(ECO20B) MACRO. ECON - How To Think and Reason

Macroeconomics-cover-FAp.
indd 1 9/7/09 3:17:17 PM

How to think and reason in
Macroeconomics
Frederick C v N Fourie
Philippe Burger
chapter 00a prelims.indd 3 9/3/09 2:10:22 PM

How to think and reason in Macroeconomics 3e
First published 2013

Print edition first published 2009
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Preface and acknowledgements
The idea for this book was born in 1981, when I was studying at Harvard University.
Although much impressed with the ability of fellow students to manipulate extremely
complex mathematical models of the economy, I realised (and experienced) that a typical
economics graduate could have a master’s degree in economics – or even a PhD – and yet
not have the ability to analyse the basic operation and dynamics of the economy. Graduates
often have very limited knowledge of the institutions, the processes and the data involved,
and often have to unlearn or disregard prior theoretical studies when they start work as
practising economists in the private or public sector. This typically leads to the accusation
that universities provide ‘ivory tower’ training, with limited applicability in practice – a
quite unsatisfactory and unnecessary state of affairs.
The point of departure of this textbook is that theoretical insights and refinements should
always be rooted in a thorough intuitive understanding of economic behaviour, processes
and institutions. While intuitive understanding may not be sufficient for sophisticated
economic analysis and professional policy analysis, if such understanding is absent, further
technical and theoretical sophistication rarely adds to economic wisdom. In addition,
without the ability to situate theoretical insights in real-life institutional context, theory
becomes almost sterile. Institutions often have as large a bearing on economic processes
and outcomes as intrinsic economic forces.
Therefore, in this text, topics typically evolve from a thorough intuitive understanding,
through increasing levels of theoretical sophistication. Pertinent institutional and
historical information and data tips reinforce the link between theory (abstraction) and
reality.
My experience with this approach to teaching macroeconomics has been that students
retain more than with conventional, more-or-less purely theoretical analysis. They also
feel confident in discussing both theory and its practical aspects.
In order to contribute to active learning and a higher knowledge retention rate, the
text has been written in an interactive style, interspersed with questions, data tips,
institutional tips, and so forth. While these may sometimes appear to break the flow of the
argument, they ensure that practical knowledge of institutions and data is continually
integrated with the theoretical analysis. Students are encouraged to ask questions about
the operation of the economy – why do things happen, what if they do, how do the
institutions operate, how does the process actually occur? 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’ macroeconomic problems,
Preface and acknowledgements v

but demonstrate how intelligent economic analysis can help one think more effectively
and make fewer policy mistakes.
All of this will help, I hope, to impart to users of the book (both students and practitioners)
an enduring and satisfying understanding of – i.e. the ability to think and reason about –
macroeconomics.
In the 27 years since its inception as a draft course manual, this text has gone through the
hands of many colleagues who have taught the second-year course in macroeconomics
at the University of the Free State. I am grateful for their considerable input in improving
the content and style of the text. My understanding of fiscal issues, processes, institutions
and data benefited significantly from my stint as head of the Unit for Fiscal Analysis at
the Department of Finance in Pretoria. All my colleagues from that period deserve my
thanks.
While the second edition primarily comprised a data, terminological and institutional
update, the third edition is both an update and a major upgrade of the text.
All data tables and graphs have been updated and new internet sources provided. All
theory sections have been refined and often reorganised to improve clarity and ease of
comprehension, incorporating many proposals from current users of the book. All policy
sections have been freshly updated to incorporate the newest policy approaches as well as
institutional changes since the second edition of 2001 to 2008. New examples have been
added, including several that are related to the 2008–09 subprime crisis in the USA and
its effects on the rest of the world and South Africa.
The book retains its consistent and thorough integration of the open economy context,
right from the word go. It also retains its unique attempt to provide a consistent but
also institution-rich treatment of the complex role of government in macroeconomic
relationships, events, policies and official South African data. The attention to the
developing-country context and issues like structural unemployment is also retained (see
below).
The upgrade comprises both new theory and an upgraded presentation approach. The first
level of change is the addition of new theory chapters or significant additions to existing
chapters.
Economic growth added
The first, and perhaps most significant change to the theory is the addition of economic
growth as a major theme of theory and policy. A full chapter on economic growth
theory has been added (chapter 8), as well as a new section on low growth as a policy
problem, alongside inflation and unemployment, in the final chapter of the book. In many
macroeconomics courses growth theory often is disregarded, or otherwise is experienced
as somewhat disconnected from macroeconomic models that focus on the business cycle,
inflation and unemployment. The treatment in this book is presented as a natural extension
of the theory of aggregate supply, encountered in an earlier chapter, in the context of a
time frame stretching from the short run and medium run to the long run and very long
run.
The sequence and nature of the presentation 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, human
capital and human development. The policy section in chapter 12 also considers aspects
vi How to think and reason in macroeconomics

particularly relevant to understanding low growth in African countries, e.g. institutions,
political barriers, culture, trust, ethnicity, social division, geography and colonialism. The
relationship between economic growth and the environment is also discussed.
Supply side analysis more exhaustive

A second change to the theory is the more exhaustive treatment of the aggregate supply
side to match the depth of the derivation of the aggregate demand side (chapter 6). The
short- and long-run 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
and related supply adjustment processes towards a long-run or structural equilibrium.
The new AS-curve derivation enables a better analysis of supply shocks than in earlier
editions, revealing new complexities, also in the policy context.
A related improvement is a more explicit clarification, throughout the book, of the short,
medium and long run (as well as the ‘very long run’, i.e. the growth context). This attempts to
aid the reader’s understanding of the time dimension of disturbances, various secondary money
market and balance of payments adjustment processes, and aggregate supply adjustment
processes. New timepath diagrams have been developed to demonstrate the possible course of
several variables over time, affording a strong real-world feel to examples.
Inflation context more integrated
A third change to the theory is the more intensive and integrated treatment of inflation
and the inflationary context. This occurs in two ways:
(i) The definitions of variables and all behavioural relationships are situated in an
inflationary context from the beginning of the book. While a variable price level is
only formally introduced with the AD-AS model in chapter 6 and inflation only in
chapter 7, the distinction between nominal and real variables is introduced in the
first theory chapters (chapters 2 and 3). This includes the distinction between real
and nominal interest rates, which 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.
(ii) A new chapter (chapter 7) recasts the AD-AS model in the form of an inflation-
augmented AD curve combined with inflation-augmented AS curves, renamed the
short- and long-run Phillips (or PC) curves. By making the rate of inflation an explicit
variable on the vertical axis of the typical price-output diagram, it strengthens the
ability of the reader to analyse macroeconomic shocks and adjustments in a context
where inflation is a permanent phenomenon. This chapter also includes a discussion of
the monetary reaction (MR) function, typically associated with an inflation-targeting
policy regime.
Formal theory and mathematical treatment strengthened
A second level of change is that the formal theory and mathematical content of the text
has been strengthened, inter alia through the addition of ‘maths boxes’ throughout the
theory chapters that show the relevant mathematical derivations alongside the intuitive,
chain-reaction and diagrammatical analyses.
Nevertheless, the book retains one of its main characteristics: the ability to read and
understand the theory at different levels. These now are: (a) mainly intuitive with the help
Preface and acknowledgements vii

of chain-reaction arguments and relatively simple diagrams, or (b) more theoretical with
the help of more complex diagrammatical aids such as the IS-LM-BP model and the PC-
MR curves, or (c) with the aid of mathematical derivations and analysis.
Developing country and African context strengthened
A third level of change is a stronger highlighting of the developing country and African
context of macroeconomics in South Africa. A new first chapter, based on the previous
chapter 6, sets the scene by discussing the main macroeconomic problems, also in the
policy context.
However, the text integrates the standard macroeconomic issues and policy objectives
with the broader development context of a developing country such as South Africa
(within Africa). A brief overview of the definition, measurement and analysis of human
development is presented.
The chapter concludes with perspectives on the economic debate in South Africa, including
an introduction to the political-economic elements of race, class, capitalism and apartheid
that continue to shape the macroeconomic policy debate in South Africa.
The development aspect gets attention throughout the book – whether in the form of
informative boxes and reader activities or explicit discussions of, for instance, the link
between economic growth and development in the chapter and sections on economic
growth. The problems of HIV and Aids also receive attention wherever appropriate.
Moreover, as before, the treatment of unemployment and a long-run equilibrium output
level in the theoretical model is couched in a way which is able explicitly to accommodate
the existence of structural unemployment and a structural rate of unemployment (SRU),
whilst retaining easy comparability with developed-economy texts and theory.
I would like to thank the many users of the book who have provided constructive proposals
in improving the text, notably Lorraine Greyling of the University of Johannesburg. In
particular I would like to thank Philippe Burger of the University of the Free State, who
has joined me as a co-author, for his contributions to the new theory sections as well as his
knowledge of macroeconomic theory, policy and data, which was of great help in updating
and upgrading this book.
Frederick C v N Fourie
University of the Free State
Bloemfontein
South Africa
May 2009
viii How to think and reason in macroeconomics

On economics . . .
He who teaches facts and facts alone

Lives only for today and dies when facts have changed.
But he who teaches people to think
Lives for the future and survives as long as thought does reign.
Anonymous
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.
Joan Robinson
The habit of asking questions and not being satisfied with a pompous non-answer is one
of the great things that the study of economics can hope to implant in students.
Robert Solow
On economics . . . ix

Table of contents
0. Introduction and orientation ..........................................................................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
1.3.1 Economic growth and increasing employment....................................... 12
1.3.2 Output and employment stability ........................................................... 15
1.3.3 Stable and low inflation .......................................................................... 16
1.3.4 Balance of payments (BoP)..................................................................... 17
1.3.5 Distributional and equity objectives........................................................ 18
1.4 The development objective ..................................................................................... 21
1.4.1 What is development? ............................................................................. 21
1.4.2 How does one measure development?..................................................... 22
1.4.3 The development picture – South Africa and other countries ................. 22
1.4.4 What has macroeconomic policy to do with development?..................... 24
1.5 Intermediate objectives ........................................................................................... 25
1.6 Conflict between the standard objectives – priorities and trade-offs ..................... 26
1.7 Priority choices of the South African government .................................................. 27
1.8 Main perspectives in the economic debate in South Africa – a review .................. 28
1.8.1 Economic schools of thought – Classicism, Marxism and
Keynesianism.......................................................................................... 28
1.8.2 Political-economic perspectives – race, class, capitalism and
apartheid ................................................................................................ 33
2. The basic model I: consumers, producers and government

2.1 The basic framework ............................................................................................... 40
2.2 The real (or goods) sector ....................................................................................... 44
2.2.1 Real consumption ................................................................................... 46
2.2.2 Real investment (capital formation)........................................................ 50
2.2.3 Macroeconomic equilibrium – the basic idea .......................................... 55
2.2.4 Changes in the equilibrium – multipliers ................................................ 56
2.2.5 Real government expenditure and taxation ............................................ 59
2.2.6 Real exports and imports (introductory)................................................. 64
Table of contents xi

3. The basic model II: financial institutions, money and interest rates
3.1 The monetary sector and interest rates .................................................................. 70
3.1.1 The practical determination of nominal interest rates in the
money market......................................................................................... 71
3.1.2 More formally – the supply of and demand for money............................ 74
3.2 Linkages between the monetary and the real sectors ............................................ 92
3.2.1 The Keynesian transmission mechanism in the short run...................... 93
3.2.2 Secondary effects and ‘crowding out’ ..................................................... 97
3.2.3 Financing the budget deficit.................................................................. 100
3.3 The IS-LM model as a powerful diagrammatical aid.............................................103
3.3.1 Essentials of the IS-LM model ............................................................... 103
3.3.2 Deriving the IS curve ............................................................................ 106
3.3.3 Properties of the IS curve ..................................................................... 107
3.3.4 Deriving the LM curve .......................................................................... 110
3.3.5 Properties of the LM curve.................................................................... 112
3.3.6 IS and LM together – simultaneous equilibrium in the real
and monetary sectors ........................................................................... 115
3.3.7 Different slopes and policy effectiveness................................................ 122
3.3.8 The potency of monetary policy – an important
counterintuitive result .......................................................................... 126
4. The basic model III: the foreign sector

4.1 Background – why trade internationally? ..............................................................131
4.2 Imports, exports and capital flows ........................................................................132
4.2.1 Imports (M) .......................................................................................... 133
4.2.2 Exports (X)............................................................................................ 136
4.2.3 Capital flows ......................................................................................... 142
4.3 The balance of payments and exchange rates .....................................................146
4.3.1 The balance of payments (BoP) ............................................................ 146
4.3.2 Exchange rates...................................................................................... 152
4.3.3 The BoP and exchange rates – a restatement and summary................. 160
4.4 The BoP adjustment process ................................................................................161
4.5 The complete model – the BoP, the exchange rate and the domestic
economy ................................................................................................................162
4.5.1 Monetary policy steps – consequences and effectiveness ...................... 163
4.5.2 Fiscal policy steps – consequences and effectiveness ............................ 166
4.5.3 External disturbances ........................................................................... 168
4.5.4 Analysing internal and external disturbances – a general method....... 170
4.5.5 Chain reactions in reverse – the likely causes of events ........................ 171
4.5.6 Thirteen open economy puzzles ............................................................ 173
4.6 Conflict between internal and external considerations.........................................178
4.7 The IS-LM-BP model for an open economy..........................................................178
4.7.1 The IS curve in the open economy ........................................................ 179
4.7.2 The LM curve in the open economy ...................................................... 179
4.7.3 The BP curve ........................................................................................ 181
4.7.4 Using the IS-LM-BP model – the basics ................................................. 183
4.7.5 Using the model for an open economy – disturbances and policy
effectiveness.......................................................................................... 187
xii How to think and reason in macroeconomics

5. National accounting identities and macroeconomic analysis:
uses and abuses
5.1 From equilibrium conditions to identities ..............................................................196
5.2 The interpretation of identities – uses and abuses ...............................................198
5.3 Expenditure, production and current account deficits..........................................201
5.4 The sectoral balance identities .............................................................................201
5.4.1 Interpretation 1 – external imbalances................................................. 204
5.4.2 Interpretation 2 – saving and investment imbalances .......................... 205
5.4.3 Interpretation 3 – current fiscal deficits................................................ 207
5.5 The financing of gross capital formation ...............................................................207
5.6 The SNA at a glance – relationships between subaccounts .................................210
5.7 Using the sectoral balance identities for decision making ...................................214
Addendum 5.1 National accounting definitions and conventions –
a student‘s guide .............................................................................................................217
6. A model for an inflationary economy: aggregate demand and supply

6.1 Essentials of the AD-AS model .............................................................................223
6.2 Aggregate demand (AD) ........................................................................................225
6.2.1
What is the aggregate demand relationship? How is it derived? ............ 225
6.2.2
What determines the slope of the aggregate demand curve? ................ 226
6.2.3
Deriving the AD curve from the IS-LM model ....................................... 227
6.2.4
How steep is the AD curve?..................................................................................... 228
6.2.5
Which factors shift the AD curve? How far does AD shift? .................... 229
6.3 Aggregate supply (AS) ...........................................................................................231
6.3.1 Deriving aggregate supply – the labour market..................................... 233
6.3.2 The labour market and aggregate supply in the long run (ASLR)........... 239
6.3.3 The labour market and aggregate supply in the short run (ASSR) ......... 248
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together ..................254
6.4.1 Macroeconomic equilibrium in the ‘short’ and ‘long’ run .................... 254
6.4.2 Demand-side disturbances leading to points off the ASLR curve............... 255
6.4.3 Supply-side disturbances leading to points off the ASLR curve.................. 265
6.4.4 Combination patterns ........................................................................... 270
6.4.5 Can this theory explain the course of the South African
economy?.............................................................................................. 273
6.4.6 A comprehensive explanation of the consequences of economic
disturbances ........................................................................................ 275
Addendum 6.1 Labour market changes following demand stimulation .........................277
Addendum 6.2 Labour market details following a domestic supply shock ....................278
Addendum 6.3 A complete example of IS-LM-BP and AD-AS for an increase
in the repo rate ........................................................................................279
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) ..................................................280
Table of contents xiii

7. Extending the model: inflation and policy reactions
7.1 Adjusting the model: inflation-augmented AD and AS curves ..............................284
7.1.1 A state of steady inflation ..................................................................... 284
7.1.2 Disturbances in the π-Y plane............................................................... 286
7.1.3 The AS-adjustment process in the π-Y plane with AD and PCSR .......... 287
7.1.4 A permanent increase in output above YS? The augmented
Phillips curve policy lesson ................................................................... 290
7.1.5 The short-run and long-run Phillips curves (PCSR and PCLR) –
history and insight................................................................................ 292
7.1.6 Summary: some Phillips curve lessons for policymakers ...................... 295
7.2 Managing inflation – policy options and the monetary reaction
(MR) function .........................................................................................................298
7.2.1 Basic effects of anti-inflationary policy................................................. 298
7.2.2 Steering the process – more activist policy strategies ............................ 299
7.2.3 Conclusion............................................................................................ 304
8. Macroeconomics in the very long run: growth theory

8.1 The importance of growth .....................................................................................307
8.2 Why growth theory? ..............................................................................................308
8.3 From intuition to formal analysis – from AD-AS to the Solow growth model ........310
8.4 Rearranging the model – towards income per capita ...........................................314
8.4.1 Recasting the production function........................................................ 314
8.4.2 Moving along TP, shifting TP ................................................................ 315
Y
8.5 Sources of sustained growth in ] N
: first conclusions .............................................316
8.6 Is any capital–labour ratio possible? The idea of balanced growth ......................318
8.6.1 The concept of balanced growth .......................................................... 318
8.6.2 Conditions for a balanced growth point – a first version ....................... 319
8.6.3 Automatic adjustments towards the balanced growth point ................ 321
8.7 Expanding the model – the expanded balanced growth condition ......................322
8.7.1 Technology and institutions – conditions for a balanced growth
path ...................................................................................................... 322
8.7.2 The balanced per capita growth path over time .................................... 324
8.8 Using the model – changes in the balanced growth path due to changing
parameters ............................................................................................................326
8.8.1 Changing the saving rate s.................................................................... 326
8.8.2 A change in the population growth rate n ............................................ 329
8.8.3 A change in a (the growth rate of A, the labour efficiency index) ......... 330
8.9 Convergence between developed and developing countries? .............................332
8.10 Human capital – the previously missing element ..................................................333
8.11 Summary and conclusions ....................................................................................336
8.11.1 Main conclusions from growth theory .................................................. 336
8.11.2 Possible complications and new theoretical developments ................... 338
8.12 A last word on growth (for now…) .........................................................................339
Addendum 8.1 The Cobb-Douglas production function .................................................341
Addendum 8.2 An illustration of balanced growth – the course of ratios
between key variables ............................................................................343
xiv How to think and reason in macroeconomics

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............................................................................349
9.2 Monetary policy design – five important choices..................................................353
9.2.1 Overarching policy objectives or mission .............................................. 353
9.2.2 Intermediate or final policy targets?...................................................... 354
9.2.3 Which intermediate policy variable – interest rates or the
money stock? ........................................................................................ 355
9.2.4 Direct or indirect measures? ................................................................. 357
9.2.5 Which specific target values? ................................................................ 359
9.3 Inflation targeting in South Africa ..........................................................................360
9.4 The practice of monetary policy ............................................................................363
9.4.1 Monitoring the monetary policy environment...................................... 363
9.4.2 The operational procedures of the Reserve Bank .................................. 365
9.5 Public debt management – the interface between financial markets and
fiscal and monetary policy ....................................................................................366
9.6 Exchange rate policy and the problems of monetary policy in an
open economy .......................................................................................................369
10. Fiscal policy: the role of the government

10.1 State, government and public sector ....................................................................375
10.2 Definition and instruments of fiscal policy ............................................................375
10.3 The choice of overarching policy objectives .........................................................380
10.4 Constraints on fiscal policy choices .....................................................................383
10.4.1 The sectoral balance identities.............................................................. 384
10.4.2 The budget identity............................................................................... 385
10.4.3 Fixed budgetary commitments ............................................................. 386
10.5 The decision on the main fiscal aggregates..........................................................388
10.5.1 Aggregate government expenditure...................................................... 388
10.5.2 The aggregate level of taxation (tax burden) ........................................ 394
10.5.3 The budget deficit and the borrowing requirement............................... 398
10.5.4 The sequence of decisions – the budget process.................................................. 404
10.6 Public debt and public debt management ............................................................407
10.6.1 The size of public debt .......................................................................... 407
10.6.2 How does SA’s public debt compare internationally? ............................ 409
10.6.3 Domestic vs. foreign debt ...................................................................... 409
10.6.4 Budget implications of the interest on public debt ................................ 410
10.6.5 The Reserve Bank, monetary policy and public debt............................. 410
10.7 Fiscal discipline and fiscal norms .........................................................................412
10.7.1 A variety of fiscal balances ................................................................... 413
10.7.2 The conventional deficit as fiscal norm?................................................ 415
10.7.3 The current deficit as fiscal norm? ........................................................ 418
10.7.4 The primary balance and sustainability ............................................... 421
10.8 Fiscal policy and development: broader criteria ...................................................426
Addendum 10.1 Measuring aggregate government expenditure ...................................429
Addendum 10.2 Measuring government revenue and the deficit ...................................434
Table of contents xv

11. Policy problems: coordination, lags and schools of thought
11.1 Monetary vs. fiscal policy? ....................................................................................435
11.2 Policy problems .....................................................................................................438
11.2.1 Policy lags ............................................................................................. 438
11.2.2 Forecasting and theoretical uncertainty............................................... 440
11.3 The larger problem – different schools of thought ................................................441
11.3.1 Background: the Classical model and the Quantity Theory
of Money .............................................................................................. 441
11.3.2 Monetarism and the transmission mechanism ..................................... 444
11.3.3 The New Classical school...................................................................... 447
11.3.4 New Keynesian economics.................................................................... 449
11.3.5 The policy debate between Monetarists/New Classicals and
New Keynesians.................................................................................... 451
12. Inflation, unemployment and low growth: causes and remedies

12.1 Inflation .................................................................................................................455
12.1.1
Definition and measurement ................................................................ 455
12.1.2
The Monetarist/New Classical explanation of inflation ........................ 458
12.1.3
A broadly Keynesian explanation and policy approach ........................ 461
12.1.4
Structuralist and conflict views of inflation.......................................... 473
12.2 Unemployment ......................................................................................................475
12.2.1 Definition and measurement ................................................................ 475
12.2.2 Causes and remedies – conventional views ........................................... 484
12.2.3 Structural unemployment .................................................................... 489
12.2.4 Shortcomings of the policy debate on unemployment.......................... 497
12.3 Low economic growth ...........................................................................................497
12.3.1 The definition and measurement of economic growth ......................... 497
12.3.2 The growth experience – a global overview .......................................... 499
12.3.3 Low growth: causes and remedies – conventional views....................... 506
12.3.4 New views – the deeper dimensions of growth ..................................... 512
12.3.5 Colonialism and low economic growth in Africa .................................. 519
12.3.6 Economic growth and the environment .............................................. .521
12.3.7 Last thoughts on economic growth ..................................................... 523
12.4 A final thought – the structural dimension of macroeconomic problems ............524
Index ................................................................................................................................... 525
xvi How to think and reason in macroeconomics

Introduction and orientation 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. It strives to teach an active way of thinking, not dry, static theory.
Consequently, the subject matter is presented in a particular style which 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.
Part I presents the basic theortetical framework. The first chapter sets the scene. After
a brief introduction to macroeconomics as a field and its usefulness to you as a citizen
and other illustrative role-players in society, the main macroeconomic problems and
issues are described. These also constitute the main macroeconomic policy objectives, as
practiced by policymakers in the fields of, notably, fiscal and monetary policy – within
the broader development context of a middle-income developing country such as South
Africa (within Africa). A brief overview of the definition, measurement and analysis of
human development is presented. 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 shape the macroeconomic
policy debate in South Africa.
The text covers the main topics and components of macroeconomics at the level of a
second course. While it generally assumes prior knowledge of the basic Keynesian model
at an introductory economics level, this not absolutely essential. In the first chapter 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. 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, especially disturbances and resulting short-run
fluctuations (i.e. the business cycle).
The second chapter 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.
After studying this chapter, you should feel comfortable with discussions of financial markets
and interest rates in the financial news media, and understand the linkages between
Chapter 0: Introduction and orientation 1
chapter 00b introduction.indd 1 9/3/09 11:33:50 AM

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.
(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 ap-
proach 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 main insights and abilities can be acquired without having to learn the details or
mathematics of the IS-LM model.
S This book accordingly enables you to understand the subject matter in either a logical-
intuitive or a more formalistic manner, or both. Nevertheless, there are many benefits
to mastering the more formal model, and you are strongly encouraged to put in the
necessary effort to do so.
The South African economy is an open economy, strongly subject to international eco-
nomic 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
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.
S 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.
S 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.)
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:
2 How to think and reason in macroeconomics

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.
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.
An area of data fraught with dangers of false reasoning is the national accounts and the
national accounting identities. The national accounts can be a dry subject area, dominated
by numerous definitions and accounting conventions. Often these can seem rather obscure
or irrelevant. Chapter 5 provides a different, perhaps unique, treatment. It shows you how
to use the national accounting identities as tools to bolster your logical-intuitive reasoning
and analysis of macroeconomic change. Used correctly, these identities can be powerful
analytical instruments. 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.
Most readers of this text were born at a time in history when inflation seems as natural as
sunlight. 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.
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).
Chapter 7 adapts the AD-AS model, which is designed to explain changes in the average
price level, to a model which explains inflation as such, i.e. sustained increases in the price
level over the years. The adapted AD-PC model has the aggregate supply 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 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.
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 depends 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.
Part II deals with macroeconomic policy and institutions, 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. Notably, the institutional dimension – which may
often be more decisive than formal economic knowledge – is incorporated throughout the
discussion.
The chapter on fiscal policy is especially rich in this regard, and is something that
distinguishes this publication from most other available textbooks. 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 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.
S This is one area where Joan Robinson’s adage (above) 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.
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.
Chapter 1 sets 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 two mainstream schools of thought. 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 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 developing country like South Africa.
Consequently, this last chapter also broadens your understanding to include elements
outside conventional macroeconomics. 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.
So, there it is. Now read – and enjoy thinking and reasoning about macroeconomic events
and policy!
Legend for boxes
! Take note box
Activity box
π Maths box
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:
Q understand and explain what macroeconomics entails and why it is useful to you
and others;
Q understand and interpret the main concerns that are the focus of macroeconomics;
Q identify and explain the standard objectives of macroeconomic policy;
Q analyse and assess the complexities involved in defining and pursuing these objectives,
including the potential for conflict between objectives; and
Q integrate macroeconomic objectives in a broader development context, and evaluate the
relative importance of macroeconomic goals in the broader social context.
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 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 are 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 get an
understanding of how things work.
1.1 What is macroeconomics?

The economy comprises millions of individuals, workers and families, 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 macroec onomics 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 like the business cycle (upswings,
downswings, recessions, 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 (like economic
instability, high inflation, high unemployment and poverty) and enhancing positive
processes like economic growth and development.
1.1 What is macroeconomics? 9
chapter 01final.indd 9 9/3/09 11:35:31 AM

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 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 can help the following:
S 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 US or Japan (such as the ‘subprime’
financial crisis of 2008).
S Individuals hoping to get a job due to new factories being erected by private companies,
or roads being constructed through public works programmes.
S 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?
S Young people concerned about their future income and wealth prospects, or families
concerned about the impact of their mortgage interest rate on their monthly budget.
S 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 didn’t 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.
S 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.
S Farmers planning major export initiatives for their product, but concerned about
possible changes in the exchange rate or in sales prospects abroad.
S Farmers or factories concerned about the effect of the international oil price on their
input costs (diesel, etc.).
S 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 RDP), environmental policy, or other policies.
S 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 like the containment of
inflation.
S NGO or government officials and politicians caring about equity and social justice, or at
least the social consequences of things: understanding 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).
10 Chapter 1: Why macroeconomics? An introduction to the issues

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 – interest rates,
the inflation rate, the exchange rate, the gold price, the oil price, US interest rates, China’s
economic growth, and so forth.
The macroeconomic dimensions noted above can be summarised as comprising the
following:
S 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 it 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);
S Ongoing medium-term phenomena like 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
S The very long-run growth trend and ways to influence it, within the broader context of
the development challenges of a middle-income developing country with deep-seated
problems of poverty, underdevelopment and skills deficiencies, as well as health-related
issues such as HIV and Aids – and of course the wider issue of 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 like 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 the problem of climate change.
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. low unemployment)
2. Stability of output and employment levels
3. Stable and low inflation
4. The balance of payments
5. Distributional and equity objectives
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
1.3 Main macroeconomic problems and policy objectives 11

macroeconomic performance of a country. However, for South Africa as a middle-income
developing country, macroeconomic events and discussions of policy objectives can never
be severed from the encompassing concern of economic and human development.
For any student in a developing country, it is essential to understand the linkages and
broader context of these issues. Section 1.5 below 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, surely, is the objective that 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.
Economic growth is defined as a sustained increase in the trend level of either (a) aggregate
production (GDP), or (b) per capita GDP (i.e. average GDP per person).
The trend level is used in this definition to indicate that cyclical deviations from the trend
are not of concern here. The focus is on the behaviour of the full-capacity level of output
(GDP) over time. Therefore, economic growth is a long-run policy consideration.
S 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. with the business
cycle).
S 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 than
fluctuations in GDP for the welfare and wealth of people.
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. (See chapter 12 for
more details on the definition and calculation of the growth rate.)
S 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 unfortu- Table 1.1 Average economic growth in South Africa
nately does not exclude the cyclical com-
Real GDP Per capita real
ponent of the behaviour of GDP – it mixes growth GDP growth
cyclical increases and decreases in GDP
1971–75 3.66 1.22
with the long-run trend. To see the long-
run pattern, one has to smooth the an- 1976–80 3.12 0.72
nual growth rates by taking averages over 1981–85 1.40 –0.90
longer periods, as shown in table 1.1.
1986–90 1.68 –0.48
The data in table 1.1 and figure 1.1 clearly
1991–95 0.89 –1.22
show how dramatically the South African
growth performance declined since the 1996–2000 2.80 0.66
mid-1970s (amongst cyclical increases 2001–2005 3.87 2.22

and decreases in growth) – with the 2006–2008 4.49 3.23
1980s and early 1990s being the worst
Source: South African Reserve Bank.
– but also how it has recovered since the
change in government in 1994.

Figure 1.1 Real GDP growth rate 1960–2008
10
4
Percentage
–2
–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
Source: South African Reserve Bank (www.reservebank.co.za).
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.
S Up to 1990 the South African population growth rate averaged approximately 2.5%
per annum. Since 1991 it has fallen steeply, averaging only 1%.
S While real economic growth rate was insufficient to compensate for the population
growth for many years, the period since 1990 has seen average GDP per person
actually increase (see figure 1.2).
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.
GDP growth and the reduction of unemployment

Assuming a direct link between GDP growth and 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. The phenomenon of ‘jobless growth’ or ‘low labour-intensive growth’ is a puzzling
one for many countries. Growth in GDP therefore does not necessarily lead to a corresponding
long-run increase in employment.

Figure 1.2 Real per capita GDP (2000 base year) 1960–2008
28 000
26 000
24 000
Real GDP
per capita
22 000
20 000
Rand
18 000
16 000
14 000
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
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 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 amongst the population, i.e. the extent to which people share
in the growth. This is the issue encapsulated in objective 5 above (also see section 1.3.5 below).
Unfortunately, it often happens that the benefits of growth largely flow to a relatively small group
of already well-off people and do not ‘trickle down’ to the poor. This phenomenon explains much
of the political tension and mobilisation in South Africa in the 1960s and 70s. Of course, it is much
worse if per capita GDP starts to decline, as seen in the mid-1980s and early 90s.
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. (Important: see the discussion of development in section 1.4 and
also chapter 12, section 12.3.6.)
1.3.2 Output and employment stability

Since the definition, measurement and causes of unemployment are discussed thoroughly
in chapter 12, only selected aspects are touched upon here.
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, and 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. (As we will see later, ‘full’ employment does not actually mean
0% unemployment. It allows for frictional unemployment and seasonal unemployment –
see box in chapter 6, section 6.3.2.)
In developing countries with significant poverty, such as South Africa, unemployment
is one of most important issues from the point of view of both government and labour
unions. During cyclical downturns in the economy the plight of those losing their jobs
whilst 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. It is
assumed, therefore, that cyclical fluctuations in GDP will cause corresponding changes in
total employment.
S The standard objective of stabilisation policy, therefore, is to moderate cyclical fluctu-
ations in GDP and thus simultaneously moderate fluctuations in employment.
While far from correct in the context of long-run growth, it may be less of a problem in
the short-run context. Nevertheless, cyclical fluctuations in production do not necessarily
translate into corresponding fluctuations in employment. An upswing in production does
not necessarily imply a corresponding proportional increase in employment, for example, if
the extra output is produced using machines and capital goods with surplus capacity, or with
current employees working below capacity. Likewise, in a downswing, employment can fall
either less than production if labour unions use their power to prevent retrenchments, or 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.)
S Therefore, policy steps aimed at either long-run or short-run levels of GDP are not
automatically appropriate or sufficient for the employment objective.
The important implication is that, to a significant extent, the unemployment problem is
outside the reach of normal macroeconomic policy remedies. Steps to moderate fluctuations
in GDP or to promote growth cannot be automatically assumed to be sufficient to dispense
with the problem of unemployment. If employment is chosen as a legitimate objective
of public policy (a socio-political decision), it has to be pursued as an objective in its own
right, and is likely to require specific policy steps geared towards employment promotion

or creation. Different kinds of unemployment (as discussed in chapters 6 and 12) may
require different kinds of policy steps. Of course, the impact of macroeconomic events and
policies on employment must be taken into account in all employment policy planning.
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 1.2 displays
the five-year averages for inflation in South Africa since the 1960s. Notice the steep
increase in the inflation rate in the 1970s, an increase that was reversed only in the
late 1990s.
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.
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.
The formulation and pursuit of this policy objective is Table 1.2 The rate of inflation in South Africa
no simple matter. For example, one must distinguish
1961–65 2.3%
between the prevention of higher (or increasing)
inflation and the actual reduction of the inflation 1966–70 3.2%
rate. That the latter is automatically preferred to the 1971–75 9.1%
former is not accepted by all.
1976–80 12.1%
S Also bear in mind that, specifically when inflation
is a policy objective, the existence of various 1981–85 14.0%
trade-offs will be of utmost importance. The most 1986–90 15.3%

prominent (and controversial) of these is the 1991–95 11.3%
inflation–unemployment trade-off (see chapters
1996–00 6.7%
7 and 12).
2001–05 5.1%
Another important link between inflation and
other policy objectives derives from the impact 2006–08 7.8%
of high domestic inflation on the international Source: South African Reserve Bank.
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):
S People with debt (borrowers) benefit from inflation, since the real value of the debt
decreases gradually due to inflation. Home-owners 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.
S Inflation harms any person with a constant or slow-growing income source. Pensioners
and people dependent on interest income are important examples.
S 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).
S 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.1
S 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
1 Chapter 4 demonstrates that the different channels of the BoP adjustment process can drastically affect the
effectiveness of, for example, monetary policy.

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 (as has been the case with South Africa between since 1994
and especially 2003).
1.3.5 Distributional and equity objectives

The equity of the distribution of
income and wealth between indi- Equity or equality?
vidual members of the population Equity does not mean that everyone should have an
is an important consideration equal share (or quantity) of income or wealth. This is
when evaluating just how opti- not what it is all about. Equity is about fairness and
mal the overall results of the eco- justice, which are complex concepts. Equity cannot
nomic institutions, processes and and should not be reduced to a one-dimensional
interactions in a country are. The measure such as equality in the quantity of income or
issue is whether each individual wealth of persons or households.
or household in society earns or
possesses a sufficient, fair or equit-
able share of the national income and wealth.
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
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). First World countries usually
have Gini values around 0.40 and Third World countries values between 0.50 and 0.60.
For South Africa the Gini value was estimated at 0.68 in 1991 – one of the highest in the world.
The Income and Expenditure Survey of 2005/6 estimated several different Gini coefficients.
The Gini coefficient for income from work was 0.80. The Gini coefficient for income from
work and social security benefits was 0.73. The payment of various social grants contributes
significantly to a reduction in income inequality in South Africa.
Inequality can also be measured from the expenditure side, and not only the income side.
When measured from the expenditure side it is 0.69 when tax payments are included in
expenditure and 0.67 when tax payments are excluded from expenditure. That the payment of
taxes causes a marginal decline of the Gini coefficient indicates that taxes overall are slightly
progressive in their effect.
Although inequality in South Africa has a significant racial pattern, there is also significant
inequality within each population group. The Gini coefficient for disposable income for
blacks is 0.63 – more unequal than that for whites, which is 0.53 – and appears to have been
increasing.
For more information on income and expenditure inequality in South Africa, visit the website of
Stats SA at www.statssa.gov.za.

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, it often 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.
In South Africa the distribution of personal income is exceptionally unequal compared
to other countries – even some Third World countries. Together with Namibia and Brazil,
South Africa has the ominous reputation of having the highest degrees of income and
expenditure inequality in the world.
S According to the 2005/6 Income and Expenditure Survey, the richest 10% of the
population as a group receive 51% of total income, while the poorest 50% of the
population receive less than 10% of total income in the country.
S Another way of putting this is to say that 10% of the population receives half of all
income, while the remainder 90% of the population receives the other half of all income.
The political and policy relevance of this inequality cannot be underestimated.
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.
S Unfortunately, the traditional macroeconomic policy debate, especially in the private
sector, often disregards the distributional objective.
It is true that the South African government has been giving increasing attention to the
inequity of economic conditions – even before the political transition. In a number of budget
speeches in the 1980s, for instance, the equity and political dimensions of government
spending and taxations were examined explicitly. 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:
S 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.
S 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.

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 with 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.
R This viewpoint is present in the initial policy documents of the ANC, as well as, for example, in the proposals
of MERG (the Macroeconomic Research Group) or its successor NIEP (the National Institute for Economic
Policy) which have had some influence on ANC policy and thinking. Cosatu (the Congress of South African
Trade Unions) also argues from this broad perspective, as do other labour unions such as Numsa.
Different and subtler variants of these two viewpoints have developed in the past few years. In the
Reconstruction and Development Programme (RDP) of the ANC, elements of both viewpoints are present.
The redistribution sentiment remains strong, though – not in its original crude form, but still with a strong
focus on economic empowerment and capacity building. In this the government is accorded a significant
responsibility, with certain elements 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 South Africa (ASGISA). With
its emphasis more on microeconomic policy aspects, ASGISA, more than GEAR, recognises the need for
some human development as a prerequisite for growth. This means that, within the constraints of the budget,
government recognises that some human development can and must take place without waiting for growth.

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:
‘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:
S Income is a means, not an end. The well-being of a society depends on the uses to which income
is put, not on the level of income itself.
S 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.
S Present income of a country may offer little guidance as to its future growth prospects.
S Multiplying human problems in many industrial, rich countries show that high income levels,
by themselves, are no guarantee of human progress.
S The simple truth is that there is no automatic link between income growth and human
progress.’
United Nations Development Report (1990: 10)
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.
S This results in economic growth and redistribution through development. Develop-
ment 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.
R This has been demonstrated by the failed efforts of the First World, in previous decades,
to solve the poverty and development problems of the Third World through large capital
projects to achieve economic growth. (Also see chapter 12, section 12.3.)
1.4 The development objective 21

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. 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 key indicators:
S life expectancy (which implicitly includes factors such as nutrition, health and shelter);
S knowledge (which includes adult literacy and enrolment in education, i.e. schools); and
S income (purchasing-power-adjusted real GDP per capita, which measures people’s
access to the means necessary for a humane existence).
1.4.3 The development picture – South Africa and other countries

For South Africa, the development picture as compared with three groups of countries is
shown in table 1.3.
The data show that South Africa compares quite well with other middle and lower income
countries in terms of average income levels, but relatively poorly in terms of literacy and,
especially, life expectancy – and also with regard to the overall development index, the
HDI. A country such as Tajikistan, for example, has an income level only 20% of that of
South Africa, but its HDI is higher.
S The spectre of AIDS has had a marked downward effect on life expectancy in South Africa
and other African countries since 1995, with a similar effect on the HDI values.
S Life expectancy in South Africa fell from 62.2 years in 1992 to 53.2 in 1998 to 50.1 in
2006. That is a quite disturbing decline.
Income and development

Study table 1.3 below. 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.)
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________

Table 1.3 Development indicators 2006
Life Adult Combined GDP per

expectancy literacy enrolment capita
Rank Country HDI
at birth rate ratio in
education
High Human Development 1980 1990 2000 2006 (years) (%) (%) PPP US$
1 Iceland 0.888 0.915 0.945 0.968 81.6 99 96.0 35 814
6 Netherlands 0.887 0.916 0.949 0.958 79.4 99 97.5 36 099
8 Japan 0.886 0.916 0.941 0.956 82.4 99 86.6 31 951
10 Switzerland 0.896 0.917 0.945 0.955 81.4 99 82.7 37 396
15 United States 0.892 0.920 0.944 0.950 78.0 99 92.4 43 968
109 Indonesia 0.520 0.623 0.671 0.726 70.1 91.0 68.2 3 455
Medium Human Development
116 Egypt 0.483 0.572 0.665 0.716 71.0 71.4 76.4 4 953
124 Tajikistan .. 0.709 0.648 0.684 66.5 99.6 70.9 1 609
125 South Africa 0.657 0.698 0.687 0.670 50.1 87.6 76.8 9 087
126 Botswana 0.538 0.680 0.619 0.664 48.9 82.1 70.6 12 744
129 Namibia .. 0.653 0.636 0.634 51.9 87.6 67.2 4 819
132 India 0.428 0.494 0.561 0.609 64.1 65.2 61.0 2 489
141 Swaziland 0.545 0.617 0.593 0.542 40.2 79.6 60.1 4 705
144 Kenya .. .. 0.516 0.532 52.7 73.6 59.6 1 436
152 Tanzania .. 0.436 0.445 0.503 51.6 72.0 54.3 1 126
Low Human Development
162 Malawi .. 0.386 0.445 0.457 47.0 70.9 61.9 703
163 Zambia .. 0.481 0.410 0.453 41.2 68.0 63.3 1 273
175 Mozambique 0.281 0.274 0.333 0.366 42.4 43.8 54.8 739
177 DRC .. .. 0.335 0.361 46.1 67.2 33.4 281
179 Sierra Leone .. .. .. 0.329 42.1 37.1 44.6 630
Source: United Nations Development Programme: www.undp.org. (Note: PPP US$ is a special income measure designed
to solve the currency problem encountered in international comparisons of income data.) Human Development Index
1980–2006 (components of index 2006; adult literacy rate 1999–2006 censuses).
In 2006, Iceland had the highest HDI in the world and Sierra Leone the lowest. The US
had the highest per capita income in 2006, but it was ranked only number 15 given that
other developed countries performed better in terms of life expectancy and education
enrolment. (However, the first 20 countries all have very similar HDI values ranging from
0.945 to 0.968.)
For 2006, South Africa ranked number 125 in a list of 179 countries. With the exception of
East Timor, all countries from number 150 to 179 are African countries. This demonstrates
the enormous developmental backlog still faced by Africa.
1.4 The development objective 23

1.4.4 What has macroeconomic policy 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 reas-
on as if development and redistribution are synonymous. Proponents of the redistribu-
tion-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.
S 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 increas-
ing tax burden or an excessive budget deficit or crowding-out or inflation or excessive
stimulation of the economy. Therefore unwise development policy can threaten macro-
economic 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 which does not address the problems of severe
poverty and underdevelopment. In particular, excessively conservative fiscal policy can ser-
iously 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.
Wealth and development

‘The tension between wealth maximisation and human development is not merely academic
– it is real. Although there is a definite correlation between material wealth and human well-
being, it breaks down in far too many societies. Many countries have a high GNP per capita,
but low human development indicators – and vice versa. Countries at similar levels of GNP
per capita may have vastly different human development indicators, depending on the use they
have made of their national wealth. The maximisation of wealth and the enrichment of human
lives need to move in the same direction . . . Even when intercountry data show a general
positive relationship between GNP per head and indicators of quality of life, much of that
relationship depends on the use of extra income for improving public education and health and
for reducing absolute poverty.’
Human Development Report, 1990.
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.
S Achieving such a balance requires that macroeconomic objectives should not be
regarded as of absolute 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.
S 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 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. They are important
because they have crucial implications for the other, main objectives – and are sometimes
important in their own right.
Most notable amongst 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.
1.5 Intermediate objectives 25

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 con-
siderations. 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.
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 amongst citizens of a country, can make limited
impact on the level of human development, or can harm the environment.

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:
S The high priority accorded to economic growth in the 1970s is notable. These were
the last years of the ‘golden age’ in South Africa since the 1960s. From 1976, when
international economic pressure on South Africa (e.g. trade sanctions) began, the BoP
demanded increasing attention. Price stability became more prominent after the 1973
OPEC oil crisis, which introduced the period of high inflation all over the world.
S A rather low priority was given to growth (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, government and the Reserve Bank came to associate
growth with unwanted inflation. This led to an under-emphasis of growth. The official
view, notably pushed by the Reserve Bank, was that a low inflation rate (and strong
BoP) was a prerequisite for growth. This was a distinct characteristic of the official
Reserve Bank policy of the De Kock era. Dr Gerhard de Kock was the governor of the
Reserve Bank at the time. His policy approach was strongly influenced by Monetarist
thought (see below), though during his governorship the Reserve Bank was not able to
reduce and keep inflation below 10%. (This contrasts strongly with the record of many
other countries like the US, UK and Australia that, like South Africa, also experienced a
sharp increase in inflation in the 1970s. They were able to reduce inflation to low levels
in the early 1980s.)
S The under-emphasis of growth appears to have changed in 1986. That year’s budget
speech was unique in that it expressly gave the highest priority to the economic condi-
tions for social and policy reform – i.e. the distribution and equity objective, in conjunc-
tion with the employment objective (indicated in the table). This was a first for a Min-
ister of Finance (then Barend du Plessis). The political unrest of those years (perhaps
partly due to the previous neglect of the employment and growth objective?) is likely to
have been a major factor in this policy shift.
S In 1989–90 growth again received a low priority, with the BoP being exceedingly
prominent. This can be ascribed to the financial sanctions imposed against South Af-
rica, which caused tremendous pressure on the BoP.
S The early 1990s represent a period of 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%.
S With 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.
S 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 International Monetary Fund (IMF) and the World
Bank – both located in the US capital Washington DC – as well as the US government.)
1.7 Priority choices of the South African government 27

The basic principles of the Washington consensus included an emphasis on growth,
fiscal prudence and no government dissaving (which might require cutting government
expenditure and deficits), monetary prudence (to get low inflation) and privatisation.
With the GEAR emphasis on a 6% growth target, many – but most notably the trade
unions – accused government of neglecting employment, redistribution and social
spending. Although government succeeded in reducing the budget deficit and the public
debt burden, it was less successful in stimulating investment and economic growth. Even
though the earlier shortage of international capital inflows was reversed, much of it was
short-run or speculative capital and did not lead to foreign direct investment.
S Since 1999, when Tito Mboweni became governor, the Reserve Bank was able to use
conservative monetary policy to maintain an inflation rate of 6% on average – though
there have been periods when the inflation rate temporarily exceeded 10% due to
exchange rate or oil price shocks.
S 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 experienced
increasing pressure to turn to the more microeconomic and redistributive aspects of policy.
Since 2000, a systematic expansion of the social welfare system – including different forms
of social and child grants – was systematically introduced. Whereas only 5.8 million people
received one or another type of social grant in April 2003, by April 2009 13.3 million
people received a social grant – which is roughly one in four South Africans. The largest
increase took place in child support grants. In April 2003 there were 2.6 million child
grants, while in April 2009 there were 9.1 million.
S In 2006, government introduced the Accelerated and Shared Growth Initiative South Africa
(ASGISA). ASGISA was not so much a comprehensive growth strategy as a collection
of policy initiatives.
1.8 Main perspectives in the economic debate in South Africa –

a review
Any person reading the overview of policy choices and priorities of the South African gov-
ernment 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:

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 amongst people and na-
tions – whilst 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.
S Whilst 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.
S 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 which 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.)
1.8 Main perspectives in the economic debate in South Africa – a review 29

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’.
S 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 economics paradigm up to the end of the third decade
of the twentieth century, the Great Depression of 1929–33 all but killed the Classical
proposition that unemployment at most is a temporary aberration (disequilibrium) which
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 US 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 macro-
economic theory demonstrated that the economy can stabilise (stagnate) at an equi-
librium 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 come-backs, 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 suited 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 don’t 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 2008, the subprime crisis struck in the
US and quickly spread to other countries, leading to the greatest financial and economic
crisis in the world economy since the infamous Great Depression. Analysts quickly
pointed fingers to the legacy of Thatcher, Reagan and others. By making deregulation
and unfettered markets the centrepiece of policy in major First World 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.
Not one but several newspapers proclaimed – with a certain sense of irony – that this
marked a return, in the US at least, to Keynesianism on a huge scale.

South Africa – always a microcosm?
While most of this ideological battle occurred in the US and 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 US, 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 amongst 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 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 amongst 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
self-determination of the volk.)
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 which
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 establishment circles,
whether political or economic. The 1960s were an era of high economic growth based
largely on high gold export earnings. 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 like Jan Lombard and Nic Wiehahn). By this time,
socialism was increasingly associated with the communist threat. In addition, there was
its very immediate 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, 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. Political breakaways
signalled the growing possibility that a major split could develop between those with
stronger 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
(albeit with a social conscience).
These broad political divisions would continue to shape the South African debate, also on
economic policy, in the years to follow.
S 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 is the main dividing factor amongst
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
corresponded necessarily.
R The political left-to-right has always been along race-and-culture views, politics and
policies.
R 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 always have 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:
R 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).


R 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
ANC; elements of the DA and Cope).
R 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 ANC; SACP and Cosatu).

