MACROECONOMICS.

AN OVERVIEW OF MACROECONOMICS
 Macroeconomics is a branch of economics, which is a study of the behaviour of the whole economy.
 It is concerned with the determination of the broad aggregates of the economy, in particular the
national output, unemployment, inflation and the Balance of Payments.
 Macroeconomic analysis is concerned with why macroeconomic activity is at a given level and how
it can be raised or lowered.
NATIONAL INCOME ACCOUNTING.
 National income is the measure of output of goods and services produced by an economy over a
period of time.
 Since it measures production per period of time, it is referred to as a flow concept (flow is the rate at
which stock is changing).
 It is the money value of that flow of output which is usually measured.

THE IMPORTANCE OF MEAS URING NATIONAL INCOME.

 It allows us to keep a finger on the economic pulse of the nation – it allows us to measure the level of
production in the economy at some point in the time and explain immediate causes of that level of
performance.

 By comparing national income accounts over a period of time we can plot the long run course which
the economy has been following; the growth and stagnation of the economy will show up in the
national income accounts

 National income accounting allows us to keep an eye the economic health of the society and
formulate policies which will improve that health. This economic health is called the standard of
living of the society.

 National income accounts are used to compare the standard of living between Zimbabwe and other
countries using GNP per capita or income per head or capita.

 To study performance of different sectors within the economy thus by looking at output of each
industry government will know how well or how badly industries are and formulate appropriate
policies to improve their performance

Gross National Product (GNP) and Gross Domestic Product (GDP)

 There are two closely related basic national income accounting measures which are Gross National
Product and Gross Domestic Product.
 GDP is the value of output produced by factors of production located within a country for example it
is the sum of all incomes earned by Zimbabwean residents when producing goods and services inside
Zimbabwe.
 GNP measures the total value of output produced and incomes received by Zimbabwean residents
from the ownership of resources whenever these happen to be located.
 GNP therefore takes account of the fact that Zimbabwean residents own factors of production some
of which are located abroad.
 The flow of income from abroad mainly arises because foreign subsidiaries remit payment to the
Zimbabwean parent company. This is known as property income received from abroad.

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  Similarly foreign subsidiaries located in Zimbabwe remit payments abroad and these are known as
property income paid abroad.
 The difference between (received, paid) these two flow of property is known as net property income
from abroad.
 Net property income from abroad is the addition of receipts of interests, profits and dividends
received by local residents from assets that they own overseas minus the receipts of interests, profits
and dividends earned on assets located in the country by foreign owners.
 mathematically
Property income – property income = net property income
from abroad paid abroad from abroad
 The figure may be positive or negative depending on whether there is net inflow or net outflow of
funds.
 Therefore GDP + net property income = GNP.

GNP and NNP.

 GNP as the total value of incomes received by Zimbabwean residents on the course of a year includes
the full value of plant and equipment produced during the course of the year that is gross domestic
fixed capital formation.
 However over this period existing plant and equipment will depreciated that is declining in value due
to wear and tear. So in order to obtain a time measure of national income appropriate deduction for
capital depreciation must be made thus:
GNP – depreciation = net nati0onal product.
 Depreciation can also be called capital consumption.
 GNP is preferably used as a measure of national income to NNP because in practice it is very
difficult to measure value of depreciation.
 It is easier to measure gross investment then net investment therefore GNP can give values of output
and income which can be meaningfully compare over time and between countries.

MARKET PRICE AND FACTOR COSTS.

 National income at market prices means that the value of output and expenditure has not been
adjusted to take account of the effect of indirect taxes and subsidies
 For the economy the value of output produced must equal the gross income paid to factors of
production.
 This is unlikely to be true if market prices are considered since the prices include indirect taxes and
subsidies.
 Indirect taxes inflate the value of total output while indirect taxes have the effect of understating the
value.
 Nevertheless for all firms in the economy aggregate value of final output produced must equal the
value of gross factor income, hence national output = national income.
 To find the true value of total output we adjust the value of total output from market prices to factor
cost

GNP at market prices – indirect taxes + subsidies = GNP at factor cost

GDP at market prices - indirect taxes + subsidies= GDP at factor cost
NNP at market prices - indirect taxes + subsidies= NNP at factor cost

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Methods of measuring national income

 Thus we can use income, output and expenditure methods of measuring income and so we establish
the basic national accounting identity:

National = national = national

Output expenditure income

Output Method
 In this approach total values of output produced by all firms or economic agents in all sectors of an
economy are aggregated or added together.
 In other words output from the primary, secondary and tertiary services or sectors are added at the
end of the year to ascertain the total value of output produced in the economy.
 One problem of using output approach is the problem of double counting.
 Double counting is a problem that arises because counting output would mean counting the value or
impact in the final product twice since one firm’s output may be another firm’s input.
 Double counting is then avoided by adding value added at each stage of production or by adding
together the final value of output produced
 Whichever method used to obtain the value of output produced must ensure that both additions to
stock and work in progress are included in the output figures for each sector.
 Public goods and merit goods provided by government through non-market sector are part of national
output but do not have market price as they are not sold through market.
 Therefore output is measured at resource cost or factor cost, i.e. the value is assumed to be equal to
the cost of resources used to produce the public good.
 Export earnings must be included because they are domestically produced goods which are sold
abroad; if they are not included the value of output produced will be less than value of incomes
received from producing that output.
 Value of imports must be deducted from GDP figures because expenditures on these imports results
in a flow of factor incomes abroad,
 Net property income from abroad must be added to GDP when calculating value of domestically
owned output hat is GNP.
 When we deduct capital consumption from GNP we left with net national product (NNP).

