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Department of Economics

Faculty of Commerce, Management Sciences, and Law

Basic Macro- economics

Eco 1241/1641 for Bcom Students

Chapter 13
Macroeconomics refers to the study of the economy as a whole

Measuring Economic Growth (GDP)

• What is GDP
• What does it mean
• Why do we care about GDP

Economic growth rate refers to the increase in the inflation adjusted market value of the
goods and services produced by an economy over a specific period.
GDP is the total value of all final good and services produced within the boundaries of a
country in particular period (a year/quarter)

Four parts of the definition

i) Total (market) value e.g. if the price of apple is R1.00, the market value of 50
apples is R50.
ii) Final goods and services e.g. A Toyota Yaris is the final product but Dunlop tire
on the Yaris is an intermediate good.
iii) Produced within the country e.g. Anglo American a South African firm, mine
coal in a Columbia South American mine, the market value of the coal mined
forms part of Columbia’s GDP
iv) In a given the period – either a quarter or a year called quarterly GDP data or
called the annual GDP data.

Second component of the definition: final goods and services. When calculating GDP,
problems such as double counting must be avoided. Double counting means counting
something twice.

Three methods of calculating GDP.

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A. Production method (Gross value added, GVA)

B. Income method
C. Expenditure method

Production method. e.g. The value of a motor car already includes tires and the value
of PC already includes the value of a chip inside it

Participant Value of sales Value added

Farmer R10 000 R 10 000

Miller R12 500 R 25 000

Baker R 18 000 R 5 500

Shopkeeper R 21 000 R3000

Total R61 500 R21 000

Why is Domestic Product “Gross”?

Gross means before subtracting capital depreciation. The opposite of ‘gross’ is ‘net’ which
means subtracting capital depreciation.

Expenditure method

Measures GDP as a sum of consumption expenditure (C), Investment (I),

Government Expenditure on goods & services(G), Net exports of goods & services
(X-M)

Terminology

a) Personal consumption expenditure (C) – expenditure by households (on durable,

semi-durable and services) not this does not include the purchase of new house,
which is counted as part of investment.
b) Gross private domestic investment (I) – Expenditure on capital, buildings by firms,
inventories, expenditures by households.
c) Government expenditure (G) – Expenditure by government on goods and services
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e.g. national defence, garbage collection. Transfer payment excluded and

unemployment benefit.
d) Net exports of goods and services (X-M) – value of exports minus value of imports

GDP Expenditure Approach

Item Symbol RBN (2011) % GDP

Personal consumption expenditure C 1738 59.1

Gross private domestic investment I 636 21.6

Gross expenditure on goods and service G 585 19.9

Net Export of goods and services X-M -18 -0.6

GDP Y 2941 100.6

Income Approach

Measurers GDP by summing the incomes that firms pay households for the services
of factors of production they hire (wages for labour, interest for capital, rent for land
and profit for entrepreneurship

1. Formula for Income Approach

It's possible to express the income approach formula to GDP as follows: Total National
Income + Sales Taxes + Depreciation + Net Foreign Factor Income. Total national income
is equal to the sum of all wages plus rent plus interest and profits.

By the income or allocation approach, GDP is calculated as the SUM of:

1. Compensation of Employees – It constitute the largest share of national income.

It includes wage and salary supplements, in particular payments by employers into
social insurance and into a variety of private pension, health, and welfare funds for
workers.
2. Rent – it consists of the income received by the households and business that
supply property resources.
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3. Interest – It consist of the money paid by private business to the suppliers of

money capital. It includes interest received on savings deposits, certificates of
deposit , and corporate bonds
4. Proprietor’s Income - Profit is broken down into two accounts : Proprietor’s
income and Corporate profits
5. Corporate profits – Corporate profits are the earnings of owners of corporations.
National income accounts subdivide corporate profits into three categories :
 Corporate income taxes- These taxes are levied on corporation’s net
earnings and flow to the government
 Dividends – These are part of corporate profits that are paid to the
corporate stockholders and thus flow to households
 Undistributed corporate profits- These are monies saved by corporations
to be invested later in new plants and equipment. They are called retained
income.

• Market process and factor cost diverge because of indirect taxes and subsidies.

Indirect taxes - tax paid by consumers when they buy goods and services e.g. VAT
subsidy- payment that the government makes to a producer e.g. payment made to
daily farmers.
• To get from factor cost to market price, we add indirect taxes and subtract
subsidies.
• To get from a net measure to a gross measure we add depreciation

Income Approach
Item RBN %

Compensation of employees(remuneration of factors of production) 1318 44.5

Net interest -10 -03

Rental income 0 0.0

Dividends -54 -1.8

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Proprietors’ income 1001 33.8

Net domestic income at factor cost 2 255 76.1

Indirect taxes 363 12.2

Less: subsidies 30 1.0

Net domestic income at market prices 2 588 87.3

Depreciation 376 12.7

GDP (Income approach) 2 964 100.0

Statistical discrepancy -23 -0.8

GDP (expenditure approach ) 2 941 99.2

The gap between expenditure approach and the income approach is called the statistical
discrepancy and is calculated as the GDP income total, minus the GDP income, minus
the GDP expenditure total.