The basic model I:
consumers, producers and government 2
Q understand and construct a basic model of production and income determination;
Q use the model to explain why and how total income in the economy tends to
fluctuate over the course of the ‘business cycle’;
Q compare and explain the behaviour of the main components of expenditure in an open
economy, i.e. consumption, investment, government expenditure, imports and exports;
Q 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
Q 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.
S 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 frequently are 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 run, 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 37

The simple model focuses on the so-called real sector (or goods sector) of the economy, where
real economic activities like 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).
S 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 chap-
ters 7 and 12.)
S 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.
S 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.
S 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. 2000. 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, as shown below, real investment reacts to real
interest rates, but money demand reacts to nominal interest rates.
38 Chapter 2: The basic model I: consumers, producers and government

S 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 since September 1999
Jan 1978 – Aug 1981 Sept 1981 – March 1983 have been the longest since World War II. (See graphs below and 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 turning point
Sept 1999 – Nov 2007 Dec 2007 – date.
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 2000? 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
DATA TIP
South African Reserve Bank. It is available from the Bank or from libraries.
On the internet, the Quarterly Bulletin text and data can be found at: www.reservebank.
co.za
Tables and graphs depicting the course of the main macroeconomic variables in South
Africa can be found throughout the book.
Chapter 2: The basic model I: consumers, producers and government 39

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 below). 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).
S 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 only focus 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 is shown in figure 2.3:
Figure 2.3 A basic circular flow
,_WLUKP[\YLÅV^
(Payments for
goods)
Firms Households
(Producers) (Consumers)
0UJVTLÅV^
(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 41

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.
S 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
1 400 000
1 300 000
1 200 000
1 100 000
R million
1 000 000
Mild recession
900 000
Severe recession
800 000
Potential GDP/trend line
700 000
600 000
1980/01
1982/01
1984/01
1986/01
1988/01
1990/01
1992/01
1994/01
1996/01
1998/01
2000/01
2002/01
2004/01
2006/01
2008/01
The graph in 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 the smaller fluctuations around a strong upward trend after that.
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. In the financial press, 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.
S 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.
S 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.
S 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 43

The income–expenditure diagram or ‘45° dia- Figure 2.5 Equilibrium income determination
gram’ shown in figure 2.5, is the basic graph-
ical aid of the simple Keynesian approach. E
This shows the real sector (or goods sector) of 45° line
the economy, and illustrates the interaction
between total expenditure E and total produc-
tion to determine the equilibrium level of real Aggregate
income Y. The graphical indication of this lev- expenditure
el 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 ver-
tically). Any other Y level is a disequilibrium
level, since production can be seen to be either
higher or lower than expenditure. Y0 Income Y
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:
S as a guide or ‘road map’ to indicate where an economic chain of logic (‘chain reasoning’) must
end up, or
S 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 accounts section.
DATA TIP
S 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.
S The national accounts are explained in chapter 5; section 5.6 shows the relation
between the different accounts and tables. Chapter 5 also contains many tables 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
2000 prices). Observe the relative magnitudes of these categories of expenditure and
Figure 2.6 The components of aggregate expenditure
1 000 000
900 000
Household
800 000 consumption
700 000
600 000
R million
500 000
400 000
300 000
Government
expenditure
200 000
100 000 Business capital

formation
0
1960/01
1962/01
1964/01
1966/01
1968/01
1970/01
1972/01
1974/01
1976/01
1978/01
1980/01
1982/01
1984/01
1986/01
1988/01
1990/01
1992/01
1994/01
1996/01
1998/01
2000/01
2002/01
2004/01
2006/01
2008/01
2.2 The real (or goods) sector 45

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.
S Total consumption expenditure is usually a very stable component of aggregate ex-
penditure.
S The national accounts for South Africa, discussed in more detail in chapter 5 (and which
can be obtained from www.reservebank.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 below 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.
S 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).
S 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.
S The part of disposable income that is not spent on consumption is saved. Therefore
saving also depends on disposable income.
S The essence of the relationship between real consumption and real disposable income
can be found in the marginal propensity to consume (MPC).
S 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?
_______________________________________________________________________________________
_______________________________________________________________________________________
_______________________________________________________________________________________
_______________________________________________________________________________________
Go online to www.reservebank.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 1980 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. How is it related to the marginal propensity to save
(MPS)?
_____________________________________________________________________________________
_____________________________________________________________________________________
S 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.
S 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 corresponding
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.

S The slope of the consumption function is Figure 2.7 Keynesian consumption function
directly related to the marginal propensity
C
to consume. (How?)
S Graphically, any change in consumption
due to a change in Y is indicated by a
movement on or along the C line.
S 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 in-
tercept 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 relations 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.
S 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.
S 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:
1 (Y + ∑ N Y
t+i
Ct = ] ]]]i + At )
T t t+i (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.
S 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.
S From this equation it can be seen that a R1 change in Yt will cause consumption to only
Yt
change by the rand amount __ T
S 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 in-
come – 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.
S Note that consumption in these alternative theories does not include durable consump-
tion. 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 lifespan 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 (though 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.)
S Typically, real investment is a very unstable element in the economy. It is one of the
main sources of instability in a market economy.
S In the national accounts, investment is called ‘capital formation’. These two terms are
synonymous and are used interchangeably in this book.
S Study the behaviour of investment (fixed 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 merely is 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 below, 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, the way business investment
is. Hence the focus on understanding and explaining (private and public) business fixed
investment (capital formation).
In the national accounts and in published investment figures in e.g. the Quarterly Bulletin of the
DATA TIP
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 inter-
est rate have an inverse or negative Sensitivity vs. elasticity
relationship: an increase in the This book refers to parameters such as b and h as
real interest rate is likely to dis- indicators of sensitivity. As slope parameters, they
courage capital formation, while denote the absolute change in one variable due to an
a decreased real interest rate is absolute change in the other, such as ]] Δx
Δy
likely to stimulate capital forma-
Some macroeconomics textbooks incorrectly call
tion. This is so because the real in- these parameters elasticities. An elasticity measures
terest rate is the opportunity cost the percentage change in one variable due to a
of capital formation. percentage change in the other: ]] %Δx
%Δy
S The meaning of the term the
One would only be able to call these parameters
real interest rate was noted in
elasticities if, instead of the actual values of
the introduction, and is ex-
say, consumption and income, one uses natural
plained in detail in the box logarithms of both the left- and right-hand variables.
below. Basically it is the after-
inflation rate of interest. It is
very important to distinguish it from the nominal interest rate. Real investment behav-
iour 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.
S 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.
S 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.
S Real interest rates are the effective interest rates after the eroding effect of inflation has been
removed.
A lender lending e.g. 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
Suppose the real rate is 4% and inflation is 10%. Then the
rate. The nominal rate thus comprises the
nominal interest rate is:
following elements:
Correct formula:
i = r + π + rπ
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:
1+i
r = _____
1+π –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 own funds. Why?
______________________________________________________________________________________
______________________________________________________________________________________
Is there a positive or a negative relationship between financial investment and interest rates?
Why?
______________________________________________________________________________________
______________________________________________________________________________________
S 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. Fac-
Figure 2.8 The investment function
tors such as tax incentives and depreciation
allowances, or decentralisation incentives, are r
often more important, if not decisive, in the de-
termination of investment in South Africa.
r0
S 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
S Changes in confidence and expectations will 45° Line
shift the curve in the diagram.
S The potent influence of expectations and
psychological factors is one reason why in-
vestment can fluctuate wildly at times.
S 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 above diagram (see figure Income Y

2.9). In 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
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
below for the general case.)
S 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 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 experienc es an upswing. In brief:
r L I K total expenditure K production K Y K
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 person 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 6Exp – 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 6Y 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. 6Y) and the original change in expenditure that caused it, i.e.
6Y
KE = _____
6Exp
On the 45° diagram, it can be seen as in figure 2.12.

The value of the multiplier shows the extent to Figure 2.12 The multiplier effect
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 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 ]]1 – b is the multiplier KE and (1 – b) is the marginal leakage rate given for the above
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.
S 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.
S 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).
S 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.
S 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, etc.

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 even contradictory. This is due to
reasons such as the following:
S Different definitions of ‘government’ or ‘public sector’ and the inclusion or exclusion of
different public institutions (universities, public corporations, etc);
S 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
S 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.)
S 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.
S 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 (2005) Economic
Indicators.
We define total government expenditure G as the sum of general government consumption

expenditure and general government investment.
S 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).
S 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.
S 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 (2005) 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
Total government expenditure

25
20
Government consumption
Percentage
15
10
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
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, although the years since 2005 may show some reversal of the
trend, as government investment in infrastructure has started to pick up.

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.
S 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.
S 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.
S 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.
S Graphically, the consumption function is shifted up or down as a result of tax
changes.
S 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
1 – b , with tax (and government expenditure G) we now have:
multiplier was equal to ]]
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.
S 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
1 – b(1 – t) , which is
the smaller is b(1 – t), the larger is 1 – b(1 – t), and thus the smaller is ]]]
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.
S 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
S 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.
S 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 be-
tween 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 av- economy is in an upswing phase, total taxation T
erage 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 tax the upswing. This effect automatically tempers the
T paid will be more at higher upswing. Similarly, in a downswing phase, income
levels of GDP than at lower tax payments will automatically decrease, which
stimulates expenditure and restrains the severity of
levels of GDP. In both cases,
the downswing. In this way, income tax serves as an
a decrease in the average in-
‘automatic stabiliser’ of the business cycle.
come tax rate does not pro- S This also implies that income tax is yet another
duce a parallel upward shift factor that effectively decreases the value of the
in the consumption function, expenditure multiplier.
but rather rotates the C line
upwards (anti-clockwise)
from its intercept with the
vertical axis: the slope of the C line increases, without any change in the intercept.
The activity above for the case of a reduction in income tax will thus appear differ-
ent, graphically, 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 below shows South African imports and exports in real terms since
1960 (at constant 2000 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.
64 Chapter 2: The basic model I: consumsers, producers and government

Figure 2.15 Exports and imports (real terms)
500 000
Real imports of goods

400 000
and services
300 000
200 000 Real exports of goods

R million
and services
100 000
0
Real exports minus
real imports
–100 000
–200 000
1980/01
1982/01
1984/01
1986/01
1988/01
1990/01
1992/01
1994/01
1996/01
1998/01
2000/01
2002/01
2004/01
2006/01
2008/01
Source: South African Reserve Bank (www.reservebank.co.za)
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:
S add spending in foreign countries on South African goods to domestic expenditure, and
S 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).
S 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
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 sub-sector 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
+G
+ I – M)
C X
(
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.

The basic
The basic model
institutions, money
institutions,
model II:
money and
II: fifinancial
and interest
nancial
interest rates
rates 3
Q understand and explain the everyday, practical operation of financial markets;
Q explain the way interest rates are determined by money supply and demand;
Q explain movements in nominal and real interest rates and compare the different roles of
nominal and real interest rates in economic behaviour;
Q 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
Q 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 like 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 like
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 which are channelled via financial institutions. The same is
true for international financial flows deriving from foreign trade or foreign investment.
S The monetary sector can be seen to handle the ‘oil’ (money, credit and financial trans-
actions) necessary for the smooth functioning of the ‘wheels’ of real activities (pro-
duction, 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 analysi s 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 69
The location of this topic in
the circular flow diagram
(compare page 67 in FINANCIAL
chapter 2): INSTITUTIONS
Supply of credit
Savings
Interest Monetary
policy RESERVE
rates
BANK
Demand for credit
FIRMS Government C HOUSEHOLDS

o ns
it borrowing um
red er c
ial c
KLÄJP[ redi t
erc
Co mm
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:

S ‘Monetary aggregates’: money stock figures.
S ‘Money market and related interest rates’: short-term interest rates, such as the BA
rate and the prime rate.
S ‘Capital market and related interest rates’: long-term interest rates.
On the internet, consult the Quarterly Bulletin at: www.reservebank.co.za. Also see Mohr
(2005): 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.)
S 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.
70 Chapter 3: The basic model II: financial institutions, money and interest rates
S 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.
S 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:
S 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.
S 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 gambling.
S 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 71
chapter 03final.indd 71 9/3/09 12:33:14 PM

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

Treasury bills are issued by the Treasury/government when it borrows from the private
sector during the course of the year in order 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.
S 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:
97 000 )( 91 ) × 100 = 12.45%.

( ]]]
3 000 365
]]
S Note: The higher the price the lender has to pay, the lower the nominal interest rate,
and vice versa. If the price of TB went down to R96 000, the rate of return would be:
96 000 )( 91 ) × 100 = 16.71%.

( ]]]
4 000 365
]]
S Since TBs are issued/sold on tender, the initial or issue rate is also called the ‘tender TB
rate’.
S 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).
S 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 sells it for R98 200, say, then the corresponding nominal interest
rate on the TB will be:
98 200 )( 61 ) × 100 = 10.97%.

( ]]]
1 800 365
]]
S Thus, trade and prices in the

A free market?
secondary market determine
corresponding nominal TB Although these transactions occur in the money
interest rates. In this way the market, where supply and demand are of
decisive importance, this trade does not occur
TB rate is determined daily,
in a completely free market. The Reserve Bank
depending on the buying and
continually monitors the market and steers it in the
selling (demand and supply) of direction it desires by intervening in the market in
TBs. various ways, pushing it away from the result that
For example, if investors have sur- market forces would have produced otherwise (see
plus funds and are eager to invest in the discussion of the money supply below).

TBs, the demand for financial paper is high and the price increases accordingly, leading to a de-
crease 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 was 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 banker’s acceptance 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, e.g. 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 seller to accept the bill, the producer asks her bank to guarantee the bill (by signing
on the back, thereby ‘accepting’ it). Such a banker’s acceptance constitutes a claim on the
bank, entitling the holder to receive a certain amount from the bank at a certain date in the
future. The initial recipient of the BA can now sell it in the secondary market; the price –
once again, lower than the face value – results in a corresponding 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 bonds) all share
the following characteristics:
S there is an inverse relation-
ship between the price and the In layman’s terms, one can describe a BA as a ‘post-
dated, bank-guaranteed cash cheque’. While this is
nominal interest rate;
not 100% correct technically – a BA is an instrument
S the price, and thus the nominal
of credit; a cheque is not – this does give one a rough
rate of interest, is determined idea. As is the case with a post-dated cheque, the BA
by the buying and selling of gives the holder the right to receive a certain amount
the paper, i.e. by the demand in future. As with a cash cheque, it is payable to
for and supply of such instru- whoever holds it – in fact, a BA is transferable and
ments. can be sold – and it is guaranteed by a bank.
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.

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, 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.
S The supply of and demand for financial instruments can be understood in terms of the
underlying supply of, and demand for cash or money.
S 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:
S 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.
S 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).
S 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.
S 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 half-way 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 below. 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.
S 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.
S Therefore, the opportunity cost of holding money is the nominal interest rate.
Formally, the demand for money can be divided into three types:
S 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.
S 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.
S 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.

S 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.
S To convert them to real values, the convention is to write them as a fraction, i.e. divide
S D
M M
P and ]
them by the price level P, i.e. ] P .
S We will also work increasingly with the real interest rate r.
The above relationship can be rewritten for the real demand for money:
MD
]] = f(i; Y)
P
We can then express the real money demand mathematically as:
MD
]] = kY – li ......(3.1)
P
D
M
In this equation ] P indicates the real amount of money required in the economy for
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.
D
M
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 follows 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 bank notes 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)
2 500 000
2 000 000
M3
M2
1 500 000
R million
1 000 000
M1
500 000
Coins and notes

0
Jan-90
Aug-90
Mar-91
Oct-91
May-92
Dec-92
Jul-93
Feb-94
Sep-94
Apr-95
Nov-95
Jun-96
Jan-97
Aug-97
Mar-98
Oct-98
May-99
Dec-99
Jul-00
Feb-01
Sep-01
Apr-02
Nov-02
Jun-03
Jan-04
Aug-04
Mar-05
Oct-05
May-06
Dec-06
Jul-07
Feb-08
Sep-08
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 it is that one wants to
analyse.

Who creates money in the economy? The government? The Reserve Bank? How is it created?
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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.
S 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.
S Money creation does not occur via the printing of notes but, rather, via the extension
of credit (loans) by banks.
S 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.
S 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.
S 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.
S 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
S 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 balance sheet subsection below). 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.
S For example, should banks choose to hold excess reserves equal to 1% of deposits, while
1
0.025 + 0.01 = 28.6.
therequired reserve requirement is 2.5%, the effective multiplier will be ]]]]
1
0.025 = 40 if no excess reserves are held. The formula of the
Compare this to the value of ]]
credit multiplier thus indicates a maximum value.
S 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.
S 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?
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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 do 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 below). 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.
S Increases in the repo rate discourage commercial banks from borrowing from the
Reserve Bank and, accordingly, restrain their ability to create credit/money.
S 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).
S 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.
S 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

5VTPUHSPU[LYLZ[YH[LZ
15
10 Bank rate/repo rate
0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
Source: South African Reserve Bank (www.reservebank.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 above) and open market operations (dis-
cussed below), the repo rate conveys a direct price signal to the financial markets as
to the Reserve Bank view regarding the direction into which 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
government bonds (or other instruments) 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.)
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 above).
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?

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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.
S We will see linkages between key, corresponding items in the Reserve Bank and com-
mercial bank balance sheets.
S 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 Bank notes 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.
S The gold and foreign reserves include the dollars, euros, yen and pounds etc. held by
the SARB.
S 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’.
S 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:
S Notes and coins circulating in the economy. Just as a treasury bill is an IOU where-
by 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 bank notes Basel II
had such a promise written
The liability side of banks also includes capital. In decid-
on them).
ing how much capital they must keep, South African
S Deposits made by government banks follow the Basel II Accord of 2001. It states that
(the SARB acts as banker to the amount of capital that banks should keep depends
government) and commercial on the credit, market and operational risks that they face.
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 banks includes:
S The deposits that they hold at the SARB (the required reserves as well as the excess
reserves), and
S Loans and advances that the banks extended to firms and households. These include the 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 commercial banks includes:
S Private deposits (i.e. if you deposit money at the bank, the bank owes you the money).
S 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.
S 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.
S Observe the mechanism through which changes in the repo rate will affect the liability side
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.
S 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.
S 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:
S Loans from the Reserve Bank to banks are symmetrically reflected as assets for the
Reserve Bank and liabilities for commercial banks.
S 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
2 500 000
Total credit extended to

2 000 000 private sector
M3
1 500 000
1 000 000
R million
500 000
Foreign assets
Net credit extended
0 to government
Net other assets

–500 000 and liabilities
–1 000 000
Jan-90
Oct-90
Jul-91
Apr-92
Jan-93
Oct-93
Jul-94
Apr-95
Jan-96
Oct-96
Jul-97
Apr-98
Jan-99
Oct-99
Jul-00
Apr-01
Jan-02
Oct-02
Jul-03
Apr-04
Jan-05
Oct-05
Jul-06
Apr-07
Jan-08
Oct-08
Figure 3.6 Private credit extension and its main components
2 500 000
2 000 000 Total credit extended

to private sector
1 500 000
R million
1 000 000 Mortgage advances
Other loans and

advances
500 000
Instalment sale
credit
0 3LHZPUNÄUHUJL
Jan-90
Sep-90
May-91
Jan-92
Sep-92
May-93
Jan-94
Sep-94
May-95
Jan-96
Sep-96
May-97
Jan-98
Sep-98
May-99
Jan-00
Sep-00
May-01
Jan-02
Sep-02
May-03
Jan-04
Sep-04
May-05
Jan-06
Sep-06
May-07
Jan-08
Sep-08

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,
S
M
indicated as ]P . This parallels the formulation of the money demand function in real terms
above. We will also increasingly use the real interest rate r in our analysis.
S Henceforth, when we use the term ‘money supply’, we mean the real money supply
S
M
]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?
S In a period of uncertainty excess reserves provide security.
S 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.
MS
P curve.
For most macroeconomic chain reactions, it is sufficient to use the simple, vertical ]
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 9LÄULKMVYT! MS

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

S If a portion of the money supply curve is interest responsive (i.e. non-vertical graphically), then
the money supply is partially endogenous (= dependent on factors within the economy)
and reacts spontaneously to changes in the economy.
S If policy makers 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 Figure 3.8 Money market equilibrium
to indicate that the equilibrium between
i M S
the supply of and demand for money isD ]]
P
M
determined
S
by the intersection of the ] P
M
and ]P curves which determines an equilib-
rium interest rate as well as an equilibrium
quantity of money.
Mathematically the equilibrium in the money i0
market can be expressed as:
MS MD
]] = ]]
P P
M D MD
and because ] = kY – li, the money market ]]
P
P
equilibrium condition can be rewritten as:
Real quantity of money
MS
]] = kY li ……(3.2)
P

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 M
]]
D
M D P
market instruments in particular. Changes in ]
S
P
M
or ]P , and changes in the equilibrium interest 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
D
M
to increase (]P shifts right graphically). The following chain of events would occur in the
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 what 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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D
M
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. S
M
S At both equilibrium points: ]P = kY – li.
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?
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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.
S 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.
S 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.
S 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 each type for a few years and compare the levels, also on a graph. Is there any
pattern?
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(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, S 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 S 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. These transactions are conducted every Wednesday. 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
often 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).
S 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.
S Only when the shortage becomes unusually large can one really expect upward pressure
on interest rates.
S In 2008 the average shortage (amount of accommodation) was approximately R13 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

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 (whilst 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).

S 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 K MS L upward pressure on r I discouraged; if I L 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 G+X–
]]
P C + I0 +
M
G+X–
C + I1 +
I0
I1
MD
]]
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 93

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 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
D
M
demand for money MD – the parameter l in ] P = kY – li. We have seen that interest rate
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.
S 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.
S 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.
S 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.
S 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 of
D
M
l in ]P = kY – li – the real impact of a monetary policy step such as an increase in the
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 economic is extremely low. The Great Depression in the US and many
other countries was one such event, and the first months of the 2008/9 financial crisis
were another.)
S 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 reactionand a relatively larger real impact can be expected. In such a situation
monetary policy is relatively powerful.
S The diagrams below 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).
S 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 r MS
]]
P
]]
P
r1
r1
r0 r0
MD MD
]] ]]
P
P
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:
S 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
S 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, say) 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 increases,
D
M
i.e. money demand increases (graphically, ] P shifts right); this puts upward 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 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
¬0
r
Primary effect
M Net
G0 + X –
C+I+ effect
on
income
MD I
]]
P
Real quantity of money ¬0 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.

S 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).
S 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
below.)
S 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.
S 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
It indicates the stimulation of private investment
exports X and the autonomous that may result from government investment in,
components of consumption for example, infrastructure. This is due to the
(the a-term) and investment (the opportunities that the stimulation of the economy
Ia term). It also applies to changes creates for private economic activity in general, or
in investment due to monetary specifically for the private sector to supply inputs to
policy pressure on the real inter- government projects. These backward and forward
est rate and changes in consump- linkages with government investment can serve to
tion due to income tax changes create more room for private investment, hence the
(affecting disposable real income idea of crowding in.
(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.
S 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:
S The extent of the crowding-out effect depends first on the income responsiveness of the
D
M
demand for money – i.e. the k in ]P = kY – li. Recall that the secondary effect is initiated
by an increasein the transactions demand for money due to an increase in production and
D
M
income. In the diagram ] P shifts to the right. If this reaction is strong – k is relatively large
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.
S 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
D
is also relevant in this process. A market with
M
P = kY – li. The increase in
l 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 D
M
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?)
S 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.
S 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 government
expenditure.
Potency of
In reality, the strength of the fiscal policy
crowding-out effect is an em-
Income responsiveness of money demand: High Lower
pirical 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 in Interest responsiveness of investment: High Lower
South Africa appears to be rela- Low Higher
tively insensitive with regard to
Expenditure multiplier: Large Higher
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:
S The increasing use of credit cards implies that the direct need for cash reacts less quickly
to increases in transaction volumes.
S 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.
S 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
S 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 mark
to cause upward pressure on II – from the indirect one analysed above – ‘crowding
interest rates, which is likely to out mark I’.

discourage private investment and is likely eventually to have a contractionary effect
on aggregate expenditure and production.
S 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.
S The impact of the budget deficit on interest rates is particularly important in understanding
interest rate patterns in the US, 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 stock to the Reserve Bank. The payment that the government
receives for the bills constitutes the loan.
S 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, the ultimate increase in

the money supply will in all
likelihood be much larger than This method is also called financing of the deficit
the initial injection into the via money creation. In the media one often notices
the expression ‘financing the deficit with the printing
money supply resulting from
press’, as if the government finances the deficit by
the government financing its
printing money. This is merely a manner of speaking,
deficit with ‘new money’. and does not indicate what usually really happens.
Since such monetary expansion is Remember that the government in South Africa does
commonly regarded as inflationary not control the printing or issue of money – only the
(see chapters 7 and 12) and has Reserve Bank is mandated to do so. Also, actual paper
indeed in reality led to inflationary notes and coins are not the issue where the money
and even hyperinflationary epi- supply is concerned – recall that notes and coins
sodes – Zimbabwe being a case constitute only a fraction of the total M3 money supply.
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).
S 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 and stock issues there. The inflow of the borrowed funds from outside implies
a monetary injection which increases the money supply. The macroeconomic effect is
expansionary.
S 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).
S 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.
S 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.
S 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.
S 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 = R8 to $1 = R12, it means
that for every $1 that the South African government borrowed, it now effectively owes the
lender (maybe a US bank) R4 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.
S 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:
S 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?)
S 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 US, 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 US.)
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 which 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
which directly shows consumption behaviour. The IS-LM curves are indirect, derived
curves.
3.3 The IS-LM model as a powerful diagrammatical aid 103

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 which 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.
S The IS curve shows combinations of the real interest rate r and real income Y that are consistent
with equilibrium in the real sector.
S 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.
S The LM curve shows combinations
Overall macroeconomic
of the real interest rate r and real equilibrium Y1 and r1:
income Y that are consistent with
r1
r simultaneous equilibrium in
equilibrium in the money market.
r0
r real and monetary sectors
S It is a series of potential equilibrium

points, from the point of view of
relationships and behaviour in the
IS curve
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:
S IS: Investment, Savings and other real sector variables.
S LM: Liquidity, Money and other monetary sector variables.8
While potent, IS-LM theory is more technical than the intuitive economic reasoning encountered
! so far. If you feel that the opportunity cost of mastering this material is too high, the following
sections can be skipped without much loss. The non-IS-LM analytical capabilities and simple
diagrams developed in the first two sections of this chapter are sufficient to analyse most closed-
economy macroeconomic problems (excluding inflation; see chapter 6) on a basic level.
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 to be at another level, say r1, it would imply a different level of
investment I and of aggregate expenditure, and hence of equilibrium real income – there-
fore, 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.
S 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.
S 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
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 )
M
r0 X–
+ G+ X–
M
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
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.
S 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. The IS curve alone cannot be used to analyse
(If this is not clear to you, scru- sequences of events in the economy. It summarises
tinise the derivation diagrams only one part of the economy, i.e. relationships and
of the IS curve again, focusing changes in the real sector. The addition of the LM
on the level of investment I as- curve is necessary to incorporate monetary effects and to
sociated with each of the two complete the model.
points on the IS curve: I1 is as- S Diagrammatically: to determine the actual
equilibrium point and value of Y, a specific point
sociated with point Y1 and i1 on
among the series of potential equilibrium points
the IS curve.)
on the IS curve must be selected.
This will depend on the LM curve (see below).

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 which 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):
(
Y = ]]]]]
1
1 – b (1 – t) )
(a + Ia + G – hr) ……(3.3 = 2.6)
= KE(a + Ia + G) – KEhr
1
If this equation is solved for r, one can see that the slope parameter of the IS curve is ]]
K Eh
and its
_1_
intercept h (a + Ia + G):
1 1
h (a + Ia + G) – KEh Y
r = ] ……(3.4)
]]
If exports and imports are included, we have, from chapter 2 (equation 2.8):
(
Y = ]]]]]]
1
1 – b(1 – t) + m )
(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
S 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.
S 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 above.)
changes.
A shift in the IS curve would occur if, for S 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.
S 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 in New real sector
any factor other than the interest rate, which equilibrium Y1 at
unchanged r0
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.
S 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
S Any exogenous change in expenditure
which 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:
S If the multiplier is small, IS shifts relatively little (for a given change in G).
S 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 6Expenditure × 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 L I K total expenditure K production K Y K
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. 0:ÅH[[LY
the interest responsive-
ness of investment – i.e.
the size of h in I = Ia
– hr (or in the formula Y0 Y1 Y2 Y
for 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
1
relatively large. This would make the IS curve relatively flat (its slope being ]] K h ). 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 above). If
the multiplier 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
1
therefore make the IS curve flatter (its slope being ]] K h ). A smaller multiplier would
E
make the IS curve steeper. (Remember that the size of the multiplier depends on vari-
ous marginal leakage rates.
Note that the multiplier affects both the slope of the IS
See 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 the link between monetary relationships and real income Y explicit.
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 above).
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
]] = f(i; Y)
P
= kY – li
But with i = r π:
MD
]] = f(r; π; Y)
P
= 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.
S 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
D
M
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 above, 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.

S 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
S D
M M
moneymarket. For a given real money supply ] P , each different money ]P curve would
imply a different equilibrium real interest rate.
S 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

r Corresponding pairs of Y r demands is at a higher level. Hence a higher
and r denote points that LM curve r is necessary for money market equilibrium
form the LM curve
MS
(r1;Y1
r1 r1
(r0;Y0 MD for income at Y1

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

S The starting point for this derivation is an equilibrium in the money market (right-hand
diagram). For a given money supply (and inflation rate), this shows an equilibrium
interest rate which 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.
S 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.
S 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).
S 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:
( )
S
k 1 M
r = ]l Y – ]
l P + lπ
]] ……(3.6)
(
1 MS
Thus the slope of the LM curve is ]kl and its intercept is ] )
]] + lπ .
l P
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 which
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
S
M
supply ] P and inflation π).
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 the diagram 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
D S
M M
increase inthe real demand for money ] P , and a change in the real money supply ]
P . In
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.
S 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.
S 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.
S Diagrammatically, this is shown as a rightward shift of the LM curve.
When we analyse disturbances in an IS-LM diagram, this means:
S 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.
S If the price level increases, the LM curve shifts left. If the price level decreases, the LM
curve shifts right.
S 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
S
M 1
P multiplied by ]
(horizontally) by a distance equal to the change in ] k.
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: D
M
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 above). This determines the extent to which
monetary demand increases following a given increase in real income Y. D
M
S If k, the income responsiveness of money demand, is high, money demand ] P will
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 de-
pends on how much r has 34J\Y]LÅH[[LY
to increase to re-establish
r1
money market equilibrium
for a higher level of Y
r0
(r0; Y0
Y0 Y1 Y
S If monetary demand is relatively unresponsive to changes in Y, meaning k is small,

the LM curve will be relatively flat.
D
M
2. The interest rate responsiveness of the demand for money (which is l in the ]P equation;
also see the LM equation (3.6) in the maths box above). 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).
S 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).
S 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.
S A high interest responsiveness of money demand implies a relatively flat]] MD curve and a
P
relatively flat LM curve.
S 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 1 M
( S
P + lπ
r = ]l Y – ]l ]] ) ……(3.6)
Substituting (3.6) into (3.3) produces:
( k
[ MS
Y = KE a + Ia + G – h _l Y – 1/l __
P + lπ ( )])
Solving for Y and simplifying produces:
P + lπ
Y = A1 (a + Ia + G) + A2 ] (M S
) ……(3.7)
where
E
K
A1 = ]]]
K hk E
1 + ]]l
K Eh
A2 = ]]]
l KEhk
Equation 3.7 shows how the equilibrium level of real income Y depends in expenditure
elements as well as real money supply – as captured in the IS and LM curves respectively.
Note that A1, 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:
M
P lπ
r = B1 (a Ia G) B2 ]] ( S
) ……(3.8)
where
kKE
B1 = ]]]]
l KEhk
1
B2 = ]]]]
l + KEhk
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 equi-
librium 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 par-
ticular 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:
S 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.
S 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.
S 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

Figure 3.21 Fiscal expansion in the IS-LM model
equilibrium shows a higher level
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
r0
line in the 45° diagram. The subse- 1
quent upswing in Y would increase
monetary demand, depicted as a
D
M
rightward shift of the ] P curve in
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.
S 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).

S This example compellingly illustrates ‘crowding out’, explained in section 3.2.2
above.
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
above. The path of adjustment of the economy will depend on the speed of adjustment in
each sector or market.
S 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
S If the money market adjusts
2
slower, a bigger loop from point
1 to 3 can materialise (blue
dotted arrow). 1
S 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 rightwards. 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
S
M
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
D
M
in Y will increase monetary demand – a rightward shift of the ] P curve – resulting in
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. On 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-mar- Y0 Y1 Y
ket 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.
S 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
S 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).
S 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).
S 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 discussion and examples above illustrate the basic application of the IS-LM mechanics
for disturbances originating in either the monetary or the real sectors 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:
S the interest responsiveness of money demand l;
S the interest responsiveness of investment h, and
S 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?
S For a similar but somewhat surprising analysis regarding the potency of an interest
rate step, see section 3.3.8 below.
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
S
1 M 10
P . Equilibrium Y will increase, combined with a decline in the real interest rate r.
]k ]
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):
S If the LM curve is relatively steep, the change in Y is relatively large – monetary policy
is more potent.
S 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 above (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
ÅH[[LY34WYVK\JLZHZTHSSLY
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
D
M
demand for money. If this responsiveness is low – the ]P curve is relatively steep, as is the LM
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, 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. In a sense, this event reaffirmed the relevance of the liquidity trap theory.
However, its relevance seems to be limited to very limited periods characterised by crises of
confidence. Thus, under normal conditions the liquidity trap theory is not applicable.
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): 0M0:J\Y]LPZÅH[[LY
S If the IS curve is flat, the change in Y is
larger and change
change in real income is large in r smaller
– monetary policy is very r0
potent.
S If the IS curve is relatively
steep, the change in Y is IS curve
smaller – monetary policy is ºÅH[»
IS curve
less potent. ºZ[LLW»
The economic reasons for the Y0 Y
latter case are as follows:
S If the interest responsiveness
of investment (h in the investment equation) is high, investment will react strongly to
the policy-induced drop in interest rates;
S 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:
S the LM curve is relatively steep, and/or
S 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:
S the income responsiveness of money demand k;
S the interest responsiveness of money demand l;
S the interest responsiveness of investment h, and
S 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. R1m) in government expenditure. It r smaller and change in r larger: stronger
would shift the IS curve horizontally to ZLJVUKHY`LMMLJ[JYV^KPUNV\[
the right. Equilibrium Y will increase, LM curve
combined with an increase in the real ºZ[LLW»
interest rate r. LM curve
The diagram in figure 3.25 illustrates the ºÅH[»
influence of a flat or a steep LM curve on
the change in Y: r0
S 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
S 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:
S 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,
S 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):
S If the IS curve is relatively flat, the change in real income Y is smaller – fiscal policy is
less potent.
S If the IS curve is relatively steep, the change in Y is relatively large – fiscal policy is more
potent.
The latter result occurs since:
S the interest responsiveness h of investment is low – this reduces the restraining effect of
the secondary interest rate increase on investment;

S 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 which 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:
S the LM curve is relatively flat (i.e. the ‘ramp’ is less steep, implying limited crowding out),
and/or
S 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 – an important counterintuitive result

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.
S In the money market diagram (see figure 3.8), this relates to equivalent horizontal
S
M
dimensions of shifts (e.g. rightward) of the ] P line (measured by its position on the
horizontal axis).
S In the IS-LM diagram, it relates to equivalent horizontal shifts of the LM curve (measured
by the change in its intercept on the horizontal axis).
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 (also see chapter 9).

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
interest rate conditions.
S In the IS-LM diagram, it relates to
equivalent vertical dimensions of right- or Horizontal dimension of rightward
shift of LM curve
leftward shifts of the LM curve. This is
measured by the change in its intercept
on the vertical axis. Income Y
S Visually this is indicated by equivalent
downward displacements of the LM curve
(see figure 3.27). 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.
S The potency result becomes the opposite of that for equivalent money supply changes.
In figure 3.28, the diagrams contrast the impact on Y, for different LM slopes, of equivalent
interest rate 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 (or,
equivalently, by rightward LM curve shifts different and large enough so that the intercept
of LM on the vertical axis reflects the desired interest rate step).
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 (see diagram). Compare the changes from Y0 to Y1 in the two cases.

S A flat LM curve makes such a monetary policy step more potent in changing Y.
S 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.
S A flat LM curve makes such a monetary policy step more potent in changing Y.
S 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 it can also be done through a
money supply change. These policy rules implicitly assume that central banks change
the money supply and/or the repo rate with whatever amount necessary to bring about
the desired change.
Analysing the world economic crisis of October 2008

The world economy was shattered by the so-called subprime credit crisis in the US that came
to a head in September–October 2008. It led to the failure of several banks in the US (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 firms, e.g. the Big Three motor companies in the US, faced serious
financial ruin. (These recessionary conditions spread to many countries, e.g. the UK, Europe and
Japan.)
In reaction to this, the US government and President Barack Obama launched a massive
national infrastructure investment programme in 2009 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 and reduced the bank rate to stimulate credit creation.
We will analyse this as a case study in this and the following chapters. As a first step: how would
you explain and analyse the events in the US economy in terms of the macroeconomic model
we have developed? Can you depict the events and their expected consequences in the 450
model and the IS-LM model?
Second, how should these events in the US impact on the SA economy? Analyse using the 450
model and the IS-LM model.
* * *
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).

The basic model III:
the foreign sector 4
Q understand and explain the behaviour of international trade in goods and services (i.e.
imports and exports), and foreign investment and lending (international capital flows);
Q appraise the role and importance of the balance of payments, the current account, the
financial account and foreign reserves;
Q assess and explain movements in exchange rates, including the practical, everyday
determination of these rates in foreign exchange markets;
Q assess the external implications of domestic economic disturbances and fluctuations;
Q 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;
Q analyse the role of the balance of payments adjustment mechanism in creating cyclical
forces; and
Q 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 (2005) Economic Indicators, sections 7.2 and 7.3.
Chapter 4: The basic model III: the foreign sector 129

The location of this topic in the circular
flow diagram (compare pp. 67; 70): 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 lat-
ter 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 = R9.00 or £1 = R14.00. (The latter represents the
indirect way of quoting the exchange rate. The direct way would be the other way around,
i.e. R1 = $0.11 or R1 = £0.07.)
Another relevant variable is the price ratio betweenPaverage price levels in the home country,
SA
e.g South Africa, and those in the rest of the world: ]]
P Foreign
The exchange rate and the price ratio can be combined into one concept, the real effective
exchange rate, denoted by U (where U is the Greek letter theta). (The term ‘effective’ indicates an
average exchange rate; see section 4.3.2 below on exchange rate definitions). It is defined as:1
1 PSA SA
P
U = ]]]]]]]]]
Average exchange rate PForeign = Average exchange rate in direct form PForeign
]]] ]]]
1 Note that in many US 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.
130 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 exchange rate of the rand against the US dollar, the British pound, the Euro and the
Japanese yen at the moment?
______________________________________________________________________________________
Warning: Data on foreign economic transactions are almost as complex as data on the
government sector (also see chapter 2).
S 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.
S 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.
S 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.
S The foreign trade statistics of the SA Revenue Service (Customs and Excise division)
pertain to trade in goods only (including gold). They are published each month.
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 below.)
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.reservebank.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 or 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 that of the Economist
magazine to be found at www.economist.com.)
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 actual pattern of imports and
exports. (E.g. why does South Africa import clothes pegs – surely they can be manufactured
4.1 Background – why trade internationally? 131

locally?) Such questions are explored in courses on international economics. In macroeco-
nomics 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 top 10 trading partners in 2007 (and their shares in 1997)
Import share 2007 1997 Export share 2007 1997
Germany 11.7% 13.6% USA 10.8% 5.8%
China (mainland) 10.7% 2.5% Japan 10.1% 5.2%
USA 7.7% 12.5% Germany 7.3% 4.3%
Japan 6.6% 7.5% United Kingdom 7.0% 6.9%
United Kingdom 4.8% 11.3% China (mainland) 6.0%
France 3.4% 3.6% Netherlands 4.1% 3.2%
Italy 2.8% 3.9% Spain 2.5% 1.4%
Korea 2.2% Belgium 2.5%
India 2.2% Italy 2.0% 2.1%
Australia 1.8% Zambia 2.0%
Total imports (R millions) 561 194 126 912 Total exports (R millions) 491 253 132 347
Source: South African Revenue Service (www.sars.co.za).
Our pattern of trade with the rest of the world is revealed by these figures. Note the
persistence of certain large countries such as the US, UK, Germany and Japan. On the other
han d, the top 10 list has changed quite a bit since 1997. Note the new prominence of China
(coupled with the disappearance from the list of Taiwan) and the increasing role of non-
European countries such as Korea, India, Australia and Zambia.
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.
S 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.
S 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 Real imports and exports
500 000
Real imports of goods

400 000
and services
300 000
Real exports of goods

200 000 and services
R million
100 000
0
Real exports minus
real imports
–100 000
–200 000
1980/01
1982/01
1984/01
1986/01
1988/01
1990/01
1992/01
1994/01
1996/01
1998/01
2000/01
2002/01
2004/01
2006/01
2008/01
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 to1994.
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 (based on Jan 2009 data) are typically mineral products (23%),
manufactured jewellery (21%), base metals (15%), machinery and equipment (8%), vehicles
(7%) and chemical products (6%).
The main import categories are typically machinery and equipment (29%), mineral products
(22%), chemical products (8%) and vehicles (7.6%).
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 133

Which factors determine imports?
SA
P
M = f(YDSA; ]]]
P ; rand; ...)
Foreign
+ + +
A part of import expenditure involves the purchase of imported consumer goods. There-
fore, 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 in-
puts (machinery and intermediate inputs, often high-tech items). Since increases in out-
put require more inputs, the demand for imported inputs is strongly influenced by total
production Y (see box above). 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
(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.)
S 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 below).
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 = R9.50 and an imported video
recorder costs $300, the price in rand is R2 850. 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 = R9.50 to It is published in the Quarterly Bulletin of the Reserve
Bank and is calculated as the export price index
$1 = R9.00 – imports are encour-
divided by an import price index, expressed as an
aged because the rand price of
index. A weakening of the terms of trade means that
imports effectively declines. The South African export prices have decreased relative to
international purchasing power the prices of imported products: the country earns less
of the South African rand has in- from exports, compared to what it needs to pay for
creased. Therefore the likely rela- imports.
tionship between M and the rand
is positive. See Mohr (2005) Economic Indicators, section 7.4.
S Be very careful here. If you
think in terms of the actual
number 9.5 or 9.0, the rela-
tionship is negative: a stronger Each international transaction actually comprises a
double transaction: the necessary foreign exchange
rand means the exchange rate
or currency is bought first, and then the item is
number decreases – which leads
bought with that foreign currency. It also means
to an increase in imports M. that the demand for foreign currency is a derived
The price ratio and the exchange demand, i.e. it is derived from the demand for the
rate jointly determine the real products that importers want to buy.
effective exchange rate U, defined
above. The real effective exchange
rate can be thought to impact on m, the marginal propensity to import. If U 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 U 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 U, i.e. m(U).
S In thinking and reasoning about open economy chain reactions it will often be better
to workP
in terms of the constituent elements of U, i.e. the exchange rate and the price
SA
ratio ]]
P . One must be able to work in both formats.
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 below.
A more complete import function thus would be:

M = ma + m(U)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 rate – E
are built into the import propensity parameter.
(While we will not always write m as m(U) in
diagrams and mathematical expressions, its
presence must always be remembered.)
S An increase in U – due to a strengthening M ma mY
rand and/or a higher price ratio – will en- m
a
courage imports, i.e. the import propensity
m will be higher.
S 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
be apparent as a move along the M curve. Income Y
S An increase in U 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.
S 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 ac-
tually imports by other countries Insufficient domestic production of exports can
from South Africa, the explanation occur if there are not enough South African goods
of exports is relatively simple. Ac- to meet export demand. However, at this stage we
cordingly, South African exports assume that there are no supply-side restrictions.
(This will change in chapter 6.) However, as a rule,
are determined by factors similar to
aggregate supply bottlenecks very rarely constitute
those concerning imports. It is im-
a real constraint on export levels – except in the
portant to realise, though, that the case of agricultural products, where a drought can
export decision is primarily taken have a disastrous effect on exports. It is quite simple
in another country, i.e. a South to analyse the expected effects of a drought (or a
African producer’s supply of export miners’ strike) on export performance, and hence on
goods occurs on demand from for- aggregate economic performance.
eigners. It specifically does not de-
pend on domestic income or produc-
tion (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; ]]]
P ; rand; ...)
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:
X = va + v(U)Yf + … .......(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 U – 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).
S 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.
S A change in the trade share v (due to a change in the real effective exchange rate U) 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. (Why?)
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. (Why?)

Figure 4.3 Exports and net exports Figure 4.4 A change in net exports
E E
C I G (X M)0
Imports M
C I G (X M)1
Exports X
$(X M)
Y
Net exports (X 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)
decline’s total expenditure decline’s production discouraged GDP and Y decline.
Foreign inflation declines

______________________________________________________________________________________
______________________________________________________________________________________
Upswing in the US
______________________________________________________________________________________
______________________________________________________________________________________
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).
Important 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 only includes imports and exports of goods. Services are
excluded. Therefore the trade balance also is 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’.
S In our macroeconomic reasoning and chain reactions this is how we interpret
(X – M).
3. Net exports still excludes inflows and outflows of income payments, i.e. compensation
of employees as well as returns on investment (dividends and interest earned abroad).
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 2008. The two balances
differ markedly. It shows how ‘invisible trade’ can affect the current account significantly,
often negatively. For example, in 2008, the net figure for income receipts and payments
was approximately the same magnitude (–R73.8 billion) as net exports (–R70.8 billion).
Income payments always exceed income receipts by far. Thus the net income outflows
easily doubled the negative payments balance before transfers.
This is a frequent occurrence, which indicates that the large current account deficit is not
necessarily the result of high imports and/or low exports. Such deficits often originate
in large dividend and other factor payments, notably as salaries and wages paid to
foreigners. Many of the latter are from SADC countries.
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
DATA TIP
national accounts column.

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 (see box). For macroeconomic analysis, it is best to use the SNA
data.
National accounts 2008 R million Balance of payments 2008 R million
Exports of goods and services 807 704 Merchandise exports 655 759
Exports of goods 704 293 Net gold exports 48 534
Exports of services 103 411 Service receipts 103 411
Less: Imports of goods and services –878 482 Income receipts 48 254
Imports of goods –739 852 Less: Merchandise imports –739 852
Imports of services –138 630 Less: Payment for services –138 630
Exports minus imports –70 778 Less: Income payments –122 098
Current transfers (net receipts (+)) –24 528
Balance on current account –169 150

Income payments thus reflect trade in factors of production – labour and capital. Also
excluded are international transfers.
S These excluded items are denoted as ‘invisible trade’.
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 below).
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:
S For BoP analysis, the rand values are decisive.
S 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 1985 to 2008,
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 below.
See also Mohr (2005): Economic Indicators, 133–5.

Figure 4.5 International capital flows – the financial account
60 000
50 000
40 000
30 000
Financial account
20 000
R million
10 000
–10 000
–20 000
1985/01
1986/01
1987/01
1988/01
1989/01
1990/01
1991/01
1992/01
1993/01
1994/01
1995/01
1996/01
1997/01
1998/01
1999/01
2000/01
2001/01
2002/01
2003/01
2004/01
2005/01
2006/01
2007/01
2008/01
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 in-
creased dramatically (albeit with some volatility). Also see figure 4.6 below.
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
rForeign ; relative SA rates of return; rand; expectations)
K-inflow = f (]]]
?
Optimism about expected real returns on real investment (i.e. economic growth possibil-
ities) should attract foreign investors. Furthermore, local interest rates that increase rel-
ative 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 US 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 developing 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 US 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.
S The risk premium for South Africa, compared to the US or other OECD countries, may
be in the order of 3%. This can increase dramatically if events occur that signal political
uncertainty and risk.
S In a stable situation, the gap between SA 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 developing 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

The so-called Rubicon speech of former president PW Botha in Durban in August 1985 is
regarded as one of the best examples of the reaction of foreign capital flow to political events.
What happened on that occasion? What were the consequences for the financial account?
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
not mean that politics does not play a role. Rather, the more legitimate and more stable
post-1994 political environment has reduced political uncertainty. This has reassured
investors and allowed them to focus more on the financial aspects of their investments.
Of course, elections and changes of party and national leadership still cause heightened
political concern. Democracy in South Africa is relatively young and the country is part of
the so-called emerging markets. Investors will for the foreseeable future pay more attention
to political events in South Africa than in the democratically mature and industrialised
economies such as the US, UK and Japan.
Therefore, in contrast to South Africa, there is high international mobility of capital into
the US. In particular, there is a tremendous international sensitivity to American interest
rates. A small rate increase in the US can cause a tremendous inflow of foreign capital into
the US.
S This illustrates the fact that one should be careful in applying macroeconomic reasoning
to different countries.
S The US example is crucial in understanding movements in the gold price, the dollar and
the rand. (See section 4.5.3 below.)
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
boosts the domestic pool of funds available to
qualification that the effect of
finance investment. In this way it is important for
the financial account cannot be
long-term real economic growth (see chapter 12,
determined and analysed on its section 12.3).
own. Below 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 ac-
count 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 below.
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
Figure 4.6 The current account and the financial account

180 000
150 000
120 000
Financial account
90 000
60 000
30 000
0
R million
–30 000
–60 000
–90 000
Current account
–120 000
–150 000
–180 000
–210 000
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008

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 sustainability 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).
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 example below adds the financial account figures to the current
account figures shown in the example above.
Balance of payments 2008 (R billion)
Current account:
Merchandise exports 655 759
Net gold exports 48 534
Service receipts 103 411
Income receipts 48 254
Less: Merchandise imports –739 852
Less: Payment for services –138 630
Less: Income payments –122 098

DATA TIP
Current transfers (net receipts (+)) –24 528
Balance on current account –169 150
Capital transfer account (net receipts (+)) 208
Financial account:
Net direct investment 103 497
Net portfolio investment –131 512
Net other investment 131 712
Balance on the financial account 103 697
Unrecorded transactions 91 311
Balance of payments 26 066
S The capital transfer account item is relatively insignificant in economic analysis.

