Macroeconomics

MACROECONOMICS
BAF1&BBA1
Course Content
 National Economy and National Income
Analysis
 Business Cycle and Economic Growth
 Unemployment and Inflation
 Money and Banking
 Public Finance
 International Trade and Balance of Payments
NATIONAL INCOME ANALYSIS
TOPIC 1
 Introduction
 National Equilibrium and the Circular Flow of Income
 National Income Identity: Variables and Definitions
 Approaches in the measurement of National Income
 Inter industrial analysis and the concept of Value Added
 National Income Determination: Aggregate Demand
Approach
 The concept of multiplier and policy implications.
 Income Distribution and the Lorenz Curve
INTRODUCTION
 Microeconomics is the study of economic behaviour
of individual decision makers (consumers, producers
and owners of factors of production) and price
determination of individual products and factor inputs.
 In contrast, macroeconomics is the study of the

economy as a whole.
 It deals with the study of the structure and performance
of national economies and of the policies that
government uses to try to affect economic performance
INTRODUCTION …
 Precisely, macroeconomics studies the relationship
and interaction between factors that determine:
 The level of economic growth
 General price level
 National output and employment and
 Balance of payment
 The major theoretical issues that arise out of

macroeconomic literature are:
1. How is the level of employment determined in a country?
2. What causes fluctuations in the national output and
employment?
3. What determine the general price level in a country?
INTRODUCTION …
4. What causes disequilibrium in the balance of payment of
a country?
5. What roles can the government play in correcting
economic imbalances?
Therefore macroeconomics provides analytical

framework and guidelines for finding reasonable
solutions to these problems.
NATIONAL EQUILIBRIUM AND THE
CIRCULAR FLOW OF INCOME
 In the market directed (free) economies, goods and
services are produced only when there is a market
demand for them.
 If firms produce more than what customers can buy;

excess aggregate supply will develop, leading to
decline in prices. As a result, firms will cut down
production, laying off workers.
 Conversely if customers demand more than it is

being produced i.e. excess aggregate demand
develops, leading to price rise and hence firms will
tend to increase output and employment
CIRCULAR FLOW OF INCOME …
 For any economy to be in equilibrium then national
output must equal to total (national) income.
 This can be explained by what is known as a

Circular Flow of Income.
 The circular flow of income is a simple model of

the economy showing flows of goods and services,
factors of production and income between firms
(producers) and households (consumers).
 Assumptions of the simple economy model:
1) There are only two sectors namely; household
and firms.
2) There is no government and no foreign trade
(closed economy) hence, payments made to firms
are equal to payments made to households.
3) Households own all factors of the production and
consume all goods and services
4) Households income consist of wages, rent,
interest and profits.
5) Business firms, hire factors of production from
households,
6) They (business firms) produce and sell goods
and services to households
7) No Saving to households and firms
8) Production in a given year is sold in that year
Revenue Spending
(=GDP) (=GDP)
MARKETS FOR
GOODS AND
Good and SERVICES
Good and
services sold
services bought
FIRMS HOUSEHOLDS
Land, labor
Inputs for
and capital
Production MARKETS FOR
FACTORS OF
PRODUCTION
Wages, rent, Income (=GDP)
interest and
profit (=GDP)
Flow of goods & services
Flow of money
THE CIRCULAR FLOW DIAGRAM
CIRCULAR FLOW OF INCOME ...
 For the business sector to produce goods and services
should hire the services of the household sector, in the
form of labour, land and capital etc.
 In exchange for the services the business sector pays

wages, salaries, rents, interests and profits to the
household sector (labours, firms and land owners).
 Thus, there is a flow of earnings or income to the

household sector which matches the flow of services to
the business sector.
 NB:
 An important feature of the product and money flow
is that the value of real flows equal to the money
flows.
 This is due to the fact that factor payments (wages,
rent, interest, and profits) are equal to households
income.
 Since households spend all their income on goods
and services, households expenditure equals the total
receipts of the firms which equals to the value of
output.
 This means that the value of output produced in
this economy can be measured in three ways
1. National output = value of goods and services
flowing from the firms to households
2. National income = value of rent, wages, interest
and profit paid to households
3. National expenditure = value of spending by
households on goods and services
 Therefore:
The THREE are to be equivalent
 Criticisms
1. In reality the households do not spend all their
current income, some is saved. This represents a
leakage from the circular flow.
2. Firms also carry out investment spending. This is
an injection to the circular flow of income, as it
does not originate from consumers' current
income.
3. In the real world the government and
international trade sectors must also be included.
 To make the model more realistic and useful, it is
necessary to introduce injections and leakages,
which are accompanied by an increase in the number
of active groups in the economy such as
government and international trade.
 Injection = money joins the circular flow as a result
of spending on goods and services from a group
other than the households.
 Leakage = money leaves the circular flow passing
from the households to a group other than the firms.
 The influence of government in the circular flow of income is
divided into parts namely; government spending and taxation
 Government spending will be injected into the circular flow
 The injection provided by the government sector is
government spending (G) that provides collective services
and welfare payments to the community
 Taxation will leak income from the flow
The leakage that the Government sector provides is through

the collection of revenue through Taxes (T) from
households and firms. It reduces the expenditure on current
goods and services
 The influence of international trade is through
export and import
 Exports (X) of goods and services which generate
income for the exporters from overseas resident
 Imports flows leaked. Imports (M) represent
spending by residents into the rest of the world.
With government and foreign
agents
 Need to account for :
a. Government purchases of goods and services.
b. Government payments for factor services (wages, rent,
interest).
c. Transfer payments between different agents.
d. Firms and households pay taxes to government.
e. Taxes paid on income, property, goods and services.
f. Transactions with the foreign sector.
Transfer payments
 Transfer payments – are transactions wherein
one party is not obliged to deliver a good or
service in return for the payment.
 Examples: retirement benefits, unemployment
benefits, scholarships, and donations.
Transactions with foreign sector
 Includes sales of goods and services, assets,
and transfers
 Exports - sales of domestically produced goods to
other countries
 Imports - goods bought from other countries
NATIONAL INCOME V IDENTITY:
VARIABLES AND DEFINITIONS
 Some Basic Concepts
 National Income- National Income is the money
value of all final goods and services produced in a
country during a period of one year.
 National Income is the most important
macroeconomic variable and determinant of the
business level and economic status of the country.
 Other macroeconomics variables are: Inflation,
Employment, Price Level, Interest etc.
VARIABLES AND DEFINITIONS ...
 Gross National Product (GNP)- the total market
value of all final goods and services that the
country's citizens have produced in a year,
regardless of their location.
 It includes income earned abroad by nationals and
excludes income earned locally by the foreigners.
 Gross Domestic Product (GDP) – the total market
value of all final goods and services produced within
a country’s national borders in a year, regardless
of who owns the factors of production.
 It includes income earned locally by foreigners and
excludes incomes earned abroad by nationals.
National Income (NI):-
 This is the total of all incomes earned by the
factors of production in the country (land,
capital, labour, entrepreneur) at a specified
period of time usually one year.
 It is the total money value of all incomes
received by persons and enterprises in the
country during the year.
 Such income may be in the form of wages,
salaries, interest, rents and profit.
 Net National Product (NNP)-This is the (Net)
market value of final goods/services produced in the
economy over a specified period of time, usually one
year.
 Personal Income (PI)-Is the total income received by
all individuals in the economy i.e. what individuals
have to spend, save or pay tax.
 Disposable Personal Income (DPI)-This is what
people are left with after they pay taxes.
 Nominal national income -national income measured
at the current level of prices
 Real national income - national income measured at
constant prices to remove the effect of inflation
National Income Accounting
 Refers the the measurement of indicators of
national output/income. For example; GDP,
GNP
Measurement of economy’s output:
The Gross Domestic Product (GDP)
 The GDP measures the market (money) value of all final
goods and services produced within an economy in a given
period.
 GDP only measures current production. Transfer payments
and transactions involving goods produced in other
periods are NOT included in the calculation of GDP.
 GDP is usually expressed in the currency of a particular
country. E.g. Philippine peso, Tanzania Shillings etc …
indicates the market value of the goods and services in that
country.
Mathematical Definition of GDP
 The market value of good i (V i) is equal to
PiQi
 GDP = sum of the market values of all final
goods and services produced within the year.
n n
GDP   V  P
i1
i
i1
i  Qi
GDP includes final goods and
services only
 Final goods - goods and services that are not
purchased for the purpose of producing other goods
and services or for resale
 Eg. Rice (final) and palay or unhusked rice (intermediate
product)
 Including intermediate goods and final goods will

result in “double counting”.
Three Approaches for measuring
GDP
1. Expenditure Approach (upper loop) – measures
GDP as the sum of expenditures on final goods and
services.
2. Income Approach (lower loop) – measures GDP as
the sum of incomes of factors of production (wages,
rent, interest and profit.
3. Value-added Approach – measures GDP as the sum
of value added at each stage of production (from
initial to final stage)
Expenditure Approach
 Uses the upper loop of the circular flow
diagram.
 Example: Suppose the economy has only
one final product, namely, rice.
Good Price per Q sold Expenditure
unit
Rice 20 1000 20,000
GDP 20,000
Income Approach
 Uses the lower loop of the circular flow diagram: sum of
payments to the various factors of production.
 Suppose that in the production of rice the sales and expenses
are as follows:
Sales 20,000
Expenses:
Wages 8000
Rent 4000
Interest 2000
Total 14,000
Profit 6,000
GDP=Sum of Payments 20,000 20,000
to factors
Value Added Approach
 Suppose that rice is the only final product of an
economy: It goes through several (3) stages of
production.
Value of
Stage of Production intermediate Value of Value-added
good Sales
Farmer – Palay 12,000 12,000
Rice Miller -Milled 12,000 15,000 3,000
Rice
Retailers - Rice 15,000 20,000 5,000
GDP= Total Value 20,000
Added
Example:
THE NATIONAL ACCOUNTS OF THE PHILIPPINES
 Same principles as above but need to make

adjustments in order to accommodate the
realities in modern economies
 Expenditure approach
 GDP = C + G + I + X –M+ SD
Table. Expenditures on GDP, 2002 in million pesos.
Item Symbol Value
Personal Consumption Expenditure C 2,750,9000
Government Consumption G 488,700
Expenditure
Gross Domestic Capital Formation I 776,200
Exports of Goods and Services X 1,968,500
Less: Imports of Goods and Services M 1,989,100
Statistical Discrepancy SD 27,500
Gross Domestic Product GDP 4,022,700
Expenditure Approach …
 C - spending of households and private non-profit institutions on goods
and services
 Non-durables - goods and services that are consumed rapidly
 Durable goods - that last for a longer period of time
 I - investment spending of domestic agents. Its major components are
“changes in” Fixed Capital and Changes in Stocks
 G - government’s payments for the salaries of its workforce as well as
purchases of goods and services  used for the government’s day to day
operations and projects.
 X - the spending of the rest of the world on goods and non-factor services
produced in the country
 M- the country’s purchases of goods and non-factor services from the
rest of the world.
 SD - accounts for accounting and reporting errors in the accounts. Needed
to ensure that GDP value from all approaches are the same
Income Approach
ITEMS SYMBOLS VALUE
Compensation of Employees COE 1,093,800
Net Operating Surplus NOS 2,215,100
Depreciation D 357,200
Indirect Business Taxes less IBTS 356,600
Subsidies
Income Approach …
 GDP = COE + NOS + D + IBTS
 In a simple world, GDP = COE + NOS. In practice, require
two adjustments (D and IBTS)
 D - accounts for the wear and tear of physical capital
 “D” is treated as a business cost  not included in NOS.
However, “D” is part of “I” in the expenditure side of the
national accounts
 IBTS - includes taxes on the use or purchase goods and
services and grants from government to firms. E. g sales
taxes, value added tax
 Not included in NOS but is part of the market prices, of
which the items in the expenditure accounts are quoted
Value added or Industrial Origin
approach
 GDP = value added of different activities
(sectors)
ITEM VALUE
Agriculture, Fishery and 519,400
Forestry
Industry 1,307,400
Services 2,123,900
Gross Domestic Product 4,022,700
Additional Concepts
 GDP vs GNP
 Real vs current GDP
 Inter-country comparisons of GDP
 Convert to international currency like US dollars
 Convert to per capita measures
The distinction between GDP and GNP
 GNP = GDP + Net Factor Income from the
Rest of the World (NFIRW)
 NFIRW - measures the difference between the
earnings of Philippine residents in other
countries and foreign residents in the
Philippines.
The distinction between GDP and GNP
Net Factor Income from the NFIRW 267,500

