ECO202

Pr
inci
plesofEconomi
csI
I

1
2
Tabl
eofCont
ent
Page
Vice-Chancellor'
smessage… … … … … …
vi
Foreword… … … … … … … … vi
i
Gener al
Introducti
onandOut li
ne…… … … … vi
ii
LectureOne: Disti
nct ionbetweenMi croand
Macr oEconomi cs…… … … 1
LectureTwo: Unempl oy ment … … … …
8
LectureThree: Nat i
onal I
ncomeAccount i
ng… … 14
LectureFour : TheDet er mi nat
ionofNat i
onalI
ncome…
23
LectureFive: TheConsumpt i
onFunct ion.… … 32
LectureSix: I
nv estment…… … … … 40
LectureSev en: Gov ernmentAggr egateDemandand
Fi
scal Policy… … … … 47
LectureEight: Pr i
ceLev el andMoney … … …
56
LectureNine: MoneyandBanki ng… … …
66
LectureTen: I
nter nationalTrade… … … …
75
LectureEleven: Barrierst oTrade.…… … … 81
LectureTwel ve: TheBal anceofPay ments… … …
85
LectureThirteen: TheTheor yofExchangeRat es… … 92
LectureFour teen: Mai nSchool sofEconomi cThought… 99
LectureFift
een: Economi cSy stems… … … …
111

3
4
LECTUREONE

Di
sti
nctionbet
weenMi
croeconomi
csand
Macroeconomics

I
ntroducti
on
I
nt hi
slectureweshalldi
scusst
hetr
ansit
ionfr
om microeconomics
t
omacr oeconomi
cs.Hencewehi ghl
ightthedif
fer
encesbet ween
micro-andmacroeconomics.

Obj
ect
ive
Att
heendoft hi
slect
ure,youshoul
dbeableto:
1.explain t he meani ng of mi cr
oeconomi
cs and
macr oeconomics;
and
2.recognizeandmakeadi sti
nct
ionbet
weenthetwoaspect
s
ofeconomi cs.

Pr
e-Test
1.Def i
nethefollowingconcepts:
a.Mi cr
oeconomi cs
b.Macr oeconomi cs
2.What ar e the maj or dif
fer
ences bet
ween mi
cro and
macroeconomi cs?

CONTENT
I
nmicroeconomi
cs,t
hef
ocusofanal
ysi
sist
hei
ndi
vi
dual
.Inot
her

5
words,mi croeconomi csi sconcer nedwi tht hest udyofeconomi c
behav i
our s of t he i n¬di vidual agent s i n t he economy .I n
macr oeconomi cs,howev er,t hef ocusshi f
tst ot heaggr egat e.The
focalpoi ntthenbecomest heeconomyaswhol eandnoti ndi vidual
partsofi t.
I
nr eali
ty ,t her ei sat hin di viding l ine bet ween mi cr o and
macr oeconomi cs.Howev er ,i ti s st i
llpossi bl
et o show some
dif
ferencesbet weent het wo:
1.Mi croeconomi csof fer sadet ail
edt reatmentofoneaspect
oft heeconomi csy stem buti gnor ei tsinteracti
onwi tht he
restoft heeconomy .Ont heot herhand,macr oeconomi cs
looks att he i nt erdependency among al lsect ors oft he
economyf orpol i
cyanal y sis.
2.Whi le i n mi croeconomi cs, we ar e concer ned wi t
h
opt i
mi zat ion deci si ons househol ds, and f i
rms, i n
macr oeconomi cs we ar e mor e concer ned wi th gener al
nat i
onali ssues,such as t ot alempl oyment ;money and
banki ng;ag¬gr egat enat ionalout put ;thegener alpricel evel;
et c.
3.I nt ermsofout put,mi croeconomi csdeal swi t
ht otalout put
ineachmar ket,whi lemacr oeconomi csisi nterestedi nt he
aggr egat eout puti nt heeconomy .
4.Macr oeconomi cs f ocuses on t he gr owt h of t he t otal
economy whi l
e mi cr oeconomi cs t akes a mor e
disaggr egat edappr oachbyl ooki ngatchangesi nout puti n
thei ndiv idual mar ket .
5.I nmi croeconomi cs,t hest udyofequi li
brium condi tionsar e
anal ysedatapar t
icul arper i
od.Buti tdoesnotexpl aint he
timeel ement .Ther ef ore, mi croeconomi csi sconsi deredasa
stat i
canal y sis.Ont heot herhand, macr oeconomi csisbased
ont imel ags, ratesofchangeandpastandexpect edv alueof
thev ar i
abl es.
Thi sr oughdi visionbet weenmi croandmacr oeconomi csi s
notr i
gid,fort hepar tsaf fectt hewhol eandt hewhol eaf fect st he
part.Justas we not ed ear lier,t herei sav er
y st rong i nter-
dependencybet weenmi croandmacr oeconomi cs.Pr esent ly
,t he
branchofeconomi cscal ledGener alEqui ¬li
brium Theor yseekst o

6
bri
ngt ogetherthet woaspect sofeconomi cs.Interest
ingl
yalso,
becausemacr oeconomicsf ocusesmor eont heeconomyasa
whole,itr
eceivesgreat
erattenti
onfrom t
hepeopl esinceitssubj
ect
mat t
eraffectstheirli
vesdi r
ectl
yori ndi
rect
ly;forexampl e,high
i
nflati
onaryrate,unemploymentr at
e,recessionsint heeconomy ,
bal
anceofpay mentpr oblem,etc.

MacroeconomicGoal sandPerfor
mances
Therearecertaingoalswhichev er
yeconomydesir
est
oachi
eve.
Theseare:
1.highlev
elsofempl oymentandproduct
ion;
2.stabl
epr i
ces;
3.economi cgrowth;and
4.equit
yindi st
ri
buti
onofincome.

1. HighLev elsofEmpl oymentandPr oducti

on
Grossout puti naneconomyi spr oducedbyacombi nationof
l
abourand capi ¬tal,which ar e empl oyed inthe product i
on
process.Theout putofaneconomywoul dbemaxi misedi fall
i
tsf act
ors ofpr oducti
on ar e al lempl oyed and ar e also
effi
cientl
yused.Unf ort
unat ely,thi sisnotal waysobt ai
nabl e.
Moder neconomi csischar acterizedbygr ossunempl oyment
and under empl oyment of f act ors of pr oducti
on, whi ch
therefor
ekeepl ev elofout putper manent l
ybelow pot entialor
maxi mum out putl evel
.Ther efore,i tisoneoft hegoal sof
macr oeconomi cst oseehow av ailablelevelofoutputcanbe
brought cl ose t o its pot ent i
al level by mi nimising
unempl oymentandunder empl oy mentoft hemai nfact orsof
production.

2. Stabl
ePrices
Everycountr
yseekst ocontrolr
api
di ncr
easesorf l
uct
uati
onsin
it
spr i
celevel.Thisisbecauser i
singorf l
uctuati
ngpricesof
goodsandser vi
cesmaykeeppr oductsoutoft hehands,of
thosewhowoul dotherwi
sebeabl et oobtai
nt hem and,inso
doing,change the distr
ibuti
on oft he goods and servi
ces

7
 producedbyt hef i
rmsint heeconomy .Periodsofr i
singpr i
ces
areusual lyassoci at
edwi t
ht heper iodofi nfl
ati
on.I nflati
on
occurswhent her eisagener alincreasei nthepr i
cel evel .As
weshal lseel ater,i
nflat
ionproducesmanynegat i
veeff ectsand
onlyl i
tt
le posi tive eff
ecton an economy .Fori nstance,i t
reducest hepur chasingpoweroft hoseonf ixedi ncomesl i
ke
thepensioner s.Addi ti
onall
y,inflati
onmayal sor educel evelsof
savingsi nt heeconomy ,sincemuchmoneywoul dnow be
requir
edbyhousehol dst omaket heirbasicpur chases.
Howev er
,despi tethedebi l
itati
ngef f
ectsofi nf
lati
on,many
countri
eshav ef oundi tdiff
icultt ocont rolt herapidr at eof
i
nflati
onint heirdomest i
ceconomi es.

3. Economi cGr owt h

Thisi sthet hirdmacr oeconomi cgoal .Economi cgr owthr efers
toincreasesi nther eal outputlev el.Howev er
,amaj orl
imitation
ofthisgr owt hist hatitonl yr ecogni seschangesi noutputl ev el
butnegl ectsot herwel f
arei ndicat ors,like,li
teracylevel,l i
fe
expect ancy l evel
,l eisure,pov ertyl ev el
,et c.In addi ti
on,i t
ig¬norest heev er-i
ncr easingpol luti
onandot hersoci alcost s
thatmaybeas¬soci atedwi t
hi ncreasingout putlev el
s.Despi te
itslimitati
ons,economygr owthi sst illcommonl yaccept edt o
refl
ectwel f
ar elev eland ev ery count r
y desi r
es a mar ked
increasei nhereconomygr owt hr ate.

4. Di
st r
ibuti
onofIncome
Thisisanotherareawhichhasincr
easinglycrepti
ntothereal
m
ofmacr o¬economics.Itis now a st ated macroeconomic
objecti
veofev erycountr
ytopromoteequi t
yindist
ribut
ionof
i
ncome,whi chisassoci
atedwithi
ncreasingr at
eofeconomi c
growt h

Dependenceofmi croeconomictheoryonmacroeconomics
Takef ori
nstance,
whenaggr egatedemandr i
sesduri
ngaper i
odof
prosperi
ty,t
hedemandf ori
ndivi
dualproductsalsori
ses.Ifthi
s
i
ncreaseindemandi sduetoar educti
onintherat
eofinter
est,t
he

8
demandf ordiff
erenttypesofcapi talgoodswi l
lgoup.Thi swilll
ead
toani ncreaseint hedemandf ort hepar t
iculart ypesoflabour
neededfort hecapitalgoodsi ndust r
y .Ift
hesuppl yofsuchlabour
i
slesselastic,i
tswager atewillri
se.Ther i
seinwager at
eismade
possi
blebyi ncr
easei n prof
itsasaconsequenceofi ncr
eased
demandf orcapitalgoods.Thus,amacr oeconomi cchangebr i
ngs
aboutchangesi nt hev aluesofmi croeconomi cv ari
abl
es-inthe
demand f orpar ti
culargoods,i nt he wage r ate ofpar ti
cul
ar
i
ndustr
ies,intheprofitsofparticularfirmsandi ndust r
ies,
andinthe
employmentposi ti
onofdi ff
erentgr oupsofwor kers.

Dependenceofmacr oeconomi ct heor yonmi croeconomi cs

Ont heot herhand,macr oeconomi ct heor yi sal sodependenton
microeconomi canaly sis.Thet otal i
smadeupoft hepar ts.National
i
ncomei sthesum oft hei ncomesofi ndi v i
duals, househol ds,fi
rms
and i ndustri
es. Tot al sav i
ngs, t ot al i nvest ment and t ot al
consumpt i
on ar et he r esul t of t he sav i
ngs,i nvestment and
consumpt i
ondeci sionsofi ndiv i
duali ndust ri
es,f ir
ms,househol ds
andper sons.Thegener alpr i
cel ev elist heav erageofal lpr i
cesof
i
ndividualgroupsandser vices.Si mi l
arly, theout putoft heeconomy
i
st hesum oft heout putofal lindiv i
dualpr oduci nguni ts.Thus,the
aggregatesandav eragest hatar est udi edi nmacr oeconomi csar e
nothi
ngbutaggr egat esandav er agesoft hei ndividualquant i
ties
whichar estudi
edinmi croeconomi cs.

WhyMacr oeconomi stsSomet i

mesDi sagr ee
Macr oeconomi cs ist hus t he resultofa sust ained pr ocess of
constructi
on,ofani nteractionbet weeni deasandev ents.What
macr oeconomi st
sbel i
ev et odayi st her esultofanev ol
uti
onary
processi nwhi chtheyhav eel i
mi nat
edt hosei deast hatfail
edand
keptthoset hatappeart oexpl ainreali
tywel l.
Thisdoesnotmean t hatmacr oeconomi cst odayi s‘ri
ght.
”
Surely,new eventwi l
ll eadmacr oeconomi ststoquest i
onsomeof
thei
rt hi
nking:somemayev enleadt or adicalrethi
nki ng.Nordoesi t
i
mpl yt hatt he lessons ofhi st
ory and t he interact i
ve process
betweeni deasandev ent sar esost rongt hatal lmacr oeconomists

9
agreeonev er ything.Theydi sagr eeonmanyi ssues,al thoughof ten
l
esssot hani scommonl yper cei ved.Whent heydi sagr ee,t heydo
sof ort wov er ydi fferentr easons.
First ,ev enwhent heyshar et hesamev iew oft hewayt he
economywor ks,t heyof tendi sagr eeont hewei ghtt heyassi gnt o
dif
fer entobj ect i
v es.Someeconomi stsar ewi lli
ngt or educei ncome
i
nequal ityev eni fsomeoft hemeansneededt oachi ev ei smor e
i
mpor tant .Someeconomi st sputmor ewei ghton f i
ght ing hi gh
unempl oy ment t han on f ight ing i nflation because t hey see
unempl oy mentasamaj orsoci alev il
.Ot her sputmor ewei ghton
fi
ght i
ngi nf l
at ion,whi cht heyseeasmor edanger oust osoci et y.
Often,l inesofdi sagreementr unal ongpol i
ticall ines.Fori nst ance,
i
nt heUni tedSt at es,Democr at s,andeconomi st swi t
hDemocr at i
c
l
eani ngs, usual ly car e mor e about i ncome i nequal i
ty and
unempl oy ment ;Republ i
cans,and economi sts wi th Republ i
can
l
eani ngs,usual l
ycar emor eaboutgr owt handf i
ght ingi nfl
ation,
whicht heyseeasmor edanger oust osoci ety .Themeasur est hat
bothgr oupsr ecommendeddi fferaccor dingl y.Asl ongaspeopl e
(andt heseeconomi sts)hav edi fferentv alues, t
hesedi sagr eement s
willremai n.
Second,r ealityof tendoesnotspeakst rongl yenought omake
alleconomi st sagr ee.I ncont rastt or esear cher si nmostot her
appliedsci ences,economi st scannotdocont rol ledexper iment s.
Fori nst ance,when an engi neerwant st of i
nd outhow t he
temper at ureaf fectst heconduct i
v it
y,ofamat er ial,hebui ldsan
exper imenti nwhi chhechangest het emper atur e,maki ngsur et hat
every thing el ser emai nst hesame,and l ooksatt hechangei n
conduct iv it
y .Butmacr oeconomi st s who wantt of ind outf or
exampl e,how changes i nt he money suppl y af fectaggr egat e
acti
v itycannotper form suchcont roll
edexper iment s;t heycannot
maket hewor ldst opwhi let heyaskt heCent ralBankofacount r
yt o
changet hemoneysuppl y.Or , cant hey ?
Ty pi cal l
ychangesi nt hemoneysuppl ycoi nci dewi t
hmy riad
otherev ent s,r angi ngf rom changesi nt axl egi slat ion,t ost ri
ke,t o
unusualweat her ,and so on.Thus,t oi solatet heef fectoft he
changei nt hemoneysuppl yonout put,economi st smust ,whent he
l
ookatt hei rdat a,cont rolt heot herv ari
abl est hatmov edatt he
same t i
me.Thi si s difficultenough,and i ti s because oft hi s

10
dif
ficulty
,t hatdiffer
enteconomi stslookingatt hesameepi sode
canr eachdi ffer
entconclusions.Looki ngatthesameepi sode,one
economi stcanseeast rongef fectofmoneyonact i
vi
ty,whi l
e
anotherseesaweakeref fect.
Theav ai
labil
i
tyandt hest udyofmor eandmor eepisodes,and
theuseofbet t
erandbet tertechni questoexami nethedata,narrow
suchdi fferencesofopi nionov ert i
me.Forexampl e,thereislarge
agreementaboutt heeffectsofmoneyoneconomi cacti
vit
y,ifnot
aboutt hespeci fi
cchannel sthroughwhi chtheseeff
ectstakepl ace.
Butdi sagreement sdoandwi llsti
ll r
emain.

Summar y
Inthislecture,wehav etri
edt oacquai nty ouwi ththedi f
ference
betweenmi cr
oandmac¬r oeconomi cs.Youwer etoldthatwhilethe
formerisconcer nedwi t
heconomi cbehav i
oursofi ndi
vidualagents
i
nt heeconomy ,
t helatt
erismor econcer nedwi t
ht hetotal
it
yoft he
economy and t herefore addresses such na¬t i
onali ssues,as
unemploy ment,economi c growth etc.Dependence oft he t wo
theori
es;mi cr
oeconomi csandmacr oeconomi csoneachot herwas
alsobroughtt othef orebynot i
ngt hatthet otali
smadeupoft he
parts.Also,ther easonswhyeconomi st ssomet imedi sagreeon
economi cissueswer egiveninthislect
ure.

Post-
Test
1.Whydoy outhinkpeopl
ear emor econcernedwi t
hmacr o
moret hanmicroeconomics?
2.Stat
ef ourdi
ff
erencesbetweenmi cr
oandmacr oeconomics
3.Expl
ain what y ou underst
and by i nt
erdependence of
microeconomicsandmacr oeconomics?
4.Expl
ainwhyeconomi st
ssomet imesdisagreeoneconomi c

11
 i
ssues?

References
Aboy ade,O.( 1983).Integrated Economics:A St udy of
DevelopingEconomi es:Addi son-Wesl eyPubl
ishersLtd
Dwi vedi,D.N.( 2005).Macr oeconomicsTheor yandPol icy:
TataMcGr awHi ll
.
Jhingan,M. L.(2000) .Macr oeconomicTheory:10thRev i
sed
andenl argededi t
ion.Vr indaPublicati
on(p)Ltd
Lipsey ,R.G.( 1971) .I nt
r oducti
on to Posit
iveEconomi cs.
London.Wi edenfeldandNi col
son,
Blanchar d,O.( 1997).Macr oeconomics.Prenti
ce-Hall
,Inc.
Olofin,S. 2001. An I nt r
oducti
on t o Macr oeconomi cs:
MalthousePubl i
sher s.

12
LECTURETWO

Unempl
oyment

Int
roducti
on
Macroeconomi csdeal swi t
ht hreemai nv ari
ables-empl oy ment,
outputandt hegener alpr i
cel evel
.Inthislecturewewantt ol ookat
employment .Or dinar i
l
y,y ou know t hatt he empl oy ed r efersto
peoplewhoar edoingsomewor kforaliving.Thisnat ural
l
yi ncl
udes
thosewho ar esel f-employed.Conv ersely,theun¬empl oy ed ar
e
thosewhoar ewi l
li
ngt owor kbutar enotcur r
entl
yempl oyed.
I
nther estoft hisl ecture,weshal lbel ookingmor ecl oselyat
unemployment ;causesofunempl oymentandpol i
cieswhi chcoul d
beusedt oaddr esst hepr oblem ofun¬empl oyment.

Obj
ect
ives
Att
heendofthislect
ure,y
oushouldbeableto:
1.defineunemployment;
2.explai
ncausesofunempl oy
ment;and
3.discusshowt ocontr
olunempl
oyment.

Pr
e-Test
1.What do y ou under
stand by unemployment
? Why i s
unemploymentapr obl
em i
nmodem economics?
2.Def i
ne and explai
nt he var
ious t
ypes ofunemployment
knowntoy ou.
3.I fy
ouar et
hePr esi
dentofacountr
ywithhi
ghunemployment
rat
e,whatarethemeasuresyoucanadopttocontr
oli
t?

13
CONTENT
Unempl oy ment
Oneoft hemaj orpr oblemsconf ronti
ngev er
ymoder neconomyi s
thatofun¬empl oy ment.I tisaneconomi ccondi ti
oni nwhi chthe
numberofpeopl ewhoar ewi l
l
ingandabl etowor kbutar ewi thouta
j
ob.Unempl oy menti sast ockconceptmeasur edatapoi ntint i
me;
i
ti sani ndicationoft her esour cesoft hecountryt hatispr esent l
y
unutil
ised.
Theimpl icationsofunempl oy mentinaneconomyar egr i
ev ous.
First
,i ti mplies thatt he economy i s operati
ng atbel ow f ul
l
empl oymentl eveli n whi ch case i tmeans t hatt he soci etyi s
foregoing some pot entialout put .Second,itwi l
li n¬crease the
pressureont hosewhoar epr esent l
ywor ki
ngsi ncet heyhav et o
caterfort heirunempl oyedr elativesori nsomecasespar toft heir
taxeswi llbeusedt opr ovidef ort heunempl oyed.Thi rd,itcoul d
alsoleadt oincr ementi nso¬ci almenacesuchasar medr obber i
es,
prostit
ution,etc.

Volunt
aryversusInvolunt
aryUnemployment
Keynes di sti
nguishes bet ween v ol
unt
ary and i nvol
unt
ary
unemployment . Volun¬t
ary unemployment occur
s when t he
unemployedi sunwill
ingtotakeupt heavai
labl
ejobatthegoing
wager ate.Invol
untaryunempl oy
mentoccurswhenaper sonis
wil
li
ngtoacceptaj obatthegoingwageratebutcoul
dnotfi
ndone.

CausesofUnempl oyment
I
n di scussing t he causes of unempl oyment,i ti s usefulto
di
stinguishdi ffer
entki ndsofun¬empl oy ment.
1.Fr icti
onal unempl oyment : Thi s i s t he amount of
unempl oymentt hatisassociat edwi thnormalt urnoverof
labour .Itisunempl oymentt hatoc¬cur sint hecour seof
leavingonej obandf i
ndinganot her.
2.St ruct ur
alunempl oyment:Str
uct uralchangesinaneconomy
canbeacauseofunempl oyment .Thepr ocessofeconomi c
dev elopmenti mpli
eschangesi ni nputandout putmi x.Whi
le
thedemandf orsomepr oductswi llbeincreasi
ng,otherswil
l

14
 be decr easing.Howev er,i tmi ghtt ake some¬t imes f or
worker swhoar el aid-offi nthedecl iningindust r
yt olear nt he
re¬quired ski l
lst o cr oss ov ert ot he gr owi ng indust ry
.
Essent ially,
st r
uct ural unempl oymentt husoccur swhent her e
i
s a mi smat ching bet ween t he un¬empl oy ed and t he
avail
abl ej obsi nt ermsofr egionall ocat i
on, r
equi r
edski l
ls,or
anyr elev antdimensi on.
3.Deficient demand unempl oy ment : Unempl oyment t hat
occur sbecauset her ei si nsufficientaggr egat edemandt o
purchase f ull empl oy ment out ¬put i s cal l
ed def i
cient
demandunempl oy ment .Iti smeasur edbyt heex¬cessof
thesuppl yofwor kersl ookingf orj obsov ert henumberof
j
obsav ai l
able.I twi l
lbeposi tivewhen t her ei sdef i
cient
aggregat e demand and negat iv e when t her ei s excess
aggregat edemand.
4.Search unempl oy ment :Thi s occur s among peopl e who
couldf indwor koft het ypef orwhi cht heyar ef itt
edbutwho
remai nedunempl oy edi nor dert osear chf orabet terof fer
thant heyhav er eceiv edsof ar.
5.Seasonal unempl oy ment : Thi s r esul t
s f rom seasonal
fl
uctuat ionsi ndemandf orl abour .Forexampl e, empl oy ment
i
ni cef actoriesi sonl yfort hesummer ;simi l
ar ly,i
ce- cr
eam
sell
ersr emai nunempl oyeddur ingwi nter.Thesamei st he
casewi thagr i
cultur alwor ker swhor emai nempl oyeddur ing
harvest ingandsowi ngseasonsandr emai ni dlef ort her est
ofthey ear .

Cont r
ol ofUnempl oy ment
Thebestr emedyf orunempl oymenti sanunder standingoft he
natureandcausesofsuchunempl oyment.Inot herwor ds,one
needs an under standi ng oft he t
ype ofunempl oymentbef ore
appropr i
atecontrolmeasur escanbet aken.Forinstance,f ri
cti
onal
unempl oymenti si nev i
tablei nanyeconomy .Howev er
,anypol icy
measur et hatmakesmov ingbet weenj obseasierandqui ckercan,
howev er,reducethev olumeoff ri
cti
onal unemploymentsomewhat .
Str
uct uralunempl oy mentmay be checked by pol i
cies of
ret
raining and relocat ¬ing labouraspar tofagener alef for
tt o

15
faci
litatet headj ustmentofl aboursup¬pl iest ochangingpatterns
ofdemand
Unempl oymentt hatisduet odef ici
entaggr egatedemandcan
ber esol vedbyi ncr easingaggr egatedemand.Thi scanbedoneby
anyexpansi onaryf iscal (
e.g.incr
easi nggov ernmentexpenditure)or
monet ary(e.g.reduci nginterestrates)pol icies.
Genui ne sear ch unempl oymentmay be r educed,fi
rst,by
maki ngi teasierf orin¬dividualstolocat ejobv acanciesandsecond,
byi ncr easingthepossi bil
it
yt hati ndividualswi l
lacceptanof fer
receivedear l
ierint heirsearchper i
od.Thef i
rstcanbedone,f or
exampl e,byt hepr ov isi
onofmar keti nformat iononj obavail
abil
ity
;
the second r equi res increasing t he cost of sear ch to t he
unempl oyed indiv i
dual ,forexampl e,byr educing unemployment
benef it
s.

TheUnempl oymentRat e
Thelaborf orcei sdef i
nedast hesum oft hoseempl oy edand
thoseunempl oyed:
L= N +U
Laborforce=Empl oyment+Unempl oy ment
Theunempl oymentr atei nt urni sdef i
nedast her ati
ooft he
numberofunempl oyedtot hel aborfor ce.
u= U
L
Unemploy mentr ate = Unempl oy ment
Laborf orce
Whatdet ermineswhet herawor keri sdef inedasunempl oyed
ornot?Unt i
lthe1940si nt heUni tedSt atesandunt i
lmor er ecentl
y
i
n mostot hercount r
ies,t he numberofpeopl er egistered in
unempl oymentof f
iceswast heonl yav ai l
ablesourceofdat aon
unempl oyment,and onl yt hosewor kerswho wer eregistered in
unempl oymentof ficeswer ecount edasunempl oyed.Thissy st
em
l
edt oapoormeasur eofunempl oy ment .How manyoft het rul
y
unempl oyedact uallyregisteredv ariedbot hacr osscount riesand
acrosst i
me.Thosewhohadnoi ncent iv
et oregist
er,forexampl e,
thosewho had exhaust ed t heirunempl oymentbenef its– wer e

16
unlikelyt ot aket het i
met ocomet ot heunempl oy mentof fi
ce;t hus,
they wer e not count ed. Count ri
es wi th l ess gener ous
unempl oyment benef it sy stems wer e l ikely t o hav e f ewer
unempl oyedr egi steri
ng; thus, thosecount rieshadsmal lermeasur e
ofunempl oy mentr ates.
Today ,mostcount ri
esr elyonl ar gesur vey sofhousehol dst o
comput et heunempl oy mentr ate.I nt heUni tedSt ates, thissur veyi s
called t he cur r
entpopul ation sur vey ( CPS) ,and i tr elies on
i
nter viewsof60, 000househol dsev erymont h.Thesur v eycl assi fi
ed
somebodyasempl oyedi fheorshehasaj obatt het imeoft he
i
nter view;i tclassi fiessomebodyasunempl oy edi fheorshedoes
nothav eaj obandhasbeenl ooki ngf orwor ki nt hel astf ourweeks.
Mostot hercount ri
es use a si mi l
arconceptofunempl oy ment ,
alt
hought hedef initi
onofwhat“ looki ngf orwor k”meansexact ly
variesacr osscount ri
es.I nt heUni tedSt at esi n1994,est imat es
basedont heCPSsur veyshowedt hatont heav er ageov ert hey ear,
123 mi ll
ion peopl e wer e empl oy ed and 8 mi llion peopl e wer e
unempl oyed.Theunempl oy mentr at ewast hus8/ (123+8) ,or6. 1
percent .
Not e an i mpor t
antchar act eristic oft he def initi
on oft he
unempl oymentr ate.Onl yt hosel ooki ngf orwor kar ecount edas
unempl oyed;t hosewhoar enotl ooki ngar ecount edasnoti nthe
l
abourf orce.Butwhen unempl oy menti s hi gh,manyoft hose
withoutj obssi mpl ygiv eupl ooki ngf orwor kandt husar enol onger
count edasunempl oyed.Thesepeopl ear eknownasdi scour aged
wor ker s.Tot akeanext remecase, ifal lwor ker swi thoutaj obgav e
up l ooki ng,t he unempl oy mentr ate woul d equalzer o,and t he
unempl oymentr ate woul d be a v er ypoori ndi catorofwhati s
happeni ngi nt hel abormar ket .Thi sext remecasedoesnothol d,
butami l
derv ersioni spr esent .Ty pically,hi ghunempl oy menti s
associ at edwi thmanywor ker sdr oppi ngoutoft hel aborf orce.
Equi valent ly,ahi ghempl oy mentr atei sty pical l
yassoci atedwi tha
l
owpar t i
cipat i
onr ate, definedast her atiooft hel abourf orcet othe
totalpopul ati
onofwor kingage.Si ncet hest artofeconomi cr ef orm
i
nEast ernEur opei nt heear ly1990s, unempl oy menthasi ncr eased,
often dr amat ical l
y.Butequal l
ydr amat ic has been t he dr op in
participat ionr at es.I nPol and,f orexampl e,70%oft hedecr easei n
empl oy menti n1990 wasaccount ed f orbyear lyr etirement s-i
n

17
ot
herwor
ds,
bypeopl
edr
oppi
ngoutoft
hel
abourf
orce.

Summar y
Inthecour seoft hislecture,youhav ebeent oldthatunemploy ment
ref
erst o peopl e who ar e wi l
li
ng t o wor k butar e cur r
entl
y
unempl oyed.Ther e arev arious types ofunempl oyment.These
i
nclude f r
icti
onal un¬empl oyment , struct ur
al unempl oy ment,
defi
cient demand unempl oyment,sear ch unempl oyment and
seasonal unempl oy ment. Gi ven t he negat i
ve ef fects of
unempl oymenton t heeconomy ,sev eralcon¬t rolmeasur esar e
oft
enunder takenbyt hegov er
nmentt or educei t.Howev er,the
parti
cular measur e chosen wi ll depend on t he t ype of
un¬empl oymentbei ngaddr essed.
Post-Test
1.Whatdo y ou under stand byunempl oyment ?Whyi si ta
problem inmoder neconomi cs?
2 Di ff
erentiate bet ween v oluntary and i nvoluntar
y
unempl oyment
3.Expl ainthet ypesofunempl oymenty ouknow.
4.Whatar et hev ari
ousmeasur eswhi ch could beused t o
controlhighunempl oy mentrate?

Ref
erences
Aboy ade,O.( 1983) .I ntegr ated Economi cs:A St udy of
DevelopingEconomi es:Addi son-Wesl eyPublishersLtd
Blanchar dO.( 1997) .Macr oeconomi cs.Prenti
ce-Hall
,Inc.
Bradley ,R.Schi l
ler
.( 2003).TheEconomyToday :9t
hedi t
ion.
McGr aw-Hill
Dwi vedi,D.N.( 2005) .Macr oeconomi cst heoryandPol icy.
Tat
aMcGr awHi l
l
.
Jhingan,M. L.(2000) .Macr oeconomi cTheor y10t hrev.and
enl
argededi t
ion.Vr i
ndaPubl icati
on( p)Ltd
JoeU.U.( 2007) .Economi cs:AnAf ri
canPer specti
ve.2nd(ed)
Mil
lennium TextPubl ishers, Lagos:
Lipsey ,R. G.( 1971) .I ntr
oduct i
on to Positi
ve Economi cs,

18
London:Wiedenfel
dandNicol
.
Olof
in S.(2001). An I
ntr
oduct
ion t
o Macr
oeconomi
cs.
MalthousePubli
shers.

19
LECTURETHREE

Nat
ional
IncomeAccount
ing

Int
roduction
Gross domest i
c pr oduct( GDP)measur es the v al
ue ofout put
producedbyf ac¬torsofpr oducti
oni nthedomest i
ceconomyov er
aper i
odoft ime, r
egar dl
essoft hosewhoownt hesefactors.Agai n,
youwoul dnot i
cet hattheconceptofGDPi saf low.Itmeasur es
outputov eraper i
odoft ime.Fort hepurposesofcomput a¬tion,we
onlyr ecognize fi
nalgoods and ser v
ices.Thi si sto av oidt he
problem ofdoubl ecount ingandunnecessar yexagger at
ionoft he
valueofgoodsandser ¬vi
cespr oduced.
Inadditi
on,GDPonl ytakesintocogni zancepay mentsear ned
asar esultofonlygoodsandser vi
cespr oducedwhi lepay ment s
notmade i nr espectofpr oduced goods and ser vi
ces ar e not
counted. Such uncount ed pay ments ar e known as t ransfer
pay ments.