INCOME METHOD.
 It measures the national income by adding total income generated.
 It is the addition of wages, rents, interests, profits, dividends etc.
 It is important to ensure that only factor rewards are included in other words only those incomes paid
in return for some productive activity and for which there is a corresponding output are included in
national income i.e. only the gross value of these factor rewards.
 The addition of wages and salaries of labour including those of self employed, net interest payment
on the use of capital, interest paid by households and net interest payment by foreigners, the rent
earned for use of lands, farms and houses and the gross corporate profits including those earned by
sole proprietorships, partnerships and producers co-operatives gives the total income earned by the
country (Zimbabwe) at factor cost.
 Transfer payments must not be included in the aggregate of factor incomes, they are simply transfers
of income within the community and they are not made in respect of any productive activity.
 The changes in money values of stock caused by inflation are just windfall gains and do not represent
real increase in the value of output.

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  Again net property income from abroad must be added to the aggregate of domestic income to obtain
GNP.

EXPENDITURE METHOD.
 Measures national income by adding the expenditures needed to purchase all the final goods and
services, it consists of four parts.
a) Personal consumption expenditure.
b) Government expenditure on goods and services.
c) Gross private domestic investment.
d) Net exports.
 The personal consumption expenditure consists of expenditure on durable and non durable goods.
 Government expenditure includes expenditures by government departments on goods and services
directly or indirectly through subsidies and on capital expenditure.
 Gross domestic private investment falls into three categories that is residential services, plant and
equipment and changes in inventories.
 Residential construction is included as investment because it is built to gain income.
 Plant and equipment is constructed factories, warehouses, stores and non residential structures.
 A change in inventories is the changes in stocks that is goods that are stocked up and not used in
production process or for consumption.
 A negative value would show a disinvestment whilst a positive will be mean an investment.
 Net exports are the excess of total exports over total imports.
 The addition of all these give GDP at market price as shown below:

Pers o n al Co n s u mp tio n (C). *****

+Gro s s Do mes tic Priv at e 1n v es tmen t (I). *****
+Go v ern men t Exp en d it u re On Go o d s + Serv ices (G). *****

= GDP at market p rices . *****

+ Su b s id ies . *****
- Taxatio n . (* * * * * )

= GDP at fact o r co s ts . *****

-Dep reciatio n . (* * * * * )

= Net Do mes t ic Pro d u ct at facto r co s ts . *****

NATIONAL INCOME AND STANDARD OF LIVING.

 Standard of living of a nation is the economic well being of the citizens of the country.
 The most widely used statistic for measuring change in the country’s standards of living is GNP per
capita.
 GNP per capita is the amount of national income available to each person in a country.
 It is calculated by the following formula.

GNP/head = ___GNP__________
total population.
 It provides the measure of the average amount of output available per head per year.
 For comparisons to be accurate its important to measure GNP at constant prices from one year to the
next, otherwise per capital income would not necessarily imply that standards of living had increased.
 More output also imply more choice and hence a higher standard of living

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LIMITATIONS OF USING GNP PER HEAD TO MEASURE STANDARDS OF LIVING.
it does not consider changes in the number of hours worked.
 Changes in GNP might be influenced by the changes in the number of hours worked.
 A reduction in the size of the working hours, or an increase in the number of the leisure time will
have a positive effect on economic welfare even though GNP might be adversely affected
 Comparisons of economic welfare should therefore include a measure of the increased value of
leisure.

It does not consider qualitative changes in output.

 Another factor to consider is that over time there would be qualitative changes in the goods people
consume.
 GNP does not show improvements in quality of goods thereby leading to inaccurate comparisons.

It does not include non market activities.

 Problems also arises because many services are performed neither by the government nor the market
and therefore do not appear in the national income figures.
 Services of the housewives are the biggest are the biggest omission here, yet they also contribute
GNP, hence this reduces reliability of GNP statistics

Incomplete or unavailability of data

 The necessary data are often incomplete, unrealizable or not available.
 This is explained by all the points under problems of measurement.
 A country with a bigger informal sector will miss significant contributions in its figures.

Unfair distribution of the national cake

 National income statistics do not show distribution of income.
 A country may have a high figure but the income may be concentrated in few hands.
 Per capita (average) incomes tell us nothing about the distribution of income

Failure to reflect the effect of production on the environment

 The statistics do not reflect the effects of production on the environment e.g. negative by-products,
air and land pollution, noise pollution and environmental degradation.
 A country may end up with a high GDP but a poor quality of life as a result of social and
environmental effects.

Silence on other aspects of welfare

 It does not say anything about political environment, crime rates, literacy rates etc

Does not consider the composition of output

 A country may be producing goods that does not contribute to improved welfare or those goods
which may have minimal effect e.g. military goods

Problems of International Comparisons

In trying to compare living standards between countries, a number of difficulties arise:

 We have to convert figures to a common currency (usually US). Exchange rates often fluctuate
 Composition of national output differs. One country may be mass-producing military equipment resulting
in a high figure but low living standards

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 Omissions differ from one country to another because of different laws. For instance drug trade is
allowed (and hence recorded) in some countries and forbidden (not recorded) in others.
 Also the share of the informal sectors differs - A country with a bigger informal sector will miss
significant contributions in its figures.
 There are natural and climatic factors which give rise to differences in the composition of output. For
example some countries will devote more resources in the production of heat than in the countries where
heat is provided freely by nature.
 In some countries per capita incomes may be higher in relation to domestic consumption e.g. in OPEC
countries high per capita incomes are derived from export earnings unmatched by an equivalent
expenditure on imports

