. (These three countries also rank significantly
lower than South Africa in terms of per capita GDP.)

12.5 Policy design in practice – the National Development Plan
The National Development Plan (NDP) of 2012 is intended to be the main policy framework
for government’s economic and social policies until 2030.27 What is its approach to
inflation, unemployment and low growth, as well as to the other macroeconomic policy
objectives noted in chapter 1? Recall that these are:
1. Economic growth and increasing employment (i.e. low unemployment)
2. Stability of output and employment levels
3. Stable and low inflation
4. The balance of payments
5. Distributional and equity objectives and the reduction of inequality
6. Economic development and poverty reduction.
12.5.1 Overarching objectives and strategies

The NDP has three overarching objectives, which also suggest the main indicators of
success. By 2030 it wishes to:
❐ Reduce unemployment to 6% (in terms of the official definition);
❐ Eliminate income poverty by reducing the poverty headcount from 39% to zero (with
the poverty line defined as monthly income of R419 [in 2009 prices] per person); and
❐ Reduce inequality by reducing the Gini coefficient from 0.69 to 0.6.
The plan notes that failure to achieve these targets could lead to social and political unrest
and instability, as well as room for dangerous populist politics.
Accordingly to the NDP, the key instruments in reaching these objectives are: faster
economic growth, improving the quality of education, skills development and innovation,
and building the capability of the state to play a developmental, transformative role (NDP
p. 27). In supporting roles are: attaining an inclusive rural economy, improving health
care for all, transforming human settlements, improved housing and basic services,
better access to public transport, better social protection, safer communities, a ‘capable
developmental state’ and so forth. These various aspects are conceived as being intricately
linked in a multidimensional, virtuous ‘cycle of development’.
12.5.2 Macroeconomic approach

The NDP appears to have a relatively narrow conception of macroeconomic policy, i.e.
limited to dealing with the stability-related objectives 2, 3 and 4:
The principal task of macroeconomic policy is to provide a stable and enabling platform upon
which firms and individuals invest, work and consume. A crucial role for macroeconomic
policy is to minimise the cost of shocks to the economy, especially in its impact on workers
and the poor. It does this by ensuring relative stability in prices, and in critical variables, such
as interest rates and the exchange rate.
NDP p. 137
Nevertheless, the NDP strongly links good macroeconomic policy to the successful pursuit of
its broad objectives, which do include the longer-term economic growth and employment,
inequality, development and poverty reduction objectives. What the NDP says, is that
macroeconomic policy must provide a stable and enabling platform for growth and development.
27 National Development Plan. Prepared by the National Planning Commission. The Presidency, Pretoria, 2012. The
precursor of the NDP, the National Growth Path (NGP) of 2010, has lost its prominence and has effectively been
subsumed into NDP-derived policy planning in government.

In this regard, the NDP argues
for effective countercyclical Specific economic targets of the NDP
fiscal policy and continued fiscal Unemployment (official definition) to decrease:
discipline, as well as monetary 14% (2020), 6% (2030)
policy that keeps a careful balance Employment to increase from 13 million in 2010 to
between curbing inflation and 24 million in 2030
keeping growth alive. A stable Labour force participation to increase from 54%
currency, stable interest rates and to 65%
low and stable inflation are seen GDP to increase 2.7 times at an average growth
rate of 5.4% per annum
as key elements of a supportive
Per capita GPD to increase from R50 000 to
macroeconomic framework. The
R110 000
balance of payments is hardly Proportion of income earned by the bottom 40%
mentioned, but the prevention of of the population to increase from 6% to 10%
an overvalued currency, which Raising exports so as to grow at 6% per annum
could hurt exports, is highlighted. (10% for non-traditional exports)
Inflation is also seen as important Saving rate to increase from 15% to 25%
to reduce the cost of business Investment/GDP ratio to increase from 17% to 30%
and the cost of living for the poor Public sector investment/GDP ratio to increase to
(especially the prices of basic 10% from 7.3% in 2013
commodities and administered Public employment programmes to employ
prices). However, there are no 1 million people by 2015 and 2 million by 2030.
specific measures to address in
flation – perhaps also because the NDP was written in a low-inflation era.
The NDP does not say much about output and employment stability as such, but does so
by implication when arguing for countercyclical fiscal policy. Monetary policy is to keep an
eye on growth, yes. But – and this is important – the NDP does not see the pursuit of a high
level of employment as primarily a macroeconomic objective. Job creation is to be pursued as
part of a longer-term economic growth strategy, mostly determined by supply-side factors
(see the next section). In this respect the NDP is in line with the broad approach of growth
theory in chapter 8.
By not directly tasking standard monetary and fiscal policy with the longer-term growth of
output and employment, it avoids stretching these policies beyond their legitimate terrain
and limits (and thereby avoids populist policies which could lead to fiscal unsustainability).
12.5.3 Promoting job creation

The focus of the chapter on the economy and employment is the promotion of economic
growth via policies to support mining and manufacturing, export industries, small business,
service industries, and so forth – thereby also diversifying the economy. Service industries
and small businesses (which typically are quite labour intensive) with strong linkages to a
growing export sector are seen as one of the key drivers of job creation. Rising exports is seen
as the main driver of GDP growth, but not of direct employment, since most export industries
are relatively capital intensive. (Interestingly, and contrary to the New Growth Path, the NDP
also does not see infrastructure projects as a way to generate employment directly.)
The proposed strategies include investment in productive capacity, infrastructure, human
capital development (education and skills), technology, etc. and addressing supply-side
constraints such as rail infrastructure, energy and water infrastructure, urban planning
and counter-productive labour-market regulations. Other strategies include: improving
12.5 Policy design in practice – the National Development Plan 559

telecommunications, banking and other business services, as well as ways to lower the
cost of doing business and reduce barriers to entry and growth – especially for small
businesses. Public procurement also is an essential element of the employment strategy.
The NDP also proposes measures to reduce youth unemployment in particular. In addition,
it recommends the simplification of dismissal procedures and strengthening of dispute
resolution mechanisms to reduce labour-market tensions and violence.
Table 12.8 shows the NDP’s employment projections. Note that Agriculture, Mining,
Manufacturing and Construction are projected to have a declining share of total
employment from 2010 to 2030, continuing their relatively low direct employment
contribution. These are not the sectors where the real employment growth will occur.
Increasing its share in total employment will be the dominant service sector. The service
sector is projected to grow from close to 4 million (a 30.1% share) employees in 2010 to
almost 9.2 million (a 38.5% share) in 2030.
A total of 10.6 million new jobs are to be created by 2030. Of these, the service sector is
to create 5.2 million new jobs and the informal sector (plus domestic work) 2.1 million
new jobs. (The latter sector’s share of total employment is projected to remain more or less
unchanged at 21–22%.)
Table 12.8 The NDP’s employment projections
Numbers in thousands and rounded Share Empl New Empl Share

of empl in 2010 jobs in 2010 of empl
2010 ’(000s) ’(000s) 2030
Sectors % %
Agriculture 4.8 625 180 805 3.4
Mining 2.3 300 140 440 1.8
Manufacturing 11.9 1 550 740 2 290 9.6
Construction & utilities 6.3 830 575 1 405 5.9
Services (finance, transport, retail, personal) 30.1 3 955 5 200 9 155 38.5
Informal sector & domestic work** 22.3 2 920 2 090 5 010 21.1
Public sector, private social services & parastatals 19.3 2 530 1 695 4 225 17.8
EPWP 3.2 420 10* 430 1.8
TOTAL employment 100 13 130 10 630 23 760 100
Unemployment rate 25% 6%
Assumptions:
GDP growth rate (average over the period) 5.4%
Employment coefficient overall 0.56
Employment coefficient formal sector 0.61
* EPWP to contribute to a peak of 2m jobs in 2010, but phase out as other sectors grow jobs.
** Domestic workers constitute approximately 30% of this category.
The assumed employment coefficients are higher than the actual average for 2000 to 2010. If the higher values do not materialise, the
unemployment rate will be much higher than 6% by 2030.
As an interim measure, to get unemployed people working until faster growth can
absorb more labour, the NDP wants to broaden the expanded public works programme to
eventually provide the full-time equivalent of two million jobs by 2020; however, it should
decline thereafter as the other sectors start growing and absorbing more labour.

12.5.4 Structural unemployment and inclusive growth
The NDP acknowledges that structural unemployment is a problem that requires specific
remedies to promote economic inclusion and the protection of the vulnerable. However,
tellingly this recognition of structural unemployment does not appear in the chapter on
‘economy and employment’ (chapter 3), but in the chapter on social protection (social
grants, etc.). Thus structural unemployment is seen as part of the broader, ‘non-economic’
chapters of the Plan that deal with spatial patterns, education, health, social protection,
crime, public services, corruption and the need for social cohesion.
❐ While these social dimensions indeed are part of the context in which structural
unemployment and poverty persist, a more direct link to economic strategies is a
pertinent omission.
The NDP’s chapter on ‘Economy and employment’ (chapter 3) is strictly formal-sector
focused. It does not mention the informal sector or propose any measures to promote
employment there – despite projecting employment growth of 2.1 million up to 2030 in
the informal sector (plus domestic work), which is more than that of Agriculture, Mining,
Manufacturing and Construction combined (approximately 1.6 million net jobs). There is
a section in the chapter on the promotion of small business, but the unique problems and
constraints faced by informal enterprises are not alluded to at all. The chapter also does
not mention discouraged workers (or the expanded definition of unemployment).
❐ In this sense the NDP has a narrow approach to employment creation.
Likewise, in its economic proposals the NDP does not address the deeply rooted causes of
economic marginalisation (formerly also called the problem of the ‘second economy’). In
the whole NDP, marginalisation is mentioned merely in passing, mainly in the contexts
of the former homelands and rural areas (or employment equity and the position of
women).
Although it frequently mentions an inclusive economy (or society) and more inclusive
growth, the NDP does not analyse or define these directly. Indirectly it may do so when it
refers to aspects like broadening ownership of assets, broadening opportunities (also for
black-owned firms and smaller businesses), a more labour-absorbing economy, sharing
the fruits of growth equitably, and so forth. However, there is no real engagement with the
concept of inclusive growth, as defined in the literature (see section 12.4).
❐ Not having been defined clearly, the concept of inclusive growth is used rather loosely,
and indiscriminately, to justify favoured policy steps. This is not good for policy
consistency and effectiveness. In addition, this opens the door for interest groups and
parties with vested interests to use the concept opportunistically to further their own
interests at the expense of those the NDP is intended to serve.
❐ Without a proper understanding of inclusive growth permeating all policy planning and
eventual implementation, there is a substantial risk of unfocused and/or inconsistent
policy design and implementation.
12.5.5 Fiscal considerations: financing the NDP’s strategies

Several fiscal questions arise. First, there are questions relating to affordability in the long
run:
❐ To what extent does the financial viability of the NDP initiatives depend on the projected
average growth rate of 5.4% being realised to generate the revenue needed to finance
them?
12.5 Policy design in practice – The National Development Plan 561

