Economic Theory

Shashi Abeysinghe
B.Sc(eng), CIMA
Micro-economics

Whats the difference between
Microeconomics & Macroeconomics?
Microeconomics examines small economic
units, the components of the economy.
For example: individuals, households, firms,
industries
Macroeconomics looks at aggregates.
For example: national output, overall price level,
aggregate unemployment
What is a market?
The interaction of buyers & sellers of a
good or service
Questions relevant to all economies,
market-oriented or not
1. What goods & services should be
produced and how much?
2. How should the goods & services be
produced?
3. Who gets the goods & services?
4. How do changes in the production &
distribution mixes take place?
In a market economy, these questions are
handled by the market.
What & how much to produce:
determined by demand & supply conditions,
individual choices, & pursuit of profit.
How to produce:
determined by technology & resource costs.
Distribution:
based on ability & willingness to pay the price.
What if consumer wants or technology change?
Those changes alter demand & supply, which
changes prices, profits, & consequently output
levels & distribution.
The Circular Flow
Households &
Resource Owners
Firms
Product Markets
Resource or Factor Markets
money to pay for goods & services
goods & services
labor & other resources
resource payments such as wages, rents, & interest
The market is not the only way that the basic
questions of economics can be answered.
In some less developed nations, a
traditional economic system is used.
Custom & tradition determine the answers.
Social arrangements & culture dictate the
solutions.
Change occurs very gradually.
Historically the former Soviet Union had a
command economy.
Resources are government/publicly owned
and centralized control is used to
determine what is produced, how it is
produced, and how it is distributed.
No country in the world has
a purely market or purely command economy.
They have mixed economies with both
market and government sectors.
In this course, we will deal primarily with
the market system.
The Market:
Supply and Demand
What is the law of demand?
The lower the price of a good, the larger
the quantity consumers will buy.
So the demand curve slopes downward
from left to right.
What is the difference between
demand & quantity demanded?
Demand is the entire curve that shows the
relation between price & quantity
purchased.
Quantity demanded is one particular
quantity on the demand curve.
Example: Apple Market
Price of apples
(in dollars)
Quantity of apples
(in thousands of bushels)
D
$ 0.25
6
The demand for apples is the curve D.
The quantity demanded of apples when
the price is 25 cents is 6 thousand
bushels.
What factors change demand
(that is, shift the entire curve)?
1. Consumer income
2. Prices of substitutes and complements
3. Tastes
4. Consumer expectations
Example: Apple Market
Price of apples
(in dollars)
Quantity of apples
(in thousands of bushels)
D
1
If income increases, people
will buy more apples at
every price & the entire
curve will shift to the right.
D
2
What makes the quantity demanded of
apples change?
In other words, what causes a movement
along the demand curve for apples?
A change in the price of apples.
Thats it, only a change in the price of
apples.
Example: Apple Market
Price of apples
(in dollars)
Quantity of apples
(in thousands of bushels)
D
$ 0.25
6
Suppose the price of apples
falls from 25 cents to 20 cents.
Then the quantity demanded of
apples rises from 6 thousand
bushels to 8 thousand bushels.
8
$ 0.20
What is the law of supply?
The higher the price of a good, the larger the
quantity firms will be willing to produce and
sell.
So the supply curve slopes upward from left
to right.
What is the difference between
supply & quantity supplied?
Supply is the entire curve that shows the
relation between price & quantity provided.
Quantity supplied is one particular quantity
on the supply curve.
Example: Apple Market
Price of apples
(in dollars)
Quantity of apples
(in thousands of bushels)
S
$ 0.22
7
The supply of apples is
the curve S.
The quantity supplied of
apples when the price is
22 cents is 7 thousand
bushels.
What factors change supply
(that is, shift the entire curve)?
1. Technology
2. Prices of inputs (for example: land, labor,
machinery, raw materials)
3. Weather (in the case of agriculture)

Example: Apple Market
Price of apples
(in dollars)
Quantity of apples
(in thousands of bushels)
S
1
If rainfall is low, the
supply of apples will be
reduced. At each price,
there will be fewer
apples provided.
S
2
What makes the quantity supplied of
apples change?
What causes a movement along the supply
curve for apples?
Just a change in the price of apples.