Obj
ect
ives
Att
heendoft hi
slect
ure,youshoul
dbeableto:
1.explai
n witht he basi
c concept
s oft
en used i
n nat
ional
incomeaccount i
ng;
2.explai
nhowt ocomput enati
onali
ncomeaccount
ing;
and
3.discussthemaj orl
imit
ati
onsofusingGNPasameasur eof
welfare.

Pr
e-Test
1.Def i
nenat
ional
income.

20
 2.Disti
nguishbetweenr ealandnominalincome.
3.Whatar ethemaj orlimit
ati
onsofusingGNPf ort
hepurpose
ofinter
nation¬alcomparisonorwell
-being?
4.Whatar et hedi f
ferentapproacheswhi chcanbeusedt o
measur enationali
ncome?

CONTENT
WhenGNPi smeasur edatcur r
entmoneyv al
ue, i
tsv alueisgoingt o
beaf fectedbyt hepr i
cel evel
.Itispossibleforthev alueofGNPt o
doublebet weent woy ear s,
butthisdoesnoti mplyt hatwelfarelev el
hasi ncreased.Ift hepr icelevelalsodoublesov ert hetwoy ears
thent hev alueofGNPhasnotchangedi nt het woy ears.Thus,
whenGNPi sv aluedatt hecur r
entpricelevel,itisr ef
erredtoas
nominalorGNPatcur rentpri
ces.Ont heot herhand,GNPwhi ch
hasbeencor ¬rectedf orchangesi nthepr i
cel ev
eliscal l
edGNPat
realpricesoral ternat
ivelyasrealGNP.I ti
st heact ualmeasur eof
changesi nwelfar eleveloveragivenper i
od.

Def
ini
ti
onsofRel evantConcept s
1.Gr ossDomest i
cPr oduct(GDP) :Thi si sthemonet aryv alue
of al lgoods and ser vices pr oduced i n an economy ,
i
rrespect i
v eoft henat i
onalit
iesoft hosewhopr oducedt hem,
overagi v
enper iodoft i
me, usual l
yay ear.
2.Gr ossNat ionalPr oduct(GNP) :Thi sist hemonet aryv al
ueof
goodsandser ¬v i
cesproducedbyt henat i
onalsofacount ry
whet herr esidentwi t
hinorout sidet hecount ry.Itissi mpl y
GDP pl us i ncome f r
om abr oad ( i
.e.income ear ned by
nationalsoft hecount ryresidentabr oadmi nusi ncomeof
foreignersr esidentwi t
hinthecount ry).
3.NetNat i
onal Product(NNP) :Thi sisGNPmi nusdepr eciation.
I
ti st hev alueofnat ionalproductaf termakingal lowances
fort he depr eciati
on oft he capi t
alused t o produce t he
out¬put .

Li
mitat
ionsofGNPandNNP
Ther
e are cer
tai
nli
mit
ati
ons i
nthe use ofGNP and NNP as

21
measur
es of economic well
-being or for t
he purpose of
i
nter
nat
ionalcompar
isonofwel
l-being.Someofthesel
i
mi t
ati
ons
ar
e:

1.Popul at i
on:GNPandNNPar enotv erymeani ngfulunl ess
one knowst he si ze oft he popul ation oft he count ryi n
quest ion.Fori nstance,acount r
y'
sGNPmaybe$50bi l
li
on
buthav eapopul ati
onof500mi l
lionwhi l
eanot hercount r y
mayhav ea$20bl li
onbutwi t hapopul at i
onof10mi ll
ion.
Clear l
y ,thesecondcount ry,thoughwi thasmal l
erGNPhasa
higherst andar dofl iving.Tomakei nter -count rycompar i
son
mor emeani ngf ul
,percapi tai ncome( PCI )-GNPdi vi
dedby
thepopul ation-i sof tenused.
2.Leisur e:GNP andNNP do nott akei nt o accountl ei sur e.
Usual ly,aspeopl ebecomemor eaf fluent ,t heysubst it
ut e
l
eisur ef ori ncr easedpr oduct i
on.Yet ,thisi n¬creasei nleisur e
ti
me whi ch cont r i
but est oi ncreased wel l-
bei ng doesnot
show up i n GNP and NNP.Nei ther do t he per sonal
sat i
sfact ion( ordi spleasur e)peopl egetf r om t hei rj
obs.
3.Qual it
yChanges:GNP andNNP donott akei ntoaccount
changesi nt hequal ityofgoods,unl essi tspr i
cer efl
ectst he
i
mpr ov ement .Forexampl e,forabr andnew t y peofdr ug,i f
theout putandcostoft henewdr ugi st hesameast heol d
drug,GNPwi l
lnoti ncr ease,ev ent hought henew dr ugi s
twiceasef f
ec¬t iveast heol done.
4.Val ueandDi stribution: Bot hGNPandNNPsaynot hi
ngabout
thesoci aldesi rabil
ityoft hecomposi t
ionanddi stri
butionof
the nat i
on' s out put .Each good and ser vi
ce pr oduced i s
valuedati tspr i
ce.I fthepr i
ceofabi blei sN100andt hatofa
por nogr aphi cbooki sN100, bot har ev al uedatN100. 00each
andent er edi ntoGNP comput ati
onwi t houtr ev eali
ngt hei r
relativ
ei mpor tance.Thet womeasur esdonotr evealhow
the goods and ser vices pr oduced ar e di stributed int he
soci et
y .Ar et heyev enl ydi st
ributed?Ordi stri
but edi nf avour
oft her ich?GNPi ssi lentont hesequest ions.
5.Soci alCost :GNPandNNPdonotr ef l
ectsomeoft hesoci al
cost ,ar i
si ngf rom t hepr oduct ionofgoodsandser vi
ces.I n

22
 parti
cul
ar,they do not r
efl
ect en¬v
ironment
alcost of
product
ionacti
vi
ti
es.

MeasurementofGNP
Therearethreebasi
cappr oachestomeasur
ingGNP.
Thereare:
1.TheExpendi t
ureAppr oach
2.TheI ncomeAppr oach
3.TheOut putApproach.

Weshal
lexami
net
heabov
eappr
oachesser
ial
l
y.

1. TheExpendi t
ur eAppr oach
Thi
si nv olvesaddi ngt oget heral ltheexpendi tureonf inalgoods
andser vices.Economi stsdi stingui shamongf ourcategor i
esof
expendi ture:
a.Per sonalConsumpt ion Expendi t
ure:These i nclude t he
spendi ng by househol ds on dur abl e goods,non- durable
goods and ser vices.Per sonalconsumpt i
on expendi ture
usual ly account sf or t he gr eat
est pr opor t
ion of t ot al
expendi ture.
b.Gr ossPr i
vateDomest icI nv estment :Theseconsi stofal l
i
nv est mentspendi ngbyf irmsi ntheeconomy .Thr eebr oad
typesofexpendi turesar ei ncludedi nthiscat egory.
i.al lfinalpur chasesoft ools,equipmentandmachi nery;
i
i.al lconst r
uct i
onexpendi t
uresi n¬cludingexpendi tur
eon
resident i
al houses; and
i
i
i.t hechangei nt ot al i
n¬v entor i
es.
c.Gov er nmentPur chasesofGoodsandSer v i
ces:Thisi ncludes
the ex¬pendi tures of t he Feder al, State and Local
Gov er nment sint heper f
or manceoft heirfunctions.Howev er,
i
texcl udest ransf erpay ment s,sincet heydonotar isef rom
product ionpr ocesses.
d.NetExpor ts:Thi si s simpl yt he difference between t he
count r y'
sexpor tsandheri mpor ts.

23
 Thus, GNP using t he expendi
ture approach can be
summar
isedas:
GNP =Per sonalConsumptionExpenditur
e+Gr ossPr i
vate
Domesti
cI nvestment+ Gov ernmentPur chases of
GoodsandSer vi
ces+Netex¬por t
s.

2. TheI ncomeAppr oach

Touset hisappr oach, wesi mpl ysum upal lthei ncomesear ned
byfactor sofpr oduct i
on-l abour , capi tal,landandent repreneur,
fortheircont ribut i
ont opr oduct i
onoft hey ear'sout put.Thi s
i
ncomei sofv arioust ypes, theyar e:
a.Compensat ion ofEmpl oy ees:Thi si st he l argestoft he
incomecat egor ies.I tincludest hewagesandsal ariest hat
arepai dbyf i
r msandgov er nmentagenci est osuppl i
erof
labour .I naddi t i
on,i tcompr isesav ariet yofsuppl ement ary
pay ment sbyempl oy ersf ort hebenef i
toft hei rempl oyees,
suchaspay ment si nt opubl i
candpr ivatepensi onschemes
andwel ¬faref unds.
b.Rent s:I nt hepr esentcont ext ,r enti sdef i
nedaspay mentt o
househol ds f or t he suppl y of pr oper tyr esour ces.For
exampl e, i
ti ncl udeshouser ent sr ecei vedbyl andl or ds.
c.I nterest :Thi si ncl udespay mentofmoneybyent erprisest o
suppl iersofmoneycapi tal.Int er estpai dbyt hegov ernment
on t reasur ybi ll
,sav ings,bonds and ot hersecur i
ti
es ar e
excludedont hegr oundst hatt heyar enotpay ment sf or
currentgoodsandser vi
ces.Theyar er egar dedast ransfer
pay ment s.
d.Pr opr ietors'I ncome: Thi s consi st s of net i ncome of
unincor porat edbusi nesses.I not herwor ds, itconsi st soft he
neti ncomeofpr opr ietorshipsandpar tner shi ps.
e.Cor por atePr of its:Thi si st heneti ncomeofcor porations.
Thisi smadeoft hr eepar t
s: ¬
i. di videndsr ecei vedbyst ockhol der s;
ii
.r et ainedear ni ngs; and
ii
i.theamountpai dbycor por ationasi ncomet axes.

24
 Al
ltheit
emsdi scussedabov earef ormsofi ncome.Inadditi
on,
therearetwonon-incomei t
ems, depreciati
onandi ndi
rectbusiness
taxes,t
hatmustbeaddedt othesum oft heincomei t
emst oobtain
GNP.
Ont hebasisoft heabov edi scussion,GNP v iathei ncome
approachcanbesummar i
zedas:
GNP= Compensat ion ofEmpl oyees + Rent+ I nterest+
Propriet
ors' In¬come + Cor porat
e pr ofit
s +
Depreciati
on+ndirectBusi nessTaxes.

3. TheOut put(orValue-Added)
Thisissi mpl ythemonet aryv al
ueofal lt hev al
ue-addedt o
everysectorint heeconomy .I
not herwords,itisthemonet ary
value ofthe cont r
ibuti
ons ofal lthe outputofgoods and
servi
cesbyv ari
oussectors,
intheeconomy .Itshouldbenoted
thatthe emphasi sis on v al
ue-added.Val ue-added ist he
amountofv alueaddedbyaf ir
m orindustr
yt ot hetotalworth
oftheproduct .

Nati
onalIncome, Per
sonalI
ncomeandDi
sposabl
eIncome
Besides,GNP and NNP,ot herimpor
tantnati
onalaccounti
ng
concepts include ¬nati
onal i
ncome, per
sonal income and
di
sposableincome.

NationalI
ncome
Thisisthetotalamountpaidt ofact
or sofpr
oducti
on-land,
labour,
capitalandent r
epreneur
.I tisderivedfrom GNP bysubtracti
ng
fr
om t hel
att
erindir
ectbusi¬nesstaxesanddepreci
ati
on.

Personal I
ncome
Thisisthet otalamountanav erageindi
vi
dual r
eceivesasincome.I t
dif
fersfrom nat ionalincomei nt woway s.Fi
rst,somepeopl ewho
haveacl aim oni ncomedonotact ual
lyrecei
v eit.Forexampl e,
alt
houghal lthepr ofi
tofaf orm belongst otheowner s,notallof
thi
si sev entual
lypai doutt ot hem.Second,somepeopl er ecei
ve
i
ncomet hatisnotobt ainedi
nexchangef orserv
icesrendered.
To reconci l
e per sonali ncome and nat ionalincome,y ou

25
subt
ractcorporat
epr
ofi
tsfr
om nati
onali
ncome, andadddi v
idends
tothe result
.Then you mustdeductcontributions f
orsoci al
i
nsuranceandaddgovernmentandbusi
nesstr
ansf erpayments.

Disposabl
eIncome
Thisissimplythet akehomepayofwor ker s.I
tmeanst heactual
i
ncomewhi chcanbespentonconsumpt ionofindiv
idual
sand
famili
es. The whol e of the per sonal cannot be spent on
consumption,becauseiti st
hei ncomest hataccr
uebeforedirect
taxeshaveact uall
ybeingpaid.Ther efore,inordertoobtaint he
disposabl
ei ncome,di recttaxes ar e deducted fr
om per sonal
i
ncome.ThusDi sposabl
eincome=per sonal i
ncome–directt
axes

Nomi nal andReal GDP

Nomi nalGDP:Thi si ssi mplyt hesum oft hequant i
tiesoff inal
goodspr oducedt imest heircurrentpr ice.Awar ni
ngi sinor derher e.
Peopl e of ten use t he wor d nomi nalt o denot e smal lamount s.
Economi stsusenomi nalf orv ariablesexpr essedi nuni t
soft he
currencyoft her elev antcount r
y.
Nomi nalGDPi ncreasesov ert imef ort wor easons.Thef ir
sti s
thatthepr oduct i
onofmostgoodsi ncreasesov ertime.Thesecond
i
st hatt henai rapr iceofmostgoodsal soi ncreasesov ert i
me.We
producemor eandmor egoodseachy ear,andt heirnai rapr ice
i
ncr eases each y earas wel l
.I fouri ntenti
on i st o measur e
product i
onandi tschangeov ert i
me,weneedt oel i
mi natet he
effectofi ncr easingpr i
ces.Fort hispur pose,economi stsf ocuson
realrathert hannomi nalGDP.
Toconst ructr ealGDP,wef irstchooseabasey ear;wet hen
const r
uctr ealGDPi nanyy earast hesum ofquant it
iespr oduced
ti
mest heirpr i
ce i nt he base y ear.An exampl e wi l
lhel p her e.
Supposet hataneconomypr oducest wogoods, potatoesandcar s.
Iny ear0-whi chweshal ltakeast hebasey ear– i tpr oduces
100,000poundsofpot atoesandsel lst hem atN100apound,and
10car st hatsel lforN400,000acar .Oney earlater,i
ny earone,i t
producesandsel l
s100, 000poundsofpot atoesatapr i
ceofN120

26
apound,and11car satN400,000acar.NominalGDPi ny
ear0
(baseyear
)ist
husequaltoN5,000,
000andnominalGDPinyear1
equalt
oN230,000.Thi
sinfor
mati
onissummari
zedintabl
e3.
1:
Tabl
e3.
1.Nomi
nal
GDPi
nYear0andi
nYear1.

Year0
Quantity NPr i
ce NVal ue
Pot at oes 100, 000 X 100 = 10, 000, 000
Car s 10 X 400, 000 = 4,000,000
Nomi nal GDP 14,000, 000
Year1
Quant i
ty NPr i
ce NVal ue
Pot at oes 100, 000 X 120
12, 000,000
Car s 11 X 400, 000
4,400, 000
Nomi nal GDP
16, 400,000
Thei ncr easei nnomi nalGDPf rom y ear0t oy ear1i sequalt o
N2, 400,000/ N14, 000,000=17percent .Butwhati sthei ncreasein
realGDP?Letust akey ear0ast hebasey ear–t hati s,let’
sadd
quant i
ti
esi nbot hy ear0and1usi ngy ear0pr icesf orpot atoesand
cars.Becausewet akey ear0ast hebasey ear ,r
ealGDPi sequalt o
nomi nalGDPi ny ear ;r
ealandnomi nalGDPar eal way sequali nthe
basey ear .I ny ear1,r ealGDP i sconst ructed t o usi ng year1
quant i
ti
esandy ear0pr ices,sot hati tisequalt o( 100, 000xN100)
+( 11xN400,000)=14, 400, 000.Thei ncreasei nr ealGDPi sthe
equal toN400, 000/ N14,000, 000or2. 86percent .
Insteadofusi ngy ear0ast hebasey ear ,wecoul dhav eused
year1,ori ndeedanyot hery ear .Thechoi ceoft hebasey earwil
l
typicall
yaf fectt hemeasur eofr ealGDPgr owt h.Forexampl e,i
fwe
hadusedy ear1ast hebasey ear,realGDPi ny ear0woul dbeequal
to( 100, 000 x N120)+ ( 10 x N400,000)= N16,000, 000.By
const r
uct ion,r ealandnomi nalGDPwoul dbet hesamei ny ear1,
bothequalt oN16,400, 000.Thei ncr easei nr ealGDP woul dbe

27
equalt
oN400,000/N16,000,
000,thus2.
5per
cent.I
twoul
dthus
besmallert
hanthei
ncr
easeinrealGDPweobtai
nedusi
ngyear0
asthebaseyear
.

Summar y
Youhav ebeent akenthrought hemai nconceptscommonl yappl i
ed
i
nna¬t i
onalincomeaccount i
ng.Nationalincomei ssimplythet ot al
i
ncomeear nedbyal lthefactorsofpr oducti
onov eragivenper i
od
oft ime,usual l
ya y ear.Ther e ar
et hree basi
c approaches t o
measur ing GNP.These i nclude the expendi t
ure approach,t he
i
ncomeappr oachandt heout putapproach.Youwer efur t
hert old
thattheset hreeappr oacheswoul dgiv ethesamev al
uefornat i
onal
i
ncomeaf termaki ngappr opriat
eadj ustments.Theconcept sof
personneli ncomeanddi sposableincomewer eclearl
yexpl ai
ned.
Furthermor e,realandnomi nalGDPwer eexpl
ainedandconst r
ucted
i
nat abularform, whilesimplecalcul
at i
onswer edemonst rated.

Post-
Test
1.Whati sNational I
ncome?
2.Disti
nguish bet ween GNP atcurrentprices and GNP at
constantprices.
3.Discusst het hreeappr oachesofmeasur i
ng thenat i
onal
incomeofast ate.
4.Whati st herelati
onshipbetweennati
onalincome,personal
incomeanddi sposableincome?
5.Explai
nthef ollowingconcepts:
a.GNP
b.NNP
c.Per sonal I
ncome( PI )
d.Percapi taincome( PCI )
e.Real GDPandNomi nalGDP

Ref
erences
Jhingan,M.
L.( .Macr
2000) oeconomi
cTheor
y,10t
hRev
ised

28
andenl argedediti
on.Vr indapubl icati
on(p)Lt d
Lipsey,R. G( 1971) .Introduction to Positive Economi cs,
Wiedenf eld and Ni colson, London: Bl anchar d O. ( 1997).
Macr oeconomi csPrent ice-Hall
,I
nc.
Dwi vedi,D.N( 2005).Macr oeconomi csTheor yandPol i
cy.
TataMcGr awHi l
l.
Ol of
in S.( 2001) . An Int roduct
ion to Macr oeconomi cs.
MalthousePubl i
shers.
Dav idC.Col ander( 2004) .Economi cs,(5th ed)Mi ddlebury
Coll
ege, McGr aw-Ir
win.
JoeU.U.( 2007) .Economi cs:AnAf r
icanper specti
ve(2nded)
Mil
lennium TextPubl isher s,Lagos:

LECTUREFOUR

TheDet
ermi
nat
ionofNat
ional
Income

I
ntr
oducti
on
I
nt heprevi
ouslect
ure,youwereintr
oduced t
ot heconceptof
nat
ionali
ncome.Inmostcount
riest
odayanex aminat
ionofthei
r
GNPf orv
ari
ousyear
swill
showthefl
uctuat
ionswhi
chtakepl
acein

29
thesecountr
ies.Aper i
odofri
singGNPfol¬l
owedbyanot herperi
od
ofdecli
ningGNP andsoon;howev er,thesef
luctuat
ions,cause
seri
ousstrai
nsont heeconomy .
I
nt hi
sl ectur
e,we wantt o expl
ain why nati
onali ncome
fl
uctuat
es.Inaddition,wewantt oshow how i
ti sdeterminedin
vari
oustypesofeconomi cs.

Obj
ect
ives
Att
heendofthisl
ectur
e,youshoul
dbeabl et
o:
1.explai
nwhatthecir
cularf
lowofincomemeans;
2.explai
ntheequil
i
bri
um condit
ionsofaclosedeconomy
;and
3.definet
heconceptsofinj
ect
ionandwithdr
awal.

Pre-Test
1.Dr awt heci r
cularfl
owofI ncome.
2.Descr ibet heequili
bri
um conditionsofacl osedeconomy .
3.Supposet heconsumpt i
onf unct ionisC=0. 8Yandpl anned
i
nvestmenti sN45m.
a.Dr awadi agram showingtheaggr egatedemandschedul e.
b.I factualoutputis120, whatwi l
lbethel evelofunpl
anned
i
nv estment?
4.Def inewhati smeantbyequi l
ibrium output .
CONTENT
TheCi rcularFlowofI ncome
Theci rcularf low ofi ncomeshowst het r
ansact i
onbet weenthe
agentsi nt heeconomy .Forinstance,i nacl osedeconomyi fwe
assumet herear etwoeconomi cagent s,i
.e.thehousehol dandthe
fi
rms,t heci rcularfl
owofi ncomei nt hateconomycanbedepi ct
ed
asfollows:

30
Fi
g.4.
1:Ci
rcul
arRowofI
ncomei
naTwoSect
orCl
osedEconomy
.

TheCi r
cularFlowofIncome
Intheabov eeconomy ,firmspur chasefactorsofproducti
onfrom
thehouseholdsandf ortheset heypayincomest othehouseholds.
Thisfir
stpar tofther elati
onshipisdepictedbyt heinnerfl
owsi n
thefigureabov e.Oni tsownpar t,t
hehousehol dsbuygoodsand
servi
cesf r
om t hefi
rmsandf orthesetheymakepay mentstot he
fi
rms.Sinceweassumet hatthereisnol eakageintheeconomy ,
thenallsidesoft het r
ansactionsmustbeequal .Thismeanst hat
theincomeear nedbyhousehol dsmustbeequalt othev al
ueof
outputproducedbyt hef ir
ms.

31
 Fi
g4.
2Ci
rcul
arf
lowofi
ncomewi
thi
nject
ionsandl
eakages

Howev er,ifwe i ntr

oduce leakages and i nject
ions int o our
cir
cularf l
ow ofi ncome v i
a sav i
ngs and i nvestment ,then t he
cir
cularfl
owi nincomewoul dbealteredasi l
lustr
atedinFi g.4.2
I
nt heeconomyi ll
ustr
atedbyt heFi g.4.2,weassumet hat
householdsdonotspendal lthei
rincomeoncur rentconsumpt ion
ofgoodsandser vi
cesbutsav epar tofi t
.Theamountsav edthen
constit
utesal eakagef r
om thesy stem.Ont heot herside,f ir
msdo
notsellallt
heiroutputtohouseholds, somear ein¬vestmentgoods.
Thisrepresentsani nj
ectionint
otheci rcul
arf l
ow.Ani njecti
oni san
additi
ontot heincomeofdomest icfir
mswhi chdoesnotar isefrom
expen¬ditureoft hehousehol dsoranaddi ti
ont othei ncomeof
householdst hatdoesnotar isefrom t hesaleoff actorserv i
cest o
thefir
ms.

Component sofAggr egat

eDemand
I
nacl osedeconomyandi ntheabsenceofgov
ernment
,ther
ear
e
twosour cesofdemand.Ther ear
e:
a.Consumpt iondemand, and
b.I nvestmentdemand.
Thiscanber epresentedas
AD=C+I

Wher eAD i saggregat edemand;C i sconsumpt iondemand;

andIisi nvestment
1.Consumpt i
ondemand:Thi sist het otalamountofmoney
spentbyhousehol dsongoodsandser vicesconsumedi n
theeconomy .Suchgoodsandser vicesr angesf rom car s
and f oods tot heatre perf
or mances and el ectri
city
.Thi s
consumpt ionpur chasesaccountf ort hehi ghestpropor t
ion
ofaggr egatedemand.
2.Investmentdemand:Thi s consists off irms,desi red or
plannedaddi ti
onst oboostt hei
rphy si calcapital(factor
ies

32
 and machi
nes)and tothei
ri nv
entor
ies.I
n¬vent
ori
es ar
e
goodsbei
ngheldf
orfut
ureproducti
onorsal
e.

Aggr
egat
edemandcanbei
l
lust
rat
edbyt
hef
oll
owi
ngdi
agr
am.

Fi
g.4.3:Aggregatedemandcur
vei
ntheabsenceofgov
ernment
andexter
nalsector
s.

CASEA:Equi libri
um Nat i
onalIncomei naCl osedEconomy( without
theGov ernment )
Earli
eron i nt hisl ect ure,we i ntr
oduced i nj
ect i
ons inf orm of
i
nv est mentandwi thdrawal vi
asav i
ngintocircularflowofi ncomei n
acl osedeconomy .Thet woar ehowev ercar riedoutbydi f
ferent
agent si nt heeconomy .Howev er,insuchaneconomy ,equili
br i
um
nationali ncomeoccur swher esav i
ngsequali nvest¬ment ,thatis,
withdr awalequal si nject i
on.When sav i
ngs exceed i nvest ment,
i
ncomef all
s,t hi
swi l
ll eadt oar educti
oni nhousehol dssav i
ngand
thi
swi llcont inueunt i
lt het woar eequal.Theopposi tehol dswhen
i
nv est mentexceedssav i
ngs.
The equal i
ty bet ween sav i
ngs and i nv estment coul d be
demonst ratedei therst atisti
cal
lyorgraphicall
y .
Statistically,national incomeYi sequal toconsumpt ionexpendi ture
C,plusi n¬vest mentexpendi tur
eI .
i.e. Y=C+I……………….( 1)

33
 Fr
om (
1)I=Y–C……………….(
2)

But,we know thatincomemi nusconsumpti

on i
sequalt
o
sav
ings;t
her
efore,
equation(2)canbewr i
tt
enas
I=S………………. .
...
..
..(
3)
Geometr
ical
ly,
thisequal
itycanalsobeshownasfol
l
ows:

Fi
g4.4Equi
li
bri
um out
putl
evelatwhi
chpl
annedi
nvest
mentequal
s
pl
annedsav
ings

Inthefigur
eabov e,sav
ingsandi nvestmentsareequalwhen
i
nv estmentisN20m.Theequi li
bri
um nationali
ncomeatt hispoi
nt
i
sN100m.Thei nvestmentcurveisahor i
zont
alli
nebecausewe
assumei tisexogenouslydeter
mined,thatis,f
ixedir
respecti
veof
thelevelofnati
onali
ncome.

Ont heotherhand,t
hesavi
ngsfunct
ionisanupwar
dstr
aight
l
i
nebecauseweassumesav i
ngstobeafixedpr
opor
ti
onofagiven
l
evelofnati
onali
ncome.

Theincome– Expendi
tur
eAppr oach:Thi
sisanot hergr
aphi
cal
methodforshowi
ngt
heequil
i
bri
um level
ofnat
ional
income.Thi
sis
i
ll
ustr
atedbelow:
¬

34
Fig 4.5 Det
erminat
ion of nat
ional I
ncome v
ia t
he I
ncome-
expendi
tur
eapproach

The45°lineshowst heequali
tybetweenact ualexpendit
ureand
actuali
ncome.Poi ntsaboveorbelowt helineshowsacombi nat i
on
forwhichexpendi t
ureex¬ceedsincomeorexpendi t
ur eisl
esst han
i
ncomer especti
vely
.Inthi
sfigur
e,theequilibr
ium l
ev elofi
ncomei s
determined at t he point of interact
ion of t he ag¬gr egate
expenditurefuncti
onandt he45°l i
ne.Att hispoint,theaggregate
demandwi lljustbesuf f
ici
enttobuyupt hetotalofal lgoods
produced.Anyot herpoi
ntleadstodisequil
ibri
um.

CaseB:Equi librium Nat ionalIncomei naclosedeconomybutwi th

thepresenceoft heGov ernment
Atthisjunctur e,wer ecogni zet hepr esenceoft het hi
rdeconomi c
agent,thegov ernmenti n ouranal ysis.Thei ntroducti
on oft he
governmenti nt otheeconomybr i
ngsi ntoouranal y
sisanothertype
ofwi thdrawalv ariable( i
.e.taxes)and i nj
ect i
on v ari
abl
e( i
.e.
governmentexpendi ture).
Thei ntr
oduct ionoft hesev ari
ables,howev er,didnotalterthe
basiccondi¬tionsf orequi li
bri
um int heeconomy .Theequi l
ibri
um
conditi
onsst il
lr equi ret heequal it
yoft ot
alwi t
hdr awalsandt otal
i
njecti
ons.Thus,t heequi li
bri
um condi ti
oni nthiseconomycanbe
stat
isti
cal
lyst atedas: ¬
Inject
ion( I)=Wi thdrawal (W)
Or I+G=S+T
Wher e I =Inv estmentexpendi t
ure
G =Gov ernmentexpendi ture

35
 S =Sav i
ngs
T =Taxes
TheI ncome-expendi
tur
eAppr oach:Inthi
seconomy ,wenow
alt
ert hecom¬ponentofouraggr egatedemandbynow i ncl
udi
ng
gover nmentexpendit
ure;t
hus,AD=C+I+G.
Nationalincomewi l
lbei n equil
ibr
ium ifaggregat
edesi r
ed
expenditureis equalto nati
onalincome because inthatcase,
desiredpurchasewi l
lbeexact
lyequaltotot
alproduct
ion.

CASEC: Equi l
i
bri
um NationalIncomei ntheOpenEconomy .
Wenowr elaxourassumpt ionofacl osedeconomybyal lowingf or
thei nfl
uenceoff or
eignt r
ade,t hati s,impor t
sandexpor t
s.The
i
nt r
oduction of i mports and ex¬por ts introduces additional
vari
ablesi ntoouranalysis.Wenow hav enew f orm ofwithdrawal,
i
.e.Impor tsandanot hernew i njectionwhi chi sexports.Impor t
const i
tut
esawi t
hdrawalbecausemoneyspentoni mportgoesout
oftheeconomyandhenceconst i
tutesal eakaget othesystem.On
theot herhand,expor tconstitut
esani nj
ectionintotheeconomy
from thesal eofexport
s.

1. Equil
ibri
um int
ermsofWithdrawalandInj
ecti
ons
Again,weassumet hatl
i
keot herprev
iousinj
ect
ions,expor
t(x)
i
sf ixed,whileimportl
ike otherwithdr
awals,is al
lowed to
changepr opor
ti
onal
lywi
thincome.Ther esul
ti
ngequili
bri
um is
shownbel ow

Fig.4.
6 Equi l
ibri
um i
ntermsofwi t
hdrawal andinject
ions
I
fwi thdr
awal sarelesst han i
nject
ions,there wi l
lbe a net
expansionaryforceintheeconomy ;i
ncomewi l
lrise.Thiswil
lalso
maket ax,savingsandi mport
sr i
se.Theexpansi onwi llcometoa

36
haltwhent otalwit
hdrawalshav
erisentothelevel
oftotali
nject
ions
andv icev ersa.
Nationali ncome wi l
lbe in equi
li
brium when totaldesired
wit
hdr awal sequal t
otal
desiredinjections.Thus,t
heequil
i
brium condi
ti
onis,
onceagai n,W
=I.Thati s,
S+T+M =I+G+X.