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7
MONEY AND BANKING

EVOLUTION OF MONEY
 Three forms of money have existed:

a) Commodity money
 Early forms of money were commodities with an intrinsic value e.g. cattle beads, shells, gog teeth,
etc.
 The precious metals latter replaced other forms of commodity money because of their scarcity,
uniformity, durability, portability and divisibility.

b) Representative money
 Gold smith began to provide storage services to wealthy individuals.
 Precious metals were deposited to goldsmiths for safe keeping in return for a payment.
 Goldsmiths accumulated huge deposits and turned into banks
 They issued receipts for deposits which later developed into bank notes.
 The notes were acceptable as a means of payment since they were a document of title- the bear could
claim precious metal in the hands of the issuing gold smith. These notes were representative money.

c) Token money
 Cash and bank deposits are nowadays token money with no backing of assets with intrinsic value.
 The state has monopoly over the issuing of notes and coins
 Cash can now be called state money
 It is also called legal tender- fiat money made legal by government decree.

FUNCTIONS OF MONEY
 medium of exchange
 store of value
 unit of account
 standard of deferred payment

Functions Of Various Financial Institutions

Functions of the Reserve Bank of Zimbabwe

 Print and issues notes and coins
 Circulates notes through commercial banks
 Withdraws and replaces worn-out notes
 Banker’s bank i.e. keeps minimum deposit for commercial banks
 Acts as a clearing house
 Ration foreign currency
 Advisor to government on economic issues
 Selling treasury bills
 Custodian of the nation’s gold and foreign currency reserves
 Acts as a banker to the government
 Acts as a lender of last resort to banking institutions
 Controls the country stock of money
 Applies the government’s monetary policy
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Functions of building societies
 Maintain share accounts and subscription accounts for their clients
 They run savings accounts for the private sector
 They issue cheques on request
 They provide long term loans(mortgage loans) for the buying of homes

Functions of finance houses

1. hire purchase
o provide finance for hire purchase

2. leasing
o The finance house buys assets such as land, machinery and plants
o The asset is then rented to a companies which wants to use it
o The leasing company pays for the use of the asset

3. advances
o These are loans given to individuals and firms
o The loans are for a specific period
o On maturity, the loans are paid back
o The borrower pays interest on borrowed funds

4. factoring
o they buy invoiced debts from their clients
o the factor becomes responsible for debt collection
o the company receives a discounted value of its invoiced debts
o this provides immediate cash to the company

Functions of commercial banks

 Accept deposits from clients
 Give loans and overdrafts to clients
 Discount bills of exchange used in international trade[
 Give information on client’s credit worthiness
 Provide safe custody of valuables eg insurance policies, marriage certificates etc
 Register stocks and shares for companies and local authorities
 Act as an executor of wills or as trustees under trust deed
 Carry out standing order to make regular payments for their clients
 Accept direct debits in settlement of customers’ payments
 It offers savings account for small amounts
 It assists in international trade by providing information

Functions of the post office savings bank

 Accepts deposits from individuals and companies
 Lends money to large organizations e.g. to discount houses
 Invests money e.g. in treasury bills and municipal stocks
 Operates savings accounts and stop order facilities
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  Operate fixed deposits accounts on which interest is tax free

Modern Banking
 Modern banking is based on a double entry system of recording assets and liabilities.
 Bank's assets are the things that the bank owns; the most important being the loans that it has issued
out.
 Other bank assets include the cash on hand (vault cash) and its deposits with the central bank.
 The bank's liabilities are what the bank owes or simply its debts.
 A balance sheet is a summary of the bank's assets and liabilities reflecting its financial position
 By definition a balance sheet always balances.
 In modern banking, the bank does not need to back up its demand deposits by an equivalent amount
of currency or cash.
 We operate a system of fractional reserve banking.
 Under this system it is assumed that withdrawals and deposits usually cancel each other.
 Only a relatively small fraction of deposits need to be kept in hand to meet excess withdrawals over
deposits at any given time.
 The fraction legally required for this purpose is called the cash reserve ratio.

The Creation of Bank Deposits

 Bank deposits are the largest part of the stock of money
 We will consider the model of credit creation

Assumptions
 There is one bank in the economy
 All the country's residents have accounts in this bank
 There are no leakages - all cheques obtained are deposited into the bank
 The bank aims to maximise profits and loans up to the point where they are limited by the reserve
required restriction
 The bank is required to operate a 10% cash ratio
 The bank starts with nothing as shown by the balance sheet below:

Balance sheet (extract)

Assets Liabilities
Reserves 0 Deposits 0

 Suppose Prudence deposits $100m into the bank;

 The bank has $100m in reserves (assets) and $100m deposits (liabilities) as shown
below:

Balance sheet (extract)

Assets Liabilities
Reserves 100m Deposits 100m

 The bank is required to keep 10% of the deposit (10m) so it has excess reserves of 90m.
 It is a profit maximiser and it loans out the entire 90m to Farai.
 Farai makes a purchase using the 90m by writing a cheque to Tatenda.
 Tatenda deposits the cheque in her account.