Example: Apple Market
Price of apples
(in dollars)
Quantity of apples
(in thousands of bushels)
S
$ 0.22
7
When the price of apples
falls from 22 cents to 20
cents, the amount provided
falls from 7 thousand
bushels to 6 thousand
bushels.
$ 0.20
6
What is equilibrium?
It is a state of balance, where there is no
tendency for things to change.
P Q
D
Q
S

condition
price
pressure
0.25 6 8
excess
supply
0.22 7 7
Q
D
= Q
S
0
0.20 8 6
excess
demand
Equilibrium occurs where the quantity demanded equals
the quantity supplied, which is at the intersection of the
supply and demand curves.
Example: Apple Market
Price of apples
(in dollars)
Quantity of apples
(in thousands of bushels)
D
Here the equilibrium
price is 22 cents & the
equilibrium quantity is
7 thousand bushels.
7
$ 0.22
S
quantity
D
1
Suppose there is an increase in
the price of pears
(a substitute for apples).
Then the demand for apples
will increase.
Equilibrium price increases &
equilibrium quantity increases.
price

S

Q
1


Q
2
P
2
P
1


D
2
quantity
D

price

S
1
Q
1


Q
2
P
2
P
1


S
2
Suppose there is a long spell
of bad weather for apple
growing.
Then the supply of apples
will decrease.
Equilibrium price increases
& equilibrium quantity
decreases.
Suppose that the surgeon general comes out with
stronger health warnings.
That will reduce the demand for cigarettes.
Simultaneously, there is a year of bad weather.
That decreases the supply of cigarettes.
Example: cigarette market
price
quantity

D
1
S
2
S
1
Q
1
D
2
So S & D both decrease.
The equilibrium quantity
decreases. Equilibrium
price may increase,
decrease or stay the same.
In this example, the price
remained the same.
P
1
P
2
=
Q
2
Resources are limited; wants are unlimited
Scarcity = not enough resources to produce the goods to satisfy
our wants.

Resources: Adam Smith in his Wealth of Nations (1776)
divided resources into land, labor and capital.

http://www.adamsmith.org/smith/won-intro.htm
Adam Smiths 3 resources: Land, Labor and Capital

1. LAND: used as shorthand for any natural resource,
not simply for agricultural land.

2. LABOR: manual power + skill ("human capital")

3. CAPITAL: produced means of production
for example, hammers, drill presses, computers ...
.

Although money is used to BUY all the above,
money is not itself a productive resource.

Capital grows through investment .
Scarcity means that choices are
necessary.
When you cant have all you want of
everything, you must make choices.

Microeconomics is the study of how to make
the best possible ( or the optimal) choice
under the constraint of limited resources.
Tradeoffs and the Production Possibility
Frontier
Economists would want to develop a more precise
model of the tradeoffs involved

And that model can be represented graphically by
a Production Possibility Frontier, showing the
choices which are
-- possible (on or within the frontier)
-- efficient (exactly on the frontier)
-- inefficient (within the frontier)
-- impossible (beyond the frontier)
Cadillacs ... 1944 and 1946
M5 Tank Cadillac Coupe
Opportunity cost of tank = 10 passenger autos
500
M5 tanks
Autos
5,000
The tank-auto trade-off:
an economist's view using the

Production Possibility Frontier
500
M5 tanks
Autos
5,000
The tank-auto PPF:
one POSSIBLE point is
(2000 autos, 300 tanks)




another POSSIBLE point
is
(4000 autos, 100 tanks)
300
2,000
500
M5 tanks
Autos
5,000
The tank-auto PPF:

an IMPOSSIBLE point is
(4000 autos, 300 tanks)






300
4,000
500
M5 tanks
Autos
5,000
an INEFFICIENT point is
(1000 autos, 200 tanks)






200
1,000
500
M5 tanks
Autos
5,000
The tank-auto equation:
TANKS = 500 0.1 AUTOS
Check out a few values:

AUTOS TANKS
0 500
1000 400
2000 300
2001 299.9
500
M5 tanks
Autos
5,000
Equation in general form:

TANKS = a + b AUTOS

How to find the equation from the graph:

1. a = Y-INTERCEPT = 500

2. b = SLOPE = rise over run
= - 500 divided by 5000 = - 0.1

500
M5 tanks
Autos
5,000
What the intercept means:

TANKS = 500 0.1 AUTOS

IF we produced zero autos, we could produce up to
500 tanks, since

TANKS = 500 0.1 (0) = 500
500
M5 tanks
Autos
5,000
What happens when the intercept changes:
TANKS = 600 0.1 AUTOS

IF we produced zero autos, we could produce up to
600 tanks, since
TANKS = 600 0.1 (0) = 600

The PPF would shift OUT and parallel to itself.
600
6000
This might be due to an increase
in the resources available for
production for example, an
increase in the labor force, and a
new assembly line in the factory
500
M5 tanks
Autos
5,000
What the slope means:
TANKS = 500 0.1 AUTOS

IF we were producing 2000 autos and 300 tanks
and if we decided to produce one more auto, we
would have to reduce tank production to 299.9

The OPPORTUNITY COST of an auto is
one-tenth of a tank.

500
M5 tanks
Autos
10,000
What happens when the slope changes:
TANKS = 500 0.05 AUTOS
If autos = 0, TANKS = 500
If autos = 5,000, TANKS = 250
If autos = 10,000, TANKS = 0

The possibility exists of producing more autos
perhaps some way of producing auto
transmissions (but NOT tank transmissions) more
rapidly has been discovered.

5000
Macroeconomics?
A Study of aggregate behavior of
Macroeconomic variables
- GDP
- Price level
- Employment
- Interest rate
- BOP

Let us look at the world economy
today


Some Statistics
Share of World GDP in 2005 (US$ billion)
Italy
4%
Japan
9%
Rest of the World
21%
Germany
6%
India
2%
Korea
2%
Russian
Federation
2%
Spain
3%
Mexico
2%
France
5%
China
5%
Australia
2%
Canada
3%
Brazil
2%
UK
5%
United States
27%
GDP growth rates in selected regions, 1995-2005
-4
-2
0
2
4
6
8
10
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Year
G
D
P

g
r
o
w
t
h

r
a
t
e

(
%
)
Africa: Sub-Sahara European Union
Newly industrialized Asian economies World (All WEO countries)
The circular flow of
income
The interdependence of
goods markets
and
factor markets
FIRMS
(suppliers of goods and services,
demanders of factor services)
HOUSEHOLDS
(demanders of goods and services,
suppliers of factor services)
The interdependence of goods and
factor markets
Q
1
P
1
Q
F
2
P
F
2
Q
2
P
2
P
F
1
Q
F
1
D
2
D
2

P
Q
P
Q
Rs
Rs
Rs Rs
Factor
services
Goods
Goods
Factor
services
S
S
D
1
D
1
(1)
Consumer
demand
(4)
Factor
supply
(3)
Factor
demand
(2)
Producer
supply
O O
D2

The circular flow of
income
Consumption, injections, withdrawals and equilibrium
Factor
payments
Consumption of
domestically
produced goods
and services (C
d
)
The circular flow of income
Firms
Households
Factor
payments
Consumption of
domestically
produced goods
and services (C
d
)
Investment (I)
Government
expenditure (G)
Export
expenditure (X)
BANKS, etc
Net
saving (S)
GOV.
Net
taxes (T)
ABROAD

Import
expenditure (M)
The circular flow of income
In an opened economy
WITHDRAWALS
INJECTIONS
Macroeconomics policies
Microeconomic policies are intended to influence or control macroeconomics variables in
order to achieve macroeconomics relationships and outcomes.

Fiscal policy-
The governments decision over taxation and public spending, which are incorporate in
the governments budget, is referred to as fiscal policy.

Monetary policy-
Central banks control over money supply affecting interest rate is known as monetary
policy.

Trade policy-
The governments actions influencing international trade constitute trade policy.
Eg: - Tariffs,
Quantitative restrictions on import trade,
Subsidies on export trade,
Controls over the payments of foreign exchange

Macroeconomics policies cont..

Exchange Rate policy-
The system of exchange rate maintained in the economy is the exchange rate policy.
This includes different systems such as fixed, floating or managed floating exchange
rate systems.



