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A2 Macroeconomic
Unit 1 Macroeconomics (National income accounting)
National income measures include;
GDP (Gross Domestic Product)
GNP (Gross National Product)
NDP (Net Domestic Product)
NNP (Net National Product)
Topic 1 GDP:
It is the total money value of all final goods and services produced within geographical
boundaries of a country over a year.
What GDP includes/excludes:
1 Only money value
2 Produced in a particular period e.g., a year
3 Produced within the boundaries of the country including MNCs output
4 Official trades only (Excludes hidden/black economy)
5 Includes earned incomes e.g., wages, rent etc., but excludes transfer payments e.g.,
pensions, unemployment benefits etc.
Topic 2 Refining GDP:
GDP to GNP/GNI (Gross National Product/ Gross National Income) GDP + Net
property/Factor income from abroad. We add incomes earned by domestic citizens
from abroad and subtract incomes earned by foreigners domestically.
An economy may be an open economy which has four sectors i.e., households, firms,
government and international trade sectors. For an open economy there will be a
difference between values of GDP and GNP/GNI as mentioned above.
For a closed economy which does not have international trade sector, value of GDP and
GNP/GNI will be then same as there will be NO inflows of money from and outflows of
money to other countries.
From GDP to Net Domestic Product
GDP – Depreciation on capital
Depreciation is the wear and tear and causes loss in value of a fixed asset
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NNP/NNI (Net National Product/Net National Income)

GNP – Depreciation on capital. This is referred to as national income
NYd (Disposable National Income)
NNP – Direct Taxes (such as Income tax) + Transfer payment

Topic 3:
Nominal VS Real GDP:
Nominal GDP is calculated at current year prices and includes inflation in it.
Whereas Real GDP is calculated at base year prices and has been adjusted for inflation.
Calculating Real GDP:
We use deflator formula to calculate real GDP,
Real GDP =
Nominal GDP/ Deflator (Current year Price index/Base year Price index)
Example:
2019 Nominal GDP = 100 million $
2020 Nominal GDP = 120 million $
Inflation Rate in 2019 was 10%
Deflator = 110/100 = 1.1 …
Real GDP = 120/1.1 = 109.09 million $
Topic 4
Difference between GDP and market prices and GDP at basic prices or factor cost:
GDP at market prices is simply the value of output at current year’s prices.
Whereas GDP at basic prices or factor cost is the actual payment made to the 4 factors
of production for making the output i.e., rent, wages, interest and profits.
GDP at market prices + Subsidies – Indirect taxes becomes GDP at basic prices or
factor cost.
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This is because subsides reduce market price below the actual payment to factors of
production and indirect taxes raise the market price above the actual payment to
factors of production.

Topic 4:
Circular flow of money in an economy (closed and open economies):
Before we analyze how incomes flow through households, firms, govt and international
economy, we need to understand various models of economies and their respective
sectors. We need to understand the concept of injections and withdrawals from the
circular flow.
Sectors of an economy:

Households Firms Government Net exports (X-M)

Consumption Investment Government Exports
Spending

Saving Taxes Imports

C, S I G, T M
As consumption is the original injection than generates the circular flow of incomes in
an economy, we will not treat it as a separate injection.
Types of Economies:
2 sector (No govt) closed (no international trade)
There are only two sectors in a closed economy with no government and they are
Households and Firms
I (Injection)
S (Withdrawal)
3 Sector closed economy:
There will be three sectors in such an economy i.e., Households, Firms and Govt. There
will no international trade sector (Net Exports).
I + G (Injections)
S + T (withdrawals/leakages)
3 Sector open economy (Includes international trade)
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There be Households, Firms and International trade sectors, but no government in such
an economy.
I + X (Injections)
S + M (Withdrawals)

4 sector open economy

This is the real world model with all 4 sectors Households, Firms, Govt and International
trade existing in it.
I + G + X (Injections)
S + T + M (Withdrawals)
Let’s analyze how incomes and money flows through the above-mentioned economies
via circular flow model in the diagram below.
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As seen in the above diagram households provide factor services to the firms and
receive rewards for those services i.e., rent, wages, interest and profit. These rewards
are spent by households on buying goods and services from firms. If the factor rewards
are equal to spending economy will be in equilibrium as circular flow of incomes will
stay at the same level. However, households save some of the earning which are
channeled through banks to firms again, hence in a 2-sector closed economy if S = I,
economy is in equilibrium and so on for 3 sector and 4 sector economies equilibrium is
where injections are equal to the withdrawals.
Injections (J):
Investment (I) by firms on;
1 Capital goods (machinery, roads)
2 Finished and semi-finished goods
Govt spending (G)
Exports (X)
J=I+G+X
Withdrawals (W)
Net Savings (S):
Savings – borrowing/dissaving (taking out of past savings)
Net Taxes (T):
Taxes – transfer payment (unemployment benefits)
Imports (M)
W=S+T+M
National income equilibrium/disequilibrium and return from disequilibrium to
equilibrium:
Equilibrium is when
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Injections = Withdrawal
I+G+X=S+T+M
Disequilibrium is when J > W or W > J
If J > W = AD rises -> Incomes/profits/employment rises
S + T + M = W all rise till J=W back to equilibrium
If W > J = AD falls -> Incomes/profits/employment falls, S+T+M falls till J=W back to
equilibrium (JUSR READ AGAIN FOR A2)
……
(A2 CONTENT)
Keynesian Theory of Income and Employment (How components of AD/AE changes
effect national income)
All the above were actual injections and withdrawals and next are planned injections
and withdrawals for future years called Aggregate Expenditure (AE)
An economy is very complex, hence to simplify things J.M. Keynes makes the following
assumptions

• There is a fixed level of potential national income which means there is full
employment of resources. This is given by the symbol YF. Thus, the level of
actual national income Y may be less than (if there is unemployment) or even
greater than YF if everyone starts working overtime.
• It is assumed that there is some unemployment of resources and it is possible to
increase the level of Y by using the unemployed resources
• Constant prices i.e., no inflation or deflation
• Constant state of technology
AE = C + I + G + (X-M) planned
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As seen above exports are autonomous injection as they depend on foreigners’ income
and not on domestic national income. Imports on the other hand are induced as they
depend on domestic national income and change with it.
Marginal Propensities:
It is the fraction of additional income that is used to consume, save, import and pay
taxes.
Marginal propensity to Consume (MPC)
MPC = Change in consumption /Change in income
If a person spends 800£ of his additional income of 1000£. His MPC = 800/1000 = 0.8
Marginal propensity to Save (MPS)
MPS= Change in saving/change in income
Marginal propensity of Taxation (MPT)
MPT = change in tax/change in income
If govt takes 100£ out of additional 1000£ income MPT will be 100/1000= 0.1
Marginal propensity to Import (MPM)
MPM = change in imports/change in income
Marginal propensity to withdraw
(MPW)= MPS + MPT+ MPM
Average Propensities:
It is the fraction of total income that is used to consume, save, import and pay taxes.
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Average propensity to Consume (APC)

APC = Consumption /Income
If a person spends 800£ of his total income of 1000£. His APC = 800/1000 = 0.8
Average propensity to Save (APS)
APS= saving/income
Average propensity of Taxation (APT)
APT = tax/income
If govt takes 100£ out of total 1000£ income MPT will be 100/1000= 0.1
Average propensity to Import (APM)
APM = imports/income
Average propensity to withdraw
(APW)= APS + APT+ APM
Consumption Function: It is how consumption changes with changes in national income
C = C0 + MPC(Y)
Where C is consumption
C0 = Autonomous consumption (necessities/for survival)
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Change of MPC
When MPC changes it causes an induced shift. From C0 to C1 is when MPC rises say
due to poor having more income and spending a greater proportion of the additional
income and vice versa.

If Consumption increases due to any external factor like reduced indirect taxes.
Consumption function will shift up to C1 and if consumption reduces it will shift to C2.
Factors shifting consumption:
1) Wealth
2) Direct Taxes (along the curve movement)
3) Indirect Taxes
4) Future confidence
5) Population
6) Age structure (the more the older population less the consumption and vice versa)
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Saving Function:
S = f(Y)
Y rise, S rise
S = -S0 + MPS(Y)
Where S = Saving
-S0 = Dissaving (spending to be made on basic necessities even with no income)
MPS = Marginal propensity to save

All points on 45* degree line will have C = Y. Before national income Y0, C > Y, hence
dissaving and after Y0, C < Y, hence there is saving.
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Saving function starts negative due to dissaving (amount that has to spent even with
zero income. It is taken from past saving or through borrowing).

When MPS changes it causes an induced shift. From S0 to S1 is when MPS rises say
due to rich having more income and saving a greater proportion of their additional
income and vice versa.
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Determinants of saving
1 Social attitude
Culture of saving or spending
2 Availability of saving schemes
3 Interest rate: Rise -> Saving rises and vice versa
4 Target savings
When people save for a particular purpose e.g., buying a new car. In target saving if
interest rate rises, target of savers is met early and target saving tends to reduce and
vice versa.
5 Future confidence
High … savings less
3 & 4 Tax and import Function:
Remember we are considering net taxes here i.e., Tax – Transfer payments. Tax and
imports are withdrawals from circular flow of national income and therefore are
endogenous factor meaning the tax and import function depends on national income.
National income rises and so do taxes paid and imports bought as seen in the figure
below.
T = f(y) (function of national income)
T = MPT(Y)

5 Export Function:
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Exports have no link with domestic national income (Yd), as foreigners by them. As it is
purely exogenous, changes in national income will not affect exports. Refer to figure
below,

Factors determining imports:

1 Exchange rate appreciate/depreciate
2 Protectionism/free trade
3 Relative quality of imports
4 Price competitiveness of imports
Factors Determining Exports:
1 Exchange rate appreciate/depreciate
2 Protectionism/free trade
3 Relative quality of exports
4 Price competitiveness of exports
6 Govt expenditure:
Govts spends on
1 Capital expenditure: Infrastructure e.g., schools, roads etc.
2 Current Expenditure: Salaries, medicines, uniforms etc.
3 Debt-interest: Interest paid on loans
Factors of govt spending:
1 Need for infrastructure
2 Political reasons
3 Need for economic reasons (e.g., recession and growth)
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4 Conflicts/wars… Peace
As it is purely exogenous, changes in national income will not affect exports. Refer to
figure below,

7 Investment:
Investment in economics is spending on capital goods and can be categorized in 3
ways;
1 Fixed capital formation:
Spending on capital goods e.g., machinery, roads etc.
2 Residential houses: new construction only is considered investment
3 Stocks (Finished goods by retail company)
Marginal Efficiency of capital (MEC):
Investment takes place according to theory of “Marginal efficiency of capital” which is
the expected return on additional capital investment. Interest is the cost of capital
investment hence,
If MEC > Interest Rate .. Investment rise
IF MEC < Interest Rate.. Investment falls
When MEC = Interest rate .. Optimum investment

MEC falls due to diminishing returns to capital as capital and labor ratio is disturbed
when we add more and more capital to fixed number of workers.
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Note: interest rate changes will cause movement along the MEC curve.
National income equilibrium: (Effects of changes in AD/AE on national income)
1 Aggregate Expenditure (AE) Model:

At Y2 AE>Y, shortage of stocks, production rises, unemployment reduce, national

income rises to Y0.
At Y1, AE < Y, surplus of stocks, production falls, unemployment rises, national income
falls to Y0.
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2 Withdrawals and Injections Model:

As seen in the figure below up till Y0 national income J (injections) are greater than W
(withdrawals) and national income/output rises to reach equilibrium. After Y0 national
income W > J hence national income/output falls to reach equilibrium. Shift of J and W
will automatically determine a new level of national income.
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Economy is in equilibrium at YE which is above full employment level YF. There is YE to

YF inflationary output gap. Govt should reduce spending to eliminate d to EF inflationary
expenditure gap.
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To shift* AD from AD to AD1

Government should reduce spending to shift AD from AD to AD1

Multiplier:
When increase in an injection (withdrawal) causes a greater change in national income
than the original injection.
K = change in Y / change in Injection
For example, a 100 m $ investment causes 500 m $ increase in national income (Y)
500/100 = 5
This is because each spending causes incomes, 100 m investment caused incomes of
100 m $. Now lets’ say marginal propensity of consumption is 0.8. Out of 100 m $, 80 m
$ will be spent. Next time 0.8 of 80 m $ will be spent again i.e., 64 m $. This will keep
happening till initial injection is withdrawn.
Calculating multiplier in advance
K = 1/1-MPC or 1/MPW
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K = 1/1-0.8
1/0.2 = 5
1/0.2 = 5
The higher the MPC, the more the multiplier effect.
The lower the MPC, the lower the multiplier effect.
MPC = 0.5

As seen above figures higher MPC (lower figure) causes AE curve to become steeper
and multiplier effect is stronger.
Assumptions/limitations

• There is only autonomous investment and no induced investment

• MPC is constant for the economy
• No time lags
• Price level is constant
• Economy is currently operating below full employment
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In the above table each machine can make 10 units and one machine depreciates each
year. As seen in the above table when consumer demand (national income) rose from
80 to 100 units i.e., 25%, investment rose from 1 to 3 i.e., 200%. When consumer
demand rises at a faster rate from 100 to 160 unit i.e., 60%, investment rose from 3 to 7
machines i.e., 125%. Therefore, as per accelerator theory if national income rises at a
faster rate, investment increases by a greater proportion.
When national income / consumer demand rose from 160 to 180 units i.e., only 12.5%,
investment fell from 7 machines to just 3 as per the theory.
Limitations of accelerator theory

• If the firms have spare capacity i.e., unused machinery, they will not invest more
even if national income rises faster than previous year as they can use the spare
capacity available
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• If firms train their workers and become more productive, they may not invest
more in new machinery even if national income rises faster than previous year as
they can produce more with more efficient workers
• If technological advances make machinery more productive, accelerator theory
may not apply as firms maybe able to meet the extra demand through fewer
machines
Relationship between Multiplier and Accelerator and vice versa
When an economy moves towards boom, there is a multiplier effect on national income
as discussed earlier. The national income rises at a faster rate and that causes firms to
invest more bringing an accelerator effect. Rise in investment causes an injection in “I”
component of AD and again national income rises manifolds due to multiplier effect. To
sum up multiplier causes accelerator and accelerator causes multiplier.
Past Paper Questions
MJ 20 P41 Q6 a
Explain what is meant by an inflationary gap and discuss why this is considered to be an
economic problem. Use a diagram to support your answer. [20]
MJ 18 P43 Q5 a
Explain what is meant by a deflationary gap and discuss why this is considered to be an
economic problem. Use a diagram to support your answer. [20]
MJ 16 P41 Q6 a
Explain what is meant by equilibrium level of national income and consider whether it is
possible to have such an equilibrium and unemployment at the same time. [20]
ON 15 P41 Q6 b
“If investment increases it will cause an increase in output. If output increases it will
cause an increase in investment.”
Discuss whether both these statements can be true. [20]
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Unit 2 Macroeconomics: Money and banking