See Table 13-4 in your textbook P.244

OTHER NATIONAL ACCOUNTS

1. Net Domestic Product

NDP = GDP – Consumption of Fixed Capital

NDP is simply GDP adjusted for depreciation
2. National Income
NI = NDP – Net Foreign factor Income – Indirect Business Taxes
3. Personal Income
PI = NI – Social Security Contributions (payroll taxes) - Corporate income taxes –
Undistributed Corporate profit + Transfer payment
4. Disposable Income
DI = PI – Personal Taxes
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Question 1 (practical example)

Below is list of domestic output and national income figures for a certain year. All figures
are in billions, Use the data given to determine GDP by both the Expenditure and the
income approaches.

Personal consumption expenditure 245

Net foreign factor income earned in SA 4

Transfer payments 12

Rents 14

Consumption of fixed capital(depreciation) 27

Social security contribution 20

Interest 13

Proprietor’s income 33

Net exports 11

Dividends 16

Compensation of employees 223

Indirect business taxes 18

Undistributed corporate profits 21

Personal taxes 26

Corporate profits 56

Calculating economic growth GDP growth= GDP current period- GDP previous
period x100

GDP previous period

Explanation of concepts

Nominal GDP-the market value of the final production of goods and services within a
country in a given period using that year’s prices (also called “current prices”)
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Real GDP-nominal GDP adjusted for changes in the price level, using prices from a base
year (constant prices) instead of “current prices” used in nominal GDP; real GDP adjusts
the level of output for any price changes that may have occurred over time

GDP deflator-a price index used to adjust nominal GDP to find real GDP; the GDP
deflator measures the average prices of all finished goods and services produced within
a nation’s borders over time.

Base year-the year is used for comparison in the determination of price changes using
the GDP deflator price index; the deflator in a base year is always equal to 100.

Current prices-the prices at which goods are sold in a nation in a particular year; current
prices are used when calculating nominal GDP.

Constant prices- the prices from a base year that are used to calculate real GDP in
other years; this allows for a more accurate measure of how a country’s actual
output changes over time because constant prices cancel out any changes in the price
level between years.

Misconceptions about economic growth.

• An increase in GDP does not necessarily mean a nation has produced more output; it
must be specified whether the GDP in question is nominal or real. An increase in nominal
GDP may just mean prices have increased, while an increase in real GDP definitely
means output increased.

• The GDP deflator is a price index, which means it tracks the average prices of goods and
services produced across all sectors of a nation's economy over time. With this index,
changes in the average price level (inflation or deflation) can be calculated between years.
However, this is not the most commonly used price index for tracking inflation and
deflation. The consumer price index (CPI) is the most commonly used price index, which
you'll learn more about later in this course.
The business cycle

• The pattern of expansion and contraction that was discerned in economic activity
over a number of years.
• A complete cycle has four elements: trough, expansion peak, contraction
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Long term trend

Peak

Trough

TIME

Causes of business cycles

Classical view Keynesians view

• Market are stables • Endogenous factor

Fluctuations area results of exogenous, factors
(e.g. change in weather condition
• Government should intervene
• Jevon’s sun spot theory-British economist Jevon to apply appropriate monetary
formulated and
A sun spot theory which states that changes in fiscal policy
solar radiation causes weather conditions to Keynesian: they believe that
change agriculture, Production and the level of the business cycle is part of
economic activity the modern economy.
Government should intervene
In the economy by applying
• Causes originate outside the economic system
appropriate monetary and
fiscal policy. Business
• Government should not intervene conditions improve as a result

Market forces will sort out all economic of multiplier (strong upswing
problems which carries seeds of its own
destruction) when economic
growth increase, interest
increase, import prices
increase and foreign
exchange decrease
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Structuralist view

• Fluctuations are caused by various structural or institutional changes

• Markets are not inherently stable
• They focus on unpredictable events e.g. oil shocks, political unrest, uncertainty,
changes in technology and production techniques, international financial crisis, and
imposition of trade and financial sanctions.

Measuring business cycle

The leading indicator tends to peak before the peak and reach a trough before the ore
trough in aggregate activity. They give warning of changes: variable: the number of new
motorcars sold.

Coincident indicators- they coincide with movement in aggregate economic activity

Lagging indicators – which tend to lag behind the movement in aggregate economic
activity.