❐ Conversely, to what extent is the 5.4% growth rate itself the result of these projects (i.e.
the growth rate only materialises if and when the infrastructure and other growth-
enabling project have been implemented and operational)?
Most of the proposals relating to infrastructure, education, health, and high-density
urbanisation are essential to reach the aims of the NDP. But the plan does not consider
affordability and does not indicate any prioritisation in the case of insufficient budgetary
room for all of them. Therefore, secondly, there are questions regarding the budgetary
and, hence, fiscal impact of the policy:
❐ If rolled out over the next 10–15 years, what will be the NDP’s impact on budgetary
expenditure, revenue, deficits and debt?
❐ The plan proposes several large capital expenditure projects. Will these be financed
through debt or taxes, or by reducing the growth of current government expenditure?
(See the box on the NDP and the national accounting constraint.)
Thirdly, there appear to be some inconsistencies. In 2012 the government also announced
the National Infrastructure Plan. It contained plans for R827 billion in the first three years
of the project. The National Infrastructure Plan (and the National Growth Path) both see
infrastructure investment as a direct way of creating employment opportunities. However,
the NDP does not see infrastructure construction as a potential job creator; only as a way
to lift growth constraints. Indeed, most of the infrastructure priorities listed in the NDP –
for example, transport (such as the rail corridor for coal, roads, and ports), electricity, gas,
liquid fuels, water, and ICT (broadband) – are heavy and large-scale engineering projects
that are not likely to be labour intensive.
From a fiscal point the question still remains: how will these be financed and what is the
scope for government to finance them either through taxation or debt? Once again, what
comes first: infrastructure (financed from which revenue?) or growth (can it occur without
the new infrastructure?)? In other words, does public infrastructure lead or follow higher
economic growth?28
The NDP and the national accounting constraint

There is a potential problem regarding the financing of large government and parastatal capital
expenditure projects.
This flows from the national accounting identities, discussed in chapter 5. The NDP wants to increase
public sector investment (i.e. investment by general government plus parastatals) from 7.5% to 10% of
GDP. (Note, though, that by 2019 public sector investment had in fact decreased to 5.7%.) If we combine
parastatal investment (IPC) with general government investment (IG) to get public sector investment
(IPS = IG + IPC), the national accounting identity can be rewritten as:
IPS  (S – IP ) + (T – GC ) – (X + TR – M)
which is derived from equation 5.6b in section 5.4.3. (Also see the box on government investment in
section 5.1; recall that IT = IP + IG + IPC.)22
For 2018 the actual values (as percentages of GDP) corresponding to the identity above are:
5.66  + 2.13 – 0.02 + 3.55
⇒
28 For simplicity, inventory investment is left out of this exposition, it does not affect the analysis.

⇒
The equation shows that the 5.66% of public sector investment in GDP for 2018 was reflected in a
saving gap (gross saving minus private corporate investment) of 2.13%, government dissaving of 0.02%,
and a current account deficit of 3.55%.
Increasing public sector investment to 10% on the left-hand side means that an additional 4.34% also
needs to be found in the right-hand side of the equation. Thus, increased public sector investment has
to be matched by one or more of the following, cumulatively amounting to 4.34% of GDP:
❐ An increase in the saving gap. If IP should not decrease, then S (household and corporate saving)
needs to increase.
❐ A reduction in government dissaving (the current government deficit, which normally is a negative
number). Thus, tax revenue, T, needs to increase and/or government current expenditure, GC, needs
to decrease.
❐ An increase in foreign capital inflows and therefore a larger financial account surplus – which implies
having a larger current account deficit (compare section 5.5 in chapter 5 to see how a surplus on the
financial account is linked to a deficit on the current account).
Increasing S will require a significantly improved saving culture – household saving in South Africa is very low
(less than 2% of GDP). Corporate saving is done by companies through retained earnings, to be used for
their own investment. Thus, corporate saving is unlikely to be a source for higher government investment.
The share of tax revenue in GDP in South Africa is already high compared to most emerging market
countries, while the South African current account on the balance of payments regularly registers very
high deficits in excess of 4% of GDP.
This leaves a reduction in government’s current expenditure as a (or the only) possible option. In this
regard, analysts point to government’s wage bill as the component most in need of a cut – from 2008 to
2018 the general government's salary bill increased from 11% to 14% of GDP, which is higher than in
most emerging economies.
Recall from chapter 5 that the national accounting identities show inescapable constraints for
macroeconomic variables – the envelope within which variables will always remain. Thus, it appears that
it could be quite problematic for South Africa to find the space to increase government investment (IPS)
by 3.34% of GDP, as proposed in the NDP.
This creates the following dilemma. If the national accounting constraint prevents higher government
investment, and if that investment is a prerequisite to enable the 5.4% economic growth rate that the
NDP foresees, then that economic growth target will not be realised. Furthermore, if the 5.4% economic
growth rate is a prerequisite to generate the number of jobs foreseen by the NDP, the unemployment
target will likely not be attained either.
Therefore, improving household and government saving together with maintaining foreign confidence in
the country to ensure continued foreign capital inflows, will be key to the success of the NDP.
12.5.6 Will the NDP work? Can the NDP work?

Whether the NDP will and can succeed depends on several factors. These include:
❐ the ability of the economy to generate the targeted 5.4% growth;
❐ the type of employment growth that is targeted (e.g. the feasibility of pursuing an
export-oriented policy, with labour-intensive service sectors benefiting from links to the
export sectors);
❐ how the relationship between business and labour unfolds;
❐ the extent to which economically marginalised people are empowered and the informal
sector expands (especially if no focused policy support is provided);
12.5 Policy design in practice – the National Development Plan 563

❐ the success in overcoming the spatial dimensions of unemployment (people living far
from places of work and business); and
❐ the capacity of the education system to generate the skills required.
Lastly, the NDP is likely to have a budgetary impact that has not been fully considered in
the plan.
Nevertheless, it is one of the most comprehensive and well-considered social and economic
development plans that South Africa has ever seen. Though incomplete, sometimes narrow,
sometimes inconsistent and with many faults – and contested by interested parties across
the political and ideological spectrum – it at least attempts to integrate economic objectives
and policies with larger social and human development considerations and goals. That in
itself is a huge step forward.
A final factor is the commitment of government to the Plan and the capacity of the various
government departments to implement the necessary strategies and policy measures. In
the era of President Zuma the NDP faded from prominence, with other issues and concerns
occupying the minds of government leaders. With the election of President Ramaphosa,
who was the deputy chairperson of the National Planning Commission (which put together
the NDP), the chances for renewed commitment and energy towards the implementation
of the NDP appear to have improved significantly. Indeed, in his 2019 State of the Nation
Address he recommitted the government to implementing the NDP.
However, the considerable deterioration of South Africa’s fiscal and public debt position
after 2008 – inter alia due to huge new government spending commitments and the
financial (and operational) erosion of state-owned enterprises such as Eskom – has created
significant constraints on the successful pursuit of NDP objectives. At the same time,
factionalism in the ANC could undermine the commitment, or ability, of the government
to implement the NDP effectively.
12.6 A final thought – the structural dimension of macroeconomic

problems
The discussion of inflation, unemployment and low growth, three of the main
macroeconomic problems of this era, also in South Africa, shows that they are not simple
problems, to be easily understood and ‘solved’. They are extremely complex phenomena.
Even the simple Monetarist/New Classical and somewhat more elaborate Keynesian
explanations suggest this. But the complexity extends far beyond that acknowledged by
conventional analysis. It is intimately related to the total social, historical and institutional
context in which economic activities and decisions occur. This is revealed, in particular,
by structuralist insights into unemployment as well as inflation, and of course economic
growth.
The point is that one must realise that conventional macroeconomic theory alone is
not sufficient to fathom the full complexity of the problems of inflation, unemployment
and low economic growth. Macroeconomic theory is extremely useful as a means to
understanding what happens, on a macroeconomic level, in a country such as South
Africa. Yet it is not the whole story. Much more complex structural and institutional forces
are at work – including the role of the interaction between political and economic power.
Many of these forces are not fully understood, and in any case are not incorporated into
standard theories. No single theory, conventional or unconventional, seems to encompass
all these complexities.

This means that simplistic, self-assured recipes for the ‘solution’ of the problems of
unemployment, inflation and low economic growth are clearly improper, based on
ignorance, and nothing but arrogant. Actually, economists and other social scientists
have only limited insights into the true functioning of an economy, and of society as a
whole. This is a reflection of the limitations of science (the natural sciences included).
Despite all the wonderful scientific advances and modern techniques of analysis with the
aid of the computer, to a significant extent the world is still a mystery to the human mind.
One should proceed humbly and unpretentiously with the macroeconomic knowledge
encountered in this and other books – as with any knowledge.
In economics, one is always treading on thin ice. It is wise to know how thin the ice is and
to tread and talk accordingly.

1. South African GDP growth between the first quarter of 2019 and the fourth quarter
of 2018 was –3.2%, leading to alarming assertions of a recession by the media and
political commentators. How would you interpret this economic data, or interrogate
the information?
2. ‘There’s a nugget of good news in the latest unemployment figures. We should be
alarmed at our continually rising unemployment rate. But we should also carefully
look at the statistics and understand what is going on. While the unemployment
rate increased from 27.6% to 29% between the first and second quarters this year,
total employment in the economy has not fallen. Instead, employment increased by
21 000! It is important to recognise that the increase in unemployment was not the
result of net job losses, which is what a lot of the commentary to date has assumed.
The rise in the unemployment rate has been caused by more people wanting to work.
Moreover, 248 000 of these 476 000 people had previously been discouraged work
seekers – those who had given up looking for a job …’ (Daily Maverick, 1 August 2019).
Explain this statement with reference to the way the rate of employment is calculated,
including the relevant formulae.
3. ‘In the second quarter of 2019, 49 000 jobs were lost in the formal sector (especially
mining, transport and finance) and 49 000 in private households. These numbers
raise the question whether the introduction of the national minimum wage in January
2019 is encouraging discouraged workers to come back in to labour force, while at the
same time households and other sectors may have reduced employment in response to
the minimum wage.’ Discuss critically.
4. ‘In the second quarter of 2019, amidst job losses elsewhere, employment in the
informal sector increased by 114 000. Across the developing world, with the
exception of South Africa, the informal sector provides employment opportunities for
a large proportion of workers. In South Africa, a much lower proportion of workers
is employed in the informal sector.’ Critically discuss the actual and potential role of
informal enterprises in job creation, but also the extent to which the informal sector
may be acting as a buffer that absorbs some of the people who lose their jobs in the
formal sector during a downswing in the economy. 29
29 Further reading: Burger P and Fourie FCvN (2018) The informal sector, economic growth and the business cycle in
South Africa: Integrating the sector into macroeconomic analysis, in Fourie FCvN (ed): The South African informal
sector: Creating jobs, reducing poverty, HSRC Press, Cape Town. Download from: https://www.hsrcpress.ac.za/books/
the-south-african-informal-sector-providing-jobs-reducing-poverty
12.7 A final thought – the structural dimension of macroeconomic problems 565

