COURSE OUTCOME: Discuss economic development and its nature.

Specific Learning Outcome:

1. Recall the basic concepts of economics.

2. Illustrate the economic circular flow diagram

UNIT 1–ECONOMIC DEVELOPMENT

Definition of Economics

A. Wealth Definition

Really the science of economics was born in 1776, when Adam Smith published his famous book “An
Enquiry into the Nature and Cause of Wealth of Nation”. He defined economics as the study of the
nature and cause of national wealth. According to him, economics is the study of wealth- How
wealth is produced and distributed. He is called as “father of economics” and his definition is
popularly called “Wealth definition”.

B. Welfare Definition

It was Alfred Marshall who rescued the economics from the above criticisms. By his classic work
“Principles of Economics”, published in 1890, he shifted the emphasis from wealth to human welfare.
According to him wealth is simply a means to an end in all activities, the end being human welfare.
He adds, that economics “is on the one side a study of the wealth; and the other and more important
side, a part of the study of man”. Marshall gave primary importance to man and secondary
importance to wealth.

C. Scarcity Definition

Lionel Robbins formulated his own conception of economics in his book “The Nature and Significance
of Economic Science” in 1932. According to him, “Economics is the science which studies human
behavior as a relationship between ends and scares means which have alternative uses”. He gave
importance to four fundamental characters of human existence such as;

1. Unlimited wants- In his definition “ends” refers to human wants which are boundless or unlimited.
2. Scarcity of means (Limited Resources) – the resources (time and money) at the disposal of a person
to satisfy his wants are limited.
3. Alternate uses of Scares means- Economic resources not only scarce but have alternate uses also. So
one has to make choice of uses.
4. The Economic Problem –when wants are unlimited, means are scarce and have alternate uses, the
economic problem arises. Hence we need to arrange wants in the order of urgency.
D. Modern Definition

The credit for revolutionizing the study of economics surely goes to Lord J.M Keynes. He defined
economics as the “study of the administration of scares resources and the determinants of income and
employment”.

Prof. Samuelson recently given a definition based on growth aspects which is known as Growth
definition. “Economics is the study of how people and society end up choosing, with or without the
use of money to employ scarce productive resources that could have alternative uses to produce
various commodities and distribute them for consumption, now or in the future, among various
persons or groups in society. Economics analyses the costs and the benefits of improving patterns of
resources use”.

Simple Definition

Economics is the science of making decisions in the presence of scarce resources.

MICROECONOMICS VS MACROECONOMICS
 ECONOMIC DEVELOPMENT

INTRODUCTION TO ECONOMIC DEVELOPMENT

Economic growth and development is often used interchangeably but there is a difference. Economic
growth is an increase in the amount of the goods and services produced over a specific period of time.
Generally, economic development refers to policymakers' actions which promotes the health, political,
and social well-being of a specific area. Common areas of development includes literacy rates, life
expectancy, unemployment, and poverty rates. Economic development leads to the economic growth
of a country. Economic Growth is a narrower concept than economic development. It is an increase in
a country's real level of national output which can be caused by an increase in the quality of resources
(by education etc.), increase in the quantity of resources & improvements in technology or in another
way an increase in the value of goods and services produced by every sector of the economy.
Economic Growth can be measured by an increase in a country's GDP (gross domestic product).

Economic development is a normative concept i.e. it applies in the context of people's sense of
morality (right and wrong, good and bad). The definition of economic development given by Michael
Todaro is an increase in living standards, improvement in self-esteem needs and freedom from
oppression as well as a greater choice. The most accurate method of measuring development is the
Human Development Index which takes into account the literacy rates & life expectancy which affect
productivity and could lead to Economic Growth. It also leads to the creation of more opportunities in
the sectors of education, healthcare, employment and the conservation of the environment. It implies
an increase in the per capita income of every citizen.

Economic Growth does not take into account the size of the informal economy. The informal economy
is also known as the black economy which is unrecorded economic activity. Development alleviates
people from low standards of living into proper employment with suitable shelter. Economic Growth
does not take into account the depletion of natural resources which might lead to pollution, congestion
& disease. Development however is concerned with sustainability which means meeting the needs of
the present without compromising future needs. These environmental effects are becoming more of a
problem for Governments now that the pressure has increased on them due to Global warming.
Economic growth is a necessary but not sufficient condition of economic development. Economic
development is the sustained, concerted actions of policy makers and communities that promote the
standard of living and economic health of a specific area. Economic development can also be referred
to as the quantitative and qualitative changes in the economy. Such actions can involve multiple areas
including development of human capital, critical infrastructure, regional competitiveness,
environmental sustainability, social inclusion, health, safety, literacy, and other initiatives. Economic
development differs from economic growth. Whereas economic development is a policy intervention
endeavor with aims of economic and social well-being of people, economic growth is a phenomenon
of market productivity and rise in GDP. Consequently, as economist Amartya Sen points out:
“economic growth is one aspect of the process of economic development.”
 Economic Development Economic Growth
Economic development implies changes in
income, savings and investment along with
Economic growth refers to an increase in
progressive changes in socio-economic
Implications the real output of goods and services in
structure of country (institutional and
the country.
technological changes).

Development relates to growth of human Growth relates to a gradual increase in

capital indexes, a decrease in inequality one of the components of Gross Domestic
Factors
figures, and structural changes that improve Product: consumption, government
the general population's quality of life. spending, investment, net exports.

Qualitative. HDI (Human Development

Index), gender- related index (GDI), Human
Measurement poverty index (HPI), infant mortality, Quantitative. Increases in real GDP.
literacy rate etc.

Brings qualitative and quantitative changes Brings quantitative changes in the

Effect
in the economy economy

Economic growth is a more relevant

Economic development is more relevant to metric for progress in developed
Relevance measure progress and quality of life in countries. But it's widely used in all
developing nations. countries because growth is a necessary
condition for development.

Concerned with structural changes in the Growth is concerned with increase in the
Scope
economy economy's output

Economic growth

From the answer to the previous question you will have noticed that the listed characteristics once
again say more about goals than the processes or mechanisms for achieving them. So what drives a
country towards achieving these goals? The orthodox view, espoused by most governments, most
major international organizations, and the economists that advise them, is that a big part of the answer
lies in economic growth.

However, economic growth can follow many different paths, and not all of them are sustainable.
Indeed, there are many who argue that given the finite nature of the planet and its resources, any form
of economic growth is ultimately unsustainable. We shall leave these debates for later. For now let us
look at what exactly economic growth is and how it is measured.

Economists usually measure economic growth in terms of gross domestic product (GDP) or related
indicators, such as gross national product (GNP) or gross national income (GNI) which are derived
from the GDP calculation. GDP is calculated from a country's national accounts which report annual
data on incomes, expenditure and investment for each sector of the economy. Using these data it is
possible to estimate the total income earned in the country in any given year (GDP) or the total income
earned by a country's citizens (GNP or GNI).

GNP is derived by adjusting GDP to include repatriated income that was earned abroad, and exclude
expatriated income that was earned domestically by foreigners. In countries where inflows and
outflows of this sort are significant, GNP may be a more appropriate indicator of a nation's income
than GDP.

There are three different ways of measuring GDP

 the income approach

 the output approach
 the expenditure approach

The income approach, as the name suggests measures people's incomes, the output approach
measures the value of the goods and services used to generate these incomes, and the expenditure
approach measures the expenditure on goods and services. In theory, each of these approaches should
lead to the same result, so if the output of the economy increases, incomes and expenditures should
increase by the same amount.

Figures for economic growth are usually presented as the annual percentage increase in real GDP.
Real GDP is calculated by adjusting nominal GDP to take account of inflation which would otherwise
make growth rates appear much higher than they really are, especially during periods of high
inflation.

Relationship between growth and development

Now take a moment to think about what GDP and GDP growth tell us about a country's level of
economic and social development.

Do high levels of GDP necessarily correspond with high levels of development? Not necessarily. It is
not aggregate GDP that is important, but GDP per capita. Countries like China and India have much
higher levels of GDP than, say, Singapore, New Zealand or Belgium, but few would suggest that the
latter are economically less developed than the former.

If GDP growth is to translate into higher GDP per capita, it has to outpace population growth.
Assuming that it does, is it reasonable to say that development is taking place?

Gross domestic product (GDP) is the total monetary or market value of all the finished goods and
services produced within a country's borders in a specific time period. As a broad measure of overall
domestic production, it functions as a comprehensive scorecard of a given country’s economic health.

Development indicators and indices

There are various types of macroeconomic and sociocultural indicators or "metrics" used by
economists and geographers to assess the relative economic advancement of a given region or nation.
The World Bank's "World Development Indicators" are compiled annually from officially-recognized
international sources and include national, regional and global estimates.
GDP per capita Income distribution

Literacy and education Access to healthcare

Social security and pensions Modern transportation

THE CIRCULAR FLOW OF ECONOMY

 HOW ECONOMY WORKS?

