ECONOMIC GROWTH AND DEVELOPMENT

Economic Growth occurs whenever there is a

quantitative increase in a countrys input and
output over time. It occurs when an economy
achieves an increase in it national income,
measure by gross national product (GNP),
above its rate of population, economic growth
leads to increase in GNP per capital.
Economic growth is the increase in the quantity
of goods & services produced in an economy
which raises her national income. It can occur
in a country without economic development
 Economic growth leads to economic development. For
this to exist all the sectors of the economy must be
growing and this must be sustainable. Therefore, a
developed economy must have been highly diversified.
A developed economy is a matured and highly
dependable economy.
Economic Development occurs when there is
quantitative and qualitative improvement in all or
almost all the sectors of an economy and which can be
sustained. It is wider than just increase in GNP and
encompasses better education, higher standard of
living, less poverty, cleaner environment, freedom, and
a richer cultural life.etc
 Economic development talks about
the maturity of the quality of goods
and service produced in a country,
the transformation of her economy
from primary to secondary sector etc
 SUSTAINABLE ECONOMIC
GROWTH
Economists and governments are creating awareness
of the significant of the environment in influencing the
equality of peoples lives. In assessing an economys
performance, economists judge not only the rate of a
countrys growth but whether it is sustainable.
Sustainable economic growth is economic growth
which is achieved in such a way as not to damage
future generations ability to produce more e.g. a
country may grow very rapidly in the short run by
chopping down forests, using intensive farming
methods which erode the soil and fertilisers which are
washed into rivers causing pollution.
It can be achieved by using renewable resources, less
pollution, technology etc.
 INDICATORS OF COMPARATIVE DEVELOPMENT

1. Classification according to the level of income:

Economy can be classified according to the
value of their gross national product (GNP) per
capital.
Economy can be classified as developing
economies and developed economies.
Developing countries are often referred to as
low income and middle income economies e.g.
African countries, some Middle East countries
(Iran, Iraq, and Saudi Arabia etc), Asia countries
e.g. China, Thailand, Singapore etc.
Developed countries are referred to as high
income economies e.g. the advance countries
of Europe and North America Nations (Britain,
France, USA, Germany, Japan etc)
Categorising economies according to the
level of income can be misleading it is
assumed that all countries classified as
developing are at the same stage of
production. The level of development goes
beyond relative levels of income.
 Nevertheless, classifying economies in this
way is convenient and it provides a simple
and a measurable way of grouping
economies to know those economies in need
of help and assistance from aid providers
a. Low income earners- US $905 or less
b. Middle Income
US $906 US $3,595 (lower
middle)
US $3,595 US $11,115 (upper middle)
c. High income - US$ 11,116 or above
2. Classification according to the level of
indebtedness: Economy can be classified
according to the level of their
indebtedness which may include highly
indebted, moderately indebted and less
indebted.
The proportion of GNP which is devoted to
servicing the debt measures the category
a country falls under.

3. IMF classification: IMF divides countries into three

categories
A. Industrial countries- highly industrialised (developed
countries)
B. Developing countries- less industrialised
C. Transitionary economies/ emerging economies/
newly industrialised economies. This is because they
are growing fast to become First world economy e.g.
China, South Korea, Singapore etc. There may be
substantial differences between the so-called third
world countries e.g. countries like the United Arab
Emirates have a relatively high income per capita
compared to the UK and the US i.e. not all third world
economies are poor
 CHARACTERISTICS OF DEVELOPING COUNTRIES

1. ECONOMIC STRUCTURE- Several less

developed countries (LDCs) rely on a single
commodity for more than half of their export
earnings, if exports earning (exchange rate)
fluctuates, the whole economy will be affected
Economic activities can be placed in the
following sector: primary, secondary and
tertiary sectors.
Developing countries have a high dependency
upon the primary sector. In those economies
agriculture contributed 30% to 60% of output
in 1990s
 Developing countries depend solely on
primary sector. Agriculture constitutes
greatly to the gross national products (GNP).
The economies that depends solely on
agriculture for their exports can be affected
by national disasters e.g. drought which can
wipe out their foreign currency earning.
In High income economies, the average
figure for agricultural production was only
5% or less of GDP.
2. POPULATION GROWTH AND STRUCTURE- The
population of developing nations grows at geometric
progression while the food supply production grows at
arithmetic progression. This means that more money
needs to be invested to provide jobs and goods for
this growing population. Fast population growth tends
to bring a higher dependency ratio.
In 2008, around 85% of the worlds population lived in
developing economies. Reverend Thomas Malthus in
his essay in 1798, wrote that there is tendency for
population to grow at geometric rate while food
supply had a tendency to grow at arithmetic
progression due to fixed supply of the quantity of land
and increasing quantity of labour which may
eventually lead to diminishing returns.
 But theory failed to recognise the
impact of change in technology upon
food production. Mechanisation,
application of fertilisers and
insecticides have increase food
production. Nevertheless,
malnourishment and famine remain
features of many developing
countries.
3. HIGH BIRTH RATE, HIGH DEATH RATE AND LOW LIFE
EXPECTANCY- In Africa, fertility rates are generally
high than that of developed countries which to
increase in population. There is high dependency
ratio which means that a proportionally small working
population has to produce enough goods and services
to sustain themselves and the dependants.
But in developed countries the population of some
countries are falling due to low birth rate which is
below the rate required to replace the present
population. The result is that the population is ageing.
4. POOR HEALTH- Third world countries tend
to have poorer health. This may be due to
poor nutrition , lack of access to facilities
such as clean water, proper sanitation and
proper health care provision
5. INCOME DISTRIBUTION- There is unequal
distribution of income because income
generating assets (e.g. land) are owned
by the few which leads to extreme of the
rich and the poor
6. UNEMPLOYMENT- The
unemployment rate in the
developing countries rises in
accordance with their population.
Developing economies suffer from
shortage of capital and entrepreneur
skills, in addition, there is pressure
on the supply of land for production
process.
7. External trade- foreign trade of many developing
countries shows a great reliance on the export of
primary produce, this made them vulnerable in their
trading relationship because of demand for primary
products which tends to be price inelastic and supply is
also price inelastic.
Weather may also affect their harvest which leads to
severe fluctuation in prices. These countries relying on
primary products receive low price for their exports of
primary products and pay high price for imports of
manufactured goods, while developed countries
depend on manufactured goods for foreign currency
earnings.
8. Urbanisation- there is high
proportion of the population in
developing countries who live in rural
areas. Also there is rapid rates of
rural- urban migration which can
cause extra pressure on resources in
already overcrowded urban areas.
There is pressure on the
infrastructure, housing, roads and
schools incapable of coping with
9. Multinational Corporation and foreign
direct investment- a multinational
company is a firm that operates in more
than one country. Such companies
provide foreign direct investment (FDI) to
the economies where they operate. Most
of the MNC are in developed countries
e.g. coca-cola corporation, Ford,
McDonalds, Toyota etc. FDI involves
capital flows between countries. So there
are less MNC in developing countries.
10. External debt- some countries are
categorised as heavily indebted poor
countries (HIPC). In some developing
countries, the proportion of debt service
exceeds 80% of GNP. Such economies
are classified as heavily indebted.
Debt is the major obstacle to the future
economic development and growth of
many developing countries
 The BRICS Countries

The BRICS countries are made up of Brazil, Russia,

India, China and South Africa.
The BRICS are both the fastest growing and largest
emerging market economies.
The group boasts of a combined population of more
than 2.85 billion, that is, around 45% of the present
global total. In business terms this constitutes a
massive potential group of consumers.
They have also contributed to the majority of world
GDP growth e.g. Chinas GDP was approximately
10% in the last decade.
 The countries are undergoing tremendous change in
terms of industrialisation, modernisation and
urbanisation.
Much of this growth is being assisted by receipt of
foreign direct investment from the mature industrial
countries. But in recent years the BRIC economies
themselves have been investing increasingly in the so-
called Triad (USA, Japan and the EU).
These countries are a magnet for multinational
enterprises (MNEs)that are attracted by low cost labour
and access to a huge and growing consumer market.
The standard of living has improved in these emerging
economies. Although millions continue to live in
poverty but a growing urban middle class provides an
expanding market for both domestic products and for
imports from abroad.
 BUSINESS/ECONOMIC/GROWTH
CYCLE
Business cycles describe the continuous ups
and downs in growth rate around a long term
trend.
1.Trend rate- this is the expected increase in
potential output overtime. It is a measure of
how fast an economy can grow.
2. Actual growth- this is the actual increase in the
output of a country. It measures the rate at
which real GDP is changing
3. Output gap- this is the difference between
actual output and trend rate. Output gap is
when the level of expenditure in an economy is
more/ less than the capacity of an economy to
GDP

boom/peak long term

growth rate
a (full
employment)
b c
d Actual
growth rate
depression

Time
a. Boom- high level of spending, increase
investment, increase in output, increase in
employment etc.
b. Recession- falling demand, rising stock of
unsold goods, unemployment etc.
c. Slump or depression- heavy unemployment,
low level of aggregate demand, deflation etc.
d. Recovery- economy picks up, demand
increases, investment increases etc.
 Stages of the Business
Cycle
Boom (peak) Fast economic growth
Consumer spending and investment high
Business will have high demand for
goods/services
Increasing incomes (increasing competition
for workers)
Profits high (high demand for resources =
prices rise can lead to inflation)
Wages rising?
High output due to high demand
Steady economic growth
Business and consumer confidence high
 Stages of the Business
Cycle
Recession (downturn/economic slow
down)
Incomes start to fall
Output starts to fall
Possible fall in demand for products
Decline in profit
Lay off workers unemployment
Consumer (save) and business confidence is
low
Reduced investment
 Stages of the Business
Cycle
Slump (depression)
High unemployment
Consumer confidence low
Investment low
Profits low
Closures
Any growth will be slow
 Stages of the Business
Cycle
Recovery (expansion/ upswing)
Income starts rise
Output increases
Spending and consumer confidence
increases
More employment as a result
 ECONOMIC GROWTH
Economic growth refers to the increase in
the amount of goods and services the whole
economy produce over and above what it
produced in the last year.
It occurs when the productive capacity of a
country increases.
It can be illustrated by a shift to the right of
the production possibility curve.
The main indicator of economic growth is
the real GDP
 DETERMINANTS/CAUSES OF
ECONOMIC GROWTH
1. Discovery of new resources- discovery of more
natural resources e.g. Oil, coal, gold etc as given
countries the ability to increase their output.
2. Investment in capital equipment- investment in
new capital equipment e.g. Tools, machinery and
factories is a key to growth. People can produce
more if they have the tools and machinery to use
3. Technology- as technology improves e.g. Better
method of production, better transport and
communication etc. countries can use their
existing resources more productively
4. Investment in human capital- Education and
training is a key factor to economic growth. A
more skilled and knowledgeable workforce is able
to produce more and better goods and services.
5. Reallocation of resources- movement (conversion)
of resources from primary production to
manufacturing and services will lead to increase in
output.
6. Savings- savings enable investment by providing
the funds for firms to invest which later leads to
higher output.
 MEASUREMENTS OF ECONOMIC
GROWTH
A. GDP (gross domestic products )
B. GNP/GNI (gross national products)
C. PPF (production possibility curve)
D. Per capita income
E. Current and constant prices
(inflation)
 BENEFITS OF ECONOMIC
GROWTH
1. Improved standard of living- with more
income, people will have money to buy better
goods and services
2. Increase in employment- as demand
increases, more workers will be needed to
produce goods demanded therefore, the rate
of unemployment will reduce
3. Increase in output- higher level of output can
be achieved by using fewer labour. People may
benefit from shorter working weeks and longer
holidays
4. Increase in government revenue- government
revenue will increase due to increase in tax
rate as a result of increase in income. This
money can be used to provide facilities for the
citizens.
5. Increase in international trade- more output
means more exports and more foreign
exchange
Others include increase in demand, recognition
by other countries, increase in foreign
investment etc
 DISAVANTAGES
A. Opportunity cost- economic growth might be
achieved by producing more of capital goods but at
the expense for fewer consumer goods like
televisions etc
B. Depletion- scarce resources e.g. Oil, coal etc may
be used up quickly as a result of economic growth
C. Externalities- noise, fumes and river pollution may
increase as economic activities increase which can
destroy plants and animals
D. Quality of life- increase in the number of factories
will reduce the available land for parks and other
recreational activities
E. Structural unemployment- workers
may be replaced with machines so
that many people find themselves
without work and unemployed for
long periods of time.
To help growth government can
promote saving, research and
development, education, mobility of
factors of production between
industries and promote supply side
ACTUAL VERSUS POTENTIAL GROWTH IN NATIONAL OUTPUT

Change in the actual output of goods and services

could be achieved when there is better utilisation
of existing factor of production.
If an economy move from any point within the
production possibility curve which represents
ineffective/inefficient use of resources to a point on
the curve, there will be an increase in the output of
both goods and services and this will lead to
increase in Gross Domestic Product which is
considered as actual economic growth
In the long run, total shift of PPC outward indicates
a growth in the potential output of the economy
 GRAPH OF A SHIFT IN PPF

Qty of goods
Growth in potential
output

Y
X

ppc1 ppc2
qty of service

Movement from point X to Y indicates actual growth while

outward shift of PPC indicates potential growth.
 NATIONAL INCOME
National Output is the total value of output
(goods and services) produced in an economy.
Usually in a year.
Factors of production are used to produce the
national output.
Firms pay workers and the owners of factors of
production (resources and capital) for their
production. These payments are cost to firms but
income for the owners of factors of production.
Similarly,owners of firms will receive income in
form of profits if their businesses are successful.
 Therefore National income is the total amount
of income /money earned by individuals, firm
and the government in the production of goods
and services in a country during a given year.
Governments measure the total output of the
country in order to assess the performances of
the economy.
An economy is usually considered to be doing
well if its output is growing at a high and
sustainable rate.
 CONCEPTS OF NATIONAL INCOME