5. ‘After 1994, South Africa decided to pursue a high-skills, high-wage development path
in the economy. This appeared to be in line with a worldwide trend. However, given
the deficient basic education system, workers (and especially the youth) currently
do not have the necessary skills for such an economy. As a result, they cannot get
employment.’ Discuss, also with reference to the option of a labour-intensive approach
with lower skills and non-high wages in industries such as clothing.
6. What is the Reserve Bank’s view of the potency and the appropriateness of using interest
rate policy to address high unemployment, given the nature of the unemployment
problem in South Africa? Discuss and explain. (Consult their website if you need more
information.)
7. ‘To address the persistent unemployment problem in South Africa we need
economic growth, growth, growth.’ Discuss critically, with reference to the causes of
unemployment.
8. ‘If South Africa wants to create work and prosperity in future, it must invest in
people (education) and fixed capital (machinery, equipment and buildings used in the
production of goods and services).’ Discuss critically, with reference to the causes of
unemployment.
9. ‘The core of the challenge of tackling poverty, inequality, low growth and unemployment
in South Africa is that it has become a patronage state, where parallel to a normal
bureaucracy there is a system of patronage networks that succeed in distributing,
or milking, public resources for private benefit, rather than using it properly for the
high-quality delivery of public benefits (public health, education, infrastructure, etc.)
to citizens.’ Discuss critically how/whether patronage-based governance and policy
implementation can negatively impact the key drivers of growth and employment.30
10. The sudden announcement of free higher education by president Zuma in December
2017 implied a large increase in higher education spending, thus putting the national
budget under severe pressure. In the March 2018 budget, the Minister of Finance
announced the following:
a. All first-year students with a family income of below R350 000 per year will be
funded for the full cost of study. This will be rolled out in future years until all
years of study are covered.
b. The reallocation of resources towards higher education will amount to an
additional R57 billion to fund the phasing in of fee-free tertiary education. This is
in addition to the R10 billion provisionally allocated in the 2017 budget.
c. To find R57 billion to fund free tertiary education, government has committed to
raising VAT (from 14% to 15%) and also hold back on some of its capital projects
and reduce spending on goods and services.
Analyse and discuss the different considerations, pros and cons, as well as trade-offs,
in considering such a decision about free higher education especially in the context of
pursuing employment and development goals but an underperforming economy and
the already existing threat of fiscal unsustainability.
11. In 2019 Eskom was unable to avoid load shedding and provide affordable electricity.
It also ran up huge losses such that government had to bail it out using government
funds. This forced the government to borrow more money to finance this addition to
the (already large) budget deficit, thus racking up public debt. The combined effect of
these steps puts a huge question mark over economic growth prospects. According
to the World Bank, Eskom could be 66% overstaffed compared to similar institutions
30 Further reading: Burger P (2018) Getting it right: A new economy for South Africa. KMMR Press, chapter 2.

internationally (its staff complement has grown by 50% since 2003, while its power
output remains largely unchanged). Thus, it is argued, the reduction of Eskom’s total
wage costs has become imperative for it to survive as a business and for South Africa to
avoid an unsustainable level of public debt – and thus avoid credit-rating downgrades
or having to request intervention by the IMF.
On the other side of the debate, the National Union of Mineworkers (NUM) and labour
union Cosatu vehemently oppose any reductions in wages or retrenchments of staff
or organisational restructuring to reduce costs in Eskom or any SOE – or the public
sector in general: ‘We shall mobilise to shut down government indefinitely and render
the system ungovernable.’ (Business Day, 2 August 2019).
What would you, as a trained economist, advise given this clash of perspectives?
Critically analyse aspects such as the elasticity of consumer demand, supply-side
constraints on growth, the fiscal deficit and public debt situation, the public sector
wage bill, Eskom’s options, and labour union perspectives.
12. In August 2019, amidst the Eskom bail-out crisis, there was growing alarm South
Africa’s public debt burden is spiraling out of control, threatening to collapse the
entire economy. There were suggestions South Africa may soon need ‘assistance’ from
the International Monetary Fund (IMF) – a ‘bail-out’ loan – for the first time ever. ‘The
choice is stark yet simple. Either we prescribe our own medicine, or someone else will
prescribe it for us. And it will be bitter, bitter medicine.’ (Sipho Pityana, President of
Business Unity South Africa, August 2019.)
Once a country falls into a crisis and requests IMF help, such IMF loans come with
conditions attached, detailing policy changes that the borrowing government promises
to make to resolve the crisis. The basic condition is for government to spend less. This
belt-tightening is not easy – people lose jobs and/or have wage cuts (especially in the
public sector), state entities are privatised, prices rise, etc. (compare the case study
of Greece and the Euro zone in chapter 4). And, the loan must be repaid! It is a very
unpleasant experience, but after several years the country is supposed to emerge with
a stronger, healthier economy.
Consult internet sources (including factsheets at https://www.imf.org/en/about), to
answer the following questions:
a. What is the role of the IMF in assisting countries that are in trouble?
b. What kind of ‘assistance’ could it provide for South Africa in the situation
described above?
c. What is IMF ‘conditionality’ in the case of an IMF loan?
d. What are the typical effects of the implementation of IMF on the borrowing
country? Analyse the likely impact on South Africa with the aid of suitable
diagrams.
13. In 2018–19, US President Trump initiated a ‘trade war’ with China, instituting several
rounds of tariffs on Chinese goods imported into the USA (accusing the Chinese
government of stealing intellectual property and flooding the US with cheap Chinese
goods, as reflected in a large US trade deficit with regard to China). China responded in
kind with tariffs on e.g. American electronic goods (cell phones, etc.). This resulted in
a dip in the growth forecasts for China. Analyse and explain what would be the likely
effect on the South African economy in terms of growth and employment.
14. In the first half of 2019, foreign investors withdrew about R70 billion from South
African bond and equity markets. What does this imply for the pursuit of economic
growth and development? Explain.
12.7 A final thought – the structural dimension of macroeconomic problems 567

Index
A Monetarist view of 471

Ability to pay (tax) 418 shifts 247
Absorption: see Labour absorption slope 246
Accommodation together with AS 272-93
in money market 86, 92, 97, 173, 197, 374 and inflation 484, 487-98
of inflationary expectations 490, 495-96 Aggregate supply (AS) 239, 242, 249-71
of popular demands 490 adjustment process 270-71, 485-95, 511-13, 542
of supply-side shocks 288, 493-95 derivation 251-72
Accrual basis 398, 454, 459 determinants 249
AD-AS model 239-304 inflation-augmented 306-08, 485, 487
equilibrium in 272-73 long run (ASLR) 257-66
equilibrium, mathematics of 273 long run and short run 249, 272-93, 314-17,
essentials 241-43 487-90, 511-15, 525
and AD-PC model 306-08 mathematics of 257, 264, 269, 273
and economic growth 241, 249, 251, 259, 262, Monetarist view of 472
266, 275, 289-90, 294 New Classical view 473-74
and inflation 239-42, 276, 294, 305-08, 485, 487 shocks 283-88, 293, 311, 329, 489, 497, 513
see also Aggregate demand; Aggregate supply short run (ASLR) 266-71, 316
Administration lag: see Policy lags together with AD 272-92, 485
AD’-PC model 306-14 and growth 251, 289-90, 329-32, 536-39, 542
basic operation 306-08 and inflation 487-98
examples 308-11 and labour market 251-56
mathematics 319 and Phillips (PC) curve 306-11, 316-17
and augmented Phillips-curve 312 and price-setting relationship 251, 254-56
and demand expansion 308-11 and taxation 400
and monetary reaction function 320-26 and wage-setting relationship 252-56
and Phillips curve 314-21 and (un)employment 257-62, 267-71, 511-19,
and policy lessons 312-14, 317-20 518, 521
and steady-state inflation 306 Agriculture 510, 520-23, 525, 527, 532, 538, 540,
and supply shocks 311 547, 550, 560-61
Affirmative action 409, 524-27 Aids: see HIV/Aids
Africa ANC (African National Congress) 39-41
ethnicity, and growth 549 Anti-cyclical policy: see Stabilisation policy
geography, and growth 550 Anti-inflationary policy: see Inflation, policy
growth rates 530-33, 537, 541, 548-50 Apartheid
unemployment in 477 and capitalism 38-41
Aggregate demand (AD) 237-38, 243-48 and unemployment measurement 511
derivation in IS-LM model 245 Appreciation (currency) 146, 148, 150, 166, 166-168,
inflation-augmented 306-08 174, 177, 189, 193, 195-96, 201, 203, 279,
in Phillips-curve model 306-14 281,390
mathematics 246, 273 ASGISA 24, 534
568 Index

Augmented Phillips curve 312-13, 317 Budget deficit, conventional
Austerity 205, 208-10 effect of financing on real sector 106-09, 182, 401,
Automatic stabilisers 70, 420 425-26
Average tax rates: see Tax rates financing methods 106-09, 387-89, 425-26, 440
in budget identity 407, 430
B in national accounting identities 220-21, 223-25,
Balanced budget 421, 441, 449, 464 230
rule 441, 464 measurement 221-25, 421-22, 459
Balance of payments (BoP) 156-62 relevance as fiscal norm 438-40
adjustment process 159-62, 171-81, 193-204, Reserve Bank role 426, 435
278-87, 302-04 rules for 439-40, 450
as a policy objective 12, 23, 32, 384, 497 SA data 422-25, 438, 459
constraint 21, 162, 172, 175, 177, 197-99, 497, and accommodating monetary policy 462
522 and anti-cyclical policy 421
definition, data and measurement 140, 156-57 and balance of payments 109, 152, 155, 182, 427
determinants 158, 170 and business cycle 421, 424-25
equilibrium/disequilibrium 159, 162, 171-72, and crowding out of exports 182
176-77, 196-97, 278-87, 303-04 and economic growth 425
pros and cons of a deficit/surplus 21, 183 and financial account 152, 182
SA data 141, 156-57 and foreign borrowing 155, 426
and exchange rates 162, 166, 170 and inflation 426, 441, 449
and foreign reserves 159, 183 and the ‘printing press’ 108
and inflation 497, 500 and public debt management 436
and money supply 161-62, 170 see also Fiscal rules; Government borrowing; Public
see also Capital account; Capital flows; Current debt
account Budget deficit, current 221, 407, 421, 437, 442-45
Bankers’ acceptances (BAs) 79-80, 94 relevance as fiscal norm 442-45, 449
Bank rate 87, 128, 378 SA data on 230, 438
see also Repo rate and BoP current account 444-45
BA rate 79-80, 94 see also Dissaving; Sectoral balance identities
Bantustans: see Homelands Budget deficit, cyclically adjusted; see Budget deficit,
Barro, Robert 473 structural
BBBEE 526, 527 Budget deficit, operational 441
Bonds 79, 82, 88-90, 95, 106, 108, 426, 435-36, 441, Budget deficit, primary 321, 438, 445-46
448 relevance as fiscal norm 446-47
Borrowing, foreign: see Foreign borrowing SA data on 438, 450
Borrowing, government: see Government borrowing and sustainability 447-50
Borrowing requirement: see Government borrowing Budget deficit, structural 421, 425
Bottlenecks (in aggregate supply) 146, 268, 490, 498 Budget identity 407-8, 430
BP curve 191-97 Budget Review 398, 412-13, 422, 454, 457
derivation 191 BUSA (Business Unity South Africa) 402
shifts 193 Business cycles 144
slope 192-93 importance of understanding 10
USA case 192-93 taxation and 419-21
see also IS-LM-BP model SA data 45
Bracket creep 21, 420, 430, 451 and budget deficit 421, 424-25
as fiscal drag 420 and current account 183-84, 186
Bretton Woods agreement 169 and fiscal policy 419-20
Brexit 11, 212 and macroeconomic policy 11
Budget and poverty 510
data: see Budget Review and unemployment 186-87
process 420, 428-31 see also Stabilisation; Stability
role of Reserve Bank 398, 402, 429 Business sector view: see Policy objectives
Budget balances: see Budget deficits (various)
Budget cycle: see Budget, process
Index 569