Redistributive policy-
The governments usually design policy measures to redistribute income for the benefit of
low-income groups. Income distribution through taxation and welfare are important
components of the redistributive policy, included in the government budget.


Economic
Growth
Therefore increasing economic output, is possible
under two conditions:

More resources are used in the economy.

Existing resources are used more efficiently.
Economic growth
- An increase in an economy's ability to produce goods
and services
- Sustainable increase in real output or real income of
an economy

Measurement of Economic Growth

1. Current Real GDP

2. National Output

3. PPF
Current Real GDP
Rate of GDP growth in year
t

=
[Real GDP
t
- Real GDP
t-1
]/Real GDP
t-1


Country 2002 2003 2004 2005 2006 2007 2008 2009 2010
GDP in
Sri
Lanka
(billion)
62.70 73.70 80.58 86.07 95.55 82.02 91.87 96.74 106.5
Calculate GDP Growth

Country 2002 2003 2004 2005 2006 2007 2008 2009 2010
GDP in
Sri Lanka
(billion)
62.7 73.7 80.58 86.07 95.55 82.02 91.87 96.74 106.5
Growth 18% 9% 7% 11% -14% 12% 5% 10%
Controversies in economic growth

GDP is not regarded as a good way of indicating the standard of living of individuals
and households in an economy.

The current measure of GDP is not good at reflecting
the damage to the environment caused by much
economic activity.
Ignores unpaid, voluntary work
How has an economy developed?
Which industries does it depend on?
How sustainable are the routes that a country has
chosen to follow towards the goal of growth?
How can we measure human happiness?
National Output
Relationship between total national outputs
(Y) to inputs:
Output = Level of technology in the
economy+ (productive services of capital +
Labour input + Natural resource input)
Y = A+ (K+L+R)


Output Grows due to:
-An increase in productive factors (K, L or R)
-An improvement in Technology (A)
Contribution to the economic Growth
1. Human Resources
- Increase in number of workers
- Increase in working time
- Improvement in quality of work force
- Education, Training, Experience,
Positive working attitudes
- Use of technology
- Computers, automated equipments
- Improve working conditions
- Rewards, pleasant working environment

Employment Rise
Increase in
Contribution
2. Natural resources
- Resources availability within the country

3. Capital Formation
- Machines, equipments, buildings and
inventories
- Depreciated when used in production
- Grows due to investment
4. Technology change and Innovation
R & D is an economic activity aimed at producing
technology

Invention Discovery of New knowledge

Innovation Incorporate new knowledge into production
techniques
New tools and machines
Training and Experience
New Management practices & new ways of organizing
activities
Sources of Growth - Where does it come from?

The sources of growth include:
Natural resources
Labour
Capital
Technology
The pace of technological change will depend on:
1.Scientific skills of the country
2.Quality of education
3.Amount of GDP devoted to research and
development

The four Wheels of Progress
Factor Income Growth Examples
Human Resources Size of the labour force
Quality of Labors (Education,
skills, discipline)
Natural Resources Oil and gas
Soils and climate
Capital Formation Equipment and factories
Social overhead capital
Technology change and
Innovation
Quality of scientific and
engineering knowledge
Managerial know-how
Rewards and innovation
Total Factor Productivity
Increase in output given the productive
factors
-Total Factor Productivity measured by change in
Technology
A = Y - (K+L+R)
-Labour Productivity output per unit of Labour input
Y/L
-Labour productivity can improve due to :
Technology improvements
Capital accumulation Capital Labour ratio



(Actual and potential economic growth)
Economic Growth and the Production
Possibility Curve

v
x
y
O
Growth through making a fuller use of resources
F
o
o
d

Clothing
Production inside
the production
possibility curve
O
Growth in potential output
F
o
o
d

Clothing
Now
O
F
o
o
d

Clothing
Now
Growth in potential output
5 years time
Cost of Economic Growth
Inequality of income

Pollution and other negative externalities

Loss of non-renewable resources

Lifestyle changes
Growth and the
business cycle
The business cycle
O
N
a
t
i
o
n
a
l

o
u
t
p
u
t

Time
Potential output
1
2
3
4
1
2
3
4
Actual
output
The business cycle
O
N
a
t
i
o
n
a
l

o
u
t
p
u
t

Time
Potential output
Actual
output
Trend
output
The business cycle
Growth and the
business cycle
The business cycle
in practice
A
n
n
u
a
l