S ‘Other investment’ mainly includes trade credits, and is typically quite large.
S Unrecorded transactions denote a capital flow error term, and can be significant.
S In the published table, the final total is not denoted as the ‘balance of payments’, but
strangely as the ‘change in net gold and other foreign reserves owing to balance of
payments transactions’. However, they are the same.
4.3 The balance of payments and exchange rates 147

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 always is 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 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 mon-
etary policy step, e.g. an increase in the repo rate, were explained in chapter 3 (sec-
tion 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).
S 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.
S 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.
S 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.
S 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 US. (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.
S Increasing exports are directly reflected in an improved current account.
S Increased export earnings imply an expenditure injection in the economy, which
causes income Y to increase (see chapter 2, section 2.2.6).
S The upswing in income is likely to lead to a rise in imports (why?), which is a
negative impact on the current account.

S 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 1980. The balance of payments is a net figure, reflecting the current and financial
accounts above. 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
a temporary dip in 2002 and 2003, whereafter it resumed its upward trend. 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.

Figure 4.7 The balance of payments and foreign reserves
360 000
330 000
300 000 Gross gold and
foreign reserves
270 000
240 000
210 000
R million
180 000
150 000
120 000
90 000
60 000
Balance of payments
30 000
0
–30 000
–60 000
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
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:
S Change in net gold and other foreign reserves, and
DATA TIP
S 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.
S A rule of thumb in this regard is that a country should have sufficient reserves to cover
three months’ imports.
S 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, after 2001 the foreign reserve position
improved. As the table indicates, the foreign reserve position improved from 7.9 weeks
(or about two months) of imports in 2003 to 14.6 weeks (or three and a half months)
in 2008. Still, it was 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, home owners, negatively.
Therefore the level of foreign reserves is of great importance for everyone.
S 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 Imports of goods and services covered
Bank wants to support the rand in foreign exchange by reserves (average number of weeks)
markets as part of its exchange rate policy (see
2003 7.9
section 4.3.2 below).
2004 8.6
If there is a continuous current account deficit, the
financial account should be in surplus to compen- 2005 12.0
sate. As long as capital inflows occur continually, a 2006 13.2

country can sustain a current account deficit with- 2007 13.2
out running into foreign reserve problems. However,
2008 14.6
if there is a sustained capital outflow, current ac-
count deficits cannot be tolerated for very long.
(2) Impact on the money supply

An important consequence of a BoP deficit or surplus, referred to above, is that it influences
the nominal money supply MS. A net inflow of payments (even if in foreign currency
initially) leads to an increase in the domestic money supply, as follows:
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 comes 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.
S 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.
S 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 = R9.00 or £1 = R14.00. 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 = R9.00) 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 = 9.50 to $1 = R9.20 represent a strengthening
of the rand? Think of the $ as an item that you buy, just like a can of cola. If the price of cola
decreases, from R9.50 to R9.20, 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 R9.50 to R9.20, 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.
S 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.
S The terms ‘devaluation’ and ‘revaluation’ have a similar but different meaning. This is
explained below.
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 = R9.00. (The real exchange rate is expressed in the direct form.)
1 PSA
Real exchange rate = ]]]]]]
Exchange rate × PForeign
]]]
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 US. It is expressed as an index.
By combining these two operations, a real effective exchange rate, indicated with the symbol
U, can be calculated (also as an index):
PSA
Real effective exchange rate (U) = 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
250
200
150
R million
Real effective exchange rate of the rand
100
50 Nominal effective exchange rate of the rand
0
1990/01
1991/01
1992/01
1993/01
1994/01
1995/01
1996/01
1997/01
1998/01
1999/01
2000/01
2001/01
2002/01
2003/01
2004/01
2005/01
2006/01
2007/01
2008/01
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 2001/2). The nominal effective exchange
rate displays a downward trend, especially prior to 2001, which is an indication of the
impact of inflation. After 2001 there is no 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.
S For instance, a currency dealer will buy dollars from you at R7.5112 (it is always quoted
to four places after the decimal point), while they will sell to you at R7.7353. The R0.2241
difference is the profit margin of the dealer.
S 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.
S Rates quoted and published by the SARB are middle rates, calculated as weighted
average daily rates of banks at approximately 10:30.
S 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 per 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.
S 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 = R9.00 to
$1 = R8.80). 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.
S 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.
S 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.
S Each outflow of funds from the country implies a demand for foreign exchange – which
is mirrored by an exactly equivalent supply of rands.
S Each inflow of funds into South Africa implies a demand for rands (i.e. a supply of foreign
currency).
S 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.
S 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.
S 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.
S 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.
S 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.
S In practical terms, one can state the argument as follows: the only way in which South
African exporters can remain competitive in world markets whilst the 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,
S One may therefore expect an annual rate of depreciation over the long term which 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
PDomestic
situation where the exchange rate is precisely equal to the price ratio (]]]
PForeign
). The exchange rate
would change precisely proportionate tochanges 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 it has 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:
S 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.
S 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 constantly are
monitored by policymakers.
S 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 of course have to be repaid).
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.
S 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 October 2008 the
international liquidity position of the Reserve Bank was positive $32.1 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:
S Suppose the Reserve Bank wants to prevent the rand from going above, for example,
$1 = R9.00. 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 $0.11 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.
S Likewise, if the Reserve Bank wants to prevent the rand from depreciating below $1 =
R9.00, 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.
S 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.
S 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.
S 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).
S The current account (X – M) influences total expenditure (C I G X M) – and
thus also production GDP and Y – directly.
S The financial account on its own has no direct short-term effect on expenditure (see
section 4.2.2 above).
S In other words, the real sector is influenced, in the first instance, by the current account,
since it affects expenditure directly.
S 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.
S All this means that the exchange rate has an effect on the BoP.
Therefore:
S There is an important interaction and two-way causation between the exchange rate
and the BoP (and its components).
S 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 below.
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 p 0). On the
whole, what happens is the following complex chain reaction. This constitutes the BoP
adjustment process:
S
M
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 p 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 below).
4.4 The BoP adjustment process 161

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 above –
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).
S 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.
S 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.
S 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 163

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 a upswing (or
downswing). Thus one finds signs of inherent sources
money market effect), the BoP ad-
of cyclical movements in production and income in the
justment activates monetary for-
BoP adjustment process. In practice, this factor in itself
ces in the opposite direction – via is not sufficient to explain the larger cyclical movements
foreign reserves – which reverse in the economy. However, it does contribute to cyclical
the upswing and pushes Y into forces and fluctuations.
the early phases of a downswing.
However, before long the ex-
change rate adjustment again places upward
pressure on income – the downswing may be Figure 4.9 Illustrative time path of key variables due to
a decrease in the repo rate
short lived, and an upswing period may re-
cur. 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 appreciation 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
R This is in contrast to example 3 below
(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 Up to 3 years

over time during the primary and three secondary effects of the example above. Study it
carefully and see whether it conforms to your understanding of the whole chain reaction
above.
R Of course, in reality time paths never are so smooth, and shocks and disturbances
occur on top of one another. 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’.
The examples above illustrate 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.
S 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.
S 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.
S 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 in- Figure 4.10 Illustrative time path of key variables due
come Y (held back somewhat by the second- to a government expenditure cutback
ary, money market effect), the BoP adjust-
ment activates monetary forces in the same r
direction – via foreign reserves – which ex-
acerbates the decline in Y into a deeper reces-
sion. Only after the exchange rate adjustment
occurs do we see the first signs of recovery. Time
Real income would have gone through a busi-
ness cycle trough – which is no surprise, giv- Y
en the contractionary fiscal step that initiated
everything. Only at the end is there a small
recovery.
Interest rates first decrease, but in the BoP Time
adjustment stages they experience upward Rand
pressure twice. The net effect should still be a
rate decrease, though.
The rand depreciates during the latter stages
Time
of the BoP adjustment phase (phase 4). This
depreciation is the main cause of the final BoP
recovery down towards the end – the depre-
ciation stimulates exports and discourages BoP adjustment
imports, thereby boosting aggregate expend- phase
iture.
Demand contraction
The balance of payments goes into deficit, Up to 3 years
which is then reversed. The current and
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 US on the SA economy

Primary effect:
(1) Lower YUS US imports MUS 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 450 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 rate 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 above (internal to a decrease in exports
monetary 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:
R 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 still will 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.
R 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
R 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.
R The real interest rate first drops, but increases in the BoP adjustment phases.
R 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:
S 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.
S The BoP adjustment process is much longer in the export example.
S 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.

S 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 – of a BoP recovery process.
change in exports, while a quickly
adjusting exchange rate puts a
damper on export-led economic fluctuations. (This parallels the conclusion about the pos-
itive 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 in itial 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:
S internal causes, the main candidates being one or several restrictive monetary policy
steps; or
S 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)
above.)
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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:
S 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).
S 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 US 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 American interest
rates, this causes a significant inflow of capital. The subsequent demand for dollars causes
the dollars 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’.
S 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.
S This effect decreases the fiscal multiplier, because the restriction of exports counteracts
any fiscal stimulation.
The world economic crisis of October 2008: open economy aspects

We introduced this case study at the end of chapter 3. Reread that box on page 128.
Now redo that analysis, with the additional analytical tools and insights acquired thus far in this chapter.
Focus especially on the external sector aspects of developments both in the US and in South Africa.

(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 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.
S 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 mines can show low profits in a period when the international
gold price is 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 what 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 discussion about
the ‘twin deficit phenomenon’ and the crowding out of exports above.)
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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 which 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.
S However, the Reserve Bank might still be concerned about the sustainability of such
capital inflows – particularly when these flows mostly comprise easily reversible port-
folio 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 ac-
count 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 policy makers 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:
S 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.
S 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 remarks on inflation above 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 which 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.
S 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.
S 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.
S 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 developing countries that are dependent on agricultural exports of protecting
European farmers with such subsidies. Governments of developing and industrialised
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.)
S 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 177

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.
S Direct import-restricting steps are called a policy of ‘expenditure switching’.
S 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. Furthermore, as was noted in
chapter 3, the reader can choose to skip the IS-LM-BP sections and rely only on the foregoing
intuitive reasoning and simple diagrams (albeit with some loss of clarity and precision).

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 US which
How far would IS shift?
is 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 US) 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 a new equilibrium 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.
S 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.
S 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 179

S 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:

(M )
S
k 1
l P + lP
r = ]Y – ] ]] …… (4.5 = 3.6)
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. 9 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:
( k
[ 1 MS
(
Y = KE (a + Ia + G + X – ma) – h ]l Y – ]l ]]
P + lπ )])
Solving for Y and simplifying produces:
MS
Y = A1(a + Ia + G + X – ma) + A2 (]]
P + lπ) ......(4.6)
where
KE
A1 = ]]]]
1 + KEhk/l
K Eh ......(4.6.1)
A2 = ]]]]
l + KEhk
Equation 4.6 shows how the equilibrium level of real income Y depends in 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 which 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.
S Points on the curve indicate a state of BoP equilibrium.
S 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 is IS or
LM, and get to an equilibrium point such as r0 )V7KLÄJP[
(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 processes Y0 Income Y
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:
S Real income affects imports, which affect the current account of the BoP.
S Interest rates affect capital inflows, which affect the financial account of the BoP.

The BP curve is derived as follows (see figure Figure 4.13 Deriving the BP curve
4.13): r
S 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.
S 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 them Y0 Y1 Income Y
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.
S 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.
S 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 US, 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 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:
S 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.
S If capital mobility is relatively high, the BP curve would be flatter than the LM curve.
This would be the case in the US, 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 developing countries it would in any case be steeper.
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), it does make a
crucial difference.
S 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.
S 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.
S 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:
S If the disturbance improves the BoP position, the BP curve shifts to the right.
S If the disturbance weakens the BoP position, the BP curve shifts to the left.
Two main factors shift the BP curve – an exogenous change in exports, and the exchange
rate:
S An increase in exports would shift the BP curve to the right. A drop in exports would
shift the curve to the left.
S An appreciation of the rand, which stimulates imports and inhibits exports, 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.
S 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
S 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
KLÄJP[
as a reference point from which to evaluate
the BoP dimension of the new IS-LM
intersection point (internal equilibrium).
S 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
S 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 (thus BP flatter),
a BoP surplus develops. Lower capital mobility implies that a BoP deficit develops. (Why?
See examples below.)
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 KLÄJP[
IS0 IS1 IS0 IS1

Y0 Y1 Y Y0 Y1 Y
Figure 4.16 An increase in exports – IS and BP shift

S If the disturbance improves the BoP posi- r LM
tion, the BP curve shifts to the right. For
example, an increase in exports would shift BoP in
the BP curve to the right. A drop in exports surplus
r1
would shift the curve to the left. BP0
S If the disturbance weakens the BoP posi-
r0
tion, the BP curve shifts to the left. An ap- BP1
preciation of the rand, which stimulates
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 graph- IS0 IS1
ical impact on the IS or LM curves as well as on Y0 Y1 Y
the BP curve must be shown (see figure 4.16).
S 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).
S 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 only shows 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 BP
3
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 End: internal
and external IS
phase of BoP adjustment. This moves the equilibrium
equilibrium from point 1 to point 2.
(b) Flexible exchange rate effect: both IS and Y
BP shift to the left (due to currency ap-
preciation) in the concluding BoP adjust- Figure 4.18 BoP adjustment from a deficit
ment phase. This moves the equilibrium r
from point 2 to point 3 in 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) in and external
initial BoP adjustment phase. This moves BP equilibrium
the equilibrium from point 1 to point 2. 2 Start: BoP
(b) Flexible exchange rate effect: both IS and PUKLÄJP[
BP shift to the right (due to currency de- 1

preciation) in the concluding BoP adjust-
ment phase. This moves the equilibrium
IS
from point 2 to point 3.
LM
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
S If the exchange rate is fixed (not just rigid), only the rigid exchange rate effect and shift will
occur.
S 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 point in 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 which produces a BoP deficit or surplus. Then they actually show the
effect of the BoP adjustment process very clearly.
S 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 above, 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.
S The main impact of this secondary effect is that the changes in r, I, Y and M will
be smaller than what it 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 on 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
1 LM0 0 Initial equilibrium
r1 Y0r0 with BoP equilibrium
1 New equilibrium
BP1 Y1r1 with BoP surplus
3 2 (point is above BP0 curve)
r3 2 Temporary equilibrium
Y2r2 after initial BoP adjustment
0 BP0 phase (foreign reserves effect).
r0
Still BoP surplus
3 Final equilibrium
Y3r3 after concluding BoP adjust-
IS0 TLU[WOHZLÅL_PISLL_JOHUNLYH[L
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 rand (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 Figure 4.20 Illustrative time path of key variables –
macroeconomic variables, i.e. income Y, interest increase in the repo rate
rate, rand, BoP and exchange rate. As far as r
and Y are concerned their cyclical movements r
can be 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 variables over Time
time during the primary and three secondary
effects of the example above. Y
S As noted before, in reality time paths never
are 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 regarding
policy effectiveness: the effectiveness of mone-
Time
tary policy is undermined by a rigid or slowly ad-
justing exchange rate (which allows the money
BoP adjustment
supply effect time to take hold), and enhanced by phase
a quickly adjusting exchange rate.
S 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.
S 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 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.
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.
S 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
34ZOPM[ZYPNO[PUP[PHSS`PU[OLÄYZ[
LM0 BoP adjustment phase
LM1 BP shifts left in the concluding BoP

adjustment phase
r1 1 BP1
0 Initial equilibrium
2 BP0 Y0r0 with BoP equilibrium
r3 3 1 New equilibrium
Y1r1 with BoP surplus
r0 0 (point is above BP0 curve)
2 Temporary equilibrium
Y2r2HM[LYÄYZ[)V7HKQ\Z[TLU[
phase. Still BoP surplus
3 Final equilibrium
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- Figure 4.22 Illustrative time path of key variables –
increase in government expenditure
ment): The initial BoP surplus also leads
to (ii) an excess demand of rand (excess
supply of foreign exchange) upward
pressure on the rand stimulation of r
imports and discouragement of exports
decrease in (X – M) current ac-
count deficit increases again. This helps Time
to eliminate the remaining BoP surplus
– the BoP tends towards equilibrium. The Y
process will continue as long as BoP ≠ 0
and until BoP = 0.
Note how, towards the end, the apprecia-
Time
tion of the rand is responsible, via an in-
duced decrease in (X – M), for a contraction Rand
of aggregate expenditure. 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) il-
phase
lustrates 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 YUS US imports MUS 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
r1 BP0 0 Initial equilibrium
Y0r0 with BoP equilibrium
2 BP2 1 New equilibrium
3 BP1 Y1r1 with BoP surplus
r3 (point is above BP0 curve)
r0 0 2 Temporary equilibrium
Y2r2HM[LYÄYZ[)V7HKQ\Z[TLU[
phase. Still BoP surplus
3 Final equilibrium
Y3r3 after entire BoP adjustment
process. Simultaneous internal and
IS1 external equilibrium
IS0 IS2
IS shifts right initially, then left in the
Y0 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 rand (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.]
Overview 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 variables –
similar to the fiscal stimulation example. Note increase in exports
the following differences, though:
S 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,
on top of which a FA surplus develops, so Time
that the BoP improves much quicker and
goes into a much larger surplus. Y
S The BoP adjustment process is much
longer in the export example.
S 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.
S 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.
S 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.
S To get more specific forecasts one has to use much more sophisticated mathematical
analysis and empirical econometric estimates of the various parameters and
multipliers.
S 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 economic crisis of October 2008 – using the IS-LM-BP model
We introduced this case study at the end of chapter 3 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 US
and South Africa.

National accounting identities
and macroeconomic analysis:
uses and abuses 5
Q analyse and interpret the different national accounting identities;
Q use national accounting identities, not only to measure the economy but as an analytical
tool to evaluate the functioning of an economy;
Q integrate the constraints implied by these identities into macroeconomic analysis;
Q critically confront the misuse of the national accounts relationships that leads to invalid
conclusions regarding cause-and-effect relationships; and
Q understand the basic structure of the System of National Accounts (SNA) and the
relationships between the different subaccounts.
Economics is intimately involved with the observation, measurement and understanding

of real economic events in a country. The measurement and quantification of economic
conditions and changes are therefore of central importance in economic analysis and
policy making. To be a competent economist, one must be able to analyse and interpret
real-world data. Likewise, the business manager must be able to interpret economic
information, often in quantitative form.
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.
S The system prescribes, first, the correct methods to collect, measure and process the
data. It is the basic measurement system for macroeconomics in a country.
S Second, it offers a complete system of definitions of macroeconomic aggregates/
variables such as consumption, investment, imports and exports – the well-known
variables encountered in macroeconomic theory and in the circular flow. The definitions
are very important once one starts working with published figures.
S Third, it offers an accounting framework within which all these figures can be placed
to provide and ensure a consistent set of data.
S Fourth, it offers a set of identities which show important linkages between certain
variables within the national accounts. These identities constitute a powerful additional
method of analysis for the economist.
Most of the key definitions were encountered in the previous chapters. Further distinctions
and refinements occur in the SNA, for example:
S gross domestic expenditure vs. expenditure on gross domestic product
S aggregate production vs. aggregate income
S gross domestic product vs. gross national income, and
S national income at market prices vs. gross value added at basic prices or factor cost.
Chapter 5: National accounting identities and macroeconomic analysis 195

These distinctions are briefly explained in the addendum to this chapter, to be consulted
whenever necessary. In many cases, one can get by without them. However, they are
critically important when one starts working with published data and must understand
the various tables and formats in which the SNA data are published. (These tables can be
found in the Quarterly Bulletin of the Reserve Bank – the main source of macroeconomic
data.)
This chapter concentrates on the use of the national accounting identities as macro-
economic instruments of analysis (sections 5.1 to 5.5). Section 5.6 offers a bird’s eye view
of the different components of the SNA. It also shows the interaction and links between
different subaccounts, the operation of the identities, and the way economic changes and
processes are reflected in the real numbers.
All this is illustrated using the actual breakdown as it appears in the Quarterly Bulletin of
the South African Reserve Bank. It is also, therefore, a handy reference section. (Many
of the questions asked in boxes in previous chapters can be answered using these data.)
At the same time, it is an opportunity to get to know the data published in the Quarterly
Bulletin.
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 + G C + (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).
196 Chapter 5: National accounting identities and macroeconomic analysis

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 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:
S 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 below (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.
S 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).
S 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.
S Government current expenditure is relevant when calculating saving by general
government (see section 5.4).
The equality shown 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 any difference between aggregate planned expenditure and production
(which then causes unplanned inventory investment) automatically is included in the gross
investment figure.1
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.
S 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.
S The identity is always true, while the equilibrium condition is only true on the infrequent
occasion when the economy actually is in macroeconomic equilibrium.
S The major substantial difference lies in the way in which the investment term is defined.
S 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 197

Figure 5.1 Nominal domestic expenditure and production
2 500 000
GDP
2 000 000
1 500 000 C
R million
1 000 000
I*
500 000 GC
0 X–M
–500 000
1985/01
1986/01
1987/01
1988/01
1989/01
1990/01
1991/01
1992/01
1993/01
1994/01
1995/01
1996/01
1997/01
1998/01
1999/01
2000/01
2001/01
2002/01
2003/01
2004/01
2005/01
2006/01
2007/01
2008/01
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.
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.
S 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, 1987–2008
The graph in figure 5.2 shows the main variables from the national income identity for
1985 to 2008. 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:
S Real GDP has increased every year since 1994 (following ‘negative growth’ between
1989 and 1992).
S Following the Asian crisis, gross capital formation by (private and public) businesses
slumped slightly in 1998, whereafter it recovered strongly.
S After being relatively stable for more than a decade, government expenditure
(consumption plus investment) increased markedly after 1999.
S Net exports (in real terms) was positive up to 1995. Net exports again turned positive
between 1999 and 2003, whereafter it developed a rather large and persistent deficit.
S Household consumption expenditure increased steadily, but was stable as a ratio of
GDP.
The data patterns in figure 5.2 are open to various interpretations. For example, in the
period of stagnation between 1988 and 1992, it appears that the increase of G was
the cause of the decline in investment I – i.e. that excessive government expenditure G
was crowding out private investment and private economic activities in general. To take
another example, it might be argued, as is often done in the media, that the sharp increase
Figure 5.2 Real domestic expenditure and production
1 400 000
GDP
1 200 000
1 000 000
C
800 000
R million
600 000
400 000
I*
200 000 Gc
0
X–M
–200 000
1985/01
1986/01
1987/01
1988/01
1989/01
1990/01
1991/01
1992/01
1993/01
1994/01
1995/01
1996/01
1997/01
1998/01
1999/01
2000/01
2001/01
2002/01
2003/01
2004/01
2005/01
2006/01
2007/01
2008/01
5.2 The interpretation of identities – uses and abuses 199

in negative net exports is the result of increasing imports, themselves resulting from the
sharp increase in real GDP, consumption and investment.
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 unwarranted and invalid to deduce it from the identity. It is unwarranted
because a number of other explanations are possible for the same pattern.
S For example, the decline in investment could just as easily have been due to political-
economic uncertainty and a lack of investor confidence. And the increase in GC may
have prevented the downswing from being much more serious than it would have been,
had GC not increased. Thus the increase in GC was a reaction and a partial remedy,
rather than a cause, of the recession (in this view).
S As far as the imports example is concerned, it is also possible to argue that, due to
promising returns on investment in South Africa, foreign investors invested significant-
ly in the country since 2003. This significant inflow of funds would have increased the
demand for rands, and the rand would have appreciated, which would have discour-
aged exports and encouraged
imports.
Two versions of the identities
Is this view of the sequence of
The national accounting identities can be expressed
events more correct? The answer
in terms of either GDP or GNDI (i.e. gross national
again is that one cannot deduce
disposable income). The major difference between
anything about causes and conse- GDP and GNDI is net ‘primary’ income from the rest
quences merely by inspecting the of the world (payments to migrant labour from other
identity. If one considers only the countries, and so forth), as well as current transfers.
identity, one has to say that either Each version is characterised by the way exports and
of the two explanations – or a third imports are defined and measured:
or a fourth – may be correct. One S If GDP is used, (X – M) is net exports, and only
simply does not know. The identity includes foreign trade in goods and services.
cannot help one in this regard at S If GNDI is used, net primary income receipts and
all. current transfers are included in (X – M).
(Also see the data tip in chapter 4, section 4.2.1.)
To use the identity to generate ex-
It is immaterial which option is chosen. They are
planations constitutes abuse and
equivalent, since the same element is added to both
irresponsible ‘scientific’ analysis.
sides of the definition.
The danger of the identities lies in
their simplicity, in how ‘obvious’ One reason to work with GNDI is that it allows a
things look. The actual relation- direct link-up with the current account data in the
ships and cause-and-effect rela- balance of payments table (which always includes
international income flows). It also provides a direct
tions in economic reality are not
link-up with the important table called ‘The financing
so simple. To understand the latter
of gross capital formation’ (see section 5.5 below).
at all, one has to use logical anal- S Hence the data and diagrams below are shown
ysis and theoretical frameworks. in terms of gross national disposable income.
S The identities do not describe This means that the expression (X + TR – M)
behaviour. Rather, they record encountered below is identical to the current
the outcome of behaviour. account.
Economic theory, such as the S Since balance of payments data are only
theory and chain reactions published in nominal terms (i.e. in current prices),
contained in chapters 2 to 4, the rest of this chapter will mostly work in
describe behaviour and can be nominal terms.
used to explain how change in

one variable leads to changes in other variables. The identities are blunt and dumb as
far as explanations are concerned.
Nevertheless, the identities provide important insights into certain linkages and the way
things cohere. In addition, they give some indication of the quantitative range of changes
and constraints in the economy. As long as one is very careful not to use them incorrectly,
identities can be valuable (see the conclusion to this chapter).
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:
S A current account surplus means that GDE is less than gross national disposable
income or GNDI.
S A current account deficit means that GDE exceeds gross national disposable income or
GNDI.
OR
S If GDE is less than gross national disposable income or GNDI, it implies a current
account surplus.
S 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 201

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, whilst 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
S 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.
S 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.
S 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
S Production, distribution and accumulation accounts of South Africa, and

S 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 expend-
iture, i.e. gross and net government saving). This term often is negative, indicat-
ing general government ‘dissaving’.
S This is not the overall, conventional budget balance. Government capital
expenditure (and revenue) is not included. It only shows current expenditure
and revenue.
S 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.
S 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.
S 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.
S 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 2008 (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.)
S 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.
S Column four shows the gross and net saving by government, denoted by the current deficit
(T – GC).

Table 5.1 The sectoral balances (R million, current prices)
H’holds Non-fin Fin Gen Domestic economy Foreign

corp corp govt sector
S (T – GC ) S + (T – GC ) I* (S – I*) (S – I*) + (T – GC ) = (X + TR – M)
Gross saving /
34 894 199 123 72 184 44 954 351 155 520 305 –214 104 –169 150 –169 150
Investment
Cons of fixed
–40 559 –215 107 –5 597 –45 683 –306 946 –306 946 45 683
capital
Net saving /
–5 665 –15 984 66 587 –729 44 209 213 359 –168 421 –169 150 –169 150
Investment
S 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.
S 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:
S (T – GC) plus S is gross domestic saving (by government and businesses – i.e. private firms
and government corporations – and households).
S 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.
S 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.
S This parallels the conclusion in section 5.3 above: 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 below for a further interpretation of this
situation.)
S 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
600 000
I*
500 000
400 000
S + ( T – GC )
300 000
200 000
R million
(S–I*) + ( T–GC )
100 000
–100 000
X + TR – M
–200 000
–300 000
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
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 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 a 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.
S 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).
S 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
800 000
700 000 T
GC + depr.
600 000
I*
500 000
400 000
300 000 S
R million
200 000
100 000
–100 000
X + TR – M
–200 000
–300 000
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008

positive in 2004. This means that government eliminated gross dissaving in 2004 (in
national accounting terms).
S 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.
S 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.
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.
S 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 above, i.e. interpretation 1 of the identity.
The top 4 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 207

Table 5.2 Financing of gross capital formation (R millions, current prices)
2004 2005 2006 2007 2008
1. Saving by householdsa 3 673 1 296 –5 088 –6 827 –5 665
2. Corporate savinga 53 215 40 265 29 322 14 914 50 603

a
3. Saving by general government –28 090 –12 217 5 953 27 810 –729
b
4. Consumption of fixed capital 172 970 190 705 219 506 256 373 306 946
5. Gross savingc 201 768 220 049 249 693 292 270 351 155
6. Foreign investment 44 631 62 179 110 198 146 076 169 150
7. Net capital inflow from rest of the world 85 108 99 019 134 537 186 261 187 455
8. Change in gold and other foreign reservesd –40 477 –36 840 –24 339 –40 185 –18 305
9. Gross capital formation 246 399 282 228 359 891 438 346 520 305
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 +.
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 reserve
+ 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:
S 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.
S 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:
S 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.
S 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.
S 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.
S 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.
S 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
VHYHUHSUHVVXUHRQWKH¿VFXV
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:
S Private consumption C may not be stimulated, since that may depress personal saving.
S Government consumption expenditure GC may not be used for stimulation, since that
would increase government dissaving.
S Tax cuts may not be used to stimulate growth, since that also increases government
dissaving.
S 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).
S 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 209

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 above).
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 na- variables in the tables, consult the addendum to this
tional accounts at a glance. Study chapter which provides a simple explanation of the
main definitions.
it carefully and thoroughly. Nine dif-
ferent 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:
S the main domestic economic activities (production, income, expenditure, and saving),
and
S the main domestic sectors (incorporated business enterprises, general government, and
the household or personal sector).
S The external sector 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:
S 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).
S Account 2 calculates aggregate output from the income side of the circular flow, i.e.
from the income earned by different production factors.
S 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
GNP 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).
S 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 2008 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).
S 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 211

THE NATIONAL INCOME AND PRODUCTION ACCOUNTS AT A GLANCE (2008, R billion, current prices)1
chapter 05final.indd 212

212
A) NATIONAL PRODUCTION, INCOME AND EXPENDITURE: Y = C + I* + GC + (X – M)
1. Production 2. Income 3. Expenditure

Primary sector 264.5 Compensation of employees 956.6 Final consumption expenditure by households 1 385.0 C
Secondary sector 496.0 Net operating surplus 759.8 Final consumption expenditure by government 464.8 GC2
Tertiary sector 1 293.0 Consumption of fixed captital 306.9 Gross fixed captital formation 530.2
I*
Gross value added at factor cost 2 023.3 Change in inventories –9.9
*
+ Other taxes on production 36.9 Residual –15.5
– Other subsidies on production 6.7
Gross value added at basic prices 2 053.5 Gross value added at basic prices 2 053.5 Gross domestic expenditure (GDE) 2 354.6 C + I* + GC
+ Taxes on products 237.0 + Exports 807.7 X
– Subsidies on products 6.7 – Imports 878.5 M
Y GDP at market prices 2 283.8 Expenditure on GDP 2 283.8 C + I* + GC + X – M
Net primary income from the rest of the world –73.8

Total production equals total expenditure GNI @ at market prices 2 209.9
(on the right-hand side of the table) Net current transfers from the rest of the world –24.5 Difference between GDE and GNDI equals
GNDI @ at market prices 2 185.4 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 655.8
Saving by households –5.7 34.9 Net gold exports 48.5
Total corporate saving 50.6 271.3 Service receipts 103.4
S Total private saving 44.9 306.2 Income receipts 48.3
(T – GC)2 Saving by genl government –0.7 45.0 – Merchandise reports 739.9
(S + T – GC )2 Total savings 44.2 351.2 – Payment for services 138.6
I* – Total capital formation –213.4 –520.3 – Income payments 122.1
Net current transfers –24.5
–169.2 CURRENT ACCOUNT –169.2 (X + TR – M)3
Chapter 5: National accounting identities and macroeconomic analysis

(S – I* + T – GC) SAVING–INVESTMENT BALANCE
Capital transfer account* 0.2

Direct investment 103.5
Total capital flows (marked with *) Portfolio investment –131.5
minus change in gross reserves Other investment 131.7
matches the difference between FINANCIAL ACCOUNT* 103.7
saving and capital formation. It also Unrecorded transactions* 91.3
equals the current account. BALANCE OF PAYMENTS 26.1 ('Change in net reserves')
Special capital flows*4 66.6
Change in gross reserves 92.7
9/3/09 12:50:45 PM
chapter 05final.indd 213
C) SECTORAL PRODUCTION, DISTRIBUTION AND ACCUMULATION ACCOUNTS
6. Financial corporations 7. Non-financial corporations 8. General government 9. Households
Gross value added 192.5 Gross value added 1 154.4 Gross value added 317.0 Gross value added 389.6
– Compensation of employees 69.1 – Compensation of employees 518.4 – Compensation of employees 271.2 – Compensation of employees 97.9
– Other taxes on production 5.0 – Other taxes on production 17.7 – Other taxes on production 3.5 – Other taxes on production 10.7
Other subsidies on production 0.1 Other subsidies on production 4.2 Other subsidies on production 0.2 Other subsidies on production 2.2
Gross operating surplus 118.5 Gross operating surplus 622.6 Gross operating surplus 42.5 Gross operating surplus 283.1
Taxes on products 237.0 Compensation of employees 953.8
Other taxes on production 36.9
– Subsidies on products 6.7
– Other subsidies on production 6.7
Net property income –11.4 Net property income –272.1 Net property income –42.1 Net property income 254.4
Gross balance of primary income 107.1 Gross balance of primary income 350.5 Gross balance of primary income 260.9 Gross balance of primary income 1 491.4
Current taxes on income and wealth 376.2
Social contributions received 152.8 Social contributions received 15.1 Social benefits received 155,6
Other current transfers received 96.4 Other current transfers received 22.0 Other current transfers received 4.4 Other current transfers received 108.0
– Current taxes on income and wealth 35.5 – Current taxes on income and wealth 147.7 – Social benefits paid 90.1 – Current taxes on income and wealth 192.9
– Social benefits paid 65.4 – Social benefits paid 11.3 – Social benefits paid 156.6
– Other current transfers paid 97.5 – Other current transfers paid 24.9 – Other current transfers paid 56.7 – Other current transfers paid 76.2
Gross disposable income 157.8 Gross disposable income 188.6 Gross disposable income 509.7 Gross disposable income 1 329.3
– Final consumption expenditure 464.8 – Final consumption expenditure 1 385.0
– Adj for change in net equity of house- + Adj for change in net equity of house-
holds in pension reserves 87.4 holds in pension reserves 87.4
– Residual –1.7 – Residual –10.5 – Residual –3.3
Gross saving 72.2 Gross saving 199.1 Gross saving 45.0 Gross saving 34.9
– Consumption of fixed capital 5.6 – Consumption of fixed capital 215.1 – Consumption of fixed capital 45.7 – Consumption of fixed capital 40.6
Net saving 66.6 Net saving –16.0 Net saving –0.7 Net saving –5.7
Sectoral saving produces total saving
1) Due to rounding of numbers small discrepancies may appear in some totals,

2) GC in Block B4 is government current expenditure, whereas in Block A3 it is government consumption expendi-
ture – see section 5.4.
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).
5.6 The SNA at a glance – relationships between subaccounts

4) Changes in liabilities related to reserves (short-term loans by the Reserve Bank and the government from
international organisations and governments), plus SDR allocations and valuation adjustments, plus net mon-
213
etisation/demonetisation of gold.
9/3/09 12:50:45 PM
Items that appear in more than one place must match. For example:
S 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.
S 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.
S Indirect taxes and subsidies, in account 2, match the indirect tax revenue received and
subsidies paid by general government in account 8.
S Gross capital formation in account 3 matches that in account 4.
S The different sectors’ saving, derived in accounts 6 to 9, reappear as components of
domestic saving in account 4.
S 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.
S 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.)
S 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).
S 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:
S 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 which 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).
S 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 on the sequence of events as they took their
course. An economy is continually subject to multiple influences.)
S 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
which 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 215

S 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.
S Without theoretical insights and reasoning, any identification of problem areas is a very
dangerous, mechanical exercise which 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.

Addendum 5.1: National accounting definitions and conventions:
a student’s guide
The intricacies of national accounting match that 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.
The same principle applies to calculations of aggregate production in a country.
Therefore:
9 See the relevant section in Mohr (2005) Economic Indicators for a more complete explanation
Addendum 5.1: National accounting definitions and conventions: a student’s guide 217

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 2008, for example, GDP at market prices was R2 283.8 billion while
GDP at factor cost was R2 023.3 billion. GDP at basic prices was somewhere in the middle
of these two, at R2 053.5 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 only is 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:
S ‘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.
S ‘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 2008, GDP was R2 283.8 billion while GNI was R2 209.9 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
foreigners on South African goods and services). Note that the residual term is included in
published estimates of GDE.10
10 See Mohr (2005) for an explanation of the residual term.
Addendum 5.1: National accounting definitions and conventions: a student’s guide 219

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.
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
Q use the aggregate demand (AD) and aggregate supply (AS) model to explain both
fluctuations in real GDP and changes in the average price level;
Q explain how the interaction between wage-setting and price-setting relationships
determines both a short-run and a long-run aggregate supply relationship;
Q analyse and assess the importance of the short-run supply adjustment process towards a
long-run, structural equilibrium and a long-run AS curve;
Q assess the importance of structural unemployment in determining the position and nature of
this long-run equilibrium, especially in a developing country context; and
Q 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 tradi-
tional 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 221

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. 67; 70; 130)

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.
S 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.
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Remarks
1. In chapters 2 and 3 you have been 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)
222 Chapter 6: A model for an inflationary economy: aggregate demand and supply

can 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 2005 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
S
M
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

DATA TIP
S The national accounts section in the Quarterly Bulletin shows all expenditure
components, income and product (GDP) in both real and nominal terms.
S Price indices (CPI, PPI) can be found in the section ‘General economic indicators’,
while inflation rates are shown in the section ‘Key information’.
S Real interest rates and real money supply data are not published by the Reserve Bank.
S 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).
S Recall that we defined the short-run as a period of usually up to three years. In section
6.3.3 below 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 average
approximately four to seven years. Short- and medium-term changes and adjustments
frequently are discussed in the context of business cycles with references to ‘booms’
and ‘busts’, ‘upswings’ and ‘downswings’.
S 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 223

The AD-AS model is a powerful analytical tool to focus on the price level, whilst 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 a Short-run
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).
S Any disturbance will shift one or both of the curves, leading to a new intersection and
a new equilibrium level of Y and P.
S 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.
S 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.
S 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 de- Figure 6.2 Deriving the AD curve from the 45° diagram
mand relationship is simply that it
shows, for each price level, the ag- E
Equilibrium points
gregate quantity of goods and ser- for different price
vices demanded in the economy. levels
While this is a useful interpretation,
it is not entirely correct. This is ap-
(C + I + G + X – M)UP0
parent from the way the aggregate
demand relationship is derived di- (C + I + G + X – M)UP1
rectly from the Keynesian expend-
iture model and the 45° diagram, as
described below (and in figure 6.2).
l0
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 demand
as point 0 in the P-Y plane. curve
Suppose the price is at a higher
level P1. For several reasons (ex-
1
plained in section 6.2.3 below) a P1
higher average price level implies a P 0
0
lower level of aggregate expenditure
(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.
S A similar analysis follows for a lower price level.
S Connecting these and other such points yields the AD curve.
6.2 Aggregate demand (AD) 225

The aggregate demand curve therefore 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.
S Below we will show that sup-
ply considerations actually limit the choice between these potential equilibrium points.
(This interpretation will become clearer once the aggregate supply curve has been dis-
cussed.)
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
S
M 1
supply ]P ; this forces interest rates upwards, which is likely to depress expenditure.
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.
Recall the formal rule for shifting vs. moving along
It is applicable only if the ‘price a curve. A curve shifts if a relevant variable not on
level’ is understood not to include one of the axes of the diagram changes. If one of the
the price of labour and other fac- variables on the axes changes, there is a move along
tors of production, i.e. only prices the curve.
of final goods and services are in-
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.

cluded (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
LMUP1 LMUP0
change in expenditure which 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
S Y1 Y0
M
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
P . Expressed diagrammatically, this is a leftward shift of the LM curve from the initial LM
]
1
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.
S 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 income 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 above, i.e. the fact that an increase in the average price level P decreases the
S
M
real money supply ] P . Since this is analytically equivalent to a contractionary 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:
S 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 above, for a given
S
M
increase in P (and thus a decrease in ] P ), Y will decline a lot. Hence the AD curve will
be relatively flat.
S If the interest sensitivity of investment is high, monetary contraction will have a largeS
M
impacton the real economy. Therefore, for a given change in P (and thus in ] P ), Y will
decline much. As a result, the AD curve will be relatively flat.
S 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
S
M
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:
S the interest sensitivity of money demand is high;
S the interest sensitivity of investment is low; or
S 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:
MS
Y A1(a Ia G X – ma) A2 __ (
P + lP ) ...... (4.6)
where: KE
A1 ________
1 + KEhk/l
......(4.6.1)
K Eh
A2 ______
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.
S The slope parameter A2 contains several responsiveness parameters and multipliers
(k, l, h, KE).
S 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 AD and an increase in the repo rate
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
S 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.
S All the internal factors (real and monetary) and external factors which 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.
S 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.
S More specifically, any change in the equilibrium level of Y (due to real, monetary or ex-
ternal disturbances or adjustments) – except due to a change in the average price level
P – will shift the AD curve with 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
S The AD curve shifts right-then-left. The final, net
step (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 S 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 below, we will see
changes in Y resulting. These will impact on the final, net change in equilibrium real income
Y (together with P).
Policy potency
The analysis of policy potency can also be transferred to explain the magnitude of any
shift in the AD curve:
S If fiscal policy is very potent, the AD curve will shift relatively far if an expansionary
fiscal step occurs.
S 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 de-
mand, 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:
S a high interest sensitivity of money demand;
S a low income sensitivity of money demand;
S a high interest sensitivity of investment, or
S 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.
S 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.
S 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:
S size of the labour force (and thus also population growth);
S productivity of labour;
S labour skills levels (and thus education and training);
S cost of labour (wages);
S availability of raw materials;
S cost of raw materials;
S availability of capital goods (and thus investment);
S cost of capital goods;
S technology (which increases the productivity of labour and capital goods);
S cost of financial capital, i.e. interest rates;
S exchange rates (which affect the cost of imported inputs), and
S 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) 231

In fact, this is how we will define long run and short run for purposes of the AS curve:
S 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.
S 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 dis-
cussion below will show:
S 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.
S 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 below (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 The maths of aggregate supply
level of output for considerable
The derivation of the aggregate supply relationships
periods of time – depending, as
and curves requires more mathematics than was
we will see, also on the state of the case with aggregate demand. In the exposition
aggregate demand at the time (see below, basic equations will be shown in the text, but
section 6.4 below). more advanced equations and derivations will be
S We will also see that even the shown in maths boxes.
long-run level of output 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:
S 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.
S 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.)
S 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).
S 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.
S This level of output to which supply tends to return in the long run – amidst short-term
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 ).
S 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.
S 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 of firms.
S 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 put 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, _Q_ is a measure of
W
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).
S 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.)
S A higher nominal wage W implies a higher cost per unit produced, and should lead to
a higher price P being set.
S 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.)
S 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.
S 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.
S 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.
S 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 below.
Several factors are relevant to understanding wage-setting behaviour:
S 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).
S 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.
S 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 below).
S 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:
S 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 competition amongst
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.
S 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, a positive relationship between N and W.
S 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).
S 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 wage lower than what 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, i.e. to
remain outside the labour force).
S 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 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 e
equation 6.3, which shows the expected real wage, ] P (because P is the ‘expected’ price
e
level) as a function of employment N and the institutional factors Z:

_W_ = f(N; Z) ...... (6.3) [Indirect WS relationship]
Pe
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
W
wage on the y-axis and employment on the x- ]
P WS
axis. Given the positive relationship between
N and W discussed above, the WS curve will
have a positive slope.
S It must be understood that wage negotia-
tions and wage setting occur in terms of a LS once a
nominal wage, not the implied real wage. UVTPUHS^HNL
However, whether or not workers expli- has been set
citly factor in their cost of living or expect-

ed 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 price setting in the future. N
S 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, as usually
assumed in labour supply theory.
S 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.
S The set nominal wage W becomes the price of employable labour for the duration of the
contract period, e.g. one to three years.
S 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
...... (6.4) [Indirect PS relationship]
P 1 + μ Q(N)
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.
S 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 decreases
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
real wage ] P paid (i.e. 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
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_ ...... (6.5)
P 0
P Pe
This equation is not very revealing, though.
At this stage it becomes necessary to dis-
tinguish between the labour market situa- PS
tion 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_ or
1
______ Q(N) = f(N; Z)
P Pe (1 + μ)
The equilibrium can be under-
stood as follows. Recall that A formula for the PS-WS equilibrium π
equilibrium implies that the real 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
P e · (1 + μ) · f(N; Z)
equal to the real wage implied P = _____________
Q ......(6.6)
by the price setting of firms. Be-
This equation describes the equilibrium between PS
cause workers in effect set their
and WS (for a given nominal wage W). We will return
labour supply on the basis of to it below.
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 pre-
viously contracted with workers.
S 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 defined If a formula is specified for f(N,Z) the equation can be
by the equilibrium of the price- solved for N, the long-run equilibrium level of output,
setting and wage-setting rela- as a function of Q, μ and Z.
S An important insight is that the long-run equilibrium
tionships. Graphically, the loca-
level of output is independent of the price level P. We
tion of this equilibrium is where will return to equation 6.7.
PS intersects WS.
S 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 like 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
price level to increase which, in turn, will cause the real wage ] P that producers in effect
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
W
structural equilibrium will be established at a ]P
lower real wage and a lower level of employ- WS
ment NS1. (Similar reasoning applies to a
decrease in the mark-up.) W 0
]
S An increase in taxes and non-labour input P 0
costs may cause the mark-up to increase, W 0

]
leading to a new ‘long-run’ equilibrium P 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).
S An increase in economic concentration and the degree of product market power in
the economy may thus cause the mark-up to increase and 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.
S 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.

S 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 skills 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.
S 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 W WS1
]
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 ( ]WP )1
efficiency premium to workers, or if the
ability of employer organisations to depress ( ]WP )0
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.
S Note that structural market character-
istics that constrain competition either
between firms in the goods market or be- Staggered contracts?
tween workers in the labour market tend In reality it is not the case that all contracts
to lower the long-run equilibrium level of are simultaneously revised every year
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 only shift at the time of of renegotiations is not even.
new wage bargaining. (Recall that the WS S 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 the year with a big amount, the LS (and
curve becomes dormant until the next round WS) moves every month with a
of wage bargaining.) fraction of where it needs to go.
S This means the WS curve is institution- S In the analysis, however, we will
assume one move per period and not,
ally rigid. Thus changes in the location of
say, 12 small moves spread across a
the long-run equilibrium due to changes
period.
in the underlying determinants of the
wage-setting relationship will be slow.

S Recall that this also implies that the effective labour supply curve post-bargaining –
indicated as LS – is horizontal. We will return to this when we consider the labour
market and aggregate supply in the short run (section 6.3.3 below).
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, full employment, 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 are 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 chapter 12 for further analysis).
S Structural unemployment is involuntary unemployment and arises from the nature, location and pattern
of employment opportunities. A major portion of structural employment is due to intrinsic mismatches
between worker skills and the skills requirements of available jobs. 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
processes, determine what kinds of, and how much, labour can be employed.
S More generally, structural unemployment can be ascribed to structural rigidities, distortions
and imperfections in markets and in the manner in which the economy as a whole is organised.
Institutional factors and economic power relations play an important role.
S 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. The rest is excluded, as it were, 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.


S The structurally unemployed thus remain without jobs ‘in the long run’, being more or less excluded
from the labour market proper.
S 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 as 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.
P
S Below Y there is cyclical unemployment in the labour ASLR
S
market, leading to downward pressure on wages.
Area of cyclical
S Above YS cyclical ‘over’-employment occurs, which is Area of
unemployment
likely to imply upward pressure on wages. The latter cyclical ‘over’-
employment
may happen amidst and despite the existence of +VÛ^HYK
substantial structural unemployment. pressure on
<W^HYK
^HNLZ
pressure on
Such upward (or downward) pressure on wages and input ^HNLZ
prices in short-run positions above or below YS is important Structural
unemployment
when the short-run supply curve ASSR is considered in Structural
ever present unemployment
relation to YS (section 6.3.3 below).
still present
S One must also remember that the position of ASLR and YS Structural
can also vary over time. equilibrium
Full employment and the natural rate of YS YFE Y

unemployment (NRU)
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.
S Some theoreticians who adopt this 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 30%), calling the long-term
unemployment rate natural might sound 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 above).
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. Changes in the Figure 6.10 The total production curve
usage of new technology will also rotate the Y
TP
TP curve correspondingly.
S 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.
S Note in the diagram (figure 6.10) that, al-
though TP has a positive slope, the slope
becomes flatter at higher levels of employ-
ment: as employment increases, output in-
10 11 12 N
creases but at a decreasing rate. This reflects

the decreasing marginal productivity of labour (an economic phenomenon which, above,
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.
S 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.
S 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 what total level of output firms will supply in the long run graphically, 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 45o 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
S 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’ S 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.
S 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.
S The diagrammatical position of ASLR, like the ‘long run’ or structural level of aggregate
output, is variable over time.
S 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 below.)
S Changes from the price-setting side can change the position of the ASLR curve at any
time, while changes from the wage-setting side only occur 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, causes the PS
curve in figure 6.12 to shift upwards from PS0 to PS1. A new equilibrium is established
at the intersection of PS1 andWWS0. It is a characteristic of the new equilibrium
W
that its
1 0
real wage would behigher (at P ) than that of the initial equilibrium (i.e. P ). Likewise, its
]
0
]
0
long-run employment level would be at the higher level of NS1 compared to NS0 initially.

Figure 6.12 Shifts in the ASLR curve
Y Y 45° line
TP
YS1
YS0
NS0 NS1 N YS0 YS1 Y
]
W P
P
ASLR0 ASLR1
WS0
W1
]
P
P0
0
W0
]
P 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.
S 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 level would be at a lower level.
S This is an important case, since it is also the avenue through which increases 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.
S Increases in monopoly power that cause increases in 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.
S 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 below, 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 e.g 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.
S 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 ]P . But how will producers and
e
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, helps 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
]
P0
LS0
W0
]
P1
LS1
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 YMAX 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 (1 + μ) f(Y; Z)
e
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 only be willing to produce more 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.
S 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
at a maximum level of output YMAX, say. Even if prices increase and more workers are
employed, output can and will not increase beyond this level.
S 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 (see shaded area in figure 6.14).
It reflects the increasing difficulty 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 full capacity (unless
additional capital is added).
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.

