Mulungushi University

SCHOOL OF SCIENCE, ENGINEERING AND TECHNOLOGY

DEPARTMENT OF ENGINEERING

CIE 421 – ENGINEERING MANAGEMENT &

SOCIETY I
(PRE-REQUISITE – N/A)

FOURTH YEAR 1ST SEMESTER– CIVIL ENGINEERING

LECTURER: MICHAEL M. KOPULANDE

BENG (CIVIL), MSC ENG. (STRUCT), MSC. (INFRA. & MGT), MEIZ, R.ENG.
 ECONOMIC CONCEPTS

• LETS THINK THE ECONOMY;

• WHAT DO YOU UNDERSTAND BY THE TERM “ECONOMY”?
• WHAT IS “ECONOMICS”
• WHY IS IT IMPORTANT THAT AS AN ENGINEER, IN PARTICULAR A CIVIL ENGINEER YOU SHOULD BE MORE
THAN CONVERSANT IN ECONOMIC MATTERS?
• WHAT EFFECTS ARE YOUR DECISIONS AS A CIVIL ENGINEER AFFECT THE ECONOMY?
• LET US THINK AGAIN – FINANCE, ECONOMICS, ACCOUNTANCY…….WHAT ARE THEY AND WHY ARE THEY
RELEVENT TO YOU AS AN ENGINEER?
• THE STUDY OF ECONOMICS IS DIVIDED INTO TWO SECTIONS; MICRO & MACRO ECONOMICS, WHAT ISSUES
DO WE SPECIFICALLY LOOK AT IN THE TWO SECTIONS?
 INTRODUCTION

• Economics is a discipline which deals with the broad issue of resource allocation.
• At its core, an ongoing debate is raging over the question of how best to organise economic activities
such that the allocation of resources will achieve that which society desires.
• Individually, economics affects our livelihood as we all make decisions on how our resources can be
allocated.
• Think about the number of things you would want to have to make your life better, think about the
amount of money you earn, can you afford to have all your wants? How then can you decide to allocate
your finances to your unlimited wants?
 DEFINING ECONOMICS
• Economics is a study of human behaviour, how they allocate limited resources to their unlimited wants. It is
mainly concerned on how society makes choices under the conditions of scarcity of resources. Economics is
about deciding what, how and for whom to produce.
• According to Brue et al (2010, p43) a market system will have to decide on the specific types and quantities of
goods to be produced.
• Therefore only goods and services that are produced at continuing profit will be produced. The “How” question
is a decision based on what combinations of resources and technologies will be used to produced goods and
services, how will the production be organized?
• In your opinion, what do you think are human wants?
• Biologically, basic human needs include; air, water, food, “clothing” and shelter.
• But in modern society people desire goods and services that make their livelihood more comfortable ….bottled
water, flat screen tv’s, iphones…., Hilux, Landcruiser, a Merc, recliner chairs, fancy girlfriends & blessers, etc!
• What are the resources available…….?

• We as individuals and Society in general possesses productive resources such as labour and managerial
skills, tools and machinery, land and mineral deposits that are used in the production of goods and
services that satisfy our wants.
• Unfortunately, the reality is that our wants always exceed the productive capacity of our resources.
• That is to say we have limitless wants and limited resources.
• For example the income we have is not enough to buy what we need. Therefore, scarcity restricts
options and demand choices.
• Because we can’t have it all we must decide what we will have and what we will forgo.
 OPPORTUNITY COST

• In economics – actually in life - there is no ‘‘free lunch’’. According to Sloman and Garratt (2010, p7) making a
choice involves sacrifice.
• You buy yourself some food, the money spent could have been used to buy something else which you have forgone
just to buy the food.
• On the other hand the resources (land, equipment, labour) which have been used to prepare that very lunch could
have been used to produce something else instead.
• Such sacrifices are what we call opportunity costs.
• Opportunity cost is the value of the good, service, or time forgone to obtain something else.
• To obtain more of one thing, society forgoes the opportunity of getting the next best thing.
 RATIONAL BEHAVIOUR
• The viewpoint that guides individuals to make rational decisions is comparing the marginal benefits and marginal costs of their
actions.
• [A marginal benefit is the maximum amount of money a consumer is willing to pay for an additional good or service. The
consumer's satisfaction tends to decrease as consumption increases]
• [The marginal cost, which is directly felt by the producer, is the change in cost when an additional unit of a good or service is
produced]
• Human behaviour reflects rational behaviour. – not always though!
• This implies that Individuals look for and purse opportunities that increase their utility, pleasure, satisfaction.
• Begg et al (2011, p92) defines Utility as the satisfaction obtained from consuming a good or service. We allocate our time, energy
and money to maximise our satisfaction.
• Therefore we weigh our costs and benefits to make rational (sensible) choices.
• Consumers are rational on what to buy; firms are rational on what to produce and how to produce it.
• Rational behaviour doesn’t mean you cannot make a mistake with your choices but it means people make decision with some
desired outcome in mind.
• Self -interest does not mean selfishness it means that each economic unit tries to achieve its own particular goal, which usually
requires delivering something of value to others.( Brue et al , p 38).
• For example, you want to get a raise on your salary then you would need to work hard and satisfy the employer’s wants – it may
involve working late, upgrading your academics, always being handy, etc,.
 MICROECONOMIC AND
MACROECONOMICS
• Economics has two branches- microeconomics and macroeconomics. Micro means small and macro
means big.
• Microeconomics is concerned with individual units such as a person, a household, a firm or an industry.
• At this level, details of economic units or a very small segment of the economy are observed under a
figurative microscope.
• In microeconomics we look at the decision making of the units.
• Macroeconomic examines aggregate units such as the economy, business sectors and the government.
• Aggregate is the collection of specific economic units as if they were one.
• This is to obtain an overview or a general outline of the structure of the economy and the relationships
of its major aggregates.
INDIVIDUALS ECONOMIC PROBLEM (BUDGET
LINE)

• Having learnt that our wants are limitless and that our resources are limited, consumers have to make a
decision on what to buy and forgo.
• This is because our wants go beyond our basic needs of food shelter, clothing.
• Therefore the economic problem can be depicted by a budget line/ budget constraint.
• Our individual budgets are constrained by our income. You can only buy what your income can allow
you to buy.
• The budget is also constrained by the prices of the goods and services.
• Lets put it into perspective, lets say you have K 50 and you have two things you would want to buy;
apples and note books. Apples are selling at K2.5 each and books K5 each. The choices you can make
are;
•  You can decide to spend all your money on apples and you will buy 20 apples and no books bought.
•  You can decide to just buy books and you buy 10 books and no apples bought.
•  If you only bought apples, you can decide to give up 2 apples so that you can buy a book. You will buy
18 apples remaining with K5 to buy one book at K5 each.
•  On the other hand if you bought books only, you may decide to give up one book to buy apples. You
will buy 9 books remain with K5 and buy two apples.
• From table 1.1 below we see how we can combine apples and book with the available income of K50.
The budget line shows all the combinations of any two products that can be purchased, given the prices
of the products and the consumers’ income.
• From the graph every point shows the combination of apples and books, including fractions, which can
be bought with the income of K50.
• The slope of the graph measures the ratio of the price of apples (pa) to the price of books (pb), slope =
pa/ pb=-(K2.5/K5) = -1/2.
• Therefore you need to give up one book to get two apples.
• All combinations of books and apples on and inside the budget line are attainable from the income
available.
• This means that whatever combination or point on the budget line and anywhere under the curve is
affordable to this consumer.
• The combinations on the line exhaust all the available income while the combinations under the curve
leave the consumer with some change.
• Let’s assume tomorrow you will not be able to find the two goods available for sell, to maximise your
utility you will spend all your income today.
• Contrary, the combinations above the curve are not attainable. This means that the consumer cannot
afford the combinations above.
• He/she will need extra income to afford them but unfortunately K50 is the only available income at the
moment.
• Now let us apply the concept of opportunity cost to our example.
• Remember the definition of opportunity cost - in our example, for us to buy the first book we give up 2
apples.
• That is we trade off 2 apples for a book. So the opportunity cost of a first book is 2 apples.
• To obtain the opportunity cost of a second book we still give up another two apples.
• Therefore the opportunity cost remains the same for an extra book we buy. This is what is called
constant opportunity cost.
• This is why we have a constant slope for the budget line. A straight budget line has a constant slope.
• Choices are different among consumers, each consumer picks a combination that is best for them. One
that maximises their marginal benefit.
• To get opportunity cost for buying one apple = what you give up in terms of books/what you gain in
terms of apples=1 book/2apples= ½
• This means the opportunity coat of buying one apple is ½ the book forgone.
• What shifts the budget line?
• An increase in income moves the budget line upwards or outwards. This is because your income is now
enough to buy you more of both goods.
• On the other hand a reduction in income shifts the budget line inwards or downwards. This is because
the income is now little.
• From our example suppose your income increased to K100. The prices of apples and books remain the
same. How will the new budget line shift?
• The budget line shifts upwards. This is because an increase in income makes you afford to buy more of
both goods.
• With an income of K100 you now are able to buy 20books only or 40 apples only. The combination of
the two goods are now more than before.
• This comes to a conclusion that higher budget lines imply higher incomes and lower budget lines implies
lower income.
• What else can shift the budget line?
 SOCIETY’S ECONOMIC PROBLEM
(PRODUCTION POSSIBILITY FRONTIER)

• Let us now look at how society makes decision under scarcity.