G
D
P

g
r
o
w
t
h

r
a
t
e

(
%
)

-2
0
2
4
6
8
10
1
9
5
9
1
9
6
1
1
9
6
3
1
9
6
5
1
9
6
7
1
9
6
9
1
9
7
1
1
9
7
3
1
9
7
5
1
9
7
7
1
9
7
9
1
9
8
1
1
9
8
3
1
9
8
5
1
9
8
7
1
9
8
9
1
9
9
1
1
9
9
3
1
9
9
5
1
9
9
7
1
9
9
9
2
0
0
1
2
0
0
3
2
0
0
5
2
0
0
7
%
Sri Lanka GDP Growth Rate
A
n
n
u
a
l

g
r
o
w
t
h

r
a
t
e

(
%
)

UK
France USA
Germany
Japan
-3
-2
-1
0
1
2
3
4
5
6
7
8
9
10
1970 1975 1980 1985 1990 1995 2000
Growth rates in selected industrial countries
Causes to the booms and Recession
Random shocks

Policy-induced

Imported cycles

Expectations
Insufficient or contaminated land

Substandard labor supply

Poor technical infrastructure

Poor social infrastructure

Poor industrial infrastructure
Barriers to economic growth

International Trade
Why international trade is essential ?
Every Country lack some vital resources that it
can get only by trading with others

Each countrys climate, labour force, & other
endowments make it a relatively efficient
producer of some goods & efficient producer of
other goods

Specialization permits larger outputs & offer
economies of large-scale production
Modern Governments use three main
devices when seeking to control trade
Tariff
Tax on imports

Quota
Legal limit on amount of goods import

Export Subsidy
Payment by the government to exporters to permit
them to reduce the selling price
Foreign Exchange Market
Foreign currencies are bought and sold for
local currencies

Exchange Rate
The price of foreign currency that has to
be paid by the buyers of and, received by
the suppliers of foreign exchange
Participants in the Market
Bank customers
Commercial Banks
Central Bank

Balance of Payment
Statistical Records of foreign exchange
transactions of a country
Two main accounts
Inflow
outflow
The Balance of Payments Account
The current account
International Trade in goods and services
Net Factor income flows
Net transfers
CURRENT ACCOUNT
1. Trade in goods
a) Exports
b) Imports
Balance on trade in goods
2. Trade in services
a) Exports
b) Imports
Balance on trade in services
Balance on trade in goods and services
3. Net income flows (wages and investment income)
4. Net current transfers (government and private)
Current account balance
+191 211
224 259
33 048
+77 076
62 373
+11 114
21 345
+11 151
7 246
17 440
Balance of payments: (Rs millions)
CURRENT ACCOUNT
1. Trade in goods
a) Exports
b) Imports
Balance on trade in goods
2. Trade in services
a) Exports
b) Imports
Balance on trade in services
Balance on trade in goods and services
3. Net income flows (wages and investment income)
4. Net current transfers (government and private)
Current account balance
+191 211
224 259
33 048
+77 076
62 373
+11 114
21 345
+11 151
7 246
17 440
Balance of payments: (Rs millions)
CURRENT ACCOUNT
1. Trade in goods
a) Exports
b) Imports
Balance on trade in goods
2. Trade in services
a) Exports
b) Imports
Balance on trade in services
Balance on trade in goods and services
3. Net income flows (wages and investment income)
4. Net current transfers (government and private)
Current account balance
+191 211
224 259
33 048
+77 076
62 373
+11 114
21 345
+11 151
7 246
17 440
Balance of payments: (Rs millions)
CURRENT ACCOUNT
1. Trade in goods
a) Exports
b) Imports
Balance on trade in goods
2. Trade in services
a) Exports
b) Imports
Balance on trade in services
Balance on trade in goods and services
3. Net income flows (wages and investment income)
4. Net current transfers (government and private)
Current account balance
+191 211
224 259
33 048
+77 076
62 373
+11 114
21 345
+11 151
7 246
17 440
Balance of payments: (Rs millions)
CURRENT ACCOUNT
1. Trade in goods
a) Exports
b) Imports
Balance on trade in goods
2. Trade in services
a) Exports
b) Imports
Balance on trade in services
Balance on trade in goods and services
3. Net income flows (wages and investment income)
4. Net current transfers (government and private)
Current account balance
+191 211
224 259
33 048
+77 076
62 373
+11 114
21 345
+11 151
7 246
17 440
Balance of payments: (Rs millions)
CURRENT ACCOUNT

