Zica Accountancy Programme: Macro Economics (Zica) Accounting

ZICA
ZICA ACCOUNTANCY PROGRAMME
PAPER T4
ECONOMICS
TEXTBOOK
MACRO ECONOMICS (ZICA) ACCOUNTING Page 1

MACROECONOMICS

CHAPTER 8
NATIONAL INCOME
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After studying this chapter, the students should be able to:
 Describe the national income of a country

 Explain the relationship between output, income and expenditure using the circular flow of
income
 Explain the measurement of the national income
 Discuss the problems associated with the measurement of national income
 Appreciate the uses of national income figures
 Explain the factors that determine a country‟s national income
_______________________________________________________________________________
1.0 Introduction
Measures of national income and output are used in Economics to estimate the value of goods
and services produced in an economy. They use a system of national accounts or national
accounting first developed during the 1940s. Some of the more common measures are Gross
National Product (GNP), Gross Domestic Product (GDP), Gross National Income (GNI), Net
National Product (NNP), and Net National Income (NNI).
There are at least three different ways of calculating these numbers. The expenditure approach
determines aggregate demand, or Gross National Expenditure, by summing consumption,
investment, government expenditure and net exports. On the other hand, the income approach and
the closely related output approach can be seen as the summation of consumption, savings and
taxation. The three methods must yield the same results because the total expenditures on goods
and services (GNE) must by definition be equal to the value of the goods and services produced
(GNP) which must be equal to the total income paid to the factors that produced these goods and
services (GNI).
In practice, there are minor differences in the results obtained from the various methods due to
changes in inventory levels. This is because goods in inventory have been produced (and therefore
included in GDP), but not yet sold (and therefore not yet included in GNE). Similar timing issues
can also cause a slight discrepancy between the value of goods produced (GDP) and the payments
to the factors that produced the goods, particularly if inputs are purchased on credit.
Gross National Product

Gross National Product (GNP) is the total value of final goods and services produced in a year
by a country's nationals (including profits from capital held abroad).

Gross Domestic Product
Gross Domestic Product (GDP) is the total value of final goods and services produced within a
country's borders in a year.
To convert from GNP to GDP you must subtract factor income receipts from foreigners that
correspond to goods and services produced abroad using factor inputs supplied by domestic
sources. To convert from GDP to GNP you must add factor input payments to foreigners that
correspond to goods and services produced in the domestic country using the factor inputs supplied
by foreigners.
GDP is a better measure of the state of production in the short term. GNP is better when analysing
sources and uses of income
Real and nominal values

Nominal GNP measures the value of output during a given year using the prices prevailing during
that year. Over time, the general level of prices rises due to inflation, leading to an increase in
nominal GNP even if the volume of goods and services produced is unchanged.
The national income of any country is important because it helps to assess the performance of a
country over a period of time, usually in a year.
National income accounting is much like the accounting carried out by the individual firms to
detect growth or decline in the profitability of a company. The national income figure that is
calculated is used to compare the performance of the country in the previous years as well as the
performance of that country with other countries.
In theory, the three methods of measuring the national income should provide the same figure as
illustrated by the circular flow of income.
1.1 The circular flow of income
The circular flow of income describes how money moves between the different sectors in the
economy. The expenditure of one sector is the income of another sector.
For a closed simple economy where there are only two sectors, firms and households, firms
employ labour to produce goods and services. Firms spend on labour since households receive
income for providing labour. Household income is spent on goods and services from firms.
HOUSEHOLDS
Consumption
Factor Goods
Markets Market
Income
FIRMS
1.2 THE NATIONAL OUTPUT OR THE VALUE ADDED METHOD
This is the total of consumer goods and services investment goods (including additions to stocks)
produced by the country during the year. The production of goods and services in different sectors
of the economy is added together. For example what is produced in the agriculture and fisheries,
forestry, manufacturing, hotels, banking, national defence, education, health sectors etc, is all
added together to arrive at the national income using the output method.
It can be measured by
- Totaling the value of the final goods and services and produced or
- Totaling the value added to the goods and services by each firm, including the government.
This is done to avoid double counting and in order to use this method, a detailed knowledge
of pricing is required. This explains why the output method is also known as the value
added method.
The usefulness of this method is that it shows the changing shares of the industrial sectors in an
economy, that is a sector which is expanding or falling it its contributions to the national income.
1.3 NATIONAL INCOME
Using this approach, the total factor incomes received by persons and firms for the provision of
factors of production, is added. Income from employment, trading profits, rent and interest are all
added together to arrive at the national income using the income method.
When using this method:
- Transfer payments or transfer incomes are excluded because the people receiving them do
not produce anything. It includes private money gifts, sale of second hand goods such as a
house, a car etc.
- Stock appreciation is deducted from the total because when inflation makes existing unsold
stocks more valuable, production has not increased.
- Residual error (statistical discrepancy) is added to make statistics from each method
balance.
1.4 NATIONAL EXPENDITURE
This involves adding together all total amounts spent on final goods and services by households,
central and local government, including what is spent by firms on the net additions to capital goods
and stocks in the course of the year.
The calculation of the national income using the expenditure method is what is known as the
aggregate demand. This total spending is made up of consumption expenditure, plus investment
expenditure, plus government expenditure, plus net exports (that is exports minus imports).
Adjustments have to be made for taxes and subsidies as they distort market prices, the idea
is to measure the national expenditure, which corresponds to the cost of the factors of

production used in producing the national product, which is known as national expenditure
at factor cost.
The usefulness of this method is in detecting changing trends in consumption and investment,
although this is the most widely used method, it trends to over estimate national output.
GROSS DOMESTIC PRODUCT (GDP)
The GDP is the first value arrived at in the national income calculations, before any adjustments
are made. This is often referred to as the value of the output produced in the country during one
year and if it increases in real terms, then it is a sign that the economy has grown. The GDP is
calculated at market prices, but after taxes are deducted and subsidies are added, the GDP is at
factor cost.
GROSS NATIONAL PRODUCT (GNP)
This refers to the value of the output produced by residents of a country in a year. It is arrived at
after including the output produced by companies and individuals of a country but they are based
abroad. In addition, output produced by foreigners and overseas companies in that country is
deducted. This is summarized as net property income from abroad, which maybe positive or
negative.
CAPITAL CONSUMPTION
Capital assets suffer wear and tear as such depreciation, termed capital consumption is deducted
from GNP to arrive at the Net National Product or the National Income is short.
In summary
GDP at market Prices

- indirect taxes
+ Subsidies
= GDP at Factor cost

+ Net property income from abroad
= GNP
- Depreciation
=NI

1.5 ZAMBIA’S GROSS DOMESTIC PRODUCT BY KIND OF ECONOMIC ACTIVITY
AT CURRENT PRICES (K'BILLION), 2003 – 2005 USING THE VALUE ADDED
(OUTPUT) METHOD
KIND OF ECONOMIC ACTIVITY 2003 2004 2005*

Agriculture, Forestry and Fishing 4,244.6 5,568.2 6,856.6
Agriculture 1,008.2 1,249.5 1,526.0
Forestry 2,960.3 3,998.5 4,953.6
Fishing 276.1 320.2 377.0
Mining and Quarrying 564.8 809.6 980.5
Metal Mining 558.2 798.3 960.4
Other Mining and Quarrying 6.6 11.3 20.0
PRIMARY SECTOR 4,809.4 6,377.7 7,837.0
Manufacturing 2,241.0 2,827.7 3,458.1
Food, Beverages and Tobacco 1,397.2 1,726.6 2,145.5
Textile, and Leather Industries 352.9 450.7 491.2
Wood and Wood Products 164.7 222.2 283.7
Paper and Paper products 93.1 123.6 161.0
Chemicals, rubber and plastic products 178.9 231.7 286.3
Non-metallic mineral products 30.0 41.0 51.6
Basic metal products 3.1 4.0 4.6
Fabricated metal products 21.0 27.7 34.2
Electricity, Gas and Water 595.1 694.7 922.7
Construction 1,590.0 2,402.1 3,689.8
SECONDARY SECTOR 4,426.1 5,924.5 8,070.6
Wholesale and Retail trade 3,873.8 4,843.7 6,079.7
Restaurants, Bars and Hotels 527.7 670.9 895.9
Transport, Storage and Communications 1,058.2 1,252.3 1,408.3
Rail Transport 89.5 100.8 99.9
Road Transport 393.9 464.0 546.7
Air Transport 152.7 203.0 246.7
Communications 422.1 484.6 515.0
Financial Intermediaries and Insurance 1,847.7 2,282.7 2,776.9
Real Estate and Business services 1,341.2 1,691.8 2,105.8
Community, Social and Personal Services 1,757.0 2,046.5 2,529.1
Public Administration and Defence 683.0 723.9 869.4

Education 688.6 867.7 1,127.1
Health 252.4 292.8 329.1
Recreation, Religious, Culture 26.4 28.8 36.1
Personal services 106.6 133.3 167.3
TERTIARY SECTOR 10,405.6 12,787.9 15,795.8
Less: FISIM (1,061.8) (1,311.8) (1,595.8)
TOTAL GROSS VALUE ADDED 18,579.3 23,778.3 30,107.6
Taxes on Products 1,899.9 2,219.1 2,541.1

TOTAL GDP. AT MARKET PRICES 20,479.2 25,997.4 32,648.6
Growth Rates in GDP 25.97 29.95 25.58
Current GDP per Capita (Current Prices) 1,852,017.00 2,317,860.00 2,909,857.00
Source: Central Statistical Office
1.6 Zambia’s GDP by expenditure method, in Kwacha (bn) at current prices
1990 1991 1992 1993 1994 1995 1996 1997
Total consumption 95 200 574 1316 1980 2779 3608 4752

Government consumption 17 35 102 192 313 489 714 857
Private consumption 78 165 472 1124 1667 2290 2894 3895
Total investment 20 24 68 223 284 394 582 701
Gross fixed capital formation 19 25 65 217 276 385 566 681
Public fixed capital formation 8 13 23 50 235 198 239 278
Private fixed capital formation 11 12 42 167 41 187 327 403

Changes in stock 1 -1 3 6 9 9 16 23
Net exports -1 -6 -72 -57 -23 -175 -246 -284
Exports of goods and services 41 76 210 498 785 1109 1344 1715
Exports of goods 38 70 195 454 714 1027 1200 1565
Imports of goods and services -41 -81 -282 -555 -809 -1284 -1590 -2000
Imports of goods -33 -62 -233 -465 -671 -1034 -1275 -1601
Total GDP 113 218 570 1482 2241 2998 3945 5169
Source: Internet
2.0 USES OF NATIONAL INCOME FIGURES
- The main use is to assess the performance of an economy over a year. It is used as an
indicator of a growing or a contracting economy, Economic growth or lack of it is
assessed using the national income figures.
- The figures are used to indicate the overall standard of living, especially after dividing by
the total population in a country to calculate the per capital income.
- This enables comparisons to be made between different countries. To ascertain which are
rich and which ones are poor countries.
- To assist the government in managing the economy, using Keynesian demand
management.
- The trade or Economic cycles depend on the national income figures. The figures are also
used to estimate future movements.
2.1 LIMITATIONS IN NATIONAL INCOME CALCULATIONS
1. There are differences in the accuracy of the figures. Different countries collect and invest in
data collection differently.
2. Economic welfare affected by medical and educational facilities per head. There is need to
know what proportion of the national income is spent on the provision of better social sector
facilities and not on defence! As with all mathematical averages, per capita income data does
not take into account how the GDP is distributed amongst the population. If the income is
unevenly distributed, then increases in the GDP per capita may disproportionately benefit a
small group of high income earners and have little impact on reducing poverty. If GDP per
capita data is to be used then its distribution must also be taken into account.
3. Arbitrary definitions, for example when calculating the national income, only those goods and
services that are paid for, are normally included. Do it yourself jobs, such as gardening,
repairing one‟s own car, housework etc, are excluded, and their exclusion distort the national
income figure. These unpaid services, which are normally provided by housewives, are
included in the calculation of the national income when done by someone else. If an
individual lives a in a house for which he pays rent to the landlord, this will be treated
differently from owning a house for which he no longer pays rent
4. Incomplete information, which can be attributed to, the high levels of subsistence sector,
barter and black economies that are more pronounced in developing countries.
5. Danger of double counting, for example, the cost of raw materials and that of finished goods
should not both be counted, this difficult to avoid when using the output method of calculating
the national income.
6. Using any monetary data, such as GDP per capita over time, must recognise that output and
incomes measures can increase for many reasons other than the country producing more
goods.
It is an increase in goods and services that is necessary if poverty is to be alleviated or

peoples‟ livings standards rose. Output and incomes measures may increase because the rate
of inflation has simply increased the money value of goods and service produced rather than
their real value. Real GDP per capital would be a better indicator, as this is a measure of the
physical value of goods and services produced. Real GDP is equal to the nominal GDP
adjusted for price changes, (minus inflation).
The different rates of inflation and the constant variations in the exchange rate within and in

different countries make comparisons difficult.
7. The national income measures the standard of living. This has to relate to the size of the
population. Some countries have a high-income figure and a correspondingly high population.
8. Some countries have high national income figure but are paying a high penalty for living
beyond their means and borrowing heavily.
9. It should be remembered that GDP only includes output that involves a financial transaction
i.e. is marketable. A considerable amount of Zambia's agricultural output is produced on
small-scale communal farms for subsistence purposes. It is currently estimated that only 25%
of production on communally owned land involves monetary transactions. The rest is not
included in any national income calculations. Likewise the output of the informal sector will
not be included.
10. Increasing national income and growth may occur at the expense of the environment rapidly
growing economies may result in negative externalities. An agricultural sector that increases
productivity by intensive use of pesticides and fertilisers or deforestation. may reduce future
land fertility and worsen the level of poverty for future generations
2.2 FACTORS DETERMINING A COUNTRY’S NATIONAL INCOME
Income is not evenly distributed, and the factors determining a country‟s national income can be
classified as internal and external, the latter resulting from a country‟s relationships with the rest of
the world.
The most important internal factors are
Original Natural Resources
Natural resources are nature-given, such as mineral deposits, sources of fuel and power, climate
soil fertility, fisheries, navigable rivers, lakes that help communications etc. New techniques allow
national resources to be exploited while the exhaustion of minerals resources reduces national
income. Some countries are well endowed by nature, and if the resources were well managed, then
the national income would be high.
Where a country‟s economy is predominantly agricultural, variations in weather may cause

national income or output to fluctuate from year to year, this happens to be the problem with most
developing countries.
The nature of the people, particularly of the labour force
This includes the quantity of the labour force, the higher the proportion of workers to the total
population and the longer their working hours, the greater s the national income figure.

Another factor is the quality of the labour force, their health, nutrition, energy, inventiveness,
judgment and ability to organize them to cooperate in production, the climate, working conditions,
peace of mind as well as education and training.
Capital Equipment
Productivity or labour will be increased if the quality of the other factors is high, for example, the
more fertile the land, the greater is the output per man.
In addition, the quality of the capital equipment employed is the most important factor, the output
of workers varies almost in direct proportion to the capital equipment, and the single most
important material progress is investment in capital.
Consider the output per man where the majority of the farmers are using a hoe and an axe, while in
advanced countries, farmers use tractors and combine harvesters!
Knowledge of techniques
This is acquired through the development of Research and inventions. The government can
encourage this by financing research schemes. Alternatively the government can go into
partnership with the private sector or offer incentives such as tax rebates to companies that are
spending a lot on research and development. New inventions can bring in more income into the
economy.
The organization of resources
One of the known factors that can improve production and therefore national income in most of the
developing countries is the organization and the management of resources.
The leaders of any economy should have a vision for their countries. They have to be focused, set
goals and objectives, have the right people and the right resources in order to achieve those
objectives.
Political stability
A country has to be politically stable in order to produce. If the resources are being used on
warfare, very little production of goods and services takes place. This again is a common problem
in developing countries. Even if some are well endowed, they are not politically stable and the
organization of resources is poor.
The external factors are
Foreign loans and investments
These are an injection of funds that lead to an addition of stock, adding to the national income.

Related to the above, gifts or handouts from abroad for the purposes of Economic development
and defence improve the national income of the receiving countries.
Terms of trade
This is the rate at which one country‟s exports exchange with another country‟s imports. The terms
of trade is not constant, it changes as export and import prices change.
Developing countries generally deal in the primary sectors and not in the secondary sectors in
production. They export goods at low prices in their raw form, but import goods at relatively high
prices as these are finished goods.
3.0 CHAPTER SUMMARY
The national income of any country is simply the total value of goods and services its people
produce during the year. The national income can be measured in three different ways, the value
added (output) method, the income method and the expenditure method. In theory, all the three
methods should provide the same national income figure, based on the circular flow of income. A
simple model of the circular flow of income assumes a two-sector economy of firms and
households.
Factors of production move from households to firms, for the production of goods and services.
Firms pay factor incomes, such as wages and salaries to households in exchange for the factors.
The income earned by households is spent on goods and services produced by firms.
Calculation of the national income is very important in every economy as the figure has a number
of uses. It is used to assess the performance of the economy over the years, to indicate the overall
standard of living, and to enable comparisons to be made, from one year to the next, as well as
comparisons between countries.
Unfortunately, there are a number of difficulties that are encountered in measuring national
income, which provides unreliable testimony as to how the real welfare of the people has changed,
and when making comparisons.
The national income, and therefore Economic growth depends on the natural resources of a
country, the quality of the labour force and its participation rate, the capital equipment being used
etc.

REVIEW QUESTIONS
1. Outline the three approaches used in calculating national income

2. Distinguish between GDP and GNP
3. What is the difference between nominal and real GDP?
4. What are transfer payments? Give examples.
5. Explain why the transfer payments must not be included in the national income figure
6. What is net national income at factor cost + capital consumption + indirect taxes on
expenditure – subsidies equal to?
7. From the hypothetical data below relating to the economy of a country over a one year period
K‟m
Subsidies 2 000
Exports 25 000
Government expenditure 40 000
Net property income from abroad 1 000
Imports 53 000
Capital consumption 8 000
Capital formation 38 000
Taxes on expenditure 30 000
Consumers‟ expenditure 97 000
Value of physical increase in stocks 5 000
You are required to calculate:
a) The GDP at market prices

b) The GDP at factor cost
c) The GNP at factor cost
8. Why are the figures above considered as “gross”
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EXAMINATION TYPE QUESTION 8.1
a) Explain the three ways of measuring the national income figure. (9 Marks)
b) Give a brief explanation why theoretically the national income figure should be the same
whichever method is used in its measurement. (2 Marks)
c) Give three reasons why national income accounts are not very useful in making comparisons
of living standards between countries. (9 Marks)
(TOTAL: 20 MARKS)

The following data relates to the economy of a country over a one-year period.
K‟B
Subsidies 1 000
Gross domestic fixed capital formation 2 400
Exports of goods and services 2 000
Government final consumption 3 000
Property income from abroad 300
Imports of goods and services 2 500
Value of physical decrease in stocks 10
Consumer‟s expenditure 8 000
Capital consumption/Depreciation 1 500
Taxes on expenditure 1 750
Property income paid abroad 500
Required
Calculate the following from the above data:
(a) Gross domestic product at market prices (5 marks)

(b) Gross domestic product at factor cost (5 marks)
(c) Gross national product at factor cost (5 marks)
(d) Net national product at factor cost (5 marks)
(TOTAL: 20 MARKS)

CHAPTER 9
NATIONAL INCOME DETERMINATION

______________________________________________________________________________________________
 Explain the relationship between national income, consumption expenditure, savings and
investment
 Discuss the factors that determine consumption, savings and investment
 Explain how the multiplier and the accelerator works
 Explain what the circular flow of income for an open (complex) economy is
 Discuss Economic or business cycles and their characteristic features
_______________________________________________________________________________
1.0 Introduction
In macroeconomics, there are mainly theories of two schools of thought. The monetarists, the
famous one being Milton Friedman, their arguments are mostly on the money supply and the
effects of changes in the money supply.
The Keynesians, advocates of Sir John Maynard Keynes. Keynes wrote a book entitled General
Theory of Employment, Interest and Money, published in 1936. His work was at the time of the
great depression.
1.1 CONSUMPTION EXPENDITURE
From the circular flow of income, spending by households is termed consumption

expenditure. It is an endogenous part of the circular flow of income.
Consumption expenditure depends on an individual‟s income, it is therefore a function of income.

C = F (Y).
As Y increases the level of consumption also increases but Lord Keynes maintained that each
successive increment to real income is marched by a smaller increment to consumption
expenditure, the rest is saved.

Consumption
and
Savings
AS (Y)
Savings
S
Dissavings
a 450
Disposable income
The extent to which consumption changes with income is termed the marginal propensity to
consume (MPC). The marginal propensity to consume is the proportion of each extra kwacha of
disposable income spent by households. That proportion of each extra kwacha of disposable
income not spent by households is known as the marginal propensity to save (MPS).
If out of the extra kwacha increase, eighty ngwee is consumed, then the marginal propensity to
consume is 80% or 0.8, and the marginal propensity to save is 20% or 0.2.
Therefore the MPC is the ratio at which the extra income earned is consumed, and it is denoted by
the formula:
MPC = C, and it depends on the slope of C.

Y the steeper the slope, the larger is MPC
MPC depends on the slope of the consumption function, the steeper the slope, and the larger the
MPC, which implies a small MPS.
The nature of the relationship between consumption and income is given by the straight-line
equation:
C = a + by
Where
C = consumption
a = C when an individual is not working and income from employment is zero, it is also known as
autonomous consumption.
b = MPC
y = income,

For example, assume K650 000 is required for a family of three people to survive, whether the
head of the family is working or not. The K650 000 has to be found for the family to stay alive; it
can come from social security, dissavings, begging, borrowing etc.
When in employment, for every extra kwacha earned, 80 ngwee is consumed. The equation
becomes
C = 650,000 + 0.8Y.
Factors influencing consumption are income, interest rates, government policy such as taxation,
which reduces the disposable income, hire purchase and other credit facilities, and invention of
new consumer goods, which are later, introduced on the market.
Note that in any economy households, firms and government undertake consumption of goods and
services
2.0 SAVINGS
Savings is defined as the part of income not spent, it is a withdrawal or a leakage from the
circulation flow of income.
Y=C+S
S=Y–C
Therefore consumption and savings are two sides of the same coin and the consumption function
tells us not only how much households consume, but also how they save. The factors that influence
consumption naturally affect savings.
MPS is denoted by the formula = S

Y where  is change.
Since any increment in income must be either spent or saved, MPC + MPS = 1
3.0 INVESTMENT EXPENDITURE
Investment is spent on the production of capital goods (houses, factories, machinery, etc) or on net
additions to stocks such as raw materials, consumer goods in shops, etc.
In national income analysis, investment takes place only when there is an actual net addition to
capital goods or stocks.
Investment is a major injection into the circular flow of income and affects national income and
aggregate demand. Investment through the multiplier is needed to achieve Economic recovery.
Investment is very dynamic, it determines future shape and pattern of Economic recovery.

Economic growth determined by technological progress, increase in size and quality of labour and
the rate at which capital stock is increased replaced. Addition to stock should be greater than stock
depreciation.
Investment therefore determines long-term growth, and both the private and the public sector can
carry it out. If it is undertaken by the private sector, the government is expected to provide an
enabling environment by stimulating business confidence by providing a stable Economic climate.
Setting and achieving macroeconomic targets like low levels of inflation, controlling the money
supply and therefore controlling the interest rates and consumption. The government can offer tax
concessions or finance research schemes, sometimes in conjunction with the private sector.
Keynesian demand management emphasizes the importance of the role, which the government
plays to influence investment.
4.0 KEYNESIAN DEMAND MANAGEMENT
National income determination is a Keynesian concept. Keynes emphasized the importance of

aggregate demand in the economy. The national economy could be managed by taking appropriate
measures to influence aggregate demand up or down depending on whether there was a
deflationary or an inflationary gap in the economy.
The aggregate demand (AD) is the total demand for goods and services in the economy. Aggregate
demand is made up of consumption expenditure (C), government expenditure (G), investment
expenditure (I) and exports (X) minus imports (M), that is AD = C + G + I + (X – M).
The aggregate supply curve (AS) is the total supply of goods and services in the economy, and a
typical Keynesian aggregate supply curve is an inverse “L”. The explanation is that the AS curve
becomes vertical when all the resources are fully employed.Keynes concentrated on shifting the
AD, hence the name Keynesian demand management, and it involves manipulating national
income by influencing C, I, G, or (X – M). According to Keynes, the equilibrium is where the
AD is equal to AS at the full employment level. This is the „ideal‟ position where all the
resources are fully employed.
Prices
AS
AD
0 (Real national income)

Output, employment and Income

Suppose the economy is in a recessionary stage, and there is underemployment of resources, it
means there is a deflationary gap.
Prices AD AS
P
D
P1
O Y YFE (Real national income)

Where D is the deflationary gap, this is the extent to which the government needs to increase AD
to shift it to the right or upward to reach the „ideal‟ full employment level in the economy.
Alternatively, the economy maybe experiencing inflationary pressures if AD is above the „ideal‟
full employment position. The resources cannot be increased any further and this puts pressure on
the prices of goods and services.
Prices
AD AS
AD1
P
I
P1
(Real national income)

Where I is the inflationary gap, the extent to which the government needs to reduce AD to shift the
curve from AD to AD1, back to the equilibrium level.

4.1 THE MULTIPLIER PRINCIPLE
Keynesian demand management involves manipulating national income by influencing C, I, G, or

X – M, while C is an endogenous part of circular flow of income, the others are injections into the
circular flow. Any injection into the circular flow of income of a country starts a snowball effect.
If the government decides to build a big hospital in Zambezi district costing K10 billion, the
increase in government expenditure through the construction of the hospital provides incomes to
the factors of production employed in the construction of the hospital. Part of the K10 billion goes
to the contractor as profits, part of it goes to the workers as wages and part of it is used for the
purchase of building materials. The three groups who will earn the income will spend it.
Any expenditure becomes someone else‟s income, which is then in turn spent, generating a whole
series of rounds of additional spending and income generation, the snowball effect. However, not
all the income earned is consumed, some of it is saved. Savings is a leakage from the circular flow,
other leakages from the circular flow of income are imports and taxes. The total amount leaked out
is known as the marginal rate of leakages.
The effect on total national income of a unit change any of the injections into the circular flow
income can be measured, it is called the multiplier.
The investment, government or export multiplier = Eventual change in NI

Initial change in I, G spending or X
The multiplier is denoted by the symbol K, and can be re-written as
K = Total increase in NI
Initial increase in NI
The shortcut method is to take into account the leakages, therefore
K = 1
Marginal rate of leakages
Numerical example in a simple closed economy starts with the assumption that income is either
consumed or saved. Suppose the MPC in the example above where there is an injection of K10
billion is 80% (0.8). & income increases by £200

Increase in Increase in
Expenditure Savings
(K‟billion) (K‟billion)
Stage
1 Income increase 10 -
2 80% consumed 8 2
3 A further 80% is
consumed 6.4 1.6
4 A further 80% is
consumed, etc 5.12 1.28
It works out to be K=1= 1 = 1 = 5 times

1 – MPC MPS 0.2
This translates to 5 times the initial investment of K10 billion, meaning that the eventual change in
national income is K50 billion! If the marginal propensity to consume were much higher than
80%, then the multiplier effects would be much higher and vice versa.
Multiplier in a complex, open economy would be lower because all the leakages or withdrawals
from the circular flow of income would be taken into account.
THE CIRCULAR FLOW OF INCOME FOR AN OPEN (COMPLEX) ECONOMY
SAVINGS
TAXATION
WITHDRAWALS/
IMPORTS
LEAKAGES
HOUSEHOLDS
Consumpt
Factor iiiiion Goods
Market Market
s Income
FIRMS INVESTMENT
GOVERNMENT
INJECTIONS EXPORTS
4.2 Accelerator theory
The accelerator relates to a small change in the output of consumer goods, which is said to result in
a greater change in the output of capital equipment. This change in the production of capital
equipment depends on the capital-output ratio.

The accelerator theory suggests that the level of net investment will be determined by the rate of
change of national income. If national income is growing at an increasing rate then net investment
will also grow, but when the rate of growth slows net investment will fall. There will then be an
interaction between the multiplier and the accelerator that may cause larger fluctuations in the
trade cycle.
In the multiplier principle, an increase in investment affects income and consumption, while under
the accelerator, consumption affects investment. When the economy is expanding, and income as
well as consumption is high, then the business sector is encouraged to produce more goods. Thus
investment increases. The increase in investment leads to an increase in income and consumption,
and so on.
The combined effect of both the multiplier and the accelerator results in the sequence of rapid
growth in the national income followed by a slow growth, the business or trade cycles. These are
made up of four phases namely, the recession, depression, recovery and boom.
GROWTH (%)
Boom
Recession
s
Recovery
Depression
TIME
When aggregate demand falls, businesses are discouraged, and both employment and production
fall this is the recession stage. If this continues, then a full depression sets in.While a recession is
quicker, recovery is slower because of lack of business confidence. Once recovery starts it is
likely to quicken as business confidence returns. As output, employment and income increase,
there is even more investment because of business expectations until a „business boom‟ is reached.
4.3 THE PARADOX OF THRIFT
In theory, investment depends on savings. In order to increase savings, consumption must reduce
because income is either consumed or saved.
Unfortunately, a reduction in consumption reduces business expectations, and the business sector
reduces investment. A reduction in investment causes greater reductions in income. When income
reduces, savings also reduces.
The paradox of thrift explains the working of the „demultiplier‟.

5.0 CHAPTER SUMMARY
The level of national income of any country is determined by the relationship between decisions by
households to spend and save and decisions by the business community to invest.
The consumption function is C = a + bY. Where b is the marginal propensity to consume, this is
the proportion of an increase in income, which is spent (consumed).
Therefore, the most important determinant of the level of consumption is income.
Savings is that amount of income not spent, and therefore, it also depends on income. However,
there are other factors that influence consumption and savings, such as interest rates, inflation,
levels of taxation, existence of financial institutions etc.
In theory, the national income remains the same from one period to the next if people decide to
save an equal amount as the one, which business houses decide to invest.
Investment is the actual increase in stocks, the creating or buying capital equipment, not goods
which are for immediate consumption. Investment depends mostly on the expected returns.
When national income is at its full employment level, and the total spending, commonly known as
aggregate demand, is less than this figure, the deficiency is known as a deflationary gap.
If, on the other hand, at full employment, aggregate demand is in excess of the full employment
national income, then an inflationary gap occurs.
An increase in aggregate demand gives rise to additional income due to the workings of the
„multiplier‟, but a reduction in aggregate demand gives rise to multiple reductions in income,
called the de-multiplier.
The „accelerator‟ theory links consumption expenditure to investment decisions. An increase in

consumption expenditure results in more investments in capital goods in order to increase output to
satisfy customers.
The combined effect of both the multiplier and the accelerator results in the business or trade
cycles. A business cycle consists of simultaneous expansion in many fields of business activity,
followed by widespread contraction.
The „paradox of thrift‟ reflects the fact that a decision to increase the rate of savings may result in a
decline in income.
Note the fact that the theory of income determination is developed on simplified models whose
application in practice may be limited. However, Keynesian demand management is important
because governments intervene in order to stabilize their national economies, and even if their
interventions may not be fully successful, they do influence the level of Economic activity.