• Society has to decide what goods to produce and what services to provide.
• They have to decide what to produce given the limited resources available.
• The economic resources available to society are; land, labour, capital and entrepreneurial skills.
Economic resources are all the natural, human and manufactured resources that can be used to
produce goods and services.
• This may include equipment, tools, machinery, building, farms, factory, agricultural products,
transportation, and all types of labour and mineral resources.
• All these are called factors of production (F.O.P).
• Land is all natural resources used in the production such as arable land, forests, mineral and oil deposits
and water resources.
• Labour this involves physical and mental talents of individuals used in the production of goods and
services
• Capital is all manufactured aids used in producing consumer goods and services.
• This includes all factory, storage, transportation, tools and machinery. The purchase of these goods is
what is called investment.
• Entrepreneurial ability. This is a special form of human resource. he innovates, makes decisions, risk
bear
 PRODUCTION POSSIBILITY MODEL

• Under this model we will assume the following;

• Full employment meaning society is using all the resources available

in the production process
• Fixed resources-the quantity and quality of F.O.P are fixed.
• Fixed technology the state of technology is constant
• Two goods. Society is only producing two goods i.e. clothing and
food.
• A production possibility table lists the different combinations of two
products that can be produced with a specific set of resources,
assuming full employment.
• At alternative A all resources are employed to produce clothing and at E all resources are employed to
produce food products.
• These are very unrealistic extremes, an economy will produce both food products and clothing as at B,
C, and D.
• As we move from A to E we increase the production of food and giving up the production of clothing.
• Plotting the data above we have a production possibility
curve.
• Each point on the production possibility curve represents
some maximum combination of two products that can be
produced if resources are fully and efficiently employed.
• As you move down the curve society is shifting resources from
the production of clothes to the production of food thus,
producing more of food products and less of clothing and vice
versa.
• The curve is a constraint because it shows the limit of
attainable outputs.
• Points on the curve are attainable because society uses all the
available resources in production of the two goods.
• Points under the curve are attainable but are not efficient this
is to say that they are using less of the resources or rather
some resources are not fully utilised, thus these points are
not desirable as those on the curve.
• Points beyond the curve are not attainable with the current
available resources and technology.
 PRINCIPLE OF OPPORTUNITY COST
• Scenario TWO
• At point A society is producing o units of food and 10 units of clothing.
• To produce one unit of food society shifts resources from clothing to food production thus giving up one
unit of cloth.
• Therefore the opportunity cost of producing the first unit of food is one, which is the unit of cloth
forgone.
• To produce the second unit of food society gives up 2units of cloth.
• The opportunity cost of producing an additional unit of food is increasing.
• This is what is called increasing opportunity cost.
• To have more of food society has to give up more units of clothes.
• From the shape of the curve is shows that society must give up greater amounts of cloth to acquire
equal increments of food products.
• Why is this so?
• This is because economic resources are not completely adaptable to alternative uses.
• Many resources are better at producing one type of good that at producing others.
• Let’s relax the assumption that quantity and quality of resources and technology are fixed.
• When the amount of resources changes the PPF shifts positions and the potential maximum output of
the economy changes.
• Although resources are fixed at a particular time, over
time they increase.
• For example an increase in labour and entrepreneur
skills due to an increase in population, there’s also a
new discovery of mineral resources, new and many
more.
• The net result is the ability to produce more of both
goods.
• The economy will grow by expanding its output. This
will result in the PPF shifting outwards as in the graph
above.
• An advancing technology also brings both new and
better and improved ways of producing the good.
• Therefore economic growth is as a result of increases
in supplies of resources, improvement in resource
quality and technological advancement.
 OPPORTUNITY COST, ABSOLUTE AND
COMPARATIVE ADVANTAGE

• When two individuals (or firms and nations)

have different opportunity costs of performing
various tasks, they can always increase the
total value of available goods and services by
trading with one another.
• The idea of opportunity cost can provide a
reason why individuals trade and why trade
can be mutually beneficial.
• Let us consider an example - We have two
individuals’ martin and Natasha. They both
can produce two different goods, wheat and
cotton on one acre piece of land.
• Martin can produce three times the wheat that Natasha can on one acre of land, and Natasha can produce three times the cotton.
• We say that Natasha has absolute advantage in the production of cotton and Martin has absolute advantage in the production of
wheat.
• Absolute advantage is when a country/individual uses fewer resources to produce that product than the other country does. (Begg et
al, 2011. P12)
• We suppose that they both use the one acre of land to produce both wheat and cotton.
• They divide the land in half to produce the two products; martin will produce 3bushels of wheat and 1 bale of cotton, Natasha will
produce one bushel of wheat and 3bales of cotton.
• They consume exactly what they produce; martin 3wheat and 1cotton and Natasha 1 wheat and 3cotton.
• This can be seen from the graph below.
• Because both individuals have absolute advantage in the production of one product specialisation and
trade would be of benefit.
• Martin can specialise in the production of wheat only and Natasha can produce cotton only and they
can exchange in trade.
• For martin if he gets the half acre that is used in the production of cotton and uses it to produce wheat.
He will produce 6bushels of wheat.
• The same applies to Natasha if she uses the half acre of land for wheat to produce cotton, she will
produce 6bushels
• They can therefore trade 2bushels of wheat for 2bales of cotton. This is more than their initial
consumption of 3 to 1.

• We see from the graph that they are now

consuming way beyond their budget line.
• This is what we call gains from trade.
• Martin has gained one more bale of cotton and
one bushel of wheat.
• This is as a result of specialising in the
production of a good he has absolute
advantage in and trading it for a good he has no
absolute advantage in..
• The same applies to Natasha.
• A person or a nation has a comparative
advantage in the production of a product when
it can produce the product at a lower domestic
opportunity cost than can a trading partner.
• The real cost of producing cotton is the wheat
that is sacrificed to produce it.
• Example. …..
• Martin has absolute advantage in producing both cotton and wheat. This is because he is producing
more of both goods on an acre piece of land than Natasha.
• Who has comparative advantage?
• The opportunity cost of producing wheat by martin is 1bale of cotton. This is because martin is
sacrificing the 6bales of cotton to produce 6bushels of wheat. His opportunity cost of producing cotton
is also 1. He is sacrificing 6bashels of wheat to gain 6bales of cotton.
• Natasha’s opportunity cost for producing wheat is 3 bales of cotton. She is sacrificing 3bales of cotton to
produce 1bushel of wheat. Then, her opportunity cost of producing cotton is 1/3 bushel of wheat. She is
sacrificing 1 bushel of wheat to gain 3bales of cotton.
• The opportunity costs shows that martin has a lower cost in
producing wheat and Natasha has a lower cost in producing
cotton.
• Therefore they can specialize in the product of their
advantage.
• If they used half the acre to produce both goods, they
would consume exactly what the produce.
• They need to specialize in the
product of comparative
advantage.
• However martin will not fully
specialize. He will produce
both goods.

• Martin is willing to sacrifice 1bushel of wheat for 1bale of cotton.