Money: It is anything generally acceptable as a means of payment. For example, notes
and coins, but the major form of money in form of bank deposits.
In a broader sense, gold, silver, houses, shares etc. are all money if they can be
converted into liquid (Immediately usable) cash.
The money supply is the total amount of money—cash, coins, and balances in bank
accounts—in circulation. The money supply is commonly defined to be a group of safe
assets that households and businesses can use to make payments or to hold as short-
term investments
Note: Bit coins, credit and debit cards, cheques are not money. They are instruments of
credit.
When there was no common money, barter system was in place which was exchange of
goods for goods etc. There were many problems of barter such as no double
coincidence of wants, problems of divisibility, portability problems, durability problems
etc.
Concept of liquidity:
It is the ease with which asset can be converted into cash without a major loss.
Liquid assets:
Cash, Treasury bills (These are govt saving certificates issued for 90 days at discount
rate)
Illiquid assets: Bonds (These are long-term saving certificates issued by govt at a
discount rate usually over a year).
Narrow money M0 (Liquid):
Cash, Bank current account
Broad Money M4: M0 + Bank fixed deposits + building society deposits
Concepts of money: (Mainly for Mcqs)
1 Legal tender: It is illegal to refuse to accept money if the vendor is selling goods and
services
2 Extrinsic and intrinsic value of money: Extrinsic is the face value and intrinsic is the
actual value. Todays' money has much higher extrinsic value.
3 Treasury bills: these are short term loan certificates issued by govt usually for 90 days
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4 Promissory notes: These are drawn by the creditor on the debtor for the amount
payable
Characteristics of money:
These are the qualities required for money to perform its’ functions.
1 General acceptability
2 Scarcity: Money should be in limited supply to have value as anything in unlimited
supply as no value for example sand on the beach
3 Portability: It should be easy to move money over long distances
4 Durability: It should be able to last longer to act as store of value
5 Divisibility: Money should be dividable into smaller denominations for easy use, Rs
5000 note and Rs 5 coin
6 Uniformity (Easy to recognise and difficult to Counterfeit i.e. copy)
Functions of money:
1 Medium of exchange: Money should be generally acceptable in exchange for
goods/services and it should be scarce to have value.
Money as a medium of exchange facilitated specialization where each worker/firm
specializes in producing only a narrow range of goods. This was only possible if money
exists.
Countries also managed to specialize on a narrow range of goods as they can get
money from exporting their specialized products and get from other get countries what
the country is not making.
2 Store of wealth/value:
Money performs the function of saving for future use. Money should be durable and
retain its’ value. If there is high inflation, this function of money gets weak.
3 Means of deferred (Future) payments:
Money can be used for credit purchases i.e. buy now, pay later. For this function money
needs to be durable and divisible. Inflation effects this function badly
4 Measure of value/ unit of account: Money is a yardstick to compare the worth of
different goods in terms of prices.
Money also records all accounting transactions. E.g., profits, losses etc. Money needs
to be divisible for this purpose.
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Functions of central bank:

It is usually govt owned and controls the banking system e.g., State bank of Pakistan

• Prints money
• Acts as a govt bank
• Makes rules for commercial banks
• Banks’ bank
• Monetary policy decider
Functions of Commercial banks:

• Accept deposits
Commercial banks accept our deposits in form of current account/demand
deposits which are immediately accessible and no interest on them.
They also keep our saving deposits or fixed deposits where savers receive
interest on their amount deposited
• Extend loans
They give out loans from the peoples’ deposits received. Loans can be
commercial like a car or holiday loan or commercial loans to businesses like
overdrafts etc.
• Transfer of money
It can be within the city, between cities and even countries
• Keep valuables
Commercial banks keep customers’ valuables e.g., documents, wills, gold etc. in
safe lockers
• Other facilities
Bill payments, tax and investment advice and currency exchange etc.
• Create money
Next topic
Objectives of commercial banks

• Commercial banks aim for profitability through charging different rates of

interest on saving and lending. They also provide various services for a fee as
discussed above
• They also aim for liquidity and keep enough cash reserves i.e., portion or
percentage of deposit liabilities in form of cash (Reserve Ratio = cash reserves /
deposit liability) to fulfil day to day requirement of cash by their customers.
Commercial Banks maintain their liquidity position through their treasury division by
interbank transactions (borrowing and lending) with other financial entities.
• Another aim is security. In order to keep surviving in the commercial market, they
ensure good service provision and sound decisions for future such as
investments etc.
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Credit creation process:

It is a process where commercial banks accept deposits and keep a small ratio of these
deposits in cash and lend the rest.
Assumptions:
1 Multiple bank systems
2 two types of assets i.e., cash and loans
3 All payments are through checks
4 No cash drain
5 All deposits are current account
6 Keep no excess reserves over the liquidity required
Banks know from experience how much % of their accounts people use, hence they
keep just that much cash and lend out the rest to create money.
Example: (20% liquidity ratio)
Mr. Ali deposits 1000£ in bank A
Bank A
Will keep only 200£ cash and will lend 800£ to Mr. Danyal in check form
Danyal deposits in bank B
Bank will keep 160£
Lend 640£ to Mr. Ahsan in check
Ahsan deposits £640 in Bank C
Bank C will keep 128£ (20% of 640)
And lend 512 to Mr. Ibrahim
This process will continue till the 1000£ deposited by Mr. Ali is zero
Liquidity Ratio: Total cash reserves / Total deposit liabilities
200£/1000£ = 0.2
Credit multiplier = 1/Liquidity ratio 1/0.2 = 5 times
1000£ will be converted into 5000£
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Created money = 4000£ (Created money – initial deposit)

Total liability = 5000£
Initial deposit = 1000£
Limitations:
1 Banks may keep different liquidity ratios at different times of year according to cash
drains, e.g., wedding season, Eid, summer vacations etc.
2 Insufficient demand for credit
3 Lack of credit-worthy customers
4 Cash drain society
Interest rates determination: (Important)
Interest = It is the cost of borrowing and return on saving
Base interest rate: This is the rate from which all other interest rates are derived. LIB0R,
KIB0R (Karachi interbank rate). There is an upper and a lower limit e.g., 9% to 16%
Nominal Interest rate: It is the interest rate at current year rate i.e., not adjusted for
inflation
Real interest rate: It is at base year rate and has been adjusted for inflation
Real interest rate = Nominal interest rate – inflation rate
10% nominal interest rate
Inflation rate = 7%.. Real interest rate = 3%
Liquidity Preference Theory (LPT) (Important)
According to J.M.Keynes Interest rate is determined by interaction of demand and
supply of money.
According to Keynes money supply is determined by central bank and is inelastic to
changes in interest rate.
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Determinants of money supply;

1 open market operations
This is when govt sells/buys its’ bonds to/from general public.
When govt redeems/buys back its’ bonds, money supply will rise as money will transfer
from govt’s account to peoples’ accounts. (QUANTITATIVE EASING)
2 Liquidity ratio:
If central bank wants to increase money supply, they will reduce liquidity ratio and vice
versa

3 Discount rate:
Central bank lends to commercial banks a last resort (last loan) if they are in liquidity
crisis.
If central bank reduces the rate of interest on this loan, commercial banks take it and
start lending.. money supply will rise and vice versa
4 Special deposits
Sometimes central requires commercial banks to keep a deposit with it in a special
account.
When central bank needs to reduce money supply, they will freeze these accounts. If
they wish to increase money supply, they will release these deposits.
5 Qualitative measures:
Central bank will directly order commercial banks to follow a loose or tight lending
policy
6 Deficit financing by govt:
When govt spends more and takes less taxes (Expansionary fiscal policy)
Effects of govt spending on Money supply=
1 If govt increases spending by selling bonds to commercial banks… money supply falls
as bonds are illiquid
2 If govt increases spending by selling treasury bills to commercial banks.. money
supply increases
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3 If govt increases spending by taking loan from central bank.. Money supply will rise
4 If govt increases spending by taking loan from general public by selling bonds ---
money supply will be unchanged
5 If govt increases spending by privatization … money supply will be unchanged

Topic: Demand for money (why people demand money) (V important)

According to LPT by Keynes, people demand money/cash/liquid assets for three
motives i.e., transaction motive, precaution motive and speculation motive.
1 Transaction motive: People keep cash/liquid assets for day-to-day purchases e.g.,
groceries, fuel, utility bills etc. Firms also keep cash for day-to-day expenses such
as running expenditure e.g., wages, bills, raw materials etc. Govt also keeps liquid
money for their office supplies etc.
This motive of demand for money is perfectly inelastic to changes in interest rates.

This motive of demand for money is influenced by changes in income, Inflation rate and
Intervals of pay etc.
Rise in incomes, inflation and interval of payment will cause an increase in demand for
money and vice versa

2 Precautionary motive:
It is the demand for cash/liquid assets for unforeseen emergencies e.g., surgery,
accident etc. Firms also keep cash for unexpected break downs of machinery etc.
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3 Speculation motive:
This is when people invest for short term gains e.g., government bonds. They try to gain
from difference in selling price and purchase price.
Govt bonds are saving certificates which are sold at a discount rate and have a fixed
interest.
For example, a bond with face value of £100 and has fixed interest of 10£.
If price of bond falls in the open market e.g., £50, now the interest rate would be 10/50 *
100 = 20%.
People do not invest in bonds when their price is high and interest rate is low. They keep
holding cash and demand for money rises.
Thus, it shows that demand for money for speculative purposes is interest elastic.

When speculative motive is added to other motives of demand for money, the whole
demand curve / liquidity preference curve become interest elastic.

Interest rate determination: (Important)

According to LPT, interest is determined through demand for and supply of money.
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As seen in the figure, interest rate was determined at IR0 through demand and supply of
money. If IR rises to IR1, Money supply is greater than demand for money a to b area.
People will have surplus liquid assets and will invest in bonds as bond price is low and
interest is high. Demand for bonds will rise and their price will rise, bringing interest rate
down and vice versa.

Limitations of LPT:
1 The view that transaction and precaution motives are interest inelastic is not correct.
They do change when interest rate changes
2 The notion that people only invest in bonds for speculation is incorrect as people
invest in stocks, property etc.
3 Money supply being perfectly inelastic to interest rate changes may be true in short
run only
4 According to Keynes changes in money supply may not affect interest rates if
“liquidity trap” exists. This is a situation when price of bonds is too high and interest
rate is too low. People keep holding their cash and do not invest in bonds.
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Loanable funds theory:

The neo-classical theory of interest or loanable funds theory of interest owes its origin
to the Swedish economist Knut Wicksell.

Later on, economists like Ohlin, Myrdal, Lindahl, Robertson and J. Viner have
considerably contributed to this theory.

According to this theory, rate of interest is determined by the demand for and supply of
loanable funds. In this regard this theory is more realistic and broader than the classical
theory of interest.

According to this theory demand for loanable funds arises from

• Households may borrow money to buy houses and cars.
• Firms may borrow more for investment especially if future looks good
• Govt may borrow if it has a budget deficit i.e., its’ spending more than the revenue
gained from taxes
Demand for loanable funds has a negative relationship with interest rate lower the
interest rate, the more likely that economic agents will borrow more. Therefore demand
for loanable funds slopes downwards.

Supply of Loanable Funds:

The supply of loanable funds is derived from poples’ savings, and bank credit.

Supply of loanable funds has a positive relationship with interest rate as people save
more when interest rate rises and vice versa, hence supply of loanable funds curve
slopes upwards.
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Determination of Rate of Interest:

According to loanable funds theory, equilibrium rate of interest is that which brings
equality between the demand for and supply of loanable funds. In other words,
equilibrium interest rate is determined at a point where the demand for loanable funds
curve intersects the supply curve of loanable funds. It can be shown with the help of a
Figure below;

Above figure A shows how an increase in savings leads to lower interest rate as supply
of loanable funds increases.
Above figure B shows how an increase in demand for loanable funds increases interest
rate.
How is loanable funds theory better than classical theory of Keynes

1. Loanable funds theory recognizes the importance of hoarding as a factor affecting

the interest rate which the classical theory has completely overlooked.
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2. Loanable funds theory links together liquidity preference, quantity of money, savings
and investment.

3. Loanable funds theory takes into consideration the role of bank credit which acts as a
very important source of loanable funds.

Criticism on loanable funds theory

1. Full Employment:
Keynes opined that loanable funds theory is based on the unrealistic assumption of full
employment. As such, this theory also suffers from the defects as the classical theory
does.

2. Indeterminate:
Like classical theory, loanable funds theory is also indeterminate. This theory assumes
that savings and income both are independent. But savings depend on income. As the
income changes savings also change and so does the supply of loanable funds.

3. Impracticable:
This theory assumes savings, hoarding, investment etc. to be related to interest rate.
But in actual practice investment is not only affected by interest rate but also by the
marginal efficiency of capital whose affect has been ignored.

Constancy of National Income:

Loanable funds theory rests on the assumption that the level of national income
remains unchanged. In reality, due to the change in investment, income level also
changes accordingly.

Past paper Questions

MJ 20 P42 Q7 a

Q) Explain how interest rate is determined according to LPT by Keynes? (20)

MJ 19 P42 Q6
Discuss how far
i) An increase in wages and
 34

ii) A loss of business confidence might affect the rate of interest. [20]
 35

Unit 3 Govt macroeconomic policies:

Main macroeconomic problems for a country;

1 Unemployment

2 High inflation

3 BOP disequilibrium

4 Low/negative economic growth

Subsidiary problems:

1 Exchange rate instability

2 Poverty

3 Low literacy

Main macroeconomic aims of a govt:

1 Full employment

2 Price stability

3 BOP equilibrium

4 Sustainable economic growth

Subsidiary aims

1 Exchange rate stability

2 Poverty alleviation

3 High levels of literacy

 36

Topic: Policies to achieve these aims:

1 Demand-side policies

Fiscal policy, monetary policy + Exchange rate policy

2 Supply-side policies

Demand-side policies:

Govt may use expansionary fiscal policy if there is a recession and unemployment is
high. There is low economic activity.