2. TheIncome- Expenditur
eAppr oachinanOpenEconomy
In the open economy , aggr egate expendi ture incl udes
expendit
urebyf or
eignfirms,househol dsandgov ernment son
domest i
call
ypr oducedgoodsandser ¬v i
ces.Thi simpliest hat
aggregateexpendi tureincludesexpor tv alues.Att hesame
ti
me,some consumpt ion expendi t
ure made by domest i
c
households,fir
ms,andsomegov ernmentexpendi turemaygo
topurchasegoodsandser ¬vicesproducedi nf oreigncount ries.
Hence,i mpor tv al
ues mustbe excl uded f r
om aggr egate
expendit
ure.Thus, wehav e
AD=C+I+G+( X-M)
Onceagai n,nationalincomewi llbei ntheequi l
ibri
um when
aggregatedesi r
edex¬pendi tureisequalt onat i
onali ncome.
Whent hisist r
ue,totaldesiredpur chaseswi l
ljustbeequalt o
tot
alproduction.

Fi
g4.7Equi
l
ibr
ium nat
ioni
ncomet
hrought
heI
ncome-expendi
tur
e
appr
oach

37
Summar y
Int hecour seoft hisl ecture,youhav ebeent aughthowequi li
bri
um
l
ev elsofnat ionali ncomear edet erminedi ndi ff
erenteconomi c
syst ems.Youhav eal sobeent oldt hattheequi l
i
brium conditi
onsin
allthesedi ff
erenteconomi csy stemsar ebasicall
yt hesame.These
equi li
bri
um condi tionsr equiret hat;thet ot
alwi thdrawalsint he
economymustbeequalt ot het otalinj
ec¬ti
onsi ntotheeconomy ,
and t hat geomet ricall
y,t he equi l
i
brium l evel of income i s
det erminedatt hepoi ntatwhi chaggr egateexpendi tur
ef unct
ion
i
nt ersectsthe45l ine.

Post-
Test
1.Constructt heci r
cul arflowofI ncomef oranopeneconomy,
showing t he v ari
ous wi t
hdr awals and inj
ecti
ons i
ntothe
economy .
2.Discusstheequi l
ibrium condi ti
onf oranopeneconomy .
3.Supposet heconsumpt i
onf unctionofanopeneconomyi s
C=8+0. 2Y
a.Whati st hecor respondingsav ingsfunct
ion?
b.Whatshoul dbet heplannedl evelofinv
estmentt
hatwil
l
guarant eeequi l
ibrium i
nt heeconomy ?
4.Definethef oll
owi ngconcept s:¬
a.i nj
ecti
ons;
b.wi thdrawal s;and
c.equi l
ibr i
um out put .

Ref
erences
Aboy adeO.( 1983) .IntegratedEconomi cs:ASt udyofDev el
oping
Economies:Addi son-Wesl eyPublishersLtd
Dav id C.Col ander( 2004) .Economi cs,Fift
hedi t
ionMi ddl
ebury
Coll
ege:McGr aw-Ir
wi n.Dwi vedi,D.N( 2005).Macroeconomi cstheoryand
Poli
cy.TataMcGr awHi ll
.
Jhingan,M. L.( 2000) Macr
. oeconomi cTheor y,10t
hRev i
sedand
enl
argededi ti
on.Vr i
ndapubl icati
on( p)Ltd
Oli
v erBlanchar d( 1997)Macr oeconomicsPr enti
ce-
Hall,
Inc.
OlofinS.( 2001) .AnI ntr
oduct i
ont oMacr oeconomics.Malthouse

38
Publ
i
sher
s.

39
LECTUREFI
VE

TheConsumpt
ionFunct
ion

Int
roducti
on
Int hi
sl ectur
e,we shal lexami ne one oft he mosti mportant
component sofag¬gr egat eexpenditure-t
heconsumptionf unct
ion.
Theshapeoft hi
sf unction i
sv eryi mpor t
antforanalyzing the
i
mpactofgov ernmentpol i
ciesont heeconomy .
Hence,weshal ldiscusstheimpor tanttheori
esofconsumpt ion
andalsot hevariousfactorsthataffecttheconsumpti
onf uncti
on.

Obj
ect
ives
Att
heendoft hi
sl ect
ure,youshouldbeabl eto:
1.explai
nwhyconsumpt ionfunct
ionisveryi
mpor tanti
nmacro
-economi cs;
2.discussthet hreei mport
anttheoriesoft heconsumption
functi
on;and
3.highli
ghtt he factors which inf
luence the shape ofthe
consumpt ionfunction.

Pr
e-Test
1.Whyi stheconsumpt ionfunct
ionver
yi mpor t
antforpoli
cy
pl
anning?
2.Di scusst
hef actor
sthataf
fectt
heconsumpt ionfuncti
on.
3.Whatar et hemaj orfeat
uresofKey nesian theor
yoft he
consumptionfunc¬ti
on?
4.Di sti
ngui
shbet weentwoconsumpti
ont heori
esy ouknow.

40
CONTENT
Consumpt i
on( c)
Themai ndet erminantofconsumpt i
onissurelyincome,ormor e
precisely di
sposabl ei ncome,t he income that remains once
consumer shav ereceiv
edt ransf
ersfrom t
hegov ernmentandpaid
thei
rt axes.Whent hei
rdi sposabl
eincomegoesup,peopl ebuy
mor egoods;wheni tgoesdown,t heybuyfewergoods.Thesear e
otherv ari
ati
onst hataffectconsumption;f
orthemoment ,weshall
i
gnor ethem.
LetCdenot econsumpt ionandYD denot
edi sposabl
ei ncome.
Wecanwr i
te
C=c( YD)
(
+)

Thi sisj ustaf ormalwayofst at i

ngt hatconsumpt ioni sa
functionofdi sposabl ei ncome.Thef unct i
onC( YD)iscal l
edt he
consumpt ionf uncti
on.Theposi ti
vesignbel owYDmeansaposi t
ive
rel
ationbet weendi sposabl eincomeandconsumpt i
ons;I tcapt ures
the f act t hat when di sposable i ncome i ncrease, so does
consumpt ion.Economi st s callsuch an equat ion a behav iour al
equat i
on,t oi ndicatet hatt heequat i
oncapt uressomeaspectof
behav iour-
int hiscase, thebehav i
ourofconsumer s.
I
ti sof tenusef ult obemor especi f
icaboutt hef orm oft he
function-f
orexampl e,toassumet hatt hefunct ioni sl i
near.Her eis
suchacase.I tisreasonabl etoassumet hatt her elat
ionbet ween
consumpt ionanddi sposabl eincomei sgi venby :
C=co+c1YD
Wear eassumi ngnowt hatt hefunct i
oni sal i
nearr elati
on:i tis
charact er
izedbyt wopar amet ers,Co andC1.Let ’
sl ookateachi n
turn.The par amet erC1 i s cal l
ed t he mar ginalpr opensityt o
consume.I tgi vestheef fectonconsumpt i
onofanaddi ti
onalnai ra
ofdisposabl eincome.I fC1i sequalt o0. 7,thenanaddi ti
onalnai ra
ofdi sposabl ei ncomei ncreasesconsumpt ionbyN1x0. 7=70
percent .Anat uralrest r
ictiononC1i st hatitbeposi t
ive:Ani ncrease
i
ndi sposabl ei ncomei slikelytoleadtoani ncreasei nconsumpt i
on.
Anot hernat uralrestrict
ioni sthatC1bel essthan1: peopl earelikel y
toconsumeonl ypar tofanyi ncreasei nincome,andt osav et he
rest.

41
 Thepar ameterCohasasi mplei nt
erpretati
on.Itiswhatpeople
woul dconsumei ftheirdisposableincomei nthecur r
entyearwere
equalt ozero.Anat uralrestri
cti
oni sthatifcur r
entincomeisequal
tozero, consumpt i
onisst il
lposi
tive.Thisimpl i
esthatCoisposit
ive.
Howcanpeopl ehav eposi t
iveconsumpt ionift hei
rincomeisequal
tozer o?Thi sismadepossi bleeitherbydi ssavi
ng,borrowingor
both.Thi smeanst hataconsumercanei therleanbackonwhathe
hadsav edbef oreoract uall
ygoonbor rowing.

Theor i
esofConsumpt ionFunct i
on
1. TheKey nesi anTheor y
The basi c hy pot hesis of t he Key nesian t heory of t he
consumpt i
onf unct ioni st hatcur r entconsumpt ionisrelat
edt o
curr
enti ncome.Al gebr aical l
y,thisi mpliest hat:
C=f (
Y)
Wher e: Ci scur r
entconsumpt i
onandYi scur r
entincome.
Howev er,mor eappr opriately,theYi nthef uncti
oni ssupposed
tobeYd, thati s,disposabl ei ncome.
Tof ullyexposehi shy pot hesis,Key nesi ntroducedt woot her
concepts:t heav erageandt hemar ginalpr opensityt oconsume.
Averagepr opensi tytocon¬sume( APC)i sthepr opor t
ionofincome
spent on consumpt i
on. I n ot her wor ds,i tist he rati
o of
consumpt ionexpendi tur etot otalincomei .e.APC=C/ Y.Mar gi
nal
propensityt oconsume( MPC) ,ont heot herhand,measur est he
rel
ation bet ween changes i n consumpt i
on,ΔC and changes i n
i
ncome, ΔY.I tisther atioofΔCt oΔY( i
.e.MPC=ΔC/ ΔY).
Twobasi chy pothesespr ov i
det hecor eoft heKey nesiantheory
oftheconsump¬t ionf unct i
on:
1.Ther ei sabr eak- evenl evelofi ncomeatwhi chAPC =1.
Bel owt hislevel,APCi sgr eat ert hanuni tyandabov eitAPC
islesst hanuni ty.
2.TheMPCi sgreat ert hanzer obutl esst hanuni t
yforalll
evels
ofi ncome( seet hef i
gur esbel ow) .

Fact
orsInfl
uenci
ngConsumption
Empir
icalst
udiessuggestt
hatmanyf
act
orsi
nfl
uenceconsumpt
ion.

42
Thefir
standar
guablyt hemosti
mportantfact
ori
sthedisposable
i
ncome oft he people.The fi
gur
es below show the posit
ive
rel
ati
onshi
pbet
weent hetwovari
abl
es:

Fi
g.5.
1:Twopossibl
estagesforaconsumpti
onfunct
ion:
1.TheMPCi sconstantbuttheAPCdecli
nes:
2.Botht he APC and MPC decl i
ne as di
sposabl
eincome
i
ncr
eases.

Theabov er elat i
onshi pbet weenconsumpt ionanddi sposable
i
ncomeassumesot herf actorsaffectingconsumpt ionar econst ant.
Some ot her fact or s woul d howev er ,cause a shi ftin t he
consumpt ionfunct ion.Thesef actorsar et hefoll
owi ng:
1.Changesi nincomeDi stri
buti
on:I fhouseholdshav ediff
erent
MPC,aggr egat e consumpt i
on dependsnoton aggr egate
i
ncomebutal soont hedi stri
but ionoft hisi ncomeamong
househol ds.Changes i nt he di str
ibu¬ti
on ofi ncome wi ll
cause a change i nt he aggr egat el evelofconsumpt i
on
expenditure associ ated wi t
h any gi ven lev elofnat i
onal
i
ncome.
2.Changesi nt heTer msofCr edi t:Manydur ableconsumer
goodsar epur ¬chasedoncr edi t.Ifcreditbecomesmor e
dif
ficul
tormor ecost lyto obt ain,manyhousehol dsmay
postponet hei rpl annedcr edit-financedpur ¬chases.Ther e
woul d t hen be a t empor ary r eduction i n cur rent
consump¬t ionex penditureunt i
lt henecessar yextrasavings
areaccumul at ed.
Monet ary aut hority can by cont r
oll
i
ng t he cost and

43
 avai l
abili
tyofcr editshi ftst heconsumpt ionf unct ionand
thusaf fectsaggr egat edemand.
3.Changes i n Exi sting St ock ofDur abl e Goods:I ti s now
recogni zedt hatanyper iodi nwhi chdur ablesar edi f
ficultor
i
mpossi ble t o pur chase and monet ary sav ings ar e
accumul ated,i tisl ikelyt obef oll
owedbyasuddenout burst
ofexpendi tureondur ables.Ther ef ore, thiswi l
lshiftupwar ds
theconsumpt ionf unct ion.
4.Changesi nPr iceExpect ation:Ifhousehol dsexpecti nf l
ation
tooccur ,theywoul dbewi lli
ngt opur chasedur ablegoods,
whi cht heywoul dot her¬wi senothav eboughtf oranot her
oneort woy ears.I nsuchci r
cumst an¬ces,pur chasesmade
nowy ieldsav ingsov erpur chasesi nthef uture.
5.Gov ernmentPol i
cy :Changesi ngov ernmentpol i
ciescanal so
affectt her elat i
onbet weennat i
onali ncomeanddi sposabl e
i
ncome;f orexampl e,byal teri
ngt axr at es.Ani ncreasei n
i
ncomet axr atewi ll
,f orexampl e,r educet heamountof
disposabl ei ncome t hat r eaches t he hands of t he
househol dsoutofanyl ev elofnat ionali ncome.Thi swi l
l
therefore make t he consumpt i
on f unct i
on cur vet o shi f
t
downwar ds.

Theori
esoft heConsumpt i
onFuncti
on
The Keynesi an theory as enunciated above r
elates cur
rent
consumption to cur ¬r
enti ncome.Howev er,empiri
calstudies
carr
iedoutbyr esearchershavenotsupport
edthist
heory.Thi
shas
l
edt oseveralmodi f
icati
onsoft hehypot
hesi
sasdiscussedbelow.
¬

1. The Per manentIncome Hy pothesis(PIH)Thi stheor y was

developed by ProfessorMi l
ton Fri
edman.The hy pothesis
makes t wo i
mpor tantassumpt ions.¬First
,people'sincome
fl
uctuates;second,peopl e disl
ike fl
uctuati
ng consumpt ion.
Thus,peopl e willalway st ryt o minimize the ef f
ect of
fl
uctuati
oninincomeont hei
rconsumpt i
on.
Friedmanbel i
evest hatpeople'sconsumpt i
onisi nfl
uenced
byt heirpermanenti ncome,r atherthan currentincome as

44
 arguedbyKey nes.Thus, dur
ingperiodoft empor ar
yi ncr
easei n
theirincome,househol dsdonoti ncreaset heircon¬sumpt ion
byt hesamepr oportion.Thisisbecauset heyper ceiv
esuch
i
ncr ementast empor ary.Theref
ore,theywi l
lsavemostoft his
tempor aryext raincomeand putmoneyasi det o seet hem
throught hey earwheni ncomei susual lylow.Peopl ewi l
lonly
i
ncr easet hei
rlevelofconsumpt ionift hei
rper manenti ncome
hassi gni
ficantl
yincreased

2. TheLi f
e-Cycl
eHy pothesis(LCH)Thi swasj oi
ntl
ydev el
opedby
ProfessorsFrancoModi gli
aniandAl bertAndo.Thet heoryi s
verysimil
artot hePIH.Thet heoryassumest hatpeoplehav ea
clearconcept i
onaboutwhatt heiri ncomewi l
lbeov ertheir
l
ifeti
meandont hatbasisform alifetimeconsumpt ionpl an.
Justli
ket hepermanenti ncomehy pothesi
s,thel i
fecy cle
hypothesissuggestst hatitisaver agel ongrunincomer ather
thancurrenti
ncomet hatisli
kelytodet erminethetotaldemand
forconsumerspendi ng.
TheLCHi sill
ustr
atedbyt hediagram bel ow

Fi
g.5.
2:Consumpt
ionandt
heLi
feCy
cle

Fig.5.2showsahousehol dactuali
ncomeov erit
sl if
eti
me.OFi s
the househol
d's permanentincome.OF is also the maximum
amountt hatt
hehouseholdcouldspendonconsumpt ioneachy ear
withoutaccumulati
ngdebtst
hatarepassedontofuturegenerat
ion.
Iftheinter
estrateswerezero,per
¬manentincomewoul djustbe

45
t
hesum ofal
lexpectedi
ncomedivi
dedbyt
henumberofexpected
y
ear
soflif
eorsimplyputav
eragei
ncomeoverone'
sli
fespan.

3. TheAbsol uteI ncomeHy pothesis(AIH)Key nes’consumpt i

on
i
ncome r elat
ionshi p is known as t he absol ut
e i ncome
hypothesis, whi ch st at
es t hat when i ncome i ncr eases
consumpt ional soi ncreases,butbyl esst hant heincr easei n
i
ncome,and v i
ce v ersa.Thi s means t hatt he consumpt i
on
i
ncome r elati
onshi pi s non pr oporti
onal.James Tobi n and
ArthurSmi thiest estedthishy pothesisinsepar atestudi esand
camet ot heconcl usionthattheshor trunr elationshi
pbet ween
consumpt ion and i ncome i s notpr opor t
ional,butt he t ime
seriesdatashow t helongr unr elati
onshipt obepr opor t
ional.
Thel att
erconsumpt i
oni ncomebehav iourr esul t
sthr oughan
upwar d shi ftor“ drif
t”i nt he shor tr un non pr opor tional
consumpt ionf unct i
onduet of actorsotherthani ncome.

4. The Rel ati

veI ncome Hy pothesis( RIH) -Thi st heor y was
developedbyJamesDuesenber ry.I tisbasedont her ejection
oft he two f undament alassumpt ions oft he consumpt ion
theori
es of Key nes. Duesenber ry st ates t hat ( 1) ev er y
i
ndividual’
s consumpt i
on behav i
ouri s noti ndependentbut
i
nterdependentoft hebehav i
ourofev eryotheri ndivi
dual ,and( 2)
thatconsumpt ionr el
ati
onsar ei r
rev ersibleandnotr ev ersibl
ei n
ti
me.
I
nf ormul at
ing hi st heor
y oft he consumpt i
on f unction,
Duesenber r
ywr it
es“ Ar ealunder st andingoft hepr oblem of
consumerbehav i
ourmustbegi nwi thaf ullrecogni ti
onoft he
socialchar acter of consumpt ion pat terns.By t he soci al
characterofconsumpt ionpat terns,hemeanst het endencyi n
humanbei ngsnotonl yt okeepupwi thJonesesbutal sot o
surpasst heJoneses.I not herwor ds,t het endencyi stost rive
constantlytowar dsahigherconsumpt ionl evelandt oemul ate
the consumpt i
on pat terns of one’ sr ich nei ghbour s and
associates.

I
mpl
i
cat
ionsoft
het
heor
ies

46
 1.Theef fectofchangesi nincomeonconsumpt i
on.Themajor
i
mpl icati
onoft heset heoriesisthat,
changesinahousehold
currentincomewi llaffectactualconsumptiononl
y,sofaras
theyaf f
ecti t
spermanenti ncome.
2.Implicati
onsont hebehav ioursoftheeconomy:Thetheori
es
alsohol dt hatact
ualconsumpt i
onisnotmuchaf fect
edby
tempor arychangesi nincome.
3.Thet heorieslaystressonf actorsothert
hanincome,which
affecttheconsumerbehav i
our

Summar y
Inthisl ectur
e,wehav et aughtyouconsumpt i
onf unction.Thi sis
thel argestcomponentofag¬gr egatedemand.Var i
oust heori
es
havespr ungupt oexpl
ainthebe¬hav i
ourofthisimportantf uncti
on.
Ther eist hetheorybyKeynes(AbsoluteIncomeHy pot
hesi s),which
states t hat consumption depends on cur r
ent income.Ot her
theories,notablythePermanentIncomeHy pothesis,t
heLi fe-Cycl
e
hypot hesisandt heRel
ativeIncomeHy pothesi
showev erar gued
thatconsumpt ionisaf uncti
onofper manentr at
hert hancur r
ent
i
ncome.

Post-
Test
1.Whyi st heconsumpt ionf unctionv er
yimportanttopolicy
planni
ng?
2.Discussfact or
sthataf f
ectt heconsumpt i
onfuncti
on.
3.Whatar et hemaj orf eaturesofKey nesi
antheoryont he
consumpt ionfunc¬tion?
4.Disti
nguish between Key nesian theoryand the Li
fe-
cycle
hypothesisonconsumpt ionf uncti
on.
5.Whatar et hei mplicati
onsoft het heori
esofconsumpt i
on
functi
ons?

Ref
erences

47
 Aboy ade O.( 1983).I nt
egrated Economi cs:A St udy of
Developi
ngEconomi es:Addi son-
Wesl eyPublishersLtd
Blanchar dO.( 1997) .Macr oeconomicsPr enti
ce-Hall
,Inc.
t
h
Dav i
dC.Col ander( 2004) .Economi cs,(5 ed. )Mi ddlebur y
Coll
ege,McGr aw- I
rwi n.
Dwi vedi ,D.N( 2005).Macr oeconomi csTheor yandPol icy.
TataMcGr awHi ll
.
Jhingan,M. L.( 2000).Macr oeconomi cTheor y
,10thRev ised
andenlargededi t
ion.Vr i
ndaPubl i
cationLtd
Li
psey ,R. G.( 1971) .Intr
oduct i
on to Posi t
ive Economi cs,
London: Wi edenf eldandNi colson.
Olofin S.( 2001) .An I ntroducti
on t o Macr oeconomi cs.
MalthousePubl i
sher s.
LECTURESI
X

I
nvest
ment

Int
roduct i
on
Inthepr eviouslecture, wet reatedoneoft hemaj orcomponent sof
aggregateexpendi t
ure,t heconsumpt i
onf unct
ion.I nthepr esent
l
ecture,we shal lex¬ami ne anot hercomponentofaggr egate
expenditure, t
hatis,i
nv est ment.Itisdividedint
ot hreedisti
nctparts,
business f ixed investment s;r esidentialconstructi
on;and net
changesi nbusi nessi nv entori
es.Fur thermore,weshal llookatt he
determinant sofinvestmentandal sot heacceleratorpri
ncipl
e.

Obj
ect
ives
Att
heendoft
hisl
ect
ure,
youshoul
dbeabl
eto:

48
 1.explainthemeaningandcl assi
ficat
ionofinvest
ment;
2.discusst hedet
erminantsofinvestment;and
3.discuss how t he acceler
atorpr i
ncipl
e operates and i
ts
l
imi t
ation.

Pr
e-Test
1.Whatar ethemaj ordeter
mi nantsofinvestment?
2.Def i
netheaccelerat
orprincipl
e.Howdoesi toperate?
3.Whatar etheli
mi t
ationsoftheacceleratorpri
nciple?
4.What ar et he ef f
ects of expendi t
ure on t he levelof
inv
estment?

CONTENT
TheDetermi nantsofI nv estment s
Sever
alf actorsI nf
luencet hel evelofI nv estmenti nanycount ry
.
Chi
efamongt hesefact or sar eexami nedbel ow:
1.TheRat eofI nter ests:Thi sisper hapst hemosti mpor t
ant
det erminantofi n¬v estment.Mosti nv estment saremade
withbor rowedmoneyf orwhi cht hebor r
owermustpaya
mar ketrateofi nt erest.Thus,t hedeci siont oi n¬v
estornot
dependsonwhet hert heexpect edr ateofr etur
nonnew
in¬v estmenti sgr eat erorl esst hant hei nterestratethat
mustbepai dont heamountt obebor r
owedt oacquirethese
asset s.Logically,t helowert her ateofi nterestthehigherthe
amountofnewi nv estmentt hatwi l
lbemade.I naf uncti
onal
form, we expect a negat iv
e r elati
onshi p between
in¬v estment( I
)andr ateofinterest( r)
i.
e. I=1/ r…………. .…(1)
I=f (r)…………. .
…( 2)

Margi
nal
Ef f
ici
encyofCapi
tal
(MEC)andt
heRateofInterest
Themarginaleffi
ci
encyofcapi
tali
stherat
eofr eturnsonnew

49
i
nvestment .Somet i
mes,itisalsoreferr
edt oas" expectedr at
eof
ret
urnov ercost ”onnew i nvestment.Atequi l
i
brium,MECandt he
rat
eofi nterestwillbeequal.Thisisbe¬causef irm woul dcontinue
tomakenewi nvestmentsasl ongast her ateofreturnont henew
i
nvestmenti sgreaterthant heint
erestrates.Sincecapi talisalso
subj
ectt odi mini
shingreturns,weexpectt herateofr eturnonnew
i
nvest¬ment soral ter
nati
velytheMECt of allasthest ockofcapi tal
i
ncreasesasshowni nthecur v
ebelow.

Capi
tal

Fig.6.
1:NewI nvest
mentExpendit
ure.
Thef i
gureaboveconfi
rmsourpr oposit
ionthatt
heMECi s
negati
velyrel
atedtothestockofcapit
al.Forinst
ance,afal
linthe
rateofinter
estfrom r
2tor1causesanincreaseinnewinvestment
expendit
urefrom k1t
oK2.

2. TheLev elofI ncome

Resear chst udieshav eshownt hatthel evelofincomemi ghtbea
betteri nduce¬mentt oinvest
mentt hant heinterestrate.Thisis
becausei ncreasei nincomewi l
lleadt oi ncr
easei ndemandf or
goodsandser vices.Assuredoft hepr esenceofawi ll
i
ngdemand
fort hei
rout put ,businessmenwi llundoubt edl
ybeen¬cour agedto
i
ncr easet heirinv estmenti
nor dertocashont hepot ent
iali
ncrease
i
nt heirpr of
itlevel .

3. ChangesinI ncome
Thi
si stheaccelerat
ortheor
y.Accordingtot hi
stheor
y,inv est
ment
i
sr elat
ed tot he change in nat
ionalincome.When i ncome is
i
ncreas¬ing,i
ti s necessar
yt oinv estin ordertoincr ease t
he

50
capaci
tytopr oducecon¬sumpti
ongoods.Howev er
,wheni ncome
i
sf al
li
ng,itmaynotev enbenecessarytorepl
aceoldcapit
al,asi
t
wearsoutletalonetoi
nvesti
nnewcapi t
al
Insymbols,I=f(ΔY)
Thisi
mpliesthatinv
estmentdependsonchangeinoutput
.

Howt heAccel erat orPr i

ncipleWor ks
Let'sassumet hatt hereisapar ticularconst antst ockneededt o
produceagi venl ev elofani ndustry'sout put .( Ther atiooft hev alue
ofcapi taltotheannualv alueofout putiscal ledt hecapi tal-out put
rati
o) .Wi tht hi s assumpt ion,sup¬pose t hat t he i ndust ryi s
produci ngatf ull capaci t
yandt hedemandf ori tsproducti ncreases.
Ifthei ndustryi st opr oducet hehi gherl ev elofout put,i tscapi tal
stockmusti ncrease.Thi snecessi t
at esnewi nv estment .
Tabl e 6.1 pr ovides a si mple numer i
calexampl e of t he
acceler ator.Weassumet hati tt akesN5ofcapi talto pr oduce
N1.00ofout putpery ear.Iny earoneandt wo,t herei snoneedf or
newi nv estment .Iny earthr ee, anincr easeofN10ofsal esr equires
anew i nv est
mentofN50.Thesamet hingappl iesiny earf our;an
i
ncr easeofN20. 00ofsal esr equiresanaddi tionali nv
est mentof
N100. 00.As col umns ( 3)and ( 5)show,t he amountofnew
i
nv est menti s pr opor ti
onalt ot he change i n sales.When t he
i
ncr easei nsal est apersof finy ear ssev enandni ne,i nvestment
declinesandev ent uallybecomeszer oiny eart en.

Tabl
e6.
1Ani
l
lust
rat
ionoft
heaccel
erat
ort
heor
yofI
nvest
ment

(
1) (
2) (
3) (
4) (
5)
Year Annual Changesin Requi
redstockof Netinvestment
sales sales capit
alassuminga i
ncreasesinrequi
red
(N) capit
aloutputr
ati
oof capitalst
ock(N)
5:1(N)
1 100 0 500 0
2 100 0 500 0
3 110 10 550 50

51
 4 130 20 650 100
5 160 30 800 150
6 190 30 950 150
7 220 30 1100 150
8 240 20 1200 100
9 250 10 1250 50
10 250 0 1250 0

Thisideaofaccel
er at
orpr i
ncipl
et hati
nvestmentdependson
the changes i
n demand r epresent
s an i mport
ant source of
i
nstabil
i
tyinnati
onalincome.I tcom¬bi neswi t
hthemul t
ipli
erto
generat
eeconomiccyclesviathemul t
ipli
er-ac¬cel
erat
ormodel.

Threegener al predicti
onsoft heaccel eratoraret hef ollowi ng:
1.Ri sing,r atherthanhi ghl ev el sofsal esar eneededt ocal l
forthneti nvest¬ment .
2.Forneti nvestmentt or emai nconst ant,salesmustr i
sebya
const antamountpery ear .
3.The amountofneti nvest mentwi l
lbe a mul tiple ofan
i
ncr easei nsal esbecauset hecapi tal-
outputr atioi sgr eater
thanone.
Limitationsoft heAccel erator
Theaccel er
atormodelposi tsamechani calandr i
gi dr esponseof
i
nv estmentt o changes i n sal es.I tdoes t hi
s by assumi ng a
proport i
onalr elationshipbet weenchangesi ni ncomeandsi zeof
thedesi r
edcapi talstock,andbyassumi ngaf i
xedcapi tal-out put
rati
o.Eachoft heseassumpt i
onsi si nvali
dt osomedegr ee.
Int heshor trun,ther ear emanyr easonswhyi nv est mentmay
notconf or mt ot her i
gidpr opor ti
onal ityimpliedbyt heaccel erator
pri
nciple.Themostobv iousreasoni st hattheadj ustmentofact ual
desired capaci tyi s asy mmet ric wi thr espectt o posi ti
ve and
negat i
veout putchanges.Whent heeconomyexpandsandact ual
capacityl agsbehi nddesi redcapaci ty,businessf i
rmsexpandt heir
capitalst ock.Ont heot herhand, nof ir
m woul ddel i
ber at elydest roy
enoughofi tsmachi net obr i
ngact ualcapaci tyinlinewi thdesi red
l
ev el
swhent heeconomyent er sasl umpanddemanddecl i
nes.

52
4. Expectations
Sincepr esentinvestmentsareusuallymadei nexpect ati
onof
futur
edemand,t hedecisiontoi nv
estdependsont hehope
aboutt hef ut
ure.Whenaf ir
m hasahi ghoptimi sm aboutthe
futur
e,itcanembar konincreasedinvestmentspr esent¬l
yand
vice versa.Howev er
,because oft he uncer
taintyaboutt he
futur
e, f
irmsareusual l
yverycauti
ousaboutincreasingt hel
evel
ofinvestmentt heymade.

Relati
onshipbet weensav ings, i
nvestment sandt herateofi nt
erest
Therei sacl osei nt
erdependencebet weensav i
ngs,inv est
ment s
andt her ateofi nter
est.Wehav ement i
onedi nt heear li
erpar tof
thi
sl ecturet hatmostoft hef undsusedf orinvestmentpur poses
arebor rowedf r
om banksandot hersour ¬cesofcr editschemes.
Whenev ertheamountoff undspr esentlyav ai
lablef r
om al lthese
sourcesi snotenought osust ainthemagni tudeofi nvestment sthe
i
n¬v estorsint heeconomywantt omake,t herewi l
lbecompet it
ion
forav ail
ablef unds.Sincet hemar ketr ateofi nterestishowev er
determined by t he forces ofdemand and suppl y,the excess
demandi nt hemar ketforf undswi llthereforepushupt hemar ket
rat
eofi nterest .

Financi
alTheori
esofI
nvest
ment
Someeconomi st
shavelai
demphasi
sont heeff
ect
soffinanci
al
factor
soni nv
estment
.Butweshal
lst
udyonlyt
heprof
it
stheoryof
i
nv est
ment.