• He would even be happy if he got more of cotton for 1 bushel of wheat.
• As for Natasha she is willing to sacrifice 3bales of cotton to have 1 bushel of wheat.
• She would be happy if she could give less cotton for 1 bushel of wheat.
• Therefore martin will trade 1 bushel of wheat for 2bales of cotton.
• Natasha would be happy to give 2bales of cotton for 1 bushel of wheat.
• They both gain from trade because they move
beyond their production possibility frontier.
• The price at which the will trade is 1bushel of wheat
for 2bales of cotton.
• The price of the product is determined by the
opportunity cost of the seller and the buyer.
• Therefore the number between 3 and 1 is 2 therefore
Natasha is happy to give less cotton for one wheat.
Martin two is happy to gain 2 cotton for 1wheat.
 SUMMARY

• Economics analyses what, how and for whom society produces. It is the study of how limited resources are
allocated amongst unlimited wants.
• Microeconomics is the study of small units such as individuals, firm, market and an industry.
• Macroeconomics is the study of aggregated units on the economy.
• The production possibility curve or frontier shows the maximum amount of one good that can be produced given
the output of the other good.
• The opportunity cost of a good is the quantity of the other goods sacrificed to make an additional unit of the
good. It is the slope of the PPF
• A country enjoys an absolute advantage over another country in the production of a product if it uses fewer
resources to produce that product than the other country does.
• A country enjoys a comparative advantage in the production of a good if that good can be produced at a lower
cost in terms of other goods.
 DEMAND AND SUPPLY

•  Think of how much of a good you would buy if its price fell or rose?
•  Think of the factors that would affect how much of a good you would buy apart from its own price?

• We will therefore endeavor to understand how individuals demand and the supply for a particular good
will determine the price at which the good will be sold in the market.
 DEMAND

• Demand is a schedule or a curve that shows the various amounts of product that consumers will
purchase at each of the several possible prices during a specified period of time.
• Quantity demanded is the amount consumers are willing and able to buy at a given price over a period
of time.
• From our example on the budget line we can draw up demand for that consumer at different prices.
• As we change the prices of either apples or books the quantity bought also changes.
• Thus, the law of demand states that as prices falls, holding all other things equal or constant, the
quantity demanded rises and as prices rise the quantity demanded falls. This is an inverse relationship.
• Why are we holding other things equal or constant?
• There are many factors that affect the demand of goods purchased. but for now we look at just prices.
• What other things do you think will affect the quantity purchased?
• There are two reasons for this law;
• 1. People will feel poorer. They will not be able to buy much of the goods with their income.
• Their purchasing power will go down and this is what is called the income effect of price rise.
• ***note purchasing power is the amount of goods you can buy in the income available.

• 2. In comparison to other goods related to it, it will be more expensive and people will switch to
alternative products. This is the substitution effect.
• QUESTION. How do you think people will react in the case of a fall in price?
• Take a look at the example below;
• The table below shows the how many kilos of potatoes per month will bought at various prices. We
have demand schedules for Tracey, Darren and a market demand.
• The market demand is the total demand for Tracey and Darren and everyone else in the market
• If we plot the market demand, then we have the following;

• The graph is downward sloping

showing the inverse relationship that
quantity demanded has with price.
• From the graph we start at point E
where at k100 the total demand is
100 going down the graph prices are
falling and quantity demanded is
increasing
• Determinants of demand.
• What are the other factors that affect demand?
• 1. Tastes/preference. Taste is affected by advertising, fashion, observing, health consideration and experiences of
consuming the good. The more desirable people find the product the more they will demand for it.
• Therefore a change (let’s say, a favourable change) in a consumers taste, the demand for that commodity will increase at
each price. Thus, the demand curve will shift outwards. The reverse is true.
• 2. The number of buyers. An increase in the number of buyers increase the amount demanded at each price. The individual
demand curve is not affect by the number of consumers but the market demand curve will shift outwards.
• 3. The number and price of related goods. There are four types of good; substitute goods, complementary goods, normal
goods and inferior goods.
• Substitute goods are goods which are considered by consumers as alternatives to each other e.g coffee and tea. As the
price of one goes up, the demand for the other rises. Complementary goods are goods which are consumed together e.g
bread and butter. As the price of one goes up the demand for both goods reduces.
• Therefore demand is affected by the number and the price of substitute and complementary goods. If the price of a good
rises, consumers will buy more of a substitute good and less of that good, thus, the demand curve will shift downwards.
• In reverse a rise in price of a substitute good will increase the demand of the good in question and the demand curve will
shift outwards. For a complementary good a rise in price will shift the demand for both goods downwards.
• 4. Income. As peoples income rise, their demand for the good will either rise or fall depending whether
the good is normal or inferior. Normal goods are goods whose demand rises as income increases. And
inferior goods are goods whose demand fall as income increases. For a normal good the demand curve
will shift outwards and inferior good it will shift inwards.
• 5. The distribution of income also affects demand. The poor demand for inferior goods because they
cannot afford luxury goods but if income was redistributed from the rich to the poor, the demand for
luxury goods will increase.
• 6. Expectations of future price changes. If people thought that the price of a good will rise in the near
future, they will buy more of that good now before it goes up.
• 7. Advertising; a successful advertising campaign increases the demand for a product or service
 SUPPLY
• Let us begin with an illustration.
• From the production side; Let’s suppose you are a farmer and you have a piece of land which you wish to use to
produce crops for sell. Your decision of what crop to grow will depend on the price of the commodity in the market.
• If you notice that the price of apples is high you will plant apples. And if the price gets higher you will increase the
production of apples.
• This illustrates the relationship between supply and price. When the price of a commodity rises, the quantity
supplied increases.
• This is because as output increase beyond a certain level, costs raise more and more rapidly, thus the price has to
rise so that it is worth to produce more and incur the higher costs.
• It has to be profitable for the producer. And when it is profitable more people will also be encouraged to produce
the good and thus the market supply will increase.
• [Take for example the issue of rearing chickens in Zambia]
• Let us consider the table below;
• The table shows the quantity of apples that will be supplied at different prices for an individual supplier
and market supply.
• The market supply curve is the total
individual supplies in the market.
• From the graph the supply curve is
upward sloping showing that as
prices rise quantity supplied also
increases.
• There are other factors that affect the supply of a commodity. These are;
• 1. Cost of production. The higher the cost of producing a good the less profitable it is at any price.
• Thus producers will cut back on production and shift to producing goods with lower costs.
• Costs change because of input prices such as wages, raw material prices, rent, interest rate etc.; changes in
technology, organisational changes and government policies such as subsidies and tax.
• 2. Profitability of alternative products. If some alternative products become more profitable to supply than before,
producers will shift resources to produce that good.
• The goods become profitable if their prices rise. This is what are called substitute goods. Substitute goods are two
goods where an increase in production of one good means diverting resources away from producing it. Thus supply
of the first good fall and shifts the curve inwards.
• There are goods that are produced together e.g. sugar and molasses. An increase in profitability of sugar will
increase the production of both sugar and molasses thus shifting the supply curve outwards.
• 3. Expected prices changes. When prices are expected to rise, producers may reduce the amount they sell so that
they increase the stock and sell when the prices go up.
• 4. Number of seller. A greater number of sellers in the market will increase the supply of the good.
• 5. Nature, random shocks and unpredictable events. These may include weather, disease affecting farm outputs,
war, earthquakes, breakdown of machinery.
 MARKET EQUILIBRIUM

• Now we see how the decisions of a consumer and a producer will interact to determine the price and
quantity they will both be happy with.
• We are assuming that no buyer or seller can set the price.
• So look at the two examples for apples. The table below shows the total market demand and supply.
• From the graph if we start with price k20, consumers demand 700 while suppliers supply 100.
• There is too much demand that suppliers cannot supply at that price. This is called excess demand With
this situation consumers will be willing to pay a higher price and producers are willing to accept a higher
price.
• Therefore, the shortage in the market will drive the price up. The price will continue to rise, demand will
fall and supply will increase until there is no more shortage at price 60. .
• If we start at price k100 consumers will only demand 100tonnes and suppliers will supply 700 but this is
too much for the market.
• This is called excess supply. There will be excess goods on the market. The farmers will start to compete
with themselves and drive the price down to capture consumers.
• As the price fall the demand will increase and supply will reduce until at price 60 where both demand
and supply are equal.
• Thus the market will clear, there will not be any excess supply neither will demand be too much.
• This is what is called the equilibrium price
• The area above the equilibrium is excess supply while the area below equilibrium is excess demand.
 CHANGE IN EQUILIBRIUM

• Now let’s put into play changes in demand and supply due to other factors.
• A change in demand.
• We assume there is an increase in the consumers’ income.
• The demand curve will shift outwards to the right.
• At price k60 consumers are now demanding 550 which is more than what suppliers are supplying (350)
in the market.
• This creates a shortage and consumers will be willing to pay a higher price.
• Therefore, the new equilibrium is realised at price 70 and the quantity is 500.
 A CHANGE IN SUPPLY
• We assume there is an improvement in technology advance and it has lowered the cost of production.
• With a lower cost of production the producer will now produce more goods.
• This will shift the supply curve outwards.