REVIEW QUESTIONS
1. What does the equation „C = a + bY‟ mean?

2. When, in theory, is an economy in equilibrium?
3. Mention why in practice, the above is not possible
4. Name two injections into the circular flow of income
5. How does the aggregate demand „differ‟ with the injections into the circular flow of income
6. According to Keynes, why does investment grow faster than consumption?
7. Explain the „multiplier‟ principle, and indicate the formula for both a closed and an open
economy.
8. What is a trade or a business cycle? Indicate its correct sequence.
9. Why does the „paradox of thrift‟ arise?
10. When can a „deflationary gap‟ occur?
-------------------------------------------------------------------------------------------------
EXAMINATION TYPE
QUESTION 9.1
a) Explain why the level of investment is considered to be important in any economy? (4 marks)
b) How might governments encourage a high level of business investment? (6 marks)
c) Explain what is meant by the multiplier in the context of national income. (5 marks)
d) Explain the paradox of thrift. (5 marks)
(TOTAL: 20 MARKS)

CHAPTER 10
MONEY AND INTEREST RATES

______________________________________________________________________________________________
 Define and differentiate forms of money

 Describe the basic characteristics of money
 Appreciate the functions of money in the economy
 Explain the demand for money
 Explain how the money supply is defined
 Explain how Interest rate is determined
 Discuss the Economic effects of interest rate changes
______________________________________________________________________________
1.0 INTRODUCTION
Money is defined as anything that is generally acceptable in repayment of a debt. It is a medium of

exchange, a legal tender.
The early forms of money where items that were in common use and generally acceptable, such as
cattle, hides, furs, tea, salt, shells, cigarettes, etc.
These early forms of money had a lot of limitations, some items like cigarettes are not generally
acceptable to be used by all to settle debts. Other early forms of money like cattle were not easy to
carry around, and therefore not convenient. Some were perishable products like hides and as they
were deteriorating with frequent handling.
In addition, there was no homogeneity in terms of size, colour and weight. The money that is used
now such as the one, ten or fifty kwacha bank notes are similar and they are easily recognizable.,
Therefore, a good monetary medium must be:-
- Generally acceptable
- Fairly durable
- Capable of being divided into small units
- Easy to carry (portable)
- Should be relatively scarce
- Should be uniform in quality

1.1 The Origin of Money
Money came into use due to the abundance of some things, after producing in greater quantities
than what is required for immediate consumption. There was need to exchange the surplus with
another person for some other commodity. Initially, it was mostly the exchange of goods for
goods, the barter system.
This method had a lot of limitations and inconveniences such as the „double coincidence of wants‟.
Finding a person who had an item or service you wanted and in return you also have an item,
which is wanted by that person, before any, exchange can take place.
There was also the problem of the rate of exchange. That is, how much of item X has to be given
for item Y. Related to this was issue of one party to a transaction having only a large commodity to
offer, but requires a small item in exchange.
The barter system is still being practiced among some people but to a very small extent.
Given the shortcomings of the barter system it is easy to appreciate and understand the functions
that money performs in modern economies.
1.2 Functions of money
Money performs four main functions:
 A Medium of Exchange
This is its earliest function and the most important one. Money facilitates the exchange of goods,
buyers and sellers meet and trade easily without the inconveniences of the barter system. This in
turn promotes specialization, productivity, efficiency and wealth creation. Money is considered to
be the „oil, which allows the machinery of modern buying and selling to run smoothly‟.
 A Unit of Account and a Measure of Value
Another drawback of the barter system is the difficulty of determining a rate of exchange between
different kinds of goods especially large indivisible articles. Money acts as a common measure or
standard value of the unit account of goods and services.
The value of goods and services is reduced to a single unit of account, and therefore the process of
exchange is greatly simplified.
Money makes possible the operation of a price system and automatically providing the basis of
keeping accounting records, calculating the profit and loss accounts the balance sheet etc.
 A Store of Value
Money is the most convenient way of keeping any income, which is surplus to immediate
requirement. It makes possible a build up of stores of many things for future use, a store of wealth.

Money can also be stored in the form of other assets such as houses, but money is a preferred
because it is a liquid store of wealth. This means that money can be converted almost immediately
into a medium of exchange without „loss of face value‟. Assuming that money is stable in value!
 A standard for Deferred Payments
Use of money makes it possible for payments to be deferred from the present to some future date.
Borrowing and lending are greatly simplified, loans are taken and repaid in the form of money.
Credit transactions cannot easily be carried out unless money is used. Given the assumed stability
in its value, future contracts are fixed.
Credit transactions cannot easily be carried out unless money is used.
1.3 The Demand For Money
Demand for money means the desire to hold money, as distinct from investing it. This
desire to hold liquid reserves is known as liquidity preference. According to Lord Keynes there
are three motives for holding money.
 The transactions motive
Both consumers and businessmen hold money to facilitate current transactions. A certain amount
of money is needed for every day requirements, the purchase of food, clothing, to pay casual
workers etc.
 The Precautionary Motive
Most people like to keep money in reserve, in case an unexpected payment has to be made, e.g.
illness, funeral, accident, car defects, household appliance defects, etc.
„Active‟ balances, depends any, fairly inelastic, less inelastic in the 2nd and elastic in the 3rd known
as „idle‟ balances.
 The Speculative Motive
This is for the purpose of accumulating more, since holding money in active balances does not
yield any interest.
Speculation depends on the expectation of the future tend in securities e.g. attractive shares and
govt. stock, this generally moves in the opposite direction with interest rates if interest rates go up
i.e. people think the price of stocks will go down in the future they will hold money …

2.0 THE SUPPLY OF MONEY
Money supply in any economy is a very important part of government policy. Money supply has
to be monitored as a guide to Economic policy.
The argument of the monetarists is based mostly on the money supply. However both the
Keynesians and monetarists accept the importance of money supply.
The money supply is the stock of money existing at any particular point in time. It is basically
made up of coins and notes in circulation as well as bank deposits. Coins and notes make up
approximately only one fifth of the total money supply while bank deposits make up four fifth.
This is because commercial banks „create‟ money through the creation of credit and the creation of
deposits.
2.1 MONETARY AGGREGATES
The definition of the money supply is carried out in order to measure monetary aggregates. In
practice, money is measured either narrowly or broadly, with a very thin dividing line between the
two.
 Narrow Money
This is money that is available to finance current spending, money that is held for transaction
purposes, it highlights the function of money as a medium of exchange. Narrow money is
designed in different ways, the narrow measure of money starts from MO (Pronounced as „m
nought‟), is the narrowest definition of narrow money. It comprises mostly notes and coins in
circulation, plus commercial banks operational deposits held by the bank of Zambia.
 Broad Money
This is narrow money plus balances held as savings, that is the function of money as a medium of
exchange and as a store of value. Therefore, broad money is money held for transactions purposes
and money held as a form of saving.
Broad money includes assets, which are liquid but not as liquid as assets under narrow money.
Broad money is also defined in different ways. The first broad definition of money is M4, and
when foreign currency deposits are included, the definition is M3.
3.0 INTEREST RATE DETERMINATION
Interest is the price of money, and in the credit market, it is determined by the market conditions of
demand for and supply of money. According to the Keynesians, the demand for money, liquidity
preference is partly depend on the rate of interest. The supply of money is perfectly inelastic, the
supply might increase or decrease depending on the government policy.

The equilibrium market rate of interest is determined at the point where the supply of money
equals the demand for money
Interest
Rate MS
LP = d
O m Quantity of money
As in other markets, changes in either demand or supply conditions lead to a change in interest
rates. In the Keynesian model, an increase in the money supply is associated with a fall in interest
rates and vice versa.
Interest
Rate MS MS1
r1
LP = d
O m m1 Quantity of money
If the money supply increases from MS to MS1, the equilibrium rate of interest reduces from or to
Or1.

3.1 THE MONETARISTS VIEW
Monetarists ensure that there are no three motives for holding money. Monetarists hold the view
that money is held mostly for transactions purposes and enjoyment, and that demand for money is
interest rate inelastic. As a result, any slight change in money supply leads to a big change in the
rate of interest. This explains the need to maintain stability in the money supply in order to
maintain stable interest rates.
Interest D MS Interest MS MS1
Rate rates D
r
r
D r1
O m Quantity of money O m m1 Quantity

of money
Another argument by the monetarist is the microEconomic view known as the loanable funds
theory (explained under factor markets).
3.2 EFFECTS OF INTEREST RATE CHANGES
Stable interest rates are important in any economy, if there is a large increase in the rate of interest,
then the economy is affected in a number of ways.
- The cost of credit increases borrowing reduces and investment expenditure reduces.
- Spending by households also reduces savings is encouraged, since income is either consumed
or saved, an increase in savings reduces consumption expenditure.
- Investment and consumption expenditure are components of aggregate demand, if spending by

both households and firms reduces, then inflation is likely to be lowered. Low prices and less
borrowing is a sign of less Economic activity.
- The foreign flow of funds increase financial speculators with „hot money‟ are likely to be
attracted to the high rates of interest.
- An increased flow of foreign funds puts pressure on the exchange rate. The high demand for
the kwacha causes the kwacha to appreciate in value.
- A strong kwacha makes exports less attractive on the international market, reducing the
demand for exports. Some workers are likely to be laid off, this reduces the level of
Economic activity furthers.

- The business sector is also affected by the likely impact on profitability and investment
projects that are appraised. High costs of borrowing compared to reduced cash flows due to a
reduction in consumption expenditure.
3.3 VARIATIONS IN THE INTEREST RATES
Interest rates are determined by the market forces supply of and demand for money. In practice,
there are several variations of interest rates that financial intermediaries apply, financial
institutions do not give or charge exactly the same interest rates.
Finance bank, Indo-Zambia bank, Zambia National Commercial Bank etc all have their own rates
that they offer to customers.
„Lending rates‟ given to surplus units (the depositors/savers who supply funds) and „borrowing
rates‟ charged to deficit units are different.
An individual bank can give or charge different rates to customers depending on estimated
compensation for trying up the money, perceived „risk‟ of the customer, amount and period of the
loan etc.
In addition, there is the real rate of interest, which is the nominal rate of interest adjusted for
inflation. The nominal rates of interest are the expressed rates, in monetary terms, hence they are
also known as the money rate of interest.
The relationship between the inflation rates, the real rate of interest and the money rate of interest
are:
(1 + real rate of interest) x (1 + inflation rate) = 1 + money rate of interest. This is usually
approximated as real rate of interest + inflation rate = money rate of interest (nominal interest
rate).
5.0 CHAPTER SUMMARY
Money is a medium of exchange, anything that is generally acceptable in the settlement of a debt.
Early forms of money were items in common use, but had a number of limitations, hence a good
monetary medium has a number of characteristics.
Money performs a number of functions in the economy, it is a medium of exchange, unit of

account and measure of value, and it is a store of value and a standard for deferred payments.
The demand for money, according to Keynes, is the desire to hold money, and it is held as active
balances, for the transactions and precautions motive, this depends on an individual‟s income and
it is interest rate inelastic. Money is also held as idle balances for speculative reasons, and this
depend on the rate of interest.

The money supply in any economy is simply made up of notes coins and bank deposits; however,
money supply is a very important part of government policy, and it can be measured both narrowly
and broadly.
Generally, the market forces of supply and demand determine interest rates. Interest rates should
have some degree of stability, as they are very important in Economics and in the business
environment.
In practice, there are variations in the rate of interest, which affect savings and loan repayments.
REVIEW QUESTIONS
1. What is money?
2. Give a brief explanation of the characteristics of money
3. What are the four functions of money in an economy?
4. Distinguish between narrow money and broad money
5. What do broad measures of money include?
6. Why do people demand money?
7. If interest rates rise, will bond prices rise or fall?
8. What is the real rate of interest?
9. What effect has an increase in the rates of interest have on the exchange rate?
10. Sketch a liquidity preference schedule
------------------------------------------------------------------------------------------------------ ---
a) In what ways might a business be affected by a large change in interest rates? (8 Marks)
b) Sketch and explain a liquidity preference schedule. (6 Marks)
c) Explain the loan able funds theory of interest rate determination. (6 Marks)
(Total: 20 Marks)

CHAPTER 11
FINANCIAL SYSTEMS AND MONETARY POLICY

_____________________________________________________________________________________________
 Appreciate the flow of funds and financial intermediation

 Identify the main elements of the monetary and financial system
 Explain the importance of the monetary environment to the business sector
 Explain the functions performed by commercial banks and the central bank.
 Understand how commercial banks „create‟ money
 Explain the Economic role of government through monetary policy and its basic
instruments
 Understand commercial bank‟s conflicting objectives of liquidity, profitability and security
_______________________________________________________________________________
1.0 INTRODUCTION
A financial system is made up of financial markets and financial institutions, it may also include
formal and unregulated systems of finance, such as moneylenders, trade credit, micro finance and
co-operative credit.
Financial markets are the capital market, the money market and the foreign exchange market.
Financial institutions are commercial banks, building societies, insurance companies, national
savings and credit bank etc.
A financial system brings in many benefits in the economy, it facilitates payments, raise the level
of savings and investment. Capital is accumulated and allocated to uses where there are highest
returns. The system helps to provide a means of transferring and distributing risk across the
economy. Risk is diversified or pooled among a large number of savers and investors, by offering
assets with different degrees of risk, financial institutions assess and manage risks and assign to
individuals having different attitudes and perceptions towards flow of funds.
1.1 THE FLOW OF FUNDS
Funds flow between three sectors in the economy. Individuals give and lend money to each other.
Organizations lend money and purchase goods from each other. The central government provides
funds to the local government and loss making nationalized industries.
In addition, there is also a flow of funds between the different sectors of the economy.

Business Sector Personal Sector
Government sector
A go-between, known as a financial intermediary, such as a commercial bank or building society,

facilitates the flow of funds. Banks provide a means by which funds can be transferred from
surplus units in the economy to deficit units.
Linking lenders to borrowers.
Surplus Unit Financial Intermediary Deficit Unit
An individual deposits saving with a bank, the bank provides a loan to a company, as explained
under credit creation.
If no financial intermediation takes place, lending and borrowing is direct.

Lends
Surplus Unit Deficit Unit
To
Direct lending is also known as financial disintermediation. Savers wishing to lend have to find a
trust worthy borrower. The lender bears the risk of default.
The borrower has to locate savers with money to lend. This results in high information cost and
high default risk.
In practice, financial intermediaries also lend abroad, as well as borrow from abroad. Therefore, a
detailed diagram of the flow of funds showing the role of financial intermediation in an open
economy is as shown below:

Business Personal
sector sector
Government Financial Overseas

sector Intermediaries sector
1.2 BENEFITS OF FINANCIAL INTERMEDIATION
- A convenient way in which lenders save money

- They can package the amounts lent by savers and lend on to borrowers in bigger amounts
(aggregation)
- They provide a ready source of funds for borrowers.
- The lenders, capital is secure, bad debts are borne by the financial intermediary.
- They bridge the gap between the wish of most lenders for liquidity and the desire of most
borrowers for loans over longer periods. This is known as maturity transformation.
- They provide tangible returns to savings i.e. Interest rates.
- They act as an important medium for the implementation of financial (monetary) policies.
1.3 FINANCIAL INTERMEDIARIES
The banking system is made up of commercial banks and the central bank, and the non-banking
financial intermediaries e.g.
 Building societies
 National credit and savings bank
 Insurance companies invest premiums paid on insurance policies by policyholders.
 Pension funds are mobilized through forced contributions from employees, and these are
invested in financial markets and real estate.
 Investment trust companies invest in the stocks and shares of other companies and the
government. Investment trusts simply trade in investment.
 Unit trusts are similar to investment trusts in that they invest in stocks and shares of other
companies, but they enable small investors to invest with minimum risk. Unit trusts comprise
of portfolios (stocks or shares in a range of companies or for example shares in mining
companies), the trust creates a large number of small units, which are then sold to individual
investors.
 Development banks are specialized financial institutions that provide long term and medium
term funds.

 Venture capital is investment in long-term, risky equity finance, where the reward is an
eventual capital gain, a takeover, a trade sale or a stock market flotation, rather than dividend
income or interest. The main providers are investors in industry.
 Hire-purchase companies, facilitate the acquisition of physical assets through extension of
credit.
2.0 FINANCIAL MARKET
The market for finance is basically divided into the following
- Money markets
- Discount market Short term and commonly known as the money market.
- Capital market
- Stock market Long term capital market
Money markets deal with short-term finance i.e. lending and borrowing for less than one year.
Active participants in the market are commercial banks, the central bank, big organization and
brokers. Financial instruments traded are:
- Certificate of deposits
- Commercial paper, I Owe You ( I O U )
- The discount market, which performs the following functions:
 Help finance short-term trade debts by purchasing commercial bills at a discount.

 Create a market in bills of exchange
The money markets also includes
 Inter-bank markets for unsecured loans between banks; this facilitates smoothing out
fluctuations in receipts and payments of banks, and determines likely future trends in interest.
 Eurocurrency markets, which are short-term deposits and borrowing mainly for the purposes
of working capital. It is in other currencies either than that of the denomination of a particular
country. With the growth in mergers largely involving multinational companies, there is need
to shop around for favourable terms and avoid domestic government credit restraints.
2.1.0 Capital Markets
This market is divided into primary market for the new issue of shares, and the secondary market,
which deals with reselling of existing securities. Instruments traded on the capital market are
equity shares, mortgages, corporate and government bonds etc.
Note that the international capital market for medium term and long term are known as the
eurocredit (for working capital and investment purposes) and the Eurobonds respectively.

The Eurodollar or the Eurobond market deals with long-term finance. Bonds are issued by very
large companies, banks, governments and institutions such as the European Union. The bonds are
denominated in a currency other than that of the borrower.
The bonds are bought and traded by investment institutions, banks etc.
2.1.1 The Stock Exchange
The Lusaka stock exchange is an organized capital market, which plays an important role in the
functioning of the economy.
 It makes it easy for large firms and the government to raise long term capital, by providing a
market for borrowers and investors to come together
 It publishes the prices of quoted (or listed) securities, which are then reported in the media.
 It tries to enforce certain rules of conduct for its listed firms and for operators in the market to
provide investor confidence, and make them more willing to put their money into stocks and
shares.
 It is a primary market for newly issued shares. Note that a firm‟s new shares are issued by an
issuing house with the help and advice of a stockbroker.
 A secondary market exists for the buying and selling of existing shares, the buyers of new
issues know that they can sell them in future.
The capital instruments traded are equities/securities such as ordinary shares, preference shares and
debentures, as well as government bonds/gilds.
It also acts as an Alternative Investment Market (AIM), where small companies gain access to
capital, under less stringent, less costly procedures.
A stock market is usually given as an example of a perfectly competitive market, even if it is

affected by political factors such as wars, elections or any other form of uncertainty, including the
general mood of the business.
3.0 COMMERCIAL BANKS AND CREATION OF MONEY
Commercial banks are financial intermediaries, with the same roles and benefits as other financial
institutions.
A Commercial bank‟s activities can be one or more of the following:
 Clearing – settling payments

 Retail – traditional banking, offers small deposits and small loans to customers.
 Wholesale – bank dealing with large quantities
 Investment-also known as merchant banks, are specialized and deal with corporate
customers.

3.1 Functions of commercial banks
Banks provide a payment mechanism and a place to store surplus money; they also provide means
of obtaining and selling foreign exchange.
Commercial banks advise and assist companies in the issue of shares, and give investment unit
trust advice and business.
They also engage in financial leasing, debt factoring or collection management, including
executorships (trustee) services.
Banks finance import and export operations and investments.
The most profitable business of commercial banks is lending money in the form of overdrafts,
discounting bills of exchange and loan facilities. This particular function is always expanding
because banks create credit, create deposit and therefore create money.
3.2 Credit creation
Commercial banks are financial intermediaries, who accept deposits and extend loans. They
operate on the assumption that they know from experience that customers only withdraw a fraction
of what they have deposited and that not all depositors withdraw all their cash at the same time.
Therefore, banks only keep a small fraction of their assets as actual cash, known as fractional
reserve system.
To simplify the explanation on credit creation, assume that there is only one commercial bank,
which is already in business with lenders and borrowers. Assume also that the bank knows from
experience that the reserve ratio, that is, funds that a commercial bank must keep, as actual cash is
10% of a customer‟s deposit.
If a customer deposits K100 million in the bank, then the bank‟s balance sheet on day one with
appear as follows:-
DAY ONE
Liabilities Assets
Km Km
Share Capital 10 Fixed assets 10
Customer deposit 100 Cash 100
110 110

Note that the share capital is used to finance fixed assets, and therefore, can be ignored; it is not
part of the credit creation process.
If the bank loans 90% of the deposit, then the bank‟s balance sheet will appear as follows:
DAY TWO
Liabilities Assets
Km Km
Share Capital 10 Fixed Assets 10
Customer deposit 100 Cash 10
Loan 90
110 110
An individual, firm or a government borrows money for a purpose. Suppose the loan of K90m is
used to purchase a motor vehicle, the person receiving the money deposits it in the bank, and the
bank‟s balance sheet will appear as follows:
DAY THREE
Liabilities Assets
Km Km
Deposit - original 100 Cash 10
New deposit 90 Cash from new deposit 90
Loan 90
200 200
The bank will again maintain only 10% of the new deposit as actual cash and lend the rest to
customers. This process continues, however, the credits and deposits being created reduce until it
becomes too small to generate a fresh loan.
It is possible to calculate the total deposits created from any initial deposit and to come up with the
final balance sheet by using the formula.
D =C where D = final deposits created

R C = initial cash deposit
R = cash reserve ratio
D = 100 = 100 x 100 = 1 000

10% 10

From the initial deposit of K100m, the bank‟s final balance sheet appears as:
Liabilities Assets
Km Km
Total deposit 1000 Cash 100
Loans 900
1010 1010
Note that the bank has created credit worth K900m from the initial deposit of K100m, this has
resulted in additional deposits of K900 which is in circulation as part of the money supply.
In practice there are several banks in any economy and billions of money is „created‟, but the
process remains basically the same. This process is very important to know because it is closely
linked with the money supply in the economy and as such the level of Economic activity.
3.3 LIMITS TO CREDIT CREATION
A deposit of K100m with a cash credit multiplier of 10% may not result in K1 billion total
deposits. Some of the restrictions on credit creation may be summarized as:
 Since there are several banks, an individual bank cannot adopt an expansionist policy, unless
other banks are willing to do the same. The clearing bank may have an overcautious credit
policy, and restrict lending.
 A bank‟s ability to lend depends on its ability to acquire deposits, this may sometimes be
limited by the lack of public confidence in the banking sector, and their inability to make
abnormal demands for cash.
 Lack of collateral security may also hinder the process of lending and borrowing.
 The government, through the central bank, may decide to restrict lending and borrowing, in
order to control the money supply in the economy.
 There is an inverse relationship between the cash reserve ratio and the money that is „created‟
by banks. In developing countries, the cash ratios are relatively high, this means less
Economic activity
 If the loans are spent on imported goods, then the foreign banking system benefits instead of
domestic banks.
4.0 CONFLICTING OBJECTIVES OF PROFITABILITY, LIQUIDITY AND SECURITY
A commercial bank‟s assets and liabilities reflect a balance between conflicting demands of
liquidity, profitability and security. A commercial bank has to serve the interests of its
shareholders, which is maximising profits, and to attain this, the bank has to lend as much as
possible. However, the bank has to ensure that it has adequate liquidity to meet the cash demand
from depositors. As far as depositors are concerned, their money is secure at the bank.

- Liquidity
Used to settle daily cash withdrawals from customers and to settle accounts with other commercial
banks in the clearing system, but balances for these purposes earn no interest and are unprofitable.
Banks have to make sound investment policy, by investing in assets that can be easily converted
into cash.
- Profitability
A commercial bank‟s profit is normally obtained from interest charged on assets minus interest
paid on liabilities.
Commercial banks have an objective of trading profitably like other commercial organizations. To
pursue this objective they need to earn high interest rates. Therefore, they have to lend for a long
term and to high-risk customers. This reduces the choice of liquidity and security.
- Security
Commercial banks are expected to act prudently to safeguard the interests of depositors and
shareholders; this however reduces opportunities for profitable lending.
5.0 THE CENTRAL BANK
This is the principal financial institution in a country, and it acts as a regulator of the banking
system. Zambia‟s central bank is known as the Bank of Zambia (BOZ), it was established to take
over from the Bank of Northern Rhodesia on the 7th of August 1964 although its Act was only
passed in June 1965.
The central bank does not deal directly with the general public, but provides services to the
commercial banks and the government and manages the money supply on behalf of the
government and the people of Zambia for the good of the economy and not for profit
maximization.
The Bank of Zambia‟s stated functions are:
 To ensure appropriate monetary policy formulation and implementation

 To act as the fiscal agent of the Government
 To license, regulate and supervise banks and financial service institutions registered under the
Act to ensure a safe and sound financial system
 To manage the banking and currency operations of the Bank of Zambia ensuring the provision
of an effective service to commercial banks, Government and other users.
5.1 Other functions of a central bank
- Issuing notes and coins. Bank of Zambia has the sole right to issue coins and notes in the
economy.
- It acts as banker to the government. The government is the most important customer of the

central bank. In addition, the central bank performs many tasks for and on behalf of the
government such as:
 Keeping the central government accounts and the accounts of the many other government
departments.
 Giving assistance by means of “ways and means” advances if the account is in “red” or
overdrawn
 Conducting government borrowing through the issue of Treasury Bills and government
stock.
 Advising the government on financial matters
- It acts as banker to the commercial banks, use the central banks use the central bank in the
same way as private customers use the commercial banks. Commercial banks:
 Draw coins and notes from their balances at the central bank as required.
 Set off the net payments which has to be made to other banks as a result of the days
clearing by drawing on the balance held at the central bank
 Take advice on financial matters from the central bank
- Acting as lender of the last resort

- Holding the gold and foreign currency reserves in the exchange equalization account,
which the central bank uses to stabilize or manage the kwacha.
- The central bank maintains close contact with other central banks and monetary authorities
of other countries with the aim of achieving greater international monetary stability.
- It works in conjunction with international monetary organization like the international
monetary fund and the world bank
- The central bank manages the national debt. It is responsible for floating new loans and the
repayment of maturing loans plus interest as well as payment of interest to holders of
government securities.
5.2 BANKING SUPERVISION
- Capital Adequacy Rules

Commercial banks make profits by charging interest on amounts borrowed, some amounts are not
repaid, bad debts arise; hence the need to set capital adequacy ratios. The central bank imposes
certain rules and requirements.
- Liquidity
Commercials banks need to hold money to meet customer demand, the central bank discusses with
each individual commercial bank the adequacy of its stock of liquidity and can advise on changes.
- Provision.
The central bank encourages commercial banks to make adequate provision for bad and doubtful
debts. In addition a bank is not allowed to lend more than 10% of its capital base to one single
borrower.

- Systems
Each commercial bank reports periodically on its procedures and controls. The central
Bank examines methods for monitoring credits risks, its systems for recoverability, its
arrears patterns etc.
- Personnel
The directors, managers and large shareholders of banks have to satisfy the central bank that they
are “fit and proper” people for such positions that is in terms of honesty, competency, diligence
and are of sound judgment.
5.3 MONETARY POLICY
Monetary policy is becoming increasingly important in Economic management. Fiscal (budgetary)

policy is once a year, in between, the government has to rely on monetary policy. The central bank
controls the money supply in order to help the government achieve its macroeconomic objectives.
Monetary policy is decisions and actions of the government regarding the supply of money and its
price (the rate of interest). An increase in the money supply, which is loose monetary policy leads
to a lot of borrowing and spending. With too much money in circulation, inflation as well as an
external trade deficit is the likely result.
To reduce the money supply, the central bank has to curtail the borrowing and spending by
limiting the commercial bank‟s capacity to create credit, create deposits and therefore „create
money‟. The instruments that the central bank uses to control the money supply are:
 Open Marketing Operations

By intervening in the open market to buy or sell securities, the central bank can directly influence
the size of bankers‟ deposits. If the central bank wants to reduce the rate of inflation, it has to
control (reduce) the money supply, and if it sold securities, e.g. treasury bills if it is a short term
measure or government bonds if it is a long-term measure, the central bank receives payment by
cheques drawn on commercial banks. This brings about a reduction in commercial banks deposits
as well as the amount of money circulating in the economy.
 Bank Rate (interest rate changes)

The importance of central bank rate is that other rates of interest used, depend on it, the rate
charged to discount houses, the rates charged on advances to customers and the rate offered on
deposit accounts.
These rates move up or down with central bank rate. To check inflation, i.e. to reduce the money
supply, the interest rate is raised to make credit expensive and as such discourage people from
borrowing.
 Special Deposits
To reduce the cash basis for credit creation and to contract credit, the central bank can request
commercial banks to place specified amount or to increase the percentage of these specified
amounts, which are supposed to be kept in frozen accounts with the central bank. The government

pays interest on the „special deposits‟. When following an expansionary policy, to encourage
lending, the special deposits are returned.
 Assets Ratios
The central bank dictates or compels commercial banks to keep certain proportions of specified
assets. To control inflation the ratio is raised.
 Directives (moral suasion)

This is a direct instruction from the central bank to the commercial banks to restrict their lending.
The directive can be in two forms:
- Qualitative, this is when commercial banks are requested to restrict lending only to purposes
regarded as being in the national interest. Commercial banks would be encouraged to lend only
to important sectors in the economy such as agriculture, mining and manufacturing.
- Quantitative, this is when banks are instructed to reduce their lending by a required amount.
Note that directives are easy to enforce in a command, planned Economic system. In a liberalized
market Economic system, firms including banks have the freedom to meet new market demands
without much government intervention.
5.4 Limits to Monetary Policy
In practice, monetary policy is not easy to achieve, not only because of a liberalized market
Economic system, but because it also depends on commercial banks curtailing credit, given the
fact that lending is the most profitable business of commercial banks, the banks find ways of
circumventing the policies.
In addition, central banks face problems in applying monetary policy, for example
- A central bank may lack adequate, detailed, up to date information on the economy and the
money supply.
- The central bank has to closely supervise the commercial banks to ensure that they have
reduced their lending to customers, in order to reduce the money supply in the economy.
- Conflicting objectives of reducing the money supply, which results in an increase in the rate of
interest, lower investments, less Economic activity and increased unemployment. The
government has to trade inflation for unemployment or vice versa.
- The reluctance of the central bank to undermine initiative and commercial banks‟ ability to
make profits, as mentioned earlier, lending is the most profitable business of commercial
banks.

6.0 CHAPTER SUMMARY
Financial systems are made up of financial institutions and financial markets. Financial institutions
enable the three sectors of the economy, the households, firms and government to borrow and lend
to each other as financial intermediaries.
Some of the functions of financial intermediaries are to provide savings facilities and tangible
returns to savers, maturity transformation, ready source of funds for borrowers, and as a medium
for the implementation of monetary policy.
The financial market is composed of the money and the capital market, dealing in short and long-
term finance respectively. Both markets are divided into primary and secondary markets, meaning
issuance of new securities and trading in second hand securities respectively.
One of the significant groups of financial intermediaries is the banking sector. Commercial banks
perform a number of functions, such as providing a payment mechanism, offering financial advice,
financing import and export operations etc.
More importantly, the operation of the banking system increases the money supply, as commercial
banks „create‟ money. This depends on the cash deposited in the banking system and the cash
reserve ratio.
When pursuing the most profitable business of commercial banks, which is lending to customers, a
bank has to try and balance liquidity, profitability and security.
The central bank is the primary financial institution in any country, and it performs a number of
functions. The most important of which is banking supervision and controlling the money supply
in the economy, known as monetary policy.

