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Notes SocioEconomic Development 4
Notes SocioEconomic Development 4
1. INTRODUCTION
Basic concepts and scope of macroeconomic analysis
Economic Theory
Is a statement that tries to explain economic phenomena, to interpret why and how the
economy behaves and what is the best to solution – how to influence or to solve the economic
phenomena. They are comprehensive system of assumptions, hypotheses, definitions and
instructions what should be done in a certain economic situation.
Economic Models
Economic model is a construct incorporating two or more variables that: describes the
relationship that exists between the variables; depicts the economic outcome of their
relationships; predicts the effects of changes in the variables on the economic outcome.
Macroeconomics
This is the branch of economics that attempts to analyze and explain the interrelationships
between aggregate (totals) variables such as output, employment, interest rates, money and
prices in the economy. These are the key variables that determine economic activities and
level of national income in an economy. Macroeconomics therefore analyses the performance
of the economy as a whole.
Macroeconomic Models
These are simplified explanations or theories of how the economy works, i.e. simplified
explanations of the real word.
For example
The behaviour of consumption spending in an economy can be represented by a simple model
as follows
This model is a simplification of the real world situation because some factors that are
important in influencing consumption behaviour are excluded. The other factors that affect
level of consumption in the economy include; wage rate, interest rate, price, capital gains,
money stock, attitudes, consumer credit and money illusion among others.
3. Economic growth
- Economic growth takes place when real output increases more rapidly than the
increase in population, thus with economic growth the society has more goods and
services at its disposal and a correspondingly higher standard of living.
4. External balance
- If a country has a fovourable balance of payment (BOP), its foreign exchange
reserves will increase, hence can import the much needed capital for investment.
Unfavourable BOP would lead to an outflow of foreign exchange to finance the
trade deficit
Importance of Macroeconomics
1. Facilitates estimation of GNP, which aids in the analysis of the economy’s performance;
2. Facilitates the study of the nature and size of material welfare of the society;
3. Knowledge of macroeconomics is important in economic policy formulation by
governments. For example we are able to understand how aggregate variables like GNP,
wage rate, consumption, savings, investment, interest rates etc, will be affected by a
change in government expenditure, tax policy, monetary policy, foreign exchange rates,
For simplicity, consider an economy with only two actors; households and firms. They
interact in a circular pattern as in the diagram below
Product
Market
Households Firms
Resource
Markets
The households
- Supply resources (land, labour, capital and entrepreneurial skills) to the resource
markets and receive earnings for those resources
- Demand goods and services from the product markets. make payments for those
goods and services using the incomes they receive
The firms
- Demand resources from the resource markets for production of goods and services
- supply goods and services to the product markets
Products and resources flow in a counterclockwise direction while payments for these items
flow in the opposite direction
The above case assumes an economy with no government and does not participate in foreign
trade. However, many countries trade with others and also have governments that actively
participate in the economic activities. Thus in such an economy there are 4 actors;
Households, firms, government and rest of the world
Other than there being only resource and product markets there are also money markets in the
economy. a more elaborate circular flow model would therefore include all these actors and
the markets in which they interact as follows.
Rest of
M The world
I
X
G
Money C+I+G+X-M
C Market
S
Households B Firms
GNP
Disposable Government Tax
Income es
Transfers
Leakages
These refer to any diversion of aggregate income from the domestic spending i.e. a
withdrawal from the circular flow. They include; Savings (S), Taxes (T), and Imports (M)
Injections
These refer to any payment of income other than by firms or any spending other than by
domestic households on an economy. These include; Investments, Government purchases
including transfers (G), Exports (X),
Three approaches to measurement of National income
(i) Expenditure Approach
Sum up all the market expenditures by final consumers including the purchases of
capital goods by the business community. we include expenditures on final goods and
services only.