• At price 60 there is now excess supply of

goods.
• Consumers are demanding 350 whilest
producers are supplying 550.
• With this excess supply price will be forced
to go down to 45 and quantity to
somewhere between 400 and 500, so lets
says 450.
• Now let the changes happen at the same time. • We have a new equilibrium but the price remains
the same although both quantity demanded and
supplied have now increased to 550. This is
because the excess supply created by the rise in
supply is cleared by the excess demand created by
the rise in income.
• We can describe the equilibrium in a given market
in a simple mathematical way.
• Remember demand function is a relationship
between the quantity demanded and the price of a
given good or service, keeping other things equal.
The relationship between price and quantity
demanded is negative therefore the equation will
take the form;
• where y represents quantity demanded, -m represents the slope of the curve.
• Its negative because the demand curve slopes downward.
• X represents price of the commodity, b is the intercept of the equation.
• This is a direct function -And inverse function is when price is on the Y axis.
• For the supply curve the quantity supplied has a positive relation with the price of the commodity.
Therefore the slope of the supply equation is positive .

• Equilibrium is met determined when demand is equal to supply.

• Equating the two equations and solving for y and x will give us equilibrium price and quantity.
• Example.
• We have a demand function and a supply function
• Find the equilibrium price and quantity.
• Since demand= supply in equilibrium we equate the two functions

• We have found the value of q, we need to replace it in any of the equations to

find the value of p. Or

• Therefore, the equilibrium price is 38 and equilibrium quantity is 837.5. these

are the value at which the market clears.
 NATIONAL INCOME
• Our focus now is on macroeconomics.
• We examine the economy as a whole.
• In this section, we shall look at national output or income.
• LETS THINKS
• What determines the size of national output ?
• What causes it to grow?
• Why do growth rates fluctuate ?
• What is GDP,GNP,NI and how do we calculate it?
• What is Zambia’s GDP?
• How is it measured?
 CIRCULAR FLOW OF INCOME
• Macroeconomics examines economies at the aggregate (international, national, regional) level.
• Some aspects of macroeconomics are about comparing two aggregate economies at the same time.
• Much of macroeconomics is concerned with policies such as money supply or tax policy which is national in
scope.
• Equilibrium effects mean that outcomes are different when we consider the economy in aggregate.
• There are certain phenomenon like economic growth and business cycles which affect the aggregate economy
equally.
• Most macroeconomic issues include; Economic growth, Price stability, Reduction of unemployment, Balance of
payment(B.O.P) surplus.
• The focus is to know what causes national output to grow and fluctuate. What happens in booms and
recessions? What causes unemployment? Why prices rises .why is inflation a problem?
 MACROECONOMIC GOALS

• Economic growth: achieving high and stable rates of growth, sustained over a long period.
• Unemployment: reducing unemployment to reduce the wastage of human resource and as it is a drain
on government revenue.
• Inflation: government policy is to keep inflation low and stable. It aids the process of economic decision
making E.g. business will be able to set prices and wage rates and make investment decisions with far
more confidence.
• Balance of payment surplus: a country BoP account is a record of all transaction between the residents
of that country and the rest of the world. The aim is to have more exports than imports so that the
country can record a surplus in the B.O.P
• How are the four goals related?
• To pursue one objective may make at least one of the others
worse. If we cut down taxes to boost consumer spending so as to
have economic growth and encourage investment, this may lead to
higher inflation.
• The objectives are linked through their relationship with aggregate
demand.
• Aggregate demand is the total spending on goods and services
made within the country by consumers (C),firms on investment (I),
the government (G), investment and people abroad on exports(X)
and we subtract imports(M).
• AD = C + G + I + X - M
CIRCULAR FLOW

• The diagram shows the circular flow of income.

• Let’s focus on firms and households. This is the first
phase of the circular flow.
• Firms are producers of goods and services. They also
employ labor and other factors of production.
• Households are consumers of goods and services and,
they supply labour and various factors of production.
•
Note that there is a difference between money and
income. Money is a stock while income is a flow.
• If households spend all their income on buying domestic goods and services, and if firms pay out all this
income to households. The flow will continue at the same level indefinitely.
• Therefore, income is flowing from firms to households as a payment for using their labour and other
factors of production. Then as households purchase the goods and services, income flows back to the
firms.
• However, in real world households and firms are not the only two units that can exist, we include other
sectors of the economy in which some income is withdrawn, while some is injected into the inner flow.
• We introduce government, foreigners and financial institutions. Financial institutions act as a link
between those who wish to borrow money and those who wish to save.
WITHDRAWAL/LEAKAGES
• The withdrawal or leakages is money that leaves the inner flow of income.
• Net savings(S) is the money deposited in the bank deducting borrowing and drawings.
• This money is not spent on goods and services therefore; it is leaked from the flow.
• Net taxes (T); VAT, PAYE, excise tax, pension contribution, corporate taxes minus transfer payment from
government e.g. unemployment benefits. This is the money that households pay as a statutory
obligation to the government. This money is also not spent on goods and services.
• Import expenditure (M). Consumers, government and firm spend on imports.
• When people spend on foreign gods and service, the money does not end up with domestic firms but
instead leave the country, therefore this money is a withdrawal from the circular flow of income.
• Total Withdrawals are savings, taxes and imports =S + T + M
INJECTIONS
• Injections is the money that enters the inner flow but not from households. These include;
• Investment (Id) on domestically produced goods. This is the money that firms spend on expanding their
plant so as to produce more and also includes increases in inventory.
• Government expenditure (G) on domestic goods and services. The money the government spends on
purchasing goods and services including infrastructure development.
• Exports expenditure(X). Foreigners abroad buy domestic goods. Foreigner spend their money on
domestic goods and services, this money ends up in domestic firms hands.
• Total Injections are investment, government and exports =I + G + X
• Aggregate demand is the household spending on domestic goods and services plus injections.
• AD=C + I + G +X
• From the inner flow, what constitutes output is the consumption of goods and services and the
investment firm have in inventory GDP=C + I. and household income is the income spent on goods and
services and the money saved. Y=C + S.
• We suppose that what is produced is equal to the income of households, then GDP = Y. this implies that
what is saved is exactly equal to the investment by firms. i.e. GDP= C+ I=Y=C+S then I=S
• Actual savings=actual investment
• This follows that government spends exactly what it collects in tax revenue. G=T. this applies to imports
being equal to exports M=X . this is the equilibrium condition.
• It follows that Injections =withdrawals.
• If injections are greater than withdrawals, expenditure will rise, Aggregate demand will rise.
• This extra spending will increase firm’s sales and encourage them to produce more. Output rises
together with income, as wages, salaries, profits rent and interest rise. Rise in Aggregate demand results
in;
• • Economic growth; the greater the initial excess of injection over withdrawals the bigger will be the rise
in national income.
• • Fall in unemployment; firms will employ more workers to meet the extra demand for output.
• • Inflation rises. The greater the rise in Aggregate demand relative to the capacity of firms to produce,
firms find it difficult to meet the demand and it is likely prices rise.
• Current account deteriorates. High demand sucks more imports and higher domestic inflation makes
exports expensive relative to imports.
• When injections are not equal to withdraws there is disequilibrium. a chain reaction brings the economy back to
equilibrium.
• The increase in income results in increase in consumption, savings, imports, taxes. Withdrawals rise too. Output fall
back to its original point.