Rest of the World
Gross National Product GNP 4,290,200

Nominal and Real GDP
 GDP at current prices or nominal GDP - GDP measured
using the prices of the year for which it is calculated
 Nominal GDP can be a misleading indicator of changes in output or
income because it also embodies changes in the prices of goods and
services.
 Real GDP or GDP at constant prices - measures the total
value of output using the prices of a selected year (the base
year).
 Real GDP better for analysis overtime because it eliminates the
effects of price changes
YEAR 1 YEAR 2
QUANTITY
Ice Cream 100 100

Buko Pie 100 100
PRICE
Ice Cream 50 100

Buko Pie 100 200
VALUE
Ice Cream 5,000 10,000

Buko Pie 10,000 20,000
NOMINAL GDP 15,000 30,000
The real GDP (using prices of year
1 only)
 GDPyear 1 = (100) (50) + (100) (100) = 15,000
 GDPyear 2 = (100) (50) + (100) (100) = 15,000
 In practice, calculating real GDP using the previous approach

is a tedious process because there are so many goods and
services are produced in an economy. Can simplify the
calculation process by using the GDP deflator.
 GDP deflator (or a price index) allows us to convert
nominal GDP into real GDP. (Note: Price index to be defined
later)
Real GDP
 Mathematically,
Nominal GDP
Real GDP   100.
GDP deflator
Calculation of Real GDP
Item 1990 1998 2002
GDP at current
prices 1,072,000 2,665,100 4,022,700
(million PhP)
GDP deflator
(base year 149.5 300.1 384.6
1985)
GDP at
constant
720,700 888,000 1,046,100
prices
(million PhP)
GDP Deflator, (1985=100), Philippines
500.0
450.0
400.0
350.0
300.0
250.0
200.0
150.0
100.0
50.0
0.0
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Inflation Rate, Philippines
18.0
16.0
14.0
percent per year
12.0
10.0
8.0
6.0
4.0
2.0
0.0
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Inflation Rate
CPI t  CPI t 1
Inflation Rate 
CPI t 1
Estimates of the CPI and Inflation Rate, 1990-98
Year Consumer Price index Inflation rate
(CPI) (in percent)
1990 62.7 --
1991 75.6 20.6
1992 83.8 10.8
1993 91.6 9.3
1994 100.0 9,2
1995 108.2 8.2
1996 117.3 8.4
1997 125.1 6.6
1998 137.9 10.2
GDP per capita
 Measures how much output or income
was produced or received, on the average,
by an individual in an economy
 Useful for comparing the performance of
a country overtime and a country’s
performance relative to its neighbors
GDP
GDP per capita 
population
Per capita GDP
Item 1990 1998 2002
GDP at constant
(million pesos) 720,700 888,000 1,046,100
Population (millions)
62.0 75.2 81.8
Per capita GDP at

constant prices 11,624.20 11,808.5 12,788.5
Selected output Indicators for the Philippines, selected years
Item 1984 1985 1995 1996 1997
(1) GDP at current

prices (million 524,481 571,883 608,887 2,171,922 2.423.640
pesos)
(2) GDP deflator (base

85.01 100.00 102.95 255.78 271.40
year -1985)
(3) GDP at constant

prices (million 616,964 571,883 591,440 849,137 893,014
pesos)
(4) Per capita GDP at
current prices 9,890 10,524 10,935 30,208 32,961
(pesos)
(5) Per capita GOP at
constant prices 11,634 10,524 10,662 11,810 12,145
(pesos)
(6) Population (million

53.03 54.34 55.68 71.90 73.53
persons)
Source: NSCB (1998), Philippine Statistical Yearbook.

GNP for cross country comparisons
 Convert a country’s GNP to US dollars, or

some common currency, by using the
country’s exchange rate
 When comparing income across countries, it
also makes sense to use per capita estimates
 eliminates differences in population size.
E.g. (data is for 1998)
Some Limitations of GDP or GNP as
measures of growth
 Ignores income distribution
 Ignores environmental degradation
 Does not include activities that do not go
through the formal markets sectors
 Does not include “illegal” activities like drug
trafficking, prostitution e.t.c
NATIONAL INCOME
DETERMINATION
INTRODUCTION
 The theory of national income determination
tries to answer major two questions:
1. What factors determine the level of national
income?
2. How is the equilibrium level of national income
determined?
 These two questions will be answered by the
Keynesian Theory of Income
Determination.
KEYNESIAN THEORY OF INCOME
DETERMINATION
 To explain the Keynesian theory of income
determination, the entire economy is divided
into four sectors namely:
1. Household sector
2. Firms or the business sector
3. Government sector
4. Foreign sector
 The four sectors of the economy form three
sector models:
1. Two sector- model including the household and
business sectors
KEYNESIAN THEORY OF INCOME
DETERMINATION ….
2. Three sector model including household, business
and government sector
3. Four sector including, household, business,
government sector, and foreign sector.
TWO SECTOR MODEL
 Assumptions of the two sector model:
1. The economy has only two sectors; household
and firms.
2. No government
3. The economy is closed one, there is no foreign
trade.
4. Households either spend income on consumption
(C) or they save it. Saving is defined to be the
part of Income that is not consumed
5. All prices remain constant
6. Supply of labour and capital and the state of
technology remain constant
TWO SECTOR MODEL ...
 According to the Keynes, national income is
determined by two factors: Aggregate Demand
(AD) and Aggregate Supply (AS).
 The equilibrium level of national income is
determined where AD equals AS.
 (i) Aggregate Supply
 Aggregate supply (AS) refers to the total value
of goods and services produced and supplied
in an economy .
 AS include both consumer and producer
goods
 To get the total value of national output, the
goods and services produced are multiplied by
 Aggregate Supply Curve
 Assume that, all output sold, and the
aggregate supply grows at a constant rate,
then this can be shown by a 45o line as follow:
 Figure 1: Aggregate Supply Curve
AE AS=AE=Y
45O
Aggregate Income (Y)

 The 45o line is also called the aggregate
supply curve.
 In the Keynesian theory of income
determination, aggregate income equals
consumption (C)+ savings (S)
 Therefore, AS curve is also known as C+S
curve.
 The AS curve is sometimes called Aggregate
Expenditure curve (AE).
 This is based under the assumption that total
income is spent (or all output is sold).
TWO SECTOR MODEL …..
 (ii) Aggregate Demand:
 Refers to the aggregate expenditure made by
the households and firms in a year.
 Aggregate demand has two components:
1. Aggregate demand for consumer goods (C)
2. Aggregate demand for capital goods (I)
 Thus AD= C+I………………………..(i)
 Aggregate Demand Curve:
 Is also called C+I curve
 It is assumed that I remain constant in the
short run but C varies with income (Y).
 Therefore consumption function can be
written as: C=a + bY……………(ii)
 Where a is a constant, when Y=0; C=a
 b is the proportion of income consumed i.e
ΔC/ ΔY
 Plug in equation (ii) into equation (i), AD
function can be written as:
 AD= a+ bY + I………………………(iii)
TWO SECTOR MODEL …
 Table 1: Aggregate Demand Schedule: AD=a+bY+ I
AD=10+0.5Y+10
Income C=10+0.5Y I=10 C+I Schedule
(Y)
0 10+0=10 10 20
10 10+5=15 10 25
20 10+10=20 10 30
30 10+15=25 10 35
40 10+20=30 10 40
50 10+25=35 10 45
60 10+30=40 10 50
EQUILIBRIUM: TWO SECTOR
MODEL ...
Figure 2:National Income Equilibrium
60
Expenditure
AS=C+S
50 AD=C+I
C
40 E
30
20
10
I
45o
0
10 20 30 40 50
Income (In Billions Tshs)

MODEL ...
 From table 1 and figure 2:
 AS and AD are equal only at one level of
income at Tshs 40 Billion.
therefore determined at Tshs 40 Billion.
 The AS curve is drawn under assumption that,
total income (Y) is equal to total expenditure
(E).
 The AD (C+I) curve is the vertical summation
of C and I.
 C+I and C+S curves intersect at point E,
determining the equilibrium level of income
at Tshs 40 billions.
MODEL …..
 Note that at point E:
AD=AS
C+I=C+S
30+10=40
 What happens when there is disequilibrium?
(AD<AS)
 Beyond the equilibrium level of national income,
C+I<C+S.
 For instance if firms produce more than 40 billion, they
will have excess output. Excess supply will force price to
fall down, therefore firms will cut down production and
cut down their expenditure on inputs.
 This process will continue until the equilibrium level of
40 billion is reached.
 Similarly, below 40 billion level of national
income, AD>AS
 For instance if firms produce at 30 billion
level of national income, AD exceeds AS by
10 billion and price is pushed up.
 Therefore firms will be encouraged to
produce more and generate income.
 The households will continue to buy until the
equilibrium level of national income is
reached.
 Once the national equilibrium level is
reached, then it is supposed to remain stable.
CONSUMPTION FUNCTION
 Represents the demand for goods and services
by individuals and households in the economy.
 The relationship between consumption and
income is described by the consumption
function.
 The consumption function represents the
"planned" or "desired " level of consumption
for a given level of income.
 Other non-income factors that may affect
consumption such as the weather, wealth,
interest rates, and prices are assumed to be
constant.
 The consumption function can be written as:
 C = a + b Y……………………….(i)
CONSUMPTION FUNCTION ….
C = desired level of consumption spending
a = fixed (autonomous) level of consumption, (a >
0), denoting C when Y=0
b = (0 < b < 1), is a proportion of income
consumed ΔC/ ΔY, also called the marginal
propensity to consume (MPC)
Y = total income
 Consumption is made up of two components:
1) Autonomous consumption (a), which is