AE = C + G + I + (X – M)
Aggregate income(Y) = w + r + i + π
Disposable Income
Referred to as the after tax personal; incomes to households. Thus it is computed as;
DI = PI – Personal income taxes. This is the total amount of income which is available for
use by households. This money can either be saved or incurred in the form of consumption
expenditure (DI = C + S)
Difficulties in measuring National income
1. Incomplete Information- some important information may not be available or may be
inaccessible
2. Danger of double counting- Costs of raw materials (intermediate goods) may be
included in national income accounting
3. Unpaid services- Services that people do for themselves and others that are not paid
for are usually excluded from national income accounting
4. Depreciation- Replacement costs for worn out parts may not be considered
5. Inventory valuation- there are many methods that can be used and each may give
different results.
6. Changes in the value of money- changes in the market prices (value) of final products
due to inflation may result into changes in the measure of national income even if real
output may not have changed.
Properties of Money
As a medium of exchange, money needs the following properties.
1. Durability: Money needs to be durable to withstand the frequent movement from one
hand to another as a medium of exchange.
2. Acceptability: Money must be acceptable by all those involved in transactions
otherwise it will collapse as a medium of exchange.
3. Divisibility: Money should be divisible to facilitate effective exchange since different
goods and services fetch various prices.
4. Portability: Money should not be cumbersome to carry
5. Liquidity: Money should be liquid i.e. it should be easy to carry out transactions using
it.
Financial Institutions
Are organizations legally bound to deal with finances. There are three categories of these
institutions namely: -
Commercial Banks
Central Bank
Non-bank financial institutions
A commercial bank is a financial institution, which accepts deposits and gives credit. It
performs three main functions:
To facilitate exchange
To provide facilities for savings to depositors
Distribute credit to business enterprise and consumers
Central bank is the financial institution at the center of the banking system. Its functions
include:
Issue of currency (notes and coins)
Supervision of banks and other financial institutions
It is the bankers’ bank (lender of last resort)
Government’s bank
Represents the country in international monetary meetings.
P2 b
a AD'
Pe
AD
Q
0 Q full
Case 2:
In a case where the economy is responsive to increase in aggregate demand, economy
is not at full employment level, and is responsive to policy changes.
At the point of wide spread unemployment, increase in aggregate demand would not only
create additional output but would cause inflation as well.
A trade off would exist, in other words, between changes in the level of output and
employment and changes in the level of prices.
In other words, the level of employment at Q2 is higher than Q1 . Associated with high
employment level is higher price level or some level of inflation.
(More about trade-off between unemployment and inflation will be covered later)
AS
d
P2
P1
c
AD'
AD
Q1 Q2
Use of fiscal and monetary tools to solve macroeconomic problems.
Use of fiscal policy tools.
Case 1: Depression Period.
At the onset of depreciation, the government attempts to affect aggregate demand
(increase) by a combination of tax cuts and increase government spending programs
that would increase national employment and output.
Case 2: Period of Inflation
Fiscal remedy during inflation period is to increase taxes or tax rates in combination
with reduction in government spending, hence reducing aggregate spending (demand)
and choking off both private and public demand.
Definitions
(i) Bank reserves: are “cash backing” of deposits (checking, saving and other types
of deposits) held by commercial banks and other financial institutions.
(ii) Discount rate: is the interest rate central bank charges financial institutions for
“discounting” promissory notes and treasury bills.
(iii) Open market operations: involves selling and buying of securities on the private
bond market. Such buying and selling changes the price and yields the bonds and
hence the holdings of bonds by financial systems and the public.
(iv) Legal reserve requirement: is the percentage of cash reserve financial
institutions are requires to hold against checking, savings and other types of
deposits.
Reasons for controlling monetary reserves.
By controlling monetary reserve, the central bank affects the money supply and\or
interest rates, which can change private consumption and investments expenditure
(aggregate demand) and thus employment, output and price.
Case 1: depression period
To increase aggregate demand, the central bank needs to increase money supply and
lower interest rate.
The central bank achieves this by
(i) Lowering discount rates hence enabling financial institutions to acquire more
reserves that enable them to explore lending and money supply creation.
(ii) Buying securities through open-market operations at higher prices, lowering
the yields of bonds. As a result financial system and the public hold less bonds.
Money stock increases and interest rates decline, boosting private consumption
and investment expenditure.
(iii) Aggregate demand may also be boosted by lowering the legal reserve
requirement applied to commercial banks.
