BCom HRM - Fundamentals of Macroeconmics 1B

Bachelor of Commerce
in Human Resource Management

(Year 1)
FUNDAMENTALS
OF MACROECONOMICS 1B
Module Guide
Copyright© 2021
MANCOSA
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Bachelor of Commerce
Human Resource Management (Year 1)
FUNDAMENTALS OF MACROECONOMICS 1B
Preface.................................................................................................................................................................... 1
Unit 1: Introduction to Macroeconomics .................................................................................................................. 8
Unit 2: Measuring the Performance of Economy................................................................................................... 25
Unit 3: The Monetary Sector ................................................................................................................................. 33
Unit 4: The Public Sector. ..................................................................................................................................... 46
Unit 5: Macroeconomic Theories .......................................................................................................................... 60
Unit 6: Inflation ...................................................................................................................................................... 76
Unit 7: Unemployment........................................................................................................................................... 87
Unit 8: Economic Growth and Development ......................................................................................................... 93
Unit 9: The Foreign Sector .................................................................................................................................. 106
References.......................................................................................................................................................... 114
MANCOSA – BBA YEAR 1 i

i
Fundamentals of Macroeconomics 1B
Preface
A. Welcome
Dear Student
It is a great pleasure to welcome you to Fundamentals of Macroeconomics 1B (FME6). To make sure that you
share our passion about this area of study, we encourage you to read this overview thoroughly. Refer to it as often
as you need to, since it will certainly make studying this module a lot easier. The intention of this module is to
develop both your confidence and proficiency in this module.
The field of Fundamentals of Macroeconomics is extremely dynamic and challenging. The learning content,
activities and self- study questions contained in this guide will therefore provide you with opportunities to explore
the latest developments in this field and help you to discover the field of Fundamentals of Macroeconomics as
it is practiced today.
This is a distance-learning module. Since you do not have a tutor standing next to you while you study, you need
to apply self-discipline. You will have the opportunity to collaborate with each other via social media tools. Your
study skills will include self-direction and responsibility. However, you will gain a lot from the experience! These
study skills will contribute to your life skills, which will help you to succeed in all areas of life.
We hope you enjoy the module.
MANCOSA does not own or purport to own, unless explicitly stated otherwise, any intellectual property
rights in or to multimedia used or provided in this module guide. Such multimedia is copyrighted by the
respective creators thereto and used by MANCOSA for educational purposes only. Should you wish to
use copyrighted material from this guide for purposes of your own that extend beyond fair dealing/use,
you must obtain permission from the copyright owner.
1 MANCOSA – Bachelor of Commerce in Human Resource Management (Year 1)

B. Module Overview
 The purpose of this module is to introduce learners to macroeconomics and macroeconomic policy enabling
them to contextualize the macroeconomic human resources management operates in.
 This module focuses on the five macroeconomic objectives of an economy building an appreciation of past
occurrences such as the global financial economic crisis of 2008 and other historical occurrences in the South
African context.
 The module explores the core macroeconomic objectives of low unemployment, economic growth, price
stability, balance of payments and equitable distribution of income.
 The module is a 15 credit module at NQF level 6
 Students must familiarize themselves with the content of each unit and thereafter assess their understanding
of the content of each unit by going through the possible short and essay type questions at the end of each
unit
C. Exit Level Outcomes and Associated Assessment Criteria of the Programme

Exit Level Outcomes (ELOs) Associated Assessment Criteria (AACs)
 Demonstrate the ability to make decisions and  Scope and context of organisational structure,
act appropriately through an understanding of systems and relevant policies human resource
organisational structure, systems and relevant management practice understood
policies in human resource management
practice
 Apply various methods and systems in the  Various methods and systems in the
development of human resource strategies development of human resource strategies and
and plans plans applied
 Evaluate, select and apply appropriate  Various appropriate methods, procedures or

methods, procedures or techniques when techniques of evaluated, selected and applied
effecting human resource management when effecting human resource management
functions functions
 Demonstrate an ability to develop and  Human resource management concepts, ideas

communicate ideas and opinions in well- and opinions presented in well - formed
formed arguments using appropriate academic arguments using appropriate discourse
and professional discourse when engaged in
human resources management contexts
MANCOSA –Bachelor of Commerce in Human Resource Management (Year 1) 2

 Demonstrate the ability to manage processes  Processes and accountability is demonstrated to

and take accountability in a variety of contexts manage processes in various contexts relating
relating to the management of human to the management of human resources
resources
 Demonstrate the ability to take decisions and  Ethical and professional conduct regarding
act ethically and professionally; and decision – making demonstrated
 Contribute to improving organisational culture  Organisational culture and climate strategies of

and climate organisations are analysed and evaluated to
contribute to continuous organisational
development
D. Learning Outcomes and Associated Assessment Criteria of the Module
LEARNING OUTCOMES OF THE MODULE ASSOCIATED ASSESSMENT CRITERIA OF THE

MODULE
 Discuss the concepts and measurement of  Concepts and measurement of gross domestic
gross domestic product, unemployment, and product, unemployment, and inflation are
inflation discussed to understand its impact on the
economy
 Compare the defining features of business  Defining features of business cycles and economic
cycles and economic growth and the factors growth and the factors that contribute to each are
that contribute to each compared to understand its impact on the
economy
 Describe the concept of macroeconomic  Concept of macroeconomic equilibrium is

equilibrium described to understand its influence on the state
of economy
 Discuss the concepts, tools, and  Concepts, tools, and implementation of fiscal
implementation of fiscal policy, its limitations policy, its limitations and relative advantages and
and relative advantages and disadvantages, disadvantages are discussed to understand how it
and how it affects aggregate economic activity affects aggregate economic activity
 Outline the concepts, tools, and  Concepts, tools, and implementation of monetary
implementation of monetary policy, its policy, its limitations and relative advantages and
limitations and relative advantages and disadvantages are outline to provide an

disadvantages, and how it affects aggregate understanding on how it affects aggregate

economic activity economic activity
 Identify the essential differences that separate  Essential differences that separate and distinguish
and distinguish the Classical and Keynesian the Classical and Keynesian Schools are
Schools in macroeconomics investigated to understand the differing views
impact the economic markets
 Explain the concepts of comparative  Concepts of comparative advantage, balance of

advantage, balance of payments and its payments and its components are explained to
components, and the determinants of understand its impact on the currency exchange
exchange rate
E. Learning Outcomes of the Units

You will find the Unit Learning Outcomes on the introductory pages of each Unit in the Module Guide. The Unit
Learning Outcomes lists an overview of the areas you must demonstrate knowledge in and the practical skills you
must be able to achieve at the end of each Unit lesson in the Module Guide.
F. Programme Notional Learning Hours

This Notional Learning Hours Table is for the Bachelor of Commerce in Human Resource Management programme
which is 360 credits. The South African Quality Authority (SAQA) equates one credit with ten notional hours of
learning. Notional learning hours are defined in terms of the amount of time it takes for the average student to
achieve the learning outcomes.
Learning time
Types of learning activities
%
Lectures/Workshops (face to face, limited or technologically mediated) 10
Tutorials: individual groups of 30 or less 0
Syndicate groups 0
Practical workplace experience (experiential learning/work-based learning etc.) 0
Independent self-study of standard texts and references (study guides, books, journal articles) 60
Independent self-study of specially prepared materials (case studies, multi-media, etc.) 20
Other: Online 10
TOTAL 100

G. How to Use this Module

This Module Guide was compiled to help you work through your units and textbook for this module, by breaking
your studies into manageable parts. The Module Guide gives you extra theory and explanations where necessary,
and so enables you to get the most from your module.
The purpose of the Module Guide is to allow you the opportunity to integrate the theoretical concepts from the
prescribed textbook and recommended readings. We suggest that you briefly skim read through the entire guide
to get an overview of its contents. At the beginning of each Unit, you will find a list of Learning Outcomes and
Associated Assessment Criteria. This outlines the main points that you should understand when you have
completed the Unit/s. Do not attempt to read and study everything at once. Each study session should be 90
minutes without a break
This module should be studied using the prescribed and recommended textbooks/readings and the relevant
sections of this Module Guide. You must read about the topic that you intend to study in the appropriate section
before you start reading the textbook in detail. Ensure that you make your own notes as you work through both the
textbook and this module. In the event that you do not have the prescribed and recommended textbooks/readings,
you must make use of any other source that deals with the sections in this module. If you want to do further reading,
and want to obtain publications that were used as source documents when we wrote this guide, you should look
at the reference list and the bibliography at the end of the Module Guide. In addition, at the end of each Unit there
may be link to the PowerPoint presentation and other useful reading.
H. Study Material
The study material for this module includes tutorial letters, programme handbook, this Module Guide, a list of
prescribed and recommended textbooks/readings which may be supplemented by additional readings.
I. Prescribed and Recommended Textbook/Readings

There is at least one prescribed and recommended textbooks/readings allocated for the module.
The prescribed and recommended readings/textbooks presents a tremendous amount of material in a simple,
easy-to-learn format. You should read ahead during your course. Make a point of it to re-read the learning content
in your module textbook. This will increase your retention of important concepts and skills. You may wish to read
more widely than just the Module Guide and the prescribed and recommended textbooks/readings, the
Bibliography and Reference list provides you with additional reading.
The prescribed and recommended textbooks/readings for this module is:

 Mohr, P. & Fourie, L. (2015). Economics for South African Students. (5th edition) Pretoria: Van Schaik

J. Special Features
In the Module Guide, you will find the following icons together with a description. These are designed to help you
study. It is imperative that you work through them as they also provide guidelines for examination purposes.
Special Feature Icon Explanation
The Learning Outcomes indicate aspects of the particular Unit you have
LEARNING to master.
OUTCOMES
The Associated Assessment Criteria is the evaluation of the students’

ASSOCIATED
understanding which are aligned to the outcomes. The Associated
ASSESSMENT
Assessment Criteria sets the standard for the successful demonstration
CRITERIA
of the understanding of a concept or skill.
A Think Point asks you to stop and think about an issue. Sometimes you
THINK POINT are asked to apply a concept to your own experience or to think of an
example.
You may come across Activities that ask you to carry out specific tasks.
In most cases, there are no right or wrong answers to these activities.
ACTIVITY
The purpose of the activities is to give you an opportunity to apply what
you have learned.
At this point, you should read the references supplied. If you are unable
READINGS to acquire the suggested readings, then you are welcome to consult any
current source that deals with the subject.
PRACTICAL Practical Application or Examples will be discussed to enhance
APPLICATION understanding of this module.
OR EXAMPLES
KNOWLEDGE You may come across Knowledge Check Questions at the end of each
CHECK Unit in the form of Knowledge Check Questions (KCQ’s) that will test
QUESTIONS your knowledge. You should refer to the Module Guide or your
textbook(s) for the answers.
You may come across Revision Questions that test your understanding
REVISION
of what you have learned so far. These may be attempted with the aid
QUESTIONS
of your textbooks, journal articles and Module Guide.

Case Studies are included in different sections in this Module Guide.
CASE STUDY This activity provides students with the opportunity to apply theory to
practice.
You may come across links to Videos Activities as well as instructions
VIDEO ACTIVITY on activities to attend to after watching the video.

Unit
1: Introduction to
Macroeconomics

Unit Learning Outcomes
CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:
1.1 Introduction  Introduce topic areas for the unit
1.2 Macroeconomics versus Microeconomics  Distinguish between macroeconomics and

microeconomics
1.3 An Overview of macroeconomic policies  Provide a brief overview of the five major
components of macroeconomic policy
 Describe what is meant by full employment and price

stability
 Define economic growth
 Describe what is meant by balance of payments and

the redistribution of income
1.4 The Circular Flow of Income  Identify the major role players in the macro economy
and describe the flow of income using the circular
flow model
1.5 Summary  Summarise topic areas covered in unit
Prescribed Textbook:
 Mohr, P. & Fourie, L. (2015). Economics for South African Students. (5th
edition) Pretoria: Van Schaik

1.1. Introduction
The aim of any economic activity is the production of goods and services for the satisfaction of (unlimited)
human wants. In order to satisfy these wants, firms produce the goods and services that households consume
– this takes place within a broader framework that policy-makers such as government, agencies such as the
South African Reserve Bank, create in conjunction with organised commerce, organised labour and civil society
organisations. The result is a legal framework and a set of economic policies that are also in line with our
Constitution.
This study unit firstly highlights the distinction between macroeconomics and microeconomics. While this
distinction is important for the ease of study, it is imperative that the student not consider the two as mutually
exclusive disciplines. Secondly, we briefly explore the five major components of macroeconomic policy and
mention some of the dilemmas encountered in policy formulation.
Finally, markets and the flow of income, expenditure, goods and factors of production in an economy are
discussed, using a simple circular flow model.
1.2. Macroeconomics versus Microeconomics

Macroeconomics is concerned with the economy as a whole. It focuses on aspects such as the stability of
the general price level (commonly known as inflation), the maintenance of full employment, economic growth,
the distribution of income, government spending, and the nation’s money supply.
Microeconomics, on the other hand, focuses on the individual participants in the economy: producers (firms),
and households (workers, entrepreneurs and consumers). Microeconomic policies focus on specific markets
and how prices are established.
Understanding the basics of microeconomics is a necessary prerequisite to understanding the functioning of

the macroeconomy. Macroeconomic relationships cannot be analysed without understanding the behaviour of
the individuals and businesses which make up the economy.
Conversely, sound economic decisions and policy formulation that impacts the microeconomic level can only
be made by giving due consideration to the macro economy.
Activity
Classify the following as microeconomics or macroeconomics concepts:
1.1.1 The consumer price index

1.1.2 Inflation
1.1.3 The production of cars
1.1.4 A firms decision to import from abroad The demand for a product

1.3. An Overview of Macroeconomic Policies

Macroeconomics is policy oriented. It asks questions such as the following:
 To what degree can government policies affect output and employment?
 To what degree is inflation the result of unfortunate government policies?
 What government policies are optimal in the sense of achieving the most desirable behaviour of aggregate
variables, such as the level of unemployment or the inflation rate?
 Should government policy attempt to achieve a target level for foreign exchange rates?
For example, to what degree were government policies to blame for the massive unemployment during the
world depression of the 1930s or for the simultaneous high unemployment and inflation of the 1970s and the
economic meltdown caused by the financial crises of 2008?
An overview of five major variables that are considered in formulating macroeconomic policy will now be
discussed alongside how they are measured.
1.3.1. Full Employment

At a certain level of output in an economy, it can be said that all factors of production are being fully utilised
(Pape, 2000). In such a situation, all workers would be employed, all machinery would be in use and all usable
land would be involved in production. This is called full employment – all factors of production are in full use.
The importance of full employment lies in the fact that unemployment causes social and political instability.
Governments in power are often discredited and blamed for high levels of unemployment.
Any form of unemployment should be seen as a loss in potential production, since the country could have
earned more if those who were unemployed were economically active. Clearly, a drop in the standard of living
occurs as production is lost.
Calculation:
In principle it is quite easy to measure employment and unemployment. To measure employment you simply
have to find out how many people have jobs at the time the measurement is done. To measure the number of
unemployed persons you simply have to ascertain how many people are willing and able to work but do not
have jobs at that time. The number of unemployed persons can then be expressed as a percentage of the total
number of people who are willing and able to work. This percentage is called the unemployment rate (Mohr, P
& Fourie, L, 2015, p. 244).
In practice, however, total employment and unemployment in the economy are quite difficult to measure. When
exactly is a person employed? What about part-time or seasonal workers? Are housewives employed or

unemployed? When is a person unemployed? What about someone who does not have a job but is also not
actively seeking work? What about people who are making a living by selling things on the pavement or from
illegal activities like prostitution and dealing in drugs? These are but some of the problems that government
agencies or private researchers are faced with when trying to estimate total employment and unemployment in
the economy (Mohr, P & Fourie, L, 2015, p. 244).
On account of all these problems, there are two definitions of unemployment: a strict definition and an expanded
definition. To qualify as unemployed according to the strict definition, a person has to have taken steps recently
to find work, but according to the expanded definition the mere desire to find employment is sufficient (Mohr, P
& Fourie, L, 2015, p. 244).
Activity 1.2
In a country with a population of 50 million people, there are 20 million children under
the age of 15 years, 16 million employed, 9 million pensioners, 4 million unemployed and
1 million people who are physically unable to work. Calculate the unemployment rate
1.3.2. Price Stability

Price stability does not mean that all prices should always stay constant. It is common knowledge that the price
of goods and services generally increase from one year to the next. The process of increases in the money
supply and the rises in the general level of prices is called inflation. When economists talk of price stability
they mean keeping inflation as low as possible. An inflation rate of 1% to a maximum of 2% is regarded in most
Western economies as a “healthy” inflation rate.
Rising prices per se are not a problem, but the accompanying effects are undesirable. Among these effects are
the negative impact on savings, the skewed distribution of income, the country’s balance of payments and
social as well as political effects.
CALCULATION:
Economists want to know what is happening to the purchasing power of the consumer’s rand. But to estimate
changes in purchasing power, they have to know what is happening to prices in general. Instead of investigating
what is happening to individual prices, we therefore use one of the general or composite price indices compiled
and published by Stats SA. The best known of these is the consumer price index (CPI) (Mohr, P & Fourie, L,
2015, p. 246).

The consumer price index (CPI)

The consumer price index (CPI) is an index of the prices of a representative “basket” of consumer goods and
services. The CPI thus represents the cost of the “shopping basket” of goods and services of a typical or
average South African household. In constructing the CPI, Stats SA
• selects the goods and services to be included in the basket
• assigns a weight to each good or service to indicate its relative importance in the basket
• decides on a base period for calculating the CPI
• decides on a formula for calculating the CPI
• collects prices each month to calculate the value of the CPI for that month (Mohr, P & Fourie, L, 2015, p.
246)
To select the goods and services to be included in the basket and to determine their relative weights, Stats SA
conducts a comprehensive, in-depth survey of household income and expenditure\
in South Africa. The weight allocated to each good or service is based on the relative importance of the item in
the average consumer’s budget or “shopping basket”. This requires a lot of time and effort and is therefore only
done every few years (Mohr, P & Fourie, L, 2015, p. 246).
The base period is then selected. Once the items in the basket and their relative weights have been determined,
this information is inserted into a standard price index formula (see box 1-1). All that is then required to calculate
the CPI are the prices of the goods and services concerned (Mohr, P & Fourie, L, 2015, p. 246).
BOX 1-1 CONSTRUCTING A PRICE INDEX: A SIMPLE EXAMPLE

Suppose that only two goods, meat and bread, are consumed. Suppose further that it has been established
that the typical or average consumer purchases 4 kg of meat and 10 loaves of bread per week, in other words,
the typical consumer basket consists of 4 kg of meat and 10 loaves of bread. In 2012 meat cost R35 per
kilogram and bread cost R10 per loaf. In 2013 meat cost R45 per kilogram and bread R12 per loaf. By how
much did the cost of the basket (i.e. the weekly cost of living) increase between 2012 and 2013?
We first calculate the cost of the basket in 2012. The total cost of the basket in 2012 is
(4 × R35) + (10 × R10) = R140 + R100 = R240.
The total cost of the same basket in 2013 is (4 × R45) + (10 × R12) = R180 + R120 = R300. If we were to set
the cost of the basket in 2012 (or the consumer price index) equal to 100, then the relative cost in 2013 would
be
300
× 100 = 125.0
240
Mohr, P & Fourie, L, 2015, p. 247

Activity 1.3
Year Consumer Price Index

2016 100,0
2017 112,1
2018 120,8
From the above, calculate the inflation rate in 2018.
1.3.3. Economic Growth

In a growing economy, the total production of goods and services will increase from one period to the next (as
measured by the Gross Domestic Product or GDP). If the population is growing and there is no economic
growth, average living standards cannot increase, and it will not be possible to create enough jobs for the
growing population.
Since economic growth and employment go hand in hand, these two policy objectives should be seen as one.
The government has to make provision for employment-generating policies and create a climate for investment
that will promote growth. Economic policies – such as the monetary and fiscal policies – can affect output
quickly (Samuelson & Nordhaus, 2002), but the impact of these policies on potential output trends operates
slowly over a number of years.
CALCULATION:
The first step in measuring economic growth is to determine a country’s total production of goods and services
in a specific period. In other words, the production of all the different goods and services must be combined
into one measure of total production or output. This complicated task is performed in South Africa by the national
accounting sections of Statistics South Africa (Stats SA) and the South African Reserve Bank (SARB) (Mohr,
P & Fourie, L, 2015, p. 235).
The central concept in the national accounts is the gross domestic product (GDP). The gross domestic product
is the total value of all final goods and services produced within the boundaries of a country in a
particular period (usually one year) (Mohr, P & Fourie, L, 2015, p. 235).
The first important element is value. How is it possible to add together various goods and services such as
apples, pears, skirts, shoes, medical services, education and computers to arrive at one meaningful figure of
the total production of goods and services? The solution is to use the prices of the various goods and services
to obtain the value of production. Once the production of each good or service is expressed in rand and cents,
the total value of production can be determined by adding the different values together (Mohr, P & Fourie, L,
2015, p. 235).