ThePr ofit
sTheor yofI nvestment
Thepr ofit
st heor yregardspr ofi
ts,i
npar ti
cul
arundist
ri
but edprof i
ts,
asasour ceofi nternalfundsf orfinancingi
nvestment.Inv est
ment
dependsonpr of i
tsandpr ofit
s,int ur
n,dependoni ncome.I nt hi
s
theory,profi
tsr elatet othelevelofcur r
entprof
itsandoft herecent
past.Iftotalincomeandt otalprof
itsarehigh,t
her et
ainedear nings
off i
rmsar eal sohi gh,andv i
cev ersa.Retai
nedear ningsar eof
greatimpor tancef orsmal landl argefirmswhent hecapi talmarket

53
i
si mper f
ectbecausei ti scheapert ouset hem.Thus,i fpr ofitsare
high,t her etai nedear ni ngsar ealsohi gh.Thecostofcapi t
ali slow
andt heopt imalcapi talst ocki slarge.Thati swhyf irmspr eferto
reinv estt hei rext ra pr ofitsf ormaki ng i nv est ment si nstead of
keepi ng t hem i n banks i n ordert o buy secur iti
es ort o gi v
e
dividendst oshar eholder s.Cont rariwise, whent heirpr of it
sf all,t
hey
cutt hei ri nv est mentpr ojects.Thi si st hel iqui dit
yv er sionoft he
prof i
tst heor y .
Anot herv ersi
oni st hatt heopt i
malcapi talst ocki saf unct ionof
expect ed pr of it
s.Ift he aggr egat e pr ofitsi nt he economyand
busi nesspr of i
tsarer ising, t
heymayl eadt ot heexpect at i
onoft heir
cont inuedi ncr easeint hef uture.Thus,expect edpr of i
t sar esome
funct ionofact ualprofitsi nt hepast .
Kt*=f (t-1)
Wher e Kt*i sthe opt imalcapi talst ockand f (t-1)is some
funct ionofpastact ual pr of i
ts.
Edwar dShapi r
ohasdev el
opedt hepr ofitst heor yofi nvest ment
i
nwhi cht otalpr ofi
tsv arydi r
ectlywi tht hei ncomel ev el.Foreach
l
ev el ofpr of its, t
hereisanopt imal capital stock.Theopt imal capital
stockv ari
esdi rect
lywi tht hel evelofpr of i
ts.Thei nterestr ateand
thel ev elofpr ofit
s,int ur n,det erminet heopt imalcapi talst ock.For
anypar t
icul arl evelofpr of i
ts,the hi ghert he i nterestr at e,the
smal lerwi llbet heopt i
mal capi t
alstock, andv icev ersa.

Summar y
We hav e di scussed y et anot her component of aggr egate
expenditure,investmentint hislecture.Inthepr ocesswedef i
ned
whatinv estmenti sallabout ;exami nedt hefactorsthatinfl
uence
thelevelofi nvestmentinanycount ry,aswel lashowt hepr i
ncipl
e
ofacceleratorwor ks.Weal sol ookedi ntotherelat
ionshi
pbet ween
savi
ngs,i nvestmentandt her ateofi nter
est.Final
ly,wediscussed
theprofi
tst heoryofinvestment .

Post
-Test

54
 1.Explaintheaccel eratorpri
ncipl
e.How doesitoper
ate,and
whatar eitsmajorl i
mi t
ati
ons?
2.Ment i
onanddi scusst hevari
ousfactor
swhichi
nfl
uencethe
l
ev elofin¬vest
menti naneconomy ?
3.Discusst herel
ationshipbetween
a.sav i
ngsandinv estment
b.mar ginalef
ficiencyofcapi tal(MEC)andlevelofnew
investment.

References
Aboy ade O.( 1983).Integrated Economi cs:A St udy of
DevelopingEconomi es:Addi
son-Wesl eyPubl
ishersLt d
Blanchar dO.(1997).Macr oeconomicsPr ent i
ce-Hall
,I
nc.
Dwi vedi,D.N.( 2005).Macr oeconomicst heor yandPol i
cy.
TataMcGr awHi ll
.
JoeU.U.( 2007).Economi cs:AnAfri
canper specti
ve.(2nded.
)
Lagos: Mil
lennium TextPubl i
shers.
Lipsey, R. G and Chr ystal, A.
K ( 1999) . Pr i
nci
ples of
economi cs,(9thed.)OxfordUniversi
tyPressOxfor d:
Olofin,S.( 2001). An Introducti
on to Macr oeconomi cs.
MalthousePubl i
shers.

55
LECTURESEVEN¬

Gover
nment
,Aggr
egat
eDemandandFi
scal
Pol
i
cy

Intr
oduct i
on
Gov ernmentexer t
sal otofinfl
uenceont hecircularflowofincome.
Through i ts controlov er taxes and spendi ng decisions,the
gov ernmental so inf
luences the behav iours ofot hereconomi c
agent s,suchast hehousehol dsandt hef i
rms.Fi scalpoli
cyisthe
useoft axesandgov ernmentspendi ngdeci si
onst oin¬fl
uencethe
l
ev elofaggr egatedemand.Ther efore,inthislect ur
e,weshal lbe
l
ook¬i ngatt herol
eofgov er
nmenti nt heeconomy ,andhowi tuses
i
t sfiscalpowertoinfl
uencet helevelofeconomi cact ivi
ty.

Obj
ect
ives
Att
heendoft hi
slecture,youshouldbeableto:
1.definetheterms‘ aggregatedemand’and‘
fi
scalpoli
ty’
;
2.explai
n how t he gov ernmentuses itsf i
scalpolicy to
infl
uenceaggregat edemand;and
3.statet he di
fference bet ween bal
anced and unbalanced
budget.

Pr
e-Test
1.Explainwhatyouunderstandby‘bal
ancedbudget
’.
2.Def i
nethefol
lowi
ngt er
ms.
a.balancedbudget;
b.balancedbudgetmultipl
i
er;

56
 c.budgetsur pl
us;and
d.budgetdef i
cit
3.Dist
ingui
shbet weenautomati
cstabil
i
ser
sanddiscr
eti
onar
y
poli
cy.
4.Descri
be,withappropr
iatedi
agrams,howagov
ernmentcan
cl
osedeflat
ionarygapinaneconomy .

CONTENT
1. TheGovernmentandAggregat
eDemand
TheAggregatedemand(AD)canbedefi
nedas:
AD=C+I+G
Where C=Consumpt i
ondemand
I=I
nvestmentdemand
G=Gov ernmentdemandforgoodsandser
vices

Si
nce governmentdemand is one oft he components of
aggregat
edemand,t hegover
nmentcan usei t
staxpolicyand
expendit
ure progr
ammes t oinfl
uence the l ev
elof aggregate
demandi ntheeconomy .Weshal
lnowl ookatt heeff
ect
sofeither
ofthesetool
sofgov er
nmentonthelevelofaggregat
edemand.

a. TheEff
ectofTaxesonNat i
onal I
ncome
Thegovernmentcani ncr
easeaggr egatedemandi nordert o
cl
oseadef l
ati
on¬arygapbyr educi
ngt hetaxrates.Thiswi l
l
haveanindi
recteff
ectont heeconomybyi ncreasingthelev el
ofaggregat
e disposablei ncome.And,si nce consumpt ion
demandisaf unct
ionofdi sposabl
ei ncome,thiswi l
lboost
domes¬ti
cdemand and t husl ead t
oi ncr
easei n aggregate
demand.

57
 Fl
g.7.
1Usi
ngt
axest
ocl
osedef
lat
ionar
ygap

A change intaxr ate wil

lnotshi f
tt he aggregate demand
f
uncti
onbutwi l
lonlyal t
erthesl opeoft hef uncti
on,sincet ax
r
evenuewillvarywithnati
onalincome.InFig.7.1,reducti
oni ntax
r
atehasincreasedaggregatedemandf r
om AD1t oAD2bychangi ng
t
hescopeoft hefuncti
on.Thus,thedef
lat
ionarygapcanbecl osed.

b.TheEf fectofGov er
nmentExpendi tur
eonNat i
onal I
ncome
An al ternativ
e waybywhi ch gov er
nmentcan i ncrease the
aggr egatel evelofeconomyi sthroughi t
sexpendi turepol i
cy.If
increasedgov er nmentexpendi t
ureismetbyt axr ev enue,then
the ef fecton aggr egate demand wi llbe mi ni
mal .Thisi s
becauset hei ncreasei ngov ernmentexpendi turewoul dhav e
beenmat chedbyanequi v
alentdecreaseinprivateexpendi ture.
Ther educt i
oni nprivateexpen¬di tureiscalled‘ crowding-out
effect’.
Howev er,theef fectofi ncreasei ngov er
nmentexpendi t
ure
onaggr egat edemandf uncti
onisdi ff
erentfrom t heef fectof
taxeswhi chwehav ej ustenun¬ciatedabov e.Ani ncreasei n
gov ernment expendi ture willshiftt he aggregat e demand
funct i
onupwar ds,parall
el t
othef or
merone

58
FI
G.7.
2usinggov
ernmentexpendi
tur
eto Fi
g7.3.Usi
nggovernmentexpendi
tur
eto
eli
minat
eadefl
ati
onarygap el
i
minateaninf
lat
ionar
ygap

Thus,adef lati
onarygapmayber emovedbyanappr opr
iat
e
i
ncreaseingov ern¬mentexpendi
tur
eordecr
easeintaxrates.An
i
nfl
ationar
ygapmayber emovedbyanappropri
atedecreasein
gov
er nmentexpenditur
e.

2. Compar at i
veEf fect sofExpendi t
ureandTaxChanges
Thereisadi fferencei nt hecompar ati
v eef fectofgov ernment
expenditureandt axrev enueoft hesameamountonaggr egat
e
demand.Thi si sbecausei n¬creasei ngov er nmentexpendi tur
e
willhavei mmedi at eanddi recteffectonag¬gr egatedemand;
thesamei snott rueoft axes.Ar eductioni ntaxesofequal
amountwi l
lnothav esameamountofef f ectonaggr egat
e
demand because onl y par tofext rai ncome r eal
ized from
reducti
oni nt axeswi l
lbespent .Fori n¬st ance,ifgov ernment
expenditurei srai sedbyN100,000t ocloseadef l
ati
onarygap,
andgi vent hatt hemul ti
plierist wo,t hef inalr i
seinnat i
onal
i
ncomei sN200,000.Ont heot herhand,i fgov ernmentcut s
i
ncomet axr atessuf f
icientlytoreducei tsrev enuebyN100, 000
househol dswi l
l hav eanext raN100, 000ofdi s¬posabl ei
ncome.
Consumpt i
onexpendi turewi ll
,howev errise, bylessthanN100,

59
 000becauseonl ypartoftheextrai
ncomewillbespent.I
f
marginalpropen¬si
tytoconsumeis0.
75,thent
hefi
nalri
sein
nat
ionalincomewi l
lbeN150,000.

TheTheor yofFiscalPoli
cy
BalancedandUnbal ancedBudgets
Peoplef ormerl
ybelievedthatapr udentgovernmentmustal ways
balancei t
sbudget.Butnowaday s,i
tisgenerallyacceptedthata
gov er
nmentcanr unanunbal ancedbudgetinor dertostabi
li
zethe
economy .Forexampl e,agov er
nmentcanr unadef ici
tbudgetto
sti
mul at
et heeconomydur i
ngperiodofrecessi
on.

Defini
ti
ons
1.Abudgeti sr egar dedasbalancedwheni t
scur r
entrev
enueis
equal tocur ¬rentexpendi t
ure.
2.A budgeti ssai dt obeunbal ancedwhent hereisbudget
deficitorsur plus.
3.Budgetsur plusoccur swhengov ernmentr evenueexceeds
it
sexpendi ture.
4.Abudgetdef icitoccurswhengov ernmentr evenuefal
lsshor
t
ofitsexpen¬di ture.
A budgetcanbef inancedeitherbyr aisi
ngt axesort hr
ough
borrowing.Whengov ernmentspendsmor ewi t
houtraisi
ngit
staxes,
i
tsext r
aexpendi turei ssaidt obedef ici
tf i
nanced.Thi sdef
ici
tcan
bemetbyi ncreasei nbor rowingeitherfrom thecent r
albankofthe
stat
eorf rom t hepr i
v atesectoroftheeconomy .

TheBal ancedBudgetMul t
ipl
ier
Whatwoul d be t he effectofbal anced budgetspending on
aggregate demand? A nat uralassumpt i
on would be thatan
equival
entincreaseingov ernmentspendi ngandtaxeswouldleave
aggregatedemandandequi li
bri
um outputunchanged.Butthisis
nottrue.Let'
sassumet hatgov er
nmentf i
nancesanewexpendi t
ure
ofN300, 000byt axrevenueofequal amount .Al
though,
thisi
mplies
thatthebudgeti sbalanced,butweshal lsoonseethatthi
saction

60
hasposi t
iveef ¬fectonaggr egatedemand.Thei ncreaseofN300,
000i ngov ernmentspendi ngr ai
sesaggr egatedemandbyN300,
000.Butsi ncet hemar ginalpropensi t
yt oconsume( MPC)outof
disposablei ncomei slesst han1( say0.7)t hi
sr educt i
oninincome
byN300, 000r educesconsumpt i
ondemandbyonl yN210, 000( 0.7
x300, 000).
Thus,t he i niti
alef fectoft axand spendi ng package i st o
i
ncr easeaggr egat edemandbyN300,000becauseofgov ernment
spendi ngbutr educei tbyonl yN210,000becausehi ghert axes
reduce consumpt ion demand. Thus,a bal anced ag¬gr egate
demandhasi ncr easedaggr egatedemandbyN90,000( i.
e.N300,
000-N210, 000) .Thi sexampl ei l
lustr
atest hepr incipleofbalanced
budgetmul t
iplier,whi ch st at
est hatan i ncreasei n government
spendi ng,accompani edbyanequali ncreasei nt ax,resul
tsi nan
i
ncr easeinout put .

ToolsofFi
scal
Poli
cy
Thesetoolscan becl
assi
fi
ed i
nto aut
omat
icand di
scr
eti
onar
y
measures.

1. Aut omat i
cTool sofFi scal Pol
icy :Built-i
nSt abiliser
Aut omat i
cst abili
zersar emechani smsi nt heeconomyt hat
reducest heresponseofnat i
onali ncomet oshock.Theyar e
aut omat i
csincet heyar eal r
eadybui l
t-i
ni ntot hef unctioningof
the economy and,t hus,t hey do not r equire del iberate
i
nt er¬ventiontomaket hem wor k.Thus,t heyt endt ocause
i
nject i
onsasi ncomef allsorwi t
hdr awal sasnat ionalincome
ri
sesand v i
ce-versa,wi thoutt hegov ernmentmaki ng pol icy
deci si
onst obringaboutt hesechanges.Exampl esofaut omat ic
stabi l
i
zersi nclude taxes,nat ionali nsurance orpr ogr essive
taxes.Thesey ieldin¬creaseswhennat ionali ncomer i
sesand
decr easeswheni tfall
s,t herebyr espect ivelybr ing¬ingabout
expansi onaryandi nfl
ationaryf orcesont heeconomy .

2. Acti
veorDi
scr
eti
onar
yFi
scalPoli
cy
Al
though t
he automat
ic stabi
li
ser ar
e al
way
s at wor
k,

61
gov er nmentcan embar k on act iv e ordi scr etionar yf iscal
policieswhi chal terspendi ngl evel sort axr atesi nor dert o
stabi l
ise t he l ev el of aggr egat e demand. Whi l
e bui lt-i
n
stabi l
iser sar eof tendesi gnedf orshor tter m mi norf luctuat ions,
discr etionar yf i
xed pol i
ci esar eused t o cat erf orper sistent
fl
uct uat ionorgapi nt heeconomy .Count ercy clical Fi scal Pol icy:
Aut omat icandDi scr eti
onar yChanges
I
tmaybei nf er redf rom t her elationshi pbet ween( a)Publ ic
expendi tur e and GNP; ( b) t axat ion and GNP; t hat a
count ercy cli
calf iscalpol icywoul dr equi r
ei ncr easei npubl i
c
expendi tur eandr educt ioni nt axat iont of i
ghtdepr essi on,and
reduct i
on i n publ icexpendi ture and i ncr ease i nt axat ion t o
cont rollingi nf lat i
on.I not herwor ds,f i
ght ingdepr essi onwoul d
requi redef icitbudget ingandcont roli nflationr equi ressur plus
budget ing
Someoft hebudget arychangesar eaut omat i
candsomear e
discr etionar y .Theaut omat i
cbudget aryadj ust mentt akespl ace
onlywhenf iscalpol i
cyhasbui l
t-i
nf l
exi bili
ty .Theaut omat i
c
budget ar ychangesshoul df ollow t hechangei nGNP.Bui lt-i
n
fl
exi bilit
yi nt hef i
scalpol icyi mpl i
est hatasGNP f all
s,bot h
i
ncomeandconsumpt i
ondecl i
ne.
Consequent ly,t he r ev enue f rom bot h di rectand i ndi rect
taxes decl ines.Gov ernmentest abl ishmentand commi tted
expendi tur er emai ningt hesame, publ icexpendi tureexceedsi t
s
revenue,andt hebudgetaut omat i
cal lyr unsi ntodef i
cit.Thi s
effecti s mor e qui ck and power fuli nt he count ries,whi ch
prov ideunempl oy mental lowancesandot herr eliefbenef its.
When GNP i ncr eases,t ax base expands and t ax r ev enue
i
ncr eases.Expendi tur el ev elr emai ningt hesame,t hebudget
automat icallyshowssur plus.
Thedef i
citsur pl usr esul tingf r
om f luct uat ioni nGNPwor ks
as aut omat i
cal l
yst abili
seroft he economy .Howev er,i ti s
gener all
y bel iev ed t hataut omat ic st abi li
zer s pr ov et o be
adequat e and ser v e usef ulpur pose onl yf or shor t
-ter m
fl
uct uat ions i nt he economy .Aut omat ic st abi l
izer s pr ove
gener all
yt obei nadequat et ocont rolt heeconomi cf l
uct uat i
ons
of l ar ger ampl itude;under such condi tions,di scret i
onar y
changesi nbudgetbecomenecessar y.

62
 Thedi screti
onarychangesi nthebudgetr efertot hechanges
i
nt het axst r
ucture,and int heleveland pat tern ofpubl i
c
expenditure by t he gov ernment on i ts own di screti
on.
Discreti
onar ychangesi nclude change int axr ate structure,
abolit
ionofexi sti
ngtaxes,impositi
onofnewt axes,increasing
anddecr easingthepubl i
cexpendi t
ure,changingt hepat ternof
publicexpendi ture,et
c.Discreti
onarychangesar esodesi gned
ast oarrestt heinfl
ati
onanddef l
ati
onarytr
endsi nt heeconomy
andt omi ti
gatet hedestabi l
i
singforces,suchas,i ncreaseor
decreasei naggr egatedemand.

Probl
emsi nFor mul at i
ngCount er-Cy cli
cal Fi
scal Policy
Formulat
ingacount er-cy clicalfiscalpol i
cyisnotast r
aightf orwar d
aff
air
.Iti nvolvescer taincompl icat i
ons,whi chshoul dbebor nin
mindwhi ledev isingt het axandexpendi turepol icyt ost abiliset he
economy .Eckst einhaspoi ntedoutsomecompl i
cationsasf ol l
ows.
1.Allexpendi turesdonothav ethesamemul tipli
eref fect .For
exampl e, transf erpay ment sbyt hegov ernmentdonotcr eate
a di r
ectdemand f orgoods and ser vi
ces.Some publ i
c
expendi t
ur e( e.g.f ree educat ion and hospi talf aci l
iti
es)
repl acest hepr i
v ateexpendi ture.
2.Notal ltax–changeshav et hesamemul ti
pl i
eref f
ect .For
exampl e, taxespai dbyt heupperi ncomesgr oupshav el ower
mul ti
pli
eref fectt hant hosepai dbyl oweri ncomegr oups.
Thi si s because of t he di ff
erences i nt heir mar ginal
propensi tyt oconsume ( MPC) .Themul t
ipliereffect sof
indirectt axesar enotcl ear lyknown.
3.Def icitf inanci ng t hrough publ ic bor rowing may r educe
privat einv est ment .Thi ski ndofdef i
citf i
nanci ngreducest he
mul ti
pli
eref fect .
4.Ther earepr act icaldi ff
icultiesi nrelationt ot heassessment
oft imel agsandaccur acyoff orecast s.Ther efore,t her eis
uncer t
aintyi nr elationt oef fectivenessoff i
scal policy.

63
Summar y
Wehav eseeni nt hisl ecturet hatgov ernmentexer tsi mportant
i
nf l
uenceont henat ionaleconomy ,throught hemani pulati
onofi ts
fi
scalpolicy.Thegov ernmentcani ncreaseordecr easeaggr egate
demand i n or dert o cl ose a def l
ationar y and i
nf l
ati
onary gap
respecti
vely.Ther ear et wo t ypesoff iscalpoli
cy .Therei st he
automaticst abil
iserandt herei sal sot heact iv
eordi screti
onary
poli
cy.Whi l
et hef or
meri susedf orshor ttermf l
uctuationsint he
economy ,thel att
ert akescar eoft hemor epersi
stentfluctuati
ons.
We al so hinted atsome pr oblems l ikelyto be encount ered in
formulat
ingcount er-
cy cli
cal f
iscalpol i
cy .

Post-
Test
1.A pr udentgov er
nmentmustatal ltimes ensuret hati
t
oper atesabalancedbudget :Tr
ueorFal se?Explai
n.
2.Ifthegov er
nmentdesi restor emov eunemploy mentinthe
economybyi n¬creasingi tsspendingbyN1,000, 000,and
sher ai
sesmoneyt of i
nancet hisin¬cr
easedexpendi t
ureby
raisi
ngt axratesequalt ot heamountspent ,whati sthe
effectoft hi
sspendingont heeconomy ?
3.Wr it
eshor tnotesont hef ol
lowing:
a.Def ici
tbudget
b.Sur plusbudget
c.Bal ancedbudget
4. Explainwhaty ouunder standby‘ t
oolsoffi
scalpoli
cy’
.

Refer
ences
Aboy ade O.( 1983).I nt
egrated Economics:A St udy of
Devel
opingEconomi es:Addison-
Wesl eyPubli
shersLt d
Dav i
dC.Col ander( 2004).Economics,(5th ed.)Middl
ebury
Col
lege:McGr aw-I
rwi n.
Dwi vedi
,D.N( 2005).Macroeconomicst heor yand Policy
.
Tat
aMcGr awHi l
l
.
Jhingan,M. L.( 2000).MacroeconomicTheor y,10thRevised
andenlargedediti
on.Vr indapubl
icati
onLtd

64
 Li
psey, R.
G and Chr yst
al, A.K ( . Pr
1999) i
ncipl
es of
Economics,Oxfor
d:9thed.
( )Oxf
ordUniver
sit
yPress
Olof
in S.(2001). An I
ntr
oducti
on to Macroeconomi
cs.
MalthousePubli
sher
s.

65
LECTUREEI
GHT

Pr
iceLev
elandMoney

I
ntroduction
Thislectureandt henextarerel
ated.I
nt hi
slect
ure,weshal llookat
thehistoryandt heroleofmoneyi ntheeconomy .Moneyper forms
usefulfuncti
onsi nt heeconomywhi chmakei tindispensablef or
thef uncti
oningoft heeconomy .Justasi thasi t
sadv antages,
moneyhasal sobr oughtaboutt heproblem ofinfl
at i
oni ntothe
moder nsoci ety
.I nf
lat
ionisseenbymanypeopl et odayast he
numberonepubl icenemy.

Obj
ect
ives
Att
heendoft hisl
ecture,youshoul
dbeablet o:
1.explai
nt hemeani ngofinf
lat
ionanddef l
ati
on;
2.discusstheeffectofinfl
ati
onintheeconomy ;
3.discusshowi nfl
ationcanbecontrol
led;
4.highli
ghttheroleofmoneyi ntheeconomy ;and
5.discussthehistoryofmoney .

Pr
e-Test
1.Def i
neinfl
ati
on?
2.Justasi nf
lat
ionhasi tsbadsi de,italsohasitsposi
ti
ve
i
mpactont heeconomy .Discuss.
3.Ifyouar emadet heMi ni
sterofFinance,whatmeasur
eswill
youtaketocontr
olinf
lati
onint heeconomy?
4.Gi v
et hr
eereasonswhypeopl edemandf ormoney.

66
CONTENT
ThePr iceLev el
Rightf rom t het imeoft heclassicaleconomists,economyhasbeen
divided i nt ot wo parts: t he realpar tand t he monet arypar t
.
Allocationofgoodsandser v i
cest akeplaceint herealsector.Only
relativepr icesmat terinthi
spar toftheeconomy .
Ont heot herhand, moneypr i
cesort hepriceleveli
sdet ermined
i
nt he monet ary sectoroft he economy .Her e pri
ce l evelis
det ermi nedbyt hequantit
yofmoneysuppl yi ntheeconomy .The
classicaleconomi st
s hav e considered these two par t
s oft he
economyasi ndependentofeachot her.Moneyhasnoi mpacton
ther ealsect oroft heeconomyandt hushasbeenconsi der edasa
veilbehi ndwhi chactualpr oductiontakespl ace.Thisdoct r
ineis
referredt oast heneut r
ali
tyofmoney

Inf
lationandDef l
ation
Inf
lationisaper i
odofper sistentincr easei nthegeneralpricel evel
.
Deflationrep¬resent st heopposi t
e.Al leconomi st
sagr eethatr apid
i
nflationordef l
at i
oni shar mf ultoaneconomy ,andof tenmany
peopl egethur tasar esult.Economi stsal soagreedthatinflationis
amonet aryaf f
air.Inot herwor ds,infla¬t i
onarisesbecauset hereis
i
ncr easei ndemandofr ealgoods,t her ebyleadi
ngt oincr easei n
pri
ces.Theef f
ectofi nf l
ationont heeconomydependsonwhet her
i
tisant i
cipatedornot .Wheni nfl
ationi santi
cipat
ed,thenecessar y
cushionsar eal¬readybui ltint ocont ractagreementset c.sot hat
peopl ear epr otected.Anot herexampl eist hecaseofi ndexed
wages.

EffectsofInfl
ati
on
Infl
ationinfl
uencest heallocati
onofr esour
cesi ntheeconomyby
changi ngthestructureofr elati
vepri
cesof teninanabsur dway .
Since,pr i
cesarenotr isi
ngi nthesamepr oport
ion;commoditi
es
whi ch areenjoyi
ng hi gherr el
ati
vepr i
ceswi l
lwi t
nessinfl
ow of
product i
onresources,whichmi ghtnotnecessari
lybetothebenefit
ofthesoci et
y.
I
nfl
ati
onalsor edistri
buteswealthf r
om lenderstoborrowers.

67
Lenderssuf f
eral ossont her ealv al
ueoft heirmoneyi ft heyar e
paidbackdur i
ngt heper i
odofi nfl
at i
on.Fori nstance, Mr.XlendsMr .
YN100, 000at5per centi nterestforoney ear.Ifthepr i
celevel ri
ses
by10percentov ert hey ear,Mr .Xhasact uall
year nedanegat i
ve
rateont heactualamountl oan( int ermsofpur chasingpower )than
theN100, 000hel entt ohim att hebegi nning.
Anothermajoref fectisont hef ixedincomeoft hepeopl e.This
i
sbecauset hepur chas¬i ngpoweroft hei ri
ncomef al
lsduringt he
periodsofinfl
ati
on.
Howev er
,inflationi snotent irelyal oss;somepeopl eact ually
gain outofi t.I nflati
on mi ghtal so lead t oi ncrease int otal
producti
onconsi der ingt hef actt hatpr oducer sgainf rom inflati
on
and mayt herefore be encour aged t oi ncrease theirpr oduct i
on
activi
ti
es.

CausesofI nfl
ation
Aswenot edear 1ierint hisl ect ure,infl
ationcannotbeper manent ly
sustained wi t
houtan i ncr ease i n money suppl y.Thus,al lthe
permanentcausesofi nflationar emoney -
related.
Thef irstcauseofi nf lationi sanappr eci ablei ncreasei nthe
quant i
ty ofmoney suppl y .When t he gov ernmentpr ints mor e
moneyi nor dert of i
nanceadef icitbudgetort oprosecut eawar ,
thi
swi l
lhav etheef fectofi ncr easingaggr egat emoneysuppl y,and
therefore, thegener alpricel ev el
.
Anot hercauseofi nf l
at ion isof t
en excessi vedemand ov er
supply.Thati si n¬crease i n demand wi thouta cor r
espondi ng
i
ncreasei nsuppl y .Thei ncr easei naggr egat edemandmi ghtbe
causedbyi ncreasei nwagesofwor kersaswehadi nNi geriadur i
ng
theUdoj iAwar d.Theconsequenti ncreasesi ncashbal ancewi th
thewor ker swi l
lcausear ight war dshifti naggr egatedemandand
withaf ixedsuppl ycur ve, thepr i
cel evel wil
lincr ease.
Thet hirdcauseofi nflat i
oni scost -pushI nfl
at i
on.Thi si sa
resultofi ncreasei npr oduct ioncost stopr oducer swhot henr eview
upwar dst hepr i
cesoft hei rpr oductsi nor dert ost i
llmakepr ofi
t.A
commonexampl eoft hisi st heincr easei nexchanger ateofNai ra
todol lars.Manyf i
rmsi nNi geriadependoni mpor tedi nputst o
produce.Hence,whent heexchanger atei ncr easesf r
om about

68
N1.00=$1. 00t oN7.00=$1. 00,ther
ewi l
lbeacor responding
sevenfol
dincreaseinthei
rproducti
oncosts.Thus,
theywereforced
toincr
easet hepricesofthei
routputbecauseofthechangeint he
exchangerate.

Cont r
ol ofInf l
ation
The cont r
olofi nfl
ati
on isal wayshi nged on the cause oft he
i
nflati
on.Fori n¬stance,f ora money -i
nduced infl
ation,ef f
orts
shouldbemadet oreduceag¬gr egatemoneysuppl y.TheCent ral
BankofNi geriahas,f orsomet imenow,beent ryi
ngt or educet he
supplyofmoneyi ntheeconomyt hroughcr edi
tsqueezeont he
commer ci
al banks.
Fi
scalpol i
cy coul d also be used t o cont
rolinflati
on.The
governmentcoul dr educe its budgetdef i
citorr atherpr omot e
budget arysur plus.
Alsor elevanther eisthef amousPhi ll
ipscurv
e.Thi scurvewas
developedi n1958byPr of.A.W.Phi l
li
ps.Thiscur v
esuggest sthat
i
tispossi blet ot rade-
offmor einfl
ati
onf orlessunempl oymentor
vi
ce-ver sa.

Fi
g8.1Phili
psCurve
Thenthroughacombi nati
onoff i
scalandmonetar
ypol
ici
es,it
wasthoughtthatthegovernmentcouldreducet
herateofi
nfl
ati
on
f
orsomel ev
el ofunemployment.

Money
Moneyisanythi
nggeneral
lyaccept
ableasameansofpaymentf
or
goods and ser
vices and f
ort he set
tl
ementofdebts.Money

69
perf
ormsv ar
iousf unct i
ons,anddi fferentkindsofmoneyv aryi
nthe
degreeofef fi
ciencywi thwhi cht heycanf ulf
il
lthesef unct
ions.
Thesef uncti
onsi ncludet hefoll
owi ng:
1. TheMedi um ofExchange:Thi si st hemosti mpor t
antfuncti
on
per f
ormedbymoney .Moneyal lowst hecompl exi
tyofmoder n
economybasedonspeci ali
sationt obepossi bl
e.Thisremov es
bar t
er,whi chi st hesy stem ofexchangi nggoodsf orgoods
directl
y.Thi si s a cumber some sy st
em i n whi ch every
trans¬actionr equiresadoubl ecoi ncidenceofwant s.

2. UnitofAccount :Moneypr ovidesacommondenomi nat orby

whi ch allothercommodi t
iesareexpr essed.Ther ef
or e,this
makesi tveryeasyt orecordeconomi ctransact
ions,inv ol
vi
ng
differ
entcommodi t
ies.Asauni tofac¬count,moneyal lowsf or
thef ormationofpriceswhi chcant henbeusedf orrecor di
ng
transacti
onent r
iesinbooksofaccount s.