1. INCOME- It is the total monetary value of

what an individual, a group or a government
get from economic activities
2. PERSONAL INCOME- It is the total amount of
money that gets into the pocket of an
individual after economic activities e.g.
salary, profit of a firm etc.
3. DISPOSABLE INCOME- It is the amount of
money left for a worker to spend or save after
tax has been deducted from the income.
4. GROSS DOMESTIC PRODUCT (GDP) - This is the total
monetary value of goods and services produced in a
country within a particular period, inclusive of
depreciation of capital consumption. GDP shows the
level of economic growth of a nation.
In calculating the GDP of a country, no account is
taken of what it took in producing the goods and
services and the nationality of those that produce
them. It is calculated as;
GDP=AE=C+I+G+(X-M)
Where AE= AGGREGATE EXPENDITURE,
C=CONSUMPTION, I=INVESTMENT, G=GOVERNMENT
EXPENDITURE, X= EXPORT, M=IMPORT
GDP is the most popular measure of national income.
5. GROSS NATIONAL PRODUCT GNP- It is the total
monetary value of goods and services produces in a
country plus the countrys net income from abroad.
GNP is the total value of output from resources
owned by the citizens of a country wherever these
resources are located.
It excludes the contributions of the foreigners to the
GDP and includes the earnings of the citizens of the
given country residing abroad e.g. interest on loans
they make abroad, rent from properties owned
abroad, profit from companies owned abroad and
dividend from shares they have in foreign
companies.
 The basic distinction of between gross domestic
product and gross national product is that the
former refers to the production of goods and
services within a geographical boundary,
whereas the latter refers to the production of
the national citizens working abroad.
GNP=GDP+NET PROPERTY INCOME FROM
ABROAD
To adjust from domestic product to national
product, we have to add income from abroad
less income paid to abroad or net property
income from abroad; domestic income income
paid abroad + income received abroad or net
property income abroad
6. NET PROPERTY INCOME FROM ABROAD- This is
the difference between the flow of income
coming into a country and those being paid
overseas.
When net property income from abroad is added
to gross domestic product, we will obtain gross
national product.
Net property from abroad is the addition of
receipts of interest, profits and dividends
received by local residents from assets that they
own overseas minus the receipts of interest,
profits and dividends earned on assets located in
the country but owned abroad.
7. Gross National Income (GNI)- This is a
measurement of a country's income. It includes all
the income earned by a country's residents and
businesses, even if it's made abroad.
Itdoesnot count income earned by foreigners
located in the country.
GNI measures income earned, including that from
investments, that flows back into the country.GNP
(Gross National Product) includes the earnings
from all assets owned by residents, even if it
doesn't flow back into the country.
Also, GNP omits the earnings of all foreigners living
in the country, even if they spend it within the
country. GNP only reports how much is earned by
the country's citizens and businesses, no matter
where it is spent in the world.
Income GDP GNI GNP
Earned by:

Residents in C+I+G+X C+I+G+X C+I+G+X

Country

Foreigners in Includes Includes If Excludes all

Country Spent in
Country

Residents Out Excludes Includes If Includes all

of Country Remitted Back

Foreigners Excludes Excludes Excludes

Out of
Country
8. NET NATIONAL PRODUCT (NNP) - This is defined
as the difference between GNP and depreciation
that occurred in a period.
Machines, cars, computers, building etc can
become old and need repair. The amounts
spend on the repair or replacement of old, worn-
out capital is known as depreciation or capital
consumption.
Net National Product (NNP) is calculated by
deducting the value of capital goods replaced
(depreciation) from the total output of a country.
 Net National Product (NNP) = Gross National
Product (GNP) Depreciation.
NNP can also be referred to as national income.
NNP is also a gain or addition to capital good
(e.g. computer, cars produced in a year).
Depreciation is the capital consumption
allowance.
GDP at factor cost = GDP at market prices -
indirect taxes + subsidies.
GDP at market prices = GDP at factor cost +
Indirect taxes Subsidies.
Factors that determine the national income of a country

nature of factors of production

availability of natural resources
level of technology
level of industrialisation
working population
political atmosphere
 WAYS OF MEASURING GDP OR NATIONAL INCOME

1. THE OUTPUT METHOD- This is the

method of calculating the monetary value
of goods and services produced in a year.
In calculating national income through
this approach, double counting is avoided
by subtracting the total monetary value
of input because output method
measures only the added value in
production which is the difference
between the sales revenue received and
the cost of raw materials used
 e.g. if the value of cars sold by car
manufacturers is added to the value of
output of tyre, double counting will occur i.e.
if the cost of tyre and other accessories are
200,000 and a car is sold for 350,000, the
value added to output will be 350,000 -
200,000 = 150,000.
Therefore output method adds up the added
value of every firms output or adds up the
output of final goods and services.
 THE EXPENDITURE APPROACH- This is the calculation
of the total monetary value of expenditures of goods
and services by the government, individuals,
organisations, etc within a country in a year.
Expenditure on intermediate goods and services i.e.
capital goods or services bought and used for further
production must not be calculated in order to avoid
double counting therefore, only the expenditure on
final goods and services are calculated.
Incomes that are not spent but saved are also added
in other to arrive at true national income.
 Expenditure on exports are added because the sales
of exports represents the countrys output and
creates income in a country likewise.
Expenditures on imports are deducted because it is
a n expenditure on goods and services made in
foreign countries and create income for people in
those countries.
Indirect taxes are deducted and subsidies are added
to get a value that tallies with the income generated
on output.
The expenditure method adds up the spending in
the economy i.e. C+I+G+X-M where,
 C= consumers expenditure (the personal consumption
expenditure on durable goods which are goods that last
more than a year, non durable goods such as food and
services.
I= investment spending by firms (gross domestic
private investment falls into 3 categories that is
residential services, plant and equipment and changes
in inventories.
Residential construction is included as an investment
because it is built to gain income. Plants and
equipment is the construction of factories, warehouses,
stores and other non residential structures.
 Change in inventories is the changes in stocks
i.e. goods that are stocked up and not used in
the production process or consumed.)
G= government expenditure (the government
expenditure for goods and services consists of
expenditure by the government departments
on goods and services directly or through
subsidies and on capital expenditure.
X= export spending
M= import spending
 THE INCOME APPROACH- In this method. The
total monetary values of incomes received by
individuals, firms, and government agencies are
calculated.
These incomes include all interests, salaries,
rents, profits, etc received and made in a year.
All these payment represent income paid to
factors of production.
In using this method, all transfer payments are
not included e.g. gift received by beggars and
aged people and other welfare payment are not
included.
 The income method involves adding
up:
Wages and salaries
+ Self employed income
+ Trading profit
+ Rent
+ Interest
 These 3 methods should give the
same total because they all measure
the flow of income produce in an
economy.
The value of output is equal to the
income which it generates i.e. wages,
rent, profit and interest.
If it is assumed that all incomes are
spent, expenditure will be equal to
income.
 USES OF NATIONAL INCOME ESTIMATE

Standard of living assessment- it is used to

assess the standard of living in a country in a
year compared to the next and compared with
other countries.
Planning- economic planning can be done
properly if the national income estimate is
known.
International use- national income estimate is
what United Nations and other international
organisations demand from a country before
giving any economic aid.
 Investment decision- it helps
government and investors to decide
the level of investment, extent of
economic growth and the need of
each sector of an economy in terms
of investment.
Economic forecast- future economic
needs, growth and development of
every country are known from the
national income estimate.
 PROBLEMS OF MEASURING NATIONAL INCOME

Smuggling- this creates a problem in

measuring national income because goods
smuggled in and out of a country are not
counted
Illiteracy- some illiterate people do not keep
account of their income therefore they do not
supply exact data for measuring national
income.
Lack of experts- in most countries, experts to
collect and evaluate the data needed for
national income evaluation are lacking.
 Double counting in developing countries,
it is problematic differentiating capital
goods from consumer goods, therefore
they are counted twice which give false
national income.
Self employment- the reward of some
services like that of full-time house wives,
subsistence farmers, self employed etc
constitutes problems to national income
measure because they are not recorded
 LIMITATIONS OF NATIONAL INCOME STATISTICS

National income estimate does not take

into account how income is distributed.
It does not measure economic problem
associated with production of goods and
services e.g. pollution congestion, disaster
like war, floods etc
The economic welfare of producers/workers
are not taken into account by national
income estimates therefore, it is not a true
measure of standard of living
 COMPARISON OF ECONOMIC GROWTH OVERTIME AND BETWEEN
COUNTRIES

Economic growth refers to the increase in the

amount of goods and services the whole economy
produce over and above what it produced in the
last year. Economic growth is an increase in the
real output of the economy over time.
Economists measure the rate of economic growth
by how much National Income or Gross Domestic
Product (GDP) has increased each year in a
country. E.g. if the real GDP of Nigeria grows from
#50bn in 2006 to #52bn in 2007, then the rate of
economic growth is (# 2/50100) 4%
 People are only better off if real GDP per
capita i.e. real income per head increases.
This is calculated by dividing the real GDP of
an economy by the size of the population.
In comparing economic growth rates over
time and between countries, care must be
taken over a number of issues because the
official real GDP figures may underestimate
the true change in output due to hidden,
informal or shadow economy which is
undeclared economic activities.
 PROBLEMS OF COMPARING ECONOMIC GROWTH OVER TIME AND
BETWEEN COUNTRIES

HIDDEN ACTIVITIES-Some people may not declare their

income in order to invade tax also, income of some
illegal activities like smuggling may not be declares
therefore will not be included in the GDP. These hidden
activities may make international comparisons of
economic growth rate difficult because people will be
spending the income they have not declared.
ILLITERACY- if there is high level of illiteracy in a
country, it will be difficult for government agents to get
information about all economic activities. Some people
might not be able to fill the tax form while some may
not fill it accurately. Therefore shadow estimate will
have to be made to cover up.
 NON MARKET GOODS- GDP figures include only
marketed goods and services (goods that are brought
into the market with prices attached to them). Goods
and services produced but not marketed like the
services provided by housewives and other voluntary
works are not included in official figures therefore,
estimates also have to be made for them.
GOVERNMENT SPENDING- it is difficult to value the
output of government goods and services which are
not sold e.g. defence, health services etc. Initially, the
output was value at cost which is value of input but
this gave a wrong view of what is happening to output.
 THE NATURE OF ECONOMIC GROWTH- A country might
experience high rate of economic growth but this might
not be sustainable in the long run. A countrys output
might increase because of high demand which may lead
to machinery being overworked or workers doing
overtime but in the long run, workers might not be
willing to do overwork and machinery may need repair
which may eventually lead to collapse of the economic
growth. High growth achieved by depleting of natural
resources and creating pollution will not be sustainable
in the long run e.g. over fishing, chopping down of trees
without new trees being planted etc.
 The income figures of each country have
to be converted into a common currency.
It can be difficult deciding what exchange
rate to use because the value of exchange
is often changing all the time.
Price level and the income figure of a
country should be taken into
consideration. A country may have less
average income and may also have lower
prices on goods and services.
 Other factors e.g. climate should be
considered. One country may have to
produce heat while another may get
it free of charge.
Some economies have much more
barter and a greater black economy
(illegal) than others.
The distribution of income may vary.
Is income evenly distributed or not?
 INDICATORS OF LIVING STANDARD

Standard of living is a term

expressing the capacity of a person
in satisfying his basic needs from his
disposable income. When a person
can satisfy his basic needs like food,
cloths, housing, and other necessities
of life from his income, the person is
enjoying high standard of living.
 GDP per capita (per capita income) can be used
to measure standard of living
Per capita income= national income
population

It is assumed that increase in national

income /GDP will increase the standard of living
which will lead to (a)more income for individuals
(b) better quality goods and services (c)choice
(d) higher employment (e) more infrastructural
amenities etc
PROBLEMS OF USING GDP AS A MEASUREMENT OF STANDARD OF LIVING

1. GDP is not evenly distributed in most countries.

Sometimes when GDP rises, some people may not
experience increase in their income. Some people in
power may be getting more income; majority may not.
2. GDP measures the quantity of output produced but not
the quality. Output could rise but if the quality of goods
produced reduces, the standard of living may likely fall
3. Decline in environmental conditions will lower the
living standard but not the GDP this is because as GDP
increases, quality of the environment in some countries
declines as a result of pollution.
4. A country may have larger GDP per head but
if the prices of goods and services are higher,
standard of living will be low. E.g. Nigeria
5. GDP figures do not reflect the number of
hours or the amount of work people put in to
earn their income. A country whose GDP per
head is twice that of another country but put in
three times the effort of others cannot be said
to have a higher standard of living e.g. Japan
standard of living is high at the same time,
Japanese overwork themselves.
 DECREASE IN GDP VERSUS DECREASE IN STANDARD OF LIVING

A fall in GDP may not really be a fall in living standard

for these reasons
1. A reduction in GDP may not be a reduction in GNP.
The GNP shows the income of the citizens of a country.
If a country has a positive net property income from
abroad, the income might offset the fall in GDP. So, the
per capital income might be high likewise the living
standard
2. Government can spend the national reserve of the
country to ensure stability in consumption level.
Government may use the reserve to subsidise
education, health and public facilities. The standard of
living might not really fall though the GDP might fall.
3. The fall in GDP may be due to a fall in productive
activities that have no direct relationship to welfare
(e.g. reducing the size of armed forces or laying off of
redundant labour civil servants) which may not have
any effect on the standard of living
4. Living standard can improve even with a lower GDP
if the government decides to aim for more equal
distribution of income e.g. government may use tax
to get money from the rich and use it to subsidise for
necessity items e.g. food, health, education etc.
Therefore a person of $20,000 income may consume
only $16,000 while a person of $4,000 income may
consume $10,000. So with a lower GDP, the living
standards of the majority can still improve.
 OTHER INDICATORS OF STANDARD OF LIVING

GDP is not a complete measure of

standard of living. Other measures may be
more appropriate which include;
1. MEASURE OF ECONOMIC WELFARE (MEW)
- this adjust GDP figure by taking into
account other factors that have impact on
the quality of life e.g. leisure hours while
factors that reduce standard of living are
deducted e.g. pollution.
2. HUMAN DEVELOPMENT INDEX (HDI) this measures the
quality of peoples life. HDI takes into account GDP, life
expectancy at birth, educational attainment and a decent
standard of living.
3. HUMAN POVERTY INDEX (HPI)- This is an index which
assesses three elements of deprivation in a country
longevity (which is defined as the probability of not
surviving to the age of 40), knowledge (which is assessed
by looking at the adult literacy rate) and a decent standard
of living in both developing and developed economies.
4. MULTIDIMENSIONAL POVERTY (MDP) Poverty is often
defined by one-dimensional measures, such as income. But
no one indicator alone can capture the multiple aspects that
constitute poverty. Poverty is made up of several factors
such as poor health, lack of education, inadequate living
standard, lack of income, disempowerment, poor quality of
work and threat from violence.
 INDICATORS OF MDP
The following indicators are used to calculate the MPI
Years ofschooling: deprived if no household member
has completed five years of schooling
Child mortality: deprived if any child has died in the
family
Nutrition: deprived if any adult or child for whom by
nutritional information is malnourished
Electricity: deprived if the household has no
electricity
Sanitation: deprived if the households sanitation
facility is not improved, or it is improved but shared
with other households
 Drinking water: deprived if the household does not have
access to safe drinking water/ safe drinking water is more
than a 30-minute walk from home.
Floor: deprived if the household has a dirt, sand or dung
floor
Cooking fuel: deprived if the household cooks with dung,
wood or charcoal
Assetsownership: deprived if the household does not
own more than one radio, TV, telephone, bike, motorbike
or refrigerator and does not own a car or truck
A person is considered poor if they are deprived in at
least a third of the weighted indicators.
5. Kuznet curve- The Kuznets curve is a hypothetical
curve that graphs economic inequality
againstincome per capita over the course of
economic development i.e. as an economy
develops from a primarily rural agricultural society
to an industrialized urban economy.
Simon Kuznets hypothesized that as an economy
develops, market forces first increase then
decrease the overall economic inequality of the
society, which is illustrated by the inverted U-
shape of the Kuznets curve.
 For instance, the hypothesis holds that in the
early development of an economy, new
investment opportunities increase for those
who already have the capital to invest. These
new investment opportunities mean that those
who already hold the wealth have the
opportunity to increase that wealth.
Conversely, with the influx of inexpensive
rural labour to the cities keeps wages down for
the working class thus widening the income
gap and escalating economic inequality.
 The Kuznets curve implies that as a society industrializes,
the centre of the economy shifts from rural areas to the
cities as rural labourers such as farmers begin to migrate
seeking better-paying jobs. This migration, however, results
in a large rural-urban income gap leading to inequality.
Economic inequality is expected to decrease when a certain
level of average income is reached and the processes
associated with industrialization, such as democratization
and the development of a welfare state, take hold.
It is at this point in economic development that society is
meant to benefit from trickle-down effect and an increase of
per-capita income that effectively decreases economic
inequality
 GRAPH