consumption that is independent of the level of
income.
CONSUMPTION FUNCTION….
2) Income induced consumption, (b . Y), that
does depend on the level of income.
1. Autonomous Consumption
 Autonomous simply means "independent" of
income. When income is zero total
consumption is equal to the autonomous level
of consumption.
 You might think of autonomous consumption
as the minimum level of consumption
necessary to survive (often called the
"subsistence" level).
 Graphically, it corresponds to the y-intercept
of the linear function.
 Autonomous consumption will be positive
since households will spend some money
(drawing on saving if necessary) to purchase
consumption goods (like food) even if income
were zero.
2. Income Induced Consumption and the
Marginal Propensity to Consume
 Marginal propensity to consume - the amount
that consumption changes in response to an
incremental change in income.
 The change in consumption for every shilling
change in income is called the marginal
propensity to consume, or MPC.
 If the MPC is 0.8, then a 1 shilling increase in
income raises consumption by 0.80 cents. A
1,000 shillings increase in income raises
consumption by 800 shillings.
 It is found by dividing the change in
consumption by the change in income that
produced the consumption change.
 MPC = change in consumption
change in income
 Symbolically, MPC = ΔC/ ΔY
 The MPC can be derived from the
consumption function as follow:
C=a+bY
If Y increases by ΔY, then
C+ ΔC = a+ b (Y+ ΔY)
= a + bY+ bΔY
ΔC =-C+ a + bY+ bΔY
Substitute a + bY for C
ΔC =- (a + bY) + a + bY+ bΔY
ΔC =bΔY
b = ΔC/ ΔY
 Figure 3: Consumption Curve: C=8+0.7Y
C=Y
C=8+0.7Y
Consumption
Expenditure (C) ΔC
ΔY
Autonomous
expenditure
=8 45o
INCOME (Y)
 Figure 3 shows Consumption Function
 The consumption function shows desired
aggregate consumption at each level of
aggregate income
 There is an intercept on the vertical
(expenditure) axis equal to the autonomous
component, a= 8.
 The y-intercept for consumption is positive
reflecting 'dis-savings' or the sale of assets if
there is no disposable income.
 The slope equal to the marginal propensity to
consume, c=0.7 for each additional shilling
of income, 70 cents is consumed.
 The value of the MPC must be in the range of
0 to 1 and is most likely to be between 0.5
and 0.8 for most economies.
 If MPC were equal to one, then households
would spend every additional shilling of
income.
 However, because most households put some
of their income into savings (i.e into the bank,
or pensions), not every extra shilling of
income will lead to a shilling increase in
consumption demand
 Average Propensity to Consume (APC)
 Average Propensity to Consume is defined as
the proportion of total income on consumer
goods and services.
 APC= C/Y
Where C =total consumption
Y= total disposable income
Given C= a+bY
APC= C = a+bY
Y Y
If a = 0; Then APC =b=MPC
SAVING FUNCTION
 The saving function shows desired saving at
each income level.
 That fraction of the shilling not used for
consumption but put into saving is called the
marginal propensity to save (or MPS).
 Saving is also the function of income i.e. S=f
(Y)
 Since Y= C+S
C= a+bY; then S=Y- (a+bY)
S=Y-a-bY
S=-a+ (1-b)Y
1-b= Marginal Propensity to Save (MPS)
SAVING FUNCTION …..
 This can be proved as follow:
Y= C+S
ΔY= ΔC + ΔS
(dividing both sides by ΔY)
ΔY= ΔC + ΔS
ΔY= ΔY+ ΔY
ΔS =ΔY - ΔC
ΔY ΔY ΔY
MPS= 1-b
SAVING FUNCTION…..
 Assume we have the following saving
function S=-8+0.3Y; This function can be
shown in figure 4 as follow:
SAVING
S=-8+0.3Y
0 INCOME
-8
SAVING FUNCTION…..
 From figure 4, the marginal propensity to
save MPS (the slope of the function) is 0.3
 For each additional shilling of income, 30
cents is saved.
 Since all income is either saved or spent on
consumption, MPS+MPC=1 in this particular
example 0.3 + 0.7 = 1
 When income is zero households dis-save 8
units of their wealth to spend on consumption
DETERMINATION OF NATIONAL
INCOME
 Equilibrium condition of national income is
given as:
 AD=AS=Y
 C+I=C+S
 Since C is common to both sides, the
equilibrium condition can also be stated as:
 I=S
DETERMINATION OF NATIONAL
INCOME ……
 Equilibrium level of national income is given by: C+I=C+S
 C+I =Y
We know that C=a+bY
Then Y= a + bY+ I
Y-bY= a + I
(1-b)Y= a + I
Y= a + I or Y= 1 (a +I)
(1-b) (1-b)
b= MPC
THREE SECTOR MODEL
 Introduction
 An economy has three sectors; households, firms
and government.
 The inclusion of government into the model affects
aggregate demand through government spending and
taxation.
 Government spending adds to the aggregate demand,
while taxes reduce it.
 The main assumption under the three sector model is
that, government spending (G) and taxes (T) are
exogenously determined. i.e they are not determined
within the model.
NATIONAL INCOME EQUILIBRIUM IN
THE THREE SECTOR MODEL
 The aggregate demand (AD) in the three sector model
can be expressed as:
 AD= C+I+G
 AS= C+S+T =(Y)
determined where AS=AD
 Y= C+I+G
 C= a+bYd
 Yd= Y-T (disposable income)
 There is one additional change to the Keynesian
model. Consumption is no longer influenced by total
income, is influenced by disposable income.
THE THREE SECTOR MODEL …
 Disposable income is total income plus government
transfer payments less taxes:
 For simplicity we assume that transfer payment =0
so disposable income = Total Income- taxes.
 T= lump sum tax: A tax that is collected as a "lump-
sum" amount, regardless of changes in income. Ex.:
Everyone pays Tsh1000, so if there are 20 people, =
Tsh 20,000 will be collected.
THE THREE SECTOR MODEL ….
 By substituting a + bYd for C and Y-T for Yd, then
the equilibrium condition can be written as:
 Y=a+ b (Y-T)+I+G
 Solving for Y we get equilibrium level of national
income as follow:
 Y=a+ bY-bT +I+G
 Y-bY= a-bT +I+G
 Y(1-b)= a-bT +I+G
 Y=a- bT + I + G or Y= 1 (a – bT + I + G)
1-b 1- b
FOUR SECTOR MODEL
 Introduction
 In a four sector model foreign trade is included.
 In foreign trade, exports are injections and imports
are outflows from the circular flows of income.
 When dealing with foreign trade, only the net export
is considered for analysis, i.e. X-M
 When X >M, there is net injection and national
income level increases; and if X<M, there is a net
withdrawal which causes national income level to
decrease.
EXPORT AND IMPORT FUNCTIONS
 In order to examine the national equilibrium in the
four sector - model we need to have export and
import functions.
 Export functions:
 There are a good number of factors affecting export
such as: price of domestic goods Vs imported
goods, tariffs and trade policies, export subsidies
etc.
 However for simplicity we assume that export is
determined by factors operating outside the
economy.
 Therefore X is treated as an autonomous
(independent) variable and is given as X.
EXPORT AND IMPORT FUNCTIONS ..
 Import Function
 Imports of a country is determined by a number of
factors such as: import prices Vs domestic prices,
the level of domestic tariffs, domestic trade policy,
level of income, income- elasticity of import etc.
 However for simplicity, it is assumed that imports
(M) depend on the level of domestic income (Y)
and the marginal propensity to import (MPM=g).
 Therefore M= M + gY
 Where M =autonomous imports
 g= ΔM/ ΔY=MPM
THE FOUR SECTOR -MODEL
 The four sector-model can now be expressed as:
 Y=C+I+G+(X-M)
 Where C=a + bYd
I=I
G=G
These variables are constant
X=X
Yd=(Y-T)
M=M+gY
 By substitution, national income equilibrium can be
expressed as;
Y=a +b(Y-T)+I+G+X-(M+gY)
Y= a+bY-bT+ I+G+X-M-gY
THE FOUR SECTOR- MODEL …..
Y- bY+gY= a-bT+I+G+X-M
Y(1-b+g)= a- bT+I+G+X-M
Y= a- bT+I+G+X-M or
1-b+g
Y = 1 (a- bT+I+G+X-M)
(1-b+g)
THE CONCEPT OF MULTIPLIER
 The Concept of Multiplier
 In economics, a multiplier effect – occurs when a
change in aggregate demand causes a further
change in aggregate output of the economy.
 The multiplier has been used as an argument for
government spending or taxation relief to stimulate
aggregate demand.
 The concept of multiplier tries to answer the
following questions:
1. What happens to total output and national
income if there is a change in autonomous
variables (e.g. Investment, government spending
and export? )
THE CONCEPT OF MULTIPLIER….
2. If the economy is in a recession, how much of an
increase in autonomous spending is needed to
increase total output and income to the level of
full-employment output?
 The multiplier answer these questions by telling us
how much total output or income increases when
there is a one shilling increase in autonomous
spending (Investment, government spending and
export).
 For example, an increase or decrease in autonomous
spending (the intercept) would shift the aggregate
expenditure line up or down, which would lead to an
increase or decrease in national income.
THE CONCEPT OF MULTIPLIER …
 If the economy is in a recession so that national
income is less than it would be at full
employment ,all we have to do is increase
autonomous government spending to shift the
aggregate expenditure line up.
 But we have to do more than that. We have to be
able to say by how much.
MULTIPLIER IN A TWO SECTOR-
MODEL
 Introduction
 In order to understand the concept of multiplier in a
two model sector, we first need to identify the
autonomous spending.
 In two sector model, the autonomous spending is
investment. Investment is an independent variable;
i.e not influenced by the level of income.
 On the other hand, consumption is influenced by the
level of income.
 Therefore the change in the equilibrium level of
national income is caused by the change in
investment rather than consumption.
MODEL ….
 What needed is to investigate the relationship
between ΔY and ΔI.
 The national income in a two sector model is
expressed as:
Y = 1 (a +I)………………(i)
1-b
 When national income changes as a result of the
change in investment, then the national income
equilibrium will be expressed as:
Y+ ΔY = 1 (a +I+ ΔI)………………(ii)
1-b
MODEL ….
 Subtracting equation (i) from equation (ii) we get:
Y+ ΔY - Y =1 (a +I+ ΔI) - 1 (a +I)
1-b (1-b)
ΔY = 1 ΔI
1-b
ΔY = I
ΔI 1-b
 b= MPC
 1 = multiplier m
1-b
MODEL ….
 The value of multiplier can also be found through
the MPS.
 Note that:
 b= MPC
 1-b=MPS which is same as 1-MPC =MPS
 Therefore m = 1 = 1
1-MPC MPS
Example:
if MPC=0.75, and MPs = 0.25 what is the value of m?
m= 1 = 1 =4
1-0.75 0.25