• From the graph above we have withdrawals sloping upwards, injections are constants.
• We are in equilibrium at point x where withdrawals are equal to injections.
• At point injections are more than withdrawals, this will result in economic growth output will rise and we move from
y1 to ye.
• When withdrawals are more than injections. There is high savings , more imports. The demand for domestic goods and
services reduce therefore firms will reduce their production and output will reduce from y2 to ye.
 NATIONAL INCOME

• National income measures the monetary value of the flow of output of goods and services produced in
an economy over a period of time.
• Measuring the level and rate of growth of national income (Y) is important for seeing:
•  The rate of economic growth
•  Changes to average living standards
•  Changes to the distribution of income between groups within the population
• Gross domestic product (GDP) is the total market value of all final output in an economy in a year.
• GDP includes the output of foreign owned businesses that are located in a nation following foreign
direct investment.
• Gross National Product (GNP) is the aggregate final output of citizens and businesses of an economy in
one year.
• There difference is that GDP measures the economic activity that occurs within a country while GNP
measures the economic activity of the citizens and businesses of a country.
• GDP does not measure total transactions in the economy. It counts final output but not intermediate
goods.
•  Final output – goods and services purchased for final use
•  Intermediate products are used as inputs in the production of some other product
• There are three methods to calculating GDP; value added,income and expenditure approach.
1. VALUE ADDED

• We shall begin with an example;

• A car company in Zambia imports steel and other parts of the car and assembles it from its plant here.
The car is then sold out in the market. The car is a finished product-final output.
• The steel and parts are intermediate products. Thus, when calculating GDP we include the value added
to the car i.e. the cost of a car minus the imported inputs.
• Calculating value added to the car helps eliminate double counting.
• Value added is the increase in value that a firm contributes to a product or service.
• We look at an example that will calculate GDP using all the three approaches.
• In economics, double counting is defined as including the same costs or benefits more than once in the
belief that different measures are involved. Double counting inflates expenditure or income since the
final figure is considerably more than what was spent or earned.
• Double counting usually occurs when calculating the cost of a project. An example is when the price of
materials is included as part of the total costs as well as the final price of the product to be sold. In this
instance, only the final price should be counted, as the cost of the materials is included in the sale price.
One way to avoid double counting is to assign finances as either benefits or costs but not both at the
same time
• EXAMPLE
• A Steel maker mines the iron ore and makes steel out of it, he sells some of the steel to car maker and
machine maker for 3000 and 1000 respectively. He pays out wages and rent worth K4000.
• The machine maker uses the steel to make a machine that he later sells to the car maker for 2000. He
pays out K1000 to his employees in wages and salaries.
• The car maker buys tyres from the tyre company worth K500 as an addition to the other inputs, he
makes a car that he sells to K 5000 and pays wages and rent worth K1500.
• The tyre maker pays K500 in wages and rent. Calculate GDP using value added, expenditure and income
approaches.
• The value added approach gives the same figure for GDP as the expenditure and the income
approach. One of the three approaches can be used to measure GDP.
• There are some transactions that are not included in calculating GDP.
•  Selling your car to a neighbor does not add to GDP.
•  Selling a stock or bond does not add to GDP, though the stock broker's commission for the
sales does add to GDP.
•  Pension payments, welfare payments, employment insurance benefits, and other
government transfer payments are not included in GDP.
•  The work of unpaid house spouses does not appear in GDP calculations
 EXPENDITURE APPROACH

• The expenditure approach is shown on the bottom half of the circular flow. Specifically, GDP
is equal to the sum of the four categories of expenditures.
• GDP = C + I + G + (X - IM)
 COMPONENTS OF GDP
• Consumption;
• When individuals receive income, they can spend it on domestic goods, save it, pay taxes,
and buy foreign goods. Consumption is the largest and most important of the flows.
• To understand changes in output we understand what affect the purchases of households.
These are;
•  Disposable income; is the income available to households after paying tax, napsa
deductions. When disposable income increases, individual spending increases too.
•  Expected future incomes; people take into account current and future incomes when
planning. when expecting high future incomes people borrow for current consumption
•  Financial system and consumption. When lending interest rates are high, people borrow
less for consumption but save more. Low interest rates, more borrowing for consumption and
fewer saving.
 INVESTMENT

• The portion of income that individuals save leaves the spending stream and
goes into financial markets and enters the circular flow as investment by the
firms. Business spending on equipment, structures, and inventories is counted
as part of gross private investment.
• Due to using of these equipment and structures they reduce in value. plant
and equipment wears out. This wearing-out process is called depreciation.
There is a difference between total or gross private domestic investment and
the new investment that is above and beyond replacement investment. Net
private investment – gross private investment less depreciation
• There are factors that affect the level of investment. These are;
•  Increased consumer demand. The more the demand for goods and services,
the greater the need to expand and invest.
•  Expectations. Investment depend on firms future expectations about future
market condition.
•  Cost and efficiency of capital equipment. The lower the cost of capital, or
machines become more efficient the return on investment increases. firms
will invest more.
•  The rate of interest. Investment is financed by borrowing; firms weigh
annual income against interest payment.
•  Availability of finance. A firm cannot invest if it cannot raise the finances.
 GOVERNMENT EXPENDITURE

• Government collects revenue from individuals paying taxes, the taxes are
either spent on goods and services or are returned to individuals in the form
of transfer payments.
• Government payments for goods and services or investment in equipment
and structures are referred to as government expenditures.
• Government spending is independent of the level of national income in the
short run.
• The government can run a budget deficit (G>T) or surplus (G<T).
• In the long run government expenditure will depend on national income.
• The higher the levels of income, more income collected in taxes, more
spending.
• Transfer payments is government spending on pension, unemployment
benefits, subsidies etc. these redistribute existing income.
 EXPORTS AND IMPORTS

• Spending on foreign goods escapes the system and does not add to domestic
production, thus spending on imports are subtracted from total expenditures.
• Exports to foreign nations are added to total expenditures.
• These flows are usually combined into net exports (exports minus imports).
• The determinant of net exports are;
•  National income; as income rises imports increase.
•  Exchange rate; foreign units per unit of domestic currency.an appreciation of domestic
currency increases imports as foreign goods and services become cheaper. a depreciation will
lead to a fall in imports and a rise in exports as domestic goods become cheaper for
foreigners.
• We can move from GDP to national income through the following break down.
•  GDP plus factor incomes from abroad minus factor income abroad= GNP
•  GNP- depreciation= net national product. NNP
•  NNP-indirect taxes-subsidies=national income
•  National income-corporate taxes-dividends-social insurance payment+ personal interest
income received from government and consumers + transfer payments to persons=personal
income.
• Nominal GDP is GDP measured in current prices, or the current prices we pay
for things.
• Nominal GDP includes all the components of GDP valued at their current
prices.
• When a variable is measured in current prices, it is described in nominal
terms.
• Real GDP is nominal GDP adjusted for inflation.
• Mainly this is done by choosing one particular year that would be a base year.
A base year is the year chosen for the weights in a fixed-weight procedure.
• A fixed-weight procedure uses weights from a given base year e.g. GDP
deflator
• Real GDP is calculated by dividing nominal GDP by the GDP deflator.
• The GDP deflator is one measure of the overall price level.
• It is hard to compare GDP in different years as prices are not the same.
• We can compare GDP in 2000 and in 2008 by valuing output quantities using
2000 prices as base year.
• The table below shows nominal and real GDP calculated at 1995 as a base year.
• It can be noted that Nominal GDP increased from 1960 to 2008.but without considering changes in
price we can’t tell what happened to output.
• The GDP deflator tells us what percentage increase in prices occurred during the period. with1995 as
base year, in 2008 prices where 41% higher than 1995.
• Taking inflation into account, real GDP gives a true reflection of changes in output. From 1960 to 2008
GDP tripled.
• There some important measurements that are not included in the calculation of GDP.
• These are; legal drug sales, Under-the-counter sales of goods to avoid income and sales taxes, Work
performed and paid for in cash, unreported sales, Prostitution, loan sharking, extortion, and other illegal
activities.
• A second type of measurement error occurs in adjusting GDP for inflation.
• If the price and the quality of a product go up together, has the price really gone up? Is it possible to
measure the value of quality increases?
 FISCAL AND MONETARY POLICIES
• FISCAL POLICY
• There are various types of policy the government or the central bank can use to tackle the
problems of low and fluctuating economic growth, unemployment and inflation.
• Fiscal policy refers to the government’s choices regarding the overall level of government
purchases or taxes.
• It influences saving, investment, and growth in the long run but in the short run, fiscal policy
primarily affects the aggregate demand.
• Government can either pursue an expansionary or contractor fiscal policy. An expansionary
fiscal policy will involve raising government expenditure (an injection in the circular flow of
income) or reducing taxes (a withdrawal from the circular flow)
• A deflationary or contractionary fiscal policy will involve cutting government expenditure or
raising taxes.
• Expansionary is meant to increase AD; Y=C + I + G+X-M, whilst Deflationary is meant to
reduce AD and reduce inflation.
• Fiscal policy is used to smooth fluctuations in the economy associated with business
cycles.
• This is the Stabilisation policy which involves government adjusting the level of AD so
as to prevent output deviating from the potential output.
• Fiscal policy can also be used to influence aggregate supply.
• Now Let’s go back to the circular flow.
• We start with a closed economy with no foreign trade therefore we do not have
exports not imports. We will assume all taxes are direct taxes.
• The aggregate function is AD= Y=C + I + G .
• Disposable income is spent on consumption and part on saving.
• Consumption is broken into two parts; autonomous consumption (which is
consumption that does not depend on the level of income) and consumption that
depends on the level of income.
• The consumption function is written as ;