The inverted U-shape of Kuznets curve shows that income

inequality first increases before decreasing after hitting a
peak as per-capita income increases over the course of
economic development and government intervention.
MONEY GDP AND REAL GDP
Money GDP (current price) is GDP measured in
term of the prices operating in the year in
which the output is produced, and it is a
measure which has not been adjusted for
inflation. Real GDP (constant price) figure is
the one that has been adjusted for inflation.
Real GDP = money GDP price index in base year
Price index in current
year
% in GDP = change x 100
original GDP
 Example, In 2000, a countrys GDP was 500
billion and the price index was 100. In 2002,
money GDP rose to 550 billion and the price
index was 105. Calculate the real GDP and %
increase in real GDP
CLASSWORK
Assuming Nigeria GDP is #200bn in 2005, the
nominal GDP increased to #250bn in 2006 and
the price index increased by 5%. Calculate;
1. Real GDP
2. The percentage increase in real GDP
 NATIONAL DEBT
Government debt(also known aspublic
debt ornational debt) is thedebtowed by
acentral government. It is the accumulated
debt of a country over a period of time.
It is different from budget deficit (which relates
to a given financial year and is part of fiscal
policy). A fall in the size of a budget deficit in
one financial year will still lead to an increase in
the size of national debt
Government debt is a of financing government
operations. Governments usually borrow by
issuingsecurities,government bondsand bills.
Less creditworthy countries sometimes borrow
directly from asupranationalorganization (e.g.
 As the government draws its income from the
population, government debt is an indirect debt of
the taxpayers. Government debt can be
categorized asinternal debt(owed to lenders
within the country) andexternal debt (owed to
foreign lenders).
Another common division of government debt is
by duration until repayment is due. Short term
debt is generally considered to be for one year or
less, long term is for more than ten years. Medium
term debt falls between these two boundaries.
 LABOUR FORCE
Labour force is made up of the employed and the
unemployed in a country.
Labour force measures/components are based
on;
1. The civilian non-institutional population of 16 years
old and over. (Excluded are persons under 16 years
of age, all persons confined to institutions such as
nursing homes and prisons, and persons on active
duty in the Armed Forces.).
2. The remainderthose who have no job and are not
looking for oneare counted as "not in the labour
force."
FACTORS INFLUENCING THE SIZE OF LABOR FORCE

Population:As expected, population

increase will result in labour force increase.
A 1% increase in population may result in
a 0.74% increase in labour force size.
Income:As income grows, it attracts
labour force entrants hoping to take
advantage on increase in income.
Educational Attainment:A more educated
society has a larger labour force.
 LABOUR PRODUCTIVITY
Labour productivity is concerned with the amount (volume)
of output that is produced by each employee. It is a key
measure of business efficiency, particularly for firms that
practise labour-intensive.
Formula
output per period (units)
number of employee at work/total hour
Example 1. Marcouse plastic makes 5,000 widgets each
month. Total monthly labour hours are 1,250. what is
labour productivity?
2. Suppose a country's total output for 2010 was $5 trillion.
All members of its labor force worked a total of 100 billion
productive hours for theyear. Calculate labour productivity
 UNEMPLOYMENT

Unemployment is defined as a situation where

people who fall within the age of the working
population; capable and willing to work are unable
to obtain befitting work.
Full employment is the level of output at which all
the factors of production in the economy are fully
utilised at given factor price. It occurs when all
those willing and able to work at the given real
wage are working i.e. unemployment is voluntary.
It is achieved when unemployment falls to 2-3 %
(this is because some people may be experiencing
a period of unemployment as they move from one
job to another)
 THE NATURAL RATE OF
UNEMPLOYMENT
Natural rate of unemployment is the
percentage of workers who are voluntarily
unemployed. It occurs when the economy is
at full employment i.e. when the labour
market is at equilibrium.
It consists of frictional, structural and other
types of unemployment. These are people
who are not employed because they are
unaware of vacancies (frictional), unsuitable
to take up the vacancies (structural) or are
unwilling to take up the vacancies (classical)
 Some economists argue that these people
are voluntarily unemployed because they
could put more efforts into finding out about
job vacancies and could be ready to accept
for a period of time at least a lower paid job.
Economists believe that in the long run, the
only type of involuntary unemployment is
cyclical/demand deficiency unemployment
which is caused by recession or decrease in
aggregate demand
NATURAL RATE OF UNEMPLOYMENT

Real wage Agg. ss of labour Agg Labour

Force

w1

Demand for labour

0 L1 L2 Quantity
Natural Rate of Unemployment
 The effect of real wage being above equilibrium

Real Wage ASL ALF

involuntary unemp. voluntary unemployment

W2

W1

Demand for labour

0 L2 L3 L4 L5 Quantity
of labour
 GRAPH OF INVOLUNTARY
UNEMPLOYMENT(LOW DEMAND)
PRICE LEVEL

LRAS

AD

0 D E Output
Equilibrium full employment exists at OE. Cyclical
unemployment occurs if an economy is below the
equilibrium level of output OE such as OD.
 The level of natural rate of unemployment
depends on the supply side of labour market.
Overtime, natural rate of unemployment might
fall as a result of increase in aggregate supply of
labour due to;
1. An increase in mobility of labour
2. An improvement in the education and training
level of workers.
3. A reduction in trade union restrictive practices
4. A reduction in state unemployment benefits
5. A reduction in income tax
 TYPES OF UNEMPLOYMENT
1. Frictional unemployment: it arises when people leave
their present job with the hope of getting a new and
better one but couldnot do so. This is the period
between the time a worker left his former work and
the time of getting a new work.
2. Cyclical unemployment: this occurs when there is
decrease in demand or there is over production which
results in fall in prices. Industries will be affected
which may cause retrenchment in the industries
affected because demand for labour is a derived one
which depends on the demand for goods and services.
3. Voluntary unemployment: this unemployment is
deliberate. It occurs when some people refuse to take
up any paid employment or decide not to do any work.
4. Seasonal unemployment: this is caused by
seasonal changes that affect some types of work.
Workers that work in road construction companies
remain unemployed during rainy season.
5. Structural unemployment: this is as a result of
slight changes in the industrial structure of a
country. It may also occur as a result of changes
in production techniques e.g. switching from
labour intensive to capital intensive method of
production.
6. Classical unemployment- classical or real wage
unemployment exists when the real wage rate is
above the equilibrium in the labour market.
Employers are not willing to pay so much and may
off some workers.
 CAUSES OF UNEMPLOYMENT

a. Demand deficiency- when there is

insufficient/lack of demand for goods
and services or when there is
recession, unemployment will rise. It
is not only labour that will become
unemployed, factories, machines,
offices etc. become unemployed too.
Less demand for goods and services
will lead to less demand for labour.
 DEMAND DEFICIENCY
Price Wage rate

LRAS supply
of labour

P W
P1 AD W1
DL
AD1
DL1

Y1 Y output Q1 Q no
of workers

Decrease in aggregate demand will reduce demand for labour

leading to unemployment of labour.
b. Excessive cost of labour-
unemployment might occur when the
wage rate is very high and employers
are not willing to pay the high wage
rate. In this situation, jobs may exist,
but workers choose not to take them
because they are not prepared to accept
lower wage. Therefore, labour market
will be at disequilibrium .
Causes of excessive cost of labour are;
trade union, minimum wage,
employment benefit etc
 EXCESSIVE COST OF LABOUR
When the minimum wage is set above the level that balances
supply and demand, it creates unemployment.
Unemployment from a Wage Above the
Wage Equilibrium Level...
Surplus of labor = Labor
Unemployment supply

Minimum
wage

WE

Labor
demand

0 LD LE LS Quantity
of Labor
 COSTS/EFFECTS OF UNEMPLOYMENT
A. Costs to the unemployed and their dependants;
1. There will be loss of income that could have been
earned had the person been in a job
2. There is the stigma of being unemployed.
Unemployment is equated with failure by the
unemployed and the society
3. unemployed suffer from social problems like marital
breakdown, physical suicide, illness and mental
instability.
4. unemployed people increase the number of
dependants and contribute in sapping the income of
their families instead of contributing to it
5. Unemployment leads to decrease in investment
because money used in training them could have
been invested
B. Cost to local communities: unemployment,
particularly among the young, leads to increase in
crime rate, violence on the streets, vandalism and
civil unrest.
secondly there will be increase in unemployment
benefits (increase in government expenditure).
thirdly government loses revenue because these
people would have paid taxes if they had been
employed.
C. Costs to the economy as a whole:Firstly there is the
loss of output which those unemployed could have
produced had they been in work.
Secondly there are social costs such as increased
violence and depression which are borne by the
unemployed and the communities in which they live.
 BENEFITS OF
UNEMPLOYMENT
1. Unemployment creates an
opportunity/time for the unemployed to
seek for better paid job
2. Unemployed enjoy unemployment benefit;
this can be used to set up a business
3. It gives time for innovation and invention
4. employers pay low wages during this
period. This reduces the cost of production
5. It gives the employer opportunity to
employ more and better qualified staff
from the pool of the unemployed
6. Lower inflation- high rate of unemployment
reduces the purchasing power/demand of
the people thereby reducing the price level
7. flexible labour market- activities of labour
union is reduced during unemployment e.g.
strike, excess salary increment etc
8. increase in productivity- labour productivity
will increase because there will be less
strike actions which can disrupt productivity.
MEASURES OF UNEMPLOYMENT

1. CLAIMANT COUNT- this the total number

of people claiming state benefit i.e. those
officially registered . Governments use this
method to count all those who registered
as unemployed. Claimant count excludes
those that are not eligible for benefit e.g.
adult over 65 years. The advantage is that
it is relatively cheap and quick to calculate
as it is based on information which the
government collects as it pays out benefits.
 Claimant count is opened to government
manipulation i.e. government may introduce different
changes to the way in which it is calculated, which
aim at reducing the numbers officially unemployed. it
is not an internationally recognised way of measuring
unemployment.
2. STANDARDIZED UNEMPLOYMENT MEASURE OR
INTERNATIONAL LABOUR ORGANISATION (ILO) ILO
count is taken from a wider survey of unemployment
called the Labour Force Survey (LFS) 60,000
households, with over 100,000 adults are surveyed.
The questionnaire used covers household size and
structure, accommodation details, basic demographic
characteristics such as age, sex, marital status etc.
 To be counted as unemployed an individual has to
be without a paid job, be available to start a job
within a fortnight and has either looked for work at
some time in the previous four weeks or waiting to
start a job already obtained. i.e., it measures as
unemployed all working age that actively sought
for job for 4 weeks or are waiting to take up job in
the next 2 weeks.
This measure picks up some of the groups not
included in the first measure. It is also based on
internationally agreed concepts and definition, it
makes international comparisons easier.
 DIFFERENCES BETWEEN CLAIMANT
COUNT AND ILO
1. Many female unemployed workers may be actively
looking for work but may be excluded from the
claimant count because their partners earn so much
that they do not qualify for benefit, but are included in
the ILO
2. Older workers may be collecting a pension and are
not entitled to benefit likewise people in their 50s and
60s but may be looking for work. They are not
included in the claimant count but are included in the
ILO
3. Workers who are made unemployed (in suspension)
cannot claim benefit for a number of weeks though
they would be counted as unemployed in the ILO
survey.
4. Claimant count may include some unemployed
who would not be counted in the ILO e.g. those
working in the hidden economy may claim
benefits for being unemployed but actually
working as self employed worker
5. The figures obtained through claimant count
may not be entirely accurate because some of
those receiving unemployment benefits may
not be actively seeking employment and some
may be working and claiming benefit illegally.
 DIFFICULTIES IN MEASURING UNEMPLOYMENT

Both the ILO and the claimant count might

underestimate unemployment because
1. They do not include part time workers who are
actively seeking for full employment
2. Those on government training and work scheme
will not be counted even if they want to work full
time. This particularly affects young workers
3. There are some out of work who are not actively
seeking for work or receiving benefits for being
unemployed but would take a job if offered. E.g.
nursing mothers
 OTHER PROBLEMS OF MEASURING
UNEMPLOYMENT
1. Data collection is expensive and time consuming
2. ILO is subjected to sampling errors because it is
based on sample survey
3. Claimant count is prone to manipulation i.e. It
changes every time there is a change in criteria
for qualifying for benefit.
4. Inadequate data collection method i.e. There are
only 2 recognised methods
5. Those claiming benefits illegally
6. Problem of defining the unemployed
7. Unemployed being excluded from benefits
 CIRCULAR FLOW OF INCOME

Circular flow of income explains how income

circulates or flows within the economy (i.e.
Exchange of money from households to firms
and vice- versa)
In a monetary economy, firms are producers;
households are made of individuals who are
consumers and owners of factors of production.
Households supply services/factors of production
to firms in production of goods. In returns, they
receive income from the firms. With the income,
they buy from the firms goods they consume.
 The firms after sales use their
income to pay households for
another supply of services/factors of
production to produce goods and
services which households will later
demand.
 TYPES OF ECONOMY

1. CLOSED ECONOMY: This occurs when there

is no international trade e.g.
a. Two sector economy : households and firms
b. Three sector economy: households, firms
and government
2. OPEN ECONOMY: This occurs when there is
international trade
a. Four sector economy: households, firms,
government and international trade
CIRCULAR FLOW OF INCOME IN A CLOSED ECONOMY

The outer circle/sphere shows the

flow of factors of production and
products/ services while the inward
sphere/circle shows the money flow
of spending and incomes. It is
assumed that all income is spent and
households and firms are the only
agents in the economy
The circular flow of income
Factors of production (Land, Labour and Capital)

Factor Income (wages/salaries ,

interest and rent)

Households Firms

Expenditure on goods and

services

Goods and
services
 CIRCULAR FLOW OF INCOME IN AN OPEN ECONOMY

An economy is opened if it engages in

international trade. There are four actors;
households, firms, government and
international trade.
Government serves as intermediary and
controls the activities of both households and
firms. Government makes money from
households and firms in form of direct and
indirect taxes and also gives money back to
them in form of benefits/government
spending.
 Household may not want to spend all its
income, therefore, some income is saved, some
is taxed and some is spent on imports. Some
expenditures leak out of the circular flow in form
of savings, taxation and imports. Other
spending are injected or added into the circular
flow in form of investment, government
spending and exports.