The second important element is the word final. One of the major problems that national accountants have to
deal with is the problem of double counting. If they are not careful they can easily overestimate or inflate the
value of GDP by counting certain items more than once (Mohr, P & Fourie, L, 2015, p. 235).
To avoid the problem of double counting, the national accountants use a concept which became familiar to
most South Africans with the introduction of value-added tax (VAT) on 30 September 1991. Starting with the
full value of the initial product produced they subsequently add only the value added by each of the other
participants in the production process (Mohr, P & Fourie, L, 2015, p. 235).
One way of avoiding double counting is therefore to count, in each transaction, only the value added (i.e. the
addition to the value of the output). Double counting can also be avoided by only counting the value of those
sales where a good or service reaches its final destination. Such sales involve final goods and services which
have to be distinguished from intermediate goods and services. Any good or service that is purchased for
reselling or processing is regarded as an intermediate good or service. Intermediate goods and services do not
form part of GDP. Note, however, that it is the ultimate use of a product which determines whether it is a final
or an intermediate product. There is another way in which double counting can be avoided. That is by
considering only the incomes earned during the various stages of the production process by the owners of the
factors of production (Mohr, P & Fourie, L, 2015, p. 235).
These methods are discussed in greater detail in study unit 2.
Think Point 1.1
Should the production of steel, an input into the production of vehicles in South
Africa be included in the calculation of GDP?
1.3.4. External Stability or Balance of Payments

Countries do not live in isolation. They trade with foreign countries in order to increase their wealth. South
Africa’s growth rate is also dependant on the foreign sector. For example, if the American economy experiences
a boom, it will demand more South African goods which will consequently lead to an increase in local output,
resulting in economic growth in South Africa.
South Africa also imports technology in the form of machinery, equipment and other goods from abroad as well
as a range of consumer goods. To pay for these imports the country has to earn the necessary foreign currency
(dollars, pounds, euros, etc.) by exporting goods and services that it has a comparative advantage in.
In the short term all foreign transactions are accounted for by the transacting parties, but some balance between
exports and imports is required in the longer term otherwise the terms of trade will become unfavourable. From
a policy point of view, the balance of payments and exchange rates should be maintained at a fairly stable level.

If exports exceed imports:

 The exchange rate would initially favour the exporting country;
 As the local currency becomes stronger, foreign countries will refrain from buying goods/services;
because the
 Goods will become too expensive in the countries exported to, resulting in a drop in foreign demand.
Local output will decrease, resulting in growing unemployment but general price levels would
however fall which could lead to a growth in the economy.
If imports exceed exports

 The exchange rate will initially favour foreigners that export to a local country;
 Demand for local goods will decrease; but as the local currency becomes weaker; the
 The price of imported goods will become more expensive, but employment will pick up
because of the increase in demand for the relatively cheaper local goods.
We now have the ongoing dilemma of having to choose between price levels and employment levels! Thus the
aim of government (policy-makers) should be to maintain exchange rate stability and balance of payments and
equilibrium in the long term.
CALCULATION:
Each country keeps a record of its transactions with the rest of the world. This accounting record is called the
balance of payments. The South African balance of payments summarises the transactions between South
African households, firms and government and foreign households, firms and governments during a particular
period (usually a year). The balance of payments consists primarily of two major accounts, the current account
and the financial account (Mohr, P & Fourie, L, 2015, p. 249).
Just as each business keeps a record of its purchases and sales of goods and services, so does a country. All
the sales of goods and services to the rest of the world (i.e. exports), all the purchases of goods and services
from the rest of the world (i.e. imports) as well as all the primary income receipts and payments are recorded
in the current account of the balance of payments (Mohr, P & Fourie, L, 2015, p. 250).
Just as everyone with a bank account has an accounting statement showing all the funds going into the account
and all the funds going out of the account, so does a country. All the purely financial flows in and out of the
country, like purchases and sales of assets such as bonds and shares, are recorded in the financial account
of the balance of payments (Mohr, P & Fourie, L, 2015, p. 250).
If there is a surplus on the current account, it indicates that the value of the country’s exports exceeded the
value of its imports during the period under review. If there is a deficit, then imports were greater than exports
(Mohr, P & Fourie, L, 2015, p. 250)..

Likewise, if there is a surplus on the financial account, it indicates that more funds flowed into the country
than flowed out during the period concerned. In this case we say that there was a net inflow of foreign capital
into the country. If there is a deficit, it indicates that the outflows exceeded the inflows. We then say that there
was a net outflow of foreign capital (Mohr, P & Fourie, L, 2015, p. 250).
Think Point 1.2
Is it good for a country to have exports exceeding imports?
1.3.5 Equitable or Redistribution of Wealth (Income)

This would entail a policy where the wealthier people of a country have to contribute more (mainly through taxes)
towards the underprivileged without harming the incentive to work.
While most people agree with the other four policies outlined above, not everyone will agree with the
redistribution policy. Some, for example, regard an unequal distribution of income as a means of stimulating
saving and investment which will benefit the poor. On the other hand, a highly unequal distribution of income
tends to generate social and political conflict. It can also have important effects on the structure and
development of the economy.
CALCULATION:
In this section we explain three of the measures that are often used to measure the equality or inequality of the
distribution of income, once the necessary basic information has been obtained.
 Lorenz curve:
The Lorenz curve is a simple graphic device which illustrates the degree of inequality in the distribution of
income. To construct the Lorenz curve illustrating the distribution of income, the different individuals or
households in the economy first have to be ranked from poorest to richest. This is done on a cumulative
percentage basis. In other words, we start with the poorest per cent of the population, the second poorest per
cent and so on until we come to the richest per cent of the population. The cumulative percentages of the
population are plotted along the horizontal axis. The vertical axis shows the cumulative percentage of total
income. In other words, if the poorest per cent of the population earns 0, 1 per cent of the total income in the
economy, that number will be plotted vertically above the first per cent of the population. If the second poorest
per cent of the population earns 0,2 per cent of the total income in the economy, it means that the first two per
cent earned a cumulative share of 0,3 per cent (i.e. 0,1 plus 0,2 per cent) of the income. This number (0, 3) will
then be plotted vertically above the 2 on the horizontal axis (Mohr, P & Fourie, L, 2015, p. 252).

The construction of the Lorenz curve can be explained with the aid of a simple example. Table 1-1 shows a
hypothetical distribution of income. To keep things simple, we show only the income of each successive 20 per
cent of the population.
The first two columns in Table 1-1 contain the basic data. The last two columns are simply the cumulative totals.
For example, these two columns show that the first 60 per cent of the population (the poorest 60 per cent) earn
25 per cent of the total income (Mohr, P & Fourie, L, 2015, p. 253).
The last two columns are then plotted as in Figure 1-1. Point a
shows that the poorest 20 per cent of the population earns 3
per cent of the income, point c shows that the poorest 60 per
cent of the population earns 25 per cent of the income, and so
on (Mohr, P & Fourie, L, 2015, p. 253).
Note two other features of the diagram. The first is that the axes have been joined to form a square. The second
feature is the diagonal running from the origin 0 (bottom left) to the opposite point B (top right) of the rectangle.
The diagonal serves as a reference point. It indicates a perfectly equal distribution of income. Along the diagonal
the first 20 per cent of the population receives 20 per cent of the total income, the first 40 per cent receives 40
per cent, and so on. Like the diagonal, any Lorenz curve must start at the origin 0 (since 0 per cent of the
population will earn 0 per cent of the income) and end at B (since 100 per cent of the population will earn 100
per cent of the income) (Mohr, P & Fourie, L, 2015, p. 253).
Activity 1.4
Population Cumulative Percentage

Population Income
Poorest 20% 20 5
Next 20% 40 10
Next 20% 60 25
Next 20% 80 60
Richest 20% 100 100
In this country, the richest 40% of the population earn ________ of the total
income; whilst the poorest 40% of the population earn ________ of the total
income.

The degree of inequality is shown by the deviation from

the diagonal. The greater the distance between the
diagonal and the Lorenz curve, the greater the degree of
inequality. In Figure 1-1 the area between the diagonal
and the Lorenz curve has been shaded. This shaded
area is called the area of inequality. The greatest
possible inequality will be where one person earns the
total income. If that is the case, the Lorenz curve will run
along the axes from 0 to A to B (Mohr, P & Fourie, L,
2015, p. 253).
 Gini coefficient
Another measure of inequality is the Gini coefficient (or
Gini ratio). This is obtained by dividing the area of
inequality shown by a Lorenz curve by the area of the
right-triangle formed by the axes and the diagonal (the
line of equality). In Figure 1-1 the latter area is shown by
the triangle formed by points 0, A and B. The Gini coefficient can vary between 0 and 1. The Gini coefficient is
sometimes also multiplied by 100 to obtain the Gini index, which varies between 0 and 100 (Mohr, P & Fourie,
L, 2015, p. 253).
If incomes are distributed perfectly equally, the Gini coefficient is zero. In this case the Lorenz curve coincides
with the line of perfect equality (the diagonal) and the area of inequality is therefore zero. At the other extreme,
if the total income goes to one individual or household (i.e. if the incomes are distributed with perfect inequality)
the Gini coefficient is one. In this case the area of inequality will be the same as the triangle 0AB. In practice
the Gini coefficient usually ranges between about 0,30 (highly equal) and about 0,70 (highly unequal) (Mohr, P
& Fourie, L, 2015, p. 254).
 Quantile ratio
A third possible way of expressing the equality or inequality of the distribution of income is to use a quantile
ratio. A quantile ratio is the ratio between the percentage of income received by the highest x per cent of the
population and the percentage of income received by the lowest y per cent of the population. For example, we
can compare the income received by the top 20 per cent with that earned by the bottom 20 per cent of the
population. Using the figures in Table 1-1, the answer will be 50 ÷ 3 = 16, 7. The higher the ratio, the greater
the degree of inequality. The ratio between the top 20 per cent and the lowest 40 per cent (50 ÷ 10 = 5 in our
example) is also often used to compare income distributions between countries (Mohr, P & Fourie, L, 2015, p.
254).

Macroeconomic policies do not stand in isolation. Sometimes, the different policies could be in conflict with
each other, making the choice of an appropriate policy extremely difficult. For example, a government may have
an economic policy geared towards economic growth – this may lead them towards reducing taxes. This in turn
may reduce their short term income which could negatively affect their ability to spend on social grants.
To summarise, the goals of macroeconomic policy are:
 A high and growing level of national output;
 High employment with low unemployment; and
 A stable or gently rising price level.
1.4. The Circular Flow of Income

The circular flow of income shows the flow of inputs, outputs and payments between households and firms
within an economy. This model captures the essence of macroeconomic activity. The economy is seen as
nothing more than:
 A flow of goods from Producers to Consumers through the goods market;
 Production resources from Households to Firms through the factor market; and
 Financial payments flowing in the opposite direction through the above markets.
Figure 1Fig 1.2 The three major flows are:
Source: (Mohr & Fourie, 2015 p. 41):

The circular flow model illustrates the mechanism by which income is generated from the production of goods
and services and how this income is spent on the factors of production which in turn forms the income to
households arising from the ownership of these factors. This is best understood by analysing the Figure 1.3
Firstly, let us consider households who are buyers, and firms who are producers and sellers of goods and
services in the goods and services market: Firms are buyers of factors of production and households become
sellers of factors of production in the factor market. The money flow is denoted by the inner anti-clockwise
arrows. So, the income flow or flow of rands for the use of factors of production to the households is denoted
by the inner line (bottom left anti-clockwise direction of the arrow), whereas the inner line (top right anti-
clockwise direction of the arrow) represents the flow of income to firms from the sale of goods and services in
the economy. The spending by firms on factors of production is denoted by the inner line (top left anti-clockwise
direction of the arrow), whereas the inner line (bottom right anti-clockwise direction of the arrow) represents the
flow of spending on goods and services in the economy. It is important to note that these flows are equivalent.
Figure 2Fig 1.3 A Simple Circular Flow Model of Income and Spending
Source: (Mohr & Fourie, 2015 p. 51)
The next participant that we introduce into the model is the government. The government is responsible for
providing public goods and services, such as roads, bridges, etc. for usage by households and firms. In order
for government to provide these public goods and services, it receives tax revenue from households and firms.
Hence, again we have flow of income in the form of tax paid by firms and consumers and tax received by the
government. In addition, government provides subsidies to firms and households - flow of income.

Next, we introduce the financial sector in figure 1-4, which mainly comprises of financial institutions, where
consumers and firms deposit funds and earn interest on savings. In addition, firms and consumers take loans
to invest in capital goods and assets, and have to pay interest on loans.
Finally, we introduce the foreign sector in figure 1-5. In the foreign sector, importing countries pay using foreign
exchange for imported goods and services, and exporting countries earn foreign currency for exporting goods
and services.
This simple circular flow model of income, output and spending represents the workings of a simple economy,
and illustrates the economic interdependence of the major constituencies. It further highlights the
interrelationship between microeconomic analysis and macroeconomic analysis.
1.5. Summary
This section introduces the five main policy objectives of any economy. It discusses the economic variables that
can be measured in order to assess the level at which those economic objectives are being achieved. It discusses
the circular flow of income and expenditure that illustrates the interactions of the major role players in an economy.

YOU ARE NOW READY TO ANSWER THE QUESTIONS FOUND IN THE WORKBOOK RELATING TO THIS
STUDY UNIT
Revision Questions
Example short and essay type questions:

1] Explain what is meant by economic growth and discuss how it is
measured.
2] With the aid of a diagram, discuss the circular flow of income and
spending in an economy.
3] With the aid of a diagram, discuss how the Lorenz curve is used to
measure income distribution in the economy.
4] Identify and discuss the five macroeconomic policy objectives.
1.6. Answers to revision questios and activities.

Activities:
1.1.1 Macroeconomics
1.1.2 Macroeconomics
1.1.3 Microeconomics
1.2 20%
1.3 7.8%
1.4 60%, 15%
Think points:
1.1 No. GDP by definition is a measure of the final goods and services produced in an economy during a
specific period. Steel, is not a final good but rather an intermediate good in the production of other goods
and services.
1.2 If exports exceed imports:

 The exchange rate would initially favour the exporting country;
 As the local currency becomes stronger, foreign countries will refrain from buying goods/services; because
the
 Goods will become too expensive in the countries exported to, resulting in a drop in foreign demand. Local
output will decrease, resulting in growing unemployment but general price levels would however fall which
could lead to a growth in the economy.

Revision questions:
1] See section 1.3.3
2] See section 1.4
3] See section 1.3.5.1
4] See section 1.3

Unit
2: Measuring the
Performance of Economy

2.2 The concept of Gross Domestic Profit  Define Gross Domestic Product
(GDP)
2.3 Gross National Product (GNP)  Define Gross National Product
2.4 Net Domestic Product (NDP)  Define Net Domestic product
2.5 Nominal vs Real GDP  Distinguish between Nominal and Real GDP
2.6 Some factors to consider when using  Identify and describe some of the shortcomings of GDP as a
GDP as a measure of economic measure of economic performance
performance

2.1. Introduction
There are various macroeconomic instruments that are used to assess the state of the economy of any country.
It is on the basis of these instruments that comparisons of economic growth and development are made with
other economies (countries).
2.2. The Concept of Gross Domestic Product (GDP)

The primary reason for calculating GDP is that it measures the performance of a country’s economy during a
specified period. This value is then compared with previous years’ output (GDP) to establish the country’s
performance over time.
2.2.1. GDP Defined

Definition: GDP refers to the total market value of final goods and services produced in an economy during a
specific period of time (normally a year).
This definition is made up of 4 elements:
 Market Value - refers to the market price of the various new goods and services produced in the specified
time period;
 Final goods and services – these are used or consumed by individuals, households and firms. An
intermediate good, on the other hand, is purchased to be used as inputs in producing other goods and is
not counted (to avoid the problem of double counting);
 Economy-refers to the geographic area (country borders) within which all the goods and services are
produced; and
 Specific time period – Normally a year or quarter during which only the new goods and services are
produced.
2.2.2 GDP Statistics Matter to Business for at Least Four Reasons (Mcaleese, 2001):
 Forecasts for future aggregate or combined demand (we will discuss AD later on) are usually expressed
in terms of projected growth in GDP;
 Assessments of the current state of the economy are based on the current and recent past level of GDP;
 Economic performance do have political and policy implications. Fast growth is perceived as an electoral
plus while weak growth an electoral minus; and
 International comparisons of aggregate market size are based on GDP data. Country credit ratings stock
exchange prices and business outlook forecasts are all affected by economic data.
2.2.3 Methods for Calculating GDP

There are three methods of calculating GDP:
I. Production Method (value added)
This method is the summation of the value added at each phase of production. Since only the added value is
counted no double counting can take place.

Consider the following example:

 A farmer produces 1 000 bags of wheat which he sells to a miller at R10 per bag, yielding a total of
R10 000.
 The miller processes the wheat into flour, which he then sells to a baker for R12 500.
 After baking bread with the flour, the baker sells it to a shop for R18 000.
 The shop subsequently sells the bread to final consumers for R21 000.
What is the total value of these four transactions? A spontaneous reaction to this question will probably be to
add the value of all the sales together. This gives an answer of R61 500 (i.e. R10 000 + R12 500 + R18 000 +
R21 000); see the first column of Table 2-1. But this is clearly wrong. The total value of the farmer’s production
cannot be added to the total value of the miller’s sales to the baker, since the value of the production of the
wheat is included in the value of the flour sold by the miller. The same applies to the value of the bread (Mohr,
P & Fourie, L, 2015, p. 235).
As discussed earlier, to avoid the problem of double counting,

the national accountants use a concept which became familiar
to most South Africans with the introduction of value-added tax
(VAT) on 30 September 1991. Starting with the full value of the
farmer’s production they subsequently add only the value
added by each of the other participants in the production
process. This is summarised in the last column of Table 2-1
(Mohr, P & Fourie, L, 2015, p. 235).
II. Expenditure Method (final goods and services)

This approach adds up the value of all transactions once they have reached their final destination. It combines
the spending by consumers (C) on consumer goods, the spending of firms on capital goods (I), government
spending (G) and the net spending on imported goods (X – Z) (Exports minus Imports), or the spending by
foreigners on South African goods).
Thus, in our example we ignore the sales of the farmer to the miller as well as those of the miller to the baker
and of the baker to the shopkeeper.
III. Income Method (incomes of the factors of production)

This approach is related to the production approach since costs incurred for the factors of production for
businesses are in fact income to households for these factors of production. For example, rent and wages are
factor costs for a business but are income for the landlord and employee, respectively.

In our example R10 000 is earned during the farming stage, R2 500 (i.e. R12 500 minus R10 000) during the
milling stage, R5 500 (i.e. R18 000 minus R12 500) during the baking stage, and R3 000 (i.e. R21 000 minus
R18 000) during the final selling stage. This again yields a total of R21 000 (R10 000 + R2 500 + R5 500 + R3
000). Note, in addition, that the income earned during each stage of the production process is equal to the value
added during that stage (Mohr, P & Fourie, L, 2015, p. 236).
The three methods measures the monetary value of the circular flow at different points so should arrive at the
same amount.
Think Point 2.1
If economists are not careful, they can easily overestimate the value of GDP by double
counting. What is double counting and how can national accountants avoid this problem?
2.3 Gross National Product (GNP)

Definition: GNP refers to the production resulting from the employment of the permanent residents of South
Africa (Haydam, 1997) wherever they might be.
To derive the GNP from the GDP, one has to subtract the factor incomes (rent, profit, wages and interest) of
foreigners earned by foreigners in South Africa from the factor income of permanent residents earned
abroad. For example, the salary of a mineworker from a neighbouring state will be included in the GDP but will
not be part of the GNP, whereas the tournament earnings of Ernie Els on the US/European tour will be included
in the GNP and not in the GDP.
The difference between the payments that SA makes to ‘foreigners’ and the monies received by its permanent
residents abroad, is called the net factor payments to the rest of the world. In other words, the difference
between GDP and GNP = net factor payments.
Activity 2.1
1. If South Africa’s GDP is greater than its GNI, then the income earned by foreign
owners of companies and foreign workers in South Africa is ________ the income
earned by South Africans who have invested, or who are working, abroad.
a. greater than
b. added to
c. subtracted from
d. less than
e. deflated by

2.4 Net Domestic Product (NDP)

Definition: NDP = GDP – depreciation. Allowance is therefore made for depreciation of assets.
Think Point 2.2

Suppose GDP = R276m and depreciation amounted to R42m, then NDP at market prices =
R234m. Therefore, one can conclude that in order for the country to maintain its production
capacity, R42m should actually be saved or R42m of new machines should be acquired. What
are the consequences to the economy if this is not done?
2.5 Nominal vs Real GDP

As pointed out earlier, a comparison of the current GDP value with that of previous years provides a reasonable
assessment of the country’s performance. An increase in GDP could have been caused by increased prices
(inflation) and not necessarily higher output.
In this case, GDP would not reflect the true picture of a country’s well-being. To overcome this problem of price
inflation in GDP calculations, a distinction has to be drawn between nominal GDP and real GDP.
Nominal GDP =  (current prices of products x their current quantities)

Real GDP, on the other hand, expresses the GDP at constant prices. In other words, it is the value of the current
output of the country expressed in terms of prices of a previous (base) year. Since the average business cycle
in SA is five years, the base year is generally changed every five years. Hence, real GDP is updated every five
years though comparisons can be made over longer periods since the data is available.
Real GDP =  (base year prices of products x their current quantities)
Table 2-2 shows South African GDP at current prices and constant prices and also shows nominal and real
growth.