Decision Makers:

1. Firms: (business sector)

Produce and sell goods and services/ Hire and use factors of production

2. Consumers: (Household sector)

Buy and consume goods and service/ Own and sell factors of production

Markets for Goods and Services

• Firms sell

• Households buy

Markets for Factors of Production

• Households sell

• Firms buy

The Household Sector is the owner of all of the Factors of Production w/c includes the ff:

Factors of Production:

1. Labor- brain power and muscle power resources

2. Land- natural resources of all kinds

3. Capital- all equipment, building, and tools

In return for the Factors of Production the Business Sector gives the Factors of Payment to the h/s and it includes
the ff:

Factors of Payment:

1. Wages – salary of Income paid by the business firms to workers

2. Rent – the reward that goes to the land resources

3. Interests- the cost of borrowing or the price paid for the rental of funds

4. Profit – the rewards of management or entrepreneur who take risks.

 PERFORMANCE TASKS

ACTIVITY 1:

1. What is economics? Economic development?

2. Distinguish microeconomics versus macroeconomics?

3. Compare economic development versus economic growth.

4. Explain what Gross domestic product (GDP) is and GDP per capita?

5. Enumerate and explain the World Bank's "World Development Indicators" or indices.

ACTIVITY 2:

1. Based on the “Circular Flow of Economy” diagram, explain how the economy works?
(Use at least 10 sentences and must be in paragraph form)

ACTIVITY 3:

1. If I were the President of the Philippines, how can I attain positive economic
development?
(Use at least 10 sentences and must be in paragraph form)
COURSE OUTCOME: Explain the concepts of national income, cost of living, production
and growth.

Specific Learning Outcome:

1. Define national income and Gross Domestic Product (GDP).

2. Determine the factors affecting productivity and growth.

UNIT II: MEASUREMENT OF GROWTH

(MEASURE MENT OF NATIONAL INCOME)

Introduction

National income accounts (NIAs) are fundamental aggregate statistics in macroeconomic analysis.
The ground-breaking development of national income and systems of NIAs was one of the most
far-reaching innovations in applied economics in the early twentieth century. NIAs provide a
quantitative basis for choosing and assessing economic policies as well as making possible
quantitative macroeconomic modeling and analysis. NIAs cannot substitute for policymakers’
judgment or allow them to evade policy decisions, but they do provide a basis for the objective
statement and assessment of economic policies.

What Is Gross Domestic Product (GDP)?

Gross domestic product (GDP) is the total monetary or market value of all the finished goods and
services produced within a country's borders in a specific time period. As a broad measure of overall
domestic production, it functions as a comprehensive scorecard of a given country’s economic health.

Though GDP is typically calculated on an annual basis, it is sometimes calculated on a quarterly basis
as well. In the U.S., for example, the government releases an annualized GDP estimate for each fiscal
quarter and also for the calendar year. The individual data sets included in this report are given in real
terms, so the data is adjusted for price changes and is, therefore, net of inflation.

IMPORTANT NOTES:

 Gross Domestic Product (GDP) is the monetary value of all finished goods and services made
within a country during a specific period.
 GDP provides an economic snapshot of a country, used to estimate the size of an economy and
growth rate.
 GDP can be calculated in three ways, using expenditures, production, or incomes. It can be
adjusted for inflation and population to provide deeper insights.
 Though it has limitations, GDP is a key tool to guide policymakers, investors, and businesses
in strategic decision making.
GDP FORMULA:

1. Expenditure Approach

The expenditure approach is the most commonly used GDP formula, which is based on the money
spent by various groups that participate in the economy.

GDP = C + G + I + NX

C = consumption or all private consumer spending within a country’s economy, including, durable
goods (items with a lifespan greater than three years), non-durable goods (food & clothing), and
services.

G = total government expenditures, including salaries of government employees, road

construction/repair, public schools, and military expenditure.

I = sum of a country’s investments spent on capital equipment, inventories, and housing.

NX = net exports or a country’s total exports less total imports.

The expenditure approach, also known as the spending approach, calculates spending by the different
groups that participate in the economy. The GDP is primarily measured based on the expenditure
approach. This approach can be calculated using the following formula: GDP = C + G + I + NX (where
C=consumption; G=government spending; I=Investment; and NX=net exports). All these activities
contribute to the GDP of a country.

Consumption refers to private consumption expenditures or consumer spending. Consumers spend

money to acquire goods and services, such as groceries and haircuts. Consumer spending is the
biggest component of GDP, accounting for more than two-thirds of the U.S. GDP. Consumer
confidence, therefore, has a very significant bearing on economic growth. A high confidence level
indicates that consumers are willing to spend, while a low confidence level reflects uncertainty about
the future and an unwillingness to spend.

Government spending represents government consumption expenditure and gross investment.

Governments spend money on equipment, infrastructure, and payroll. Government spending may
become more important relative to other components of a country's GDP when consumer spending
and business investment both decline sharply. (This may occur in the wake of a recession, for
example.)

Investment refers to private domestic investment or capital expenditures. Businesses spend money in
order to invest in their business activities. For example, a business may buy machinery. Business
investment is a critical component of GDP since it increases the productive capacity of an economy
and boosts employment levels.

Net exports refers to a calculation that involves subtracting total exports from total imports (NX =
Exports - Imports). The goods and services that an economy makes that are exported to other
countries, less the imports that are purchased by domestic consumer, represents a country's net
exports. All expenditures by companies located in a given country, even if they are foreign companies,
are included in this calculation.
2. Income Approach

This GDP formula takes the total income generated by the goods and services produced.

GDP = Total National Income + Sales Taxes + Depreciation + Net Foreign Factor Income

Total National Income – the sum of all wages, rent, interest, and profits.

Sales Taxes – consumer taxes imposed by the government on the sales of goods and services.

Depreciation – cost allocated to a tangible asset over its useful life.

Net Foreign Factor Income – the difference between the total income that a country’s citizens and
companies generate in foreign countries, versus the total income foreign citizens and companies
generate in the domestic country.

What are the Types of GDP?

GPD can be measured in several different ways. The most common methods include:

 Nominal GDP – the total value of all goods and services produced at current market prices.
This includes all the changes in market prices during the current year due to inflation or
deflation.
 Real GDP – the sum of all goods and services produced at constant prices. The prices used in
determining the Gross Domestic Product are based on a certain base year or the previous year.
This provides a more accurate account of economic growth, as it is already an inflation-
adjusted measurement, meaning the effects of inflation are taken out.

Understanding Gross Domestic Product (GDP)

The calculation of a country's GDP encompasses all private and public consumption, government
outlays, investments, additions to private inventories, paid-in construction costs, and the
foreign balance of trade. (Exports are added to the value and imports are subtracted).

Of all the components that make up a country's GDP, the foreign balance of trade is especially
important. The GDP of a country tends to increase when the total value of goods and services that
domestic producers sell to foreign countries exceeds the total value of foreign goods and services that
domestic consumers buy. When this situation occurs, a country is said to have a trade surplus. If the
opposite situation occurs–if the amount that domestic consumers spend on foreign products is greater
than the total sum of what domestic producers are able to sell to foreign consumers–it is called a trade
deficit. In this situation, the GDP of a country tends to decrease.

In addition, there are several popular variations of GDP measurements which can be useful for
different purposes:

 Nominal GDP: GDP evaluated at current market prices, in either the local currency or in U.S.
dollars at currency market exchanges rates in order to compare countries' GDP in purely
financial terms.
 GDP, Purchasing Power Parity (PPP): GDP measured in "international dollars" using the
method of Purchasing Power Parity (PPP), which adjusts for differences in local prices and
 costs of living in order to make cross-country comparisons of real output, real income, and
living standards.
 Real GDP: Real GDP is an inflation-adjusted measure that reflects the quantity of goods and
services produced by an economy in a given year, with prices held constant from year to year
in order to separate out the impact of inflation or deflation from the trend in output over time.
 GDP Growth Rate: The GDP growth rate compares one year (or quarter) of a country's GDP to
the previous year (or quarter) in order to measure how fast an economy is growing. Usually
expressed as a percent rate, this measure is popular for economic policy makers because GDP
growth is though to be closely connected to key policy targets such as inflation and
unemployment rates.
 GDP Per Capita: GDP per capita is a measurement of the GDP per person in a country's
population. It indicates the the amount of output or income per person in an economy can
indicate average productivity or average living standards. GDP per capita can be stated in
nominal, real (inflation adjusted), or PPP terms.
 Since GDP is based on the monetary value of goods and services, it is subject to inflation.
Rising prices will tend to increase a country's GDP, but this does not necessarily reflect any
change in the quantity or quality of goods and services produced. Thus, by looking just at an
economy’s nominal GDP, it can be difficult to tell whether the figure has risen as a result of a
real expansion in production, or simply because prices rose.
 Economists use a process that adjusts for inflation to arrive at an economy’s real GDP. By
adjusting the output in any given year for the price levels that prevailed in a reference year,
called the base year, economists can adjust for inflation's impact. This way, it is possible to
compare a country’s GDP from one year to another and see if there is any real growth.
 Real GDP is calculated using a GDP price deflator, which is the difference in prices between
the current year and the base year. For example, if prices rose by 5% since the base year, the
deflator would be 1.05. Nominal GDP is divided by this deflator, yielding real GDP. Nominal
GDP is usually higher than real GDP because inflation is typically a positive number. Real
GDP accounts for changes in market value, and thus, narrows the difference between output
figures from year to year. If there is a large discrepancy between a nation's real GDP and its
nominal GDP, this may be an indicator of either significant inflation or deflation in its
economy.
 Nominal GDP is used when comparing different quarters of output within the same year.
When comparing the GDP of two or more years, real GDP is used. This is because, in effect, the
removal of the influence of inflation allows the comparison of the different years to focus solely
on volume.

Types of Gross Domestic Product (GDP) Calculations

GDP can be determined via three primary methods. All three methods should yield the same figure
when correctly calculated. These three approaches are often termed the expenditure approach, the
output (or production) approach, and the income approach.