 Factors of production (Land,

Labour and Capital)
Factor Income
D .Tax savings (wages/salaries ,
interest and rent)
Ind. Tax Import

Households Firms

Govt spend
Expenditure on goods and
export Invest.
services
Goods and
services
 AGGREGATE EXPENDITURE

Aggregate expenditure is the total amount

which is spent at different levels of
income in a given period.
Total spending is made up of
consumption(C), investment (I),
government spending (G), and net exports
which is exports minus imports(X-M)
Therefore, C+I+G+(X-M)
COMPONENT OF AGGREGATE EXPENDITURE
CONSUMPTION

Consumption it is defined as the expenses

households or firms make on goods and services from
their disposable income to satisfy their wants e.g.
cloths, shelter, food etc
Autonomous consumption is the expenses on the
basic needs of life which include food, clothing and
shelter and do not depend on the level of income.
FACTORS DETERMINING CONSUMPTION
1. income- higher income leads to higher consumption
2. Savings- the higher the amount saved from a
consumers income, the lower the amount left for
consumption
 3. Taxation- high taxes reduce peoples disposable
income thereby affecting their level of consumption
4. Influence of other households- some people use
others as parameter for measuring their level of
consumption
5. Interest rate- the more the interest rate on
saving, the more the disposable income and
the higher the level of consumption
6. Future expectation- expectation of a rise in
the prices of goods and services will increase
the level of consumption expenditure.
 AVERAGE PROPENSITY TO CONSUME (APC)

Average propensity to consume (APC) is the

proportion of national income that is consumed.
When income rises, the proportion of income spent
tends to fall though total spending may rise
APC= consumption (C)
Income (Y)
E.g. If total income is #1,500 and total consumption
is #300, calculate APC
APC falls with higher income because when income is
low the level of consumption is high due to the
autonomous consumption. As income increases
autonomous consumption becomes less significant.
Marginal propensity to consume (MPC) is the
change in the tendency to consume goods and
services due to a change in the disposable income
i.e. the proportion of extra income which is spent
MPC= change in consumption
Change in income
As income increases, MPC reduces
E.g. if total national income increases from
#1,460m to #1,535m and total national
consumption increases from #630m to #660m,
calculate MPC
 CONSUMPTION FUNCTION
The consumption function indicates how
much will be spent at different levels of
income. It is given by the equation:
C=a+by, where C is consumption, a is
autonomous consumption (amount spent
when income is 0, and does not vary with
income), b is marginal propensity to
consume and y is disposable income
E.g. assuming C=10+0.8y and income is
$100, calculate APC
 DIAGRAM (GRAPH OF CONSUMPTION FUNCTION)

consumption
Output ( Y = C)

Consumption

45

Y0 Y1 Y2
Output Y
 At income level Y0, the level of consumption is
greater than the level of income, consumers are
spending more than they earn, this mean they are
dissaving e.g. withdrawing from past
savings/borrowing
At income level Y1, the level of consumption
equals the level of income; consumers are
spending all they are earning i.e. there is no
savings
At income level Y2, the level of consumption is less
than the level of income; consumers are saving
 CLASSWORK
1. If total income is #3,000 and total
consumption is #500. Calculate APC
2. Given the consumption function
C=10+0.8Y, calculate APC if income is
$500
3. If national income increases from #450m
to #570m and leads to a rise of total
consumption from #46m to #106.
Calculate MPC
 SAVINGS

Savings are part of disposable income kept for future

use i.e. part of income which are not consumed
immediately but reserved for future purposes.
FACTORS THAT AFFECT SAVINGS
1. Size of income- the higher the income, the higher the
amount saved
2. Size of the family- the larger the size of a family, the
little the savings
3. Interest rate- when the interest rate is high, people
will be encouraged to save
4. Availability of banks- this also encourage people to
save
5. Future expectations- if people are worried about the
future state of the economy and whether they will
have a job, they may save more
Average propensity to save (APS) is the tendency to
save part of disposable income or the proportion of
the national income that is saved
APS= total savings
Total income
e.g. if total savings is $60m and total national income
is $600m, calculate the APS
APS is equivalent to 1-APC. As income rises actual
amount saved and APS tend to increase.
 MARGINAL PROPENSITY TO SAVE
(MPS)
Marginal propensity to save (MPS) is the change in
the tendency to save due to a change in the
disposable income
MPS=change in savings
Change in income
e.g. if national income increases from #450m to
#570m and lead to a rise in total savings from #46m
to #106m. Calculate MPS
The rich have a lower marginal/average propensity to
consume (MPC and APC) and a higher
marginal/average propensity to save (MPS) than the
poor.
 Savings function is S=-a+sy. S=savings, a is
autonomous dissaving; sy is savings which is
determined by the level of income. Dissaving
occurs when consumption exceed income and
people withdraw past saving or borrow to meet
their needs
Autonomous dissavings indicates how much of the
savings people will draw when their income is zero.
This amount does not change as income changes.
Savings are related to consumption. If we are
spending more of our income, we are saving less
 SAVINGS GRAPH

saving
Saving

Dissaving
output/income/GDP
 INVESTMENT
This is the expenditure on a project which is expected
to yield future benefits. It is the expenditure on
physical assets e.g. factories, machinery, vehicle etc
which are not for immediate consumption but for the
production other goods.
FACTORS THAT DETERMINE INVESTMENT
1.Income- the more the income earned, the more the
investment
2. Tax-high taxes discourage investment because the
amount spent on tax could have been used for
investment
3. technology- increase in the level of technology will
increase investment as more machinery will be
available
4. Business expectations- Expectations are key
element to investment. If the producers believe
that future price and profit will increase they will
wish to increase their investment.
5. Rate of interest/marginal rate of returns (MEC)-
lower rate of interest encourages investment as
firms will borrow more to invest. MEC shows the
rate of returns on investment
If the expected rate of returns is greater than
the interest rate firms will invest and vice-versa.
DIAGRAM
 GOVERNMENT SPENDING

Government spending include spending on

health, education, law and order, transportation,
social security, housing, defence etc
One of the most significant elements of UK
government spending is social security which
often represent over 20% of total spending. After
this heath and defence are usually the most
significant element of government expenditure
The amount of government spending is
influenced government policy, tax revenue etc
 FACTORS THAT DETERMINE GOVERNMENT SPENDING

1. Tax revenue- higher government tax revenue will

enable the government to spend more without resulting
to borrowing
2. Population- increase in population will increase
government spending e.g. education for children,
employment for adult, health care and pension for
elderly people
3. Capital project- government may borrow in order to
finance a huge capital project
4. War materials/equipment- there may be need for
government to increase its expenditure in order to
procure materials with which to prosecute the war
5. Natural disaster- sudden outbreak of disasters such as
flood, epileptic etc may increase government spending
 NET EXPORT

Net export is the difference between exports and

imports
Factors that influence net exports are; a
countrys GDP, other countries GDP, exchange
rate, price and quality of goods etc
A rise in GDP of a country leads to a rise in
demand for import. Improvement in the quality
of products, improvement in marketing may
increase the exports of a country
FACTORS AFFECTING EXPORTS
1. Output of the economy- the higher the level of
domestic output the more a country can sell to
the rest of the world
2. Domestic market- if the domestic market is large then
the goods and services produced will be consumed at
home and only a small fraction left for export
3. Competitive of export- if a countrys products are of
good quality they will be bought in the world market
but if they are not , they will not be competitive with
goods quality product from other countries
4. Rate of inflation- if the domestic price level of a
country is rising faster than that of the rest of the
world, its products will be expensive in the world
market and they will not be bought
5. World income- if the world economy is buoyant there
will be income to buy goods and services
 NATIONAL INCOME EQUILIBRIUM

National Income equilibrium can be

explained in two ways;
1. It is a situation where injections equal
withdrawals (J=W)
2. It also refers to a situation where a
countrys aggregate expenditure equals its
aggregate income in a given year.
The level of national income equilibrium is
determined where aggregate expenditure is
equal to output.
 If aggregate expenditure exceeds output
(income), firms will produce more output
to meet demand, this will cause the GDP
to rise. If aggregate expenditure is below
output i.e. supply is more than demand,
firms will reduce production.
Therefore, output will change until it
matches aggregate expenditure. In order
to maintain equilibrium, the output will be
altered not the expenditure
 Aggregate demand and output (THE
KEYNESIAN 45 DIAGRAM)
Equilibrium on the market
Aggregate
Output ( Y = E)
Demand/Aggr
egate
expenditure
Aggregate Demand
(planned expenditure)
AD= C+I+G+X-M

Keynesian
Equilibrium Output

45

Y output (Y )

The 45 line shows the point where
aggregate expenditure equals national
income (GDP). Output is determined
where C+I+G+X-M line cut the 45 line.
At Y1, aggregate expenditure/AD is
more than the income level, therefore,
prices will rise, savings will fall, and
economy will expand output towards
Ye.
AD/AE
Output ( Y = E)

Aggregate Demand
(planned expenditure)
AD= C+I+G+X-M

45

Y1 Ye Y2
AD>Y AD<Y Output Y
Demand is too high Demand is too low
 At Y2, the income/output level is
more than the expenditure therefore,
savings will grow and prices will fall.
The economy will reduce output till
income is at Ye (equilibrium)
EFFECT OF A RISE IN AGGREGATE EXPENDITURE

Increase in consumption and

investment on the part of consumers
and firms will increase aggregate
expenditure and output will also
increase.
 EFFECT OF INCREASE IN
AGGREGATE DEMAND

AD
Output ( Y = E)
AD1= C1+I1+G+X-M

AD=C+I+G+X-M

45

Y Y1 OUTPUT
 WITHDRAWALS AND INJECTIONS

Injections are the money that flow into the

economy e.g. investment, exports and
government spending. While withdrawals
(leakages) are the money that flow out of
the circular flow of income e.g. savings,
imports and taxes.
 EQUILIBRIUM

W/J
Planned
withdrawal

Planned
Injection

Dissaving Y
output/income/GDP
 For an economy to experience
equilibrium, injections must be equal
to withdrawals i.e. S+T+M=I+G+X
In a 2 sector economy (households
and firms) injection is investment
while withdrawal is saving. Income
might be spent, saved or invested.
 Equilibrium will occur where C+I=Y (consumption
and investment) or C+S=Y (consumption and
savings) and where injection equals withdrawal
i.e. I=s (investment and savings)
Investment is drawn as a straight line which is
assumed to be unrelated to the level of national
income (i.e. autonomous of income), rather, it
tends to be related to interest rates and
expectations about the future level of income
rather than the present income level in the
economy.
EQUILIBRIUM IN A 2 SECTOR

W/J
S

Dissaving Y
output/income/GDP
 In a 3 sector economy, injections are
investment and government spending
while withdrawals are saving and taxation
Equilibrium income is achieved where
aggregate expenditure equals output i.e.
C+I+G=Y and injection equals withdrawal
i.e. I+G=S+T
Government spending is also drawn as a
straight line (autonomous of national
income), it depends on government policy.
EQUILIBRIUM IN A 3 SECTOR

W/J
S+T

I+G

Dissaving Y
output/income/GDP
 A four sector economy is the most
realistic model. It is an open economy
because it includes international trade.
Injections are I+G+X while withdrawals
are S+T+M. Equilibrium income is where
aggregate expenditure equals output i.e.
C+I+G+(X-M) = Y, and injections equals
withdrawals i.e. I+G+X = S+T+M
Exports depends on the exchange rate.
EQUILIBRIUM IN A 4 SECTOR

W/J
S+T+M

I+G+X

Dissaving Y
output/income/GDP
 EFFECT OF A RISE IN
INVESTMENT
W/J
S+T+M
I1+G+X

I+G+X

Dissaving Y Y1 output/income/GDP

A rise in investment will cause a rise in GDP

 ASSIGNMENT

1. Show the effect of decrease in

savings on the GDP and explain your
answer.
2. Show the effect of a rise in
government expenditure and export
and explain the effect on the GDP
 PARADOX OF THRIFT
Paradox of thrift explains the
consequences of attempts to save
more in an economy (when the
decision to save more result in less
savings). This is because higher
savings (withdrawal) will reduce
demand and GDP which will in turn
reduce income and the ability to
save. In the long run, it may lead to
recession.
 FULL EMPLOYMENT LEVEL OF INCOME
AND
EQUILIBRIUM LEVEL OF INCOME
According to the classical economists,
equilibrium level of income is attained always at
full employment level, i.e. there is absence of
involuntary unemployment and LRAS is perfectly
inelastic. However, as per the Keynesian theory,
equilibrium level can be achieved at:
(i) Full employment level; or
(ii) Underemployment level, i.e. less than full
employment level; or
(ii) Over full employment level, i.e. more than full
employment level.
FULL EMPLOYMENT EQUILIBRIUM:

It refers to a situation when the aggregate

demand is equal to the aggregate supply at
full employment level.
1. In below diagram, E is the full employment
equilibrium because aggregate demand EQ is
equal to full employment level of output OQ.
2. At OQ level of output, all those who are willing
to work at the prevailing wage rate, are able
to find employment, i.e. there is no involuntary
unemployment.
 UNDEREMPLOYMENT EQUILIBRIUM:

It refers to a situation when the aggregate demand is equal to the

aggregate supply when the resources are not fully employed. It occurs
prior to the full employment level.

1. In Fig. 8.4, AD1= AS at point F which is lower than full employment level.
2. As OQ1is less than OQ, point F signifies the under employment
equilibrium.
 Over Full Employment Equilibrium:

It refers to a situation when AD is equal to AS beyond the full

employment level. It occurs after the full employment level.