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 The balance sheet is now as follows:

Balance sheet (extract)

Assets Liabilities
Reserves 100m
Loans 90m Deposits 190m
190m 190m

 Since the bank's deposits are now 190m its required reserves are 19m.
 So from the total reserves of 100m now available, it has excess reserves of 81m.
 The bank loans out the entire 81m to Talent who uses the cheque to pay Elder.
 Elder pays shepherd (by writing out a cheque) who then deposits the cheque into the bank. The bank's
balance sheet will be as follows:

Balance sheet (extract)

Assets Liabilities
Reserves 100m
Loans 171m Deposits 271m
190m 271m

 The bank is expected to have 27.1m as cash reserves;

 It therefore has excess reserves of 72.9m, which it has to loan out.
 It loans out the money Sam.
 Having received the 72.9m, Sam writes out a cheque to Jacob paying for goods bought from the
latter.
 Jacob takes the cheque to the bank and makes a deposit.
 The bank's balance sheet appears as follows:

Balance sheet (extract)

Assets Liabilities
Reserves 100.0m
Loans 243.9m Deposits 343.9m
190m 343.9m

 The process continues with additional demand deposits being created in each stage.
 The deposits created in each stage is shown below:

Stage 1 100.0m
Stage 2 90.0m
Stage 3 81.0m
Stage 4 72.9m
. .
. .
. _ _ .___
Total 1000m_______

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The Money Multiplier
 It refers to the multiple by which deposits can increase for every dollar increase in reserves.
 An increase in reserves leads to a greater than one for one increase in money supply.
 Economists call this multiple the money multipliers.
 In the preceding example a deposit of 100m resulted in a 1000m change in deposits.
 In this case the multiplier was 10.
 The multiplier is obtained mathematically as

Multiplier = 1
Cash ratio

Comments
a) The model assumed a monopoly bank situation. However when we drop this assumption and assume
a multi-bank situation, the general conclusions of our simple model still hold.
b) The model also assumed no leakages of funds. In practice however, not all funds received will be
channeled to the bank. The extend of credit creation may be reduced if there is a cash drain from the
system. Thus relaxing this assumption does not invalidate the model but simply reduces the extend to
which credit is created.
c) The model assumes a ready demand for excess reserves. In practice it is possible for excess reserves
to accumulate at the banks when there would be no demand for loans.

Monetary Policy
 Monetary policy refers to the deliberate action taken to achieve the government's objective using
monetary instruments.
 In Zimbabwe the monetary policy is administered by the central bank, the Reserve Bank of
Zimbabwe.

Monetarists and monetary policy

 Monetarists led by Milton Friedman hold that the money supply is a key economic magnitude that
exerts a strong influence on other macroeconomic variables.
 They believe that there is a strong relationship between money supply on one hand and income,
employment and the price level on the other hand.
 As such it is important for them to manage the level of money supply in order to win the economic
war.
Instruments of Monetary Policy

Open Market Operations

 This is the name given to the buying and selling of government securities in order to influence credit
creation by banks.
 a sale of government securities draws money from the public and leads to a multiple contraction of
credit and total assets
 conversely a purchase of securities injects money into circulation and leads to a multiple expansion of
credit and total assets.

Contractionary monetary policy

 The primary effect of the sale is the instant fall in money supply by the amount of the sale.
 A sale also has secondary effects.
 The sale reduces the volume of reserves thus forcing banks to reduce deposits to restore cash reserve
ratios.
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  The banks reduce lending and total deposits on the liabilities side to restore the ratios.
 Total bank deposits will contract by the size of the initial fall X the money multiplier.

Expansionary monetary policy

 It occurs when the government buys securities from the general public
 When the purchase cheque is cleared, money supply rises instantly by the amount of the purchase-
this is the primary effect.
 There is a secondary effect - banks find their cash ratios higher than expected (excess reserves
accumulate).
 This enables banks to expand total lending until all excess reserves have been loaned out.
 Total deposits increase by the size of the initial purchase X money multiplier

Special Deposits
 These are kept with the central bank by other financial institutions particularly commercial banks.
 When the central bank wants to reduce money supply it calls for special deposits.
 This reduces the banks' cash reserves thus forcing them to reduce lending and total deposits.
 When the central bank wants to increase money supply, it releases special deposits.
 This increases liquidity and cash reserves held by banks.
 Banks lent out excess reserves thus increasing deposits.

Direct Control
 The monetary authorities can impose controls directly on the bank's freedom to make their
commercial decisions.
 Such controls can be qualitative or quantitative

Quantitative controls
 When the central bank wants to reduce money supply it imposes strict maximum or ceilings upon the
rate at which banks can expand total deposits.
 When the central bank wants to increase money supply, it lifts up the ceiling.

Qualitative controls
 These are directional controls.
 They persuade or force banks to lend only to certain customers.

Cash Ratio
 The central bank can alter the cash ratio to influence levels of money supply.
 To reduce money supply the central bank simply raises the cash ratio.
 This will cause a multiple contraction of money supply.
 The bank's excess reserves will decline by the increase in cash reserves.
 The money multiplier will also fall and the growth of money supply will be suppressed.
 Conversely to increase money supply, the authorities simply reduce the ratio.
 The bank excess reserves will increase by the reduction in reserves.
 Money supply will increase because the increased excess reserves are going to be loaned out.

Moral Suasion
 It involves direct with the central bank.
 The central bank persuades financial institutions to be supportive of the prevailing monetary policy
stance.

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  When there is too much liquidity, institutions are persuaded to tighten their credit allocation systems.
 When there is a shortage of liquidity, institutions are persuaded to loosen their credit allocation
systems.
 This measure is not mandatory but persuasive and as a result it is difficult to influence the currency
ratio and consequently money supply.

The discount Rate

 The central bank can manipulate interest rates to influence levels of money supply.
 The discount rate is the rate charged to banks when they borrow directly from the central bank.
 When they borrow indirectly through the discount houses, they are charged a rediscount rate.
 The discount rate is a benchmark for commercial bank lending.
 Changes in the central bank's lending rate tend to act as a psychological signal to financial institutions
and markets that the central bank wants interest rates to move in a particular direction.
 To reduce money supply, the central bank increases the discount rate vice versa

Interest rate
 The interest rate is the cost of borrowing.
 The central bank can also vary the rate of interest in a bid to regulate money supply.
 This method acts on the general public's demand for bank loans.
 The rate of interest is used as a policy instrument with the money supply becoming the policy
objective.
 An increase in the rate of interest reduces the demand for money and hence borrowing thus reducing
money supply
 At lower interest rates the public demands more money; borrowing increases and so does money
supply.