CHAPTER 13 & 21.Measuring employment and

unemployment
Unemployment rate – is the percentage of the people in the labour force who are
unemployed. Number of people employed
Labour force x 100
Unemployment rate – refers to a people who are available for work 15 years or older
without work in the reference week; actively looked for work or tried to start a business in
the four weeks (7 days) preceding the survey interview and would have been able to start
work or would have started a business in the reference week. (Narrow or official, strict
definition)
The broad or expanded definition excludes the criteria of pursuing active efforts to find a
job in the four weeks prior to the interview.
The labour force participation rate – is the sum of the employed and the unemployed.
Formula (number of people employed x number of people unemployed)

Labour force participation rate – the percentage of the working-age population who are
members of the labour force. Labour force X 100
Working age population
Absorption rate – the percentage of people of working age who have jobs.
Number of people employed x 100
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Working age population

Costs of unemployed
• Lost income and production
• Loss to society
• Cost human capital

Types of unemployed

1. Frictional unemployment – people entering and learning the labour force, also
called search unemployed. It is a healthy phenomenon in growing economy.
2. Structural unemployment – when changes in technology or international
completion change the skills needed to perform jobs or locations of jobs. A
mismatch between worker qualifications and job requirements.

The following are examples of structural unemployment.

a) Lack of necessary education, training and skills required to obtain a job

b) Changes in production methods or techniques
c) Changes in the types of goods & services being produced as a result of changing
consumer preferences
d) Foreign competition – increased foreign as a result of trade liberalization and
globalization
e) Structural decline in certain industries e.g. the closure of gold mines
f) Discrimination (in the apartheid era certain jobs were reserved for whites

3. Youth unemployment

• Youth between 15 and 24 globally experience unemployment

• In South Africa youth unemployment rose from less than 50% in 2009 to 52 in 2012

4. Cyclical unemployment
When recession in the economy gives rise to unemployment because of demand
deficiency

5. Natural unemployment
Unemployment arises from frictions and structural change when there is no cyclical
unemployment full employment is a situation in which the unemployment rate
equals the natural unemployment rate.
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It is influenced by the following

a) The age distribution of the population

b) The scale of structural change
c) The real wage rate (e.g. minimum wage)
d) Unemployment benefits

Policies to reduce unemployment. Study page 402 textbook (both demand and supply
side)

Unemployment and inflation: the Phillips curve.

Short-run Phillips Curve- shows the relationship between inflation and

unemployment, holding constant:

a) The expected inflation rate

b) The natural unemployment rate
Trade-off principle/ The Phillips curve.

Stagflation is illustrated by a rightward shift of the

Phillips Curve. This is caused by a leftward shift in
Aggregate Supply which resulted from supply shock. The
original PC is PP with inflation rate of 5% and
unemployment of 4%. At point A. Factors such as a
higher rate of increase in wages as a result of trade
unions pressure or higher profit margins PC shift to the
right, P’P’ as a result the economy moves to point B
where the economy is experiencing stagflation.
Unemployment is 7% and inflation is 8%.

In this situation, cost-push inflation cannot be

remedied by policies that affect Aggregate Demand
in the economy. The solution is to apply policies that
will lower inflation and unemployment
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If inflation rises above its expected rate, unemployment falls below its natural rate
(movement up along from PC from A to B)
• If inflation falls below its expected rate, unemployment rises above its natural rate
(the movement down along PC from A to B)

Long run Phillips Curve (LRPC) Eco 2641 further study for Bcom students only.

• Shows the relationship between inflation and unemployment when the actual
inflation rate equals the expected inflation rate.
• LRPC is vertical at the natural unemployment rate
• LRPC tells us that any expected inflation rate is possible at the natural
unemployment rate (consistent with the AS-AD model which predicts that when
inflation is expected, real GDP equals potential GDP and unemployment is at the
natural rate)
• A change in the expected inflation rate shifts the SRPC but it does not shift the
long-run Phillips curves.

Unemployment
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• If the actual inflation rate falls from 10% to 6% there is a movement down the
Philips curve from A –D.

Simultaneous increase inflation and unemployment

8 B

A P1
5

4 7 Unemployment rate (%)

• When Phillips curve (pc) shift to the right an increase in inflation can be
accompanied by an increase in unemployment.
• This is called stagflation (movement from point A to Point B)
• A right ward shift in PC is caused by the same factors that give rise to a leftward
shift of as curve (as is aggregate supply curve).

CHAPTERS 13 AND 20 MEASURING PRICES: THE

CONSUMER PRICE INDEX & INFLATION
Definition: inflation is defined as a continuous and considerable rise in prices in general.
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Four aspects of the definition

a) It is a neutral definition (it does not attach itself to a specific cause)
b) It is a process. It is not a once-off thing it is continuous
c) It is a considerable increase in prices. An increase of 2 %per annum might not be
inflation but it might be caused by an improvement in the quality of goods and
services
d) It is the general increase in prices. An increase in the price of particular good (e.g.
petrol) is not inflation.