1. AD, = AS at point G which is higher than the full employment

level.
2. As OQ, is more than OQ, point G signifies the over full
employment equilibrium.
 INFLATIONARY AND DEFLATIONARY GAP

An inflationary gap occurs if aggregate expenditure

exceeds the potential output of the economy at full
employment. This causes upward pressure on
prices. In this case not all demand can be met; as a
result the excessive demand drives up the price. It
occurs when consumers are left with higher real
income and start demanding for more goods and
services. Excess demand pushed prices and brings
about inflationary gap.
An inflationary gap shows an undesirable impact on
the economy in terms of balance of payments and
eventually unemployment.
 It requires a contractionary government
policy and the aim is to curb demand so
as not to bring an unfavourable balance of
payment and collapse the local industries.
Government may reduce inflationary gap
by cutting its own spending and /or by
raising taxation in order to reduce
consumption.
 INFLATIONARY GAP

AE
Y=AE
AE1

AE
INFLATIONARY GAP

45

Y Y1 OUTPUT
 DEFLATIONARY GAP

This occurs when the level of aggregate demand is

below the level of output/full income level at full
employment and producers are only willing to supply
enough to meet the demand so as not to have excess
inventory.
It indicates that lack of aggregate demand i.e people
are not spending enough and producers are not
investing and fully utilising the resources, this result in
an equilibrium level at a GDP below the full
employment level.
The Keynesian solution to a deflationary gap is increase
in government spending financed by borrowing i.e. to
induce higher consumption so as to achieve full
employment, government may use expansionary fiscal
policy or expansionary monetary policy by reducing tax
and reducing the rate of interest.
 DEFLATIONARY GAP

AE
Y=AE
AE

AE1

DEFLATIONARY GAP

45

Y1 Y OUTPUT
 THE MULTIPLIER
Multiplier explains how an initial increase in
planned injections into the economy increases
the national income/output by more than the
initial amount of injection while increase in
withdrawals lead to decrease in national income.
e.g. An increase in government spending by 1
million may increase national income by 5
million; in this case multiplier is 5.
It is a process whereby money income generates
multiple of the original (initial) income and initial
expenditure generates another expenditure
The size of multiplier shows how much output in
the economy will increase relative to the initial
increase in planned injections.
Multiplier is also based on the principle that one
persons spending is another persons income
E.g. If government spends #200m on roads. The
contractors, employees and suppliers will earn
#200m. Assuming #100m is spent on other
goods and services. The producers of these
goods and services earn #100m; from this,
#50m is spent and so on. This means initial
income of #200 has generated Income of #200m
+ #100m + #50m.......there is a multiplier effect.
 The size of multiplier depends on
how much is spent at each stage i.e.
the marginal propensity to consume.
The larger the MPC, the bigger the
multiplier.
MPC= change in consumption spending
change in income
E.g. If MPC is 0.8, it means 80% of extra income is
spent domestically. If 1 million is injected,
800,000 will be spent on goods and services.
 There are different formula to calculate multiplier (K);

Formula K= change in income i.e. K= Y

change in injection J

OR 1
Marginal propensity to withdraw where MPW (S+T+M)

In a 2 sector economy, the formula for multiplier is

1 1
MPS or 1-MPC
 In a 3- sector economy, multiplier will be
1
MPS+MRT
In a 4 sector economy,
1
MPS+MRT+MPM
Formula for change in income (new income)
Y= K x J OR Y= J
W (mps+mrt+mpm)
 E.g. If the amount injected into the
economy is #100m and MPS is 0.2.
calculate the multiplier and the
change in income
Solution
graph
 Aggregate
Output ( Y = E)
Demand/Aggr
AD1
egate
AD

100

expenditure

500

45

Y Y1 Y
 Initial injection of #100m pushed AD from AD1
to AD2. the multiplier increased income to
#500m. therefore, increase in injection led to a
larger increase in output and income
CLASSWORK
1. If the value of multiplier is 2 and increase in
savings is #20. calculate change in income,
draw the graph and interpret your result.
2. Calculate the multiplier and change in income if
the value of export is #50m and MPM is 0.5,
draw the graph and interpret your result.
3. Calculate the multiplier and change in income if the
value of export is #50m and MPC is 0.5
4. In an economy, mps is 0.1, mrt is 0.1 and mpm is
0.2. GDP is $300bn. The government raises its
spending by $6bn in a bid to close a deflationary gap
of $20bn.
Calculate;
The value of the multiplier
The increase in GDP
Whether the injection of the extra government
spending is sufficient, too high or too low to close the
deflationary gap.
DETERMINANT OF THE SIZE OF THE
MULTIPLIER
1. If the economy is open rather than close,
consumers will but more imports. This reduces
the amount of money passed on at the each
stage of the multiplier process
2. Higher interest rates might encourage more
saving and less spending this will reduce
multiplier
3. With higher income tax rate, more of each
pound is given to the government and less is
spent on domestic goods and services; the
multiplier is smaller
The value of multiplier might differ between countries
for these reasons

In the real world, open economies are better

than close economies in terms of economic
growth, standard of living, investment and
employment, in such countries, injection will
be more than withdrawal and such countries
will enjoy greater increase in income.
The value of multiplier might be different
because of differences in the MPT (marginal
propensity to tax), MPM (marginal propensity
to import), and MPS (marginal propensity to
save).
 The value of MPS differs due to differences in
interest rate, financial institution, income level etc
The MPM may differ due to the extent of economic
specialisation, exchange rate, taste for import and
natural endowment. A country who subscribes to
free trade has a higher MPM
The level of MPT depends on the number of taxes a
country has e.g. both direct and indirect. A country
that is heavily in debt will have more taxes (to
settle the debt). This makes MPT higher and the
multiplier weaker
IMPORTANCE OF MULTIPLIER
1. Investment: The multiplier theory highlights the
importance of investment in income and employment
theory. A fall in investment leads to a cumulative
decline in income and employment by the multiplier
process and vice versa.
2. Saving-Investment Equality: It also helps in
bridging the equality between saving and investment. If
there is a divergence between saving and investment,
an increase in investment leads to a rise in income via
the multiplier process by more than the increase in
initial investment. As a result of the increase in income,
saving also increases and equals investment.
3. To achieve full employment: The government decides
upon the amount of investment to be injected into the
economy to remove unemployment and achieve full
employment. An initial increase in investment leads to the
rise in income and employment by the multiplier. If a single
dose of investment is insufficient to bring full employment,
the government can inject regular doses of investment for
this purpose till the full employment level is reached.
4. To control trade cycles: The state can control booms and
depressions in a trade cycle on the basis of the multiplier
effect. When the economy is experiencing inflationary
pressures, the state can control them by a reduction in
investment which leads to a cumulative decline in income
and employment via the multiplier process. On the other
hand, in a deflationary situation, an increase in investment
can help increase the level of income and employment
through the multiplier process.
 AUTONOMOUS AND INDUCE INVESTMENT

Investment can rise or fall by significant

amounts and it interact with changes in
income to cause significant change in
economic activities
Investment that is not affected by income i.e.
undertaken independently of income is called
autonomous investment e.g. a firm might buy
more machinery or build additional factory
because of reduction in the rate of interest.
This increase in investment will increase the
GDP of a country
 Induce investment is an investment that is
influenced by changes in income. If there is
increase in income, peoples demand will increase
and firms will likely buy more capital equipment
Gross investment is the total amount spent on
capital goods. It includes depreciation which is
spent to replace existing ones which have worn out
or become outdated.
Net investment is spending on extra capital good,
bought to increase the stock of capital. Net
investment is gross investment minus depreciation.
 MARGINAL EFFICIENCY OF CAPITAL (MEC)/MARGINAL EFFICIENCY OF
INVESTMENT (MEI)

MEC shows the rate of returns on

each additional unit of capital.
If the expected rate of returns is
greater than the cost of borrowing
(interest rate) the firm will invest. If
the expected rate of returns is lower
than the cost of borrowing, the firm
will not invest.
Rate of return/
interest rate % At r0 all investment projects up to
L0 give a

higher return than the cost of

borrowing.

r0
MEC
L0 qty
When interest rate increases, investment will fall and
vice versa. This is because it is expensive to borrow and
there are now fewer projects which have higher rate of
returns than the cost of borrowing.
Rate of return/
interest rate %

MEC1
MEC
qty
With more positive expectations, each project is
expected to have a higher rate of return and so
the MEC shift outward.
 If future prices of products are expected to
rise, profit margin will also tend to rise.
Taking an optimistic view of the future, the
businessmen will wish to increase their
investment.
During inflation, though the interest rate
may be high, investment will be
encouraged due to high MEI. On the
contrary, during deflation, though interest
rate may be low, investment will be
discouraged due to low MEC.
 An increase in the level of investment
will increase the national income of
the country, provided it a quality
investment. When aggregate demand
increases, national income increases
assuming full employment level is not
reached. But if full employment level
is reached, increase in investment
will only lead to inflationary gap.
 ACCELERATOR THEORY
Accelerator theory states that investment
depends on the rate of change in income
which will lead to a greater proportionate
change in investment.
An increase in demand for consumer
goods will lead to increase in demand for
capital goods (e.g. machinery). E.g. if 1
million increase in GDP causes induced
investment to rise by 5 million, the
accelerator co-efficient is 5
 COMPLETE THIS TABLE
YEAR ANNUAL in Required Net
SALES OR sales or stock of investment
OUTPUT output capital /increase
in stock
1 10 0 50 0
2 10
3 11
4 13
5 16
6 19
7 22
8 24
9 25
10 25
 If output increases by increasing amount, firms
will buy more machinery each time i.e. net
investment will increase e.g. from year 3-5
If output is increasing by a constant amount,
firms will buy the same number of machines
i.e. net investment will be constant e.g. year 6
&7
If the output is increasing but less than the
year before, firms will not need to buy more
machines and net investment will fall e.g. year
8 &9
 LIMITATIONS OF ACCELERATOR MODEL/THEORY

The model assumes that the capital output

ratio is constant over time. However it can
change because In the long run, new technology
can make capital more productive
Firms may choose not to satisfy extra demand if
they believe that demand will be short lived.
If there is increase in income/demand, firms may
respond not by investing in additional capital but
by fully utilising the equipment which had been
underutilised
Firms may decide not to satisfy sudden increase
in demand. Therefore some investments will be
cancelled.
 MONEY SUPPLY (THEORY)
Money supply is the total amount of all forms of
money in circulation in a country at a given
period of time.
QUANTITY THEORY OF MONEY
The quantity theory of money explains the
relationship between the quantity of money in
circulation and the price level (P). The theory
states that an increase in the quantity of
money in circulation would bring about a
proportionate rise in the prices of goods and
services.
 Professor Fisher introduced a concept known as
the velocity of circulation of money because
money changes from hand to hand. Velocity of
money is the number of times that money
changes hand over a period of time
The quantity of money is MV=PT
M = the total amount of money in circulation
V = velocity of money in circulation
P = general price level
T = total no of transaction that takes place with
money
 MV = PT (the rate or number of times that
money changes hand over a given period of
time is equal to the total amount of monetary
transactions that occur in an economy over a
given period).
E.g. if the number of transaction is 100 and
the general price level is 30, the total
amount spent is 100 30 = 3000. If total
money in the economy is 300 it means that
the velocity is 10 i.e. the pound has been
used 10 times
 TYPES OF MONEY

1. NARROW MONEY (M0) - This is the money that

can be used as a means of exchange. The
measure of narrow money is M0. It consists of
notes, coins and bank deposits. M0 is also known
as money base.
2. BROAD MONEY (M4) This is the addition of
narrow money and near money. It includes items
which are used not only as a means of exchange
but also as store of value. The measure of broad
money is M4. It includes notes and coins, bank
deposit, building society deposit, shares etc
 SOURCES OF MONEY SUPPLY IN
AN OPEN ECONOMY
1. CREDIT CREATION
Credit creation by banks is a process whereby the
banks receive deposits from customers and give
the deposit to borrowers in form of loan after
deducting cash or reserve ratio.
Commercial banks are required by law to keep
certain percentage of their deposits with them
which is known as cash ratio or liquidity ratio or
cash reserve. This done in order to protect
customers deposits and prevent bank crisis, when
money is deposited in a bank, some are kept in
reserve while the rest are given out
 This percentage is fixed by the central bank and
varies from one country to another. If the central
bank fixes 10% as the cash ratio, it means that for
every deposit a bank receives, 10% of the deposit
must be kept in the bank while the remaining 90%
can be given out as loan or overdraft
The total credit created by banks or credit
multiplier can be calculated using this formula;
Total credit/money created/credit multiplier =
Initial Deposit Cash reserve ratio

Calculate credit multiplier if initial deposit is

1,000 and the cash reserve ratio is 10%.
 LIMITATIONS OF CREDIT CREATION

1. If the cash deposit ratio increases by the central

bank, it will decrease the money with the
commercial banks which means they have little
to lend out
2. The willingness of members of the public to
borrow
3. The amount of cash available to banks
4. Other actions of the central bank in regulating
the volume of money in circulation e.g. the use
of bank rate (the rate of interest the central bank
charges commercial banks to discount their bills)
 Open market operation (it involves buying and
selling of securities from and to commercial banks in
order to increase or reduce the money in
circulation). If the central bank feels that the money
in circulation is too small and want to increase it, it
will buy securities from commercial banks.
2. DEFICIT FINANCING- Government may decide to
borrow money from banks and firms in order to
finance its budget deficit by selling government
securities to them. If a budget deficit is financed by
borrowing from commercial banks or central bank,
the supply of money will increase.
 This is because the cheques drawn
on these banks will increase the
commercial banks liquid asset
(money) e.g. government may use
the money for capital project, when
the contractors collect the cheques
from the banks which in turn give the
contractors liquid cash to spend. This
can lead to creation of money and
will increase money supply
 3. FUNCTIONS OF CENTRAL
BANK
This is a national bank that issues a countrys currency.
1. It controls a countrys currency- the central bank has
the sole power to issue notes and coin.
2. It is the governments bank- it provides an account for
the government, manages the national debt by
arranging the sale of bonds, pays interest on behalf of
the government on debt etc. It looks after the tax
revenue received by the government and manages its
payment or expenditure on schools, health etc.
3. It is lender of last resort- it supports financial
institutions by lending to them if they are in difficulties
to prevent them going bankrupt
4. It regulates and supervises the banking system-
central bank can set rules to determine how banks
conduct their business. It holds the deposit of the
commercial banks and transfer funds between their
accounts to settle the many millions of cheques and
other payments made by their customers
5. It manages a nations foreign currency reserves-
these reserves are used to make payment overseas
and to stabilise the value of the national currency.
6. It maintains close contact with other international
financial institutions- these financial institutions
include World Bank, International Monetary Fund, etc
4. QUANTITATIVE EASING
This is a process by which liquidity in the economy
is increased when the central bank purchases
assets from banks.
Central bank purchases assets such as government
and corporate bonds thereby releasing additional
money into the system through the banks and
other financial institution from which it buys the
assets.
The hope is that this will allow banks to increase
their lending and thus combat the treat of
deflation/unemployment and also speed economic
recovery.
 5. TOTAL CURRENCY
FLOW
The total currency flow of the balance
of payment refers to the total outflow
or inflow of money resulting from
international transactions. If there is
net flow of money into a country (i.e.
when the money flowing into a country
is more than the money flowing out of
a country) the excess money will be
added to the countrys money supply
 TRANSMISSION MECHANISM OF
MONETARY POLICY
This is the channel by which monetary policy affects
aggregate demand. Monetary policy is primarily used
to control inflation.
It also show the interaction of money supply, interest
rate and exchange rate.
When interest increases, investment reduces as the
cost of borrowing has increase also savings will
increase which means consumption expenditure will
also reduce.
This increase in interest rate will encourage foreign
investors to keep their money in the local banks
leading to increase in demand for the local currency
and appreciation of the exchange rate.
 Higher exchange rate subsequently increase
imports and reduce exports which will further
reduce investment and productivity thereby
lowering aggregate demand.
To achieve higher interest rate supply of money
will need to fall which will cause a fall in
investment and aggregate demand.
The aim of monetary policy is not only to keep
inflation low but to improve business confidence
and boost investment . This will lead to economic
growth and improved standard of living.
Int. Rate int. Rate price

MS

qty of money inv.