Fiscal policy is the use of taxes and govt spending to achieve macroeconomic
objectives

Expansionary Fiscal policy:

Govt will reduce taxes and increase their spending.

Reduced taxes will increase disposable incomes, consumption will increase, and firms
will increase investment to meet the increase in demand. Govt spending will also inject
in AD. AD will rise

This will result in reduced unemployment and GDP/economic growth will increase.

However, increased income maybe spent on imports of luxury goods worsening the
current account of BOP. Rise in AD, not matched by increased Aggregate supply

as the economy was on full employment, will cause demand-pull inflation.

Contractionary fiscal policy:

During high inflation,

Raise taxes and reduce Govt spending

 37

Monetary policy:

When govt changes interest rates and/or money supply to achieve its’ macroeconomic
objectives. Exchange rate is sometimes also used.

When AD is low, unemployment is high and GDP is low.

We will use expansionary monetary policy.

Interest rate will be reduced and money supply will be increased.

Reduced interest rates will reduce cost of borrowing and return on saving. People will
save less and borrow more, consumption will rise. Firms will also investment more. AD
will rise.

Unemployment will fall and economic growth/GDP will rise. However, Demand-pull
inflation might occur and BOP current account will worsen.

Contractionary policy will be used during high inflation.

Interest rate will increase and money supply will reduce.

Graph for expansionary/contractionary fiscal/monetary policy:

As seen in the above figure (1), expansionary fiscal policy boosts AD and the AD curve
shifts to the right causing economic growth and generating employment as real GDP
rises from Y0 to Y1, however there will be inflation as price level rises from P0 to P1.
Increased incomes will be spent on imports causing a current account deficit.
 38

As seen in the above figure (2), contractionary fiscal policy reduces AD and the AD
curve shifts to the left causing a fall in economic growth and caused employment as
real GDP fell from Y0 to Y1, however there will be reduced inflation as price level fell
from P0 to P1. Reduced incomes will mean less imports and a reduced current account
deficit.

Exchange rate devaluation / revaluation:

If the economy is in recession and unemployment is high and economic growth is low.
Govt will devalue their currency.

Devaluation will make exports cheaper and their demand will rise. Imports will become
expensive and their demand will fall leading to BOP current Account surplus. Ad will rise

Unemployment will fall and economic growth will increase. However demand-pull
inflation will occur if AS cannot match increase in AD.

Same graph as expansionary/contractionary fiscal/monetary policy

If economy is facing high inflation, govt will revalue the currency…..

Note … in contractionary policy explanation means use your own skills to reverse the
argument.
Topic Supply-side policies:
These are aimed at increasing Aggregate supply of goods/services through greater
efficiency.
1) Education and training of labor
This will increase skills and productivity of workers and potential growth will result.
Long run AS will shift to the right
2) Subsides:
3) Privatization:
Private sector will be more efficient due to profit motive and there will be greater
competition. More use of advance technology.
4) Reducing barriers to entry / Contestable markets development
This is done through Deregulation: This is when govt makes laws on new business set
up e.g., licensing requirements easy, hence AS increases.
 39

5. Investment in research and development (RND)

Government can either use their own resources or encourage private sector to develop
advance technology through more research and development. This will make firms
more productive and Long run AS curve will shift to the right
6) Trade union reforms: govt reduces their power of going on strike etc. to ensure
smooth production
7) Development of infrastructure:
Government can develop hard infrastructure like roads, bridges and soft infrastructure
like schools and hospitals. This will reduce firms’ distribution costs and increase their
profitability causing expansion in the economy’s productive potential.
8) Reducing direct taxes
Government can reduce direct taxes like income tax to create incentive for current
workers to work more hours and those who were not joining labor force due to high
taxes may join now. Reduction in corporation tax on firms’ profits will also leave more
retained profit for firms’ expansion.
9) Free trade

The above figure shows result of supply side policies. It will shift long run AS. Govt can
achieve all its’ aims if it is able to use demand side policies (AD shifts out) along with
supply side policies in the long run.
 40

Limitations of Supply side policies:

1 Long run effect and opportunity cost:
These policies will increase AS and all the aims will be achieved in the long run however,
they are costly and there will be an opp cost of govt spending. The benefit will only
materialize in the long run.
2 Demand-pull inflation:
Increase in either government spending or investment by private sector firms will cause
demand-pull inflation in short run due to injections of G and I before increasing long run
aggregate supply (LRAS)
3 Brain drain:
The highly trained and skilled workers may leave the country and all the expenditure on
their training may become a wasted effort
4 Free trade may result in closure of some infant and sunset industries as they will not
be able to withstand the competition from cheap and good quality imports, causing
unemployment in short run
Limitations of fiscal policy:
1 Time lags:
Fiscal policy especially govt spending is slow to operate.
A . Recognition lag:
Sometimes it may take govt a little longer to realise the recession has set in or inflation
has started rising beyond the safe limits
B. Implementation lag:
Govt ministers will hold meeting and take time in deciding the right rates of taxes and
govt spending
C. Affectivity lag:
Govt spending such as on education and health may produce results in very distant
future
2 Political interference:
Fiscal policy is often used for political purposes rather than sound economic logic. For
example, politicians may increase spending near elections to gain popularity.
 41

They may avoid an unpopular tax especially income tax that was needed for economic
improvement.
3 Unreliable data:
GDP and CPI are themselves prone to error, hence policies designed on basis of such
data may be inaccurate
4 Future policy reversals:
If people and firms feel govt will retract/change the tax rates back again. They will save
the extra disposable income rather than increase spending.
5 Crowding out effect:
If govt increase spending by borrowing they compete with everybody else in the
economy who wants to borrow the limited funds available. As a result of this, the real
interest rate rises (due to more demand for loans) and causes a fall in private
investment.
6 Laffer curve:
According to USA president Regan’s adviser (Laffer), if govt reduces the additional rate
of tax at the higher level of incomes, tax revenue will rise. This is because of greater
incentive to firms and workers.

In reality, the tax revenue fell when tax rates reduced.

Limitations of monetary policy:

1 Time lags:

It is faster than fiscal policy but still there are time lags. Change in interest rate may
affect the economy in 12 to 16 months.

2 Unreliable data:
 42

GDP and CPI are themselves prone to error, hence policies designed on basis of such
data may be inaccurate

3 Future confidence:

If firms and people are confident about future, an increase in interest rates may not
deter Investment and spending and vice versa.

4 Liquidity trap:

It is a situation where interest rate is too low and bond prices are too high. Any change
in Money supply will not affect interest rate and economy.

5 External shocks:

For example, Covid-19 and 9/11 attacks may make govt policies ineffective as people
and firms will not react as expected.

Topic Monetary Transmission Mechanism (MTM):

Whenever govt changes money supply, the way it affects the economy is called MTM.

Direct MTM:

MS rises … AD rises … Unemployment falls, GDP rises, but inflation also rises and BOP
current account may worsen and vice versa

Indirect MTM:

According to this view Money supply changes first affect interest rate and then affects
economy.
 43

When money supply increase, interest rates fall. This results in lower cost of borrowing
and lower return on saving. People save less and borrow more. Consumption rises,
firms meet the increase demand by more investment. As a result, AD rises.

Fall in interest rates reduce the inflows of hot money in country’s banks and demand for
currency falls, resulting in depreciation of currency. Now exports will cheaper and their
demand will rise. On the other hand, imports will become expensive and their demand
will fall. Current account improves.

This will cause unemployment to fall and GDP to rise, however demand-pull inflation
may occur if AS cannot rise as much.

Quantity Theory of money: (MTM)

According to monetarist economists’ view, inflation is always and everywhere a

monetary phenomenon.

Any increase in money supply always causes inflation as economy operates on its full
employment level.

According to Fischer’s equation;

MV = PT

Where M = Money supply

V = Velocity of income circulation (how many times money changes hands over a year)

P = Price level
 44

T = Transactions/Quantity/GDP

Basically, MV is income measure of GDP

And PT is output measure of GDP

V and T stay constant

Therefore, any increase in money supply will only cause increase in price level

Initially Later on

M 1000$ 2000$

T 25 25

V 5 5

MV = PT

P = MV/T

1000 * 5 / 25 = 200 2000*5/25 = 400

According to Fischer

“Double the money supply, double will be the price and half will be the value of money.
Halve the money supply, half will be the price level and double the value of money”
 45

Past paper Questions

MJ 2022 P42 Q 7 b
Discuss if monetary policy alone is sufficient for a govt to achieve its’ macroeconomic
aims simultaneously [20]
MJ 22 P41 Q 6 a
Explain what is meant by a transmission mechanism of monetary policy and consider
why it may not work in practice [20]

Unit 4 Macroeconomic objectives and their conflicts / Links between macroeconomic

problems and their interrelatedness:
Major macroeconomic problems and government’s aims regarding them
 46

Conflicts among Macroeconomic aims:

Relationship Inflation and unemployment:
Short run Philips curve:
 47

It is a curve that shows the relationship between inflation rate and unemployment rate.
Philips as per his research concluded that there is a trade-off between inflation and
unemployment.
He suggested that govt can reduce unemployment by expansionary policies. AD will rise
and unemployment will reduce, however some level of demand-pull inflation will occur.

As seen in the graph, govt in order to reduce unemployment from U to U1, will have to
increase AD, which will cause rise in inflation rate from P to P1.
Endogenous (internal) factors Change:
Any change in demand-pull inflation and cyclical unemployment will cause the
movement along Short-run Philips curve.
Exogenous (External) factors change:
Philips curve shifts due to change in;

• Cost push inflation

• Natural Rate of Unemployment (NRU)
• Expectations of inflation by workers

Long run Philips Curve:

In 1970’s inflation rate worldwide rose as well as unemployment rose. It is a situation
called “stagflation”
 48

At this point original Philips curve failed to explain the situation. Therefore, Friedman
came up with “expectation augmented Philips curve / Long Run Philips Curve (LRPC)”.
He suggested that trade-off between inflation and unemployment only exists is short
run. In the long run there is no trade off.

Initially the economy Was in its long run equilibrium at point a, where unemployment
was at U* (NRU) and inflation was 0%. Now govt uses expansionary policies to boost
AD and reduce unemployment. Workers were offered slightly higher wages by firms say
2%, workers were expecting 0% inflation, hence, they joined as they thought they were
better off. But in the long run they realized inflation has risen to P1 say 4%. Workers
realize they are worse off in real terms as inflation rate is higher than wage rise.
They will negotiate higher wages. When wages are raised, cost push inflation will occur
and SRPC0 will shift out to SRPC1
Now wages and prices rise at 4%. Economy returns to equilibrium at point c,
unemployment rises back to U* (NRU). If govt again uses expansionary policies to
reduce unemployment. Again, workers will join as firms raise wages, but in the long run
they realize that they were worse off as prices rose faster than wages. Economy again
shifts to a new short-run Philips curve, SRPC 2, as workers negotiate even higher wages.
The trade-off is only short run between unemployment and inflation. Joining all the
points on short-run Philips curves gives us the long-run Philips curve.
This is because workers are rational and they form expectation of inflation. They cannot
be fooled for long time.
49
50
51
 52

Past Paper Questions

MAR 19 P 42 Q 7
“Keynesian policies to solve the problem of unemployment will not work because they
will conflict with the attainment of other key macroeconomic aims.
Assess the accuracy of this statement. [20]
MJ 20 P 42 Q 5
In January 2018 tax reductions were introduced in the US, and the Federal Reserve
Bank, (the US central bank) announced it would raise the interest rates later in the year.
Discuss how these policies may cause conflicts for a govt in trying to achieve its
macroeconomic aims. [20]
 53

Unit 5 Exchange Rates & Balance of Payments

Topic Exchange Rate: (Important)
Nominal exchange rate:
It is the price/value of one currency in terms of another currency. In other words, how
many units of another currency can be bought with one unit of a particular currency e.g.,
1£ = 1.5$.
Exchange rate appreciation:
When price/value of one currency rises in terms of another. It can buy more units of
another currency e.g., 1£ = 2$.
Exchange rate depreciation:
When price/value of one currency falls in terms of another. It can buy less units of
another currency e.g., 1£ = 1$.
Exchange rate changes and effect on exports and imports’ prices:
Example $150 (T Shirt) 150/1.5 = 100£
When £1 = 2$ 150/2 = 75£
Demand for UK imports will increase and demand for UK exports will decrease. Current
account becomes deficit.
When £1 = $1
Price of T shirt will be 150/1 = £150
Demand for UK imports will decrease and demand for UK exports will increase. Current
account becomes surplus.
Real Effective Exchange Rate:
It is the value of one currency in terms of its’ real purchasing power. In other words, we
adjust the value of currency for inflation changes.
A real effective exchange rate takes price level changes as well as exchange rate
changes into account to assess the competitiveness of a country’s products on global
market. A real exchange rate shows the price of domestic products in terms of foreign
products.
Real Exchange Rate = Nominal Exchange Rate * Domestic Price index / Foreign price
index
Trade Weighted Exchange Rate Index:
 54