S When the ASSR curve shifts on its Figure 6.15 Two types of shift in the ASSR curve
own, its intercept on the verti- P
cal ASLR line changes: it shifts UP ASLR1 ASLR0
Vertical shift
ASSR2
or DOWN. In the diagram, for ex-
of ASSR alone: ASSR1 ASSR0
ample, the intercept on the verti- intercept on
cal ASLR1 line changes from P0 to P1 ASLR changes
(the blue arrows in figure 6.15).
S When ASSR shifts in lock-step with P1
ASLR the intercept on the vertical P0
ASLR line does not change – it re- Lock-step
mains at P0 in the diagram – and horizontal shift
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 intercept 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.)
S This shift thus only occurs if and when such negotiations occur.
S 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 causal
In the text it is stated that ‘any ASSR curve is
factors. Both of these curves thus
drawn for a given nominal wage’. What does this
shift left or right for the same distance
mean for shifts in the ASSR curve? The nominal
due to the same factors. Thus the ASSR wage is the vehicle through which the expected
curve will shift right or left – together price manifests itself.
(in lock-step) with the ASLR curve – if S If it changes due to a change in P e it implies a
there are changes in the mark-up μ vertical shift of the ASSR curve.
(which includes non-labour input S If it changes for a reason unrelated to
costs and taxes), labour productivity expected price, e.g. the exercise of labour
Q, a Z factor, or in capital stock K, the union power, it is analysed as a change in
use of other inputs and technology A, that particular causal factor, which implies a
or the labour force LF. lock-step shift of ASSR together with ASLR. In
S 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.
S 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 which 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 below 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 which 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 e.g. 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.
S 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.
S 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.
S 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 also is
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.
S 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.

To see the combined impact of disturbances and resulting adjustments, we must complete
the model and combine aggregate demand (AD) and the two aggregate supply relationships.
We can then analyse the impact of demand-side or supply-side disturbances and shocks.
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:
S 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.
S Second, the presence of a structural Structural
equilibrium
equilibrium with its output level YS
(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 to-
wards ASLR through a dynamic pro- YS Y1 Y
cess involving adjustments 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 equilib-
rium 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 point of equilibrium is, however, somewhat different
from how it is understood in microeconomics. We saw above that the AD curve is a collection
of potential equilibrium points – each for a different price level. However, all these points 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 which can be attained are indicated by the ASSR
curve.
S 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.
S 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

π
in the diagram above.
Shifts of the short-run The AD-AS equilibrium mathematically
supply curve would Having derived an equation for the AD curve in
change the set of attain- section 6.2 of this chapter:
able points of equilib-
rium. In the same way, (
Y = A1(a + Ia + G + X – ma) + A2 __
P )
MS + lπ …… (4.6)
shifts of the demand and an equation for the ASSR curve in section 6.3.3 above
curve change the point (based on equilibrium in the labour market):
of equilibrium. P e (1 u) f(Y, Z)
P = ______________Q …… (6.10)
S Given the way AD
was constructed from these two relations simultaneously determine the equilibrium
the goods and money level of Y and P ‘in the short run’. They can be solved to obtain
equilibrium values of Y and P.
markets (i.e. the real
S For the long run equilibrium, one simply substitutes P for
and monetary sec- P e in the equations.
tors and the IS and
LM curves), any point
on the AD represents equilibrium in the goods and money markets.
S 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.
S 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.
S 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.)
S 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 and with the price level at P0 and P e = P0.
S 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 and aggregate demand together 255

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 set-
ters. Moreover, increased output also P0
requires a higher price because of
increased costs. As employment in- AD0 AD1
creases to produce the higher output
demanded, the marginal product of
labour decreases; at the existing nom- YS Y1 Y
inal wage rate the unit cost of produc-
tion increases. Producers will only be
willing to employ these additional workers 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 dia-
gram. 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.
S 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.
S 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 below.)
S 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
S 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.
S The structural equilibrium, meanwhile, has relocated to the intersection of AD1 with
the long-run supply curve ASLR at point (YS; P2).
S 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.

S 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. P2
supply adjustments
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 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’.
S We see here the ‘upward el- Since the long-run effect of the monetary expansion
bow’, the typical pattern of the on output is eventually zero, it has no long-term
ASSR adjustment process fol- benefit regarding output or employment. The price
lowing stimulation of aggreg- level P will eventually increase exactly in proportion
ate demand AD that pushed Y to the increase in the money supply M – the only
above YS. long-run change.
S Remember that the move of the S 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
S 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
S 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
P ASLR ASSR0
emerges. In this case Y drops ASSR1
below YS. The adjustment process ASSR2
entails a downward adjustment in
Equilibrium after
the average price level P, this being demand decrease
part of the process of moving back P0
towards YS. P1 Equilibrium after
S Such a change can be caused supply adjustments
PS
by a decrease in government
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 Y
S 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.
S 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.
S 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.
S 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).
S 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.
S 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.
S The supply adjustment (a medium-term 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 below.
S 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.
S 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 discussion above may suggest. Nevertheless, the existence of such adjustment
forces is clear.
S 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 below. 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 declines, 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
D
in M which holds back (but does not
ASSR1
reverse) the repo-initiated rise in r and
the consequent drop in I and Y. Moreover, P 0
(b) the simultaneous decline in the average P03 3 2
S
M
P.
price level P implies upward pressure on ] 1
(Why?) This acts as a further restraining P4
force on the increase in r and the decline 4
in I and Y (and M).
S Note that, now that P is not assumed
to be constant any more, P changes
and has feedback effects on compon-
Y1 Y3 Y2 YS Y
ents of expenditure (investment and
imports).
S 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.
S 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.
S 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 increases 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 S The AD curve shifts right-then-left.
is reduced, and so is the S 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, Y
process will continue until BoP
went through a noticeable up-down cycle in the
= 0. This cumulative decrease 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.
S 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.
S
M
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 low- Y
er than at its starting level. The contrac-
tionary monetary policy step followed
by the AS adjustment has unequivocally
Time
reduced the average price level.
2. Real income is back where it started, P
after a deep cyclical downswing, with
the recovery – punctuated by a dip on
the way – lasting several years. Time
Rand
3. Unemployment increases for several
years, but decreases during the AS ad-
BoP
justment phase.
Time
4. The balance of payments goes through
two cycles of surplus and deficit, but
ends up in balance.
Demand contraction Supply adjustment
5. The real interest rate goes through a phase phase
strong upward phase initially, but de- Up to 3 years 3–7 years
clines during the BoP as well as AS ad-
justment phases. It will probably end
Overall (with overlap): 4–7 years
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 S
M
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.
Figure 6.22 AD-AS and an increase in government expenditure
In the diagram the entire set of
demand-side primary and second- ASLR ASSR2
P ASSR1
ary effects is summarised in the
net rightward shift of AD from ASSR0
AD0 to AD1. (If shown in detail, Equilibrium after
2 supply adjustments
the AD curve will display the typ- P2
ical right-then-left shift pattern, Equilibrium after
P1 1
associated with phases 3 and 4 for all demand-side
0 secondary effects
a BoP surplus, before reaching the P0
AD1 position.) AD1
The short-run equilibrium has
moved from (P0; YS) to point
AD0
(P1; Y1).
[The economy is at point 1 on the YS Y1 Y
diagram.]
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.
S
M
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.]
P
Summary of final, net effects
1. The price level ends up significantly Time
Rand
higher than at its starting level, follow-
ing interrupted years of increase. The
expansionary fiscal policy step followed BoP
by the AS adjustment has unequivoc- Time
ally increased the average price level.
2. Real income goes through a substantial Demand contraction Supply adjustment
cyclical upswing, followed by a down- phase phase
swing lasting several years (the whole Up to 3 years 3–7 years
process lasting perhaps four to seven
years on average). In the end, output and Overall (with overlap): 4–7 years
income are back where they started.

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.
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).
S 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.
S On the wage-setting side, such a change can result from an increase in union power
which 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 shifts both
equilibrium is not on ASLR –
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 e. The
normal ASSR supply adjustment YS2 Y1 YS0 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.
S 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 – 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.
S It could thus be several years before the new structural equilibrium point on ASLR1 is
reached. A prolonged economic contraction is likely.
S 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.)
S 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 graphical examples above). 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
S The development of a large 3 shifts both
P3
initial current account defi- ASSR and ASLR
P2 2 left. Then sup-
cit is an important charac- ply adjustment
teristic of this case (in con- P0 0 process shifts
P1 1
trast to a domestic supply ASSR up
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 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
S
M
supply ]P , which increases the interest rate and causes investment and thus aggregate
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 which 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).
S The AD curve zig-zags left-then-right. Y would decline a bit, then rise again. P would
decline a bit, then rise again.
S 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.
S 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 equilib-
rium, 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 adjust-
ment 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.
S
M
The increase in P also decreases the real money supply ]
P , which puts upward pressure
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- Figure 6.26 Illustrative time path of key variables –
then-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 expenditure, putting down-
ward pressure on prices initially. Yet the Rand
price level soon starts to increase due to
the cost shock. The contractionary effect
of the outflow of reserves temporarily BoP Time
brakes the upward momentum of P,
before it resumes a sustained increase. Contraction due to Supply
2. Real income (and together with it supply shock phase adjustment phase
Up to 3 years 3–7 years
employment) decreases significantly.
Except for a brief upturn due to the
first exchange rate effect of the BoP, Overall (with overlap): 4–7 years
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.

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 the supply shock diagram in the introductory part of section 6.4.4 above, 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 aggreg- Figure 6.27 Supply shock followed by accommodation
ate supply curve has moved left P ASLR1 ASLR0 ASSR3
to ASLR1 due to the initial shock.
ASSR2 ASSR1
The expansionary demand pol-
ASSR0
icy then pushes the economy to
a point to the right which again P4
is off ASLR1 (combined with an
Adjustment
increase in the price level to P3, P3 process then
say). A new round of supply ad- P 2 shifts ASSR up
justment – which increases the again
price level yet again (eventually P0 AD0 AD1 Policy
to P4) together with a reversal of stimulation
the policy-led expansion to YS2 – shifts AD right
is likely. YS2 YS0 Y
S The reason for the frequent oc-
currence of the latter zig-zag
pattern is that, as indicated Understanding the structural equilibrium level
earlier, a supply shock leaves The level of structural employment, i.e. YS, can
the economy with twin prob- now unambiguously be understood as the level
lems: more unemployment around which cyclical disturbances, fluctuations and
plus an increasing price level. adjustments in Y occur (see box on unemployment
Political pressure and/or socio- on page 242). It is the output level (together with its
economic considerations of- price level PS ) from which the ‘gravitational pull’ that
ten persuade a government to we have been speaking about is exerted. In other
adopt unemployment as the words, YS is the cyclically neutral level of income (and
first priority of policy, and to employment).
stimulate aggregate expend- Nevertheless, its own position is not permanent, since
iture. it can also be relocated due to economic factors and
S This is called the ‘accom- forces.
modation’ of the supply shock.

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 or after supply
the private sector, has two effects. ASSR2 NYV^[OHUK
It increases aggregate demand supply
ASSR0 adjustment
in the short run (and thus shifts ASSR1
P2
the AD curve to the right); and it Equilibrium
P1
after demand
boosts productive capacity in the stimulation
P0
medium to long run. As shown in
the diagram (figure 6.28) it thus
shifts the ASLR curve together AD0 AD1
with the ASSR curve to the right.
Thus there is a combination of
YS Y2 Y1 Y
a positive supply shock and a de-
mand 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, or to the left or right of, the new ASLR curve. If off the ASLR
curve, it may be followed by supply adjustment processes until the short-run equilibrium
settles on the new, augmented ASLR.
S It is important to note that, in the illustration of an increase in investment expenditure
– compared to a standard non-investment aggregate demand stimulation (see example
above) – the price level increases by less (to P2) or not at all, and that there is a net
increase in the long-run, structural equilibrium output to Y2.
S This will be important when discussing the determinants of economic growth, which
graphically is equivalent to a steadily outward shifting ASLR curve and a steadily
increasing structural equilibrium output YS.
S 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.
S Expenditure on new technology and human capital would have similar effects to those
shown above.
S 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.
S An important real-world example is the massive government investment in infra-
structure initiated in the US in 2009 to counter its recession after the worldwide
financial crisis of 2008 and 2009.

YS and the rate of unemployment in a growing economy
The diagrams above 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.
S 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 which grows at the same rate as the
labour force would imply an unchanging long-run or structural unemployment rate (SRU)
only if technology is not augmenting labour productivity.
S 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 if increased employment or labour absorption. Thus the
long-run or structural rate of unemployment (SRU) would decline.
S The structural dimensions of unemployment imply that changes in YS on their own are not
sufficient.
The world economic crisis of October 2008 – 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 US that came to a head in September–October 2008. It led to the failure of
several banks in the US (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 US, faced serious financial ruin. (These recessionary conditions spread to
many countries, e.g. the UK, Europe, and Japan.)
In reaction to this, the US government and President Barack Obama launched a massive
national infrastructure investment programme in 2009 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 and reduced the bank rate to stimulate credit creation.
Now analyse these events 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.


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:

S increasing prices?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
S decreasing prices?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
S increasing prices combined with an upswing?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
S increasing prices combined with a downswing?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
S 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
2007
2003
1997
1993
Average price level (log scale)
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.reservebank.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, reaching a peak in 2007.
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 – amongst 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 450 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 inter-
est rates and exchanges rates and several real and monetary economic variables along the
way, often initiating complex ad-
justment processes – until it ends Truth or theory?
with a final impact on the price
level and output/income. Remember that this is still only a theory of the way
the economy works. While it is sophisticated, and
Note that in many cases the supply the product of the work of highly regarded theorists
adjustment process will appear to and economic scientists, including Nobel Prize
be inoperative. This is because of winners, it should never be regarded as the absolute
the length of time it takes – from Truth (with a capital T).
three to seven years – and the fre- S No theory or science can ever be that. Human
quent occurrence of new disturb- knowledge and insight are and always will be
ances or policy steps which over- limited, should be regarded as provisional, and
should be used unpretentiously and in full aware-
ride the adjustment.
ness of their fallibility.

Figure 6.30 The whole model – monetary and real sectors, aggregate demand and aggregate supply
Monetary sector Real sector
Transmission
mechanism
r MS
] r E P ASLR ASSR
P
C+I+Gc+X–M
MD
]
P I AD
Money I Y Y
Feedback
mechanism
NOTE
r . POFUBSZDIBOHFTBSFUSBOTNJUUFEUPUIFSFBMTFDUPSWJBUIFJOUFSFTUJOWFTUNFOUMJOL BMFGUUPSJHIUDBVTBMJUZ
r 3FBMTFDUPSDIBOHFTJODMVEFBHHSFHBUFJODPNF Y) as well as the average price level (P).
r $IBOHFTJOUIFSFBMTFDUPS Y, P) have secondary, feed-back effects on the monetary sector via the demand for
money (a right to left, indirect causality).
r 5IFàSTUJNQBDUPGNPOFUBSZQPMJDZJTJOUIFNPOFUBSZTFDUPS XIJMFUIFàSTUJNQBDUPGàTDBMQPMJDZJTJOUIFSFBM
sector.
Therefore one often focuses on the initial impact on the AD-AS diagram, largely leaving
the supply 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.
This model enables one to consider and analyse specific problem areas of macroeconom-
ics. The first of these is macroeconomic policy; the second, the problems of inflation, un-
employment 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 once-off occurrences, but a permanent feature.

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.
S In the expansion phase, the LS curveWshifts down to LS1. WS remains stationary because P e has
0
not changed. The real wage drops to ] P because of the increase in actual price to P1; employment
1
increases to N1.
S As the ASSR adjustment starts, Pe and the renegotiated nominal wage increases (to W1) to
matchup
W
with price P1. However, the actual price has already risen above P1 to P2. The new real
1
wage ] P
2
still is 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.
S 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.
3 0
The real wage would have recovered all the way so that ] P
3
= ]
P .
0
Employment drops yet further,
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
W P ASLR ASSR2
]
P
WS
2 ASSR1
P3
0;2
W
]
3 W
=] 0
LS0;3 ASSR0
P3 P 0 P2
W1
LS2
P1 1
]
P2
W0
LS1 0
]
P P0
1
1 AD1
PS
AD0
NS N1 N YS Y1 Y
Addendum 6.1 Labour market changes following demand stimulation 277

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.
S 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 0
P1) to reflect the higher input costs, the LS curve shifts down to LS1. The real wage drops to ] P 1
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.
S As the ASSR adjustment starts, P e and the renegotiated nominal wage increases (to W1) to match W 1
up with price P1. However, the actual price W
has already risen above P1 to P2. The new real wage ] P 2
0
still is lower than the starting real wage ] P . But the real wage has recovered some of the ground
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.
S 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
3 0
recovered to ] P
3
which is lower than ]
P0
. Employment drops yet further, back to the new, post-
shock structural equilibrium level at N2.
Y TP Y 45° line
N2 N1 N0 N YS2 Y1 YS0 Y
W
] Y
P ASLR1 ASLR0 ASSR2
PS0
WS ASSR1 AS
SR0
PS1
P3
Phase 1: Supply
W0
LS0 P2 shock shifts
]
P 0 P1 both ASSR and
W3 P0 ASLR left
]
P3 LS3
W1 Phase 2:
]
P 2
LS2 AD Supply adjust-
W0 ment process
]
P 1
LS1 shifts ASSR up
NS N1 N0 N YS2 Y1 YS0 Y

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
LM0
S In chapter 4 (section 4.7.5) 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
r0
S In section 6.2.5 the diagram
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
S 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. P AD1 AD3 AD2 AD0 ASLR
ASSR0
The direct correspondence be-
tween changes in the IS-LM-BP
model and the AD-AS model are
shown below in one set of dia- ASSR1
grams.
S Note how the short-run
equilibrium points 1 to 3 in 0
P0
2
the IS-LM-BP diagram have P3
their exact counterparts in 3
1
the AD-AS diagram.
P4 4
S 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.
Y1 Y3 Y2 Y0 Y
One important thing to notice is
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 – imply changes in the price level P. This impacts correspondingly on the real money supply
S
M
]P , 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.
S 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 6.3 A complete example of IS-LM-BP and AD-AS for an increase in the repo rate 279

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 its 6
r7
BP0
power in showing the ra- 7 4
ther complex behaviour of r0 0
r2 3
the BoP and its constituent 2
components, the CA and r1
FA. Thus we concentrate 1
IS0
on the graphical analysis –
which is quite complex and IS2
requires careful scrutiny. IS1&3
From point 0 to point 1: Y

The decrease in domestic Y AD3&5
AD ASSR2 ASSR1 ASSR0
expenditure causes the IS AD2 AD1&4 0
and BP curves to shift left
from IS0 to IS1 and BP0 to
BP1, while the LM curve
momentarily shifts right to P5 7
LM1 due to the decline in
S
M
P (and increase in ]P ). The 2
IS-LM intersection moves P 4
left, and AD shifts the P1

P0 3 4 1 0
same horizontal distance
left from AD0 to AD1. The
equilibrium moves from
point 0 to point 1 on both
the IS-LM-BP and AD- ASLR1 ASLR0
AS diagrams. This point YS1 Y3 Y4 Y1 YS0 Y
is below the BP1 curve,
indicating that a BoP
deficit has developed (CA and FA in deficit).
From point 1 to point 2:

S
M
As supply contracts, Y decreases while P increases; thus ] P decreases. LM starts shifting
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:

a. Through the interaction between ASSR1 and AD1 a temporary equilibrium (P2; Y2) is
reached at point 2 on the AD-AS diagram, and
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 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.
S
M
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.
Addendum 6.4 A complete example of IS-LM-BP and AD-AS for an increase in the price of 281
imported inputs (e.g. oil)

Extending the model: inflation
and policy reactions 7
Q understand and 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;
Q use the Phillips (or PC) curve to assess and analyse possible short-run and long-run
relationships between inflation and GDP;
Q 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
Q 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 back 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 – the average price level is
always increasing, even in reces-
sionary times or when the central Do you want to know more about inflation?
bank or government is pursuing
More information on and discussions of inflation
a contractionary policy. Does this
in South Africa and other countries, including the
make the above model irrelevant? probable causes of inflation, can be found in chapter
The answer is no, but it requires a 12, section 12.1.
slight adjustment to the model to set
it in an inflationary context.
An inflationary context means
an economic environment where AS by a different name? The Phillips curve
it has become normal for prices An essential part of analysing the inflationary context,
and wages to increase year by and policy in that context, is a name that will crop up
year and where, indeed, prices in all textbooks: the Phillips curve. For reasons that
and wages are expected to increase are explained below, the aggregate supply curves in
continually. The rate of inflation this context are frequently called Phillips curves, and
may vary, but inflation is always indicated as PCSR and PCLR in diagrams. We will also
do so below.
there.
Chapter 7: Extending the model: inflation and policy reactions 283

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
π = ]]]
P
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.
S 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 a higher rate of inflation is considered normal,
and the central bank may be happy with
Figure 7.1 AD-AS and a continually increasing price level
a rate between 3% and 6% (e.g. South
Africa; see chapters 9 and 12). AS
P LR
7.1 Adjusting the model: inflation-

augmented AD and AS curves
P4
7.1.1 A state of steady inflation
ASSR2
Consider an economy with a steady rate of
P3
inflation at x%, and assume that it is steady
at the structural equilibrium output level YS. ASSR1
This means that the price level P increases by P2
x% every year, while the economy remains
on ASLR. If we illustrate this ‘steady inflation ASSR0
state’ graphically on the P-Y plane, using the P1
AD-AS curves, it would show a repeatedly AD2
upward-moving AD-AS cross, pushing the
equilibrium point up repeatedly along the P0
vertical ASLR line (see figure 7.1). The price AD1
level increases from P0 to P1 to P2 and so forth
without end. This process would soon push
the AD-AS curves off the page! AD0
YS Y
284 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 (%Δ) 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.
S 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 ASSR.
A quasi-ASLR curve can also be plotted (it will remain vertical).
S 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
ASSR is that, in a state of steady in-
flation, they remain stationary in the P
ASLR VY7*LR )
new π-Y plane – while AD-AS would
soon drop off the top edge of the page
ASSR VY7*SR )
in the P-Y plane.
As we will see below, disturbances
would once again lead to short-run :[LHK`PUÅH[PVU
equilibrium points off the ASLR curve, structural
followed by supply-side adjustments. P equilibrium
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
S At every equilibrium point in both
diagrams (figures 7.1 and 7.2), the
expected price equals the actual price. Thus ΔP e = ΔP and thus also %ΔP e = %ΔP. 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 ASSR is on ASLR
all the time.
S 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.
S 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 12.2.
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 285

S
M
the real money supply ]
P ). In other words, the nominal value of aggregate expenditure
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
unexpected shifts in the ASSR and AD that P e2
take place over and above the expected, AD2
continual shifts shown in figure 7.1 or, ASSR0
equivalently, in figure 7.2. P1
A demand expansion example

P0
Suppose expected inflation is steady at
π e = 4% and has been so for some time. AD1
S 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.
S In the π-Y plane (figure 7.4), both AD and ASSR (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 by more than normally and causes
aggregate expenditure to grow by e.g.
6%. Figure 7.4 Higher expenditure growth in the π-Y plane
S In the P-Y plane this will cause AD to P
ASLR VY7*LR )
shift upwards and to the right (to AD2)
faster than ASSR (since the expected
price P e2 is now lagging behind). ASSR0;1 VY7*SR )
This involves shifting in excess of its
Equilibrium
‘normal’ (and expected) upward shift after demand
of 4%. Therefore, a larger increase P Z[PT\SH[PVU
1
in the price level will occur (from P1 P
0
to P2), in excess of the normal 4%,
AD2
together with an increase in output AD0;1
beyond long-run output (output will
climb to Y1).
S In the π-Y plane, the AD curve shifts
YS Y1 Y
up and to the right, while PCSR (i.e.

ASSR) remains stationary since its intercept with PCLR (i.e. ASLR ) is at π0 (and the
expected inflation rate π e = π0). The short-run equilibrium shifts along the ASSR curve
to the right of ASLR, 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.
S 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 ASLR 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 P
inflation has increased from π0 to π1 7*LR 7*SR2
(figure 7.5), inflation expectations 7*SR1
are sure to adjust upwards and there
7*SR0
will be upward pressure on nominal Equilibrium
P2 after supply
wages. Once wages are renegotiated
adjustments
upwards, this will shift the ASSR, P1
now renamed the short-run Phillips P Equilibrium
0 after demand
curve (PCSR), to shift upwards from Z[PT\SH[PVU
PCSR0 to PCSR1. Prices, real wages
AD1
and employment will adjust (as in AD0
the AD-AS model), and inflation will
increase together with a decrease
in output. The actual inflation rate YS Y1 Y
will, 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).
S 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.
S 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).
S Using the illustrative numbers of expenditure growth of the example above, the annual
inflation rate will have increased from 4% to 6%.
S As noted in the AD-AS context, the whole process of expansion followed by supply
adjustment (in this case a contraction combined with an increase in inflation, i.e.

stagflation) could take between
four and seven years, requiring What is stagflation?
successive rounds of wage re- The short-run Phillips curve associates higher output
negotiations. 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 ASSR (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.
S 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.
S 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.
S 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 just now, as long
as the focus of any increased expenditure is the creation of new productive capacity
(see section 7.1.6 below).
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 AD1, 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 Figure 7.6 A supply shock in the π-Y plane
net result of a contraction in output
and employment combined with an P 7*LR1 7*LR0
increase in the inflation rate is classic 7*SR2
P3
stagflation.
S The structural rate of unemploy- 7*SR0
ment SRU would have increased – Equilibrium
more involuntary unemployment after supply
P2 ZOVJR
would be present. Involuntary
P1
unemployment, whether cyclical P0 AD2
or structural, can be understood
as the difference between actual AD0
unemployment and what it would
have been with completely com-
petitive labour and product mar-
kets. YS2 Y1 YS0 Y
If policymakers come under political pressure to counter the contraction in output and
employment, they may try to stimulate demand (to AD2) 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
P
debate (see below). It is the following: should the
7*LR 7*SR4
government or the central bank wish to increase
7*SR3
output to Y1 and keep it there permanently, it
will only be possible through repeated increases 7*SR2
in the growth rate of aggregate demand which 7*SR1
will translate into a continually increasing 7*SR0
P3
inflation rate. Thus, not only will the average AD4
P2
price level increase from period to period, it will
AD3
increase at an increasing rate. P1
P0 AD2
Consider the process following an increase in AD1
the aggregate expenditure growth rate from
e.g. 4% to 6% with the aim of increasing output AD0
to Y1. YS Y1 Y
In year 1, the expansionary policy shifts the
AD curve from AD0 to AD1, 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 AD1 – unless the supply adjustment is countered by
pushing AD up further to AD2 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 PCSR to PCSR2
(whose intercept with PCLR is at π2). It will need to stimulate aggregate expenditure growth
again, this time shifting AD2 to AD3. 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.
S 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.
S 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, etc.)
will shift the PCLR line to the right. This may significantly moderate the harshness of the
process described above, since the inflation rate will increase less or not at all, depending
on the growth in YS.
S 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.
S 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.
S 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.
S 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.
S 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. short enough
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.
S As we will see in section 7.2 below, 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
ASSR) 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.
In its popular form, the Phillips curve refers Figure 7.8 The original Phillips curve
to an inverse correlation between the rate
Inflation
of unemployment and the (price) inflation rate
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
low unemployment, but paired with high Unemployment rate (%)
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:
Pw P P 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 which shifts up and down the
short-run aggregate supply curve – i.e. a series of equilibria on the ASSR curve. The price lev-

el and unemployment move in Figure 7.10 A shifting Phillips curve
opposite directions – an inverse
relationship between inflation
Inflation
and unemployment. This is rate
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 dis-
integrating curve but a shifting
Phillips curve. Theoretically
this is explained by shifts in the Unemployment rate (%)
short-run AS curve. For exam-
ple, shifts of ASSR due to sup-
ply 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.
S 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.
S 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.
S 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.
S This result is especially clear in the inflation-augmented AD-PC version of the
theory.
S This means that the ASLR 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.
S 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 $P
when output is above YS means that ;`WPJHSKH[HWVPU[Z
generated by ‘new’
higher output (i.e. lower unemploy- 6 L_WLJ[H[PVUZ
ment, below SRU) will be associated H\NTLU[LK7OPSSPWZ
with an increase (positive change) in YLSH[PVUZOPW
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.
Δπ 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 which differs significantly from the original Phillips
relationship.
S The implied trade-off for an expansionary policy stance is thus between lower un-
employment and rising inflation.
S If this theory is correct, it should also be displayed in real-world economic data. In the
case of the US, 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.
7.1 Adjusting the model: inflation-augmented AD and AS curves

295

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.
S 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.)
S Examples include a sudden weakening of the rand as in 2001, or an unexpected increase
in the oil price as in 2007/8. In both cases, the inflation rate decreased fairly quickly in
2002 and 2009 following a period 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 counter-cyclical stimulation of expenditure (demand) to get the economy

The mathematics of the Phillips curve π
The augmented Phillips curve is typically written in one of two forms: either with reference
to output Y and the structural equilibrium YS, or with reference to unemployment U and the
SRU, or US:
e
P = Pt + B(Yt – YS ) + Wx where B > 0 ...... (7.1)
or
e
P = Pt + A(Ut – US) + Wx where A < 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. A and B are slope parameters when π is graphed relative
to (Y – YS), while W is a parameter measuring the response of π to a change in x.
S 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.)
S 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).
S (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.
S 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.)
back to the structural equilibrium output level (but not further) is appropriate. This
can be either monetary or fiscal policy, although monetary policy may be more
appropriate as counter-cyclical medication. 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
‘downward elbow’ in chapter 6 P 7*SR0
7*LR
(section 6.4.2). Let us start from a 7*SR1
high inflation equilibrium point on
PCLR with inflation at π2 (figure 7.12). 7*SR2
A reduction in the growth rate of P 2 Equilibrium
nominal aggregate expenditure below P3 after demand
decrease
the current rate (which will equal the
P4 AD1
rate of inflation in the equilibrium)
AD2 Equilibrium
will cool the economy down, reduce
after supply
production and push output below adjustment
the long-run, structural level YS to
point (π3; Y3). The inflation rate will
drop to π3. Since the latter is below Y3 YS Y
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
AD2 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.)
S By appropriately choosing the position of the new AD2 curve, the policymaker can
steer the economy towards a desired, target inflation rate such as π4 (assuming rather
accurate 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 anti-clockwise
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).
S The inflation rate and the output level would have fluctuated accordingly.
S The final, target inflation rate (indicated as π4 in the diagram) need not be the same
as the initial inflation rate π0, as was done in this illustration. It could be either higher

or lower. That would dictate Figure 7.13 Demand contraction to counter demand inflation
the appropriate position of
P
the final AD curve. 7*LR 7*SR1
7.2.2 Steering the process –

7*SR0;2 Equilibrium after
more activist
P2 demand increase
policy strategies 3 2 plus supply
P3 adjustment
Policy authorities may want to
4
intervene to change the route P0;4 1
AD1 Initial equilibrium
of the short-run equilibrium. AND equilibrium
Remember that the only thing after demand
AD0;2 decrease plus
that they can affect with de- supply
mand policy (fiscal or mon- adjustment
etary), is to effect and affect Y3 YS Y1 Y
the downward shift of the AD
curve. They can manage the
timing, speed and magnitude of this shift.
S In reality, policy authorities do not have the information and mechanisms to control
aggregate demand so 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

Consider the second example above, Figure 7.14 Different policy paths to counter demand inflation
i.e. of excessive demand growth (figure
7.13). Let us regard its graphical de- P 7*LR )HZLSPULWH[O[V
piction as a baseline path (represented eradicate excess
KLTHUKPUÅH[PVU
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
very far and before inflation reaches its
PT
peak on PCLR. 4VYLNYHK\H[LK
HU[PPUÅH[PVUWVSPJ`
This would create a flatter circular route path
back to the target inflation rate (rep-
resented by the dashed arrow curve). YS Y
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 above as the baseline path (i.e. the bold blue arrow
curve in the diagram in figure 7.15).
7.2 Managing inflation – policy options and the monetary reaction (MR) function 299

The contraction in aggregate expenditure Figure 7.15 Different policy paths to reduce inflation
can be managed so that the AD curve shifts P
down slower, giving the aggregate supply and 7*LR 7*SR
wage adjustment process more time to kick
in. This would produce a less roundabout
route to the target equilibrium point (and 4VYLNYHK\HSPZ[
target inflation rate) (represented by the HU[PPUÅH[PVU
WVSPJ`WH[O
finely dashed arrow curve to the right of the
baseline arrow curve). The drop in output 4VYLYLHJ[PVUPZ[
HU[PPUÅH[PVU
that is necessary to squeeze the unwanted WVSPJ`WH[O
inflation out of the system is less in this PT
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 a more gradualist YS Y
process.
S 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 quicker
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 quicker.
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 so as 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 from 2000 till at least 2009. For most of the time since 2000, 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.

S 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 value P
7*LR
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 PT
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 equilibrium 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 so as to steer the equilibrium along the MR line towards the targeted level of inflation
πT (together with its matching output level YS).
S 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.
S Graphically, the differences in
approach are reflected in differ- Figure 7.17 A gradualist MR curve
ent MR slopes. P
S The difference between these 7*LR 7*SR0
approaches will be evident in the 7*SR1
extent to which the central bank
7*SR2
chooses to increase interest rates
P0 7H[OMVYJLKI`49
via a repo rate increase.
M\UJ[PVU¶Z[LW^PZL
The gradualist MR curve is illus- decrease in AD
curve
trated in the diagram in figure 7.17. PT
It shows how the fall in output is
moderated by decreasing aggregate
AD0
demand gradually, in stepwise fash- AD2
Baseline path
ion, until it reaches AD2, allow- MR curve
ing the supply adjustment process
YS Y1
to kick in and take the economy

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 US:
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 ).
S 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.)
S 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).]
S 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).]
S If both inflation and output are below the target values, there is twofold pressure to reduce the real
(and nominal) interest rate.
S 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.
S For the US, Taylor found that putting 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.
S 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 2.5% = 8.4% minus 6%.
S 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%.
S A higher value of h thus implies a more stringent interest rate policy when inflation is above the target
value: the central bank attached 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.
S 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.

towards the long-run equilibrium output level. The fall in output is less than in the basic
example in figure 7.12 – indicated as the ‘baseline path’ in the diagram. As noted, this
path will take longer than the baseline example to reach the target level of inflation πT. Un-
employment will increase less, but those unemployed will remain unemployed for longer.
S 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.
S 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 the gradualist approach. Demand is contracted further than
AD2. 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 declines much quicker
than in the baseline example, and obviously also quicker than the gradualist case. The re-
covery of output and employment may not be so quick, though.
S 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.
S The necessary increase in interest rates will be much larger in this case.
An extreme example of the reactionist Figure 7.18 A reactionist MR curve
approach is the so-called cold-turkey ap- P
proach. It aims to eradicate excessive 7*LR 7*SR0
inflation in one decisive move and in 7*SR1
one period by increasing the repo rate
drastically.
S Graphically, the cold-turkey approach P0 Baseline path
is indicated by a horizontal MR func-
tion, indicating an uncompromising
anti-inflationary stance by the cen- PT AD0
tral bank.
MR curve
S The cold-turkey approach has the 7H[OMVYJLKI`49 AD2
M\UJ[PVU¶ZL]LYLPUP[PHS
benefit that inflation returns to its decrease in AD curve,
low level within one period. However, [OLUNYHK\HSYLJV]LY`
the drastic increase in unemployment YS Y1

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.
S In some textbooks, you will find a so-called IS-PC-MR three-equation model. This is like
the diagram shown above, 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 Which policy objective?
target interest rate to produce At the moment most central banks consider price
the desired fall in output. stability to be their main objective. This is a broad
S This ‘underplaying’ of the LM current consensus in central bank and monetary
curve is not purely innocuous. policy circles. The South Africa Reserve Bank (SARB)
It reflects a particular way of is no exception to this consensus.
thinking about what central S 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 US 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
S 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.
S In any case, the world financial crisis of 2008, and initial political reactions to it, re-
minds one that different eras may also make different approaches appropriate. One’s
analytical apparatus should not be constrained by a single approach that currently is
in vogue.
Analysing the world economic crisis of October 2008 – 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 six, 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.
S 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 timeframe 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.

Macroeconomics in the very long run:
growth theory 8
Q understand how the analysis of aggregate supply, and the production function in
particular, provides the key to explaining economic growth;
Q analyse and evaluate how the concept of balanced growth helps to explain the long-run
growth path of economies;
Q 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;
Q evaluate the potent roles of technology, institutions and human capital in economic
growth;
Q evaluate how policy measures can and cannot be used to increase the long-term growth
prospects and performance of an economy; and
Q 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 307

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.
t
GDP – GDP
t–1
Y –Y
t t–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). 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.
S 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 US. 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
308 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 function However, per capita GDP is an average. Despite an
(TP), which captures the way ag- increase in per capita GDP, some people may not be
gregate output Y depends on the better off. Or, the living standards of some people
may increase much faster than those of others.
quantities of labour N, capital K
It depends on how the growing income flows to
and technology A that are em-
different households and individuals are apportioned.
ployed in the multitude of produc- S South Africa has one of the highest degrees of
tion 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 narrowest diverge from each other. The adjustment in economic
sense, human capital can be de- behaviour that brings output and expenditure back
fined as the skills of individuals into balance takes the economy to a new equilibrium
that allow them be more efficient. point. Moving equilibrium points are the substance
Such skills are accumulated of the business cycle and medium-term patterns in
over a lifetime, notably through output and employment.
schooling and post-school train- In the very long run, our interest is the long-run
ing and education. Expenditure trend in aggregate income. Thus we intentionally
in education that increases the ignore short-term and medium-term deviations
amount or years of schooling of from the trend. To exclude that element, we regard
individuals can be seen as an in- expenditure and output as being in equilibrium in
vestment in human capital, i.e. the long run. This means we can only focus on the
the ability of people to be produc- behaviour of output (and thus income) in the long
tive. Other forms of knowledge, run, since expenditure will behave concurrently.
such as workplace experience, on Obviously the economy will not be on the long-run
the job training, life skills, etc., growth path at all times, as we will see, and will
improve labour efficiency as well. regularly be busy, over time, adjusting back to the
A broader interpretation would long-run trend. Nevertheless, to see this we first
also allow for the development need the long-run trend.
of human ability/capacity due
8.2 Why growth theory? 309

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 below 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:
S 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.
S 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.
S 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 developing 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 a quite important variable, particularly in a developing country context, 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 A can What about natural resources as a source of
be largely replicated, with some growth?
adjustments, for the analysis of H Countries rich in natural resources such as oil
(see section 8.10 below). 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 S See the box in section 8.5 below.
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.
S Graphically diminishing marginal returns are seen in a curved TP function which
gradually flattens out as the variable on the horizontal axis increases (given that
the other factors remain constant). The diagram below shows diminishing mar-
ginal 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 which approximate real-world situations
quite well. It looks as follows:
New technological or institutional
A 1–A
innovations and refinements that Yt = AtKt Nt where 0 < A < 1
add proportionally (or more) to
output growth always appear to The parameters A and 1– A 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 anal-
ysis and conclusions that follow.
S The absence of diminishing marginal returns means that there are either constant
marginal returns for that factor, or increasing marginal returns.
S 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 AD-AS to the Solow growth model 311

Figure 8.1 TP and growth in long-run real income
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.
S 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.
S 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 Figure 8.2 The impact of technology and institutions
more complete; see section 8.10 below.) on TP
However, growth in Y is not without con- Y TP1

straints and limitations.
TP0
S Regarding N (as a proxy for the labour force LF):
First, it is constrained by natural limits on the
Y1
population growth rate. Moreover, increasing Y0
employment N is subject to diminishing
returns, so increasing N out of line with K is
less productive in the long run.
S 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) K0 K1 K
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.
S 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.
S 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 initial graphical depiction of the production
function above (figure 8.1) we have chosen to place employment N on the horizontal axis.
Thus, changes in K, which is not on either of the axes, will shift the TP curve. The same
applies to changes in A. By contrast, changes in N result in moves along the TP curve.
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 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.
S 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.
S For reasons that will immediately become clear, our further development of the
TP relationship will build on the second diagram above (figure 8.2), with K on the
horizontal axis.
8.3 From AD-AS to the Solow growth model 313

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 inter-
]
changeably.
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.
S 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:
N (
_Y_ = f _K_; A
N ) ...... (8.2)
where
Y
N = 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.
S 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
S Increasing ]N is called capital deepening. Its opposite is capital widening.
S 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 below).
This function enables us to generate a diagram with ]NY on the vertical axis and ]NK on the
horizontal axis (see figure 8.3).
S 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
Y K
sustained annual increase in GDP Working in terms of ratios such as ] N
and ]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
Y
the ]N ratio on the vertical axis. illustrative numerical example. It is worth studying it
Y
A higher value of ]N is beneficial carefully.
for the population, but it does not
constitute growth (just as an in-
crease in the price level does not constitute inflation). Economic growth is about sustained,
recurring annual increases in ]NY over time.
The TP curve in the ]NY -]NK plane has the same general shape as in the Y-K plane, for the same
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
S If K is increased (for constant N), ]NK increases to ]
1
N . Graphically, there is a move to the right

0
along TP0. Output Y will increase due to

the Yadditional capital and ]NY will increase Figure 8.3 Changes in TP
1
(to ] 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
S If only N is increased (for constant K),
there is a move to the left along TP0 (not
Y
shown). ] N will decline.
S Note that the variable N (or LF) has
an unexpected effect on ]NY . 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 315

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
does ]NK (of course).
S 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
change in N and K. This means output per worker ]NY will remain constant. The economy
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
2
the right (from TP0 to TP2, say). Income per worker increases to ]
N . 0
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 ,
graphically implies (and requires) a sustained increase in the ]NY ratio on the vertical axis.
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
required sustained increase in ]NY .
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.
S 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
S Thus, sustained growth in K alone cannot produce sustained growth in ] N.
S In addition, as we will see below, the move along TP is constrained by being dependent
on capital formation (investment) which 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 of
Although we will only discuss
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:
below.)
S In a growth model, their main impact is on the
level of GDP (or the level of the GDP growth
Growing labour and capital together path).
Synchronised sustained growth S Since the extraction of such resources involves
in the labour force and the cap- huge capital expenditure, there is also a capital
ital stock will increase aggregate effect – but also only on the level of GDP.
output in the same proportion (in S However, natural resources do not determine the
Y
terms of the assumption of con- growth rate of Y (or ]
N
).
K S The infusion of new technology into mineral
stant return to scale). ]N remains
constant. This means, however, extraction and mining will, however, affect the
growth rate of GDP.
that output per worker, ]NY , remains
constant in the long term. This is
explained by the fact that the be-
nefit 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.
S 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.
S This produces one of the most important results of the Solow growth model: sustained growth
in ]NY , i.e. per capita GDP, can only be produced by sustained growth in labour efficiency resulting
from sustained progress in technology and institutions. (But also see section 8.11.)
Historically, this factor, much more than capital accumulation, is understood to explain the
most important eras of sustained growth in living standard in the US and other countries,
e.g. the post World War II period up to the middle 1970s.
8.5 Sources of sustained growth in _NY_: first conclusions 317

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.
This will enable us to focus on ]NY and ]NK . We will relax this assumption in section 8.7.
The first question amounts to asking whether or not there is an optimal value of K relative
to N, i.e. an optimal value of the ]NK ratio (the capital–labour or capital per worker ratio).
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.
S 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
S In such a balanced growth situation, ] Y (capital intensity) remains constant.
S 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.
S 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
N ). As we will see below, this is a situation where the factor A has no growth.
growth (in ]
For the more or less normal situation where A has positive growth, the definition will
have to be broadened (section 8.7. below).

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, which 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,
that Y also grows at rate n, so that ]NY is constant. Moreover, it must imply 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 capital
stock K, or rather capital stock per worker ]NK .
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 DKt, where D 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 = D Nt + n Nt
Kt
= (D + n)__
Nt
This equation shows, for all values of ]NK , the required investment per worker to keep the ]NK
ratio and ]NY stable.
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 constitute 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 319

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 below.
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 = (D + 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.
S 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).
S The actual investment rela- Figure 8.4 Deriving a balanced aggregate growth point
tionship simply is a fraction
Y/N Required investment
(= s) of the TP relationship; per worker
and K
thus it proportionally fol- (D n) ]
t
I/N t
N
lows the curvature of TP.
S The required investment TP f(K/N; A)
I t
K t
relationship N] = (D
t
+ n) ]
N is
t
a straight line through the Y /N Actual investment

0 0
per worker
origin of the diagram. Its s·f(K/N; A)
slope is equal to D + 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 0 K0 /N0 K/N
be read off the TP curve as ]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 D) and equip the growing workforce (given n).
S 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.
S Or, given s and D 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.
S Y grows at a constant rate n, enabled by steadily growing capital stock K, which also
grows at rate n.
S ]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.
S In the diagram in figure 8.5 this is indicated by arrowsKthat represent
Y
the forces push-
0 0
ing the economy towards the indicatedstable points at ] N and ]N .
0 0
K0
This can be explained as follows. For ]NK less than ] N , investment per worker will exceed
0
depreciation
Y K
per worker and the absorption of capital by a growing workforce:
t t K
N > (D +n)]
s]t
N . Thus ]
t
N , or capital per worker, increases.
8.6 Is any capital–labour ratio possible? The idea of balanced growth 321

S Y will also rise to a higher level Figure 8.5 Adjustment towards a balanced growth point
due to the increased ]NK ratio Y/N Required
(rightwards in the diagram); and investment
thus ]NY also increases. I/N per worker
K
(D n) ]
N
t
Opposite conclusions apply for

TP f(K/N; A)
values of ]NY above the stable
growth point, i.e. for ]NK larger
K
Y0 /N0
0
than ] N . If investment per work-
0
Actual
er is less than the absorption of investment
capital by depreciation and a per worker
Y
t s·f(K/N; A)
growing
K N < (D +
workforce, s]
t
t
n)]N
t
. Thus the change in capital
per worker is negative. ]NK , or cap-
ital per worker, decreases.
S Y will also decrease due to
K0 /N0 K/N
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 .
S 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).
S However, on the way towards this point there will be positive (or negative) growth in ]NY
for the transition period.
S 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
] remained constant. From now on, balanced growth
a series of growth points, or a N
Y
refers to steady growth in ]
N
(= per capita income).
growth path.) 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).
S 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.
S 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 only remain constant 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).
Balanced growth still requires correspondence between ]NY and ]NK . 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 D + n. Whereas the required investment for capital stock K to keep up with the
growth in N thus was
It
__ Kt
__
Nt = (D + n) Nt
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
__
Nt = (D+ n + a) Nt ......(8.4)
Y
From here, the balanced growth condition (initially equation 8.3 above) in a growing __
N
context now becomes:
Yt Kt
s__ __
N = (D + n + a) N ......(8.5)
t t
The diagram does not change materially (see figure 8.6 below), except that the slope of the
required investment line now also incorporates parameter a.
S Compared to the case without growth in A, this line will be steeper.
S An increase in the parameter a will increase the slope of the required investment line,
and vice versa (see section 8.8.3 below 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 below shows one
of those rotations in some detail. It shows the upward rotation of TP and of the actual
investment curve.
S 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 below.)
Balanced growth implies, and requires, that both curves rotate concurrently, so as to
Y K
maintain equality between the rates of growth of ]N and ]N over time.
8.7 Expanding the model – the expanded balanced growth condition 323

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 K
(D n a)]t
per capita income, or ]NY , of the N t
economy. More such points can

TP f(K/N; A)
be derived. Let’s consider that
further. Actual investment
Y0 /N0
per worker
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 = (D + n + a)Kt ...... (8.6)
the balanced growth condition can also be stated (after some rearrangement) as:
Kt
__ s
________
Yt = (D + n +a) ...... (8.7)
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 below.
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
__ (D n a)
_________ TP1 ment per worker
Kt/Nt = Kt = s (D n a)]
N
t
K
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
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
K
Dna t
growth point). ]]]
s ]
N t
S 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
S 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 capita
growth path, there is substan- All these ratios …? A numerical example
tive growth in aggregate out-
put Y. The growth rate of Y It can be confusing to understand how some of these
ratios involving Y, K, N etc. can grow at equal rates while
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 ] Y
N
rate of labour efficiency) – and ] K K
grow at the same rate, while ] remains constant.
N Y
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 .
S 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.
S We see thus that A in partnership with K constitutes a quite 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 325

S This line is the balanced growth path Figure 8.9 The per capita growth path over time
of ]NY over time.
Y/N
S The slope of the line reflects the steady (log
growth rate of ]NY , and is equal to a. scale)
S 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 bal-
anced 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 .
S 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. ment per worker
and K
(D n a) ]t
However, this will be a one-off impact I/N N t
on the level of ]NY – albeit spread over

TP f(K/N; A)
a number oears – but not sustained Y1/N0
growth in ]NY . Investment
Y0 /N0 per worker
Y s1·f(K/N; A)
Sustained growth in would require
]
N
the saving rate to be increased Investment
per worker
continually. Logically, this would 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
which is impossible. ]N must stabilise, K0 /N K1/N K/N
and thus also investment and the
saving rate.
S 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
income. growth points
K
______
D n a __t
S 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-
D+n+a
comes flatter (as its slope ]]]
s decreases). The balanced growth points cross over to the 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 327

S 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
S However, when the upper

Growth path of Y/N
growth path is reached, the at growth rate a with
rate of growth in ]NY again initial savings rate s
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
ments, per capita income (or ]NY ) rate in transition to
higher trajectory
goes onto a permanently higher
growth trajectory due to the in-
crease in the saving rate. During t0 Time
the decades of transition, the av-
erage material living standard 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 .
S To repeat: in this model the growth rate of ]NY 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
.)
S 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 only depend 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
regarding a change in the popu- per worker
and K
(D n0 a) ]t
lation growth rate (or the labour I/N N t
K
force, or N in the model). While (D n1 a) ]
N
t
an increase in N will increase TP

output Y, diminishing marginal Y1/N1
returns to labour will cause Y Y0 /N0 Actual investment
Y
to increase less than N. Thus ]N , per worker
s·f(K/N; A)
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
population growth rate n will K/N0 K/N1 K/N
result, according to the model,
in an increase in per capita in-
Y
come. Y will drop, but less than N; thus ]N will increase. The average standard of living will
increase.
S 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.
S 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 S From 1950 to 1990 the average population
growth path. growth rate in South Africa was 2.5% per annum.
S Note that the direction of the S 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) S 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 poplation Figure 8.14 Impact of change in n on balanced growth path
growth rate has two seemingly Y/N
contradictory effects. (log Growth path of Y/N
at growth rate a with
S 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
S 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 a developing country context, 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 impact
Y
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 (D n a1) ]
N
t
new legislative frameworks Y1 N K

(D n a0) ]
N
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
s·f(K/N; H/N; A)
trinsic societal developments
and/or influences from other
countries, especially in an era
of increased global commun-
ication and information flows
(television, the internet, etc.).
K0 /N K1/N K/N
What remains is to consider
the impact of a permanent
change in a, the growth rate of Figure 8.16 Impact of change in a on balanced growth path
labour efficiency. Consider the Growth path of Y/N
case of a one-off but perman- Y/N Increase in a at growth rate a1 after
(log increases slope the increase in a
ent increase in a. scale) of growth path
Section 8.7.1 (figure 8.7)
showed a rotation of TP when Growth path of Y/N
there is sustained growth in at growth rate a 0
before the increase
A (i.e. a > 0). However, if the in a
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-
manent increase in a, the rate t0 Time
of rotation (and elongation) of
the TP and actual investment
curves becomes higher permanently. Hence, in every period (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 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).
S 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 bring about
a sustained increase in ]NY and thus What about the environment and climate
a positive growth rate in per capita change?
income. The theoretical result that technological and
S This means the growth path institutional progress can deliver unlimited growth
in the semilog graph has a does not take account of constraints that can flow
positive slope. from natural resource depletion, the effects of global
S Moreover, it can even rotate the growth on the environment and climate change.
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
a steeper growth path of ]N over countries in the past, where both the population
time. The average standard of and the utilisation of natural resources were growing
living will increase faster. exponentially, accompanied by increasing pollution
and stress on global climate systems. (See chapter
We must bear in mind, though, 12, 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 devel-
opments in growth theory have indeed suggested that other factors, notably human capital,
may also exhibit such a character.
S 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 developed and developing countries?