Measurement of inflation

CPI (Consumer price index)

• Is a measure of the average prices paid by urban consumers for a fixed basket of
consumer goods and service.
• The CPI tells you about the value of the money in your pocket

Constructing the CPI

• Selecting the CPI basket

• Weighing the goods in the basket
• Conducting the monthly price survey
• Decide on the base period
• Calculating the CPI

Calculating the CPI

1) Find the cost of the CPI basket at base year prices

2) Find the cost of the CPI basket at current period prices
3) Calculate the CPI for the base period and the current period.
Formula

CPI CPI at current prices X 100

CPI at base year prices

Inflation rate = CPI this year – CPI previous year X 100

CPI previous year

The CPI: A Simplified calculation

a) The cost of the CPI basket at base year prices: 2012

CPI basket Cost of CPI Basket
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Items Quantity Price

Oranges 10 R1.00 R10

Hair cut 5 R30.00 R150

Cost of CPI basket at base year price R 160

b) The cost of the CPI basket at current –period prices: 2013

CPI basket Cost of CPI Basket

Items Quantity Price

Oranges 10 R2.00 R10

Hair cut 5 R40.00 R200

Cost of CPI basket at current–period prices R 220

Producer Price Index PPI

• It measures prices at the level of the first significant commercial transaction e.g.
manufactured goods when they leave the factory gate.
• Measures the cost of production.
Differences between CPI and PPI
Consumer price index (CPI) Producer price index (PPI)

Pertains to the cost of living Pertains to the cost of production

Basket of consumer goods and Basket of goods only
services
Capital and intermediate goods Capital and intermediate goods
excluded included
Prices include vat Prices exclude Vat
The implicit GDP deflator

An index of the prices of the items in consumption investment, government

expenditure and net exports. GDP deflator (nominal GDP ÷ Real GDP) X 100
Effects of inflation
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a) Distribution effects
• Inflation benefits the debtors (borrowers) at the expense of creditors(lenders)
• South Africa has a progressive personal income tax (i.e. marginal and average tax
rates increase with the income level)
• During inflation taxpayer’s nominal incomes (wages & salaries) rise even when
their real income is unchanged. (this is known as brackets creep)
• Bracket creep results from a combination of inflation and a progressive income
tax.
• An increased government revenue from taxation through inflation is called (a fiscal
dividend)
• Inflation affects poor households.

b) Economic effects
• Anticipating inflation – producers anticipate inflation more than seeking out
profitable new production opportunities.
• Speculative practices – speculation of inflation in real estate, foreign currencies
etc.
• Inflation may also discourage savings in fixed deposits
• It can also produce a balance of payments problems – increases the cost of export
industries and import-competing industries
c) Social and political effects. Page 386 textbook

d) Expected Inflation
• The greatest cost of inflation is the inflation it causes.
• An increase in the rate of inflation often reads e.g. unions may base their wage
claims on the expected high inflation
• This may result in hyperinflation if unchecked
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Causes of inflation
Demand pull Cost push

Occurs when the AD of goods or Increase in the cost of production

services increases while as
remains unchanged. i.e. too much
money chasing too few goods Components

Increases in wages and salaries

Components Cost of imported capital and
intermediate goods
Increase in profit margin
decrease in productivity
Increased consumption spending natural disaster
households e.g. credit availability
Increased in investment spending
by firms(I) (When is low)
AS2
Increased government spending
Increase export earning
AS1

E2
All these are accompan ied by increase in Gen
eral P2
money stock

E1
Price P1
AS
AD
3
2
AD3 Level
Y1 Y2
1
AD2
AD1 Total production income
1 2 3
Total production income
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Inflation targeting
• a monetary policy framework to set inflation rate at a target range
• South Africa target inflation between 3% - 6%

Features of inflation targeting

• the announcement of quantitative target
• the primary of price stability as the objective of monetary policy
• a broad –based, pragmatic approach to the analysis of inflation (wide range of
variables)
• Transparency (SARB must inform the public and markets about its plans,
objectives & decisions.)
• accountability (SARB should be held accountable for attaining its inflation
objectives)
Structuralist approach to inflation textbook P390-394 textbook and conflict approach
P394. Anti-inflation policy P395 not for exam (self-study)

Inflation targeting in SA (3%-6%)

- SARB uses the repo rate as its policy instrument

- The rate is set by the Governor of SARB in consultation with the MPC
- Governor reports regularly to the parliamentary portfolio committee on finance.

Measuring the links with the rest of the world: the BOP (balance of payment)

BOP – Is the record of all transactions of all South African households, firms or
governments and the rest of the world.