A Trade Weighted Exchange Rate Index is a measure, in index form, of the value of one
currency against a basket of currencies. These are weighted according to relative
importance of various currencies we trade with. Higher weights are assigned to
currencies that the home country trades with most.
For example,
Pakistan let’s suppose trades with only 2 countries USA and Japan. Its’ 90% of trade is
with USA and only 10% with Japan. In the base year we assign the value of both
currencies an index number of 100.
In the next year, Rupee appreciates by 10% against US $ and by 50% against Japanese
YEN.
Calculate Trade weighted index now,
Step 1: assign weights as per % of trade i.e., 90% trade with USA means 0.9 weight and
10% of trade with Japan means only 0.1 weight.
Step 2 calculate the change in values by multiplying the change with weights
USA = 0.9 * 10 (% appreciation of Rupee) = 9 index number rise
Japan = 0.1 * 50 (% appreciation of Rupee) = 5 index number rise
Trade weighted index jumps from 100 in base year to 114 (9 + 5).
Exchange Rate Systems / How Exchange rate is determined:
There are 3 systems:
1) Free-floating Exchange rates:
This is when demand and supply of currency in FOREX market determines the rate of
currency and there is no govt intervention
2) Fixed Exchange rate:
This is when govt intervenes and keeps the rate of currency at a particular point. They
use 2 major tools to manage their exchange rate;
a) Foreign Exchange reserves: Govt uses its’ reserves of foreign currencies to affect
the value of domestic currency. If local currency is depreciating, they will sell
reserves and buy local currency to boost the exchange rate. If currency is
appreciating, they will sell the local currency and buy FOREX reserves. Supply of
domestic currency will increase and it will depreciate.
b) Interest Rate:
If interest rate in Pak > Other countries, hot money will flow in to Pakistani banks.
Demand for RS will rise and cause appreciation of RS and locals will also save in
 55

domestic banks and supply of RS will fall, exchange rate will appreciate and vice
versa.
Note= when govt changes the exchange rate it is called devaluation or revaluation
Refer to figure below to see how govt intervenes to keep exchange rate on a fixed rate’

As seen in the figure above, govt wanted to maintain exchange rate of Pound at fixed
official ER. If for any reason supply of domestic currency increase in FOREX market say
due to more impots by UK citizens from USA, Exchange rate would depreciate. To keep
the currency at the fixed exchange rate, they will sell FOREX (Foreign exchange)
reserves and buy Pound. This will result in increase in demand for Pound and exchange
rate will return to the fixed rate again. They will need to buy Q to Q1 quantity of Pounds.
Similarly, interest can be changed to affect the rate of domestic currency as explained
above. (Use the graphs practiced in class)
3) Managed-flexibility:
Govt sets an upper and a lower limit for their currency exchange rate and allows it to
freely float between those limits. They only intervene if currency is going above or below
the set limits. The same tools are used. Refer to the graph below;
 56

As seen in the graph above, govt set an upper limit ER1 and a lower limit ER2 for its
currency. They will let the exchange rate freely float between these limits and will only
intervene if exchange rate goes beyond these limits.
It can be seen that when supply increased for domestic currency from S to S1 due to
more imports etc., govt did not intervene as the exchange rate would depreciate, but
stay within the limits assigned.
However, when supply increased again from S1 to S2, exchange rate would have gone
below the lower limit. Now govt intervened and sold FOREX reserves and bought
pounds. This caused demand curve for Pounds to shift to D1, bringing the currency
back into the acceptable limits.
Similarly, interest can be changed to affect the rate of domestic currency as explained
above. (Use the graphs practiced in class)

Benefits and problems of free-floating exchange rate:

Benefits:
1) There is no pressure on FOREX reserves and they can be used for other important
purposes.
2) Govt can focus on other aims if they are not managing currency e.g. controlling
inflation or unemployment
3) The auto-correcting mechanism of free-floating exchange rate will convert current
account deficits into surplus and vice versa without govt’s intervention
Problems:
1) There will be constant fluctuation of exchange rate and this will cause uncertainty of
trade
2) Foreign investment will reduce due to foreigners being worried about converting their
stable currency into an unstable one
3) Speculators will interfere in FOREX market and increase the ups and downs of the
currency
The benefits of free float are the problems of fixed exchange rate and vice versa
Note the above benefits become problems of fixed exchange rates system and above
problems become benefits of fixed exchange rates system
 57

Q) Discuss if free floating exchange rate is always to be preferred over fixed and
managed exchange rates (6) (Past Paper practice)
It is better than fixed ER as there is no pressure on FOREX reserves…….
It allows govt to focus on other aims if they are not managing ER e.g., inflation AND
unemployment can be focused on.
The auto correct mechanism of free float will allow deficits and surpluses to correct
themselves.
However Fixed ER is better as it allows govt to use ER for handling current account
deficits and surpluses.
Managed ER is better as it gives stability along with less pressure on reserves.
Managed ER is best as it gives benefit of both systems
Effects of changes in exchange rates on the external economy
J Curve Effect:
An appreciation or depreciation of currency effects current account of balance of
payments differently in short and long run.
Depreciation:
When currency depreciates, export prices fall and import prices rise. It should increase
demand for exports AND reduce demand for imports and current account should go
into a surplus. However, it does not happen in short run. This is because PED for
exports and imports tends to be inelastic in short run due to signed contracts for
exports and imports.
However, in long run when Marshall-Lerner condition is met i.e. joint sum of elasticity of
demand for exports and imports becomes greater one. Now current account will
become surplus in long run.
Appreciation:
When currency appreciates, export prices rise and import prices fall. It should increase
demand for imports AND reduce demand for exports and current account should go
into a deficit. However, it does not happen in short run. This is because PED for exports
and imports tends to be inelastic in short run due to signed contracts for exports and
imports.
 58

However, in long run when Marshall-Lerner condition is met i.e., joint sum of elasticity of
demand for exports and imports becomes greater one. Now current account will
become deficit in long run.

Note; The effects of exchange rate changes will be stronger on an open economy that
trades more internationally compared with a closed economy that does not trade
internationally.
Topic: Balance of payments (BOP):
It is a record of money inflows from exports, investment etc. and outflows for imports,
investments etc. for a country over a year.
It has 3 accounts namely current account, capital account and financial account.
1 Current Account (Important for AS)
It is the most frequent transactions Between one country and the rest of the World. It
has 4 sections,
a) Trade in goods:
We record the inflows and outflows of Money from exports/imports of tangible Goods.
For example Pak sells sweaters to UK For 10,000$
(outflows) Debit (Inflows) Credit
10,000
Pak buys cars from Japan for 20,000$ 20,000
Balance of trade In goods 10,000$ Deficit
b) Trade in services
 59

We record the inflows/outflows from Export/import of Services

For ex, Pak student in UK University 20,000
Pak bank service Used by Americans 15,000
Balance of trade in services 5,000$ Deficit
C) Primary income Transfers:
We record the inflows/outflows
From rewards of factors of
Production. These are earned
Incomes
e.g., Rent
Wages
Interest
Profit
Incomes balance 20,000$ Surplus
D) Secondary Incomes
These are unearned incomes e.g.
Gifts of cash, charity, Govt
Spending on overseas embassies etc.
Secondary incomes balance 5,000$ Surplus
Current Account Balance 10,000 $ surplus

2 Capital Account:
It records the transfer of Ownership of non-financial Non-produced assets between
Citizens of one country and the Rest of the world.
For Example;
1 Immigrants/emigrants permanent transfer
2 Copyrights, patents, logos etc. sold/bought 3 Govt debt forgiveness
 60

3 Financial Account:
It has one-time major transactions
It has 4 sections;
a) Direct inward/outward investments Ex, Honda in Pakistan and PTC in Malaysia
Profits sent and received is recorded in current account’s primary income section
(Profit head)
b) Portfolio investment
This records the sale and purchase of shares of Public limited companies e.g. Pak
citizen buys shares in General Motors.
Dividends received and sent are recorded in current account, primary incomes under
profit head.
c) Other financial flows:
The money saved in foreign banks by domestic citizens and by foreigners in domestic
banks.
Interest received and sent on these savings will be recorded in current account primary
incomes under head of interest d) Reserves entry:
A country’s reserves consist of
Forex reserves
Gold
IMF drawing rights
If BOP is in deficit, we use reserves to balance the deficit. If BOP is in surplus, we add to
the reserves.
Balancing entry:
If there is still disequilibrium, we attribute it to human errors and omissions and balance
the account.
Topic: Government policies to correct Balance of payments (BOP) deficit/surplus;
There are 2 broad-based policy measures govt can use to correct imbalances in the
balance of payments and these are Expenditure-switching policies and Expenditure-
dampening policies.
1 Expenditure-switching policies:
 61

This is when govt tries to switch the expenditure of domestic citizens towards
domestically produced products and also tries to switch expenditure of foreigners
towards local products as well.
Expenditure-switching policies include;

• Devaluation of domestic currency (part of monetary policy already covered)

• Protectionism (includes trade barriers e.g., tariffs and quotas already covered)
• Supply-side policies (already covered)
Devaluation:
A govt will devalue their own currency to make exports cheaper, hence making them
more internationally competitive so that foreigners buy more of their exports. If demand
for exports and imports is elastic, it will improve current account balance, reduce
unemployment and accelerate economic growth.
Similarly, imports will become expensive as domestic currency can buy less of foreign
currencies, hence people will switch towards cheaper locally produced goods.
This policy will be successful only if;

• Marshal Lerner condition is met i.e., the joint demand for exports and imports is
greater than 1
• Other countries do not devalue their currencies more than the home country’s
currency
• No retaliation by other countries in form of tariffs etc. otherwise our exports will
not be cheaper and they will not gain international competitiveness
• Rise in Inflation rate does not offset the devaluation
Protectionism:
Imposing tariffs, quotas and bans on imports will reduce imports and giving exporters
subsidies will make them cheaper and more competitive in the international market.
This policy will be successful only if;

• The demand for exports and imports is elastic

• The other countries do not retaliate and impose tariffs and quotas on our exports
• The country is not part of a trading bloc such as EU, BRICKS etc.
• Local firms have the capacity of supplying according to the rise in demand for
domestic products i.e., supply is elastic
Supply-side policies
Govt can reduce cost of production and increase aggregate supply through education
and training, subsides, developing infrastructure etc. This will make domestic output
 62

more competitive in the international market and current account of balance of

payment will improve.
Better infrastructure, good quality of labour, more subsidies and deregulation will
encourage MNCs to set up in the country improving its’ financial account of BOP.
Easy immigration rules will encourage greater inward immigration of foreigners leading
to improved capital account of BOP.
There are certain limitations of these policies such as

• They are costly and there is opportunity cost of other areas where govt could
spend
• They take a long time and AS only shifts to the right in long run
• Brain drain might occur as educated workers may leave the country for high pay
in other countries
• Demand-pull inflation will occur in short run due to injection of govt spending

Past Papers Questions

Specimen paper 2023 P4 Q 4
“Devaluation of a country’s currency will reduce a persistent balance of payments
deficit on its current account in goods and services in the short run, but will inevitably
lead to high levels of inflation in the long run.”
Evaluate this statement [20]
 63

Unit 6 Employment and Unemployment

Topic 1: labor mobility
Labor mobility is the ability of workers to move from one occupation to another
occupation i.e., occupational mobility and from one location to another location i.e.,
geographical mobility.
Factors affecting occupational mobility;

• Quality of education and training

The better educated and trained the workers are on multiple skills, the easier it is for
them to switch between different occupations.

• Availability of information about jobs

The more informed the workers are about availability of jobs in occupations
experiencing increase in demand, the easier they can switch from occupations
experiencing fall in demand.

• Barriers to entry and exit

Trade unions and other professional bodies may try to restrict supply of labor in some
occupations to drive wage rate up. Workers themselves may have signed long term
contracts which may make switching to another occupation difficult.

• Time
The longer the time available for workers, the easier it will be for them to gain necessary
qualifications and skills required to change their occupation.
Factors affecting geographical mobility;

• Price and availability of housing

Workers may not be able to switch to jobs in another area due to lack of affordable
housing being available

• Availability of information
Workers will only be able to move to other areas for jobs if there is easy availability of
information regarding jobs available, wage rates etc.

• Personal ties
Workers may find it difficult to leave their family and friends to go work at another
location especially a different country.
 64

• Immigration controls
Workers may be unable to move to a job in a different country due to restrictions on
visas and work permits etc.

• Language barriers
Workers may be unable to move to a job in a different country as they cannot speak the
required language.

• Cultural differences
Workers may not move to better jobs as they may not like the culture in those countries
where jobs are available.

• Differences in pay and cost of living

Sometimes workers may prefer staying unemployed at their home due to very high cost
of living in other areas where jobs are available.
Topic 2: Full employment
Full employment is the highest level of employment possible in an economy. It is often
achieved when unemployment rate falls to 3%, although it may vary between countries,
because frictional and structural unemployment are unavoidable in a dynamic
economy.
Note: full employment is always below 100% employment of the labor force.
Topic 3: Voluntary and involuntary unemployment

Voluntary unemployment Involuntary unemployment

This occurs when workers choose not to This arises when workers are willing to
accept jobs at the current wage rate. They work at current wage, but cannot get a
can get a job, but do not because they job.
wait till, they can get a higher wage rate.
Mostly search unemployment which is Most of structural and cyclical
part of frictional unemployment tends to unemployment is involuntary
be voluntary as people wait for higher
paid job. Also, if the wage they can get
now is too close to or below the
unemployment benefits they receive.
 65

Topic 4: Equilibrium and disequilibrium unemployment

Aggregate demand for labor (ADL)
It is the total demand for labor by all firms in an economy at the given real wage rate. It is
downward sloping as firms higher less workers as real wage rate rises and vice versa.
Aggregate supply of labor (ASL)
This includes the part of labor who found and chose to accept jobs at the current wage
rate.
Aggregate labor force (ALF)
It includes;

• Those prepared to work at the current real wage rate and are able to find a job
• Those seeking better paid jobs or are in between jobs
• Those who are unable to do the jobs on offer as they are in another part of the
country or lack the skills or qualifications required

Equilibrium unemployment Disequilibrium unemployment

This unemployment exists when ADL = This unemployment exists when ADL is
ASL at the current real wage rate less than ASL and the current wage rate is
above equilibrium wage rate
There is NO pressure on the real wage There will be downward pressure on the
rate to change real wage rate
Those willing and able to work on current Some of those willing and able to work on
wage rate will have a job current wage rate will not have a job
However, some people who are part of the Reasons for wage rate to be above
labor force will not have a job. This is equilibrium wage rate are
because they are not willing to work at the • Minimum wage law
current wage rate, lack info about job • Trade union negotiation
vacancies or lack the skills required • ADL might have fallen, but workers
resisted job cuts
 66

Above figure of equilibrium unemployment shows Y no of workers are employed and YZ

are unemployed. These workers are experiencing voluntary unemployment due to
frictional unemployment e.g., search unemployment. The problem here is due to supply-
side reasons.
The ALF curve moves closer to ALS curve as the real wage rate rises. This is because
more people are willing to work now, who were previously unwilling to work as real
wage rate rises.