Think Point 2.3
Compare and discuss the nominal and real GDP figures in 2004 and 2005
and comment on the rate of growth of the economy across these two years
2.6 Some factors to consider when using GDP as a measure of economic performance
GDP and the other national accounting totals are all subject to certain shortcomings. As a result, GDP is
sometimes jokingly referred to as the ‘grossly deceptive product’ or the ‘grossly distorted picture.’ The problems
associated with GDP include the following;
 Non-market production: It is difficult to measure or estimate the value of activities that are not traded in
a market. This problem applies, for example, to the production of goods and services by the government.
Since most of these goods and services are not sold in market, they have to be valued at cost. A good
example of non-market production is farmer’s consumption of their own produce.
 Unrecorded activity: A more serious problem is that many transactions or activities in the economy are
never recorded. Such transactions or activities are described by terms such as the unrecorded economy,
the underground economy, the shadow economy and the informal sector. Unrecorded activities range
from illegal activities such as smuggling, drug-trafficking and prostitution to unrecorded cash transactions,
barter transactions and transactions that escape the tax net and transactions that make use of alternative
or encrypted electronic currencies (such as bitcoin).
 Data revision: Original estimates are frequently adjusted as new and better data become available. This
can be quite frustrating to analysts, since they are never sure whether or by how much the figures are
going to be revised. These are only estimates of the performance of the economy. There are many ‘in-
built’ mistakes which are hard to eliminate and the accuracy of the figures relies upon the information
provided by the company interviewed.
 Economic Welfare: Some argue that GDP and other national accounting totals are not good measures
of economic welfare. They point out, for example, that unwanted by-products or negative externalities
such as pollution, congestion and noise are not taken into account. They argue that the value of these
‘bads’ should be subtracted from the value of ‘goods’ included in GDP. They also argue that it is
inappropriate to regard R1 billion spent on military equipment in the same light as R1 billion spent on
health and education. Moreover, it is difficult to account for productivity improvements and improvements
in the quality of goods and services over time.

2.7. Summary
This Unit discusses one of the variable used to gauge the output produced in an economy, namely gross
domestic product in terms of its definition and measurement. It identifies other variables that are used to
measure output. It discusses factors to consider when using gross domestic product as a measure of economic
performance.
STUDY UNIT
Revision Questions

1] Identify and discuss the different methods of calculating GDP.
2] Discuss the problems / shortcomings of GDP as a measure of economic performance.
3] Define GDP and discuss why GDP statistics matter to business.
2.8 Answers to Revision Questions and Activities

Think points:
2.1 Double counting refers to a situation whereby the calculation of goods and services produced in the
economy are overstated or inflated due to counting certain items more than once. This problem can be dealt
with by using the three methods of calculating gross domestic product, discussed in this unit. See section 2.2.3.
2.2 Depreciation represents a depletion in the quality and useful life of capital, an input in the production
process. The depreciation of capital is estimated based on the capital’s life cycle. As capital is used in the
production process, its usefulness eventually depletes and has to be replaced. Accounting for depreciation
allows firms to make provisions for such a situation failing which, they will not be able to maintain productions
levels when the capital becomes obsolete.
2.3 Both nominal and real GDP have increased across the two years. Nominal GDP increase is reported at an
average of 11.1 ([11.0 + 11.2] ÷ 2) across the two years. This is quite substantial when compared to the average
rate of 4.95 ([4.6 + 5.3] ÷ 2) increase in real GDP across the two years. The reason for this substantial
differences in the growth measures of these economic indicators is based on the fact that unlike nominal GDP,
real GDP takes into account the effect of an increase in the general price level or inflation.
Activities:
2.1 a
Revision questions:
2] See section 2.6
3] See section 2.2.1 and 2.2.2

Unit
3: The Monetary Sector

3.2 The South African Reserve Bank  Understand the functions of the South African Reserve Bank
(or any central bank)
3.3 The supply of money  Understand the functions of money
3.4 The demand for money  Understand the demand for money
3.5 Interest Rates  Understand and explain interest rates
3.6 The monetary policy framework in  Understand the instruments of monetary policy
South Africa
3.7. Other Instruments  Identify the number of other measures may be used by the
monetary authorities in pursuit of their goals

3.1 Introduction
Money is one of the most important institutions in the economy. Money, it is said, talks, makes the man (or
woman) and makes the world go round. The Bible says that the love of money is the root of all evil. Everyone
is fascinated by money.
3.1.1 What Is Money?
 Money is anything that is generally accepted as payment for goods and services or that is accepted in
settlement of debt. The unique feature is that the marginal value of money does not decrease when
additional units are added.
3.1.2 What Money Is Not?

 Money is often confused with other things. Money should not, for example, be confused with income or
wealth. Because income and wealth are usually measured or expressed in monetary terms (e.g. in rand),
they are often confused with money.
 Income is the reward earned in the production process. Natural resources, labour, capital and
entrepreneurship are rewarded in the form of rent, wages and salaries, interest and profit. The fact that
income is calculated and paid in monetary terms is coincidental. Income is something completely different
to money.
 Wealth consists of assets that have been accumulated over time. Wealth can take many forms, such as
fixed property, shares, oriental carpets or paintings. It can, of course, also take the form of money. This is
one of the possible reasons for the confusion between wealth and money. Another reason is that wealth,
like income, is usually calculated in monetary terms.
Think Point 3.1
Observe any paper currency note (also known as fiat money) of your country.
How valuable would that note be, if the signature by the Central Bank
Governor / President was missing? Why?
3.1.3 Different Kinds of Items Used As Money.

 Through the ages various goods have served as money. For example, cocoa beans, beads, seashells,
tea, cattle, silver and cigarettes have all served as money at one time or one situation or another.
 The earliest forms of money were commodities, where the intrinsic value of the commodity was equal
to the exchange value assigned to it. Naturally, certain commodities were more suitable for use as
money than others. Properties such as uniformity, durability, divisibility and the ability to be carried
(which is determined by size and weight) were not to be found in all commodities. For example, cattle
are not divisible into “change”, nor can they be carried around easily.

3.1.4 Characteristics of Money

Gold for centuries has emerged as the ultimate money despite a concerted attempt to dethrone it – the reason
is that of all substances it meets the characteristics of an ideal medium of exchange and store of value:
 Uniformity – One part has exactly the same characteristics as another
 Divisibility – It can be divided into infinitely small units
 Durability – It does not corrode
 Portability – The value to weight ratio is high
Activity 3.1
How does currency/money avoid the problem of double coincidence of wants

found in barter transactions?
3.1.5 The Functions of Money

 Money as a medium of exchange
The inefficiency of the barter economy led, even in early primitive communities, to the use of some form of
money. The advantages of a monetary economy, where exchange takes place through the medium of money,
are just as obvious as the disadvantages of a barter economy. In a monetary economy a double coincidence
of wants between parties is no longer required. The farmer no longer has to look for a tailor who needs wheat.
As long as a buyer can be found for the wheat, the money received in exchange for the wheat can be used to
buy clothes. Money therefore serves as a lubricant or intermediary to smooth the process of exchange and to
make it more efficient. This is the first and most basic function of money. Money functions as a medium of
exchange (Mohr, P & Fourie, L, 2015, p. 256).
 Money as a unit of account

A unit of account is an agreed measure for stating the prices of goods and services. In a money economy the
prices of all goods and services are expressed in monetary terms. Money thus functions as a unit of account.
We need a common measure of the cost of various goods and services to be able to decide how best to spend
our income. The fact that income and prices are all expressed in rand and cents enables us to calculate what
we can afford. If we know that a beer costs R12 and a soft drink costs R8, then we can also immediately
calculate the opportunity cost of a beer in terms of the number of soft drinks that we have to sacrifice for a beer.
In addition, the use of money as a unit of account enables us to obtain measures of the total value of all goods
and services produced in the economy, such as GDP. Money is not, however, the only possible unit of account.
Any other commodity or product can serve as a unit of account. The item used as the medium of exchange
(money) is simply the most convenient unit of account (Mohr, P & Fourie, L, 2015, p. 257).

 Money as a store of value

Money is also a store of value. In any society there is a need to hold wealth (or surplus production) in some
form or another. A common form for holding wealth is money, since it can always be exchanged for other goods
and services at a later date. Wealth can, however, also be held in other forms, such as fixed property, real
assets, stocks and shares. The advantage of using money as a store of value lies in the fact that it is usually
more convenient and can be used immediately in exchange for other assets. We therefore say that money is
the most liquid form in which wealth can be kept (Mohr, P & Fourie, L, 2015, p. 257).
By looking at the functions that money should fulfil one can see that many modern currencies are losing the
ability to meet all the requirements. As an extreme example let us consider the Zimbabwean dollar. At the height
of the inflationary period it was still used as a medium of exchange. There its functionality stopped – as an
accounting unit it lost its ability to compare prices from one period to the next (apart from the fact that there was
no space to write all the zeros and computer software bombed out). As a store of value it was meaningless and
could not be used to settle debts in the future (unless massive interest was levied). All official present day fiat
currencies have the same problem though not as extreme.
3.1.6 Money in South Africa

 The South African Reserve Bank who administers the South African currency and sets monetary policy,
uses three different measures of the quantity of money. These measures are labelled M1, M2 and M3
respectively (Mohr and Fourie: 2015, p. 259).
The Conventional Measure (M1)

 M1 is defined solely on the basis of the function of money as a medium of exchange.
 M1 includes coins and notes (in circulation outside the banking sector) as well as all demand deposits
(including cheque and transmission deposits) of the domestic private sector with monetary institutions.
 Note first, that only coins and notes in circulation outside the monetary sector constitute a part of the
money stock. The reason is that only cash in the hands of the public can be used as a means of payment.
The cash in the bank vaults obviously cannot be used directly to pay for goods and services. It must first
be withdrawn by someone who intends to spend it.
 Secondly, demand deposits refer to deposits that can be withdrawn immediately by means of a cheque
or electronic fund transfer (EFT). It is simply a term that is used to describe the money against which
cheques may be written out or EFTs made.
 Everything that normally serves as a means of payment is included in the definition of M1.
A broader definition of money (M2)
 M2 is equal to M1 plus all other short-term and medium-term deposits of the domestic private sector with
monetary institutions.

 The short-term and medium-term deposits in question are not immediately available as a medium of
exchange. They are deposits invested for a certain period (less than 30 days for short-term deposits and
less than 6 months for medium-term deposits) and can only be withdrawn earlier at some cost.
The Most Comprehensive Measure of Money (M3)

 For many years M1 and M2 were the only measures used to quantify the money supply, but nowadays
great significance is attached to the M3 measure.
 M3 is equal to M2 plus all long-term deposits of the domestic private sector with monetary institutions.
 The long-term deposits in question have a maturity of longer than six months. The monetary authorities
regard M3 as the most reliable indicator of developments in the monetary (or financial) sector of the
economy. Note that M3 is a reflection of the store of value function and not only the function of money as
a medium of exchange. As we move from M1 to M2 and M3, the emphasis on the medium of exchange
function decreases while the emphasis on the store of value function increases (Mohr and Fourie: 2015,
p. 259).
3.2 The South African Reserve Bank

 South Africa’s central bank is the South African Reserve Bank (SARB), which was established in the early
1920’s.
 The Constitution of the Republic of South Africa clearly states that;
o The primary object of the South African Reserve Bank is to protect the value of the currency in the
interest of balanced and sustainable economic growth in the Republic.
o The SARB, in pursuit of its primary object must perform its functions independently and without fear,
favour or prejudice, but there must be regular consultation between the Bank and the cabinet members
responsible for financial matters.
 The Reserve Bank is the monetary authority in South Africa and its current functions can be grouped into
the following four major areas of responsibility;
3.2.1 Formulation and Implementation of Monetary Policy.

The SARB is responsible for formulating and implementing monetary policy. The Bank’s accommodation policy
(also referred to as the Bank’s refinancing system or more commonly the repo rate tender system) is the main
instrument through which monetary policy is conducted in South Africa. Through its refinancing system the
Bank meets the daily liquidity needs of private banks (Mohr and Fourie: 2015, p. 261).
3.2.2 Service to the Government.

The services provided by the SARB to the central government are threefold:
• Banker and advisor. Until the early 1990s the Bank handled all financial receipts and payments of the
central government. Nowadays the government also has accounts (called tax and loan accounts) with
private banks. Nevertheless, the Reserve Bank is still the main banker for the government.

• Custodian of gold and foreign exchange reserves. With the exception of necessary balances held by
banks and the Treasury, the Reserve Bank keeps all the country’s gold and foreign exchange reserves.
Gold coins and gold bullion are added to the reserves at a market-related price.
• Administration of exchange control. The Reserve Bank is responsible for exchange control in South
Africa. Exchange control restricts the movement of foreign exchange in order to protect an economy from
disruptive fluctuations in capital movements and other international economic shocks (Mohr and Fourie:
2015, p. 261).
3.2.3 Provision of Economic and Statistical Services.

The Bank collects, processes, interprets and publishes economic statistics and other information. The data
these publications contain are a major source of information for policymakers, analysts and researchers (Mohr
and Fourie: 2015, p. 262).
3.2.4 Maintaining Financial Stability.

The SARB presently regards financial stability (particularly price stability) as its most important objective. In
pursuit of this objective the Bank plays a pivotal role in the following areas:
• Bank supervision. The Reserve Bank is responsible for bank regulation and supervision in South Africa.
The purpose is to achieve a sound, efficient banking system in the interest of depositors of banks and the
economy as a whole. This function is performed by issuing banking licenses to banking institutions and
monitoring their activities.
• The National Payment System. The Bank is responsible for overseeing the safety and soundness of the
National Payment System (NPS).
• Banker to other banks. The Bank acts as custodian of the minimum cash reserves that banks are legally
required to hold or prefer to hold voluntarily with the Bank. By exerting control over the level and composition
of these reserves the Reserve Bank can, to a certain extent, affect the quantity of money. The reserves are
also used to clear the banks’ mutual claims and obligations to one another. In this way the Reserve Bank
acts as a clearing bank. In terms of its “lender-of-last-resort” activities the Bank may in certain
circumstances provide liquidity to banks experiencing liquidity problems.
Banknotes and coins. The Reserve Bank has the sole right to make, issue and destroy banknotes and
coins. The SA Mint Company, a subsidiary of the Bank, mints all coins on behalf of the Bank while the SA
Bank Note Company, another subsidiary of the Bank, prints all banknotes on behalf of the Bank (Mohr and
Fourie: 2015, p. 262).
3.3 The Supply Of Money

The creation of money (as we know it today) is the result of a credit transaction between the Treasury and the
Central Bank and Commercial Banks – The treasury issues and bond which the Central Bank buys by issuing
money (either cash and coin or guarantees).

Money is also created by the banks. Banks accepts cash or cash related deposits from the general public and
lend these funds to borrowers. Because of the fractional reserve system they can lend out and receive as
deposits the “same” money unit more than once - which in effect creates money. The difference between the
lending rates and the deposit rates represents the income that banks receive for their intermediation role.
The money supply can also be influenced by transactions with foreign countries and by government
transactions. Foreign trade and international capital movements can also exert a significant influence on the
domestic money supply. If a local exporter earns foreign currency and exchanges it at his bank for a demand
deposit, the money supply will be directly increased. On the same principle, payment for imports will have a
negative effect on the money supply.
Capital inflows have the same effect as exports while capital outflows decrease the money supply in the same
way as imports do. A country’s money supply generally increases when its gold and foreign exchange reserves
increase and falls when the gold and foreign exchange reserves decrease. (Mohr and Fourie: 2008, p.325)
3.4 The Demand For Money

The demand for money is the amount that the various participants in the economy plan to hold in the form of
money balances.
The demand for money does not relate to the amounts of money that people want. The demand for money is
concerned with the choices of those participants who earn an income or possess wealth. The opportunity cost
of holding any money balance is the interest that could have been earned had the money been used to purchase
bonds instead.
Money will only be held if it provides a service that is valued at least as highly as the opportunity cost of holding
it. The demand for money is therefore directly related to the functions that it performs. Two most important
functions of money are the medium of exchange and the store of value functions. On the basis of these two
functions we can distinguish two basic components of the demand for money:
o The transactions demand for money which arises from the medium of exchange function.
o The demand for money as an asset which arises from the store of value function.
Reasons for holding money.

 Transaction motive
In a money economy all participants have to hold money as a medium of exchange. Without money it is
impossible to enter into transactions. The need to hold money arises because participants’ payments and
receipts of money do not coincide. For example, wages and salaries are normally paid weekly or monthly, while
purchases of goods and services occur more regularly. Workers therefore have to hold money to buy food and

other commodities between paydays. The amount of money required for transaction purposes will depend
mainly on the total value of the transactions concerned. This, in turn, will depend on the level of income. At the
macro or aggregate level, the transactions demand for money is therefore a function of the total income in the
economy (Mohr and Fourie: 2015, p. 263).
 Speculation motive
The speculative motive for holding money is related to the function of money as a store of value. To understand
the speculative demand, we must consider the choice between holding money (which earns little or no interest)
and holding bonds (which earn interest). The opportunity cost of holding money is the interest that is forgone
by not holding bonds. This is because interest is earned on bonds, while little or no interest is earned by holding
money. It follows, therefore, that the quantity of money demanded for speculative purposes will be low when
the interest rate is high (since the opportunity cost of money is then also high). Likewise, the quantity of money
demanded for speculative purposes will be higher when the interest rate (and therefore the opportunity cost of
money) is low (Mohr and Fourie: 2015, p. 264).
3.5 Interest Rates

 Interest rates may generally be described as the prices of loanable funds (the cost of money). The
suppliers of funds would like to earn an income on the funds invested or lent out, while borrowers are
usually willing to pay a price for the right to use these funds. This could be in order to finance production
or non-production related activities.
Types of Interest Rates

 Repo rate (which plays a dominant role in the money supply process).
 The interbank lending rate
 The prime rate of banks.
 Various deposits rates e.g. fixed interest rates
 Mortgage rates
 Rates on government stock etc.
Though all the rates differ and there are sound economic reasons for these difference, the rates nevertheless
tend to move in harmony with each other. Therefore, the term interest rate is regarded as a representative rate
for all the individual rates encountered in practice.
Think Point 3.2
What happens to the demand for holding money in money balances when the
interest rates increase and why?

3.6 The Monetary Policy Framework In South Africa

Monetary policy can be defined as the measures taken by the monetary authorities to influence the quantity of
money or the rate of interest with a view to achieving stable prices, full employment, and economic growth.
Monetary policy in South Africa is formulated and implemented by the South African Reserve Bank. Decisions
on the appropriate monetary policy stance are taken by the Monetary Policy Committee (MPC) of the SARB.
The MPC consists of the governors and a few senior officials of the Bank. Regular Monetary Policy Forums are
also held to provide a platform for discussion of monetary policy issues with a broad range of stakeholders.
Activity 3.2
Carry out a research on the evolution of the monetary policy framework in

South Africa from 1960 to 2000
3.6.1 The Instruments Of Monetary Policy

The key market-oriented policy instruments are;
 Accommodation policy (or the refinancing of the liquidity requirements)
 Open market policy.
 Public debt management.
 Intervention in foreign exchange markets.
The South African Reserve Bank relies extensively on its accommodation policy to influence interest rates.
Open market policy is the main supporting instrument of the accommodation policy. Therefore a fairly detailed
description of the two is provided below;
o Accommodation Policy
A crucial element of the classical cash reserve system is the fact that banks are obliged to hold 2,5 per cent of
their total liabilities to the public in the form of cash reserves with the Reserve Bank. When a bank experiences
a shortage of cash reserves, it can either change other financial assets into cash or borrow funds on the
interbank market to eliminate the shortage. Normally one would expect banks that are in need of funds to make
use of the overnight interbank market where they borrow from other banks that have excess funds at their
disposal. These funds are obtained at the interbank overnight rate. However, if all banks have the same liquidity
problems, the Reserve Bank, as bankers’ bank, acts as lender of last resort and the banks can then obtain
funds by means of the repo system.