• Where co is autonomous consumption, c1 is the proportion of disposable income spent on

consumption called marginal propensity to consume, yd is disposable income after deducting taxes. Yt is
the income paid in taxes. If c1 is the proportion of disposable income spent on consumption then (1-c1)
will be the proportion saved.
• G and I are fixed; they do not depend on the level of output and income.
• The aggregate demand function is now written as;

• When government increases it’s spending G, there is an increase in aggregate

demand AD.
• There are two ways government can raise money to finance its spending.
• The government can increase the tax rate, so that it collects more tax revenue
or it can borrow money from the local banks.
• These two ways have two effects on the economy, which are multiplier effect
and the crowding out effect.
 MULTIPLIER EFFECT

• We know that the government can use a lump sum tax or a proportional tax.
• A lump-sum tax is an amount that is to be paid in tax regardless of the amount of income earned, while
a proportional tax is a percentage of the income earned that is to be paid in tax.
• This gives us two scenarios for our analysis.
 LUMP-SUM TAX

• With a lump sum tax the consumption function is given as ;

• Where T is the tax amount. The aggregate demand function is

• We put like terms together and make y the subject of the formula
• From the equation in the previous slide, we would want to know how y will
change when there is a change in government spending.
• To do so we take the derivative of y with respect to G.
 PROPORTIONAL TAX

• Where t is the proportional of income to be paid in tax. We put like terms together and make y the
subject of the formula
• From the equation above, we would want to know how y will change when there is a change in
government spending.
• To do so we take the derivative of y with respect to G.

• is the multiplier when it’s a proportional tax.

• Income y will increase as a result of an increase in government depending on the size of the multiplier.
• The size of the multiplier depends on how much consumers respond to increases in income through
MPC.
EXAMPLE

• The tax rate is 20% and mpc=0.9. how much will income, consumption and
savings increase by a K1 increase in government spending? no autonomous
consumption

• A K1 increase in government spending will increase national income by 3.57.

• Due to an increase in income which was as a result of increase in government
spending, consumption will increase by 2.57

• Savings increase by 0.2856

• Therefore, the multiplier effect is that when government spending increases by K1, income
will increase by K1 the first round.
• This K1 increase in income will increase individuals’ disposable income and will spend K0.9 on
consumption.
• The aggregate demand will increase income by K0.9 this is the second round. Consumption
will increase by .09*K0.9=K0.81 as a result of the second round increase in income. The K0.81
increase in consumption will increase income by K0.81, this is the third round.
• This will go on until there is no further increase income. Multiplier effect: the additional
shifts in AD that result when fiscal policy increases income and thereby increases consumer
spending.
• A $20billion increase in G (for example) initially shifts AD to the right by $20b.
• The increase in Y causes C to rise, which shifts AD further to the right.

• The $20billion will increase in G will shift AD from AD1 to AD2.

• Output increase from Y1 to Y2 this increase is by the entire $20billion. This increase in Y causes
consumption to increase which further shifts the AD curve to AD3 .
 AUTOMATIC FISCAL STABILIZER
• Government expenditure and taxation will have the effect of automatically
stabilising the economy.
• As national income increases, the amount of tax people pay automatically
rises. This raises withdrawals and helps dampen the rise in national income
until it gets back to equilibrium.
• Automatic stabilisers cannot prevent fluctuations, the merely reduce their
magnitude. Government can make deliberate changes in tax rate or
government spending in order to influence the level of AD.
• This is called discretionary fiscal policy.
• Money spent by government is all spent and it boosts the economy, this why
cutting taxes has a smaller effect on national income than raising government
expenditure.
• This is because cutting taxes increases peoples disposable income which is not
all spent on consumption.
• Not all the tax cut is passed on round the circular flow of income.
• If Government implemented a deflationary fiscal policy by either reducing its
expenditure or increasing taxes, the fall in G will reduce national income
which will result in the shift in AD from ADo to AD-ΔE.
• This will result in a fall in consumption which will further reduce national income.
• The AD shifts to AD1 ,this shift is because of the multiplier effect.
• Another scenario is where the economy is operating under full employment and government
implements an expansionary fiscal policy to increase output.
• Potential GDP is $10 trillion, real GDP is $9 trillion, and there is a $1 trillion recessionary gap.
• An increase in government expenditure or a tax cut increases expenditure by ΔE.
• The multiplier increases induced expenditure. The AD curve shifts rightward to AD1. The price level rises
to 110, real GDP increases to $10 trillion, and the recessionary gap is eliminated.
 CROWDING OUT
• Fiscal policy has another effect on AD that works in the opposite direction.
• If government borrows money from the bank, it competes with firms for finances thus causing interest
rate to increase in the economy.
• The rise in interest rates, r, reduces investment by the firms has the cost of borrowing money is high.
This reduces the net increase in aggregate demand.
• So, the size of the AD shift may be smaller than the initial fiscal expansion. This is called the crowding-
out effect.
• The initial $20billion will shift the AD curve to AD3 by $20billion. But due to a
rise in interest rate investment reduces shifting the AD curve to AD2 .
therefore output increases from y1 to y2.
• This is as a result of crowding out.
• Government borrowing from banks and rising the interest offered to firms
discourages firms and household to borrow. Thus invest and consumption will
reduce aggregate demand.
MONETARY POLICY

• How does the interest-rate effect help explain the slope of the aggregate-demand curve?
How can the central bank use monetary policy to shift the AD curve?
• The Aggregate demand curve slopes downward for three reasons: The wealth effect, the
interest-rate effect, the exchange-rate effect.
• Money demand reflects how much wealth people want to hold in liquid form. For simplicity,
suppose household wealth includes only two assets:
•  Money – liquid but pays no interest
•  Bonds – pay interest but not as liquid

• A household’s “demand for money” reflects its preference for liquidity. The variables that
influence money demand: are income, interest rates and price levels.
 LIQUIDITY PREFERENCE THEORY