GDP vs. GNP vs. GNI

Although GDP is a widely-used metric, there are other ways of measuring the economic growth of a
country. While GDP measures the economic activity within the physical borders of a country (whether
the producers are native to that country or foreign-owned entities), the gross national product (GNP)
is a measurement of the overall production of persons or corporations native to a country, including
those based abroad. GNP excludes domestic production by foreigners.
Gross National Income (GNI) is another measure of economic growth. It is the sum of all
income earned by citizens or nationals of a country (regardless of whether or not the underlying
economic activity takes place domestically or abroad). The relationship between GNP and GNI is
similar to the relationship between the production (output) approach and the income approach used
to calculate GDP. GNP uses the production approach, while GNI uses the income approach. With
GNI, the income of a country is calculated as its domestic income, plus its indirect business taxes and
depreciation (as well as its net foreign factor income). The figure for net foreign factor income is
calculated by subtracting all payments made to foreign companies and individuals from those
payments made to domestic businesses.

In an increasingly global economy, GNI has been put forward as a potentially better metric for overall
economic health than GDP. Because certain countries have most of their income withdrawn abroad by
foreign corporations and individuals, their GDP figures are much higher than the figure that
represents their GNI.

Measuring the Cost of Living

Cost of living indexes are meant to compare the expenses an average person can expect to incur to
acquire food, shelter, transportation, energy, clothing, education, healthcare, childcare, and
entertainment in different regions. A cost of living index is also used to track how much the costs of
basic expenses rise over a period.

Although there is no official cost of living index created or reported by the U.S. government, there are
a few offered by organizations that track the costs of living in different regions.

What Goes Into a Cost of Living Index

The costs of consumer goods and services vary between different urban and suburban residential
areas. A person's salary might provide a high standard of living in a small city in the Midwest since
rent and utilities would likely be cheaper than a large city like New York, LA, or Boston.

Another way to interpret what a cost of living index represents is to ask the question: "How
many goods and services does a given sum of money purchase in a certain location?" For example,
$100 tends to purchase more goods and services in Denver than it does in New York City.

The cost of living can impact a person's choice in work, and needed salary as well as where to live. The
costs of living also directly impact a person's ability to save for a home, pay off college debt, whether
to have a child, or when to retire.

Need-based expenses such as housing, clothing, healthcare, food, and electricity can increase over
time and comprise of a greater share of a person's monthly income. A cost of living index can be used
to track the changes in basic expenses so that a person can see how much costs are increasing. Also,
the index can demonstrate how much need-based expenses vary from one city or town to another.

A cost of living index can help a person determine whether the income or salary being earned is
enough to cover basic expenses. From there, a person can assess whether there's enough extra income
left over to save for retirement or pay off debt.
How a Cost of Living Index Works

Although there are various types of cost of living indexes that use different variables and metrics,
most set a base cost of living, often represented by 100. The base can either be the cost of living in
one region—for instance, Chicago could be pegged as the base city and its cost of living set at 100—or
it can be an average of multiple regions. Other regions are measured against the base region and
assigned a cost of living number accordingly. If on average, it is 20% more expensive to live in Boston
than in the base city, Boston's cost of living number would be 120.

It's important to consider the average income for a geographic area as well. For example, a town in the
south might have a lower cost of living than most towns on the east or west coasts. However, the
southern town's median income might be below the cost of living for that area.

IMPORTANT NOTES:

 Cost of living indexes are meant to compare the expenses from one town or geographic region
to another.
 Cost of living indexes include expenses such as food, shelter, transportation, energy, clothing,
healthcare, and childcare.
 A cost of living index is also used to track how much the costs of basic expenses rise over a
period.

Production and Growth

What Is Economic Growth?

Economic growth is an increase in the production of economic goods and services, compared from one
period of time to another. It can be measured in nominal or real (adjusted for inflation) terms.
Traditionally, aggregate economic growth is measured in terms of gross national product (GNP) or
gross domestic product (GDP), although alternative metrics are sometimes used.

Economic growth is an increase in the production of goods and services over a specific period. To be
most accurate, the measurement must remove the effects of inflation.

Economic growth creates more profit for businesses. As a result, stock prices rise. That gives
companies capital to invest and hire more employees. As more jobs are created, incomes rise.
Consumers have more money to buy additional products and services. Purchases drive higher
economic growth. For this reason, all countries want positive economic growth. This makes economic
growth the most-watched economic indicator.

KEY TAKEAWAYS

 Economic growth is an increase in the production of goods and services in an economy.

 Increases in capital goods, labor force, technology, and human capital can all contribute to
economic growth.
 Economic growth is commonly measured in terms of the increase in aggregated market value
of additional goods and services produced, using estimates such as GDP.

How to Measure Economic Growth

Gross domestic product is the best way to measure economic growth. It takes into account
the country's entire economic output. It includes all goods and services that businesses in the country
produce for sale. It doesn't matter whether they are sold domestically or overseas.

GDP measures final production. It doesn't include the parts that are manufactured to make a product.
It includes exports because they are produced in the country. Imports are subtracted from economic
growth.

Most countries measure economic growth each quarter.

The most accurate measurement of growth is real GDP. It removes the effects of inflation. The GDP
growth rate uses real GDP.

Production and Growth

A country’s standard of living depends on its ability to produce goods and services. Within a
country there are large changes in the standard of living over time. In the United States over the
past century, average income as measured by real GDP per person has grown by about 2 percent
per year.

u Productivity refers to the amount of goods and services produced for each hour of a
worker’s time.
u A nation’s standard of living is determined by the productivity of its workers.

Why Productivity Is So Important?

Productivity plays a key role in determining living standards for all nations in the world.
Productivity refers to the quantity of goods and services that a worker can produce from each hour
of work. To understand the large differences in living standards across countries. We must focus on
the production of goods and services.

How Productivity is Determined?

u The inputs used to produce goods and services are called the factors of production.
u The factors of production directly determine productivity.

The Factors of Production

u Physical capital
u Human capital
u Natural resources
u Technological knowledge
The Factors of Production

Capital

u Capital is a produced factor of production.

u It is an input into the production process that in the past was an output from the production
process.

Physical capital

u Physical capital is the stock of equipment and structures that are used to produce goods and
services.
u Tools used to build or repair automobiles.
u Tools used to build furniture.
u Office buildings, schools, etc.

Human capital

u Human capital is the economist’s term for the knowledge and skills that workers acquire
through education, training, and experience.
u Like physical capital, human capital raises a nation’s ability to produce goods and
services.

Natural Resources

u Natural resources are inputs used in production that are provided by nature, such as land,
rivers, and mineral deposits.
u Renewable resources include trees and forests.
u Nonrenewable resources include petroleum and coal.
u Natural resources can be important but are not necessary for an economy to be highly
productive in producing goods and services.

Technological Knowledge

u Technological knowledge is the understanding of the best ways to produce goods and
services.
u Human capital refers to the resources expended transmitting this understanding to the labor
force.

The Production Function

Economists often use a production function to describe the relationship between the quantity of
inputs used in production and the quantity of output from production.

The Production Function

u Production functions with constant returns to scale have an interesting implication.

u Setting x = 1/L,
Y/ L = A F(1, K/ L, H/ L, N/ L)

Where:

Y/L = output per worker

K/L = physical capital per worker

H/L = human capital per worker

N/L = natural resources per worker

The preceding equation says that

productivity (Y/L) depends on physical

capital per worker (K/L), human capital

per worker (H/L), and natural resources

per worker (N/L), as well as the state of technology, (A).

 PERFORMANCE TASKS

ACTIVITY 1:

1. Define Gross National Product (GDP)?

2. Enumerate the importance of GDP.
3. Compare and contrast GDP vs. GNP vs GNI.
4. Explain what is economic growth?
5. Why Productivity is so important?

ACTIVITY 2:

1. In this time of pandemic, describe the real situation of our economy,

especially the growth and productivity.

ACTIVITY 3:

2. Imagine yourself as President of the Philippines, how can you improve the current
status of our economy?
(Use at least 10 sentences and must be in paragraph form)
COURSE OUTCOME: Determine the principle of savings, investment and
financial system.

Specific Learning Outcome:

1. Identify the importance of savings, investment, and financial system.

2. Ascertain some of the important financial institution in the Philippines

economy.

UNIT III–SAVINGS, INVESTMENTS AND

FINANCIAL SYSTEM

What Is an Investment?

An investment is an asset or item acquired with the goal of generating income or appreciation.
Appreciation refers to an increase in the value of an asset over time. When an individual purchases a
good as an investment, the intent is not to consume the good but rather to use it in the future to create
wealth. An investment always concerns the outlay of some asset today—time, money, or effort—in
hopes of a greater payoff in the future than what was originally put in.

IMPORTANT NOTES:

An investment is an asset or item that is purchased with the hope that it will generate income or
appreciate in value at some point in the future.

An investment always concerns the outlay of some asset today (time, money, effort, etc.) in hopes of a
greater payoff in the future than what was originally put in.

An investment can refer to any mechanism used for generating future income, including bonds,
stocks, real estate property, or a business, among other examples.

Investment means expenditure on capital spending, e.g. buying new machines, building bigger
factories, buying robots to enable automation. (in economics investment does not mean saving money
in a bank)

The rate of economic growth also affects the level of investment. Business investment tends to be quite
volatile. If businesses see an improvement in economic forecasts, they will increase investment to meet
future demand. Therefore, an improvement in the rate of economic growth can cause a substantial rise
in investment. But, if there is an economic downturn and a fall in the rate of economic growth,
business will cut back on investment.