Through the repurchase tender system (repo system), liquidity is provided to the banks by means of repurchase
agreements (repos) between the Reserve Bank and its banking clients. Banks apply for refinancing by tendering
for central bank funds at weekly auctions of repos with seven-day maturities. Eligible underlying assets for these
repos are restricted to government bonds, Treasury bills, Land Bank bills and Reserve Bank debentures of all
maturities. The fixed rate determined by the Bank represents the interest rate that banks have to pay for their
required reserves.
The accommodation policy of the Reserve Bank thus mainly comprises changes in the repo rate and other
conditions on which cash is made available to banks. It is therefore an instrument by which the SARB can
regulate the quantity of money through variations in the cost of credit. Changes in the repo rate lead to
adjustments in the interest rates at which credit is made available by the banks to their clients. The cost of credit
in the economy is therefore directly linked to the repo rate. Other interest rates (e.g. deposit rates and mortgage
rates) also tend to move in sympathy with the repo rate (Mohr and Fourie: 2015, p. 270-271).
o Open Market Policy

Open-market transactions as an instrument of monetary policy consist of the sale or purchase of domestic
financial assets (mainly Treasury bills and government bonds) by the central bank in order to exert a specific
influence on interest rates and the quantity of money, via its influence on the cash reserves of the banks.
As mentioned earlier, the repo system (or accommodation policy) will be effective only if the banks are “forced”
to approach the central bank for funds, that is, if they experience a liquidity shortage. The central bank uses
open-market transactions to ensure such persistent shortages of liquidity, also called the money market
shortage. If it wishes to create or enlarge the banks’ liquidity shortage, the central bank sells government bonds
or other securities to the banks, thereby reducing their cash reserves (directly or indirectly). In this way the
banks are compelled to make use of the central bank’s financing facilities through repurchase agreements,
thereby rendering the central bank’s accommodation policy more effective.
When the central bank wishes to stimulate the creation of bank deposits it can also use open market operations
to ease liquidity conditions and lower interest rates. In such a case (which is sometimes called quantitative
easing) the central bank will buy government bonds and other securities. In order to persuade institutions to
sell the securities, the central bank will offer higher prices to induce the bondholders to part with their bonds.
Bond prices will therefore tend to rise and, given the inverse relationship between bond prices and the yield
(interest rates) that can be earned on them, interest rates will tend to drop (Mohr and Fourie: 2015, p. 271).
3.7 Other Instruments

In addition to the policy instruments mentioned above, a number of other measures may be used by the
monetary authorities in pursuit of their goals. These include non-market oriented instruments measures such
as;

 Credit ceilings
 Deposit rate control
 Changes in the terms of hire purchase agreements
3.8 Summary
This study unit discusses the characteristics, functions and the different measures of money. It explores the
functions of the South African Reserve Bank as well the demand and supply of money. It discusses interest
rates and monetary policy framework in South Africa.
STUDY UNIT
Revision Questions

1] Identify and discuss the four major areas of responsibility of the South
African Reserve Bank.
2] Identify and discuss the three measures of the quantity of money.
3] Discuss the different functions of money.
4] Identify and discuss the different reasons for holding money.
5] Discuss the monetary policy framework in South Africa
3.9 Answers to revision questions and activities

Activities:
3.1 In a barter transaction, there must me a double coincidence of wants which refers to a situation where
supplier of good X wants good Y and supplier of good Y also wants good X. In absence of this (one of the
suppliers is not willing to part with his good in exchange for the good being offered) a transaction cannot take
place. Money avoids this problem by functioning as a store of value where. In this instance, supplier of good X
or Y would be willing to part with their goods in exchange of some store of value of which money, is a generally
accepted store of value. In this instance, what is being offered does not necessarily have to be goods that the
supplier is willing to exchange for.
3.2 See CASTELEIJN, A.J.H (2001). South Africa’s Monetary Policy Framework. Mimeo
Think Points:
3.1 Without the signature of the Central Bank Governor/President, paper currency (bank note) would be so
worthless that you wouldn’t even be able to use it to blow your nose. The signature on a bank note is a guarantee
by the Central Bank that the paper held can be exchanged for goods/resources/commodities of a certain value
from the central bank and that is why people/firms are willing to accept it in exchange for goods and services.

Revision questions:
1] See section 3.2
4] See section 3.4
5] See section 3.6

Unit
4: The Public Sector

4.1 The role of government in the  Understand why government believes it should be involved
economy: an overview in the economy
4.2. Market failure  Understand market failure
4.3 Government Intervention in the  Describe how governments intervene in the economy
economy
4.4 Fiscal Policy and the budget  Distinguish between fiscal and monetary policy and
4.5 Expansionary and contractionary describe the main elements of each
policies
4.6 Components of Aggregate Demand  Outline the four components of aggregate demand
4.7 Taxation  Understand the three basic criteria for good tax
 Mohr, P. & Fourie, L. (2015). Economics for South African Students.

(5th edition) Pretoria: Van Schaik

4.1 The role of government in the economy: an overview

In Chapter 2 of the prescribed text, Mohr and Fourie (2015), it is suggested that nowadays all economies can
be classified as mixed economies, in which the government, the private sector and market forces all play
an important role. In this section, an appropriate mix of markets and government intervention is investigated.
Economics is not only concerned with the efficient allocation of resources but also maximising the benefit to the
whole of society, including those who have been disadvantaged to maximise their potential and fulfil their needs
in an optimal way. The allocation of resources is efficient when it is impossible to reallocate the resources to
make at least one person better off without making someone else worse off. Also that society’s welfare is
maximized when the marginal cost of each product is equal to its price in the long run and where the marginal
costs are being driven down through entrepreneurship, finding new and better ways of producing and
harnessing the creativity of human beings in solving the economic problem.
Market failure occurs when the market system is unable to achieve an efficient allocation of resources.
Issues such as pollution, the problem of the commons (and here overfishing is a good example of this) and
unethical corporate actions (Enron) are examples. In many cases that which is ascribed to market failure is
really the result of Government failure – where some intervention in the marketplace by government has led to
the resultant inefficient allocation of resources. The best example of this is the prevalence of Monopolies in the
SA economy as a result of restrictive legislation (the energy situation in 2009 – 2015 springs to mind).
Government intervention usually arises in an attempt to improve a situation where certain short term social
objectives need to override what could make sense in the long term. Refer to the prescribed text, (Mohr and
Fourie, 2015:277), of incidences of market failure (where the government could try to correct these).
4.2 Market failure (as justification for government intervention)

We examine the following cases of market failure:
• Monopoly and imperfect competition
• Public goods
• Externalities
• Asymmetric information
• Common property resources
• Income distribution
• Macroeconomic growth and stability
• Merit goods
4.2.1 Monopoly and imperfect competition

Monopoly and imperfect competition were dealt with in the Economics 1A module. There it was shown that in
contrast to perfect competition, monopoly, monopolistic competition and oligopoly are not allocatively efficient
(Mohr and Fourie: 2015, p. 278).

4.2.2 Public goods (or non-private goods)

A second type of market failure arises from the failure of the market to provide sufficient quantities of certain
goods and services.
A good is rivalrous in consumption if no two persons can consume the same unit of a good. For example, if
you buy and eat a hotdog, no one else can buy and eat that same hotdog. Most consumer goods and services
are rivalrous in consumption. On the other hand, a good is non-rivalrous in consumption if its consumption by
one person does not reduce its consumption by others. National defence, for example, protects all the people
in a particular geographical area, not just some, and the protection enjoyed by one person does not reduce the
protection enjoyed by another person.
A good is excludable if it is possible, or not prohibitively costly, to exclude someone from receiving the benefits
of the good after it has been produced. In other words, a good is excludable if people can be prevented from
obtaining it. A good or service can only be excludable if its owner is able to exercise effective property rights
over it in order to determine who uses it – usually only those who pay for the privilege. For example, if I do not
pay for a chocolate I can be prevented from consuming it. Most consumer goods and services are excludable.
On the other hand, a good or service is non-excludable if, once it has been produced, there is no way of stopping
anyone from consuming it.
What are the broad implications of this classification for the role of government in the economy?
• First, the production of private (i.e. rivalrous and excludable) goods should be left to the market. Private
firms can produce and sell these goods. If the firms are price takers, they will also fulfil the condition for
allocative efficiency by operating where marginal cost is equal to price.
• Second, private firms will not provide public goods because they are non-excludable. The provision of
public (i.e. non-rivalrous and non-excludable) goods is thus ultimately the responsibility of government.
But who should pay for the provision of public goods, like national defence, weather forecasts and policy
services? Such goods are usually paid for from tax revenue and provided free to all users.
• Third, mixed (i.e. excludable but non-rivalrous) goods can be provided by private firms. For example, a
museum, fenced park or art gallery provides an excludable service, but as long as there is no overcrowding
the consumption of the service is non-rivalrous (i.e. one person’s use does not reduce the availability to
another person). However, since the marginal cost of adding another user is zero (until capacity is
reached), any admission fee that the owner charges will result in an inefficient allocation of resources (i.e.
the non-optimal use of the facility). To avoid such inefficiency, the government often provides such mixed
goods. However, even in such cases we usually find that a fee (called a user charge) is levied by
government. Examples include toll roads and entrance fees to parks, museums and public swimming
pools (Mohr and Fourie: 2015, p. 279-280).

4.2.3 Externalities
Externalities are costs or benefits of a transaction or activity that are borne or enjoyed by parties not directly
involved in the transaction or activity. They are also called third-party effects, spill over effects or neighbourhood
effects. Where there are external costs, we refer to negative externalities. Where there are external benefits,
the term positive externalities is used. Both consumption and production may be subject to externalities, but
we confine our discussion to externalities in production.
When there are external costs or benefits to production, the full costs to society differ from the private costs
faced by firms. Since markets register private costs only, the market mechanism fails to bring about a socially
efficient allocation of resources in such cases (Mohr, P & Fourie, L, 2015, p. 280).
4.2.4 Asymmetric information

Perfect competition requires that all market participants have perfect knowledge of market conditions. To make
informed choices, households and firms must have full information on the quality, availability and prices of
goods, services and inputs. In the real world, however, there is often a great deal of ignorance and uncertainty
which make it virtually impossible for consumers and firms to equate marginal benefit with marginal cost.
We can use the market for cigarettes to explain the effects of
asymmetric information. Suppose the suppliers of cigarettes
are aware of the health hazards of smoking but do not release
this information to potential buyers of cigarettes. In Figure 4-1
the demand and supply of cigarettes are represented by DD
and SS respectively. The equilibrium price is P0 and the
equilibrium quantity Q0. Suppose the potential buyers then
acquire the information about the health hazards associated
with smoking. The demand thus decreases, illustrated by a
leftward shift of the demand curve to D1D1. The new
equilibrium price is P1 and the quantity Q1. In this example
fewer units of the good are thus bought at a lower price with
symmetric information (as assumed in the models of perfect
competition) than in the case of asymmetric information. The
new equilibrium is the socially efficient one. With asymmetric
information there is an inefficient allocation of resources
(Mohr, P & Fourie, L, 2015, p. 281-282).
4.2.5 Common property resources

Common property resources are those that are non-excludable but rivalrous in consumption. Common property
resources belong to no one and are available free of charge to anyone who wants to use them. No one can be

excluded from using them. But they are rivalrous in consumption. One person’s use of the common resource
reduces the availability to other persons. Examples of common property resources include the fish in the ocean,
other wildlife, rivers and common land.
A common resource will be efficiently exploited if the marginal cost of exploitation is equal to the marginal
benefit of exploitation. However, since no one owns the resource, no one can be excluded from using it, and
the free market cannot produce an efficient result. Instead, common resources tend to be overexploited, even
to the extent of destruction. This is often referred to as the tragedy of the commons.
Consider the example of fish in the ocean. No one owns the fish until they are caught, and in a free market no
one can be excluded from catching them. But once a fish is caught by someone it is no longer available to
others. Moreover, there are no incentives for any individual fisherman (or fishing company) to consider the
impact of his (or its) activities on others (e.g. by limiting the catch or returning undersized fish). In the absence
of regulation there will thus be a tendency to overexploit the resource. Clearly the government has a role to play
in protecting or avoiding the overexploitation of common property resources (Mohr, P & Fourie, L, 2015, p. 282-
284).
4.2.6 Income distribution

The free market tends to generate an unequal distribution of income. A free market system rewards certain
participants and penalises others. Because the workings of the market may be stern, even cruel, society often
chooses to intervene in an attempt to produce more socially acceptable income distributions.
By definition, a socially undesirable income distribution is one with which society is unhappy. Government, as
the representative of society, must therefore take steps to achieve a more acceptable (or more equitable)
distribution. The measures that governments usually take in this regard include progressive income taxation
(which means that the greater your income, the greater the percentage tax you pay), free or subsidised provision
of certain goods and services (e.g. primary health care and primary education) to those who can least afford it,
cash transfer payments to the needy (e.g. old-age pensioners and very poor families that have to raise children)
and legislation and other forms of regulation (e.g. labour laws) (Mohr, P & Fourie, L, 2015, p. 284-285).
4.2.7 Macroeconomic growth and stability

A number of economists argue that the free market system tends to fall short of achieving important
macroeconomic objectives such as rapid economic growth, full employment and price stability and that
governments have to intervene in an attempt to achieve these objectives. They emphasise that market systems
tend to experience business cycles, that is, phases of rapid economic growth (called upswings or booms),
followed by periods of stagnation or decline (called downswings or recessions).

Other economists disagree and maintain that unfettered market systems tend to produce the best possible
results at the macroeconomic level (as well as at the microeconomic level).
At this point, however, you need only be aware that governments around the world try to achieve
macroeconomic objectives such as economic growth, full employment and price stability by applying
macroeconomic policy. Macroeconomic policy consists of monetary, fiscal and other policies (Mohr, P & Fourie,
L, 2015, p. 285).
4.2.8 Merit goods

Some goods are excludable but have social benefits (i.e. positive externalities), with the result that they are
often provided by government in addition to, or in place of, private provision of such goods. Merit goods can be
defined as goods that are regarded as so beneficial to society that everyone should be in a position, irrespective
of their incomes, to receive or consume them. Examples include education, health, shelter, fire protection and
sports facilities (particularly in poor neighbourhoods). Take education as an example. It is excludable, but
society gains in various ways if its members are educated. However, if the provision of education were left to
the private sector, many parents would not be able to afford to send their children to school. The higher the
level of education, the smaller the social benefit becomes relative to the individual benefit, and therefore the
weaker the merit goods argument tends to become. Note that the provision of merit goods to those who would
otherwise not have access to such goods amounts to a redistribution of income in favour of the recipients. Also
note that a decision to provide merit goods does not imply that government should actually produce the goods
– the goods can, for example, be produced by the private sector and financed or subsidised by government.
Just as there are socially beneficial merit goods, there are also merit bads or demerit goods that are regarded
as socially harmful. Examples include tobacco, other addictive drugs and gambling. In these cases
governments often take steps to discourage consumption. Since merit goods and bads involve value
judgements (by government, as the representative of society), the provision of such goods can be quite
controversial. Some observers object, for example, to the paternalistic notion that government knows what is
best for society and its members. Their objections are even stronger when government intervenes to protect
people from others and, especially, from themselves by discouraging or prohibiting certain activities or products
(Mohr, P & Fourie, L, 2015, p. 285-286).
4.3 Government Intervention in the Economy

The great strength of the market system is its ability to generate very efficient outcomes in the majority of cases
through a system of decentralised decision-making in which each individual participant tries to maximise his or
her benefit. Not surprisingly, however, markets do not perform well in the short term when broader social goals
are at stake. Much of the justification for government’s role in the economy can be traced to the inability of the
market system to achieve such broader goals such as equitable income distribution as quickly as the persons
in power need in order to maintain their political credibility.

4.3.1 How does government intervene?

 Public provision of goods and services: This can be achieved by public ownership or by public
financing of production undertaken by the private sector. Some services such as policing, national
defence, and the justice system are seen as public goods and fall within the legitimate ambit of the state.
Services such as schools and hospitals fall into an area where there are many models and different views
exist as to how best serve the populace as a whole. Infrastructure is often financed by the state but built
and operated by the private sector, to achieve the best results.
 A second way in which government can try to achieve its objectives is through its role as a market
participant. For example, government is the largest employer of labour in the economy and through its
wage policy and other employment practices it can try to achieve certain objectives (training of technicians)
and also set an example for other employers to follow in areas such as women empowerment and
employment of people with disabilities.
 Government spending is a powerful tool. Both the level and the composition (or structure) of government
spending have a powerful impact on the economy. Apart from deciding which and what quantity of goods
and services to purchase, government also makes transfer payments, that is, payments for which it
receives nothing in return. Examples include old-age pensions, child support grants, disability grants and
various subsidies. Transfer payments are a powerful instrument that can be used to change the
distribution of income.
 A fourth instrument at the disposal of government is taxation. Although the primary purpose of taxation is
to finance government expenditure, the level and structure of taxation can be used to achieve various
objectives. Taxation can be used to redistribute income, to promote certain desirable activities and to
penalise other socially undesirable activities. For instance, tax incentives (possibly in the form of lower tax
rates or tax holidays) are often provided to stimulate investment spending and small business
development, while tobacco products and alcoholic beverages are subject to additional taxes to
discourage use.
 A fifth important instrument that government can use to affect economic outcomes is regulation.
Regulation refers to all laws, rules and regulations that affect private behaviour. Examples include the
labour laws (which govern the labour market); competition policy (which governs the goods markets); the
anti-tobacco law (which regulates smoking in public places); and fixing of maximum or minimum prices
and minimum wages. In many cases these regulations are enforced through a system of fines and criminal
penalties.

4.3.2 Nationalisation and Privatisation

One of the aspects of the role of the public sector that has been debated vigorously in South Africa is the issue
of nationalisation and privatisation (i.e. the desirability of public vs private ownership)
o Nationalisation
 Nationalisation means that the government takes over the ownership or management of private enterprise
(with or without compensation) – if the owners are not compensated it will amount to the confiscation of
assets which is tantamount to theft.
 Proponents of nationalisation in South Africa often mistakenly argue that nationalisation was a significant
element in the solving of the poverty problem of the poor white in the 1930’s. They cite the establishment
of a national transport system, a national posts and telecommunications, Iscor and Sasol as examples of
successful nationalisation by the South African government. This is, however, an incorrect interpretation.
The establishment of state-owned industries is not the same as nationalisation (i.e. the transfer of
ownership from private enterprise to government).
 The understanding of the ills of a command economy has improved with the experiences of the late 20 th
century and the dismal performance of countries that have a low freedom index (2014, freetheworld.com).
o Privatisation
 Privatisation refers to the transfer of ownership of assets from the public sector to the private sector (i.e.
the sale of state-owned assets to the private sector).
 The case for privatisation is usually based on three broad arguments.
 The first concerns the problem of financing increasing government expenditure in a situation where tax
burdens are already very high. In South Africa, for example, privatisation is regarded as a possible way of
obtaining funds that can be used to reduce public debt and lower personal income tax.
 The second argument is based on the view that government ownership is always less efficient than private
ownership. According to this argument the role of the government in the economy should be reduced and
more scope should be created for private ownership and private initiative.
 The third is based on the view that the losses of inefficient state-owned enterprises are important source
of budget deficits and other fiscal problems.
Activity 4.1
Discuss the differences between nationalisation and privatisation using

examples of such in your country.

The arguments for privatisation include the following;

 State-owned enterprises are bureaucratic, inefficient, and unresponsive to consumer wishes and often a
burden on the tax payer. They are also characterised by a lack of creativity and innovation by
management, poor investment decisions, poor financial control, a lack of accountability to taxpayers and
low levels of productivity. Privatisation, it is argued, will eliminate these shortcomings.
 Privatisation will attract foreign direct investment, thereby also augmenting the country’s foreign exchange
reserves.
 To the extent that public enterprises do not pay tax, privatisation will broaden the tax base (since the
privatised enterprises have to pay tax)
 Privatised enterprises will have greater access to investment capital and will be able to adapt more easily
to changing economic conditions.
 The proceeds from privatisation will make funds available for spending on housing, education, health and
so on.
 Privatisation will increase share ownership in the economy and serve as an instrument of black economic
empowerment.
Arguments against privatisation include the following;

 Privatised firms will not necessary be exposed to greater competition and be more efficient than state-
owned firms. In the extreme case, privatisation may simply entail the replacement of a state monopoly
with a private monopoly if the same protections are afforded the organisation.
 Whereas state-owned firms are expected to, privately owned firms will not take a broader view of the
public interest. For example, the provision of postal services, rail transport, telephone services and
electricity to rural areas often entails losses which have to be recouped from the more profitable provision
to metropolitan and urban areas. If these services are privatised, the services to the rural areas may be
terminated or become more expensive if the government does not subsidise the users of such services.
o Commercialisation
 Commercialisation means the transformation of state-owned enterprises into commercial entities, subject
to commercial legal requirements and governance structures, while retaining state ownership. In other
words, the enterprise remains in the public sector but is run like a private company and is also liable for
tax. This is what has happened in recent years at Transnet, Eskom and other enterprises.
4.4 Fiscal Policy and the Budget

The government purchases goods and services, raises taxes and borrows funds to finance its expenditure. It
is, therefore, necessary that government have policies with regard to the level of government spending, taxation
and borrowing. This is known as the fiscal policy. The main instrument of fiscal policy is the budget and the
main policy variables are government spending (capital and social spending) and taxation (direct and indirect).