• This is a theory that gives the motive for people to hold money, why people demand for money.
• There are three motives and these are; transaction, precautionary and speculative motive.
• Transaction motive; people hold money for transaction purposes. This is because they want to
buy goods and services.
• When their income is high, they will demand for more money so that they can buy more goods
and services.
• The higher the price the more people need to hold to afford the previous basket.
• For example if prices double, the purchasing power of the income reduces, therefore to buy
the same amount of goods as before, income has to double as well.
• Precautionary motive; people hold money for precautionary purposes. They hold money in
case of uncertainties.
• Therefore, when there income increases they will increase the amount of money they hold
for uncertain events.
• Asset motive; people hold money when other assets are not profitable. This is derived from
moneys function as a store of value.
• People can hold money in terms of bonds, stock, property etc. the want to hold money as an
asset.
• Money is an attractive asset to when the prices of other assets e.g. bonds are expected to
decline. When the interest rates for other assets like bonds are low, it is therefore more
profitable to hold money than to buy bonds.
• But when the interest rates are high, it’s not profitable to hold money, therefore buy bonds
so that you have some interest earnings on the money.
• Demand for money is affected by the level of income,
prices and interest rates in an economy.
• The higher the income and the lower interest rate, the
more people will demand for money. The reverse is true.
• The supply of Money is assumed fixed by central bank; it
does not depend on interest rate.
• What consists of money supply?
• M is what is considered to be money supply, it consists of
currency (coins and paper money) in the hands of the
non-bank public and all checkable deposits.
• This is the most liquid. Money supply is the money in
circulation and deposits at bank.
• Ms curve is vertical implying changes in interest rates r
do not affect money supply, which is fixed by the central
bank.
• Md curve is downward sloping implying a fall in r
increases money demand.
• A rise in r will increase the cost of holding money, people
will hold financial assets instead, thus demand for money
falls.
• A change in GDP will shift transaction demand and thus
shift the total demand for money curve.
• A fall in prices reduces money demand, shifting the Md
curve downwards.
• Interest rate falls from r1 to r2. This fall in interest rate
will increase investment which will increase output of
goods and services.
 TOOLS FOR MONETARY POLICY
• The central bank affects money supply by affecting money in circulation or affecting the number of
deposits for any given amount in circulation. They use;
• 1. Reserve requirement. Central banks use the reserve ratio in order to manipulate commercial banks’
ability to lend. When the central bank raises reserve ratio reduce the money available for banks to lend
and create money. Thus money supply falls. Lowering reserve ratio enhances the ability of banks to
create new money by lending. The reserve ratio is a percentage of deposits that the bank should keep in
its vaults and cannot give it out as loans.
• 2. Discount rate. The central bank as a lender of last resort, lend money to commercial banks and
charge interest on those loans. The interest rate charged is called discount rate. A lower discount rate
increase bank loans thus increasing money supply. A high discount rate reduces bank loans. Central
bank will raise the discount rate to restrict money supply.
• 3. Open market operations. The Central bank uses the sell and purchase of securities to carry out
monetary policy. the Central bank sell government bonds to banks and the public. when the Central
bank buys bonds from the banks and the public it increases money supply and when the CB sells bonds
to the banks and the public it reduces money supply.
• The central bank uses monetary policy to affect AD through affecting money supply using the
policy instruments available.
• Suppose there is a recession and central bank wants to increase money supply. It can do this
by;
• 1. Buying securities
• 2. Lowering reserve ratio
• 3. Lowering the discount rate
• To reduce inflation the central bank can reduce aggregate demand by limiting money supply
through;
•  Sell of securities
•  Increase reserve ratio
• . Raise discount rate
• If the central bank implements an expansionary
monetary policy ;
• The supply curves shifts outwards to MS2, interest
rates fall to r2. The fall in interest rate will increase
investment thus increasing demand for goods and
services, shifting the AD curve to AD2. Output
increases to Y2.
• The increase in money supply results in lower interest.
This affects investment. Firm borrow more funds to
expend the business thus AD increases. This shifts the
AD outwards and output increases.
 EXCHANGE RATE AND OPEN
ECONOMY
• Balance of payment
• The balance of payments is the record of a country’s transactions in goods, services, and assets with the rest of the
world; also the record of a country’s sources (supply) and uses (demand) of foreign exchange. The Credit side records
receipts from abroad and the Debit side records all payment to abroad.
• The balance of payment has three main parts 1) current account, 2) capital account and 3) financial account.
• A country’s current account is the sum of its:
• • net exports (exports minus imports),
• • net income received from investments abroad, and
• • net transfer payments from abroad.
• Trade in goods; records imports and exports of physical goods. Exports results in inflow of money whereas imports are
outflow of money. Thus, Exports are on the credit side, imports are on the debit side.
• Trade in services; records imports and exports of services e.g. transport, tourism and insurance.
• The balance of trade is the difference between a country’s exports of goods and services and
its imports of goods and services.
• Net balance of trade deficit is a net leakage from the circular flow of income. A trade surplus
is a net injection into the circular flow of income.
• A trade deficit occurs when a country’s exports are less than its imports. Net exports of goods
and services (EX – IM), is the difference between a country’s total exports and total imports.
• Investment income consists of holdings of foreign assets that yield dividends, interest, rent,
and profits paid to domestic asset holders (a source of foreign exchange).
• Transfer payments include government contribution to international organizations and
international transfers of money by private individuals and firms.
• Net transfer payments are the difference between payments from the domestic country to
foreigners and payments from foreigners to the domestic country, e.g. money sent from USA
to a Zambian student in Zambia will be a credit.
• The balance on current account consists of net exports of goods, plus net exports of services,
plus net investment income, plus net transfer payments.
• It shows how much a nation has spent relative to how much it has earned.
• For each transaction recorded in the current account, there is an offsetting transaction recorded in the capital
account. The capital account records the changes in assets and liabilities.
• It records the flow of funds into and out of the country, associated with the acquisition and disposal of fixed
assets.
• The balance on capital account is the sum of the following (measured in a given period):
• • the change in private domestic assets abroad
• • the change in foreign private assets domestically
• • the change in domestic government assets abroad, and
• • the change in foreign government assets domestically
• If the capital account is positive, the change in foreign assets in the country is greater than the change in the
country’s assets abroad, which is a decrease in the net wealth of the country.
• In the absence of errors, the balance on capital account would equal the negative of the balance on current
account
• The financial account records cross border changes in the holding of shares, property, bank
deposits and loans, government securities.
• The following are the parts;
• • Direct investment; a foreign company invests money from abroad in one of its branches in
Zambia.. This an inflow of money and it is credited in the balance of payment.
• Profits from this investment flowing abroad will be recorded as investment income in the
current account. Investment abroad by Zambians is an outflow.
• • Portfolio investment; changes in holding of paper assets e.g shares in an overseas company
is an outflow. Portfolio investment is likely to be affected by relative interest rates.
• Other financial and investment flows; short term monetary movements. E.g bank deposits by
foreign residents
• A balancing account of the balance of payment are
flows to and from reserves; all countries hold reserves
of gold and foreign currencies.
• The central bank can sell some of the resources to
purchase the kwacha on the foreign exchange market.
This is to support the exchange rate.
• Drawing on reserves represents a credit. Reserves can
be used to support a deficit elsewhere in the balance of
payment. Reserves also build up when there is a surplus
in the balance of payment.
• The balance of payment should always balance.
Credits=debits
• If it doesn’t balance, exchange rate has to adjust until
they are equal or government has to intervene.
• Net errors and omissions. When statistics are compiled
a number of errors occur. This figure is to ensure there
will be exact balance in the balance of payment.
• Lets have a look at the layout of the balance of
payment.
 EXCHANGE RATE
• The main difference between an international transaction and a domestic transaction
concerns currency exchange.
• International exchange must be managed in a way that allows each partner in the
transaction to wind up with his or her own currency.
• The exchange rate is the price of one country’s currency in terms of another country’s
currency; the ratio at which two currencies are traded for each other.
• Foreign currency is simply all currencies other than the domestic currency of a given
country.
• Thus, foreign exchange market is a market in which foreign currencies are exchanged and
relative prices established.
• Exchange rate can be expressed as; Foreign per unit of domestic currency or domestic per unit foreign
currency’.
• In our analysis we will take exchange rate as foreign per domestic currency. In a world where there
are only two countries, the United States and Zambia, the demand for kwacha is comprised of holders
of dollars wishing to acquire kwacha.
• The supply of kwacha is comprised of holders of kwacha seeking to exchange them for dollars.
• Demand for kwacha (supply of dollars) includes
• 1. Firms, households, or governments that import Zambian goods into USA
• 2. U.S. citizens traveling in Zambia
• 3. Holders of dollars who want to buy Zambian stocks, bonds, or other financial instruments
• 4. U.S. companies that want to invest in Zambia
• 5. Speculators who anticipate a decline in the value of the dollar relative to the kwacha
• Supply for kwacha ( demand for dollars) includes
• 1. Firms, households, or governments that import U.S. goods into ZAMBIA
• 2. Zambian citizens traveling in the United States
• 3. Holders of kwacha who want to buy stocks, bonds, or other financial instruments in the
United States
• 4. Zambia companies that want to invest in the United States
• 5. Speculators who anticipate a rise in the value of the dollar relative to the kwacha.
• The demand for kwacha in the foreign exchange
market shows a negative relationship between the
price of kwacha (kwacha per dollar) (ZMW/$) and the
quantity of kwacha demanded.
• When the price of kwacha falls, Zambian-made goods
and services appear less expensive to U.S buyers. If
Zambian prices are constant, American buyers will buy
more Zambian goods and services, and the quantity
demanded of kwacha will rise.
• The supply of kwacha in the foreign exchange market
shows a positive relationship between the price of
kwacha (kwacha per dollars) and the quantity of
kwacha supplied.
• When the price of kwacha rises, the Zambians can obtain more dollars for each kwacha. This
means that U.S.-made goods and services appear less expensive to Zambia buyers.
• Thus, the quantity of kwacha supplied is likely to rise with the exchange rate.
• The equilibrium exchange rate occurs at the point at which the quantity demanded of a
foreign currency equals the quantity of that currency supplied.
• An excess supply of kwacha will cause the price of kwacha to fall—the kwacha will depreciate (fall in value)
with respect to the dollar.
• An excess demand for kwacha will cause the price of kwacha to rise—the kwacha will appreciate (rise in
value) with respect to the dollar.
• Thus, Excess supply of kwacha shows that banks would not have dollars to exchange for all the kwacha. The
banks make money by exchanging currency, they will raise the exchange rate in order to encourage demand
for kwacha and reduce excess supply.
• The rate below the equilibrium, results in a shortage of kwacha (excess demand for kwacha). The banks
would find themselves with fewer kwachas to meet demand.
• There is an excess supply of the dollar. The exchange rate will thus rise until the demand equaled supply.
• Depreciation is a decrease in the relative value of a currency relative to another currency.
• When a currency depreciates, more units of that currency are needed to buy a unit of another currency.
Appreciation is increase in the value of a currency relative to another. Fewer units of that currency are
needed to buy a unit of another.
• If the demand for a nations currency increases, that currency will appreciate.
• If the demand falls the currency will depreciate.
• If the supply of a nations currency increases that currency will depreciate. If the supply decreases, that
currency will appreciate. If a nations currency appreciates, some foreign currency depreciated relative to it.
FACTORS THAT AFFECT EXCHANGE
RATE