The level of investment also depends on the rate of interest, business confidence, technological
progress and government regulations.

Investment is the amount of goods purchased or accumulated per unit time which are not consumed
at the present time. The types of investment are residential investment in housing that will provide a
flow of housing services over an extended time, non-residential fixed investment in things such as
new machinery or factories, human capital investment in workforce education, and inventory
investment (the accumulation, intentional or unintentional, of goods inventories).

In measures of national income and output, "gross investment" (represented by the variable I ) is a
component of gross domestic product (GDP), given in the formula GDP = C + I + G + NX, where C is
consumption, G is government spending, and NX is net exports, given by the difference between the
exports and imports, X − M. Thus investment is everything that remains of total expenditure after
consumption, government spending, and net exports are subtracted (i.e. I = GDP − C − G − NX ).

Significance

Investment is the value of machinery, plants, and buildings that are bought by firms for production
purposes.

Investment plays six macroeconomic roles:

1. it contributes to current demand of capital goods, thus it increases domestic expenditure;

2. it enlarges the production base (installed capital), increasing production capacity;

3. it modernizes production processes, improving cost effectiveness;

4. it reduces the labor needs per unit of output, thus potentially producing higher productivity and
lower employment;

5. it allows for the production of new and improved products, increasing value added in production;

6. it incorporates international world-class innovations and quality standards, bringing the gap with
more advanced countries and helping exports and an active participation to international trade.

How an Investment Works

The act of investing has the goal of generating income and increasing value over time. An investment
can refer to any mechanism used for generating future income. This includes the purchase of bonds,
stocks, or real estate property, among other examples. Additionally, purchasing a property that can be
used to produce goods can be considered an investment.

In general, any action that is taken in the hopes of raising future revenue can also be considered an
investment. For example, when choosing to pursue additional education, the goal is often to increase
knowledge and improve skills (in the hopes of ultimately producing more income).
Because investing is oriented toward the potential for future growth or income, there is always a
certain level of risk associated with an investment. An investment may not generate any income, or
may actually lose value over time. For example, it's also a possibility that you will invest in a company
that ends up going bankrupt or a project that fails to materialize. This is the primary way that saving
can be differentiated from investing: saving is accumulating money for future use and entails no risk,
whereas investment is the act of leveraging money for a potential future gain and it entails some risk.

Economic Investments

Within a country or a nation, economic growth is related to investments. When companies and other
entities engage in sound business investment practices, it typically results in economic growth.

For example, if an entity is engaged in the production of goods, it may manufacture or acquire a new
piece of equipment that allows it to produce more goods in a shorter period of time. This would raise
the total output of goods for the business. Taken in combination with the activities of many other
entities, this increase in production could cause the nation’s gross domestic product (GDP) to rise.

Investment from Abroad

Governments can increase capital accumulation and long-term economic growth by encouraging
investment from foreign sources.

Investment from abroad takes several forms:

u Foreign Direct Investment

u Capital investment owned and operated by a foreign entity.
u Foreign Portfolio Investment
u Investments financed with foreign money but operated by domestic residents.

SAVINGS

What are Household Savings (Individual)?

Savings is the money a person has left over when they subtract their consumer spending from their
disposable income over a given time period. Savings can be used to increase income through
investing.

Savings refers to the amount left over after an individual's consumer spending is subtracted from the
amount of disposable income earned in a given period of time. Savings can be used to increase income
through investing.

NATIONAL SAVINGS

Significance

What people save, avoiding to consume all their income, is called "personal savings". These savings
can remain on the bank accounts for future use or be actively invested in houses, real estate, bonds,
shares and other financial instruments.
National savings are personal savings plus the business savings and public savings. Business savings
can be measured by the value of undistributed corporate profits. Public savings are basically tax
revenues less public expenditure.

National savings, in turn, are the sum of personal, business, and state savings. Business save when the
do not distribute all their profits: these sums, however, are usually quite tiny on a macroeconomic
scale. The states often run public deficits, so that they rather dis-save. All this would lead to the
conclusion that personal savings are the largest and more important part of national savings.

But this is not the entire story: some empirical analyses have shown a negative correlation between
personal savings and the state savings (public surplus). High savings rate would be counterbalanced
by high deficits, whereas the reduction in public deficits would not increase by the same amount the
national savings since a symmetric contraction of personal savings takes place. To the extent this
relationship holds, national savings would be more stable than their components.

What Is a Deficit?

In financial terms, a deficit occurs when expenses exceed revenues, imports exceed exports, or
liabilities exceed assets. A deficit is synonymous with a shortfall or loss and is the opposite of a
surplus. A deficit can occur when a government, company, or person spends more than it receives in a
given period, usually a year.

IMPORTANT NOTES:

A deficit occurs when expenses exceed revenues, imports exceed exports, or liabilities exceed assets in
a particular year.

Governments and businesses sometimes run deficits deliberately, to stimulate an economy during a
recession or to foster future growth.

The two major types of deficits incurred by nations are budget deficits and trade deficits.

What Is a Budget Surplus?

A budget surplus occurs when income exceeds expenditures. The term often refers to a government's
financial state, as individuals have "savings" rather than a "budget surplus." A surplus is an indication
that a government's finances are being effectively managed. A budget surplus is when income exceeds
expenditures.

Cumulated and invested personal savings give rise to personal wealth stock.

Savings left in bank accounts are an important part of money. To the extent the banks decide to
finance business investment with respect to the amount of deposits they received, an increase of
personal savings could foster investment by the established firms. If money deposited is converted in
subscription to equity in one's own firm, savings serve for personal careers and independence, again
with a possible link to investment in a macroeconomic sense.

Invested in Treasury bonds, savings finance public expenditure. Invested in shares, they can directly
or indirectly finance the firms. Savings can also be transfer abroad by remittances, giving rise to a new
choice their between consumption and savings (e.g. in the form of purchasing an existent house or in
funds for entrepreneurial activity).

Insufficient and reduced savings due to an intentional policy to promote GDP growth by autonomous
consumption alone might reduce, if this policy is only weakly effective, the capability of the national
economy to absorb treasury bonds, what in certain circumstances can put the country under heavy
pressure by foreign creditors, if public debt is large and prevalently held by foreigners.

Saving, process of setting aside a portion of current income for future use, or the flow of resources
accumulated in this way over a given period of time. Saving may take the form of increases in bank
deposits, purchases of securities, or increased cash holdings. The extent to which individuals save is
affected by their preferences for future over present consumption, their expectations of future income,
and to some extent by the rate of interest.

There are two ways for an individual to measure his saving for a given accounting period. One is to
estimate his income and subtract his current expenditures, the difference being his saving. The
alternative is to examine his balance sheet (his property and his debts) at the beginning and end of the
period and measure the increase in net worth, which reflects his saving.

Total national saving is measured as the excess of national income over consumption and taxes and is
the same as national investment, or the excess of net national product over the parts of the product
made up of consumption goods and services and items bought by government expenditures. Thus, in
national income accounts, saving is always equal to investment. An alternative measure of saving is
the estimated change in total net worth over a period of time.

Saving is important to the economic progress of a country because of its relation to investment. If there
is to be an increase in productive wealth, some individuals must be willing to abstain from consuming
their entire income. Progress is not dependent on saving alone; there must also be individuals willing
to invest and thereby increase productive capacity.

FINANCIAL SYSTEM’S ROLE IN THE ECONOMIC DEVELOPMENT

Without financial system it is quite difficult and expensive to allocate resource and shift risks to its
lowest level (low economic development). Financial system plays an important role in the economic
development and it is divided into financial markets and institutions. The role of the financial
system is to gather or pool money from people and businesses that have more than they need
currently and transmit those funds to those who can use them for either consumption or investment.
The larger the flow of funds and the more efficient their allocation is, the better the economic output
and welfare of the economy and society. A healthy economy is dependent on efficient transfers of
resources from people who are net savers (surplus) to firms and individuals who need capital.
Without efficient transfers, the economy simply could not function. Obviously, the level of
employment and productivity, hence our standard of living, would be much lower. Therefore, it is
absolutely essential that our financial market functions efficiently, not only quickly, but also at a
minimal cost. So this paper is written to describe the importance of financial system to the economic
development of a nation. It will also seek to highlight the techniques used to allocate funds or resource
and also risk minimization. Lastly, it attempts to identify the financial intermediation players and the
instruments used in doing so.
ASSET ALLOCATION BETWEEN SAVERS (SURPLUS) AND BORROWERS (DEFICIT) PARTS

The financial system consists of financial markets and institutions. Financial markets are where people
buy and sell, win and lose, bargain and argue about the price and the product/services. The only
difference between financial markets and normal market that we know is that in the financial
markets people buy and sell financial instruments like stocks, mortgage contracts, and bonds and so
on. Financial institutions, as part of financial system, they also play an important role in economic
development by facilitating the flow of funds from surplus unit (savers) to the deficit unit
(borrowers). They are firms such as credit unions, commercial banks, finance institutions, insurance
companies and etc.