MODEL ….
In a two model a term multiplier can thus be defined
as a ratio of change in income due to change in
investment.
 Since ΔY is a result of ΔI, the multiplier is also
known as investment multiplier. The larger the
marginal propensity to consume, b, the larger the
multiplier as we can seen from the table.
 MPC Investment Multiplier m [1/(1-MPC)]
0.5 2.0
0.6 2.5
0.7 3.3
0.8 5.0
0.9 10.0
MULTIPLIER IN A THREE SECTOR-
MODEL
 When dealing with three sector- model we analyse
the impact of a government spending and taxes on
national income.
 This is done by identifying government multiplier
and tax multiplier.
 The impact of change in government spending on
national income is similar to the impact of change in
autonomous investment on national income.
 National income equilibrium in three sector- model
is given as:
 Y= 1 (a – bT + I + G) ………………(i)
1-b
MODEL ….
 When government spending increases, then national income
will also increase and expressed as:
 Y+ ΔY = 1 (a – bT + I + G+ ΔG)…..(ii)
1-b
By subtracting equation (i) from equation (ii) we get:
 Y+ ΔY-Y = 1 (a – bT + I + G+ ΔG)- 1 (a – bT + I + G)
1-b 1-b
ΔY= 1 ΔG
1-b
Gm=ΔY = 1
ΔG 1-b
Note that, the value of government multiplier is the same as
investment multiplier.
 MODEL ….
Assume that the government increases spending by 100
shillings. That spending is income to someone
 If the MPC is 0.8, whoever gets the 100 shillings,
spends 80 shillings of that income (0.8 x 100 shs = 80
shs).
 That 80 shillings spending is income to someone else.
That person then spends 64shs of that 80 shs income
(0.8 x 80shs = 64shs).
 That 64shs is income to someone, and so on. National
income will increase by the original 100shs plus the
subsequent spending of 80shs and then 64shs and
then…..
 The cumulative increase in national income according
to the multiplier is 500shs.
 Tax multiplier
MODEL ….
 To find out the impact of taxes on national income,
we apply the same process as used in government
spending and investment. The equilibrium level of
national income is determined at:
 Y= 1 (a – bT + I + G) ………………(i)
1-b
 Increase in the level of taxes (income tax and lump
sum tax) will lead to change in national income as
expressed below:
 Y+ΔY= 1 (a – bT - bΔ T+ I + G)…..(ii)
1-b

MODEL ….
By subtracting equation (i) from equation (ii) we get the
following equation:
 Y+ΔY-Y = 1 (a – bT - bΔ T+ I + G)-1 (a – bT + I + G)
1-b 1-b
 ΔY= 1 (- bΔT) = - bΔT
1-b 1-b
 Tm= ΔY= - b
Δ T 1-b
 The tax multiplier Tm is negative means that increase in tax
have a negative impact on the national income.
 If compared with government multiplier ,Tax multiplier,
therefore is smaller than government multiplier
MULTIPLIER IN A FOUR SECTOR-
MODEL
 Foreign Trade with income tax function
 This more complex where it includes the impact of
income tax.
 The foreign trade multiplier is given as:
 ΔY = 1
 ΔX 1-b(1-t)+g
THE IMPORTANCE OF THE MULTIPLIER
THEORY
1. It is an important tool in analysing the process and
the forces of economic fluctuations. For example, if
the economy is in a recession the government could
increase autonomous spending, increase transfer
payments, reduce lump sum taxes, or reduce the
income tax rate.
2. The multiplier has been used as an argument for
government spending or taxation relief to stimulate
aggregate demand.
3. It is important in analysing the impact of public
expenditure, taxation and foreign trade on the
economy.
LIMITATIONS OF THE MULTIPLIER
1. It is assumed that if the MPC is low, then multiplier
will also be low. However in most developing
countries MPC is higher while multiplier is low as
compared to developed countries.
2. For multiplier to work, it assumed that those who
earn income through multiplier process will
continue to spend a certain percentage of their
income on consumption. However this is not
always the case where by people may decide to
spend their income on: payment of debts, purchase
imported goods, invest in financial assets etc.
LIMITATIONS OF THE MULTIPLIER.
3. It is also assumed that goods and services are
available in adequate supply. If there is scarcity, the
actual consumption expenditure will be reduced
whatever the rate of MPC.
4. Under the full employment condition the theory of
multiplier will not work, additional goods and
services can not be produced or additional real
income can not be generated.
QUESTION 1
 Suppose that we have the following income-expenditure
model of the economy; Y = C + I + G+NX; Where
 C = C0+ 0.8(Y - T) (consumption function)
 T = 0.25 Y (Lump sum tax)
 NX = X - M (net exports)
 M = 0.2 Y (imports)
 And suppose that I, G and X are exogenous variables:
determined externally, outside this model.
a) Solve, algebraically, for Y
b) What is the value of a multiplier? What does it
connote/imply/suggest?
C= C0+ bYd; Yd= (Y-T)
C= C0+0.8(Y - T) (Cons. Function)
T = 0.25 Y (Lump sum tax)
NX = X - M (net exports)
SOLUTION M = 0.2 Y (imports)
a) Solve for Y
 Y = C + I + G+NX
 Y= C0+ 0.8(Y – 0.25Y) + I+ G+X –M
 Y=C0+0.8Y-0.2Y+I+G+X-0.2Y
 Y=C0+0.4Y+I+G+X
 (Y-0.4Y)=C0+I+G+X
 Y(1-0.4)=C0+I+G+X
 Y= C0+I+G+X
 (1-0.4)
 Y= 1 x (C0+I+G+X)
 0.6
SOLUTION…….
b) The multiplier in this model is (1/0.6)=1.67,
 This means that when any of the autonomous
variables (G, I or X) increases by 1 unit, National
Income increases by 1.67 units
QUESTION 2
 Consider a simple macro economy with no foreign trade so
total expenditure = C + I + G). If the consumption function
can be described by the equation C = 100 + 0.8(Y-T), where
Y is income and T is the amount of tax payments the
government collects form consumers.
 Fill in the following table when the government taxes (T)
total $ 100 million (taxes are assumed to be autonomous
“lump sum” taxes), government spending (G) is equal to $
130 million and autonomous investment (I) is $ 170 million
QUESTION 2 ….
Table 1.
GDP=National Income DI C I G Total Expenditure
800 170 130
1200 170 130
1600 170 130
2000 170 130
2400 170 130
DI= Disposable Income