The figure shows unemployment of XY workers as ASL > ADL. The disequilibrium
unemployment is equivalent to cyclical unemployment.
The problem may not be solved by simply lowering the wage rate as lower wage rates
may reduce aggregate demand and as a result aggregate demand for labor and a
downward spiral maybe created.
 67

It is possible that an economy may experience both equilibrium and disequilibrium

unemployment at the same time. Following figure shows the economy experiencing XZ
unemployment, out of which XY is disequilibrium unemployment and YZ is equilibrium
unemployment

Topic 5: Natural rate of unemployment (NRU) and policies to reduce natural rate of
unemployment
Meaning
It exists when labor market is in equilibrium i.e., ADL = ASL.
Or
According to new classical economists it is the rate an economy will get back to in the
long run and there will be a constant rate of inflation. It is also known as NAIRU i.e., non-
accelerating inflation rate of unemployment.
Factors affecting NRU/NAIRU
NRU = No of naturally unemployed / Labour force * 100
Determinants of NRU:
1 Info about jobs
2 Mobility of workers
3 Level of education and training
4 Level of income tax etc.
 68

Policies to reduce NRU/NAIRU or supply-side factors

To reduce Natural rate of unemployment (NRU), govt might try to increase the
willingness and ability of workers to join jobs at current wage rate. They can use the
following policies;

• Widen the gap between low pay and unemployment benefits

This can be done by cutting unemployment benefits or reducing basic rate of income
tax.

• Removing the minimum wage law

If minimum wage law is removed, firms will hire more workers as their cost of
production falls.

• Improving education and training

A more skilled labor force is likely to find it easier to switch from one job to
another and so suffer less from structural unemployment. Training of the
unemployed can be important in overcoming the problem of “hysteresis”.
Workers who experience long periods of unemployment can lose confidence in
gaining another job and their skills may become out of date. Firms may also be
reluctant to employ someone who has been out of work for they may think the
long term unemployed will have lost the work habit and may have to be
restrained at the firm’s expense.

• Improve labor mobility

If workers are more mobile, it is likely that more job vacancies will be matched
with the unemployment
• Increase the flexibility in the labor force
New classical economist favour reducing the power of trade unions and a
national minimum wage. They argue that trade unions and a national minimum
wage can push the wage rate above equilibrium level. They also think that trade
unions can restrict the tasks workers are prepared to do, which may reduce
labour productivity. Greater flexibility by firms may also increase employment.
The more flexible firms are in terms of, for example, the hours worker can work
and where they can do work, the more workers may be prepared to accept the
jobs on offer at the current wage rate
 69

Topic 6: Patterns and trends of unemployment

Patterns of unemployment
Unemployment is not usually evenly spread. This might be because;

• There will be higher unemployment in declining or sunset industries

• It can also vary between different regions of the country due to difference in
transport links, infrastructure and housing costs etc.
• Unemployment also might be higher among younger workers due to firms being
reluctant in hiring them as they are inexperienced and need training
• Discrimination may also cause higher unemployment rates among women and
ethnic minorities etc.
A rise in number unemployed and unemployment rates might be a cause of concern for
a govt especially if people stay out of work for long as workers may lose work habits
and experience hysteresis.
Trends of unemployment
The latest trends of unemployment/employment are as follows;

• As countries develop, employment tends to change from primary to secondary to

tertiary sector leaving certain skills demand to fall and cause unemployment in
that sector
• More women are joining work force due to lesser discrimination, greater skills
and qualification gained by women, better pays and childcare provision.
• More workers are becoming self-employed due to govt policies, more startups
and internet-based businesses.
• Proportion of full-time and part-time workers varies over time due to changes in
demographic factors like if there are more single parents, they will look for part-
time work or if there is an economic downturn, people will be forced to work part-
time.
• Public and private sector employment varies from country to country. In some
countries, public sector jobs are more prestigious and pay highly, whereas in
some countries, there is more employment in private sector due to more
privatization.
• Employment in formal and informal economy
Workers in formal economy are protected by law e.g., minimum wage and health
and safety laws etc. whereas informal economy’s workers don’t receive such
protection.
 70

Past Paper Questions

O/N 18 P 43 Q5 b
Some economists argue that govt intervention is the best way to reduce natural rate of
unemployment while others suggest that it would be better to allow market forces to
reduce this type of unemployment.
Compare both approaches and assess which one is likely to be more effective. [20]
 71

Unit 7 Economic growth and sustainability

Topic: Economic Growth:
Economic Growth: This is when real GDP rises over time. It can be actual or potential
growth.
Economic Growth: Real GDP 2 – Real GDP 1 / Real GDP 1 * 100
Real GDP 2 (Current year) and Real GDP 1 (Previous year)
2020 = 103 B $
2019 = 100 B $
3% Economic Growth
Actual Economic Growth

Potential Growth:
It is when economy’s productive potential increases. This is linked to outward shift of
PPC and outward shift of long run aggregate supply. This occurs in long run due to
increase/improvement in quantity and/or quality of resources.
 72

The above graph shows potential growth through shifts of PPC and LRAS curves and
Actual growth through shift of AD curve and movement from a point “u” inside PPC to
the point “B”.
Reasons for Actual growth:
Causes of shift In AD i.e. Expansionary Fiscal and Monetary policies
Fiscal = Taxes reduce and Govt spending increase
Monetary = Money supply increase and/or Interest rates decrease and/or exchange rate
devaluation
Reasons for Potential growth:
All the factors that shift PPC outwards.
Govt uses supply-side policies
Some of these are explained below
Causes of potential economic growth
1 Exploration of new oil, gas, etc.
A country with more natural resources will have greater supply of energy sources and
their cost of production will fall causing PPC and LRAS (Long run AS) curves to shift
outwards causing potential growth
2 Use of fertilizers, hybrid seeds, modern technology etc.
This will increase agricultural productivity leading to potential economic growth
3 Education and training of labour (human capital investment or soft infrastructure)
 73

This will increase workers skills and productivity. They will be able to handle latest
technological equipment and more efficient working will cause a shift of productive
potential
4 Investment in physical capital
Physical capital refers to hard infrastructure like roads, bridges and communication
networks etc. If Gross investment on physical capital is greater than its’ depreciation
(wear and tear). Economy will experience economic growth due to reduced distribution
costs and quicker movement of resources and finished products.
5 Research and development of new technology
Latest technology developed would reduce processing time and increase potential
output
6 Increase in labour force
This could be possible in short run through positive net migration i.e., immigration into
the country of skilled workers is greater than emigration out of the country or reduced
school leaving age and increased retirement age. In the long run this may happen due to
change in population structure resulting in a larger % of younger people in the country.
Larger work force will shift the PPC outwards.
Topic 2: Combination of actual and potential growth
For an increase in productive capacity (potential growth) to lead to higher output, this
increase in capacity must be utilized through increase in aggregate demand (actual
growth). The following figure shows both actual and potential growth through increase
in AD and LRAS.
 74

The figure on the left shows an economy producing at point ‘u’ inside the PPC. Then
both AD rises to cause actual growth and LRAS (long run aggregate supply) rises to
increase potential growth and output increases to point ‘b’. Although point b shows a
higher level of output, it is still inside the new PPC (CD) showing inefficiency and
unemployment of resources. Maximum output would be achieved if the economy
produces at new PPC i.e., CD.
The above figure on the right shows increases in both productive capacity as LRAS
curve shifts outwards from LRAS0 to LRAS1 and increase in output as AD curve shifts
from AD0 to AD1. Output rises from Y0 to Y1, but at both these output levels, economy
is below maximum possible output which is the vertical part of LRAS curve.
Relationship between actual and potential growth with employment and unemployment.
Actual Growth Potential IF Employment Unemployment
Rate (AGR) Growth Rate
(PGR)
Positive Zero Rises Falls
Zero Positive unchanged Rises
Positive Positive AGR = PGR Rises Unchanged
Positive Positive AGR > PGR Rises Falls
Positive Positive AGR < PGR Rises Rises

Positive and negative output gaps

The difference between actual and potential growth is known as the output gap. It may
be negative or positive output gap.
Fig 1 (Negative output gap) Fig 2 (Positive output gap)
 75

Negative output gap Positive output gap

Figure on the left shows negative output
gap which is caused by a lack of AD.
Economy can produce at YF, but is only
producing at Y.
Negative output gap is Y to YF and there
is unemployment
It is when the economy is producing more
than its’ maximum potential through over
time working of labor and machines not
being stopped for repairs as AD is much
higher than maximum potential of the
economy
YF to Y is Positive output gap.
This cannot be sustained as at some
point machines will need to be stopped
for repairs and workers will need rest

Topic 3: Business cycle

These are the stages an economy through over time through changes in real GDP. They
happen automatically over time.

Economic Growth: This is when the real GDP rises over time.
Boom: When real GDP rises rapidly
Recession/downturn: When real GDP falls for at least 6 months or two quarters
Slump/trough: When real GDP keeps falling over an extended period of time
 76

Symptoms:

Causes of business cycle

The changes in business cycle occur due to changes in AD and AS.
Changes in AD

• Business confidence plays a role in changing AD. If businesses are pessimistic

about future, they will reduce investment. This will reduce AD, GDP will fall and
there will be a negative multiplier and accelerator effect causing a recession and
even slump. On the other hand, if they are optimistic about future, multiplier and
accelerator will work in the opposite direction.
• Money supply changes may also affect AD. If money supply reduces, there be
reduced consumption and investment causing AD to fall and result in negative
multiplier and accelerator effect causing a recession and vice versa.
• Political cycles also affect AD. Before an election govts increase their spending
and cut taxes to gain popularity causing economic growth, but after election
spending is cut causing a downward multiplier effect and may cause a recession.
Changes in AS

• Positive supply shocks such as advancement in technology that reduces cost and
increases productivity, such as artificial intelligence may increase AS causing
economic growth.
• Negative supply shocks such as a rise in worldwide price of oil or a natural
disaster or pandemics like covid-19 cause a world-wide recession due to reduced
AS causing a fall in GDP.
 77

Topic 4 Inclusive economic growth (important)

Inclusive economic growth is that is distributed fairly across society and creates
opportunities for all. It enables everyone to benefit not just particular groups of society.
There are two aspects to the benefits of economic growth being distributed fairly. One
is in monetary terms, with all experiencing rise in incomes. The second one is in non-
monetary terms, with all experiencing better opportunities in jobs generated, better
healthcare, education, safety and working conditions.
Policies to promote Inclusive economic growth
These policies seek to spread the benefits and opportunities created by economic
growth more evenly.

• Redistribution of incomes via progressive taxation and transfer payments

• High national minimum wage to ensure those in work can enjoy a good quality of
life
• Anti-discrimination laws can be used to ensure no group is excluded from the
benefits of economic growth.
• Improvement in transport and communication links to reduce geographical
immobility of labor and regional differences in income.
• Trade union legislation which gives trade unions more power to protect workers’
rights.
• Laws against slavery and child labor to ensure these groups are not exploited
Topic 5 Sustainable economic growth
Sustainable economic growth is the growth that can continue over time. To achieve this,
a deliberate and determined effort is required to balance economic, social and
environmental objectives. This is because social divides, lack of access to some people
of good education, healthcare and housing or a damage to the environment can threaten
a country’s ability to continue to produce a higher output.
Using and conserving resources
Arguments for using resources

• Using resources now can bring about economic growth, at least in the short run.
For example, cutting down trees, extracting more gas and oil, hunting animals
can increase output and create jobs
• Exports can be increased which will improve current account of balance of
payments, leading to injection of X-M into AD and may cause multiplier effect.
• More tax revenue for govt from increased production and economic activity. This
revenue can be used to improve soft infrastructure like education and healthcare
along with hard infrastructure like roads and ports etc.
 78

• Natural resources like oil, gold etc. maybe expensive now and can be sold to bring
inflows of money into the country
Arguments for conserving resources

• Tourism can be attracted by conserving resources like rainforests, wildlife and

areas of scenic beauty.
• Environment can be saved by saving rainforests etc. as they absorb carbon
emissions
• Conserving resources maybe beneficial for future generations and may develop
comparative advantage in particular products. Prices of resources maybe low
now and can be sold for higher amounts in future
Factors influencing the decision

• Whether demand for the products made by the resources is likely to increase or
decrease in the future. If it is thought that demand will fall in the future, it is better
to use them now
• If resources are non-renewable, it is important to invest the revenue from their
sales into development of projects for future growth
• It is advisable to conserve resources if the country does not have a comparative
advantage now, but maybe able to develop it in the future. For example, a country
should conserve its gold reserves if the current cost of extraction is too high.
• If the country has high debts, it might be forced into using resources now
Topic Impact of economic growth on environment and climate change / policies to
reduce this effect
Economic growth can harm the environment and speed up climatic changes.
Primary sector

• Keeping more livestock results in more emissions of methane gas. Using water
for cattle drinking will reduce water sources for future.
• More crops output through usage of fertilizers and chemicals will emit more
nitrous oxide and reducing rainforests for cultivation land will reduce carbon
absorption by trees.
• Large-scale fishing will reduce fish stocks.
• Mining can pollute rivers and nearby lands with arsenic and mercury

Secondary sector
 79

More output of manufactured goods will release greenhouse gases, e.g., burning of
fossil fuels such as coal to power steel plants can release more carbon dioxide.
Tertiary sector
Growth of tertiary sector also contributes to environmental problems and global
warming in a number of ways;

• More tourism leads to more flights and generation of greenhouse gases. There is
also destruction of areas of natural beauty and coral reefs.
• Consumption also creates environmental damage e.g., more cars on the road
creates air and noise pollution.
• Higher incomes lead to more shopping and as a result use and disposal of plastic
bags that take years to degrade in land ills, polluting worlds’ oceans.
It is certainly possible to generate economic growth with reduced damage to
environment by use of greener methods of production and planting trees.
Policies to lessen the impact (same as ones in economic efficiency chapter)

• Subsides cleaner sources of energy such as windmills and planting more trees to
absorb carbon dioxide. Subsides though have an opportunity cost and may not
be used efficiently.
• Provide information on the damage that certain activities like dumping in the
ocean can cause the environment. This might persuade people to change their
behaviour. Govts have been using nudge theory for this purpose recently.
• Pass legislations to ban production and consumption of certain products e.g.,
many countries have banned the sale of plastic shopping bags. Laws are easy to
understand and have immediate effect, however they are a rather blunt
instrument and there be cost of enforcing laws.
• Using indirect taxes on firms creating pollution is another way. In this, polluter
pays principle is applied as it turns external costs into private costs. Output levels
might come close to socially optimum levels and some of the tax revenue can be
used compensate those who have suffered.
However, govt may over or under tax due to difficulties in measuring external
costs and indirect taxes have a regressive affect.
• Pollution permits can also be used. This involves setting a limit on how much
firms can pollute and then selling them these licenses. Licenses are tradable,
hence cleaner firms who use less than the limit can sell their license to dirty firms.
This will create incentive for firms to become cleaner to reduce their costs.
 80

Past paper questions

O/N 21 / P41 / Q7 a
Explain what is meant by infrastructure and consider the view that an increase in
investment in infrastructure will promote both an increase in actual and potential
growth [20]
MAR 16 P 42 Q5 b
Consider whether the main cause of growth is an increase in population, and hence an
increase in labor supply. [12]
M/J 18 P4 42 / Q 6 a
Consider how the causes of recession may differ from causes of inflation [12]
M/J 15 P42 Q5 a
What is a recession and is it always caused by a lack of consumer spending? [12]
 81

Unit 8 Income distribution and policies to redistribute incomes and wealth

Note: We have already covered in microeconomics (last 5 pages of notes / unit 12, right
after labor market). Here is a screenshot for easy reference plus additional material
here.