1. Trade in goods
a) Exports
b) Imports
Balance on trade in goods

2. Trade in services
a) Exports
b) Imports
Balance on trade in services

Balance on trade in goods and services

3. Net income flows (wages and investment income)

4. Net current transfers (government and private)

Current account balance



+191 211
224 259
33 048


+77 076
62 373
+11 114












21 345

-11 151

+7 246

25 750

Balance of payments: (Rs millions)
The Balance of Payments Account
The capital account
The financial account
investment
flows to and from reserves
CAPITAL ACCOUNT
5. Net capital transfers
Capital account balance
FINANCIAL ACCOUNT
6. Investment (direct and portfolio)
a) Net investment in UK from abroad
b) Net UK investment abroad
Balance of direct and portfolio
7. Other financial flows (mainly short-term)
a) Net deposits in UK from abroad and
borrowing by UK residents
b) Net deposits abroad by UK residents and UK
lending to overseas residents
Balance of other financial flows
8. Reserves (drawing on +, adding to )
Financial account balance
+ 75 496
118 750
+219 087
161 063
+1 439
+1 439
41 254
+58 024
+3 085
+19 855
Balance of payments (Rs millions)
CAPITAL ACCOUNT
5. Net capital transfers

Capital account balance

FINANCIAL ACCOUNT
6. Investment (direct and portfolio)
a) Net investment in SL from abroad
b) Net SL investment abroad
Balance of direct and portfolio

7. Other financial flows (mainly short-term)
a) Net deposits in SLfrom abroad and
borrowing by SL residents
b) Net deposits abroad by SL residents and SL
lending to overseas residents
Balance of other financial flows

8. Reserves (drawing on +, adding to )

Financial account balance







+ 75 496
118 750



+219 087

161 063

+1 439

+1 439





41 254






+58 024

+3 085

+19 855

Balance of payments: (Rs millions)
CAPITAL ACCOUNT
5. Net capital transfers

Capital account balance

FINANCIAL ACCOUNT
6. Investment (direct and portfolio)
a) Net investment in SL from abroad
b) Net SL investment abroad
Balance of direct and portfolio

7. Other financial flows (mainly short-term)
a) Net deposits in SL from abroad and
borrowing by SL residents
b) Net deposits abroad by SL residents and SL
lending to overseas residents
Balance of other financial flows

8. Reserves (drawing on +, adding to )

Financial account balance







+ 75 496
118 750



+219 087

161 063

+1 439

+1 439





41 254






+58 024

+3 085

+19 855

Balance of payments: (Rs millions)
CAPITAL ACCOUNT
5. Net capital transfers

Capital account balance

FINANCIAL ACCOUNT
6. Investment (direct and portfolio)
a) Net investment in SL from abroad
b) Net SL investment abroad
Balance of direct and portfolio

7. Other financial flows (mainly short-term)
a) Net deposits in SL from abroad and
borrowing by SL residents
b) Net deposits abroad by SL residents and SL
lending to overseas residents
Balance of other financial flows

8. Reserves (drawing on +, adding to )

Financial account balance







+ 75 496
118 750



+219 087

161 063

+1 439

+1 439





41 254






+58 024

+3 085

+19 855

Balance of payments: (Rs millions)
CAPITAL ACCOUNT
5. Net capital transfers

Capital account balance

FINANCIAL ACCOUNT
6. Investment (direct and portfolio)
a) Net investment in SL from abroad
b) Net SL investment abroad
Balance of direct and portfolio

7. Other financial flows (mainly short-term)
a) Net deposits in SL from abroad and
borrowing by SL residents
b) Net deposits abroad by SL residents and SL
lending to overseas residents
Balance of other financial flows