3. A St or
eofVal ue:Possessionofmoneyconf erspur chasi
ng
poweront heholderwhocant hendeci deei t
hert ospendi tnow
orsav eforf ut
uretr
ansac¬ti
ons.Mor eimpor tantl
y,moneyasa
storeofv alueint
roducesfl
exibil
it
yint ot hemoneyeconomy .It
i
snowpossi bl
etosellgoodst oday,st orethemoneyunt i
lone
needsi tlateron.Howev er
,f ormoneyt obeabl etof uncti
on
effecti
velyasast or
eofv al
ue, t
heni tmusthav east ablev al
ue.
Rapidf l
uctuati
on int he generalpr ice levelr educes the
usefulnessofmoneyasast oreofv alue.

4. A Standar
dofDef err
edPay ment:Moneyal soallowsf orthe
practi
ceofcr edi
tsystem inaneconomy .Inotherwor ds,itis
possiblet
obuynow andpayl ateroralternati
vel
yspeaki ng,to
sellnow and col l
ect money l ater on.Howev er
,t hi sis
i
mpossi bl
e i n a bar ter economy . Thi s decoupling of
purchase/
sales and pay ments pr ov i
de much of t he
development,whichchar act
eri
sesoureconomyt oday .I ti
sa
factthatmanycompani esbor row fr
om banksormakeuseof
credi
tfaci
li
ti
est obeablet of
unct i
oneffectiv
ely.

TheDet
ermi
nant
sofDemandf
orMoney

70
Moneycoul dei therbehel dasl i
quidcashorbeusedt opur chase
i
ncomeear ningasset swhi chwoul dgener atesomer at esofr eturn.
Thehol dingofmoneyt hereforehav eanoppor tuni
tycostwhi chi s
therateofI nterestt hatcoul dhav ebeenear nedi fthemoneywer e
usedt opur chasei ncomeear ningasset ssuchast reasur ybi l
ls.
Thet otalamountofmoneybal ancest hatev eryonewi shest o
holdf orallpur posesi scalledt heDemandf orMoney .Ther ear e
generall
yt hreepur posesf orhol di
ngmoney .Thesear et ransact i
v e
motive,pr ecaut ionar ymot i
veandspecul ativemot i
v e.Thet hree
motivesar edi scussedf ull
ybel ow.
1. Tr ansact i
v eDemandf orMoney :Thisi st het otalamountof
moneyt hatpeopl ewantt oholdinor dert ocarryoutt heirday -t
o
-day act i
vities such as set t
li
ng theirbi l
l
s.The t ransact i
v e
demand f ormoney ar ises because oft he time di fference
bet ween t he r eceipts and expendi tures ofhousehol ds and
firms.Fori nst ance,whi l
ewor kersarepai dwagesandsal ari
es
att heendoft hemont ht heyof tenneedmoneyt omeetsome
financialcommi t
ment sbet weenoneper i
odofsal ar ypay ment
andanot herper iod.Moneyhel dfort hispur posedependson
twof actors.
1. t hesi zeofnat i
onali ncomemeasur edatcur r
entpr ices;
and
2. t het i
mespanbet weenonepay mentper i
odandanot her

2. ThePr ecautionaryDemandf orMoney :Thi

sr eferstot hemoney
heldf ort hepur posesofmeet ingunexpect edcont ingenci es.
Life i s of ten full of uncer tainty. Unexpect ed busi ness
oppor tunit
iesmayar ise,forwhi chaf irm mayneedmoneyt o
takeadv antage.Ifthef i
rm hasnotmadeadequat epr ovisions
forsuchanoccur rence,theni tmaynotbeabl etobenef itf r
om
suchunexpect edoppor tunit
ies.
Thedemandf ormoneyf ort hispurposehowev erdepends
ont her ateofinterest.Thehighert herateofi nter
est ,
thehi gher
theoppor tunit
ycostofhol dingmoneyandi nvari
ablyt hel ess
theamountofmoneyhel dforpr ecauti
onarymot ive.Howev er,
thet otalamountofmoneyhel df orthi
spur posev ari
esdi rectly
witht hesizeoft henat i
onalincome.

71
3. TheSpecul ativeDemandf orMoney :Thi sist hemoneyset
asidef orthepur posesofspecul ativet rading.Fori nstance,i f
onet hinkspr i
cesar enow v erylow andmayr i
seint hef uture,
thetendencyi stobuynowandt opost ponesel l
ingunt i
lpr i
ces
ri
seandv ice-ver
sa.Hence,whenpr icesar elow,peopl ewi ll
rusht opur chaseandt hi
swi l
lthereforer educemoneyhel dfor
speculat i
on.Ont heot herhand,i nasi tuationwhenpr iceshav e
comedown.I nsuchasi tuation,l
ar gequant i
tiesofmoneymay
behel di nant ici
pationofamor ef av orablechangei npr i
ce
beforet heymaket heirpurchasesi nt hef uture.Thespecul ati
ve
demandf ormoneyal sov ari
esi nverselywi thther at
eofi nterest.

Itisv eryimpor tantto notethedi f

ferencesbetween t
he
tr
ansact
ive,pr ecaut i
ons and the speculati
ve demands for
money.Wher eas,t hetr
ansacti
veandpr ecauti
onarymotiv
es
emphasizet her oleofmoneyasamedi um ofexchange,t
he
specul
ati
v emot i
v eemphasizesit
sroleasast oreofweal
th.¬

TheDemandf orMoney
Let’sformalizeourdiscussionoft hedemandf ormoneyasf oll
ows.
Let“NWeal th”representt hef inancialweal thofhousehol dsi n
naira-
thus, t
henairasign.Atapoi ntint i
me, f
inanci alwealt
hisgiv en.
Househol dsmustchoosehow mucht ohol di nmoneyandhow
mucht ohol dinbonds.Lett hei rdemandf ormoneybedenot edby
Md andt heirdemandf orbondsbyBd ( thesuper scri
ptdst andsf or
demand) .What evertheychoose,t heirdeci sionsmustbesucht hat
moneyandbondhol dingaddupt ot heirweal th:
Md+Bd=NWeal t
h (8.
1)
We j ustsaw t hatan i ndiv i
dual ’
s money demand depends
pri
mar il
yont wov ar
iables,hisl ev eloft ransact ionandt heinterest
rate.Thissuggest sthatmoneydemandf ort heeconomyasa
whol edependsont heov eralllev eloft ransact ionsint heeconomy
andont hei nt
erestrate.Theov erallleveloft ransacti
onishar dt o
measur e.Buti ti sr easonabl et o assume t hatiti sr oughly
proporti
onalt o nominali ncome- equivalently nomi nalout put.If
nomi nalincomei ncr
easesbysay ,10%, i
tisreasonabl etothi
nkt hat

72
t
heamountoft r
ansact
ionsi
ntheeconomywi
l
lal
soi
ncr
easeby
r
oughl
y10percent .Thus,wewri
te
Md=NYL(i)
(
8.2)
(
-)

Thisequat i
onr eadsas“ Moneydemandi sequalt onomi nal
i
ncomet imesaf unct ionoft hei nterestr at e,denot edL( i
).”Thi s
equat i
onsummar i
zeswhatwehav esai dsof ar :
1.Fi r
st,t he demand f ormoneyi ncr eases i n pr oportion t o
nomi nalincome.I fincomedoubl es,i ncr easingf rom NYt o
N2Y,t hen,t hedemandf ormoneyi ncr easesf r
om NYL( i)to
N2YL( i
);thusi tal sodoubl es.
2.Second,t hedemandf ormoneydemandsnegat ivel
yont he
i
nterestr ate.Thi srel ationi scapt ur edbyt hef unctionL( i
)
andt henegat i
v esignundert hei nter estr ate,whi chindicat es
anegat i
ver elationshi p.Thi sdemandf ormoneydecr eases
whent hei nterestr atei ncreases.
Ther elationbet weent hedemandf ormoneyandt heint erest
ratei mpl iedbyt heequat i
onabov ei sr epr esent edi nFi g8. 2,t he
i
nt erestr ate,i,i smeasur ed on t hev er ti
calaxi s.Money ,M,i s
measur edont hehor izontalaxi s.TheMdcur ver epresentst he
demandf ormoneyf oragi v enl ev elofnomi nalincome,NY.I tis
downwar dsl oping,becauseal oweri nter estr ateleadst oahi gher
demandf ormoney .TheMdcur vegi vesr at e,sayi ,ani ncreasei n
nomi nalincomef rom NYt oNYi ncreasest hedemandf ormoney
from, say, Mt oM’ .Putanot herway , t
hedemandf ormoneyshi f
t sto
ther i
ght ,from Mdt oMd’ .Atanyi nter estr ate,thedemandf or
moneyi slargert hanbef oret hei ncr easei nnomi nalincome.

73
 nt
I at
estr
er i
e,

Md’
(
$Y’
>$Y)

Md
M M’

Money
,M
Fi
g.8.
2Thedemandf
ormoney

TheDemandf orBonds
Remembert hatthedemandf ormoneyandt hedemandf orbonds
arenoti ndependentdeci sionbutt hatthetwohav et oaddupt o
fi
nanci alweal th.Wecant husl ookatt hedemandf orbondsi mpl i
ed
byt hedemandf ormoney .From equat i
ons( 8.1)and( 8.2)
,t he
demandf orbondsi sgivenby
Bd =NWeal h-Md
t
=NWeal t
h-NYL( i)
Ani ncr easei nweal t
hl eadst oaone- for-
onei ncr
easei nt he
demandf orbonds.Thi sconcl usi
oncomesf r
om outassumpt ion
thatt hedemandf ormoneydependsoni ncomeandt hei nt
erest
rate,notonweal th.Thus,ani ncr
easei nweal t
hgoesi ntohi gher
bondhol dingsr at
herthani ntohighermoneyhol dings.Ani ncr
ease
i
ni ncomel eadst oani ncreasei nthedemandf ormoney ,andt hus
toadecr easei nt hedemandf orbonds.Andani ncr
easei nt he
i
nter estr ate,whi ch makes bonds mor e attr
active,leads to an
i
ncr easei nt hedemandf orbonds.

Summary
I
nt hi
slect
ure,wehav
etaughty
out
hati
nfl
ati
oni
soneoft
he

74
greatestproblemsofmoder ngov ernments.Iti
saper i
odofgener al
i
ncreasei npr icelevel.I nflationcannotbesust ainedlongwi t
hout
i
ncrease in moneysuppl y.Thus,i tisregarded asa monet ar y
phenomenon.Thecont rolofi nf
lationisalsosai dtobeaf unct
ion
oft hecausesofi nf
lat ion.Howev er
,through a combi nati
on of
monet aryandf iscalpolicy ,Inflat
ioncanber educedi ntheeconomy .
Youwer eal sot aughtthatmoneyi sanygener all
yaccept edmedium
ofexchange.I thasf ourf unctions:a medi um ofexchange;a.
meansofpay ment ;a st oreofv al
ue;a unitofaccountand a
standardofdef err
edpay ment .Moneyi sdemandedf orthr
eemai n
reasons,fort ransaction,pr ecaut ionaryandl astl
yf orspeculati
ve
purposes.

Post-
Test
1.Whatisinfl
ati
on?
2.Inf
lat
ionisamonetaryaff
air
,Tr
ueorFalse?
3.Inf
lat
ionisnotent
ir
elybad.Doyouagr
ee?Expl
ain.
4.Whati smoney?Whyi smoneyessenti
alfort
hefunct
ioni
ng
ofmoderneconomy ?

References
Aboy ade O.( 1983).I nt
egrated Economi cs:A St udy of
DevelopingEconomi es.Addison-
Wesl eyPubli
sher sLtd
BlanchardO.( 1997).Macr oeconomicsPr enti
ce-
Hal l
,I
nc.
Dwi vedi
,D. N( 2005).Macr oeconomicsTheor yandPol icy.
Tat
aMcGr awHi l
l.
Jhingan,M. L.(2000).Macr oeconomicTheor y,10thRev i
sed
andenl argedediti
on.Vr i
ndapublicati
onsLtd.
JoeU.Umo? (
2007).Economi cs:AnAfricanPer specti
ve(2nd
ed.
)Lagos: Mil
lenniumTextPubl i
shers.
Olofin S.( 2001) . An Introduct
ion to Macr oeconomi cs.
MalthousePubl isher.

75
LECTURENI
NE

TheBanki
ngSy
stem

Intr
oduct i
on
Moneyandbanksar esomeoft hemostf ami l
iarsubj ectstomost
people;wecomeacr ossbot hoft hem al mostev erydayofourl i
v es.
Theyar ebot hveryi m¬por t
antf ort hesmoot hr unni ngoft oday '
s
highlyadv ancedeconomi csy stem.Whi l
emoneyi st hemedi um
throughwhi checonomi cexchangest akepl ace,banksser veasa
usefulmedi um throughwhi cht hosewhoneedmoneyar ebr ought
i
nt o contactwi tht hose who hav e money ,whi ch t hey do not
presentlyneed.
Thebanki ngsy stem coul dbev ariouslycat egor ized.Ther ear e
commer cialbankst hatdealwi ththeor dinarypubl i
c.Theyaccept
depositsf rom cust omer sandal sot ransfert hesedeposi tsamong
theircustomer s.Whenor der edtodosobycheques,banksmake
l
oansav ailabl
etot hei rcustomer sandmanyal soi nv esti ninterest-
earningfinancialasset s.
Inaddi ti
on,ther ear especi ali
sedbanki ngi nstitutionsl i
ket he
mer chantbanks,i nv estmentbanks,bui ldingsoci etieset c,whi ch
perform speciali
sedbanki ngf uncti
onsf ortheircus¬t omer s.
Thet hirdmai nel ementoft hebanki ngsy stem i st heCent ral
Bank.Itist heapexoft hebanki nginst i
tuti
ons, andi talsoser vesas
ther egulatoroft hef inancialinsti
tutionsi ntheeconomyofany
givenmoder nstate.

Obj
ect
ives
Att
heendofthi
scourse,youshouldbeabl
eto:
1.descri
betheoperat
ionsofthebanki
ngsyst
em;
2.explai
nhowbankscr eat
emoney ;

76
 3.st atethef unctionsofthebanki ngsy st
em; and
4.di scusshow t heCent ralBankcont rol
smoneysuppl yinan
economy .
Pr
e-Test
1.Gi veaclassi fi
cationofbankingsy st
em knownt oyou?
2.Di sti
nguishbet weent heCent ralBankandt heCommer ci
al
Bank?
3.Whatar et hemai nfunct i
onsoft heCentralBank?
4.Howdoest heCent ralBankcont rolt
hemoneyi ncircul
ati
on?
5.Anal yset hepr ocessofcr editcreati
oni naneconomy .What
arethelimi t
a¬tionst othi
sprocess?

CONTENT
Creat
ion ofDeposi tMoney :Thisis underthe province oft he
commer ci
albanks.Theyareabletodot hi
sbecausebankdeposi ts
needtobeonl yfract
ion¬al
l
ybackedupbynot esandcoi ns.Wecan
i
ll
ustr
atehowt hisprocessoccur
sbytakingtwohy potheti
calcases:
1.Whent hereisonlyonecommer ci
albank;and
2.Intr
oducecompl i
cat
ionscausedbyt heexi st
enceofmany
i
ndependentbanks.

1. ASi ngl
eMonopolyBank
Assumi ngther
eisonl yonebanki naneconomy(wit
hmany
branches)andas¬sumet hatadeposi
tofN100,
000ismadeby
Mr .A.i
ncash.Thetransacti
onwil
lberecor
dedont
hebooksof
thebankasf ol
l
ows:

Tabl
e9.1:Anewdeposi
tofN100,000i
smade
Li
abil
it
ies Asset
s
Deposi
t N100,000 Cash N100,
000

Withthisdeposi
t,i
tispossi
blef ort
hebanktocreat
emult
ipl
e
deposi
ts.Letussaythatadepositneedstobebackedbya10per
centcashr eser
ve.I
tist henpossiblefort
hemonopolybankto

77
createfurt
herdepositofN90,000.Assume, bywayofexampl ethat
thebankl oansN50,000toacust omerandbuy sN40,000wor t
hof
bondsi ntheopenmar ket
.Thistransactionwil
lappearinthebank's
books,oncet heborrowerhaswr it
tenchequesont heloanable
amount .ThisN90,000wi l
lnowconst i
tuteaddit
ionalmoneytot he
economy .
Table9.2: N90,000i sinvest
edi nloansandbondswi t
hnocash
drain.
Li
abil
it
ies Assets
Deposi
tsN100, 000 CashN10, 000
LoansN50, 000
BondsN40, 000

'
Thus,withaf ew st
rokesofthepen,thebankhascr eateda
furt
herN90, 000indepositmoneywiththeor
igi
nalN100,000cash
deposit.
Theabov eexampleishowevertoosimpl
ist
icconsi
deringthat
therearemanybanksi naneconomy .Weshallnow considera
mor ereal
ist
icexampleofmanybanks

2. ManyBanks
Theanal y sishowev erdependsonanumberofassumpt i
ons:
1.Ther ear emanybanksi nt hesystem.
2.Thel egalr eser veratioi s10percent .Thisistheamountof
cashr eser vet hatisassumedt obehel dagai nstdeposit
l
iabili
ties.
3.Al lbanksi nt hesy stem hav emadel oansupt ot heli
mitset
byt her eserver equirementbef orether ecei
ptofaddi t
ional
cash.
4.Al lf unds,l oans and cheques dr awn on one bank ar e
deposi t
edi nthesameoranot herbank.
6.Ther ei snocashdr ainont hesystem.
Thepr ocessmaybedescr ibedasf ol
lows.Thef i
rstbank,on
receiv
ing the N100,000,pl aces N10,000 i nt he reser
ves and
proceedst ol endt her emai ni
ngN90, 000.Thisislenttoacustomer ,

78
wholaterwrit
esachequet oacredi
torforN90, 000.Thereceiverof
thechequethendeposi tsi
tinabank.Ther ecei
vingbankpr oceeds
tokeepN9,000andl endoutN81,000.Themoneycomesi ntothe
possessionofanotherperson,whenitisspentbyt heborrowerand
thechequedeposi t
edi nabank.Ther ecei
v i
ngbankkeeps10per
centinthereserv
eandt herestisl
entout .Whent heoriginalcash
recei
ptofN100,000hasdi f
fuseditselfthroughoutthesy stem,
deposit
swi l
lamountt oN1,000,000( t
ent i
mest hecashreserved)
andloansupt oN900, 000

Tabl
e9.3.TheProcessofMul
ti
pleBank-
Deposi
tExpansi
ont
hrough
theBanki
ngSys¬tem

(1) (
2) (
3)
NewDeposi
ts(
N) Reser
ves(
N) Loansand/ or
i
nvestments(N)
1ststep 100,000 10,000 90,
000
2ndstep 90,
000 9,
000 81,
000
3rdstep 81,
000 8,
100 72,
900
: : : :
: : : :
AllBanks 1,000,000 100,000 900,000

Thi
sprocessofdeposi
tcr
eationi
sshowni nschemati
cformi n
Tabl
e9.3Column1isthesum ofgeometr
icseri
es.
Thi
scanbeexpressedas
2 n
100,
000+100,000 (9)+ 100, 000 (9) +………+100,000(9)
(
10) (
10) (
10)

Thi
scouldbereducedt
o
N100,000 ( 1) = 1,
000,000
(
1–9/ 10)

79
Li
mi tat
ionst otheCr edi tsExpansi onofanI ndivi
dual Bank
1.Deposi t
:Theamountt hatani ndivi
dualbankcanl endi s
dependentont heamountcust omer shav edepositedwi t
hit.
2.Legalr eserver equi r
ement :Thi si sinverselyrelatedt ot he
amountofcr edi tcr eat ed.
3.Theext enttowhi chchequesar eusedf ortransactionsi nthe
economy .
4.Asamemberofabanki ngsy st
em,abankcannotexpand
creditmor er api dlyt hanot hermember soft hesy st em.I fit
did,itwoul dl ose much ofi tsreser v
es t o otherbanks
throught hecl ear inghouse.
TheRol eoft heCent ral Bank
TheCent ralBanki st heagentofmonet arypol i
cy.Thi scanbe
defi
nedast heat ¬temptt or egul atethesuppl yofmoney ,thet er
ms
andav ailabil
it
yofcr edi t.TheCent r
alBanki stheapexf inancial
system in an economy .Howev er,thei nstrumentbywhi ch the
CentralBankper f
ormsi tsr olev ariesfrom onecount r
ytoanot her.

Funct
ions
1.Banker t o t he Gov ernment : Government s, li
ke ot her
economi cagent s,needt ohol dtheirf
undsi nanamounti nto
whicht heycanmakedeposi t
sandagai nstwhi cht heycan
draw cheques.Suchgov ernmentdeposi tsar eusual l
yhel d
bytheCent ralBank.
2.Manageroft hePubl icDebt :TheCent r alBankhel pst he
government wi t hi t
s debt . management .It helps t he
governmenti nr aisi
ng new f undsand managi ng itsdebt
inst
rument s. For I nst ance, the Cent r al Bank usual l
y
purchasesanypar tofnew i ssuesofpubl i
cdebtt hatisnot
takenupbyot herl ender sont hedayofi ssueatwhatseems
li
kear easonablei nterestr ate.
3.Bankert o Commer cialBanks:The Cent ralBankaccept s
depositsfrom commer cialbanksandwi llonor dert r
ansfer
thesedeposi t
samongt hem.Cent r
alBanksal solendmoney
to commer ci
albankswhent heyareshor tofcashori n
li
quidi
tycrises.

80
 4.LenderofLastResor t:Commer cialbanksof t
enhavesudden
needsforcashandonewayofget t
ingitistoborrow from
theCent r
alBank.Cent ralBanki sal enderoflastr esort
becausewhenot hersourceshav ef ai
ledtheCent ralBank
would lend money t o commer cial banks with good
i
nvestments but i nt em¬porary need of cash. Those
commer ci
albankspayi nter
estont heloanatar at ethat
used to be cal l
ed the bank rate buti s now called the
minimum lendingr at
e.
5.Regulat
oroft heMoneySuppl y:TheCent r
alBankhasgr eat
powert oin¬fluencet hemoneysuppl y.Byt hi
spowert he
Central
Bankt riestocontroli
nfl
a¬tionintheeconomy .

I
nst
rumentsusedbyt heCent ralBankt ocont rol Commer cialBanks
1.CurrencyCont rol
:Inmostcount ri
es, t
heCent r
alBankhast he
solepowert oissuepapermoney .No at tempti smade,
howev er,tocont r
oltheov erallmoneysuppl ybycont r
oll
ing
thequant i
tyofbanknot esinci r¬culation.Supposet hatthe
publicwi shestoincreaset hef ractionoft otalmoneysuppl y
itholdsasnot esandcoi ns.Facedwi t
hacashdr aint othe
public,thecommer cialbankswi llwithdr aw deposi tsf r
om
theCent ralBankandt hebankwi llpri
ntt henecessar ybank
notes.
2.TheReser veBase:Muchmor eimpor tantlyt hant hecur rency
controli st he CentralBank' s cont r
olov ert he r eserves
avail
ablet othebanki ngsy s¬tem.TheCent ralBankr equires
commer cialbankst o hol dr eserv esagai nstt heirdeposi t
li
abil
iti
es.Theser eser v
esar ecal ledt her eser vebaseoft he
moneysuppl y
.Thr ough t he mani pulati
on oft hisr eserve
base, t
heCent ralBankcani nfluencet hemoneysuppl yinan
economy .

Monet
aryPol
i
cy
TheCentr
alBanki
sresponsi
blef
ort
heoper
ati
on ofmonet
ary

81
poli
cy .Onemaj orobj ect iveofmonet arypoli
cyi st oi nfluencet he
aggregat edemandandt hrought hatnationalincome,empl oy ment
and pr i
ces.Anot herobj ect
ivei st o provi
de a cushi on f ort he
country'sf i
nanci alsy stem f rom t hekindsofpani csandcr ashes
thathav ecausedoccasi onal f
inancialhavocs.
Themaj ort oolsofmonet ar
ypol i
cyhav echangedov ert he
years.I nt he past ,t he Cent ralBank soughtt oi nfluence t he
economybyi nfl
uenci ngt het erm andav ail
abili
tyofcr edit.Itwas
beli
evedt hataggr egateexpendi t
urecoul dber aisedbymaki ngi t
easyt ogetcr edi
toneasyt er
msandv i
ce-ver
sa.
Mor er ecent l
y,Cent ralBanks hav e shi ft
ed emphasi st o
controll
ingt hesuppl yofmoneydi rect
lyandexpect ingt hi stohav e
a definite effecton t he i nterestr at
e and the amountofl oan-
fi
nancedexpendi ture.Ther ear esev er
alway sbywhi cht heCent ral
Bankt r
iest oachi ev ethi s.Thesei ncl
udeopenmar ketoper ations,
bank r ate,r eserv e r equi r
ement s,mor al suasion and cr edit
guideli
nes.

Open Mar ket Operations invol

ve t he sale or pur chase of
governmentsecur
it
iesi ntheopenmar ket.Thr
oughthis,theCentral
Bankwoul dbeablet oi n¬fl
uencecommer ci
albankr eservesand
i
ndirectl
y,t
he money suppl yi n an economy .An open mar ket
operati
on i
sv ery effecti
ve,part
icul
ar l
y,in count
ri
es wi th well
developedmoneymar kets.

BankRateisthepri
cepaidbytheownerofsecur i
ti
est
ot heCentral
Bankforconver
ti
ngthesecurit
iesint
ocash.Inter
estr
atescharged
bythebanksfoll
owt hebankrate.Hence,byvary
ingt
hebankr ate,
thecentr
albankinfl
uencestheav ai
labi
li
tyandcostofcredi
tand
hencethemoneysupply.

ReserveRequir
ementi stherati
oofi t
sdepositsthatacommer cial
bankmustkeepi nt
hef orm ofcashandcommoni nter
estearning
bal
anceswi t
ht heCentralBank.Thi
sr equi
rementreserv
erati
opr e-
deter
minesthemaxi mum amountofcr edi
tthatcanbecr eatedby
banki
ngsy stem.Byt hemani pulat
ionoft hereserverequi
rement

82
r
ati
o,t
heCent
ral
Banki
nfl
uencest
hemoneysuppl
yint
heeconomy
.

Mor alSuasioni saper suasi

veattemptbyt heCentr
alBanktothe
commer cialbankst oreducetheamountoft hei
rcr
editt
othepubli
c.
Creditguideli
nei salsousedt ocontr
oltheamountofcr edi
tgi
ven
byt hecommer ci
albanksandt owhichsectorsoftheeconomyiti
s
gi
v en.

MoneyandCapi t
al Mar ket s
Wher e expendi t
ure exceeds t he r ecei pt s of f i
rms orof t he
gov er nment ,t hedef icitshav et o bebr idged bybor rowi ng.The
i
nst ituti
ons wher ef unds ar e made av ailabl et of irms and t he
gov er nmentatapr i
ce-t her at eofi nterestar et hef i
nanci al mar ket s.
Becausef inancei sr equi redbydi ffer entt ypesoff irms,byt he
gov er nmentandbynat ional isedi ndust ries,f ordi f
ferentpur poses
andf ordi fferentper i
odsoft i
me, therei sagr eatv ari
et yi nt hetypes
ofloanav ail
abl eandi nt hei nstit
ut i
onspr ov i
dingorar rangi ngsof t
l
oans.Nev ertheless,f i
nanci almar ket scanbecl assifiedi ntot wo
broadgr oups: Themoneymar kets( deal ingi nshor t-t
er ml oans)and
thecapi talmar ket(wher emedi um andl ongt er m capi talisr aised) .
Itmustbest ressedt hatnei thert hemoneymar ketnort hecapi tal
mar keti saf or malor gani sat ionwher ebuy er sandsel l
er smeet
regul arl
yi napar t
icularbui l
di ngt ot ransactbusi ness.I nst ead,they
aremer elyacol lectionofi nst i
tutionswhi char econnect ed,i nt he
caseofmoneymar ket s,bydeal ingsi nbi llsofexchangeandshor t
terml oans.I nt hecaseofcapi talmar ket s,i tist hroughchannel ing
medi um andl ongt ermf inancet othoser equi ri
ngi t.
Gener al l
y,moneymar ketcompr i
sesof( i
)t hedi scountmar ket
(whi chi nt urnconsi stsofi nstit
ut i
onsl i
nkedbydeal ingsi nbi lls
discounthouses;mer chantbanks,commer ci
albanks and t he
cent ralbank) ,bi l
lsofex changear ei mpor tantsour ceofshor tterm
fi
nance–t hecommer cialbi ll
sar ef orf irmsandt reasur ybi l
lsar e
fort hegov ernment( 2)par al lelmoneymar ketwhi chhasdev eloped
tomeetspeci ficr equi r
ement sofpar ticul arbor rower sandl ender s
tomakef ort her estrictionspl acedonbankl ending.
The capi talmar ketconsi sts of such i nstit
utions as t he
i
nsur ance compani es,i nvest ment st rust s,uni tt rust s,f i
nance

83
compani
es,
bui
l
dingsoci
eti
es,
etc

Summar y
Youhav ebeent aughtthemai ninst i
tuti
onsint hebanki ngsy st
em
andt heoper ati
onsoft hei nstitut
ions.Wehav egi venat hreeway
classi
fi
cation oft he bank¬i ng sy stem -t he commer cialbanks,
special
isedbanksandt heCent ralBanks.Thej obofcr editcreati
on
i
sdonebyt hecommer cialbanks.Howev er,thev ol
umeofcr edit
theycancr eatedependsonanumberofl i
mit i
ngf actorssuchas
thereserver equirementr atio, l
eakagei nthesy stem, etc.Thepr i
me
roleoftheCent ralBanki st heov er allsuper
visionoft hemonet ar
y
system ofaneconomy .TheCent r
alBanki nf
luencest hequant i
tyof
moneyi ncirculationthroughsuchsy stemsasv aryingt hebankr ate,
thecash-deposi trati
o,mor al suasion, etc.

Post-
Test
1.Giveaclassif
icat
ionofbanki nginsti
tuti
onsinyourcountr
y.
2.Explai
nhowt hecr eat
ionofmoneypr ocesswor ks.
3.Discusstheli
mi t
ingfactor
sont heprocessin(2)above.
4.Supposet heCent r
alBankr aisescash-deposi
tr at
iof
rom 5%
to10%.Whatwi l
lbet heeffectont helevelofmoneysupply
intheeconomyofast ate?

5.Di
scussthefunct
ionsoftheCent r
alBankinaneconomy.
Canyoucont
rastt
hese f unct
ions wi
ththose per
for
med
bythecommerci
albanks.

Ref
erences
Aboy ade O.( 1983) .Int
egrated Economi cs:A Study of
dev
elopi
ngeconomi es.Addison-WesleyPubl
ishersLtd
Dav i
dC.Col ander( .Economi
2004) cs,5thediti
onMiddl
ebury
Col
lege:McGr aw-I
rwin.
Dwi vedi
,D.N( 2005).MacroeconomicsTheor yandPolicy
.
Tat
aMcGr awHi l
l
.
Jhingan,M. L.(2000).MacroeconomicTheor y,10t
hRevised

84
andenlargedediti
on.Vr i
ndapubl i
cat
ionLtd
Li
psey ,R.G( 1971) .Intr
oducti
on to Posi
ti
ve Economi
cs.
WiedenfeldandNi colson:London.
Olofn S. 2001. An I
i nt
roduct
ion to Macroeconomi
cs.
MalthousePublishers.

85
LECTURETEN

I
nter
nat
ional
Trade

I
ntroduction
I
nt her ealm oft r
adingforeconomi cpurposes,nocountryi
san
i
sland.Ther earetraderel
ationsbetweenonecount r
yandanother.
I
nt hi
slect ure,weshalldiscussthebasictheori
esofint
ernat
ional
t
radeandt hereasonswhycount r
iesengageintrade

Obj
ect
ives
Att
heendofthislecture,y oushoul
dbeabl eto:
1 explai
nwhycount riesengageininter
nati
onal
trade;
2.discussthedifferenttheori
esofinter
nati
onal
trade;
and
3.definethephrase, t
er msoftrade.