REVIEW QUESTIONS
1. State the role of financial intermediaries in the economy

2. Give everyday examples of disintermediation
3. What is a cash ratio?
4. Which assets are most profitable to commercial banks?
5. What are capital adequacy rules?
6. What are open market operations (OMOS)?
7. Suggest limitations/problems with monetary policy
8. What do capital markets provide?
9. Distinguish between primary and secondary capital markets
10. What is a money market?
11. Which instruments are traded on the money market?
------------------------------------------------------------------------------------
a) Define the term financial intermediaries and give four examples of major financial
intermediaries (6 marks)
b) Explain any four functions of financial intermediaries. (8 marks)
c) Describe the role of financial intermediaries to government, and business organizations

(6 marks)
(Total: 20 marks)
a) Explain briefly, the importance of each of the following for the structure of bank assets:
i) Profitability (4 marks)
ii) Liquidity (4 marks)
iii) Security (4 marks)
b) State briefly four important functions of the Bank of Zambia. (8 marks)
(Total: 20 marks)

CHAPTER 12
INFLATION AND UNEMPLOYMENT

______________________________________________________________________________________________
 Define and explain causes of inflation

 Understand how to measure changes in the value of money
 Identify the negative effects of inflation
 Explain the measures used to control inflation
 Define and explain types of unemployment
 Understand how to measure changes in unemployment levels
 Identify the negative effects of unemployment
 Explain the relationship between inflation and unemployment
 Appreciate the supply-side policies
_______________________________________________________________________________
1.0 INTRODUCTION
In any economy, the government can follow expansionary or contractionary monetary or fiscal
policies by either increasing the money supply and increasing aggregate demand or reducing the
money supply and reducing the aggregate demand respectively. Unless the „supply side policies‟
are put into effect, a government cannot easily control both inflation and unemployment at the
same time. One Economic „evil‟ has to be „traded off‟ for the other.
2.0 INFLATION
Inflation is a sustained rise in the general price level of goods and services. It is
measured using price indices.
Inflation can be classified between two extremes depending on the speed at which prices are
changing. Creeping inflation is when there are small price increases while hyperinflation is the
worst case of inflation. The prices of goods and services change very rapidly.
2.1 CAUSES OF INFLATION
There are three main causes of inflation, one view from the Monetarists, and two views from the
Keynesians. Demand-pull and cost-push are essentially Keynesian explanations of inflation.
Monetarists reject these and believe that inflation is caused by an increase in the money supply.
Keynesians on their part do not accept that an increase in the money
Supply actually causes inflation.
They believe that an increase in the money supply is an indication that there is inflation in an
Economy. It is not a cause of inflation.

2.2 MONETARISTS VIEW AND THE QUANTITY THEORY OF MONEY
Monetarists consider the increase in the money supply as the only cause of inflation. The
argument of the monetarists is based on the quantity theory of money. The theory is summarized as
the fisher equation, Irving Fisher developed the Fisher equation of exchange. It appears in various
guises, the most common is:
MV = PT
where:
M is the amount of money in circulation

V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place
MV = PT states that money supply multiplied by the velocity of circulation equals the price level
multiplied by total transactions. This equation is true by definition since receipts are equal to
expenditure. PT can therefore be thought of as equivalent to National Expenditure.
Assuming that V is constant in the short run as it is determined by the money supply, and T is also
fixed in the short run. Then, an increase in the money supply would lead to an increase in the
general price level.
2.3 COST-PUSH INFLATION
This inflation is caused by an autonomous increase in the costs of production, considered as cost-
push factors. These may then cause cost-push inflation. Cost-push factors may be changes in
wages, changes in the exchange rate, which change the price of, imported raw materials or perhaps
changes in indirect taxation. Cost-push inflation occurs when a company's costs rise and to
compensate, a firm has to put prices up. Cost increases may happen because wages have gone up
or because raw material prices have increased. The increase in the costs, with aggregated demand
remaining uncharged, causes the aggregate supply curve to shift to the left from AS to AS1, and
price increases from OP to OP1.
Prices
AS
AD
P1
AS
1
P AS
0 Y National output, employment and income

Cost-push factors that can contribute to the increase in the cost of production include:
- Strong, powerful trade viewers who force employers to concede high wage increases, costs
then rise and these are later passed on to consumers in the form of price increases. This
situation is worse during periods of low unemployment.
- Import cost inflation, especially for a country which depends on one or more of the
- Imported raw materials or other imported inputs
- Imported finished products, capital equipment and more especially the ever
- Increasing price of imported fuel.
- High indirect taxes such as when there is an increase in value added tax or excise duties,
consumers simply notice an increase in prices.
2.4 DEMAND-PULL INFLATION
If there is an excess level of demand in the economy, this will tend to cause prices to rise. This
type of inflation is called demand-pull inflation and is argued by Keynesians to be one of the main
causes of inflation. Inflation occurs when increases in aggregate demand pull up prices, with
aggregate supply remaining constant.
The aggregate demand is the total demand in an economy, made up of government expenditure,
consumption expenditure, investment expenditure and exports minus imports. Any increase in one
or more of these components of aggregate demand can put pressure on prices. As demand
increases from AD to AD1 there is increasing inflationary pressure on prices. This is demand-pull
inflation - "too much money chasing too few goods."
Price
level AS
AD1
AD
P1
O Y YFE (Real
national income)
Increase in demand can be caused by either expansionary monetary or fiscal policies. If there is a
high public sector net cash requirement, then total demand in the economy is stimulated.
The Keynesian original aggregate supply curve is an inverse “L”. According to them, the pressure
on prices is when aggregate demand expands after the full employment of resources, before that
point, an increase in aggregate demand acts as an incentive for firms to increase output.

When the resources are fully employed, the aggregate supply curve becomes vertical, and if
aggregate demand increases beyond this point, an inflationary gap is created.
Price AD AS
Inflationary
gap
Output/employment/income
2.5 ANTI INFLATIONARY MEASURES
To control inflation, first, it is necessary to know the cause. Unfortunately, this is difficult to do
because inflation tends to feed on itself and there is the price wage spiral.
Suppose the prevailing inflation is demand driven, then, measures to reduce aggregate demand
should be put in place; such as tight fiscal and monetary policies like increasing direct taxes and
interest rates to reduce consumption expenditure and investment expenditure respectively.
Government expenditure should also be reduced. This means that the government must aim for a
budget surplus, by increasing its income through increased taxes, but reduce government spending,
the excess money should be kept frozen at the central bank.
If the inflation is due to an increase in the money supply then the government should attempt to
reduce the money supply by reducing commercial bank lending using the instruments mentioned
under the control of the money supply. These are open market operations, increasing interest rates
and asset ratios to discourage lending. Directing commercial banks to reduce their lending and
requesting them to make special deposits at the central bank.
If the source of inflation is an autonomous increase in the cost of production, then measures should
be taken to stop the wage-price spiral, reducing the power of trade unions or match the increased
costs with increased productivity.
A country‟s currency can be allowed to depreciate in order to discourage imports, while

encouraging exports, this means increased production. An increase in supply lowers the price.
Prices and incomes policy that is wage and price controls can also be instituted to control inflation.
This means freezing prices and incomes. This may not work well in a liberalized market economy.
It also means controlling the consequence and not the cause of inflation!

2.6 ECONOMIC CONSEQUENCES OF INFLATION
A little inflation is considered to be good for any economy as it provides an impetus for firms to
increase output. High prices are a sign that there is a high demand for goods and services and there
is a prospect of higher profits.
Generally, the negative effects of inflation are as follows:
- Inflation redistributes income

- Retired people who are on fixed incomes suffer a lot from inflation. Some people earn K20,
000 per month as pension. At the time of retirement, they were able to purchase a lot of goods
and services from that amount, but due to inflation their purchasing power and standards of
living falls.
- Inflation distorts consumer bahaviour. Consumers purchase a lot of goods because of expected
future price increases. They hoard goods hoping to „beat‟ inflation and in the process create
shortages.
- Inflation undermines business confidence. Businesses are unable to make concrete future
plans because of uncertainty in price fluctuation in addition, they have to change the price tags
on products on a regular basis and this can be so costly and time consuming.
- Inflation and interest rate and savings. The real rate of interest, which is the money rate of
interest after making an allowance for inflation, is reduced. Lenders demand for high money
rates to compensate for lower real values.
- Lower real interest rates discourage savings and encourage spending. This may have a long-
term effect on long-term finance for investment.
- Inflation reduces a country‟s international competitiveness.
- High prices make products (exports) unattractive on the international market, consumers are
likely to prefer cheaper imports to locally produced products. This affects the balance of
payments. A country has an adverse balance of payments when exports are lower than
imports.
- Inflation causes the currency to depreciate when there is a low demand for exports, therefore,
the demand for the currency is low compared to its supply, and the currency depreciates in
value.
- Inflation redistributes wealth, it causes borrowers to gain at the expense of lenders as it
reduces the value of the debt. The lenders receive less relative to what they had lent. This is
related to the time value of money.
- Inflation leads to uncertainty in price forecasting, both at central government level and at
corporate business level.
- Money is unable to perform its functions properly.
 Inflation has little impact on money‟s function as a medium of exchange. Money is still
used to purchase goods and services.
 The use of money as a means of deferred payment is rendered less effective by inflation.
Credit is granted but payment is deferred. This leads to redistribution of wealth where
borrowers or those who purchase goods on credit gain but lenders lose.
 The greatest effect of inflation on the functions of money is the function of money as a
store of value. The value of money is measured indirectly through prices when prices rise,
it is a sign that the value of money has fallen since few items can be brought from the

same amount of money. Money becomes an ineffective store of value. Interest rates paid
are supposed to compensate, and this is one of the explanations why interest rates rise
during periods of inflation.
 Money is used as a unit of account and as a measure of value. This function is also
hampered by inflation as the relative values of things being compared keep on changing
in monetary terms.
3.0 UNEMPLOYMENT
Unemployment simply means people do not have jobs. It occurs when people capable of and
willing to work are unable to find suitable paid employment.
Unemployment is measured as # of unemployed x 100

Total workforce
Full employment is when there are more jobs than people. The number of unfilled vacancies is
equal to the number of people out of work. It is the level of national income at which everyone
who wants to work is able to do so, in other words, there is sufficient demand to employ everyone.
Classical economists argued that the economy would automatically tend to this equilibrium, due to
the market forces of supply and demand. Keynesians maintain that it is the role of government,
using policy instruments at their disposal, to ensure that there s full employment in an economy.
3.1 CAUSES OF UNEMPLOYMENT
In some books the words „causes‟ and „types‟ are used interchangeably. However there is a
distinction.
Type is the label given to describe the main common characteristic of some unemployment, while
Cause is more analytical, an attempt is made to explain how some unemployment has arisen.
Causes of unemployment can be broadly divided into demand and supply factors:
- Demand deficiency unemployment is caused by lack of demand for goods and services, and as
a result, firms lay off workers. This is usually when the economy is in the recession stage of
the economic or trade cycle and there is little economic activity.
Keynesians argue that a shortage of aggregate demand is one of the key causes of
unemployment.
- Monetarists view Supply side factors such as strong trade unions demanding for high wages as
causes of unemployment as firms employ less labour while the supply of labour increases, as
shown below:

Price
D S
W1
S D
O Q1 Q Q2 Number of workers
At a high wage rate of OW1, the demands for labour by firms reduces to OQ1, supply naturally
increases to OQ2, because individuals who were unwilling to work at wage rate OW are now
encouraged by the high wage rate. The difference between OQ1 and OQ2 is unemployment caused
by the activities of trade unions.
- Firms lay off workers if import prices are too high, like the high price of oil, which reduces a
firms‟ competitiveness, and loss of customers.
- State benefits tend to encourage „voluntary unemployment‟. When the benefits are higher than
the market wage, as in the diagram above, a person feels „better off‟ being unemployed
earning OW1 than earning a low wage (OW) while in employment.
3.2 TYPES OF UNEMPLOYMENT
- Seasonal unemployment is considered to be temporal and occurs in certain industries where

Economic activity is in specific periods or seasons, examples are tourism, agriculture and
construction industries. There is a high demand for labour during certain periods of the year,
and then most of the workers are laid off during off peak periods.
- Frictional unemployment is of a short-term duration. It refers to secondary school or college

graduates who are searching for jobs, as well as individuals who are in between jobs, the
transitional period between workers leaving one job and starting another. Frictional
unemployment is also an indication of imperfections in the market such as lack of knowledge,
the geographical immobility of labour or a mismatch between the requirements of the
employers and the available skills of the unemployed.
The more efficiently the job market is matching people to jobs, the lower this form of
unemployment will be. However, as long as there is imperfect information and people don't
get to hear of jobs available that may suit them then frictional unemployment is likely to be
high.

- Structural unemployment refers to long-term changes in the pattern of demand and supply in
an economy. On the demand side, a firm may fail to compete with rival firms, demand for the
company‟s product declines and the firm is likely to lay off workers and close the business.
Changes in the supply of a product, for a example if the product like copper ore is getting
depleted, there is no need to employ miners and this can also lead to unemployment in the
Copperbelt. It may also result from changes in the production methods labour is replaced by
machines or capital equipment, termed technological unemployment. Structural
unemployment also includes regional unemployment, some regions in a country may have
higher unemployment levels compared to other regions because of different regional
economic performances.
Unemployment results because individuals do not respond quickly to the new job
opportunities, they find themselves with no readily marketable talents. Their skills and
experiences are unwanted, as they have become obsolete.
- Cyclical unemployment is the same as deficiency in demand unemployment. It is

characterized by fluctuations in economic growth, characterized by booms and recessions, the
trade cycles. During the recession phase, there are high levels of unemployment.
- Voluntary unemployment is a relatively new concept, defined by the monetarists as being due
mostly to high state benefits, either unemployment benefits or being on welfare. This causes
people to be unwilling to work at existing low wage rates. They realize that they are “better
off” not working and receiving state benefits.
Voluntary unemployment also includes individuals who simply do not want to work!
3.3 NEGATIVE EFFECTS OF UNEMPLOYMENT
The Economic consequences of unemployment are classified as Economic, financial, social or

political costs:
 Labour is a factor of production, and due to unemployment, the Economic resource is not being
utilized, this is at a cost, the opportunity cost of goods and services not produced, quality of
workforce diminishes as idleness causes labour to be less efficient, this in turn increases the cost
of retraining it.
 Government revenue is mostly from taxes, unemployment results in a loss of government

revenue, as the unemployed do not pay any tax, in some rich countries they receive state
benefits, which means that unemployment is a financial cost to the government.
 Unemployment may lead to social undesirable behaviour like theft, vandalism, riots or general
discontent. The mental and physical health of the unemployed tends to deteriorate, the
unemployed are more prone to commit suicide. This is considered to be a social cost.

 Whenever there are high levels of unemployment in the country, the political party that forms
the government, is likely to lose popularity, this is a political cost to the government.
4.0 THE PHILLIPS CURVE
It shows the relationship between inflation and unemployment. In 1958, Professor A. W. Phillips
found a statistical relationship between unemployment and money wage inflation. Inflation and
unemployment are two sides of the same coin. If the rate of inflation falls, unemployment rises and
vice versa.
Zambia under the United National Independence party (UNIP), was experiencing high levels of
inflation, up to three digit figures, but the levels of unemployment were relatively low. Under the
Movement for Multiparty Democracy (MMD), the country has experienced low levels of inflation
but very high levels of unemployment.
The Phillips Curve explains the “trade off” between inflation and unemployment; it is a graphical
illustration of the inverse relationship between inflation and unemployment. It shows that the
lower the rate of inflation the higher the rate of unemployment.
Inflation rate
0
Unemployment rate
High inflation is associated with low unemployment. Note that the curve crosses the horizontal
axis at a positive value for the unemployment. It is not possible to have both zero inflation and
zero unemployment, zero inflation is associated with some unemployment.
The above means that the government cannot achieve two of its macroEconomic objectives of low
rates of inflation or stableness and low rates of unemployment at the same time. The two are
mutually exclusive. The government can only achieve one objective at the expense of the other.

4.1 STAGFLATION
Once in a while, in any country the “trade off” does not apply, as both inflation and unemployment
move in the same direction. This situation is known as stagflation.
Stagflation is a term coined by economists in the 1970s to describe the unprecedented combination
of slow Economic growth and rising prices. The Phillips curve does not apply, there is no “trade
off”, and instead, there are unacceptably high levels of both inflation and unemployment. This
means a country can be experiencing stagnation, the recession phase of the trade cycle and very
high levels of price increases.
The a above maybe as a result of high costs of production, especially the price of crude oil, which
may cause the supply curve to shift to the left. This causes the price to increase from 0P to 0P1 and
output, employment and income reduces from 0Q to 0Q1
Price D S1
P1 S
P
S1 D
0 Y1 Y Output, Employment, Income
5.0 SUPPLY-SIDE POLICIES
Monetarists believe that stagflation is as a result of ignoring the aggregate supply side of the
equation on supply and demand analysis. Keynesians believe in manipulating aggregate demand in
order to manage the national economy, and monetarists argue that Keynesian demand management
is inflationary, the solution is to put in place measures to improve the supply of goods and services,
known as supply side policies.
Supply-side policies can be used to reduce market imperfections. This should have the effect of
increasing the capacity of the economy to produce, that is increase output, employment and
income and reducing prices at the same time. It is without doubt the only non-inflationary way to
get increases in output.

Price D S
P S1
P1 S
D
0 Y Y1 Output, Employment, Income
The idea is to increase aggregate supply from SS to S1S1 in order to increase output to Y1 and at
the same time reduce prices from 0P to 0P1.
The above is an indication of the need to shift both Economic and government policy towards
supply side policies. The long run Economic growth and standard of living are both functions of
both production and supply. The low prices from increased supply imply that a country can
compete with the low cost producing countries of South East Asia.
In general, supply side policies aim to remove market imperfections and encourage individualism
in order to increase efficiency and raise competitiveness. They are micro orientation, unlike
Keynesian policies that are macro.
Some of the best-known supply side policies are:
 Lower income taxes. High direct taxes are a disincentive to enterprise and hard work, more
especially overtime. There is need to encourage individuals and firms to be more enterprising,
and to increase production.
 Privatization and deregulation, since government intervention and regulation weakens a
country‟s ability to make the economy dynamic and self regulating, Adam Smith‟s „invisible
hand‟ in the market. Public provision of services, government grants and subsidies encourage
inefficiencies, and state owned industries are not competitive.
 Strong trade unions and employment legislation lead to unemployment and encourage over
manning. There is need to have weak trade unions and workers who will accept „flexible‟
wages.
D S
W1
0
Q1 Q2 Q3 Number of workers

Strong trade unions can successfully bargain for high wage rates (0W1), which results in few
workers (0Q1) being employed, while the supply is high at 0Q3. By accepting lower wages (0W),
more workers would be in employment (0Q2). The inflexibility in the labour market creates
unemployment.
 Related to the above, are wage controls, wage regulations and employment legislation which
all contribute to inflexibility, workers „pricing themselves‟ out of the market and ultimately
unemployment. According to the supply side policies, these should be abolished.
 Better information on job opportunities and adequate training is what is required for the
aggregate supply curve to shift to the right.
6.0 CHAPTER SUMMARY
Inflation to a layman is simply a sustained increase in the price of goods and services. Inflation is
measured as a percentage change, and the two extremes are creeping inflation to hyperinflation.
Inflation can be caused by demand factors, supply factors, or according to the monetarists, any
change in the money supply is inflationary.
There are several reasons why inflation is considered to be economically undesirable, it affects
planning both at central government and at corporate business level and it also undermines
business confidence. Inflation reduces a country‟s international competitiveness and causes the
currency to depreciate given a low demand for exports. Inflation discourages savings, and
ultimately, investment. It also distorts consumer behaviour, consumers purchase a lot of goods in
the hope of „beating‟ inflation. More importantly, inflation has a big impact on people who are on
fixed incomes, their purchasing power and standard of living falls, and money is unable to perform
its functions properly.
Unemployment simply means people do not have jobs. The words „types‟ and „causes‟ of
unemployment are usually interchanged, but generally, unemployment is categorized as cyclical,
structural, seasonal, frictional and voluntary. Unemployment also has a number of negative
consequences, classified as Economic, financial, social or political.
A government can control both inflation and unemployment using either fiscal or monetary
policies, or both. Unfortunately, there is a negative relationship between inflation and
unemployment, which is illustrated by the Phillip‟s curve. The government has to „trade off‟
inflation for unemployment or vice versa. Sometimes, there is an increase in inflation and
unemployment, a situation known as stagflation.
An effort to „cure‟ both inflation and unemployment is explained by the monetarists using the
supply-side policies. These policy measures are intended to free up the supply of goods and
services in all markets, eliminating market distortions, increasing production, the „supply‟ side of
the equation, through deregulation. The government has to reduce taxes, privatize, allow the labour
supply to move freely, weaken trade unions, etc.

REVIEW QUESTIONS
1. What is the quantity theory of money?

2. Define inflation, and state how it is measured
3. What are the two main types of inflation?
4. What could be the underlying causes of demand-pull inflation?
5. What are the economic consequences of inflation?
6. List three important types of inflation
7. Specify three costs of unemployment
8. How do Keynesians explain unemployment?
9. What does the Phillips curve show?
10. What is „supply side‟ economics concerned with?
--------------------------------------------------------------------------------------------------
(a) Describe five economic effects of a continuous, moderate inflation.

(15 marks)
(b) How might governments use monetary policy to reduce the rate of inflation?
(5 marks)
(Total: 20 marks)
(a) Distinguish between “Structural unemployment” and “cyclical (demand deficiency)

unemployment” (8 Marks)
(b) Explain any four “supply -side” policies, which might be used to reduce the level of
unemployment. (12 Marks)
(Total: 20 marks)

CHAPTER 13
PUBLIC SECTOR ECONOMICS

______________________________________________________________________________________________
 Appreciate the role of government in the economy.

 Identify the main items of government expenditure
 Explain of the different sources of government revenue and
 Understand the advantages and disadvantages of the main sources of government
revenue
 Understand fiscal policy
 Identify the fiscal stance through the public sector net cash requirements
 Explain of the nature and composition of national debt
_______________________________________________________________________________
1.0 Introduction
There are many aims to public finance, but the priority on how the government deals with its
finances in the course of performing its functions varies with political complexities. However,
generally, the bulk of government revenue is spent on socially desirable expenditures such as
education, health and social services. Therefore, public finance is concerned with government
expenditure and government revenue, and the difference between them, which is the public sector
net cash requirements.
2.0 Government expenditure
Government capital expenditure refers to government spending on investment goods. This means
spending on things that last for a period of time. This may include investment in hospitals, schools,
equipment and roads.
Government current expenditure refers to government day to day spending. This means spending
on recurring items. This includes salaries and wages that keep recurring, spending on consumables
and everyday items that get used up as the good or service is provided
In general, the main items of government expenditure in most countries can be can be classified
under the following headings;
- Defence
- Internal security that is, the police, fire brigade etc.
- The merit goods under the social sector like education, health and housing.
- Economic policy covering subsidies to agriculture and industry, the provision of capital to the
nationalised industries (government investments).

- Social security and other transfers make up a big chunk of government expenditure in
developed countries
- Debt interest payments on the national debt are a big burden for the poor countries.
- Miscellaneous expenditure such as diplomatic services.
2.1 Government revenue
This is mostly from taxation. However, taxation has other functions besides
covering central and local government expenditure.
The other reasons for taxation are:
- To check the consumption of demerit goods like beer and cigarettes and to cause the pricing of
the products to reflect the social costs to society of smoke related illnesses.
- To reduce inequality of incomes and wealth through a progressive system of
taxation.
- To put into effect the „automatic stabilisers‟, that is increase the levels of direct taxes to
dampen the upswings and reduce on the inflationary pressures when the economy is at the
„boom‟ phase of the trade cycle.
- To protect infant, strategic and declining industries by introducing indirect taxes like import
duties to discourage imports by making them more expensive and therefore less competitive.
2.2 Principles of taxation
Adam Smith outlined the basic characteristics of a good tax system as the four canons of taxation,
namely:
- Equity, which means that taxes should be fair and therefore should depend on
- an individual‟s ability to pay. Taxes must be proportional to one‟s income.
- Certainty, with regard to the amount to be paid, how, where and when it should be paid.
- Convenience of payment and collection by the taxpayer.
- Economy, that is, the cost of collection should not be excessive especially in relation to yield.
The additional principles of taxes considered by governments are summarised as efficiency and
flexibility. Taxes must as far as possible achieve its objective efficiently and not undermine other
aims and taxes. It should also be adjustable to changes in policy.
2.3 Classification of taxes
Taxes can be classified in several ways depending on:
 Who is levying the tax? This can either be the Central or the Local government.
 What proportion of a person‟s income is taxed? There are three categories:

a) A progressive tax
A progressive tax is a tax that takes an increasing proportion of income as income rises. The rate of
tax keeps on increasing with every subsequent increase in income. Most direct taxes are
progressive, a good example is income tax, and the rate increases as a person earns more.
b) A regressive tax
This takes a higher proportion of a poorer person‟s income. Most indirect taxes are regressive.
A regressive tax is a tax that takes a smaller proportion of income as income rises, this means it
takes a higher proportion of a poorer person‟s income. In other words it is a tax that hits less well-
off people harder than the better off. Most indirect taxes are regressive. An example of a regressive
tax is the television licence. It is exactly the same amount for everyone, which makes it a much
smaller proportion of a large income than a small one.
c) A proportional tax
This is when the tax is the same proportion on all incomes, whether large or small. It simply taxes
a given proportion of one‟s income for example 10% of K500,000.00, 10% of K5,000,000.00 and
10% of K50,000,000.00.
Tax burdens that are proportion to income are considered to be fair, however, they do not
contribute towards equal distribution of wealth.
 Who is paying the tax? Is it a direct or an indirect tax?
A direct tax is a tax on income, profit or wealth. It is paid directly to the

revenue authorities by the taxpayer. Examples of direct taxes are
 Income Tax
 Corporation Tax
 Capital Tax
 Inheritance tax
 Other taxes to the local government like personal levy, motor vehicle duties
Advantages of direct taxes:
1. Are equitable, that is they conform to the principle of „ability to pay‟, through the
progressive system of taxation.
2. Have an elastic and high yield; the rate of taxation can be increased and therefore
increasing government revenue.
3. Are certain, both the taxpayer and the government know the amount to be paid, how, where
and when it should be paid.
4. Lead to equal distribution of income and wealth, this again is through the progressive
system of taxation.

5. Are automatic stabilizers through their progressive nature, taking more money out of the
economy (withdrawals) when the economy is in its „boom‟ phase, while taking less money
and increasing welfare payments when the economy is faced with a depression.
6. Are not inflationary like indirect taxes.
Disadvantages of direct taxes
1. High rates acts as a disincentive to efficiency, effort and enterprise. Tax reduces the return
on the investment and reduces a firm‟s ability to invest and expand as this depends on the
retained profits. Workers are less inclined to put in extra hours. Individuals and firms want
to make money for themselves and not to contribute to government revenue.
2. High rate might also encourage migration of skilled manpower to „tax havens‟
3. High rates encourage tax avoidance. People find loopholes so as to avoid paying tax. It also
encourages tax evasion, which is illegal non-payment of tax especially in the informal
sector.
An indirect tax is a tax on expenditure. Tax is paid indirectly to the revenue authorities as part of
the payment for a commodity or service, whenever particular purchases are made. Examples of
Indirect taxes are:
 Customs or import duties

 Excise duties, this is a tax on some locally produced commodities
 Value added tax.
The advantages of indirect taxes:
1. Revenue yield from indirect taxes help to avoid high direct taxes.
2. Payment is certain since they are difficult to avoid and to evade.
3. Convenient to the taxpayer since they are paid in small amounts and at intervals instead of
one big lump sum of money which is deducted and paid every month like pay as you earn. In
addition, they are convenient in that they are paid when an individual is in a position to buy
the commodity and therefore can afford to pay the tax.
4. Economical in collection as companies and traders collect on behalf of the government and
reduce the administrative burden that should fall on the revenue authorities.
5. It is not harmful to effort and initiative like direct taxes. Instead, it is less painful since it is
hidden in the price of a commodity or service.
6. Most importantly, indirect taxes are flexible instruments of policy as they can be adjusted to
specific objectives of Economic policy such as:-
- Protecting infant industry or vital (strategic) defence industries

- Strengthening political links e.g. Southern African Development Cooperation
(SADC) and Common Market for East and Southern Africa (COMESA).
- Citizen‟s health may be safeguarded as indirect taxes can be used to encourage or
discourage the production and consumption of particular goods and services.
- The balance of payments may be strengthened or improved by taxing certain
imports.

The disadvantages of indirect taxes:
1. There are regressive, a flat rate like a poll tax, a specific tax charged as a fixed sum per unit
sold or an ad valorem tax which is charged as a fixed percentage of the price of the good with
no concessions for people in the low income bracket, take a higher proportion of the income
of low income earners than high income earners.
2. They do not depend on a person‟s ability to pay both the rich and the poor pay the same
amount as tax as long as they both buy the same product or service. Therefore they are not
equitable.
3. Some people who use unauthorized border entry points, the „black economy‟, may evade
indirect taxes like customs duties.
4. May encourage inflation, whenever value added tax, customs duties or excise duties increase,
the prices of taxed goods and services also increase.
5. Possibly harmful to industry especially for goods with elastic demand
3.0 LAFFER CURVE
Government revenue is mostly from taxes. A Laffer curve shows how tax revenue and tax rate are
related.
The Laffer curve is named after Professor Art Laffer who suggested that if the tax rate is 0%, then
government revenue would be zero. If the tax rate is 100%, again there would not be any
government revenue as individuals and firms would not be willing to contribute 100% of their
income to the government. No one would be willing to work.
The Laffer curve also shows the rate at which the government can achieve a maximum revenue Tr,
the tax rate should be Tx. In addition, it also shows that the government can achieve very high tax
revenue at two rates, 25% and 75%.
Given the fact that a high tax rate discourages hard work and enterprise, the best option is a tax
rate of 25%. According to the advocates of supply side policies, lowering tax rates increases
production and supply. This in turn increases the national income.

Tx represents the optimum tax rate where the maximum amount of tax revenue can be collected.
4.0 PRIVATISATION VS NATIONALISATION
Privatisation implies
- The transfer of the nationalized industries to private ownership.
- Selling state assets, either completely or partially
- Opening up state monopolies to outside competition
- „Contracting out‟ to the private sector services paid for out of public funds, such as, refuse
collection, which was previously done by the local government.
- Charging beneficiaries „Economic fees‟ for publicly provided goods and services like
hospitals and schools.
Therefore, privatization implies more than the movement of assets from the public to the private
sector. It embraces all the different means by which the disciplines of the free market in the
provision of goods and services can be applied to the public sector.
The case for privatisation is the argument that is put forward for deregulation of industries, which
is, the removal or weakening of any form of state interference with the operation of free market
activity
The main aim of deregulation/privatisation is to improve competition and efficiency.