To a large extent, the lower level of income in developing countries relative to that of
developed countries can be explained by the relatively lower level of capital per worker in
the developing countries. Thus it is likely that developing countries can shift their growth
path to a higher level – and one closer to those of developed countries – by increasing their
capital per worker. This will require an increase in the saving rate and total saving per
worker in developing countries to levels comparable to those of developed countries, as
illustrated in section 8.7.2 above.
The increase in the saving rate will cause developing 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 developed countries.
As noted above, while a (developing) 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 developing countries should unquestionably adopt the technolo-
gies of the First World. Given the implications of such technology, not only for skills and organisational
requirements, capital and infrastructure, but also for pollution, environmental impact and climate
change, is it necessarily the most appropriate thing for poor countries to do? What do you think?

Most developing countries strive to close the technological gap between themselves and
developed countries. Often this is not in the form of new technology development, but
transfer and adoption of existing technology from developed countries – also called
technological ‘catch-up’.
S This means that the rate at which domestic technology improves (which impacts on a)
actually climbs higher than that in the developed countries. While they are catching up,
the economic growth rate in developing countries can thus be temporarily higher than
in developed 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 developed countries. The technology-related component of
rate a will decrease to the level at which technology improves in developed countries.
S As a result, their economic growth rate will also decrease and converge with those of
developed countries.
S 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 US or UK – they are
catching up. By contrast, many other developing countries simply are not catching up
technologically and institutionally.
Rich country, poor country

Can you mention ten countries that you think are amongst the richest in terms of having the
highest per capita GDP in the world?
Can you mention ten countries that you think are amongst the poorest in terms of having the
lowest per capita GDP in the world?
If you need information, consult the following website:
http://pwt.econ.upenn.edu/php_site/pwt62/pwt62_form.php
Note that 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 developed 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.)
S Where some convergence has occurred is amongst 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
N (
_Y_ = f _K_; _H_; A
N N ) ...... (8.1.1)
8.10 Human capital – the previously missing element 333

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.
S 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.
S 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.
S 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, life
expectancy, etc., can be considered to understand the concept of human capital.
We have noted the problem in
developing countries of skills de- Aspects of human development in growth
ficiencies (amidst an often grow- theory
ing population and labour force). Note that we are encountering several issues in
There usually are enough people macroeconomics that present – and require – a link
who want to work, but many are to development economics and the problems of
not skilled enough, or skilled cor- human development and poverty alleviation. So far
rectly, for modern production pro- we have encountered:
cesses and technology. In the S Human capital and human skills development (H),
growth model, this can be interpret- and
ed as a human capital deficiency. If S The development of social and economic
institutions, capacities and processes (via
human skills levels are improved,
factor A).
for example due to increasing re-
sources for secondary or higher While such aspects used to be rare in mainstream
education, it can be interpreted as macroeconomics, it is possible to augment and
an increase in human capital. By refine the analysis to make provision for what clearly
are important aspects of human economic activities.
contrast, a sustained drop in life
In a developing country such as South Africa, it is
expectancy can be interpreted, in
imperative not to forget these aspects (see chapter
the economic growth model, as a 12, section 12.3).
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
S Increasing ]N , the level of human capital per person, will increase aggregate output and
output per worker ]NY .
S 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
K
than the increase in ] N.
Y
S ]N 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.)
S Thus there are limits to the contribution that increases in HK on their own can make to
producing growth in Y and ]NY .
S 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.
S 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).
S 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 335

HIV/Aids and economic growth again
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 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 above).
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 e.g. 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
quicker, 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 Level of ]NY Permanent Permanent Permanent
growth ]KY growth rate growth growth rate
of Y rate of ]NY of ]NK
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 D 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 ]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 337

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.
S 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 developing countries.
S This is one reason why foreign direct investment (FDI) is seen as important to in-
creasing growth in developing 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 capita Exogenous and endogenous growth
GDP have to be moderated. Their role S The earlier growth theory is called models of
in creating a positive per capita ‘exogenous growth’ due to the way technology is
growth rate may be much more treated as if it falls from the sky.
complex, but also more potent S The newer insights that stress that technology is
and less constrained, than implied the result of the development of physical and/or
by the Solow model. The exact human capital, as well as other linkages, are called
mechanics and dynamics of these models of ‘endogenous growth’. While the details
of these models are beyond the scope of this
roles are still being sorted out by
textbook, it is important to be aware of some of the
economists. The precise impact for
main implications of these theories noted here – so
a certain country will also have to that you treat the conclusions of the exogenous
be ascertained through empirical growth model with some circumspection.
research.

How to understand growth paths and observed data patterns
Consider the graph of South African per capita GDP from 1950 to 2005 again, 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 SA 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 …) 339

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 like 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 like the saving rate, tax rates, capital accumulation and innovation, as
against broader variables such as human capital, human development and institutional
development.

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 which approximate real-world situations quite well. The Cobb-Douglas function
looks as follows:
A 1–A
Y t = A tK t N t
where the parameter A is a number between zero and one. The fractions A and 1– A
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 A = 0.33 and 1 – A = 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 A and 1 – A are smaller than one. The
value of A shows the rate at which diminishing returns to capital K will set in, and
likewise for 1 – A 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:
A 1–A
log Yt = log At + log Kt + log N t ...... (A8.1)
which becomes:
log Yt = log At + A log Kt + (1 – A) 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 + A log Kt–1 + (1 – A) 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 + Ad log Kt + (1 – A)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 341

K and labour N. The weights are determined by the share of capital and labour in income,
i.e. by A and 1– A.
For example, let A be constant. If A = 0.33 then 1– A = 0.67. Assuming 2% growth in both
the labour force and capital stock, output will also grow by 2%, as follows:
d log Yt = Ad log Kt + (1 – A)d log Nt = 0.33(0.02) + 0.67(0.02) = 0.02
If only capital increases (by 2%), output will increase but with less than 2%:
d log Yt = Ad log Kt + (1 – A)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 + Ad log Kt + (1 – A)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:
a 1–A
Y t = A tK t 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 1 worker, output Y becomes:

A 1–A
Y t = A tK t 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:
a 1–A
Y t = A tK t 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 with 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 2000 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 are 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, ie 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 D 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 bold numbers show 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:
S N grows at a constant rate n (by assumption).
S K and Y grow steadily at equal rates (4.04% = n + a).
S The two ratios ]NK and ]NY grow at constant but equal rates (= a).
S The ratio ]KY 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, ie 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):
S N still grows at a constant rate n (by assumption),
S K and Y again grow steadily at equal rates, but the rate has increased (to 4.55%
= n + a)
S ]NK and ]NY again grow at constant but equal rates, but the rate has increased (to 2.5%
= a).
S ]KY decreases from on constant level to another, at a lower value of 2.31. At all times ]KY is
s K Y
equal to ]] D+n+a . (The decrease in ]
Y , which mirrors an increase in ]
K , is due to an increase in
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 343

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’.
S Figure A8.1 shows the base and alternative runs for aggregate Y and K (together
with N).
S 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.
S 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:
1. How Y as well as ]NY (per capita income) go onto a steeper trajectory after the increase
in a. At 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 5th and 6th points in 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.

Param- Savings rate Depreciation Population Initial value of a = 2.00%
eters s = 15.00% rate D = 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

Y %Δ K %Δ N %Δ K Y K A
Variables ]
N
%Δ ]
N
%Δ ]
Y
%Δ
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 4.04% 4.04% 2.00% 2.00% 2.00% 0.00% 2.00%

rates s
Growth at Growth at Growth at Growth at Growth at = ]]]
D+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

Y %Δ K %Δ N %Δ K Y K A %Δ
Variables ]
N
%Δ ]
N
%Δ ]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 9787,76 8.64% 23490.62 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% 25 676.908 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 4.55% 4.55% 2.00% 2.50% 2.50% 2.31% 2.50%

growth s
= Per capita = ]]]
D +n + a
rate
growth rate
Addendum 8.2 An illustration of balanced growth – the course of ratios between key variables 345

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 _
Y
and _
K
high a
paths: _NY against _NK N N
5.00
Per capital income _
N
Y
4.80
Balanced growth path
of _
Y
N
and _
K
N
low a
4.60
4.60
4.20
4.00
10.0 10.50 11.00 11.50 12.00
Capital per worker _K
N
Figure A8.3: 5.25

Balanced growth time Per capita income _
Y
N
high a
paths: _NY against time 5.00 Upper trajectory
is for higher a
4.75
Ratios
4.50
4.25
Per capita income _
Y
N
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

Monetary policy: the role of the
Reserve Bank 9
Q understand and appraise the main instruments of monetary policy, and demonstrate their
impact on the economy;
Q assess the policy and other choices that the Reserve Bank has to make in conducting
monetary policy, including the daily practice of monetary policy;
Q analyse and evaluate the role of the Reserve Bank with regard to public debt, including its
impact on fiscal policy; and
Q value the complexity of monetary policy in an open economy, particularly for a small
economy such as that of South Africa.
Monetary policy and fiscal policy

are the two main components of Monetary policy information on the internet
macroeconomic policy. This chap- Updated money and capital market information, Reserve
ter considers the main features of Bank policy statements, and other pertinent information
monetary policy from a macro- can be found on the internet homepage of the
economic perspective. Monetary Reserve Bank at: http://www.reservebank.co.za
events and variables (especially
interest rates) are critically im-
portant 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 Re-
serve 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 Reserve Bank (as the ‘monetary authority’).
The Reserve Bank is also responsible for exchange rate policy. Exchange rates are so closely
interwoven with interest rates and monetary conditions that this area is seen and man-
aged 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.1
1 The government also appoints seven of the 14 directors of the Reserve Bank.
9.1 Definition and main instruments 349

The location of this topic in the circular flow
diagram (compare pp. 70, 222)
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
it borrowing sum
cred er c
mercial KLÄJP[ redi t
Com
GOVERNMENT
S 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 as-
sert its ultimate authority.
Other functions of the Reserve Bank
S There are also two types of
independence: (a) Goal inde- S The Reserve Bank has important functions
pendence refers to the ability of relating to the supervision and regulation of
the central bank to define the banks and other financial institutions. The Bank
ultimate goals that it pursues, sees to it that financial transactions occur without
irregularities and that banks apply sound financial
where these goals are defined
management (using clients’ money), and it keeps
in terms of aggregate demand,
an eye on the operation and development of
production, income, inflation, money, capital and foreign exchange markets.
the exchange rate and the bal- S The Reserve Bank has the exclusive right
ance of payments. (As will be (monopoly) to issue notes and coins.
discussed below, the central S The Reserve Bank has sole supervision and
bank usually does not pursue control over the marketing of gold, as well as all
all these goals simultaneously, trade in foreign currency.
and is in any case not able to
350 Chapter 9: Monetary policy: the role of the Reserve Bank

do so. It will have to select one or two.) (b) Instrument independence refers to the freedom
that the central bank has to change the money supply, the availability of credit, and
interest rates in the pursuit of its ultimate goals. It is possible that a central bank can
have both goal and instrument independence, or only instrument independence but
not goal 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 (see section 9.2.1). The goal can (only) be
changed through a constitutional amendment approved by a two-thirds majority in
Parliament.
How independent should the Reserve Bank be? What are the arguments for and against
independence?
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
The basic monetary policy instruments are:

S the cash reserve requirement (as well as liquid asset requirements),
S the repo rate (as part of the Reserve Bank’s accommodation function),
S open market transactions, and
S direct measures, such as credit and interest rate ceilings.
At times, the Reserve Bank uses ‘moral persuasion’ to prompt banks and financial insti-
tutions 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.
9.1 Definition and main instruments 351

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
section 3.1.2 Bank in influencing the money supply process.
Chapter 3 The transmission of a change in the repo rate to the real sector (via inter-
section 3.2.1 est rates) in 45° diagram context. This includes the factors (sensitivities and
multipliers) 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
sections 3.3.7/8 of the IS and LM curves.
Chapter 4 The impact of the BoP adjustment process on the chain reaction following
section 4.5.1 a monetary policy step.
Chapter 4 The BoP adjustment process following a monetary policy step in
sections 4.7.4/5 IS-LM-BP context.
Chapter 6 The impact of monetary contraction on real income and the average price
section 6.3.5 level in the AD-AS model.
Chapter 7 Demand expansion and contraction in the inflationary context, and impor-
section 7.1 tant Phillips-curve lessons for policymakers.
Chapter 7 The monetary reaction (MR) function and gradualist versus reactionist
section 7.2.2 anti-inflation policy paths
(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.
S 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.
S In sections 9.2.3 to 9.2.5 below, 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.
S 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 bond holders 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.
S 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.
S 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 discussion below 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 – five 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 mandate given to the
Reserve Bank in the Constitution and the Reserve Bank Act is ‘the protection of the value
of the rand’. 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 inflation – the internal value of the currency – is the primary
objective of monetary policy.
Other macroeconomic variables such as production, income, employment and the
exchange rate are being accorded less weight. These are of direct relevance only to the
extent that they have an impact on inflation (and perhaps the exchange rate). In other
words, these variables are regarded as constraints on the Bank in its efforts to protect the
internal value of the currency.
S 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
9.2 Monetary policy design – five important choices 353

stability as its objective. In particular, the Reserve Bank does not accept formal responsibility
for macroeconomic stabilisation policy. Its focus is on inflation.2
S This choice of mission is not without controversy. Critics claim that the Reserve Bank
should also be concerned with unemployment and cannot ignore that dimension,
especially in South Africa.
S Reserve Bank policy on interest rates can also impact detrimentally on the cost of
public debt and thus harm the pursuit of fiscal policy objectives (see chapter 10, section
10.6.5 and chapter 11, section 11.1).
The Reserve Bank motivates its choice of mission by pointing to the harm done to the
South African economy over almost twenty years of double-digit inflation and financial
instability, 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 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 Reserve Bank introduced an approach of official inflation targeting.
This means that the Reserve Bank (together with the Minister of Finance) specifies an
interval within which it wants to contain the inflation rate. For example, in his 2000/01
budget speech, the Minister of Finance announced that this interval would be between 3%
and 6%. Policy measures are then put in place to attain 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,
2 This is so, even though the Bank has said that it protects the value of the rand ‘in order to obtain balanced and
sustainable economic growth in the country’. (A new monetary policy framework, SARB Quarterly Bulletin, June
2000, p. 57).

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)?
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 the case of an interest rate focus, 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, as has been clear since 1973.
S Prior to 1979, monetary policy in South Africa was mainly concerned with stabilising
the interest rate (primarily via direct control of credit creation and/or interest rates).
The prime overdraft rate varied little – between 8% and 12.5%.
A money stock approach can be pursued in more than one way. Each way differs in the
manner in which the desired quantity of money is attained, and whether it is done via the
demand side or the supply side of the market.
(a) In a pure money stock approach, the Reserve Bank controls the money supply
process with instruments such as open market operations and the cash reserve
requirement, and allows the determination of the interest rate to the interaction
of the money supply with monetary demand. It is therefore a pure supply-side
approach.3
3 In such a case, accommodation must be limited to emergencies.

(b) A second way to pursue a money stock target is to manipulate the demand side of the
money market. The only way in which the Reserve Bank can significantly influence
the demand for money is by making money (credit) either cheaper or more expensive.
This means that the Reserve Bank must manipulate interest rates in order to constrain
or stimulate the amount of money demanded. (This is indicated graphically by a
movement along the MD curve.)
If the second way is chosen, the money stock target is pursued primarily by changes in the
repo rate which, through its signalling effect and its cost-of-funds effect on banks, causes
immediate changes in lending rates. This has a direct effect on the demand for credit/
money, which is either stimulated or constrained. The resulting level of the demand for
money then generates a corresponding level of credit/money creation.
This approach therefore uses the repo rate to control the demand for money in order to elicit
the desired quantity of money (money stock).4 This means that a money stock goal is pursued by
the manipulation of interest rates. In this way, interest rate adjustments (to necessary ‘target’
levels) become instrumental in the attainment of money stock/supply targets.
S In practice, this is what has been happening in South Africa between 1979 and 2000:
the Reserve Bank used monetary policy instruments to control, via interest rates, the
domestic demand for credit so that it did not elicit excessive money creation and money
supply growth. While the money supply may have been the eventual objective or target of
policy, the operational focus of policy was to obtain the interest rate levels necessary to
achieve that.
S This does not change the fact that the target of policy between 1979 and 2000 was the
money stock, or, more specifically, the growth rate of the stock of money.
S Depending on the behaviour of those demanding credit in the market – their reaction to
interest rates (the interest rate elasticity) – and lags in market reactions, it can require
significant changes in interest rates to achieve the target level of the money stock/supply.
This is apparent from the behaviour of the prime overdraft rate, which fluctuated heavily –
between 9.5% and 25%, the peak being attained in August 1984.
In 1986 the Reserve Bank adopted a system 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 (i.e. an interval such as 6% to 10%).
Monetary policy instruments were then used continually to manipulate interest rates in
an attempt to keep the nominal M3 growth rate within this guideline interval.
S This did not change the substance of the monetary control process. The manner in which
the Reserve Bank pursued the desired M3 growth rate still was, primarily, by influencing
interest rates (via the then bank rate).
S What this system added was to give market participants some kind of indication of the
intentions of the monetary authority. This created greater certainty in the market and
some policy transparency.
4 Actually, the matter is still more complicated. The repo rate is effective as a policy lever only if banks are active borrowers
from the Reserve Bank (i.e. they need to obtain accommodation). This requires that they must be in a continuous
liquidity shortage position. In fact, the entire money market must be in a shortage position. To ensure that, the Reserve
Bank uses open market operations to ensure that a sufficiently large shortage in the money market is sustained at all
times (compare the discussion in chapter 3). The repo rate is operational as a means to manipulate the demand side of
the money market only if and for as long as supply-side instruments are used to force banks to obtain accommodation. In
this way, the money supply instruments support the use of monetary demand-oriented policy steps.

The introduction of inflation targeting in 2000 has changed the target variable of
monetary policy to the inflation rate as such. This means that the Minister of Finance, in
consultation with the Governor of the Reserve Bank, specifies an interval within which
the Reserve Bank must keep the inflation rate. However, in principle, the focus of the
system is still to manipulate the demand side of the money market through the Reserve
Bank’s influence over interest rates. But now the idea is not to manipulate the demand for
money in order to generate a desired level of money creation (money supply). Rather, the
intention 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).
Keynesian vs. Monetarist/New Classical economists?

Usually an interest rate target approach is regarded as typically Keynesian, and a money
supply target approach as typically Monetarist/New Classical. The latter association largely
derives from the strong focus of Monetarists/New Classical economists on excessive money
supply growth as the singular cause of inflation, and their proposal for strict control of the
money supply as the main policy solution.
In practice, the approach of the Reserve Bank is not strictly Monetarist/New Classical. Rather,
it reflects a pragmatic mix of Monetarist/New Classical and Keynesian views. The Reserve
Bank appears to have Monetarist/New Classical objectives, but tends to use Keynesian
control methods.
S In any case, the distinction between the two options is not watertight. Interest rates usually
play a role in attaining money supply objectives, as explained above.
S A pure Monetarist/New Classical approach would only allow the money supply to grow at a
rigidly fixed rate – according to a so-called monetary rule. In such a situation, the monetary
authority has no discretion.5 The extensive discretion of the Reserve Bank in the current
system shows that it is not following Monetarist/New Classical control methods at all.
9.2.4 Direct or indirect measures?

A fourth choice concerns the types of policy measures to be used in pursuing objectives.
S The category of direct policy measures comprises direct prescriptions – based on the
legal powers of the Reserve Bank over banks and financial institutions – relating to
maximum lending rates, maximum deposit rates, credit ceilings, and so forth.
S Indirect measures, e.g. the repo rate and open market transactions, are intended to
influence the voluntary behaviour of market participants on either the demand side
or the supply side of the market in such a way that desired outcomes are achieved.
(Therefore these measures constitute a market-related approach.)
5 This means that the accommodation facility is closed: there is no accommodation function.

The development of monetary policy and anti-inflation policy since 1980
Monetary policy in South Africa went through several regime and other changes since 1980. Three
sub-periods coincide with the tenure of three Reserve Bank governors, i.e. Gerhard de Kock during the
1980s, Chris Stals during the 1990s and Tito Mboweni since 2000. This period is also marked by the
liberalisation of financial markets during the 1980s and a significant increase in financial market activities
(‘market deepening’) since the mid-1990s.
S Despite the world-wide high inflation of the late 1970s, the Reserve Bank, unlike central banks in
countries such as the US and UK, did not adopt a consistently effective anti-inflationary stance. The De
Kock era of 1981 to 1989 was one with high double-digit inflation. Despite anti-inflation rhetoric, it was
a period of ineffectual monetary policy with haphazard and ad hoc (if sometimes forceful) responses to
inflation. Real interest rates were negative for several years in the decade (as they were from 1973 to
1983), but rates also had a couple of very high peaks. A system of money supply targets/guidelines was
introduced in 1986. The M3 guidelines acted as intermediate targets, with price stability the ultimate
objective. The implementation of these targets showed the influence of Monetarist thinking. According to
this line of thought, an increase in the money supply will cause a corresponding increase in the price level
(see chapter 11 for more on Monetarism).
S A stronger and more consistent anti-inflationary stance was implemented when Chris Stals took over as
governor in 1989. 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 abandoned the system of money supply
targets in 1997. 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).
S A system of official inflation targets was implemented in February 2000, with the first target range
set for 2002. With governor Mboweni 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. In May-June 2009, the last months of the second term
of governor Mboweni, there was significant political pressure from Cosatu and the SACP on the
governor to abandon the practice of inflation targets and pursue employment creation as an objective
by keeping nominal interest rates low (and on the President not to reappoint Mboweni). In July 2009,
Gill Marcus was appointed to succeed Mboweni as governor from November 2009. Speculation was
rife on whether or not her approach to inflation targeting would differ from that of Mboweni.
S The cash reserve requirement is semi-market-related: while it operates via an influence

on the supply of money, it implies significant quantitative restrictions on the ability of
banks to create credit.
In the past three decades, monetary policy in South Africa has gradually moved away
from strong reliance on direct measures to an increasing emphasis on indirect or market-
related measures. This trend gained considerable momentum after the report of the De
Kock Commission in 1984/85. This coincided with a broader movement to a more free-
market-oriented policy approach (a shift ascribed to the growing influence of the policy
thinking of the Thatcher government in the UK and the Reagan administration in the
United States in the 1980s). It has not changed since then.

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.)
S From statements of the Monetary Policy Committee (e.g. the MPC statement of 24 March
2009), 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).
S 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).
9.2.5 Which specific target values?

The fifth important policy choice is that of specific quantitative targets or guidelines for
the chosen variable. How this is done depends on the variable chosen.
For 1995 to 2000, for example, the lower and upper guidelines for the growth rate of nomi-
nal money supply (M3) were 6% and 10% respectively. How were these limits decided? It
relates to the reasons why money supply growth was chosen as policy target in the first
place (rather than interest rates as such). The Reserve Bank regarded excessive growth in the
money supply as one of the main causes of inflation – the typically Monetarist/New Clas-
sical element in Reserve Bank thinking. (See the discussion of Monetarism in chapter 11.)
At the same time, the interval was chosen to facilitate GDP growth while keeping inflation
under control. In the opinion of the Reserve Bank, an M3 growth rate above the interval
might have delivered more vigorous GDP growth (due to monetary stimulation), but it was
likely that inflation would be increasingly out of control. With an M3 growth rate below the
interval, inflation would, in the opinion of the Reserve Bank, have been firmly under control,
but GDP growth would have been unnecessarily constrained. The Reserve Bank determined
the interval so that, in its judgement, an appropriate balance was achieved.
The actual interval was chosen following an analysis of the macroeconomic situation and
dynamics at that stage: the entire complex coherence between interest rates, exchange
rates, the current account and BoP, domestic expenditure relative to domestic production,
wage and price tendencies, and so forth. The long-run aim was to set the target interval
at successively lower levels as part of a long-run anti-inflationary policy stance. Given
economic conditions in South Africa, this amounted to a high real interest rate policy
(compare the historical interest rate patterns in figure 3.3 in chapter 3). The Reserve
Bank’s view was that, while high interest rates would tend to slow the economy in the
short term, higher rates would actually help the economy grow in a sustainable way in
the long term by ensuring price stability (low inflation). It saw high interest rates as a
temporary price to be paid for re-establishing price stability, and the latter as the key to
long-run economic growth.

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
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. Table 9.1 shows the inflation rates
of some of the main trading partners of South Africa. For 2002 (the first year for which
there was an inflation target) the target interval of 3% to 6% approximates these inflation
rates, and also recognises the relatively high inflation rate in South Africa before and at
the start of the new policy era. Except for a brief period in which the target interval was
3% to 5%, it has remained at 3% to 6% since implementation.
Table 9.1 Inflation rates in selected countries – 3rd quarters 2006 and 2008
2006 2008 2006 2008
Japan 0.6 2.1 Angola 11.1 12.7
United States 3.3 5.3 Argentina 10.6 8.6
Germany 1.6 3.0 Bangladesh 6.8 10.4
United Kingdom 3.3 4.9 Chile 3.5 8.6
Italy 2.2 4.0 China 1.3 5.3
France 1.7 3.3 India 6.2 9.0
Botswana 11.0 14.7 South Africa 5.2 13.1
Korea 2.5 5.5 Africa 5.6 11.0
Namibia 5.3 12.0 World 3.6 6.5
Source: International Monetary Fund. 2009. International Financial Statistics (www.quantec.co.za).
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 a time horizon within which the Bank must
contain the average annual inflation rate. For example, in his 2000/01 budget speech,
the Minister of Finance announced that this interval would be between 3% and 6%,
and that it would apply to 2002 as a whole. 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 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.
S 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-inflationary 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 only has policy responsibility
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.
S 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.
S 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).
S 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
9.3 Inflation targeting in South Africa 361

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.
S 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 has
stopped using CPIX in 2009, and will instead define 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.
S 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. Since the
implementation of inflation targeting, the CPIX exceeded its 6% upper bound in 41 of
the 84 months between January 2002 (the first month of the first year that inflation
had to be within its target range given a 24-month policy lag since the implementation
in 2000) and December 2008. (On the other hand, inflation rates and inflationary
expecations definitely have declined since the mid-1990s.)
With the inflation rate exceeding its upper range in 2008, some have already been calling
for an increase in the target interval, while opponents of the system have called for the
abandonment of the inflation targeting system. 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 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 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
the market participant should have excessive expectations of what monetary policy can
do. 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.6
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.)
6 See footnote 4 in this chapter.
9.4 The practice of monetary policy 363

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.
S 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 US 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 rate7 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
7 This is the rate at which banks in the US lend to each other, and it is also the rate that the US Federal Reserve targets.

inflation (i.e. in the relevant price indices) is large and lasting enough 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.)
S 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.
S 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 above, 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 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.8
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.
8 Read the box ‘Why always a shortage?’ in chapter 3, section 3.1.2. Also see footnote 4 in this chapter.
9.4 The practice of monetary policy 365

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 have been scheduled monthly or 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 im-
portant interactions with mon- Bond issues – a monetary or a fiscal step?
etary policy (even though the If the Treasury issues new government bonds
Reserve Bank does not have the specifically to finance government spending, it does
responsibility for debt manage- not have a net monetary effect. At most there may be a
ment anymore). Traditionally, the momentary monetary effect. The funds are borrowed
Reserve Bank acted as the agent because the state wants to spend that money
of the fiscal authority in market- forthwith; they therefore promptly flow back into the
ing government bonds, and thus economy and the money stock.
in the management of the public S A bond issue is a pure monetary policy step only
debt. In 1998, the Treasury (then when extra (‘unnecessary’) funds are borrowed,
called the Department of Finance) i.e. the funds are not turned over to the state
to spend but are kept in reserve. Traditionally,
took the marketing function out
the Reserve Bank has had the authority to issue
of the hands of the Reserve Bank
government bonds for pure monetary reasons,
The move of the Treasury to play a i.e. to absorb money market liquidity. Changes in
more active role in public debt man- the late 1990s have curtailed this authority of the
agement was related to an intrinsic Reserve Bank.
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.

S 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).
S 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.)
S 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.
S The term of bonds (and the rate of interest at which they are issued)9 must be chosen
so as not to disrupt the concerned sub-segment of the market. (Each term category – 3
years, 5 years, 10 years, 20 years, etc – constitutes a sub-segment of the market with
its own ‘product’ and ‘price’.)
S 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.
S 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.
S 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.
S 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 This is called the coupon rate.
9.5 Public debt management 367

S 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:
S 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.
S 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?
S 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.
S 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 will 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.10 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.11
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.
S 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).
10 Given an expected decline in interest rates, current rates must be high in relative terms.
11 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 Primary vs. secondary bond market
by the fact that its pure monetary When government bonds are issued for the first time,
policy steps (especially repo rate this occurs in the so-called primary bond market.
changes) could affect the cost of When existing bonds are traded, this is said to occur in
government borrowing consider- the secondary market.
ably. In practice, the Reserve Bank In marketing its securities to the primary dealers,
gave preference to the monetary government faces the same considerations as the
consideration. Reserve Bank faced. Currently, government gives
primacy to the refinancing consideration.
In the current public debt man-
agement dispensation, the Re-
serve Bank and its monetary policy decisions are institutionally separate from the mar-
keting 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.12 The primary dealers buy government securities on a tender basis di-
rectly 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 partici-
pants.
Another decision concerns the choice between domestic loans and foreign loans. Monetary
considerations that are relevant in this decision include:
S The financing options in domestic financial markets (for example, whether markets are
tight or may be disrupted), and
S 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.
12 At the time of writing, these were ABSA, Barclays Bank of SA, Deutsche Morgan Grenfell, Genbel Securities Bank,
Investec Bank, JP Morgan, Nedcor Investment Bank, RMB, Standard Corporate and Merchant Bank.
9.6 Exchange rate policy 369

S 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.)
S 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.
S Exporters are likely to argue that the rand is overvalued, while importers often proclaim
undervaluation. (Why?)
S 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.
S 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.
S 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.
S 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.)
S 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 all these interrelated
elements – amid both internal and The sectoral balance identities (see chapter 5) show
external shocks and influences the interaction between internal monetary elements
and the external sector in another way. If monetary
– is one of the biggest difficulties
policy influences domestic investment via interest
of monetary and exchange rate
rates – (S – I) changes – it must be reflected in the
policy. other sectoral balances, in this case probably only
Second, in an open economy, the in the current account term (X + TR – M), as mirror
effectiveness and independence of image of the change in capital inflow.
monetary policy decisions are en-
cumbered by external side-effects
and flows of funds. As explained earlier (chapter 4, sections 4.5.1 and 4.7.5), the basic im-
pact 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.
S This implies that a rigid or fixed exchange rate weakens the effectiveness of monetary
policy, while a promptly adjusting exchange rate strengthens monetary policy.
S 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).
S 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).
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.
Developing 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.
9.6 Exchange rate policy 371

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 disrupt monetary policy severely. 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 so as to contain inflation and inflationary expectations.

Fiscal policy:
the role of government 10
Q describe the main instruments of fiscal policy, and assess their macroeconomic impact;
Q understand the practice of fiscal policy and the budgetary cycle, including institutional
dimensions;
Q 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;
Q understand and assess the constraints on choices regarding main budget aggregates;
Q analyse and evaluate the key issues regarding the budget deficit and its financing;
Q assess public debt issues, including the interaction between debt cost and monetary
policy;
Q evaluate the applicability of different deficit measures as fiscal criteria, including the key
norm of fiscal sustainability;
Q value the complexity of fiscal policy in a developing economy such as that of South Africa;
and
Q 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 perspec-
tive. (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 per- Fiscal policy information on the internet
son and taxpayer. The budget is the
The National Treasury site contains budget
principal policy document in which
documents of national and provincial governments,
the fiscal plans and objectives of the as well as links to other relevant sites such as
national government are set out. It the Financial and Fiscal Commission, or various
is of major macroeconomic signif- government departments.
icance and essential to understand- This site is at: http://www.treasury.gov.za
ing the policy steps of the fiscal au-
thority (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:
S Budgetary policy – notably expenditure and taxation – directly affects people at the
micro level. It has decisive micro-financial or public finance ramifications which 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 373

Location of this topic in the circular flow diagram
(compare p. 222)
FOREIGN
COUNTRIES
Government
expenditure FINANCIAL
INSTITUTIONS
Government HOUSEHOLDS
FIRMS
borrowing
KLÄJP[
GOVERNMENT
(Budget and
ÄZJHSWVSPJ`
Corporate taxes; Personal income
VAT tax; VAT
S The budget also has important political implications. People want to know: who pays?
Who gets what?
S 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.
S 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 process 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
374 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.
S In discussions about macroeconomic issues one usually works with the general
government. This combines central government, provincial governments and local
governments.
S 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 375

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:
S The different definitions of ‘government’ or ‘public sector’ and the inclusion or
exclusion of various institutions (universities, public corporations, etc).
S Different institutions which 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.
S 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.
S 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 occur (i.e. SNA
DATA TIP
is on an accrual basis).
S 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.
S 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.
S 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.
S 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 provides more details. Study these carefully. This is an important area for
macroeconomic analysis.
This is deliberately a relatively narrow definition which 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.
S 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 deter-
mined 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
S Government expenditure – government?
both the aggregate level and Note that the main budget, which is traditionally
the composition of spending the focus of fiscal analysis, relates only to the
(e.g. current vs, capital expend- national government, not the general government.
iture, or spending on economic In fiscal analysis, one often has to try to draw a link
services vs. social services). between main budget figures and the parallel course
S All the kinds of direct and in- of general government figures. Often this is not
altogether possible. Still, the two levels of analysis
direct tax, such as personal in-
often produce comparable results, especially if one
come tax, corporate taxation,
considers broad trends.
value-added tax (VAT) and ex-
cise duties. (There also are dif- What renders the analysis more difficult in the South
ferent forms of transfers, e.g. African case is that the transfer of the ‘equitable
pension payments, which can shares’ of provinces appears as an expenditure
item on the national budget. Provinces in South
be analysed as negative taxes.)
Africa do not collect their own taxes (barring a few
S Government borrowing, part of
exceptions), and depend for more than 90% of their
public debt management (see revenue on the equitable share transfer from national
also chapter 9, section 9.5). government. Thus, even though the national budget
Proposed changes to these fiscal does not focus on provincial expenditure, it does
instruments constitute the core of include as an expenditure most of the funds that
provinces will spend.
the annual budget of the national
government, as presented in Par-
liament by the Minister of Finance. The main activities of Parliament (and parliamen-
tary 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
section 3.2.2 (that 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
section 3.3.7 crowding-out effect) in terms of the slopes of the IS and LM curves.
Chapter 4, The impact of the balance of payments adjustment process on the chain
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 6.3.5 the AD-AS model.
Chapter 7 Demand expansion and contraction in the inflationary context, and important
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.
S 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.
S 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).
S 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:
S Domestic loans from the private non-banking sector an addition to the demand for
money upward pressure on interest rates contractionary impact.
S Domestic loans from the Reserve Bank monetary injection money stock increased
downward pressure on interest rates expansionary impact.
S 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
always is 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.
S 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.
S 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).
S Of similar importance is stature in the business world and the financial news media, which can
sometimes make or break a Minister of Finance.


S In 2009 two ministers were appointed in the Office of the President, one heading a newly-created
National Planning Commission (NPC). The main task of the NPC was expected to be the co-
ordination of the policies, planning and activities (and thus budgets) of government departments
within a larger Medium Term Strategic Framework (MTSF). (The other minister’s responsibilities
include the monitoring and evaluation of government performance.)
Other important role-players include:
S Voters, who increasingly demand a direct say in the affairs of government.
S 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 below).
S Parliamentary standing committees such as the standing committee on public accounts, the standing
committee on finance and the standing committee on appropriations.
S The Financial and Fiscal Commission, which has the task of designing and overseeing the system of
inter-goverment fiscal relations and making recommendations on fiscal policy matters to all tiers of
government.
The National Treasury, specifically the director-general (DG), has to compete with the Governor of the
Reserve Bank for macroeconomic policy influence, but does not have a matching degree of power.
S Whereas the Governor of the Reserve Bank is the chief executive officer and the chief policymaker, a
DG only is the most senior official. Because a DG must implement the wishes of a Minister, she or he
has much less influence and room to manoeuvre.
Two important pressure groups are the business sector and the labour unions. Influential business
organisations such as the South African Chamber of Commerce and Industry (SACCI, formerly known as
SACOB), and even individuals, sometimes appear to have more influence on a Minister of Finance than
Parliament or the Treasury. In the past, the views and interests of ‘Johannesburg’ appeared to outweigh
everything else. However, the organised labour union movement (e.g. Cosatu) is increasingly asserting
itself in this regard.
S A related factor is a Minister’s background, e.g. the group with which he or she feels at home
intellectually. (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.
S The IMF releases, for each member country (thus, also for South Africa), an Article IV Staff Report
annually. This report deals with the economic conditions in a country and focuses on issues such as
fiscal and monetary policy.
S 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. Given that low ratings (such as C ratings) usually reflect higher risk,
a low rating means that the government and possibly also private borrowers will pay higher interest
rates on their international loans.
S 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.
S 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. 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).
S In his budget speech of 2009, the Minister of Finance used such a phrase when he stated
that ‘… while responding to the changed economic outlook, our primary goal remains
the reconstruction and development of our economy, and the progressive building of
a shared future in which we can take pride in the quality of our public services, the
creation of jobs for our people and the security in our communities’.
S These formulations suggest a realisation of the coherence between broader socio-
economic objectives and macroeconomic considerations or constraints (compare
chapter 1).2 The meaningful realisation of this coherence in practice is one of the greatest
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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. Although
the fiscal authority may not take explicit responsibility for short-run macroeconomic
goals (stabilisation), the underpinning of sustainable, long-run growth and employment
creation 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 US, UK and Germany, to announce
some of the largest stabilisation packages in economic history. Internationally, there seems
to be a new awareness of, and even a move back to, acceptance of the validity of short-run
stabilisation goals. The latter were swept under the policy carpet in the preceding very long
period of worldwide prosperity and growth which was seemingly without end. The crisis
of 2008 changed the latter delusion. The South African government is likely to follow
the international trend of placing renewed emphasis on these short-run stabilisation
goals, especially when cyclical downturns exceed unspecified limits of social and political
tolerance.
2 A discussion of this can be found in F C v N Fourie (1996): Macro-economic balance or development? Towards a
strategic framework for fiscal policy. Development Southern Africa, June.
10.3 The choice of overarching policy objectives 381

Digression: 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.
S 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 adverse international consequences of the 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 (see chapter 9) 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.
S In South Africa, macroeconomic considerations remained important, but no longer in the sense of
cyclical stabilisation. The focus shifted to inflation and economic growth (with the BoP as added
concern).
S From 1975 onwards, fiscal discipline appeared on the fiscal agenda (the term of office of Minister
of Finance Owen Horwood). This was partly due to the increasing influence of Monetarist thinking,
especially in monetary policy circles. The monetarist approach 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 of the South African economy.
S 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 financial sanctions were instituted against South
Africa in the second half of the 1980s, BoP problems demanded priority treatment. Accordingly, social
considerations declined in prominence.
S In this period fiscal discipline often received little more than lip service (as reflected in the persistent
overspending by government). In the 1990s it was again given centre stage in the form of a deficit
reduction target, with socio-economic and development objectives secondary. This was initiated by
Minister Derek Keys, and has been an important theme in the fiscal policy pronouncements of his
successors, Ministers Chris Liebenberg and Trevor Manuel. In part this has been in recognition of
the discipline 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.)
S 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. 3

3 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 lackluster growth, employment and investment performance of the economy.

S In GEAR, socio-economic and development objectives are of secondary importance. However,
the priority awarded to these objectives is still significantly higher than during the early 1990s.
The composition of government expenditure has changed continuously so that the share of social
expenditure in total government expenditure has been increasing steadily (within the budget
constraints of GEAR). This has allowed the government and finance minister Trevor Manuel to argue
that it has reconciled the socio-economic and development objectives of the Reconstruction and
Development Program (RDP) with the classical principles of sound public finance. However, some
commentators (particularly from the labour unions) have accused government of abandoning the RDP
in favour of GEAR. These critics maintain that the RDP and GEAR are philosophically and economically
irreconcilable.
S 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 spending on social grants
and benefits (amongst others). This expansion of social grants and related entitlements indicated an
important new phase, characterised by a more explicit pro-poor focus, in South African fiscal history.
In the 2008/9 fiscal year, more than 13 million South Africans received some or other government
grant. While playing a crucial role to alleviate the burden of the day-to-day existence of those in
poverty, such entitlements have major long-term implications for the fiscus and the fiscal balancing
act required of the new Minister of Finance, Pravin Gordhan, appointed in May 2009. Given indications
at the time that government was preparing a ‘pro-poor growth strategy’ to bring about a consciously
post-GEAR era, the fiscus will have a challenging task in the government’s new efforts to stimulate
growth, development, employment and poverty reduction.
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.
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:
S 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.
10.4 Constraints on fiscal policy choices 383

S 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.
S 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.
S For example, if a current account deficit cannot be tolerated, a current budget deficit
is possible only if domestic saving exceed 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.
S 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.

S 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 other. If values for two are chosen, the third is determined automatically. Therefore
decisions on each element can never occur in isolation:
S If a smaller deficit is desired, it will require either expenditure cuts or increases in
revenue (taxation), or both.
S If tax relief is a goal, one must be willing to accept either a larger deficit or a cut in
government expenditure, or both.
As a result, specific numerical
targets cannot be determined in- Current vs. capital expenditure
dependently. For example, if the
S Current expenditure mainly comprises the
deficit is to be kept at 3% of GDP wages of government employees, interest
and total tax revenue not higher on public debt, subsidies, and transfers to
than 25% of GDP (the GEAR tar- households (mostly social pensions). The wage
gets), then aggregate government bill and interest are the dominant components of
expenditure may not exceed 28% current expenditure. Government consumption
of GDP. expenditure is a subset of current expenditure.
(See boxes below and addendum 10.1.)
A similar restriction applies when S Capital expenditure includes the acquisition
one considers the subcomponents of fixed capital assets, land, stock and other
of each of these three elements. intangible assets, and capital transfers to
An important instance concerns businesses and households. Government
the distinction between the cur- investment is a subset of this, and pertains only
rent and the capital expenditure to capital formation (new capital assets, e.g.
of government (or, between gov- construction of roads). (See addendum 10.1.)
ernment consumption expendi-
ture and government investment).
This is called the economic classification of government expenditure.4
These two expenditure components cannot be manipulated independently of each other
or of the main elements of the budget identity.5 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.
4 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, mining,
5 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.

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.
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 below (sections 10.5.3 and 10.7.3), where this distinction also features.
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.
S 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 indi-
viduals. 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.
S 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.
S As mentioned above, in the 2008/9 fiscal year more than 13 million South Africans already
received some form of a grant. This number constitutes almost a quarter 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 the population. Because unemployment levels
are very high among the poorest 40% of the population, 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 58% of general government consumption expenditure (2008) calculated
using SNA data. Since it is difficult to reduce staff numbers in the public service, a growing
salary and wage bill due to wage demands or, for example, extensive affirmative action
programmes 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 expenditure6

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).
S ‘Interest’ is primarily interest paid on public debt.
S ‘Transfers’ include social pensions and other government grants to households, e.g.
child grants and disability grants.
6 According to Table 5, Budget Review (2009). Also see addendum 10.1.

Table 10.1 presents the 2008/9 breakdown of the above categories for general government.
(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% of government expenditure. The single largest component of this is
subsidies and transfers, followed by compensation of employees. Interest payments
constitute less than 10% 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 (2008/9 fiscal year)
R million %
Current expenditure 640 537 95.4
Current payments 362 624 54.0
Compensation of employees 211 178 31.4
Goods and services 97 135 14.5
Interest and rent on land 54 288 8.1
Financial transactions in assets and liabilities 24 0.0
Transfers and subsidies 277 913 41.4
Transfers to households 109 017 13.7
Other transfers and subsidies 168 896 27.7
Payments for capital assets 31 481 4.7
Total consolidated expenditure 672 018 100
Source: Budget Review 2009, 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
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 se- Table 10.2 Government consumption and investment as a ratio of GDP (SNA data)
lected data on general
government expenditure Government Government Total government
consumption investment expenditure
as percentage of GDP
since 1960. The data are 1960 9.55 7.02 16.57
SNA data on government 1970 12.79 8.10 20.89
consumption and invest-
1980 14.29 6.38 20.67
ment. Note that many
items of government cur- 1990 19.66 3.89 23.56
rent expenditure, notably 2000 18.15 2.70 20.85
transfers to households,
2005 19.57 2.46 22.03
are not included in these
numbers. (This explains 2008 19.75 2.84 22.59
why the government ex- Source: South African Reserve Bank, national accounts (www.reservebank.co.za).
penditure ratio is signi-
ficantly lower than in main budget data – see addendum 10.1.) In a macroeconomic sense
this may not be inappropriate, though. If what matters is the flow of real expenditure
through the actions of government, the SNA total is the correct one.7
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 below 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. For 30 years since 1978, the government expenditure to GDP ratio
has stayed inside a channel between 22% and 24% (in terms of SNA figures; see box on
measurement below).
7 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.
10.5 The decision on the main fiscal aggregates 389

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. Since the late 1990s, 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) more often than not exceeded the amount of taxes
government planned to collect (as reflected in the budget).
S 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.
S 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?

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:
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.
DATA TIP
the public finance context). The budget data are supplied by the Treasury in the Budget
Review. These only pertain 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 April 1
to March 31 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.
S 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, 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.
S 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.
S According to the 2009 Budget Review, total consolidated government expenditure
DATA TIP (continued) in South Africa for the fiscal years 2007/8 and 2008/9 was approximately 26.7% and
27.5% of GDP.
S According to the national accounts, total expenditure for general government for the
calendar years 2007 and 2008 was 23.0% and 22.6% respectively.
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 done in table 10.2.
S 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.
S If one wishes to compare a government expenditure ratio to a tax ratio (see below)
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).
S 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.
S 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 developing 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 developing
countries is necessarily smaller. Because of low income levels, the tax base of developing
countries is limited. This limits the extent to which government can spend – hence the
lower expenditure to GDP ratio in developing 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. Developed 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?
S 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.
S 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.
S 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 below).
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 – amongst
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 this focus becomes apparent if one considers 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 dramatic
drop in government investment in physical capital that only stabilised in the mid-1990s,
while consumption expenditure by general government grew unceasingly up to the mid-
1990s, whereafter it also stabilised. Though investment in physical capital by government
stabilised in the mid-1990s, it did so at an extremely low level of between 2% and 3%
of GDP. Only since 2007 have there been indications that government investment might
start to increase again.
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 defini-
Figure 10.1 General government expenditure relative to GDP
30
25 Total government expenditure

Percentage of GDP
20
Government consumption
15
10
Government capital formation

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
Source: South African Reserve Bank, national accounts (www.reservebank.co.za).

tional issues complicate the mat-
ter, and in any case a line of cau- Which aggregate measure?
sation cannot be derived by simply One problem, if a fiscal authority wants to commit
observing a pattern (compare sec- itself to a specific government expenditure ratio
tion 5.2). As before, one should be as fiscal target, is that different statistical systems
careful in drawing simple conclu- and definitions of ‘government’ can produce quite
sions. (We shall take up the debate different figures (see the addendum to this chapter).
on government dissaving and fisc- This can make the use of a simple aggregate fiscal
al balances in section 10.7.) target all but impossible in practice.
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:
S 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.
S 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
DATA TIP
and the 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.8 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.
S 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 2008
amounted to approximately 28.5% of GDP (using SNA data – see addendum 10.2). In
8 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
15 Taxes on income and wealth
10
Taxes on production and imports
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
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.
S 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).
S An important tax principle in the development context is that taxation should not make
the poor poorer.
S 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.
S All over the world personal income tax has a progressive structure. This means that the
tax rate increases as taxable income increases.9 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.
S 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.
S 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.
S 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
9 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.
S 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.
S 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.
S 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.
S 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 which warrant its
regular elimination by the fiscal authority.
S First, it constitutes a dangerous licence for uncontrolled growth in government expenditure.
S Moreover, the question is whether it is fiscally ethical and democratic to increase taxation
in such an unannounced and non-transparent manner.
S 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.
S 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.
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
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.
S 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).
S 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 bal- Do not confuse the budget deficit or surplus and the
anced budget (i.e. one where ex- BoP deficit or surplus. This is a danger especially
penditure = revenue). when we discuss the current budget deficit, which
sounds similar to the current account deficit (of the
S If it pursues an anti-cyclical
BoP).
policy, the desired macroeco-
nomic effects usually require
a budget which 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.
S 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.
S Deficit spending, i.e. spending financed by borrowing, is also warranted where
government investment which 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.)
S 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:

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 only pertain to the national government,
and exclude provincial and local government borrowing.
S In debating the deficit, the Budget Review and GFS figures are used most of the
time.10
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.
S Conventional deficit = Aggregate expenditure – aggregate revenue

S Current deficit = Current expenditure – current revenue
S Primary deficit = Non-interest expenditure – aggregate revenue
S Cyclically adjusted deficit
or
Structural deficit = Cyclically corrected expenditure – cyclically corrected
revenue
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.
10 Other deficit data sources are the tables in the 'Public Finance' section of the Reserve Bank Quarterly Bulletin. The
interpretation of these are complex and beyond the scope of this textbook. However, see addendum 10.2 for an illustration.