Problems associated with controlling money supply via interest rates

 It may require authorities to raise interest rates to levels that are counter productive.
 Authorities may not in practice be able to determine the levels and structure of interest rate to the
extend that they may like
 If the demand curve is inelastic, substantial changes in interest rates may have little effect
 If the demand curve is unstable, changing the interest rate may have unpredictable effects
 Higher interest may increase instead of reducing the demand for money. At higher interest rates
borrowers may find themselves unable to repay previous debt. This forces them to borrow to finance
previous debt (distress lending). Thus an increase in interest rate causes bank lending to rise and
hence money supply to grow.

INFLATION
Definition of Inflation
 Inflation is the general and prolonged rise in price level.
 Inflation means the value of money is falling because prices keep rising.
 The value or purchasing power of money refers to the amount of goods or services a unit of money
can buy.

Calculating the Retailing Price Index

 The retail price index (RPI) can be used to measure inflation.
 The retail price index (RPI) is a monthly survey carried out by the government which measures price
changes.

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  The flowing procedure used;
a) A basket of goods and services consumed by the average family is listed.
b) For example food, clothing and transport are included in the basket.
c) The price of items in the basket in the base (first) year is noted.
d) Each item in the basket is given a number value (weighted) to reflect the proportion of income
likely to be used by the average family
e) The price of goods in the basket is recorded every month and compared with base year as a
percentage (price relative) using the equation;

Price Relative = Current Price X 100

Base Price 1
Example
2010 2011
PRICE WEIGHT PRICE WEIGHTED PRICE WEIGHT PRICE WEIGHTED
INDEX PRICE INDEX PRICE
INDEX INDEX
Food $120 60 100 6000 180 60 150 9000
Hosing $80 30 100 3000 96 30 120 3600
Transport $50 10 100 1000 55 10 110 1100
Total $250 100 10000 100 13700
 The rate of inflation is the percentage age change in the RPI over the last 12 months and is calculated
using the equation;

 Rate of inflation = Current RPI -Last RPI X 100

Last RPI 1

= 13700 – 10000 X 100

10000 1

= 3700 X 100
10000 1

= 37%

Problems in Using the Retail Price Index

 The RPI is narrow – only a few goods out of the thousands produced in the economy are included
 Which items should be included or excluded from the basket of goods? – choice of the components of
the basket is relatively subjective
 Different families have different tastes hence different weighting. It is therefore difficult to determine
the expenditure patterns of an average family.
 Not all regions in the country experience identical price changes.
 For a while new products (e.g. mobile phones) may not be included in the index.
 The weighing or proportion spent on components of the basket varies from time to time

Advantages of Inflation
Not everyone suffers from inflation. Some parts of the society actually benefit;
 The government finds that people earn more and so pay income tax.
 Firms are able to increase prices and profits before they pay out higher wages.
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  Debtors (borrowers) gain because they have use of money now, when its purchasing power is greater

Disadvantages of Inflation
 People on fixed incomes are unable to buy so many goods.
 Creditors (savers) lose because the loan will have reduced purchasing power when it is repaid.
 Domestic goods may become more expensive than foreign -made products so the balance of
payments suffers.
 Industrial disputes may occur if workers are unable to secure wage increase to restore their standards
of living.
 Inflation makes life difficult to the lower classes of the society who then fails to acquire the basics
 Tallied with increased poverty is the prevalence of social ills such as prostitution, drug abuse and
crime
 There is loss of confidence in money as a medium of exchange making trade difficult
 It causes unrest as people struggle to make ends meet – demonstrations and riots characterize
inflationary periods
 The country suffers from brain drain as people seek greener pastures
 The environment is not business friendly and investors shun investment opportunities in the country
as real returns will be lower
 As investment is reduced there is likely to be a rise in unemployment

CAUSES OF INFLATION
a) Cost-push inflation
 Cost-push inflation occurs when a firm passes on an increase in cost of production to the consumer.
 The inflationary effect of increased costs can be the result of; increased wages, leading to

i. A wage -price spiral, which occurs when price increases spark off a series of wage demands
which lead to further price, increases and so on;
ii. A wage-wage spiral, which occurs when one group of workers receive a wage increase which
sparks off a series of wage demands from other workers.
iii. Wages may also rise due to trade unions, which may force the wages to rise. This squeezes
profits of firms and they raise prices to meet targeted real profits.

b) Increased import prices which can be the result of;

i. A rise in the world prices for imported raw materials;
ii. A depreciation of domestic currency.
iii. Increased indirect taxation – increased tariffs increase the import price of raw materials

Cost-Push Remedies
 Introduce price and income policies to freeze price and wage increases.
 Encourage an appreciation of domestic currency.
 Reduce indirect taxation.

Demand Pull Inflation

 Demand-pull inflation occurs when there is too much money chasing too few goods.
 It occurs because the demand for current output exceeds supply.
 The figure below shows increased demand and increased prices as consumers compete to buy goods
still available.

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  As aggregate demand increases, supply also increases as firms have spare capacity

price AS

W3

W2

W1 AD3
AD2
AD1

Q1Q2 output

iv. Further increases in supply exhaust spare capacity as the economy approaches the full
employment level.
v. Thus prices generally increase to ration the output
vi. This general increase in price is inflation

Demand pull inflation remedies

 Reduce government spending.
 Increase income tax to reduce consumer spending.
 Reduce people's ability to borrow money by increasing interest rates and tightening credit
regulations.
 Control the supply of money.