C Chain reactions 1-2, 43, 48, 73
Cabinet, role of 67, 398, 401-02, 429-30 closed economy: 1 sector 48-50, 62-63
Capital account: see Financial account closed economy: 2 sector 78, 94, 98-104, 109-10,
Capital expenditure: see Capital formation 123-26,
Capital flows 140, 152-56, 192 open economy: 3 sector 139, 158, 172-81, 197-203
basic determinants 153-54 with a variable price level 239, 242-43, 274,
impact on economy 155-56, 162, 175, 186 276-77, 278-88
in AD-AS chain reactions 278-88 Change in reserves
in balance of payments table 157 in gold and other foreign reserves 225
in national accounting identities 225-27 in gross gold and other foreign reserves 160
in open economy chain reactions 172, 176-80, in reserves 228n, 230, 231
197-203, 278-303 in liabilities related to reserves 225, 228n, 230
SA data 157, 226 Circular flow: see Income-expenditure flow
and BP curve 191 Class 35, 38
and budget deficit 152, 427 Classical liberalism: see Liberalism
and macroeconomic policy 389, 426 Classical School/model 11, 59, 90-91, 220, 288, 334,
see also Capital mobility; Financial account; Net 356-61, 366, 374, 383, 389, 35-40, 49,
capital inflow from the rest of the world 100,129-31, 399, 444, 467-73, 475
Capital formation 50, 56-61 Climate change 551-52
determinants 58-60 Cold turkey, approach to policy 325
financial vs. real 56, 78-80, 152 Colonial times/post-colonial 1, 11, 38, 549, 550, 552
fixed vs. inventory 57 Commercial rand: see Financial Rand
foreign: see Foreign investment Communism 38-41
government: see Government investment Competition, atomistic or ‘perfect’ 468
gross domestic 222, 225-27, 228-32 Concentration (of economic power) 499-500, 540
gross vs. net 57 Constant prices, measurement in 44, 241
in Classical model 468-70 see also Real values
in 45° model 60 Constraints on policy 18, 21, 29-30, 168, 391-92,
in national accounting identities 213, 215-16, 218, 402-10, 434, 444-45
228-32 Consumer price index (CPI) 241, 245, 482-83
interest sensitivity of 102, 104-5, 115, 248 Consumption 52-56
investment function 58 function 52-53
opportunity cost of 58 in Monetarist view 471
SA data 51, 57, 217, 220-22, 226, 229-31 in national accounting identities 216, 219, 227,
savings balance/gap 220n, 219-25, 417, 443-45 229
and crowding in 104-5 Keynesian approach 54
and financial account 152 life-cycle approach 55
and political factors 153-55, 217 permanent income approach 54
and real vs. nominal interest rates 59 SA data 51
see also Crowding out smoothing 55
Capital intensity 522 and interest rates 374-75, 399
Capitalism, and apartheid 38 and taxation 68
Capital market 77, 375-76, 407 Cosatu 24-25, 40-41, 326, 402, 424, 501, 567
see also Money market see also Labour unions
Capital mobility 154-55, 176, 182, 184, 186, 192-94, Cost-plus prices 500
198, 200-01 see also Mark-up
Cash flow basis 398, 454, 459 Cost-push: see Inflation
Cash reserve requirement 85-86, 101, 374 CPI: see Consumer price index
and size of credit multiplier 85-86 CPIX 381
see also Monetary policy Credit: see Money supply
Causality 213, 217-19, 222, 225, 232, 469, 486, 495 Credit multiplier process 85
Cause and effect: see Causality Crowding in 104, 415
Ceilings, credit and interest rate 374 Crowding out 28, 103-05, 125, 130-32, 399, 407,
Central Bank: see Reserve Bank 411, 426, 439-40, 461, 478
Central government: see Government of exports 109, 182
570 Index

Current account (balance of payments) 139, 141, SA data, comparative 27
149-50, 156-57, 421, 442 vs. GDP growth 27, 543-44
as a policy consideration 21, 406, 444-45, 497 vs. income growth 26
causes of changes in 150, 167, 182 vs. redistribution 22, 29
consequences of 170 and fiscal policy 398, 408-9, 415, 417-18, 438-40,
in AD-AS model chain reactions 278-82 451-52
in balance of payments table 149, 157 and growth 528, 530, 537, 540, 543-49, 553-57
in J curve 151 and inflation 495
in national accounting identities 219-27, 229-34, and monetary policy 450
406-8, 444-45 and taxation 417-18, 451-52
in open economy chain reactions 172-83, 197- 203 and unemployment 507-13, 515, 522
pros and cons of a deficit/surplus 21, 182-86 see also Growth
SA data 149, 222, 230 Diagrammatical aids, purpose 50
and aggregate expenditure 170 Dichotomy, Classical 470, 472, 484, 487
and BoP constraint 162 Dirty floating: see Exchange rates
and business cycle 150-1 Discount on treasury bills 78
and inflation 19-21, 167, 497 Discouraged workers 17, 502-6
and trade balance, net exports 147-48 Discretion (vs. rules), in policy 378, 440, 463, 478-79
see also Balance of payments see also Fiscal policy constraints; Fiscal rule;
Current budget/fiscal deficit: see Budget deficit, current Monetary reaction function; Monetary rule; Taylor
Current expenditure by government 215, 219-21, 223, rule
231 Disincentives (of taxation): see Tax
see also Government expenditure Disintermediation 377-78
Current prices: see Deflation Disposable income 52, 70, 144, 220, 400
Cyclical forces, built-in 97, 174 Dissaving, government 221, 223, 227, 406-07, 442-
45
D in SNA identities 221-22
DA (Democratic Alliance) 41 SA data 226, 230
Decision lag: see Policy lags see also Budget deficit, current
Debt: see Budget deficit; Public debt Distribution of income: see Redistribution
Debt trap: see Public debt Dollar: see USA
Deficit: see Balance of Payments; Budget deficit; Current Dot-com bubble 134-36
account; Financial account Du Plessis, Barend 32, 404
Deflation 309, 38
of nominal values 241, 290 E
De Kock, Gerhard 32 Economically active population 501-03, 506, 521
Demand, aggregate: see Aggregate demand Economic classification (of government expenditure)
Demand-pull: see Inflation 407-08
Demographic factors 521, 527 Economic growth: see Growth
see also Population growth Economic power: see Concentration
Department of Finance: see Fiscal policy; Treasury Education 6, 23-25, 522
Depreciation (currency) 146, 150, 163, 165, 167, higher 5, 33, 405, 453, 566
168, 196, 274, 346, 390 indicators of 26
causes of 181 in Freedom Charter 29
see also Foreign reserves in NDP 558, 559, 561
Depreciation (of capital goods) provision for 220, 226, and aggregate supply 249, 265
228 and economic growth 266, 331, 356, 359-62, 409,
Depression, Great 18, 36-37, 49, 470 522, 534, 542-47
Devaluation (currency) 146, 163, 169 and government expenditure 405, 411, 434, 443,
Developing country term 1n; 484n 453, 566
Development 25-30 and inclusive development 556, 567
as a policy objective 9, 12, 24-26, 396, 495, 510-11 and SDGs 29, 451
concept and measurement 25-27 and structural unemployment 260, 522, 523-25
indicators 27 see also Development; Indicators, social
inclusive 552-57 Efficiency: see Tax efficiency
Index 571

Elasticities see also Fixed exchange rate effect; Flexible exchange
versus sensitivity 58 rate effect
see also Sensitivity Excise duties 399-400, 419
Electricity crisis: see Eskom Exogenous money supply 93
Employment: see Unemployment Expansionary (vs. contractionary) policy 69, 106-09,
Employment coefficient 16, 509, 560 123-26, 422, 462, 490-93
Employment intensity: see Labour intensity see also Chain reactions
Entitlements 408 Expectations 52, 58, 82, 153, 158, 247, 250-51, 466,
see also Pensions 475, 509
Environment, and growth 550 price, wage and inflation 247, 250-60, 267-72,
Equilibrium, macroeconomic 306-17, 490-497
conditions for 48, 61, 72 rational 473-75
in 45° diagram 50, 61, 72 Expenditure, Government: see Government Expenditure
in AD-AS model 242, 272-74 Expenditure on gross domestic product 71-72, 148,
in AD-AS-BP model 191 214, 219, 237
in AD-PC model 307 Expenditure reduction/switching 188
in IS-LM model 110-12, 117-18, 121, 123-24, 190 Exports 50, 64, 70-72, 103, 146-52, 178-79, 202-03
Keynesian concept of 49, 61 crowding out of 109, 182
and SNA identities 215 determinants 147
see also Multiplier, expenditure impact on economy 148, 178-79, 202-03
Equity objectives: see Redistribution in 45° diagram 72, 147-48
Equity, tax: see Tax equity in AD-AS model 244, 273-74
Eskom 4; 33, 95, 155, 211, 234, 294-98, 327, 405, in IS-LM model 113-14, 127, 189, 202-03
416, 423, 432, 453, 564; 566, 567 in IS-LM-BP model 195
Euro crisis 204-10, 439 net exports 50, 71, 142, 147-48, 150, 152, 157,
and PIGS countries 205-10 217
and Germany 208-10 SA data 71, 141, 149, 157, 216, 217
and Greece 206-08 volumes vs. values 151
Euro zone 204-10 and expenditure multiplier 150
Excess reserves (banks) 86, 374-75 and trade balance, current account 148
Exchange rate 140, 162-70 see also Foreign sector; Imports
as policy objective: see policy External disturbances 178-79
buying and selling rates 164 chain reactions following 178, 194
definition 140, 144, 162 general method to analyse 180-81
determinants 165-67 in AD-AS model 284-87, 303
determination in forex markets 165 in IS-LM-BP model 194-96
dirty floating 168, 389 see also Internal disturbances
effective 163 External sector: see Foreign sector
fixed vs. floating 168-69 External value of the rand 140, 145, 163
impact of balance of payments on 162, 166, 170 see also Exchange rate
in AD-AS model chain reactions 278-83 Extrabudgetary institutions/funds 398, 423-24, 454,
in balance of payments adjustment process 173-86 459
long-term prospects 166-67
nominal 163 F
overvalued, undervalued 390 Factor cost, measurement at 213, 229, 230, 235-38
policy 29, 168-69, 372, 376, 389-92, 480, 483 Finance, Department of: see Treasury
pros and cons of a weak/strong rand 183, 390 Finance, Minister of: see Minister of Finance
real 163 Financial account 109, 140, 152-56, 170, 184
real effective 163 as a policy consideration 21, 31, 186
rigidity and fiscal policy 177 impact on exchange rate 170
rigidity and monetary policy 175, 199-200, 391 impact on monetary sector/money supply 170
SA data 141, 164 in AD-AS chain reactions 273-87
spot vs. forward 165 in IS-LM-BP model 191-93, 197-203
spread 164 in national accounting identities 225-27
and inflation 484, 493, 497 in open economy chain reactions 173-81
572 Index