Pr
e-Test
1.Whati sint
ernati
onaltr
ade?
2.Gi vefourreasons whycount r
ies engage i
nint
ernat
ional
tr
ade.
3.St at
etheprinci
pleofcomparat
iveadvantage.
4.Def net
i ermsoft r
ade.

CONTENT
Justasi
ndi
vidual
stradeamongt hemselves,
nati
onsalsoengagein
tr
adewit
honeanot her.Thi
st r
adebetweenonenationandtherest
oftheworl
discall
edi n¬t
ernati
onalt
rade.Nati
onsengageintrade

86
forv ari
ousr easons.Inthef i
rstplace,t r
adeper mi
tsspeci ali
sation,
andspeci al
isat
ionincr
easesout put.Becauseacount ryspeci ali
ses
i
nt hegoodsi tproducespar ti
cularlywel l
,itcant radet hem f or
goodst hatothercountr
iesar eespeci all
ygoodatpr oducing.Thus,
botht hecount r
yandhert radingpar tnerbenefit
.
Inaddi t
ion,somecount rieshav emor eandbet terr esourcesof
certaint y
pest hanothers.Ni ger
iahasoi l
;Canadahast i
mber ;and
Japanhasski l
l
edlabourfor ceandsoon.I nter
nat
ionaldi fferences
i
nr esourceendowment s,andi nt her elati
vequant i
tyofv ar i
ous
types ofhuman and non- human r esources,ar
ei mpor t
antf or
speci al
i
sat i
on.

Theori
esofI nternati
onal Trade
1. Absol uteAdv antage
Thist heor ywaspr opoundedbyAdam Smi t
ht oexpl aint he
need f ort r
ade.Thi st heory can be i ll
ustrated as f ollows:
Assumi ngt hatt herear et wocount ri
esAandB,andal sot wo
commodi t
iesXandY.Wi ththesamequant i
tyofr esour ces,if
count ryAcanpr oducemor eofcommodi t
yXt hancount ryB,
thencount ryAi ssai dt ohav eabsol uteadvant ageov ercount r
y
Bi ncommodi t
yXwhi l
ecount ryBhasab¬sol utedi sadv ant age
incommodi tyX.Thet wocount rieswoul dbenef i
tf rom t radeif
count ry A has absol ute adv ant age in commodi ty X whi l
e
count ryBhasabsol uteadv antagei ncommodi tyY.
A numer icalexampl e wi l
lsuf f
ix.Suppose Ni geria can
produce1el ectroniccomput eror10, 000casesofwi newi t
h1
unitofr esour ces.Supposet hatJapancanpr oduce2el ect r
onic
comput er sor5, 000casesofwi newi th1uni tofr esour ces.I f
Niger i
ashi ft
s1uni tofi t
sr esour cesf rom produci ngcomput ers
topr oduci ngwi ne,itwi l
lincreasei tsproduct ionofwi neby
10,000casesandr educei t
spr oduct i
onofcomput ersby1
comput er .Ont heot herhand,i fJapanshi ftsoneuni tofi t
s
resour ces f rom pr oduct ion ofwi ne to comput er s,i twi ll
increase t he pr oduct i
on ofcomput erby2 comput ers and
reducei tspr oduct i
onofwi neby5, 000casesofwi ne.
Tabl e10. 1showst henetef fectoft hisshiftint heut il
isation
ofr esour cesonwor ldout putofcomput ersandwi ne.

87
 TABLE10.1
CaseofAbsol
uteAdvant
age

I
ncreaseordecr easeinout
putof
:
Wine(thousandofcases)Comput er
Ef
fectofJapan'sshifti
ng
1unitofresour
cesf rom -
5 +2
wi
net ocomput ers

Eff
ectofNigeri
ashi
ft
ing
1unitofresour
ces +10 -
1
fr
om comput er
stowine¬ _
_ _
___
_ _
___
___
Neteffect +5 +1

Thus,wecanseef r
om thetabl
ethatworldout
putofbothwine
and comput er
s hav eincr
eased wit
ht r
ade.Theref
ore,int hi
s
si
tuat
ion,
Ni geri
ashouldspeci
ali
seinproduci
ngwines,whi
leJapan
mustspeciali
seinproduci
ngcomputers.

2. Compar at
iveAdv antage
Thist heor yowesi tsor igintoDav i
dRi cardo.Thistheoryisan
extensi onoft heabsol uteadv antaget heoryoftr
ade.Thet heory
mai ntained thatev en i n a si t
ua¬t i
on wher e a countryhas
absol uteadv antagei npr oducing-thet wo commodi ti
es,over
anot hercount rytradecoul dstil
loccurpr ovi
dedthatt her
ear e
dif
fer encesi nt her elativeef f
icienci
esi nproducing thetwo
goodsi nthet wocount r
ies.
A numer i
calexampl ewi l
lmaket hispointclearer.Letus
makeadj ustmentt oourear l
ierexampl e.SupposeNi geri
acan
produce1el ectr
oniccomput eror4, 000casesofwi newith1

88
 unitofr esources whi l
e Japan can pr oduce 2 el ectronic
comput ersand5, 000casesofwi newi t
h1uni tofresources.I n
thi
scase, Japani samor eef ficientpr oducerofbot hcomput ers
andwi ne.Nonet heless,asweshal lsee,wor ldout putofbot h
goodswi llincreasei fJapanspeci alisesi nt hepr oduct i
onof
comput ersandNi geriaspeci alisesi nt hepr oduct i
onofwi ne.
Table10. 2demonst ratest hisconcl usion.I f2uni tsofJapan
resourcesar eshi ft
ed f r
om wi net o comput erproduct ion,4
additi
onalcomput ers and 10, 000 f ewercases ofwi ne ar e
produced.I f3 uni ts ofNi ger i
ar esour ces ar e shift
ed f rom
comput erpr oducti
ont owi nepr oduct i
on,3f ewercomput ers
and12, 000addi ti
onalcasesofwi near epr oduced.Thus,t he
combi nedef fectoft hisr edepl oyment ,ofr esourcesi nbot h
countriesist oincreaset hewor ldout putofcomput ersby1and
toincreaset hewor ldout putofwi neby2, 000cases.

TABLE10.2
CasesofComparat
iveAdv
ant
age
I
ncreaseordecreaseinout
putof:
Wine(thousandsofcases) Comput
ers
Eff
ectofJapan'sshif
ti
ng
2unit
sofr esour
ces -10 +4
fr
om winet ocomputers

Eff
ectofNi
geria'
sshif
ti
ng
3unit
sofresources +12 -
3
fr
om computerstowine _
___
___ _
___
___
Neteff
ect +2 +1

Wecanseef r
om theabov ethatev ent houghJapani smor e
eff
ici
entthanNi geri
aintheproducti
onofbot hcomput erandwine,
worldoutputofbot hgoodswillbemaxi mi sedIfJapanspecial
i
ses
i
ncomput ersandNi ger
iainwine.Basicall
y ,t
hisissobecauset he
degreeofef f
ici
encyofJapani nthepr oductionofbot hgoods
di
ffers.I
ti stwiceasef f
ici
entasNi geri
ai npr oduci
ngcomput ers

89
butonl y25percentmor eef ficientt hanNi geriai nwi ne.
Thet heoryofcompar ativeadv antagef ormst hebasi soft rade
amongnat i
ons.A nat i
onhasacompar ativ
eadv antagei nt hose
product swher ei t
sef f
iciencyr elat i
vet oot hernat ioni shi ghest .
Howev er,unliket hepr edictionsoft heset wot heor i
es, whatwehav e
i
nr eall
ifeisincompl et
especi alisation.
TheTer msofTr ade
Thephr aset er msoft r
adei sdef inedast hequant ityofi mpor t ed
goodst hatacount rycanobt ai ninexchangef orauni tofdomest i
c
goods.I ti sther atiooft hepr iceofexpor ttot hepr iceofi mpor t.In
theabov et ablei tispossi blef orJapant opr oduce2, 500casesof
wi nes by gi v i
ng up 1 comput er.Thus,t he r atio ofdomest i
c
exchangeshoul dbe2, 500:1.Si milarlyNiger i
acanexchangeacase
ofwi nef or1/ 4,000ofacomput erbydi vert
ingi t
sownr esour ces
from wi net ocomput er.Thus,whi l
eJapanwi l
lnotbewi ll
ingt o
exchangeonecomput erf orl esst han2, 500casesofwi ne,Ni ger i
a
wi l
lnotbewi lli
ngt oexchangeacaseofwi nef orl esst han4, 000of
acomput er.
Butwher ewi llthepr icer at i
ol iebet ween2, 500:1and4. 000: 1?
Theanswerdependsonwor ldsuppl yanddemandf ort het wo
product s,thest r ongert hedemandf orcomput ers( relat
ivet ot heir
suppl y)
, andt heweakert hedemandf orwine( relati
vet oitssuppl y
)
thehi ghert hepr icer at
ioandv ice-versa.

Opennessi nFinanci al Mar kets

Opennessi nf i
nanci almar ketsal l
owsf i
nancialinvest orst ohol d
bothdomest icandf orei
gnasset s,thust odiversif
yt hei rportf
oli
os,
andt ospeculateonmov ement si nforeignv er
susdomest icint
erest
rates,exchange r ates,and so on.Gi ven thatbuy ing orsel l
ing
foreignasset si mpl i
es,aspar toft heoper ation,buy ingorsel l
ing
foreigncur r
ency( somet i
mescal l
edf oreignexchange) ,thesizeof
transact i
onsi nf orei gn-exchangemar ketsgi vesasenseoft he
i
mpor tanceofi nternat i
onalf inancialtransactions.In1994t hedai l
y
volume off oreign- exchange t ransactions int he wor ld was $1
tri
ll
ion, ofwhich80%- about$800bi ll
ion-invol
veddol larsononesi de
oft hetransacti
on.
Mostofthet ransact i
onsar eassoci atednotwi tht rade, butwith

90
pur chases and sal es of f i
nanci al asset s. The v ol ume of
transact i
onsi nf or eignexchangemar ketsisnotonl yhighbutal so
rapidl yincreasing.Foracount ryasawhol e,opennessi nf i
nanci al
mar ketshasani mpor tanti mpl i
cat i
on.I tal l
owst hecount rytor un
tradesur plusesandt r
adedef icit
s.Recal lthatacount r
yr unni nga
tradedef i
citisbuy i
ngmor efrom t her estoft hewor l
dt hani tis
sellingt or estoft hewor ld.Thus,i tmustbor row t hedi f
fer ence.I t
doessobymaki ngi tat tracti
v ef orf oreignf inanci alinv estorst o
i
ncr easet heirhol dingofdomest icasset s,i neffectt olendt ot he
count ry.
Summar y
Youhav ebeent aughtt hei mpor t
anceofi nt er
nat i
onalt r
adet ot he
economi c dev elopmentofa st ate.I nt he process,we cl early
def i
nedi nternati
onalt r
adeandweal sodis¬cussedt wot heor i
esof
i
nt er nati
onalt rade-t het heoryofabsol utead¬v antageandt he
theor yofcompar at i
veadv antage.Thet heor yofabsol uteadv antage
stat est hatacount ryshoul dexpor tthosegoodsi nwhi cht heyhav e
absol uteadv antageandi mpor tthosei nwhi cht heyhav eabsol ute
disadv antage. Ri char dian t rade t heory ,howev er,st at es t hat
compar ati
ve adv ant age r athert han absol ute adv antage shoul d
i
nf or mt hebasi soft rade.Bef or eweconcl udedt hel ecture, weal so
stat edt hatt het er msoft radei sr atiooft hepr i
ceofexpor ttot he
priceofi mpor t.Thehi ghert het ermsoft r
adet hebet terf oran
economy ,andt hisr elati
onal sohol dsi nconv er
se.

Post-
Test
1.Whatdoy ouunder andbyi
st nternati
onaltrade?
2.Whydoy out hi
nky ourcount rypartici
patesini nt
ernati
onal
tr
ade?
3.Compar at
ive advantage rathert han absol ute advantage
shouldbet hebasi sforinternati
onalt r
ansact i
ons,Trueor
False?Expl
ain.
4.Explai
nwhaty ouunder st
andbyt het ermsoft rade.

Ref
erence
Aboyade O.( .I
1983) nt
egr
ated Economi
cs:A St
udy of

91
Developi
ngEconomi es:Addi son-WesleyPubl i
sher
sLt d
Dwivedi,D.N.( 2005) .Macr oeconomicsTheor yandPol icy.
TataMcGr awHi l
l.
JoeU.U.( 2007) .Economi cs:AnAf r
icanperspectiv
e.(2nded.)
Lagos:Mi l
l
ennium TextPubl ishers.
Li
psey ,R.G( 1971).I ntroducti
on to Positiv
e Economi cs,
London:Wi edenfel
dandNi colson,
Oli
verBlanchar d(1997) .Macroeconomi csPrenti
ce-Hall
,Inc.
Olofi
n S.( 2001) . An I ntr
oducti
on t o Macr oeconomi cs.
MalthousePubl i
shers.

LECTUREELEVEN

Bar
ri
erst
oInt
ernat
ional
Trade

I
ntroducti
on
I
nt hi
slecture,weshal
ldi
scussthev ari
ousr estri
cti
onst ofreefl
ow
oft r
adeamongna¬t i
ons.Ther estri
ctionsar ecol l
ectivel
ycall
ed
barri
erstotradeandtheyincl
udet ari
ffs,quot as,exportsubsidi
es,
l
icenses,etc.Theneteffectoft hesebar r
iersist hattheymake
domest i
cpricest
obediff
erentf
rom inter nat
ionalmar ketpri
ces.

Obj
ect
ives
Att
heendoft hi
slect
ure,
youshouldbeableto:
1.explai
nt he meaning oftari
ffand otherf
orms oft
rade
barri
ers.
2.discusswhyacount r
yimposestar
if
fs;and

92
 3.expl
aint
hei
mpl
i
cat
ionoft
ari
ff
sonf
reet
rade.

Pr
e-Test
1.Whatdoy ouunderstandbyt ari
ff
s?
2.Whydocount r
iesimposet arif
fsonf r
eetrade?
3.Ar etheargumentsfort ar
if
fsjustif
iedinviewoft hebenef
it
s
whichcanbeder i
vedfrom freetrade?Givereasons.
4.Di st
ingui
shbet weent ari
ff
sand non- t
ari
ffbarri
erstof r
ee
tr
ade.

CONTENT
Despi tet headv antagest obeder ivablef rom f reet r
ade,exper i
ence
hasshownt hatnotev eryonebenef i
tsequal l
yf rom f r
eet rade.Thus,
forv ariousr easonsr ang¬i ngf rom r easonabl et ospur iousones,
count ri
es i mpose r est ri
ctions on f ree t r
ade.Such r est r
icti
ons
i
ncl udet arif
fs, quot as, subsidiesandot hernon- tariffbar ¬riers.
Tar i
ffcanbedef i
nedasat ax,whi cht hegov ernmenti mposes
oni mpor ts.Usual ¬ly,t hepur poseofat arif
fi st ocutdownon
i
mpor tsi nor dert opr otectdomest i
ci ndust ri
esandwor kersf rom
foreigncompet i
tion.Asecondar ypur posehowev eri st ogener ate
revenuef ort hegov ernment .Ont heot herhand,quot asr ef ertot he
maxi mum amountofcer taincom¬modi tiest hatcanbei mpor ted
annual lyintot hecount r y
.
Finally,expor tsubsi diesr epr esentanot hermeansbywhi ch
gov ernment st ryt ogiv et heirdomest icindust riesanadv antagei n
i
nter nationalcompet i
tion.Suchsubsi diesmayt aket hef orm of
outrightcashdi sbur sement s,t axexempt i
ons,et c.Ot hernon-t arif
f
barriers t o f ree t r
ade i nclude l icensi ng r equi rement s and
un¬r easonabl epr oductqual i
tyst andar ds.Bygr ant i
ngf ewl i
censes
toi mpor tfrom ot hercount ries and byi mposi ng unr eal i
sti
cal l
y
stri
ngentpr oductqual it
y st and¬ar ds,gov er nmentdi scour ages
i
mpor ts.
Awor l
doff reet r
adewoul dbeonewi thnot ar i
ffs, quot asorany
otherr est ri
c¬t i
onsoni mpor t
ingorexpor ti
ng.I nsuchawor ld,a
count rywoul di mpor tal lthosecommodi tiesthati tcoul dbuyf rom
abroadatadel i
v eredpr i
cel owert hant hecostofpr oduci ngt hem at

93
home.
Nowsupposet hatacount ryimposesa20percentt ari
ffonall
i
mpor t
s.Thisdoesnotpr ohi
bittradebutbymaki ngal li
mpor ted
goodsmor eexpensi v
e, i
taf¬f
ectst hepr ofi
tmargi
nofi mports.Any
for
eigngoodst hatenjoyacostad¬v antageoflessthan20percent
arenowef f
ecti
v el
yprohibit
ed;whil
ei mpor tedgoodst hatenj
oycost
advantageinexcessof20percentwi l
lsti
l
lbei ndemand,but
becausetheirdomest icpri
cehasi ncreased,asmal lerquantitywil
l
bedemandedt hani ftherewerenot arif
f.

Ar
gumentsf orTar iffsandQuot as
1.Themostf r
equentci tednon- economi cr easonf ort ari
ffi s
nationaldef ence.Be¬cause oft he sensi ti
vit
y ofsome
i
ndust riest ot heeconomy ,t ariffsasbar r
iermaypr ot ect
them agai nstf oreigncompet i
t i
on.
2.Anot herr eason f ort ari
ffsi st he need t o protecti nfant
i
ndust ries.Iti sar guedt hatbecausesomei ndustri
esar enew
theycannotwi t
hst andf oreigncompet i
¬t i
on.For eignf i
rms,
thear gumentgoes, areexper iencedandenj oyeconomi esof
scale whi ch enabl et hem t o char ge l owerpr ices t han
domest icindust r
iest hatar est i
l
lv erynew.Whi l
ei tmayl ook
reasonabl e,t hisar gumenti showev erwi delyabused.I thas
prov i
dedacov erf ori neffici
entf irmst ocont i
nuet ooper ate.
Many of t hese f i
rms ev en af ter decades of t heir
establishmentcont inuet ocl aimt hatt heyar e'i
nfants'.
3.Tar i
ffsar esomet i
mesi mposedt opr otectdomest icjobsand
tor educe un¬empl oy mentathome.Thi s argumenti s
howev er cr i
ticised on t he gr ound t hati tcan l ead t o
retali
ationf rom ot hercount ries.I tismai ntainedt hatwi thout
tari
ffs,gov ernmentcanst i
l
lachi evet hisobj ecti
vet hrough
monet aryandf i
s¬cal t ools.

Summar y
I
nt hi
slectur
e,y
ouhavebeent aughtwhatbarr
ierstointer
nat
ional
tr
ade are al
laboutyou have seen t
hatdespi t
et he immense
benef
itsthatcoul
d be deri
ved from i
nter
nationaltrade,many

94
countri
essti
llconti
nuetoimposesuchbar r
ier
sliketari
ff
sandt r
ade
quotasonf r
eef lowoft r
ade.Sev er
alreasonssuchast heneedto
generaterevenue ar eto protectinf
anti ndustri
es,to maintai
n
nati
onaldefenceet c.hasbeenad¬ducedf orthis.However,many
ofthesereasonsar enott enableandt heyareonl ybei
ngusedt o
maintai
nineff
icientdomesticindust
res.
i

Post-
Test
1.Whatist hemeani
ngoftari
ff
?
2.Whatar ethear
gumentsfori
mposingtradetar
if
fs?
3.Whatar ethear
gumentsagainstt
ari
ff
s?
4.Dist
inguishbet
weentar
if
fsandnon-tari
fft
radebarr
ier
s.Gi
ve
examplesofeach

Ref
erences
Aboy ade,O.( 1983).Int
egrated Economics:A Study of
Devel
opingEconomi es.Addison-
Wesl eyPubl
isher
sLtd
Blanchard,
O.( 1997).MacroeconomicsPrenti
ce-
Hal
l,I
nc.
t
h
Dav i
d,C.Colander( 2004).Economics,(5 ed.)Middl
ebury
Col
lege,McGr aw-
Ir
wi n.

Dwivedi
,D. N(2005).MacroeconomicsTheoryandPol i
cy.
TataMcGr awHi l
l.
Li
psey, R.G and Chr yst
al, A.K (1999). Pri
ncipl
es of
t
h
economics,(9 ed.)Oxfor
d:Oxf
ordUniversi
tyPress
Olof
in S. 2001. An Introducti
on to Macr oeconomi
cs.
MalthousePubl i
sher
.

95
LECTURETWELVE

TheBal
anceofPay
ment
s

Int
roducti
on
Tradetransactionthatt
akesplacebetweeni ndi
vidualsgiveriseto
twot hi
ngs,Firsttheexchangeofphy sicalgoodsorser vicesand
second,theexchangeofmoneybet weent het ransact
ions.Asi t
happensi nthecaseofi ndi
vidual
ssoi tiswithinter
nati
onalt rade.
Theexchangeofcommodi t
iesbetweenonenat ionandhert r
ading
partner
snecessi tat
esthepay mentbyt henationt ohert r
ading
partner
s.A r ecord whi
ch summar i
zessuch pay mentsi scal l
ed
balanceofpay ¬ments.

Obj
ect
ives
Att
heendofthisl
ecture,youshouldbeablet
o:
1.explai
nthemeani ngofbalanceofpayments;
2.discussthevariousclassi
fi
cati
onsofbalanceofpayment
s;
and
3.explai
nwhybal anceofpaymentsmustalway sbal
ance

Pr
e-Test
1.Def i
nebalanceofpay ments.
2.Balanceofpay mentsmustal waysba1ance.
TrueorFal
se?
3.Wr it
eshor tnotesont hefol
lowi
ng;
a.Cur r
entaccount
b.Capi t
al account
c.Of f
ici
al fi
nancing

96
 4.Whatdoy ouunder standbybal anceoft rade?
CONTENT
Thisr ef erstot herecordoft r
ansact ionsbet weenonecount r
yand
hert radi ngpar tners.I
nor dert oknow whati shappeni ngt ot he
courseofi nternat i
onalpay ¬ment s,gov ernment skeept rackoft he
actualt ransact ionsamongcount ries.Ev erytransaction,whet herof
i
mpor tsorexpor tsisr ecordedandcl assifiedaccor d¬ingt ot he
payment sorr eceiptsthatwoul dt ypicall
yar isef r
om i t.Anyi t
em
thatgi vesr i
set othepur chaseoff oreigncur rency( e.g.pay ingf or
i
mpor ts)i srecor dedasadebi tont hebal anceofpay mentaccount s
andanyi tem thatgi vesrisetot hesal eoff oreigncur rency( through
expor ts)i srecor dedasacr edi
t.
Onef eatureofbal anceofpay ment saccounti st hati talway s
balances.Whi lei tis possiblef orhol ders ofnai rat o wantt o
purchasemor edol l
arsinexchangef ornaira,thanhol der sofdol l
ar s
wantt osel linexchangef ornai r
a,i tisnotpossi blef orhol dersof
nairaact uallyt obuymor edollart handol larhol derswi sht osel l
.
Everydol l
art hati sboughtmustbesol dbysomeone,andev ery
doll
art hati ssol dmustbeboughtbysomeone.Si ncet hedol l
ar s
actuallyboughtmustbeequalt ot hedol l
ar sact uall
ysol d,the
payment smadebet weencount riesmustbal ance;ev ent hough,
desiredpay ment smaynot .
Asani mpor tanttoolofi nternat i
onalt rade,usual l
yi sdi vi
ded
i
ntot hr ee.

TheCur rentAccount
Thisr ecordsal lt
ransactionsingoodsandser vi
ces.Goods( v
isi
bles)
aregoodst hatcanbeseenwhent heycrossint
ernati
onalbor ders,
e.g.car s,oi
l,cocoa,andgr oundnut .
Ser vi
ces( invi
sibles)aret hingst hatwecannotsee,suchas
i
nsur ance and f r
eighthaul age,and t our
istexpenditures.Other
i
tems underi nvi
sibles arei nter¬estand dividends.When t he
count ryreceivesdividendsandi nterestsonloansandi nvestmentin
forei
gncount r
ies,thesear ecr editedinherbalanceofpay ments
andv ice-versa.

TheCapi
tal
Account

97
Thisrecordst ransact i
onr elatedt omov ementofl ongandshor t
ter
m capital.Capi talmov ement smaybedi v
idedi nsev eralway s.
Oneimpor tantdiv isionisbe¬t weendi r
ectandpor tfol
ioinv estment .
Dir
ectforeigninv est mentoccur swhenf i
rmstransferfundsi norder
tocreatenew capi tali
nf or eigncountri
es.Por tf
olioi nv est
ment ,
however,occur s when equi ties orbonds ar e purchased.I ffor
ex¬ample,aNi ger iansav erbuy sashar eissuedbyanAmer ican
Company ,thisisapor t
foli
oi nv est
ment,andi trepresent sadebi t
i
tem ontheNi ger ianbal anceofpay ments.
Capitalmov ement smayal sobecl assi
fi
edaccor dingt otheir
ter
m.Pur chaseofbondsi nanot hercountr
ymaybet er medl ong
ter
m capitaloutflow.Howev er, adeposi
tmaybecl assifi
edasshor t
ter
m sincet hef orei gnbankhast heobli
ga¬ti
ont opayt hedeposi t
ondemand.

Offici
alFinanci ng
Thisr epr esent st ransact ions i nvolvi
ng the Cent r
alBank oft he
count r
ywhosebal anceofpay ment sisbei ngr ecorded.Ther ear e
threeway sinwhi chcr edi titemsmayoccuront heof f
icialfi
nanci ng
account .Fi rst,t he Cent r
alBank may bor r
ow f rom I MF.Thi s
represent sacapi talinflowandi st husacr edi titem ont hebal ance
ofpay ment s.Second,t hebankmaybor row f rom ot herCent ral
Banks.Thi rd,t hebankmayr undowni tsof fi
cialreser vesofgol d
andf oreignex¬change.Thi sisacr edi
titem becausei tgivesr i
set o
theselli
ngoff oreignex¬changeandapur chaseofnai r a.
Thef undament alrelat ionamongt het hreemai ndi vi
sionsi s
thattheirsum mustbeequalt ozer o.Thati st hebal ancesont he
current,capi talandof f
icial settl
e¬mentaccountmustbezer o.
Whyt hisi tispossi bleandwhathappensi nmostcasesi sthat
acount rymi ghthav esur plusordef i
citint hecur rentaccount .A
defici
toccur swhent hev alueoft hecount ry'simpor tsexceedsher
expor t
s.Thi sdef i
citmusthowev erbemat chedbyanetsur pluson
capitalplusof fici
alset tlementaccount swhi chmeansbor ¬rowi ng
abroadorr unni ngdownexchanger eserves.
Innor malt erms,whenwespeakofbal anceofpay mentdef icit
orsur plus,wer efert oabal anceonsomepar t soft heaccount s.
Usual l
y,wer efertot hebal anceoncur rentpl uscapi talaccount .
Balance ofpay mentdef icit
s has been t he bane ofmany

98
dev eloping count ri
esi ncluding Ni geri
a.Ithasl ed toincreasi
ng
foreigni ndebt ednessoft hesecount r
iesandamassi vedepleti
onof
theirf oreignr eserves.Way sbywhi chdef i
citont hebal anceof
pay ment si sr esolved i nclude dev aluat
ion of l ocalcur r
ency,
borrowi ngf rom I MFandot herinter
nat i
onalorganisat
ions,depl
eti
on
offor eignr eser ves,i
mpor tr est
ricti
ons,andexpor tpromotion.
TABLE12. 1
AHy pothet i
calBalanceofPay mentsforNigeria,(
N'b)

Visi
bleExpor
t. 55.54
Visi
bleImpor
t. -53.
32
I
nv i
si
bles:
Credit
.
30.56
Debit -
28.
70

1. Cur
rentaccountbalance 4.08
NetinvestmentinNiger
ia -6.
31
Nettradecredi
t -1.
42
Netfinanci
altr
ansacti
ons 5.99

2. Capi
tal
Accountbal
ance -
1.74

3. Bal
anci
ngit
em -
3.42
4. Bal
anceofpay
ment
s(A)+(
B)+(
C) = -
1.
18

5. Of
fi
cial
Financi
ng 1.
18

TheChoicebetweenDomesti
candForeignAssets
Opennessinfi
nalmarket
simpli
esthatfinanci
ali
nvest
orsfacet
he
choi
ceofholdi
ngdomesticv
ersusf
oreignassets.
Itmightappeart
hatwehav et
ot hinkaboutatleastt
wonew

99
deci sions,t hechoi ceofhol dingdomest icv ersusf or eignmoney ,
andt hechoi ceofhol dingdomest icver susf oreignint er est -
pay i
ng
asset s.Butr ememberwhy peopl e hol d money :t o engage i n
transact i
ons. For somebody who l ives i n Ni ger i
a, whose
transact i
onsar et husmost lyorf ull
yinnai r
a,t hereisl ittlepoi nti n
hol dingf or eigncur rency :Itcannotbeusedf ortransact ions,andi f
thegoali st ohol df or
eignasset s,holdingf oreigncur rencyi scl early
l
essdesi rabl et hanhol di
ngf oreignbonds, whi chpayi nt erest .Thus,
the onl ynew choi ce we hav et ot hink abouti st hatbet ween
domest icandf oreigni nterest-
pay ingasset s.Let ’
st hi
nkoft hem f or
thet i
mebei ngasdomest i
candf oreignone- yearbonds.Consi der,
forexampl e,thechoi cebet weenU. S.andGer manone- yearbonds.
Supposet haty oudeci det ohol dU. S.bonds,Leti tbet heone- year
U.S.nomi nali nt erestr ateiny eart .Then,asTabl e12. 1shows,f or
ev erydol lary ouputi nU. S.bonds,y ouwi llget ( 1+i t)dol l
arsnext
year .
Supposey oudeci dei nsteadt ohol dGer manbonds.Tobuy
Ger man bonds,y ou mustf i
rstbuyDM.LetEt bet henomi nal
exchanger atebet weent hedol larandt heDM.Thus, forev erydol lar
youget( 1/ Et)DM.Leti *tdenot etheone- yearnomi nali nt erestrat e
onGer manbonds( i
nDM) .Whennexty earcomes,y ouwi l
lhav e
(1/ Et)(1+i t)Et +1dol larsnexty earf orev erydol l
ary oui nv est.Thi s
setofst epsi sr epr esentedi nthesecondpar tofTabl e12. 1bel ow.