• There are several factors that affect exchange rate, these include;
• • Rates of inflation; changes in the relative prices of two nations change the demand for and
supply for currencies and exchange rate between the two nations. If U.S price levels rise
rapidly relative to Zambia, U.S consumers will seek lower priced goods in Zambia, increasing
the demand for kwacha.
• Zambian too will buy less of U.S goods reducing the supply of kwacha.
• A high rate of inflation in one country relative to another puts pressure on the exchange rate
between the two countries, and there is a general tendency for the currencies of relative
high-inflation countries to depreciate.
• A higher price level in the United States increases the demand for kwacha and decreases the
supply of kwacha.
• The result is appreciation of the kwacha against the dollar
• • The level of a country’s interest rate relative to interest rates in other countries is another
determinant of the exchange rate.
• If U.S. interest rates rise relative to Zambian interest rates, Zambian citizens may be attracted
to U.S. securities. USA loans will be more attractive, Zambians will supply the kwacha and
demand for dollar. The supply curve will shift outwards and kwacha will depreciate and dollar
appreciates.
• A higher interest rate in the United States increases the supply of dollars and decreases the
demand for kwacha. The result is depreciation of the kwacha against the dollar.
• Relative income; a nations currency is likely to depreciate if its growth of nation income is
more rapid than that of other countries .i.e imports directly vary with income level.
• As total income rises Zambians will buy more of both domestic and USA goods, they will
demand more dollars and supply kwacha. This will result in kwacha depreciating.
• • Tastes; any change in consumers tastes for foreign good relative to domestic good will alter
the demand for than nations currency and exchange rate.
• Due to technological advances USA goods are preferred to Zambian goods. USA goods are
more attractive.
• Zambians will supply more kwacha and Americans will demand less of the kwacha.
• The supply curve shifts to the right, demand curves shifts outwards. Resulting in a
depreciation of the kwacha.
• Speculation; currency speculators are people who buy and sell currency with an eye towards
reselling and purchasing them at a profit.
• Suppose speculators anticipate that the kwacha will appreciate and the dollar will depreciate.
Speculators having dollars will convert them to kwacha. This increases the demand for
kwacha.
• Kwacha appreciates and dollar depreciates. This is because speculators believe that the
changes will in fact take place. What will happen if the speculate that the kwacha will
depreciate?
• • Changes in relative expected returns on stock, real estate and production facilities.
Investment depends on the relative expected returns. To make investment, investors in one
country must sell their currencies to purchase the foreign currencies needed for investment.
• Suppose there is positive outlook on expected returns on stocks, real estate in Zambia, US
investors will sell their assets in USA to buy in Zambia. They will sell their dollar to get
kwacha.
• Increased demand for kwacha will shift the demand curve outwards causing the kwacha to
appreciate and dollar to depreciate.
 THE EFFECTS OF EXCHANGE RATE.
• When a country’s currency depreciates (falls in value), its import prices rise and its export prices (in
foreign currencies) fall.
• When the U.S. dollar is cheap, U.S. products are more competitive in world markets, and foreign-made
goods look expensive to U.S. citizens.
• A depreciation of a country’s currency can serve as a stimulus to the economy, which are;
• Foreign buyers are likely to increase their spending on Zambian goods
• • Buyers substitute Zambian-made goods for imports
• • Aggregate expenditure on domestic output will rise
• • Inventories will fall
• • GDP (Y) will increase
• Depreciation of a country’s currency tends to increase the price level.
• Export demand rises and domestic buyers substitute domestic products for the now more expensive
imports. If the economy is operating close to capacity, the increase in aggregate demand is likely to result
in higher prices. If import prices rise, costs may rise for business firms, shifting the aggregate supply curve
to the left.
EXCHANGE RATE AND THE BALANCE OF PAYMENT

• In free float exchange market, the balance of payment will automatically balance.
• This is because the credit side of the balance of payment constitutes the demand for kwacha.
For example, when foreigners buy our Zambian goods they demand for kwacha in order to pay
for the goods.
• The debit side constitutes the supply side of the kwacha. When we buy foreign goods we are
to pay for them in foreign currency.
• A floating exchange rate ensures that the demand for kwacha is equal to the supply. Thus
ensures that the credit on the balance of payment equals the debits.
• A current account deficit must be matched by a capital plus financial account surplus and vice
versa.
• Example; suppose interest rates in zambia rise relative to the rest of the world. This encourages
short term financial inflow as people abroad are attracted to deposit money in Zambia.
• The demand for kwacha rises shifting to the right. It will also cause smaller short term financial
outflows as Zambians keep more money in the country.
• The supply curve shifts to the left. The financial account will go into surplus, and exchange rate
appreciates.
• Exports are now expensive while imports become cheaper. The current account will move into a
deficit.
• We move up along the new demand and supply curves until a new equilibrium is reached.
Financial account surplus is matched by an equal current account deficit.
• Central bank and government would intervene in fixing exchange rate.
• This is because free float causes exchange rate to change frequently and this brings about
uncertainty for business.
• Central bank will intervene either to reduce the day to day fluctuations in the exchange rate or
to prevent longer term shifts in the exchange rate.
• Assume that government believes that an exchange rate of $0.2/k (i.e.K5/$) is approximately
the long term equilibrium rate.
• However shifts in the demand and supply of currency are causing exchange rate to fall below
this level. What can government do to maintain the rate $0.2/k. there are three way to
intervene;
• 1. Using reserves; central bank can sell gold and foreign currency from the reserves to buy
kwacha. This shifts the demand for kwacha back to the right. Why? When government sells
foreign currency it induces a demand for kwacha.
• 2. Borrowing from abroad; the government can negotiate a foreign currency loan from other
countries or IMF to buy kwacha on the forex market. This shifts the demand for kwacha to
the right
• 3. Raising interest; if central bank raises interest rates, it encourages people to deposit
money in Zambia and encourage Zambians to keep their money. the demand for kwacha will
increase and supply decreases.
•END!