QUESTION 2 ….
a) Given the information above, the marginal propensity to
consume for this economy is?
b) The equilibrium level of GDP for this economy is?
c) The multiplier for Government spending (G) is?
d) The multiplier for autonomous taxes (T) is?
SOLUTION
GDP=National DI C I G Total
Income Expenditure (TE)
800 700 660 170 130 960
1200 1100 980 170 130 1180
1600 1500 1300 170 130 1600
2000 1900 1620 170 130 1920
2400 2300 1940 170 130 2240
DI= Income –tax
Y =800; C= 100+ 0.8 (800-100); C=660
Y=800; DI= 800-100=700
Y= 1200; C=100+0.8(1200-100); C=980
Y=1200; DI =1200-100=1100
Y=1600; C=100+0.8(1600-100); C=1300
Y=1600; DI= 1600-100=1500
Y=2000; C=100+0.8(2000-100); C=1620
Y=2000; DI=2000-200=1900
Y=2400; C=100+0.8(2400-100); C=1940
Y=2400; DI=2400-100=2300
SOLUTION …..
a) MPC can be obtained by dividing changes in values of consumption
(ΔC) with changes in the value of income (ΔY)
i.e = ΔC = 320 = 0.8
ΔY 400
 Alternatively, the marginal propensity to consume can be obtained by
differentiating the consumption function with respect to income (Y).
C=100+0.8(Y-T); C= 100+0.8Y-0.8T
dc = 0.8
dy
b) The equilibrium level of GDP for this economy is determined at a point
where TE=National Income (Y). In our case; this is found when
TE (1600) = 1300+170+130 (Y)
c) The multiplier for government spending = ΔY = 1 = 1 = 5
ΔG 1-b 0.2
d) The multiplier for autonomous taxes (T) = - ΔY = -b = 0.8 = -4
ΔT 1- b 0.2
BUSINESS CYCLE AND
ECONOMIC GROWTH
TOPIC 2
Content
 Definition of business cycle
 Phases of business cycles and consequences
 Causes of Business Cycle Fluctuations
 The concept of Economic Growth
 Sources and measurement of Economic growth
 Policies to boost Economic Growth
 Costs of Economic Growth
The Concept of Business Cycle
 The term business cycle (or economic cycle) refers to
the fluctuations in production or economic activity over
several months or years.
 These fluctuations occur around a long-term growth
trend, and typically involve shifts over time between
periods of relatively rapid economic growth (expansion
or boom), and periods of relative stagnation or decline
(contraction or recession).
 Despite being termed cycles, these fluctuations in
economic activity do not follow a mechanical or
predictable periodic pattern.
 It should be noted that a business cycle is a short term picture
of the behavior of real output in a private enterprise economy.
 Industrialized economies having free market mechanism have
economic growth over the long period.
 But the process of economic growth is often shaken by
business cycles, which show up-turn and downturn of income,
output and employment.
Phases of Business Cycle
 A business cycle can be shown to be a wave-like path of the
economy’s real output.
 Economists often describe a business cycle with the help of
distinct phases or stages.
 The four phases of a business cycle are:
1. Trough/ Depression
 This is the most critical and fearful stage of a trade cycle.
 It is a state of affairs in which real income consumed or volume of
production per head and the rate of employment are falling
 There are idle resources and unused capacity, especially unused labour.
 The is a decline in general output and employment.
 Prices and wages continue to decline.
 This is really a painful experience for both the producers and workers.
2. Recovery
 This is when output and employment are expanding toward
full‑employment level.
 A recovery occurs when real national output picks up from the trough
 The pace of recovery depends in part on how quickly aggregate
demand starts to rise after the economic downturn.
 Wages and other incomes show a noticeable rise.
 Profits also start rising, which spurs the producers to establish fresh
investments.
 This a right time for government to pursue stabilization policies and
show special initiatives of encouraging more investments
3. A peak/boom/Prosperity
4. This is when business activity reaches a temporary maximum
 During the recovery phase, rise in output and incomes of the
people induce substantial increase in aggregate spending.
 This has a multiplier effect. This cumulative process of rising
investment and employment continue ahead.
 As investors become more confident, expanding productive
activity takes the economy to a boom or prosperity phase.
 Industrial and commercial activity shows remarkable expansion.
 Construction activity gets a big boost.
 When this happens we might see the number of people being employed
rising and the number of people unemployed falling.
 Financial institutions tend to expand credit as the interest rates and
discount rates go up.
 Thus, everyone seems to be happy during the state of prosperity, which
ultimately, of course, proves to be short-lived.
4. Recession
 The end to boom/prosperity phase comes because of certain
tendencies prevailed during the boom conditions. These
are:
 As prices rise, wages tend to lag behind. As a result, purchasing
power of workers, tends to lag behind the supply of consumer goods.
 Expansion of production may be hampered by shortages of some
inputs and bottlenecks in production.
 The non-availability of credit beyond a particular rate of expansion
might also act as a serious break on prosperity.
 Financial institutions including banks cannot expand credit beyond a
limit put by their reserve requirements.
 As these limits reached, economic activity will start slowing down
as a result economic growth also slows down.
 If a decline in total output, income, employment, and trade is lasting
six months or more, then it known as recession.
 Phases of Business Cycle
Actual Growth
Boom Average Growth
Boom Recovery
Boom Recession
Recession Recovery
Recovery
Recession Trough
Trough
Trough
Causes of Business Cycle Fluctuations
 There are various theories explaining the causes:
1. Random shocks - events often occur that are
relatively unpredictable, but have a significant
effect on the economy.
— Recent example include the failure of financial
markets in USA and Europe.
2. Policy-induced - politicians have often been
known to put in place policies to boost the
economy.
— This situation may occur around election time which
can lead to booms forcing the incoming government to
slow the economy down again.
3. Imported cycles - if the rest of the world is growing in cycles,
then this will affect our country.
— Our exports may fluctuate, which means that aggregate demand
will change and therefore growth changes.
4. Expectations - expectations can have a powerful effect on
growth.
— For example if firms expect slowdown in economic growth, they may
delay investment plans.
— If they do that then aggregate demand will fall. If aggregate demand falls,
so does economic growth.
5. Sunspot activity (illegal activity)
‒ There have also been suggestions that growth cycles are linked to cyclical
sunspot activity.
6. Change in innovations
‒ Major innovations may trigger new investment and/or consumption
spending.
Economic Growth
 Economic growth is defined as an increase in an economy's
ability to produce goods and services.
 Over a period of time, there are changes in the level of
economic activity in an economy.
 In some years economic growth might be quite slow and in
other years growth rates tend to be stronger.
 There is a tendency for patterns of economic growth to occur.
 Governments would like as much economic growth as
possible, but the trouble is that too much growth causes other
problems.
 So the aim of the government is to create as much economic
growth as possible without inflation and balance of payments
problems.
Measurement of Economic Growth
1. Real GDP Growth
 Economic growth is a growth in the level of national income.
 All governments want to generate growth.
 Economic growth means higher incomes, and higher incomes mean
higher living standards.
 Governments would like as much growth as possible, but the trouble is
that too much growth causes other problems.
 So most of the governments would aim at creating as much growth as
possible without inflation and balance of payments problems.
 Economic growth is therefore measured as the percentage change in
GDP.
 This means the change in GDP after inflation has been taken into
account.
2. Real GDP per capita
 In recent years many economists have preferred the use real
GDP per capita rather than real GDP.
 This definition is superior if comparison of living standards
is desired.
 For example, in 2010 China’s GDP was $744 billion
compared to Denmark’s $155 billion, but per capita GDP’s
were $620 and $29,890 respectively.
Sources of Economic Growth - Where does it
come from?
1. Natural resources - if an economy has a plentiful
supply of natural resources it may help it to expand.
However, natural resources on their own are not
enough. There also have to be the skilled people to
exploit the opportunities.
2. Capital - more capital generally means more
production, and more production means more
growth.
 To get capital, countries have to invest and so the level of
investment may be a big determinant of future growth.
3. Rate of savings - to have more tomorrow you often
have to have less today. This is true with savings as
well. To provide funds for investment there needs to be
a good level of savings. This should in turn mean more
growth in the future.
4. Technological progress - this is perhaps the most widely
accepted (and easiest to understand) source of
economic growth.
 This is because technology makes it possible to produce
more from the same quantity of resources (or factors of
production). This boosts the potential level of output of
the economy. The pace of technological change will
depend on:
— the scientific skills of the country
— the quality of education
— the amount of GDP devoted to research and development (R&D)
Policies to boost Economic Growth
 High economic growth makes the people in the country
better off, and if they are better off they are hopefully
happier.
 Governments don't want to let growth get out of hand
because that will cause other problems, so they aim for
steady long-term growth.
 Because of this, many policies will be aimed at
attempting to generate a high, steady rate of economic
growth.
 To achieve this what policies can the government use?
 The policies to boost growth split into two types:
1. Demand-side policies
2. Supply-side policies
 Demand-side policies
 To boost the level of aggregate demand and therefore growth,
the government needs to use reflationary policies.
 These are policies that help to generate more demand. They
include:
 Cutting tax rates to boost people's disposable income
 Increasing the level of government expenditure
 Cutting interest rates to encourage more borrowing and
spending
 Supply-side policies
 These are policies that aim to boost the potential for the
economy to grow - in other words to supply more.
 They are policies that should make the economy more
productive and more responsive to change.
 Examples include:
 Cutting tax rates (tax on inputs) - this gives investors the
incentive to produce more
 Promoting education and training - this should make the
workforce more skilled and therefore more productive.
 Promoting research and development (R & D) - spending on
R & D will help find new more efficient ways to produce
and should lead to better and more varied products.
Costs of Economic Growth - Who pays?
1. Inequality of income - growth rarely delivers its benefits evenly .
— It often rewards the strong, but gives little to the economically weak.
This will widen the income distribution in the economy.
2. Pollution (and other negative externalities)
‒ The drive for increased output tends to put more and more pressure on the
environment and the result will often be increased pollution.
— This may be water or air pollution, but growth also creates
significantly increased noise pollution. Traffic growth and increased
congestion are prime examples of this.
3. Loss of non-renewable resources
‒ The more we want to produce, the more resources we need to do that.
The faster we use these resources, the less time they will last.
4. Loss of land - increased output puts further pressure on the
available land. This may gradually erode the available land
in the countryside.
5. Lifestyle changes - the push for growth has in many areas
put a great deal of pressure on individuals. This may have
costs in terms of family and community life.
SEMINAR QUESTIONS
1. What is the relationship between economic growth and
business cycle?
2. The economy doesn't grow regularly; it tends to grow in
cycles, usually called trade cycles. Give out the reasons why
this happens.
3. Discuss on different conditions that are necessary for the
economy to grow successfully
4. Explain the costs that may result from high economic
growth.
5. Economic growth can be caused by changes in the level of
aggregate demand. Discuss
PUBLIC FINANCE
LECTURE 3
Introduction
 The proper role of government provides a starting point for
the analysis of public finance.
 In theory, under certain circumstances private markets will
allocate goods and services among individuals efficiently
 If private markets were able to provide efficient outcomes
and if the distribution of income were socially acceptable,
then there would be little or no scope for government.
 In many cases, however, conditions for private market
efficiency are violated, this is where the issue of
government intervention comes in.
 That is, the provision of public goods and the process of
rising money to finance those public goods.
What is Public Finance?
 Is the field of economics that deals with budgeting the
revenues and expenditures of a public sector entity,
usually government.
 The field is often divided into questions of:
1) What type of activities should the government do? and
2) How is the government going to pay for those activities?
Sources of Government Revenue
 Taxation is the dominant source.
 In addition there are other important sources of
government revenue such as:
– User charges/benefit taxes
– Administrative fees
– Borrowing/Government debt (foreign or locally
denominated)
– Printing of money (Government-induced inflation)
Taxation
 Taxes are transfers of resources from persons or economic
units to government and are compulsory (or legally
enforceable).
 A tax may be defined as a pecuniary (monetary) burden laid
upon individuals to support the government
 A tax is not a voluntary payment or donation, but an
enforced contribution, where by the government is legally
granted the power to tax.
Aims of Taxation
 To raise money to pay for government spending.
 To discourage people from buying harmful goods
such as cigarettes, strong alcohol.
 To influence the level of total demand in the economy.
 To redistribute income from the rich to the poor.
Canons/Principles of Taxation
 The 'Canons of taxation' were first developed by Adam
Smith as a set of criteria to judge taxes.
 They are still widely accepted as providing a good basis
by which to judge taxes.
 Smith's four canons were:
1. The cost of collection must be low relative to the yield.

‒ A tax should be economical with the cost of
collection representing only a small part of the
revenue raised.
Canons/Principles of Taxation….
2. The timing and amount to be paid must be certain to the
payer
— Everyone knows the amount, method and time of tax
payment
3. The means and timing of payment must be convenient to
the payer.
— A tax should be convenient so that tax collection is at a
time and in a form suitable to the payer.
4. Taxes should be levied according to ability to pay.
— A tax should be equitable (fair) so that wealthy people
pay more than poor people
Canons/Principles of Taxation….
 Modern economists have added three more canons to
these to update and extend them:
1. A tax should not hinder efficiency
— A tax should not act as a disincentive and stop people
from working.
2. A tax should be compatible with foreign tax systems
3. A tax should be flexible so that the government can use
tax changes to help control the level of demand in the
economy.
Types of Taxes
 The level and pattern of taxation is important because it
affects both efficiency (economic performance) and
equity (the distribution of income)
 There are various types of taxes, broadly divided into:
1. Direct and
2. Indirect taxes
 Direct taxes are paid straight to the Revenue Authority.
- They are therefore taxes on income.
 Indirect taxes are first collected by the seller and then
passes on to customers.
- These taxes are therefore taxes on expenditure.
Criteria for Evaluating Taxes
 There are “four” main criteria used by most
economists to evaluate forms of taxation:
 These criteria are such as:
1. Equity
2. Efficiency
3. Administration and Compliance Costs
4. Visibility
Criteria for Evaluating Taxes ….
1. Equity
 Equity does not refer to equal amounts paid by
citizens.
 Equity can be interpreted based on the following
principles:
i. “Benefit” Principle – tax burden should be
distributed in relation to the benefit that an
individual receives from public services.
— Benefit Principle – can be applied to the financing of
public sector activities where there is a clear link
between activity and benefit received.
Criteria for Evaluating Taxes…..
ii. “Ability-to-Pay” Principle
— Tax burden should be distributed in relation to an
individual’s ability to pay that tax.
— The difficulty in this approach is in defining what
constitutes “ability to pay”.
— Income is the most used measure, but lifetime
consumption and wealth are also regarded by some
economists as appropriate.
2. Efficiency
 Efficiency – usually focuses on the administration or
compliance costs of taxation.
 Therefore, a simple tax, with low collection costs, is
efficient.
 Efficiency – is also concerned with measuring the
effect the tax has on market behavior.
 Taxes have efficiency costs when they cause firms and
individuals to change their behavior in production,
consumption, savings, work, or investment decisions.
 Although a tax may be effective in raising a lot of
money for government, it may carry with it a
distortionary side-effect impact that makes the tax
inefficient.
 Distortionary Taxation – taxes that change the patterns
of consumption, savings, and production within a
market, thus generate a less “efficient” allocation of
resources.
Criteria for Evaluating Taxes cont…..
3) Compliance & Administration Costs
 Compliance & Administration Costs – these are cost
that are imposed on the private sector in complying
with the tax system and the costs incurred by the public
sector in administering the tax system.
Criteria for Evaluating Taxes cont…..
4) Visibility
 The fourth common criteria used by economists for
evaluating the use and usefulness of a tax is
“visibility.
 It is generally agreed that visible taxes are preferable
so consumers know how much they pay in taxes in
order to make informed choices about the level of
public sector spending they are prepared to support.
Tax Burden- Who pays what?
 Some taxes are fairer than others.
 A tax can be:
1. Progressive
2. Regressive
3. Proportional
 Progressive tax - a tax that represents a greater
proportion of a person's income as their income rises.
— In other words, the average rate of taxation rise as
their income rises.
— Income tax in an example of progressive taxation.
Tax Burden- Who pays what?......
 Regressive tax - a tax that represents a smaller
proportion of a person's income as their income rises.
— In other words, the average rate of taxation falls.
 Proportional tax - a tax where the percentage of