Two major accounts

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Current account and financial account.

Current account
Items
• Merchandise imports and exports (i.e. visible exports and imports) plus net gold
exports.
• All these constitute the trade balance (i.e. merchandise exports minus
merchandise imports plus net Gold)
• Services and payments of receipts (invisible transactions) e.g. travel, insurance
services.
• Income receipts and payments – income earned by SA residents and payments
refer to income earned by SA residents and payments refer to income earned by
non-residents in SA.
• Current transfers – social security contributions e.g. remittances, charitable
donations

Financial account

Items
Direct investment – the purpose of the investor is gain control or have a meaningful say
e.g. through acquisition of shares)
Portfolio investment – investor is interested only in the expected financial return on
investment e.g. shares or bonds
Other investment – is a residual category which includes items must be included in the
portfolio and direct investment e.g. loans

Unrecorded transaction

Captures all errors and omissions while compiling the BOP of the country
It serves to ensure that the BOP actually balances.

Measuring inequality: the distribution of income

Three measures of equality or inequality

1. Lorenz curve – illustrate the degree of inequality in the distribution of income

A hypothetical income distribution

Percentages Cumulative percentage

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Population Income Population Income

Poorest 20% 3 20 3

Next 20 % 7 40 10

Next 20 % 15 60 25

Next 20 % 25 80 50

Richest 2% 50 100 100

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100

90

80

70

60

50

40

30

20

60

10
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Point a – poorest 20% of population earns 3% of income

Point b – poorest 40% as pop earns 7% of income

Point c- poorest 60% of population earns 15% of income

2. Gini co- efficient

• If income is distributed equally the Gin Co-efficient equal to zero
• If income is distributed in perfect inequality the Gini co-efficient is equal to 1
Usually Gini co-efficient range from 0.30 (highly equal and 0.70 (highly unequal)
To calculate the Gini Co-efficient, we divide the area of inequality which is
OAB.

3. Quintile ratio
Is the ratio between the percentage of income received by the highest percent of the
population and the percentage of income received by the lowest percent of the
population? E.g. from the table above
50÷3=16.7
The higher the ratio, the greater the degree of inequality

Distribution of income in SA
• SA has the most unequal distribution of income
• The Gini co-efficient is estimated at 0, 68 the highest in the world.

CHAPTER 14 MONETARY SECTOR

Functions of money

1. Money as medium of exchange

Serves as a lubricate or intermediary to smooth the process of exchange and to
make it more efficient

Def.: Money is anything that is generally accepted as payment for goods and services
or that is accepted in settlement of debt

2. Unit of account
Is an agreed measure for stating the prices of goods and services
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3. Money as a store of value

The most liquid form in which wealth can be kept

Money is not income and is not wealth (NB) (For MCQ)

Kinds of money

M1, M2 and M3

Coins / paper money / deposits/ fiduciary or credit money and cheque accounts

Conventional measures (M1)

M1- coins notes and demand deposits

M = C+ D

M (Quantity of money)

Broader definition of money (M2) (quasi money or near money)

M2 = M1 + all other short-term and medium – term deposits of the domestic private sector
with monetary institutions.

The most comprehensive measure of money (M3)

M3 is equal to M2 plus all long term deposit of the domestic private sector with monetary
institutions. (Money as a store of value)

Financial intermediaries Page 251 (self-study)

SARB
Objectives:
(i) to protect the value of the currency in the interest of balanced and sustainable
economic growth in the republic
(ii) Must perform its function independently and without fear, favour or prejudice,
but there must be regular consultation between the Bank and the cabinet
member responsible for national financial matters.

Function of SARB A. formulation and implementation of monetary policy

The repo rate is the main monetary policy instrument through which monetary policy
is conducted.
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B. Service to the government

i) Banker and adviser – grant credit, deals with weekly issue of treasury bills,
advices the government with regard to monetary and financial matter.
Responsible for exchange control regulation.
ii) Custodian of gold and foreign exchange reserves Reserve bank keeps all the
country gold and foreign exchange reserves. Formulate exchange rate policy
iii) Administration of exchanged control – responsible for exchange control in SA.
Exchange in order to protect an economy from disruptive fluctuations.

C. Provision of economic and statistical services

• SARB collect, processes, interprets and publishes economic statistics and other
information.
• Data helps researchers, policy makers and analysis

D. Maintaining financial stability

i) Bank supervision
Monitors and issue licenses to commercial banks
ii) The national payment system
Aim is to reduce interbank settlement risk
iii) Banker to other Banks – acts as custodian of the minimum cash reserves that
banks are legally required to hold or prefer to hold voluntarily with the bank. It
acts as a clearing bank and lender of last resort
iv) Bank notes and coins
SA Mint Company mints all coins
SA Bank Note Company print all banknotes

The demand for money

• It is the amount that the various participants in the economy plan to hold in the form
of money balances.