SA data 153 and development 24, 28-30, 451-52
and capital formation 152 and economic growth 401, 402-03, 424, 542
Financial and Fiscal Commission 395, 402, 430 and inflation 500
Financial crisis 101, 129, 134-38, 182, 204, 290, 292, and policy lags 464-66
326, 373, 392, 432, 448, 507, 515, 540 and political factors 430
and dual mandate of the Reserve Bank 373 and public debt management 399, 431-36
and South African fiscal policy 403, 405, 432 and unemployment 424
Financial institutions: see Monetary policy; Monetary see also Government expenditure; Policy objectives;
sector Taxation
Financial rand 153n Fiscal year 399, 413, 439, 454, 457, 459
Financial Stability Oversight Committee 373 Flexible exchange rate effect 175, 177, 180, 196-97
Financial year: see Fiscal year Forecasting 466-67
Financing of budget deficit: see Deficit; Government Foreign borrowing/debt/loans 20, 152, 155, 182
borrowing and balance of payments position 21, 162
Financing of gross domestic formation 221, 225-27, and budget 155, 182
228-29 and foreign reserves 21
Fine-tuning: see Stabilisation policy see also Capital flows
Finrand: see Financial rand Foreign exchange markets 165
Fiscal authority 395 institutional arrangements 165
see also Fiscal policy; Treasury operation 165
Fiscal balances: see Budget deficits and exchange rates 161, 165
Fiscal deficit: see Budget deficit Foreign investment 21-22, 153
Fiscal discipline 404, 410, 432, 436-50 Foreign loans: see Foreign borrowing
Fiscal drag: see Bracket creep Foreign reserves
Fiscal federalism: see Government, provincial as policy consideration 21-22, 186-87
Fiscal norms 396, 434, 436-50 gross vs. net 160
see also Fiscal discipline impact of balance of payments position on 173-74,
Fiscal policy 67, 395-459 176-78, 198-99, 200-01, 202-03
constraints 406-10 importance of 161, 168
definition 397-99 in national accounting identities 225-27, 229
development of 404-06 SA data on 157, 158-59, 160-61
fixed commitments 408-10 and currency depreciation 168-69
in AD-AS model 240, 247, 273-76, 281-83, 288- Foreign sector 139-204
89, 300 data on 141, 143, 149, 151, 157, 160
in IS-LM model 124, 130-32 location in circular flow 140
in IS-LM-BP model 176-77, 200-01 with variable price level 240
institutions and processes 397-402, 428-31 see also Balance of payments; Exchange rate
instruments 399-401 Forex markets: see Foreign exchange markets
measurement 65, 397-98, 412-13, 416-17, 421- Formal sector 502n, 506, 509
22, 454-59 see also Informal sector; Small business
mission/objectives 402-05 Freedom Charter 2, 39
Monetarist view 399, 404, 414, 439-40, 444, 478- Freedom, individual 478
80 Friedman, Milton 37, 54, 470, 471, 473, 484
open economy chain reaction 176-77, 200-1 Full employment 49, 239, 257, 260-61, 381, 470,
potency of 103-05, 130-32, 177, 248, 478-79 472, 513-14, 515, 519, 525-28
Reserve Bank role 402, 425-26, 434-36 as policy objective 381, 417-20
rules 416-17, 438-41 definition 260-61
SA data 410, 411, 415-416, 418, 423, 425, 431- in Classical model 468-70
33, 438, 443, 446n, 450, 454-59 in Keynesian model 49, 239, 469, 519-20
sustainability of 445-50 in Monetarist(/New Classical) model 470, 472, 514,
targets 407-8 519-20
vs. monetary policy 478-79 and structural unemployment 260-61
and business cycles 425, 439-40 see also Unemployment
and crowding out 103-05, 106, 109, 182, 399-400, Functional classification (of government expenditure)
407, 426, 439 408n
Index 573

G in IS-LM model 110, 114, 123, 130-32, 200-01
GCF: see Capital formation in open economy chain reactions 176-77, 200-01
GDE: see Gross domestic expenditure measurement and data systems 65-66, 398,
GDI: see Capital formation 412-13, 454-58
GDP: see Gross domestic product non-interest current 410, 421, 430, 445-46,
GEAR 40, 404-8, 424, 429, 432, 439 456-57
General government 51-52, 57, 65-67, 215, 221, 228, on economic services 399
397-99, 406, 412-13, 422, 430, 454 on social services 399, 406, 407, 409-10, 453
in main budget 399, 407, 412-13, 417, 422, 430, ratio 412-13
454 SA data 51, 66, 411-13, 454-58
in national accounts 228-29, 454-59 secondary effect 103-05
see also Government targets/rules 404-05, 414, 417, 438-40, 445
General Theory of Employment 36, 470 and bracket creep 419, 430
GFS (Government Finance Statistics) 65, 397, 437-38, and crowding out (see also Crowding out) 104-05
454,456, 459 and development 259, 396-98, 402-5, 409, 451-53
see also SNA Gini coefficient 22 and economic growth 401, 409, 411, 415, 451-53
Glen Grey Act 2, 38 and expenditure multiplier 68
GNP (gross national product) 229, 237 and public debt cost 431, 455-56
SA data 230 and redistribution 24
Goals, of macroeconomic policy 11-27 see also Fiscal policy
Gold Government investment: see Government capital
marketing by Reserve Bank 372 formation
price 11, 43, 49, 420, 522 Government wages: see Remuneration Gradualism
and rand, dollar 139, 155, 184-85 (policy) 323, 490, 496-97
Gold and other foreign reserves: see Foreign reserves Grants, social 25, 32, 254, 405, 409, 410, 412n, 457,
Gordhan, Pravin 33, 405 524, 560
Government Grey market (for credit) 378
general, central, national: see General Government Gross (vs. net values) 57, 160
measuring 398 Gross domestic expenditure (GDE) 71, 148, 213, 219n,
provincial, local 398, 412-13, 422, 454, 459 230, 237
role of 4, 33-39, 40 Gross domestic product (GDP) 12, 25, 44
vs. state, public sector 397 at market prices vs. factor cost 235
and economic growth 399, 401, 402-05, 409, 414 expenditure on 213, 219n, 228-30, 232, 237-38
and private sector 415 fluctuations 13-14, 45, 48
see also Public sector growth rates 12-14
Government bonds: see Bonds; Treasury bills per capita 12-14
Government borrowing 67, 76, 106-09, 182, 386-89, SA data 12-14, 45, 48
401 versus GNP (gross national product) 229, 237
SA data 423 and development 25-27
see also Budget deficit; Public debt Growth, economic 9, 11-14, 43, 48-49, 156, 162,
Government capital formation 66, 163, 169, 293, 343, 227, 409, 329-68, 411, 481, 528-55
407, 445n African rates of 530-33
definition in national accounts 66 as policy objective 11-14, 162, 329, 402-05,
in SNA identities 163, 220, 220n 414-15, 444, 451-53, 490, 528-29, 534-36,
investment in human capital 300, 333 552
SA data 32, 66 balanced 329, 332, 340-54, 365-67
Government expenditure 65-70, 399-401, 404-06, basic theory 330-38
411-17, 451-53 broad-based 553
budget process 428-31 causes of 537-41, 543-50
components 66, 410-12 convergence 354-55
current, consumption, capital 215, 324-25, 407-10 costs 14, 552
economic/functional classification 408 definition 44, 528-30
financing of: see Budget deficit example of ratios and numbers 365-68
in 45° model 50-51, 65-68, 103-05, history of 530-33
in AD-AS model 242, 266, 273, 275, 281-83 inclusive 25, 33, 537, 553-54, 561
574 Index

in low- and middle-income countries 354-55, Housing bubble 135
530-32 Housing, indicators of
international comparisons 530-33 see Indicators, social
jobless 16, 31, 519 Human capital 331, 332, 339, 352, 355-62, 521, 522,
measurement of 44, 518 528, 537-45, 547, 559
Monetarist views 444 Human Development Index (HDI) 26-27, 356, 543
political barriers to 548-49 SA data 27
per capita 12, 22-27, 329-31, 336-54, 529, 531-33 see also Development
pro-poor 553
real vs. nominal 44, 330 I
remedies 542-43 Icons 5 Identities
required rate 518 defined 214-25
SA data on 12-14, 361, 450, 534 uses and abuses 216-18
shared 24, 32, 534, 553, 553n see also National income identity; Sectoral balance
Solow model 332-35, 337, 339-43, 356, 360, 362 identities
sources of 24-6, 31-2, 544 Ideology 36, 39-40, 552
and budget deficit 431-32, 447-49, 539 and schools of thought 467
and Cobb-Douglas production function 333, 363 IMF (International Monetary Fund) 32, 160, 402, 415,
and culture 548 439, 555
and development 25-26, 28-30 Imports 21, 31, 44, 50-51, 70-73, 140, 142-46
and employment/unemployment 12-14, 507-10, definition 143
513-19, 522-25 determinants of 141-46, 187
and environment 550-55 impact on GDP 72
and ethnicity 536, 549-50 in 45° diagram 50, 70-3
and fiscal policy 409, 410, 414-15, 444, 539, 542 in AD-AS model 240, 244, 247, 273-83
and geography 550 in IS-LM model 113-14, 123, 188-90
and HIV/Aids 11, 352, 358, 521, 540-41 in IS-LM-BP model 191-97
and human capital 331, 332, 339, 352, 355-62, in national accounts 213, 218-25, 227
522, 528, 537-41, 541-45 income sensitivity of 144, 192
and inequality 23n, 24, 28-29, 536, 545-47, 546n, marginal propensity to import 72, 155, 150, 189
553-56 mathematics 144, 190
and inflation 490-93 SA data 71, 142, 143, 216-17, 230
and institutions 547-48 trade patterns 142
and natural resources 333, 339 volumes vs. values 151
and population growth 330, 335, 337, 340, 343, and business cycle 144, 150, 162, 183, 186, 227
347, 351-52, 359, 540, 550 and exchange rates 145-46, 166
and production function (TP) 329, 332-34, 336-37 and expenditure multiplier formula 64, 72, 190
and public debt 431-35, 447-50 and foreign reserves 21, 160, 384
and redistribution 241, 245-47, 249 and J curve 151
and savings 444, 538 and Marshall-Lerner condition 151
and semilog graphs 533, 536 and tariffs 187
and sustainability 18, 447-50 and trade policy 187
and taxation 417-21, 537-39, 542-43, 545, 547 see also Current account; Exports, net; Foreign sector
and technology 331-39, 344-46, 352-57, 358-62, Incentives (and taxation): see Tax
532, 538-41, 543-49, 552 Inclusive Development: 552-57
and trust 549 in South Africa 556
see also Development see also Development, inclusive
Inclusive growth: 553-55
H in South Africa 554, 561
High-income country term 1n see also Growth, inclusive
HIV/Aids 11, 266, 351-52, 357, 359, 484n, 521, 540- Income 12-19, 43-50, 61-64
41 disposable, life-cycle, permanent, relative 52, 54-56
Homelands 510-11, 524-25; 527, 561 distribution 22-23
Horizontal equity: see Tax equity equivalence with, production and expenditure 61,
Horwood, Owen 404 237
Index 575