The budget is essentially a reflection of political decisions about how much to spend, what to spend it on and
how to finance the spending. But the size and composition of government spending and the way in which it is
financed can have significant effects on important macroeconomic variables such as aggregate production,
income and employment and the price level, as well as on the distribution of income. These effects have to be
taken into account when the budget is prepared. Though it is often not the main intent, the government often
uses the budget (or fiscal policy) to attain economic objectives such as to stimulate economic growth and
employment, redistribute income, control inflation or address balance of payments problems.
Fiscal policy is often regarded as an effective means of influencing total spending (aggregate demand
for goods and services) in the economy. Mohr and Fourie (2015: 289) refer to this as demand management.
Monetary policy, introduced in study unit 3, is also recognised as demand management. Whilst fiscal policy
deals with government spending, taxation and borrowing, monetary policy deals with manipulation of
interest rates. Whilst fiscal policy is controlled by government, monetary policy is controlled by the
central bank. These policies have to be applied in harmony; otherwise the one may counteract or negate the
effects of the other. There is, therefore, some liaison between the National Treasury, which is responsible for
the execution of fiscal policy and the South African Reserve Bank, which applies the monetary policy in South
Africa.
4.5 Expansionary And Contractionary Policies

One of the functions of governments in a mixed economy is to counteract economic instability. When the
economy is in a recession, the tendency is, therefore, to apply expansionary fiscal and monetary policies to
stimulate economic activity. On the fiscal side, this means taxes are reduced and government spending is
increased, and vice versa.
4.6 Components of Aggregate Demand

Aggregate demand is the total quantity of output demanded at alternative price levels in a given period of time,
ceteris paribus. A recession occurs when aggregate demand declines and it persists when aggregate
demand remains below the country’s capacity to produce.
Aggregate demand is made up of four components:
 Consumption (C);
 Investment (I);
 Net Exports (X-M); and
 And Government Spending (G).
The government can alter aggregate demand by:

 Purchasing more or fewer goods and services;

 Raising or lowering taxes;

 Changing the level of income transfers (payments to individuals for which no current goods or services
are exchanged, such as social pension, welfare, unemployment benefits); and
 Increasing government spending turns into income for the people who provide goods and services to the
government.
Think Point 4.1
The South African government has announced budget cuts in order to fund
free education for the poor. How will this affect aggregate demand for goods
and services?
4.7 Taxation
Taxes are compulsory payments to government and are the largest source of government revenues.
There are a number of criteria for good tax, here are three:
 Neutrality
In a market-based economic system the economic problem is largely solved by the market mechanism.
Market prices play a key role in determining what should be produced and how and for whom it should be
produced. But taxes affect prices and therefore also the decisions of the various participants in the economy.
They can therefore distort the allocation of resources and lower the welfare of society. Taxation can also act as
a disincentive to the owners of the factors of production. For example, workers might decide to work less if they
are taxed at high marginal rates of personal income tax.
These costs of taxation – economists refer to them as the excess burden or deadweight loss of taxation – have
to be kept as low as possible. This is usually achieved through taxes which do not induce taxpayers to change
their behaviour. Taxation should have the minimum possible effect on relative prices, which are the signals on
which the various market participants base their decisions. They should therefore be as neutral as possible.
 Equity
The tax burden should be spread as fairly as possible among the various taxpayers. If a tax system is generally
perceived to be equitable, taxpayers might be quite willing to pay high taxes. But if it is perceived to be
inequitable, the willingness to pay taxes might be undermined. But what is an equitable or fair tax system? Who
should pay tax and who should pay the most tax?
Two principles can be used to answer these questions: the ability to pay principle and the benefit principle. As
its name implies, the ability to pay principle means that people should pay according to their ability. For
example, in the case of an income tax the ability to pay is determined by the level of income. There are two
notions of equity in this regard: horizontal equity and vertical equity. Horizontal equity requires that people in

the same position (i.e. two taxpayers who have the same income) should be taxed equally. Vertical equity
requires that people in different positions should be taxed differently. Rich people should therefore pay more
tax than poor people.
According to the benefit principle, the recipients of the benefits generated by a particular government
expenditure should pay for the goods or services concerned. In this case taxation can therefore be viewed as
a charge or levy that has to be paid for goods and services provided by government – the more you receive,
the more you have to pay. As mentioned in the previous section, benefit taxes are usually called user charges.
They can be levied where exclusion is possible. Examples include toll roads, parks, library services, hospital
services, the provision of electricity and water and university education. In the case of public goods, however,
exclusion is impossible and it is therefore also impossible to allocate the benefits of government services (e.g.
defence, justice, law and order) among those who receive them. Even where the benefits can be estimated,
services such as education or health services are often provided to the poor free of charge specifically because
they cannot afford them (and the services have positive externalities).
 Administrative simplicity.
Taxes are a cost to taxpayers. In addition to the tax payments that they have to make, taxpayers have to keep
records and complete tax returns or pay accountants to do it for them. These costs are called compliance costs.
Government also has to employ people to write tax laws, design tax forms, collect taxes and assess tax returns.
These costs are called administration costs. A good tax (or tax system) is one that keeps the compliance and
administration costs as low as possible. Taxes must therefore be simple. Complicated taxes entail high
compliance and administration costs and also present taxpayers with a variety of tax loopholes. The practice
of exploiting these loopholes is called tax avoidance. This is quite legal but it lowers the government’s tax
revenue. It can also create frustration among those taxpayers (like ordinary salaried workers) who are not in a
position to avoid tax. Tax avoidance should be distinguished from tax evasion, which occurs when people do
not pay the taxes that they are supposed to pay. For example, when someone makes shirts, sells them at a
flea market and does not declare the profit as income, the person is evading tax. Tax evasion is illegal.
Taxes can be classified into two major categories, direct and indirect. Direct taxes are levied on persons or
companies, whilst indirect taxes are levied on transactions. Examples of direct taxes are personal income
tax, company tax and estate duty. Examples of indirect taxes in South Africa are VAT, customs duties and
excise duties.
Think Point 4.2
The South African government has announced an increase in the Value Added
Tax from 14% to 15%. What effect will this have on the economy?

4.8 Summary
This unit discusses the reasons and justification for government intervention as well as the ways in which
government intervenes. It explores the concepts of nationalisation, privatisation as well as commercialisation.
It discusses fiscal policy and taxation.
STUDY UNIT
Revision Questions

1] Identify and discuss the different causes of market failure.
2] Discuss the different ways that government can intervene in an economy.
3] Discuss fiscal policy and the budget and contrast it to monetary policy.
4] Discuss the arguments for and against privatisation.
5] Discuss the criteria for a good tax.
4.9 Answers to revision questions and activities

Activities:
4.1 See section 4.3.2.1 and 4.3.2.2
Think points:
4.1 Government spending no doubt has an effect on aggregate demand but this is highly dependent on how that
government spending is financed. If the finance comes from increased government revenue as a result of an
increase in government revenue due to an expanding economy, this will definitely increase aggregate demand. In
the case of the South African example in the think point, the government aims to finance the increased government
spending on higher education in the form of budget cuts. This effectively means that government will decrease its
spending in other items of its budget in order to increase its spending on the higher education item. This will clearly
have no effect on aggregate demand since it is a substitution from one type of expenditure item in the government’s
budget, to another.
4.2 From the government perspective, this will clearly result in increased revenue which the government can use
to fund the public provision of goods and services. This could be either in the form of increased transfer payments,
other budget item allocation or the payment of government debt.
Revision questions:
1] See section 4.2
3] See section 4.4 and 4.5
5] See section 4.7

Unit
5: Macroeconomic Theories

5.2 Economic Schools of Thought  Describe the main characteristics of a free market economy;
 Describe the main characteristics of Marxist/socialist economy
5.3 Keynes versus Classical Economic  Compare Keynesian economic theory with classical free
Theories market economics
5.4 A Simple Keynesian Macroeconomic  Understand the simple Keynesian model of a closed economy
Model without the government and without a government or the foreign sector
foreign sector

5.1 Introduction
The term macroeconomics originated in the 1930s – when production, employment and prices collapsed in
much of the industrial world (The Great Depression).
The development of macroeconomics has been one of the major breakthroughs of twentieth-century economics
leading to a much better understanding of how to combat periodic economic crises and how to stimulate long-
term economic growth.
Every discussion of macroeconomic policy invariably starts with John Maynard Keynes (1883-1946). His
principal contribution was a new way of looking at macroeconomics and macroeconomic policy. This study unit
focuses primarily on the main contributions made by Keynes. To obtain a more holistic picture of
macroeconomic theory and to fully appreciate Keynes’ contribution, a good starting point would be a brief
overview of the main economic schools of thought.
5.2 Economic Schools of Thought

According to John Pape (2000), there are essentially three economic schools of thought:
5.2.1 Free market economics (sometimes referred to as: orthodox theory, neo-classical theory, conservative
economics, free enterprise economics, neo-liberalism, bourgeois economics or capitalistic
economics);
5.2.2 Marxist economics (or socialist economic theory or communist economic theory or radical economic
theory); and
5.2.3 Keynesian economics (or the theory of the mixed economy or interventionist economics).
5.2.1 The Free Market School

o Major Beliefs
There are three central beliefs in free market economics:
 Human beings are motivated mainly by profit and self-interest (personal gain);
 Business should be given a free hand in all economies; and
 Competition between different businesses should be promoted (encouraged).
 It is by acting in one’s own self-interest that people will produce goods and services and trade.
According to free market economics, an economy works well when businesses make high profits, i.e., anything
which limits the making of profit (excluding force and fraud) is bad for the economy. For example, free marketers
oppose high taxes. They argue that if government coercively takes large amounts of tax from businesses,
companies will not want to continue to produce. They will lose motivation, since extra profits will be paid as tax.

They also argue that everyone will benefit if companies are allowed to keep all of their profits to:
 Build new factories and produce more goods;
 Create more jobs; and
 Increasing employment means that people will have more money to spend; and
 There will be more money for the business to pay better salaries and higher dividends for owners.
They believe that the major obstacle to the success of their model is government intervention in the trade
activities of consenting parties. Free marketers oppose high taxes and nationalization (where government owns
and runs businesses). They believe that government should pass laws and take other measures that aim at
ensuring the environment is conducive for business – e.g. Property rights are protected, an open, fair and
accessible legal system is established, that special interest groups are not advantaged, no special privileges,
no onerous regulations and tariffs are implemented and sound money policies are followed. In such a society
force will not be used to attain social objectives, laws that force people to act against their personal preferences
or own self-interest are not promulgated.
o Type of Economic System Supported

Free marketers are capitalists, i.e., they support a society where classical liberal concepts are followed – the
key tenets of the capitalist economic system is consent and furthermore that works according to the idea of
private ownership of the factors of production and private property rights.
o Countries where Practised (to some degree)

USA, Switzerland, Singapore
Think Point 5.1
What are the disadvantages of a free market economy?
5.2.2 Marxist Economics

The German writer, Karl Marx (1800s) together with Friedrich Engels, wrote extensively and had a big influence
on the spread of socialism and communism. These ideas have had a profound effect of the world economy, but
also caused the death of millions of people under the communist and socialist dictators like Hitler (National
Socialism), Stalin, Mao Tse Tung, Pol Pot and others. Since the 1990’s these ideas have lost favour in most
industrialised countries, though pockets of this thinking remain in the more so-called “mixed” economies.

o Major Beliefs
Marxist economists disagree almost totally with free market theory. There are two basic points on which they
differ. They do not believe that:
 Property rights should vest with individuals
 Profit should drive an economy, that money should be eliminated; and
They do believe that the end justify the means, even if it is to the disadvantage of some individuals or groups –
individuals should sacrifice their own interests for the greater good of society.
They argue that human beings are not driven by self-interest. Because human beings are capable of problem
solving, they are capable of cooperation. Hence, an economy should be based on cooperation rather than
competition or self-interest.
o Type of Economic System Supported

They believe in a socialist economic system.
o Countries where Practised

Former Soviet Union, Cuba, People’s Democratic Republic of Korea (North Korea), and previously some other
eastern European countries. Though China and South Vietnam have communist rulers, they have liberalised
their economies dramatically. China has since the takeover of Hong Kong created numerous Free Trade Zones
along the east coast which are driving the economic revival; Vietnam has instituted the Doi Moi economic
programme that has put land back in private ownership and have instituted many other reforms such as the
owning of property by foreigners – both of these countries have however faced serious human rights violation
allegations.
Think Point 5.2
What are the disadvantages of a Marxist economy?
5.2.3 Keynesian Theory

o Background
In the late 1920’s, the world economic system began to break down after the shaky recovery that followed
World War 1. With the global drop in production, critics of the global standard, market self-correction, and
production-driven paradigms of economics moved to the fore. Dozens of different schools contended for
influence. Further, some pointed to the Soviet Union as a successful planned economy which had avoided the

disasters of the capitalist world and argued for a move toward socialism. Others pointed to the alleged success
of fascism in Mussolini’s Italy.
Into this void stepped Keynes, promising not to institute a revolution but to save capitalism. He circulated a
simple thesis:
There were more factories and transportation networks than could be used at the current ability of individuals
to pay and that the problem was on the demand side.
But many economists still insisted that business confidence, not lack of demand, was the root of the problem,
and that the correct course was to slash government expenditure and to cut wages to raise business confidence
and willingness to hire unemployed workers. Yet others simply argued, “nature would take its course,” solving
the depression automatically by “shaking out” unneeded productive capacity.
5.3. Keynes versus Classical Economic Theories

Keynesian economics is a theory of total spending in the economy – aggregate demand – and of its effects on
output and inflation.
According to “classical” economic theory, adjustments in prices would automatically make demand tend to the
full employment level. Keynes argued that this self-correcting process never happened in the early 1930s when
employment and output fell sharply.
In the neo-classical theory, the two main costs are those of labour and money. If there was more labour than
demand for it, wages would fall until hiring began again. If there was too much saving and not enough
consumption, then interest rates would fall until either people cut savings or started borrowing. These two price
adjustments would always enforce Say’s Law (which states that “supply creates its own demand”), and,
therefore, the economy would be at the optimal level of output.
5.3.1 Wages and Spending

Even in the worst years of the depression, the classical theory defined economic collapse as simply a lost
incentive to produce. Mass unemployment was caused only by high and rigid real wages. The proper solution
was to cut wages.
To Keynes, the determination of wages is more complicated. First, he argued that it is not real but nominal
wages that are set in negotiations between employers and workers. It is not a barter relationship.

Nominal wage is the amount paid in money terms while real wage is the value in terms of the purchasing
power i.e. real wage takes into account the effects of inflation.
First, nominal wage cuts would be difficult to put into effect because of laws and wage contracts. Even classical
economists admitted that these exist; unlike Keynes, they advocated abolishing minimum wages, unions, and
long-term contracts, and increasing labour-market flexibility. However, to Keynes, people will resist nominal
wage reductions, even without unions, until they see other wages falling and a general fall of prices.
Secondly, he also argued that to boost employment, real wages had to go down: nominal wages would have
to fall more than prices. However, doing so would reduce consumer demand so that the aggregate demand for
goods would drop. This would, in turn, reduce business sales revenues and expected profits. Investment in new
plant and equipment -- perhaps already discouraged by previous excesses -- would then become more risky
and less likely. Instead of raising business expectations, wage cuts could make matters much worse.
5.3.2 Excessive Saving

To Keynes, excessive saving, i.e., saving beyond planned investment, was a serious problem encouraging
recession or even depression.
Recession – fall of a country’s GDP in two successive quarters – may involve falling prices which can lead to
a depression (where the country “can’t get up”).
Excessive saving results if investment falls, perhaps due to falling consumer demand, over-investment in earlier
years, or pessimistic business expectations, and if saving does not immediately fall in step.
Third, Keynes argued that saving and investment are not the main determinants of interest rates, especially in
the short-run. Instead, the supply of and the demand for the stock of money determine interest rates in the
short-run. Neither change quickly in response to excessive saving to allow fast interest-rate adjustments.
Finally, because of fear of capital losses on assets besides money, Keynes suggested that there may be a
“liquidity trap” setting a floor under which interest rates cannot fall. (In this trap, bond-holders, fearing rises in
interest rates (because rates are so low), fear capital losses on their bonds and thus try to sell them to attain
money (liquidity). Even economists who reject this liquidity trap now realize that nominal interest rates cannot
fall below zero (or slightly higher).
Even if this "trap" does not exist, there is a fourth element to Keynes's critique (perhaps the most important
part). Saving involves not spending all of one's income. It thus means insufficient demand for business output,
unless it is balanced by other sources of demand, such as fixed investment. Thus, excessive saving

corresponds to an unwanted accumulation of inventories, or what classical economists called a “general glut”
". This pile-up of unsold goods and materials encourages businesses to decrease both production and
employment. This, in turn, lowers people's incomes -- and saving.
For Keynes, the fall in income did most of the job, ending excessive saving and allowing the loanable funds
market to attain equilibrium. Instead of interest-rate adjustment solving the problem, a recession does so.
Whereas the classical economists assumed that the level of output and income was constant and given at any
one time (except for short-lived deviations), Keynes saw this as the key variable that adjusted to equate saving
and investment.
Finally, a recession undermines the business incentive to engage in fixed investment. With falling incomes and
demand for products, the desired demand for factories and equipment (not to mention housing) will fall. This
accelerator effect would shift the investment curve (I) to the left again. This recreates the problem of excessive
saving and encourages the recession to continue.
In summary, for Keynes, there is interaction between excess supplies in different markets, as unemployment
in labour markets encourages excessive saving -- and vice-versa. Rather than prices adjusting to attain
equilibrium, the main story is one of quantity adjustment allowing recessions and possible attainment of
underemployment equilibrium.
5.3.3 Government Policy – Active Fiscal Policy

Fiscal Policy, as mentioned previously, describes the behaviour of governments in raising money to fund
current spending and investment for collective social purposes and of transfer payments to citizens and
residents of the territory for which the government is responsible.
Classical theorists wanted to balance the government budget through:
 Slashing expenditure; or
 If this was not possible to raising taxes.
Keynes felt that either policy would exacerbate the underlying problem since it will raise saving, thereby lowering
demand for both products and labour. He suggested that active government policy – policies which acted
against the tide of the business cycle - is more effective in managing the economy. By that he meant:
 Deficit spending when a nation’s economy suffers from recession or when recovery is delayed by
persistently high unemployment.
Note: When the expenditure of a government (its purchases of goods and services, plus its transfers (grants)
to individuals and corporations) is greater than its tax revenues, it creates a deficit in the government budget.
 Suppression of inflation in boom times by:

o Increasing taxes; or
o Reducing government spending.
5.3.4 The “Multiplier Effect” and Interest Rates

The Multiplier Effect
The effect on demand of any exogenous (refers to an action or object coming from outside a system)
increase in spending, such as an increase in government outlays is a multiple of that increase - until
potential is reached.
Thus, a government could stimulate a great deal of new production with a modest outlay: if the government
spends, the people who receive this money, spend most on consumption goods and save the rest. This extra
spending allows businesses to hire more people and pay them, which, in turn, allows a further increase in
consumer spending.
This process continues. At each step, the increase in spending is smaller than in the previous step, so that the
multiplier process tapers off and allows the attainment of an equilibrium. This story is modified and moderated
if we move beyond a "closed economy" and bring in the role of taxation: the rise in imports and tax payments
at each step reduces the amount of induced consumer spending and the size of the multiplier effect.
Interest Rates
Classical Model – The supply of funds (savings) determined the amount of fixed business investment.
Keynes – The amount of investment was determined independently by long-term profit expectations and, to a
lesser extent, the interest rate. This approach opens the possibility of regulating the economy through money
supply changes via the monetary policy.
5.3.5 A Summary of the central Themes of Keynesian Economics

According to Blinder (1987), six principal tenets are central to Keynesianism – the first three describe how the
economy works and the next three are distinguishing features (from other economic theorists) on economic
policy:
 Aggregate demand is influenced by a host of economic decisions – both public and private – and sometimes
behaves erratically. The public decisions are mainly on monetary and fiscal policy.
 Changes in aggregate demand, whether anticipated or unanticipated, have their greatest short-run impact
on real output and employment, not on prices.
 Prices, and especially, wages, respond slowly to changes in supply and demand. This results in shortages
and surpluses, especially in labour.