QUANTITY THEORY OF MONEY

 A major source of inflationary pressure is the government which can print money to buy goods.
 The monetarist view of inflation can be stated in the equation ;

MV = PT

Where M = the money supply,

V = the number of times each unit of money changes hands (the
velocity of circulation),
P = the average price of goods and ,
T = the number of goods bought (transaction)

 Monetarists believe that the values of V and P are very stable and can be assumed fixed
 This implies that any increase in the money supply (Ms), must raise the level of prices (P), and this is
inflationary.
 There is always an associated price increase with money supply to balance the two sides of the

17
 equation.

INTERNATIONAL TRADE
 International trade is the exchange of goods and services between countries.
 An import is the Zimbabwean purchase of a good or service made overseas.
 An export is the sale of a Zimbabwean made good or service overseas.

Reasons for international trade

 Trade allows a greater variety of goods and services – the country receives goods which they cannot
produce locally because of, climate, lack of specialist labour, capital or technology needed to
manufacture a particular good.
 A nation trades to obtain the raw materials and hence increase production of locally produced goods
 It increases variety by bringing in more goods into the market
 It is a source of foreign currency
 It encourages specialization and hence low cost production
 It gives rise to expertise and technology
 It promotes regional and international relations
 It promotes employment as more goods are produced

Disadvantages of international trade

 There is too much dependence on others
 It reduces employment where foreign goods are cheaper and preferred to local goods
 It results in poor standards of living because of BOP deficits

Specialization and division of labour

 The principles of specialisation and division of labour were founded by Adam Smith.
 Specialization exists when a country concentrates on producing a product, which it is best at leaving
other products to be produced by other countries.

THEORIES OF ABSOLUTE AND COMPARATIVE ADVANTAGE

Assumptions
 In analysing the theory, the following assumptions are made
 There are only two countries Zimbabwe and Zambia
 There are only two goods X and Y
 There are no barriers to entry
 Resources within each country are easily transferable from one industry to another.
 Each country has 10 units of resources

Absolute advantage
 Let us suppose that in each country production possibilities are such that they can produce the
following:
X Y
Zambia 40 or 20
Zimbabwe 10 or 80

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  The table shows that if Zambia diverts all resources to the production of good X it will produce 40
units.
 Conversely if it decides to produce good Y it will produce 20 units.
 Similarly Zimbabwe can produce 10 units of good X using all of its resources or 80 units of Y if it
decides to channel all resources to the production of Y.
 Zambia has an absolute advantage in the production of good X since it can produce more of good X
than Zimbabwe.
 Similarly Zimbabwe has an absolute advantage in the production of good Y since it can produce
more of good Y with its resources.

 Suppose initially there is no international trade and each country devotes half of its resources to
each product:

X Y
Zambia 20 and 10
Zimbabwe 5 and 40
Total 25 And 50

 If international trade was possible, these countries could tend to specialise.

 If they specialise completely each country will devote all the resources at its disposal towards the
production of the good over which it has an absolute advantage.
 Zambia will devote all of its resources towards the production of good X while Zimbabwe will
devote its resources towards production of Y.
 The world output would be as follows:
X Y
Zambia 40 and 0
Zimbabwe 0 and 80
total 40 and 80

 Total world output is much greater when countries specialise.

 The countries would then exchange the output at a rate beneficial to both parties.
 The principle of absolute advantage states that if each of the world's countries with its own
endowment, man made and natural specialise in the production of the good in which it has an
absolute advantage total output will increase.
 The principle cannot however solve cases where a country has absolute advantages over the
production of both goods.
 This led to the development of the theory to the principle of comparative advantage.

Comparative Advantage
 The theory of comparative advantage states that world output will increase if an individual country
specialises in the production of what it is best at leaving all other goods to be produced by other
countries.

Suppose the production possibilities are as follows:

X Y
Zambia 20 or 50
Zimbabwe 10 or 20
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 Total 25 or 50

 The table shows that Zambia has absolute advantages over the production of both goods.
 The opportunity cost of producing each good in any country can be obtained by dividing quantities
produced by each country by one of the quantities so that either X or Y has a quantity of 1.

X Y
Zambia 20 50
20 20

Zimbabwe 10 20
10 10

 The table below shows the opportunity costs of producing the two goods in each country:
X Y
Zambia 1 2.5
Zimbabwe 1 2
_______

 The table shows that the opportunity cost of producing one unit of X is 2.5 units of Y in Zambia and
2units of Yin Zimbabwe.
 It can be concluded that Zimbabwe produces X more cheaply than Zambia.
 Zimbabwe has a comparative advantage in the production of X.
 Zimbabwe has to give up 2 units of good Y to produce one unit of X while Zambia has to give up 2.5
units of Y to produce 1 unit of X.
 Comparative advantage is measured in terms of opportunity cost.
 The country which gives up least when increasing production of a commodity by one unit has a
comparative advantage in the production of that good.
 When a country possesses absolute advantage in the production of both goods, its comparative
advantage will always lie in producing the good in which its absolute advantage is greatest.
 When a country possesses a comparative advantage in the production of one good, it automatically
possesses a comparative disadvantage in the production of the other good.
 A country that possesses an absolute disadvantage in the production of both goods possesses a
comparative advantage in the production of the good in which its absolute disadvantage is least.
 In the table above Zimbabwe has a comparative advantage in the production of good X while Zambia
has a comparative advantage in the production of good Y

 Suppose there is no international trade each country devotes half of its resources to each good.
The world output will be as follows

X Y
Zambia 10 25
Zimbabwe 5 10
Total 15 35

 Suppose each country specialises completely by devoting its 10 units of resources towards the
production of the good in which it has a comparative advantage, world output will be as follows:

X Y
20
 Zambia 0 50
Zimbabwe 10 0
Total 10 50

 It is possible to show that the increase in output of Y in value terms more than offsets the fall in fall
in the output of X.
 However this is not necessary as world output of X may be insufficient.
 We can show that by partially specialising both X and Y will increase.
 If Zimbabwe completely specialises and Zambia partially specialises by diverting only 2 /10 of its
resources to X production the world output will be as follows:

X Y
Zambia 600 4000
Zimbabwe 1000 0
Total 1600 4000

 The table shows that by specialising world output will increase and countries will benefit from the
increase if they trade at an exchange rate between the opportunity costs.