in Classical model 468-69 and money demand 81n, 81-83, 98
in national accounts 230 and money supply 88, 98, 379, 383, 385-86, 486,
SA data 230 488-90, 494
and expenditure multiplier 63-64 and Phillips curve 305-327
and human development 25-27 and political factors 490-93
see also Gross domestic product (GDP); Real sector and real exchange rate 163
Income-expenditure diagram/flow 46-47, 73, 76, 140, and quality improvements 306
240, 372, 396 and supply shocks 311, 315-18, 493-97
Income, per capita: see Per capita GDP and taxation 21, 244, 417, 420, 430, 451-52, 500
Income tax: and theory of Purchasing Power Parity 167
see Tax, income and trade-offs 20-21, 30, 313-19, 322, 493-94,
Indicators, fiscal: see Budget deficit; Fiscal norms 497, 513-14
Indicators, social 152-53 and unemployment: see Phillips curve
SA data 153 see also Underlying factors; Bracket creep
see also Human Development Index (HDI); SDGs Inflationary expectations
Inequality 5, 10-2, 22-25, 31, 33, 34, 331, 403, 522, see Expectations, inflation
536, 545-47, 546n, 556 Inflation targeting 380, 380-85
measurement 22 Informal sector viii, 16, 33, 260, 502, 505-07, 521,
and growth 23, 23n, 28-29, 536, 545-46, 554-56 526-27, 554, 560-61, 563, 565
Inflation 19-20, 43-44, 187, 239, 294, 481-501 Initiating factors (inflation) 488-99
as a policy objective 19-20, 28, 30-31, 314-17, 376, Interest groups (and inflation) 500-01
379, 380-83, 384, 403, 450, 462, 479 Instability, inherent: see Stability
as a process 488-90 Instruments of policy: see Fiscal policy; Monetary policy
causes of 380, 473-77, 484-501 Interest on government debt: see Public debt
conflict approach 500-01 Interest rates 75-134, 371-94
definition 306, 481 as policy consideration 371, 377-78, 381, 383-84,
demand-pull, cost-push 487, 500 386-89
distributional impacts of 20, 420, 451-52 as symptom of prosperity 97
hyperinflation 492 causes of changes in 76-80, 93-95
in AD-AS model 239, 244, 292, 488, 490-97 determination in money market 77-80
in AD-PC model 305-327 different kinds 78-80, 95-96
initiating, propagating factors 488 in Classical model 468-69
Keynesian view of 11, 30, 239, 487 in Keynesian transmission mechanism 99-101
measurement aspects 19-20, 481-83 real vs. nominal 59, 98, 100, 241, 449-50
Monetarist view of 379, 472-73, 479, 484-86, SA data 76, 449-450
487-89, 492, 494, 498 short vs. long term 77, 95-96, 387-89
New Classical view of 474-75, 498 term structure 95
policy, paths 321-26 and AD curve 450
policy, remedies 320, 486, 490-97, 500-01 and balance of payments position 22, 158-59
SA data 20, 241, 292, 483 and capital flows 153-55
structuralist view 488n, 499-500, 564 and demand for money 81-3
Zimbabwe 492 and government borrowing 106-09, 386-89, 424-
and balance of payments (BoP) 20, 159, 497 27, 451,462
and bracket creep 20, 420, 430 and inflation 381-82
and budget deficit 108, 425, 449, 498 and price of money market instruments 79
and development 28, 451-52 and public debt 386-89, 434-36, 447-50
and exchange rate 162-64, 167, 170, 184, 187 and repo rate 385-86
and expectations 250-61, 267-71, 306-17, 490-97 and Reserve Bank 86-8, 377-78, 381-86
and exports 20, 145, 147 and risk premium 154
and external value of the rand 163-64, 167, 170, and sustainability 449-50
187, 384 and Taylor rule 324
and fiscal drag 419 see also Crowding out; Monetary policy; Monetary
and imports 20, 144-45, 188 sector
and interest on public debt 441 Internal disturbances
and interest rate costs 102 general method to analyse 180
576 Index

in AD-AS model 278-289 data 505
in IS-LM-BP model 194 demand and supply 256
see also External disturbances entry barriers vi, 11, 260, 519
International competitiveness 20, 167, 522 institutions 253-54
Inventory investment 57, 214-15, 216-17, 219-20, minimum wage 253-54, 283, 523, 526, 565
222, 228, 237 Monetarist model 471-72
planned vs. unplanned 215, 220, 237 New Keynesian model 476
Investment: see Capital formation price setting 251
Invisible hand 468 segmentation vi, 11, 260, 520-21
Invisible trade 149 wage setting 252
IS curve and aggregate supply 251, 266
basic definition, graphics 110 see also Unemployment
formal derivation and properties 111-116 Labour mobility 524
in the open economy 189 Labour unions 19, 24, 253-57, 266, 270, 283, 402,
mathematics 109 482, 499, 523-27, 567
see also IS-LM model see also Cosatu
IS-LM model 109-34 Lags, policy: see Policy lags
in the open economy 188-90 Laissez faire 468
mathematics 113, 118, 121, 190 Land Act of 1913 2, 525
and AD-AS model 241, 245 Land reform 2, 6, 39, 501, 523-27
see also IS-LM-BP model Leakages 63-64, 102, 105, 115, 142, 189, 238, 240,
IS-LM-BP model 188-97 419
in Classical model 469
J in income-expenditure flow 469
J curve 151 in money creation process 85
Job reservation 522-25 Left, viewpoint 40
Legend, for box icons 5
K Lender of last resort 86
Keynes, John Maynard 36, 49, 54, 470 Liabilities related to reserves
Keynesianism 33-38 see also Foreign reserves; Change in liabilities
and fiscal policy 30, 399-401, 404-05, 414, 439, 490 Liberalism, classical 467-68, 477-78
and inflation 487-90, 498-99 Life-cycle, income hypothesis: see Consumption
and Monetarism compared 469, 477-79, 486, 487, Life expectancy, indicators: see Indicators, social
494, 514 Literacy, indicators: see Indicators, social
and Phillips curve 514 Liquid asset requirement 374
and policy priorities 31-32, 378-79, 463 Liquidity: see Money market shortage
and unemployment 469 Liquidity trap 129-31
Keynesian theory 33-38, 43-49 Living standards
aggregate demand and supply 239-304 and GDP growth 12-14, 20, 183, 411
consumers, producers, government 43-74 see also Development
financial institutions, money, interest rates 75-134 LM curve
foreign sector 139-204 basic definition, graphics 109-10
see also Keynesianism formal derivation and properties 116-21
Keys, Derek 404 in the open economy 189-90
mathematics 118
L slope, relative to BP curve 193
Labour absorption 11, 290, 505, 521, 524, 561 USA case 192-93
Labour force 167, 249, 260-61, 501-3, 507, 519 see also IS-LM model
SA data 505-18 Local government: see Government
Labour Force Survey 502-7, 519 Locke, John 35, 467
Labour intensity 14, 24, 260, 290, 519-20, 522-26, Long run, defined 43, 250
559, 562 Low-income country 1n, 484n
Labour market vi, 3, 11, 17, 19, 39, 46, 197, 240, Lucas, Robert 37, 473, 515, 535, 542
251-67, 273-74, 290, 300-01, 503, 513, 519-24
Classical model 468
Index 577

M development of 379
M3 money supply: see Money supply gradualist approach 323
Macroeconomics, definition and uses 9-11 guidelines: see Money supply guidelines
Malthus, Thomas 550 history of 379
Mandela, President 41, 404, in 45° model 98-102
Manuel, Trevor 404-5 in AD-AS model 240, 246-48, 275, 278-81
Marcus, Gill 379 in IS-LM model 125-26, 128-30
Marginalised people 11, 16, 19, 25, 32-33, 260, 510, in IS-LM-BP model 194, 197-203
553-54, 561, 563 in closed economy chain reaction 99-102
Marginal propensity in open economy chain reaction 175, 197-203
to consume 52, 63, 68 instruments 77, 86-8, 99-100, 371-76, 383-84
to import 64, 144, 150, 189 mission/objectives 326, 376-77
to save 64 Monetarist view 478-79
see also Consumption; Imports moral persuasion 374
Marginal tax rates; see Tax rates potency of 101, 128-30, 175, 198, 248, 391-92,
Market prices, in SNA 213-14, 229-31 479
Mark-up 251-52 reactionist approach 323, 325
Marshall-Lerner condition 151 role of Reserve Bank 76-83, 107-08, 372, 380-83
Marx, Karl 35 targets (see also guidelines) 379-83
Marxism (policy priorities) 30, 35 vs. fiscal policy 461-63
Mbeki, President 41 and budget deficits 462
Mboweni, Tito 32-33, 379, 405 and development 451
MBS: see Mortgage Backed Securities and exchange rates 389-92
MERG (Macro-Economic Research Group) 24 and inflation 488-97
Middle-income country term 1n, 484n and political factors 372, 402-3, 451-52
Migration 521 and public debt 386-89 425-30, 462-63
Minimum wages: see Wages, minimum and Taylor rule 324
Mining sector 229, 339, 408n, 419-20, 521, 525, and unemployment 326, 513-16, 525
538, 540, 547, 550, 559-61 see also Constraints on policy; Money supply; Policy
Minister of Finance 32, 221, 398, 401, 402-05, 420, objectives; Reserve Bank
430, 465 Monetary reaction function 320-26
Monetarism 49, 470-73 Monetary rule 378, 440, 463, 478-79, 484
critique 486 see also Discretion
fiscal rule 440 Monetary sector 75-134
and budget deficits 498-99 changes in equilibrium 93-96
and economic growth 444 defined 73, 75
and government expenditure 399, 439 impact of balance of payments on 171
and inflation 378, 484-86, 494, 498-99, 514 in IS-LM model: see LM curve
and Keynesianism compared 30, 49, 99, 477-80, linkages with real sector 98-109
486, 487, 494, 514 with variable price level 239-40, 246-48
and Phillips curve 514 and budget deficit 106-8, 423-24
and policy priorities 30, 399, 414, 439-40, 444, and transmission mechanism 98-102
463, 477-80, 513-14 see also Monetary policy; Money supply
and SA Reserve Bank 32, 378, 463 Monetary targets: see Monetary policy targets; Money
and unemployment 30, 513-20, 564 supply guidelines
see also Classical School; New Classical School; Monetisation, of budget deficit or public debt 446,
New Keynesian economics Money
Monetary authority: see Reserve Bank; Monetary policy definition 80
Monetary policy 75, 85-91, 371-92 stock of 83
accommodating 462 velocity of circulation 469, 484, 486
approaches 374-80 vs. income 80
characteristics 461-63 and interest rate determination 80-93
cold turkey approach 325 see also Interest rates; Monetary policy; Money
constraints on 486 supply
definition 371 Money, demand for 81-83
578 Index