Economic elements or parties that are involved can be divided into households, business
organizations, and government. Business often needs capital to implement growth plans; government
requires funds to finance building projects; and households frequently want loans for example to
purchase homes, cars and so on. Fortunately, there are other individuals or households and firms with
incomes greater than their expenditures (surplus budget position). Therefore financial markets bring
together people and organizations needing money with those having surplus funds. In other words,
the purpose of the financial system is to transfer funds from savers to the borrowers in the most
effective and efficient possible manner. And that job can be done by direct financing or by indirect
financing. Despite the method of transferring the resources the objective is to bring the involving
parties together at the lowest possible cost.

a. Direct Financing: In direct financing borrowers and savers exchange money and financial
instruments directly. Borrowers or deficit units issue financial claims (they are claims against someone
else’s money at a future date) on themselves and sell directly to savers or surplus units for money.
The savers hold the financial claims as interest bearing instruments and they can sell it in financial
markets. Upon agreed time or maturity date borrowers have to give back the savers principle plus the
agreed interest rate.

b. Indirect financing: A problem that arises from direct financing brought the usage of indirect
financing. Sometimes the savers or surplus units can’t wait to hold financial claims till maturity date
therefore they sell the financial claims to the financial intermediation and take their funds from
them to do whatever they please.

SERVICES OF FINANCIAL INSTITUTIONS

In transferring resource allocation from direct financing to indirect financing,

financial institutions provide the following five basic services:

a. Currency alteration: Buying financial claims denominated in one currency

and selling financial claims denominated in another currencies.

b. Quantity Divisibility: Financial institutions are capable in producing a

broad range of quantity from one dollar to many millions, by gathering
from different people.

c. Liquidity: Easy to liquidate the instruments by buying direct financial

claims with low liquidity and issuing indirect financial claims with more
liquidity.
d. Maturity Flexibility: Creating financial claims with wide range of maturities so as to balance the
maturity of different instruments so as to reduce the gap between assets and liabilities.

e. Credit Risk Diversification (portfolio investment): By purchasing a broad

range of instruments, financial institutions are able to diversify the risk.

TYPES OF FINANCIAL INSTITUTIONS

Different financial institutions exist in our economy and they serve to accomplish one function i.e. to
purchase financial claims from borrowers (deficit unit) and sell it with different characteristics to the
savers (surplus unit). Here are the major types of intermediaries:

1. Commercial banks are the major institutions that lend money, handle checking accounts, and also
provide an ever-widening range of services, including stock brokerage services and insurance.
Commercial banks are the largest and most diversified institutions on the basis of range of
assets held and liabilities issued.

2. Thrift Institutions - Mutual savings and savings and loan associations are commonly called thrift
institutions. They serve individual savers and residential and commercial mortgage borrowers, take
the funds of many small savers and then lend this money to home buyers and other types of
borrowers.

3. Credit unions are cooperative associations whose members are supposed to have common bond.
Credit unions are often the cheapest source of funds available to individual borrowers.

4. Mutual funds sell equity shares to investors and use these resources to purchase stocks or bonds.
These organizations pool resources and thus minimize risks through diversification. They also achieve
economies of scale in analyzing securities, managing portfolios, and buying and selling
securities.

5. Life insurance companies take savings in the form of premiums and then invest these funds in
bonds, stocks, mortgages, real estate and so on, and then make payments to beneficiaries.

6. Pension funds are retirement plans obtain their funds from employers and employees and
administered generally by the trust departments of commercial banks, or by life insurance companies.
Pension funds invest their money primarily in stocks, bonds real estate and mortgages like
insurance companies.

CONCLUSION

Financial system plays a significant role in the economic development of a country. Financial markets
present three major efficiencies for the sake of development and they are allocation, information, and
operational efficiency. Financial institutions are profit maximizing businesses that earn profits by
acquiring funds at interest rates lower than they earn on their assets.
What Is a Central Bank?

A central bank is a financial institution given privileged control over the production and distribution
of money and credit for a nation or a group of nations. In modern economies, the central bank is
usually responsible for the formulation of monetary policy and the regulation of member banks.

Central banks are inherently non-market-based or even anti-competitive institutions. Although some
are nationalized, many central banks are not government agencies, and so are often touted as being
politically independent. However, even if a central bank is not legally owned by the government, its
privileges are established and protected by law.

IMPORTANT NOTES:

A central bank is a financial institution that is responsible for overseeing the monetary system and
policy of a nation or group of nations, regulating its money supply, and setting interest rates.

Central banks enact monetary policy, by easing or tightening the money supply and availability of
credit, central banks seek to keep a nation's economy on an even keel.

A central bank sets requirements for the banking industry, such as the amount of cash reserves banks
must maintain vis-à-vis their deposits.

A central bank can be a lender of last resort to troubled financial institutions and even governments.
 PERFROMANCE TASKS

ACTIVITY 1:

1. Enumerate the significance of investments?

2. What is national savings?
3. What is the role of financial system in the economic development?
4. Discuss the functions of Central Bank.
5. Discuss the concept of mutual funds.

ACTIVITY 2:

2. In this time of pandemic, how can a massive investments and savings

help our economy?

ACTIVITY 3:

3. As President of the Philippines, your flagship infrastructure project the “BUILD! BUILD!
BUILD!” has been completed. What would be the impact of this project to our economy?
(Use at least 10 sentences and must be in paragraph form)
COURSE OUTCOME: Discuss economic development and its nature.

Specific Learning Outcome:

1. Determine the cause and effect of inflation and unemployment.

2. Discuss the factors affecting inflation and unemployment.

UNIT IV– INFLATION AND UNEMPLOYMENT

What Is Inflation?

Inflation is the decline of purchasing power of a given currency over time. A quantitative
estimate of the rate at which the decline in purchasing power occurs can be reflected in the
increase of an average price level of a basket of selected goods and services in an economy over
some period of time. The rise in the general level of prices, often expressed as a percentage,
means that a unit of currency effectively buys less than it did in prior periods.

Inflation can be contrasted with deflation, which occurs when the purchasing power of money
increases and prices decline.

IMPORTANT NOTES:

Inflation is the rate at which the the value of a currency is falling and consequently the general
level of prices for goods and services is rising.

Inflation is sometimes classified into three types: Demand-Pull inflation, Cost-Push inflation,
and Built-In inflation.

Most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale
Price Index (WPI).

Inflation can be viewed positively or negatively depending on the individual viewpoint and rate
of change.

Those with tangible assets, like property or stocked commodities, may like to see some inflation
as that raises the value of their assets.

People holding cash may not like inflation, as it erodes the value of their cash holdings.

Ideally, an optimum level of inflation is required to promote spending to a certain extent instead
of saving, thereby nurturing economic growth.
  CAUSES OF INFLATION:

The causes of inflation are generally grouped under two main heads (a) Demand Pull Inflation (b) Cost
Push Inflation.

A. Demand Pull Inflation:

Inflation caused by increase in aggregate demand, not matched by aggregate supply of goods,
resulting in rise of general price level is called demand pull inflation. Demand pull inflation to be
simpler, occurs when the demand for goods and services in the country is more than their supply. The
effective demand for goods increases due to many factors such as increase in money supply, increase in
the demand for goods by the government, increase in the income of various factors of production etc.
In short, the excessive increase in the money supply causes inflationary conditions. Demand pull
inflation is generally characterized by shortage of goods and shortage of workers.

Demand pull inflation occurs when aggregate demand for goods exceeds aggregate supply of
goods at current prices, thus leading to an increase in the price level. The factors of which bring about
increase in aggregate demand for goods or rise in the general level of prices are grouped under two
separate heads; (i) Factors operating on demand side (ii) Factors operating on the supply side.

(a) Factors operating on the demand side: These are the factors which bring continuous rise in the
general price level.

(1) Increase in money supply: An increase in money supply leads to an increase in money income. The
increase in money income raises the aggregate demand for goods and services in the country. The
supply of money increases when the govt. resorts to deficit financing or the commercial banks expand
credit. When too much money chases too few goods, the result is an increase in general price level.

(2) Increase in Government expenditure: If there is increase in govt. expenditure due to adoption of
development and welfare activities of the country has to flight a war, it causes as increase in govt.
expenditure which leads to increase in aggregate demand for goods and services and hence the price
level goes up.

(3) Increase in private expenditure: A continuous increase in consumption and investment expenditure
in the private sector raises the demand for goods and services and leads to inflationary rise in prices.

(4) Increase in population: The rapid rising population exerts pressure on the demand for goods and
services. If the supply of goods and services fail to match with the demand, the general price level moves
upward.

(5) Black money: The money generated through smuggling, tax evasion etc. raises the demand for
luxury and other goods. Hence black money is also one of the causes in raising the aggregate demand
for goods and a rise in general price level.

(b) Factors causing decrease in supply of goods: If the increase in aggregate demand for goods and
services is matched by an increase in the supply of goods, it will not cause inflationary situation. When
the aggregate supply of goods is at a slower pace than the growth in aggregate demand, it then causes
inflationary rise in prices. The following factors are identified for relatively slower growth in the supply
of goods.
(i) Lagging agricultural & industrial production: The increase in population, incomes, employment
and urbanization exert pressure on the demand for goods and services. However, the agricultural and
industrial production grows at a slower pace, due to shortage of essential inputs like fertilizers, water,
cement, iron etc. When aggregate demand for goods and services exceeds the aggregate supply of it, it
causes a rise in the prices of agricultural and industrial goods.

(ii) Inadequate infrastructure facilities: If, in a country there is shortage of power, transport and
communication facilities are slow and inefficient, it results in the slowing down of overall production
of goods. When the supply of goods falls short of demand, the prices go up in the country.

(iii) Long gestation period: If the time lag between investment and the production of goods is long, the
shortage of goods will arise. This will also contribute to inflationary pressure in the economy.