8. Reserves (drawing on +, adding to )

Financial account balance







+ 75 496
118 750



+219 087

161 063

+1 439

+1 439





41 254






+58 024

+3 085

+19 855

Balance of payments: (Rs millions)
Balance of payments (Rs millions)
TOTAL CURRENT + CAPITAL + FINANCIAL ACCOUNTS

Total current account

Total capital account

Total financial account

Total current + capital + financial accounts

9. Net errors and omissions

Overall balance of payments




25 750

+1 439

+19 855

+3 854

3 854

0



UK balance of payments: 2001 ( millions)
TOTAL CURRENT + CAPITAL + FINANCIAL ACCOUNTS

Total current account

Total capital account

Total financial account

Total current + capital + financial accounts

9. Net errors and omissions

Overall balance of payments




25 750

+1 439

+19 855

+3 854

3 854

0



Exchange Rate
The domestic price of a foreign currency unit
or the foreign price of a domestic currency
unit
LKR 100=US$ 1
US$ 0.01=LKR 1
Spot Exchange Rate Current exchange rate
quoted for immediate delivery
Forward Exchange Rate Future exchange
rate quoted for today for delivery after a time
lag
Depreciation Reduction the value of
domestic currency against foreign
currency
Appreciation Increase in value in domestic
currency against foreign currency
Appreciation or depreciation occur in the
foreign exchange market due to BoP
imbalances



Exchange Rate System
Floating exchange rate System
ER is determined in the foreign exchange
Market demand for and supply of foreign
exchange
Fixed exchange system
Determined by the central Bank
Where do the Supply & Demand come of
Foreign Exchange?
International Trade in Good & Services
International trade in financial instruments
(Stocks & Bonds)
Purchase of physical assets
Determination of exchange rates

The equilibrium exchange rate
BoP equals zero
Demand Inversely related to the ER
Supply Positively related to ER
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Determination of the rate of exchange
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Determination of the rate of exchange
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Determination of the rate of exchange
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Q of
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D by UK
Fixed versus Floating Exchange Rates
Advantages of fixed exchange rates
certainty
no speculation (if rate is absolutely fixed)
prevents 'irresponsible' government policies
Disadvantages of fixed exchange rates
conflicts with other macro objectives
danger of competitive deflations
problems of international liquidity
difficulties in adjusting to shocks
speculation
Fixed versus Floating Exchange Rates
Advantages of free-floating rates
automatic correction
no problem of international liquidity
insulation from external events
less constraint on domestic macro policy
Disadvantages of free-floating rates
possibly unstable exchange rates
speculation
uncertainty for business
but use of forward markets
lack of discipline on economy
How to Boost Economic Growth - How
can we grow more

The policies to boost growth split into two
types:

Demand-side policies ( fiscal policy and
monetary policy)

Supply-side policies

Demand-side policies

To boost the level of aggregate demand and therefore
growth, the government needs to use deflationary
policies. These are policies that help to generate more
demand. They include:

Fiscal policy
Cutting tax rates to boost people's disposable income
Increasing the level of government expenditure
Monetary policy
Cutting interest rates to encourage more borrowing and
spending

Supply-side policies

These are policies that aim to boost the potential for the economy to
grow - in other words to supply more. They are policies that should
make the economy more productive and more responsive to
change. Examples include:

Cutting tax rates - this gives people the incentive to work harder and be more productive
Cutting benefits - this gives the unemployed a bigger incentive to find a job; a harsh
policy (but a fair one???).
Promoting education and training - this should make the workforce more skilled and
therefore more productive.
Promoting research and development (R & D) - spending on R & D will help find new
more efficient ways to produce and should lead to better and more varied products.
Promoting mobility - if the economy is to be as flexible as possible, people need to
retrain where necessary and they need to move to where the jobs are. The
government has to help encourage this.

The Causes of Economic Growth

Economic Growth is caused by improvements in the quantity and quality of
the factors of production that a country has available i.e. land, labour, capital
and enterprise. Conversely economic decline may occur if the quantity and
quality of any of the factors of production falls.


Improving the Quantity and Quality of Land Resources

Improving the Quantity and Quality of Human
Resources

Improving the Quantity and Quality of Capital
Resources

Thank you