Policies to redistribute incomes/wealth

We learned various govt policies such as progressive taxation, transfer payments, price
stability and negative income tax to redistribute incomes in microeconomics. Now one
more policy is being explained below.
Govt’s free provision of certain goods
Govt uses tax revenue to provide certain important services free of charge. If such
services are used by everyone, then those on lowest incomes gain the most as a
proportion of their income and inequality is lowered.
The two most significant examples of such free provision in economies are healthcare
and junior and secondary education. These markets are characterized by various market
failures. However, these failures do not, according to standard economic theory, justify
free provision to the consumer.
The justification must be on the grounds of equity. The view is that everyone should
have access to a certain level of healthcare and education regardless of income. Thus,
these services are provided free universally as a material equivalent of monetary
universal benefits.
 82

Past paper questions

O/N 21 / P42 / Q7 /b
Discuss whether fiscal policy alone can promote a more equal distribution of income.
[20]
O/N 19 / P42 / Q3 /b
Discuss how a govt’s policies towards income and wealth distribution can affect a
consumer’s demand. [20]
 83

Unit 9 Economic development part 1

Topic 1: Indicators of living standards:
There is a difference between economic growth and economic development (Living
standards). Economic growth is just monetary welfare whereas economic development
and living standards refer to quality of life e.g. health, education, well-being, happiness
etc.
1 GDP (National Income Measures)
If quantitative measures like GDP, GNP, NNI are rising the country will get benefits of
economic growth such as fiscal dividend, incomes, health and education etc. .. Living
standards rise. However, GDP has many weaknesses are a measure of living standards
(next question)
2 Human development Index: (HDI)
It is a composite measure of economic development which includes

• 1/3rd weightage to GNP at purchasing power parity

• 1/3rd Literacy index i.e., average years of schooling for a 25-year-old in a country
and his school attendance
• 1/3rd to life expectancy index i.e., how many years a new born can expect to live
If a country scores 1 HDI, it means fully developed and if the answer is 0, totally
underdeveloped
Benefits:
It is a more composite measure and shows better indication of development.
Problems
Not most commonly used
Figures not available easily
3 Net Economic Welfare/Measurable economic welfare (NEW/MEW):
This measure adjusts GDP to become a better measure of development
We add the value of hidden economy and leisure time to GDP and subtract the value of
external costs etc. from GDP.
Benefits:
It is an attempt to improve the most common measure of living standards i.e. GDP
 84

Problems
Difficult to find figures for comparisons
It involves a lot of guess work to estimate hidden economy and external costs etc.
hence becomes an inaccurate and normative measure.
4 Multidimensional poverty index (MPI)
It is a more recent and composite measure of living standards and economic
development. MPI contains 3 indicators namely living standards, education and health.
Refer to table below;

Category Living standards Education Health

1 COOKING 1 YEARS OF 1 CHILD
SCHOOLING MORTALITY
2 FUEL SCHOOL NOURISHMENT
ATTENDANCE
SANITATON
INDICATORS SAFE DRINKING
WATER
FLOOR SPACE
ASSETS

CUMULATIVE 33% 33% 33%

WEIGHTING

The six indicators of living standards are given a weighting of 33%. The two indicators of
education a total weighting of 33% and the two indicators of health a total weighting of
33%.
A family is considered to be multidimensionally poor if they are deprived in at least 33%
of the weighted indicators. This means a family would be regarded as poor if it lost a
child and has another child who is not attending school.
The aim of MPI is to help countries understand why people are poor and why some stay
poor even when incomes rise. MPI helps govts and international organizations to target
and help the poorest.
85
 86

Add MPI in the answer too!

a combination of quantitative GDP and qualitative indicators gives us a better
comparison of living standards.
 87

Past paper questions

O/N 21 / P 42 / Q 5
Q) Discuss the extent to which GDP is a useful measure of living standards [20] Repeat
question
O/N 20 / P42 / Q7 b
Discuss why alternatives to GDP are increasingly used to measure the standard of living
[20]
O/N 19 / P43 / Q7
There have been many attempts to measure changes in living standards both within
and between countries. Although some have been more useful than others, none of
these alternative measures has produced a sufficiently accurate, indicator of change in
living standards. “How far would you agree with this statement”? [20]
Unit 9 Economic development part 2
Methods of classification of countries / Characteristics of developed and developing
country:
Developed: They usually have a high real GDP per capita, high value of HDI, low
unemployment rate and a well-developed infrastructure etc.
Developing: They usually have a low real GDP per capita, low value of HDI, high
unemployment rate and a poorly-developed infrastructure etc.
1 According to levels of income:
Countries with a high GDP per head are considered developed usually above $ 12,376
per year average income and upper middle-income countries have between $4000 to
12,375
Whereas lower middle-income countries usually have low GDP per capita and ranges
between 1026$ to 4000 $ per head. Low-income countries will have less than $1025
real GDP per head.
2 Sector wise contribution:
If a country is more reliant on primary sector for jobs and income provision that means
it is less developed. There will a greater proportion of primary sector activity in GDP
Developing countries rely more on secondary i.e., manufacturing sector for output and
incomes.
When country relies more on tertiary sector, it is considered developed.
 88

3 Classification according to income distribution:

Developing countries usually have uneven distribution of incomes/wealth due to
unequal opportunities, large
inheritance for some families etc. This is also exacerbated (further increased) due high
rates of inflation. While developed countries have a more equal distribution of income
due to stable price level and more equal opportunities.
According to Kuznet curve, incomes are more fairly distributed when a country is less
developed as most workers are engaged in primary sector activities and earn similar
incomes.
As the country develops, secondary sector grows in size and importance. Some workers
get training and move to higher earning positions in secondary sector while some
remain in primary sector with low incomes, increasing income gaps.
When a country becomes fully developed, tertiary sector becomes the main source of
national income. Workers who move to work in tertiary sector earn much higher than
those left in primary and secondary sectors, causing widening of income gaps. See
figure below where real GDP is taken as an indicator of development;

As seen in the figure above, Gini coefficient was only 0.25 when the country was less
developed (low real DGP), but income gaps increased as the country developed and Gini
coefficient was at 0.75. However, as country became fully developed (very high real
GDP) income gaps reduced again to 0.25 value of Gini coefficient.
4 Share of international trade:
Developing countries generally tend to export low value primary goods e.g., vegetables,
fruits etc. and import expensive secondary goods e.g., cars, technology and high value
services e.g., education.
PED and PES for agricultural goods is inelastic which causes fluctuations in farmers’
incomes e.g., if one year there was a good harvest, but demand may have fallen due to
health scare of some fruits etc.
 89

According to Prebisch-Singer hypothesis, terms of trade for developing countries goes

against them. This is because world-wide incomes are rising and demand for primary
goods is income inelastic. Demand for luxuries is income elastic e.g., tourism, cars etc.
Therefore, the hypothesis that price of primary goods will rise slower than secondary
and tertiary items.
5 Rate of urbanization i.e., people moving from rural villages to urban cities is faster in
developing countries. This is because of prospects of better jobs, incomes, healthcare
and education opportunities. This puts pressure on sanitation, healthcare etc. resulting
in increased pollution, congestion in city centers.
Level of urbanization is high in developed countries. They are now discouraging
urbanization to avoid problems of pollution, slums and sanitation etc. Therefore, rate of
rural to urban migration is low in developed countries.

6 Population structure
a. Size of population
The key population data that is useful about current and future population structure
includes
The birth rate, the death rate, the infant mortality rate and net migration.
1. Birth rate
The birth rate refers to the number of live births per 1,000 of the population per year. For
Example, suppose that the total population of a certain country is two million
(2,000,000) and the number of new babies born is 4,000 in one year. The birth rate will
be:
Birth rate= Number of child births X 1,000
Size of population
= 4000 X 1,000 = 2% (per thousand)
2,000,000
Developing country:
The birth rate is high due to the following
Reasons :-
 90

1. Lack of birth control or family planning.

2. With high infant mortality rates, parents Tend to produce more in the hope that
several will live.
3 Parents produce more because many Children are needed to work on the land.
4 Religious beliefs that encourage large Families and discourage family planning.
5. Early marriages
6. Multiple marriages
Developed country
Falling birth rate may be due for:
1. Family planning, availability of contraceptives, sterilization, abortion and other
government incentives.
2. A low infant mortality rate putting less pressure on families to have more children.
3. Increased industrialization and mechanization so that a smaller work-force is needed.
4. More educated people who are aware of the opportunity cost of having more children.
5. An increased incentive for smaller families.
6. Increased desire for material possessions such cars, holidays, bigger homes and a
lesser desire for large families.
7. Emancipation of women, enabling them to develop their own careers rather than being
solely child bearers.
2. Death rate
The death rate refers to the number of deaths per year per 1,000 of the population.
Death rate: Number of deaths × 1,000
Size of population
Developing country:
Death rates are high for the following reasons:
1. Diseases and plague.
2. Famine, uncertain food supplies and poor nutrition.
3. Poor hygiene, lack of clean drinking water and proper sewage disposal.
4. Lack of medical facilities such as hospitals, doctors and medicine.
 91

Developed country:
The fall in death rates may be due to
1. The availability of better medical facilities.
2. Improved sanitation and water supply
3. Improvements in food production, in terms of quality and quantity
4. Better transportation facilities so that food and medicine is available in all parts of
the country.
5. A drop in child mortality rates.
6. A rise in overall literacy rate.

3. Net Migration
Net emigration means that more people emigrate (leave) than immigrate (arrive). Net
immigration means that more people immigrate than emigrate.
Net migration = Immigration – emigration
Net migration depends upon:
1. Relative job-opportunities home and abroad.
2. Political reasons.
3. Religious reasons
4. Personal preferences
4. Natural Increase
Natural increase in population refers to the difference between the birth rate and the
death rate. It could be positive or negative, depending on whether the birth rate is
greater than the death rate or otherwise.
Natural increase in population in a country = Birth rate – Death rate.
It does not include migration of population, for example, if the birth rate and the death
rate of a country are 25 and 20 respectively, the natural increase would be 25 minus 20
which is equal to 5 per thousand.
If the population of a country is 150,000 and its birth rate and the death rate are 10 and
7 Respectively, the natural increase in the population in a year is calculated as follows: -
 92

Natural increase = 10-7 = 3 per thousand

In relation to the entire population of 150,000, the natural increase would be:
= 3 X 150,000 = 450 people per year
1,000
A natural increase in population is said to occur if the birth rate is higher than the
mortality rate (Death rate).
Total or actual increase in population
Total or actual increase in population of a country refers to the total increase in the
population of a country over a year due to natural increase plus net migration. Thus, it is
equal to:
Total increase in population = Natural increase + immigration – emigration

Birth rate Death rate Birth rate Net migration Size of

Vs population
Death rate
0 0 - Positive
>0 0 - 0
0 >0 - 0
>0 >0 Birth rate = 0 Unchanged
Death rate
>0 >0 Birth rate = 0
Death rate
>0 >0 Birth date = Positive
Death rate
>0 >0 Birth rate = Negative Uncertain
Death rate

Whether an increase in the size of a population brings economic advantages or

disadvantages depend very much on the size of the existing population in relation to the
availability of other economic resources, i.e. whether it is above or below the optimum
size.
B Optimum Population
Optimum population is that level of population, which, when combined with the other
factors of production, i.e., land, capital and enterprise, gives the maximum output of
goods and services per head of population. It is the most efficient level of population
because it gives maximum output per head. It also gives the highest per capita income.
 93

In diagram above, the population level at less than 45 million represents under-
population, i.e., less than optimum population meaning that the population is too small
to make effective use of other resources. The country would benefit by increasing its
population size. The population level at over 45 million will be considered more than
optimum. An over-population in a country means that the population is too large and
other resources are unable to support the population properly. The country would
benefit by reducing its population.
Countries that are over-populated or under-populated will have a lower per capita
income than what can be achieved with optimum population.
Factors determining size of optimum population
The optimum population depends on the state of technology and the stock of capital.
Increase in the national stock of capital, improvement in the techniques of production
and the fertility of land all contribute towards increasing the optimum population. Most
developing countries like India and China are over-populated. New Zealand and
Australia are under-populated.
A change in the state of technology will affect the size of optimum population because
resources can be more efficiently employed even without population changes. The
population density, i.e., the number of persons per square mile does not convey the true
picture to an economist. For example, a country like Japan with 300 persons per square
mile will be considered under-populated while a poor country with just 20 persons per
square 20 persons per square mile may be over-populated. This is because factors such
as the supply of fertile land, technology and capital must all be taken into account.
An under-populated country can increase productivity by increasing its population while
an over-populated country can increase productivity by reducing its population.
When a population grows due to an excess of births over death, there will be an
increase in the numbers in the dependent age group. A high dependency ratio is adverse
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for economic development because the resources needed to care for children and
educate them could have been used for industrial investment and training purposes.
An expanding population will create increased demand for goods and services which in
turn will lead to increase investment and higher employment, thus resulting in
economies of scale in production and fuller utilization of the infrastructure of the
economy.