B. Cost Push Inflation:

Cost push inflation occurs when there is an increase in the cost of production of goods and is not
associated with excess demand. The main causes of cost push inflation are:

Cost push inflation occurs when the increasing cost of production pushes up the general price
level. Cost pull inflation occurs when the economy is below full employment with prices rising even
though there is no shortage of goods. Cost push inflation is the result of increase in wage costs
unaccompanied by corresponding increase in productivity, rise in import prices of goods, depreciation
in the external value of the currency, higher mark up etc, etc.

(1) Increase in money wage rate: The wage push inflation occurs when strong labour unions manage
to press for wage increases in excess of labour productivity. Unit cost of production is thereby raised.
The rise in cost of production exerts pressure on sellers to increase prices of goods so as to get profit
margin.

(2) Profit push inflation: If the producers of certain commodities have monopoly or near monopoly
power in the market, they fix up higher profit margins arbitrarily without any increase in other elements
of cost. When a few powerful firms increase the profit margins, the smaller firms also tend to mark up
their profit margins. The higher profit margins, thus, inflate the price level.

(3) Material push inflation: If there is increase in the prices of some basic materials such as gas, steel,
chemicals, oil etc which are used directly or indirectly in almost all industries, it causes an increase in
the cost of production and hence in the general price level.

(4) Higher taxes: If the government levies new taxes and raises the rates of old taxes the producers
generally shift the burden of taxes on to the consumers. The increases in the selling prices of the
commodities push up the inflationary trend in the economy.

(5) Import prices: If prices of imported goods increase, it also results in the contribution of inflation.

 KINDS OF INFLATION:

Inflation is of different types. It is generally classified on the following basis.

 On the Basis of Rate of Inflation:

(i) Creeping Inflation: It is a situation in which the rise in general price level is at a very slow rate over
a period of time. Under creeping inflation, the price level raises upto a rate of 2% per annum. A mild
inflation is generally considered a necessary condition of economic growth.

(ii) Walking Inflation: Walking inflation is a marked increase in the rate of inflation as compared to
creeping inflation. The price rise is around 5% annually.

(iii) Running Inflation: Under running inflation, the price increases is about 8% to 10% per annum.

(iv) Galloping or Hyper Inflation: Galloping inflation is a full inflation. Keynes calls it as the final stage
of inflation. It is a stage of inflation which starts after the level of full employment is reached. Here price
level rises very rapidly within a short period.

 On the Basis of Degree of Control:

(i) Open Inflation: It is a stage when the rise in price level gets out of control. Milton Friedman describes
it as “inflationary process in which prices are permitted to rise without being suppressed by government
price control or similar measures.

(ii) Suppressed Inflation: Under this type of inflation, the government makes efforts to check and
control the rise in price level through price and rationing. When price level is suppressed by the above
short term measures, it results in many evils such black marketing, hoarding, corruption & profiteering.

 Inflation on the Basis of Causes:

(i) Demand Pull Inflation: (Already explained above)

(ii) Cost Push Inflation: (Already explained above)

(iii) Profit Induced Inflation: Profit inflation is in fact categorized under cost push inflation. When
entrepreneur, due to their monopoly position raise the profit margin on goods. It may cause profit push
inflation.

(iv) Budgetary Inflation: When the government of a country occurs the deficits in the budgets through
bank borrowing and creating new money (Deficit Financing), the purchasing power of commodity
increases without a simultaneous increase in the production of goods. This leads to rise in the general
price level.

(v) Monetary Inflation: Milton Friedman is of the firm view that inflation is always and anywhere a
monetary phenomenon. According to him, inflation is caused by a too rapid increase in the money
supply and by nothing else.

(vi) Multi Casual Inflation: Inflation has a number of causes. It may be caused by increase in money
supply, excessive wage demands, excess aggregate demand for goods, shortage of goods etc. The chief
cause of inflation in one year may not be in the next year. Since inflation is multi causal, therefore a
variety of policy measures are needed to deal with it.
  On the Basis of Employment:

(i) Partial Inflation: According to J.M. Keynes, takes place when the general price level rises partly due
to an increase in the cost of production of goods and partly due to rise in supply of money before the
full employment stage is reached.

(ii) Full Inflation: Full inflation prevails when the economy has reached the level of full employment.
Any increase in money supply beyond full employment. It is also called as real inflation.

 Anticipated versus Unanticipated Inflation:

(i) Anticipated inflation is the rate of inflation which majority of the individual believes will occur.
When the rate of inflation (say 6%) turns out to be same (6%) we are then in a situation of fully
anticipated inflation.

(ii) Unanticipated inflation is that which comes as a surprise to majority of individuals. It can be higher
or lower than the rate of anticipated inflation.

 Remedies of inflation
The first panacea for a mismanagement nation is inflation of the currency. The second is war. Both bring
a permanent ruin. They both are the refuge of political and economic opportunities. (Ernest
Hemingway). To avoid political unrest and harmful, social and economic effects on the economy, it is
the main objective of every government to take appropriate measures to control inflation. The main
measures which are used to control inflation are (1) MONETARY POLICY (2) FISCAL POLICY and
other measures:

1. Monetary Policy
Monetary policy is a policy that influences the economy through changes in the money supply
and available credit. Monetary policy is adopted by central bank of a country. The various monetary
measures which are used to control inflation are grouped under two heads (a) Quantitative controls (b)
Qualitative controls. They are (1) Open market operations (2) Variation in bank rates (3) Credit rationing
(4) Varying reserve requirements (5) Varying margin requirements (6) Consumer credit regulations.

2. Fiscal Policy
Fiscal policy is the deliberate change in either government spending or taxes to stimulate or slow
down the economy. It is the budgetary policy of the government relating to taxes public expenditure,
public borrowing and deficit financing. Fiscal policy is based upon demand management i.e, raising or
lowering the level of aggregate demand by controlling various expenditures, government expenditure,
consumption expenditure and investment expenditure. The main fiscal measures are:

o Changes in taxation
If the Govt: of a country brings about changes in tax rates, it can help stabilization of prices in
the country. For example. A decrease in taxes relates increases disposable income in relation to national
income hence, consumption rises at every level of national income. With the increase in aggregate
demand for goods, the employment goes up in the country. A rise in tax rates has the opposite effect. A
rise in taxes causes a decrease in disposable income, creates a larger budget deficit and brings relief from
inflation.

o Changes in Govt. Expenditure

If inflation is at or above the level of full employment in the country, the government can bring
down price level by curtailing its own unproductive expenditure.
 o Public borrowing
Public borrowing is another effective method of controlling inflation. Public borrowing reduces
the aggregate demand for goods and hence price level.

o Balanced budget Changes

A balanced budget decrease has a mild contractionary effect on national income and hence on
bringing down the price level.

o Control of deficit financing

For financing the budget deficit, the govt. often resorts to deficit financing . the bank borrowing
and printing of new notes increases the money supply in the country and pushes up the price level.
Deficit financing therefore, should be avoided to control inflation.

Others Measures:

Apart from fiscal and monetary measures, the other measures which are helpful in controlling
inflation are;

(a) Price support programme.

(b) Provision subsidies.
(c) Arrangements of easy availability of goods on hire purchase to stimulate demand.
(d) Imposing direct control on prices of essential items.
(e) Rationing of essential consumer goods in case of acute emergency holding of Friday and Sunday
markets.
Since 1950’s the control of inflation has become the chief objective of both developing and
developed countries of the world. The government therefore take monetary, fiscal and other measures
to combat inflation.

UNEMPLOYMENT
The population of an economy is divided into two categories, the economically active and the
economically inactive.

The economically active population (labour force) or working population refers to the population that
is willing and able to work, including those actively engaged in the production of goods and services
(employed) and those who are unemployed. Whereas, unemployed refers to people who are willing
and a capable of work but are unable to find suitable paid employment.

The next category, the economically inactive population refers to people who are neither working nor
looking for jobs. Examples include housewives, full time students, invalids, those below the legal age
for work, old and retired persons.

The unemployment rate is expressed as a percentage of the total number of persons available for
employment at any time. The rate of unemployment may be calculated:
 Unemployment rate = (Unemployed persons / Labour force) x 100

In this section the types and causes of unemployment would be considered and how its impact may be
linked to other economic variables.

Types of Unemployment
The main types of employment are structural, frictional, seasonal, cyclical, residual, technological and
disguised unemployment.

Structural Unemployment

Structural unemployment occurs when there is a change in the structure of an industry or the economic
activities of the country. As an economy develops over time the type of industries may well change.
This may be because people's tastes have changed or it may be because technology has moved on and
the product or service is no longer in demand. The main causes are as follows:

 Changes in demand - if there were to be a decrease in the demand for a produce (due to changes in
people’s taste or cheaper imports available) and if this change were more permanent, the supply of
such a product must be reduced. Fewer workers would then be required. Retrenched may not be
readily absorbed into other industries and thus become unemployed.
 Changes in supply - the faster the changes taking place in people's tastes and demand and supply,
the more structural unemployment there may be and an industry has to adapt more quickly to
change due to depletion of raw materials required.
 The regional structure of industry - if industries that are dying are heavily concentrated in one area,
then this may make it much more difficult for people to find new jobs. Both the shipbuilding and
mining industries were heavily concentrated and some areas have taken many years to adapt and
reduce the level of structural unemployment.