Y
 SCHOOLS OF ECONOMIC THOUGHT

1. KEYNESIAN ECONOMISTS
Keynesian economists base their ideas and
approach on the ideas of John Keynes. Their
belief is that there is no guarantee in the
economy to achieve full employment level if
economy is left to market forces (equilibrium can
be below full employment level).
For most Keynesians there is need for
government intervention. They believe that fiscal
policy is more effective than monetary policy and
government should avoid unemployment.
 2. NEO-KEYNESIANS (EXTREME
KEYNESIANS) SCHOOL OF THOUGHT

They believe that;

Markets do not clear and the economy will
not move towards full employment (i.e.
there may be excess demand or supply of
labour)
The government must expand demand (by
increasing government expenditure through
subsidies etc)

3. MONETARISTS SCHOOL OF THOUGHT

Monetarists economists see the control

of inflation as the top priority for any
government. Their theory is based on
the quantity theory of money; MV=PY.
They believe that;
1. Inflation is the result of an excessive
growth of money supply ; the main role
of a government is to control the supply
of money.
b. They maintain that attempt of the
government to reduce
unemployment by increasing
government expenditure will raise
inflation in the long run
c. Prices and wages change quite
quickly, so the economy tends to
move towards full employment.
d. Government intervention should be
minimal.
4. CLASSICAL [MODERATE MONETARISTS] SCHOOL OF THOUGHT

They believe that;

a. Markets adjust fairly quickly.
b. An increase in the money supply
and demand will lead to decrease in
unemployment in the short run
c. A sharp decrease in the supply of
money may cause unemployment in
the short run
5. NEO CLASSICAL [EXTREME MONETARISTS] SCHOOL OF THOUGHT

They believe that;

a. Markets clear quickly
b. Faster growth of the money supply
will lead to inflation even in the short
run.
 DEMAND FOR MONEY

The demand for money is the desire to hold money

in liquid cash as against spending the money.
People do not spend all their salaries when they
receive them at the end of the month. Demand for
money explains how much households and firms
choose to hold in form of money as opposed to
holding either non-money financial assets (shares)
or physical assets (cars, houses).
The demand for money has an opportunity cost.
Instead of holding money in cash, it can be used to
buy physical assets, put in pension plan, buy
shares and receive dividend or put in a bank for
interest. The opportunity cost of holding money is
the benefits forgone from holding another type of
asset.
REASONS FOR DEMAND FOR MONEY

1. Transaction motive- people demand for money

for daily transaction in buying goods and services
without delay. The amount an individual holds
depends on the income. The higher the income
the higher the amount that will be held.
2. Precautionary motive- money is demanded in
order to meet up with unforeseen circumstances
or unexpected expenditures. E.g. sickness,
unexpected visitors, car maintenance. The
amount of money held depends on the level of
income. It is known as active balance as they are
likely to be spent in future. It is relatively interest
inelastic
3. Speculative motive- people also keep money with
the hope of using such money in making quick
money e.g. money may be held with the hope of
giving it out in form of loan if the rate of interest is
high or buying goods (e.g. cars) at lower prices
and reselling at higher price, purchasing shares at
lower prices and reselling at higher prices etc.
Therefore, it is the demand for money for
investment purpose. This is also called idle balance
because households and firms will hold the money
when they believe that holding financial assets like
government bonds are low
 DIAGRAM
Int. Rate Td Pd Sd Td means transactionary dd for
money
Pd means precautionary dd for
money
Sd means speculative dd for
money

qty of money
Transactionary and precautionary demand do not depend on
interest rate i.e. interest inelastic while speculative depends on
interest rate. When interest rate is low, more money is held.
 INTEREST RATE

Interest rate is the return generated on

capital (saving) and the cost of borrowing
money. When the rate of interest paid on
deposit is high, people will prefer to save
the money than to spend it. They will
also prefer to use the money in buying
shares, bonds etc when the interest rate
or dividend is high. The higher the rate of
interest, the greater the opportunity cost
of holding money
 Higher rates increase the cost of
borrowing and this affects;
1. Households mortgage , with more
money to repay, there will be less left
over for buying other goods and services
2. The cost of overdraft
3. The cost of loan
As a result, higher interest rate leads to
reduction on aggregate demand
 A rise in interest rate will affect aggregate demand
(AD)/ aggregate expenditure (AE) i.e. C+I+G+X-M.
higher interest rate will affect consumption (C),
investment (I), government spending (G), and
import directly and export indirectly.
A rise in interest rate will reduce consumption.
People will prefer to save their money when the
interest rate on savings is high and will borrow less
if the interest rate on borrowing is high.
Firms usually borrow money to finance their
investment. Increase in interest rate might reduce
the level of investment if the returns on the
investment is less than the rate the of interest
 A rise in interest rate can cause government spending
to fall. Government usually borrow money locally or
internationally to finance a deficit budget. Increase in
interest rate will force the government to borrow less
A rise in interest rate may cause export to decrease.
Increase in interest will increase the cost of
production locally this will make exports costlier to
foreigners and reduce demand for exports
Imports are expenditures by locals on foreign goods
and services. Imports are part of consumption and
directly linked to income. A rise in interest rate will
reduce imports.
 NOMINAL INTEREST RATE AND REAL INTEREST RATE

Nominal interest rate is the rate that is not

adjusted for inflation. When a bank offers a rate of
interest of 10% it is offering a nominal interest rate.
Real interest rate is the interest rate adjusted for
inflation. E.g. if the nominal interest rate is 12%
and the rate of inflation is 8%, the real interest rate
will be 4% (i.e. nominal interest rate the rate of
inflation)
The real interest rate can be positive or negative. If
the inflation rate is 15% and the nominal rate of
interest is 5%, the real rate of interest will be -10%.
Anyone saving at 5% would have lost 10% of the
purchasing power of their money during inflation.
 Why do people save when real
interest rate is negative?
1. People save because they do not
want to spend all their income when
they receive it
2. Savers might have lost (e.g. 10%)
but those who kept their money in
cash lost 15%
 STRUCTURE OF INTEREST RATE

Interest rate depends on

1. Time- the longer the period of the loan, the
higher the rate of interest. Higher interest
rate is necessary to compensate lenders as
the length of the terms of a loan increases
2. Risk- the greater the risk of default on loan
(the risky the project, the more the lender
will charge), the higher will be the rate of
interest. E.g. it is more risky to lend money
to an unemployed than to a worker
3. Imperfect knowledge- when people do not have a
perfect knowledge about interest rate, they may
receive less interest on their savings or pay more
interest on their loan. E.g. a saver with a bank may
not be aware that another bank is offering higher
rate of interest on a saving account which is
identical to his.
4. Administrative cost- the higher the administrative
cost, the higher the rate of interest. Lending $100
million to one customer will have less
administrative charges than lending the same
amount out in $100 to many customers.
DETERMINANT OF INTEREST RATE/LIQUIDITY PREFERENCE

Keynesians disagree over how interest rate is

determined. Keynesians argue that the rate of
interest is determined not by demand and supply
of loanable fund but by demand and supply of
money.
It is assumed that supply of money is determined
by the monetary authority and is fixed in the short
run. Keynesians developed the liquidity preference
theory to explain demand for money. He identified
3 main motives of demand for money which are
transactionary, precautionary and speculative
demand for money.
 Interest rate
ss of money

r
Demand for money

Q qty of money
Interest rate is determined where demand for
money equals supply of money.
 The transaction and precautionary demand for
money are called demand for active balances
i.e., there is an active reason for holding money.
A rise in the rate of interest will not result in
households and firms reducing their holding of
money for transaction and precautionary
reasons (interest inelastic) while the speculative
demand is called an idle balance i.e. money is
held when individuals and firms believe that the
returns from holding financial assets are low
(interest elastic)
 Interest rate
SS SS1

r
r1 Demand for money

Q Q1 qty of money
Interest rate is determined where demand for
money equals supply of money.
 An increase in the money supply will cause a
fall in the rate of interest. The rate of interest
falls because the increase in the money
supply will result in some households and
firms having higher money balances than
they want to hold.
As a result they will use some to buy financial
assets. A rise in demand for government
bonds will cause the price of bonds to rise
and cause the rate of interest to fall
 One of the financial assets which firms and
households may decide to hold is the
government bonds. These are government
securities that represent loan to the
government. The price of government bonds
and the interest rate move in opposite
directions.
A bond has a fixed return e.g. 10% a year. If
the price of a bond is 100 there will be 10%
return on it which represents 10. If the price
of the bond reduces to 50 the return will be
20% therefore, the lower the price of bond, the
greater the returns
 If the households or firms feel they have too much
liquidity i.e. they are holding too much money,
they will want to switch into bonds. This will
increase the price of bonds and lower the returns.
This process will continue until the price of bond
has increased (and the rate of returns on bonds
has fallen) to a point where there is no further
desire to switch away from money (liquid cash)
When the price of bond increases, the interest rate
will be low and people will decide to hold their
money than to invest in bonds because of low
interest rate.
 THE LIQUIDITY TRAP

Liquidity trap occur when an increase in the

money supply does not affect the interest
rate and does not affect investment or
aggregate demand. Although it is expected
that an increase in money supply will cause
the rate of interest to fall.
Keynesians described a situation where it
would not be possible to drive down the
rate of interest by increasing the money
supply.
 Liquidity trap occur when the rate of interest is
very low and the price of bonds very high. In
this case, he thought that speculators would
expect the price of bonds to fall in the future. If
money supply increases they would not buy
bonds for fear of making a capital loss and
because the returns from holding bonds would
be low.
This will make interest rate to be perfectly
elastic and increase in the money supply will
not have any effect on the rate of interest
 DIAGRAM
Interest rate
ss ss1

r liquidity trap

Q Q1 Qty of money
 POLICIES TOWARDS
DEVELOPING ECONOMIES
There are obstacles that have
hindered development in less
developed countries. The
government of LDCs that wish to
stimulate development needs to
devise policies that will help make
the best possible use of resources
available to them.
 PROBLEMS FACING DEVELOPING
COUNTRIES
1. Imbalance of factors of production-
abundance of labour resources and
lack of capital.
2. Underdevelopment of markets
especially financial market (savings
and investment)
3. Government failure
4. External factors e.g. Trade
interaction, globalisation etc
 HARROD-DOMAR MODEL
This is a model of economic growth that
emphasis on the importance of savings and
investment. Harrod explained in his theory
how savings are crucial to investment.
Some investment will be used to replace
existing capital that are worn out therefore
investment lead to capital accumulation.
Accumulation of capital leads to increase
in output and income which leads to further
increase in savings.
GRAPH OF HARROD-DOMAR
MODEL
 By generating a flow of savings, it is important to
transform the savings into investment. This is done
when sacrificing current consumption in order to
increase future productive capacity. Households keep
their money in banks and the money is made
available for investment in terms of loan.
Generating a flow of saving in the LCDs might be
problematic. When income is low household will
devote most of the income to consumption and there
will be low savings.
Also in some developing countries, financial markets
are underdeveloped, this made it difficult to
reprocess/recycle savings to investment.
 Government policy of reducing interest
rate in order to encourage investment has
led to less savings as household are
discouraged from saving due to less
return. Firms may wish to invest but may
not have the fund to do so.
Another problem is that there are few
entrepreneurs with relevant skills to
identify investment possibilities and also
willingness to bear risks.
 For investment to lead to higher output and
income, firms should have access to physical
capital but due to low level of technology,
developing countries might have to rely on
capital importation from developed countries.
Such imports can be possible only if such
countries have earn enough foreign exchange to
pay for the technology.
There is also lack of skilled labour to operate the
capital goods (machinery). All these can make
investment difficult in less developed countries.
 Harrod-Domar concluded that if
domestic savings is too low to
generate investment, countries may
have to rely on external sources for
funding e.g. Through foreign aids,
foreign direct investment and
international borrowing but all these
have their disadvantages.
 TRADE POLICY
This is government's policy to control foreign trade.
i.e. Lawsrelated to theexchangeofgoodsor/and
servicesinvolved ininternational trade(including
taxes,subsidies, and import/exportregulations.)
The policy include;
1. Import substitution- this is a policy that encourages
domestic production of goods previously imported
in order to reduce the need for foreign exchange.
The policy that can be used to achieve this is the
imposition of a tariff. But for import substitution to
be successful, it requires a large effective domestic
market if producers are to be able to tap into
economies of scale and increase supply. This is not
often possible for many LDCs.
2. Export promotion- a policy encouraging
domestic firms to export more goods and
services in order to earn more foreign exchange.
One way of achieving this is by making use of
existing product and converting it to finished
goods before exporting it (higher value added
activities). The problems of this policy is that it is
difficult to face competition from foreign firms
that are already in the business. Also capital
equipment needed might not be available to the
local firms.
 FOREIGN AID
Foreign aid is one the sources of
foreign exchange. It is defined as the
voluntary transfer of resources from
one country to anther. Foreign
aidincludes any flow of capital to
developing countries. Thesecan be
in the form of a loan or a grant.
There are four different types of
foreign aid.
 Types of aid