Table 10.3 National government deficit and the PSBR as % of GDP (fiscal years)
Deficit Deficit PSBR
1980 3.1 1992 3.7 4.9
1981 0.1 1993 7.3 8.7
1982 2.1 1994 5.6 9.5
1983 2.2 1995 4.6 5.7
1984 3.2 1996 5.1 4.9
1985 3.3 1997 5.0 5.8
1986 2.4 1998 3.7 4.9
1987 4.4 1999 2.8 3.8
1988 5.0 2000 2.1 1.4
1989 3.5 2001 1.9 1.8
1990 1.4 2002 1.4 0.5
1991 1.9 2003 1.1 1.4
2004 2.3 2.1
2005 1.5 1.5
2006 0.4 -0.2
2007 -0.7 0.1
2008 -0.9 0.3
Source: South African Reserve Bank, public finance table (www.reservebank.co.za).
Notice the rather sharp increase in the deficit in the early 1990s, as well as the strong
improvement thereafter.
Since 1980 the conventional deficit, on average, was 2.7% of GDP, reaching peaks during
the mid-1980s and the early 1990s – when the deficit exceeded 7% of GDP. However, since
the mid to late 1990s, public finances improved significantly, with the budget reaching a
surplus in the 2006/7 and 2007/8 fiscal years (though 2008/9 again registered a small
deficit).
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.
S 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.)
S Not only the national government 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. 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. Extra-budgetary 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.11 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 introduced 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.
Since 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 2006/7 and 2007/8 fiscal years. (At the beginning of 2009 it was
expected that in the 2008/9 fiscal year government would again register a deficit following the
dramatic slowdown in the domestic and international economy.)
As part of its GEAR strategy, 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 developing 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.
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
11 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
Percentage of GDP 4
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
Source: South African Reserve Bank, public finance table (www.reservebank.co.za),
as well as authors’ own calculations.
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 which 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 there were signs that economic
growth might deteriorate again, with the budget reverting to a deficit.
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 require panic-driven corrective actions. It is likely to improve automatically when
the downswing turns around.
S 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:
S Domestic loans from the private non-banking sector are the main and preferred form of
deficit financing. In some circumstances, this could have a restrictive macroeconomic
impact.

S 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.
S Foreign loans are readily used if available. Doing so has the disadvantage that the
country builds up a net debt obligation to other countries.
Foreign loans and private sector capital formation

Foreign loans do have an advantage in that, by creating a market in foreign-denominated
government bonds, they help 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).
S The two best-known foreign-currency-denominated bonds of the South African
government are called the Yankee bonds and the Samurai bonds. As their names indicate,
the former is a US dollar-denominated bond, while the latter is a Yen-denominated
government bond.
The choice of the fiscal authority between these options will depend on various con-
siderations, including general economic as well as money market conditions.
S In some circumstances an expansionary form of financing is desirable; in others not.
S 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.
The budget deficit and the BoP
S A further consideration, with
regard to both domestic and Foreign loans to finance the budget deficit lead to
foreign loans, is that annual an inflow of foreign capital. This creates a direct link
interest commitments can be- between the budget deficit and the BoP deficit or surplus.
come an expenditure problem. S An indirect link exists in the case where the budget
deficit is financed with domestic loans. Any
If unchecked, they can absorb
upward pressure on interest rates due to domestic
a large portion of the annual
borrowing can attract an inflow of foreign capital,
budgeted expenditure. which impacts on the capital account of the BoP,
S The relative cost of domestic and thus strengthens the BoP.
and foreign loans obviously is S The inflow of payments is likely to lead to an
relevant. appreciation of the domestic currency. This, in
S Foreign loans have the added turn, discourages exports and stimulates imports,
disadvantage that foreign ex- which causes the current account of the BoP to
change is required for repay- deteriorate.
ment. The BoP implications of S In the US, this link between the budget deficit and
both the initial capital inflow the current account deficit is often discussed as the
and the debt repayment are ‘twin deficit problem’ (see box in section 4.5.5).

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).
How much deficit financing is obtained through foreign loans?

Since the 1970s, the extent of foreign financing 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. This meant that, from the mid-1980s to 2000, foreign
loans never constituted more than 6% of total government debt. Only since 2000 have
foreign loans again become a significant element, constituting approximately 15% of total
government debt in the 2008/9 fiscal year. By far the largest portion of financing occurs in
domestic financial markets, via government bond issues.
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, whilst taking the deficit into
account.
To improve budgeting in the public sector, government introduced the Medium Term Ex-
penditure Framework (MTEF) in 1997. According to this framework, government depart-
ments must plan their expenditure each year for the three following 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:
S 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). The overarching alignment
of expenditure priorities within a larger medium-term strategic framework (MTSF) will
be a key function of the National Planning Commission, created in 2009.

S 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 such as GEAR, 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.
S 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. The minister responsible for the monitoring and evaluation of
government performance (instituted in the Office of the President in 2009) is expected
to play a role as well. 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 will make it possible for
Parliament to change the spending proposals tabled by the Minister of Finance. New
standing committees on finance and on appropriations were to be created to facilitate this.
The legislation does provide the Minister with an opportunity to respond to any changes
proposed by Parliamentary committees. This recognises the importance of a sound and
sustainable balance between spending, revenue and the annual borrowing requirement.
It remains to be seen just how forcefully Parliament and its standing committees may wish
to act 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.
S 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 economic
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 pro-
cess.
S Information on the first revenue projections forms part of the decision that fixes the
expenditure upper limit. It occurs within a macroeconomic framework within which

projected tax revenue and a
projected budget deficit are ac- Bracket creep and inflation tax
counted for. The revenue impli- It is at this point that the revenue bonus due to
cations of changes in tax poli- inflation wedges into decisions and becomes
cy and tax structure must also rooted in budgetary planning. Because these initial
be incorporated. Information projections are based on existing tax rates, using the
on projected money market projected nominal GDP of the coming fiscal year, they
conditions and the amount of already include the extra tax revenue due to bracket
government loans that can be creep. Hence, when the Cabinet considers the ‘no
change’ (sic) projections, the unannounced tax
absorbed in the market with-
increase is already firmly embedded.
out disturbing it is an impor-
S To remove this extra tax at a later stage, with the
tant input in this decision. Cabinet and the Minister having gone through
S The upshot is that expenditure, the agonising experience of cutting expenditure
revenue and the deficit are ulti- to match the projected revenue and produce an
mately decided simultaneously. acceptable deficit, is all but impossible.
Still, at this point the govern-
ment must decide which ele-
ment 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 gov-
ernment 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 ex-
penditure.)
S This is a difficult balancing act with many a trade-off and a weighing of various con-
siderations 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.
S 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.
S 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.
S 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.
S 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.
S 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 2007/8 fiscal year it was R483.2 billion. Even
in real terms (i.e. after adjusting for inflation) the public debt has more than quadrupled
since 1946. However, an increasing debt level is not necessarily a problem because the
national income from which this debt needs to be serviced (by paying of interest) might
also be growing.
Thus, the best way to gauge the level of public debt is to Table 10.4 Total national government
measure it relative to the size of the economy, i.e. GDP. debt as % of GDP (fiscal years)
Table 10.4 summarises and figure 10.4 illustrates the 1960 48.2 2001 45.3
historical path of the public debt/GDP ratio in South 1965 42.4 2002 38.9
Africa. In 1946 the ratio was approximately 70%. That was
1970 42.0 2003 39.6
the result of the debt that the South African government
incurred during the Second World War. The ratio then 1975 36.9 2004 37.2
declined steadily until the 1980s, whereafter it started 1980 31.9 2005 35.3
to increase. In the early 1990s the public debt/GDP ratio 1985 31.8 2006 33.9
in South Africa increased significantly, reaching a peak
1990 35.3 2007 27.1
of 50.4% in 1995. This upward trend in the public debt/
GDP ratio was not sustainable, which explains why the 1995 50.4 2008 23.8
government took steps in the mid-1990s first to stabilise 2000 44.4 2009
and then to reduce the debt burden.
Source: SA Reserve Bank, Quarterly Bulletin
Also notice that except for 1995, when the debt ratio (www.reservebank.co.za).
was 50.4%, the ratio never exceeded 50% since 1960.
The graph in figure 10.4 also demonstrates that it is possible to reverse a high public debt
situation. If economic growth is relatively high (as it was in the 30 years after the Second
10.6 Public debt and public debt management 407

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.
Figure 10.4 Public debt as a percentage of GDP
80
70
60
Percentage of GDP
Public debt ratio

50
40
30
20
10
0
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
2004
2006
2008
Source: South African Reserve Bank, public finance table (www.reservebank.co.za).
Therefore, not only budgetary policy but also the relatively poor growth performance
since 1975, and especially 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
improvement since the late 1990s demonstrates the opposite.
However, after 1994 the debt/GDP ratio first stabilised at just below 50% before it started
to decrease, reaching levels below 25% by 2008. This was not easy to attain, given the low
economic growth rate and the high interest rate level of the late 1990s and the increasing
demands on the fiscus for higher social expenditure. The success of government in stabilising
the debt/GDP ratio 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 10.6.4 and 10.7.4 below.
Who bears the burden of the public debt?

___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________

10.6.2 How does SA’s public debt compare internationally?
Table 10.4 shows the international context of the SA debt position. These debt ratios
vary dramatically. Compared to the public debt/GDP ratios of developed countries such
as Japan, Belgium, Italy, Japan and Portugal, public finances in South Africa seem to be in
a quite healthy state. Also note that South Africa was not alone in experiencing a rather
significant increase in the public debt/GDP in the late 1980s and early 1990s. Countries
such as the US, Spain and Ireland also experienced such increases.
Furthermore, note that the order of magnitude of the South African public debt/GDP ratio
compares well with emerging-market countries such as Turkey and Mexico.
Table 10.4 Public debt as % of GDP – some international comparisons
Australia Belgium Germany Ireland Italy Japan
1980 8.3 53.4 13.0 .. 52.7 37.3
1985 11.6 97.25 18.3 104.6 77.2 49.3
1990 6.3 106.7 19.7 86.8 92.8 46.8
1995 19.1 113.7 21.1 72.2 113.1 65.4
2000 11.7 99.7 34.1 34.9 103.6 106.1
2005 6.5 92.0 40.4 23.6 97.8 163.6
2006 6.0 88.0 40.9 20.6 97.1 161.4
2007 5.4 86.4 39.5 20.2 95.9 NA
Mexico Portugal Spain Sweden Turkey USA
1980 17.5 30.1 14.3 38.1 NA 25.7
1985 39.8 53.2 38.2 60.2 14.8 35.4
1990 46.4 53.3 36.5 39.6 10.8 41.5
1995 40.8 61.9 52.4 76.0 13.0 49.2
2000 23.2 54.1 49.9 57.4 38.2 34.4
2005 22.4 68.2 36.4 46.7 51.1 36.7
2006 23.3 69.9 33.1 42.9 45.5 36.5
2007 24.1 69.2 30.1 37.2 38.9 36.2

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 Domestic vs. foreign debt

A potentially important issue is the apportionment of the public debt between domestic
and foreign debt. As noted above, the South African foreign debt component has been
exceptionally low, prior to 2000, never exceeding 6% of total public debt. As a percentage
of GDP, foreign debt dropped as low as 0.6% in the 1990/1 fiscal year, followed by an
increase to 15.1% by the 2008/9 fiscal year.

The level of foreign debt (which includes both public and private debt) is often evaluated
by measuring the foreign interest obligation relative to a country’s export earnings, i.e.
by considering the interest–exports ratio. For South Africa, this ratio was approximately
4.4% in 2007. This is quite low compared to the position in other countries.
This information indicates that the foreign debt position and obligations of the South
African government are not a problem at present.
S It also means that almost all government debt is reflected in the assets of bondholders
who are primarily South African citizens or institutions.
10.6.4 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.
S Interest constitutes a legal obligation. Therefore it is a compulsory expenditure item, an
expenditure category over which government has no discretionary power.
S Furthermore, public debt cost has increased from approximately 6% of aggregate
government expenditure in 1975 to 14.2% in 1985/6 to 19.8% in the 1999/2000
budget of the national government. (As a percentage of GDP, the latter figure was
approximately 6%.)
S 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.
S 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 the 2008/9 fiscal year, interest constituted 9.8%
of government expenditure, or 2.6% 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.
10.6.5 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.
S 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.

S 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.)
S 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 period after 1984/5 – 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:12
S 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.
S 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).
S 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.
S 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.
S 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
12 R P Harber (1995) South Africa’s Public Debt (USAID unpublished report), p. 13.

interest rates. Given the sometimes very high real interest rates in the 1990s, this factor
was extremely consequential.
S The conflict between these considerations was largely resolved with the introduction
of the primary dealers (see chapter 9, footnote 12, 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
bonds outside the Bank to the primary dealers and required the Reserve Bank to acquire
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 since
the late 1990s.
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 also is 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.)
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 which 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 balance, the current balance and
the primary 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 deficits 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:
S 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.
S 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.)
S 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 2008 accrues to 2008 and
therefore will be recorded as a 2008 transaction in the SNA data set. However, because the
tax is very often only paid in the next year, the GFS data will only record it when the cash
payment of the tax actually flows in 2009, in our example.
DATA TIP
S 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.)
S For discussions of saving within a macroeconomic context, the most appropriate is
the current deficit measured with SNA data (see section 10.7.3 below). 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.
S 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.
S 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.
10.7 Fiscal discipline and fiscal norms 413

The two graphs in figure 10.5 show the three deficit measures as calculated with GFS and
SNA data respectively. Cyclical elements have not been removed from the data.
After reaching a peak in the early 1990s, there has been a significant improvement in the
deficit, irrespective of which definition or data source is used. The question is to what extent
these balances can be used to monitor and evaluate fiscal policy. This will be discussed in
the next sub-sections.
Figure 10.5 Different fiscal balances as a percentage of GDP (GFS and SNA data)
10
Conventional (GFS)
6
Percentage of GDP
2
Current (GFS)
Zero deficit line
0
Primary (GFS)
2
4
6
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
10
8
Conventional (SNA)
6
Percentage of GDP
4
Current (SNA)
Zero deficit line

0
2
Primary (SNA)
4
6
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
All values are for general government. Positive values indicate a deficit; negative values
a surplus. Source: South African Reserve Bank (www.reservebank.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 in the
public debate on the role of government in the economy. This was related to the impending
political transformation and competition to influence the policies of the new government.
At issue was the 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).
S 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 (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 anti-cyclical 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.
S OECD countries such as Germany and France, which are 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%.
S In practice, the use of such a fixed rule is severely limited by the cyclical elements of
the deficit. Cyclical influences can cause the budgeted deficit and the 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 practical
context of the budget 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 impact is likely to be, adherence to a rigid fiscal rule that does not allow
for a cyclical impact is all but impossible.
S Unavoidable social and developmental crises can also impact on the sustainability of a
fiscal rule.
For decades, proponents and opponents of rules could not find common ground in the
so-called ‘rules-vs.-discretion’ policy debate. Much of this could be related to the broader
debate between Keynesians and Monetarists. In recent years, the literature on fiscal rules
increasingly reflects a realisation that the issue is not so much discretion as 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 loses its credibility.
Therefore, economists such as JB Taylor (in analogy to his monetary policy rule – see box
below) 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.
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. 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.13 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.
The financing dimension and money market impact is one area where the size of the deficit
has clear macroeconomic relevance. As indicated in section 10.5.3, various considerations
apply to the financing decision and the ease with which a given budget deficit can be financed.
These are likely to vary over the business cycle, over the phases of economic development
in a country, and according to international economic circumstances.
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 indicates very little regarding the size of government expenditure or the
extent of government involvement in the economy – if that is one’s concern. The deficit
captures only one element of the budgetary picture.
There is little clear empirical evidence for the validity of a 3% guideline. Since the imple-
mentation of GEAR in the late 1990s, the South African government succeeded in main-
taining the deficit below 3% of GDP. Internationally, deficits in excess of 3% of GDP are
common, in small-government as well as large-government countries, and in all kinds of
economic circumstance. Unfortunately, there are no simple lessons in this regard.
It would appear that a simple 3% ceiling (or any other fixed percentage of GDP) does not
have a solid foundation.
S The size of the conventional budget deficit as such does not provide a solid norm or
guideline for fiscal policy.
S This does not mean that ‘anything goes’ as far as the size of the deficit is concerned.
Typically, a fiscal crisis 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.
13 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.
S This idea is quite alive in the US. It has been proposed at various times in conservative Republican
Party circles, especially during the Reagan era and in 1995/6 by the then newly elected Republican-
controlled Congress.
S In the US 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.
S Notwithstanding the ideologically inspired preference of the Republicans in the US for balanced
budgets, the Republican administrations under Presidents Reagan, Bush Sr and Bush Jr 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 is expected
to produce truly huge deficits and growth in public debt in the next decade – to the irritation of
Republicans.
S 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.
S The real interest rate is the real reward that holders of government bonds require to hold the bonds.
S 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.
S 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 with a percentage point.
They are compensated by the inflation component of the interest they received. 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 Do not confuse the current budget balance and the
current account of the BoP.
(= non-capital) expenditure ex-
ceeds its current revenue. When
this occurs, government is said to
be ‘dissaving’. (A current surplus would indicate that government is saving.)
S 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.
S 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.
S 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)
As shown in figure 10.7, in South Africa budget figures have shown significant current
deficits (government dissaving) from the 1980s to mid-1990s. This contrasts with the
period between 1946 and 1981, when the budget figures always displayed a current
surplus. Since the mid-1990s dissaving has decreased significantly, with government even
being a net saver in later years.
S As argued above, for an analysis of government saving or dissaving, the SNA data are
more appropriate. Thus this graph uses national accounts data.
S This is net saving/dissaving of government (refer to section 5.4 of chapter 5 for more
information on gross vs. net saving).

Figure 10.7 The current deficit as a percentage of GDP (SNA data)
Current deficit (SNA)

Percentage of GDP 4
2
4
6
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
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.14
The argument is that loans should be used only for projects (assets) which will provide a return
in future, enabling repayment of the debt, and not for non-productive purposes which simply
consume resources without creating assets or a stream of future returns. This is a principle
often applied in business decisions and one which 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).
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
14 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
US 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.
S This means that growth cannot be stimulated by enlarging the savings pool as long as
there is a hesitancy to invest.
S 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.
S 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.
S 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.
– 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.
S The ideal would be to devise a redefined measure of capital expenditure which appro-
priately 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.15 Does this relationship
provide a basis for deriving a fiscal norm?
S If a country experiences a significant outflow of capital, the existence of a general gov-
ernment 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.)
S 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 current deficit concept 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.
S 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.
S 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.
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
15 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 – G 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
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.
S 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.
S 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’.
S 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 which 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:
ΔD (r – g)D + F – ΔH
]] = ]]]]]]]
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:
S 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).
S 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:
S 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.
S 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).
S 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.
S 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 below 30% by 2008/9 (compare graph
10.5).
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.
S 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 2006/7 and 2007/8 fiscal years (though
2008/9 again registered a small deficit). This explains, once again, the significant decrease
in the public debt/GDP ratio.
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 below).

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:
S 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 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.)
S 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.
S 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 per-
sistently 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

10.6.5). 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.
Figure 10.9 Real interest and the economic growth rate

10
Real GDP growth rate
8
6
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
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 above).
Since the late 1990s, government succeeded first in stabilising the debt/GDP ratio and there-
after in reducing it from its high of almost 50% to below 30% 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 since 2002 also contributed significantly to this reduction.
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 most important 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 amongst 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.)
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) benefitted. 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.
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.
10.8 Fiscal policy and development – broader criteria 427

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, 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 infrastruc-
ture 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 is essential for government in-
vestment 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 increas-
ing dependence on government, which is the antithesis of development and economic em-
powerment. 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.

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 only contains 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 only pertain
to the national government. Budget figures, therefore, exclude provincial and local
government expenditure, as well as extra-budgetary 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 refer to budget plans, i.e. what does government plan or
budget 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:
S 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).
S 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:
Addendum 10.1 Measuring aggregate government expenditure 429

SNA GFS & Budget16
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.

S By including or excluding specific items, a variety of measures can be constructed.
S 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

2008 or 2008/9 GDP17 2008 or
(R million) 2008/9 (%)
National accounts (SNA) context (2008): (Reserve Bank Quarterly Bulletin)

The most straightforward SNA measure is:
Definition 1 (SNA): Final consumption 634 987 27.8%
expenditure by 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 548 908 24.0%
expenditure by general government plus gross
fixed capital formation by general government.
These two measures are most appropriate for
macroeconomic analysis.
16 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.
17 Nominal GDP calendar 2008 = R2 283 777 million. Nominal GDP fiscal 2008/9 = R2 204 111 million. The former
can be obtained from the Quarterly Bulletin, while the latter originates from the Budget Review.

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.18 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 725 999 31.8%
fixed 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:
S This figure is for general government, while the
budget figure is only for the national government.
S 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 often is excluded, producing ‘non-interest
current expenditure of general government’.
Therefore:
Definition 4 (SNA): Non-interest current expenditure 663 303 29.0%
plus gross fixed capital formation by general
government (excluding consumption of fixed capital).
Government Finance Statistics (GFS) context (2008): (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 829 127 36.3%
operating activities (current expenditure) plus net
cash flow from investments in non-financial assets
(total capital expenditure) of the consolidated
general government.
18 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.
S Hence this figure severely overstates the
net contribution of government to aggregate
expenditure in the economy.
S Yet it does show the full amount of funds/
resources that flow through the hands of general
government in a fiscal year.
S 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 552 859 24.2%
expenditure (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.
S 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 (2008/9): (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 633 910 27.5%
expenditure of the national government.
As before, one can exclude interest payments so as
to show present expenditure plans only:
Definition 8 (Budget): Total non-interest current plus 579 629 25.1%
capital expenditure of the national government.
The last definition is still not quite usable for macro-
economic analysis, since subsidies and capital trans-
fers are still included. Also remember that this figure
is only for the national government.

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.
S 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.
S 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.
S To imitate the budget in SNA context, use definitions 3 or 4.
S 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.
S 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.
S 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:
S 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.
S 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.
S 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 2008
(in the case of the SNA and GFS data) or the 2008/9 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 GDP GFS % of GDP Budget % of GDP
Tax revenue 650 024 28.5% 648 850 28.4% 627 693 28.5%
Less SACU revenue –28 921
Non-tax revenue 154 731 12 253
Total current revenue 687 663 30.1% 803 581 35.2% 611 026 27.8%
Sales of capital assets 2 295 98
Total revenue 687 663 30.1% 805 876 35.3% 611 124 27.8%
Total expenditure 725 999* 31.8% 829 127 36.3% 633 910 28.8%
Deficit –39 065 –1.7% –23 251 –1% –19 906 -1%
* 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 extra-budgetary 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).
S 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 15 in this chapter).

Policy problems: coordination, lags
and schools of thought 11
Q understand and formulate the differences and interaction between fiscal policy and
monetary policy, and between the National Treasury and the Reserve Bank;
Q appraise the problems relating to time lags and uncertainties in practical policy
formulation and implementation; and
Q 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.
S 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.)
S 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? 435

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.
S 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.
S 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.
S 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 10.6.5). Higher public debt levels are carried forward into
436 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.)
S High interest rates due to restrictive monetary policy can severely affect the sustainability
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’?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
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? 437

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.
S 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.
S 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.
S 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.
S 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.
S 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 which aggravates an already existing downswing. Similar perverse effects
can happen in the case of expansionary policy.
11.2 Policy problems 439

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 like 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 eco-
nomy. Despite very advanced theories, there is much uncertainty regarding the linkages
between variables, the sensitivities (elasticities) involved in relationships, the size of coef-
ficients and multipliers, the speed of adjustments, the nature of transmission mechan-
isms and adjustment processes, and so forth. There are no simple cause-and-effect rela-
tionships: 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.
S 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 which
finds expression in an intense debate between different schools of thought on economic
theory and policy. A broad introduction to these were 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. S 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 S 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 441

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.
S 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 production Contrast this with the Keynesian model where a
– ‘supply creates its own demand’. lack of aggregate expenditure (a demand deficiency)
can lead to an equilibrium level of output Y
Expenditure (demand) can never be
which is below the full-employment level. At the
insufficient to purchase all output
latter macroeconomic equilibrium there is labour
(supply) at the full employment market disequilibrium, i.e. unemployment. This
level; therefore production (GDP) unemployment is decidedly involuntary.
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 US, triggered by the stock market crash of 1929. It
quickly spread to the rest of the Western world. In the US 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 US (with similar rates in countries such as the
UK). This lasted until at least 1933.
S 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.
S 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.
S The market is regarded as the optimal regulator of society, and the minimum level of
government action (seen as ‘interference’) is urged.
S 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.
S 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.
S 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.
S In such an equilibrium there would be no involuntary unemployment.
S 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.
S 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 disturb-
ances have dissipated, the equi- The Keynesian view is that the ASSR curve is
librium level of real production relatively horizontal at times; that the AS adjustment
depends on the supply side, i.e. on process occurs slowly (especially downwards)
what happens in the labour mar- and therefore implies a high cost in terms of
unemployment and human suffering. Therefore, the
ket.
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.
S 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.

S 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
average price level.
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.
S 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 + A(Ut – US ) where A < 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.
S 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
policy makers. Government must therefore adopt a hands-off approach to the economy.
The question is how valid this theory is. Events in the US 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 amongst 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 which 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 US and UK monetary autorities 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 US 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.
S 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 ccording 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 equilbrium. 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 so as 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.
S 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).
S 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.
S 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.
S 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 explanations for 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 developing countries.
Given their First World origins, 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 amongst 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
developing world.
S One essential step is the full inclusion of the concept of structural unemployment into the
theory, as has been done throughout this book.
S 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.
S The deeper analysis of structural unemployment, its link to underdevelopment, 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
_________________________________________
S Given that the economy is inherently stable,
stabilisation is unnecessary and uncalled for. _________________________________________
S 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. _________________________________________
S 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.
S Indeed, the main cause of observed economic _________________________________________
instability is policy mistakes and blundering by _________________________________________
the authorities (notably the monetary authority).
S 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
_________________________________________
S 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).
_________________________________________

_________________________________________
S 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. _________________________________________
S 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.
_________________________________________
S 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.
S 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
_________________________________________
S 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).
S 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. _________________________________________

_________________________________________
S 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
_________________________________________
S 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
Q define, measure and calculate the rates of inflation, unemployment and growth, and quote
key South African statistics in this regard;
Q assess and compare the Monetarist/New Classical and Keynesian explanations of
inflation and unemployment;
Q understand and evaluate the structural dimensions of inflation and unemployment;
Q evaluate the role of policy, both as a remedial step and as a potential factor contributing
to the inflation process;
Q value the complexities of economic growth and growth-oriented policy;
Q compare differences between the relatively narrow conventional and newer, broader
understandings of the causes and remedies of low growth; and
Q 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 in this
regard.
12.1 Inflation
12.1.1 Definition and measurement
While definition and measurement are controversial aspects of the unemployment problem
(section 12.4), with regard to inflation they are not points of disagreement.
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.
12.1 Inflation 455

The average price level is meas-
ured by different price indices, One person, one inflation rate?
the consumer price index (CPI) One should remember that the inflation rate
being the most important.1 The measures the trend in the national average price
CPI measures the cost of a pre- level.
determined basket of consumer S In specific areas or cities a different trend from
goods. The contents of this basket the average price level can occur. For this reason,
correspond to the average con- Stats SA also publishes separate inflation rates
sumption patterns of consumers for certain cities.
S Specific groups of individuals, with an
(especially in urban areas). This
expenditure pattern that deviates markedly from
cost is measured monthly and the
the average – e.g. the rich or the poor, young
amount then expressed as an in- people or the elderly – can each experience a
dex with a base year value of 100. different inflation rate. Stats SA also publishes
For example, the cost of the basket such inflation rates.
in 2008 is taken as 100 (indicated S In fact, each individual or household experiences
as 2008 = 100). The cost of the its own average price level and own inflation rate.
basket in other periods is then ex- This depends on the individual’s or the household’s
pressed relative to this base value. particular expenditure pattern, e.g. expenditure
on food relative to transport relative to housing.
The CPI is calculated by Statistics
South Africa (Stats SA) on the
basis of monthly surveys of prices.
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
which 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.
S Method l: The average CPI is calculated for a whole calendar year, e.g. 2010, and
compared to the average CPI for the previous calendar year (2009). Calculating the
difference as a percentage change produces the inflation rate for 2010. This method
produces an inflation rate once a year.
S Method 2: The CPI value for a specific month, e.g. July 2010, is compared with the
CPI value for the corresponding month 12 months earlier (July 2009). Expressed as
a percentage change, this produces an inflation rate for July 2010 – more specifically,
for the 12 months up to July 2010. This method has the benefit of more frequent
measurement: inflation results become available every month. However, the results
are also more subject to short-run fluctuations as well as purely statistical or so-called
technical disturbances. Accordingly, this method gives a less reliable picture of the
underlying inflation tendency. It should be used with circumspection. However, it is
regularly reported and interpreted in the news media, and financial and stock markets
often react to it. Policymakers also cannot ignore its significance, as long as the necessary
1 Other important indices are the producer price index (PPI) and the GDP deflator. Up to the end of 2008 the Reserve
Bank also published the CPIX, which is the CPI with mortgage payments excluded. CPIX was the index that the
Reserve Bank targeted. However, with imputed rent replacing mortgage payments in the new inflation basket
introduced at the beginning of 2009, the Reserve Bank decided to work with and target CPI from 2009 onwards.
456 Chapter 12: Inflation, unemployment and low growth

care is taken to ignore transient changes. (An even more unstable or nervous measure
of inflation is to calculate the percentage change between June 2010 and July 2010
and express that at an annual rate. This method, which can be very misleading and
confusing, is – and should be – used less frequently.)
Inflation in South Africa

Table 12.1 summarises the inflation Table 12.1 The inflation rate in South Africa since 1961
history of South Africa since 1961.
1961–65 2.3% 2001 5.7%
(See chapter 9, section 9.2.5 for an inter-
national comparison of inflation rates.) 1966–70 3,2% 2002 9.2%
The data in table 12.1 and figure 1971–75 9.1% 2003 5.8%
12.1 clearly show the extent to which 1976–80 12.1% 2004 1.4%
the inflation rate in South Africa has
1981–85 14.0% 2005 3,4%
increased since 1973, with the mid-
1980s the worst period. It has shown a 1986–90 15,3% 2006 4.7%
decline since 1992, but with significant 1991–95 11.3% 2007 7.1%
peaks in 2002 and 2008 (albeit of
1996–00 6.7% 2008 11.5%
shorter duration).
2001–05 5.1% 2009
South Africa (and other Western coun-
2006–10 2010
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. This is very important, considering that inflation rates of
below 3% typically exist in countries that constitute South Africa’s main trading part-
ners. (Refer to the discussion of the impact of inflation on international trade, the cur-
rent account and the exchange rate in chapter 4. Also see the discussion of inflation
Figure 12.1 Annual inflation rate in South Africa 1960–2008
20
18
Inflation rate
16
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
12.1 Inflation 457

targeting in chapter 9, section 9.3.) The lower inflation rates have also helped to reduce
the level of expected inflation amongst the general public as well as wage and price set-
ters. 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 developing countries, and of
a neighbour such as Zimbabwe (see box below), 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 5% and 10%.
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:
S The nominal money supply MS is the principal determinant of the average price level:
ΔM ΔP.
S The only long-run effect of money is on the average price level (i.e. money is neutral).
S 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.
S 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.
S 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%.
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 below.)

In terms of the AD-AS framework, the Figure 12.2 Money supply growth and increases in
Monetarist/New Classical view is shown in the price level
figure 12.2. While increases in the money
P ASLR
stock 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 P4
process always occurs quickly (or even
ASSR2
instantaneously, as maintained by the New
Classicals in particular). The quick (or P3
instantaneous) adjustment promptly takes
the economy back to the intersection of the ASSR1
AD curve and the long-run supply curve ASLR. P2
This implies that the short-run ASSR curve
ASSR0
exists only for a very brief period of time (if at
P1
all). It can therefore be disregarded for most
purposes.
In this way, a sustained growth in the nominal P0
money stock simply means that the AD curve AD1
continually shifts up along the ASLR curve.
The only effect is a continual increase in the
average price level. AD0
Continually upward shifting AD (and ASSR) YS Y

S
curves due to sustained growth in M thus
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.
S The principal supporting evidence was data from the US which showed a strong
correlation between Ml growth rates and the inflation rate.
This situation can also be depicted Figure 12.3 Money supply growth and inflation
very effectively with the AD-PCLR- P ASLR (or PCLR )
PCSR model introduced in chapter
7, where we renamed the AS curves
as Phillips (or PC) curves – as in ASSR (or PCSR )
figure 12.3. On the vertical axis, it
has the percentage change in the
price level, i.e. the inflation rate Steady growth in
money supply causes
π. Accordingly, in this diagram, HZ[LHK`PUÅH[PVU
P0
steadily upward shifting AD and structural equilibrium
ASSR curves are represented by
stationary AD and ASSR (i.e. PCSR)
AD
curves. The intersection of AD
with the vertical ASLR (i.e. PCLR)
line gives the equilibrium inflation YS
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)
12.1 Inflation 459

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 which
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 explana-
tion and render it a partial explanation of inflation, at best.
S 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.)
S 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 ...)
S 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
unpredictable. 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)
S 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 like structural unemployment.
S The idea that money is neutral, with no ultimate impact on the real sector, is strongly
questioned.
S 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.)
S 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 approach2
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.
S 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, whilst 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:
S 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.
S 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).
2 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 below).
12.1 Inflation 461

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 ).
S 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.3
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 which curbs agricultural
production, and so forth.
S 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.
S In AD-AS terms: These – or other – factors must cause recurring larger upward shifts of
AD and ASSR.
S 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 AD1 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
3 This distinction has been borrowed from the structuralist approach to inflation, which is discussed below.

able to initiate the process of faster Figure 12.4 Demand-pull inflation
price increases in the first place).
P
Propagating factors are determinants PCLR PCSR1
of both the demand and the supply Equilibrium with
sides that can lead to permanent OPNOLYPUÅH[PVUK\L
upward shifts in AD and PCSR. to ‘demand pull’ (via
P1 some supply adjust-
On the demand side, most of the ment process)
components or determinants of ag-
gregate expenditure are disqualified, P0
since in reality most are unlikely or AD1
unable to undergo sustained, long- AD0
run real growth faster than GDP.
This, notably, is also true of govern-
ment expenditure, the sustained real YS Y1 Y
growth of which, relative to GDP,
would soon absorb all real GDP. The Figure 12.5 Cost-push inflation
latter is logically impossible. While
P Equilibrium
real growth in G for a number of PCLR PCLR
with higher
years can play a propagating role PUÅH[PVUK\L[V PCSR2
for that period, it is disqualified as a ‘cost push’ (via
long-run propagating factor. some supply PCSR1 PC
adjustment SR0
A demand-side factor which does process)

P1
qualify – and which is likely to be the
most important demand-side prop-
agating factor – is nominal money P0
supply growth. Such growth, if sus-
tained, can easily lead to a sustained AD 0
upward shift of the AD curve to
AD1, and hence to higher inflation.
YS2 YS0 Y
The Keynesian view therefore agrees
with the Monetarist/New Classical
view that money supply growth is a crucial factor in the inflation process, i.e. that infla-
tion 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 amongst
many causes and different types of cause.
S 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
12.1 Inflation 463

expectations in their negotiations on wage setting, that will lead to the PCSR curve
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.
S 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.4 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 6.3.3.5
4 Certain taxes can serve to constrain supply.

5 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 P
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. P2 supply adjust-
Diagram 12.6 shows these options ments via PC shift
P1 1
starting from point 1 (the short- Equilibrium after
run equilibrium after the initial initial demand
P0 stimulation
demand stimulation). Inflation is 3 AD1
higher than the initial level of π0, Equilibrium after
and so is Y. AD0 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.6 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:
S 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.
S 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.
6 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 465

S 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.
S 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.
S As noted in chapter 11 (section 11.3.4), the New Keynesian model – like the Monetar-
ist/New Classical model – does not recognise or allow for a phenomenon like structural
Hyperinflation and Zimbabwe 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 understood to occur when monthly inflation rates exceed 50%. If
50% is the rate, 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 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 peaked at the
second highest inflation rate in history, i.e. 98% per day (after Hungary in July 1946, which had
a daily inflation rate of 195%). Zimbabwe 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 reached approximately 250
million per cent, and by the middle of October 2008 it is estimated to have skyrocketed to 300
billion per cent. This implied that prices doubled every couple of days. After that the numbers
exploded beyond comprehension. 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, as part of the
process of forming a unity government, the government officially allowed the use of foreign
currencies in commercial transactions. After most prices (and wages) came to be expressed in
rand or US dollars, these prices even registered a slight decline in early 2009.

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 unem-
ployment (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 struc-
tural unemployment, rather than appropriate policy steps (as discussed elsewhere in this
chapter). Unfortunately, for various reasons, macroeconomic analysts and even policy-
makers tend to be hesitant to recognise the existence and extent of structural unemploy-
ment. 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.
S This problem is associated with any demand policy and cannot be escaped.
S 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.
S 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 467

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. P
PCLR1 PCLR0
S Note that the supply adjustment process,
PCSR2
although of a different nature than the
supply shock as such – PCSR shifts for a P3 3 PCSR1
different reason, and up rather than left PCSR0
– its impacts on Y and π are similar. It P2 2
aggravates and prolongs the stagflation P1 1
effect of a supply shock. P0
S Such a supply adjustment process can AD2
take approximately three to seven years. AD0
AD1
Second, they can attempt to combat the
inflation by introducing a contractionary
monetary policy (thereby shifting AD left YS2 Y1 YS0 Y
to AD1). 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 the 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 AD2 (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.
S As noted in chapter 7, on average the entire process can be thought to take approx-
imately 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.
S 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.
S 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.
S 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 2008/9 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 469

S 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.
S 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.
S 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.
S 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. Whilst 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.
S It followed this approach both in 2001 (following the severe, but temporary depreciation
of the rand) and in 2008/9 (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- …
S 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 consid-
erations. 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. Stand-
ard 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
which, 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 471

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.
S However, when the economy is not operating close to full capacity, its effect on prices is unlikely to
be significant.
S In contrast, in a Monetarist/New Classical view of the world a completely different conclusion is
reached. In this view the economy perpetually is 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.
S 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.
S 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.


S 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.
S 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). Chapter 10 also argued that since 2002 this situation may slowly but surely
have been changing as investment is increasing and the economic growth rate is improving. (Section
12.3 below contains more discussions on economic growth in South Africa.)
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 which cause an underlying susceptibility to infla-
tion in the economy. These include a wide range of non-economic (social, political and
historical) dimensions, for example:
S 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);
S the degree of materialism or greed in society, as visible in sustained efforts to wring the
maximum material or monetary benefit from every activity;
S the degree of conflict between groups, given limited resources;
S the extent to which people look to government for support and demand such support,
rather than fostering self-reliance and independence;
S the degree of competition on product markets as well as labour markets;
S the political and negotiating power of labour unions;
S the extent to which prices are downwardly rigid;
S the extent to which prices are controlled;
S the official commitment to a policy of full employment, or political pressures for such
a commitment;
12.1 Inflation 473

S the size of the public sector and of government employment (which implies political
wage setting), and
S 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 which integrates a variety of elements.
In this sense, it differs fundamentally from the ‘pure’ macroeconomic approaches which
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, increases in the demands of employee organisations
and labour unions and high profit demands 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 in South Africa since 1973.
The policy implications of this argument are that the competing demands have to
be reconciled in some way or another. Naturally, normal demand policy is futile. 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.
It also needs to be mentioned that internationally such national consensus strategies in the
form of price and wage freezes have dismal records, usually only aggravating the inflation
problems that countries face. Despite the appearance of a feeling of national unity and
reconciliation following the political transformation of 1994, it is not clear that such a
consensus does exist in South Africa at present. Even worse, it appears that excessive and
unrealistic demands following the political transformation may actually increase the
underlying conflict and pressure on the economy. This became quite clear since 2007, as
evidenced in political tensions in the ANC and its alliance partners.
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 un-
employment 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 475

What is the total population in South Africa approximately __________ million
How large is the labour force in South Africa approximately? __________ million
What is the SA unemployment rate approximately? __________%
What is the unemployment rate in a country such as the US? __________%
Can one compare the employment rates in SA and the US?
___________________________________________________________________________________
___________________________________________________________________________________
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 found on the website of
Statistics SA at: 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.
For the purposes of measuring 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, and all unemployed people.7 These are all the 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 are a subgroup of the economically active population.
Given these definitions of two populations, there is a strict (or narrow) definition, and an
extended (or wide) definition.
1. Strict definition of unemployment: The unemployed are only those who took specific
steps to find employment in the preceding few weeks.
2. Extended definition of unemployment: The unemployed are those who took specific
steps to find employment in the preceding few weeks plus those unemployed people
who did not look for work, but nevertheless say they want to or are willing to work.
These are the so-called discouraged workers.
A third, more administrative definition, is that of registered unemployment. It is even stricter
and counts only those persons who register as unemployed and as work seekers with the
relevant government department (the Department of Labour).
7 Formerly, only the formal sector was included in unemployment measurements. This was not suitable for a developing
country or a country with a significant ‘developing country’ element like South Africa. Thus the informal sector has
been included.

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 took
specific steps to find a job
B
A Registered
unemployed
Workers/employees
Economically active Not counted as Economically active

population (strict unemployed in strict population
KLÄUP[PVU) KLÄUP[PVU (L_[LUKLKKLÄUP[PVU)
Calculation of the unemployment rate:
:[YPJ[KLÄUP[PVU! ___
B
A+B
,_[LUKLKKLÄUP[PVU! _____
B+C
A+B+C
Note that the choice of a strict or an extended definition of unemployment implies a cor-
responding narrower or wider 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 underemployment
or underutilised labour. This is an imperfectly understood and imperfectly measured phe-
nomenon. It relates to people who work part time, or who work occasionally (e.g. one
day per week), or unemployed urban persons who temporarily stay with family on farms
and work a bit there. While such persons are not entirely unemployed, they are not em-
ployed in the full sense of the word either. Yet in a standard labour force survey they will
be counted as being employed.
S This phenomenon severely complicates the definition and measurement of unemploy-
ment. Some forms of underemployment are visible; others are invisible.(Invisible un-
deremployment comprises workers who are overqualified for their jobs and those who
work inefficiently.)
S The underemployed are a subgroup of the group of employed people.

S Stats SA measures visible underemployment, calling it time-related underemployment.
Time-related underemployment includes people who work, but are employed for less
than 35 hours per week – but are still counted in full in the employment numbers.
S When measured, the concept of underutilised labour adds ‘time-related underemployed’
persons to the numbers obtained under the extended definition of unemployment (see
table 12.2).8
S Underemployment is also an element of the structural unemployment problem.
How are ‘the unemployed’ defined in South Africa?

Officially the unemployed in South Africa are people, between the ages of 15 and 64 years,
who, during the four weeks preceding the counting survey,
(a) were not in paid employment or self-employment, and
(b) were available for paid employment/self-employment in the reference week of the
survey and
(c) took specific steps to find employment or self-employment.
In essence, to be counted as officially unemployed, a person needs to have taken definite
steps to obtain work. Simply having had the desire to work is not sufficient.
S This means that the current official unemployment figure is based on the narrow
definition.
Which data?
Between 1995 and 1999 the unemployment counting survey was done once a year, during
the so-called October Household Survey (OHS) of Stats SA.
From 2000 to 2008 the counting was done twice a year (in March and September) and the
DATA TIP
results were published in the Labour Force Survey (LFS) of Stats SA.
Since August 2008 Stats SA has published the Quarterly Labour Force Survey (QLFS). With
the publication of the latter, Stats SA also revised the previous LFS data (from March 2001
onward) so that the older data correspond with the definitions of the QLFS.
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.
How high are unemployment and underemployment in South Africa?

Given the complexities of definition and measurement – combined with the social and
political sensitivity of unemployment – it is not surprising that Stats SA is regularly
taken to task for its published figures, even though it is based on international labour
measurement standards. As is the case with inflation, different interest groups (e.g. unions,
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 third
quarter of 2008. It shows that the official unemployment rate, using the strict definition,
8 Note that underutilised labour does not include those who might be working more than 35 hours per week, but who
are in jobs for which they are overqualified (i.e. they would be able to contribute more to the economy, if they were
only employed in suitable jobs).

was 23.2% [B/(A + B)]. According to the extended definition, the unemployment rate was
27.1%.
S Note that the extended definition adds discouraged work seekers both to the numerator
and the denominator of the ratio, i.e. it adds the number of discouraged work seekers C
to the pool of unemployed, but also to the economically active population.
Table 12.2 Unemployment in South Africa – 3rd quarter 2008 (Quarterly Labour Force Survey)
Total employed in formal sector (A1) 8.3 million

Total employed in informal sector (A2) 4.7 million
Other employed (A3) 0.7 million
Total employed (A = A1+A2+A3) = 13.7 million
Total unemployed (official definition) (B) 4.1 million
Total economically active = A + B = 17.8 million
Total not economically active 13.0 million
Total population 15 to 64 years = 30.8 million
B
Official unemployment rate (strict definition) = ____
A+B
= 4.1/17.8 × 100 = 23.2%
Discouraged work seekers (C) 1.0 million
Total unemployed (extended definition) = B + C 5.1 million
B+C
Unemployment rate (extended definition) = _______A+B+C
= 5.1/18.8 × 100 = 27.1%
Total RSA population (approximately) 48 million
Table 12.3 presents a breakdown of underutilised labour. Underutilised labour takes the
unemployed according to the extended definition and adds those who are time-underemployed
(amongst the employed in category A). If they are denoted as AU, underutilised labour D = AU
+ B + C. There were 7.2 million underutilised workers in South Africa in the third quarter of
2008, which was about 38.3% of the labour force; 2.1 million of the 13.5 million employed were
counted as time-underemployed, which amounts to 15.3%.
Table 12.3 Underutilised labour in South Africa – 3rd quarter 2008 (Quarterly Labour Force Survey)
Time-related underemployment (AU) 2.1 million

Total unemployed (official definition) (B) 4.1 million
Discouraged work seekers (C) 1.0 million
U
Underutilised labour (D = A + B + C) = 7.2 million
D = 7.2/18.8 × 100 = 38.3%

Underutilised labour as % of labour force = _______
A+B+C
× 100
Whatever definition is adopted, it remains a problematic issue.

S It can be argued that the wider 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.
S A significant part of the employed are in the informal sector. For instance, the Quarterly
Labour Force Survey reported that, in the third quarter of 2008, of the total of 13.6
million people employed, 4.7 million were employed in the informal sector.

S In the context of a developing country, with an informal sector that is larger than is
typically found in developed countries, as well as a significant element of a subsistence
economy present, especially in rural areas, the concept of (un)employment may be
inappropriate or incongruous in a particular sense (see discussion below).
How serious is unemployment in South Africa?

Figure 12.9 below shows the official unemployment rate from 1970 to 2008. Unemploy-
ment in South Africa has been relatively high at least since the 1970s. However, the period
of faltering growth since the early 1980s led to a major increase in the rate of unemploy-
ment since then. This trend peaked at almost 29% in 2002, whereafter a significant de-
cline set in.
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, especially, the
unemployment rates of earlier periods.
S The unemployment rates of the 1970s and 1980s probably represent an underestimation
of the true unemployment rate at the time. In the political dispensation of the 1970s
and 1980s, the proper measurement of unemployment figures for blacks was not a
high priority. (See the box below on unemployment measurement during the apartheid
era).
S Likewise, later unemployment rates should also be dealt with carefully, given that
different kinds of survey were used to measure unemployment, as well as definitional
and coverage issues. While the sources of earlier undercounting were addressed, the
developing country context adds new complications to the meaning and interpretation
of unemployment figures, with overcounting a possibility that cannot be excluded
readily (see the discussion of measurement complexities below).
Figure 12.9 Unemployment rate in South Africa 1970–2008
35
30
25
Percentage
20
Unemployment rate
15
10
0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
Unemployment rate
Source: Quantec

International comparisons of unemployment rates are dangerous, given different defini-
tions and measurement practices in different countries. This is especially so in the case of
developing countries. Developed (First World) countries generally use the strict definition
of unemployment. If one wishes to compare SA with developed countries, one should use
the official rate which 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 2007
USA 4.6% UK 2.7%
Germany 9.0% Spain 8.3%
Korea 3.3% France 8.3%
Switzerland 2.8% Japan 3.9%
Poland 12.7% Botswana* 17.5%
Algeria 11.8% Brazil 9.3%
* The Botswana rate is for 2005/6.