income paid in taxation always stays the same.
— In other words, the average rate of taxation is
constant.
Tax as a policy tool
Demand-Side or Supply-Side?
 A government may choose to vary the level of tax to try to
influence the level of aggregate demand and therefore
economic growth.
 This would be using tax as a demand-side policy.
 In contrast the government may use tax as a supply side
tool.
 The government may set a tax rate as low as possible to
create incentives for people to work harder.
 Low tax should also encourage entrepreneurs as they will
not lose much of the profit in taxation.
Tax as a policy tool……..
 In practice, many governments will use taxation in a
combination of these two ways and will formulate their
policy to fit the prevailing conditions.
 However, whenever there is a change in tax then there will
be demand-side and supply-side effects.
 To cut taxes for supply-side reasons only may mean also
cutting government expenditure by the same amount.
 In this way, you increase demand through the tax cut, but
then reduce demand from the government expenditure cut.
Impact of different taxes
 The balance of different tax systems (progressive,
regressive and proportional) can have a significant
effect on income distribution in an economy.
 One of the canons of taxation said that a tax should be
linked to 'ability to pay'.
 Income tax clearly ties in with this because, the higher
a person's taxable income, the greater the rate they pay.
 This means that income tax is progressive.
 In other words, the more people earn, the greater the
proportion of their income they pay in tax.
Impact of different taxes…..
 Another impact of taxation can be drawn from regressive
taxation such as VAT
 With VAT the amount of VAT on a particular good is the
same for everyone, regardless of how much income they
earn.
 In other words, the more people earn the less the
proportion of their income they pay in tax.
Impact of different taxes…..
 If a government chooses to switch the balance of
taxation from progressive to regressive taxes then the
less well-off in society will be harder hit.
 This is due to the fact that, with regressive tax system,
the more people earn, the less the tax represents as a
proportion of their income.
 In other words, regressive taxes will hit less well-off
people harder than the better-off.
Impact of different taxes …….
 Other impacts
1. It reduces the level of disposable income,
2. It affects prices,
3. It reduces the ability to save and may affect effort
and enterprise.
Other sources of Government Revenue
1) User Charges
 Governments often run enterprises, selling private
goods and services, to raise revenues.
 This method is used to reduce reliance on taxes.
 Other charges are prices charged for the delivery of
certain public goods and services e.g. toll roads;
public university education etc.
Other sources of Government Revenue...
2) Administrative Fees
 This is similar to user charges but differ in the
sense that the service/benefit is defined broadly
and imprecisely e.g. business licenses; TV
licenses; car licenses, parking & traffics fines.
3) Government Borrowing
 The government can borrow funds from domestic savers
and using the funds to purchase goods and services and to
make income transfers.
 Similarly the government can also borrow from outside
donors through either bilateral or multilateral agreements.
 Bilateral loans are usually between two countries e.g. if
Sweden gives loans to Tanzania.
 On the other hand, the multilateral loans usually come
from International organizations such as IMF and World
Bank.
 These loans can go directly to the organizations, projects
or local government and not necessary to the central
government.
 Borrowing also brings with it the obligation to make
interest payments with the principal to be repaid at some
future date.
4) Printing of money
 Public expenditure is financed in such a way that
it is done through an “inflation means” eg.
Printing of money.
 This method is only relied upon during national
emergencies, such wars, as it carries with it the
associated risk of “inflation”.
Public Spending/Expenditure
 Public expenditure is spending by central government,
local government, and state owned industries.
 Economists classify government expenditures into three
main types.
1) Government purchases of goods and services for
current use known as government consumption.
2) Government purchases of goods and services intended
to create future benefits-such as infrastructure
investment or research spending are classed as
government investment.
Public Spending/Expenditure…..
3)Government expenditures that are not purchases of
goods and services, and instead just represent transfers
of money such as social security payments are called
transfer payments
 Aims of Government Spending
— To provide public goods and services.
— To encourage the consumption of merit goods.
— Distribution of income
— To influence the level of total demand in the economy.
Aims of Government Spending
1) To provide Public goods and services
 Public goods are goods that would not be provided in a
free market system, because firms would not be able to
adequately charge for them.
 This situation arises because public goods have two
particular characteristics.
i. Non-excludable - once the goods are provided, it is not
possible to exclude people from using them even if
they haven't paid. This allows 'free-riders' to consume
the good without paying.
Aims of Government Spending…….
ii. Non-rival - this means that consumption of the goods
by one person does not diminish the amount
available for the next person. Example - street lights
— If a street light is provided by a firm, then it cannot
exclude people from benefiting from it.
— It is not possible to charge people who walk under it.
When people walk under it, it is also true that they
don't make it go dimmer - they don't diminish the
amount available for the next user.
2) To encourage the consumption of merit goods
 Merit goods are goods that would be provided in a free
market system, but would almost certainly be under-
provided.
 Take the case of education. If there were no state
education provided at all, there would still be private
schools for those who could afford them, and indeed
many new private schools might open.
 However, there would not be nearly enough education
provided for everyone to benefit.
 This happens because the market only takes account of
the private costs and benefits.
 It does not take account of the external benefits that may
arise to society from everyone being educated.
 For this reason, merit goods will be under-provided by
the market.
Aims of Government Spending …
3) Distribution of Income
 Some forms of government expenditure are specifically
intended to transfer income from some groups to others.
 For example, governments sometimes transfer income to
people that have suffered a loss due to natural disaster.
 Likewise, public pension programs transfer wealth from
the young to the old.
 Other forms of government expenditure which represent
purchases of goods and services also have the effect of
changing the income distribution.
Aims of Government Spending …
 For example Public education transfers wealth to families
with children in these schools.
 Public road construction transfers wealth from people that
do not use the roads to those people that do (and to those
that build the roads).
Fiscal Policy
 Is the use of government expenditure and taxation to
manage the economy.
 The main changes in fiscal policy happen once a year in
the budget.
 It is in the budget that the government sets the levels of
taxation and government expenditure for the next fiscal
year.
 Fiscal policy can be used in various different ways.
1) It may be used to try to boost the level of economic
activity when the economy is not performing well.
— In this case it is called reflationary policy.
Fiscal Policy…..
2) Alternatively the economy may be performing above the
full employment level and in need of slowing down.
— In this case deflationary policy is called for.
3) The final use for fiscal policy is as a tool of supply-side