C Economic development and population structure

Developing country:
Low development is often associated with high rates of population growth.
This is due largely to natural increases in population size with the birth rate exceeding
the death rate.
The higher birth rate of countries with low development results in a relatively low
average age of population. This creates a high proportion of dependent, non-productive
members of the population. They are said to have very high dependency ratios. This
means that a proportionally small working population has to produce enough goods
and services to sustain not only themselves but also a large number of young people
who are economically dependent upon them.

Developed country:
As countries develop, the growth in their populations tend to decline.
while their death rate decreases, their birth rates fall at a greater rate. Some countries
with a high income per head and high development experience a natural rate of
decrease in population. A number of these still experience a rise in population because
they attract net immigration.
However, high development does not eliminate population problems - it just brings
new ones. The most common problem is of an ageing population. This arises from a
decreasing birth rate and a decreasing death rate. Again, dependency ratios are high,
this time because there is a high proportion of old people who are reliant upon the
productive proportion of the population for support.
 95

With people living longer, the cost of health care and pensions have been rising. To
reduce the cost of pensions, a number of governments of developed countries have
increased the retirement age.

Past Paper Question

MAR 21/P42/Q5/b
Rising population levels in a developing economy create many problems while falling
population levels in a developed economy cause even greater problems. To what extent
do you think this is a true statement?
Discuss how economies are classified into developed/high income countries and
developing/low-income countries [20]
 96

Topic: Reasons for low levels of development:

1 Poor natural resources:
Some less developed countries lack good “factor endowment”. The unavailability of
good natural resources, e.g., mineral resources, climatic conditions. Therefore, they are
unable to develop
2 Lack of investment / Lack of developed human capital:
Due to low levels of investment in education and healthcare, the level of human capital
is poorly developed. This results in lower productivity and hinders growth. When
incomes are low it is difficult for people to save so investment continues to be low. A
vicious circle of poverty or poverty trap develops as seen in the figure below;

It becomes very difficult for a country to break out of this circle without outside help.
3 High population growth:
If population is more than resources, the country becomes over populated and
dependency ratio rises. The resources and GDP gets divided over a larger population
and per capita GDP falls
4 Disadvantage in international trade:
Most less developed countries rely on exports of low value primary goods and
importing cars, technology and services which are very expensive.
The income elasticity of demand for primary goods is inelastic and for luxuries and
services is elastic. Therefore, demand for primary is increasing slower than that of
luxury services.
5 Huge foreign debt: The debt-servicing i.e., paying back the interest is around 60-80%
of GDP for some countries. Therefore, very little remains to be spent on human and
physical capital etc.
 97

6 Underdeveloped primary sector: Many developing countries have been unable to

develop good irrigation and farming techniques, resulting in poor output and quality of
raw materials etc.
7 Other reasons:

• Corruption
• Political interference
• Dictators
• Civil wars
Topic: Policy approaches to economic development:
1 Invest more in Human capital:
More to be invested in education, healthcare etc. Productivity increases and potential
growth will incur.
2 Develop financial markets:
Reforms should be placed to improve the banking sector alongside a fully functional
stock exchange etc.
3 Infrastructure development:
Better roads, communication networks will improve distribution and costs for
businesses will fall making them more internationally competitiveness
4 Development of primary based industries
5 Set up import substituting and export-oriented industries
6 Attracting Multi-nationals: (next chapter fully explains this)
7 Foreign aid: (next chapter fully explains this)
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Unit 9 Economic Development Part 3 (relationships between countries)

Topic 1: International aid
a. Forms of foreign aid
Foreign aid can take a number of forms. It may be as a grant, a loan at reduced interest
rate, technical assistance or direct provision of goods and services. Aid can be tied or
untied, bilateral or multilateral.
1. Grant vs loan at reduced Interest rate
Grants are the financial assistance that is non-repayable in nature. Loan means a sum
of money borrowed from another country or international financial institution that
requires repayment along with the interest. Loan at a reduced interest is form of help to
a developing country form a developed country or international financial institution.
2. Tied aid vs untied aid
Tied aid is aid that comes with conditions. For example, a grant may be given provided
that it is spent on buying products from the donor country. Untied aid is aid given
without conditions.
3. Bilateral vs multilateral aid
Bilateral aid is aid given by one country to another country. In contrast, multilateral aid is
aid given by countries to international organizations such as the World Bank or United
Nations (UN) agency, which then distributes it to other countries.
4. Technical assistance vs direct provision of goods and services
Technical assistance support that facilitates the preparation, financing, and execution
of development projects and programs. It helps developing countries improve their
capacities and make better use of their development resources. It includes capacity
development, policy advice, and research and development.
Developed countries may provide consumer and capital goods to countries in need e.g.,
crisis aid.

b. Reasons for giving foreign aid

It might be expected that most aid would go to the poorest countries, but this is not
always the case. This difference in the countries that would be expected to receive the
most aid and those that actually do reflects the different reasons for giving aid.
1. To support donor country’s infant industries and exports.
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Tied, bilateral aid may be given to promote the industries of the donor country. A
government may seek to increase the growth of an infant industry by requiring the
recipient country that receives the aid to spend on products from its country. For
instance, the donor government may provide money for the recipient to buy tractors.
The donor government may insist that the recipient imports tractors from firms in the
donor’s country, even if cheaper or better-quality tractors are available from firms in
other countries.
Tied aid directly increases demand for the donor country’s exports, but untied aid may
also be given in the hope of increasing the donor country’s exports. If aid does promote
economic growth in the recipient country, it is likely to result in the recipient country
buying more imports. The recipient country may be more inclined to buy from the donor
country's industries if good relationships have built up as a result of the aid giving.
2. To gain political influence
A motive behind some bilateral aid is to gain political influence. A recipient government
may feel obliged to support the donor government in its disputes with another country
or countries: for instance, a donor government may be imposing trade restrictions on
another country 2" may put pressure on the recipient country to do the same.

3. To influence the economic policies of the recipient countries

Both bilateral and multilateral aid may be given to influence the economic policies of
the recipient government. For example, a government may give aid to another country
on condition that it ends the use of child labor or that it reduces its budget deficit.
4. For humanitarian motives
Both bilateral and multilateral aid can be given for humanitarian motives, that is out of a
desire to do good. This may be the case with crisis aid, that is aid given to save lives
during natural disasters and famines. Governments and international organizations can
also recognize that the development of other countries can increase global GDP and
international trade and reduce the risk of negative external shocks
b. The effects and importance of foreign aid
Advantages
Aid can help the recipient country to experience increases in its income per head and
development. Aid can provide the investment, or the finance, for education, healthcare
and new industries that the recipient country may be lacking.
Investment may not be easy for some low-income and middle-income countries to
achieve. This may be because of the lack of savings and the lack of financial
 100

institutions to channel those savings that do exist from lenders to entrepreneurs

wanting to establish new firms and to expand the output of existing firms. There may
also be a shortage of entrepreneurs. However, if investment can be encouraged, a
virtuous cycle may be created as shown in Figure below.

A number of countries rely heavily on aid. For example, in 2019, 40% of Burundi income
came from aid.

Disadvantages
1. Heavy reliance on aid can have a number of disadvantages. Some forms of aid can
result in countries becoming increasingly indebted.
2. In some cases, low and middle-income countries transfer more money to high-
income countries in terms of interest on past loans (even if given on favorable.
terms) than they are currently receiving in aid.
3. Advice given and policies suggested or imposed on low and middle-income
economies by international organizations, such as the International Monetary Fund
(IMF) and the World Bank, are not always suitable given the conditions in the low
and middle-income countries. For example, it may not be the best advice to
recommend an economy use capital intensive methods when it has a shortage of
capital but lots of labor. In addition, requiring a government to cut spending on
primary education to cut a budget deficit may harm an economy's development and
longer-term economic growth prospects

Topic 2: The role of multinational companies and foreign direct investment (FDI)
(Important)
A multinational company (MNC) is defined as a firm that operates in more than one
country An MNC is a business with a parent company based in one country but with
production or service operations in at least one other country. The largest MNCs are
global operations, with manufacturing and retail outlets in many countries of the world.
 101

Examples of the largest MNCs include Apple, Huawei, Samsung, Tata, Toyota and
Unilever. The activities of MNCs on the economies of the host countries have been the
subject of much debate and discussion by economists and politicians.
Through their activities, MNCs provide foreign direct investment (FDI) to the economies
in which they operate. Foreign direct investment (FDI) means the setting up of
production units or the purchase of existing production units in other countries. FDI,
therefore, involves capital flows between countries. It should not be confused with
portfolio investment, which is the purchase of shares by foreign investors in businesses
that are located in another country. Low-income and some middle-income countries
lack savings to finance investment. Foreign direct investment can overcome this
shortfall; MNCs can purchase capital equipment and help to develop the country's
infrastructure. Some countries attract large inward flows of FDI. These tend to be
countries that are expected to grow rapidly and so provide large markets for the MNCs’
products or ones with low costs of production or abundant supply of raw materials.
There is a range of measures that governments take to attract FDI. These include low
corporation tax, a good education system, few rules and regulations for firms and
government subsidies.
The presence of multinational companies (MNCs) may bring a number of benefits to a
developing country.
Advantages of MNCs and FDI:
1. May bring in up-to-date technology which local firms can copy.
2. Modern management techniques and new ideas which local firms can copy.
3. Provide employment however MNCs are mainly high technology. capital-
intensive firms, although of course this means that the number of jobs they
create are not that high.
4. . Training of domestic workers
5. Contribute to the country's infrastructure.
6. Will improve balance of capital and financial account of host country when they
bring capital and financial inflows.
7. May improve balance of current account if MNCs export to neighboring
countries.
8. May improve balance of current account as many products are no longer
imported because they are now produced by the MNCs.
Disadvantages of MNCs and FDI:
1. MNCs may not create higher employment and higher incomes if they replace
domestic firms
2. They may deplete non-renewable resources
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3. May create pollution

4. They may contribute to economic growth but not to sustainable economic
development.
5. They may also send most of their profits back to their home countries and may
worsen Current account balance
6. Imports of raw materials and services purchased by the MNCS -from abroad will
worse” Current account balance
7. May employ foreign rather than home labor, especially in the top-paid jobs and will
also worsen current account balance
8. Their mobility and considerable economic powers’ mean that they often negotiate
favorable tax breaks and exemption from some environmental laws
9. Some of the products they sell may not improve people's living standards. For
instance. faced with declining sales in their home markets, a number of European and
US tobacco firms are now putting considerable time and effort into marketing their
cigarettes in Asian and African economies.

Past Paper Questions

ON 21/P41/Q6
‘In developing economies an increase in GDP determines an increase in the standard of
living. Foreign direct investment (FDI) will produce an increase in GDP therefore
governments in developing economies should encourage FDI,’
How far do you agree with this statement? {20}
ON 20/P42/Q6
“Investment by multinational corporations (MNCs) in a developing country always
promotes sustainable economic growth in that country.” Discuss. {20}
MJ 20/P42
Assess the view that foreign direct investment remains the key to economic growth in
developing countries. [20]
M/S 19/P41/Q7/a
Assess the impact of foreign direct investment (FDI) on developing economies. [20]
 103

Topic 3: The causes and consequences of external debt

External debt includes loans which have not been repaid and interest payments on
loans which have not been made to foreign banks, foreign governments and _
international organisations. More than 40% of low-income countries are heavily
indebted to other countries and international organisations.

a. Causes of external debt

There are four main reasons why countries get into debt.
1. Structural current account deficit
One is that the country has a structural current account deficit. Even in good times, the
country may spend more on imports than it earns from its exports or may have net
outflow of primary and secondary income.
2. overconfidence in the value of loans it could repay
A second reason is that the country may have been overconfident in the value of loans it
could repay. With this overconfidence, country may borrow more than it can pay back in
given time and add up to its external debt.
3. Use of the funds borrowed
A third, connected reason is that good use is not made of the funds borrowed. A
government may, for instance, estimate that investing the loan in building up a new
industry may give a return of 8% while the interest on the loan is 5%. If it has
miscalculated, and the return is 3%, the government will have problems making the
interest payments.
4. Unexpected events
The fourth reason can cause a significant rise in external debt: unexpected events can
occur. For instance, there could be an unforeseen depreciation of the exchange rate.
This would be likely to increase debt repayments as interest is usually paid in dollars.
 104

There may also be negative demand and supply-side shocks. For example, there may be
a global recession reducing demand for the country's exports or a natural-disaster
reducing the supply of its exports and creating a need for greater assistance.

b. Impact of external debt

1. Less funds for welfare and growth
External debt can be a major obstacle to future economic development. As mentioned
earlier repaying the debt can divert funds away from improving the welfare of the
population ang increasing the economy's growth potential.
2. Difficult and expensive to attract more funds
A high level of external debt can make it difficult and expensive for low-income and
middle-income countries to attract more funds for development. A country’s credit
rating may be reduced, resulting in the country being charged a higher interest rate.
Some governments reduce their ability to borrow more in the future by defaulting
(refusing to pay) on past loans. These governments may consider that, for instance,
avoiding cutting spending on education and healthcare may be more important than
meeting their obligation to repay loans.

Topic 4: The role of the International Monetary Fund and the World Bank
The International Monetary Fund (IMF) and the World Bank are two of the best known
ang most influential international organizations.
The International Monetary Fund
The International Monetary Fund (IMF) was set up in 1944 to help promote the health of
the world economy. The IMF's headquarters are in Washington, DC. In 2019, the IMF had
189 members. Not all countries are members. Cuba and North Korea, for example, are
not members.
The primary aims of the IMF include:
1. To promote international monetary cooperation
2. To facilitate the expansion and balanced growth of international trade
3. To promote exchange rate stability
4. To assist in setting up a multilateral system of payments
 105

5. To make resources available (with adequate safeguards) to members

experiencing balance of payments difficulties.
These activities have been central to the development of global trade since a stable
system of international payments and exchange rates is necessary for trade to take
place between two countries.
In carrying out its responsibilities, the IMF has three main functions, which are ‘known’
as surveillance, technical assistance and lending. The first two are in line with-its
mission of promoting global growth and economic stability by encouraging countries to
adopt sound economic policies. The third function is used where member countries
experience difficulties in financing their balance of payments.
The World Bank
The World Bank was established in 1944. Its initial aim was to help rebuild European
countries devastated during World War Il. Like the IMF, the World Bank’s headquarters
are in Washington DC. There were 189 member countries in 2019.
The World Bank has set two goals for the world to achieve by 2030:
1. To end extreme poverty by decreasing the percentage of people living on jess
than $1.90 a day to no more than 3 per cent, and
2. To promote shared prosperity by encouraging income growth of the bottom 40
per cent of every country.
The World Bank offers support to low and middle-income countries through internal
investment payments such as building new roads, improving infrastructure and
constructing new health facilities.
The World Bank Group comprises five institutions. These are:
1. International Bank for Reconstruction and Development (IBRD)
2. International Development Association (IDA)
3. International Finance Corporation (IFC)
4. Multilateral Investment Guarantee Agency (MIGA)
5. International Centre for Settlement of Investment Disputes (ICSID).