definition 81-83 Multiplier, credit 85-88
determinants of 81-83 Multiplier, expenditure 63-64, 68, 70, 72, 102, 105,
graphical depiction 83 122, 128, 130, 132
responsiveness/sensitivities of (income/interest) in IS-LM diagram 114, 122
102, 104-06, 115, 119-21, 128-29, 130-31, value 63-64, 68, 70, 72, 122
246 and AD curve 246-47
transactions, precautionary, speculative demand and openness of the economy 72
81n, 82 and policy effectiveness/potency 102, 105, 128,
Money market 130, 248
institutional arrangement, everyday operation and secondary effects 132
77-80 see also Leakages
interest rate determination 77-80 Multiplier, tax 68
money market paper 78-80
primary vs. secondary market 78 N
and government borrowing 106-07, 430 National accounting 213-38
see also Capital market; Monetary policy; Money identities 214-25
supply SA data 230-31
Money market shortage (liquidity) 96-97, 105, 378n, system of (SNA) 65, 141, 149, 151, 213, 228-32,
383, 385 235-38, 398, 410, 412n, 414, 422, 437-38,
see also Accommodation 443, 454-59
Money stock 83-86, 96, 377-78 see also Sectoral balance identities
see also Money supply National Development Plan (NDP) 10, 25, 33, 40, 405,
Money supply 83-84 416, 534, 558-64
as policy consideration 377-78, 379 National government: see Government
creation 85-86, 378 National income identity 214-16
definitions 83-84 for the open economy 216, 219
exogenous vs. endogenous 93 and macroeconomic equilibrium 214
function 92-93 Natural order (in society) 35, 468
guidelines (plus SA data) 377-78, 379, 496 Natural rate of unemployment 261, 470-74, 493,
impact of balance of payments on 161-62, 170 515-16
in balance of payments adjustment process 158, see also Structural rate of unemployment
161-62 Natural resource depletion 18
in Classical model 469-70 NCD rate: see Negotiable certificates of deposit
in Monetarist theory 471-73, 479 Negotiable certificates of deposit (NCD’s) 79
in New Classical theory 473-75 Nene, Nhlanhla 405
M1, M2, M3 83-84 Net capital inflow from the rest of the world 225-27
real vs. nominal 98-99 Net current transfers from the rest of the world:
role of Reserve Bank 85-86, 86-88, 88-90 see Transfers
SA data 76, 91 Neutrality, of money 275, 470, 484, 486
sending it overseas 175 New Classical School 30, 37, 463, 467, 473-75,
targets (see guidelines) 477-80
and bank balance sheets 89-92 and economic growth 535, 538, 542, 564
and credit 83-92 and inflation 484-86, 487-89, 492, 494, 498
and credit multiplier 85-86, 88, 107-08 and unemployment 477, 514-19
and deficit financing 107-08 New Deal, USA 36, 404, 470
and inflation 469-70, 472-73, 473-74, 475, 479, New Growth Path 25, 33, 405, 534, 559
484-86, 488-90, 492, 494, 495, 498 New Keynesian economics 37, 475-77, 477-80
and minimum cash reserve requirement 85-86, and inflation 487n, 492
87n, 89 and unemployment 477, 513-14, 516-17
and slope of AD curve 246 Newton, John 467
see also Monetary policy; Quantity Theory of NIEP (National Institute for Economic Policy) 24
Money; Reserve Bank Nihilism, state 468
Moral persuasion 374 Nominal values (income, interest rates, etc):
Mortgage Backed Securities (MBS) 88, 135, 392-94 see Real values
Multiplier, balanced budget 68 Non-interest current expenditure 430, 456-58
Index 579

Non-interest expenditure 421, 445-46 and capital flows 153-55, 376
NP (National Party) 40 and inflation 490-91
Numsa 24 and policy objectives 22-24, 30-32
and political parties 40-41
O and unemployment 504, 507, 520-25
Obama, President Barack 37, 134, 290 see also Rubicon speech
Objectives, policy: see Policy objectives Population growth 13, 249, 411, 502, 521, 540-41,
Observation lag: see Policy lags 550
October Household Survey (OHS) 505 SA data 13
OHS: see October Household Survey and economic growth 13, 351-52, 540
Oil price 10-11, 32, 143, 160, 185, 258, 265, 270, Post-Keynesian approach 34, 247, 473
283-88, 292, 303 Potential GDP: see GDP, potential
Okun’s Law 319, 511-12 Poverty 9-11, 18-20, 23-25, 28-31, 396, 408, 411,
Open economy 2, 64, 72, 113, 139 470, 490, 495, 510-11, 515, 530, 536-37, 543,
see also External sector 545, 548
Open market operations 88, 96, 100, 374, 375, 377, rate 554
378n, 383, 385, 387, 465 and inclusive development 552-57
see also Monetary policy and inclusive growth 553-56
see also Development; Inclusive development
P PPI: see Producer price index
Parliament, role of 107, 43-44, 406, 428-31, 464 Pretoria consensus 415
Pensions 399, 407, 408-9, 413, 455, 456 Price control: see Incomes policy
Per capita GDP 13-15, 25-26, 417 Price index 241, 482
Permanent income hypothesis: see Consumption see also Consumer price index
Personal disposable income: see Disposable income Price level, average 239-41, 481-83
Personal income tax (PIT): see Tax, income constant price assumption 241
Phillips curve 314-17 determination in AD-AS model 241-43, 272-94,
for South Africa 318 487-90
mathematics 319 in Classical model 472-73
see also AD-PC model in income-expenditure flow 240
Policy coordination/conflict 462-63 in Monetarism vs. Keynesianism 473
Policy effectiveness/potency: see Fiscal policy; Monetary SA data 292
policy stability as policy objective 19, 30
Policy instruments: see Fiscal policy; Monetary policy see also Inflation
Policy lags 464-66 Price ratio 140, 145, 164, 167, 497
Policy limitations 376, 401 and exports 147, 497
see also Constraints on policy and imports 144-46
Policy objectives 11-31 see also Purchasing power parity; Terms of trade
intermediate 29-31 Price rigidity 198, 217, 219, 377, 384
lessons 317-19 Price-setting relationship 251-52, 254-56
priorities 30-32 and long-run AS 257-65
reactions 320-26 and short-run AS 266-71
SA business sector view 24, 402, 411, 415 see also Wage-setting relationship
SA government priorities 31 Prices of inputs 284, 261-62, 488, 493, 498
SA Reserve Bank priorities 326, 376-77 Prices, relative 481
standard 11-24 Price stability: see Inflation; Price level
and development 25-30 Primary balance/deficit (budget): see Budget deficit,
and time horizon 477 primary
see also Fiscal policy; Monetary policy Primary market: see Secondary market
Policy rules: see Discretion Printing press 108
Political factors see also Budget deficit; Money supply
in fiscal policy 153-55, 398, 402-04, 411-12, 417 Pro-cyclical policy 420
in monetary policy 376, 403, 451 Producer price index (PPI) 482n
in South African policy making 40-41 Production possibility frontier 272
and balance of payments constraint 162 Productivity of labour, capital 249
580 Index

Progressivity, of income tax: see Bracket creep; Tax, see also Exchange rate; Purchasing power
income Rate of interest: see Interest rate
Propagating factors (inflation) 488-90 Ratings agencies 31, 135, 402, 432, 453
Provincial government: see Government Rational Expectations School: see New Classical School
Prudential regulation 373-74 RDP (Reconstruction and Development Programme)
PSBR 422 24, 38, 405
see also Government borrowing Reactionist, approach to policy 323, 325, 490, 496
Public authorities 398, 455-56 Reagan, President Ronald 441
Public business enterprises 488-89 Real sector, 43-74
Public corporations 57, 65, 398, 423 changes in equilibrium 61-3
Public debt 431-36 defined 44, 73
burden of 432-33 in IS-LM model: see IS curve
domestic vs. foreign 434 linkages to monetary sector 98-109
interest on 221, 387-89, 408-10, 434, 454-55 with a variable price level 239
international comparison 433 and transmission mechanism 99-103
management 371, 386-89, 395, 399, 434-36 see also Monetary sector
monetisation 447-49, 498-99 Real values (income, interest rates, etc.) 13, 43-45, 59,
ratio 403, 405, 431-32, 447-49 83, 98, 163, 217, 240-41, 244n, 245, 377-78,
Reserve Bank role 386-89, 424-25, 434-36 431, 435, 472, 484, 501
SA data 426-24, 431, 432 Recession 18-19, 43-44, 48, 97, 232, 292, 404, 425,
Treasury role 386-89 465, 468
and debt trap 431, 446, 449 Redistribution 20, 24, 33-40
and economic growth 424-25, 431-32, 447-49 as policy objective 9, 22-24, 27-30
and fiscal policy 386-89, 431, 434, 436, 442-45 measurement 22
and inflation 431, 449 SA data 22-23
and monetary policy 386-89 vs. development 25-30
and primary deficit 442-45 vs. economic growth 24
and sustainability 445-50 and consumption 54
see also Monetary policy and inflation 19, 500-01
Public sector: see Government Regressivity: see Tax
Public sector borrowing requirement: see PSBR Relative income hypothesis: see Consumption
Public works programmes 424, 527, 560 Remuneration of employees (government wage bill) 63,
Purchasing power of the rand 162-63 403, 406, 407-10, 453, 528, 563, 567
see also Exchange rate; Inflation Repo rate 49, 55-56
Purchasing power parity (PPP) 167 in closed economy chain reactions 58, 72
see also Price ratio in monetary policy 256-57, 269, 273
in open economy chain reactions 125, 126-27, 130,
Q 145-46, 155-56
Quality of life 18, 29 in variable price level model 203-04
see also Development; Living standards see also Bank rate; Monetary policy
Quantitative easing 88, 135-36, 137, 290, 392-94, and balance of payments position 112
428 Reserve Bank 75, 86, 96, 371-92
Quantity Theory of Money 467-72 approach to policy 31-33, 168-69, 31, 376-80,
Quarterly Bulletin of the Reserve Bank 45, 51, 57, 76, 383-85, 496
90, 95, 96, 141, 145, 149, 157, 214, 228-29, functions 372, 383-86
241, 398, 422, 454, 459 Governor 382, 385, 402
Quarterly Employment Survey (QES) 15, 504-05 independence 371-72
Quarterly Labour Force Survey (QLFS) 15, 45, 502-06, internet site 371
519 intervention in foreign exchange markets 165, 168-
69, 371, 384, 389-92
R intervention in money markets 78, 371-75
Ramaphosa, President 33, 74, 394, 405, 564 mandate 372-73, 376, 379
Rand, SA 139-40, 166, 183, 390 mandate, complementary 373-74
and gold price 184-86 mandate, dual 373-74; 379
and USA dollar, interest rates 184-86 mission 373-74, 376-77, 379
Index 581