Once the statutory barriers are removed, the economy is said to have liberalized industries or it is
following a liberalized market economic system, compared to the command economic system.
4.1 Arguments for privatisation
a) Reduced burden on the public purse as the government no longer supports loss- making
nationalized companies. Privatisation allows a reduction in the public sector borrowing
requirement and tax cutting, as it provides funds for the treasury when companies are sold.
b) There is greater economic freedom from detailed economic control as privatized companies
are not subject to state control.

c) Improved efficiency through competition in the market, this encourages producers to cut their
costs in order to be more competitive, and firms have to be innovative in the search for
profits.
d) In addition to the above, there is also improved quality since firms have to compete to survive
and have to be responsive to customer complaints.
e) If companies are not in state control, there is greater resistance to the power of trade unions,
industries are more fragmented and difficult to organise.
f) Privatisation leads to a creation of a property-owning class, more people are able to buy
shares, this gives buyers market power, they work harder and strike less, a better
understanding of private profit motive and business problems.
g) Costs and inefficiency decrease as bureaucracy from nationalized companies is reduced.
4.2 Arguments against privatisation
a) Privatisation does not mean that competition is automatically enhanced. Instead, private
monopolies have been created. An example is if the Zambia Electricity Corporation (ZESCO),
became privatized, it means a previously government controlled monopoly becomes an
uncontrolled one in private hands, with no public responsibility. Consumers may suffer.
However, this is what leads to most governments to regulate or attempt to regulate the newly
privatized companies in much the same way as the nationalized industries.
b) Just as privatization does not mean competition, it also does not guarantee efficiency.
Customers have ended up with fewer services, and at higher prices. A good example is rural
transport. The government owned United Bus Company of Zambia (UBZ), used to go to all
the rural areas, everything was timetabled (date and time).
c) The quality of service has reduced, with costs being saved by reducing the number of workers
„right sizing‟, paying lower wages and reducing the services that were being provided, as
mentioned above, some routes were termed „unprofitable‟ or the roads „impassable‟.
d) Privatisation may allow people in rural areas without Economic power to suffer, since loss-
making services are not provided by the private sector, most of which are important to the
poorest members of the society.
e) In theory, it is the loss-making companies that are supposed to be privatized, but in practice,
the privatization exercise is rarely properly done in most countries in the world, for example
asset sales are under priced to attract buyers and in the process, create big capital gains for
private investors.
f) Companies that are in private hands often pay their top executives very large salaries and offer
them very good conditions of service, while reducing the powers of trade unions and paying

union members low wages. This lowers the morale of the workers and lowers productivity
while encouraging pilfering, strikes etc.
g) If competition is enhanced through privatisation, it sometimes leads to waste of resources and

the duplication of goods and services, an example is monopolistically competitive market
structures.
4.3 Nationalised industries
The public sector includes some businesses run by the government, such as Zambia Electricity
Company (ZESCO), Zambia Telecommunications Company (ZAMTEL), Lusaka Water and
Sewerage Company etc. Managers of such companies are accountable to the elected politicians
(ministers) in charge of that sector, and government-sponsored boards such as the Zambia Energy
Regulation Board, which regulates ZESCO, regulate them.
The case for nationalization can be considered alternatively as the disadvantages of

liberalisation.
a) Nationalisation can lead to reduced costs through economies of scale, since with increased
competition, each firm produces less output on a small scale, and unit costs increase.
b) There is provision of un economic services for consumers. Nationalisation, just like the
socialism or planned economic system, social benefits are placed above private profits. It
considers the net gain to society, to the point of keeping industries that are clearly
technologically inefficient, as in the case of Maamba coalmines. Another argument in favour
of providing uneconomic services is that it helps to protect employment.
c) It is sometimes in the national interest that some basic industries are brought under public
control, especially, strategic industries which would be dangerous under private ownership
such as atomic or nuclear energy.
d) It may also be necessary to carry out government policy, like controlling the money supply, as
in the case of the Bank of Zambia.
e) Nationalised industries have sufficient capital available for investment, because of
government support. Where competition is wasteful, it maybe better to create a large state-
owned monopoly, to avoid waste and duplication.
f) A fairer distribution of wealth, the huge profits do not go to the capitalist owners, surpluses
are used for the benefit of society. A case in point is ZESCO, the supernormal profits are used
for rural electrification. The supernormal profit also justifies the high salaries enjoyed by
ZESCO employees.
5.0 FISCAL POLICY

Fiscal policy is the use of government expenditure and taxation to try to influence the level of
economic activity. It is the decisions and actions of the government regarding its expenditure
and its revenue taxes, that is, since government revenue is mostly from taxation. The government
as an instrument of economic policy uses fiscal policy, also known as budgetary policy, through
the balance between government expenditure and revenue. In order to reduce high levels of

unemployment, or to stimulate recovery from a recession, the government aims for a budget
deficit or an expansionary fiscal policy.
An expansionary (or reflationary) fiscal policy could mean:

 Cutting levels of direct or indirect tax
 Increasing government expenditure
Reducing taxes causes government revenue to be lower than government expenditure, which
results in a budget deficit, government borrowing covers the difference. The government needs to
borrow money to finance its activities. This borrowing is referred to as the public sector net cash
requirement (PSNCR). It used to be called the public sector borrowing requirements (PSBR).
The PSBR is the amount of money the government needs to borrow to meet their spending plans.
In other words it is the amount that their spending exceeds their tax revenue. Therefore, an
increase in the PSNCR or PSBR is a sign that the government is following an expansionary fiscal
policy. The effect of expansionary policies would be to encourage more spending and boost the
economy.
Budgetary policy can also be used to check inflation or an adverse balance of payment by aiming
for a budget surplus, or a contractionary fiscal policy. This is the exact opposite of an
expansionary policy.
A contractionary (or deflationary) fiscal policy could mean:

 Increasing taxation, either direct or indirect
 Cutting government expenditure.
Reducing government expenditure while increasing taxes is what leads to a government surplus.
The difference is the public sector net cash surplus. This used to be called the public sector debt
repayment (PSDR) the government is in a position to service the debts plus interest. It is a sign
that the PSNCR are low. A reduction in both government and consumption expenditure reduces
the level of demand in the economy and help to reduce inflation.
5.1 The Public Sector Net Cash Requirements (PSNCR)
The balance between government expenditure and government revenue shows the fiscal stance
being followed by the government. Government expenditure is an injection into the circular flow
of income, a component part of aggregate demand, therefore an increase in government
expenditure is an indication of the expansionary stance being followed by the government.
Whereas taxation is a withdrawal or leakage from the circular flow of income, and as such,
increasing taxes is an indication of a contractionary stance.
In practice it maybe difficult to reduce the growth rate of public expenditure due to for example
political factors such as by-elections and defence if a country is at war. Existing capital projects,
which can only be, completed over a period of years, as well an economic depression, which
results in high welfare and unemployment benefits to act as automatic stabilisers. If the size of the

PSNCR increases from one year to the next, then it is a sign that the government wants to boost the
economy.
In general, for most rich nations, the increase in the PSNCR can stem from the increased life
expectancy and an ageing population, which implies more spending on social security. High
unemployment levels which may lead to more unemployment benefits being paid. For most poor
countries, an increase in the PSNCR can stem from debt interest, political commitments like the
numerous by-elections in Zambia or high inflation levels which raises the cost of public provision
of goods and services.
Both the developed and the developing countries can be affected by tax rate changes, tax
reductions for example, reduce government revenue, so the government has to depend on
borrowing.
5.2 Parliament control procedures
The legal framework that governs the management and control of the public finances in Zambia is
made up in the constitution. Parliament is supposed to provide the necessary checks and balances
in the budget process. During the fiscal year the scrutiny of the spending reports, if any, is done by
the Committee of Supplies, while hearings on expenditures is conducted by the sessional
committees of Parliament. The Minister of Finance and Economic Planning must prepare
supplementary estimates for expenditure, for approval by the National Assembly within a
period of four months and if the National Assembly is in recess at the first sitting of the Assembly.
The Minister of Finance is required to prepare a Supplementary Appropriation Bill confirming the
approval by Parliament of such expenditure or the excess of expenditure within 15 months after the
end of the financial year. If the National Assembly is not sitting then, the bill must be tabled within
a month of the first sitting, a Bill to be known as the Excess Expenditure Appropriation Bill.
Thus, the roles and responsibilities of the legislature is moderately well assigned in principle but
the budget disbursement of resources to spending units is appropriated on the basis of ad-hoc
criteria which can later be legitimised by both supplementary and excess expenditure acts, and
there is inadequate time for parliamentarians to scrutinise budget documents.
5.3 GOVERNMENT REFORM PROCESS (from Public Expenditure Management and

Financial Accountability, PEMFA Evaluation Report)
5.3.1 General description of recent and on-going reforms

In the early 1990s, Government began a political and socio-Economic reform process, which
entailed democratising the political system and liberalizing the economy. The political reforms
gave special impetus to public demand for good governance, transparency and accountability in
the conduct and management of public affairs. The Economic reforms focused on privatization of
parastatal entities and the redefinition of the role of the Public Service from that of controlling the
overall economy to that of providing a conducive environment for market based and private sector
driven economy.

5.3.2 Public Service Reform Programme (PSRP)
In 1993, Government initiated the PSRP to restructure the Public Service in order to improve the
quality of service delivery. Therefore, Government designed the Public Service Capacity Building
Project (PSCAP) as a comprehensive strategy to build institutional and human capacity for quality
public service delivery, it became operational in October 2000 and was designed to be
implemented over a thirteen-year period (2000-2013). The focus of the first phase was on the
following five major outputs:
 right-sizing and pay reform of the Public Service,

 improved policy and Public Service management,
 improved financial management, accountability and transparency,
 improved capacity of the judicial and legal systems and
 decentralisation and participatory governance.
5.3.3 Poverty Reduction Strategy Paper (PRSP)
The PRSP was developed as the Nations‟ medium term overall policy framework for national
planning and interventions for development and poverty reduction for the period 2002-2004. The
strategy for poverty reduction was rapid economic growth and employment creation. This would
result in improvements in national resources management, a conducive macroeconomic
framework, sectoral performance improvements especially in key sectors such as agriculture and
social sectors, infrastructure developments, overall improvements in governance and public service
delivery capacity.
6.0 AUTOMATIC STABILISERS
During a recession „phase‟, income does not fall to zero because the benefit (welfare and
unemployment benefits) system provides some income. The effect of automatic stabilizers when
an economy is recovering from a recession is known as „fiscal drag‟.
Fiscal drag refers to the effect inflation has on average tax rates. If tax allowances are not
increased in line with inflation, and people's incomes increase with inflation then they will be
moved up into higher tax bands and so their tax bill will go up. However, they are actually worse
off because inflation has cancelled out their pay rise and their tax bill is higher, this is to the
benefit of the revenue authorities. It is getting more tax without increasing tax rates, a subtle means
of raising more tax revenue. To maintain average tax rates, allowances should be increased by the
amount of inflation each year.
7.0 THE PUBLIC DEBT
This is the total amount of accumulated borrowing by the local and central governments including
public corporations, to its various creditors both local and foreign, the International Monetary Fund
(IMF), the World Bank etc. Note that debt increases, interest rate payments form a large portion of
government expenditure.

The debt instruments are of two types:
Debt management in terms of contracting, servicing and repayment is a major element of the
overall fiscal policy. The financial report of the Minister of Finance and Economic Development
must include a statement showing the particulars of debt charges paid in that financial year in
respect of loans raised under the Act. A loan may be raised as a debt instrument of two types,
marketable debt, this is either short-term debt that consists of treasury bills or long-term debt that
consists of Government bonds or by agreement in writing. Non-marketable debt consists of any
other debt raised by the Government either internally or externally. In addition, the debt can be
reproductive, that is, used to purchase a real asset or it can be a deadweight debt, meaning that no
assets are covering the debt.
The Act empowers the minister to raise any loan in accordance with such conditions and upon
such terms, as s/he shall direct. If the loan is raised through the issue of a bond, stock or Treasury
bill, the Bank of Zambia is the Minister‟s agent.
The Zambian National Debt problem is being addressed with the implementation of the HIPC
Initiative (from multilateral and Paris Club bilateral creditors), voluntary additional relief on part
of some of the Paris Club bilateral creditors and the G8 debt cancellation initiative.
Prudent fiscal policy/discipline needed to reduce the budget deficit to manageable levels.
8.0.0 FIFTH NATIONAL DEVELOPMENT PLAN (FNDP)
Governments accept the Keynesian Theory that active Government involvement in the economy is
necessary for macroEconomic stabilisation. In a mixed Economic system, the party in power can
change the shape of the economy. The Government, it may decide to trim down the public sector
and fatten the private sector, or vice versa.
The Zambian government has a major Economic role and responsibility, it has articulated its long -
term development objectives in the National Vision 2030, and the FNDP is an important step
towards the realisation of this vision. The development goals are:
(a) Reaching middle-income status

(b) Significantly reducing hunger and poverty
(c) Fostering a competitive and outward oriented economy.
The theme of the FNDP is „broad based wealth and job creation through citizenry participation and
technological advancement‟. The broad MacroEconomic objectives for the FNDP are as follows:
 To accelerate pro-poor Economic growth, this is the main goal of the FNDP, to realise
this goal, the aim is to have an annual growth rate of at least seven percent, and ensure
that growth is broad based and rapid in the sectors where the poor are mostly engaged.
 To achieve and sustain single digit inflation
 To achieve financial and exchange rate stability

 To sustain a viable current account position, and
 To reduce the domestic debt to sustainable levels.
The above are the overall characteristics of the economy, which any government discern as
desirable. An additional objective, which is included in the FNDP theme of job creation, is
attainment of full employment.
The MacroEconomic objectives of Governments are interdependent, at the same time,

simultaneous success is impossible (Phillips curve!). The FNDP contains the policy instruments
that the Government intends to use to achieve the MacroEconomic objectives listed above, are
outlined as follows:
8.0.1 FISCAL POLICIES
To focus on avoiding excessive fiscal deficits and debt by reducing government borrowing which
in turn, contributes to a decline in interest rates, besides the reduced external debt servicing
through the highly indebted poor countries (HIPC) initiative. This will also allow for an expansion
of credit to the private sector, no crowding out effect!
However, budget execution need to be improved, financial accountability and expenditure

monitoring systems need strengthening, as well as strengthening the revenue base, whose weak
systems have created potential avenues for fraud.
8.0.2 MONETARY AND FINANCIAL POLICIES
To focus on achieving and maintaining single-digit inflation as a pre-requisite for reducing high
interest rates which have contributed to poor access to financial services within the economy. The
Zambian financial sector is characterised by high cost of borrowing, thin capital markets and
absence of financial services in rural and peri-urban areas. The focus in the FNDP is to develop the
capital markets, developing and implementing a rural financing policy and strategy and the
strengthening of banking and non-banking financial institutions.
8.0.3 SUPPLY-SIDE POLICIES
To reduce inflation, there is need to address supply side factors such as the poor infrastructure and
marketing systems, the vulnerability of the agricultural sector to weather fluctuations, and weak
policy implementation.
8.0.4 EXTERNAL SECTOR POLICIES
The objectives of the external sector are to achieve the following:

- Sustain a viable Current Account balance by promoting export growth and maintaining a
competitive exchange rate. The mining sector will continue to play an important role,
however, the development strategy focus is diversification away from copper.
- Improve the external competitiveness of the economy.

- Maintain a sustainable external debt position.
8.1 POLICY CONSTRAINTS
In practice, Governments have limitations in their ability to achieve MacroEconomic objectives

generally, because of various reasons. Some of the constraints are:
a) Previous policy decisions taken by the previous government, especially the fiscal and
regional policies.
b) The Government may lack perfect knowledge/information of the economy. The statistics
may be outdated or based on estimates.
c) Policy changes take time to implement and time to be effective, a time lag.
d) There is no ceteris paribus, this means that there is no technique that to hold other variables
constant. Zambia has extremely free trading with borders very wide open compared to
countries like Zimbabwe and South Africa.
e) Political factors often supersede prudent policy Economic judgement, especially in a
developing country like Zambia with not enough checks and balances and unplanned by-
elections!
f) In addition to the constraints of information and time, the methods may be inefficient in that
they do not achieve their targets, or the pursuit of one policy instrument may limit the
effectiveness of the other.
g) The fluctuating patterns of booms and recessions, the trade cycle, can affect the
achievement of macroEconomic objectives. For example, when there is international
recession, there is no Economic growth.
9.0 CHAPTER SUMMARY
Public finance deals with finances of the Government, which is reflected in terms of
expenditure and revenue. Governments spend their income on the provision of a variety of services
that the private sector does not provide. Examples are defence, internal security, education, health
etc.
The large sums of money, which governments require, are obtained primarily through taxation
levied on incomes (direct, progressive taxes), and on goods and services sold (indirect, regressive
taxes). Taxes may be apportioned among people on the basis of ability to pay or on the basis of
benefits received. Each type of tax has its advantages and drawbacks.
Another source of government revenue is through privatization. This is the transfer of assets from
public to private ownership. However, it has some advantages and disadvantages, hence there are
some arguments in favour of nationalized industries.
When it is inexpedient or impossible to raise needed funds, governments may borrow money,
either on a long or a short-term basis. In addition, governments manipulate their tax impositions,
their expenditures and their borrowing so as not to merely to finance desirable projects and
services but also to maintain the national economy in a stable condition, known as fiscal policy.

The objective of fiscal policy can be either a deflationary gap, operate a budget deficit (reduce
taxes and increase government expenditure) in order to reduce the high levels of unemployment.
Alternatively, a government can aim for an inflationary gap, that is, operating a budget surplus
(increase taxes and reduce government expenditure) in order to check inflation.
The total amount of government borrowing is known as the national debt.
The FNDP is an important step towards the realisation of national vision 2030, and the
development goals are:
a) reaching middle-income status

b) significantly reducing hunger and poverty
c) fostering a competitive and outward oriented economy.
The government came up with five discernable macroeconomic objectives, these will achieved
using various instruments such as fiscal and monetary policies. In practice, governments face a
number of policy constraints which hinder them from achieving the macroeconomic objectives.

REVIEW QUESTIONS
1. What is the difference between fiscal policy and monetary policy?

2. What are the objectives of fiscal policy?
3. Distinguish between direct taxes and indirect taxes.
4. What is:
a) A regressive tax?
b) A progressive tax?
c) A proportional tax?
5. What are Adam Smith‟s four canons of taxation?
6. If the government decides to introduce a poll tax, which would
7. involve a flat levy of K20, 000 on every adult member of the population, how would you
describe this tax? Would it be a progressive, proportional, regressive or an ad valorem tax?
8. What is the public sector net cash requirement (PSNCR)?
9. What is the fiscal stance?
10. State four arguments in favour of privatisation
------------------------------------------------------------------------------------------
Explain briefly what is meant by the term „public sector net cash requirements‟ and describe how it
might be financed? (10 marks)
Describe the problems governments face when attempting to reduce the public sector net cash
requirement and explain briefly how the business sector might be affected by these attempts.
(10 marks)
TOTAL: 20 MARKS
a) The revenue of the Zambian Government is mostly from taxation. Distinguish between direct
and indirect taxes giving two examples of each. (8 marks)
b) Explain what is meant by fiscal policy. (4 marks)
c) Outline the principles of a good tax system (8 marks)
TOTAL: 20 MARKS

CHAPTER FOURTEEN
INTERNATIONAL TRADE
______________________________________________________________________________________________
 Appreciate the growing impact of globalisation and the multinational companies

 Explain why countries undertake international trade and the benefits they get from
international trade
 Understand the law of absolute and the law of comparative advantages
 Distinguish free trade from protectionism
 Identify the reasons for trade restrictions, and the different forms of trade restrictions
 Understand terms of trade and its importance
 Appreciate of international organizations that facilitate free trade
_______________________________________________________________________________
1.0 INTRODUCTION
International trade involves the exchange of goods and services between countries. It involves
trades among nations. A nation trades because it lacks the raw materials, climate, specialist labour,
capital, or technology needed to manufacture a particular good. Thus, international trade arises
because countries have different production capacities and different demands for goods and
services.
1.1 GLOBALISATION
Economic activity has been internationalized. This is reflected in the growth of trade and other
capital flows, currency bought and sold in the foreign exchange market, has lead to the term global
economy. The global economy refers to an open economy where the ratio of exports to output
forms a significant proportion of economic activity.
World trade has been expanding to the extent that neighbouring countries that have always traded
with each other are making such arrangements more formal. Trade agreements like the free trade
areas where countries agree to reduce or abolish trade restrictions between member countries,
while allowing members to impose their own separate trade restrictions against non-member states.
Alternatively, it may be extended into a customs union, where free trade is encouraged among
members but erect a common external tariff on imports from non-member states. In addition, there
are common markets, which are similar to customs unions but include the free movement of
factors of production as well as trade.

1.2 MULTINATIONAL COMPANIES (MNCs)
The growth of multinational companies has taken place in an environment of increasing

globalisation of markets.
A multinational company is one, which owns or controls production or service facilities in more
than one country. Note that a company does not become a multinational simply by trading
internationally!
The growth of globalisation is unstoppable, and with it is their power to influence international
trade. However, the extent to which the Zambian economy benefits from MNCs is difficult to
assess.
The assessment of the impact of MNCs on national economies is considered under various costs
and benefits. Direct foreign investment by an MNC should improve economic welfare as capital is
transferred, capital inflow into a relatively poor country, and it should also promote technology
transfer. New technologies being transferred without the research and development costs.
In addition, local companies can copy superior processes and organizational patterns. Employment
can also be provided.
In practice, MNCs only transfer technologies at low levels, and once the profits from the
investment are remitted back, it becomes an outflow of foreign currency.
Most MNCs may decide to employ their own nationals in top management positions. The worst
part is that MNCs are offered grants, subsidies, tax relief etc., in order to attract them into poor
economies like the Zambian one, while MNCs can gain a cost advantage, integrating vertically by
establishing assembly plants in countries where there is abundant cheap, high-quality labour.
Some MNCs pursue a policy of horizontal integration in order to gain new markets and expand
sales. The advances in communication, cheap air travel, development of satellite systems has made
it cheaper for MNCs to develop new markets in overseas countries.
2.0 REASONS FOR INTERNATIONAL TRADE
- Products that are not produced in a certain country are available in other countries, thanks to
international trade. For instance, computers are not produced in Zambia, but are produced in
the United States.
- Unequal distribution of skills and technology. In addition, some countries have a good
reputation in the production of some commodities than other countries. An example is a
country like Japan which is more skilled in the production of goods like cars.
- Excess demand for locally produced goods may force countries to import to offset the
shortage.

- Unequal distribution of resources. For example, oil is found in Angola but not in Zambia, the
climate in South Africa is suitable for growing apples, but not the Zambian climate, etc.
2.1 THEORY OF COMPARATIVE ADVANTAGE
Comparative advantage is a country‟s ability to produce a product at a lower opportunity cost in

terms of another country. The principle of comparative advantage states that countries will benefit
by concentrating on the production of those goods in which they have a relative advantage.
A country is said to enjoy a comparative advantage over another if, with the same input of
resources, it can produce more of a good than another. A nation‟s comparative advantage is
measured in relation to all goods and services it produces. A country has a comparative advantage
in those products that it can produce cheaply.
Any product can be produced in any country but what matters most is the cost of production. It is
therefore more beneficial for each country to use its resource in the production of those goods in
which it has a cost advantage, and to trade with other countries to obtain, those goods, which
cannot be produced locally or efficiently.
The law of comparative advantage, therefore, states that a country should concentrate on producing
those goods in which it has the greatest relative cost advantage and imports from other countries
those goods in which it has the greatest relative cost disadvantage.
2.3 THEORY OF ABSOLUTE ADVANTAGE
Absolute advantage means that a country is more efficient in the production of both goods under
consideration than the other country being considered. A country‟s absolute advantage is measured
in relation to other nations. If two countries are producing the same product, the country that
produces the product cheaply has an absolute advantage over the other.
Even if a country has absolute advantage over the other in all products, there is still a possibility
for the two nations to trade as illustrated in the example below.
For example, if two nations produce computers and cars as follows:
Computers Ratio (calculate opportunity cost)

Country X 10, 000, 000 10:1 in favour of country X
Country Y 1,000,000
Cars
Country X 1,000,000 2: 1 In favour of country X again
Country Y 500,000
Given the scenario above, it is still possible for the two countries to engage in trade. Absolute
advantage cannot hamper international trade.

Country X has absolute advantage in both cases but the size of its advantage is greater in computer
production than in car production. Country Y‟s disadvantage is smaller in car production than in
the computer production. So it would be more beneficial to both countries if country X specializes
in computer production and imports cars, while country Y specializes in cars production and
imports computers.
3.0 FREE TRADE AND ITS EFFECTS
Free trade is a situation whereby the flow of goods, services and capital are not hindered by any
artificial barriers. In theory, trade on an international level, should be free from any restrictions,
and those who advocate for free trade maintain that this, would lead to numerous advantages, such
as
- Enabling countries to specialise and increase production bearing in mind that the surplus can
be exported.
- Countries export surpluses and import what they lack.
- Access to the world market, therefore enabling countries to benefit from economies of scale.
- Allowing countries to develop their industries as a result of free movement of capital.
- Promoting beneficial political links and closer cooperation between countries.
- Increasing efficiency due to competition from imports and limiting the creation of
monopolies.
- The efficient use of resources also leads to lower costs of production which in turn leads to the
reduction in the prices of goods and services.
- Provision of goods that were previously unavailable, a wider choice of goods to consumers.
3.1 DISADVANTAGES OF FREE TRADE
- It leads to unemployment especially in cases where imported goods are subsidised by the
countries of their origin.
- It has negative effects on new industries.
- Dumping of imports on the local market leads to unfair competition.
- It may lead to the importation of undesirable products.
- The government will lose revenue because it can longer impose taxes on imports.
4.0 BARRIERS TO INTERNATIONAL TRADE
In spite of the numerous advantages of international trading, countries the world over engage in
some form of protectionism. There are different forms of protectionism, and some of them are:
 Quotas. These are limits imposed on specified goods to be brought in the country. Import
quotas restrict the quantity of certain products, which can be imported into the country. If
the product is homogeneous then a simple quota is imposed. If they are heterogeneous, then
the quota can take the form of a value of imports allowed in any given currency.

The effect of quotas is to reduce the volume of imports, raise the price of imports and
encourage the demand for locally produced commodities.
Note that sometimes one country persuades another country to voluntarily reduce its exports
of a product to a certain acceptable level, this is known as voluntary export restraints
(VERs). VERs is also known as orderly market arrangements emphasizing their negotiated
manner. VERs often apply to key industries, an example is VERs negotiated by the United
States of America on Japanese exports of motor vehicles.
 Tariffs or custom (import) duties. These are taxes that are levied on imports. It can be a
fixed amount per unit (specific) or a percentage of the price (ad valorem).
The effect of tariffs is to raise prices of imports, and therefore reduce their demand,
encourage the demand for locally produced commodities, as well as raise revenue for the
government.
 Trade embargoes. This is a complete ban of imports from a particular country. Sometimes
it is a total ban imposed on particular products like drugs, from any country! During the Iraq
war of the early 1990s, the United Nations imposed a ban on Iraq‟s exports.
 Hidden export subsidies and import restrictions (Direct controls). This is a range of
government subsidies and assistance for exports and deterrents against imports as follows:
- Subsidies. The government gives subsidies to local firms to allow them to compete favourably
in terms of pricing of goods, with foreign firms.
- Export credit guarantees or insurance against bad debts for overseas sales.
- Grants or any form of financial help is provided to firms in the export sector
- Zero rating or reducing taxes on exported goods
- State assistance provided for firms in the export sector via the foreign office.
In addition, imports are discouraged through
- Health and Safety regulations. Countries sometimes put in place health and safety
regulations that limit the importation of certain goods. For example, the Zambian government
has put in place a regulation that stipulates that sugar sold in Zambian market must be fortified
with vitamin A regardless of whether this sugar is locally produced or imported.
- Administrative procedures (bureaucracy). These are long, complex and costly procedures
that importers have to go through at border posts.
- Exchange controls. These are aimed at restricting the amount of foreign exchange that is
available to importers.

4.1 ARGUMENTS IN FAVOUR OF PROTECTIONISM
a) To protect new and declining industries.

New industries need to be protected from foreign competition before they become strong to
be on their own, while declining industries might quickly collapse and lead to mass
unemployment if not protected.
b) To reduce unemployment. Unfair competition from foreign products may lead to the closure
of home industries. Therefore, the government protects its industries in order to prevent the
closure of industries and unemployment.
c) To reduce or eliminate balance of payments deficits. Restricting imports will help to reduce
or eliminate balance of payments deficits.
d) To raise revenue. The government raises revenue from import tariffs that are imposed on
imported products.
e) To protect strategic industries. Industries such as ship building, defence and aerospace are
of strategic importance to many countries. Therefore many countries protect these industries
from foreign competition
f) To protect against dumping of imported products on local market. Dumping is a situation

where goods are sold at lower prices in a foreign market than in the home market.
g) Retaliation against measures taken by another country that are unfair.
h) To prevent unfair competition. Governments may justify protectionism with reference to the
trading policies of its competitor nation, such as selling imitations at artificially low prices.
4.2 ARGUMENTS AGAINST PROTECTIONISM
a) The fear of retaliation. If a country imposes restrictions against other countries‟ exports, the
affected countries can retaliate by imposing restrictions on its exports.
b) Reduction in industrial efficiency. Protecting industries from international competition

reduces their efficiency.
c) Cost to consumers. Protectionism is costly to consumers because they are forced to pay high
prices for goods of poor quality.
d) Restricted choice of products Protectionism leads to the reduction in the range of products
available to customers.

5.0 TERMS OF TRADE
The terms of trade are the ratio of an index of (visible) exports prices to an index (visible) import
prices. They measure the relative change of the price of exports and the price of imports.
A base year is chosen, at which point the average price of exports is assigned an index value of
100, as is the average price of imports.
Suppose that in 2000, the base year, the average price of a basket of visible Zambian exports was
K450, 000, while the average price of a basket of imports was K500, 000. Each of these prices
would be assigned an index of 100, and the terms would be (100/100) = 1.
In fact, 100 multiply this ratio when the terms of trade are calculated. So the terms of trade for the
year 2000 are 100.
Now suppose that in the following year (2001) the average price of exports rose by 10%, to K495,
000, while the average price of imports rose by 6%. The index for exports would rise to 100x 1.1 =
110, and the index for imports would rise to 106 (100x1.06). The terms of trade for 2001 would be
(110/106) x 100 =104.
The rise in the terms of trade reflects the fact that export prices have risen more than import prices.
An increase in the terms of trade is called an improvement in the terms of trade, though it may not
always be desirable.
One reason for wanting an increase in the terms of trade is that a given quantity of exports will
now pay for more imports. In the example above, the foreign currency earned by exporting one
basket of exports in the year 2000 (K450, 000 worth) would buy 450/500 =0.9 or 90% of a basket
of imports.
When the terms of trade improved in 2001, so that the average price of exports was K495, 000,
while that of imports was K500, 000 x1.06 = K530, 000, one basket of exports would earn enough
foreign currency to pay for 495/530 = 0.9339 or 93.34 % of a basket of imports. This means that,
ceteris paribus, fewer exports are required to pay for imports.
An improvement in the terms of trade will be advantageous if it results in an increase in funds

coming in and/ or a decrease in funds leaving the country. This happens if the PED for imports and
exports is less than 1.