This type of unemployment is also known as the chronic unemployment or the Marxian or long-term
unemployment. It is mostly to be found in the underdeveloped countries of Asia and Africa. This type
of unemployment is due to the deficiency of capital resources in relation to their demand. The problem
in the underdeveloped countries is to get rid of this age-old chronic unemployment by accelerating the
process of economic growth.

In other words, structural unemployment results from a mismatch between the demand for labour and
the ability of the workers. IT does not affect the particular industry that can have adverse repercussion
on related industries as well.

Frictional Unemployment

This type of unemployment is caused by industrial friction, such as, immobility of labour, ignorance of
job opportunities, shortage of raw materials and breakdown of machinery, etc. Jobs may exist, yet the
workers may be unable to fill them either because they do not possess the necessary skill, or because
they are not aware of the existence of such jobs. They may remain unemployed on account of the
shortage of raw materials, or mechanical defects in the working of plants.
On average it will take an individual a reasonable period of time for him or her to search for the right
job. This creates unemployment while they look and this type of unemployment is normal and
temporary in nature. The more efficiently the job market is matching people to jobs, the lower this form
of unemployment will be. However, if there is imperfect information and people don't get to hear of
jobs available that may suit them, then frictional unemployment will be higher.

Therefore, the better the economy is doing, the lower this type of unemployment is likely to occur. This
is because people will usually be able to find a job that suits them more quickly when the economy is
doing well.

Seasonal Unemployment

This is due to seasonal variations in the activities of particular industries caused by climatic changes,
changes in fashions or by the inherent nature of such industries. The ice factories are closed down in
winter throwing the workers out of their jobs because there is no demand for ice during winter.
Likewise, the sugar industry is seasonal in the sense that the crushing of sugar-cane is done only in a
particular season. Such seasonal industries are bound to give rise to seasonal unemployment.

Cyclical Unemployment

This type of unemployment (also known as Keynesian unemployment or the demand deficient
unemployment) is due to the operation of the business cycle. This arises at a time when the aggregate
effective demand of the community becomes deficient in relation to the productive capacity of the
country. In other words, when the aggregate demand falls below the full employment level, it is not
sufficient to purchase the full employment level of output. Less production needs to be carried out
which ultimately leads to retrenchment of workers. Cyclical or Keynesian unemployment is
characterized by an economy wide shortage of jobs and last as long as the cyclical depression lasts.

Residual Unemployment

This type of unemployment is caused by personal factors such as old age, physical or mental disability,
poor work attitudes and inadequate training.

Technological Unemployment

This type of unemployment is caused by changes in the techniques of production. Technological

changes are taking place constantly, leading to the discovery of new production methods involving a
good deal of mechanization. This naturally results in the displacement of labour and finally,
unemployment.

Disguised Unemployment

This type of unemployment is to be found in the backward and the underdeveloped countries of Asia
and Africa. The term ‘disguised unemployment’ refers to the mass unemployment and
underemployment which prevail in the agricultural sector of an underdeveloped and overpopulated
country. For example, if there are four persons trying to cultivate an area of land that could be cultivated
as well by three persons, then only three of these persons are really fully employed and the remaining
fourth person represents disguised unemployment. The people in underdeveloped countries are
outwardly employed but actually they are unemployed, the reason being that agricultural production
would suffer no reduction if a certain number of them are actually withdrawn from agriculture.

This can also be seen when the growth of the labor force exceeds the amount of investment made. The
lack of investment is due to shortages in real factors such as shortage of skilled labor, managers, right
type of entrepreneurs, etc. As a result, there is over supply of labor available and these excess labor are
‘employed” (to be exact, underemployed) in jobs when there is already enough workers. Therefore, the
marginal productivity of such labor is low. This type of disguised unemployment is caused by the
chronic shortage of capital resources in relation to the rapidly growing population.

Effects of high rates of unemployment

High and persistent unemployment has presented a major challenge for the economy in two major
areas. One such area, it has eroded the funding base and secondly, it has increased the demands on
government through the use of welfare programs because of the consequences for poverty and
inequality resulting from high unemployment.

The following is an analysis of the effects that unemployment has on the economy. One such effect is
the social costs, these include increasing poverty, personal hardships, depression, decay of unused
skills, increase in crime (mostly among the young) as well as family disputes and broken marriages.
Unemployed individuals become more and more dissatisfied and resort to riots and demonstrations.

Secondly, the economic costs that are produced from unemployment. Due to unemployment, the
economy’s GNP will be less than the potential GNP, that is to say; what is possible of full employment.
This difference is known as the GNP gap. The gap is positive but can be slightly negative if the actual
GNP exceeds potential GNP and this can be possible only when the employed labour works overtime
or firms run their plants beyond their efficient level of capacity

Unemployment is an economic problem involving loss of output and income. To measure the economic
costs of unemployment, we can consider either:

1. Low output to the economy- which is measured by taking the average worker’s productivity,
then multiply it by the number of unemployed individuals
2. Loss of income to factors of production – which is measured by taking the average annual wage
and then multiply it by the number of individuals.
 PERFORMANCE TASKS

ACTIVITY 1:

1. Differentiate demand full inflation and cost push inflation.

2. Discuss the factors affecting inflations.
3. What are the main measures or remedies which are used to control inflation?
4. What is cyclical unemployment?
5. Explain the effects of high rates of unemployment.

ACTIVITY 2:

1. During this time of pandemic, the prices of basic goods and commodities rises. How can you
specifically control the effects of inflations?

ACTIVITY 3:

1. At present, millions of Filipinos are unemployed, this is primarily because of the pandemic
brought about by COVID19. As the Chief Executive being the president of the Philippines,
how can you control or lessen the unemployment rate of our country?
(Use at least 10 sentences and must be in paragraph form)
COURSE OUTCOME: Differentiate the monetary and fiscal policy of the
government.

Specific Learning Outcome:

1. Explain the importance of fiscal and monetary policy

2. Compare fiscal and monetary policy.
3. Contrast fiscal and monetary policy.

UNIT V-MONETARY AND FISCAL POLICY

Monetary Policy
What Is Monetary Policy?

Monetary policy, the demand side of economic policy, refers to the actions undertaken by a nation's
central bank to control money supply and achieve macroeconomic goals that promote sustainable
economic growth.

Monetary policy is a central bank's actions and communications that manage the money supply. The
money supply includes forms of credit, cash, checks, and money market mutual funds. The most
important of these forms of money is credit. Credit includes loans, bonds, and mortgages.

Monetary policy increases liquidity to create economic growth. It reduces liquidity to prevent
inflation. Central banks use interest rates, bank reserve requirements, and the number of government
bonds that banks must hold. All these tools affect how much banks can lend. The volume of loans
affects the money supply.

IMPORTANT NOTES:

Monetary policy refers to the actions undertaken by a nation's central bank to control money supply
and achieve sustainable economic growth.

Monetary policy can be broadly classified as either expansionary or contractionary.

Tools include open market operations, direct lending to banks, bank reserve requirements,
unconventional emergency lending programs, and managing market expectations—subject to the
central bank's credibility.
IMPORTANT POINTS

 The Federal Reserve uses monetary policy to manage economic growth, unemployment, and
inflation.
 It does this to influence production, prices, demand, and employment.
 Expansionary monetary policy increases the growth of the economy, while contractionary
policy slows economic growth.
 The three objectives of monetary policy are controlling inflation, managing employment levels,
and maintaining long term interest rates.
 The Fed implements monetary policy through open market operations, reserve requirements,
discount rates, the federal funds rate, and inflation targeting.

Understanding Monetary Policy

Monetary policy is the process of drafting, announcing, and implementing the plan of actions taken by
the central bank, currency board, or other competent monetary authority of a country that controls the
quantity of money in an economy and the channels by which new money is supplied. Monetary policy
consists of the management of money supply and interest rates, aimed at meeting macroeconomic
objectives such as controlling inflation, consumption, growth, and liquidity. This is achieved by
actions such as modifying the interest rate, buying or selling government bonds, regulating foreign
exchange (forex) rates, and changing the amount of money banks are required to maintain as reserves.

Economists, analysts, investors, and financial experts across the globe eagerly await monetary policy
reports and the outcome of meetings involving monetary policy decision-makers. Such developments
have a long-lasting impact on the overall economy, as well as on specific industry sectors or markets.

Monetary policy is formulated based on inputs gathered from a variety of sources. For instance, the
monetary authority may look at macroeconomic numbers such as gross domestic product (GDP) and
inflation, industry/sector-specific growth rates and associated figures, as well as geopolitical
developments in international markets—including oil embargos or trade tariffs. These entities may
also ponder concerns raised by groups representing industries and businesses, survey results from
organizations of repute, and inputs from the government and other credible sources.

Three Objectives of Monetary Policy

Central banks have three monetary policy objectives. The most important is to manage inflation. The
secondary objective is to reduce unemployment, but only after controlling inflation. The third
objective is to promote moderate long-term interest rates.

Monetary Policy Requirements

Monetary authorities are typically given policy mandates to achieve a stable rise in GDP, keep
unemployment low, and maintain foreign exchange (forex) and inflation rates in a predictable range.

Monetary policy can be used in combination with or as an alternative to fiscal policy, which uses
taxes, government borrowing, and spending to manage the economy.

The Federal Reserve Bank is in charge of monetary policy in the United States. The Federal Reserve
(Fed) has what is commonly referred to as a "dual mandate": to achieve maximum employment while
keeping inflation in check.
Simply put, it is the Fed's responsibility to balance economic growth and inflation. In addition, it aims
to keep long-term interest rates relatively low. Its core role is to be the lender of last resort, providing
banks with liquidity and regulatory scrutiny in order to prevent them from failing and panic
spreading in the financial services sector.