Source: IMF International Financial Statistics; Central Statistical Office, Botswana.
The official South African unemployment rate (approximately 23% in 2008) is significantly
higher than those of most other countries, be they industrialised, emerging market or less
developed countries. In a list of 60 industrialised, emerging market and less developed
countries for which the IMF has data for 2007, only Macedonia had an unemployment
rate higher than that of South Africa. In addition, in none of the other countries did
unemployment exceed 15%. (Admittedly, Africa is underrepresented in the IMF list. It
included only Ethiopia, Ivory Coast, and Mauritius as sub-Saharan countries, as no data
were available for the others.)
These figures indicate that South Africa has a serious 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
Unemployment at 47%?
Sometimes one encounters a figure of 45–50% when unemployment is discussed. This is
not an unemployment figure at all. Such a figure is derived if the number of people who
work in the formal sector is subtracted from the total workforce, and the residual expressed
as a percentage of the total. Hence it counts as ‘unemployed’ both those who really are
unemployed (in the wider sense) and those who work in the informal sector. It is therefore an
inappropriate measure of unemployment, especially in a developing country context. Actually,
it reflects only the total labour absorption of the formal sector.
S This way of measuring grossly overstates the (un)employment problem. It is especially
dangerous if used in comparisons with other countries.
S Yet the long-term trend in this figure is useful. It is estimated that in 1946 this figure was
23.6%, and up to 1975 remained below 25%. Since then it has been increasing steadily.

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.
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). Since 1970,
economic growth has regularly fallen far short of this target (see chapter 1 and section
12.3 below). Economic growth alone will therefore not solve the problem – although it has
an important contribution to make.
The limited impact of economic growth is illustrated by the growth in formal sector em-
ployment over time, relative to the economic growth rate.
Table 12.5 Growth in GDP and employment (five-year average growth rates)
Formal Informal Total

GDP employment employment employment
(%) (%) (%) (%)
1971–75 3.66 3.15 6.67 1.33
1976–80 3.12 1.73 6.73 1.35
1981–85 1.40 1.31 5.42 1.08
1986–90 1.68 1.07 6.80 1.36
1990–95 0.89 -0.24 6.61 1.32
1996–2000 2.80 0.06 3.07 0.61
2001–2005 3.87 1.44 0.34 0.07
2006–2008 4.49 1.76 5.27 2.51
The long-run decline in economic (GDP) growth in South Africa between 1970 and 1995
is reflected in declining employment growth (see table 12.5). However, formal sector
employment growth is generally at a much lower level than GDP growth.
Measurement complexities – unemployment, poverty and underdevelopment

When considering the SA unemployment data, one cannot but be struck by how much
South Africa seems to be out of line with both developed and other developing countries.
Casual observation of the situation in South Africa as against, especially, other SADC and
African countries, does suggest some unease regarding the high official unemployment
rate. Given one’s awareness of the frailties of economic data in general, and unemployment
data in particular, it is a question as to what extent there may be problems of classification
or definition or interpretation – or problems relating to the practicalities of unemployment
surveys in a developing country with high illiteracy and so forth.
The problems surrounding the measurement and interpretation of unemployment are
related to the fact that the South African economy is not a prototype First World economy
with the formal sector as the clearly dominant sector. Definitions of employment and
unemployment were often developed internationally within the context of largely (or
fully) developed wage economies with all (or the vast majority of) activities taking place in
the formal sector – people having jobs with formal employers or large organisations, etc.

The whole concept of unemployment was born in the latter context – and actually may
make sense in that context only. Unemployment rates of less than 10% are the norm in these
economies.
In developing economies, large numbers of people find themselves in subsistence agricul-
ture (in rural and also peri-urban areas) as well as the informal sector. In such a context,
the concepts of a formal ‘job’, ‘employment’ and ‘unemployment’ are, in some way, some-
what foreign, even inappropriate.
S There is a danger that significant elements of underdevelopment and subsistence are
being characterised as unemployment, a concept which largely ignores the historical
and developmental context of a country.
This does not detract anything from the severity of poverty that might characterise
individuals who survive in these activities. It also does not detract from the need to integrate
informal or subsistence activities better with the formal economy. But it does highlight the
need to be careful when using unemployment figures to measure economic conditions in
a developing country.
A traditional subsistence context may also cause varying perceptions amongst individu-
als as to whether a person regards herself as employed, self-employed or looking for work.
This can make statistical unemployment surveys quite difficult and unemployment data
potentially questionable.
In South Africa, as in many developing countries, unemployment is part of a larger
problem, i.e. underdevelopment and poverty. In such a situation one also encounters the
tragic situation of the working poor – those who do have work, but who are trapped in acute
poverty. Is it correct not to count such a person as part of the problem (which even the
wider definition of unemployment does not do)?
Actually, the issue is not just jobs.
It is the extent to which people Unemployment in the apartheid era
have access to the necessary
In the period before 1994, the unemployment rate
means to satisfy their needs
was a very controversial issue in South Africa. The
in a self-reliant way and thus reliability and credibility of official unemployment
maintain a decent, humane level figures were questioned regularly. This was linked, to
of existence. Income in some a large extent, to opposition to the political system
form or another usually is a key of the time. There were accusations that black
element of this (see section 1.4 unemployment was either seriously undercounted or
in chapter 1). But a person can ‘hidden in the homelands’.
have a job or be self-employed and Before 1983, blacks were excluded from the official
still be very poor. Hence the real measurement of registered unemployment. Even
issue is poverty. Poverty, though, after that the independent homelands were not
can be rooted in unemployment included in official calculations. Also, for many
and in low-wage-paying jobs. years, only the registered unemployment figure was
S Poverty is not much affected acknowledged. Only from 1977 onward was this
by the business cycle. For the figure supplemented with estimates obtained from
poor, the discussion of the so-called Current Population Surveys.
next upswing or downswing
is largely irrelevant.
S This also stresses the point that this is a much broader and more complex problem that
cannot be addressed with macroeconomic policy alone (if at all . . .).

In this sense, it is dangerous to describe or analyse unemployment mainly as a macroeco-
nomic problem. While unemployment surely has a macroeconomic dimension, and while
macroeconomic analysis aids our understanding of the phenomenon of unemployment,
there is a danger of narrowing the problem and prescribing inappropriate (narrow) macro-
economic policy remedies.
S This becomes even clearer when considering the various dimensions of unemployment.
In South Africa there are racial, gender, spatial and age dimensions to unemployment.
For instance, according to Stats SA, the unemployment rate for African females in the
third quarter of 2008 was 30.9% and for African males 24.3%, while that for white
males was 3.6%. Unemployment in the Western Cape was 19.7%, while that in Limpopo
was 29.5% (compared to the national figure of 23.2%).
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 450 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.
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.
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.
S 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.
S 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).
S Hence policy steps should be designed with the complex dynamic interaction between
prices/inflation and production/unemployment in mind.
S In such policy design, the insights gained from the Phillips curve experiences (see
chapter 7 and the box below) 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.
S 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.
S Therefore they would not accept that unemployment is a problem even in the short or
medium term. As far as they 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 doesn’t stabilise, it destabilises.
S Rather than pursuing ‘stabilisation’ policy, government should practise fiscal abstinence.
If this is complemented by a monetary ‘policy’ which 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 US 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 counter-cyclical 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.”
S The elimination of unemployment should therefore not be an active policy objective,
in this view.
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).
Natural unemployment? A revisit

In chapter 11 (section 11.3.4)
it was noted that both theories Missing the point? The crux of the unemployment
assume that in the longer run the debate between the two main schools of thought
economy returns to a long-run is about the speed at which a short-run equilibrium
equilibrium which is regarded, in point that is not on ASLR (such as 1 and 2) will return
to ASLR and thus output level YS. The existence of
essence, as a good position for any
a possibly large gap between unemployment at
economy to be in.
YS versus at a ‘full’ employment output level YFE –
S Neither approach consid- however conceived – is ignored.
ers the possibility that such
a long-run equilibrium may P
ASLR
still be characterised by high
structural unemployment –
as well as, perhaps, high levels ASSR
of poverty and underdevelop-
ment and significant inequali- 1
ties in income and wealth.
S The existence of structural
unemployment means that 2 AD
the long-run equilibrium may
still be significantly below
an output level that could Short-run equilibrium with
be called a full-employment cyclical unemployment AD
level (as defined in chapter 6,
YS YFE Y
i.e. allowing for the existence
of frictional and search un- Structural unemployment gap
employment, which is fairly
harmless).
In reality, unemployment is a serious and intractable problem, in developing as well
as developed countries. Neither the New Classical nor the Keynesian theories provide
explanations, or policy prescriptions, for the high levels of structural unemployment
in a country such as South Africa. And unemployment persists all over the world, also
in the US and Europe, despite many policy efforts. This suggests that the conventional
macroeconomic explanations (and remedies) may not have fathomed the true nature of
the problem of unemployment. One must probe deeper – especially in a developing country
context.

Read the large box in chapter 6, section 6.3.2 on the different types of unemployment,
including ‘structural’ and ‘natural’ unemployment.
Accordingly, when the long-run aggregate supply relationship was developed in chapter
6. care was taken to define the conception of a long-run equilibrium such that it could
capture 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.
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 developing countries, but perhaps
less so in most developed 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.
S 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.
S 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).
S 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.

S The New Keynesian approach would include selected forms of involuntary unemploy-
ment 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
their disagreement with the content given to a long-run level of 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 developing 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 below (as well as in chapter 6, section 6.3.2). Their deep nature
and intransigence warrants 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).
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 1993–1996. After 1999, the unemployment rate seems not to
have changed much even though the economy was in an upswing for a whole decade
since 1999. In March 2001 (the first year for which revised Labour Force Survey data
are available), the unemployment rate stood at 24.6%. In March 2007 it was at 23.6%.
However, between these points the unemployment rate increased to 29.3% in 2003,
whereafter it started to decrease again.
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 for a brief period in the late 1990s). However, employment opportunities grew
slower than the labour force. Not all people who entered the labour market got employed.
The growth rate was too low to absorb all new entrants into the labour market – or, the
growth was not sufficiently job-intensive (employment-intensive). Either way, the increase
in employment was too low to produce a drop in the unemployment rate.
The lacklustre reaction of the unemployment rate to the economic upswing that occurred
in the first decade since 1999 also indicates 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).
S In other words, the major part of South African unemployment is of a permanent nature.
This means that the largest part of unemployment in SA is structural unemployment.
S Cyclical fluctuations in production and employment – explained in the AD-AS framework
– actually amount to waves upon a sea of underlying, enduring unemployment.
S These fluctuations occur around a permanently high level of unemployment –
previously indicated as the structural rate of unemployment (SRU), which corresponds

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.
S 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.
S 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 labour productivity growth with 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.
8.0
7.0
6.0
5.0 Real GDP growth
4.0
Percentage
Required real GDP growth

3.0
2.0
1.0
Change in
0 unemployment rate
–1.0
–2.0
–3.0
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Source: South African Reserve Bank (www.reservebank.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 since 2003 has the actual growth rate exceeded the required growth rate, leading to a
corresponding drop in the unemployment rate (i.e. negative change in the unemployment rate).
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,
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
from the nature, location and pattern of employment opportunities. A major portion of
structural unemployment is due to intrinsic mismatches between worker skills and the
skill requirements of available jobs. 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
determine what kinds of, and how much, labour can be employed.
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. In broad terms, this implies 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. Perhaps the
market remains in disequilibrium for long periods. Or, whatever ‘equilibrium’ may come
about does not entail full employment. Whatever the case may be, the intrinsic limitations
and handicaps of the market are prominent in this context.9
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 possible causes. A much more incisive debate and analysis would be
necessary to reach a well-considered conclusion.
1. The labour market is not a single or united market. In reality it is a segmented market,
comprising a number of relatively isolated submarkets. Labour mobility between
these market segments is 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
9 This is linked, in no small way, to the wider social context in which the employment of people takes place. For this is
what it is about – people with all their non-market, socially and individually conditioned characteristics, not ‘inputs’
to be handled by some impersonal mechanism of supply and demand.

at a lower wage. 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 industrial labour market, or even different agricultural labour markets. In
so-called white-collar jobs there are even more severe barriers to mobility between
sectors or segments. A skilled and experienced worker who becomes unemployed in
one segment does not necessarily possess the necessary skills to find employment in
an entirely different part of the market – in any case, not immediately or without
some retraining. Labour is simply not homogeneous, and the demand for labour can
be very skill-specific.
2. 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.
S Population growth has a built-in momentum: most of the labour force (and the
potentially unemployed) of the third decade of this century has already been born.
Hence it takes very long to curb this momentum.
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, also contribute to the
absorption problem. Changes in the age structure, as well as participation rates, are
particularly important in this regard.
3. Changes in the health status of the population can also play a significant role. For
instance, the HIV/Aids pandemic mostly effects the economically active population
of the country, with people under the age of 35 the most affected. As discussed in
the chapter on economic growth, the impact of HIV/Aids on the economy may not
be clear cut. The poor and unemployed financially may be less capable to take care of
themselves once they get infected. This may increase the mortality rate of the poor
and unemployed relative to the employed and better-off part of the population. Thus,
in a rather perverse manner, the HIV/Aids pandemic might contribute to a reduction
of the unemployment rate. However, a higher mortality rate of people also means
that demand for products will decrease or increase at a lower rate. The lower demand
may, at least in the short run, impact negatively on employment, causing higher
unemployment. 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. With fewer skilled people (human capital)
and those with skills demanding higher wages and salaries (because of their relative
scarcity), a higher mortality rate may act like a supply shock that also causes the long-
run output level to decline. The ultimate effect may be an increase in the structural
unemployment rate – even those with few or no skills may lose their jobs.
4. Changes in the pattern of demand and output affect labour absorption in certain
market segments. Over the past 50 years, the pattern of activity in the South African
economy has changed markedly. This was part of the development process in the
economy, which has stimulated the industrial and services sectors. Factors such as
climate (affecting sectors in agriculture), and world commodity prices, such as the
gold and platinum prices (which dramatically affected the mining sector), have played
an important role in permanently depressing employment in certain segments of the
economy.

5. 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 (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; trade and financial sanctions,
disinvestment and political turmoil hampered economic growth; BoP constraints put
a ceiling on the growth rate that could be sustained; the extent of underdevelopment
limited the availability of suitable economic actors to feed/drive growth in the modern
sector of the economy.
6. The high capital intensity of production methods in South Africa is part of a broader
pattern in the use of capital and labour which 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.
S 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 always is lobbying to have new ones introduced).
S 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.
S Capital intensity is also increased by an unqualified acceptance of ‘high productivity
methods of production’, often defined as the ability to produce high output with
fewer labourers.
S The pressure from international competition, which appears to force South Afri-
can 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.
S A shortage of appropriately
skilled workers, i.e. work- Unemployment created by the increased use of
ers equipped for the em- labour-saving production methods is sometimes
ployment opportunities of- called technological unemployment.
fered by a modern economy,
also contributes to higher
capital intensity. While this is part of the development context, this problem is often
ascribed to a discriminating education system which in the past did not provide educa-
tion and training of the same standard for all. The earlier practice of job reservation
also limited skills development amongst sections of the population.
S The development of consumer preferences which can be satisfied only with relatively
capital-intensive production methods. This often occurs in imitation of overseas
trends and fads.
S The market domination of large, capital-intensive corporations excludes small,
probably labour-using, businesses or forces them to mechanise too.
S The growth and belligerence of labour unions that forcefully claim a larger share of
the ‘economic cake’ for workers. Factors such as threatened minimum wage legis-
lation may have contributed to the tendency to mechanise.

7. Restrictions on labour mobil-
ity, i.e. on the geographical High minimum wages and non-wage costs
or occupational mobility of (employee benefits) may also make employers
reluctant to expand their workforce in good times.
people, is another important
Cumbersome dismissal procedures contribute to
cause of structural unem-
this. Hence employers may prefer to pay existing
ployment. workers for overtime rather than take on new
S Earlier decades saw meas- workers, since the former step can easily be
ures such as influx con- reversed in bad times. This may explain part of
trol, group areas, labour the phenomenon of low employment growth even
preference areas and job though the economy grows, both in South Africa and
reservation. Institutional in, for example, the European Union.
and bureaucratic ob- High minimum wages may also prevent the creation
stacles facing small busi- of large numbers of low-level, low-skill service jobs
ness, and blacks especial- in e.g. the hotel, retail, recreation, health care and
ly, were also a significant service industries.
factor.
S In the 1990s, affirmative
action and the ‘transformation’ of institutions have led to restrictions on the oc-
cupational mobility of especially white males, though judging from official unem-
ployment figures it did not contribute to higher unemployment among them – in
the third quarter of 2008 their unemployment rate at 3.6% was still the lowest of
all gender and race groups.
8. Employment in agriculture has grown at a snail’s pace. Since 1960 the growth rate of em-
ployment 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. In Europe a high social welfare ‘safety net’ (social
9. Agriculture is also involved security system) appears to restrict labour mobility
in another political-econom- in another sense: in many cases jobless persons are
ic cause of structural un- not interested in job offers, because they can live
employment. This is found relatively comfortably on welfare.
in the historical interdepen-
dence (or symbiosis) of the
state and, notably, the mining sector in South Africa. Not surprisingly this is a sensi-
tive area, with several interpretations being offered. One of these is the following:
At the turn of the 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 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.
And, unfortunately, there are few unequivocal or unquestioned truths in the writing of

history. As a result, different interpretations of ‘what really happened’ will continue to
shape perceptions of problems and proposed solutions to problems. 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 un-
employment rate. Thus growth is a necessary but not a sufficient condition for lower
unemployment. Structural unemployment implies a perennial gap between the levels of
structural employment and genuine full employment (and hence between YS and YFE –
ASLR is below genuine full employment). It is clear that it is a complex phenomenon that
cannot be remedied or reduced with monetary or fiscal policy steps. Other measures are
required to reduce the gap.
Alternative policy measures that have already been proposed or instituted include:
S The drastic upgrading of education and training of black workers, inter alia by increasing
government expenditure for this purpose.
S Training and retraining programmes for the unemployed to equip them with suitable skills.
The state can do this, and/or tax incentives or training subsidies may induce the private
sector to do it.
S Changes in the tax structure to eliminate existing incentives to mechanise, and perhaps
create incentives for labour use. Tax incentives may also be used to encourage the local
development of appropriate technology.
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.
S What is the impact of affirmative action and BBBEE on the labour market?
S Is a policy of affirmative action and BBBEE a solution to, or a new cause of structural
unemployment?
S 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?
____________________________________________________________________________________
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S Wage and employment subsidies could encourage labour use. (Regional development
incentives that encourage labour use may make a contribution in particular regions/
provinces. However, the net national effect may be zero.)
S Programmes to limit population growth can serve to limit labour force growth (bearing
in mind that the impact will be felt only in 20 years’ time). Other factors that appear to
restrain family size, e.g. higher income levels, female literacy, and urbanisation, need
to be taken into account.

S Restrictions on labour union power and/or reduction in the minimum wage can remove
incentives to move away from ‘labour trouble’ and remove incentives to reduce the
use of the input (labour) that is becoming relatively expensive due to high wages and
high non-wage costs (employee benefits). That would make employers more willing to
employ new workers in good times.
S The promotion of small business via active support, as well as the removal of obstructive
regulations.
S The informal sector is highly labour intensive. The strengthening of the informal sector
by both government and the private sector can make a major contribution to limiting
structural unemployment. Government should not unnecessarily harass unregistered
activities, and bureaucratic restrictions on informal business should be lifted. The
informal sector should be supported by the provision of infrastructure and related
services (electricity, water), professional advice, and so forth – and by both government
and the private sector. Efforts to increase government and private sector purchases of
inputs from the informal sector can also help.
S The restructuring of agriculture and land use can help this sector to make a larger contri-
bution 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 ef-
fective labour-intensive production methods may be crucial. Collective or community
farming (such as the Israeli kibbutz system) has the potential to be productive as well
as labour-using.
S 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. Government could also attempt to
raise the labour used in existing construction projects.
S 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 – especially given that the causes and nature
of structural unemployment are still imperfectly understood. Complex problems and
difficult trade-offs face policy in this area. Many relate to fiscal constraints, and hence to
macroeconomic considerations. It will suffice to mention a few counterarguments:
S 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.
S 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.
S Population growth programmes take a very long time to take effect (given the built-in
demographic momentum).
S Some regulations benefit small business. Unqualified deregulation can merely create
unrestrained opportunities for large, capital-intensive corporations to enter and dom-
inate markets. Indiscriminate deregulation can also have a serious impact on the envir-
onment, or lead to unsafe working conditions for informal sector workers.
S Affirmative action and BBBEE programmes may create new forms of restriction on
occupational mobility and employment opportunities for certain groups, thereby
‘redistributing structural unemployment’.

S Land reform may be traumatic for existing farmers, distort the whole sector and actually
reduce total agricultural output and employment. This may affect the food security of
the country.
S Public works programmes, or special employment programmes, are difficult to design
and manage effectively. Numerous such programmes in the past have not always had
the desired effects. The scope and life span must also be controlled, lest they become an
uncontrolled drain on government expenditure.
S 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 share of total expenditure, and
acts somewhat as a straitjacket on efforts to improve the fiscal situation. 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 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.
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 like 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.
12.3.1 The definition and measurement of economic growth

Economic growth is defined as sustained, recurring annual increases in real GDP per
capita _N or at least in real GDP Y over time. Three elements are critical. First, it is all about
Y
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
12.3 Low economic growth 497

for the population of a country, but it does not constitute economic growth – just as an
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 ]]] 100
Yt–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.reservebank.co.za).
Quarterly data are available from 1960 onward.
The annual growth rate can be measured in two ways:
(a) As the percentage change in GDP between two years, e.g. between the GDP values for
the years 2010 and 2009; or
(b) As the percentage change between two corresponding quarters, i.e. between the GDP
values for the third quarter of 2010 and the third quarter of 2009.
The ‘corresponding quarter method’ provides an ‘annual’ (i.e. four-quarter) growth rate
more frequently and not only once a year.
A third method is to calculate the annualised percentage change between two successive
quarters, i.e. between the GDP values for the third quarter of 2010 and the second quarter
of 2010. 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.)
S One should be very careful when using these annualised measurements of the quarterly
GDP growth rate because temporary movements and shocks in GDP that tend to get
smoothed out over a year can register as large changes.
S When using any quarterly growth rates (either the second or third method above) it is
preferable to use seasonally-adjusted annualised GDP data.
The second and the third methods are frequently confused, with both often called the
growth rate ‘for the third quarter’. For the third method that is correct. For the second
method it is not quite correct – it is the ‘corresponding quarter’ growth rate, i.e. for the
preceding four quarters.
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. 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 below). Alternatively, one can smooth the growth rates by taking averages
over longer periods, as shown in table 12.7 below.

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 + nominal growth rate) ]

Method 2: Real growth rate = ]]]]]]]]] – 1 × 100
1 + 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%
Method 2: Real growth rate = ]]]] [(
1 + 0.15
1 + 0.10 ) ]
– 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 – 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 like the US, 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 developing countries.
Whilst 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,10 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
10 Maddison, A. 2003: The World Economy: Historical Statistics, Development Centre Studies, OECD, Paris. 2005:
Measuring and interpreting world economic performance 1500–2001. First Ruggles Lecture for the International Association
for Research in Income and Wealth. Review of Income and Wealth, 51(1), 1–35.

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.
The first two graphs (figures 12.10 and 12.11) 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 12.12 shows growth rates in per capita GDP for 1820 to 2001. Note that for
Figure 12.10 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 12.11 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

Figure 12.12 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
the period 1000 to 1820 some increases in per capita GDP (notably for Europe and later
the US) 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 US during the
1700s set the stage for its growth dominance after 1820.
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 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 only had its full impact 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 US, 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. (The US per capita growth rate dipped below
2% again after the oil crisis of the mid-1970s.) By 2000, the average standard of living of
US citizens was approximately three times as high as in 1950. Other First World 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 the Third World to a significant
extent for the first time. Yet the most distinguishing feature of this period is the failure of
many developing country groups to experience economic growth vaguely similar to that
of the First World. 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
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 exceeding 8%

The US experience
This graph shows more detailed per capita GDP data for the US for the period 1790 to 2006,
as well as a line indicating the underlying trend. (This is a semilog graph – see the box below
on ‘Logarithmic scales in graphs’.)
US real GDP per capita since 1790

50 000
35 000
25 000
15 000
10 000
5 000
3 500
2 500
1 500
1 000
500
1790
1800
1810
1820
1830
1840
1850
1860
1870
1880
1890
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
Source: www.measuringworth.org/usgdp
and 10% respectively after 2000. 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 2001–2005. Table
12.6 shows growth rates since 1986 for some individual SADC and other African countries.
They all did fairly well, with the notable exception of Zimbabwe since 1991.
Table 12.6 Five-year averages of GDP growth rates for some African countries
Time period Nigeria Egypt Ethiopia Kenya Moz’bique Namibia Botswana Swaziland Zimbabwe
1986 – 1990 5.7 4.9 5.3 5.6 5.0 5.0 12.0 10.3 4.6
1991 – 1995 2.7 3.4 1.4 1.6 2.8 4.5 4.4 3.0 1.4
1996 – 2000 3.2 5.9 5.1 2.2 9.5 3.5 8.0 2.8 0.9
2001 – 2005 4.0* 3.7 2.6* 3.6 8.8 4.6** 6.5 2.3 –5.4**
* = three-year average due to the lack of data ** = four-year average due to the lack of data
Source: IMF Financial Statistics (via Quantec)
Economic growth in South Africa

Since 1994 the South African government has launched two major policy initiatives, both
with a focus on growth. The first, launched in 1996, was the Growth, Employment and
Redistribution programme, better known under the acronym GEAR, while the second,

launched in 2006, is the Accelerated and Shared Table 12.7 Economic growth rates in South Africa
Growth Initiative South Africa, or ASGISA. Per capita
As noted earlier, for the most part GEAR was a Real GDP
real GDP
mainstream macroeconomic stabilisation policy growth
growth
aimed at ‘getting the basics right’ – through
1961–65 6.29 3.44
fiscal and monetary prudence – to lay the
foundation for a higher economic growth rate 1966–70 5.15 2.34
and higher employment (together with lower 1971–75 3.66 1.22
inflation). ASGISA identified what government
1976–80 3.12 0.72
called ‘binding constraints’ on economic growth
such as the lack of skills, the volatility of the 1981–85 1.40 –0.90
rand and the cost, efficiency and capacity of 1986–90 1.68 -0.48
the national logistics system. It then proposed 1991–95 0.89 –1.22
selective interventions aimed at addressing these
constraints. These interventions were to focus on 1996–2000 3.87 2.22
infrastructure, sector strategies, education and 2001–2005 4.49 3.23

skills, and public administration. 2006–2010
Figure 12.13 shows South African real GDP per Source: South African Reserve Bank
capita data for the period 1946 to 2006 (semilog
graph), while table 12.7 provides average growth rates. Due to industrialisation 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 economic growth, both in aggregate and per capita terms, has improved
significantly (see table 12.7). Yet poverty and unemployment in South Africa still hover at
very high levels. Nevertheless, in the context of the African continent, South Africa has
done well.
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.
S 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.
S Indeed, in the case of the US (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

Figure 12.13 The trend in real GDP per capita in South Africa
28 000
24 000
20 000
16 000

12 000
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
Values on y-axis are in constant 2000 prices – logarithmic scale.
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.
S A variable that grows at a constant rate will then trace out a straight line with a slope equal to the
growth rate.
S 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.


S 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.
S 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.
S A steeper area on a curve on a semilog graph implies a higher growth rate at that point in time.
S 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.
S 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.
S 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.
S 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 distribution in South Africa has increased in the fifteen years of high economic growth since
1994.


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.
S This brings one to the larger debate about the political and economic system, and how that system
can or should be improved to provide a more equitable pattern of living standards amongst the
people of the country.
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 m uch 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 Third World and the First World. Of particular relevance for us
is the failure of Africa, especially since 1950, to show significant growth performance as
compared to the First World 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.
S 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
below.)
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 unexpect-
edly point to the following basic causes of low growth, in developed countries as well as
in developing 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 developing 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
developing 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 saving 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
company saving, and (b) insufficient foreign saving and foreign investment. Both
of these are often ascribed to high personal tax and especially corporate tax rates in
developing countries (although some of the highest rates occur in some of the richest
counties).
S Foreign saving and investment may also be deterred due to risks associated with
emerging market or developing country status, exchange rate risks, and restric-
tions 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.)
S Remember that government dissaving only occurs when there is a current budget
deficit, i.e. when a conventional budget deficit exceeds government capital expen-
diture. 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 trans-
fer and technology adoption. Are all technologies good to imitate and
Given the thrust of the Solow adopt?
growth model, it is not sur-
A drawback of most developing countries is that,
prising that the conventional given limited own potential and resources to develop
approach has an intense focus new technologies, they are dependent on importing,
on ‘technological backward- adopting or imitating technologies from leading,
ness’ and slow technological developed countries. While this is cheaper and faster,
‘catch-up’ as a cause of low there is a question whether all these technologies
growth in developing coun- are appropriate for developing countries in terms of
tries. This can be linked, first, a technology’s skills requirements, its labour usage,
to insufficient investment in capital intensity, input needs, scale requirements,
capital (which often carries environmental implications, market requirements,
embedded technology). Sec- its social impact, and so forth, given the stage of
development of a particular country.
ond, low rates of foreign di-
rect investment can imply low
rates of technology transfer and technology adoption. This restricts the importation
of embedded technology in machinery and equipment.
7. Low rates of innovation. This is 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 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 below.)
8. Restriction on free international trade has been a favourite culprit identified by conven-
tional 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 developing 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 developing 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.
S The great irony of economic growth and development in developing 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.
S Note that HIV and Aids have turned around the drop in mortality rates since the
1990s. Life expectancy has fallen dramatically, notably in southern Africa.
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 view 11

As the discussion above indicated, economic growth in South Africa picked up since the
mid-1990s and especially since 2000. 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. 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.
Even though economic growth in South Africa has picked up since the mid-1990s and
especially since 2000, the growth rate is still lower than the growth rates registered in
some other emerging market countries. The question is, why?
11 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.

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 con-
ventional 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 developing countries do have higher standards of living than their predecessors,
their material position relative to those in developed 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 below.
HIV/Aids and low economic growth

statements:
Y
1. The fact that there is a loss of skilled people (human capital loss / ‘depreciation’), hurts ]
N
(‘it causes the growth rate in per capita income to decrease’).
2. The fact that the population growth (i.e. n) declines as life expectancy declines, benefits ] Y
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 from 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
like 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.
S 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.
S 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.
S 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 only increases temporarily – a heavy price
to pay for a short-term benefit with no change to the long-term per capita growth path.
S 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 developing 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 below).
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 New views – the deeper dimensions of growth12

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 developing 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.
12 This section draws on Snowdon B & Vane HR 2005: Modern Macroeconomics, Edward Elgar, chs 10 & 11.

Growth and human development – HDI vs. per capita GDP
In thinking about economic growth and human development, it is important to know that per capita
GDP growth is not a perfect indicator of human development. The following table shows correlation
coefficients between the HDI and its components (which include per capita GDP).
Correlation coefficients between the 2006 HDI, GDP per capita and HDI components
Life Adult literacy Combined gross Per capita

expectancy at rate enrolment ratio in GDP
birth education
Correlation with
0.91 0.87 0.88 0.72
HDI
Correlation with
0.60 0.49 0.59 1
per capita GDP
For the components of the HDI, the lowest correlation (0.72) is between GDP per capita and the HDI
value (though it still is a high correlation). Compared to GDP per capita, the other components of the
HDI would constitute better single indicators of human development (if we accept the HDI as a good
indicator of human development).
The correlation coefficients between GDP per capita and other components of the HDI are even lower,
between 0.49 and 0.60. Although these are not weak correlations, they are not very strong either.
These moderate correlations indicate that people living in countries with a higher GDP per capita will
probably but not necessarily also be in countries with higher life expectancy, a higher adult literacy rate
and a higher enrolment in schools.
S There are more than a few exceptions where GDP per capita is not a good indicator of the level of
human development – where a relatively high per capita GDP is associated with relatively lower levels
of all or some of the other human development indicators (as is the case in South Africa).
S Likewise, in some countries a relatively low GDP per capita is associated with relatively higher levels
of all or some of the other indicators (see Egypt).
Therefore, when using per capita income to evaluate human development, one must do so in conjunction
with several other variables, such as literacy rates and life expectancy.
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 regularly on political and
policy debates.
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.
S A related theory is the so-called Kutznets 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.
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) has 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 in-
stability, 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 amongst 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?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
In the end, a country must find a balance between the disincentive costs of high taxation
and the benefits of reduced social tension due to redistribution. If not, the negative effects
of political instability 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 developing 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 above (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; see footnote 3) 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:
S The size and capacity of government to support economic activity and growth in a
complex, competitive, globalised world economy.
S The ability and clout of a central bank to provide a stable and secure monetary, financial
and banking environment.
S 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.
S 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:
S Formal legal aspects: the constitutional framework, the rule of law, property rights,
patent and intellectual property laws, enforcement of contracts, tax law and adminis-
tration, the company law framework, labour law, competition law and policy, general
law and order, and so forth;
S Managerial and organisational aspects: dominant traditions of organisation and man-
agement, effectiveness of government service delivery, administrative competence of
government, management techniques, typical style of doing business, work ethic, mo-
tivational make-up, etc.
S 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;
S 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.
S 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.

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:
S 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.
S 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.
S 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.
S 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.
Of course, such kinds of behaviour are not unique to developing countries. However, because
First World countries do not have a ‘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 developing
world. 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. These views also seem to ignore
more subtle modern forms of kleptocracy, e.g. government officials and politicians in more
developed countries who come from ‘big business’ or ‘big oil’ and go into government and
promote policies that benefit those sectors.
S Institutional progress can flow from social and institutional policies that change busi-
ness 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 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.
Different cultures may also react to different incentives, especially as far as economic
behaviour and productivity are concerned. Many countries exhibit cultural attitudes
towards individual wealth accumulation that differ from the attitudes found in typical
developed countries. Such cultures often have 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 rather than exploiting it, and so forth. And such differences are not to be

judged summarily from a position of (colonialist?) First World superiority, but with true
insight into the role and place of such attitudes in the society where they are embedded.
S Broader cultural change may result from intrinsic societal developments and/or due to
influences from other countries, especially in an era of increased global communication
and information flows (television, the internet, etc.).
Trust, ethnicity and social division

Trust amongst 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.
S 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. 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.
S 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.
S 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.
S Distance from the major global markets significantly increases transport costs, worsens
the terms of trade for exporters, and inhibits integration with the world economy.
S The perceptual distance between some developing countries and most developed
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 developed countries in the northern
hemisphere. (The development of the internet has shrunk this perceptual distance
considerably, though, once initial contact has been established.)
S 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.
S Climate and soil conditions are decisive for agriculture 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 Colonialism and low economic growth in Africa

In Africa there is great sensitivity regarding the impact of slavery, colonialism and racism
on the welfare of African countries and their people over the centuries. Although most of
Africa’s colonial relationship with Europe lasted a relatively short period (mostly from the
1880s to the 1960s), the historic record seems to suggest that colonialism nonetheless
exerted enormous influence on Africa’s post-colonial economic performance. But there is
little consensus on whether that role has been positive or negative. A wide range of views
can be found, often reflecting either of the following two sentiments:
1. The modernisation thesis: Although colonial powers exploited Africa’s natural resources,
without it economic growth would have been much lower. Colonialism brought infrastructure,
natural resource development, capital, formal education, modern health care, communication,
exportable agricultural crops, some industries, technology, and more efficient social, economic
and political institutions, etc. to Africa. On balance, colonialism reduced the economic gap
between Africa and the West, promoted the integration of colonies into the world economy,
and laid the seeds for modernisation and the intellectual and material development in Africa.
This fostered the modernisation of colonies that otherwise would not have occurred. Without
colonialism Africa would have been further behind relative to other countries. Africa’s dismal
growth record after decolonisation shows that it hasn’t exploited the legacy of colonial rule, or
does not have the culture or the capacity to do so. A major cause of continued low growth and
underdevelopment is autocratic rule, the corrupt and inefficient management of the economy,
greed, hunger for power, disrespect for human rights, cronyism, and so forth.
2. The ‘drain of wealth’ thesis. In this view the modernisation thesis is paternalistic and racist.
The colonial experience left Africans poorer than they were before it began. While African
natural resources and labour were exploited, the continent’s capacity to grow and develop
was undermined. African economies were structured to be reliant on one or two commodities,
either agricultural or mineral. Their purpose was to produce primary goods for the industrial
economies of the West – indigenous industrial development was not a priority. This made
African countries permanently dependent on exports to Western countries and reliant on
imports of manufactured goods from those countries. Controls on trade were used to keep
African countries in weaker positions. Infrastructure development, education systems and
institutions were designed to serve colonial interests in the first instance. This left African
countries with dysfunctional institutions after independence. The artificial redrawing of borders
disrupted pre-colonial political systems and sowed the seeds for political and ethnic conflict.
Corrupt governments came from the structuring of resource exploitation to benefit a small
post-independence elite.
A small but growing research literature is starting to provide some evidence relevant
to these competing views. Empirical results suggest that many of the factors listed in
section 12.3.4 above help explain growth differences across developing countries, also
in Africa. More important is that recent cross-country statistical research suggests that
the role of colonialism in African countries (as against that in other colonies) has been
quite complex.13
13 This section draws on Masanjala, WH & Papageorgiou C 2005: Initial Conditions, European Colonialism and Africa’s
Growth, Working Paper 2006–01, Louisiana State University: http://www.bus.lsu.edu/economics/papers/pap06_01.
pdf

A pertinent observation is that non-African colonies (e.g. in South America and East
Asia) have in general not displayed the same faltering growth record as African colonies.
Thus colonialism alone cannot explain the poor African growth record. There must be
something else. This appears to be a complex interplay between geography and colonialism.
The following factors are noted:
First, at independence the colonialists bequeathed less developed economies to Africans
than they did to colonies in other regions. For Africa, much more than in the global
context, mining (the portion of GDP related to mining) is the dominant explanation of
growth. The legacy from the colonial period was a very narrow economic basis, and more
so than in non-African colonies.
S In 1960, African economies were almost three times as reliant on output from mining.
While primary commodities comprised about 61% of exports in the rest of the world,
in Africa they accounted for 88% of the exports.
Second, Africa’s geographical factors and endowments have also put Africa at an economic
disadvantage compared to other colonies.
S Relative to countries in other regions, many African countries have been, and are, less
able to benefit from scale economies because they are smaller in area.
S Exports from many African countries may be internationally uncompetitive due to high
transportation costs and lack of direct access to the sea (i.e. being landlocked).
Third, geography in the form of tropical location and the resulting prevalence of malaria
has a major role in explaining low African growth as against other regions of the world.
S African countries are more tightly wrapped around the equator – 92% of sub-Saharan
Africa’s land area lies between the tropics of Cancer and Capricorn. It is not surprising
that malaria is endemic in 88% of these countries.
The latter factor, in combination with others, may have been decisive in determining
the pattern, nature and duration of colonialism in African countries. More specifically, a
peculiar interplay between Africa’s geography, ecology and colonialism may have caused
a differential impact on Africa compared to the rest of the developing world and other
former colonies. This may have occurred as follows:
1. Climatic conditions, tropical conditions and the prevalence of malaria did not favour
permanent European settlement in large parts of Africa, notably sub-Saharan
Africa.
2. Thus Europeans established ‘extractive colonies’ – i.e. colonies and institutions
intentionally based on a narrow but intensive mining base, which enabled effective
and profitable exploitation with only a small European presence.
3. In the process, mining-related institutions strong enough to persist after independence
were created.
4. However, the model also required the empowerment and co-option of a small
indigenous elite to be part of managing the extractive process.
5. This form of colonialism then left the country with a narrow economic base, a skewed
and constricted institutional profile, and a system vulnerable to abuse and rent-
seeking by post-colonial elites when they assumed political power at independence.
The dominance of mining in GDP of African post-colonies may actually reflect the legacy
of these extractive colonial institutions. This legacy does not reflect geography as much as
it reflects the persistence of institutions that make rent-seeking easier.

A related explanation is that, except for South Africa, most of the African colonial period
proper was much shorter – approximately 70 to 100 years – than the South American
and East Asian colonial periods, which were more than 300 years. European settlers
came to Africa relatively late, extracted as much as they could and left early. Therefore the
potential positive legacy of colonialism on institutions and institutional capacity – notably
the broader development of institutional and human capacity as well as modernisation in
general – was more limited in many African countries. This increased their vulnerability
to post-independence exploitation by political elites as well as by economically powerful
countries in a globalising world economy.
S Africa started its post-colonial existence with a very low level of human development. In
Africa only 2% of the population aged 25 years and over had any secondary education in
contrast to a range of 11% of the corresponding population in all developing countries
to 21% globally.
A further possible explanatory factor is that, whereas religion (e.g. whether Catholic or
Muslim) and the prominence of a European language are important positive colonial
legacies in statistically explaining growth patterns in non-African former colonies, in
Africa these factors are not statistically significant. Churches played a much smaller
formal role in the colonisation and exploitation of Africa than, for example, the Roman
Catholic church in South America.
So, post-independence conditions reveal that colonialism has had a lasting legacy on
post-colonial economic growth in Africa. The main causality appears to lie in a complex
conjunction of especially three factors: geography, ecology and colonialism.
Nevertheless, it still is unclear whether the net effect of this colonial interplay impacted on
Africa negatively or positively. There are no substantive counter-examples to gauge what
Africa’s economic performance would have been had Africa not been colonised. Similarly,
it cannot be determined whether current economic performance would have been better
had African countries remained colonies.
Different countries are likely to exhibit different mixes of the two theses outlined above.
What does appear relatively clear is that colonies with favourable geography and ecology
developed better than those with poor geography and ecology. It also seems that in regions
with comparable climatological factors, the level of economic development was positively
correlated with the duration of the colonial period.
Whatever the net effect of colonialism may have been, the key issue is how to address
the current and future problems and prospects of African countries. In this regard, the
factors listed in section 12.3.4, in addition to the conventional diagnosis of low growth,
are all relevant. An analysis of the colonial legacy may be useful to highlight factors that
continue to inhibit growth and development or make countries vulnerable to negative
political, institutional and cultural forces.
12.3.6 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 90s, many considered the views of the Club of Rome as Neo-Malthusian
scaremongering. The pursuit of economic growth continued unabated, with developing
nations joining eagerly.
Although overly pessimistic, the Club of Rome was not wrong about the intrinsic nature
of the threat. Environmental concerns increased. In several countries ‘green’ parties
started to play an increasing political role. Environmental action groups like Greenpeace
became more activist. 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 US, 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 was turning against an unqualified pursuit of traditional forms of
economic growth. In 2006/7 the environment was suddenly high on the social and
political agenda, even in the US. This followed the Stern Report (a UK government report),
former US vice-president Al Gore’s documentary An Inconvenient Truth, and the report of
the Intergovernmental Panel on Climate Change (IPCC).14
Their collective assessments and predictions are quite dire. The period 1995 to 2006 was
the warmest period since the collection of data in 1850. 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, with a 50% probability that it might increase by 5°C – the increase in
temperature between the ice age and today! 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.
14 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.

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 come to a halt,
suffocated by its own excesses and emissions.
12.3.7 Last thoughts on 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
became 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 developing countries. The discussion above 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 institutions, government institutions, constitutional and legal frameworks, political
regimes, physical infrastructure, social infrastructure, health and education systems,
technology development and adoption, and so forth.
The second is that economic growth, as witnessed in the First World 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 – and persistent
inequalities in the economic and political power relations between the First and Third
Worlds. The high rates of growth experience by the West in the previous century are not
sustainable for the whole world.
These are difficult and emotional issues – compare the contrasting views about the impact
of slavery, colonialism and racism on economic development in Africa and other developing
countries. Yet they absolutely demand careful consideration and a willingness to probe
beyond the scope of conventional economics. Obviously, such complexities 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 turn embedded in a
larger understanding of the problems of sustainable growth and development of a global
economy. 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. Ultimately,
however, the issue also reaches far beyond economics to other social sciences and the
natural sciences.

12.4 A final thought – the structural dimension of macroeconomic
problems
The discussion of inflation, unemployment and low growth, three of the main macroeco-
nomic 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 structur-
alist 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 un-
employment, 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.