Tabl
e12.
1Expect
edRet
urnsf
rom Hol
dingOne-
YearU.
S.or
Ger
manBonds

U.
S.bonds Yeart Yeart+1
$1 → $(1+i t)=$(
1/Et)(
1+i
t
* Eet+1)
)(
German $1
bonds ↓ ↑
DM(1/Et) → DM (
1/Et)(
1+i
t
*)

I
nassessingt
heattr
act
ivenessofGermanbonds,youcannot
l
ookjustattheGermanandU. S.i
nter
estr
atesbetweent
hisyear
andthenext
.Let’
sassumethaty ouandotherf
inanci
ali
nvest
ors

100
wanttohol
donlytheasset
swiththehi
ghestr
ateofretur
n.Inthat
case,i
fbot
hGermanandU.S.bondsaretobehel
d,theymusthav e
thesameexpectedrat
eofr et
urn,sot
hatthefol
lowingarbi
tr
age
rel
ati
onmusthol
d:

1+i t=( 1/
Et)( 1+i t)(
* Eet+1) (12.1)
Equat i
on( 12. 1)i scal ledt heuncov eredi nterestpar it
yr el ati
on,
orsimpl ythei nterestpar i
tycondi tion
Theassumpt iont hatf inanci al i
nv est orswi llholdonl ythebonds
wi t
ht hehi ghestexpect edr ateofr etur ni sobv iouslyt oost rong,f or
twor easons.Fi r
st ,itignor est r
ansact ioncost :Goi ngi nandoutof
Ger manbondsr equi rest hr eesepar at et r
ansact ions,eachwi tha
transact ioncost .Second,i ti gnor esr isk:Theexchanger at eay ear
from now i suncer tain;t hus,hol dingGer manbondsi smor er i
sky ,
for a U. S. i nvest or ,t han hol ding U. S. bonds. But as a
charact er i
sati
on ofcapi t
almov ement s among t he maj orwor l
d
fi
nanci almar kets,i tisnotf arof f
.Smal lchangesi ni nt
erestr ates
andr umor sofi mpendi ngappr eciat i
onordepr eciationcanl eadt o
mov ement s ofbi ll
ions ofdol l
ar s wi thi n mi nutes.Fort he r ich
count riesoft hewor ld,t hear bitrageassumpt ioni nequat i
on( 12.1)
i
sagoodappr oxi mat ionofr ealit
y .Ot hercount r
ieswhosecapi tal
mar ket sar esmal l
erandl essdev eloped, orthathav ev ari
ousf orms
ofcapi talcont rols,hav emor eleewayi nchoosi ngt hei
rdomest i
c
i
nt erestr atethani si mpl i
edbyequat i
on( 12.1).
To geta bet t
ersense ofwhatar bitrage i mpl i
es,r ewr i
te
equat ion( 12.1)as

1+i
t=(
1+i
t
*)( Eet+1–Et)
1+( /Et) (
12.
2)

Thisgi vesar elati

onbet weent hedomest icnominalinterest
rate,thef orei
gnnomi nalinter
estrat e,andt heexpectedr ateof
depreciation.Remembert hatanincreasei nEi sadepreci
ation,so
that (Eet+1 – Et)
/Et ist he expect ed r at
e of depreci
ation of
depreciationindomest iccur r
ency.( I
ft hedomest i
ccur r
encyi s
expectedt oappreciate,t
hent hi
stermi snegat i
ve).

101
Summar y
Youhav ebeent aughtwhatthebalanceofpaymentasani mportant
toolofi nt
ernati
onaltrade,is allabout?I nt he process,we
discussedthet hreedi
scussionsoft hebal
anceofpay ments:the
currentaccount,t
hecapit
alaccountandoffi
cial
financi
ng.

Post-
Test
1.Definebal anceofpay ment s.
2.Distingui
shbet weenbal anceofpay mentsurpl
usanddefi
cits
ont hebalanceofpay mentaccount s.
3.Isittruethatbal anceoft rademustal waysbal
ance?Expl
ain.
4.Wr i
teshor tnot esont hefollowing:
a. Cur rentaccount
b. Capi talaccount
c. Of fi
cialfinanci ng
5.Whydocount riesespeci allythedev el
opi
ngcountr
iesworry
aboutt heper ¬si stentdefi
ci t
sintheirbal
anceofpayment
s?

References
Aboy ade O.( 1983) .Integrated Economi cs:A St udy of
DevelopingEconomi es:Addi son-Wesl eyPubl isher
sLt d
Dwi vedi,D.N.( 2005) .Macr oeconomi csTheor yandPol icy.
TataMcGr awHi l
l.
Jhingan,M. L.(2000) .Macr oeconomi cTheor y,10thRev ised
andenl argededition.Vr i
ndapubl icati
on( p)Lt d
JoeU.U.( 2007) .Economi cs:AnAf ri
canPer spective,
(2nded.)
Mil
lennium TextPubl isher s,Lagos.
Lipsey ,R.G.( 1971) .I ntr
oduct ion to Positi
v e Economi cs,
London: Wi edenfeldandNi col
son,
OliverBlanchar d.( 1997) .Macr oeconomi cs,Prenti
ce-Hall
,Inc.
Olofin S.( 2001) . An I ntroduction t o Macr oeconomi cs.
MalthousePubl i
sher s.

102
LECTURETHI
RTEEN

TheTheor
yofExchangeRat
es

Introduction
In t he t wo pr evious l ectures, we di d discuss di scussing
i
nt ernati
onalt radeandt hebalanceofpay ments.Howev er
,i nthe
presentl ecture,we ar e mor e concer ned wi t
ht he medi um of
ex¬changei ni nternationaltradet hatis,forei
gncur rency .Si
ncet he
cur r
encyoft hecount rywi l
lnotusual l
ybeaccept edbypeopl ein
othercount ri
es,t her emustbeanaccept edmeansbywhi chone
count ry
'scur rencycanbeconv ertedintoanotherf ort hepur poses
ofeconomi ct ransact i
ons.Thi si st herealm off orei gnexchange
transaction.Exchanger atesi mpl yreferstot hepr iceatwhi cha
count ry pur chases f or ei
gn cur r
ency and sel l
s her cur r
ency
respectively.Al terna¬tively
,itist hepriceofonecur rencyint erms
ofanot hercount ry'scurrency,forexampl e,N118t o$1. 00.

103
Obj
ect
ives
Att
heendoft hislect
ure,youshouldbeabl eto:
1.explai
nt hemeani ngofexchanger ate;
2.explai
nhowexchanger at
esaredet erminedinther
eal
wor
1d.
3.givether easonwhyexchanger atesf l
uctuat
es;and
4.diff
erentiateamongt ypesofexchanger ateregi
me.

Pr e-Test
1.Whatdoy ouunderstandbyexchanger at
e?
2.Whatar et hef actorsthatdet er
mineexchanger ateina
compet iti
veeconomy ?
CONTENT
TheDet erminationofExchangeRat es
In t oday '
s wor ld,exchange r ates ar e det
ermi ned in highl
y
compet it
ivefreemar ketsbyt hefor cesofdemandandsuppl y,and
theser ateschangeof t
ent oref l
ectt heunder l
yingdemandand
suppl yrelati
ons.
Forthepur poseofi l
lustr
ati
on,weassume- t
wocount ri
esmodel
-Ni geri
aandAmer i
ca.Therefor
e,int hismarket,thereareonlytwo
groupsofpr ivatetraders:peoplewhohav enai
raandwantdol l
ars,
tradewi t
hpeopl ewhohav edol l
arsandwantnai r
a.Alsoforthe
moment ,weassumet hattheCent ralBankofNi ger
iadoesnot
i
nt ervenei nthemar ket.

TheDemandf orDoll
ars
Thedemandf ordoll
arsarisesbecauseholdersofnair
awi shto
makepay mentsi ndoll
ars;thi
sari
sesf r
om importsofAmer i
can
goodsandser vi
cesintoNigeri
aandf rom capi
talmovementfr
om
Niger
iat
oAmer i
ca.

TheSuppl yofDoll
ars
Dollarsar
eofferedinexchangefornai
rabecauseholder
sofdol
lars
wisht o makepay mentsi nnaira.Thesupplyofdol l
arsont he
foreignexchangemar ketarisesbecauseofNi ger
ianexpor
tsof

104
goods and ser
vices t
o Ameri
ca and be¬cause of capi
tal
movementsf
rom Ameri
catoNi
ger
ia.

i
Prceofa D

Quant
it
yofDol
l
ars

Fi
gur
e13.
1.Thedet
erminat
ionoftheequi
l
ibr
ium exchanger
ate
undercompeti
¬ti
vecondi
ti
ons

Thedemandf ordol lar

si sdownwar dsl oping.Thisi ndi¬cates
thatast hedol larbecomescheaper ,hol der sofnai rawi l
ldemand
mor edol larsi
nor dert obuyAmer i
cangoods.Thesuppl ycur vefor
dollarsi supwar dsl oping.Thi si ndi¬cat est hatasnai r
abecomes
cheaper ,holder sofdol larswi lloffermor edollarsinor dert obuy
nairawi thwhi cht obuyNi ger i
ancommodi ties.
Theequi l
ibrium exchanger atei sdet erminedatt hepoi ntof
i
nter sect i
onbet weent hedemandf ordol larandsuppl yofdol lars.
Assumet hatthecur rentpr iceofdol ¬larsi stool ow,sayN30t oa
dollar.Att hi
sexchanger ate,thedemandf ordol ¬l
arsexceedst he
suppl y.Thus, somepeopl ewhor equiredol l
arstomakepay ¬ment s
toAmer icawi llbeunabl etoobt aint hem andt hepriceofdol l
ar s
willbef or cedup.Thev al
ueoft hedol larv i
s-à-vi
st henai rawi l
l
appr eciateor ,al ternative¬lyput ,t hev alueofNai r
av is-à-
v i
st he
dollarwi lldepreciat e.

WhatCausestheExchangeRatetoChange?
1.Di f
feri
ng Rate ofInfl
ati
on:Allt hi
ngs bei
ng equal,t he
exchange rat
es ofcountri
es wit
h high i
nfl
ati
on willbe
depreci
ati
ng,whil
ethosecountri
eswi t
hlow inf
lat
ion,rate

105
 wil
l beappr eciati
ng.
2.Capit alMov ement :Maj orcapitalfl
ows can exer tmaj or
i
nfluencesonex¬changer at
es,appreci
atingthecur r
encies
of capi tal impor t
ing count r
ies and depr eciat
ing t he
currenci esofcapi talexporti
ngcountri
es.
3.Str
uct ur
alChanges:Att heexisti
ngpricelevel
s,aneconomy
canunder gost r
ucturalchangest hataffecttheexchange
rat
e.I fthest ructuralchangeshav eapositivei
mpactoncost
str
uct ure( i
.e.r educing costofpr oduction,forexampl e,
thr
ough i nnov ati
on),t he value of the cur r
ency mi ght
appr eciateorv ice-versa.

CentralBankManagementoft heExchangeRat e
Inthepr evi
oussect i
on,weconsi deredexchanger atesthatare
deter
mi ned pure¬l
y by mar ketf orces ofdemand and suppl y.
Howev er,i
nrealit
y,weknow t hatonl yv er
yfew countr
iesall
ow it
s
exchange ratet o be leftsolel
yt o mar ketforces.More often,
countri
esthrought heircent
ralauthori
tiesinf
luencetheex¬change
rat
esoft hei
rcountries.

FixedExchangeRat es
Undert heBr ettonWoodssy stem t hatl ast edfrom 1944unt i
lthe
early1970's,gov ernment sdi dnotal l
owt heircurrenciestofluctuat e
freelyonexchangemar ket s.Usual ly,ther ateswer efixedwi thin
verynar r
owmar gi ns.Eachgov ern¬mentst atedanof fi
cialpricef or
i
tscur r
ency( usual lyi nt ermsofdol l
ar s)whi ch wascal led the
currency'
spar -
value.TheCent r
alBankt henent eredthemar ket,
buy ing and sel li
ng what ev er quant i
ties of f orei
gn exchange
necessar ytomai n¬t aint hi
spar -val
ue.Suchanexchanger atei s
calledaf ixedorpeggedexchanger ate.Wheni tischanged,t he
count r
y'
scur rencyi ssai dt obedev aluedorr evaluedincaseofa
fallorariseinitspar -value,r espect ively.
Anexampl ewi l
lsuffixher e.Assumet hef i
xedexchanger atei s
N70. 00to$1Howev er,forsomer easons,t hedemandf ordol l
ar s
i
ncr easessucht hati tisgr eatert hani tssuppl yt othemar ket.
Nor mally
,weexpectt heexchanger at et ochange:t opreventt his,
theCent ralBankmi ghtent eri ntot heexchangemar ketandsel l

106
suff
ici
entdoll
arst
omakedemandequalt
osuppl
yatt
hef
ixed
exchanger
ate.

Managi ngFl exibleExchangeRat es

Even wi t
ht he col lapse of Br et
ton Woods Agr eement ,when
count r
iesnol ongerf i
xt hepar -valueoft hei
rcur r
encies, t
heystil
lt r
y
toi nfl
uence t he exchange v alue oft heircur r
encies.Theyuse
vari
ous t ool st o achi evet his.Fi rst,the bank can at ¬temptt o
i
nfluencet helongt erm equi l
i
br i
um exchangebyv ariousf or
msof
pay¬mentr estri
cti
onst her ebycur t ai
li
ngt hedemandf orforeign
exchange.
Second,t he bankcan at temptt o smoot hen outshor tand
medi um t ermf l
uctua¬t i
onsi nt heexchanger atebyopenmar ket
purchasesandsal esoff oreignex¬change.
Third,throught hemani pulati
onofi nt
erestrate,t hemonet ary
authoriti
est ryt oin¬f l
uencet hef l
ow ofcapi talinandoutoft he
count r
y,thusi nfl
uenci ngt heex¬changer at
esoft heircurrenci
es.

Nomi nal ExchangeRat es

Nomi nalexchanger atesbet weencur renciesar equot ed int wo
ways:
1.t henumberofuni t
soff oreigncur rencyy oucangetf orone
uni tofdomest iccurrency ,
or
2.t henumberofuni tsofdomest i
ccur rencyy oucangetf or
oneuni toff oreigncur rency.Followingt heexampl egiven
ear li
er,thenomi nalexchanger atebet weent hedol l
arandt he
nai ra,(N),is118Nf or1dol lar,or,equivalency ,0.
008dol lar
for1nai ra.
I
nt hisst udy ,weshal ldef i
net henomi nalex changer ateast he
numberofuni t
sofdomest i
ccur r
encyy oucangetf oroneuni tof
for
eigncur rencyorequi valently,ast hepr i
ceoff oreigncurrencyi n
ter
msofdomest iccur rency ,and we shal ldenot ei tbyE.For
exampl e,whenl ookingatt heexchanger atebet weenNi geriaand
theUni tedSt atesf r
om t hev iewpoi ntoft heNi ger i
a( sot hatthe
nair
ai st hedomest i
ccur rency ),Ewi l
ldenot ethenumberofnai ra
onecangetf or1$- thus,f rom ourexchange,118.Weshal lthen

107
writei fforshor tast heN/ $( nai r
aper$)exampl er at
e.Toconv ertN
i
nto$, simpl ydivi
debyE.Toconv ert$i nt onai ra, mul t
iplybyE.
Exchanger atesbet weenf oreigncur renci esandnai r
achange
ever yday ,indeedev er ymi nut edur ingt heday .Thesechangesar e
called nomi nal appr eciat i
ons or nomi nal depr eci at
ions-
appr eciat i
onsordepr eci ati
onsf orshor t.Anappr eciationoft he
domest iccur rencyi san i ncr easei nt hepr i
ceoft hedomest i
c
currencyi nt ermsofaf or ei
gncur r
ency .Gi v enourdef i
nitionoft he
exchanger ateast hepr iceoft hef or eigncur rencyi nt ermsof
domest iccur rency,anappr eciationcor respondst oadecr easei n
theexchanger ate,E.
Thi si smor eintuitivet hani tf i
rstseems:consi derthenai raand
dollars( agai nf r
om t hev iewpoi ntoft heNi ger i
a) .Anappr eci ati
onof
thenai ra( alsocal l
edanai raappr eci ation)meanst hatt henai r
a’s
valuegoesupi nter msoft hedol l
ar s.Equi val entl
y,t hedol l
ari s
wor thf ewernai ra,whi chi st hesameassay i
ngt hatt heexchange
ratehasdecr eased.Si mi larl
y,adepr eci ationoft henai r
a( ornai ra
depr eciat i
on)meanst hatt henai rai sgoi ngdowni nt ermsoft he
dollars, andt huscor r espondst oani ncr easei nE
That an appr eci ati
on cor responds t o a decr ease i nt he
exchanger ate,anddepr eciat i
ont oani ncr ease,wi l
lal mostsur ely
be conf using t oy ou at f i
rst-it conf uses many pr of essional
economi sts-buti twi llev ent uall
ybecomesecondnat ureasy our
under standi ngofopen- economymacr oeconomi csdeepens.Unt il
then,y oumayf indi tusef ult oconsul tTabl e13. 1bel ow whi ch
summar isest het er
mi nologi es.

Tabl
e13.
1Cur
rencyAppr
eci
ati
onandDepr
eci
ati
on

Nomi nalexchange r ate Pri

ce of doll
ars in nai ra
(E) equival
entl
y
Numberofnai raperdol
lar(N/$)
Appreciat
ionofthenaira Pr i
ceofdol l
arsinnair
adecreases
Valueofnairai
ncreases Equi val
entl
y:Numberofnai r
aper
doll
ar decr eases, i .e. ( E)
decreases.

108
 Depr
eci
ati
onofthenair
a Pri
ceofdol l
arsi
nnair
aincr
eases
Val
ueofnai
radecr
eases Equiv
alentl
y:Numberofnairaper
dol
larincr
eases,
i.
e.(
E)incr
eases.

Summar y
Inthi
slecturey ouhav ebeent ol
dwhatexchanger at
ei s.Itist he
pri
ceatwhi chacount rycur
rencyexchangesf oranot
her.Inapur ely
competi
tivemar ket,
exchangeratesaredet er
minedbyt heforcesof
demandandsuppl yindependentofanyi nst
it
uti
onalinter
ventions.
Therearethreepossi bl
eexchanger ates.Wehav ethef l
oati
ng,t he
managedandt hef i
xedexchanger ates.Exchangeratebelongst o
anyoft heser egimesdependi ngont heextenttowhi chmar ket
for
cesareal l
owedt ooperatefr
eely.

Post-
Test
1.Defineexchanger at
e.
2.Discuss t he f actors t hat inf
luence exchange r
ate
determinat i
oninaneconomy .
3.Wr i
tenot esont hefoll
owing:
a.Managedexchanger ate
b.Fl exibleexchanger ate
c.Fi xedexchanger ate
4.IfN70 exchanges f or30 Deut schmarks (
Dm)and N80
exchangesf or$1,whati st heexchangerat
ebetweenDm
and$1?
5.Disti
ngui sh bet ween exchange r at
e depreci
ati
on and
appreciat i
on.

Ref
erences
Aboyade O.( .I
1983) ntegr
ated Economi cs:A Study of
dev
elopi
ngeconomi
es.Addison-WesleyPublisher
sLtd
DavidC.C.(2004).Economics,(5th ed.
)Middl
ebur
yColl
ege,
McGraw-I
rwin.

109
 Dwi vedi,D.
N. (2005).Macr oeconomi csTheor yandPol i
cy.Tata
McGr awHi ll
.
Jhingan,M. L.( 2000) ,Macr oeconomi cTheor y,10thRev ised
andenlargededi ti
on. Vri
ndaPubl i
cati
onLt d
Li
psey ,R. GandChr y stal
,A.K( 1999);Princi
pleofeconomi cs,
t
h
(9 ed.)Ox ford:OxfordUni versit
ypress.
Oli
v erBlanchard( 1997) .Macroeconomi cs,Prent
ice-Hal
l,I
nc.
Olofin S. ( 2001) . An I nt
roducti
on t o Macr oeconomi cs.
Mal t
housePubl ishers.

LECTUREFOURTEEN

110
Mai
nSchool
sofEconomi
cThought

Introduct ion
Thedev elopmentofeconomi csasadi scipli
nehaspassedt hrough
sev eralst ages,from t heMer cant i
l
istst hrought hePhy siocr atsto
the Cl assi caleconomi sts.From Mar xistt o Key nesi
ans and t o
Monet arists,Al
lthesegr oupshav einfluenceddev elopment si nthe
discipline.
Ther ehasal so beenani ndivi
dualcont r
ibutionofr eput abl
e
economi sts.Promi nentamong t hese ar e Adam Smi th,Dav i
d
Richar do,F.Quesnay ,J.J.Mi l
ls,Kar lMar x,J.M.Key nes,andM.
Friedman.Thei rideasmoul dedt hediscipli
neaswehav eitt oday .

Obj
ect
ives
Att
heendofthi
slect
ure,youshoul
dbeabl eto:
1.discusst
heimportantst
agesofhistor
yofeconomicthought
;
and
2.discusst
hecontri
buti
onsofthefore-f
ather
softhecourse.

PreTest
1.Identi
fythemai nschoolsofeconomicthoughts
2.Wr i
teshortnotesont hefol
lowi
ng:
a.Adam Smi t
h
b.Dav idRichardo
c.Kar lMarx
d.J. M Keynes
3.Whatar ethemai nideasoftheclassi
caleconomists?
4.Highli
ghtthemaj orideasofKarlMarx.
CONTENT
The classi
calschoolr epresent
st he f i
rst ser
ious schoolof
economicthought.Pr i
ortot hem,therehadbeensomepr imi
ti
ve

111
school sofeconomi ct hought ,suchast hemer canti
list
s,andt he
phy siocrat s.The mer cantilists,l ed by J.Chi l
d,wer el eadi ng
busi nessmeni nt heirtime.Theywer einterestedi nast r
ongnat i
on
wi t
hv astar myt hatwoul dbeabl et opr otecttheirforeignbusi ness
transact ions.
The mer cant ili
stsl onged f orspeci et hati s precious met al
whi cht heybel iev edcoul donl ybeobt ainedt hroughi nternat i
onal
trade.Thi sschoolal sof av our edgov ernmenti nterv
ent i
oni nt he
economy .
Thephy siocr atswer ebasedi nFr ance,andt heywer eashade
mor eadv ancedt hant hemer cant il
ists.Theybel i
ev edint henat ur al
order ,thati s, ever yt
hinghasbeenor dainedbyGod.Thephy siocr ats
gav eust hei deaofsur plusv al uewhi cht heybel i
ev edcoul donl ybe
obtai nedf rom t heagr i
culturalsect or.Themaj orcon¬t ributionof
thephy siocr at stoeconomi ct houghti st heideaoft hecircularf low
ofi ncome.The ci rcularf low i ncome owes i t
s or i
gint o Dr .F.
Quesnar y who was al so t he l eaderoft he phy siocrats.They
adv ocat edf orl aissezf air
e,t hati s,f reeent erpriseandmi nimum
gov ernmenti nter venti
oni nt heeconomy .

1. TheCl assical School

Theclassi calschool canbesub- dividedi ntotwo:
a.Thef ir
sti st het raditi
onalcl assicistsconsi stingofAdam
Smi th,Dav id Richar do,Rev .Mar thus,J. S.Mi llet c.The
secondgr oupconsi stedoft hemoder nclassicistsorwhati s
somet i
mescal ledneo-cl assicists.Economi stsint hisgroup
i
ncl udeAl fredMar shall,Irvingf isher,A.C.Pi gou,et c.This
l
at t
erschoolr efinedandbui l
tupont hemai ni deasoft he
traditi
onal classicists.
b.Thet wocor nerstonesoft hecl assicalschoolar et heSay ’
s
Law ofMar ketand t he Quant i
tyTheor yofMoney .The
classicist
sbel i
ev edi nt heexi stenceoff ullempl oymenti n
theeconomyandasi t
uat ionofl esst hanf ul
lempl oyment
was r egar ded as abnor mal . Pi guo mai nt ained t hat
unempl oymentr esul t
sf rom t her i
gidityofthewagest ruct
ure
andi nterferencei nt hewor kingoff reemar ketsy stem inthe
form oft radeuni onl egislation,mi nimum wagel egislat
ion,

112
 et
c.

Thecl assicalanal ysiswasbasedont heSay 'sl aw ofmar ket

that"suppl ycr eat esi t
sowndemand"Thecl assicist st husr ul edout
the possi bili
tyofov erpr oduct i
on.Thi s posi ti
on was,howev er,
attackedbyKey neswhopr oposedt heopposi tev iewt hatdemand
createsi tsownsuppl y .Unempl oymentr esul t
sf rom t hedef ici
ency
ofef fectiv edemandbecausepeopl edonotspendt hewhol eof
theirincomeonconsumpt ion.
Thecl assi cist salsobel i
evedt hatsav i
ngsandi nv est ment sar e
alway sequal .Accor ding t ot hem,sav i
ngsand i nv est ment sar e
functionsofr ateofi nt erest .Anyt empor arydi fferencebet weent he
twocanbecor rect edt hr ought hemechani sm ofi nter estr at es.For
i
nst ance,when t he r at e ofi nter estr ises,sav ings r i
ses and
i
nv estmentdecl inesandt hisadj ust mentcont i
nuesunt i
l t
het woar e
equal.Key nesagai nat tackedt hecl assi calposi t
ion.Hear guedt hat
i
nt ended sav ings har dl yequali nt ended i nvest ment ,since bot h
processesar eunder taken bydi ffer entgr oupsofpeopl e.Whi l
e
househol ds make sav ings deci sions,i nv estmentdeci sions ar e
madebyt hef irms.
Thecl assi cist semphasi zedt hei mpor t
anceofsav ingort hr i
ftin
capitalf or mat i
on,f oreconomi cgr owt h.Theybel iev ed t hatt he
mor et hesav ingsoft hepeopl e,t hegr eat ert hecapi talf or mat ion
andhencet hef astert hepaceofeconomi cgr owt h.ToKey nes
howev er,sav ingswasapr ivatev ir
t ueandpubl icv ice.Accor dingt o
him,i ncreasesi nsav ingsr educeconsumpt i
on,l eadi ngt oaf allin
effectivedemandand, ther ef ore, asl umpi nt heempl oy mentl ev el.
Thecl assicist sar tificial l
ydi vi
dedt heeconomyi ntot wo-t he
monet arysect orandt her ealsect or.Themonet arysect oronl y
helpsi ndet er mi n¬ingpr iceswhi l
epr oduct i
onandconsumpt ion
decisionsar emadei nt her eal sect or .
Theabov ecl assical ist’sposi tionwasdemonst rated v iat he
quant it
yt heor yofmoney .Thequant i
tyt heor y,asf ormul at edby
Irv
ingFi sher , showsapr opor ti
onalr elati
onshi pbet weenchangesi n
moneysuppl yandchangesi nthepr icelev el.Int hewor dsofFi sher ,
"Othert hingsr emai ningunchanged,ast hequant ityofmoneyi n
cir
culat i
on i ncr eases,t he pr ice l ev elal so i ncr eases i n di rect

113
propor
ti
onandt hevalueofmoneydecreasesandv i
ce-v
ersa"
.
(Fi
sher
,thePur
chas¬i
ngPowerofMoney
,Rev.Ed.1926)
.

The cl assici
sts emphasi zed t he t ransacti
ons demand f or
moneyandhencet hedemandf ormoneyi ntheeconomydepends
upont hev alueoft r
ansact i
onsun¬der takeni ntheeconomy .
Classicaleconomi cswasbasedont helaissezfairepoli
cyof
sel
f-adj ustingeconomi csy st
em wi thnogov ernmenti nter
venti
on.
Thegov er
nmenti nvol
v e¬mentintheeconomyshoul dbel imit
edt o,
maint enanceofl aw andor der,jus¬t i
ceandpr ovi
sionofsoci al
i
nfrast ructures.Accordi ngtothem,t hei nvisi
blehandwi l
lall
ocate
goodsandser vi
cesint heeconomyunhi ndered.
Thecl assi caleconomi cswasami croeconomi canalysiswhich
theor thodoxeconomi ststri
edtoappl ytot heeconomyasawhol e.
On t he ot herhand,Key nes howev erhad adopt ed the macr o
approacht oeconomi cpr obl
em.

2. TheMar xi anEconomy
TheMar xi aneconomyi sbasedont het eachi ngsanddoct rinesof
Kar lMar x( 1818-1883) .Kar 1Mar xwr otehi scel ebratedbook' Das
Kapi tal' i
nwhi chheexposeshi sdoct rines.
"Mar xcont ri
but edt ot het heoryofeconomi cdev elopmenti n
threer espect s;namel y,inbr oadr espectofpr ovidinganeconomi c
i
nt erpr etat ionofhi story,int henar rowerr espectofspeci fyingthe
mot iv ating f or ces ofcapi t
ali
stdev el
op¬ment ,and i nt he final
respectofsuggest inganal t
ernativepat ht o pl annedeconomi c
dev elopment ".
I
ni nter pr eti
ng hi stor y,he made use of t he pr i
nciple of
dialect icalmat eri
ali
sm.Hev iewedhi storicalev entsast her esultof
cont inuousst rugglebet weendi fferentcl assesandt hegr oupsi n
the soci ety .The mai n cause oft his st r
uggl ei st he con¬f l
ict
bet ween' themodeofpr oduct i
onandt heunder 1ying'r elationsof
produc¬t ion',The mode of pr oduct ion r eferst o a par ti
cular
arrangementofpr oduct ioni nasoci etyt hatdet ermi nest heent ire
soci al,pol i
ticaland r eligi
ous way s ofl i
ving,The r elations of
product ionr elat etot hecl assstructur eint hesoci ety.

114
 Mar xuseshi st heor yofsur plusv alueast heeconomi cbasi sof
hist heor y.Accor dingt ohi m capi tal ism i sdi v idedi ntot wogr eat
classes:t hewor ker swhoownnot hingbutt hei rl abourpowerand
thecapi tali
st swhoownt hemeansofpr oduct ion.Thecapi t
ali
st
purchase l abourpowerati ts own v alue whi ch i st he amount
necessar yf ort hemai nt enanceofl abour .Accor dingt oMar x,the
valueoft hecommodi tiesnecessar yf ort hesust enanceofl abouri s
nev erequalt ot hev alueoft hepr oduceoft hatl abour .Ifal abour er
wor ksf orat en- hourday ,buti tt akeshi m si xhour st opr oduce
goodst ocov erhi ssubsi stence,hewi llbepai dwagesequalt osix
hour s' labour .The' differ encewor thf ourhour s' labourgoesi nt othe
capi talist'
spocketi nt hef or m ofnetpr of i
t,r entandi nter est .Mar x
callst hisunpai dwor k" sur plusv alue" .
The capi talistappr opr iates t he sur plus v alue pr oduced by
l
abourand t hen r econv ertsi ti nt o capi tals si nce pr ofits ar e
deter mi nedbyt heamountofcapi tal.Thegoaloft hecapi t
ali
st
theref or eist oaccumul at eandaccumul atecapi tal .
The i ncr easi ng accumul at i
on ofcapi talhowev erf orcest he
capi talisttoi nt roducecost -sav i
ngt echni ques,l iker epl aci ngl abour
withmachi nes.Thi sl eadst ot hegr owt hofi ndust rialr eser v ear my
oft heunempl oy ed; ont heonehand, andar educt ionoft hesur plus
value, ont heot herhand, sincesur plusv aluei sgener atedbyl abour
onwhathecal ledv ariabl ecapi tal.Thi sl eadst owhatMar xr efer sto
ast het endencyf ort hef allingr ateofpr of i
t.Ther educt ioni nl abour
empl oy edl eadst oov er -pr oduct ionandunder -consumpt i
oni nt he
economy .Thi sf ur t
herexacer bat est hef allingr at eofpr ofitpr obl em.
Acapi tal i
stcr isishasbegun.
Ineachper iodoft hecr isis,t hest rongercapi talistsexpr opr i
ate
theweakercapi talistsandal ongwi thi tgr ow t hemi ser yoft he
wor kingcl ass.I ti st hi scent ral i
sat ionofcapi talont heonehand,
andt hegr owi ngmi ser yoft hewor ker sont heot herhandt hatf i
nall
y
prov ided t hedeat h knel lofcapi tal i
stsy st em and pr ov i
ded t he
i
mpet usf ort hecapi talism t ransf ormat iont osoci alism.Pov er tywil
l
disappear and t he " dictat or ship of t he pr olet ariat " wi ll be
establ ished.
Mar xpr edi ct i
onaboutcapi talism hasf ailedt ocomei ntobei ng.
Ther ei snoi n¬cr easi ngmi ser yofl abouri nt headv ancedcapi t
ali
st
soci etiesasasser tedbyMar x.Andt echnol ogi caldev el opmenthas

115
notincreasedthei ndust
ri
alreser
vearmy.Despit
ethef actt
hat
muchofhi spredicti
onhasnotcomet opass,Marxhasmade
usefuli
mpactont heprocessofeconomi
cdevel
opment.And,many
countri
estodayadheretotheeconomicf
ormul
ati
onsofKarlMarx.