 Keynesians do not think that the typical level of unemployment is ideal – partly because unemployment is
subject to the caprice of aggregate demand, and partly because they believe that prices adjust only
gradually.
 Most Keynesians advocate an activist stabilization policy to reduce the amplitude of the business cycle (this
will be discussed in a later study unit).
 Many Keynesians are more concerned about combating unemployment than about conquering inflation.
Keynesian theory was much denigrated in academic circles from the mid-1970s until the mid-eighties. It has
staged a strong comeback since then mainly because it was better able to explain the economic events of the
70’s and 80’s than its principal intellectual competitor, new classical economics. They were able to explain the
European depression of the eighties as follows:
Governments, led by the British and German central banks, decided to fight inflation with highly restrictive
monetary and fiscal policies. The anti-inflation crusade was strengthened by the European Monetary System,
which, in effect, spread the stern German monetary policy all over Europe.
The new classical school has no comparable explanation. In fact, they argue that European governments
interfere more heavily in labour markets (high unemployment benefits and restrictions on firing workers). But
most of these interferences were in place in the early seventies, when unemployment was extremely low.
5.4 A Simple Keynesian Macroeconomic Model Without The Government And Foreign Sector
For the purpose of this module, an examination of the simplest possible model will be conducted, i.e., this model
excludes the government and the foreign sector and only considers households and firms. The following table
(Mohr & Fourie, 2008:409) summarises the assumptions of this simple model and highlights the implications of
these assumptions.
ASSUMPTIONS IMPLICATIONS
The economy consists of households and Total spending consists of consumption spending
firms and investment spending
There is no government The model cannot be used to analyse government
spending and taxes
There is no foreign sector The model cannot be used to analyse exports,
imports, exchange rates, trade policy and exchange
rate policy
Prices are given Model cannot be used to study inflation
Wages are given Model cannot be used to study the workings of the
labour market

The money supply and interest rates are Model cannot be used to study the financial markets
given and monetary policy
Spending (demand) is the driving force Production (supply) adjusts passively to changes in
that determines the level of economic spending (demand)
activity
In an economy that consists of households and firms only, there are only two types of spending:
 Consumption spending (C) – spending by households on consumer goods and services; and
 Investment spending (I) – spending by firms on capital goods.
The economy is in equilibrium when:
Aggregate Spending (A) = Aggregate Income (Y) (Eqn. 1)
Now Aggregate spending (A) consists of consumption spending (C) and investment spending (I).
i.e. A = C + I
In other words, an economy is in equilibrium when:

C + I = Y (Eqn. 2)
Consumption Spending (C)

Consumption spending is the largest component of total spending. The relationship between consumption
expenditure by households and total income is called the consumption function. The consumption function has
three important characteristics:
 Consumption  as income ;
 Consumption is positive even if income is zero this reflects the influence of non-income determinants on
income spending; and
 When income , consumption also  but is less than the  in income since part of the additional income is
saved.
The above three characteristics of the consumption function are illustrated in Figure 5.1 below:

The consumption function is illustrated graphically in Figure 5.1.

Consumption (C) is measured along the vertical axis and total
production or income (Y) is measured along the horizontal axis.
The consumption function shows the level of consumption
spending at each level of income.
Figure 5.1 confirms the three features mentioned earlier. First it

is obvious that consumption spending increases as income
increases. The second feature is that consumption does not fall
to zero even if income falls to zero. When Y is zero, consumption
is still at some positive level, indicated by C1 in the figure. The
fact that C1 is positive means that income Y is not the only
determinant of consumption. The distance from the origin (0) to C1 is called autonomous consumption.
Autonomous consumption is that part of consumption which is independent of the level of income. This can
also be regarded as a minimum level of consumption that is financed from sources other than income, for
example, from past savings or credit. Induced consumption is that part of consumption which is determined
by the level of income and is indicated by the slope of the consumption function.
As income increases, consumption increases, but the increase in consumption is smaller than the increase in
income. As income increases from Y1 to Y2, in Figure 5.1, consumption increases from C2 to C3. However, the
change in C (i.e. ΔC) is smaller than the change in Y (i.e. ΔY). This is the third important feature of the
consumption function. The ratio between the change in consumption (ΔC) and the change in income (ΔY) is
one of the most important ratios in macroeconomics. It is called the marginal propensity to consume and it
is usually indicated by the symbol c. Note that it is equal to the slope of the consumption function. In symbols
the marginal propensity to consume may be expressed as:
∆𝐶
𝑐 =
∆𝑌
The marginal propensity (or tendency) to consume indicates the proportion of an increase in income that will
be used for consumption. It can never be greater than one, since the additional amount used for consumption
out of additional income can never exceed the additional income. The marginal propensity to consume therefore
lies somewhere between zero and one. In symbols we can therefore write 0< c < 1.

These two components of the total consumption spending are further illustrated in figure 5.2 below:
Investment Spending (I)

Investment spending is more variable and less predictable
than consumption spending. Because of its volatility,
investment spending is often the main cause of fluctuations
in economic activity. To complicate matters I is not primarily
a function of income. In fact, it is independent of the level of
income as indicated by figure 5.3 below:
However, I is determined by:

 The expected profitability from the investment. The
greater the expected profit, the greater the investment;
 The interest rate both for borrowing capital or investing
capital;
 The opportunity cost of using the funds; and
 The level of risk and or uncertainty.
To finally construct a simple macroeconomic model of
income determination, to obtain aggregate spending, we
have to add C and I at each level of Y (refer to Eqn. 2
above).
This is indicated in figure 5.4 below:

We have established that consumption (C) is primarily a

function of income (Y). We have also established that
investment (I) is not a function of income (Y). These two
relationships are illustrated in Figure 5.4 (a) and (b). To obtain
aggregate spending, we have to add C and I at each level of
Y. This yields the total or aggregate spending function in
Figure 5.4 (c). We also know that there is equilibrium when
aggregate spending (A) is equal to total income (Y). We
therefore have to establish at which point along the A curve
aggregate spending is equal to total income (Y). This is done
by using a 45-degree line.
From equation 1 above, it is known that there is equilibrium

when Aggregate Spending (A) = Total Income (Y). If you
consider graph (c) in figure 5.4.
FIGURE 5.5
Figure 3
 A straight line drawn at 45 to either axis will have the

equation A =Y, i.e., at all points along this line aggregate
spending = total income; and
 The point where the line A=Y intersects the line A = C + I
is the equilibrium point which is denoted by E in figure 5.5.
Note:
The equilibrium level of income Yo is the level of income at which the aggregate spending function A intersects
the 45 line. At any level of income lower than Yo there is excess demand (A > Y) and at any level of income
higher than Yo there is excess supply (A < Y) along the aggregate spending function.

The equilibrium level of income

Income (Y) is at its equilibrium level when it is equal to the level of aggregate spending (A). When aggregate
spending (A) is greater than total production or income (Y), firms experience an unplanned decrease in their
inventories. The reason is that current production is insufficient to meet the demand for goods and services.
Firms therefore have to draw on their stocks or inventories to meet the demand. The unplanned decrease in
inventories acts as an incentive to firms to increase their production of goods and services. When aggregate
spending (A) is less than total production or income (Y), then firms experience an unplanned increase in their
inventories. Firms find that they cannot sell all the goods and services produced and therefore lower their
production. Equilibrium occurs only when aggregate spending (A) is equal to total production or income (Y)
(Mohr & Fourie (2015:326)).
5.5. Summary
This unit introduces three macroeconomic schools of thought namely the Free market school, Marxist and
Keynesian theory. It discusses the essential differences between the Keynesian and Classical economic
theories. It then presents a summary of the central themes of Keynesian economics as well as a simple
Keynesian economic model with no government and foreign sector.
STUDY UNIT
Revision Questions
Possible short and essay questions.

1] Discuss the difference between Keynesian economic theory and classical
economic theory with respect to wages and spending, excessive saving,
government policy and interest rates.
2] Give an outline of the central themes of Keynesian economics.
3] Discuss the multiplier effect.
4] In the context of the simple Keynesian macroeconomic model without the
government and foreign sector:
4.1 Explain the components of aggregate spending.
4.2 Discuss how equilibrium is reached in the economy.
5.6. Answers to revision questions and activities

Think points:
5.1 The disadvantages of a free market economy are based on the market systems inability to meet social
outcomes like an equitable distribution of income and low unemployment. Other disadvantages are discussed
under the section of market failure in Unit 4.2

5.2 The biggest disadvantage of Marxist economic systems is that it creates a disincentive to work hard and
apply greater effort. A second disadvantage is that a few individual members of state are left with the task of
allocating resources in the economy who are susceptible to corruption and their own interest.
Review questions:
1] See section 5.3
4] 4.1 See section 5.4
4.2 See section 5.4

Unit
6: Inflation

6.2 The cause of inflation  Define inflation and describe some of the causes and effects
of inflation
6.3 The effects of inflation  Understand why policy makers regard inflation as a problem

6.1. Introduction
Inflation is often described as “public enemy number one.” However, an economy suffers from inflation when
there are constant significant increases in the general price level. Take note of the four aspects of the definition
(Mohr and Fourie, 2015:382). It is measured using an indicator known as the consumer price index (CPI). The
CPI reflects the cost of a representative basket of goods and services. Inflation is calculated by taking the
percentage change in the CPI over a period of time (not less than a year).
6.2 The Causes of Inflation

Inflation is a complex, dynamic process which cannot be ascribed to a single cause. To avoid pointing a finger
at any one party (such as the government or the trade unions), it is best to look at approaches used to explain
this process. There are four approaches identified and each provides a framework for formulating policies that
can be used to combat inflation.
6.2.1 The Monetarist Approach
 Regards inflation as a purely monetary phenomenon. Monetarists believe that inflation is caused by
excessive increases in the quantity of money.
 Sustained high rates of monetary growth cause high inflation, while low rates of monetary growth will
eventually produce low inflation.
 Shortcomings of this approach – It assumes that changes in the quantity of money does not affect real
variables such as output and employment.
6.2.2 The Demand Pull and Cost-Push Approach
6.2.2.1 Demand-Pull Inflation

 Occurs when the aggregate demand for goods and
services increases while aggregate supply remains
unchanged – “too much money chasing too few
goods.”
Demand-pull inflation can be caused by any (or a
combination) of the various components of aggregate
demand:
• increased consumption spending by households (C),
for example as a result of a greater availability of
consumer credit or the availability of cheaper credit as
a result of a drop in interest rates

• increased investment spending by firms (I), for example as a result of lower interest rates or an
improvement in business sentiment and profit expectations
• increased government spending (G), for example to combat unemployment or to provide more or
better services to the population at large
• increased export earnings (X), for example as a result of improved economic conditions in the rest of
the world or because of increases in the prices of important export products (such as minerals, in the
case of South Africa)
Demand-pull inflation can be illustrated with the aid of the aggregate demand-aggregate supply model (AD-AS
model). Demand-pull is illustrated by a rightward shift of the AD curve, as in Figure 6.1. An increase in aggregate
demand leads to an increase in the price level (P) and an increase in production and income (Y).
Demand-pull inflation thus has a positive impact on production, income and employment, provided that there
are still some unemployed resources and scope for increases in Y. When the economy is at full employment,
further increases in aggregate demand simply lead to price increases. This is indicated in Figure 6.1 by the shift
of the AD curve from AD3 to AD4 along the vertical part of the AS curve.
To combat demand-pull inflation, the authorities have to keep the aggregate demand for goods and services in
check. This can be done by applying restrictive monetary and fiscal policies. Restrictive monetary policy entails
raising interest rates and limiting the increase in the money stock. This raises the cost of credit and also reduces
the availability of credit to the various sectors of the economy. Restrictive fiscal policy entails a reduction in
government spending and/or increased taxation. These policies will tend to reduce aggregate demand. In terms
of Figure 6.1 they will cause a leftward shift of the AD curve. This will result in a fall in prices, but it may have
costly side-effects since production, income and employment will also tend to fall (Mohr & Fourie (2015:389)).
o Cost-push Inflation
As the term indicates, cost-push inflation in triggered by increases in the cost of production. Increases in the
cost of production pushes the price levels up. There are five main sources of cost-push inflation.
• The first source is increases in wages and salaries.
• A second important cost item in the South African economy is the cost of imported capital and intermediate
goods. These goods are essential to the functioning of the domestic economy, particularly the
manufacturing sector. When the prices of imported goods such as oil, machinery and equipment increase,
the domestic costs of production are raised.
• A third source is increases in profit margins. Like wages, interest and rent, profit is also included in the cost
of production. When firms push up their profit margins they are therefore raising the cost of production (and
the prices that consumers have to pay).
• A fourth source is decreased productivity.

• A fifth source is natural disasters, such as droughts

or floods, which occur periodically.
Cost-push inflation can also be illustrated with the aid

of the AD-AS model. Cost-push is reflected in an
upward (or leftward) shift of the AS curve, as in Figure
6.2. An increase in the cost of production results in an
increase in the price level (P) and a decrease in
production and income (Y). Cost-push inflation thus
has a negative impact on production, income and
employment.
To avoid cost-push inflation, measures have to be

taken to avoid increases in the costs of production.
Increases in wages and salaries and profits therefore
have to be kept under control. Increases in productivity
can also help to avoid or combat cost-push inflation. The main point to note at this stage is that cost-push
inflation cannot be combated by applying restrictive monetary and fiscal policies. Such policies may succeed in
reducing the price level but this would be achieved at the expense of even greater unemployment (Mohr &
Fourie (2015:389-390)).
The major problem with demand-pull and cost-push inflation is that both become intertwined in the inflation
process and it is difficult to distinguish between the two in practice. Neither one of the two can take place without
some increase in the money supply….and then there is time lag, the effect of the velocity of money and other
factors (discussed below) that affect the outcome.
Take this situation as an example: Let us say oil prices rise dramatically because of a war in the Middle East.
A country such as South Africa that imports its oil, now has to pay more – petrol prices rise
and so do the prices of all goods that are affected by it – though it is said that we have “imported inflation” this
is not strictly true, since it is a once off price shock and if the money supply stayed constant, expenditure will
shift from other products (people will buy less) which will cause the prices of the other products to drop in the
same relation as the rise in prices caused by the increase in the oil price so the general price levels (inflation)
would theoretically stay constant.

6.2.3 The Structuralist approach

According to this approach, inflation is the result of the
interaction between three interrelated sets of factors
(Mohr & Fourie, 2015:390):
 Underlying factors – provides the background against
which the inflation process occurs;
 Initiating factors – trigger or intensify a particular
inflation process; and
 Propagating factors – transmits the initiating
impulse(s) through the economy and over time, and,
in so doing, generates/sustains the process of rising
prices.
Table 6.1 summarises some of the most important

underlying, initiating and propagating factors.
o Underlying factors
The underlying factors, also called the structural factors
(hence the term “structuralist approach”), lie at the root of
the inflation process. They provide the background
against which the process occurs. An examination of the underlying factors gives an indication of how
vulnerable an economy is to inflation. For example, the greater the degree of class or race conflict in society,
the greater the chances that high inflation will occur. Not surprisingly, therefore, the highest inflation rates tend
to occur during wars or civil wars. On the other hand, the greater the degree of social and political cohesion,
the greater the chances will be that disputes about the distribution of income and wealth can be settled without
generating a process of inflation.
To understand inflation, the processes whereby the prices of goods and services and of the factors of production
are determined also have to be examined. This means that, amongst others, the structures of the goods market
and the labour market have to be examined (Mohr & Fourie, 2015:391).
o Initiating Factors
Although the underlying factors are important, they cannot explain why the inflation rate is what it is, why it
sometimes falls and why it sometimes accelerates. Against the background of the underlying factors, specific
cost and/or price increases are required to initiate or aggravate a particular inflationary episode. The immediate
causes of such increases are called the initiating factors. These factors can be classified into three broad
categories: demand-pull factors, cost-push factors and “other” price or cost increases. The demand-pull factors

and cost-push factors are the same as those already discussed in the section on demand-pull and cost-push
inflation. The distinction between demand pull and cost push is thus retained, but in a much narrower context.
The demand-pull and cost-push factors set the process in motion but do not in themselves explain the whole
process. Towards the end of 2001, for example, the rand depreciated sharply against the major international
currencies. As a result, the prices of imported capital, intermediate and consumer goods increased sharply.
Such increases, however, are in themselves insufficient to explain a process of inflation – see Box 20-4. They
have to be transmitted through the economy and over time by the propagating factors (Mohr & Fourie,
2015:392).
o Propagating factors
Once prices and/or costs have risen somewhere in the economy, these increases have to be transmitted to the
rest of the economy and over time to generate or sustain an inflation process. This is where the propagating
factors come in. Broadly speaking, three sets of propagating factors can be distinguished.
The first is the various interrelationships that exist between prices, wages and profits in the economy. In this
regard, economists often refer to price-wage, price-price, wage-price and wage-wage spirals. These spirals
have their origin in the underlying factors, for example the structure or degree of competition in the goods
markets and the labour market, and are explained by the statement (attributed to Harold Wilson) that one man’s
price (or income) increase is another man’s price (or cost) increase. For example, if a trade union in a key
industry succeeds with a claim for a wage increase well above the current inflation rate (and unrelated to any
productivity increase), the costs of the firms in that industry increase. If prices in that industry are set on a cost-
plus basis, it means that prices in that industry will also increase. The firms or consumers who purchase the
industry’s goods will experience cost increases and will try to pass those increases on to their customers or
employers. Workers, for example, will demand higher wages, first, because prices have increased and, second,
because the workers in the other industry have received high wage increases. Firms purchasing from the first
industry will experience cost increases which will be exacerbated if their workers succeed with wage increases
similar to those in the first industry, and so on. This simple and incomplete example gives some indication of
how price or wage increases originating in a particular sector or industry can generate a process of inflation in
the economy.
A second set of propagating factors (or elements of the inflationary transmission mechanism) is to be found in
the interaction between domestic prices, the balance of payments and the exchange rate. Consider the
following sequence of events: One of the domestic initiating factors (e.g. a sharp increase in wages) causes
price increases in the domestic economy. This leads, through a process of substitution, to an increased demand
for imports and/or a decreased demand for exports at the current exchange rate. Under a floating exchange
rate regime, this could result in a vicious circle of exchange rate depreciation and domestic inflation. The initial
trigger could also have been the depreciation of the currency (as happened in South Africa towards the end of

2001), which then results in higher import prices. If these higher prices are passed on to domestic consumers
and they, in turn, claim higher wages to compensate for the higher prices (and succeed with such claims) the
same type of vicious circle may ensue.
This brings us to a third propagating factor, namely the increase in the money stock. By definition, inflation can
occur only in a money economy. It is impossible to have inflation in a moneyless (i.e. barter) economy. If there
is no generally accepted medium of exchange, as in a barter economy, an increase in the price of one good
implies that the price of another good has fallen. In such an economy a general increase in the price level is
thus impossible. Inflation can be sustained only if the quantity of money (M) and/or the velocity of circulation of
money (V) increase. The monetarists assume that the quantity of money is exogenously determined by the
monetary authorities (the central bank). They therefore believe that inflation can be halted by fixing the money
stock. However, as we explained in study unit three, the money stock is determined by the interaction between
the interest rate and the demand for money. In other words, the money stock is endogenous rather than
exogenous. In terms of the structuralist approach to inflation, this means that expansions in the money stock
tend to be part of the inflation process (i.e. endogenous) rather than directly under the control of the monetary
authorities (i.e. exogenous).
The general policy implication of the structuralist approach is that inflation can be effectively combated only
through a broad, coordinated anti-inflation strategy that is aimed at all three sets of factors in the inflation
process (Mohr & Fourie, 2015:391-392).
Because the structuralist approach is so broad, some economists argue that it does not provide an adequate
explanation of inflation or an adequate basis for forecasting what might happen to inflation (Mohr & Fourie,
2015:391-392).
6.2.3 The Conflict Approach

Analysts are not in agreement whether the issues dealt with here are causes or results. In all cases where
these phenomena have been observed there was a disjoint between the money supply and production, income
and spending levels. According to this approach, inflation then is a symptom of a fundamental disharmony in
society which results in a continuous imbalance between the rate of growth in the real national income and the
rate of growth of the total effective claims on this income.
 The rival interest groups each strive to gain larger shares of the “pie” by claiming higher money incomes,
and this results in inflation.
 Inflation is the symptom of a lack of effective economic and/or political mechanisms to achieve a prior
reconciliation of the conflicting claims on the national income.

Think Point 6.1

From a policy perspective, which of the above explanations of the inflation
process would lead to a more informed policy intervention process?
6.3. The Effects of Inflation

The costs of inflation are not immediately obvious. Three sets
of effects of inflation will be examined:
 Distribution Effects
• Inflation benefits debtors (borrowers) at the expense of
creditors.
To understand this you have to remember that the real value

(or purchasing power) of money falls when prices increase.
The redistribution between creditors and debtors can be
explained by using a simple example. Suppose Peter
borrowed R10 000 from Paul on 1 January 2012 on the
understanding that the principal amount of R10 000 was to be
repaid on 31 December 2013. In addition Peter would pay Paul interest at 10 per cent per annum, that is, Peter
would pay Paul interest of R1 000 per year. Table 6-1 shows that the CPI rose from 95,2 in January 2012 to
105,4 in December 2013. The real value or the purchasing power of the R10 000 (in January 2012) therefore
fell to R10 000 × 95,2/105,4 = R9 032 in December 2013. In real (or purchasing power) terms Paul thus did not
receive the full amount he loaned to Peter in January 2012 when the loan was repaid in December 2013. This
clearly indicates a redistribution of wealth from the lender (Paul) to the borrower (Peter).
• Inflation tends to redistribute income wealth from the elderly to the young.
People who borrow money to purchase expensive consumer goods such as motorcars also benefit from
inflation, because it reduces the real value of their debt. Since younger people are more likely to be net
borrowers while old people tend to have relatively fixed nominal incomes (e.g. pensions or interest income),
inflation tends to redistribute income and wealth from the elderly to the young.
• Redistribution from the private sector to the government.