policy.
Fiscal Policy in regulating a national
economy
1) Reflationary Fiscal Policy
 Governments may choose to use Reflationary fiscal policy
in times of recession or a general downturn in economic
activity.
 This can be done by lowering taxes in some forms or by
increasing the level of government expenditure.
 This will encourage people to spend more.
 If indirect taxes is reduced then this will lower the prices
of the taxed goods and encourage more demand.
economy….
 Alternatively direct taxes can be reduced.
 This will raise people's disposable income (their take-
home pay) and therefore encourage them to spend more.
 Either way the level of demand in the economy should
rise and help encourage economic growth.
 Reflationary fiscal policies could therefore include:
— Cutting higher rates of tax
— Increasing the level of personal allowances
— Increasing the level of government expenditure
economy ………
2) Deflationary Fiscal Policy
 Deflationary fiscal policy is likely to be most appropriate
in times of economic boom.
 If the economy is growing above its capacity this is likely
to cause inflation and balance of payments problems.
 To try to slow the economy down the government could
either raise taxes in some form or perhaps reduce
government expenditure.
 Either of these will reduce the level of demand in the
economy and therefore the level of economic growth.
economy ………
 The government may increase indirect taxes which will
raise prices and deter people from spending so much, or it
may increase direct taxes, which will leave people with less
money in their pockets and so stop them from spending so
much
 Deflationary fiscal policies could therefore include:
— Increasing the higher rates of tax
— Reducing the level of personal allowances
— Reducing the level of government expenditure
economy ………
3) Fiscal Policy - Fiscal Policy as a Supply-side Tool
 Supply-side policies are policies that aim to increase the
capacity of the economy to produce.
 This can be done changing the level of taxes.
 Income tax will always have an effect on people's
incentives to work.
 This will be true at most income levels.
 If income tax is too high, people may choose not to
work but to remain on benefits instead.
economy………
 Alternatively, if income tax is too high, people may choose
not to work so hard and take risks.
 Ultimately they may even choose to leave the country if
taxes elsewhere are much lower.
 Supply-side fiscal policies could therefore include:
— Cutting the lower and basic rates of tax to open up the
gap between earnings in and out of work and ensure
people have an incentive to work
— Increasing the level of personal allowances for the same
reason
— Reducing the top rate of tax to encourage enterprise,
risk-taking and the incentive to work hard
Impact of Fiscal policy in the economy
 The aim of the fiscal policy is to run the economy in the
most stable way possible, and to achieve a high level of
economic growth.
 High economic growth creates higher levels of income
and therefore higher living standards for the people in
the economy.
 This makes running the economy sound very simple,
but, in practice, achieving high economic growth
through fiscal policy is fraught with problems.
- This is because the government also has to be aware
of all the other economic targets.
Impact of Fiscal policy in the economy ….
 The four main economic targets are:
1) A high level of economic growth (growth in GDP)
2) A low level of unemployment
3) A low level of inflation
4) External balance (balance between exports and
imports)
 The main problem is that achieving one of these targets
often means missing one of the others, as they often
move in opposite directions.
 For example to help the economy grow, the government
will need to maintain the level of demand in the
economy.
 This can be done by using Reflationary fiscal policy.
 To do this the government needs to encourage spending
by either cut taxes, increase personal allowances or
increase the level of government expenditure.
 However, if demand rises too much, it may cause
inflation.
 Firms may not be able to increase production quickly
enough and prices may rise instead of output.
Seminar Questions
1) In your own words explain how government revenue is
made up.
2) Government makes two basic types of expenditures -
purchases of goods and services and transfer payments.
Give the purpose and several examples of each.
3) List and briefly describe the four sources of funds for
government.
4) Briefly describe the two principles of taxation. Which of
these is the rationale for the income tax?
5) Taxes can be progressive, regressive or proportional.
Explain and give an example of each.
Seminar Questions
6) The question of how societies resources are
distributed affects the level of social welfare.
Unequal distribution of income can be seen as market
failure. How can the government use the fiscal policy
to reduce the gap between the rich and poor?
7) Discuss the two criteria which economists use to
evaluate tax structures. Provide a critical assessment
of the usefulness of these principles.
MONEY AND BANKING
LECTURE 4
CONTENT
 Introduction-The Concept of Money
 Evolution and Functions of Money
 Money demand (including Theories)
 Money supply (including Theories)
 Financial Institutions
 Money creation process
 Monetary Policy
INTRODUCTION
 Money is defined as anything which is generally acceptable as
a means of exchange
 Money is important in any modern economy, however is a
complex phenomenon
 WHY?
 There is no single theory that is accepted by all economists
concerning
 What money is,
 Why people hold it,
 Moreover the complicity of the study of money is due to the fact
that, the study of money involves also a study of large number of
other variables such as interest rate, inflation etc.
 Hence, the study of money and banking help to give some
lights on different issues concerning money.
EVOLUTION OF MONEY
 Barter System
 The earliest method of exchange was barter in which goods
were exchanged directly for other goods.
 In barter, there has to be what is known as a ‘double
coincidence of wants’.
 If I grow maize but want to consume rice, I will need to find
someone willing to trade rice but he/she must also willing to
have maize.
 Problems arose when either someone did not want what was
being offered in exchange for the other good, or if no
agreement could be reached over how much one good was
worth in terms of the other.
 Due to the weaknesses of barter trade, the following four
stages evolved indicating the different phases of the
development of money:
(i) commodity money, (ii) token money, (iii) paper money
and (iv) bank money.
1. Commodity Money
 Various commodities have worked as money such as,
cattle, sheep, ox, goat, cow, feathers of rare birds, sea-
shells, rocks, cigarettes, precious metals etc.
 However there had been a tendency for certain
commodities to be much more successful than others.
 The following qualities favoured some commodities as
the medium of exchange:
1. There were limited in supply
2. There were durable
3. There had sufficiently high value
 The above qualities were possessed by the precious
metals and therefore, gold and silver have played
significant roles as medium of exchange throughout the
world.
 Within this stage, it is possible to distinguish two sub-
stages in the development of commodity money.
 The first sub-stage is where there was no distinction
between the gold used as money and that used as
ornaments.
 The next sub-stage is when there was some recognisable
design or symbol imposed upon the pieces of the gold.
2. Token Money
 The evolution of token money begins with goldsmiths,
whose trade was based in coins and gold bars.
 These goldsmiths started to pay interests for deposits of
gold and silver coins.
 Depositors realised that apart from receiving interest,
they obtained valued services from goldsmiths in terms
of safe deposit of their gold coins.
 Since the goldsmiths issued receipts of deposits, a
practice soon developed of making payments by handing
over the goldsmiths’ receipts (token) , instead of going to
the goldsmiths to withdraw gold in order to make
payment.
 As this practice developed, the goldsmiths realised it was
unnecessary to continue operating as a safe deposit.
 The more their receipts circulated among depositors, the
more they were able to lend out part of gold and silver
which had been deposited with them.
 The receipts of goldsmiths were ‘running current’, that is
they had become a medium of exchange.
 The profitability of goldsmiths’ activities attracted others
in the business.
 Small independent banks started issuing their own notes
which became part of the circulating medium of
exchange.
 The deposits receipts were soon to be called bank notes
and they were token, that is, they were simply paper and
had no intrinsic value.
3. Paper Money
 The use of paper money had been made very popular by
the government and hence it was limited to the extent of
the boundaries of the state.
 Paper money was said to be convertible if it can be
exchanged for some other commodities such as gold at
the fixed rate.
 For instance if people want to buy gold or to pay for
goods and services imported from abroad then
institutions can issues paper money as a guarantee of
payment
4. Bank Money
 Later on it was discovered that, there were certain
disadvantages of the direct use of paper money.
1. Some other illegal agencies started printing paper
notes.
2. If these paper notes were lost, they could not be
recovered.
3. It was not also very safe to carry them from one place
to another.
 Therefore, it had been found very convenient to settle
accounts by credit instruments (e.g cheque).
 Of these, the most familiar to us is the cheque which is
not a paper money but as an order from the bank by a
person who has funds in the custody of the bank to pay a
stated sum to a third party whose name has been
indicated on it.
 This cheque is sometimes crossed (marked) with a view
to safeguard against its wrong payment.
 When it is crossed, the bank is obliged to pay money in
some one’s account; it cannot pay money in cash to any
person.
— From legal point of view, it becomes an evidence of
payment of money.
— The payment of any sum can be made through it.
— There is no danger of loss of money.
— If the cheque-book is lost, nothing is lost as such. It is
a much safer way of dealing in money.
FUNCTIONS OF MONEY
1) Medium of Exchange
 The most important function of money is its use as a
means of payment – money being used to pay for items
purchased or to settle any debts.
 Therefore money is used as an intermediary for trade, in
order to avoid the inefficiencies of a barter system, which
are sometimes referred to as the 'double coincidence of
wants'.
 A related role of money is that as a medium of exchange,
it acts as ‘an object which is taken in exchange, not on its
own account, not to be consumed by the receiver or to be
employed in technical production, but to be exchanged for
something else within a longer or shorter period of time.

FUNCTIONS OF MONEY…..
2) Unit of Account
 Money as a unit of account is a necessary prerequisite for
the formulation of commercial agreements (a standard
unit for quoting prices)
 A unit of account is a standard numerical unit of
measurement of the market value of goods, services, and
other transactions. Eg. prices of goods, services, and
assets are typically expressed in terms of money such as
shillings.
 Money is simply acting as a unit of measurement in the
same way that metres measure length and kilograms
measure weight.
 Money in this sense is being used to measure the value of
goods, services and assets relative to other goods, services
and assets.
3. Money as a Store of Value
 People may wish to hold money as an asset, that is as part
of their stock of wealth, in this sense, money serves as a
store of value
 Money is not unique as a store of value: any asset, such as
equities, bonds, real estate, antiques and works of art can
all act as stores of value.
 The only problem with these other assets as stores of value
is that they are not instantly saleable
 Money is the most liquid (spendable) of all assets and a
convenient way to store wealth.
 Money itself is sometimes a poor store of value. This will
occur when there is high rate of inflation.
 The three important functions of money can be summarised
as follow:
 MEDIUM OF EXCHANGE
(Most exclusive function)
 UNIT OF ACCOUNT
(Typical function, but not exclusive)
 STORE OF VALUE
(Least exclusive function, shared by many other commodities)
QUALITIES OF GOOD MONEY
 Thus, from these functions, it is clear that a good money will
have several qualities namely:
1. Acceptable to people as payment;
 The primary characteristic of money is that it is used as a means of
payment.
 Without money, payment of transactions would rely on barter.
 Barter is a situation where two agents exchange goods directly in a
transaction.
 The problem with barter system is that, both parties have to want
what the other party has.
 Thus we have what is called the "double coincidence of wants"
problem.
2. Scarce and in controlled supply
 The scarcity is the quality of good money material.
 Good money is always scarce.
 Money must be limited in supply as compared to demand for it.
 This quality induces the people to have more and more money
for meeting their basic necessities of life.
3. Stable and able to keep its value

 Money must have stable value because it serve as a standard
for measuring the value of other things.
 A change in its value brings change in the prices of goods
and services.
 The public confidence is developed if value of money is
stable.
 The money having ever-changing value is not liked by the
people.
5. Divisible without any loss of value
 The money is always divisible without losing its value.
 The small units of money are needed for making the smallest
payments.
6. Portable and not too heavy to carry

 Good money must be portable easily.
 It should have more value in small quantity.
 The passenger must feel easy while taking money with them.
7. Money should be durable

 The money must not lose its value with the passage of time.
 Metals are most durable as compared to other forms of money.
MONEY DEMAND
 What is Money Demand/ Demand for Money?
 The demand for money represents the desire of households
and businesses to hold assets in a form that can be easily
exchanged for goods and services.
 In deciding how much money to hold, people make a choice
about how to hold their wealth.
 How much wealth shall be held as money and how much as
other assets?
 The answer to this question will depend on the relative costs
and benefits of holding money versus other assets.
 Wealth can be held in three broad categories: real assets
(houses, cattle, vehicles machines etc), financial (bonds) and
money.
 When individuals wish to hold too much money, they are
holding too high proportion of total wealth in the form of
money.
 Depending on the costs and benefits associated with each