Two component of the demand for money

• Transactions demand
• Demand for money as an assets
Keynes discovered two motives for holding money. He referred to the demand for money
as liquidity preference which is de noted as L

a) Transactions motive – People hold money as medium of exchange (for a given

level of income Y1 there is thus a given quantity of money demanded (L1)
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b) Speculative motive – money as a store of value the choice of holding financial

assets in the form of money or bonds depend on the interest rate.

Speculative motive (there

Transaction not sensitive
is negative relative
to interest variation
between interest and
I L1 quantity of money

L1 Q of money Q of money

L=L1+L2

The role of banks in the money creation process

• Banks create deposits by making loans to creditworthy borrowers

• They create their own assets and liabilities through accounting entries
• Money creation by the banks is limited by the demand for loans and action by the
SARB
• If there is no credit-worthy borrowers and no loans required no money creation will
occur.
• Banking system is inherently unstable and the SARB has to intervene
• A growing economy requires a growing money stock.
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• SARB intervenes to prevent excessive money creation as it could lead to inflation

as well as too little money which may stifle economic growth
• SARB uses interest rates to create money. (this is the importance of monetary
policy)

The determination of the quantity of money

L
A reduction in the interest rates to i1, initiated by

i0 Eo

E1
i1

L
lowering of the repo rate, will raise the
quantity of money to M1, ceteris paribus.

m0 m1

Mo Q of money

Monetary Policy

• Measures taken by the monetary authorities to influence the quantity of money or

he rate of interest with a view to achieving stable prices, full employment and
economic growth
• Formulated by SARB
• Instrument of monetary policy are open –market policy and accommodation policy
• Accommodation policy has to do with the cash reserve that banks are obliged to
hold (2.5 % of their liabilities).
• Open market instrument consists of the sale or purchase of domestic financial
assets e.g. government bonds
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Chapter 15: Government sector

Consist of the:

1. Central government e.g. concerned with the issues such as defence, foreign affairs
2. Provincial Government – concerned with housing, education, health services
3. Local Government – concerned with local roads, sewerage, street lighting, traffic
control
4. Public corporation – e.g. Eskom, Transnet, Rand water
The role of government in the economy: an overview The mix between Government
and the Market

1. The private initiative and market forces are generally more efficient than any other
possible solutions to the basic economics of what? How and whom?
2. Free markets cannot function properly without government enforcement of the
roles
3. Markets do not always produce efficient outcomes government intervention may
be required in an attempt to correct market failure.
4. Market system produce relatively efficient out comes but not equitable outcomes
since there is often a trade-off between equity and efficiency.

Market failure

Market failure occurs when the market system is unable to achieve an efficient allocation
of resources.

Type of market failure

1. Public goods (non-private goods)

• Public goods are non-rival, this means that its consumption by one person does
not reduce its consumption by others e.g. defence force protects everybody.
• Non excludable means that once it has been produced, there is no way of stopping
anyone from consuming it.
• Rivalry – a good is rival in consumption if no two people consume the same unit of
a good
• Excludable – it means that its consumption excludes from receiving the benefits of
the good after it has been produced.

Excludable Non-excludable
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Rivalrous 1st quadrant (private ds) 2nd quadrant (common property)

goo
e.g Wild life
e.g ice cream
Non- rival 3rd quadrant (mixed goods) 4th quadrant (public goods)

e.g.museum e.g. street light

2. Externalities (spillover effects, neighbourhood effects and third-party effects)

Externalities are costs or benefits of a transaction or activity that are borne or
enjoyed by parties not directly involved in the transaction.
External benefits External costs

• Also referred to as positive • Also referred to as negative

externality.
• A rise in activities which yields
benefits for those not directly
involved. e.g. inoculation
immunization against diseases
such as polio.
externality e.g. when an industry
produces chemical discharge that
pollutes rivers.
• This led to the development of the
Coase theorem which states that if
two parties to an externality can
bargain with one another, they will
reach an efficient allocation of
resources.
• External cost result in socially
inefficient allocation of resources.
• Governments should try to improve
the situation.