objective 373-74, 376 in IS-LM model 109, 123-25, 130-31,
ownership of 394 in IS-LM-BP model 152, 158, 172-80, 197-204
prudential regulation 373-74 and capital flows 186, 200
Quarterly Bulletin: see Quarterly Bulletin and crowding out 103-05
role in money supply process 86-88, 92, 93, 425-26 and expenditure multiplier 105
twin peaks model of regulation 374 and external disturbances 103-05, 152, 178
and Financial Stability Oversight Committee 373 see also Crowding out
and fiscal policy 107-09, 395, 402-03, 425-26, Secondary market 78-9, 88, 389
419-20, 434-36 Sectoral balance identities 219-25, 229-30, 232-34,
and government borrowing/deficit 106-09, 386 391, 406-07, 444-45, 459
and interest rates 76, 96, 374-76, 377-80, 388, Semilog graphs 535-36
388n, 389-92 Sending the money supply overseas 175
and policy lags 464-67 Sensitivity (responsiveness) 58
and public debt management 386-89, 426, 430-36 of capital flows 155, 182, 192-93, 196
see also Accommodation; Monetarism; Monetary of consumption 54
policy of imports 144, 192
Responsiveness, see Sensitivity of investment 58, 102, 115, 128, 130
Revaluation 163, 169 of money demand 83, 101-02, 104-06, 119-21,
Right, viewpoint 40 128-31
Rigid exchange rate effect 171, 175-77, 180-81, of money supply 92-93
199-201, 196 versus elasticities 58
Rigid input prices: see Prices of inputs and J curve 151
Roll-over (of debt) 387, 423, 431 and Marshall-Lerner condition 151
Roosevelt, President Franklin D 18, 470 and policy effectiveness 128-29, 197-201
Rubicon speech 155 Services, payments for 139, 157, 229
see also Political factors; Sanctions in balance of payments 149
Rules vs. discretion (in policy): see Discretion see also Factor and non-factor services; Invisible trade
Short run, defined 43, 250
S Small business 33, 451-52, 526-27, 524, 559-61
SACP (SA Communist Party) 40 see also Informal sector
SAFTU 40-41 Smith, Adam 35, 467-68
Sanctions, trade and financial 145-46, 153, 404, 406- SNA: see National accounting
07, 427, 493, 522 see also GFS
and balance of payments constraint 162 Social security 397, 454, 459, 524
and unemployment 522 Social spending: see Government expenditure;
Savings 52-54, 220 Development; Pensions
golden rule 350 SOEs: see State-owned enterprises
government: see Dissaving 220, 224-25 Stabilisation
gross domestic 222, 225-28, 230-32 as policy objective 11, 18-19, 372-74, 376-77,
household, business 220, 222, 230 402-05, 420-21, 439, 462-70, 478-79, 464,
in Classical model 469 513-14
in growth model 335, 337, 341-45, 348-51, policy, problems 376-77, 406, 419, 439-40, 462,
358-60, 362 464-67, 490-93, 500, 513-15
in national accounting identities 220-25, 406 see also Fiscal policy; Monetary policy; Policy
in SNA tables 228-32, 235, 236 effectiveness
marginal propensity to save 64 Stability, inherent 52, 54-55, 57, 221, 467-70, 478,
SA data 220, 226, 230, 437 475
and economic growth 358, 444 Stagflation 239, 310, 404-05, 491n, 493-96
and fiscal norms 442-44 Stals, Chris 379
see also Capital formation State-owned enterprises (SOEs) 33, 405, 432, 567
Say’s Law 468-69 State: see Government
SDGs see Sustainable Development Goals State debt: see Public debt
Schools and unemployment 522 Stats SA 482, 505
Secondary effect 103-04, 123-25, 152, 176, 277 Stern Report 551
in AD-AS model 248, 277, 278-86 Strikes, impact of 146, 429, 489
582 Index

see also Supply shocks and price level 400
Structural rate of unemployment (SRU) 260-62, 519 and saving 537-39, 541-42
see also Natural rate of unemployment; and supply side 400, 513
Unemployment and unemployment 513, 525
Structural unemployment: see Unemployment, Tax burden (aggregate) 417-18, 420, 459
structural measurement of 417-18, 459
Subprime crisis 37, 129, 182, 204, 289-90, 326 relevance of 417-20
Subsidies SA data 417-19, 459
in fiscal policy 400, 407-09, 413, 454-55 Tax, corporate, mining 399, 419, 420, 424, 452
in national accounts 215, 221, 230-32, 235-37 Tax, direct 399, 419
and unemployment 526 in national accounts 232
Supply, aggregate: see Aggregate supply Tax equity 417, 419, 420, 451
Supply shocks 258, 265, 270, 272, 283-89, 301, horizontal, vertical 418, 451
308, 310-12, 316, 318-21, 327, 404, 489-90, Tax, income (personal) 399, 419, 420, 424, 451
493-97 progressivity 68-70, 419, 451
Sustainability: see Fiscal policy rate 69-70, 419
Sustainable Development Goals 29 and AD curve 244
and bracket creep 419, 430, 451
T and business cycle 69, 419-21
Tap issues (monetary policy) 383 and wage demands 400
Targets, of policy: see Fiscal policy; Monetary policy Tax, indirect 399-400, 451, 527
targets; Money supply guidelines in national accounts 229, 232, 235-37
Tariffs 145, 187 and inflation 500
See also Trade policy Tax rates
TARP 135n average, marginal 418, 420n, 420
Tax/taxation 52, 64, 68-69, 69-70, 400, 404-06, effective 452
407-08, 413-15, 416-21, 424-25, 430-31, 437, Tax revenue 69, 221, 232, 406-07, 420, 424, 429-30,
451, 459 432, 446, 459
composition 417-19 projections 412-13, 429
distributional effects 20, 417, 451 Tax, value-added (VAT) 49, 399, 419, 451
effects on macroeconomy 180-81, 400-01, 416-21 regressivity 419
in 45° model 49-50, 65-68 and GDP measurement 235
in AD-AS model 244, 269-70, 273 and inflation 500
in IS-LM model 114, 115, 123, 127, 130 Taylor rule 324, 379
in fiscal policy 399-403 see also Monetary reaction function
in national accounting identities 221, 232 TB rate: see Treasury bills
measurement 417-18, 459 Technology
multiplier effect 68 appropriate 522, 526, 550
principle 417-18 impact of 532, 538, 539, 552
progressive, regressive 68, 69-70, 419, 451 and aggregate supply 262, 265, 269, 289, 313, 319
SA data 417-18, 459 and growth and production (function) 266, 276,
and ability to pay 417-18 289-90, 313, 331-39, 344-45, 350, 352-54,
and AD curve 244 358, 360-64, 532, 539-43
and anti-cyclical policy 69, 418-21 and human capital 357, 359-60
and bracket creep 419, 430, 451 and structural unemployment 260; 521-22; 526
and business cycles 419-21 Terms of trade 145, 147
and capital formation (investment) 541 Term structure of
and consumption 68 interest rates 95
and cost of production 400 public debt 386-87
and development, poverty 417-19, 451 Trade balance 148-49
and economic growth 417-19, 513, 522 and net exports, current account 148-49
and efficiency, distortions 417, 544-45 see also Exports, net
and equity/fairness 417-19, 451 Trade-off, policy 11, 19-20, 30, 312-19, 319, 322,
and incentives/disincentives 513, 522, 525-27 493, 494, 513, 514
and inflation 417-18, 420, 430, 451, 500 Trade policy 145-46, 187-88
Index 583

Trade statistics 141, 384 and employment coefficient 16, 509, 560
Transfers and formal sector employment 502, 506, 508-10
in the budget: see Pensions and inflation: see Phillips curve
to/from households (SNA) 215, 219, 221, 231, 407, and informal sector 16
408-10, 411, 412-13, 455, 456 and mining sector 521, 525
to/from the rest of t he world (SNA) 215, 216, 219, and Phillips curve 312-19, 322, 514
221, 230, 456 and price stability 30-31
see also Subsidies and supply shocks 493-95
Transmission mechanism 470-73 and trade-offs 11, 20, 30, 313-14, 316-17, 319,
Monetarist 470-72 322, 493-94, 513-14
Treasury 65, 67, 395, 398, 402-03, 426-29, 436, and working poor 510
462-63 USA (United States of America)
Treasury bills (TBs) 78-79, 106 BoP adjustment process 178-80
Trickle-down effect 14, 544 BP and LM curves for 193
Trump, President 38, 211, 299, 441, 567 budget deficit 109, 182, 185
business cycle 148, 178-80, 189
U capital mobility 109, 155, 192-93
Underdevelopment: see Development 510-13 dollar interest rates 101, 107, 154, 182, 185, 192
Underemployment 503-07 Reagan era 38, 441
see also Unemployment Republicans, Democrats 40-41, 441
Unemployment (employment) 501-27 Trump, see Trump, President
as policy objective 12-13, 31-33, 515 unemployment 502, 515
broad 16-17, 502-05, 508
causes of 51, 128 V
cyclical 260-61, 515-17, 427 VAT: see Tax, value-added
definition 501-05 Velocity of circulation of money 569-70, 484, 486
discouraged workers 17, 502-06 Vertical equity: see Tax equity
expanded definition 503
in AD-AS model 294, 513-14 W
in AD-PC model 312-14 Wage bill, government: see Remuneration
in Monetarist/New Classical view 513-17, 519 Wage rigidity 487n
in Keynesian view 513-14, 516-17, 519 Wage-setting relationship 252-56
involuntary vs. voluntary 513-14, 516-17, 519 and long-run AS 257-66
measurement 501-03, 503-07 and short-run AS 266-73
narrow 16-17, 502-04, 508 see also Price-setting relationship
natural rate of (NRU) 260-61, 471, 473-74, 515-17 Wages, minimum 253-54, 283, 523, 526, 565
policy, remedies 312-13, 510-11, 513-17 Washington consensus 415
registered 511 Wealth of nations, An inquiry into the 35, 467
SA data 505, 507-09 World Economic Forum (WEF) 555-57
seasonal, frictional, cyclical 260 Work effort: see Tax, and incentives
structural 260-62, 289-90, 313, 477, 519-28, 561 Workforce: see Labour force
technological 523 Working poor 510
underemployment 503-07 World Bank 402, 415, 537, 541, 555
and AD-PC model 312-14 WTO 188
and African context 477
and apartheid 507, 510 XYZ
and balance of payments 31 Youth wage subsidy 299, 526Z
and business cycle 519 Zimbabwe 492
and development 495, 508-11 Zuma, President 405, 453, 564, 566
and economic growth 509, 518, 522, 525
584 Index

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How to think and reason in

A SOUTH AFRICAN TEXT

ABOUT THE AUTHORS Frederick C v N Fourie Philippe Burger

How_to_think_BOOK_2019.indb 1 2019/12/17 09:14

How_to_think_BOOK_2019.indb 3 2019/12/17 09:14

First published 1997

Juta and Company (Pty) Ltd

ISBN 978 1 48513 047 5 (Print)

ISBN 978 1 48513 048 2 (WebPDF)

Project manager: Seshni Kazadi

Typeset in 11 on 13 pt Photina MT Std

How_to_think_BOOK_2019.indb 4 2019/12/17 09:14

0. Introduction and orientation: macroeconomics in the South African

Part I How does the economy work?

2. The basic model I: consumers, producers and government

4. The basic model III: the foreign sector

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5. Understanding sectoral coherence and constraints: how to use

6. A model for an inflationary economy: aggregate demand

7. Extending the model: inflation and policy reactions

8. Macroeconomics in the very long run: growth theory

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Part II Macroeconomic policy, unemployment, inflation and growth

10. Fiscal policy: the role of government

11. Policy problems: coordination, lags and schools of thought

Table of contents vii

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viii Table of contents

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Combining intuitive understanding and sophisticated analysis

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Learning routes – a choice of difficulty level

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The emerging-market, middle-income and African context

Unemployment – and structural unemployment

Supply-side analysis quite exhaustive

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Inflation integrated from the start

Economic growth theory – in a way everyone can understand

A window on the real worlds of monetary and fiscal policy making

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Extensive case studies and real-world applications

Changes in the fifth edition

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Chapter 0: Introduction and orientation: macroeconomics in the South African context 1

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2 Chapter 0: Introduction and orientation

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The purpose of studying economics is not to acquire a set of ready-made answers to

Chapter 0: Introduction and orientation 3

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4 Chapter 0: Introduction and orientation

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Chapter 0: Introduction and orientation 5

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Legend for icons

! Take note box π Maths box

✍ Activity box Animation available

The data tip box is self-explanatory.

6 Chapter 0: Introduction and orientation