Index
A in Phillips-curve model 284-92

mathematics 228, 255
Ability to pay (tax) 395 Monetarist view of 445
Accommodation shifts 229
in money market 80, 86, 91, 163, 187, 351 slope 228
of inflationary expectations 464, 469-70 together with AS 254-75
of popular demands 464 and inflation 459, 461-72
of supply-side shocks 270, 467-469 Agriculture 483, 492-4, 496, 501, 507, 509, 516,
Accrual basis 376, 429, 434 518
Administration lag: see Policy lags Anticyclical policy: see Stabilisation policy
AD-AS model 221-81 Aggregate supply (AS) 221, 224, 231-54
equilibrium in 254-5 adjustment process 252-4, 459-69, 484-5, 511
equilibrium, mathematics of 255 derivation 233-54
essentials 223-5 determinants 231
and AD-PC model 284-6 inflation-augmented 284-6, 459, 461
and economic growth 223, 231, 233, 241, 244, long run (ASLR) 239-48
248, 257, 271-2, 276 long run and short run 231, 254-75, 292-5,
and inflation 221-4, 258, 276, 283-6, 459, 461 461-4, 484-6, 495
see also Aggregate demand; Aggregate supply mathematics of 239, 246, 251, 255
AD-PC model 284-92 Monetarist view of 446
basic operation 284-6 New Classical view 447-8
examples 286-9 shocks 265-70, 275, 289, 307, 463, 471, 484,
mathematics 297 492
and augmented Phillips-curve 290 short run (ASLR) 248-54, 294
and demand expansion 286-9 together with AD 254-75, 459
and monetary reaction function 298-304 and growth 233, 271-2, 307-10, 506-9, 511
and Phillips curve 292-9 and inflation 461-72
and policy lessons 290-2, 295-8 and labour market 233-7
and steady-state inflation 284 and Phillips (PC) curve 284-9, 294-5
and supply shocks 289 and price-setting relationship 233, 236-8
Affirmative action 387, 494-6 and taxation 378
Africa and wage-setting relationship 234-8
colonialism in 519-21 and (un)employment 239-44, 249-54, 484-9,
ethnicity, and growth 518 490, 492
geography, and growth 518 Aids: see HIV/Aids
growth rates 500-2, 506, 510, 518 ANC (African National Congress) 34-6
unemployment in 451 Anti-inflationary policy: see Inflation, policy
Aggregate demand (AD) 220-1, 225-30 Apartheid
derivation in IS-LM model 227 and capitalism 33-36
inflation-augmented 284-6 and unemployment measurement 483
Index 525
chapter 13Index.indd 525 9/3/09 3:44:44 PM

Appreciation (currency) 136, 138, 140, 153, 156-8, Budget
164, 167, 179, 183, 185-6, 191, 193, 261, data: see Budget Review
263,370 process 397, 404-7
ASGISA 20, 28, 503 role of Reserve Bank 376, 380, 405
Augmented Phillips curve 290-1, 295 Budget balances: see Budget deficits (various)
Automatic stabilisers 64, 397 Budget cycle: see Budget, process
Average tax rates: see Tax rates Budget deficit, conventional
effect of financing on real sector 100-3, 172,
B 379, 402-3
financing methods 100-3, 367-9, 402-3, 416
BA rate 73-4, 88 in budget identity 385, 406
Balance of payments (BoP) 146-52 in national accounting identities 202-3, 205-7,
adjustment process 149-52, 161-71, 183-94, 212
260-9, 279-81 measurement 203-7, 399, 434
as a policy objective 11, 19, 27, 364, 372, 471 relevance as fiscal norm 415-7
constraint 17, 152, 162, 165, 167, 187-9, 471, Reserve Bank role 403, 411
493 rules for 415-6, 426
definition, data and measurement 130, 146-7 SA data 399-402, 414, 434
determinants 148, 160 and accommodating monetary policy 436
equilibrium/disequilibrium 149, 152, 161-2, and anti-cyclical policy 398
166-7, 186-7, 260-9, 279-81 and balance of payments 103, 142, 145, 172,
pros and cons of a deficit/surplus 17, 173 403
SA data 131, 146-7 and business cycle 398, 401-2
and exchange rates 152, 156, 160 and crowding out of exports 172
and foreign reserves 149, 173 and economic growth 402
and inflation 471, 474 and financial account 142, 172
and money supply 151-2, 160, 372 and foreign borrowing 145, 403
see also Capital account; Capital flows; Current and inflation 403, 417, 425
account and the ‘printing press’ 102
Balanced budget 398, 417, 425, 438 and public debt management 412
rule 417, 438 see also Fiscal rules; Government borrowing;
Bankers’ acceptances (BAs) 73-4, 88 Public debt
Bank rate 81, 128, 351, 356 Budget deficit, current 203, 212, 384, 399, 413,
see also Repo rate 418-21
Barro, Robert 447 relevance as fiscal norm 418-21, 425
BBBEE 495, 497 SA data on 212, 414
Bonds 73, 76, 82-4, 89, 100, 102, 403, 411-2, 417, and BoP current account 420-1
424 see also Dissaving; Sectoral balance identities
Borrowing, foreign: see Foreign borrowing Budget deficit, cyclically adjusted; see Budget
Borrowing, government: see Government borrowing deficit, structural
Borrowing requirement: see Government borrowing Budget deficit, operational 417
Bottlenecks (in aggregate supply) 136, 250, 464, Budget deficit, primary 399, 414, 421-2
472 relevance as fiscal norm 422-3
BP curve 181-7 SA data on 414, 426
derivation 181 and sustainability 423-6
shifts 183 Budget deficit, structural 399, 402
slope 182-3 Budget identity 385-6, 406
USA case 182-3 Budget Review 376, 390, 399, 429, 432
see also IS-LM-BP model Business cycles 134
Bracket creep 17, 397, 406, 427 importance of understanding 10
as fiscal drag 397 taxation and 396-7
Bretton Woods agreement 159 SA data 39
and budget deficit 398, 401-2

and current account 173-4, 176 Capital market 71, 353, 383
and fiscal policy 396-7 see also Money market
and macroeconomic policy 11 Capital mobility 144-5, 166, 172, 174, 176, 182-4,
and poverty 483 188, 190-1
and unemployment 176-7 Cash flow basis 376, 429, 434
see also Stabilisation; Stability Cash reserve requirement 79-80, 95, 351
Business sector view: see Policy objectives and size of credit multiplier 79-80
see also Monetary policy
C Causality 195, 199-201, 204, 207, 214, 443, 460,
469
Cabinet, role of 61, 376, 379-80, 405-6 Cause and effect: see Causality
Capital account: see Financial account Ceilings, credit and interest rate 351
Capital expenditure: see Capital formation; Central Bank: see Reserve Bank
Government Central government: see Government
expenditure; Government capital formation Chain reactions 1-2, 37, 42, 67
Capital flows 130, 142-6, 182 closed economy: 1 sector 42-4, 55-6
basic determinants 143-4 closed economy: 2 sector 69, 88, 92-8, 103-4,
impact on economy 145-6, 152, 165, 176 117-20,
in AD-AS chain reactions 260-70 open economy: 3 sector 129, 148, 162-71,
in balance of payments table 147 187-93
in national accounting identities 207-9 with a variable price level 221, 224-5, 256,
in open economy chain reactions 162, 166-70, 258-9, 260-70
187-93, 260-70 Change in reserves
SA data 147, 208 in gold and other foreign reserves 207
and BP curve 181 in gross gold and other foreign reserves 150
and budget deficit 142, 403 in gross reserves 210n, 212, 211
and macroeconomic policy 369, 403 in liabilities related to reserves 207, 210n, 212
see also Capital mobility; Financial account; Net in net reserves 212
capital inflow from the rest of the world in net gold and other reserves owing to balance of
Capital formation 44, 50-5 payments transactions 147, 150
determinants 52-4 Circular flow: see Income-expenditure flow
financial vs. real 50, 72-4, 142 Class 30, 33
fixed vs. inventory 51 Classical liberalism: see Liberalism
foreign: see Foreign investment Classical School/model 11, 53, 84-5, 202, 270, 312,
government: see Government investment 334-9, 344, 351, 363, 369, 30-35, 43, 94,
gross domestic 204, 207-9, 210-4 123-5, 377, 420, 441-7, 449
gross vs. net 51 Climate change 522
investment function 52 Cold turkey, approach to policy 303
in Classical model 442-3 Colonialism 519-21
in 45° model 54 Commercial rand: see Financial Rand
in national accounting identities 195, 197-8, Communism 33-6
200, 210-4 Competition, atomistic or ‘perfect’ 442
interest sensitivity of 96, 98-9, 109, 230 Concentration (of economic power) 473-4, 509
opportunity cost of 52 Constant prices, measurement in 38, 223
SA data 45, 51, 199, 202-4, 208, 211-2 see also Real values
savings balance/gap 202n, 201-7, 394, 419-21 Constraints on policy 14, 17, 25-6, 158, 371,
and crowding in 98-9 381-8, 410, 420-1
and financial account 142 Consumer price index (CPI) 223, 227, 456-7
and political factors 143-5, 199 Consumption 46-50
and real vs. nominal interest rates 53 function 46-7
see also Crowding out in Monetarist view 445
Capital intensity 493 in national accounting identities 198, 201, 209,
Capitalism, and apartheid 33 211
Index 527

Keynesian approach 48 Debt trap: see Public debt
life-cycle approach 49 Deficit: see Balance of Payments; Budget deficit;
permanent income approach 48 Current account; Financial account
SA data 45 Deflation 287, 499
smoothing 49 of nominal values 223, 272
and interest rates 352, 377 De Kock Commission 358
and taxation 62 De Kock, Gerhard 27, 358, 411
Cosatu 20, 35, 304, 380 Demand, aggregate: see Aggregate demand
see also Labour unions Demand-pull: see Inflation
Cost-plus prices 474 Demographic factors 492, 496
see also Mark-up see also Population growth
Cost-push: see Inflation Department of Finance: see Fiscal policy; Treasury
CPI: see Consumer price index Depreciation (currency) 136, 140, 153, 155, 157,
CPIX 361 158, 186, 256, 324, 370
Credit: see Money supply causes of 171
Credit multiplier process 79, 80 see also Foreign reserves
Crowding in 98, 392 Depreciation (of capital goods) provision for 202,
Crowding out 24, 97-9, 119, 124-6, 377, 384, 389, 208, 210
403, 415-6, 435, 452 Depression, Great 15, 31-2, 43, 444
of exports 103, 172 Devaluation (currency) 136, 153, 159
Current account (balance of payments) 129, 131, Development 21-5
139-40, 146-7, 398, 418 as a policy objective 9, 11, 20-1, 374, 469, 482-3
as a policy consideration 17, 372, 384, 420-1, concept and measurement 21-3
471 indicators 23
causes of changes in 140, 157, 172 SA data, comparative 23
consequences of 160 vs. GDP growth 23, 513
in AD-AS model chain reactions 260-4 vs. income growth 21
in balance of payments table 139, 147 vs. redistribution 18, 24
in J curve 141 and colonialism 519, 521
in national accounting identities 201-9, 211-6, and fiscal policy 376, 386, 392, 395, 415, 426-8
383-5, 420 and growth 497, 499, 506, 512, 516, 523
in open economy chain reactions 162-73, 187-93 and inflation 469
pros and cons of a deficit/surplus 172-6, 17 and monetary policy 426
SA data 139, 204, 212 and taxation 395, 426-8
and aggregate expenditure 160 and unemployment 480-4, 487, 493
and BoP constraint 152 see also Growth
and business cycle 140-1 Diagrammatical aids, purpose 44
and inflation 16-7, 157, 471 Dichotomy, Classical 444, 446, 458, 461
and trade balance, net exports 137-8 Dirty floating: see Exchange rates
see also Balance of payments Discount on Treasury bills 72
Current budget/fiscal deficit: see Budget deficit, Discouraged workers 476
current Discretion (vs. rules), in policy 357, 415, 437, 452-3
Current expenditure by government 197, 201-3, see also Fiscal policy constraints; Fiscal rule;
205, 213 Monetary reaction function; Monetary rule;
see also Government expenditure Taylor rule
Current prices: see Deflation Disincentives (of taxation): see Tax
Cyclical forces, built-in 91, 164 Disintermediation 355
Disposable income 46, 64, 134, 202, 378
D Dissaving, government 203, 205, 209, 384, 418-21
in SNA identities 203-4
DA (Democratic Alliance) 36 SA data 208, 212
Decision lag: see Policy lags see also Budget deficit, current
Debt: see Budget deficit; Public debt Distribution of income: see Redistribution

Dollar: see USA rigidity and fiscal policy 167
Du Plessis, Barend 27, 382 rigidity and monetary policy 165, 189-90, 371
SA data 131, 154
E spot vs. forward 155
spread 154
Economically active population 475-7, 479, 492 and inflation 458, 467, 471
Economic classification (of government expenditure) see also Fixed exchange rate effect; Flexible
385 exchange rate effect
Economic growth: see Growth Excise duties 377-8, 396
Economic power: see Concentration Exogenous money supply 87
Education, indicators of 23 Expansionary (vs. contractionary) policy 63, 100-3,
see also Development; Indicators, social 117-20, 399, 436, 464-7
Efficiency: see Tax efficiency see also Chain reactions
Elasticities Expectations 46, 52, 76, 143, 148, 229, 232-3,
versus sensitivity 52 440, 449, 482
see also Sensitivity price, wage and inflation 229, 232-42, 249-54,
Employment: see Unemployment 284-95, 464-471
Entitlements 387 rational 447-9
see also Pensions Expenditure, Government: see Government
Environment, and growth 521-3 Expenditure
Equilibrium, macroeconomic Expenditure on gross domestic product 65-6, 138,
conditions for 42, 55, 66 196, 201, 219
in 450 diagram 44, 55, 66 Expenditure reduction/switching 178
in AD-AS model 224, 254-6 Exports 44, 58, 64-6, 97, 136-42, 168-9, 192-3
in AD-AS-BP model 181 crowding out of 103, 172
in AD-PC model 285 determinants 137
in IS-LM model 104-6, 111-2, 115, 117-8, 180 impact on economy 138, 168-9, 192-3
Keynesian concept of 43, 55 in 45° diagram 66, 137-8
and SNA identities 197 in AD-AS model 226, 255-6
see also Multiplier, expenditure in IS-LM model 107-8, 121, 179, 192-3
Equity objectives: see Redistribution in IS-LM-BP model 185
Equity, tax: see Tax equity net exports 44, 65, 132, 137-8, 140, 142, 147,
Excess reserves (banks) 80, 352 199
Exchange rate 130, 152-60 SA data 65, 131, 139, 147, 198, 199
as policy objective: see policy volumes vs. values 141
buying and selling rates 154 and expenditure multiplier 140
definition 130, 134, 152 and trade balance, current account 138
determinants 155-7 see also Foreign sector; Imports
determination in forex markets 155 External disturbances 168-9
dirty floating 158, 369 chain reactions following 168, 184
effective 153 general method to analyse 170-1
fixed vs. floating 158-9 in AD-AS model 266-9, 280
impact of balance of payments on 152, 156, 160 in IS-LM-BP model 184-6
in AD-AS model chain reactions 260-5 see also Internal disturbances
in balance of payments adjustment process External sector: see Foreign sector
163-76 External value of the rand 130, 135, 153
long-term prospects 156-7 see also Exchange rate
nominal 153 Extrabudgetary institutions/funds 376, 400-1, 429,
overvalued, undervalued 370 434
policy 25, 158-9, 350, 353, 369-72, 454, 457
pros and cons of a weak/strong rand 173, 370
real 153
real effective 153
Index 529

F rules 394, 415-7
SA data 388, 389, 393, 395, 400, 402, 407-9,
Factor cost, measurement at 195, 211, 212, 217-20 414, 419, 421n, 426, 429-34
Finance, Department of: see Treasury sustainability of 421-6
Finance, Minister of: see Minister of Finance targets 385
Financial account 103, 130, 142-6, 160, 174 vs. monetary policy 452-3
as a policy consideration 17, 26, 176 and business cycles 402, 416
impact on exchange rate 160 and crowding out 97-9, 100, 103, 172, 377-8,
impact on monetary sector/money supply 160 384, 403, 415
in national accounting identities 207-9 and development 20, 24-5, 426-8
in open economy chain reactions 163-71 and economic growth 379, 381, 401, 511
in AD-AS chain reactions 255-69 and inflation 474
in IS-LM-BP model 181-3, 187-93 and policy lags 438-40
SA data 143 and political factors 406
and capital formation 142 and public debt management 377, 407-12
Financial institutions: see Monetary policy; and unemployment 495
Monetary sector see also Government expenditure; Policy
Financial year: see Fiscal year objectives; Taxation
Financial and Fiscal Commission 373, 380, 406 Fiscal year 377, 390-1, 406, 415, 429, 432
Financial rand 143n Flexible exchange rate effect 165, 167, 170, 186-7
Financing of budget deficit: see Deficit; Government Forecasting 440-1
borrowing Foreign borrowing/debt/loans 17, 142, 145, 172,
Financing of gross domestic formation 203, 207-9, and balance of payments position 17, 152
210-1 and budget 145, 172
Fine-tuning: see Stabilisation policy and foreign reserves 17
Finrand: see Financial rand see also Capital flows
Fiscal authority 373 Foreign exchange markets 155
see also Fiscal policy; Treasury and exchange rates 151, 155
Fiscal balances: see Budget deficits institutional arrangements 155
Fiscal deficit: see Budget deficit operation 155
Fiscal discipline 382, 388, 408, 412-26 Foreign investment 17-8, 143
Fiscal drag: see Bracket creep Foreign loans: see Foreign borrowing
Fiscal federalism: see Government, provincial Foreign reserves
Fiscal norms 374, 409, 412-26 as policy consideration 17-8, 176-7
see also Fiscal discipline gross vs. net 150
Fiscal policy 61, 373-434 impact of balance of payments position on 163-4,
constraints 383-9 166-8, 188-9, 190-1, 192-3
definition 375-7 importance of 151, 158
development of 382-3 in national accounting identities 207-9, 211
fixed commitments 386-8 SA data on 147, 148-9, 150-1
in AD-AS model 222, 229, 255-8, 263-5, 270-1, and currency depreciation 158-9
277 Foreign sector 129-194
in IS-LM model 118, 124-6 data on 131, 133, 139, 141, 147, 150
in IS-LM-BP model 166-7, 190-1 location in circular flow 130
institutions and processes 375-80, 404-7 with variable price level 222
instruments 377-9 see also Balance of payments; Exchange rate
measurement 59, 375-6, 390, 394, 399, 429-34 Forex markets: see Foreign exchange markets
mission/objectives 380-3 Formal sector 476n, 479, 481, 482,
Monetarist view 377, 382, 391, 415-6, 420, see also Informal sector; Small business
452-4 Freedom Charter 34
open economy chain reaction 166-7, 190-1 Freedom, individual 452
potency of 97-9, 124-6, 167, 230, 452-3 Friedman, Milton 32, 48, 444, 445, 447, 458
Reserve Bank role 380, 403, 410-2

Full employment 43, 221, 239, 242-3, 361, 444, SA data 400
446, 485-6, 487, 490, 495-7 see also Budget deficit; Public debt
as policy objective 361, 495-7 Government capital formation 25, 57, 153, 159,
definition 242-3 275, 282, 311n, 321
in Classical model 442-4 definition in national accounts 60
in Keynesian model 43, 221, 443, 490-1 in SNA identities 153, 159, 159n
in Monetarist(/New Classical) model 444, 446, investment in human capital 277, 311
485-6, 490-1 SA data 28, 60
and structural unemployment 242-3 Government expenditure 59-64, 377-9, 383,
see also Unemployment 388-94, 426-8
Functional classification (of government budget process 404-6
expenditure) 385n components 60, 387-9
current, consumption, capital 197, 302-3, 385-7
G economic/functional classification 385
financing of: see Budget deficit
GCF: see Capital formation in 45° model 45, 59-62, 97-9,
GDE: see Gross domestic expenditure in AD-AS model 224, 248, 255, 257, 263-5
GDI: see Capital formation in IS-LM model 104, 108, 117, 124-6, 190-1
GDP: see Gross domestic product in open economy chain reactions 166-7, 190-1
GEAR 35, 382-5, 401, 405, 408, 416 measurement and data systems 59-60, 376, 390,
General government 45-6, 51, 59-61, 197, 203, 429-33
210, 375-7, 384, 390, 399, 406, 429 non-interest current 387, 399, 406, 421-2,
in the main budget 377, 384, 390, 394, 399, 431-2
406, 429 on economic services 377
in national accounts 210-11, 429-34 on social services 377, 383, 385, 387-9, 428
see also Government ratio 390-1
General Theory of Employment 31, 444 SA data 45, 60, 388-91, 429-33
GFS (Government Finance Statistics) 59, 375, secondary effect 97-9
413-4, 429,431, 434 targets/rules 382, 391, 394, 415-6, 421
see also SNA and bracket creep 397, 406
Gini coefficient 18 and crowding out (see also Crowding out) 98-99
GNP (gross national product) 211, 219 and development 241, 374-6, 381-3, 386, 426-8
SA data 212 and economic growth 379, 386, 388, 392, 426-8
Goals, of macroeconomic policy 11-23 and expenditure multiplier 62
Gold and public debt cost 407, 430-1
marketing by Reserve Bank 350 and redistribution 20
price 11, 37, 43, 397, 492-3 see also Fiscal policy
and rand, dollar 129, 145, 174-5 Government investment: see Government capital
Gold and other foreign reserves: see Foreign reserves formation
Gordhan, Pravin 383 Government wages: see Remuneration
Government Grey market (for credit) 355
general, central, national: see General Gradualism (policy) 301, 464, 470-1
Government Gross (vs. net values) 51, 150
measuring 376 Gross domestic expenditure (GDE) 65, 138, 195,
provincial, local 376, 390, 399, 429, 434 201n, 212, 219
role of 4, 28-33, 35 Gross domestic product (GDP) 12, 21, 38
vs. state, public sector 375 at market prices vs. factor cost 217
and economic growth 377, 379, 381-3, 386, 392 expenditure on 195, 201n, 210-2, 214, 219-20
and private sector 392 fluctuations 13, 39, 42
see also Public sector growth rates 12-4
Government bonds: see Bonds; Treasury Bills per capita 12-4
Government borrowing 61, 70, 100-3, 172, 366-9, SA data 12-4, 39, 42
379
Index 531

versus GNP (gross national product) 211, 219 and semilog graphs 504
and development 21-3 and sustainability 14, 423-6
Growth, economic 9, 11-4, 37, 42-3, 146, 152, and taxation 394-8, 506-8, 511-2, 514, 516
209, 386, 307-46, 388, 455, 497-523 and technology 309-17, 322-4, 330-5, 336-40,
African rates of 500-2 501, 507-10, 513, 515-9, 523
as policy objective 11-4, 152, 307, 381-2, 392-3, and trust 518
420, 426-8, 464, 499, 502-4, 523 see also Development
balanced 307, 310, 318-32, 343-6
basic theory 308-16 H
causes of 506-10, 512-8
convergence 332-3 HIV/Aids 11, 248, 329-30, 335, 337, 492, 509,
costs 14, 521-3 511
definition 38, 497-9 Horizontal equity: see Tax equity
example of ratios and numbers 343-6 Horwood, Owen 382
history of 500-2 Housing, indicators of
in developed and developing countries 332-3, see Indicators, social
499-502 Human capital 309, 310, 317, 330, 333-40, 492,
international comparisons 500-2 497, 506-510, 514, 521
jobless 489 Human Development Index (HDI) 22-3, 334, 513
measurement of 38, 479-9 SA data 23
Monetarist views 420 see also Development
political barriers to 517
per capita 12, 21-4, 307-9, 314-32, 498, 500-3 I
real vs. nominal 38, 308
remedies 511-2 Icons 5
required rate 490 Identities
SA data on 12-4, 339, 426, 502-4 defined 196-207
Solow model uses and abuses 198-200
sources of 20-1, 27-8, 514 see also National income identity; Sectoral balance
and budget deficit 407-8, 423-5, 508 identities
and Cobb-Douglas production function 311, 341 Ideology 31, 34-5, 523
and colonialism 519-21 and schools of thought 441
and culture 517 IMF (International Monetary Fund) 27, 150, 380,
and development 21-2, 24-5 393, 415
and employment/unemployment 12-3, 480-2, Imports 17, 26, 38, 44-5, 64-7, 130, 132-6
485-490, 493-5 definition 133
and environment 521-3 determinants of 131-6, 177
and ethnicity 505, 517-8 impact on GDP 66
and fiscal policy 386, 388, 391-2, 420, 508, 511 in 45° diagram 44, 64-7
and geography 518 in AD-AS model 222, 226, 229, 255-264
and HIV/Aids 11, 330, 336, 492, 509-10 in IS-LM model 107-8, 117, 178-80
and human capital 309, 310, 317, 330, 333-40, in IS-LM-BP model 181-7
492, 506-10, 512-4 in national accounts 195, 200-207, 209
and inequality 20, 24, 514-5, 523 income sensitivity of 134, 182
and inflation 464-7 marginal propensity to import 66, 135, 140, 179
and institutions 515-7 mathematics 134, 180
and natural resources 311, 317 SA data 65, 132, 133, 198-9, 212
and population growth 308, 313, 315, 318, 321, trade patterns 132
325, 329-30, 337, 509, 521 volumes vs. values 141
and production function (TP) 307, 310-2, 314-5 and business cycle 134, 140, 152, 173, 176, 209
and public debt 407-11, 423-6 and exchange rates 135-6, 156
and redistribution 223, 227-9, 231 and expenditure multiplier formula 58, 66, 180
and savings 420, 508 and foreign reserves 17, 150, 364

and J curve 141 and development 24, 426-7
and Marshall-Lerner condition 141 and exchange rate 152-4, 157, 160, 174, 177
and tariffs 177 and expectations 232-42, 249-54, 284-95,
and trade policy 177 464-471
see also Current account; Exports, net; Foreign and exports 16, 135, 137
sector and external value of the rand 153-4, 157, 160,
Incentives (and taxation): see Tax 174, 177, 364
Income 12-16, 37-44, 55-8 and fiscal drag 397
disposable, life-cycle, permanent, relative 46, and imports 16, 134-5, 178
48-50 and interest on public debt 417
distribution 18-20 and interest rate costs 96
equivalence with, production and expenditure 55, and money demand 75n, 75-7, 92
219 and money supply 82, 92, 358-9, 363, 365-6,
in Classical model 442-3 460, 462-4, 468
in national accounts 212 and Phillips curve 283-305
SA data 212 and political factors 464-7
and expenditure multiplier 57-8 and real exchange rate 153
and human development 21-3 and quality improvements 284
see also Gross domestic product (GDP); Real sector and supply shocks 289, 293-6, 467-71
Income-expenditure diagram/flow 40-1, 67, 70, and taxation 17, 226, 395, 397, 406, 426-7, 474
130, 222, 350, 374 and theory of Purchasing Power Parity 157
Income, per capita: see Per capita GDP and trade-offs 16-7, 26, 291-7, 300, 467-8, 471,
Income tax: see Tax, income 485-6
Indicators, fiscal: see Budget deficit; Fiscal norms and unemployment: see Phillips curve
Indicators, social 142-3 see also Underlying factors; Bracket creep
SA data 143 Inflationary expectations
see also Human Development Index (HDI) see Expectations, inflation
Inflation 16-7, 37-8, 177, 221, 276, 455-75 Inflation targeting 360, 360-5
as a policy objective 16-7, 24, 26, 292-5, 353, Informal sector 476, 480-1, 496
359, 360-3, 364, 381, 426, 436, 453 Initiating factors (inflation) 462-73
as a process 462-4 Interest groups (and inflation) 474-5
causes of 360, 447-51, 458-75 Instability, inherent: see Stability
conflict approach 474-5 Instruments of policy: see Fiscal policy; Monetary
definition 284, 455 policy
demand-pull, cost-push 461, 474 Interest on government debt: see Public debt
distributional impacts of 16, 397, 426-8 Interest rates 69-128, 349-72
hyperinflation 466 as policy consideration 349, 355-7, 361, 363-4,
in AD-AS model 221, 226, 274, 462, 464-71 366-9
in AD-PC model 283-305 as symptom of prosperity 91
initiating, propagating factors 462 causes of changes in 70-4, 87-9
Keynesian view of 11, 26, 221, 461 determination in money market 71-4
measurement aspects 16, 455-7 different kinds 72-4, 89-90
Monetarist view of 357, 446-7, 453, 458-60, in Classical model 442-3
461-3, 466, 468, 472 in Keynesian transmission mechanism 93-5
New Classical view of 448-9, 472 real vs. nominal 53, 92, 94, 223, 425-6
policy, paths 299-304 SA data 70, 426
policy, remedies 298, 460, 464-71, 474-5 short vs. long-term 71, 89-90, 367-9
SA data 16, 223, 274, 457 term structure 89
structuralist view 462n, 473-4, 524 and AD curve 426
Zimbabwe 466 and balance of payments position 18, 148-9
and balance of payments (BoP) 16, 149, 471 and capital flows 143-5
and bracket creep 17, 397, 406 and demand for money 75-7
and budget deficit 102, 402, 425, 472
Index 533

and government borrowing 100-3, 366-9, 402-4, and fiscal policy 26, 377-79, 382-3, 391, 415,
426,436 464
and inflation 361-2 and inflation 461-4, 472-3
and price of money market instruments 73 and Monetarism compared 357, 443, 451-3,
and public debt 366-9, 410-2, 423-6 460, 461, 468, 486
and repo rate 365-6 and Phillips curve 486
and Reserve Bank 80-2, 354-7, 361-6 and policy priorities 27, 357-8, 437
and risk premium 144 and unemployment 443
and sustainability 425-6 Keys, Derek 382
and Taylor rule 302
see also Crowding out; Monetary policy; Monetary L
sector
Internal disturbances Labour force 157, 231, 242-3, 475-8, 480, 489-4
general method to analyse 170 SA data 478-9
in AD-AS model 260-271 Labour Force Survey 476-9, 489
in IS-LM-BP model 184 Labour market 489-95
see also External disturbances Labour mobility 494
International competitiveness 16, 157, 493 Labour unions 15, 20, 235-9, 248, 252, 265, 380,
Inventory investment 51, 196-7, 198-9, 201-2, 456, 473, 493, 495-6
204, 210,219 see also Cosatu
planned vs. unplanned 197, 202, 219 Lags, policy: see Policy lags
Investment: see Capital formation Laissez faire 442
Invisible hand 442 Land, reform 494, 496, 497
Invisible trade 139 Leakages 57-8, 96, 99, 109, 132, 179, 220, 222,
IS curve 396
basic definition, graphics 104 in Classical model 443
formal derivation and properties 105-10 in income-expenditure flow 443
in the open economy 179 in money creation process 79
mathematics 103 Left, viewpoint 35
see also IS-LM model Legend, for box icons 5
IS-LM model 103-28 Lender of last resort 80
in the open economy 178-80 Liabilities related to reserves
mathematics 107, 112, 115, 180 see also Foreign reserves; Change in liabilities
and AD-AS model 223, 227 Liberalism, classical 441-2, 451-2
see also IS-LM-BP model Life expectancy, indicators: see Indicators, social
IS-LM-BP model 178-87 Life-cycle, income hypothesis: see Consumption
Literacy, indicators: see Indicators, social
J Liquid asset requirement 351
Liquidity: see Money market shortage
J curve 141 Liquidity trap 123-5
Job reservation 493-5 Living standards
and GDP growth 12-4, 17, 173, 389
K see also Development
LM curve
Keynesian theory 28-33, 37-43 basic definition, graphics 103-4
aggregate demand and supply 221-281 formal derivation and properties 110-5
consumers, producers, government 37-68 in the open economy 179-180
financial institutions, money, interest rates mathematics 112
69-128 slope, relative to BP curve 183
foreign sector 129-194 USA case 182-3
see also Keynesianism see also IS-LM model
Keynes, John Maynard 31, 43, 48, 444 Local government: see Government
Keynesianism 28-33 Locke, John 30, 441

Long run, defined 37, 232 definition 349
Lucas, Robert 32, 447, 487, 503, 511 development of 358
gradualist approach 301
M guidelines: see Money supply guidelines
history of 358
M3 money supply: see Money supply in 45° model 92-6
Macroeconomics, definition and uses 9-11 in AD-AS model 222, 228-230, 257, 260-3
Malthus, Thomas 521 in IS-LM model 119-120, 122-4
Manuel, Trevor 382-3 in IS-LM-BP model 184, 187-193
Marcus, Gill 358 in closed economy chain reaction 93-6
Marginal propensity in open economy chain reaction 165, 187-93
to consume 46, 57, 62 instruments 71, 80-2, 93-4, 349-53, 363-4
to import 58, 134, 140, 179 mission/objectives 304, 353-4
to save 58 Monetarist view 452-3
see also Consumption; Imports moral persuasion 351
Marginal tax rates; see Tax rates potency of 95, 122-4, 165, 188, 230, 371, 453
Market prices, in SNA 195-6, 211-3 reactionist approach 301, 303
Mark-up 233-4 role of Reserve Bank 70-7, 101-2, 350, 360-1
Marshall-Lerner condition 141 targets (see also guidelines) 359-62
Marxism (policy priorities) 26, 30 vs. fiscal policy 435-7
Marx, Karl 30 and budget deficits 436
Mboweni, Tito 358 and development 427
MERG (Macro-Economic Research Group) 20 and exchange rates 369-72
Migration 492 and inflation 462-471
Minimum wages: see Wages and political factors 350, 380-1, 426-7
Mining sector 211, 317, 385n, 397, 492, 494, 507, and public debt 366-9, 403-6, 436-7
509, 516, 518, 520 and Taylor rule 302
Minister of Finance 27, 203, 376, 379, 381-3, 397, and unemployment 304, 485-7, 495
406, 439 see also Constraints on policy; Money supply;
Monetarism 43, 444-7 Policy objectives; Reserve Bank
critique 460 Monetary reaction function 298-304
fiscal rule 416 Monetary rule 357, 416, 437, 452-3, 458
and budget deficits 472-3 see also Discretion
and economic growth 420 Monetary sector 69-128
and government expenditure 377, 416 changes in equilibrium 87-90
and inflation 357, 458-460, 468, 472-3, 486 defined 67, 69
and Keynesianism compared 26, 43, 93, 357, impact of balance of payments on 161
451-4, 460, 461, 468, 486 in IS-LM model: see LM curve
and Phillips curve 486 linkages with real sector 92-103
and policy priorities 26, 377, 391, 416, 420, 437, with variable price level 221-2, 228-30
451-4, 485-6 and budget deficit 100-2, 400-1
and SA Reserve Bank 27, 357, 437 and transmission mechanism 92-6
and unemployment 26, 485-91, 524 see also Monetary policy; Money supply
see also Classical School; New Classical School; Monetary targets: see Monetary policy targets;
New Keynesian economics Money supply guidelines
Monetary authority: see Reserve Bank; Monetary Monetisation, of budget deficit or public debt 422,
policy 472
Monetary policy 69, 80-5, 349-72 Money
accommodating 355n, 356n, 436 definition 74
approaches 351-60 stock of 77
characteristics 435-7 velocity of circulation 443, 458, 460
cold turkey approach 303 vs. income 74
constraints on 460 and interest rate determination 74-87
Index 535

see also Interest rates; Monetary policy; Money see also Monetary policy; Quantity Theory of
supply Money; Reserve Bank
Money, demand for 75-7 Moral persuasion 351
definition 75-7 Multiplier, balanced budget 62
determinants of 75-7 Multiplier, credit 79-82
graphical depiction 77 Multiplier, expenditure 57-8, 62, 64, 66, 96, 99,
responsiveness/sensitivities of (income/interest) 116, 122, 124, 126
96, 98-100, 109, 113-5, 122-3, 124-5, 228 in IS-LM diagram 108, 116
transactions, precautionary, speculative demand value 57-8, 62, 64, 66, 116
75n, 76 and AD curve 228-9
Money market and openness of the economy 66
institutional arrangement, everyday operation and policy effectiveness/potency 96, 99, 122,
71-4 124, 230
interest rate determination 71-4 and secondary effects 126
money market paper 72-4 see also Leakages
primary vs. secondary market 72 Multiplier, tax 62
and government borrowing 100-1, 406
see also Capital market; Monetary policy; Money N
supply
Money market shortage (liquidity) 90-1, 99, 356n, National accounting 195-220
363, 365 identities 196-207
see also Accommodation SA data 212-3
Money stock 78-80, 90, 354-7 system of (SNA) 59, 131, 139, 141, 195, 210-4,
see also Money supply 217-20, 376, 388, 389n, 391, 399, 413-4,
Money supply 77-8 418, 429-34
as policy consideration 354-7, 358 see also Sectoral balance identities
creation 79-80, 356-7 National government: see Government
definitions 77-8 National income identity 196-8
exogenous vs. endogenous 87 and macroeconomic equilibrium 196
function 86-7 for the open economy 198, 201
guidelines (plus SA data) 354-6, 358-9, 470 Natural order (in society) 30, 442
impact of balance of payments on 151-2, 160 Natural rate of unemployment 243, 445-8, 467,
in balance of payments adjustment process 148, 487-9
151-2 see also Structural rate of unemployment
in Classical model 443-4 Natural resource depletion 14, 552
in Monetarist theory 445-7, 453 NCD rate: see Negotiable certificates of deposit
in New Classical theory 447-9 Negotiable certificates of deposit (NCD’s) 73
M1, M2, M3 77-8 Net capital inflow from the rest of the world 207-9
real vs. nominal 92-3 Net current transfers from the rest of the world:
role of Reserve Bank 79-80, 80-2, 82-4 see Transfers
SA data 70, 85 Neutrality, of money 257, 444, 459
sending it overseas 165 New Classical School 26, 32, 437, 441, 447-449,
targets (see guidelines) 451-4
and bank balance sheets 83-6 and economic growth 503, 507, 511, 524
and credit 77-86 and inflation 458-60, 461-3, 466, 468, 472
and credit multiplier 79-80, 82, 101-2 and unemployment 451, 485-90
and deficit financing 101-2 New Deal, USA 31, 382, 444
and inflation 443-4, 446-7, 447-9, 449, 453, New Keynesian economics 32, 449-51, 451-4
458-60, 462-4, 466, 468, 469, 472 and inflation 461n, 466
and minimum cash reserve requirement 79-80, and unemployment 451, 485-6, 488-9
81n, 83 Newton, John 441
and slope of AD curve 228 NIEP (National Institute for Economic Policy) 20
Nihilism, state 442

Nominal values (income, interest rates, etc): see Real Policy rules: see Discretion
values Political factors
Non-interest current expenditure 406, 431-3 in fiscal policy 143-5, 376, 380-2, 389, 394
Non-interest expenditure 399, 421-2 in monetary policy 353, 381, 426
NP (National Party) 36 in South African policy making 35-36
Numsa 20 and balance of payments constraint 152
and capital flows 143-5, 353
O and inflation 464-7
and policy objectives 18-20, 25-7
Obama, President Barack 32, 128, 272 and political parties 35-36
Objectives, policy: see Policy objectives and unemployment 478, 480, 491-5
Observation lag: see Policy lags see also Rubicon speech
October Household Survey (OHS) 478 Population growth 13, 231, 389, 476, 492, 495,
OHS: see October Household Survey 496
Oil price 10-1, 28, 133, 150, 175, 240, 247, 252, SA data 13
265-70, 274, 280 and economic growth 13, 329-30, 509
Open economy 2, 58, 66, 107, 129 Post-Keynesian approach 229, 447
see also External sector Potential GDP: see GDP, potential
Open market operations 82, 90, 94, 351, 353, 355, Poverty 9-11, 15-6, 19-21, 24-26, 374, 387, 389,
356n, 357, 363, 365, 367, 439 444, 464, 469, 482-3, 487, 503, 506, 512,
see also Monetary policy 514, 516
see also Development
P PPI: see Producer price index
Pretoria consensus 393
Parliament, role of 101, 37-8, 383, 404-7, 439 Price control: see Incomes policy
Pensions 377, 385, 387-8, 390, 430, 431 Price index 223, 456
Per capita GDP 13-5, 21-2, 394 see also Consumer price index
Permanent income hypothesis: see Consumption Price level, average 221-3, 455-7
Personal disposable income: see Disposable income constant price assumption 223
Personal income tax (PIT): see Tax, income determination in AD-AS model 223-5, 254-76,
Phillips curve 292-5 461-4
for South Africa 296 in Classical model 446-7
mathematics 297 in income-expenditure flow 222
see also AD-PC model in Monetarism vs. Keynesianism 447
Policy coordination/conflict 436-7 SA data 274
Policy effectiveness/potency: see Fiscal policy; stability as policy objective 16, 26
Monetary policy see also Inflation
Policy instruments: see Fiscal policy; Monetary policy Price ratio 130, 135, 154, 157, 471
Policy lags 438-40 and exports 137, 471
Policy limitations 353, 379 and imports 134-6
see also Constraints on policy see also Purchasing power parity; Terms of trade
Policy objectives 11-27 Price rigidity 188, 199, 201, 354, 364
intermediate 25-6 Price-setting relationship 233-4, 236-8
lessons 295-7 and long-run AS 239-47
priorities 26-8 and short-run AS 248-54
reactions 298-304 see also Wage-setting relationship
SA business sector view 20, 380, 388, 393 Prices of inputs 266, 243-4, 462, 467, 472
SA government priorities 27 Prices, relative 455
SA Reserve Bank priorities 304, 353-4 Price stability: see Inflation; Price level
standard 11-20 Primary balance/deficit (budget): see Budget deficit,
and development 21-5 primary
and time horizon 451 Primary market: see Secondary market
see also Fiscal policy; Monetary policy
Index 537

Printing press 102 R
see also Budget deficit; Money supply
Pro-cyclical policy 397 Rand, SA 129-130, 156, 173, 370
Producer price index (PPI) 456n and gold price 174-6
Production possibility frontier 254 and USA dollar, interest rates 174-6
Productivity of labour, capital 231 see also Exchange rate; Purchasing power
Progressivity, of income tax: see Bracket creep; Rate of interest: see Interest rate
Tax, income Rational Expectations School: see New Classical
Propagating factors (inflation) 462-4 School
Provincial government: see Government RDP (Reconstruction and Development Programme)
PSBR 399 20, 33, 383
see also Government borrowing Reactionist, approach to policy 301, 303, 464, 470
Public authorities 376, 430-1 Reagan, President Ronald 358, 417
Public business enterprises 462-3 Real sector, 37-68
Public corporations 51, 59, 376, 400 changes in equilibrium 55-7
Public debt 407-12 defined 38, 67
burden of 408-9 in IS-LM model: see IS curve
domestic vs. foreign 409 linkages to monetary sector 92-103
interest on 203, 203, 367-9, 386-8, 410, 429-30 with a variable price level 221
international comparison 409 and transmission mechanism 93-7
management 349, 366-9, 373, 377, 410-2 see also Monetary sector
monetisation 423-5, 472-3 Real values (income, interest rates, etc.) 13, 37-9,
ratio 407-8, 423-4 53, 77, 92, 153, 199, 222-3, 226n, 227,
Reserve Bank role 366-9, 402-3, 410-2 355-6, 407, 411, 446, 458, 475
SA data 400-402, 407, 408 Recession 15, 37-8, 42, 91, 214, 274, 382, 402,
Treasury role 366-9 439, 442
and debt trap 407, 422, 425 Redistribution 16, 20, 28-36
and economic growth 402, 407-8, 423-5 as policy objective 9, 18-20, 23-5
and fiscal policy 366-9, 407, 410, 412, 418-21 measurement 18
and inflation 407, 425 SA data 19
and monetary policy 366-9 vs. development 21-5
and primary deficit 418-21 vs. economic growth 20
and sustainability 421-6 and consumption 48
see also Monetary policy and inflation 16, 474-5
Public sector: see Government Regressivity: see Tax
Public sector borrowing requirement: see PSBR Relative income hypothesis: see Consumption
Public works programmes 401, 496 Remuneration of employees (government) 57, 383,
Purchasing power of the rand 152-3 385-8
see also Exchange rate; Inflation Repo rate 43-1, 49-50
Purchasing power parity (PPP) 157 in closed economy chain reactions 52, 66
see also Price ratio in monetary policy 238-9, 251, 255
in open economy chain reactions 119, 120-1,
Q 124, 135-6, 145-6
in variable price level model 193-5
Quality of life 14, 24 see also Bank rate; Monetary policy
see also Development; Living standards and balance of payments position 106
Quantity Theory of Money 441-6 Reserve Bank 69, 80, 90, 349-2
Quarterly Bulletin of the Reserve Bank 39, 45, 51, approach to policy 27-8, 158-9, 27, 353-60,
70, 84, 89, 90, 131, 135, 139, 147, 196, 363-5, 470
210-1, 223, 376, 399, 429, 434 functions 350, 363-6
Quarterly Labour Force Survey 476-9, 489 Governor 357-8, 362, 365, 380
independence 349
internet site 349

intervention in foreign exchange markets 155, in AD-AS model 230, 259, 260-8
158-9, 349, 364, 369-72 in IS-LM model 103, 117-9, 124-5,
intervention in money markets 72, 349-53 in IS-LM-BP model 142, 148, 162-70, 187-94
mission 353-4, 359 and capital flows 176, 190
Quarterly Bulletin: see Quarterly Bulletin and crowding out 97-9
role in money supply process 80-82, 86, 87, and expenditure multiplier 99
402-3 and external disturbances 97-9, 142, 168
and fiscal policy 101-3, 373, 380-1, 402-3, 397, see also Crowding out
410-2 Secondary market 72-3, 82, 369
and government borrowing/deficit 100-3, 366 Sectoral balance identities 201-7, 211-2, 214-6,
and interest rates 70, 90, 352-3, 355-60, 368, 371, 384-5, 420, 434
368n, 369-72 Semilog graphs 504
and policy lags 438-41 Sending the money supply overseas 165, 372
and public debt management 366-9, 403, 406-12 Sensitivity (responsiveness) 52
see also Accommodation; Monetarism; Monetary of capital flows 145, 172, 182-3, 186
policy of consumption 48
Responsiveness, see Sensitivity of imports 134, 182
Revaluation 153, 159 of investment 52, 96, 109, 122, 124
Right, viewpoint 35 of money demand 77, 95-6, 98-100, 113-5,
Rigid exchange rate effect 161, 165-7, 170-1, 122-5
189-91, 186 of money supply 86-7
Rigid input prices: see Prices of inputs versus elasticities 52
Roll-over (of debt) 367-8, 400, 407 and J curve 141
Roosevelt, President Franklin D 15, 444 and Marshall-Lerner condition 141
Rubicon speech 145 and policy effectiveness 122-8, 187-91
see also Political factors; Sanctions Services, payments for 129, 147
Rules vs. discretion (in policy): see Discretion in balance of payments 139
see also Factor and non-factor services; Invisible
S trade
Short run, defined 37, 232
SACP (SA Communist Party) 35 Small business 427, 493
Sanctions, trade and financial 135-6, 143, 382, see also Informal sector
384, 404, 467, 493 Smith, Adam 30, 441-2
and balance of payments constraint 152 SNA: see National accounting
and unemployment 493 see also GFS
Savings 46-8, 202 Social security 375, 429, 434, 494
golden rule 328 Social spending: see Government expenditure;
government: see Dissaving 202, 205-7 Development; Pensions
gross domestic 204, 207-10, 212-4 Stability, inherent 46, 48-9, 51, 203, 441-4, 452,
household, business 202, 204, 212 449
in Classical model 443 Stabilisation
in growth model 313, 315, 319-23, 326-9, as policy objective 11, 15-6, 350-1, 353-4,
336-8, 340 381-3, 396-8, 415, 436-44, 452-3, 438,
in national accounting identities 202-207, 384 485-6
in SNA tables 210-4, 217, 218 policy, problems 353-4, 383, 396, 415, 436,
marginal propensity to save 58 438-41, 464-7, 474, 485-6
SA data 202, 208, 212, 413 see also Fiscal policy; Monetary policy; Policy
and economic growth 336, 420 effectiveness
and fiscal norms 418-9 Stagflation 221, 288, 382, 465n, 467-470
see also Capital formation Stals, Chris 358
Say’s Law 442-3 State: see Government
Secondary effect 97-8, 117-9, 142, 166, 259 State debt: see Public debt
Stats SA 456, 478
Index 539

Stern Report 522 and equity/fairness 395-7, 427
Strikes, impact of 136, 405, 463 and incentives/disincentives 485, 493, 495-6
see also Supply shocks and inflation 395, 397, 406, 427, 474
Structural unemployment: see Unemployment, and price level 378
structural and saving 507, 511
Structural rate of unemployment (SRU) 242-4, 489 and supply side 378, 485
see also Natural rate of unemployment; and unemployment 485, 495
Unemployment Tax burden (aggregate) 394-5, 397, 434
Subprime crisis 32, 123, 172, 194, 271-2, 304 measurement of 394-5, 434
Subsidies relevance of 395-6
in fiscal policy 378, 385, 387, 390, 429-33 SA data 394-5, 434
in national accounts 197, 203, 212-4, 217-9 Tax, corporate, mining 377, 396, 397, 401, 427
and unemployment 493, 495 Tax, direct 377, 396
Supply, aggregate: see Aggregate supply in national accounts 214
Supply shocks 240, 247, 252, 254, 265-71, 278, Tax equity 395, 396, 397, 427
286, 288-90, 294, 296-9, 305, 382, 463-4, horizontal, vertical 395, 427
467-71 Tax, income (personal) 377, 396, 397, 401, 427
Sustainability: see Fiscal policy progressivity 62-4, 396, 427
rate 63-4, 396
T and AD curve 226
and bracket creep 397, 406, 427
Tap issues (monetary policy) 363 and business cycle 63, 396-8
Targets, of policy: see Fiscal policy; Monetary policy and wage demands 378
targets; Money supply guidelines Tax, indirect 377-8, 427, 496
Tariffs 135, 177 in national accounts 211, 214, 217-9
See also Trade policy and inflation 474
Tax/taxation 46, 58, 62-3, 63-4, 378, 382-3, Tax rates
385-6, 391-2, 394-8, 401-2, 406-7, 413, average, marginal 395, 396n, 397
427, 434 effective 427
composition 395-6 Tax revenue 63, 203, 214, 384, 385, 397, 401,
distributional effects 17, 394, 427 405-6, 408, 422, 434
effects on macroeconomy 170-1, 378-9, 394-8 projections 390, 405
in 45° model 43-4, 59-63 Tax, value-added (VAT) 43, 377, 396, 427
in AD-AS model 226, 251-2, 255 regressivity 396
in IS-LM model 108, 109, 117, 121, 124 and GDP measurement 217
in fiscal policy 377-80 and inflation 474
in national accounting identities 203, 214 Taylor rule 302, 359
measurement 394-5, 434 see also Monetary reaction function
multiplier effect 62 TB rate: see Treasury Bills
principle 395 Technology
progressive, regressive 62, 63-4, 396, 427 appropriate 495
SA data 394-5, 434 impact of 501, 507, 508
and ability to pay 395 and growth and production (function) 309-7,
and AD curve 226 322-4, 328, 330-3, 336, 338-42
and anticyclical policy 63, 396-8 and human capital 335, 337-8
and bracket creep 397, 406, 427 Terms of trade 135, 137
and business cycles 396-8 Term structure of
and capital formation (investment) 511 interest rates 89
and consumption 62 public debt 366-7
and cost of production 378 Trade balance 138-9
and development, poverty 395-6, 427 and net exports, current account 138-9
and economic growth 394-7, 485, 493 see also Exports, net
and efficiency, distortions 395, 515

Trade-off, policy 11, 16, 26, 290-7, 297, 300, 467, and price stability 26
468, 485, 486 and supply shocks 467-9
Trade policy 135-6, 177-8 and trade-offs 11, 16, 26, 291-2, 294-5, 297,
Trade statistics 131, 364 300, 467-8, 485-6
Transfers and working poor 483
in the budget: see Pensions USA (United States of America)
to/from households (SNA) 197, 201, 203, 213, BoP adjustment process 168-70
385, 386-7, 388, 390, 430, 431 BP and LM curves for 183
to/from the rest of t he world (SNA) 197, 198, budget deficit 103, 172, 175
201, 203, 212, 431 business cycle 138, 168-70, 179
see also Subsidies capital mobility 103, 145, 182-3
Transmission mechanism 444-7 dollar interest rates 95, 101, 144, 172, 175, 182
Monetarist 444-6 Reagan era 358
Treasury 59, 61, 373, 376, 380-1, 404-5, 412, Republicans, Democrats 35-6, 417
436-7 unemployment 476, 487
Treasury Bills (TBs) 72-3, 100
Trickle-down effect 14, 514 VW
U VAT: see Tax, value-added

Velocity of circulation of money 443-4, 458, 460
Underdevelopment: see Development 482-4 Vertical equity: see Tax equity
Underemployment 477-8, 479 Wage bill, government: see Remuneration
see also Unemployment Wage rigidity 461n
Unemployment (employment) 475-97 Wage-setting relationship 234-8
as policy objective 12-3, 27-8, 487 and long-run AS 239-48
causes of 491-5 and short-run AS 248-55
cyclical 242-3, 487-9, 497 see also Price-setting relationship
definition 475-8 Wages, minimum 494
in AD-AS model 276, 484-5 Washington consensus 393
in AD-PC model 290-2 Wealth of nations, An inquiry into the 30, 441
in Monetarist / New Classical view 485-9, 491 Work effort: see Tax, and incentives
in Keynesian view 485-7, 488-9, 491 Workforce: see Labour force
involuntary vs. voluntary 485-7, 488-9, 491 Working poor 483
measurement 475-77, 477-80 World Bank 380, 393, 506, 510
natural rate of (NRU) 242-4, 445, 447-8, 487-9 WTO 178
policy, remedies 290-1, 483-4, 485-9
registered 476-7, 483 XYZ
SA data 478, 480-4
seasonal, frictional, cyclical 242 Zimbabwe 466
structural 242-4, 271-2, 291, 451, 495-7
technological 493
underemployment: see Underemployment
and AD-PC model 290-2
and African context 451
and apartheid 480, 483
and balance of payments 26
and business cycle 489
and development 469, 481-4
and economic growth 482, 490, 495
and formal sector employment 476, 479, 481-2
and inflation: see Phillips curve
and mining sector 492, 494
and Phillips curve 290-7, 300, 486
Index 541


(ECO20B) MACRO. ECON - How To Think and Reason

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Macroeconomics-cover-FAp.

indd 1 9/7/09 3:17:17 PM

chapter 00a prelims.indd 3 9/3/09 2:10:22 PM

First published 2013

© Juta and Company Ltd, 2013

1st Floor, Sunclare Building

ISBN: 978 0 70217 761 3 (Parent)

Publisher: Mthunzi Nxawe

Preface and acknowledgements v

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vi How to think and reason in macroeconomics

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Supply side analysis more exhaustive

Preface and acknowledgements vii

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viii How to think and reason in macroeconomics

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He who teaches facts and facts alone

The purpose of studying economics is not to acquire a set of ready-made answers to

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0. Introduction and orientation ..........................................................................1

Part I How does the economy work?

2. The basic model I: consumers, producers and government

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4. The basic model III: the foreign sector

xii How to think and reason in macroeconomics

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6. A model for an inﬂationary economy: aggregate demand and supply

Table of contents xiii

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8. Macroeconomics in the very long run: growth theory

xiv How to think and reason in macroeconomics

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9. Monetary policy: the role of the Reserve Bank

10. Fiscal policy: the role of the government

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12. Inﬂation, unemployment and low growth: causes and remedies

Index ................................................................................................................................... 525

xvi How to think and reason in macroeconomics

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Chapter 0: Introduction and orientation 1

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2 How to think and reason in macroeconomics

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Chapter 0: Introduction and orientation 3

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4 How to think and reason in macroeconomics

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Legend for boxes

! Take note box

The data tip box is self-explanatory

Chapter 0: Introduction and orientation 5

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How does the

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1.1 What is macroeconomics?

1.1 What is macroeconomics? 9

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10 Chapter 1: Why macroeconomics? An introduction to the issues

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1.3 Main macroeconomic problems and policy objectives

1.3 Main macroeconomic problems and policy objectives 11

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Income and development