DD = Market demand curve for the product

 29

• SS= Market supply which is also equal to MPC (Marginal private cost)
• Without government intervention (equilibrium – is at E1 and market price is P1 Q1
respectively
• As a result of the pollution the MSC (Marginal Social Cost) is greater than the
marginal private cost (MP)
• The difference between the two represents the additional cost to society of the
pollution caused by the industries
• E2 is called socially efficient equilibrium [P2, Q2 respectively]
• E2 is where marginal social cost is equal to the price of the product
• Triangle between E2 and E1 represents the welfare loss to society the cost
imposed on society exceeds society’s willingness to pay for that unit.
• When external costs are experienced, markets tend to produce too much of the
product concerned

Asymmetric information

• Households, firms must have full information on the quality, availability and prices
of goods, services and inputs.
• E.g. when suppliers of cigarettes are aware of the health hazards of smoking but
do not release this information to potential buyers of cigarettes.
D
S

Po D

P1
E1

• DD & SS demand and

D supply of cigarette
S respectively
D1 • Q0 P0 Equilibrium
quantity and price
P1 Po Q • If buyer acquire
information about the health hazards associated with smoking demand decreases
illustrated by a left hard shift of DD to D1 D1, New equilibrium Q1 P1 respectively.
• E1 represent socially efficient
• E0 represent inefficient allocation of resources
• Asymmetric information can occur in any market.
 30

• It can also cause principal-agent problems e.g. when doctors increase the demand
for their service by what they do or do not tell their patients.
• Therefore, government impose standards that consumer products have to meet.
• Asymmetric information can also cause moral hazard and adverse selection.

Common property resources

• Non-excluded but rivalrous in consumption

• Common resources are over-exploited to the extent of their destruction (the
tragedy of the commons) e.g. fish in the ocean)
• Government plays a role in protecting or avoiding the over-exploitation of common
property resources.
• To regulate the use of the resource
• Government can issue the fishing license
• Declare limited fishing seasons for certain –specifying the maximum daily number
• Granting property rights to private owner
• Markets cannot function efficient if property rights are not well established
Other reasons for Government Intervention in the economy

i) Income distribution
• Free market generates an unequal distribution of income
• Government take measures usually in the form of progressive income
taxation
• Subsidy in certain goods and services (education and health)
• Transfer payment e.g. (old age pension)
• Legislation and other forms of regulation
ii) Macro-economic growth and stability
• Fiscal and monetary policies
iii) Merit goods
• Goods that are regarded as beneficial to society e.g. education, health,
shelter, fire protection and sports facilities.
v) Demerit- harmful goods to society
Government failure

- Government consists of politics and bureaucrats (people with their own motives,
ambitions, Objectives and faults.
1. Politicians
- Vote maximizing agents whose aim is to be re-elected
- Wants to be popular and try to please most people by supporting a variety of
programs which serve the interest of different groups in society.
2. Bureaucrats
 31

- Rational economic agents who respond to a particular set of incentives and try to
maximize their salaries, status, power, or prestige
- They know the functioning of the government more than politicians.
- Another firm of government failure is 30 rent-seeking (attempt by households/firms/
organized business / organizes labour to benefit at the expense of the society at
large)
- Economic rent is part of their remuneration.
- Democratic governments tend to respond to special interest groups and are
vulnerable to manipulation
- The only way to limit is to reduce the role of government in the economy

Nationalization Privatization

- Means that the government takes over - Transfer of ownership of assets from
the ownership or management the public sector to the private
of private enterprise sector.

Argument for privatization

1. Privatization is regarded as a possible way of obtaining funds that can be used to

reduce public debt and lower personal income tax.
2. Governments' ownership is always less inefficient than private ownership.
3. The losses of inefficient state-owned enterprises are an important source of budget
deficits and other fiscal policy
4. Privatisation attracts FDI
5. Privatisation broadens the tax base [since Government doesn’t pay tax)
6. Privatized enterprise enterprises have greater access to investment capital and
adapt easily to changing economic
7. Serve as an instrument of BEE through an increase in share ownership in the
economy
8. The proceeds from privation will make funds available for spending on housing,
education, and health.

Demerits of nationalization

- They are bureaucratic, inefficient, unresponsive to consumer wishes and a burden

on the taxpayer
 32

- Lack of creativity and innovation by management

- Poor investment decisions, poor financial control
- A lack of accountability to taxpayers and low levels of productivity

Argument against privatisation

- No broader view of the public interest

- Do not take much account possible external costs or benefits
- Lack of exposure to greater competition

Fiscal policy and the budget

Fiscal policy Monetary policy

- A policy in respective of the level and - Manipulation of interest rate

composition of government
spending, taxation and borrowing
- Main instrument (budget)
- Fiscal variables [Govt spending and
Taxation (T)
- Effective means of influencing &
total spending in the economy
- Regarded as an instrument of
demand management
- During recession {expansionary
fiscal and monetarily policies are
applied to stimulate economic
activity}
- This means that Taxes are reduced
and government spending
increased {fiscal}
- During the expansionary phase

Financing of government expenditure

Government spending is financed through income from property/taxes/borrowing.