3. Key nesi anSchool ofEconomi cThought

Key nesi anmacr oeconomi csi snamedaf teroneman,J. M.Key nes
(1883- 1946) .Hi si deaswer econt ainedi nt hebook,' TheGener al
Theor yofEmpl oy ment ,I
nt er¬estandMoney "whi chhepubl ishedi n
1939.
Key neswasv erycr i
ti
caloft hecl assi caleconomi sts.TheGr eat
Depr essi onof1929- 1933pr ov idedabasi sforl aunchi nghi sat tack
ont hecl assi calposi tion.Key nesr eject edSay '
sLawofMar ketand
showedhow t ot aldemandf orgoodsandser ¬v i
cescoul ddi ffer
from a count ry's pr oduct ive capaci ty.The busi ness cy cle and
fl
uct uat ionsi npr ices,pr oduct ionandempl oy mentcoul dnotbe
reconci l
edwi t
ht hecl assi cali deat hatt het ot aldemandf orgoods
alway smat chespr oduct ivecapaci ty .
Key nesal sor ev oltedagai nstt hecl assi calappr oachdi chot omy
i
nwhi cht hephy sicalandmonet aryaspect soft heeconomywer e
treated i n wat er-tight com¬par t
ment s.Key nes at tempt ed t he
i
nt egrat ionofbot ht hephy sicalandt hemonet aryaspect si nhi s
analy sis. Accor di ng t o Key nes,a meani ngf ul di scussi on of
ag¬gr egat elev el ofout putandempl oy menti snotcompl etewi thout
acompl et et heor yofmonet aryeconomi cs.I nady nami ceconomy ,
expect ationspl ayakeyr ole.Moneyser vesasasubt ledev i
set o
l
inkt hepr esentt ot hef uture.
Rat hert hant hef ullempl oymentequi li
br ium posi ti
oni nt he
economyasenunci at edbyt hecl assi calschool ,Key nesst atedt hat
whati sobt ained i nr eall i
fei sunempl oy mentequi librium.Thi s
means t hat t he economy al way s set tles at l ess t han f ul
l
empl oy ment .Thus,t hequant it
yt heor yofmoneyoft hecl assi cal
schoolwhi chpost ul atedadi rectr elationshi pbet weent hemoney
suppl yandt hepr i
cel evelinaneconomymaynotal ¬way shol d.
Thi si sbecausegi v ent hepr esentempl oymenti nt heeconomy ,
i
n¬cr easei nt hemoneysuppl yr at hert hanl eadst oi ncreasei n
priceswoul dr esul ti ni n¬cr easei nout putandempl oy ment .
Key nesi anmacr oeconomi csconcer nsi tsel fabov eal lwi tht he

116
fact orst hatdet er ¬mi nedemand.Thi si sal soamaj ordi fference
witht hecl assi cal theor y.Int hecl assical economi cs, mor eat tent ion
wasf ocusedonpr oduct ion,t hati s,t ot hesupp¬l ysi de.I nt he
classi calwayoft hought ,tot aldemandadj ustst ot hesuppl y, andi n
Key nesont heor y,t heopposi t
ei st hecase.I ft her ei si nadequat e
demand,pr oduct i
onf all
sbecauset hel evelofexpendi t
ur ei st oo
l
ow.Thi scausesunempl oy ment .Thi si swher eKey nescal lsf or
gov er nmenti nv ol vementi nt he economy t o boostaggr egat e
demand. Rat her t han adv ocat i
ng f or mi ni mal gov ernment
i
nt erv en¬t ion, Key nescal l
edf ormaxi mum gov ernmenti nv olvement
i
nt heeconomy .
Key neswasal sof amousf orhi st heor yofmul tipliers.Thi si s
closel yl inked wi tht he mar gi nalpr opensi tyt o consume.The
mul tiplieri st hemul ti
pl ebywhi chnat i
onali ncomewi l
lchangei fan
i
tem ofaggr egat edemandi schanged.Howev er,t hev alueoft he
mul tiplierwoul ddependupont hev alueofmar gi nalpr opensi tyt o
consume.
Key nesi sal sor emember edf ori ntroduci ngot hert er msl ike
l
iqui ditypr ef er ence,l iquidit ytrapandmar ginalef ficiencyofcapi tal
i
nt o economi csl iterat ure.Hi si deasand post ulat i
onswer enot
ent i
rel ynew.Heowedsomeoft hem t ot heeconomi st sbef or ehi m.
Theconceptofmar ginalwhi chheusedcoul dbet racedt ot heneo-
classi cal i
st s.Andasf arast heconceptofmul t i
plieri sconcer ned,
Key neshi msel fr ecogni seshe’ si ndebt ed"t oMr .R. F.Kahn.
Key nes cont ribut ed a l ott ot he dev elopmentofeconomi c
thought .Hi sr easoni ngpr ov edv er yusef ulinbot ht radecy clet heor y
andwel fareeconomi cs.Heal soshednew l ightont hemot iveof
holdi ngmoney .Hemadeadi stinct i
onbe¬t weent het hreemet hods
ofhol dingmoneyi .e.t ransact ive,pr ecaut i
onar yandspecul ative
mot i
v es.
In post -Key nesi an er a,t her e hasbeen pr ol i
ficaddi tion and
refinementoft hebasi cKey nesi ani dea.Fori nst ance,t heconcept
ofmul tiplierwasext endedbybr ingingi nnumer ousv ariant sofi t,
forexampl e,t hebal ancedbudgetmul tipli
er,whi chshedsnewl ight
onf i
scalpol icy .Mostoft heseaddi tionsandr efinement s, howev er,
owet hei ror igint ot hest imul at i
onspr ov i
dedbyKey nes' sGener al
Theor y.

117
4. Monet aristSchool
The f oremostexponentoft his schooli sthe Nobell aur eat e,
Pr ofessor Mi lton Fr i
edman of t he Chi cago Uni ver sity. He
refor mulat edt heQuant i
tyTheor yofMoney .Inhi sr efor mul ation,
Fr i
edmanasser tedt hatmoneydoesmat ter.Her egar dedmoneyas
anydur abl ecommodi tyandt hedemandf ori tdependsont he
ser viceswhi chi tcanr endert ot hehol der .Heposi tedt hatweal th
canbehel dinf ivedi fferentf orms:
a.money ;
b.bonds;
c.equi t
ies;
d.Phy sical non- humangood; and
e.humancapi tal.
Themonet aristsemphasi zet her oleofmoneyi nexpl aini ng
shor tt erm changesi nnat i
onali ncome.Theyar guet hatt her ol eof
moneyhasbeennegl ect edbyt heKey nesians.Fr iedmanwasabl e
todemonst ratet hatchangesi nt hemoneysuppl ycausechangesi n
nat i
onali ncome.Thus,monet ar i
st sbel ievet hatal lr ecessi onand
depr essionar ecausedbysev er econt ractionofmoneyandcr edi t
whi leboomsandi nflationar etheout comeofexcessi veincr easei n
themoneysuppl y.
Whi l
eKey neshasar guedt hatdemandf ormoneyi saf unct i
on
ofbot ht hel evelofi ncomeandt her ateofi nter
est ,themonet ar ists
hol dt hatt her at eofi nterestpl ay sno par ti n det ermi ning t he
demand f ormoney .The demand f ormoneyi st he t ransact ive
demandf ormoneywhi chi sdet er mi nedbyt helevel ofi ncome.
Themonet ar i
stsal sohol dt hatmonet arypol icyi ssuper i
ort o
fiscalpol i
cy .Thi si sadi r
ectant i-thesi soft heKey nesi anschool .
Instrument sofmonet arypol icyi n¬cl udebankr ate,openmar ket
oper at i
on,changesi nr eser ver atios,sel ectivecr editcont rol.They
hol dt hatagai nstf i
scalpol icy,monet arypol icypossessesgr eat er
flexibili
tyandi tcanbei mpl ement edr apidly.
Amaj orl imi tati
onoft hemonet ar ypol icy,howev er,ist hel ong
oper at i
onl ag.Fr i
edmanhi msel fadmi tst hatthet imel agi nvolv edi s
sol ar get hatcont racy clicalmonet ar ypol i
cymi ghtact ual l
yhav ea

118
dest
abi
l
isi
ngef
fectont
heeconomy
.

CurrentDev el
opment s
Today ,threegr oupsdomi natet heresearch headl
ines;thenew
classical
,thenewKey nesians,andthenewgr owththeori
sts.(Note
thegener oususeoft hewor d“ new”unlikeproducersofl aundry
detergents,economicsstopshor tofusi
ng“ newandi mproved”.But
thesubl i
minalmessageist hesame. )

NewCl assi cal Economi csandReal BusinessCy cleTheor y

Ther at i
onalexpect at i
onscr iti
quewasmor et hanj ustacr i
tiqueof
Key nesi an economi cs.I tal so of fered i ts own i nterpretation of
fl
uct uat ions.I nst eadofr elyingoni mper fectionsi nl abourmar kets,
ont hesl owadj ust mentofwagesandpr ices,andsoont oexpl ain
fl
uct uat ions,Lucasar gued,macr oeconomi csshoul dseehow f ar
theycoul dgoi nexpl aini ngf l
uct uat ionsast heef f
ect sofshocksi n
compet iti
vemar ket swi thf ullyf l
exi blepr i
cesandwages.
Thi si sther esear chagendat hathasbeenpur suedbyt henew
classi cal.The i ntel l
ect uall eaderi s Edwar d Pr escot t
,and t he
model sheandhi sf ollower shav edev elopedar eknownasr eal
busi nesscy cle(RBC)model s.Thesemodel sassumet hatout puti s
alway sati tsnat ur all ev el.Thus,al lf l
uct uat i
onsi n out putar e
mov ement s of t he nat ur all evelof out put ,as opposed t o
mov ement sawayf rom t henat ural levelofout put.
Wher edot hesemov ement scomef rom?Theanswerpr oposed
byPr escot tistechnol ogi cal progr ess.Asnewdi scov er i
esar emade,
product ivityi ncr eases,l eadi ng t o an i ncrease i n out put.The
i
ncr easei npr oduct ivityl eadst oani ncr easei nt hewage,whi ch
makesi tmor eat t
ract i
v et owor kandt husl eadswor kerst owor k
mor e.Pr oduct ivi
t yi ncreasest her eforel eadt oincr easesi nbot h
out putandempl oymentaswei ndeedobser vei nther eal wor l
d.
The RBC appr oach has been cr iti
cized on many f ronts.
Technol ogi calpr ogr essi st her esul tofv erymanyi nnov at
ions, each
ofwhi cht akesal ongt i
met odi ffuse.I tishar dt oseehow t his
process coul d gener ate any t
hi ng l ike t he l ar ge shor t-
run
fl
uct uat ionsi nout putt hatweobser veinpr act ice.Itisal sohar dt o
thinkofr ecessi onsatt i
mesoft echnol ogi calr egress,t imesi n

119
whichpr oduct i
vit
yandout putbot hgodown.Fi nall
y ,aswehav e
seen,t herei sv eryst r
ongev i
dencet hatchangesi nmoney ,whi ch
havenoef fectonout puti nRBCmodel s,i
nf act,hav est rongef fects
onout puti nther eal wor l
d.
Thus,att hispoi nt ,mosteconomi st
sdonotbel iev ethatt he
RBC appr oach pr ovides a conv i
ncing expl anat i
on of maj or
fl
uctuat i
ons i n out put.The appr oach has nev erthel ess prov ed
useful.Ithasdr il
ledi nt hecor rectpointthatnotal lfluct uati
onsi n
outputar edev iati
onsofout putfrom itsnat urallev el.Atamor e
technicall evel,ithaspr ovidedanumberofnew t echni quesf or
solvi
ngcompl exmodel s, whichar ewidelyusedi nr esear chtoday.It
i
sl i
kelyt oev olver athert handi sappear.Already ,somer ecentRBC
model shav est artedi ntroducingnomi nalrigiditi
es,t husal l
owi ng
fortheef fectsofmoneyonout put.

NewKey nesianEconomi cs
Thet erm“ new Key nesians”denot esal oosel yconnect edgr oupof
researcherswhoshar eacommonbel i
eft hatt hesy nt hesi st hathas
emer ged i nr esponse t ot he r ational -
expect ations cr i
tique i s
basicall
ycor r
ect .Butt heyal soshar et hebel i
eft hatmuchr emai ns
tobel earnedaboutt henat ureofi mper fectionsi ndi f
f erentmar kets,
and about t he i mplications of t hose i mper f
ect i
ons f or
macr oeconomi cev olut i
ons.
One line ofr esear ch has f ocused on t he det ermi nat ion of
wagesi nt helabourmar ket.Onei nfluent i
alr esear cheri nt hisar ea
hasbeenGeor geAker l
off r
om Ber keley ,whi chhasexpl or edt her ole
of“nor ms”,ther ulest hatdev elopi nanyor ganisationi nt hiscase,
thef i
rm,toassesswhati sf airorunf air.Thi sr esear chhasl edhi m
andot herstoexpl or eissuespr eviousl yleftt or esearchi nsoci ology
andpsy chologyandt oexami net heirmacr oeconomi ci mpl icat ions.
Anotherlineofnew Key nesi anr esear chhasexpl oredt her ole
ofimper fect
ionsi ncr editmar kets.Her e,wehav et oassumet hat
theef f
ectsofmonet arypol i
cywor kt hroughi nterestr ates, andt hat
fi
rmsandpeopl ecanbor r
ow f r
eel yatt hequot edi nt erestr ate.I n
practi
ce,mostpeopl eandmanyf i
rmscanbor rowonl yf rom banks.
And banks of ten t urn down pot entialbor rower s,despi tet heir
will
ingnesst opayt hepost edi nter estr ate.Whyt hishappens,and

120
howi taf fect sourv iewofhowmonet ar ypol i
cywor ks,hasbeent he
subjectofmuch r esearch,i n par ticul arby Ben Ber nanke of
Princet on.
Yetanot herdi rectionofr esear chi snomi nalr i
giditi
es.Fi scher
and Tay lorhav e shown t hatwi th st agger i
ng ofwage orpr ice
decisi ons,out putcandev iatef rom i tsnat urall ev elforal ongt ime.
Thisconcl usi onr aisesanumberofi ssues.I fst agger ingi sindeed
responsi ble,atl easti n par t,f orf luct uat i
ons,why don’ twage
setter s/pr i
ceset terssy nchr oni sedeci si on?Whyar en’tpr i
cesand
wages adj ust ed mor e of ten?Whyar en’ tal lpr ices and wages
changed,say ,ont hef i
rstofeachmont h?I nt ackl ingt hesei ssues,
Aker lofand N.Gr egor yManki w( fr
om Har v ar d Uni versit
y)hav e
der i
vedasur pr i
singandi mpor tantr esul t,oftenr eferr
edt oast he
menucostexpl anat ionofout putf l
uctuat ions.
Eachwageorpr i
ceset teri sl argelyi ndiffer entast owhenand
howof tenhechangeshi sownwageorpr icef orar etai
ler;changi ng
thepr icesont heshel fev erydayorev eryweekdoesnotmake
muchdi fferencet opr ofits).Thus,ev ensmal lcost sofchangi ng
pricessuchast hosei nv olvedi npr inti
nganewmenu,f orexampl e,
mayl eadt oi nf requentandst agger edpr iceadj ust ment .Inturn, t
his
stagger ingl eadst osl owadj ust mentoft hepr i
cel ev el
,andt hust o
l
ar geaggr egat eout putf luct uat i
onsi nr esponset omov ement si n
aggr egat edemand.I nshor t,deci sionst hatdonotmat t
ermuchat
thei ndi viduall evel( how of tent ochangepr icesorwages)l eadt o
l
ar geaggr egat eef fects( slow adj ustmentoft hepr i
cel evel,and
thusl ar geef fect sofshi ft
si naggr egatedemandonout put).

NewGr owt hTheory

Afterbeingoneoft hemostact i
vet opi
csofr esearchint he1960s,
growtht heorywenti ntoanint
ell
ectualsl
ump.Si ncet
hemi d1980s,
howev er,growththeor yhasmadeast rongcomeback.Thesetof
newcont r
ibuti
onsgoesundert henameofnewgr owt
ht heory.
Two economi sts, Robert Lucas ( the same Lucas who
spearheaded t he r
at i
onalexpectati
on criti
que)and PaulRomer
(f
rom Ber kel
ey),hav e pl
ayed an importantr olein defini
ng the
i
ssues.Whengr owtht heoryf
adedi nlate1960s,t woi ssueswer e
l
eftl argely unresol v
ed. The first was t he determi nants of

121
technol ogicalpr ogress.Thesecond wast her oleofi ncreasi ng
returns t o scal e-whet her,say ,doubl ing capi t
aland l abourmay
actual l
yl eadt omor et hanadoubl ingofout put .Thesear et het wo
maj ori ssuesonwhi chnewgr owtht heor yhasconcent rated.Cl ear l
y,
thesepr opositionsl eav eal otofr oom f ordi sagr eement .
Themaj orar eaofdi sagr eementi si nt hel engt hoft he“ short
run” ,theper iod oft imeov erwhi ch aggr egat edemand af fects
output .Atoneext r
eme,r ealbusi nesscy clet heor iesstartf r
om t he
assumpt i
ont hatout putisal way sati tsnat urall evel:Theshor tr un
i
sv ery shor ti ndeed… Att he ot her,t heor i
es ofhy steresi si n
unempl oy menti mpl yt hatt heef fectsofdemandmaybeext remel y
l
ong- l
asting,thatt heshor trunmayi nf actbev eryl ong.
Theot herar eaofdi sagr eementi si nt her olef orpol icy.Whi l
e
concept uall
ydi st i
nct,i tisl argelyr elatedt ot hef i
rst
.Thosewho
believ ethatout putr eturnsqui cklyt oi tsnat urall evelaret ypi call
y
wi l
l
ingt oimposet ightr ulesonbot hmonet aryandf i
scalpol ici
es,
from const antmoneygr owt ht ot her equi rementofabal anced
budget .Thosewhobel i
ev et hatt headj ust menti sslow t ypi call
y
believ eintheneedf ormor ef l
exiblest abi l
izationpol ici
es.
Despi t
ethesedi sagr eement s,thiscor epr ov i
desaf ramewor kin
whi ch t o conductand or ganize r esear ch.Mor ei mpor tant ,it
prov idesaf ramewor ktoi nterpretev ent sanddi scusspol i
cy .

Summar y
Youhav ebeent aughtt hemai nschool s,ofeconomi ct hought ;the
mecant ali
st s,thephy siocrats,classi
cal , Marxi
st,Keynesi anandt he
monet ar i
st s.Whi lethef ocusoft hecl assicali
stswasonf reet rade
and mi nimum gov er n¬menti ntervent ion int he economy ,t he
mer cant i
lists argued agai nstf ree t rade and wi tht he Mar xi
st
economi st s,call
edf ormaxi mum gov ernmenti n¬volvementi nt he
economy .Al soliket hecl assi
cists,Key nesshi ftedat¬tentionf rom
microeconomi cs anal ysist o macr oeconomi cs.The monet ari
sts
emphasi zedt hesuper i
or i
tyofmonet arypol i
cytof i
scal poli
cy .Asof
recent t imes,t hree gr owt ht heorists domi natet he r esear ch
headlines; thesear et henewcl assical, thenewKey nesians, andt he
newgr owt ht heor i
sts.

122
Post-
Test
1.Identi
fythemai nschoolsofeconomicthought.
2.Whatar ethemai nideasoftheclassi
calschool
?
3.Whatar ethesimilar
iti
esbetweent heclassi
calschooland
theKey nesi
ans?
4.Wr i
teshortnotesont hefoll
owing
a.Adam Smi th
b.Dav idRichardo
c.Kar lMar x
d.J.M.Key es
5.Whatar ethepr oponentsofquant i
tytheoryofmoneyas
propoundedbyMi l
tonFriedman?

References
Aboy ade O.( 1983).I ntegrated Economi cs:A St udy of
developingeconomi es:Addi son-Wesl eyPublisher
sLt d
Dwi vedi
,D.N( 2005).Macr oeconomi csTheor yandPol icy.
Tat
aMcGr awHill
.
Jhingan,M. L.(2000),Macr oeconomi cTheor y,10thRev i
sed
andenl argededit
ion.Vr i
ndaPubl icationLtd
JoeU.U.( 2007) .Economi cs:AnAf r
icanPer spectiv
eSecond
Edi
tion.Lagos: Mil
lennium TextPubl i
shers.
OliverBl
anchar d(1997) .Macr oeconomi csPrentice-
Hall,
Inc.
Olofin S.( 2001) . An I ntroducti
on t o Macr oeconomi cs.
MalthousePubl i
sher s.

123
LECTUREFI
FTEEN

Economi
cSy
stems

I
ntroduct
ion
Economiesofdiff
erentcountr
iesoft hewor ldcanbeclassi
fi
edinto
thr
ee.Thefundament alcr
it
eri
af orsuchclassifi
cat
ionarebasedon
therol
eofthestateinsuchcount ri
esandt hemethodofallocat
ion
ofresour
ceswithi
nt hecountr
y .I
nthislecture,weshal
ldiscussthe
thr
eebasiceconomicsy st
emsandt hei
rexampl es.

Obj
ect
ives
Att
heendoft hi
slectur
e,youshoul
dbeabl et
o:
1.discussthetypesofeconomicsy st
emsthathaveevolv
edi
n
themoder nwor l
d.
2.exami nethefeat
uresofeacheconomicsystem;and
3.giveconcreteexampleofeachtypeofeconomicsyst
em.

Pr
e–Test
1.Ment i
ondi f
ferenteconomicsy stemsy ouknow.
2.Compar e and cont r
ast the command and t he mar ket
economi es.
3.Givef ourpr acti
calexampl es ofeach oft he economi c
systemsy ouknow.
4.Whatar et hedi sti
nguishi
ngchar acteri
sti
csofacapi tali
st
economy ?
5.Doy outhinkanycount rycanbest ri
ctlycl
assi
fi
edint
oanyof
thethreebasiceconomi csy stems?

124
CONTENT
Di
sti
nct
ionscanbemadeamongt
hreebasi
ceconomi
csy
stems:
1.CommandEconomy ,
2.Mar ketEconomy
,and
3.Mi xedEconomy.

Thet hreeeconomi csy stemsr el

atetothemeansandmet hods
bywhi chdi f¬fer
enteconomi estrytoanswert hei
rsocio-
economi c
problems.I tfocusesont hemeansofowner shi
pofresources,the
rol
eoft hest ate,all
ocati
onofr esour¬cesetc.wit
hineacheconomy .
Forpr operelucidati
onoft hemaj orfeatur
esofeachoft hi
ssy stem,
weshal ldiscusst hem separatel
y.

TheCommandEconomy
Thisr eferst ot heeconomysy st em inpr acticei nUSSR, Chinaandi n
mostoft heEast ernEur opeancount r
ies.I tisal sov ari
ouslyr efer
red
toassoci alism orcommuni sm.
Inacommandeconomy ,thest atepl ay st hedomi nantr olei n
answer ingt hebasi ceconomi cpr obl emsf acedbyt heeconomy .
Usual l
y, t
hest ateownst hemeansofpr oduct ion.Inot herwor ds, al
l
enterprises and busi ness v ent ures ar e owned by t he st ate.
Mor eov er,t he st ate also imposes pr oduct ion quot a on t hese
enterprises.
Theal locat i
onofr esour cesi nacommandeconomyi salso
donebyt hest at e.Thest at edet ermi neswhatt o produce,t he
quant it
y,f orwhom andt hepr i
cet ochar gef ort hecommodi ties
produced.Dev elopmentpl ansar ev er ycommoni nt hecommand
economi es.I texpr esseshowt heobj ect i
vesandgoal soft hestat e
andhow t hoseobj ect
ivescoul dbeachi ev ed.Dev el
opmentpl ans
sett ar¬get st o be achi ev ed and al lt he st at
er esour ces ar e
mobi l
isedt oat taint hesetgoal s.
Inmostcases,goodsar edi str
ibut edt opeopl ev i
ar ati
oningby
coupon.Weekl yormont hl
ycouponsar egi v enoutt ohousehol dst o
enablet hem pur chasef i
xedquant i
tyofcommodi t
iesatcer tain
pri
ces.
Incommandeconomy ,thest ateal sot akesav isi
blerol einthe

125
distr
ibut i
on ofi n¬come.A st ated theobj ecti
v eofa command
economyi st opr omoteequi tyi
nt hedi stributionofi ncome.The
state det ermines t he r emuner
at i
on t o househol ds and many
servi
cessuchashousi ngar eunder takenbyt he'st atetohel pt he
poorpeopl e.
Commandeconomi esalsoensur eaf ullutil
i
sat ionofr esources
avail
abl eint heeconomy .Employmentofl abouri sguar anteedt oall
able-bodiedpeopl eintheeconomy .Al t
houghwest erneconomi sts
often al l
eged t hatwhatobt ai
nsi sunder ¬dev elopmentbecause
l
abouri sl esst hanef f
icient
lyutil
sed.Dev elopmentpl ansli
kewe
ment ionedabov eisalsousedbyt hest atet of ullymobi l
isei ts
resour cesf orthegoalsoft hesociety.

TheMar ketEconomy
Thisi sacompl eteant i-thesi soft hecommandeconomy .Thi si s
the t ype ofeconomywhi ch i s prev alenti n West ern Eur opean
count r
ies.I tisal socal ledacapi tali
steconomy .
In a mar keteconomy ,t he sl ogans ar el aissez f aire and
mi nimum gov ernmenti nt ervent ion.Insucheconomi es,t hef or ces
ofdemand and suppl y ar e expect ed to al l
ocat et he av ailable
resour ces.
Ther ei sa st rong f ai t
hi nt he pr i
ce mechani sm.The pr i
ce
mechani sm whi ch al ¬r eady embodi es t he scar cit
y concept
det ermi neswhatt opr oduce, thequant it
yandf orwhom t opr oduce.
Ani ncreasei nt hepr iceofacommodi t
yisasi gnalf orpr oducer st o
i
ncr easet heout put.Mor eov er ,goodsar epr oducedf ort hosewho
arewi l
lingt opayt hehi ghestpr icefori t.
Unlikei nacommandeconomywher et heav ailableout puti s
distr i
but edt hroughr ationi ngbycoupons,i namar keteconomyt he
price sy stem di s¬tri
but es t he out putav ai
lable.The f orces of
demandandsuppl ydet er mi net hepr i
ceoft hecommodi ty.Thus,
thosewhocanaf forditwoul dgeti t
;ot herswhocannot ,woul dhav e
togowi thouti t.
Thest atei namar keteconomyal soconcer nsi tselflesswi th
distr i
but i
on ofi n¬come.The means ofpr oduct ion i s gener all
y
ownedbypr i
v atei ndiv idual s.Andt her eturnst oeachhousehol d
dependont her esour cesownedbyt hathousehol d.Whi l
et hose

126
whoownmuchoft heser esour cesappr opriat
et hebul koft he
i
ncome i nt he economy ,t hose wi t
hl ess resource go wi t
h
correspondi nglowi ncome.Thi siswhyt her earewidei ncomegaps
amongi ndi
v idual
si namar keteconomy .
Inapur emar keteconomy ,thereisnor oom foreconomi cplans.
Thepr esenceofeconomi cpl ansi mpliesanact i
v er oleforthe
gover nmentwi thint he economy .Thisi s howev eragai nstthe
pri
ncipleofamar keteconomy .Ther ol
eoft hestat
ei sonlylimit
ed
tolay i
ngdowngener alr ul
esgov erni
ngtheagent si
nt heeconomy .
Iti
sbel ievedt hatt heeconomi cagent si nt heeconomy ,inthe
pur¬suitoft hei
ri ndividualgoal s,wouldi nadvert
entlypr omotethe
goalsoft hesoci et y
.

MixedEconomy
Thisi s a hy brid ofbot h a command economyand a mar ket
economy .I nr eall if
e,onl yv eryf ew economi esf itrigi
dlyi ntot he
descr ipti
onofei theracommandormar keteconomy .Whatwe
hav ei sami xtur eoft hef eat ur
esofbot hsy stems.Wecanonl yt alk
i
nt ermsofappr oximat i
on, i.
e.closenesst oeithert hemar ketort he
commandeconomy .
Mi xed economyi st hemostcommon economi csy stem i n
dev elopingcount ries.I ti saneconomyi nwhi cht hegoodf eatur es
ofbot ht hecommandandmar keteconomi esar ei ncorporated.I n
suchaneconomy ,bot ht hest ateandt hei n¬dividualorputmor e
techni call
y ,bot ht hepr ivateandpubl i
csect orsjoinhandst oget her
andbecomepar tner s-in-pr
ogr essi nsol vingt hemaj oreconomi c
probl emsoft hesoci ety .
Aswenot edabov e,i nami xedeconomy ,therei stheact ive
par t
icipationoft hest ate.Ther oleoft hest ategoesbey ondl ay ing
rulesand r egul ations,t o actual lypar ti
cipat i
ng i nt he economy .
Owner ship ofr esour cesi sj ointlybor nebybot ht hest ateand
privatei ndi v idual s.Thus,j ustas t he st ate setup economi c
ven¬t uresei thersi ngul arlyorinpar tnershipwi tht hepr i
vatesect or
,
soal sodot hepr ivateent repreneur sint heeconomysetupt heir
ownbusi nessv ent ures.
Inami xedeconomy ,t
hest atei sthedomi nantpar t
icipant .It
usual lypr epar esdev elopmentpl ans;hi ghl i
ghtt he goal soft he

127
society and how r esources oft he society can be har nessed
towar dsachi evingsuchgoal s.Itthenbecomest hedut i
esoft he
stateandt hepr i
vat esectort oseehow t hesegoal sar et obe
achiev ed.
Thest atei
nt histypeoft heeconomyal soconcer nsi t
selfwi t
h
thedi stri
butionofi ncome.Thr oughf i
scalpoli
cy ,andpr ovi
sionof
servicest hatbenef i
tthepoorpeopl ei nthesociety,thestateseeks
toreducei nequal i
tyi nincomedi str
ibuti
onandt or aisetheav erage
standar dofwel far eintheeconomy .
Although,t her eisar el
ianceont hepr i
cesy stem t odistri
bute
theav ailableout ¬putofgoodsandser vi
cesint heeconomy ,there
aresomecaseswhent hest ateint
ervenesintheoper ati
onoft hi
s
mar ketsy stem, throughi mposi t
ionofmi ni
¬mum ormaxi mum pr i
ce
l
egislat i
on.

Summar y
Alleconomi csofthewor l
dcanbecl assif
iedintoanyoft hethree
basic economic sy st
ems,thatis,command economy ,market
economy and mi xed economy . Alt
hough t herei s no stri
ct
conformit
yofanycount r
ytoeithercapitali
sm orsoci al
ism,the
cl
assifi
cationisstil
ldoneont hebasi sofap¬pr oxi
mationoft he
countrytoanyoft heeconomicsy st
ems.I tisappositetosaythat
al
mostal lcountr
ies oft he world arer eal
ly mixed economy,
combingt hebasi
cf eatur
esofbot
hcapi tal
i
sm andsoci al
i
sm.

Post-
Test
1.Writ
eshor tnotesonthefol
lowi
ng:
a.Commandeconomy
b.Mar keteconomy
c.Mi xedeconomy
2.Compar e and contr
astthe capit
ali
steconomy and t he
soci
alisteconomy ?
3.Givethr eeexampl esofcountri
espr act
ici
ng t
hesoci al
i
st
syst
em.
4.Whichoft hesystemsdoy ourecommendf oryourcountr
y?
Why?

128
References
Aboy ade O.( 1983) .I ntegrat ed Economics:A St udy of
DevelopingEconomi es.Addison- Wesl eyPubli
shersLtd
t
h
Dav idC.C.( 2004) .Economi cs,( 5 ed.)MiddleburyCollege:
McGr aw-Ir
wi n.
Dwi vedi ,D.N.( 2005).Macr oeconomi csTheor yandPol i
cy.
TataMcGr awHi l
l.
JoeU.Umo( 2007).Economi cs:AnAf r
icanPer specti
ve.(2nd
ed.
)Lagos: Mi ll
enniumTextPubl isher s.
Lipsey ,R.G.( 1971).I ntroduct i
on to Posit
ive Economi cs,
London: Wi edenf el
dandNi colson.
OliverBl anchard( 1997); Macr oeconomi csPrentice-
Hall
,Inc.
Olofin S.( 2001). An I ntr
oduct i
on to Macr oeconomi cs.
MalthousePubl i
shers.

129