In this case there is no doubt as to who benefits from inflation – it is always the government. The government
is always a debtor – in South Africa the total debt of the government was more than R1 560 billion on 31
December 2013. During inflation the government therefore gains at the expense of the holders of the public
debt (e.g. the holders of government stock).

The government can also gain via the tax system. South Africa has a progressive personal income tax, which
means that marginal and average tax rates increase with the income level. The higher an individual’s income
is, the greater the percentage income tax that he or she has to pay. When there is inflation, taxpayers’ nominal
incomes (e.g. wages and salaries) rise even when their real incomes remain unchanged. Taxes, however, are
levied on nominal income and not on real income. Therefore, if the income tax schedule remains unchanged,
inflation raises the average rates of personal income tax. In other words, individuals will have to pay higher
taxes even if they are actually no better off than before.
 Economic Effects
 Anticipating inflation – Decision makers become more concerned with anticipating inflation than with
seeking profitable new production opportunities.
 Speculative practices – People try to outwit each other by speculating in shares, foreign currency
(exchange), price of precious metals etc. instead of engaging in productive investments (new factories,
machinery and other equipment).
 Discourages saving – By reducing the value of existing savings, inflation may also discourage saving in
traditional forms (fixed deposits, pension fund contributions etc.).
 Balance of payment problems – Inflation increases the costs of export industries and import-competing
industries. If the inflation rate in SA is higher than that of our major trading partners and international
competitors, then South Africa’s international competitiveness could be adversely affected.
 Social and Political Effects

Price increases make people unhappy and different groups in society blame one another for increases in the
cost of living. When rents, service charges, bus fares or taxi fares go up, the frustration often gives rise to social
and political unrest, especially among the poor. Inflation creates a climate of conflict and tension which is not
conducive to economic progress (Mohr & Fourie, 2015:38).
6.4 Summary
This unit discusses the different approaches used to explain the inflation process alongside policy intervention
that can used to combat inflation. It discusses the distribution, economic, social and political effects of inflation.
STUDY UNIT

Revision Questions

1] With the aid of a diagram, discuss demand-pull inflation, its sources as
well as policy tools to combat it.
2] With the aid of a diagram, discuss cost-push inflation, its sources as well
as policy tools to combat it.
3] Discuss the structuralist approach to explaining inflation.
4] Discuss the propagating factors of the structuralist approach and their
explanation of inflation.
5] Discuss the effects of inflation.

Think points:
6.1 The structuralist approach in the explanation of the inflation process goes beyond considering factors that
cause the inflation process to occur (initiating factors) but it also considers other factors that form the backdrop
of the inflation process such which if not considered in policy, can exacerbate the inflation problem. Propagating
factors are also considered in which also need to be considered in policy formulation failing which, the inflation
process could continue over and above other policy intervention tools (e.g. decrease in government spending).
Review questions:
1] See section 2.1
2] See section 2.2
5] See section 6.3

Unit
7: Unemployment

7.2 Measuring Unemployment  Understand how to measure unemployment
7.3 The costs of  Identify and describe some of the costs of unemployment
unemployment
 Suggest policies to tackle the unemployment problem
7.4 Types of unemployment  Define unemployment and describe the different types of unemployment
7.5 Policies to reduce  Explain the policies that address reducing unemployment
unemployment

7.1 Introduction
High and prolonged unemployment is a sign of a malfunctioning economy. Being unemployed is, for most
people, a highly distressing experience that causes damage in many ways that cannot be quantified.
Definition: According to the International Labour Organisation, unemployment (being unemployed) refers to
those of a working age, who in a specified period, are without work and are both available for, and have taken
specific steps to find work.
This definition is not comprehensive (McAleese: 2001) and has the following shortcomings since it implies that:
 People who work part-time because they cannot find full time employment are fully employed; and
 People functioning in the ‘shadow’ economy (e.g. informal traders) are considered to be unemployed.
7.2 Measuring Unemployment

Stats SA regularly publishes estimates of the unemployment rate in South Africa. However, there is some
controversy about whether the strict or expanded definition of unemployment should be used.
According to the strict definition, unemployed persons are those persons who, being 15 years and older, (a)
are not in paid employment or self-employment, (b) were available for paid employment or self-employment
during the seven days preceding the interview and (c) took specific steps during the four weeks preceding the
interview to find paid employment or self-employment.
The expanded definition, on the other hand, omits requirement (c). In other words, the expanded definition
requires only a desire to find employment (Mohr & Fourie, 2015:400).
7.3 The Costs of Unemployment

o Economic Costs
 Lost output resulting in potential GDP (the real GDP the economy would produce if its labour and other
resources were fully utilised).
 Unemployment insurance payments – payment for workers who are not working. These funds could
be utilised for other purposes.
o Non-economic Costs
 Increased crime and (labour) unrest; and
 The unemployed can become dispondent and ‘rusty’.
7.4 Types of Unemployment

 Cyclical Unemployment - Any temporary drop in aggregate demand of a country results in cyclical
unemployment. This leads to a recession – drop in real GDP – in the country. The drop in real GDP can
be caused by a drop in consumption, government spending, investments or exports.

 Structural and Technical Unemployment – results when there is a drop in demand that is of a permanent
nature. For example, if many qualified labourers cannot be employed by an industry because the industry
has undergone structural changes. If, on the other hand, people become unemployed because of
technological changes such as automation, then this type of unemployment is referred to as technical
unemployment.
 Often legislation puts people out of work (restrictive tobacco legislation reduces work opportunities along
the whole value chain), minimum wage laws makes it particularly difficult for the entry level employee to
enter the job market. Equal pay for equal work makes it difficult for designated groups to compete. Other
labour laws increase the cost of employment and cause jobs to be “exported” (through importing the goods
that are too costly to produce locally).
 Seasonal Unemployment – This type of unemployment occurs when employees only work during a certain
time(s) of the year and, therefore, during other months they are regarded as unemployed.
 Disguised/Hidden Unemployment – is said to exist if people who were previously fully employed, have
had their hours (and, therefore, salaries) reduced because of poor business performance.
 Frictional Unemployment – Even under the most favourable conditions, a certain percentage of people
will always be unemployed. This ever-present unemployment is referred to as frictional unemployment
(this includes people who are temporarily between jobs).
7.5 Policies to reduce unemployment

In South Africa the rapid increase in the unemployment rate in the recent decades originated from the supply
side of the labour market as well as from the demand side. A large number of workers (more than 350 000)
entered the labour market each year, but few new job opportunities were created in a stagnating and declining
economy. South Africa’s unemployment problem therefore stems from both a rapid increase in the supply of
labour and a constant, slowly growing or declining demand for labour. To combat unemployment, steps need
to be taken to limit the supply of labour and to stimulate the demand for labour.
Supply side policies:
 On the supply side, rapid population growth can be a significant cause of unemployment. Steps taken
to limit population growth can thus be regarded as part of the strategy to reduce unemployment.
 Any decline in the growth (or even the level) of the domestic population can be negated by a net increase
in immigration. This is a particularly serious problem in South Africa, since many unemployed workers
from other sub-Saharan countries and others seeking their fortunes in South Africa enter the country

legally or illegally in pursuit of employment and income. Stricter immigration control can therefore also
be regarded as an element of a policy strategy to reduce unemployment.
 Other relevant features of the supply of labour in South Africa are the shortage of skills and the oversupply
of unskilled and semi-skilled labour. Even when the aggregate demand for goods and services (and
therefore also for labour) is low, there are always vacancies for people with certain technical or
professional skills or qualifications. On the other hand, people with no training or skills have difficulty
finding employment, even when there is an excess demand for skilled workers. Any strategy to reduce
unemployment in South Africa must therefore include policies to improve the quality of labour, for example
through education and training (Mohr & Fourie, 2008:402).
Demand side policies:

On the demand side, additional employment opportunities can be created by raising the aggregate demand
for goods and services and or increasing the labour intensity of production.
1] Raising the aggregate demand for goods

 Government can, of course, always raise the aggregate demand for goods and services by spending
more. But increased government spending has to be financed either by raising taxes or borrowing.
 Another possible option is to stimulate consumption and investment spending by lowering taxes or interest
rates.
 A more promising strategy would be to raise the demand for domestically produced goods and services
by increasing the demand for exports
2] Increasing the labour intensity of production

The idea here is to promote types of economic activity which are relatively labour intensive.
 It is often argued, for example, that government spending on housing will create more jobs than most
other forms of government spending, both directly and through the linkages between the construction
sector and the rest of the economy
 The government can also embark on special employment programmes that are aimed at employing as
many people as possible to build and maintain roads, build dams, clean the environment, develop new
agricultural land and so on.
 Another possible avenue is to promote small businesses and the informal sector. It is often claimed
that small businesses are much more labour intensive than larger enterprises and that the promotion of
such businesses will thus raise employment (and reduce unemployment).
 Yet another possibility is tax incentives or subsidies to stimulate employment. The idea is that employers
will receive tax benefits or subsidies if they employ more people (Mohr & Fourie, 2008:403).

Think Point
Read section 21.2, Unemployment and inflation: The Philips curve in the
prescribed text. Do you think a trade-off of unemployment and inflation exists
in South Africa?
7.6 Summary
This unit discusses the definition and measurement of unemployment. It discusses the costs of unemployment
as well as the different types of unemployment. It then looks at the different demand side and supply side
policies that can used to combat unemployment.
STUDY UNIT
Revision Questions

1] Define unemployment and discuss the different types of unemployment.
2] Discus the costs that are associated with unemployment.
3] Discuss the different policy tools to reduce unemployment.
7.7. Answers to revision questions and activities.

1] See section 7 (definition) and 7.3
2] See section 7.2
2] See section 7.4

Unit
8: Economic Growth
and Development

8.2 Economic Growth defined  Describe what is meant by economic growth
8.3 The Business Cycle  Define a business cycle and identify the different phases of a
business cycle
 Describe the three different views of the business cycle
8.4 Causes of fluctuations in actual  Explain the causes of fluctuations in economic growth both
growth in the short-term and the long-term
8.5 Different views on Business Cycles  Describe the different sources of economic growth
8.6 Sources of Economic Growth  Discuss the various sources of economic growth
8.7 The Pros and Cons of Growth  Discuss the pros and cons of economic growth
8.8 Economic Development  Describe the various components relating to economic

development

8.1 Introduction
This study unit examines two important issues in macroeconomics: Economic Growth and Economic
Development. The distinction between these two concepts is relatively new and is subject to widespread
debate. For the purposes of this module, we will not engage in a debate as to whether they should be treated
separately or as one. For convenience and clarity, we will examine them separately.
8.2 Economic Growth Defined

Economic growth is defined as the annual rate of increase in total production or income in the economy. When
the rate of economic growth increases faster than the population growth rate, there is an increase in per capita
GDP. Put differently, economic growth occurs when a nation’s production possibility frontier (PPF) shifts
outward.
Such an increase is usually what is meant when we say there has been an improvement in the standard of
living. Most economists argue that economic growth is beneficial to a society because it enhances the material
well-being of the population. Critics of economic growth, on the other hand, assert that economic growth
destroys the environment, erodes traditional ways of living, and impoverishes the spiritual well-being of the
nation.
Economic growth is not a smooth process- it can vary significantly from year to year. This feature of economic
growth is related to a phenomenon called the business cycle.
Think Point 8.1
When gross domestic product increases from one period to another whilst
unemployment remains constant (or even increases), we refer to this
situation as jobless growth. What causes jobless growth?

8.3 The Business Cycle
Actual growth tends to fluctuate. In some years, there is a

high rate of economic growth: the country experiences a
boom. In other years, economic growth is low or even
negative: the country experiences a recession. This cycle of
booms and recessions is known as the business cycle which
is illustrated in figure 8.1.
Business cycle is the periodic fluctuations of national output

round its long-term trend.
There are four phases of the business cycle:

1. The upturn. In this phase, a stagnant economy begins to recover and growth in actual output resumes;
2. The expansion. During this phase there is rapid economic growth: the economy is booming. A fuller use
is made of resources and the gap between actual and potential output narrows;
3. The peaking out. During this phase, growth slows down or even ceases; and
4. The slowdown, recession or slump. During this phase, there is little or no growth or even a decline in
output. Increasing slack develops in the economy.
It is important to note that the above illustration of a business cycle, as smooth and regular, is merely done to
make a clear distinction between the four phases. In practice, however, business cycles are highly irregular.
They are irregular in two ways:
 The length of the phases. Some booms are short lived, lasting only a few months or so. Others are much
longer, lasting perhaps three or four years. Likewise some recessions are short, while others are long;
and
 The magnitude of the phases. Sometimes, in phase 2 there is a very high rate of economic growth,
perhaps 5% p.a. or more. On other occasions, in phase 2, growth is much gentler. Sometimes, in phase
4 there is a recession, with an actual decline in output (e.g., in the early 80’s and 90’s). On other occasions,
phase 4 is merely a ‘pause’, with growth simply slowing down.
8.4 Causes Of Fluctuations In Actual Growth

In the short-run
The major determinants of variations in the rate of actual growth in the short-run are variations in the growth of
aggregate demand (AD) -total spending on goods and services made within a country.

A rapid rise in AD will cause shortages. This will tend to stimulate firms to increase output, thereby reducing
slack in the economy. Likewise, a reduction in AD will leave firms with increased stocks of unsold goods. They
will, therefore, tend to reduce output.
AD and actual output, therefore, fluctuate together in the short-run. A boom is associated with a rapid rise in
AD: the faster the rise in AD, the higher the short-run rate of actual growth. A recession, by contrast, is
associated by a reduction in AD.
A rapid rise in AD, however, is not enough to ensure a continual high level of growth over a number of years.
Without an expansion of potential output (ceiling on a country’s output), rises in actual output must eventually
come to an end. Once spare capacity has been used up, once there is full employment of labour and other
resources, the rate of growth of actual output will be restricted to the rate of growth of potential output.
In the long-run
In the long-run, there are two determinants of actual growth:
 The growth in AD. This determines whether potential output will be realized; and
 The growth in potential output
Activity 8.1
Using the theory of the production possibilities frontier, how would you
distinguish between fluctuations in GDP in the short vs the long run?
8.5 Different Views On Business Cycles

There are three views (Mohr & Fourie, 2008:413) on the causes of business cycles (Fig 8.2):
 The classical view – the economy is inherently stable (indicated by the thick black line) and business cycles
are caused by exogenous (outside the market system) disturbances.
Economists who ascribe the business cycle to exogenous or “outside” forces believe that government should
leave the market system to its own devices. They believe that market forces will, if given the opportunity, sort
out all the important economic problems of the day. The government should not intervene, since such
intervention will simply cause further problems rather than solve the existing ones.
 The Keynesian view – the economy is inherently cyclically unstable (indicated by the thick wavy line).
Business cycles are endogenous to private market economies. Keynesians regard the business cycle as
an inherent feature of modern market economies.

As far as economic policy is concerned, they recommend government intervention to smooth the peaks and
troughs as far as possible. When the economy is in a cyclical downswing, expansionary monetary and fiscal
policies are recommended. When the economy is booming, restrictive measures are proposed.
 The Structuralist view – economic fluctuations are caused by various structural or institutional changes.
Adherents to this view do not believe that the market system is inherently stable (the classical view) or
systematically unstable (the Keynesian view). Instead, they focus on structural changes and unpredictable
events.
Adherents of this view do not have set ideas on economic policy. According to them, the appropriate policy
approach will vary from time to time as circumstances change (Mohr & Fourie, 2008:411-412).
Figure 4Figure 8.2
Mohr & Fourie (2015 :413)
8.6 Sources of Economic Growth

In order to have an increase in a society's standard of living, as measured by real per capita GDP, the rate of
aggregate output must increase faster than the population. An increase in the labour force will lead to an
increased aggregate output. With more workers, more output can be produced. In addition, an increase in
capital will increase output because with more capital available, a given number of workers will be able to
produce more output. This brings up another important factor. In order for real per capita GDP to increase,
there needs to be an increase in output per worker. In other words, there must be an increase in productivity.
Let us look in more detail at each of these key factors: the labour supply, the amount of physical capital, and
productivity.

8.6.1 An increase in labour supply

As was just mentioned, an increase in the number of workers will lead to an increase in output. However,
whether output per worker goes up or not is an open question. Take a look at the following table, which
illustrates how total output increases with an increase in the amount of labour supplied:
Table 1Table 8.1
As you can see, output increases with additional hours of labour; however, notice that productivity, Y/L, declines
with increasing labour. The decrease in productivity, as more labour is supplied, is known as diminishing
returns. It happens because, while labour increases, the amount of capital is held fixed. Thus, more and more
labour is being applied to a given amount of physical capital. Imagine, a farmer's field with one hoe. With no
workers, output is zero because no one is working the field.
One worker will be able to plant and tend the field using the hoe (physical capital) and get some output. What
about hiring a second worker? Output may go up somewhat, but not by as much as the addition of the first
worker.
The decline in productivity with a given amount of capital and the addition of more workers is what worried early
economists such as Thomas Malthus and David Ricardo. They were concerned that, with a fixed amount of
land, as with a fixed amount of capital, diminishing returns will dictate that the output of food per capita would
begin to decline. The concern was that, over time, a rapidly growing population would outstrip its ability to feed
itself. Societal collapse and mass starvation was viewed as the inevitable result. Increases in physical capital
alone, however, are not sufficient to ensure increased economic well-being over time. The reason is that capital,
like labour, is also subject to diminishing returns. Look at the following table, which illustrates the effect of adding
capital to a given amount of labour:

Table 2Table 8.2
Although adding capital increases labour productivity (as shown in the last column), there are diminishing
returns to capital. Diminishing returns is the change in output with a given increase in one input, holding the
other inputs constant. When capital goes from 100 to 110 units, output increases by 10 (from 300 to 310). The
addition of another 10 units of capital (from 110 to 120) increases output by only nine (from 310 to 319). An
additional 10 units of capital (from 120 to 130) results in an additional eight units of output (from 319 to 327).
Thus, the additional gain in output from adding more capital diminishes.
However, in all modern economies that have experienced economic growth over time, capital has been
increasing. In fact, capital has increased at an even faster rate than labour. Consider the table below:
Table 3Table 8.3
The growth rate of equipment has been higher than the growth rate of structures. This means there is more
equipment available for workers within factories and offices.
8.6.2 Increases in human capital

In addition to increases in the amount of physical capital available to the workforce, increases in human capital
are also crucial to increased productivity and economic growth. Human capital are investments made in human
health, education, and training. For example, by going to college (even taking this course), you are building your
human capital.
A healthy, well-educated, and well-trained population is more productive (and probably happier). One reason
that college graduates get higher incomes, on average, than people who have not attended college is because

they tend to be more productive. Increases in human capital are crucial to economic growth and increases in the
quality of life.
In many industrialized societies, the availability and extent of education is increasing. Some enlightening figures
are shown in the following table:
Table 4Table 8.4
8.6.3. Increases in productivity

As we have seen, increases in productivity are essential for continued economic growth. What enhances
productivity increases? Much of what we have already discussed increases the productivity of labour, such as
gains in the availability of capital, education, and training. In addition, technological change and innovation
increases the productivity of both capital and labour. Think of what technological change has meant to college
students, for example. Think of how much more productive you can be in writing papers with a personal
computer compared to the days of manual typewriters. Innovation, other than technological change, can also
affect productivity. The increasing use of just-in-time production techniques and other managerial innovations,
for example, has increased productivity in the manufacturing sectors of many industrialised countries in recent
decades. In addition, economies of scale can affect productivity. Think of the relatively recent development of
large, multiplex movie theatres. Ticket takers and snack-bar employees, rather than serving customers of just
one movie, now serve several screens. Each employee, therefore, serves more customers during the course
of a shift.
8.7. The Pros and Cons of Growth