Emergency or short-term aid- needed after

sudden disasters such as the 2000 Mozambique
floods or the 2004 Asian tsunami.
Conditional or tied aid- when one country
donates money or resources to another
(bilateral aid) but with conditions attached.
These conditions will often be in the favour of
country given out the aid, e.g. the controversial
Pergau Dam project in Malaysia, where Britain
used aid to secure trade deals with Malaysia.
 Charitable aid- funded by donations from the
public through organisations such as Red
Cross.
Long-term or development aid- involves
providing local communities with education
and skills forsustainable development, usually
through organisations such as Practical Action.
Multilateral aid- given through international
organisations such as the World Bank rather
than by one specific country.
 ADVANTAGES OF AID
Emergency aid in times of disastersaves lives.
Aid helpsrebuildlivelihoods and housing after a disaster.
Provision of medical training, medicinesand equipment
can improve health and standards of living.
Aid foragriculturecan help increase food production and
so improve the quality and quantity of food available.
Encouraging aidindustrial developmentcan create
jobs and improve transport infrastructure.
Aid can support countries in developing theirnatural
resourcesand power supplies.
Projects that developclean waterand sanitation can
lead to improved health and living standards.
 DISADVANTAGES
Aid can increase thedependencyof LEDCs on
donor countries. Sometimes aid is not a gift, but
a loan, and poor countries may struggle to repay.
Aid may not reach the people who need it
most.Corruptionmay lead to local politicians
using aid for their own means or for political
gain.
Aid can be used to putpolitical or economic
pressureon the receiving country. The country
may end up owing a donor country or
organisation a favour.
 Sometimes projects do not
benefitsmaller farmersand
projects are often large scale.
It may be a condition of the
investment that the projects are run
byforeign companiesor that a
proportion of the resources or profits
will be sent abroad.
 FDI AND MNCs
One the sources of external funding available to many LDCs
is foreign direct investment and multinational corporations.
Foreign direct investment FDI-are the investment
undertaken by foreign companies
Multinational corporations MNC- companies whose
production activities are carried out in more than one
country
MNCs may engage in FDI in order to reach new market or to
take of some key resources e.g. Natural gas.
The importance of this to LDCs is that it will serve as
injection of investment that may stimulate economic growth
and human development.
LDCs may also hope to raise tax revenue from the FDI.
 But these benefits might not materialise in
the sense that the technology utilised might
not be appropriate.
Also if profit are repatriated to shareholders
abroad, then LDCs will not gain much.
Also some LDCs could not attract foreign
investment because of low level of human
capital and social and physical
infrastructure are low and political
instability.
 EXTERNAL DEBT
External debt(orforeign debt) is the totaldebta
country owes to foreigncreditors. The debtors can be
the government, corporations or citizens of that
country.
The debt includes money owed to private
commercialbanks, othergovernments, orinternational
financial institutionssuch as theInternational
Monetary Fund(IMF) andWorld Bank.
These debt, including interest, must usually be paid in
the currency in which the loan was made. In order to
earn the needed currency, the borrowing country may
sell and export goods to the lender's country.
 IMF
The International Monetary Fund is a global organisation
founded in 1944. It aims was to help stabilise exchange
rates and provide loans to countries in need. Nearly all
members of the United Nations are members of the IMF
with a few exceptions such as Cuba, Lichtenstein and
Andorra.
The IMF is independent of the World Bank , World Bank
concentrates on long term loans to developing
countries.
IMF differs from the World Bank in that it oversees the
international monetary system and assists all members
both industrial and developing countries that find
themselves in temporary balance of payments
difficulties by providing short- to medium-term credits.
The IMF is not focused solely upon helping poor
countries like the World Bank.
 IMF PERFORMS THE FOLLOWING FUNCTIONS.

(i) Providing short terms credit to member countries

for meeting temporary difficulties due to adverse
balance of payments.
(ii) Reconciling conflicting claims of member
countries.
(iii) Providing a reservoir of currencies of member-
countries and enabling members to borrow on
another's currency.
(iv) Promoting orderly adjustment of exchange rates.
(v) Advising member countries on economic,
monetary and technical matters.
 WORLD BANK
TheWorld Bankis aninternational financial
institutionthat providesloanstodeveloping countries
forcapital programs. It comprises two institutions:
theInternational Bank for Reconstruction and
Development(IBRD), and theInternational
Development Association(IDA). The World Bank is a
component of theWorld Bank Group, which is part of
the United Nations system.
The World Bank's official goal is thereduction of poverty.
However, according to its Articles of Agreement, all its
decisions must be guided by a commitment to the
promotion offoreign investment andinternational
tradeand to the facilitation of Capital investment
 AIMS OF WORLD BANK
The poorest countries.Poverty reduction and sustainable
growth in the poorest countries, especially in Africa.
Post conflict and fragile states.Solutions to the special
challenges of post conflict countries and fragile states.
Middle-income countries.Development solutions with
customized services as well as financing for middle-income
countries.
Global public goods.Addressing regional and global issues that
cross national borders, such as climate change, infectious
diseases, and trade.
The Arab world.Greater development and opportunity in the
Arab world.
Knowledge and learning.Leveraging the best global knowledge
to support development.To Meet Global Challenges, Six Strategic
Themes,
 CORRUPTION AND LEGAL
FRAMEWORK
Legal framework is a key part of the structure needed to
support development.
If the rule of law is weak, corruption is more likely.
There are been cases where government officials,
politicians, civil servants have diverted money meant for
the development of the country into private use including
international borrowing.
Corruption is likely to be significant in countries where
there is little political instability. When a government
know it will not remain in power for long there is little
incentive for the government to take a long term view of
development process and to introduce policies that will
benefit the economy in the future.
 Also government may bring in populist policies
which will bring immediate benefits at the expense
of long term benefits in order to ensure re-election.
There should also be existence of property right for
individuals. This is a legal right to a particular
property. If such right does not exist or weak,
individuals will not think of improving such
property e.g. Lack of property right will not make
farmers get loans from banks to make
improvement or investment because it may not
be possible to provide security against the loan.
 GOVERNMENT MACRO POLICY
AIMS
Most national governments have four main
economic objectives for their national economies;
1. To achieve a low and stable rate of inflation in
the general level of prices.
2. To achieve a high and stable level of
employment and a low level of unemployment.
3. To encourage economic growth in the national
output and income.
4. To encourage trade and secure a balance of
balance of payment.
5. Stable exchange rate
 Objectives of UK Macroeconomic Policy

Stable low inflation- the Governments inflation target

is2.0%for theconsumer price index.
Sustainable growth growth ofreal GDP sustainable in
keeping inflation low and reducing the environmental
impact of growth.
Improvements in productivity this is designed to
improve competitiveness and global trade performance
High employment- the government wants to achievean
increase employmentand eventually a situation where all
those able and available can find meaningful work
Rising living standards and a fall in relative poverty
cutting child poverty and reducing pensioner poverty.
Sound government finances- including control over
state borrowing and the total national debt
 MACRO ECONOMIC POLICY
Macro economy has a demand side and supply
side. Government can design different policies
that attempt to control aggregate demand or
aggregate supply in order to influence price,
inflation, unemployment, economic growth or
trade imbalance in the economy.
TYPES OF POLICY
1. Demand Side Policies- attempt to influence
aggregate demand by using fiscal policy
(taxes, government spending) and rate of
interest
2. Supply side policies- attempts to influence
aggregate supply.
Policy instruments include;
Taxes and subsidies incentives
Education and training reforms
labour market reforms
Competition policy
Removing international trade barriers
Deregulation
Privatisation
3. Reflationary policies- they are policies to
increase economic activities (aggregate
demand and supply) e.g. Lower tax rates,
higher government spending, lower
interest rate
4. Deflationary policies- policies to reduce
economic activities (aggregate demand
and supply) e.g. Higher tax rates, lower
government spending, higher interest rate
 EFFECTS OF FISCAL POLICY ON
THE MACRO ECONOMIC POLICIES
Fiscal policy- this is the policy used to
influence aggregate demand through the
use of taxation and government
expenditure. Government can use this policy
to influence macro economic objectives.
TYPES OF FISCAL POLICY
1. Expansionary policy is the policy used to
increase aggregate demand and boost
economic activities by reducing taxes and
increasing government spending.
2. Contractionary policy is used to reduce
aggregate demand by increasing taxes and
reducing government spending.
FISCAL POLICY AND UNEMPLOYMENT
Government can use expansionary fiscal policy
to reduce unemployment e.g.
a. Taxes- government can reduce income tax to
encourage demand. Corporation taxes could
also be reduced to encourage investment
which may lead to increase in demand for
labour thereby reducing unemployment.
b. Government spending- when an economy is
suffering from unemployment, government will
embark on budget deficit to increase aggregate
demand i.e. Government will spend more
money in form of giving contracts, subsidy,
salary increment etc
 GRAPH OF EXPANSIONARY FISCAL POLICY AND UNEMPLOYMENT

PRICE LRAS

P1
P

AD AD1
0 Y Y1 OUTPUT
Expansionary fiscal policy will increase the money
in circulation and demand will shift from AD to
AD1, this will increase output from Y to Y1 and also
increase employment.
PROBLEMS OF USING FISCAL POLICY TO REDUCE UNEMPLOYMENT

1.Balance of payment deficit- decrease in

tax and increase in government spending
(e.g. salary increment) can lead to
increase in demand for imports which
may cause balance of payment deficit.
2.inflation- expansionary policy will reduce
unemployment if the economy is below
full employment but if the economy is at
full employment, increasing aggregate
demand will lead to inflation.
 EFFECTS OF A SHIFT IN AD AT FULL EMPLOYMENT

PRICE LRAS
P1

P AD1
AD

0 Y OUTPUT
3. Government debt- government may have to
borrow to increase its expenditure in order to
reduce unemployment which can have adverse
effect on the future generation.
4. The extent of expansionary policy will depend on
the size of multiplier, the response from
consumers and firms. If people decide to save their
excess income rather than spending it,
unemployment may not reduce.
5. If producers decide to use machinery instead of
labour to increase supply, there will be no demand
for labour and unemployment will not reduce.
 FISCAL POLICY AND ECONOMIC
GROWTH
Expansionary policy can also be used
to foster economic growth. A cut in
profit tax and tax holiday for firms and
increase in government spending in
form of subsidy, purchasing of
equipment for producers etc will lead
to increase in investment.
This will increase productivity and
lead to economic growth.
 GRAPH OF FISCAL POLICY AND
ECONOMIC GROWTH
Price LRAS LRAS1

AD
0 Y Y1
OUTPUT
Increase/outward shift of LRAS will
increase output/economic growth
PROBLEM OF USING FISCAL POLICY
TO INFLUENCE ECONOMIC GROWTH
1. Time lag- effect of increasing
government spending to boost
growth may take a long period.
2. Excess supply- government
expenditure through subsidy can
increase aggregate supply and if
there is no market for the products, it
can lead to wastage of resources.
 FISCAL POLICY AND INFLATION
Government can use contractionary
fiscal policy to reduce inflation.
To reduce demand pull inflation,
government can deliberately increase
tax rates and reduce government
spending i.e. government might
embark on surplus budget to reduce
the amount of money in circulation
and reduce aggregate demand.
 FISCAL POLICY AND INFLATION

PRICE LRAS

P
P1

AD1 AD
0 Y1 Y OUTPUT
Contractionary fiscal policy will lead to less demand
thereby, reducing the price. The problem is that
decrease in demand will lead to less employment.
 PROBLEM OF USING FISCAL POLICY TO
REDUCE INFLATION
a. Unemployment- as tax rates increase,
demand will fall and supply will also fall.
This may force firms to lay off some
workers as a result of lack of demand
and higher cost of production.
b. Low level of economic growth- if
output reduce below full employment,
GDP will also reduce which will lead to
less growth.
c. Less investment as a result of higher
cost of production due to higher tax
rate.
 FISCAL POLICY AND BALANCE OF
PAYMENT
Fiscal policy measure can be effective when an
economy is experiencing a deficit on the current
account of its balance of payment.
1. Expenditure switching- this is the policy to reduce
domestic expenditure on import and transfer such
demand to domestically produced goods.
Government can impose tariff or increase tariff on
imported goods to make them expensive and
reduce their demand.
2. Expenditure dampening- this is a policy designed
to restrict aggregate demand e.g. a rise in income
tax will reduce demand for imported goods.
 PROBLEMS OF USING FISCAL
POLICY TO CORRECT BALANCE
OF PAYMENT DEFICIT
1. Decrease in aggregate demand- expenditure
dampening method will reduce demand for
both imports and locally made goods.
2. Retaliation- less demand for import can
make trading partners place embargo on
goods coming from the particular country.
This may lead to less export.
3. Smuggling
4. Decrease in standard of living
 MONETARY POLICY AND MACRO
ECONOMIC OBJECTIVES
The major monetary policy instruments are
interest rate and Central banks instruments
e.g. OMO, Bank rate, reserve ratio, commercial
bank lending criteria etc.
If an economy is experiencing high level of
unemployment, government can use
expansionary monetary policy by reducing
interest and relaxing credit lending criteria.
This will encourage investment, increase
demand for goods and demand for labour
thereby reducing unemployment.
 GRAPH OF EXPANSIONARY MONETARY POLICY AND UNEMPLOYMENT

PRICE LRAS

P1
P

AD AD1
0 Y Y1 OUTPUT
Expansionary monetary policy will increase money
in circulation and demand will shift from AD to
AD1, this will increase output from Y to Y1 and also
increase employment.
 PROBLEM OF USING MONETARY
POLICY TO REDUCE UNEMPLOYMENT
1. Decrease in interest rate will increase
money in circulation which may lead to
inflation especially if the economy is at
full employment.
2. It can also increase demand for imported
goods leading to balance of payment
deficit.
3. Decrease in interest rate can discourage
both foreigners and locals from saving
their money in a country.
 MONETARY POLICY AND
INFLATION
In order to reduce inflation, government
will use contractionary monetary policy to
reduce the money in circulation and
demand.
This can be done by increasing interest
rate and tightens credit. When demand is
low, there is possibility that prices will fall.
Increase in interest rate will also
encourage foreign investment and can
increase the exchange rate
 MONETARY POLICY AND INFLATION

PRICE LRAS

P
P1

AD1 AD
0 Y1 Y OUTPUT
Contractionary monetary policy will lead to less
demand thereby, reducing the price. The problem
is that decrease in demand will lead to less
employment.
 PROBLEMS
1. Increasing interest rate will
discourage demand and investment
because it will be expensive to
borrow money.
2. It may reduce economic growth due
to low productivity.
3. Low investment can also increase
unemployment and reduce standard
of living.
MONETARY POLICY AND ECONOMIC
GROWTH
Expansionary Monetary policy can be
used to boost economic growth.
Government can do this by reducing
interest rate and relax lending
criteria; this will make it easy for
investors to get loan from banks for
investment.
Increase in investment will lead to
higher GDP and Economic growth.
 GRAPH OF MONETARY POLICY AND
ECONOMIC GROWTH
Price LRAS LRAS1