Types of Monetary Policies

Broadly speaking, monetary policies can be categorized as either:

Expansionary

If a country is facing a high unemployment rate during a slowdown or a recession, the monetary
authority can opt for an expansionary policy aimed at increasing economic growth and expanding
economic activity. As a part of expansionary monetary policy, the monetary authority often lowers the
interest rates through various measures, serving to promote spending and make money-saving
relatively unfavorable.

Increased money supply in the market aims to boost investment and consumer spending. Lower
interest rates mean that businesses and individuals can secure loans on convenient terms to expand
productive activities and spend more on big-ticket consumer goods. An example of this expansionary
approach is the low to zero interest rates maintained by many leading economies across the globe
since the 2008 financial crisis.

Contractionary

Increased money supply can lead to higher inflation, raising the cost of living and cost of doing
business. Contractionary monetary policy, increasing interest rates, and slowing the growth of the
money supply, aims to bring down inflation. This can slow economic growth and increase
unemployment, but is often necessary to cool down the economy and keep it in check.

In the early 1980s when inflation hit record highs and was hovering in the double-digit range of
around 15%, the Fed raised its benchmark interest rate to a record 20%. Though the high rates resulted
in a recession, it managed to bring back inflation to the desired range of 3% to 4% over the next few
years.

1. First is the buying and selling of short-term bonds on the open market using newly created
bank reserves. This is known as open market operations. Open market operations traditionally
target short-term interest rates such as the federal funds rate.
The central bank adds money into the banking system by buying assets—or removes it by
selling assets—and banks respond by loaning the money more easily at lower rates—or more
dearly, at higher rates—until the central bank's interest rate target is met. Open market
operations can also target specific increases in the money supply to get banks to loan funds
more easily by purchasing a specified quantity of assets, in a process known as quantitative
easing (QE) .
2. The second option used by monetary authorities is to change the interest rates and/or the
required collateral that the central bank demands for emergency direct loans to banks in its
role as lender-of-last-resort. In the U.S., this rate is known as the discount rate.
Charging higher rates and requiring more collateral, an example of contractionary monetary
policy, will mean that banks have to be more cautious with their own lending or risk failure.
 Conversely, lending to banks at lower rates and at looser collateral requirements will enable
banks to make riskier loans at lower rates and run with lower reserves
3. Authorities also use a third option: the reserve requirements, which refer to the funds that
banks must retain as a proportion of the deposits made by their customers in order to ensure
that they are able to meet their liabilities.
Lowering this reserve requirement releases more capital for the banks to offer loans or to buy
other assets. Increasing the reserve requirement, meanwhile, has a reverse effect, curtailing
bank lending and slowing growth of the money supply.
4. In addition to the standard expansionary and contractionary monetary
policies, unconventional monetary policy has also gained tremendous popularity in recent
times.
During periods of extreme economic turmoil, such as the financial crisis of 2008, the U.S. Fed
loaded its balance sheet with trillions of dollars in treasury notes and mortgage-backed
securities (MBS), introducing new lending and asset-purchase programs that combined aspects
of discount lending, open market operations, and QE. Monetary authorities of other leading
economies across the globe followed suit, with the Bank of England (BoE), the European
Central Bank (ECB), and the Bank of Japan (BoJ) pursuing similar policies.
5. Lastly, in addition to direct influence over the money supply and bank lending environment,
central banks have a powerful tool in their ability to shape market expectations by their public
announcements about the central bank's own future policies. Central bank statements and
policy announcements move markets, and investors who guess right about what the central
banks will do can profit handsomely.
Some central bankers choose to be deliberately opaque to market participants in the belief that
this will maximize the effectiveness of monetary policy shifts by making them unpredictable
and not "baked-in" to market prices in advance. Others choose the opposite course of action,
being more open and predictable in the hopes that they can shape and stabilize market
expectations and curb the volatile market swings sometimes triggered by unexpected policy
shifts.

Types of Monetary Policy

Central banks use contractionary monetary policy to reduce inflation. They reduce the money supply
by restricting the volume of money banks can lend. The banks charge a higher interest rate, making
loans more expensive. Fewer businesses and individuals borrow, slowing growth.

Central banks use expansionary monetary policy to lower unemployment and avoid recession. They
increase liquidity by giving banks more money to lend. Banks lower interest rates, making loans
cheaper. Businesses borrow more to buy equipment, hire employees, and expand their operations.
Individuals borrow more to buy more homes, cars, and appliances. That increases demand and spurs
economic growth.5

FISCAL POLICY

Fiscal policy is how Congress and other elected officials influence the economy using spending and
taxation. It is used in conjunction with the monetary policy implemented by central banks, and it
influences the economy using the money supply and interest rates.1

The objective of fiscal policy is to create healthy economic growth. Ideally, the economy should grow
between 2%–3% a year, unemployment will be at its natural rate of 3.5%–4.5%, and inflation will be at
its target rate of 2%.2 The business cycle will be in the expansion phase.
Expansionary Fiscal Policy

There are two types of fiscal policy. The most widely-used is expansionary, which stimulates
economic growth. Congress uses it to end the contraction phase of the business cycle when voters are
clamoring for relief from a recession. The government either spends more, cuts taxes, or both. The idea
is to put more money into consumers' hands, so they spend more. The increased demand forces
businesses to add jobs to increase supply.

Politicians debate about which works better. Advocates of supply-side economics prefer tax cuts
because they say it frees up businesses to hire more workers to pursue business ventures. Advocates
of demand-side economics say additional spending is more effective than tax cuts. Examples include
public works projects, unemployment benefits, and food stamps. The money goes into the pockets of
consumers, who go right out and buy the things businesses produce.

An expansionary fiscal policy is impossible for state and local governments because they are
mandated to keep a balanced budget. If they haven't created a surplus during the boom times, they
must cut spending to match lower tax revenue during a recession.5 That makes the contraction worse.
Fortunately, the federal government has no such constraints; it's free to use expansionary policy
whenever it's needed. Unfortunately, it also means Congress created budget deficits even during
economic booms—despite a national debt ceiling.67 As a result, the critical debt-to-gross domestic
product ratio has exceeded 100%.8

Contractionary Fiscal Policy

The second type of fiscal policy is contractionary fiscal policy, which is rarely used. Its goal is to slow
economic growth and stamp out inflation. The long-term impact of inflation can damage the standard
of living as much as a recession. The tools of contractionary fiscal policy are used in reverse. Taxes are
increased, and spending is cut. You can imagine how wildly unpopular this is among voters.1 Only
lame duck politicians could afford to implement contractionary policy.
Tools

The first tool is taxation. That includes income, capital gains from investments, property, and sales.
Taxes provide the income that funds the government. The downside of taxes is that whatever or
whoever is taxed has less income to spend on themselves, which is why taxes are unpopular.

The second tool is government spending—which includes subsidies, welfare programs, public works
projects, and government salaries. Whoever receives the funds has more money to spend, which
increases demand and economic growth.9

The federal government is losing its ability to use discretionary fiscal policy because each year more of
the budget must go to mandated programs. As the population ages, the costs of Medicare, Medicaid,
and Social Security are rising. Changing the mandatory budget requires an Act of Congress, and that
takes a long time.10 11 One exception was the American Recovery and Reinvestment Act. Congress
passed it quickly to stop the Great Recession.12

Fiscal Policy vs. Monetary Policy

Monetary policy is the process by which a nation changes the money supply. The country’s monetary
authority increases supply with expansionary monetary policy and decreases it with contractionary
monetary policy. It has many tools it can use, but it primarily relies on raising or lowering the fed
funds rate.1 This benchmark rates then guides all others.13

When interest rates are high, the money supply contracts, the economy cools down, and inflation is
prevented. When interest rates are low, the money supply expands, the economy heats up, and a
recession is usually avoided.

Monetary policy works faster than fiscal policy. The Fed votes to raise or lower rates at its regular
Federal Open Market Committee meeting but may take about six months for the impact of the rate cut
to percolate throughout the economy.14 Lawmakers should coordinate fiscal policy with monetary
policy, but they usually don't because their fiscal policy reflects the priorities of individual lawmakers.
They focus on the needs of their constituencies.

These local needs often overrule national economic priorities, and as a result, fiscal policy often runs
counter to what the economy needs. Central banks are forced to use monetary policy to offset poorly
planned fiscal policy.
 PERFORMANCE TASKS

ACTIVITY 1:

1. Explain the importance of fiscal and monetary policy?

2. Compare fiscal and monetary policy.
3. Define “Expansionary Fiscal Policy”
4. Monetary policy consists of the management of? (Please Enumerate)
5. Discuss the Fiscal policy of the government.

ACTIVITY 2:

2. During this time of pandemic, the prices of basic goods and commodities rises,
unemployment rates increases, and poverty rate goes up. What is the best policy should the
government focused on? Is it more on fiscal policy or monetary policy? Explain your answer
(Use at least 10 sentences and must be in paragraph form)

ACTIVITY 3:

2. At present, millions of Filipinos are unemployed because of the pandemic brought about by
COVID19. As the Chief Executive being the president of the Philippines, how can you solve
the problem of unemployment?
(Use at least 10 sentences and must be in paragraph form)

“No matter what life throws at you, never give up. Tomorrow is a new day with new possibilities”