The IBRD assists middle-income and creditworthy poorer countries while the IDA
focuses on the poorest countries. Grants are only provided to the world’s poorest
economies. Loans cover areas such as:
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• Health and education in order to enhance human development in a country for

improving sanitation and combating HIV/AIDS
• Agriculture and rural development for irrigation programs and water supply
projects
• Environmental protection for reducing pollution and for ensuring that there is
compliance and pollution regulation
• Infrastructure roads, railways, electricity
• Governance for anti-corruption reason

Loans tend to be linked to conditions that involve wider-reaching changes being

made to the economic policies of the recipient economies. The IMF and World Bank
have been criticised for imposing the so-called ‘Washington Consensus’ on
middleand low-income countries. The Washington Consensus was devised by a US
economist, who proposed ten economic policy prescriptions. These policy
prescriptions, which include privatisation, deregulation and trade liberalisation, are
based on increasing the role of market forces. Such an approach may increase
efficiency, which would increase productive potential. However, it may increase
income inequality, and may not work if the problem that is holding back development
is not too much government intervention but market failure and lack of financial
markets.
Policy Approaches for Economic Development
A government can adopt a number of policies to promote development.
1. Increasing agricultural productivity
The role of agriculture in improving economic development has tended to be
overlooked in the Past. This was, in part, because of the income inelastic
demand for food and the volatility of supply, discussed above. However,
increasing productivity in agriculture, as part of a development strategy, can
stimulate demand for manufactured products, for example tractors, increase the
nutrition of the population, reduce costs to any food processing and other firms
in the country, for example textiles and tobacco firms, and increase export
earnings, some of which could be spent on imported foreign capital goods.
2. Export-oriented industrialization
Export-oriented industrialization (EOI) involves an outward ‘orientation of
development, opening up the country to international trade by removing trade
barriers. However, prior to this, local industries are to be built up behind tariff
walls.
3. Import-substituting industrialization
 107

Import-substituting industrialization (ISI) involves protecting infant industries by

means of tariffs until they have built up a comparative advantage. In this case
imports are gradually replaced by domestically produced products and a more
diversified industrial structure is built up.
4. Increasing Investment
If investment can be encouraged, a virtuous cycle may be created as shown in
Figure below,

Virtuous cycle: the links between, for example, an increase in investment, increase in
productivity, increase in income and increase in saving. However, developing
countries find it difficult to arrange funds needed for investment.
5. Attracting foreign direct investment of Multinational Corporations
One way that developing economies can achieve a rise in investment is to attract
multinational companies. However, MNCs may not be helpful in sustainable
economic development and may cause current account deficit when take profits
back to home country.
6. Developing the tourist market
Tourism is the fastest growing industry in the world. It also benefits from having
high-income elasticity of demand. However, tourism tends to create low income and
low skilled jobs. There are also a number of potential disadvantages of building up a
tourist industry. It can damage the environment, result in clashes with the native
culture and can displace local industries.
7. Population control
A high birth rate results in a high dependency ratio (i.e., a high proportion of non-
workers dependent on the labor-force). Not only do the children have to be
supported, but so do the mothers (or, less commonly in developing countries,
fathers) for the time they are raising their children on a full-time basis. Also as noted
above, it creates a high need for social capital. However, population control
programs, including the provision of information of contraceptive methods and
 108

incentives to limit family size, are not always easy to operate because they
frequently come up against opposition on the grounds of religion and culture.
8. Applying for aid and external loan
Foreign aid can assist development if it is used in high productive projects which take
into account the resource endowment of the country. A developing country may
borrow from industrial countries in order, for example, to spend on investment, both
in capital goods and human capital. It may look to foreign banks because the supply
of domestic funds is low due to low savings.
If the money borrowed does result in the development of new industries and
increases in productivity, sufficient income may be used for non-productive purposes
such as military programs, that some projects may prove to be unprofitable and that
interest rates rise.
There are a number of other reasons why developing countries may experience
difficulties in paying Interest and repaying the capital sum. Those include natural
disasters and changes in exchange rates. Many developing countries have significant
levels of debts. This can result in more Money flowing out of the developing
countries into industrial countries than the other way around-a redistribution of
income from the poor to the rich. This restricts development
9. Increasing International trade
There are a number of reasons why international trade can act as an engine for
growth. It can improve supply Conditions and can reduce costs. Which can lead to
more efficient production. However, those developing economies that have
specialized in agricultural products have been at a disadvantage in trading relations
since the prices of agricultural products have declined relative to prices of
manufactured goods and services over time.
MJ 22/P41/Q5, MJ 22/P43/Q5
With the help of the circular flow diagram discuss how a policy of exported growth
might affect the standard of living in a developing economy. (20)
MJ 19/P41/Q7/b
It’s often stated that the problem of ‘vicious cycle of poverty’ exists in developing
countries. Explain what this means and discuss how this problem might be solved
MAR 18/P42/Q7
Some developing counties pursue export-led growth and argue that the overall
growth of the economy Can be generated Not only by increasing the amounts of
labour and capital but also by expanding exports
 109

Other developing countries prefer to promote growth by encouraging investment by

foreign multinational corporations Compare these approaches which is likely to be the
more effective. {20}
 110

Unit 10 Globalization?
Globalization involves the world becoming one market as a result of a reduction in the
barriers to the movement of goods and services, direct and portfolio investment and
workers. The world is becoming more like one country where there are fewer
restrictions on where people buy products from, where they set up firms and where they
work.
There is currently more restriction on the movement of workers, but a number of
countries are heavily reliant on migrant labor and within trade blocs there is usually the
opportunity for workers to work and stay in any member country.
a. The causes of globalization
The breaking down of barriers between product, capital and labor markets in different
countries has resulted from four main reasons.
1. Advances in communications and technology:
This has made it easier for firms to keep in contact with their production plants from a
greater distance and to co-ordinate the production process across the world. As a
result, there has been a growth in the number and influence of MNCs. Advances in
communications and technology have also made it easier for households to buy
products and firms to sell their products to countries throughout the world.
2. Improvements in transport: Greater speed, more reliability and lower cost of transport
have made it cheaper and easier to move parts between factories and for households to
buy goods from other countries.
3. Free trade: Removing tariffs, for instance, enables firms to compete on more equal
terms and so can promote international trade.
4. The fourth reason is the removal of restrictions on the countries in which a firm can
base part of its production. Some countries still have some limits on, for example,
foreign firms buying out domestic firms or foreign firms setting up in the countries, but
these limits have declined in recent decades.
b. Indicators of globalization
Globalization can be measured in several different ways.
1. How world trade has grown in comparison to world output. The world trade to world
output ratio is also examined.
2. Another indicator is the exports to GDP ratio of different countries. This can indicate
how integrated individual countries are in the global economy.
 111

3. Flows of portfolio and direct investment can be examined.

4. A popular indicator is the FDI to GDP ratio. This again can be measured for an
individual country or for the world.
5. Flows of migrant workers and international migration of figures are also considered.

c. The consequences of globalization

Advantages
Globalization can drive economic growth. It can encourage countries, and regions within
those countries, to specialize in what they are best at producing. A country that makes
greater use of comparative advantage should increase global output which can, in turn,
increase living standards
Where firms in different countries are allowed to compete on more equal terms, through
the removal of trade restrictions and lower transport costs, lower prices which would
increase consumer surplus. Consumers may also benefit from a greater variety of
products.

The free movement of direct and portfolio investment has the potential to reduce
income inequality between countries. If, for instance, an MNC sets up in a low-income
country, it may help to raise productivity and wages throughout the country.

Disadvantages
However, there are some potential disadvantages of globalization. One is that it can
create structural unemployment. This is because while opening an economy to greater
international competition will cause some industries to expand, it will also cause some
industries to decline. If workers who lose their jobs are not mobile, they may remain
unemployed for some time.
Countries are more susceptible to demand and supply-side shocks when they become
more closely linked with other economies. These may be negative shocks. For instance,
a natural disaster in a major supplier of a country’s raw materials could cause disruption
to the output of one of its important industries.
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The free flow of portfolio and direct investment will create the risk that it can be
withdrawn quickly, causing a negative multiplier effect.

The increase in competition from other countries and greater mobility of factors of
production can constrain domestic government policy. If, for instance, other
governments are setting low tax rates, it may make it difficult for a government which
wants to spend more to reduce poverty in the country. There is the possibility that there
may be a reduction in the provision of social welfare.
Globalization may also make it difficult for a government to implement stricter pollution
controls, as some MNCs may threaten to leave the country. Globalization creates a
greater need for international co-ordination of policies, but this is not always easy to
achieve.

Just as some individuals in a country can benefit while others lose out, some countries
gain, and some countries can be disadvantaged by globalization. A number of countries
have lost out on the benefits of globalization. For example, in recent years, Burundi has
experienced very low and negative economic growth and exports only 5% of its GDP

Topic: Trade blocs

International economic integration is when countries merge their economic affairs and
become more interlinked or trade bloc means regional regrouping of countries that have
preferential trade agreements between member countries.
a. Types of trading blocs
The following are four of the main trading blocs, each with a deeper stage of economic
integration
a. Free trade areas
in a free trade area, the governments of the member countries agree to remove trade
restrictions between each other. The members are allowed to determine their own
external trade policies towards non-members and do not share a common external tariff.
An example of a free trade area is the one between the USA, Canada and Mexico. The
three countries signed the US-Mexican-Canadian Agreement (USMCA) in 2019. This
replaced the North American Free Trade Agreement (NAFTA), which was signed in 1994.
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b. Customs union
A customs union goes a stage further than a free trade area in terms of economic
integration. As well as removing trade restrictions between members, members of a
customs unions agree to impose a common external tariff on trade with non-members.
The world’s oldest customs union is the Southern African Customs Union (SACU).
which was established in 1910. Its members include Botswana, Lesotho, Namibia,
South Africa and Eswatini. These countries impose the same tariff on goods being
imported from outside the trading bloc. The countries share tariff revenues and
coordinate some trading policies.
c. Monetary union
A monetary union includes even more economic integration. In this case, restrictions are
usually removed on the movement not only of goods and services, but also capital and
labour. The aim is to create a single market across members. The Key feature of a
monetary union is that the member countries all use the same currency and follow the
same monetary and exchange rate policies.
The European Union (EU) is even more integtated. It operates a single market and its
members have adopted the same policies on a number of labour market and social
issues. Many of the members have adopted the same currency, the euro, and the
European Central Bank operates a single interest rate.
d. Full economic union
A full economic union is the final stage of integration. A full economic union involves the
members having the same currency and following the same monetary, fiscal and
exchange rate policies. In effect, the different economies become one economy. This
occurred when the 13 original states formed the United States of America in 1776.

Topic: Consequences of formation of trading blocs:

a. Trade creation
Trade creation occurs where high-cost domestic production is replaced by more
efficiently produced imports from within the trading bloc.
Membership of a trade bloc may give rise to trade creation. This occurs when the
removal of tariffs allows members to specialize in those products in which they have a
comparative advantage. More expensive domestic products can be replaced by imports
from another member country that are lower in price. The efficient firms within the trade
bloc will be able to sell to a larger market and this may enable them to lower prices even
further because they will be able to take greater advantage of economies of scale.
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Figure below shows the effect of trade creation. Before joining the trade bloc, the price
of the product in the country is OP1 and the quantity consumed is OQ2. Of this amount,
OQ1 is supplied by domestic producers and Q1Q2 amount is imported. When the
country joins the trade bloc, it can import the product without paying the tariff. This
pushes down the price to OP2 and the amount consumed increases to OQ4 Consumers
clearly gain from the lower price and the greater quantity consumed.

Domestic producers lose as their sales fall and they gain a lower price. They may,
however be shifting resources to making products that have now become more price
competitive relative to those of member countries because of the removal of other
tariffs, indeed, trade creation permits both imports to be purchased more cheaply but
also additional exports to be sold as other members lose their tariff protection. The
domestic government will lose out on tariff revenue but there is nevertheless a welfare
gain. The lower price increases consumer surplus by a, b, c and d amount. Producer
surplus falls by an amount of a and tariff revenue by an amount of c, giving a net gain of
an amount equals to b and d.

b. Trade diversion
Trade diversion means where trade with a low-cost country outside a customs union is
replaced by higher-cost products supplied from within.

Trade diversion occurs when membership of a trade bloc results in a country buying
imports from a less efficient country within the trade bloc rather than from a more
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efficient country outside. This results in a less efficient allocation of resources. Efficient
countries outside the trade bloc may lose as they are not now able to trade on equal
terms. A country joining the trade bloc may also lose.
Figure below shows that originally the country (UK) buys a product (butter) from the
most efficient country (New Zealand) and places a tariff on imports of the product.

Before the UK, joined the EU it had a common tariff on all butter import, and bought
from low-cost New Zealand at price P1 including the tariff. The price paid is P1, quantity
consumed is Q2 and the tax revenue earned is C + H. When the country joins the trade
bloc, trade is diverted to a member country like Denmark.
After joining EU, UK can benefit from tariff free imports from Denmark and other EU
producers. The price to consumers falls to P2 and quantity consumed rises to Q4. It
gains consumer surplus of a + b + C + d and UK dairy farmers lose the producer surplus
of ‘a’. The loss of tariff revenue from imports from New Zealand is C + H.
There will be a net loss from trade diversion if b + d (the net gain in consumer surplus)
is less than H (the loss of tariff revenue from New Zealand imports).
A net gain from trade diversion will be if b + d is greater than H.
Past Paper questions
Nov 2012/P21/Q4
Explain the different types of economic integration and discuss whether it is always
beneficial for the countries. [20]