AD
0 Y Y1
OUTPUT
Increase/outward shift of LRAS will
increase output/economic growth
 PROBLEMS
1. Low interest rate can lead to excess
supply which may cause wastage of
resources.
2. It can also lead low foreign
investment as foreigners may be
discouraged to save their money in
the country.
3. It may lead to deflation as producers
will reduce the price to sell the
excess supply
 MONETARY POLICY AND BALANCE
OF PAYMENT
Monetary policy can be used to reduce balance of
payment deficit.
Government can use contractionary monetary policy to
reduce BOP deficit. This can be done by increasing
Interest rate; increase in interest rate will make
borrowing expensive and reduce the demand for loans
by consumers and firms that may be used to pay for
goods and services supplied from overseas.
Government can also tightens credit lending criteria
making it difficult to borrow money from banks.
It will also encourage foreigners to save thereby leading
to increase in demand for a currency and increase in
exchange rate.
 PROBLEMS
1. Increase in interest rate to
discourage imports will also reduce
aggregate demand because there
will be less money at hand.
2. Low demand (as a result high
interest) will reduce employment,
investment and Economic growth.
3. Decrease in standard of living
 SUPPLY SIDE POLICY
These are policies designed to increase
aggregate supply by raising the efficiency of
markets.
Policy instruments include;
Taxes and subsidies incentives
Education and training reforms
labour market reforms
Competition policy
Removing international trade barriers
Deregulation
Privatisation
 SUPPLY SIDE POLICY AND
UNEMPLOYMENT
To reduce unemployment, government
can use the following policy instruments.
Reducing government borrowing this
will mean less money has to be borrowed
by the government and so more is
available for the private sector
Reduction in direct tax- a cut in corporate
tax will increase the funds available for
investment. If investment increases,
productive capacity will increase.
 Reducing trade union power to increase the
flexibility in the labour market e.g. excessive
wage increment
Reducing unemployment benefit so there is
more incentive to work
Deregulation and privatisation of companies to
increase competition. Firms are more efficient
when privatised
Making it easier for firms to set up by giving
them subsidies and advice
Improving education and training so as to raise
the productivity of workers and productive
capacity of an economy.
GRAPH OF SUPPLY SIDE POLICY AND
UNEMPLOYMENT
Price LRAS LRAS1

AD
0 Y Y1
OUTPUT
Increase/outward shift of LRAS will
increase output/economic
growth/employment
 Frictional unemployment- this type of
unemployment can be reduced when
there is increase in the flow of
information to the unemployed workers.
Structural unemployment- education
and training can reduce this type
Classical or real wage unemployment-
Government can reduce the
unemployment benefits so as to
encourage unemployed people to take
up work.
 PROBLEMS

1. If there is reduction in income tax (in order

to encourage workers to work), it may
encourage people to work fewer hours if they
are contented with their earning
2. Privatisation may not result in an increase in
efficiency if the privatised industries act as
monopolies.
3. Supply side policy may suffer time lag which
means the policy may take time before it is
effective
4. It can also increase government expenditure
as some of the policies are capital intensive.
SUPPLY SIDE POLICY AND INFLATION

The long run solution to inflation is

increasing long run aggregate supply.
If the productive capacity of an
economy grows in line with aggregate
demand, the economy grows without
the price level rising. People will enjoy
more goods and services without the
economy experiencing inflationary
and balance of payments problems.
GRAPH OF SUPPLY SIDE POLICY AND
INFLATION
Price LRAS LRAS1

P
P1
AD

0 Y Y1
OUTPUT
Increase/outward shift of LRAS will
increase output but reduce price.
 PROBLEMS

1. Time lag- the effects of education and

training may not be immediate. Therefore
price might not reduce immediately.
2. Increase in government spending-
government may borrow money to
finance this policy which may increase
government debt
 SUPPLY SIDE POLICY AND
ECONOMIC GROWTH
For Economic growth to occur, the quantity
and the quality of resources have to increase.
E.g. Measures that raise investment will
increase long run aggregate supply.
Capital acquisition is likely to increase
investment. To use capital efficiently, it is
important to have educated and healthy
workforce. Investment in human capital
should increase productive capacity of
workers leading to increase in GDP/Economic
growth.
GRAPH OF SUPPLY SIDE POLICY AND
ECONOMIC GROWTH
Price LRAS LRAS1

AD
0 Y Y1
OUTPUT
Increase/outward shift of LRAS will
increase output/economic growth
 PROBLEMS
1. Time lag- Education and training will take a long
period before the effect is felt in the Economy,
2. Excess supply- increase in investment not matched
with increase in demand may lead to wastage of
resources.
3. Depletion of resources- in order to increase
economic growth, non renewable resources might
be used up.
4. Structural unemployment- in order to increase
aggregate supply, workers may be replaced with
machine which may lead to long run
unemployment.
 SUPPLY SIDE POLICY AND BALANCE
OF PAYMENTS
The long run solution to balance of payments
deficit is supply side policy. To raise
international competitiveness, government can
use the following policies;
Cutting corporate tax to stimulate investment
Cutting income tax to encourage enterprise
and efforts.
Privatising industries if firms will operate more
efficiently in the private sector.
Promoting education and training to increase
productivity and quality of products.
 PROBLEM
1. Time lag- this measure can take a
relatively long time to have an
effect.
2. The success the measures depends
on their appropriateness- for
example, the type of training
provided and how firms and workers
respond to incentives provided.
 EXCHANGE RATE POLICY

The exchange rate is the price of one

currency in terms of another. It is the
external value of a currency (the
internal value is what the currency
can buy in its own currency)
Government can choose between
varieties of approaches in deciding
its exchange rate.
 A floating exchange rate is determined
freely by demand and supply of a currency
in the foreign exchange market.
No government intervention. In a floating
exchange rate system, an increase in the
exchange rate (when demand for a
currency is more than supply) is an
appreciation while a fall in exchange rate
is depreciation (as a result of too much
supply of a currency)
 A fixed exchange rate is determined by the
government. Government intervenes to maintain
the exchange rate. If the rate at which the exchange
rate is fixed is increasing, there is revaluation and if
a lower rate is fixed, it is devaluation
Government may influence the value of its currency
by changing the interest rate and/or buying and
selling its currency. Increasing the value of a
currency will increase its purchasing power but it
may harm the balance of payment because import
will be cheaper. This may reduce economic activities
as a result of high importation and low demand for
local goods
 Reducing the value of the currency may
increase employment and growth but
increase inflationary pressure especially if
firms need to import raw materials to produce
their goods. In this case, it will be more
expensive to import
If the exchange rate is depreciating,
government may raise taxes to discourage
spending and thereby reducing expenditure
on imports. Such a measure may lower
economic growth and increase
unemployment
RELATIONSHIP BETWEEN THE INTERNAL & EXTRENAL VALUE OF MONEY

There is a direct relationship between the internal

value and external value of a countrys currency.
When there is inflation in a country, the value of its
currency will fall and if the rate of inflation is above
its competitors, the demand for the countrys
currency will fall because foreigners will buy less of
the country exports and the supply of its currency
will rise because residents will prefer to buy
cheaper imported goods.
This may lead to depreciation of currency (a
situation where supply is higher than demand for
currency). Likewise a change in exchange rate will
affect the internal value of a currency.
 A fall in exchange rate will increase the
price of a countrys imports, and this will
reduce the value of a country currency
because import will be expensive.
Also, reduction in exchange rate will
increase the price of imported raw
materials which also increase the price
of the domestically produced goods. This
may lead to imported inflation.
 Exchange rate S
S1
E
E1
D1 D

Q1 Quantity of
currency
Demand for exports reduced to D1 while increase in
import increase supply of currency to S1 this reduce
exchange rate to E1 (depreciation)
 RELATIONSHIP BETWEEN THE BALANCE OF PAYMENT
AND INFLATION
According to Marshall Lerner condition, if the value of a
countrys currency falls the demand of the good of such
country will increase because the exports price has
fallen in foreign currency. The extent of the increase in
demand depends on the price elasticity of export i.e. a
fall in the exchange rate will lead to a rise in export
revenue and reduction in import expenditure.
This will improve the country balance of payment
because there will be more income (export will be
greater than import). Nevertheless, if inflation occurs
as a result of imported raw materials versus finished
product or as a result of increase in demand due to
cheap price of local goods, the balance of trade will
worsen in the long run.
 J-curve condition is similar to the
Marshall Lerner condition which state
that a fall in exchange rate will
worsen the balance of payment
deficit before it will start improving it.
 J CURVE GRAPH
Balance of payment
J curve

- Time

There is initial fall in BOP but in the long

term, there is a rise.
 The demand for import and demand for
exports are likely to be inelastic in the short-
run, this is because firms and consumers have
already gotten their sources of supply and may
be reluctant to change immediately as a result
of changes in price.
If the value of a currency falls, although, the
price of exports in terms of foreign currency
falls, the total amount spent on the export will
fall because demand is inelastic (this is
because foreign importers might not be aware
of the fall in price in the short-run).
 Although the price of imports has risen, the
total amount spent on import will increase
because demand is inelastic (this is because
consumers might be reluctant to change to a
cheaper good in the short-run). The overall
result is that the balance of payment deficit will
worsen in the shot-run.
In the long-run, the demand for imports and
exports will be elastic. With lower export price,
spending on export rises; with higher import
prices spending on import reduces and the
balance of payment improves.
 In the very long-run, the balance of payments
might worsen again because the higher import
prices can cause cost push inflation because
many countries need to import raw materials
and component to produce their exports.
With the fall in exchange rate, they will pay
more for such items in the short run. This will
make the goods produced uncompetitive abroad.
Therefore, many believe that a devaluation of
currency will not improve the balance of
payment position over the very long term.
 RELATIONSHIP BETWEEN INFLATION
AND UNEMPLOYMNET
Bill Philips (Keynesian) suggested that
unemployment and inflation are inversely
related. The theory showed the relationship
between nominal wage rate and
unemployment.
He suggested a trade off between inflation
and unemployment, if unemployment falls,
inflation will rise and vice-versa. When
unemployment falls, aggregate demand
increases. Wages may also increase which may
lead to cost push inflation. So government had
to select the combination of inflation and
unemployment and can trade off the two.
Inflation %

3
7 10 Unemployment %
PC
If the current unemployment rate is 10% and inflation
rate is 3%, government may lower unemployment to
7%, when this is done, inflation may rise to 5%.
 EXPECTATIONS AUGUMENTED PHILIPS CURVE

The monetarists believe that in the

short run, there may be trade-off
between unemployment and inflation
but in the long-run expansionary
fiscal policy/ monetary policy will
have no impact on unemployment,
but will raise inflation.
This theory was explained by Milton
Friedman. This model introduced the
short run and the long run Phillips
curve
Inflation % LRPC (Long run Philips Curve)

5 b c
SRPC 2
3 a SRPC1

7 10 UNEMPLOYMENT %

Assuming initially unemployment is 10% and inflation is 3%. Due to

increase in aggregate demand there is decrease in unemployment
from 10% to 7% this decrease might increase inflation from 3% to
5%. This will move the economy to higher short run Phillips curve at
point B.
 Increase in demand will lead to increase in output/profit.
Firms will employ more workers and this will increase
the cost of production and price. As a result of higher
wage rate, firms real profit will not change likewise
workers that joined the labour force because of increase
in wage will have their real wage cut down because of
increase in inflation.
Firms might decide to reduce their output and
employment when realised that their real profit has not
increased. Likewise workers might leave the labour
force when realising that their real wages as not
changed. So, unemployment will rise from 7% back to
10% in the long run but inflation might not reduce.
Therefore in the long run, there is no trade off between
unemployment and inflation. Increase in fiscal or
monetary policy will only increase inflation but will not
reduce unemployment.
 CONFLICTS BETWEEN POLICY OBJECTIVES

Macroeconomic policy objectives may

sometimes clash.
When governments pursue an objective, the
policy used may have adverse effects in the
short run.
The objectives to increase economic growth
and full employment will lead to increase in
demand. While to control inflation and the
balance of payment equilibrium may lead to
reduction in aggregate demand and
unemployment
 UNEMPLOYMENT AND
INFLATION
According to Philips curve, there is a trade
off relationship between unemployment and
inflation. This trade-off is important when it
comes to designing policy. Attempt to reduce
unemployment will lead to higher inflation
and vice-versa. This suggests that it might
be difficult to maintain full employment and
low inflation at the same time.
A rise in income tax designed to reduce
inflation may also raise unemployment.
 ECONOMIC GROWTH AND
ENVIRONMENTAL POLLUTION
It may also be difficult to achieve
economic growth without
environmental pollution. Chinas
rapid growth has negative impact on
environment e.g. there is emission of
carbon dioxide which is one of the
key green house gases that
contribute to the process of global
warming.
 Also the type of energy being used for increase
in productivity also lead to environmental
degradation e.g. Coal, oil, natural gas etc.
For Economic growth to be sustained the
environmental effects of industrialisation should
be taken into consideration so as not to
jeopardise the quality of life of future generation.
One of the solutions to this is for growth to be
slowed in the short run in order to devote
resources to the development of renewable and
cleaner energy sources.
 INFLATION AND ECONOMIC
GROWTH
Policy of the government to increase
interest rate in order to reduce
inflation may push the value of the
currency up.
This may reduce exports and reduce
economic growth and lead to
unfavourable balance of payment.
 ECONOMIC GROWTH AND THE
CURRENT ACCOUNT OF THE BOP
When a country is operating fixed exchange
rate, policy to encourage economic growth
might lead to deficit on the current account of
the BOP. Economic growth means increase in
income which may also lead to increase in
demand for import and current account
deficit.
Policies to maintain exchange rate and reduce
deficit might contradict Economic growth
because less money will be available for both
import and investment.
 GOVERNMENT FAILURE IN
MACROECONOMIC POLICIES
Government failure arises from the complexity of
policy design and the interaction between policy
measure and objectives. It includes;
1. Time lag- this is a delay that exists between policy
formation and initiation. By the time a policy might
have taken effect, the problem which requires
solution might have gone away.
2. External shock-An external shock is an
unexpected change in an economic variable which
takes place outside the economy. An example
might be an increase in the price of oil having an
impact on firm's costs of production. This is usually
beyond government control.
3. Lax regulation- slack regulation may occur when
government is trying to make financial market
more flexible which may lead to unanticipated
problem e.g. Inflation and unemployment.
4. Role of consumers and firms- They may not react
to policy intervention the way government wants
them to which ay lead to adverse consequences.
5. Lack of adequate knowledge- Government may
not have enough up-to-date information about the
economy to take perfect decisions.
 LAFFER CURVE ANALYSIS
TheLaffer curveis a graphic representation of the
relationship between an increasingtax rateand a
government's totalrevenues. The relationship
suggests that revenues decline beyond a peak tax
rate.
The shape of the Laffer curve suggests that
governmentrevenues diminish with tax rate
increases beyond an optimal level denoted as R*.
 This is based on the theory that beyond a
certain tax rate, a country'staxpayerswillhave
a decreasing incentive to work knowing that
more and more of their moneyis being taken
by the government. In other words, according
to this model, at tax rates approaching 100%,
taxpayers will work little, if at all.
The Laffer curve has a parabolic shape plotted
on a graph: Governmentrevenueis displayed
on the vertical axis, and thetax rateappears
on the horizontal axis.