The multiplier refers to the phenomenon whereby a change in an injection of expenditure (either investment,
government expenditure or exports) will lead to a proportionately larger change (or multiple change) in the level
of national income i.e. the eventual change in national income will be some multiple of the initial change in
spending.
We need to be aware that changes in any of the components of AD (e.g. investment) may have a larger effect on
GDP than just the value of the change. This is known as the multiplier effect. Let's look at what may happen if
there was an injection of extra money into government provided health care in an economy. Certainly, some of
the money will go to doctors and nurses in the form of a salary increase or to employ new doctors and nurses,
but new building and equipment will probably also be bought. This will boost sales of those making such items
and so allow them to consume more. This 'first round effect' is the big boost to spending within the economy.
However, doctors eat, drink and consume just like the rest of us and they too will spend some of their salary
increase. The producers of the goods and services they buy will take on more labour and these people will spend
part of their salary and so it goes on. The amount that is passed on will diminish in each successive round of
spending but the overall injection into the economy will be greater than the first sum that was put into it. The
size of the multiplier can be worked out by dividing the increase in national income that eventually occurs by
the increase in injections that caused it.
So, for example, if an increase in government spending of $10m caused GDP to rise by $50m, this would be a
multiplier of 5. This would be found by dividing $50m (the change in GDP) by $5m (the initial change in
injection of expenditure).
The size of the savings ratio - the more people save of any increase in income, the less the increase in
spending at each stage of the process.
The amount spent on imports - if a lot of the extra spending created goes on imported goods and
services, then this money will be lost out of the country and not passed on within the economy.
The level of taxation - any increase in income will also mean higher tax revenue. However, if the
government use this extra revenue to spend on public sector investment and employment, then this may
help the process continue.
Overall, the value of the multiplier therefore depends on the amount of any increase in income that is spent by
the people receiving it. This is known as the marginal propensity to consume (MPC). The higher the MPC,
the higher the value of the multiplier will be.
The marginal propensity to consume is the proportion of each extra Sh of income spent by households. For
example, if a person earns Sh1 more and consumes 70c of it, then the MPC is 0.7.
The value of the multiplier can be calculated from the following formula:
Where MPC is marginal propensity to consume and MPS is marginal propensity to save.
The multiplier concept may be used to show how the use of fiscal policy to combat unemployment can be very
effective. Expansionary fiscal policy may involve an increase in government expenditure. That will have the
effect of shifting the AD curve to the right. Part of the Keynesian argument concerning the effectiveness of such
a policy relates to the multiplier effect.
The argument is that the government's own expenditure provides only the first round of increased expenditure.
The recipients of increased government contracts or government salaries increase their consumption demand,
and the recipients of this increased purchasing power are in turn able to increase their demand for goods and
services and so on.
The result is that the final increase in AD will therefore be larger than the initial increase in government
expenditure that caused it.
Accelerator
We have already looked at how economies tend to grow in cycles - we called this the trade cycle or business
cycle. One of the major factors contributing to this cycle is the instability of investment. When the economy is
doing well, firms will invest to provide the extra capacity they need for increased production. However, when
growth starts to slip, firms will tend to stop investing - in fact investment may become negative. Why invest if
there is no need for extra capacity and you cannot even sell what you are currently making! The changes in
investment during the different phases of the trade cycle may therefore be several times that of the rise or fall in
income.
So we can see that investment depends not so much on the level of income and consumer demand, but on
their rate of change. Firms are investing to provide production capacity and so they will invest according to
how much demand is growing, not according to the actual level of demand. This link between investment and
the rate of change of demand is called the accelerator theory. Fluctuations in investment will be much greater
than those in income, but because investment is an injection into the circular flow of income they will have a
multiplied effect and this will magnify the ups and downs of the trade cycle.
The accelerator principle states that changes in the level of current income, leading to changes in output of
consumer goods, will lead to proportionately greater, or accelerated changes, in the output of capital goods, i.e.
investment.
The accelerator principle indicates how changes in the level of current income will have an accelerated impact
on the level of investment and is therefore one explanation of economic instability and the upward and
downward swings of the trade cycle.