6.0 REGIONAL AND INTERNATIONAL ORGANISATIONS
6.1 THE SOUTHERN AFRICAN DEVELOPMENT COMMUNITY (SADC)
 HISTORICAL BACKGROUND
The Southern African Development Community (SADC) came into existence in 1980, as an
alliance of independent Southern African States. The Southern African Development Community
(SADC) was formerly known as the Southern African Coordination Conference (SADCC) and
formed with the goal of helping countries in the Southern African region to lessen dependence on
South Africa. The SADC headquarters are in Gaborone, Botswana.
 MEMBER STATES
The member states are Angola, Botswana, the Democratic Republic of Congo, Lesotho,
Madagascar, Malawi, Mozambique, South Africa, Swaziland, Tanzania, Zambia and Zimbabwe.
 OBJECTIVES OF SADC
- The achievement of economic growth and development in member countries.
- Promotion of peace and security
- Promotion of common political beliefs and values
- Promotion of self-sustaining development
- Achievement of self- sustaining utilisation of natural resources and protection of the
environment.
- The strengthening of long standing cultural links among the peoples of the SADC region.
 ACHIEVEMENTS
- Increase of trade among member sates.

- Member countries have strengthened their bargaining power.
 CHALLENGES
- Each member state uses a different currency and this hampers free trade.
- Over dependence on donor funding.
- Lack of participation in decision-making and other SADC activities by ordinary citizens.
 FUTURE OUTLOOK
SADC faces a bright future due to the following reasons:
- Donor confidence has been increasing.

- The SADC market is big with a population of 60 million people and rich in mineral resources.
- The region is likely to attract more investment with attainment of peace in Angola and the
Democratic Republic of Congo (DRC).

6.2 COMMON MARKET FOR EASTERN AND SOUTHERN AFRICA (COMESA)
 HISTORICAL BACKGROUND OF COMESA
COMESA was established in 1993 in Uganda replacing the Preferential Trade Area (PTA) that
was founded in 1981. Its headquarters are in Lusaka, Zambia.
 MEMBER STATES
These are Angola, Burundi, Comoros, Egypt, Eritrea, Ethiopia, Kenya, Lesotho, Madagascar,
Malawi, Mauritius, Mozambique, Namibia, Rwanda, Sudan, Swaziland, Tanzania, Uganda,
Democratic Republic of Congo (Zaire) Zambia and Zimbabwe.
 OBJECTIVES OF COMESA
- To achieve sustainable economic and social progress in all member countries.

- To promote economic cooperation among member states.
- To establish and maintain a Free Trade Area.
- To remove all tariff and non- tariff barriers.
- To create a Customs Union
- To promote free movement of capital and investment.
 ACHIEVEMENTS
- Creation of the COMESA Free Trade Area (FTA).

- Creation of an enabling environment for trade.
- A wider, harmonised and more competitive market.
- Greater industrial productivity and competitiveness.
- Increased agricultural production and food security
- More harmonised monetary, banking and financial resources.
 CHALLENGES
- Inability to participate effectively in the World Trade Organisation (WTO) negotiations.

- Resistance to elimination of trade barriers
- Lack of political stability in some member states like the Democratic Republic of Congo
(DRC).
- Difficult to co-ordinate countries of vastly different economic, social and political
backgrounds.
- Undeveloped infrastructure such as roads and telecommunication networks in some member
states.
 FUTURE OUTLOOK
COMESA faces a bright future for the following reasons:

- COMESA‟s population of over 300 million people constitutes a potentially large market and a
huge reservoir of both skilled and unskilled labour.
- The COMESA region covering an area of about 12.89 million square kilometres is rich is
minerals, lakes and rivers that can be exploited for irrigation, hydroelectric power and
fisheries.
- Increased regional integration in trade and investment will lead to an expansion of the
industrial and services sectors of member states.
6.3 THE EUROPEAN UNION (EU)
 HISTORICAL BACKGROUND OF THE EU
The European union (EU) formed in 1992 is an intergovernmental union of 25 countries of the
European continent. Its headquarters are in Brussels, Belgium.
 MEMBER STATES
The EU is made up of 25 countries namely Italy, United Kingdom, France, Germany, Greece,
Luxembourg, Netherlands, Ireland, Portugal, Spain, Belgium, Sweden, Finland, Denmark, Austria,
Cyprus (Greek Part), Czech, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and
Slovenia.
 OBJECTIVES OF THE EU
- Abolition of remaining controls on capital flows.

- Removal of all non- tariff barriers to trade.
- Progress in harmonising tax rates.
- Removal of frontier controls and bias in public sector purchasing to favour domestic
producers.
 ACHIEVEMENTS
- Creation of a single market consisting of customs union, a single currency managed by the
European Central bank.
- Establishment of a common policies in agriculture, trade, fisheries and foreign and security.
- Abolition of passport control and custom checks at many of EU‟s borders.
- Creation of single space of mobility for EU citizens to live, travel, work and invest.
 CHALLENGES
- Adoption, abandonment or adjustment of the new constitutional treaty.

- The EU‟s enlargement to the south and east.
- Resolving of the EU‟s fiscal and democratic accountability.
- Economic viability with the United States, China and India.

6.4 THE WORLD TRADE ORGANISATION (WTO)
 HISTORICAL BACKGROUND OF WTO
The World Trade Organisation (WTO) was formed in 1995. It replaced the General Agreement on
Trade and Tariffs (GATT) that was established in 1948. Its secretariat is based in Geneva,
Switzerland. The main purpose of WTO is to promote free trade by persuading countries to abolish
import tariffs and other barriers.
 MEMBER STATES
In November 2005, membership of the WTO stood at 149 countries.
 OBJECTIVES OF THE WTO
- To promote free trade by persuading nations to abolish import duties and other barriers.
- To oversee the rules of international trade.
- To police free trade agreements.
- To settle trade disputes between member countries.
- To organise trade negotiations.
6.5 THE WORLD BANK (THE INTERNATIONAL BANK FOR RECONSTRUCTION

AND DEVELOPMENT)
The World Bank came into existence in 1945 but commenced its operations in 1946. It is a non-
profit organisation owned by member governments and has its headquarters in Washington, D.C in
the United States of America.
OBJECTIVES OF THE WORLD BANK
 To fight poverty and improve the living standards of people in developing countries.
 To provide long-term loans and grants to developing countries.
 To provide technical assistance to help developing nations in their quest to reduce poverty.
 To provide assistance to developing countries on issues of economic development.
6.6 THE INTERNATIONAL MONETARY FUND (IMF)
The IMF was formed in 1944 by the Bretton Woods Agreement and started operating in 1947. The
principal function of the IMF is to help countries with balance of payment problems. Its
headquarters are in Washington, D.C in the United States of America.

OBJECTIVES OF THE IMF
 To promote international monetary cooperation and international payments.

 To encourage international trade among member states.
 To promote exchange rate stability in member states.
 To eliminate or remove of foreign exchange restriction
 To provide advisory services to member states
 To ensure that there is adequate supply of international liquidity.
7.0 CHAPTER SUMMARY
International trade is important because it allows countries to specialize according to the law of
comparative advantage.
The law of comparative advantage states that international trade is most efficient and advantageous
if each country sells the goods of which the country has the most advantage in production relative
to other goods received in exchange.
There are a number of advantages of international trading such as giving consumers in each
country more choice, encouraging efficiency in production, which is likely to result in lower
prices.
In spite of the numerous advantages of free trade, countries engage in protectionist policies for
various reasons. These include protecting employment, helping infant industries, preventing unfair
competition, protecting the balance of payments, and raising revenue.
There are some arguments against protectionism. It is argued that they encourage inefficiency, lead
to misallocation of resources, raise the cost of living, and retaliation may occur.
The methods or forms which protectionism takes include tariffs, quotas, hidden import restrictions
and export subsidies.
The terms of trade refer to the rate at which exports can be exchanged for imports. An
improvement in the terms of trade may not necessarily be beneficial as it reflects an increase in
export prices arising from domestic inflation. However, an improvement in the terms of trade does
reflect that fewer exports need to be sold to pay for each import because export prices are rising
faster than import prices.
There are a number of international institutions, which facilitate international trading. Some of the
international institutions are regional groupings that can take different forms, such as free trade
areas, customs union and/or common markets.

REVIEW QUESTIONS
1. International trade is based on which principle?

2. State the law of comparative advantage
3. State what you think is the comparative advantage of your country, and what you think are
Zambia‟s non-traditional exports.
4. What are the terms of trade?
5. Give three arguments for protectionism
6. What does the world trade organization (WTO) attempt to do?
7. What is a multinational company?
8. Why have some companies become multinational in structure?
9. How can multinational companies benefit economies?
10. Differentiate tariffs from quotas as barriers to free trade
11. What do a free trade area, a customs union and a common market mean?
12. The following data relates to the export and import prices of a country for three years.
N.B. Where 2004 = 100
Year Unit value of Unit value of

imports exports
2004 100 100

2005 112 106
2006 116 114
You are required to calculate the terms of trade in the years 2005 and 2006, and comment on your
results.
----------------------------------------------------------------------------------
(a) Malawi and Zambia each produce both tobacco and maize in thousand of tons, as shown
below:
Tobacco Maize
Malawi 20 200
Zambia 10 150
Malawi appears to have an absolute advantage in the production of both commodities.

Would you advice that trade should still take place between the two countries? Justify your
answer. (6 marks)
(b) Despite the numerous advantages of free trade, countries engage in protectionism.
mention briefly four arguments for protectionism. (8 marks)

(c) Explain three forms of protectionism. (6 marks)
TOTAL: 20 MARKS
a) Discuss five benefits of international trade. (10 marks)
b) Explain briefly
i) The comparative cost (comparative advantage) theory of trade. (5 marks)
ii) The terms of trade (5 marks)
TOTAL: 20 MARKS

CHAPTER 15
BALANCE OF PAYMENTS AND EXCHANGE RATES
______________________________________________________________________________________________
 Explain the monetary aspects of international trade transactions

 Understand the composition of the balance of payments account
 Explain how to correct a deficit balance of payments
 Appreciate of different types of foreign exchange systems
 Discuss the merits and demerits of each exchange rate system.
 Explain the difference between foreign exchange depreciation and appreciation
 Understand factors influencing foreign exchange rates
_______________________________________________________________________________
1.0 INTRODUCTION
Balance of payments (BOP) is a measure of the payments that flow into and out from a particular
country from other countries for a specific period usually a year. It is a statistical „accounting‟
record of the international trading and capital transactions that have taken place during that year.
This is determined by a country‟s exports and imports of goods, services, financial capital and
financial transfers, and since buying goods and services from foreign countries is complicated by
the fact that countries use different national currencies, this last chapter also deals with the foreign
exchange market.
1.1 COMPOSITION OF BALANCE OF PAYMENTS
The Balance of payments consists of two parts namely
(a) The current account. This shows a record of net flow of money from transactions
involving the purchase of goods and services, and transfer payments. The current account
itself is divided into basically two parts namely
i) Trade in goods (known as visible or trade account)

The exports and imports of physical commodities such as copper and maize are
recorded on this account. The account may show a surplus or a deficit. Exports are
money coming into a country and if the exports are higher than the imports, then there
is a surplus on thevisible trade account and vice versa.
ii) Trade in services (known as invisible trade account)

This is usually recorded as a net figure, implying the difference exports and imports of
services such as tourism, insurance, civil aviation, patents, foreign aid, grants, gifts etc.
It also includes the difference between factor incomes payable and receivable such as
wages to foreign workers, interest on foreign debt, dividend payments on shares held by

foreigners or income on any foreign investments. It is recorded as net transfer income
from abroad or paid abroad depending on whether there is a higher net inflow or a
higher net outflow of money respectively. This account can either be in surplus or
deficit.
The current account, being a combination of the two accounts above, can either be positive
or negative, that is either a surplus or a deficit. When exports or money received from trade
in goods, services and factor incomes exceed imports or money paid for trade in goods,
services and factor incomes, it means there a surplus or a favourable current account
balance. When imports exceed exports, it means there is a deficit or an unfavourable
current account balance. Note that this is what is referred to as the surplus or deficit balance
of payments account!
(b) The capital account. This account records all international financial transactions in
the country,the external assets and liabilities. In general it records medium and long-
term capital inflows and outflows, including official reserves.
The inflows into the capital account:
 Foreign loans
 Investment by foreigners into Zambia
 Aid from donor countries
 A reduction in external reserves
 Trade in shares in Zambian investments by people based outside Zambia.
 Selling of assets that are based in other countries.
The outflows from the capital account:
 Zambians investing in other countries.

 Zambia giving aid or loans to other countries.
 Trade in shares by Zambians in investments abroad
 An increase in external reserves.
 Selling of assets based in Zambia to people based outside Zambia.
In summary, if foreign ownership of domestic assets has increased more quickly than domestic
ownership of foreign assets in a given year, then the domestic country has a capital account
surplus. On the other hand, if domestic ownership of foreign assets has increased more quickly
than foreign ownership of domestic assets, then the domestic country has a capital account
deficit.
The capital account „finances‟ or „covers‟ the current account, since a surplus or deficit on the
current account must be „balanced‟ by a deficit or surplus on the capital account respectively. If for
example there is a negative or a deficit current account balance, then it must be „financed‟ by
inflows into the capital account and vice versa.

The above means the sum of the balance of payments account must always be zero. In practice, an
additional account is included to achieve the zero balance. This is known as net errors and
omissions or a balancing item.
1.2 Official Reserve Account
The official reserve account records the government's current stock of reserves. Reserves include
official gold reserves, foreign exchange reserves, and strategic defense reserves (SDRs), such as
the Strategic Petroleum Reserve.The Balance of Payments is the sum of the Current Account and
the Capital Account. Therefore, Balance of Payments = Current Account + Capital Account =
Change in Official Reserve Account! The balancing item is a change in the official reserves. A
negative sign is an increase in official reserves while a positive sign is a decrease in official
reserves.
1.3 Zambia’s balance of payments (extracts from the B.O.Z annual report)
The improvement in the terms of trade, on account of the increase in the international price of
copper, as well as the attainment of the enhanced HIPC Completion Point contributed to the
improvement in the performance of the external sector during the year. Consequently, the deficit in
the overall balance of payments declined. Preliminary information indicates that the deficit in the
overall balance of payments narrowed by 21.3% to US $274 million in 2005 from US $348 million
in 2004. This improvement in the overall balance was largely due to the favourable performance in
the capital and financial accounts despite the deterioration in the current account. Project loans and
grants, foreign direct investment as well as portfolio inflows registered significant increases, and
enhanced the capacity to build-up Gross Official International Reserves (GIR) of the Bank of
Zambia. This development reinforced the positive effects of the improvement in the terms of trade.
Current Account
The combination of continued strong economic activity and the appreciation of the Kwacha led to
an increase in the current account deficit through increased imports. There was a decrease in the
merchandise trade balance as well as the deterioration in net services and income accounts. The
merchandise trade balance declined by 28.0% to US $59 million in 2005 from US $82 million in
2004 while the net services and income accounts deteriorated by 17.2% and 42.7% to US $252.0
million and US $605.0 million, respectively. The decline in the trade balance resulted from a
higher increase in the value of merchandise imports than that of merchandise exports.
The value of imports increased by 19.7% to US $2,068 million from US $1,727 million recorded
in 2004. The increase in the import bill was in part explained by the continued high investment
activity in the mining sector and the rise in the price of oil on the world market. The strengthening
of the Kwacha against major trading currencies also reinforced increased domestic demand for
imports.

TABLE 17: BALANCE OF PAYMENTS IN US $ MILLION, 2003 – 2005
2003 2004 2005
Current account balance -700 -583 -826
Trade balance -311 82 59
Exports, f.o.b. 1,052 1,779 2,095
Metal sector 669 1322 1,557
Non-traditional 383 457 538
Imports, f.o.b. -1,393 -1,727 -2,068
Metal sector -169 -286 -306
Non-metal -1,224 -1,441 1,759
Goods procured in ports by carriers 29 31 32
Services (net) -238 -215 -252
Receipts 165 232 246
Payments -403 -447 -499
Income (net) -148 -424 -605
Of which: interest payments -131 -121 -110
Current Transfers (net) -3 -25 -28
Of which Official Transfers 20 0 0
Capital Account 380 235 552
Project grants (capital) 240 246 306
Financial Account 140 -11 246
Official loan disbursement (net) -141 -221 -105
Disbursement 101 110 120
Amortization (-) -242 -331 -225
Change in net foreign assets of Commercial banks 48 -90 17
Private capital (net) 233 299 334
Foreign direct investment 172 239 259
Errors and omissions, short term capital -2 63 0
Overall balance -319 -348 -274
Financing 321 285 274
Change in net international reserves of BoZ (-increase) -161 -44 -341
Gross official reserves of BoZ 89 -28 -81
BoZ liabilities -6 -6 -6
IMF (net) -244 -10 -253
Debt Relief 389 264 480
Debt relief (non-HIPC) 154 245 152
Debt relief (HIPC, including IMF) 235 19 328
Of which IMF 169 2 229
Other Debt Related Items -10 0 0

Net change in arrears (+ increase) 48 0 0
BOP support grants 45 44 105
BOP support loans 10 21 29
Multilateral 10 21 29
Bilateral 0 0 0
Financing gap (+) 0 0 0
Memorandum items:
Nominal GDP (millions of US $) 4,326 5,422 6,968
Current account balance (% of GDP) -16.2 -10.7 -11.9
Terms of trade (percentage change) 4.2 21.9 2.1
Copper volume (MT.'000) 353 393 417
Copper price (US$/lb) 0.78 1.20 1.52
Gross official Reserves 194 222 303
(In months of imports) 1.3 1.2 1.4
Debt service cash payments (US $m) 192 371 162
(In % of exports) 15.4 18.2 6.8
Of which; official debt service 108 114 129
Source: Bank of Zambia and Fund Staff Estimates

Notes: The figures reported in the Balance of Payments table are as estimated in October 2005
Total export earnings in 2005 increased by 17.8%, to US $2,095 million from US $1,779 million
in 2004, with earnings of metal and non-traditional exports (NTEs) both rising by 17.8% to US
$1,557 million and US $538 million, respectively. The increase in copper prices was mainly due to
sustained international demand particularly from China and India while export volumes edged
upwards as a result of continued recapitalisation of the existing mines and commencement of full
production at Kansanshi mine.
In contrast, cobalt exports declined. The 17.7% increase in Non-Traditional Export was explained
by growth in the exports of copper wire, sugar, burley tobacco, cotton lint and electrical cables.
The deficit in the services account deteriorated to US $252 million in the past year, reflecting large
amounts of net payments made on trade-related services. With respect to the income account, the
deficit widened by 42.7% to US $605 million. This increase was in spite of a 9.0% decline in
official interest payments on external debts to US $110 million from US $121 million over this
period.
Capital and Financial Account

The surplus on capital and financial account rose to US $552 million in 2005 from US $235
million in 2004. This was largely due to increased donor inflows, foreign direct and portfolio
investments as well as a reduction in debt amortization. Increased external capital inflows partly
resulted from the rise in investor and donor confidence following the attainment of the enhanced
HIPC Initiative Completion Point in April 2005.

Financing
The deficit in the overall balance of payments was financed mainly by debt relief of US $480
million, inflows of BoP support grants amounting to US $105 million and BoP support loans of
US $29.0 million.
The Balance of Payments Support came from cooperating partners. Specifically, Zambia received
from the European Union (EU), from the British Government under the Poverty Reduction
Budgetary Support (PRBS) to finance priority poverty reduction programmes, from Finland, from
Sweden, from the World Bank and from Norway.
2.0 THE PROBLEM OF BALANCE
When a country has an adverse or a deficit (negative) balance of payments, this is regarded with
serious concern. When a country has a favourable or credit (positive) balance, then there is
satisfaction.
Yet for all countries of the world, total payments must be equal to total receipts, since every
payment is at the same time a receipt. Since all countries cannot achieve favourable balances in
the same year, the aim should be an equilibrium balance of payments over a period of time.
Each individual country‟s balance of payments must balance each year. When all items have been
taken into account, a balance is achieved by showing how the deficit or amount of credit
(favourable) balance has been „covered‟ or „financed‟.
If a country has a deficit in its balance, it must be „covered‟ by inflows into the capital account. If
it has a credit or positive balance, then it is „covered‟ by outflows from the capital account.
2.1 CORRECTING A BALANCE OF PAYMENTS DEFICIT
- Devaluation/depreciation
Devaluation of a currency is a reduction in the exchange rate of the currency relative to other
currencies. The objective of devaluing a country‟s currency to make exports cheaper and imports
expensive, by reducing the price of exports to foreign buyers (i.e. in foreign currency terms) and
increasing the price of imports in terms of the domestic currency.
If for example the Zambian Kwacha to the US dollar is devalued form $1 = K3200 to $1 = to
K4000, then foreign consumers and firms will be encouraged to switch to Zambian goods because
with the same $1, they are able to purchase more Zambian goods. They are able to purchase K4000
worth of goods instead of K3200 worth of goods. In addition, local consumers and firms will be
discouraged from imports. They will need to have K4000 to purchase a $1 worth of goods, before
devaluation, they needed to have K3200 to purchase a $1 worth of goods.

Therefore, depreciation in the kwacha exchange rate should help to boost the overseas demand for
Zambian exports because Zambian firms will be able to supply more cheaply in international
markets.
The extent to which export sales rise following a fall in the exchange rate depends on the price
elasticity of demand for Zambian products from foreign consumers.
A lower exchange rate should also cause imports into Zambia to become relatively more
expensive, thus leading to a slowdown in import volumes and "expenditure-switching" towards
local goods. The significance of elasticity of demand is again important.
In the short run, even if elasticities are favourable, a depreciation/devaluation does not
immediately benefit a balance of payments in practice. It takes time for movements in the
exchange rate to affect trade flows. In the short run, demand for imports is likely to be fairly
inelastic, while exporters would be unlikely to increase the output to meet the increase in demand
due to the depreciation of the currency. Therefore, there is likely to be an initial worsening of the
current account because volumes are fixed.
In the long run, demand and supply become more elastic, production and volume of exports rise,
imports can be substituted and the volume of imports falls. This improves the current account
balance.
The effect of devaluation/depreciation of a currency on the current account is called the j-curve
effect. The exact shape of the curve depends on the assumptions made, and it is usually assumed
that the improvements in the current account eventually levels off.
Balance
0 Time (years)
- Deflation/Fiscal policy
This is contraction of the domestic economy. Deflationary measures are aimed at reducing
aggregate demand and this can be achieved by either increasing interest rate to discourage
borrowing or increasing tax rates in order to reduce consumption expenditure. The government can
also reduce its own expenditure.

Some of the overall trade deficit is due to the strength of domestic demand for goods and services.
If and when the economy enters a slowdown phase, the growth of imports will fall, and this should
provide an element of correction for the trade deficit
The effect of the deflationary measures is to reduce the demand for goods and services, including
the demand for imports. If imports are high, demand for them is reduced by reducing the demand
in the economy in general, as long as the demand for imports is income inelastic. If the fall in
demand is accompanied by a reduction in inflation in the home market, the competitiveness of
exports improves (as long as demand for exports in price elastic). In addition, firms are encouraged
to switch to export markets because of the fall in domestic demand.
provide an element of correction for the trade deficit. The major problem associated with deflation
is that a sharp fall in consumer spending might lead to a steep economic slowdown (slower growth
of GDP) or a full-scale recession.
- Direct controls (discouraging imports whilst encouraging exports).
These are the direct controls mentioned earlier under protectionism. A government can impose
trade restrictions like quotas, import duty, exchange controls, health and safety regulations etc.
Increase exporters‟ competitiveness on the international market by subsidising exporters. A
government may also adopt policies to promote exports e.g. zero-rating VAT on exports, export
credit guarantees etc. Eventually the policies result in more exports.
The problem with this policy instrument is that there is a danger of other countries retaliation, as
well as if the demand for imports is inelastic.
- Raising interest rates.
High interest rates are likely to make Zambia attractive to foreign investors and encourage inward
investment, an inflow of foreign currency. This short- term capital movement of currencies by
international financiers/speculators is known as „hot money‟. Higher interest rates act to slowdown
the growth of consumer demand and therefore lead to cutbacks in the demand for imports. It is a
short-term measure, which eventually leads to an appreciation of the exchange rate.
Note that the key to long-term improvements in trade performance is to focus on supply side
policies. Controlling or reducing a balance of payments deficit in the long term is to achieve
relatively low inflation with sufficient productive capacity to meet the domestic demand from
consumers.
This requires a period of low inflation, low interest rates and a competitive exchange rate matched
with sufficient non-price competitiveness in overseas markets. Price is not always the only
deciding factor in winning the demand from buyers, investment in research and development and
effective marketing strategies can have long term effects in maintaining market share.

An outward shift of long run aggregate supply would provide the economy with an increased
capacity - permitting a reallocation of resources towards exporting. Therefore, a sustained
improvement in the balance of payments requires businesses exploiting opportunities in export
markets overseas, increased investment in services (including business finance, tourism) as many
services are exportable and have the potential to earn huge sums in foreign currency. Improve
efficiency and productivity in the export sectors.
3.0 EXCHANGE RATES
Exchange rates are the price of a currency expressed in terms of another currency. An exchange
rate is the price for obtaining one unit of a foreign currency. The exchange rate refers to the value
of one currency (e.g. the Kwacha) in terms of currency (e.g. the United States Dollar).
3.1 DETERMINATION OF EXCHANGE RATES
The basic forces behind the determination of exchange rates are those of supply and demand.
Taking exchange rate for the kwacha against other currencies as an example, the exchange rate set
in the market will be affected by supply of and demand for Kwacha.
3.2 DEMAND
People and firms want the Kwacha for various reasons:
a) To pay for Zambian exports.

b) Investors based abroad wanting to invest in Zambia.
c) Speculation. Speculators will buy the Kwacha at the current exchange rate, if they think it
going to appreciate in the near future. They want to sell the Kwacha at a higher exchange rate
in future.
d) The central bank may want to buy Kwacha to push up its value on the foreign exchange
market.
3.3 SUPPLY
Supplies of Kwacha arise when people buy foreign currency in exchange for Kwacha. The factors
affecting supply are as follow:
a) Zambian residents wishing to buy imports will require foreign currency, so they need the
Kwacha to acquire foreign currency.
b) Zambian residents investing abroad will sell the Kwacha and buy foreign currency.
c) If speculators think that the Kwacha is about to depreciate they sell it.
d) The central bank may sell the Kwacha to manipulate its value.
3.4 FIXED EXCHANGE RATES
This is where the government keeps the exchange rate at a fixed level, but if it cannot control
inflation, the real value of the currency will not remain fixed.

3.4.1 ADVANTAGES OF FIXED EXCHANGE RATES
a) They make international trade more stable because of the certainty to traders.
b) They make it possible for importers and exporters to predict profits.
c) They make investors more confident about investing in other countries.
d) Importers and exports can agree prices for future delivery without having to worry about
potential losses through exchange rate movements.
3.4.2 DISADVANTAGES
a) They require substantial official reserves. The Central Bank requires a large pool of foreign
currency to enable a prolonged period of intervention to support the exchange rate.
b) They complicate Economic co-operation among countries with different Economic objectives
and policies
c) Fixed exchange rates can lead to capital flight or outflows of capital if interest rates are
attractive in other countries.
3.5 FLOATING EXCHANGE RATES
Floating exchange rates are exchange rates that are determined by the market forces of supply and
demand. Under the Floating exchange rate system, the government does not intervene in the
foreign exchange market. A system under which exchange rates are not fixed by government
policy but are allowed to float up or down in accordance with supply and demand.
3.5.1 ADVANTAGES
a) The nation‟s exchange rate will adjust automatically in the foreign exchange market to correct
any balance of payments deficits or surplus.
b) The central bank does not need to large reserves maintain a certain exchange rate.
c) Monetary policy will be more effective.
d) There is no need to work out the new exchange rate because market forces of supply and
demand will determine it.
3.5.2 DISADVANTAGES
a) Floating exchange rates lead to uncertainty in international trade and this may hinder trade
with other countries.

b) Floating exchange rates encourages speculation, which in turn leads to increased volatility of
the exchange rates.
c) Fiscal policy will be less effective.
3.6 Note the following in relation to exchange rates: In markets where exchange rates float,
an increase in the external value of a currency is referred to as an appreciation and
a decrease in the external value is referred to as a depreciation of the currency.
In markets where exchange rates are fixed, when authorities raise the external value of the
currency to a higher fixed parity, this is referred to as a revaluation and a change to a
lower parity is referred to as a devaluation of the currency.
3.7 MANAGED FLEXIBILITY OR DIRTY FLOATING EXCHANGE RATES
The system that exists in practice is a compromise between fixed and floating rates.
The market forces now play a more important role in the determination of exchange rates, but the
authorities often intervene to neutralise short run pressure on exchange rates, to ensure that it
remains fixed within a certain zone of flexibility. This system is known as a managed float.
A central bank, on behalf of the government, buys and sells currency to stabilize the exchange rate.
When one reads in the newspapers that the Bank of Zambia has offloaded foreign currency (from
its reserves) to buy the Kwacha on the foreign exchange market, the bank wants to artificially
stimulate demand, and make the Kwacha appreciate in value, and vice versa.
However, because authorities do not always make it clear that they are using the reserves to
support a currency‟s external value, and maintain an exchange rate target, which is usually
unofficial, the term dirty float is used.
4.0 CHAPTER SUMMARY
The balance of payments is an account showing the financial transactions of one nation with the
rest of the world, it records flows of funds between residents of a country and overseas residents,
normally for a period of one year.
The balance of payments consists of two parts, the current account and the transactions in external
assets and liabilities, known as the capital account.
The current account is made up of the visible and the invisibles account, while the capital account
shows the inflows and the outflows of foreign currency. The overall balance shows how the
difference between current and capital accounts is financed.
In theory, the balance of payments always balances because of the double entry system used in
recording transactions. However, in practice, there is need to include a balancing item, which is
created by errors and omissions in measuring the figures.

A balance of payments deficit indicates that what was paid out is greater than what was received.
The deficit can be adjusted by devaluation and deflationary measures as well as direct controls.
A balance of payments surplus can be adjusted by revaluation, and other measures to encourage
imports. Exchange rates are a „price‟ of one unit of a currency expressed in terms of another
currency.
There are two basic exchange rate systems, the flexible or the floating and the fixed exchange rate
systems, in practice, most exchange rates fall in between these two extremes. A „dirty‟ or managed
exchange rate is when the central bank intervenes in order to stabilize the exchange rate.
The market forces of supply and demand for a currency determine the floating exchange rate, and
the central authorities determine the fixed exchange rate system. Both systems have advantages
and disadvantages. When there is a high demand for a currency due to an increase in exports or
other factors, the currency appreciates in value and vice versa.
REVIEW QUESTIONS
1. What does the capital account show?