The Exchange Rate Beneficial to Both Parties

 The discussion has shown that Zimbabwe produces a unit of X an opportunity cost of 2 units of Y
Zambia produces a unit of Y at an opportunity cost of 0.4 units of X.
 If Zimbabwe gets more than 2 units of Y from Zambia for every unit of X given up it will have
benefited since it could have obtained only 2 units by sacrificing 1 unit of X and producing Y itself.
 If Zambia gives up less than 2.5 units of Y for every unit of X obtained from Zimbabwe, it will have
benefited since it could have given up 2.5 units of Y to produce a unit of X.
 Therefore any rate between 2 and 2.5 units of Y for a unit of X will be beneficial to both countries.

PROTECTIONISM
 Protectionism occurs when one country reduces the level of its imports.
 A number of political, social and economic reasons are put forward to justify protectionism.

Reasons for protectionism

Infant industries
 Sometimes protectionism protects infant industries from established rivals in advanced economies.
 Such infant industries will still be operating at high costs such that they cannot compete with the
established firms.

Unfair competition.
 Import controls may be meant to prevent dumping.
 Dumping is a situation whereby goods are sold in fore in markets at a cheaper price than in the home
market.
 This may kill the industry producing the commodity in the home market.
 The foreign firms may be receiving subsidies or other government benefits.
 It will then sell the product at below cost in the foreign market to create a foreign monopoly.

Strategic industries
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  Protectionism may be meant to protect strategic industries.
 This is done to ensure that a country is relatively self sufficient in vital foodstuffs, energy and raw
materials in times of political disturbances such as war.

Deterring inflow of demerit goods

 Protectionism is sometimes imposed to guard against the inflow of harmful demerit goods such as
drugs and weapons.

Promoting home industries

 Import controls are also meant to promote the sale of home produced goods.
 Such a scenario will expand home production and create or at least sustain more jobs for the people
of the home country.
 Protectionism protects declining industries from creating further structural unemployment.

Improving balance of payments

 Protectionism discourages imports.
 As expenditure on foreign goods decline, the country's terms of trade improve.
 This also improves the country's balance of payments.

Fiscal gain
 Protectionism levies constitute a significant component of government revenue.
 There is therefore a fiscal gain from tariffs and other levies used in protectionism.

Disadvantages of Protectionism
 It prevents the countries from enjoying the full benefits of specialisation and trade.
 It invites retaliation from foreign governments.
 It protects inefficient home industries from foreign competition forcing consumers to pay more for
the inefficiency.

Methods of Trade Restriction

Tariff
 Tariffs are surcharges on the price of imports.
 A tariff can be specific or advalorem.
 A specific tariff is a fixed amount for every amount of imports.
 An advalorem tariff is charge as a percentage of the value of imports
 A tariff:
a) raises the price of the import
b) reduces the demand for imports
c) encourages demand for home produced substitutes
d) raises revenue for the government

Quotas
 A quota is a non tariff restriction.
 Quotas restrict the actual quantity allowed into the country.
 A quota:
a) reduces the volume of imports
b) encourages demand for domestically made imports

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Embargo
 Another example of a non tariff restriction is an embargo.
 An embargo is a complete ban on imports.

Other Protection Techniques

 Administrative practices can discriminate against imports through customs delays or setting
specifications met by domestic, but not foreign producers.
 Exchange controls (currency restrictions) prevent domestic residents from acquiring sufficient
foreign currency to pay for imports.
 Prior to imports deposits-Before you import you are supposed to put aside an import value. This
reduces the amount of import.
 Technical specifications on imported good-The government put standards on the goods imported
causing rejection of some.
 Import licenses – they restrict imports through difficult requirements meant to exclude many.

BALANCE OF PAYMENTS
 The balance of payments is a record of one country's trade dealings with the rest of the world.
 It is a national account which shows the relation between the payments of all kinds made from one
country to the rest of the world and its receipts from other countries.
 Any transaction involving Zimbabwean and foreign citizens is calculated in dollars.
 Dealings which result in money entering the country are credit (plus) items while transactions which
lead to money leaving the country are debit (minus) items.
 Payments are mainly for the goods imported from abroad and the receipts come chiefly from the
export of goods to other countries.
 The BOP consists of three parts namely:
a) the current account
b) the capital account
c) official financing

Visible trade
 This is trade in goods e.g vehicles
 The goods are tangible
 It includes visible exports and visible imports
Invisible trade
 This is trade in services
 The services can be commercial services or direct services eg transport, tourism etc
 It includes invisible imports and invisible exports

Balance of trade
 Used when visible exports are compared to visible imports
 It is the difference between export and imports of tangible goods
 When visible exports are greater than visible imports we have a favourable balance of trade
 When visible imports are greater than visible exports we have an unfavourable balance of trade

Balance of payments
 Relates total imports (both visible and invisible) to total exports(both visible and invisible)
 Invisible trade involves both imports and exports of services e.g. transport, medical care etc
 The BOP is favourable when total exports exceed total imports

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  It is unfavourable when total exports is less than total imports

The Current Account

 The BOP on the current account measures the flow of expenditure on goods and services. It is the
most important part since it shows the country's competitiveness and the extend to which it is living
within its means.
 If receipts from exports are less than payments for imports, there is a current account deficit.
 If receipts exceed payments there is a current account surplus.
 The current account balance is obtained simply by adding together the balance of visible trade and
the balance of invisible trade.
 Other items included in the invisible account are not strictly services e.g. gifts, expenditures on
embassies, net property income from abroad, contribution to regional or world bodies and aid.