The upward leverage effect of the accelerator only takes effect if industry is operating at or near full
employment. If industry has excess capacity it can meet a larger demand by increasing output of
underutilised equipment.
Additional machines will only be ordered when the increased demand is believed to be permanent.
Otherwise firms will deal with additional orders by running down stocks or operating waiting lists.
There may be an increase in demand for investment goods, but if the capital goods industries are fully
employed, there may be an increase in the prices of capital goods and there could actually be a fall in
demand for capital with more capital saving techniques being adopted. Here the accelerator will be
reduced.
The accelerator assumes a fixed relationship between a change in consumption and a change in investment - the
bullet points above show that this is not necessarily the case.
The accelerator principle also ignores the time lags which would probably occur in reality between a change in
consumption and the implementation of any investment decisions.
Business Cycle
A business cycle is a cycle of fluctuations in the Gross Domestic Product (GDP) around its
long-term natural growth rate. It explains the expansion and contraction in economic
activity that an economy experiences over time.
A business cycle is completed when it goes through a single boom and a single contraction in
sequence. The time period to complete this sequence is called the length of the business
cycle. A boom is characterized by a period of rapid economic growth whereas a period of
relatively stagnated economic growth is a recession. These are measured in terms of the
growth of the real GDP, which is inflation-adjusted.
Stages of the Business Cycle
In the diagram above, the straight line in the middle is the steady growth line. The business
cycle moves about the line. Below is a more detailed description of each stage in the
business cycle:
1. Expansion
The first stage in the business cycle is expansion. In this stage, there is an increase in positive
economic indicators such as employment, income, output, wages, profits, demand, and
supply of goods and services. Debtors are generally paying their debts on time, the velocity
of the money supply is high, and investment is high. This process continues as long as
economic conditions are favourable for expansion.
2. Peak
The economy then reaches a saturation point, or peak, which is the second stage of the
business cycle. The maximum limit of growth is attained. The economic indicators do not
grow further and are at their highest. Prices are at their peak. This stage marks the reversal
point in the trend of economic growth. Consumers tend to restructure their budgets at this
point.
3. Recession
The recession is the stage that follows the peak phase. The demand for goods and services
starts declining rapidly and steadily in this phase. Producers do not notice the decrease in
demand instantly and go on producing, which creates a situation of excess supply in the
market. Prices tend to fall. All positive economic indicators such as income, output, wages,
etc., consequently start to fall.
4. Depression
There is a commensurate rise in unemployment. The growth in the economy continues to
decline, and as this falls below the steady growth line, the stage is called a depression.
5. Trough
In the depression stage, the economy’s growth rate becomes negative. There is further decline
until the prices of factors, as well as the demand and supply of goods and services, contract
to reach their lowest point. The economy eventually reaches the trough. It is the negative
saturation point for an economy. There is extensive depletion of national income and
expenditure.
6. Recovery
After the trough, the economy moves to the stage of recovery. In this phase, there is a
turnaround in the economy, and it begins to recover from the negative growth rate. Demand
starts to pick up due to low prices and, consequently, supply begins to increase. The
population develops a positive attitude towards investment and employment and production
starts increasing.
Employment begins to rise and, due to accumulated cash balances with the bankers, lending
also shows positive signals. In this phase, depreciated capital is replaced, leading to new
investments in the production process. Recovery continues until the economy returns to
steady growth levels.
This completes one full business cycle of boom and contraction. The extreme points are the
peak and the trough.
Explanations by Economists
John Keynes explains the occurrence of business cycles is a result of fluctuations in aggregate
demand, which bring the economy to short-term equilibriums that are different from a full-
employment equilibrium.
Keynesian models do not necessarily indicate periodic business cycles but imply cyclical
responses to shocks via multipliers. The extent of these fluctuations depends on the levels of
investment, for that determines the level of aggregate output.
In contrast, economists like Finn E. Kydland and Edward C. Prescott, who are associated
with the Chicago School of Economics, challenge the Keynesian theories. They consider the
fluctuations in the growth of an economy not to be a result of monetary shocks, but a result of
technology shocks, such as innovation.