2. Name one invisible earning
3. What do you understand by the current account of a country‟s balance of payments?
4. What can cause a country‟s balance of payments on the current account to be in deficit?
5. How can deflation help a balance of payments deficit?
6. What does the „j‟ curve show?
7. How can a fall in the exchange rate help an economy?
8. What is the difference between devaluation and depreciation of the exchange rate?
9. What is the main determinant of the value of floating exchange rates?
10. Explain the term „managed‟ floating system of exchange rate determination.
11. What is the advantage of freely floating exchange rates?
12. Give two advantages of a fixed exchange rate system.
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a) What is a Balance of Payments Account? Describe its composition. (8 marks)
b) Explain:
i) Two ways of “financing” a balance of payments deficit and
ii) Two ways of “correcting” a balance of payments deficit. (8 Marks)
c) The Zambian Kwacha rate of exchange to the United States Dollar was K8 to $1 in 1988,
fourteen years later in mid November 2002, it was over K5, 000 to $1.
Discuss two arguments in favour of a return to a system of fixed exchange rates.

(4marks)
(Total: 20 Marks)
QUESTION 15.2
a) What policies can a government pursue to remove a large balance of payment deficit?
(12 marks)
b) The following data refers to a hypothetical balance of payment values of a country

K‟m
Exports 65 500
Interest, profits and dividends (net) 1 080
Services (net) 2 400
Imports 63 200
Current transfers -1 810
Increase in external assets 30 830
Increase in external liabilities 28 570
Balancing item 1 710
You are required to calculate the balance of payments account, showing clearly
- The visible trade balance

- The invisible trade balance
- The current account balance
- The capital account balance – the movement in external assets and liabilities
(8 marks)
TOTAL: 20 MARKS

APPENDIX 1
SOLUTIONS TO REVIEW QUESTIONS
CHAPTER ONE
1. The basic economic problem facing all economies is the scarcity of resources
2. Positive economics is objective economic descriptions while normative economics is
economic value judgments and opinions of what ought to happen in an ideal world.
3. The main production decisions are what, where, how and for whom to produce
4. Land, labour, capital and enterprise.
5. Opportunity cost is the sacrifice of the next best alternative
6. A production possibilities curve shows the maximum of all possible combinations of two
types of products that can be produced with existing resources.
7. The central government authorities make most of the decisions on behalf of society.
8. An externality is a consequence of an economic transaction that affects people not party to the
transaction.
9. It is measured as the „real‟ increase in output, the actual value of goods and services produced
in a country in any given year.
10. Unbalanced economic growth is where some sectors or areas grow faster than others.
CHAPTER TWO
1. It is downward sloping from left to right

2. A shift in demand occurs when the conditions of demand change (a change in demand), while
an extension or expansion in demand is due to price changes (a change in the quantity
demanded)
3. Economically, it is not, because the price would go up if there were a very high demand for
some products, relative to the supply
4. A consumer surplus arises when consumers of a good or service gain because the market price
is less than what they were prepared to pay
5. Costs of production, government policy (i.e. taxation and subsidy), weather conditions
(especially for agricultural products), technological changes, efficient use of existing resources
6. Substitutes are goods that are alternatives to each other, competing on the market like butter
and margarine, celtel and zamtel, mosi and castle beer. Complementary goods are those
goods which are jointly demanded, they have to be bought together, such as cars and fuel,
cassettes and recorders, cell phone and sim card
7. A normal supply curve slopes upward from left to right.
8. When held above the equilibrium price, demand is less than supply, hence there is a surplus or
excess supply
9. i) Adverse weather is one of the factors that influence supply. Maize production can be
influenced by either too much or too little rainfall (floods or droughts). The supply curve
would shift to the left, and this would result in an increase in price, while the quantity of
maize traded on the market would reduce, as shown below.

Price D S1
S
P1
O Q1 Q Quantity
ii) Income changes greatly influence demand. When consumers have a lot of money to spend,
the demand of goods and services generally would increase. Therefore the demand curve
would shift to the right. This upward shift in demand would cause the price and output of
oranges to increase as shown below.
D1
Price D S
P1
O Q1 Q Quantity
CHAPTER 3
1. Price elasticity of demand measures the responsiveness of demand to changes in price.

2. 20% ÷ 10% = 2, demand is elastic
3. Degree of necessity, habit forming, income, possibility of substitution, time period
4. A good for which demand falls as household income increases
5. Elastic
6. A normal or superior good such as a Mercedes Benz car.
7. Complementary goods or those goods, which are jointly demanded like cars and petrol
8. All the exceptional demand curves like ostentatious goods, Giffen goods and most
commodities during inflationary times when consumers expect further increases in prices.

9. Price
Quantity
10.
Price D
S1
P1
S
P
0 Q Quantity
100% of the burden of the tax is borne by the consumer as price rises from P to P1
CHAPTER 4
1. The long run is the time period when all resources are considered to be variable, while the
short run is the time period when at least one factor of production is in fixed supply.
2. Fixed costs are those, which do not vary, in direct proportion as changes in output. Variable
costs change in direct relation to output.
3. In the long run all costs are considered to be variable, therefore all the costs must be covered
in the long run.
4. Marginal cost is the change in the total cost caused by producing one more unit of output.
5. The firms‟ demand for factors of production is derived from households‟ demand for the
Goods and services the firms produce.
6. Output (units) 100 101 102 103

a) Total costs 800 806 809 810
b) Average costs 8 7.98 7.93 7.86
c) Marginal costs - 6 3 1
7. Output (units) 20 30 40 50 60 70
i) Average costs 13.5 11 10 10 10.5 12
ii) Marginal costs - 6 7 10 13 21

Costs
25
20 MC
15
AC
10
0
10 20 30 40 50 60 70 Output
8. The primary sector of the economy is concerned with the production of raw materials such
as crops and minerals. The secondary sector manufactures these raw materials into finished
producer and consumer goods. The tertiary sector is the provision of services.
CHAPTER 5
1. Internal economies of scale are achieved within an individual firm, from the organization of
production. External economies are advantages to most firms in that industry because the
firms are „concentrated‟ together.
2. The four categories of internal economies of scale
 Financial, it is generally accepted that larger firms can raise funds more easily and cheaply
than small firms
 Trading economies, reducing the cost of material purchases through bulk purchase
discounts. Stockholding becomes more efficient, the most Economic quantities of
inventory to hold increase with the scale of operations.
 Organisational economies, when the firm is large, generalization of functions such as
administration, research and development and marketing may reduce the burden of
overheads on individual operating locations.
 Managerial economies, management costs remain constant, as they are not related to
output. In addition, large firms can afford to hire specialist managers to be in charge of
different departments or fields.
3. Diseconomies of scale are problems of size and tend to arise when the firm grows so
large it cannot be managed efficiently. Communication, coordination and control become
difficult. There is low morale in the workplace, and managers find it difficult to identify the
information they need because of large volumes available. Decisions are not made quickly.
4. External economies of scale are advantages, which accrue to most firms in an industry, as it
grows in size. Not to an individual firm. For example, large skilled labour force is created, and
educational services can be targeted at that industry. In addition, specialized and ancillary

industries develop in the area.
5. This is the level of output on the long run average total cost curve at which average costs first
reach their minimum point. The increasing returns to scale are not achieved indefinitely as
output rises, there will be increasing returns up to a certain minimum efficient scale, this tends
to vary from industry to industry.
6. Vertical integration occurs to eliminate the transaction costs of middlemen, increase entry
barriers, secure supplies of raw materials, improve distribution network, gain economies of
scale and make better use of existing technology.
7. Small firms benefit an economy because they provide employment and new ideas, new
products on the market, operate efficiently, provide employment etc.
8. At the level of output at which marginal cost is equal to marginal revenue
9. The long run average cost curve eventually rises because of diseconomies of scale.
CHAPTER 6
1. A market is where goods and services are bought and sold

2. A perfect market assumes a homogeneous product (a completely identical product), many
buyers and many sellers, who all have perfect information and there are no entry barriers.
3. The long run equilibrium of a firm under perfect competition is where marginal cost is equal
to marginal revenue, just like any other firms. However, it is attained at the output level where
the costs of production are at their minimum level, and the supply is equal to demand, which
means technical and Economic efficiency respectively. In short, it is at a point where AC =
AR = MC = MR = P = D.
4. Allocative efficiency refers to the best use of Economic resources, through the market forces
of supply and demand. It occurs at an output level where prices charged (demand), equal the
marginal cost of production (which is the supply curve) In theory, it occurs only in perfect
competition in the long run.
5. Reasons for the existence of monopolies:
- Existence of natural monopolies
- Existence of patents, copyrights etc.
- Government legislation
- Ownership of essential raw materials, or other inputs
6. Demand for the product.
7. Justification of monopolies are several, such as, to achieve economies of scale and thereby
lower the prices, they are necessary in an industry which faces strong competition, some
monopolies are natural, monopolies can afford to spend more on research and development
since they earn supernormal profits, monopolies find it easier to raise new capital etc.
8. Price discrimination is a practice whereby producer charges different prices to different
customers for the same product or service.
9. The conditions necessary to practice price discrimination are:-
- Being able to separate the markets.
- Having different elasticities of demand in the separate markets.
- Imperfections in the market, it cannot be practiced in a perfect market.
10. The aim of price discrimination is to maximize profits.

11. (a) (b)
OUTPUT TR AR MR
(PRICE)
50 500 10 10
60 600 10 10
70 700 10 10
80 800 10 10
90 900 10 10
100 1000 10 10
110 1100 10 10
120 1200 10 10
c) Average revenue
10 AR =MR =P = D
0 120 Quantity
d) It is perfect competition
12. (a) (b)

OUTPUT TR AR MR
(PRICE)
50 750 15 -
60 840 14 9
70 910 13 7
80 960 12 5
90 990 11 3
100 1000 10 1

c) Average revenue
15
10
AR = D= P
0 100 Quantity
d) It is a monopoly structure
13. The AR = P = D, when drawn under perfect competition, it has a horizontal demand curve
signifying that demand is perfectly elastic. The monopolist is faced with downward
sloping normal demand curve.
The equilibrium position for a firm under perfect competition is where costs are at their
lowest level, but not for a monopolist, unless the price is lowered.
The monopolist produces where output is low but prices are high, this means a welfare loss
to customers.
Monopoly advertising not persuasive or wasteful but it is informative. The super normal
profits earned are sometimes used for the development of new goods, as such society gains.
Monopolies are also beneficial in that organising for production in the most effective way
can be done easily for public utilities especially where there is strong international
competition. Monopolies enjoying economies of scale sell their products at a lower price
than that charged under perfect competition and there is greater technical efficiency
because of economies of scale.
In practice, monopolists have less incentive to be innovative. Supernormal profits are

earned both in the short run and in the long run as long as the firm is able to create barriers
to entry and undermine competition. Oligopolies are complacent (“X” inefficiency).
Occasionally, the firm sells at how prices to fend off competition, knowing there are
supernormal profits elsewhere.
CHAPTER 7
1. Products can be differentiated through extensive advertising, attractive packaging, use of

brand names, and good after sales service etc.
2. Product differentiation is important because it determines the survival of the firm, it creates
customer loyalty for the firm to have some market power.
3. A cartel is an agreement on output and or pricing policies of each member
4. Firms operating under this market are interdependent.
5. If a cartel is not formed, the pricing and output decisions of one firm will still affect the price
and output of the rival firms

6. Non-price competition occurs when firms attempt to increase their sales by other means other
than changing prices. Sales can be increased through sales promotion or through other forms
of product differentiation.
7. The kinked demand curve reemphasizes the stability of prices in oligopoly markets even when
cartels are not formed. If an individual firm in an oligopoly market decides to reduce the price
in order to increase the market share, rival firms would follow suit, while an increase in price
is likely to lead to a reduction in the market share, as the competitors would not increase their
prices.
8. The kinked demand curve
Price
D
Kink
D = AR = P
Quantity
CHAPTER 8
1. The value added method is based on measuring the total goods and services produced by
different sectors of the economy. The income method totals the individual factor incomes.
Wages and salaries, from both formal employment and self-employment, rent, interest, and
profit. The expenditure method is based on measuring total expenditure on goods and
services, that is, expenditure by households, firms and government, including exports minus
imports.
2. GDP is the total market value of all final goods and services produced within a country.
While, GNP is GDP plus/minus net property income from abroad, which are goods and
services produced by citizens of a particular country. Net property income is the difference
between income earned by Zambian residents on overseas assets and income earned by
foreign residents on Zambian assets.
3. The nominal GDP is the current market value of all goods and services, while the real GDP
takes into account price changes. Therefore, real GDP is equal to nominal GDP minus
inflation rate.
4. These are payments made to a factor of production e.g. labour earning an income when an
individual has not been productive in a particular year, examples student grants,
unemployment benefit, pension etc.

5. Transfer payments come from taxes paid out of the incomes of productive people or being
paid to someone who was productive in the past or who will be productive in the future.
Including it in the national income figure for a given year other than when labour was
productive, would amount to double counting.
6. Net national income at factor cost + capital consumption + indirect taxes on expenditure –
subsidies equals is equal to gross national product at market prices
7. Government expenditure 40 000

Capital formation 38 000
Value of physical increase in stocks 5 000
Total domestic expenditure at market prices 180 000

+ Exports 25 000
- Imports (53 000)
Gross Domestic Product at market prices 152 000

- Indirect taxes (30 000)
+ Subsidies 2 000
Gross Domestic Product at factor cost 124 000

+ Net property income from abroad 2 000
Gross National Product at factor cost 126 000
8. The figures are “gross” because capital consumption or depreciation, which is the wearing out
of assets, has not been deducted.
CHAPTER 9
1. This means that consumption is autonomous (a) it is independent of the level of income. In
addition, a proportion of consumption is dependent on income, as income changes,
consumption also changes (bY).
2. An economy is in equilibrium when injections are equal to withdrawals
3. However, in practice, the same people do not make the injections into and the withdrawals
from the circular flow of income.
4. Injections into the circular flow are investment, exports and government expenditure
5. Aggregate demand is made up of C + G + I + (X-M). C, which is consumption expenditure, is
an endogenous part of the circular flow of income.
6. The accelerator theory shows that changes in consumption expenditure may induce much
larger proportional changes in investment expenditure
7. The multiplier shows that the increase in expenditure, the injections into the circular flow, will
produce a much larger increase in total income through successive rounds of spending. The
formula for a simple economy is K = 1/(1 –MPC) or 1/MPS. For the open economy it is K =
1/Marginal rate of leakages, that is savings + imports + taxation.

8. A trade cycle is a sequence of varying rates of growth. The correct sequence is recession,
depression, recovery and boom.
9. Income is either consumed or saved, an increase in savings means that money is withdrawn
from the circular flow of income, national income reduces as investment is discouraged.
10. A deflationary gap occurs when aggregate demand is insufficient to buy all the goods and
services in the economy, when AD is less than the full employment level.
CHAPTER 10
1. Money is a medium of exchange, it is defined as anything that is generally acceptable as a

means of payment.
2 The characteristics of money can be remembered using the acronym ADDSUP. where A =
generally Acceptable
D = Durable
D = Divisible
S = Scarcity
U = Uniformity
P = Portability, meaning, easy to carry around.
3 Functions of money can be described as follows:

- Unit of account and measure of value
- Medium of exchange
- Store of value
- Standard of deferred payments
4. Narrow money is currency in circulation plus demand deposits, it is money that is

available to finance current spending, while broad money includes narrow money plus
balances held as savings, liquid assets used as a liquid store of value.
5. Broad measures of money include notes, coins and bank deposits, both current and fixed
deposits as savings.
6. Keynes argued that the demand for money is the desire to hold liquid money, and people want
to hold money for three basic motives
- Transactions
- Precautions
- Speculative
7 . There is, an inverse or negative relationship between bond prices and interest rates, therefore
if interest rates rise, bond prices will fall.
8 The real rate of interest is defined as the nominal interest rate adjusted for inflation.
9 High interest rates attract an inflow of foreign funds and investments, and therefore cause a
currency to appreciate.
10 Liquidity preference is the demand curve for money, as shown below.
Interest rate
LP = D
Quantity of money
CHAPTER 11
1. Financial intermediaries
- Facilitate payments
- Provide a means of transferring and distributing risk
- Raise the level of savings and investment
- Provide maturity transformation
- Act as mediums for implementing monetary policies
2. Financial disintermediation is when firms lend to and borrow from each other directly
without using a financial intermediary, and/or when individuals lend to and borrow from
each other directly without using a financial intermediary.
3. The amount of cash kept by commercial banks in readiness to pay withdrawals.
4. The most profitable assets to banks are loans.
5. Capital adequacy rules attempt to ensure that banks have sufficient capital to cover
potential bad debts on risk assets.
6. OMOS are purchases and sales by the Bank of Zambia of treasury bills in the money
market, as a way of influencing the money supply and the interest rates.
7. The problems with monetary policy are informational, supervisory, the effect on a bank‟s
independence, and the conflicting objectives of either reducing or increasing the money
supply.
8. Capital markets provide long term-finance for companies
9. A primary market is a market for the new issue of securities, while a secondary market is
where securities which are already issued, are traded.
10. Money markets provide short-term finance for companies, also a profitable way of lending
or investing surplus funds.
11. Instruments traded on the money market are treasury bills, certificate of deposits,
commercial paper, including IOUs, bills of exchange.

CHAPTER 12
1. The quantity theory of money claims that there is a stable link between the stock of money
in the economy and the level of prices, if the money stock increases, the price level will
also increase.
2. Inflation is defined as a persistent increase in the general price level, and it is measured
using the retail price index (RPI), consumer price index (CPI).
3. Demand-pull and cost push inflation.
4. The principal cause is aggregate demand exceeding the supply of goods and services. This
could result from injections into the circular flow of income when the economy is at or near
the full employment level.
5. The Economic consequences of inflation are as follows:-
- It affects planning both at central government and at corporate business level.
- It also undermines business confidence.
- Inflation reduces a country‟s international competitiveness and causes the currency to
depreciate given a low demand for exports.
- Inflation discourages savings, and ultimately, investment.
- It also distorts consumer behaviour, consumers purchase a lot of goods in the hope of
„beating‟ inflation.
- Inflation has a big impact on people who are on fixed incomes, their purchasing power
and standard of living falls.
- Inflation results in money being unable to perform its functions properly.
6. The main types of unemployment are: structural, frictional, demand-deficient (cyclical) and
seasonal unemployment
7. The Economic consequences of unemployment are classified as Economic, financial social

or political costs:
- Labour is a factor of production, and due to unemployment, the Economic resource is not
being utilized, this is at a cost, the opportunity cost of goods and services not produced,
quality of workforce diminishes as idleness causes labour to be less efficient, this in turn
increases the cost of retraining it.
- Government revenue is mostly from taxes, unemployment results in a loss of government
revenue, as the unemployed do not pay any tax, in some rich countries they receive state
benefits, which means that unemployment is a financial cost to the government.
- Unemployment may lead to social undesirable behaviour like theft, vandalism, riots or
general discontent. The mental and physical health of the unemployed tends to deteriorate,
the unemployed are more prone to commit suicide. This is considered to be a social cost.
- Whenever there are high levels of unemployment in the country, the political party that
forms the government, is likely to lose popularity, this is a political cost to the government.
8. Keynesians believe unemployment is the result of demand deficiency, therefore the

government should increase aggregate demand (Keynesian demand management).
9. The Phillips curve shows the relationship between the level of unemployment and the rate
of inflation.

10. Monetarists prefer to concentrate on the „supply side‟, which affect production, supply and
therefore reduce prices, rather than Keynesian policies of boosting the economy through
demand management, which tend to be inflationary.
CHAPTER 13
1. Fiscal policy is concerned with taxation, borrowing and spending, and their effects upon the
2. economy. Monetary policy is the government‟s decisions and actions regarding money supply,
interest rates, inflation and exchange rates.
3. The objectives of fiscal policy can be either a deflationary gap, that is, to operate a budget
deficit (reduce taxes and increase government expenditure) in order to reduce the high levels
of unemployment. Alternatively, a government can aim for an inflationary gap, that is,
operate a budget surplus (increase taxes and reduce government expenditure) in order to check
inflation.
4. Direct taxes are levied on income, and they are progressive, while indirect taxes are levied on
expenditure, and they are regressive.
a) A regressive tax takes a higher proportion of a poor person‟s income than the rich.
b) A progressive tax takes a higher proportion of a rich person‟s income, and a lower
proportion of a poor person‟s income.
c) A proportional tax takes the same proportion of all incomes
5. The four canons or the principles of a good tax are:
- Equity, which means that taxes should be fair and therefore should depend on an
individual‟s ability to pay. Taxes must be proportional to one‟s income.
- Certainty, with regard to the amount to be paid, how, where and when it should be paid.
- Convenience of payment and collection by the taxpayer.
- Economy, that is, the cost of collection should not be excessive especially in relation to
yield.
6. It would be a regressive tax as it would take a higher proportion of a poor person‟s income
than the rich
7. The term PSNCR has been recently introduced as the measure of the level of government
borrowing. It replaces the public sector borrowing requirement (PSBR). PSNCR is the
difference between the income of the public sector and its expenditure .
8. Fiscal stance describes the balance of government expenditure and revenue, and whether this
is likely to raise or reduce aggregate demand in the economy.
9. Arguments for privatisation
a) Reduced burden on the public purse as the government no longer supports loss-making
nationalized companies. Privatisation allows a reduction in the public sector borrowing
requirement and tax cutting, as it provides funds for the treasury when companies are sold.
b) There is greater Economic freedom from detailed Economic control as privatized companies
are not subject to state control.

c) Improved efficiency through competition in the market, this encourages producers to cut their
costs in order to be more competitive, and firms have to be innovative in the search for
profits.
d) In addition to the above, there is also improved quality since firms have to compete to
survive and have to be responsive to customer complaints.
e) If companies are not in state control, there is greater resistance to the power of trade unions,
industries are more fragmented and difficult to organise.
f) Privatisation leads to a creation of a property-owning class, more people are able to buy
shares, this gives buyers market power, they work harder and strike less, a better
understanding of private profit motive and business problems.
g) Costs and inefficiency decrease as bureaucracy from nationalized companies is reduced.
CHAPTER 14
1. International trade is theoretically based on the principle of comparative advantage

2. The law of comparative advantage states that countries should produce those goods in whose
production they are relatively most efficient.
3. Zambia is most efficient in the production of copper, and the following are the country‟s non-
traditional exports.
TABLE 18: TEN MAJOR NON-TRADITIONAL EXPORTS (C.I.F.) 2003–2005, US $’

MILLION
2003 2004 2005 2005 %

Change
Copper wire 29.2 60.1 102.7 70.9
White Spoon Sugar 30.6 33.4 68.0 103.6
Burley Tobacco 19.0 39.4 69.9 77.4
Cotton Lint 28.6 51.4 66.8 30.0
Electrical Cables 16.2 32.7 46.2 41.3
Fresh Flowers 22.4 25.5 31.0 21.6
Cotton Yarn 22.1 23.9 23.4 -2.1
Fresh 26.9 23.2 21.0 -9.5
Fruit/Vegetables
Gemstones 23.4 16.2 19.8 22.2
Gas oil 16.6 24.3 10.3 -57.6
Electricity 8.4 4.4 4.8 9.1
Source: Bank of Zambia

4. Terms of trade refer to the average price of a country‟s exports compared to the average
price of imports
5. Governments protect infant industries, employment, prevent unfair competition, help the
balance of payments etc.
6. The WTO attempts to reduce the tariff barriers and other protective measures.
7. A multinational company is a company, which has a physical presence or property in more
than one country
8. To reduce costs and expand markets and sales
9. Direct foreign investment can boost domestic capital fund, technological transfer,
Improvement in production processes and organizational structure, as well as employment
gains.
10. Tariffs are duties imposed on imported goods. They impede free trade by increasing the
prices of imported goods, thereby making them unattractive on the local market. While
import quotas are the maximum limit on the quantity or total value of specific imported
goods, once the quotas are met, the imports are completely cut off, and therefore, quotas
can be more effective than tariffs as a barrier to trade.
11. A free trade area exists if there is no restriction on trade between countries. This can be
extended to a customs union when common external tariffs are levied on imports from non-
member countries. A common market adds free movement of the factors of production,
especially labour, in addition, their maybe harmonization of Economic policy in a common
market.
12. Formula:
Terms of trade = Export price index ÷ Import price index X 100
In 2005 106 ÷ 112 X 100 = 94.64

In 2006 114 ÷ 116 X 100 = 98.28
There is an improvement in the terms of trade from 2005 to 2006.
CHAPTER 15
1. The capital account shows changes in Zambia‟s external assets and liabilities when
Zambian residents buy or sell capital items such as international trade in shares, foreign
investments, issuance of loans abroad etc.
2. Invisibles include factor incomes like profit, dividend, interest and maintenance of
embassies abroad etc
3. A current account is a record of income and expenses, much like a profit and loss account.
A current account is divided into two parts, trade in goods (visibles), and trade in services
(invisibles).
4. A deficit is caused mostly by a lack of competitiveness on the international market for a
country‟s exports, which results in more outflows from the current account than the
inflows.
5. Deflation can help the balance of payments by suppressing domestic demand for imports
and by releasing goods for export. If home sales are stagnant, that is not competitive on the
international market, deflation causes the price to reduce due to the reduction in the
aggregate demand.

6. The „j‟ curve shows the likely effect of depreciation/devaluation on the current account.
7. A fall in the exchange rate could help an economy by reducing the price of exports (and
increasing the price of imports), and thereby increasing sales of exports, which might lead
to more employment, more output and greater export earnings, that is, if demand is elastic.
8. Devaluation occurs when a fixed exchange rate is lowered, whereas depreciation refers to a
floating exchange rate, which is moving downwards due to a decrease in demand for
exports and other factors, or an increase in the supply of imports and other factors.
9. The exchange rate is determined by the demand for a nation‟s currency. In theory this
demand is by traders, but in practice it is by international financial institutions.
10. „Managed‟ exchange rates are where small fluctuations are allowed within certain defined
limits and governments (central banks) may intervene to smooth out fluctuations.
11. The main advantage of freely floating exchange rate is that they are self-adjusting in theory
and therefore, automatically rectify balance of payments disequilibrium. In addition, there
is Economic use of foreign currency reserves and the government has more time to
concentrate on domestic policy.
12. The main advantage of a fixed exchange rate system is elimination of uncertainty, this
uncertainty is a major disincentive to exporters. Another advantage is that they discourage
speculative activity, hence the currency is not volatile.
------------------------------------------------------------------------------------

APPENDIX 2
SOLUTIONS TO EXAMINATION TYPE QUESTIONS
SOLUTION 1.1
(a)
i) The central problem in Economics is that of scarcity and choice. Economic resources are
scarce relative to people‟s wants, so a choice has to be made to satisfy some wants and forgo
or sacrifice other wants.
Therefore the “opportunity cost”, is the cost of something in terms of alternatives forgone.
In practice it is not always a complete rejection of one good in favour of another, but having
to decide whether to have a little bit more of one and not quite so much of another. This is
illustrated using a production possibility curve or frontier.
ii) If a student spends her allowance on a pair of shoes then it is likely that she will
have to go without a textbook that she also wanted. In deciding to work overtime on a
Saturday afternoon, a worker forgoes leisure time and the football match he would
otherwise have watched.
A farmer, who sows maize on a piece of land, accepts that he has to go without groundnuts
which could also be grown on the same piece of land.
With the state, resource is required to build roads and hospitals, this means schools, and
colleges etc have to be forgone.
In all walks of life, having “this” means going without “that”.
(b)
(i) There is no opportunity cost for a free good, if the food is free, then nothing has to be
sacrificed in order to obtain it.
(ii) -Hedge trimmings are non-Economic goods since they are not wanted.
–A worn out suitcase is a non-Economic good since it is not wanted
–A Natech Certificate is a non-Economic good since it is not transferable.
–Sand in the Sahara is a non-Economic good since it is not scarce.

SOLUTION 1.2
(a) The law of diminishing marginal returns states that, if extra units of a variable factor are
added to a fixed factor, output will rise. However, after a point, the rate of rise of output will
decline. This is the point of diminishing marginal returns.
Number of workers Output per year Addition to Output
1 100 100
2 210 110
3 300 90
4 250 -50
The figures are summarised on the following diagram.

Output 300
per
year 250
200
150
100
50
0 1 2 3 4
Number of workers
Note that diminishing returns start after the second worker is employed, when the additions to
output start to decline from 110 to 90, and eventually being negative. It is no longer worthwhile
to employ more workers on only one hectare of land, it costs more to employ than the additional
revenue from an additional worker. Additional workers can only be employed when more land is
acquired, but this can only be achieved in the long run.
(b)
(i) In motor car production the fixed factor will be capital and the variable factor will be
labour. Note that unit cost of production will fall as the capital equipment is used more
intensively.
(ii) In wheat production the fixed factor will be land and the variable factor labour. In
other economies, the variable factor could be capital equipment and/or fertilizer as
increasingly sophisticated production methods are adopted.
(iii) Listening to lectures may seem an unusual example but if you consider how effectively
you can concentrate in the first ten minutes and compare it with the final ten minutes,
you have quite a useful example of diminishing returns.
c) The market system economy, production decisions are driven by the profit motive, and
therefore answers the key Economic questions as follows:
-
What to produce : Goods produced are for the benefit of consumers. Therefore, it is the
consumers who send the indicators or messages to producers concerning their
preference whenever consumers make a purchase. If consumers indicate low demand
for a certain product, price for that product will be low and as a result producers will
supply very little of such a product to the market, and vice versa. Thus, the market
through the price determined by the market forces of supply and demand answers the
question “what to produce”.
- How to produce: This is a question of technology, that is how to combine resources in
order to produce something. Resources need utilizing in the most cost-efficient
manner. In theory, the lowest unit cost. Production methods are regularly appraised in
order to maximize output, and therefore, profit. The price mechanism will indicate
how to combine resources. If a country has an abundance of a certain resource, relative
to another resource, the price of that resource will be relatively low. This will indicate
that more of that resource should be used and less of the other resource to produce
goods. In other words, the forces of supply and demand through the price mechanism
will reveal the comparative advantage of a country or organization.
- How much to produce: Changes in the price mechanism will indicate to the producers
how much of a product should be produced in any given period. If the price is high, it
is an indication that more of a good should be produced, than if the price is low. If the
price falls below a certain level, ie below the value of the average variable costs,
producers would not produce any more of that good.
- For whom to produce: All production is ultimately for the sake of consumers. The
decision for whom to produce is largely determined by the political system. In a
market system, the driving force is profits, self-interest. As such, it is not all consumers
who have access to all goods. Rather, it is those who have effective demand, i.e.
demand backed by money.
SOLUTION 2.1
Economists refer to „a change in supply‟ when there is a shift in the supply curve either to the right
or to the left, as a result of some factors other than price, such as a change in the cost of
production, technological changes, a change in weather conditions etc. By contrast a „ change in
the quantity supplied‟ is used to indicate the effect of a change in the price of the good on the
amount, which firms wish to sell, as shown in the diagrams below.
A CHANGE IN THE QUANTITY SUPPLIED

Price
S
0 Quantity

A CHANGE IN SUPPLY
S1
Price S
S2
S1
S2
0 Quantity
(b) The Zimbabwean government‟s fixing of a maximum or ceiling price for mealie meal is
aimed at holding the price below its free market level to the benefit of consumers, instead of
allowing the market forces of supply and demand to determine the price of mealie meal.
The government stipulated price of OP1 is below the equilibrium price of OP. At this low
price, consumers would like to buy more, OQ1 quantities, while producers can only supply
OQ2 quantities. The effect is an excess demand or a market shortage, as shown in the diagram
below.
Price D S
P1
0 Q2 Q Q1 Quantity

The government stipulated price would in turn have other effects, such as ignoring the legal price
depending on how strictly the legal price is enforced. Millers may pay the fine and then treat it as
an additional cost, and pass it on to consumers in the form of higher prices.
It would also result in
- Rationing
- Black markets
- Tie in sales
- Corrupting policemen
- Long queues
- Govt subsidy to correct the imbalance between supply and demand
SOLUTION TO 3.1
On a straight-line demand curve:
Price
PED = ∞
PED>1
PED = 1 (mid point of the line)
PED<1
PE PED = 0
0 Quantity
As shown above, along the top half of the line, PED is greater than 1. We say that demand is
elastic. Along the bottom half of the line, PED is less than 1 and we say that demand is inelastic.
Exactly half-way along the line, PED=1; demand is of “unitary elasticity‟.
In general, demand is elastic at high prices, above K5000, while demand is inelastic at
lowprices, i.e. below K5000.
That is why the demand for expensive luxurious commodities such as cars, fur coats computers
etc is elastic, while the demand for cheap products such as matches, most vegetables is inelastic.
(b)(i) Income elasticity of demand (IED) measures the degree of responsiveness of quantity
demanded of a product or a service to changes in household income. It is measured as
follows:-
Percentage change in quantity demanded
Percentage change in income.
There are three categories of income elasticity

- Positive income elasticity, this applies to the demand for normal goods which
increases with income.
- Negative income elasticity, this applies to the demand for inferior goods, this tends to
fall as income rises.
- Zero income elasticity, for some goods, demand remains constant even if incomes
change, e.g. mealie meal.
(ii) IED is largely determined by the type of product or service in question, basics or
necessities such as mealie-meal, salt, milk etc usually have a low IED, with quantity
demanded increasing marginally as income increases.
The demand for “inferior” goods actually reduces as income increases. Expensive
luxurious products or services have a high IED, with more being bought as income
increases.
In view of the above, a firm pursuing long-term growth can produce lower IED during
periods of recession of depression and produce more high IED products during “boom”
periods.
SOLUTION TO 4.1
(a)(i) Total physical product 6 16 31 43
(ii) Average physical product 6 8 10.33 10.75
(b) The distinction between fixed and variable costs arise only in the short-run period defined
as that in which at least one factor of production is in fixed supply to the firm. Fixed costs
are those, which do not change as output changes. Productive capacity is therefore
constrained by the fixed factor and the costs associated with it are the firm‟s fixed costs.
Typically, the fixed factor is the firm‟s physical capital or assets – its premises, machinery,
plant and equipment. Fixed costs thus tend to consist of rental payments, depreciation,
salaries, rates, interest on loans etc.