The Capital Account

 The transaction in the capital account section shows all movements of money in and out of the
country for investment.
 This may be direct investment - investment in productive capacity, or portfolio investment -
investment in shares or other assets
 An outward capital flow takes place when a country's residents purchase capital assets located in
another country.
 These outflows will be debits to the Zimbabwe’s balance of payments.
 An inward capital flow takes place when residents of another country purchase capital assets within
the country
 Net capital flows are the differences between these inward and outward capital flows.

Long term capital flows

 A long term capital flow occurs when residents of one country purchase or invest in productive
resources located in another country.
 Such investment can either be direct investment or portfolio investment.
 Direct investment or real investment takes place when multinational companies buy or create
subsidiaries.
 Portfolio investment involves the purchase of financial assets rather than physical assets e.g. shares of
foreign companies or securities issued by foreign governments.
 Visible, invisible trade and long term capital flows are sometimes known as autonomous or
spontaneous parts of the BOP.
 They are real flows as they result from decisions by individuals and firms to buy goods and services
or to invest in productive assets.

Short term capital flows

 Short term capital movements are sometimes called hot money flows.
 They are largely speculative- individuals and companies believe that they can make a quick
speculative profit or capital gain by moving funds out of one currency and into another.
 A hot money movement can be triggered by international differences in interest rates as funds flow
into countries where interest rates are temporarily high.
 A hot money movement may be triggered by international crisis.
 If there is an outbreak of war in Zimbabwe funds will be moved to safe havens such as precious
metals or currencies of other countries.

Official Financing
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  A deficit in the autonomous part of the BOP must be matched by an equal accommodating flow
elsewhere in the balance sheet which finances the deficit.
 Official financing takes place if the country’s central bank sells or runs down official reserves of gold
and hard currencies to finance the deficit or undertakes official borrowing to supplement the reserves
e.g. from world bank or IMF.
 A surplus might be financed by accumulating or purchasing of official reserves or by early repayment
of debt accumulated by the central bank as a result of past official financing

The Balancing Item

 Inaccuracies in data collection often results in imbalances.
 A balancing item must be added or subtracted as the last item of the BOP to balance the account.
 A very large balancing item shows that the statistics must be interpreted with caution.

Bop Disequilibrium
 Although the BOP always balances this does not mean that it is always in equilibrium.
 However, a balance of payments deficit means a persistent and large negative balance for official
financing.
 The BOP equilibrium occurs when desired spontaneous or autonomous trade and capital flows into
and out of the country are equal over years.
 The BOP is in a fundamental disequilibrium when there is a persistent tendency for international
payments to exceed receipts.
 This can be the result of excessive purchases of foreign goods and services or excessive Zimbabwean
investment overseas.
 The immediate cause of the deficit usually lie in the fact that exports are too expensive on overseas
markets while imports are too cheap at home.

Short run effects of a deficit

 A short run deficit or surplus on the current account does not pose a problem.
 In the short run a deficit allows a country's residents to enjoy living standards boosted by imports
than would be possible from consumption of the country’s output alone.

Long run effects of a deficit

 In the long run the decline of the country’s industries in the face of international competition will
lower living standards.

Correcting a balance of payments deficit.

Short-run solutions
In the short term a balance of payment deficit can be corrected by:
 continued borrowing of foreign currency
 increasing interest rate to attract overseas investors
 imposing exchange controls
 imposing tariffs and import quotas

Long-run solutions
In the long run, the government can correct a balance of payments deficit by:
 reducing demand in the economy for all goods including imports.
 reducing Zimbabwean inflation rate or
 encouraging dollar depreciation will also help

25
POLICIES TO CURE A BOP DEFICIT
Deflation
 The authorities can use monetary and fiscal policy to deflate the level of aggregate demand in the
economy.
 Deflation results in a fall in demand for both home produce goods and import.
 It an also have an expenditure switching effect by causing domestic inflation rate to fall relative to
that of competitor countries.
 Deflation increases the competitiveness of exports while reducing that of imports.
 Residents of other countries switch expenditure towards the country's exports while its own residents
switch away from imports to home produced goods.

Import Controls :protectionism

1. They do not target the underlying cause of disequilibrium -the in
competitiveness of exports.

2. They seek to gain the an advantage at the expense of other countries (beggar thy
neighbour policy) and are thus likely to be countered by retaliation

3. It may be impossible to implement import controls if a country is a member of a

trading block

Devaluation or Downward Managed Float

 Devaluation is whereby the value of the currency in terms of other countries is reduced
 This has an expenditure switching effect.
 It increases the prices of imports relative to that of exports.
 In a managed exchange rate, authorities may reduce their support, thus engineering or managing a
downward float of the exchange rate.
 Devaluation thus switches domestic demand away from imports towards home produced goods.
 Residents of other countries demand more of the country’s exports since they are now cheaper

Other Ways of improving balance of payments

 Encourage producers to exhibit their products at international markets
 Find foreign market information for foreign countries and make it available to the business sector
 Explore and promote exporting opportunities
 Design various programmes to encourage exporting e.g. export revolving fund

26