Taxation

- Compulsory payments to the government

- Largest source of government revenue

Four criteria taxations as laid down by Adam Smith

i) Equitable
ii) Economical
iii) Convenient
iv) Certain

Modern criteria

i) Neutrality
ii) Equity < horizontal equity, Vertical equity
iii) Administrative simplicity < tax avoidance –legal
 33

Tax evasion – illegal

Types of taxes
Direct Indirect

- Levied on persons and companies - Levied on transactions

- Tax on income and wealthy - Taxes on products and productions
personnel e.g. Income e.g. vat

Distinction of taxes

1. The tax is progressive – high-income earns are taxed at a higher rate than low
earners.
2. The tax is proportional – all taxpayers are taxed at the same levels
3. Tax is regressive- high-income earners are taxed at a lower rate and lower-income
earners at a high rate e.g. vat

Direct taxes

1. Personal income tax

- It is progressive
- Marginal tax rate is the rate at which additional rand of income is taxed
- Average tax rate is the ratio between the amount of tax paid and taxable income
(effective tax rate)
-
2. Capital gains tax (CGT)
- Taxed on the sale of assets e.g. shares and fixed property

3. Company
- It is proportional
- Levied on companies as an independent entity
- The better the performance of the economy, the higher the company profits and
therefore the greater the contribution of company tax.

CHAPTER 16 FOREIGN SECTOR

Why do countries trade?

- The notion of specialization is the reason countries trade

 34

-
Absolute advantage

When a country has an absolute advantage in the production of a particular product.

Product ZIM SA

Shirts 100 50

Cell 05 10

One worker produces 100 shirts or 5 cell phones per week in Zim. One worker can
produce 50 shirts and ten cell phones per week. There it can be said that Zim has an
absolute advantage in the production of shirts and SA has an absolute advantage in the
production of cell-phone.

Comparative advantage

David Ricardo formulated the comparative advantage

Product Germany SA

Cars 2 1

Barrels of wine 8 6

- Comparative advantage exists if the opportunity costs differ between countries.

- In Germany the opportunity cost of producing 2 cars is 8 barrels of wine and produces
8 barrels of wine from its scarce labour resources. This means that cost to Germany
of producing 1 car is 4 barrels of wine, whereas in SA 6 barrels of wine have to be
sacrificed to produce 1 car. According to Ricardo’s theory, the law of comparative
advantage, each country will tend to specialize in and export those goods for which it
has a comparative.
Trade policy

1. Import tariff – taxes impose on products imported into a country. Used to protect
domestic industries or sectors from foreign competition.
2. Import quotas – control the physical level of imports and are therefore a form of
direct intervention in the market mechanism
3. Subsidies- payment made to private producers by government
4. Non – tariff barriers- special licensing requirement that makes it difficult for foreign
firms to meet.
5. Exchange controls- used to restrict imports by limiting the amount of foreign
currency available for their purchase.
6. Exchange rate policy
 35

Exchange rates

The rate at which currencies are exchanged

The price of one currency in terms of another.

Appreciation Depreciation

An increase in the value or price of A decrease in the value of the

one currency in terms of another currency in terms of another
currency currency.
Foreign exchange market- An international market in which one currency can be
exchanged for other currencies.
D S
Excess supply
R/$

Price
Excess demand
S D

10 Q
- R 8 and Q10 indicate the equilibrium exchange rate
- DD represent demand and SS represent supply of US &
SA

- At a lower price that R8 per dollar there is an access demand for dollars and at
higher prices there is an excess supply of dollars.
 36

- Gold price in is quoted in dollars, a fall in the gold price means that fewer dollars
will be earned
- Decrease in supply illustrated by S1S1 means that the dollar has become expensive
as compared to the rand dollar has appreciated against the rand. This implies that
the rand has depreciated against the dollars
- Imports from US become expensive
- When the dollar depreciate, imports from US become cheaper.

Intervention in the foreign exchange market

Managed floating exchange rates

 37

• SARB intervene to stabilize a depreciating currency if it has sufficient foreign

exchange reserves to do so.
• Central Banks Monitor development in the foreign exchange market and decide
whether or not to intervene

If demand for dollars increase as result of increase in imports from US.

•
•
• At D1 D1, there is now an excess demand for dollars of 1bn dollars as illustrated by
the difference between E0 and E2.
• If there is no intervention, this will result in the increase in the price of dollars to
1dollars = R9.00 and new E1

• The rand will depreciate.

 38

• S1 S1 illustrate an intervention by the SARB of the supply of dollars which shifts

supply to S1 S1 [it does this to avoid depreciation of the rand which causes
inflationary pressures.

With a floating currency, there are three policy options

1. Do nothing (let market forces and actions of currency speculators, determine

exchange rates
2. Intervene by buying and selling foreign exchange (this is managed floating)
3. Use interest rates (this will encourage an inflow of foreign capital and will also raise
the costs of speculators who want to speculate against the rand

Terms of trade

- The ratio between export and import prices.

Terms of trade = export price index X100

Import price index

END.