Variable costs are those associated with variable inputs of factors such as labour and
materials. Therefore variable costs are wages, purchases of raw materials, electricity and
water bills etc. These costs will increase as the firm expands its output and they can be
avoided completely, even in the short-run, by closing down.
(c) The diagram is a generalised illustration of a firm‟s short-run costs.

MC
AC
AVC
AFC
SOLUTION 5.1
i) (a) (b) (b) (c) (d) (e) (f)

Output Total cost Price TR MR AR FC MC AC Profit
0 40 9 0 - - 40 - - -40
10 70 8 80 80 8 40 30 7 10
20 100 7 140 60 7 40 30 5 40
30 140 6 180 40 6 40 40 4.7 40
40 180 5 200 20 5 40 40 4.5 20
50 200 4 200 0 4 40 20 4 0
ii) The firm is operating in an imperfect market like monopoly or monopolistic competition,
the average revenue curve, which is equal to the demand curve, is downward sloping,
AR ≠ MR.
iii) The firm will aim to produce 30 units of output, where MC = MR.
iv) AR is equal to price, since TR = Quantity x Price
AR = TR/Quantity, therefore, AR = Price.

SOLUTION 6.1
a) Features of perfectly competitive markets.
 There are many buyers and sellers of the commodity each of which is too small in the
relation to the market to have perceptible effect on the price of the commodity.
 The commodity is homogeneous, identical or perfectly standardized so that the output
of each procedure is distinguishable from others.
 Resources are perfectly mobile.
 Consumers, firm and resources owners have perfect knowledge of all relevant prices
and costs in the market.
 There is free entry and exit.
 There is not transport cost.
b) Long run equilibrium under a perfectly competitive market
AC
REVENUE
AND
MC
COSTS
0 Q QUANTITY
If firms earn abnormal profits in the short run, in the long run, new firms will be attracted into the
industry. Conversely, if the typical firm is making losses in the short run, firms will leave the
industry in the long run, until normal profits are restored. Therefore all firms are earning sufficient
revenue to cover their full opportunity cost. There exits no incentive for firms to enter or to leave
the industry. The firm produces output 0Q, where MC = MR = AR = P = AC and there exits no
excess capacity.
Long run equilibrium position under monopoly.
Price
Cost
Revenue MC
AC
D(AR)
MR
0 Q1 Quantity

A monopolist maximizes profits at a level of output where MC=MR.
whereas profits will attract additional firms into a perfectly competitive market structure until all
firms break even in the long run, it is not the case with monopoly, a firm continues to earn
abnormal profits in the long run due to entry barriers.
As opposed to perfectly competitive firm, a monopolist does not produce at the lowest point on his
long run average cost curve
SOLUTION 7.1
(a) ‘Monopolistic competition‟ is a term used to describe a market type, which resembles perfect
competition in several respects. But models assume that there are a very large number of buyers
and sellers that there is free entry to and exit from the market, and that firms only make normal
profits in the long run.
However, the crucial difference between the two market types is that in monopolistic competition
each firm‟s product is similar to but differentiated in some way from that of its competitors. This
contrasts with the assumption of product homogeneity in perfectly competitive markets.
Such product differentiation may take the form of geographical location (a corner shop compared
with a High Street store), colour, shapes, size packaging, the use of a brand name and so on. This
means that consumers will not be indifferent between purchasing one firm‟s good and that of its
close substitutes. There will be some consumer loyalty, so that a price rather higher than that of
the firm‟s competitors will not mean a total loss of sales, as would be the case under perfect
competition. Putting this in a different way, the firm‟s demand curve is not perfectly elastic;
rather, it slopes downwards as illustrated in diagram (i).
MC
Cost
and
Revenue
AC
A B
D C
MR D(AR)
0 Q1 Quantity
With a downward-sloping demand curve, the firm‟s position resembles that of a monopolist. In
the short run, at least, the firm may set marginal cost equal to marginal revenue at output Q1 and
obtain supernormal profits represented by the area ABCD. However, given the assumption that

there are large numbers of competitors, with free entry to the market, these profits are unlikely to
persist. New firms will enter the field, or existing competitors vary their prices or products, and
attract away many of the firm‟s customers.
This will lead the firm‟s demand curve to shift downwards and to the left. This process will
continue until all the excess profits disappear and the firm is just making normal profits at output
Q2 as illustrated in diagram (ii).
(b)
Price MC Diagram
Cost
Revenue AC
D (AR)
MR
0 Q Quantity
This is the firm‟s long-run equilibrium position. However, it still has a downward-sloping demand
(or average revenue) curve. If average costs equal average revenue, as they must do if the firm is
making normal profits, this implies that the firm is in equilibrium on the downward-sloping section
of its long-run average cost curve. This is, of course, vary different from the case of the firm in
perfect competition, where long-run equilibrium occurs at the minimum point on the average cost
curve.
(c) Product differentiation gives the products some market power by acting as a barrier to entry as
a firm under monopolistic competition monopolises the industry by giving consumers the
impression that what they are offering is better than the competitors‟ product. Such product
differentiation may take the form of geographical location, the use of brand names, attractive size
packaging, extensive advertising, offer of guarantees and after sales service and so on.
SOLUTION 8.1
(a) MEASUREMENT OF NATIONAL INCOME
The income method

This approach involves adding up the flow of pre-tax incomes accruing to owners of factors of
production (wages, salaries, rents, dividends, interest payments, undistributed profits), which are
generated in a given year or other relevant period. Notice that factor incomes arise from the sale of
productive services of various kinds. This means that we must take income figures before tax, for
it firms are prepared to pay these amounts they must value factor marginal products at least as
highly. It also means that we must therefore exclude from national income any transfer payments,
such as social security benefits, pension payments etc.
The output method
Factor incomes arise from the sale of goods and services produced in the economy, so in principal
another method of calculating national income is to add up the value of all output created in the
relevant period, mainly for sale in the market. The output from different sectors (primary,
secondary and tertiary) of the economy is added up. When the national income is measured in this
way, it is referred to as the national product. Normally this value is measured by the supply price
of output, i.e., the price a firm receives for its product (supply price can differ from the price to the
consumer if there are indirect taxes or subsidies).
The expenditure method
Spending of all kinds provides the incentive to supply output and thus create factor incomes.
Adding up all that is spent on a country‟s output is the third way of calculating the national
income; it gives us what is called expenditure on the national product.
Thus the government expenditure plus investment expenditure plus consumption expenditure are
all added up plus exports minus imports.
A particular problem here is that the country‟s total expenditure exaggerates the value of
incomes and output if there are indirect taxes (like VAT) and underestimates it if the
government pays subsidies for the production of various goods and services. In either case, the
price to consumers does not reflect the real cost of using the resources necessary to produce the
commodities in question.
(b) The national income or product is a measure of the value of a country‟s total income from
domestic output and from overseas. Estimates are made in three ways-measurement of
income, of output and of expenditure on output, and this is clearly shown on the CIRCULAR
FLOW OF INCOME.
(c ) If the total income is divided by the population we have a figure of average income per
head. After conversion at the appropriate exchange rates, these figures are often used to
compare living standards between countries. However, the data so obtained can at best give
only very crude comparison and there are many problems, which need to be taken into
account when using data internationally:
- Income distribution Income per head is an average and there can be wide differences
in distribution of income around the average. In many developing countries, income is

highly concentrated and to that extent may exaggerate incomes for the mass of the
population.
- Non-consumption output Much output does not satisfy consumer needs and wants.
A proportion goes in investment in capital goods, which may arise income in the future
but actually reduces current living standards if investment resources come from
reducing consumption. Government spending, for example, on defence or building
prestige office blocks again may reduce current household incomes without raising
future income. The figures of national income therefore need to be adjusted to show
the income available for household spending. The proportion of national product in
the form of non-consumption output varies widely between countries.
- Non-marketed output Substantial non-marketed output is not counted in the official

income accounts. Production of goods and services in the household-housework, do-
it-yourself activities, growing fruit and vegetable-is not usually recorded but may
account for a substantial percentage of output. In poor agricultural economies much of
a peasant‟s real income is from food and other goods for direct consumption in the
household and recorded income per head may thus be misleadingly low. There is a
similar problem with government services, such as education and health, provided free
at the point of consumption. Output is measured by the cost of provision, which is
likely to underestimate the market value.
- Exchange rates these often fail to reflect the relative purchasing power of different
currencies in the domestic economy. Official fixed exchange rates are frequently
badly under – or over-valued and floating rates are distorted by capital flows.
Calculating „purchasing power‟ exchange rates though there are still problems, for
instance, which country‟s relative prices should be used to value output, can make
corrections.
- Inflation over a period of time national income figures in money terms must be
corrected for inflation to show the trends in real terms. Adjustments are necessarily
very crude in countries with high rates of inflation.
- Errors and unrecorded income Much of the income, output and expenditure have to
be estimated. The inevitable inaccuracies may be magnified in developing countries
with a large proportion of non-marketed income and poor data collection. Also, there
is the problem of the „black economy‟ consisting of unrecorded, usually illegal,
transactions such as working for cash to avoid paying tax. This is though to be very
large in some countries whose national income may therefore be badly understated.
SOLUTION 8.2
K’B

Government final consumption 3 000
Gross domestic fixed capital formation 2 400
Value of physical decrease in stocks (10)
Total domestic expenditure at market prices 13 390
+ Exports 2 000
- Imports (2 500)
Gross Domestic Product at market prices 12 890
- Indirect taxes (1 750)

+ Subsidies 1 000
Gross Domestic Product at factor cost 12 140
+ Property income from abroad 300

- Property income paid abroad (500)
Net property income from abroad (200)
Gross National Product at factor cost 11 940
- Capital consumption/Depreciation (1 500)
Net National Product at factor cost 10 440
SOLUTION 9.1
(a) Investment represents one of the main injections into the circular flow of income.
Investment, whether undertaken by the government or by private businesses, is
one of the key components of aggregate demand and any change in the level
of investment will have a multiple effect on the level of national income
In addition, investment is an important determinant of the long-term growth

rate of an economy. Investment can be seen as current consumption forgone in
order to achieve a higher rate of growth and hence a higher level of
consumption in the future.
capital
goods

C
B
O Consumption goods
An economy choosing to produce at a point such as B will have a higher current level of
consumption but a lower growth rate that an economy choosing to produce at point A. The
higher level of investment at A will enable the economy to achieve an outward movement
of the entire curve and hence consume a higher level of both capital and consumer goods
in future, such as at C.
(b) There are a number of ways in which the government might seek to encourage a higher
level of business investment. One of the first options it might consider is to controlling
interest rates. The rate of interest is often a major factor is determining the level of business
investment, which will only be undertaken if the expected return from the investment
exceeds the anticipated cost of financing it.
Although the government may attempt to stimulate investment by reducing the rate of
interest, it may be unsuccessful where the level of business confidence is low. If the
Economic outlook is poor or uncertain, firms are unlikely to be willing to undertake new or
additional investment, as they cannot be confident of a sufficient demand for the output the
investment will generate.
The government can provide direct encouragement to businesses, for example by offering
investment grants or by providing tax incentives.
c) „Multiplier‟ is the name given to the process of circulation of income, whereby an

injection of a certain size leads to a much larger increase in national income. The firms or
households receiving the injection use at least part of the money to increase own
consumption. This provides money for other firms and households to repeat the process
and so on. The value of the multiplier may be calculated as 1/MPS or 1/1 - MPC
Where MPC is the marginal propensity to consume. If MPC were equal to 0.9, the
multiplier would be 10 and an injection of K1m would lead to a rise in national income of
K10m as the money circulated. MPC is always less than one because of the effect of saving
the original injection gradually diminishes.
d) In the circular flow of income, saving and investment are associated but not all money is
invested in the domestic economy; some is invested overseas and some held on as cash.

Since extra saving don‟t necessarily result in additional investment (either because people
don‟t want to invest or because entrepreneurs‟ are not prepared to invest), three conclusions
follows
- The fall in consumption resulting from a rise in saving adversely affects entrepreneurs‟
expectations, and therefore the decision to reduce investments.
- A reduction in investment, through the multiplier, causes greater reductions in
national income.
- Since national income falls, household have smaller income and therefore save less.
Thus greater saving without greater investment ends with ends with smaller incomes
and smaller saving. This is the paradox thrift.
SOLUTION 13.1
The public sector net cash requirements (PSNCR) are the total amount the public sector needs to
borrow from the private sector and from overseas for the year. It consists of borrowing by the
central government, by the local authorities and by the public corporations, the largest
component being the central government borrowing requirements (CGBR). Part of the CGBR is
on lent to other institutions within the sector, and to this extent reduces the amount that the rest
of the public sector needs to borrow. In other words, only that part of borrowing by local
authorities and public corporations that has not been lent on by the central govt adds to the
PSNCR.
There are several methods of financing the PSNCR. One of the main methods is by borrowing
from the non-bank private sector through the sale of govt securities, treasury bills, local authority
bonds and so on, to private companies and individuals. In addition, the banks may buy private
sector debt. The most publicized aspect of the PSNCR is its effect on the supply. The money
supply will not increase when private to the public sector finances the PSNCR, but it will increase
in bank deposits. As a result, a government attempting to control the money supply will try to
avoid financing the PSNCR from the banking sector.
It may also be financed through borrowing from overseas. Another method is issuing notes and
coins in circulation. Lastly, through the privatization of public corporations.
The size of the PSNCR essentially reflects the extent to which the expenditure of the public
sector exceeds its income. It follows that, to reduce the PSNCR, a govt will need to cut its
expenditure or raise its revenue.
The main component of public sector income is the govt receipt from taxation, and these may be
changed over time in various ways. There have been a number of changes in tax system such as
reduction in the rates of income and corporation tax, increase in the thresholds and allowances
and replacement of some income tax bands, and these changes will have some impact on the
amount of tax revenue generated. In addition, tax receipts will vary with the general level of
Economic activity: In a recession, incomes and profits will fall and so too will the associated tax
revenue while, in an upturn, tax revenues will tend to rise.

A policy of increase direct taxation on personal incomes or corporate profits in order to reduce
the PSNCR faces the problem that incentives may be reduced and entrepreneurs may be less
willing to take risks.
A government could raise indirect taxes, but these tend to be regressive, and the government may
not raise these for political reasons.
The government can also reduce its own expenditure, but this would affect the level of
Economic activity as government expenditure is a component of aggregate demand (Keynesian
demand management). This will have a deflationary effect on the economy.
Another source of finance is privatization, unfortunately, it is the profitable and successful

organisations that can be easily sold off.
A reduction in aggregate demand would have a deflationary effect on the economy, and as a
result, some firms may go out of business, while others would reduce in size. Investment by
firms would be cut, and by the multiplier effects, the economy would move to a recession.
SOLUTION 13.2
(a) Direct taxes are levied on income and profits or on wealth. The impact or incidence and its
burden are borne by the same person.
Indirect taxes are levied indirectly once an expenditure is made. The impact or incidence and
its burden can be transferred to the consumer depending on the elasticities of demand and
supply on the product.
Examples of direct taxes

- income tax
- social security contributions
- company tax
- personal levy
Examples of indirect taxes
- value added tax
- excise duties
- other expenditure taxes

(b) Fiscal policy is the management of the economy through public expenditure, taxation and
public borrowing. The key aspect is the relationship between spending and taxes.
Government expenditure operates as an injection into the circular flow of national income;
taxation as a withdrawal from it. It, in a given year, the government spends more money
than it collects in taxes, this is termed a budget deficit. A deficit has an expansionary or
inflationary effect upon the economy. This might be considered appropriate if there is
much unemployment. If the government collects more in taxes than it spends this is
referred to as a budget surplus. A surplus has a restraining or deflationary effect upon the
economy. This would be considered an appropriate policy at a time of significant inflation.
For any given year, the application of fiscal policy may lead to a quite different outcome in
respect of both expenditure and taxes than had been planned. The government might have
become committed to unexpected areas of expenditure, while tax revenue might be more or
less than was expected.
(c) A good tax system should be
- Equitable
Taxes should be levied according to the ability to pay of the taxpayer. This can be
extended to the argument that people in similar circumstances should pay similar
amounts of money.
- Economical.
The tax should be cheap to collect, otherwise much revenue collected will be wasted.
- Certain
The tax payer should know when the tax should be paid, how much should be paid and
know which transactions give rise to a tax liability. The tax should be unavoidable.
- Convenient
The tax should be convenient to pay, not involving the tax payer in time consuming
activities.
SOLUTION 14.1
a) Malawi has an absolute advantage in the production of tobacco and maize, she can produce
both commodities more than Zambia. However, international trade should still take place
between the two countries because of the theory of comparative advantage, the two countries
can gain from trade when each specializes in the production of a commodity in which it has
the lowest opportunity cost.
The opportunity cost of 1 ton of tobacco is 10 tons of maize in Malawi, while in Zambia, the
opportunity cost of 1ton of tobacco is 15 tons of maize. This means if Malawi forgo 1 ton of
tobacco, she would acquire 10 tons of maize only, Zambia would get 15 tons of maize from
forgoing 1ton of tobacco.
The opportunity cost of 1 ton of maize is 0.1 ton of tobacco in Malawi, while in Zambia the
opportunity cost of 1 ton of maize is 0.06 ton of tobacco.
Therefore, Zambia has a comparative advantage in the production of maize, and should

import tobacco from Malawi, while Malawi should concentrate on the production of tobacco
and import maize from Zambia.
b) ARGUMENTS IN FAVOUR OF PROTECTIONISM
- To protect new and declining industries.

New industries need to be protected from foreign competition before they become strong to
be on their own, while declining industries might quickly collapse and lead to mass
unemployment if not protected.
- To reduce unemployment. Unfair competition from foreign products may lead to the
closure of home industries. Therefore, the government protects its industries in order to
prevent the closure of industries and unemployment.
- To reduce or eliminate balance of payments deficits. Restricting imports will help to

reduce or eliminate balance of payments deficits.
- To raise revenue. The government raises revenue from import tariffs that are imposed on
imported products.
- To protect strategic industries. Industries such as ship building, defence and aerospace
are of strategic importance to many countries. Therefore many countries protect these
Industries from foreign competition.
- To protect against dumping of imported products on local market. Dumping is a

situation where goods are sold at lower prices in a foreign market than in the home market.
- Retaliation against measures taken by another country that is unfair.
- To prevent unfair competition. Governments may justify protectionism with reference to
the trading policies of its competitor nation, such as selling imitations at artificially low
prices.
c) There are different forms of protectionism, and some of them are:
 Quotas. These are limits imposed on specified goods to be brought in the country. Import
quotas restrict the quantity of certain products, which can be imported into the country. If
the product is homogeneous then a simple quota is imposed. If they are heterogeneous, then
the quota can take the form of a value of imports allowed in any given currency.
The effect of quotas is to reduce the volume of imports, raise the price of imports and
encourage the demand for locally produced commodities.
Note that sometimes one country persuades another country to voluntarily reduce its exports
of a product to a certain acceptable level, this is known as voluntary export restraints

(VERs). VERs is also known as orderly market arrangements emphasizing their negotiated
manner. VERs often apply to key industries, an example is VERs negotiated by the United
States of America on Japanese exports of motor vehicles.
 Tariffs or custom (import) duties. These are taxes that are levied on imports. It can be a
fixed amount per unit (specific) or a percentage of the price (ad valorem).
The effect of tariffs is to raise prices of imports, and therefore reduce their demand,
encourage the demand for locally produced commodities, as well as raise revenue for the
government.
 Trade embargoes. This is a complete ban of imports from a particular country.

Sometimes it is a total ban imposed on particular products like drugs, from any country!
During the Iraq war of the early 1990s, the United Nations imposed a ban on Iraq‟s
exports.
 Hidden export subsidies and import restrictions (Direct controls). This is a range of
government subsidies and assistance for exports and deterrents against imports as follows:
- Subsidies. The government gives subsidies to local firms to allow them to compete
favourably In terms of pricing of goods, with foreign firms.
- Export credit guarantees or insurance against bad debts for overseas sales.
- Grants or any form of financial help is provided to firms in the export sector
- Zero rating or reducing taxes on exported goods
- State assistance provided for firms in the export sector via the foreign office.
In addition, imports are discouraged through
- Health and Safety regulations. Countries sometimes put in place health and safety
regulations that limit the importation of certain goods.
For example, the Zambian government has put in place a regulation that Stipulates that
sugar sold in Zambian market must be fortified with vitamin A regardless of whether this
sugar is locally produced or imported.
- Administrative procedures (bureaucracy). These are long, complex and costly

procedures that importers have to go through at border posts.
- Exchange controls. These are aimed at restricting the amount of foreign exchange that
is available to importers.
SOLUTION 14.2
a) Benefits of international trade

- It enables countries to specialise and increase production bearing in mind that the surplus can
be exported.

- Countries can export surpluses and import what they lack.Access to the world market enables
countries to benefit from economies of scale.
- It allows countries to develop their industries as a result of free movement of capital.
- It promotes closer cooperation between countries.
- Competition from imports increases efficiency and limits the creation of monopolies.
- Provision of goods that were previously unavailable.
b)
i) The theory of comparative advantage is based on the idea of opportunity cost.
Within a country, opportunity cost for any category of product may be established in terms
of the most advantageous use of national resources.
If two countries produce different goods most efficiently and can exchange them at an
advantageous rate in terms of the comparative opportunity cost of importing and home
production, then it will be beneficial for them to specialise and trade. This applies even if
one country has an absolute advantage in both goods.
The theory of comparative advantage was devised by David Ricardo to demonstrate the
gains from specialisation and free trade, and it requires assumptions such as no barriers, no
transport costs, mobile factors of production etc.
ii) International trade is influenced by changes in the relative prices. The terms of trade
indicate a relationship between the average price of a nation‟s exports and the average price
of its imports.
The rise in the terms of trade reflects the fact that export prices have risen more than
import prices. An increase in the terms of trade is called an improvement in the terms of
trade, though it may not always be desirable.
One reason for wanting an increase in the terms of trade is that a given quantity of exports
will now pay for more imports. In the example above, the foreign currency earned by
exporting one basket of exports in the year 2000 (K450, 000 worth) would buy 450/500
=0.9 or 90% of a basket of imports.
Formula: Terms of trade = Export price index ÷ Import price index X 100
Note that the terms of trade are only a guide to competitiveness because they only measure
visible trade, that is, trade in goods. Trades in services are excluded.
SOLUTION TO 15.1
(a) The balance of payment (BOP) is a statistical record, in the case of Zambia, of debits and
credits covering all financial transactions between Zambia and the rest of the world recorded
in a particular period.
The BOP accounts are in two parts. There is the current account, through which the export and
import of goods and services are posted, and the capital account through which capital flows.

By definition, the balance of payments account must always balance overall. Individual sections
of the accounts may, however, be in deficit or surplus. In the case of Zambia, the current
account deficit is usually partially offset by surpluses on the capital account (i.e. transactions in
assets and liabilities). Usually, reference to a balance of payments deficit is intended to mean a
deficit on the current account.
The visible trade balance
This is the net difference between the value of visible credits from exports and visible debits
from imports at a particular period of time. By „visible‟ here we mean goods that you can touch
and see, examples being food, basic materials like iron, oil and manufactured goods like cars and
washing machines.
The invisible trade balance
This is the net difference between the value of invisible credits from exports and invisible debits
from imports at a particular period of time. By „invisible here we mean services like travel, civil
aviation, shipping and financial and government services. Invisible also include interest, profits,
dividends and „transfers‟.
The current account balance
The current account balance is the visible trade balance and the invisible trade balance added
together. In effect, it shows the country‟s trading account with the rest of the world.
Transactions in external assets and liabilities (the capital account) may involve governments,
corporations and individuals, and may be either short or long term.
Such transactions include direct and portfolio investments, bank lending, Zambia banks to
residents overseas, other private lending and overseas deposits, changes in official reserve
balances and other external transactions of the government.
Exports of capital will increase a country‟s external assets and will show us an outflow in the
account (negative). Conversely, imports of capital increase liabilities for the country and will
show as an inflow (positive).
Overall, the balance of payments will sum to zero. It consists of a current account and an asset
and liabilities (capital) account. A deficit on one account should match a corresponding surplus
on the other. A deficit or surplus on current account implies an outflow or inflow of currency,
which must be offset, „financed‟ or covered by the sale of assets or by a reduction in liability.
Changes in official borrowings and foreign currency reserves in the assets and liabilities
accounts should be expected to achieve an overall balance with the current account. However,
because of inadequacies in compiling statistics, the official record shows a balancing item.

(b)
(i) The process of financing or covering is that by which any deficit or surplus on the
current account, and this is the part through which trade in goods and services flows, are
met or balanced by capital balances in the capital flows section.
- Borrowed from „official sources‟ such as the International Monetary Fund;

- Taken from a country‟s gold and foreign currency reserves; or
- Borrowed from overseas central banks.
- Sale of overseas investments.
- Buying on credit
- Accepting gifts etc.
These borrowings might be obtained from overseas sources with repayments being made
Over say 5, 10 or even 20 years. However, the borrowing powers and foreign currency
reserves of a country are finite, and so over the longer term a current account deficit is not
sustainable indefinitely.
(ii) Correcting a balance of payments deficit means reducing the potential deficit to a lower
level.
A deficit on current account might be rectified by one of more of the following measures: -
- A depreciation of the currency (called devaluation when deliberately instigated by the

government, for example by changing the value of the currency within a controlled
exchange rate system);
- Direct measures to restrict imports, including tariffs or import quotas or exchange control
regulations;
- Domestic deflation to reduce aggregate demand in the domestic economy.
- Interest rate to attract foreign exchange.
Deflationary measures aim to reduce expenditure, while other policies are ching
expenditure.
For example, devaluation of the currency will make a country‟s goods cheaper in export
markets while imports will become more expensive in the home economy. Such a change
in the relative prices of exports and imports should, it is hoped, encourage expenditure
switching in favour of the country‟s products.
As noted above, direct protectionist measures, for example in the form of tariff or non-tariff
barriers to trade, might be used to correct a deficit.
(c) The proponents of a return to fixed exchange rates concentrate primarily on the experience
since the early 1970s with floating rates. In particular, it is pointed out that flexible

exchange rates have been extremely unstable with frequent and often large fluctuations
particularly against the US dollar and the pound sterling. There is some controversy about
the causes of exchange rate instability. But what is clear is that since the 1970s there has
been a vast growth in the volume of liquid funds held by governments, multinational
corporations and other institutions which are prepared to shift them around between bank
deposits and other financial assets denominated in different currencies in order to maximize
the overall returns in the form of interest and capital gains.
Thus, funds are shifted into, say, dollar deposits when, other things being equal, and there is
a rise in US interest rates. A major factor in exchange instability, therefore, has been the
divergence in the monetary policies of major countries. The instability, in turn, is often
aggravated by speculation whereby treasurers and fund managers form expectations about
exchange rate movements.
Exchange instability, it is claimed, imposes costs on traders and investors. Exporters, importers
and investors face additional risks from adverse exchange rate movements which may reduce the
volume of trade and investment since the avoidance of exchange money movements and
speculation may become out of line with the rates which would be more appropriate to the
country‟s fundamental Economic position. Particularly with regard to its trade and balance of
payment.
However, while the case for a return to fixed rates seems strong there are also good arguments
against it. In particular, fixed parities inevitably become out of line with the rates necessary for
balance payments equilibrium. Countries with higher inflation will find their goods becoming
uncompetitive and their trade and payments deteriorating into deficit. Low-inflation counties
will tend to run growing surpluses. Eventually, deficit countries may be forced to lower their
parities (devalue) to restore competitiveness.
Thus, those in favour of floating rates argue that they automatically keep payments in equilibrium
and correct for divergent inflation rates. Also, it is said that they allow countries to pursue
independent monetary policies and to isolate themselves from excessive inflation in other
countries. There is also an Economic use of foreign currency reserves. The major advantage of
fixed exchange rates is that they remove uncertainty and so encourage international trade and
investment.
SOLUTION 15.2
a) Policies required in restoring a balance of payments to equilibrium
- Devaluation/depreciation
Devaluation of a currency is a reduction in the exchange rate of the currency relative to other
currencies. The objective of devaluing a country‟s currency to make exports cheaper and imports
expensive, by reducing the price of exports to foreign buyers (i.e. in foreign currency terms) and
increasing the price of imports in terms of the domestic currency.
If for example the Zambian Kwacha to the US dollar is devalued form $1 = K3200 to $1 = to
K4000, then foreign consumers and firms will be encouraged to switch to Zambian goods because
with the same $1, they are able to purchase more Zambian goods. They are able to purchase K4000
worth of goods instead of K3200 worth of goods. In addition, local consumers and firms will be
discouraged from imports. They will need to have K4000 to purchase a $1 worth of goods, before
devaluation, they needed to have K3200 to purchase a $1 worth of goods.
Therefore, depreciation in the kwacha exchange rate should help to boost the overseas demand for
Zambian exports because Zambian firms will be able to supply more cheaply in international
markets.
The extent to which export sales rise following a fall in the exchange rate depends on the price
elasticity of demand for Zambian products from foreign consumers.
A lower exchange rate should also cause imports into Zambia to become relatively more
expensive, thus leading to a slowdown in import volumes and "expenditure-switching" towards
local goods. The significance of elasticity of demand should is again important.
In the short run the change in import demand is likely to be fairly small - it takes time for
movements in the exchange rate to affect trade flows.
- Deflation/Fiscal policy
This is contraction of the domestic economy. Deflationary measures are aimed at reducing
aggregate demand and this can be achieved by either increasing interest rate to discourage
borrowing or increasing tax rates in order to reduce consumption expenditure. The government can
also reduce its own expenditure.
provide an element of correction for the trade deficit
The effect of the deflationary measures is to reduce the demand for goods and services, including
the demand for imports. If imports are high, demand for them is reduced by reducing the demand
in the economy in general, as long as the demand for imports is income inelastic. If the fall in
demand is accompanied by a reduction in inflation in the home market, the competitiveness of
exports improves (as long as demand for exports in price elastic). In addition, firms are encouraged
to switch to export markets because of the fall in domestic demand.
provide an element of correction for the trade deficit. The major problem associated with deflation
is that a sharp fall in consumer spending might lead to a steep Economic slowdown (slower growth
of GDP) or a full-scale recession.
- Discouraging imports whilst encouraging exports.