8.7.1. The pro-growth argument
Try to imagine what life was like in the past and compare it to today. Today, we can get from one place to
another rapidly by taking to the freeway/highway in cars that are far superior to what was available in the past.
Today's cars are much safer, more comfortable, and more environmentally sensitive than cars available in the
past. For example, in the past, cars were noisy, guzzled fuel, were rarely equipped with seat belts, had no air
conditioning, frequently needed maintenance, and emitted noxious fumes from their tailpipes. In contrast, we
now have air bags plus retractable seat belts, passenger compartments designed to remain intact during

collisions, effective climate controls, much smoother rides, dramatically improved fuel efficiency, and much
lower emissions. For example, since the mid-1970s, automobile emissions have fallen dramatically in spite of
a substantial increase in the total number of kilometres driven. All the result of the fact that through economic
growth we now can afford to pay for reduced emissions and reduced pollution.
Similar stories can be told about most of the items we use. In addition, we have much more spending power
than in the past, meaning that we have the ability to buy much more than we used to be able to. In the USA,
real per capita GDP in 1995 was more than twice what it was in 1950. Think of what this means. We have, on
average, the ability to buy twice as much as we could in 1950. Take a look around your room or your home.
The vast array of consumer items found there — sound systems, Satellite TVs, microwaves, dishwashers,
Smartphones and laptop computers — would have been unimaginable in the 1950s. Although they were
available, most homes had only one telephone, did not own even a single TV, and had kitchen appliances that
often consisted of little more than a toaster.
However, it is not just the increased availability of goods and services, and our increased ability to buy them
that makes us much better off. The dramatic increase in real per capita GDP means that, if we choose to limit
our purchases, we can have more savings or work less than we did in the past and still maintain the same
standard of living. By limiting purchases (and still, by the way, having more and better products), one can save
more money, spend more time with one’s family, and retire earlier than one could have in the past.
The growth in real GDP per person also makes it easier to help those who are less fortunate than ourselves
because it is more affordable to do so. To see this, consider a society with a very low per capita income level.
With most people barely getting by, it is difficult to spare anything for those even less fortunate. However, with
higher levels of average real income, we can more easily help those with less.
There are many theories of economic development. You should be aware of Rostow’s stages of economic
development and the current research emanating from economic think tanks around the world such as the Cato
Institute, the Heritage Foundation and Fraser Foundation. The relationship between economic freedom and
economic growth can for example clearly be seen from the extensive research done by the Fraser Foundation
(http://www.freetheworld.com/).
8.7.2. The anti-growth argument

Economic growth does not, however, come without costs. As technology, productivity, and efficiency improve,
it is those sectors of the economy that are less efficient or less productive that are likely to suffer.
Consider the example of modern agriculture. Because of improvements in machinery and transportation,
economies of scale, and other factors, large farms are able to produce crops more cheaply than smaller farms.
As a result, there has been a dramatic decline in the number of smaller farms and farmers in recent years. For
many of these people, a way of life has been lost due to economic development. The flip side of this, however,

is that a much wider array of food is available at lower real prices than in the past. To say that economic
development should be slowed down or stopped in order to preserve a way of life for some is to also say that
millions of consumers should have to pay more for food. It remains, however, that changes in the way we live
and the types of work we do are the natural consequences of economic growth and development. For many,
these changes are unwelcome.
Another consequence of economic growth and development is an increase in the demand for the natural
resources. Many are concerned that the rates at which we are using the earth's resources are already too high
and will increase even more as less developed countries become more developed. In addition, there is concern
that this will result in increased pollution.
For example, in the United Nations Framework Convention on Climate Change held in Kyoto, Japan during
December, 1997, many environmentalists warned that increasing development in less developed countries will
increase greenhouse gas emissions and more rapidly accelerate global warming.
There are other criticisms levelled at economic development and growth. Although there are certainly
widespread benefits to such growth, it is important to remember that there is no free lunch. Changes in
traditional ways of living, increased environmental pressures, changes in income distribution, and
other negative consequences of growth exist. As growth continues, we must take into account some of its
negative consequences.
Think Point 8.2
In your opinion, should economies continue to aspire for the expansion in

production possibilities (economic growth)?
8.8 Economic Development

Economic development refers to the improvement of living conditions in the less developed countries
(developing countries). So what then is meant by a developing country? The most important characteristic of a
developing country is that it has a low per capita income. In addition, people in developing countries (Samuelson
& Nordhaus, 2003) usually have poor health and short life expectancy, low levels of literacy, and suffer from
malnutrition.
Economic development further entails an improvement in the quality of life of the majority of the population as
a result of (Mohr & Fourie, 2015):
 Economic Growth;
 Reduction of inequality; and
 The eradication of absolute poverty.
Most of the world’s population live in developing countries.

8.8.1 Sub – Saharan Africa

According to the World Development Indicators 2017 (www.worldbank.org):
o After rebounding from the slump caused by the economic crisis of 2008, Sub-Saharan Africa has
experienced the greatest fall in GDP growth rate from 4.6 to 3 percent in 2015, a further setback to the
region’s economic recovery.
o Half of the people in the world who live on less than $1.90 a day—389 million—live in Sub-Saharan Africa.
o Sub-Saharan Africa had the lowest Internet penetration rate in 2015, 22 percent, after averaging only 2.4
percent growth over the preceding five years.
o The prevalence of underweight children fell from 28 percent in in 1990 to 18 percent in 2015.
o In 2013, 57 percent of children who enrolled in first grade of primary school remained enrolled until the last
grade of primary school.
o Net debt flows to Sub-Saharan Africa (excluding South Africa) fell 17 percent in 2015, the first decline since
2012—reflecting, as in other regions, vulnerabilities to developments in the global economy and the drop in
world market prices for oil and other commodities.
o Long-term public and publicly guaranteed inflows, which accounted for 82 percent of the total, fell 22 percent
in 2015 because of a 41 percent decrease in borrowing from bilateral creditors. However, the impact was largely
concentrated in Botswana and Mauritius and in oil exporters, notably Angola and the Republic of Congo.
o Private nonguaranteed inflows also declined almost 50 percent, to $2.9 billion, as new bond issuances
decreased sharply, but these flows are concentrated in a handful of countries. Conversely, short-term debt
inflows not only remained positive, in contrast to the outflows experienced by other regions, but also increased
to $1.9 billion, up 50 percent over 2014.
o Successes in this region include:
o Ethiopia is one of the fastest growing countries in Sub-Saharan Africa, with 7.5 percent average annual
growth of GDP per capita over 2009–15, driven by agriculture, manufacturing, and considerable government
spending on infrastructure.
Think Point 8.3
Why is economic development a better macroeconomic policy objective than

economic growth?
8.9. Summary
This unit defines economic growth and looks at the periodic fluctuations in national output. It discusses the
causes of fluctuations in actual growth and the different views on the business cycle. It explores the sources of
economic growth as well as the pros and cons of growth. It discusses economic growth and the Sub-Saharan
Africa.

STUDY UNIT
Revision Questions

1] With aid of a diagram, discuss the different phases of the business cycle.
2] With the aid of appropriate diagrams, discuss the different views of the causes
of business cycles alongside their policy recommendations.
3] Discuss the different sources of economic growth.

Activities:
8.1 Short-run fluctuations in GDP are as a result of fluctuations in aggregate demand and aggregate supply will
adjust for those fluctuations but without any affect in the potential output of an economy (maximum production
possibilities). On a production possibilities frontier, this is illustrated by movements within the curve with output
increasing or decreasing whilst the PPF curve remains constant.
Long-run fluctuations in GDP are caused by adjustments in potential output (maximum production possibilities).
These are illustrated by a shift in the PPF.
Think points:
8.1 Simply put, jobless occurs in a situation where producers in the economy opt to utilize more capital intensive
production methods, choosing machines over people. Output produced, as measured by GDP, will increase
whilst unemployment remains the same or increases.
8.2 This is an open ended question and is highly dependent on each respondent’s disposition and or beliefs. The
solution should however encompass the theoretical arguments provided in section 8.7
Revision questions:
1] See section 8.3
2] See section 8.5
3] See section 8.6

Unit
9: The Foreign Sector

9.2 Why countries trade  Understand the concepts of absolute advantage and
relative advantage
9.3 Application of political pressure  Outline the concept of political pressure
9.4 Investment in the global economy  Understand the appreciation and depreciation of a
currency in comparison to another
9.5 Trade Policy  Understand the economic impact of an import tariff
 Compare the arguments for and against the use of

trade barriers
9.6 Foreign exchange rates  Define and apply the concepts of exchange rates;
 Understand the factors that influence the exchange

rate of a country

9.1 Introduction
Up to this point in the module, we have looked at the role of the government in the macroeconomy within the
country. But as you know, the economies of all countries trade with other countries. They may buy goods from
a neighbouring country or other countries or they may ship goods and raw materials to a distant continent.
Countries participate in the global economy for three primary reasons (Pape, 2000) i.e., to:
 Trade;
 Apply political pressure; and
 Invest.
9.2 Why Countries Trade

It is far better for an individual to specialize in the activities that he or she does best, rather than attempt to do
everything. This principle is equally important to countries. By trading, certain countries are able to obtain goods
and services which their own economy cannot produce or does not possess.
Many South African companies, such as Anglo-American and South African Breweries, have invested in countries
overseas. South Africa, together with other third world countries also try hard to encourage foreign companies to
invest locally. It is believed that foreign companies will bring money, technology and skills that are not available
locally.
9.2.1 Absolute advantage

Absolute advantage occurs when one country produces more of a product than another using the same amount
of resources. Assume that South Africa and Botswana produce wool and DVD players. One worker in South
Africa can produce 100 kg wool and 4 DVD players whilst one worker in Botswana can produce 200 kg wool
and 2 DVD players. We say the South Africa has an absolute advantage in production of DVD players and
Botswana has an absolute advantage in production of wool.
9.2.2 Comparative Advantage

By means of glasses, hotbeds and hot walls, very good grapes can be raised in Scotland, and very good wine,
too, can be made of them at thirty times the expense for which at least equally good wine can be bought from
foreign countries (Smith, 1776).
The essence of comparative advantage is the idea that nations, like individuals can carry out a particular economic
activity (such as making a specific product) more efficiently than another activity and therefore should concentrate
on what they are best at producing. If one person is an accomplished musician and the other a computer wizard,
it is more efficient to allow each person to specialize in one field rather than have each of them produce their own
music as well as their own computer programmes individually. By exporting each other’s services/skills to the other
they will each benefit by ending up with more goods/service than if they try making both goods/services individually.
The same applies to nations.

The theory of comparative advantage states that:

Each country will tend to specialize in and export those goods for which it has a comparative advantage.
Consider two countries, England and Portugal, each producing two commodities, wine and clothing, as
illustrated in the table below:
Table 5Table: 9.1

Unit of output per person at work
Portugal England
Wine 6 3
Clothing 4 3
Further assume that:

 Perfect competition prevails in all markets;
 There are constant returns to scale;
 There are zero transport costs; and
 There is only one factor of production – Labour.
From the table above it can be seen that:

 A worker in England can produce 3 units of wine or 3 units of clothing, i.e., one unit of clothing will exchange
for one unit of wine;
 A worker in Portugal can produce either 6 bottles of wine or 4 units of clothing i.e. one unit of clothing will
exchange for 1.5. units of wine;
 The Portuguese are therefore more productive in absolute terms in both industries than their English
counterparts; and
 Clothing is more expensive (and wine cheaper) in Portugal than England.
Suppose England takes two workers out of the wine industry and assigns them to work in the clothing industry.
This means that wine production falls by 6 units and clothing production increases by 6 units.
The 6 units of clothing are exported to Portugal. Given that, in Portugal, 1 unit of clothing exchanges for 1.5
units of wine, the exporters of English clothing return with 9 units of wine. The net result is that England has
gained 3 units of wine and Portugal is left exactly as well off as before.
The implications of this example, in the context of international trade theory, is that:
 A country can have an absolute advantage in all goods and yet gain from trade with a more efficient
partner;
 Gain that is realized through imports and exports are useful solely as a means of obtaining imports;

 The total gain from trade may be unevenly shared. In the above example England gets all the gain;
 Countries benefit most from trade by obtaining high prices for their exports and paying the lowest prices
for their imports; and
 Trade involves mutual gain.
To conclude this section, there is just one final point for you to ponder over!
Think Point 9.1
International trade will only occur if comparative advantage exists, that is,
if the opportunity costs differ between countries. Do you agree? Discuss
the truth/ untruth of this statement with the aid of a suitable example. Refer
to Mohr and Fourie (2015:302).
9.3 Application of Political Pressure

Some countries use trade with other countries as a way of affecting or controlling another country’s political
decisions. A classic example has been the trade sanctions imposed on South Africa during the 1980s up until
1994. During this era other countries were prohibited from engaging in business transactions (in certain
business areas) with S.A. because of the existence of apartheid. In this case, trade was used as a way of
applying political pressure rather than simply for economic reasons.
9.4 Investment in the Global Economy

For industrialised countries, investment overseas can help increase profits for local companies. Many large
companies that operate internationally invest overseas to gain access to cheaper labour or move closer to
sources of raw materials.
9.5 Trade Policy

The opening up of trade between countries leads to greater world production of traded goods and, by
implication, to an increase in economic welfare. Not surprisingly, therefore, steps are taken from time to time to
open up economies to international trade and to reap the benefits of such trade. Nevertheless, every
government still takes steps to protect domestic firms against foreign competition and to control the volume of
imports entering the country. The measures used include import tariffs, quotas, subsidies, other non-tariff
barriers, exchange controls and exchange rate policy.
• Import tariffs are duties or taxes imposed on products imported into a country. They are generally used to
protect domestic industries or sectors from foreign competition, but it can be shown that they result in a net
loss of welfare to the domestic society.
• Import quotas seek to control the physical level of imports and are therefore a form of direct intervention
in the market mechanism. They have much the same economic consequences as import tariffs.

• Subsidies granted to home producers also have essentially the same economic impact as taxes on
imported goods.
• Non-tariff barriers have become increasingly significant in recent years. They take the form of, for example,
discriminatory administrative practices, such as deliberately channelling government contracts to domestic
firms, insisting on certain technical standards or specifications that may be difficult for foreign firms to meet,
special licensing requirements or, simply, unnecessary red tape.
• Exchange controls can also be used to restrict imports by limiting the amount of foreign currency available
for their purchase.
• Exchange rate policy: movements in exchange rates may have significant effects on exports and imports
and exchange rate policy may therefore be a much more effective instrument for influencing international
trade than the traditional instruments of trade policy such as tariffs, quotas and subsidies (Mohr and Fourie
(2015:304)).
Activity 9.1
Give an example of a product that is affected by each of the following trade
barriers in your country:
 Import tariff
 Import quota
 Subsidies
9.6 Foreign Exchange Rates

Foreign trade involves payment in foreign currencies such as the euro (), pound sterling (£), US dollar ($) and
Japanese Yen (¥). South African importers have to pay in these currencies for the goods and services they buy
and are, therefore, obliged to exchange South African rands for these currencies.
An exchange rate simply represents the price of one currency in terms of another currency. An increase in the
value (price) of one currency in terms of another currency (appreciation) automatically implies a decrease
(depreciation) in the value of the other currency.
Changes in exchange rates affect the relative prices of goods and services across countries. For example, an
increase in the value of a country's currency will make its goods relatively more expensive in foreign markets.
It will also have the effect of lowering the relative price of foreign goods sold domestically. In other words,
changes in exchange rates affect the flow of goods and services across nations.
A foreign exchange market is the international market in which one currency can be exchanged for other
currencies. The South African foreign exchange market consists of all the authorized currency dealers, including
all the major banks.

The main reason that people demand a given nation's currency is for the purchase of that nation's goods,
services, or financial assets. The main reason that people supply the currency of a given country is for the
purchase of another country's goods, services, or financial assets. However, private individuals, institutions,
and governments buy and sell currencies for speculative reasons and governments buy and sell currencies for
policy purposes. For example, in mid-1998, the U.S. Treasury bought large quantities of Japanese yen in order
to increase the demand for yen. To do so, the Treasury supplied dollars on the foreign exchange markets and
purchased yen. The result was an (short-run) increase in the value of the yen relative to the dollar.
A floating exchange rate is a rate determined in free markets by the law of supply and demand.
A fixed exchange rate is a rate set and maintained by the government in conjunction with its Central Bank
(e.g., South African Reserve Bank).
Think Point 9.2
What exchange rate policy is implemented in your country and why?
9.7 Summary
The increasingly global economy has made the nations of the world more economically interdependent. This
interdependence has made policy-making for all stakeholders (Governments, firms, individuals) more
challenging and demanding.
STUDY UNIT
Revision Questions

1) With the aid of an example, distinguish between comparative advantage
and absolute advantage.
2) Using a hypothetical example of two countries of your choice, discuss the
theory of comparative advantage.

9.8. Answers to revision questions and activities.

Activities:
9.1 The solution to this activity will be dependent on which country the student is from as well as which product
they choose.
Think points:
9.1 See think point
9.2 The solution will depend on which country the student is from.
Revision questions:
1] See section 9.2

References
 Blinder, A (1987): Hard Heads, Soft Hearts: Tough Minded Economics for a Just Society, Addison-
Wesley.
 Fraser Institute – Annual Report 2014, www.freetheworld.com
 Hydam, N. E (1997): Principles of Macroeconomics Van Schaik.
 Mcaleese, Dermot (2001): Economics for Business. Financial Times/ Prentice Hall.
 Mohr, P. & Fourie, L. (2008) Economics for South African Students. 4th edition. Pretoria:Pretoria.
Van Schaik
 Mohr, P. & Fourie, L. (2015) Economics for South African Students. 5th edition. Pretoria:Pretoria.
Van Schaik
 Pape John (2000): Economics: An Introduction for South African Learners. Juta and Company Ltd.
 Read, Leonard E: I pencil – The movie (adapted from the 1958 essay). http://www.ipencilmovie.org
and https://www.youtube.com/watch?v=IYO3tOqDISE
 Samuelson, Paul A. & Nordhaus, William D. (1998) Economics. McGraw-Hill.
 Smith, Adam (1778). An Inquiry into the Nature and Causes of the Wealth of Nations 2 (2 ed.).
London: W. Strahan; T.Cadell. Retrieved 8 August 2015. via Google Books.


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Bachelor of Commerce

in Human Resource Management

Unit 1: Introduction to Macroeconomics .................................................................................................................. 8

Unit 2: Measuring the Performance of Economy................................................................................................... 25

Unit 3: The Monetary Sector ................................................................................................................................. 33

Unit 4: The Public Sector. ..................................................................................................................................... 46

Unit 5: Macroeconomic Theories .......................................................................................................................... 60

Unit 6: Inflation ...................................................................................................................................................... 76

Unit 8: Economic Growth and Development ......................................................................................................... 93

Unit 9: The Foreign Sector .................................................................................................................................. 106

MANCOSA – BBA YEAR 1 i

We hope you enjoy the module.

1 MANCOSA – Bachelor of Commerce in Human Resource Management (Year 1)

C. Exit Level Outcomes and Associated Assessment Criteria of the Programme

 Evaluate, select and apply appropriate  Various appropriate methods, procedures or

 Demonstrate an ability to develop and  Human resource management concepts, ideas

MANCOSA –Bachelor of Commerce in Human Resource Management (Year 1) 2

 Demonstrate the ability to manage processes  Processes and accountability is demonstrated to

 Contribute to improving organisational culture  Organisational culture and climate strategies of

D. Learning Outcomes and Associated Assessment Criteria of the Module

LEARNING OUTCOMES OF THE MODULE ASSOCIATED ASSESSMENT CRITERIA OF THE

 Describe the concept of macroeconomic  Concept of macroeconomic equilibrium is

3 MANCOSA – Bachelor of Commerce in Human Resource Management (Year 1)

disadvantages, and how it affects aggregate understanding on how it affects aggregate

 Explain the concepts of comparative  Concepts of comparative advantage, balance of

E. Learning Outcomes of the Units

F. Programme Notional Learning Hours

Lectures/Workshops (face to face, limited or technologically mediated) 10

Tutorials: individual groups of 30 or less 0

Practical workplace experience (experiential learning/work-based learning etc.) 0

Independent self-study of specially prepared materials (case studies, multi-media, etc.) 20

MANCOSA –Bachelor of Commerce in Human Resource Management (Year 1) 4

G. How to Use this Module

I. Prescribed and Recommended Textbook/Readings

The prescribed and recommended textbooks/readings for this module is:

5 MANCOSA – Bachelor of Commerce in Human Resource Management (Year 1)

Special Feature Icon Explanation

The Associated Assessment Criteria is the evaluation of the students’

PRACTICAL Practical Application or Examples will be discussed to enhance

APPLICATION understanding of this module.

MANCOSA –Bachelor of Commerce in Human Resource Management (Year 1) 6

Case Studies are included in different sections in this Module Guide.

You may come across links to Videos Activities as well as instructions

VIDEO ACTIVITY on activities to attend to after watching the video.

7 MANCOSA – Bachelor of Commerce in Human Resource Management (Year 1)

MANCOSA –Bachelor of Commerce in Human Resource Management (Year 1) 8

Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

1.1 Introduction  Introduce topic areas for the unit

1.2 Macroeconomics versus Microeconomics  Distinguish between macroeconomics and

 Describe what is meant by full employment and price

 Define economic growth

 Describe what is meant by balance of payments and

1.5 Summary  Summarise topic areas covered in unit

9 MANCOSA – Bachelor of Commerce in Human Resource Management (Year 1)

1.2. Macroeconomics versus Microeconomics

Understanding the basics of microeconomics is a necessary prerequisite to understanding the functioning of

Classify the following as microeconomics or macroeconomics concepts:

1.1.1 The consumer price index