These are the direct controls mentioned earlier under protectionism. A government can impose
trade restrictions like quotas, import duty, exchange controls, health and safety regulations etc.
Increase exporters‟ competitiveness on the international market by subsidising exporters. A
government may also adopt policies to promote exports e.g. zero-rating VAT on exports, export
credit guarantees etc. Eventually the policies result in more exports.
The problem with this policy instrument is that there is a danger of other countries retaliation, as
well as if the demand for imports is inelastic.
- Raising interest rates.

Higher interest rates act to slowdown the growth of consumer demand and therefore lead to
cutbacks in the demand for imports. High rates would make Zambia attractive to foreign investors
and encourage inward investment, an inflow of foreign currency, giving a surplus on the capital
account.
b) Balance of Payments account

K’m K’m
Current account
Visible trade: Export 65,500
Imports (63,200)
Visible balance (balance of trade) 2,300
Invisible trade: Service 1,400
Interest, profit and dividends 1,080
Current transfers (1,810)
Invisible balance 1,670
Current account balance 3,970
K’m K’m
Transaction in assets and liabilities
Increase in external assets (net) (30,830)
Increase in external liabilities (net) 28,570
Net transactions (2,260)

Balancing item (1,710)
(3970)
Total 0

APPENDIX III MOCK EXAMINATION
NATIONAL ACCOUNTING TECHNICIAN/ADVANCED CERTIFICATE IN ACCOUNTING

JOINT EXAMINATIONS
___________________
FOUNDATION STAGE
___________________
T4: ECONOMICS
___________________
SERIES: MOCK EXAMINATION

___________________
TOTAL MARKS - 100 TIMES ALLOWED: THREE (3) HOURS

__________________

INSTRUCTIONS TO CANDIDATES
1. There are SEVEN questions in this paper. THREE in Section A and FOUR in Section B.
You are required to attempt a total of FIVE questions – TWO from Section A, TWO
from Section B and ONE from either Section.
2. Enter your student number and your National Registration Card Number on the front of the
answer booklet. Your name must NOT appear anywhere on your answer booklet.
3. Do NOT write in pencil (except for graphs and diagrams).
4. The marks shown against the requirement(s) for each question should be taken as an
indication of the expected length and the required depth of the answer.
5. All workings must be done in the answer booklet.
6. Present legible and tidy work.
7. Graph paper (if required) is provided at the end of the answer booklet.
SECTION A (MICRO-ECONOMICS)
Answer at least TWO questions in this section.
QUESTION ONE
(a) Mention any six (6) advantages of the planned (command) Economic system.
(6 marks)
(b) (i) Explain with the aid of a diagram the meaning of the term change in supply.
(2 marks)
(ii) Mention any four (4) factors that can cause a change in supply.
(8 marks)
(c) The price and quantity of cars are in equilibrium. Suppose there is a large increase in the
price of fuel, explain with the aid of an appropriate diagram the new price and quantity
traded in cars. (4 marks)

(Total: 20 marks)
QUESTION TWO
(a)
(i) Explain the four (4) features of monopolistic competition. (4 marks)
(ii) With the help of a diagram, explain the demand curve of a firm operating under conditions
of monopolistic competition. (2 marks)
(iii) “In the long run, a firm under monopolistic competition rarely makes
profits”. Discuss this statement and illustrate with an appropriate diagram.
(6 marks)
(b) Some countries have set up Monopolies Commissions in order to regulate

monopolies. Discuss:
(i) In favour of monopolies. (4 marks)
(ii) Against monopolies. (4 marks)
(Total: 20 marks)
QUESTION THREE
(a) Distinguish between fixed costs and variable costs giving two (2) examples of each.
(4 marks)
(b) Explain what is meant in Economics by:
(i) Short run. (2 marks)

(ii) Long run. (2 marks)
(c) Explain what causes the cost curves to be „U‟ shaped in the:
(i) Short run. (3 marks)

(ii) Long run. (3 marks)
(d) The table below shows units and prices for „Z‟ limited company.
Quantity (units) 1 2 3 4 5 6

Average revenue 8 7 6 5 4 3
Total revenue - - - - - -
Marginal revenue - - - - - -
You are required to calculate:
(i) Total revenue. (3 marks)
(ii) Marginal revenue. (3 marks)
(Total: 20 marks)
SECTION B (MACRO-ECONOMICS)
Answer at least TWO questions in this section.
QUESTION FOUR
(a) Explain the four (4) functions of money. (8 marks)
(b) Sketch and explain a liquidity preference schedule. (6 marks)
(c) Explain any four (4) Economic consequences of an increase in the rate of interest.
(6 marks)
(Total: 20 marks)
QUESTION FIVE
(a) Distinguish between direct and indirect taxes giving two (2) examples of each.
(6 marks)
(b) Mention three (3) advantages each, of
(i) Direct taxes. (3 marks)

(ii) Indirect taxes. (3 marks)
(c) Explain how a government can control inflation using fiscal policy. (8 marks)
(Total: 20 marks)
QUESTION SIX
(a) Explain any five (5) principal Economic benefits that a country obtains by engaging in
international trading. (10 marks)

(b) Explain the composition of a balance of payments account. (6 marks)
(c) Give a brief explanation of four (4) ways of ‘financing’ or ‘covering’ a deficit balance of
payments account. (4 marks)
(Total: 20 marks)
QUESTION SEVEN
The Zambian Kwacha rate of exchange to the United States Dollar was over K5 000 to $1 in mid
November 2002. The Kwacha has appreciated to around K3 400 to $1.
You are required to give a brief explanation on:
(a) Any four (4) reasons that can lead to an appreciation of a floating exchange rate.
(4 marks)
(b) Three (3) advantages of a floating exchange rate system. (6 marks)
(c) Three (3) disadvantages of a floating exchange rate system. (6 marks)
(d) (i) Appreciation and depreciation of a currency. (2 marks)
(ii) Revaluation and devaluation of a currency. (2 marks)
(Total: 20 marks)
END OF PAPER
T4: ECONOMICS
SUGGESTED SOLUTIONS
SOLUTION ONE
(a) The three advantages of the planned Economic system are as follows:-
- Adequate resources are devoted to community goods
- No unemployment of resources
- Introduce more certainty into production through the planning the allocation of
resources
- Eliminates the inefficiencies resulting from competition
- An attempt to distribute resources equally
- Weaker members of the society are taken care of
- Provision of basics such as food, clothing and shelter.

(b) Economists refer to „a change in supply‟ when there is a shift in the supply curve either to the
right or to the left, indicating a reduction or an increase in supply respectively.
A CHANGE IN SUPPLY
Price
S1
S
S2
Quantity
ii) The four factors that can cause a change in supply are as follows:-
- Changes in the cost of production
- Weather conditions
- Technological changes
- Government policy such as taxation and subsidies
(c) Petrol and cars are complementary goods, therefore, any change in the market for petrol would
affect the market for second hand cars. The demand for petrol is likely to be price inelastic since
there is no substitute for it.
However, a large increase in the price of fuel is a rise in the cost of owning and running a car.
There will, therefore be a fall in the demand for cars. The price and the quantity traded will reduce
PRICE
D S
D1
P
P1
0 Q Q1 Quantity

SOLUTION TWO
(a) (i) „Monopolistic competition‟ is a term used to describe a market type, which combines the
features of perfect competition and monopoly in some respects. The models assume that
there are a very large number of buyers and sellers that there is free entry to and exit from
the market.
In monopolistic competition each firm‟s product is differentiated in some way from that of
its competitors.
(ii) When a firm monopolises the industry through product differentiation, it has some market
power, and like a monopolist, it becomes a price maker. However, if the firm sets a high
price the quantity is low, but at low price the quantity demanded is high.
The firm‟s demand curve slopes downwards as illustrated in the diagram below
Price
AR = D
Quantity
(iii) One of the features is that there are no barriers to entry. New firms will enter after being
attracted by the supernormal profits that firms under monopolistic competition earn in the short
run just like a monopoly.
This will lead the firm‟s demand curve to shift downwards and to the left. This
Process will continue until all the excess profits disappear and the firm is just making
normal profits at output Q2 as illustrated in the diagram below.

This is the firm‟s long-run equilibrium position. However, it still has a downward-
sloping demand (or average revenue) curve. If average costs equal average revenue, as
they must do if the firm is making normal profits, this implies that the firm is in
equilibrium on the downward-sloping section of its long-run average cost curve.
Price MC Diagram
Cost AC
Revenue
MR
D(AR)
0 Q2 Quantity
(b) (i) Arguments FOR monopolies

- To achieve economies of scale, and therefore lower the prices
- Supernormal profits used on research and development
- Research and development leads them to be innovative
- Easier to raise new capital
(ii) Arguments AGAINST monopolies

- Output lower prices higher
- Supernormal profits are at the expense of customers
- Practice price discrimination which is a restrictive practice
- „X‟ inefficiency, complacency, not innovative
- Lower costs just used to stifle competition
- Diseconomies of scale
SOLUTION THREE
(a) Fixed costs are those costs, which do not vary with output, examples rent, interest on loan,
depreciation, rate administration costs etc.
Variable costs are those costs, which vary with output, examples cost of raw materials,
electricity, wages etc.

(b) (i) The short run in Economics is defined as that period when at least one factor of
production is in fixed supply.
(ii) The long run is a period when all the factors of production are considered to be
variable.
(c) (i) The diminishing returns cause the short run cost curves to be „U‟ shaped. Average
costs (AC), start from a high level because of high fixed costs (FC). As output
increases, AFC decline, because same level of FC is divided by a higher output.
The average variable costs are relatively constant. Therefore, ATC decline, they
will continue to decline until diminishing returns set in. After that point, the fixed
factor(s) of production need to be increased. Since this is not possible in the short
run, the AC increase, hence the „U‟ shape in the short run.
When AC are declining, MC decline faster, and when AC are increase, the MC increase
faster because they only deal with the VC of production.
ii) The diseconomies of large scale production, i.e. their disadvantages cause the long
run cost curves to be „U‟ shaped.
When a firm grows in size, there are human and behavioural problems of managing a large
organisation. Such as increasing bureaucracy, communication is hampered, morale and
motivation fall, there is „X‟ inefficiency etc.
(d)
i. TR 8 14 18 20 20 18
ii. MR - 6 4 2 0 -2
SECTION B
SOLUTION FOUR
(a) Money performs the following functions:
- Medium of exchange This is the most important function it serves as a means of

payment. Instead of the barter system and its serious drawbacks. Money allows purchases and
sales to be conducted independent of each other. With no double coincidence of wants. Money
facilitates the exchange of goods.
- Unit of account Money can act as a common measure or standard of value of the unit of
goods and services. The value of goods and services are measured in monetary terms. Money is the
common denominator, and to perform this function effectively, the value of money should itself be
stable……

- Store of value Money is a way of storing surplus wealth. While surpluses can be stored
in the form of other assets, it is usually held in the form of money because it is the most liquid
asset. Therefore money is the most convenient method of storing wealth for use whenever it is
needed, again it has to be stable……
- Standard of deferred payments Money facilitates credit transactions. Borrowing and

lending in the economy is simplified. Loans and debts are usually expressed in terms of money.
Money is the link that connects the values of today with those of the future, implying again that it
must be stable…..
(b)
Keynes argued that the demand for money, which he defined as liquidity preference – in that
money is the most liquid of assets – was made up of three elements as follows:
Transactions motive
Individuals and firms need money to pay day-to-day purchases, so money is held because it
performs a function of a medium of exchange.
Precautionary motive
Household and firms hold money in order to meet unforeseen contingencies. Money is the most
liquid asset and for this reason it is held to deal with sudden misfortunes, for example an
emergency repair to the motor, or to take advantage of an unexpected bargain or in case expenses
or costs turn out to be higher than budgeted for.
Speculative motive
Keynes argued that money may be held over and above that required for transactions and
precautionary purposes because people wish to hold money as an asset, ie people wish to hold
money because it performs a function of a restore of value.
There is an inverse relationship between bond prices and the rate of interest. If bond prices fall the
rate of interest rises, while if bond prices rise the rate of interest falls.
If the interest rate is expected to rise (ie bond prices are expected to fall), people will prefer to hold
money balances rather than bonds.
The liquidity preference schedule
We bring the three motives together in a diagram form to give a total demand curve for

money; this is called the “liquidity preference schedule” (schedule‟ is simply another
name for “curve”, as in “demand schedule”).
Liquidity
Preference
schedule
a b c
0 M
The liquidity preference schedule
The lines a, b and c represent the three motives for holding cash. The total cash held at each level
of interest would be the sum of the amounts held to satisfy each motive. This is shown graphically
by adding the three lines horizontally. Some shapes of the curves representing the transactions and
the precautionary motives are only slightly affected by the interest rate, the shape of the liquidity
preference schedule is influenced most by curve”c”, the speculative motive.
(c) The rate of interest is the price of borrowing money, which must be paid by the borrower to the
lender. Interest rates are prices, which will vary with the nature of the lending „product‟ involved.
A large rise in the rate of interest will affect the following:
- It will raise the price of borrowing

- It will therefore reduce the levels of investment. High cost of credit deters spending.
- It will lead to a reduction in consumption. Savings increase because of the high interest rates.
Income is either saved or consumed and once savings increases, consumption reduces.
- Inflation falls. A reduction in investment expenditure and consumption expenditure, which are
both components of aggregate demand, causes a reduction in Economic activity and therefore
reduces inflation.
- Asset values fall. There is an inverse relationship between bond prices and interest rates.
- Foreign funds increase. High rates of interest cause an increase in the inflow of foreign funds,
„hot money‟. This in turn
- Raises the exchange rate. The currency appreciates because of the high demand, which pulls up
the „price‟.
SOLUTION FIVE

(a) Direct taxes are levied on income and profits or on wealth. They are paid directly to the
revenue authorities. The impact or incidence and its burden are borne by the same person.
Indirect taxes are levied indirectly once expenditure is made. The impact or incidence and its
burden can be transferred to the consumer depending on the elasticities of demand and supply on
the product.
Examples of direct taxes

- Income tax
- Social security contributions
- Company tax
- Personal levy
Examples of indirect taxes

- Value added tax
- Excise duties
- Tariffs or import duties
(b) (i) The advantages of direct taxes are
- A high and elastic yield

- Certainty
- Convenient
- Equity through the progressive system of taxation
- Redistributes income and wealth more equally
(ii) The advantages of indirect taxes are
- Difficult to evade
- Not harmful to effort and initiative
- Adjustable to specific objectives of policy e.g.
1. To protect infant industries
2. To strengthen political links
3. Safeguard citizen‟s health
4. Improve balance of trade
(c) Fiscal policy is the management of the economy through public expenditure, taxation
and public borrowing. The key aspect is the relationship between spending and taxes.
Government expenditure operates as an injection into the circular flow of national
income; taxation is a leakage.
If the government collects more in taxes than it spends this is referred to as a budget
surplus. A surplus has a restraining or deflationary effect upon the economy.This
would be considered an appropriate policy at a time of significant inflation.
Whenever the government aims for a budget surplus, it increases direct taxes, which
increases government revenue while reducing its own expenditure. Government
revenue is mostly from taxes. An increase in taxes lowers the disposable income of

both individuals and firms, their purchasing power is reduced.
A reduction in both government expenditure and consumption expenditure reduces

aggregate demand. The curve shifts to the left and inflation is lowered.
PRICE AS
AD
AD1
P
P1
0 Q Q1 Quantity
SOLUTION SIX
(a) The Economic benefits of international trade are:-

- Some countries have minerals or some products can be grown in some countries but not
in others, thanks to IT all the products are available in all the countries
- Society has a wider choice of products
- IT opens up domestic markets to more competition
- It also promotes beneficial political links between countries
- Increased competition results in efficient use of resources, which lowers costs. Therefore
consumer prices are reduced which leads to a much higher standard of living.
- The market is global, which leads to large scale production and therefore benefits of
economies of scale.
- There is wider specialisation and international division of labour, which leads to an
increase in total world output.
(b) The balance of payment (BOP) is a statistical record, of debits and credits
covering all financial transactions between for example, Zambia and the rest of
the world recorded in a particular period, usually a year.

The BOP accounts are in two parts. There is the current account, through which the export and
import of goods and services are posted, and the capital account through which capital flows.
By definition, the balance of payments account must always balance overall. Individual sections
of the accounts may, however, be in deficit or surplus. In the case of Zambia, the current account
deficit is usually partially offset by surpluses on the capital account (i.e. transactions in assets and
liabilities). Usually, reference to a balance of payments deficit is intended to mean a deficit on the
current account.
The visible trade balance
This is the net difference between the value of visible credits from exports and visible debits from
imports at a particular period of time. By „visible‟ here we mean goods that you can touch and see,
examples being food, basic materials like iron, oil and manufactured goods like cars and washing
machines.
The invisible trade balance
This is the net difference between the value of invisible credits from exports and invisible debits
from imports at a particular period of time. By „invisible here we mean services like travel, civil
aviation, shipping and financial and government services. Invisible also include interest, profits,
dividends and „transfers‟.
The current account balance
The current account balance is the visible trade balance and the invisible trade balance added
together. In effect, it shows the country‟s trading account with the rest of the world.
Transactions in external assets and liabilities (the capital account) may involve governments,
corporations and individuals, and may be either short or long term.
Such transactions include direct and portfolio investments, bank lending, Zambia banks to
residents overseas, other private lending and overseas deposits, changes in official reserve balances
and other external transactions of the government.
Exports of capital will increase a country‟s external assets and will show us an outflow in the
account (negative). Conversely, imports of capital increase liabilities for the country and will
show as an inflow (positive).
Overall, the balance of payments will sum to zero. It consists of a current account and an asset and
liabilities (capital) account. A deficit on one account should match a corresponding surplus on the
other. A deficit or surplus on current account implies an outflow or inflow of currency, which
must be offset, „financed‟ or covered by the sale of assets or by a reduction in liability.

Changes in official borrowings and foreign currency reserves in the assets and liabilities accounts
should be expected to achieve an overall balance with the current account
However, because of inadequacies in compiling statistics, the official record shows a balancing
item.
Students should mention the account and examples of items found in

each account
(c)
The process of financing or covering is that by which any deficit or surplus on the current
account, met or balanced by capital balances in the capital flows section.
(i) Borrowed from „official sources‟ such as the International Monetary Fund;
(ii) Taken from a country‟s gold and foreign currency reserves; or
(iii) Borrowed from overseas central banks.
(iv) Sale of overseas investments.
(v) Buying on credit
(vi) Accepting gifts etc.
These borrowings might be obtained from overseas sources with repayments being made over say
5, 10 or even 20 years. However, the borrowing powers and foreign currency reserves of a country
are finite, and so over the longer term a current account deficit is not sustainable indefinitely.
SOLUTION SEVEN
(a) The market forces of demand and supply of a currency determine a floating or a flexible
exchange rate. A currency can appreciate if demand for a currency is high or the supply for
that currency is low. This can be due to:
- People demanding the Kwacha for example to pay for Zambian exports, i.e. Zambian goods
and services.
- Overseas investors who want to invest in Zambia will need the Kwacha.
- Speculators who think that the kwacha is about to become more valuabe in terms of other
currencies
- High interest rates will encourage people to put money in Zambian financial
institutions, in Kwacha.
- Central authorities such as the Bank of Zambia might want to offload the dollar,
pound etc to push up the value of the Kwacha.
- Any other inflow of foreign currency such as borrowing……
(b) The advantages of floating exchange rates are:-
- Automatic adjustment to the balance of payments disequilibrium, without

government intervention.
- There is greater freedom to pursue domestic goals, since the government does

not need to intervene in the exchange rate.
- There is Economic use of the foreign currency reserves.
Thus, arguments in favour of floating rates argue that they automatically keep payments in
equilibrium and correct for divergent inflation rates. Also, it is said that they allow
countries to pursue independent monetary policies and to isolate themselves from excessive
inflation in other countries. There is also an Economic use of foreign currency reserves.
(c) The disadvantages of floating exchange rates are:-

- The main disadvantage is uncertainty
- There is increased speculative activity
- The above leads to increased volatility.
It is pointed out that flexible exchange rates have been extremely unstable with frequent and often
large fluctuations particularly against the US dollar and the pound sterling. There is some
controversy about the causes of exchange rate instability. But what is clear is that since the 1970s
there has been a vast growth in the volume of liquid funds held by governments, multinational
corporations and other institutions which are prepared to shift them around between bank deposits
and other financial assets denominated in different currencies in order to maximise the overall
returns in the form of interest and capital gains.
Thus, funds are shifted into, say, dollar deposits when, other things being equal, and there is a rise
in US interest rates. A major factor in exchange instability, therefore, has been the divergence in
the monetary policies of major countries. The instability, in turn, is often aggravated by
speculation whereby treasurers and fund managers form expectations about exchange rate
movements. Exchange instability, it is claimed, imposes costs on traders and investors. Exporters,
importers and investors face additional risks from adverse exchange rate movements, which may
reduce the volume of trade and investment since the avoidance of exchange money movements,
and speculation may become out of line with the rates, which would be more appropriate to the
country‟s fundamental Economic position. Particularly with regard to its trade and balance of
payment.
(d) (i) In markets where exchange rates are flexible or they float, an increase in the external value
of a currency is referred to as an appreciation, while a decrease in the external parity is
referred to as a depreciation of the currency.
This means that an economy is following a floating exchange rate system, and the market
forces of supply and demand are determining the rate of exchange.
(ii) When the currency is made cheaper with respect to another currency e.g dollar, the
adjustment is called devaluation. A revaluation results when a currency become more
expensive with respect to another currency.

Determination of Exchange, 189
INDEX Devaluation, 186, 191
Diseconomies of scale, 62, 65
A Distribution channels, 69
Direct controls, 171, 188
Accelerator, 112, 113
Diversification, 68, 72, 163
Advertising, 64, 81, 86, 88
Division of labour, 51
Arc elasticity of demand, 30
Average cost, 54
Average revenue, 70, 239
E
Economics, 1, 2
B Economic growth, 5, 6
Economies of scale, 63
Balance of Payments, 181
Elasticity, 25, 28, 33, 35, 37, 44
Bank of Zambia, 132
Enterprise, 4
Bank‟s assets and liabilities, 131
Equilibrium market price, 19
Equilibrium position, 80
C European Union (EU), 176
Capital, 4, 57 Exchange controls, 171, 229
Capital Account, 182,183,208 Exchange rates, 189
Capital Adequacy, 133,204 External economies, 64
Capital Markets, 127,128 Expectations, 16, 113, 225, 233, 251
Capital Tax, 153
Cartels, 89, 201 F
Central Bank, 132
Factors of production, , 2, 4, 6, 10
Closed economy, 111
Fifth National Development Plan, 162
COMESA, 175
Financial Intermediaries, 126
Companies, 50, 58, 168,
Financial markets, 127
Comparative advantage, 169, 178, 179
Fiscal policy, 158, 159, 162,
Complements, 46
Fixed costs, 53, 59
Complementary goods, 15
Fixed exchange rates, 189
Consumption function, 108
Floating exchange rates, 190
Corporation Tax, 153
Foreign exchange market, 189, 190, 191
Cost-push inflation, 139
Fractional reserve system, 129
Co-operatives, 50
Functions of money, 117
Creation of Money, 128
Cross Elasticity of Demand, 45
Current account, 181, 183
G
Globalisation, 167
D Giffen goods, 44, 195
Gross Domestic Product (GDP), 95, 97
Deflation, 187
Gross National Product, 94, 97
Deflationary gap, 110, 114, 115, 165
Demand curve, 13
Demand for labour, 144
I
Demand for money, 118, 119 Income effect, 14, 45
Demand management, 109, 111, 114, 147, Income elasticity of Demand, 44
Demand- pull inflation, 140 Income tax, 153, 225, 226
Inferior goods, 15 Multiplier, 106, 108, 113
Inflation, 138
Inflationary gap, 109, 110, 114, N
Inheritance tax, 153
Narrow Money, 119
Integration, 61, 67, 72, 73, 168, 176, 198
National income, 94, 95
Interest rates, 63, 108, 109, 114, 118,
Nationalised industries, 151
Internal Diseconomies, 65
Natural resources, 2, 7, 57, 103, 174
Internal economies, 73, 197
Normal goods, 15, 216
International monetary fund IMF), 177
Investment, 94, 96, 97, 99, 102
Invisibles, 191, 208
O
Official reserve account, 183
K Oligopoly, 88
Open market operations, 134
Keynesian Demand Management, 109
Opportunity cost, 4, 145, 230
Kinked demand curve, 90, 201
P
L
Paradox of Thrift, 113
Labour, 4,
Partnerships, 49, 50
Land, 2, 3
Perfect competition, 76
Lafter curve, 155
Phillips curve, 146
Lateral Integration, 68
Planned (command) economy, 8
Law of diminishing returns, 2
Population, 4, 16, 45, 99, 100, 101
Liquidity preference schedule, 123, 239, 246
Precautionary motive, 245
Location of industry, 67
Price discrimination, 81, 82,
Long run, 52, 61
Price elasticity of demand, 25
Long run costs, 52
Price elasticity of supply, 34, 37
Primary production, 51
M Private limited company, 50
Macroeconomics, 1 Privatisation, 156
Marginal cost, 54 Production Possibility curve, 5
Marginal utility, 14 Progressive tax, 153
Marginal productivity theory, 57 Proportional tax, 153
Marginal propensity to consume, 107, 112 Public goods, 8, 9
Marginal revenue, 71 Public limited company, 50
Market demand, 12
Market economy, 7 Q
Merit goods, 8, 9, 151
Quantity theory of money, 139
Microeconomics, 1
Quotas, 170, 171, 178
Minimum efficient scale (MES), 62
Mixed economic system, 9
Monetarists, 121, 138, 139, 143, 147, 206
R
Monetary policy, 134, 190, 206 Rate of interest, 119, 120
Money, 116 Regression tax, 153
Monopolistic competition, 75, 86 Research and development, 168, 197, 198
Monopoly, 79, 82 Revenue, 3, 25, 39, 40, 41, 47,

S Technical efficiency, 88, 200
Terms of trade, 103, 173
SADC, 174 Trade embargoes, 171
Savings, 108 Transactions motive, 245
Scarcity, 1, 203 Transfer payments, 104, 181, 221
Secondary production, 51 Treasury bills, 134, 162, 204, 225
Short run, 52, 56
Social costs, 7, 71, 152 U
Sole traders, 49, 50
Specialisation, 51 Unemployment, 143
Speculative Motive, 118 Unitary elasticity, 26, 36
Stagflation, 147 Utility, 14
Standard of living, 6, 22, 45, 99
Sock exchange, 128 V
Stock of money, 119, 205 Value added tax, 140, 155, 226
Subsidies, 171 Variable costs, 52, 53
Substitute goods, 15, 18 Velocity of circulation, 139
Substitution effect, 14, 45 Venture capital, 127
Supernormal profit, 158
Supply curve, 17 W
T Wealth, 117, 118
Welfare, 103, 145, 154, 159, 161
Tariffsor custom duties 171, 177 World bank, 177
Taxation, 21, 23, 25 World trade organisation (WTO), 177

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ZICA

ZICA ACCOUNTANCY PROGRAMME

MACRO ECONOMICS (ZICA) ACCOUNTING Page 1

MACRO ECONOMICS (ZICA) ACCOUNTING Page 2

After studying this chapter, the students should be able to:

 Describe the national income of a country

Gross National Product

MACRO ECONOMICS (ZICA) ACCOUNTING Page 3

Real and nominal values

1.1 The circular flow of income

1.3 NATIONAL INCOME

When using this method:

1.4 NATIONAL EXPENDITURE

MACRO ECONOMICS (ZICA) ACCOUNTING Page 5

GROSS DOMESTIC PRODUCT (GDP)

GROSS NATIONAL PRODUCT (GNP)

GDP at market Prices

= GDP at Factor cost

MACRO ECONOMICS (ZICA) ACCOUNTING Page 6

KIND OF ECONOMIC ACTIVITY 2003 2004 2005*

MACRO ECONOMICS (ZICA) ACCOUNTING Page 7

Taxes on Products 1,899.9 2,219.1 2,541.1

1.6 Zambia’s GDP by expenditure method, in Kwacha (bn) at current prices

1990 1991 1992 1993 1994 1995 1996 1997

Total consumption 95 200 574 1316 1980 2779 3608 4752

Private consumption 78 165 472 1124 1667 2290 2894 3895

Total investment 20 24 68 223 284 394 582 701

Gross fixed capital formation 19 25 65 217 276 385 566 681

Public fixed capital formation 8 13 23 50 235 198 239 278

Private fixed capital formation 11 12 42 167 41 187 327 403

2.0 USES OF NATIONAL INCOME FIGURES

2.1 LIMITATIONS IN NATIONAL INCOME CALCULATIONS

It is an increase in goods and services that is necessary if poverty is to be alleviated or

MACRO ECONOMICS (ZICA) ACCOUNTING Page 9

2.2 FACTORS DETERMINING A COUNTRY’S NATIONAL INCOME

The most important internal factors are

Original Natural Resources

Where a country‟s economy is predominantly agricultural, variations in weather may cause

The nature of the people, particularly of the labour force

MACRO ECONOMICS (ZICA) ACCOUNTING Page 10

The organization of resources

The external factors are

Foreign loans and investments

MACRO ECONOMICS (ZICA) ACCOUNTING Page 11

3.0 CHAPTER SUMMARY

MACRO ECONOMICS (ZICA) ACCOUNTING Page 12

1. Outline the three approaches used in calculating national income

You are required to calculate:

a) The GDP at market prices

8. Why are the figures above considered as “gross”

EXAMINATION TYPE QUESTION 8.1

MACRO ECONOMICS (ZICA) ACCOUNTING Page 13

Calculate the following from the above data:

(a) Gross domestic product at market prices (5 marks)

MACRO ECONOMICS (ZICA) ACCOUNTING Page 14

NATIONAL INCOME DETERMINATION

After studying this chapter, the students should be able to:

1.1 CONSUMPTION EXPENDITURE