component, most of the individuals prefer to hold a given
mix of these components
 Therefore the demand for money is the relationship between
the quantity of money people want to hold and the factors
that determine that quantity.
 Nominal and Real Demand for Money
 Nominal Demand for Money: This is the demand for money
for a given number of specific currency units such as
shillings.
 Real Demand for Money: According to Keynes, money
demand is the demand for the REAL quantity of money (real
balances) or M/P.
 M= Money and P = Prices
 In other words, if prices double, you must hold twice the
amount of M to buy the same amount of stuff.
 So people will choose a certain amount of real balances
based on the interest rate, and income:
 M/P = f(i, Y)
 If income increases then real demand for money will also
increase.
 If interest rate increases, this will discourage demand for M/P
THEORIES OF DEMAND FOR MONEY
 Keynes Liquidity Preference Theory
 In 1936, economist John M. Keynes wrote a very famous and
influential book, The General Theory of Employment,
Interest Rates, and Money.
 In this book he developed his theory of money demand,
known at the liquidity preference theory.
 In his theory he provided three reasons why people will
demand money balances, or desire to hold a certain stock of
money as:
1. Transaction
2. Precautionary
3. Speculation
 Transactions Demand
 This is the demand for money for the purchase of goods
and services.
 Money is held because it provides the holder with a stream
of services.
 The kind of services provided by money stem from its
function as a medium of exchange and as a the most liquid
store of value.
 The transactions demand for money is positively related to
real incomes and inflation.
 As general prices increase in the shops, individuals will have
to hold more cash to carry out their everyday transactions.
 Similarly, when real income increases, individuals will hold
more money in order to buy more goods and services.
 Precautionary Balances - this is money held to cover
unexpected items of expenditure.
 People often demand money as a precaution against an
uncertain future.
 Unexpected expenses, such as medical or car repair bills,
often require immediate payment.
 The need to have money available in such situations is
referred to as the precautionary motive for demanding
money.
 As with the transactions demand for money, it is
positively correlated with real incomes and inflation.
 Speculative Balances –
 This type of money demand arises by considering the
opportunity cost of holding money.
 Note that holding money is just one of many ways to hold
value or wealth.
 Alternative opportunities include holding wealth in the form
of savings deposits, certificate of deposits, stock, bonds or
even real estate.
 The opportunity cost of holding money is the interest rate
that can be earned by lending or investing money.
 The speculative motive for demanding money arises in
situations where holding money is perceived to be less risky
than the alternative of lending the money or investing it in
some other assets.
c
 "Speculative" simply means anticipating that the value of
an asset will change and you can profit by it.
 Usually we think of speculating in terms of buying an
asset:
 If I expect that real estate is about to rise in value, I might
buy some in hope of selling after the price rises.
 But if I think that an asset's price is about to fall, I can
also speculate by holding cash, so that I can buy it after
the price falls.
 The total demand for money is obtained by summating
the transactions, precautionary and speculative demands.
 Many factors influence our total demand for money
balances.
 The three main factors are
 the level of prices
 the level of interest rates / profits from holding assets
 the level of real national output (real GDP)
1. The level of prices
 The higher the price level, the more money is required to
purchase a given quantity of goods and services.
 All other things unchanged, the higher the price level, the
greater the demand for money.
 If prices rise, then people will need to hold a higher level
of money balances to meet their payments transactions.
 If prices fall, people will need a lower volume of money
balances to support a given level of transactions.
2. The Level of Interest Rate
 The quantity of money people hold is likely to vary with
the interest rates they can earn from alternative assets
such as bonds/ stocks.
— When interest rates (financial assets) rise relative to
the rates that can be earned on money deposits,
people hold less money.
— When interest rates fall( financial assets), people hold
more money.
 Represented graphically, it is sometimes called the
liquidity preference curve and is inversely related to the
rate of interest.
 Demand for Money and Rate of Interest
3. Money Demand and change in Real GDP (Income)
 A household with an income of Tshs 100,000 per month is
likely to demand a larger quantity of money than a
household with an income of Tshs10,000 per month.
 That relationship suggests that money is a normal good: as
income increases, people demand more money at each
interest rate, and as income falls, they demand less.
 Consider a period of sustained economic growth in the
economy where there is increase in real GDP incomes
throughout the economy.
 The demand for money in the economy is therefore likely
to be greater when real GDP is greater.
 Therefore higher real national income causes an outward
shift in the demand for money.
MONEY SUPPLY
 The supply of money is the total stock of money available
for use in transactions and held by the public.
 How do we measure money?
 For the central banks to regulate the money supply (MS),
they have to know how much money is in circulation.
 There is no clear definition of exactly what money is.
 For example, if you have Tshs1,000,000 cash, that is
definitely money, but what if you have a Tshs1,000,000
Certificate of Deposit (CD) or a Tshs1,000,000 Treasury
bill?
 You can't use the CD or T-Bill to pay for goods and
services, but they fit the definition of money as a store of
value.
 Certificate of Deposit - CD
 Is a saving certificate entitling the bearer to receive interest.
 A CD bears a maturity date, a specified fixed interest rate
and can be issued in any denomination.
 CDs are generally issued by commercial banks and are
ranging from one month to five years.
 It is a time deposit that restricts holders from withdrawing
funds on demand.
 Although it is still possible to withdraw the money, this
action will often incur a penalty.
 For example, let's say that you purchase a Tshs10,000 CD
with an interest rate of 5% compounded annually and a term
of one year.
 At year's end, the CD will have grown to Tshs 10,500
(10,000 * 1.05).
 Treasury Bills
 A short-term debt obligation backed by the government
with a maturity of less than one year.
 T-bills have maturities of one month (four weeks), three
months (12 weeks) or six months (24 weeks).
 Measurement of Money Supply
 Economists use three measures of money as M1, M2 and
M3 - to account for the different functions of money.
 Therefore money is measured in terms of its liquidity,
how easily it can be converted to cash.
— Currency, by definition, is highly liquid because it is
already cash.
— Checking accounts are liquid because one can write
checks as a way to carry out transactions.
— Houses and cars, however, are not nearly as liquid.
M1-Narow definition of money supply
 The narrowest definition of money includes only the most
liquid assets is called M1.
 Thus: MI= currency + demand deposit (no-interest checking
accounts).
 M1 measures those forms of money that can be used as a
medium of exchange - money used for final payment.
 There are only three ways to make final payment: pay with
cash, write a check or use a traveller's check.
 Broader Definition of Money Supply
 The broad definition of money includes less liquid assets
and is generally known as M2
 M2 includes money used as a store of value.
 Thus M2 includes other deposits such as saving and time
deposits.
 Thus M2= MI + other deposits (time-CD and saving
deposits)+ treasury bills
M3
 This is the broadest measure of money; it is used by
economists to estimate the entire supply of money within an
economy.
 This is the category of the money supply that includes M2 as
well as all large time deposits, institutional money-market
funds (e.g hostels) and other larger liquid assets (e.g hotels).
MONEY SUPPLY……
 Money Supply Curve In drawing money supply curve, we
assume that the quantity of money
supplied in the economy is
determined as a fixed multiple of
the quantity of bank reserves, which
is determined by the Central Bank.
The supply curve of money is a
vertical line at that quantity.
This means that money supply does
not affected by interest
EQUILIBRIUM (MONEY DEMAND
=MONEY SUPPLY)
 Money Market Equilibrium
 What's equilibrium?
 Money market equilibrium occurs at the interest rate at
which the quantity of money demanded is equal to the
quantity of money supplied.
 This is a situation in which there is no further pressure for
change.
 Describing equilibrium in the money market will be a
matter of describing pressures that will push the interest
rate to change.
 Equilibrium will occur whenever the interest rate stops
changing.
 That will be whenever money supply equals money
demand.
EQUILIBRIUM (MONEY DEMAND =MONEY
SUPPLY)
 Money Market Equilibrium
The market for money is in
equilibrium if the quantity of
money demanded is equal to the
quantity of money supplied.
Here, equilibrium occurs at
interest rate r .
The interest rate must be such that the supply of money (which
is independent of the interest rate) is equal to the demand for
money.
Change in Money Supply
• The Effects of an Increase in the Money Supply on the
Interest Rate
• An increase in the supply of money leads to a decrease in
the interest rate. S S’
I’
D
M M’
Quantity of Money per Period
• The Effects of an Increase in the money demand on the
Interest Rate
• An increase in the demand for money leads to an increase
in the interest rate.
S
r1
r D1
M
FINANCIAL INSTITUTIONS
 Financial institutions specializes in financial intermediation
 That is, process that involves channeling financial savings to
firms as well as provide funds for borrowers and government
institutions.
 Examples of Financial Institutions are: (1) commercial
banks, (2) saving and loan associations, mutual savings
banks, credit unions, and (3) money market mutual funds
such as retirement funds, and insurance companies.
 The financing institutions have two general roles —
1. to mobilize surplus funds from people and organizations,
2. and to allocate them among deficit people and organizations.
 A Saver is an example of a surplus unit, whereas a borrower
is an example of a deficit unit.
 Advantages of financial institutions are:
— They provide liquidity by borrowing and lending
‒ Liquidity is simply the ease at which assets can be turned into a means of
payments and thus consumption. Banks allow their depositors to quickly
and easily turn their deposits into money quickly and easily whenever
needed.
— They minimize the cost of borrowing by bringing lenders and
borrowers together.
— If you want to run a business and you are short of funds you just
need to go the financial inst. to get the necessary funds that people
have deposited.
— They reduce cost of monitoring borrowers by investigating the
creditworthiness of individuals and companies.
— By depositing your money with your financial institutions, you
avoid the cost of losing your assets if you were to lend it to firms
which could have defaulted on the loans.
- Risk pooling- They do this by being able to lend to a large number
of borrowers, in which some may be risky borrowers. Thus, each
depositor faces only a small amount of the risk associated with
loans that would go default. No one depositor losses all there assets
when a bank loan goes unpaid
Central Bank
 Most of the central banks in the world started out as the
governments’ banks.
 Just like every other economic agent in the economy, the
government has financial needs. To solve these needs,
government form central banks.
 Over the years, the role of the central bank has evolved and
added several other functions.
 Today's central bank not only serves as the government's
bank, but also provides many services to the financial
sector such as:
 To issue currency,
 Managing the nation's money supply and international
reserves,
 Holding deposits that represent the reserves of other
banks
 Serve as a lender of last resort to the banking system
 Borrow for BOP purposes
Money Creation by Central Bank and
Commercial Banks
 In economics, money creation is the process by which the
money supply of a country or a monetary region is
changed.
 There are two principal stages of money creation.
1. A central bank introduces new money into the economy
(termed 'expansionary monetary policy') by purchasing
financial assets or lending money to financial institutions.
2. The new money is then introduced into the economy by the
commercial banks through fractional reserve banking
‒ Through the fractional reserve, the commercial banks make
loans equal to the amount of their excess reserves and create
new demand deposit money (this is known as multiple
deposit creation).
Money Creation by Commercial Banks
 Commercial banks play a crucial role in the expansion and
contraction of the money supply in our economy.
 Through their lending activities, banks increase or decrease the
deposit component of the money supply.
 Deposits make up the largest portion of our money supply.
 Banks operate under a fractional reserve system which means
they are required by law to set aside a fraction of their
customers' deposits as required reserves.
 Banks may lend an amount equal to their remaining reserves
which are called excess reserves.
 Banks earn revenue and profits through lending and charging
interest on loans.
 So banks can increase or decrease the deposit component of
the money supply through lending.
 Example on how banks create money
 Assumptions:
1. A country is served with many banks
2. A bank invest in one type of asset that is loan
3. There is only one type of deposit that is demand deposit.
4. It is assumed that banks have the same required ratio, which
does not change (20% i.e for every 5 shillings, at least 1shilling
is required as a reserve)
5. No excess reserves. It is assumed that all banks want to invest
any reserves they have in excess of the legally required amount.
6. No cash drain from the banking system. It is assumed that the
public holds a fixed amount of currency in circulation.
‒ Thus changes in money supply will take the form of changes
in deposit money. ( if money is created, the money will be
deposited in the bank; if money is destroyed, bank deposit
will decrease)
 To understand the money creation process we need to
understand the balance sheet of individual bank
 Initial balance sheet of ABC Bank ( Million of Tshs)
Assets Liabilities
Reserves………..200 Deposits………1000
Loans…………..900 Capital………... 100
1,100 1,100
ABC bank has assets of 1,100shs held in a form of
reserves(200) and loan (900).
Its liabilities are 900 shs deposits and 100 capital (100= loan
from financial market)
The bank’s reserve ratio to deposit =200/1000= 0.2. Therefore
0.2 is exactly equal to the minimum requirement
 Assume that Juma opens an account by depositing 100 shs with ABC
bank
 As a result of new deposit, both deposit liabilities and assets have risen
by 100.
 The balance sheet of ABC will now change as follow:
Assets Liabilities
Reserve …………300 Deposit ……….1,100
Loan……………..900 Capital………… 100
1,200 1,200
 Since both reserve and deposits have increased by 100shs, the new
deposit reserve ratio now increases to 0.27 (i.e 300/1100)
 The bank has now more cash than it needs to provide a 20% reserve
against its deposit liabilities.
 With 300 reserves how much deposits should be increased so as to
maintain a minimum reserve requirement of 20%?
 That is: r/deposit = 0.2
 since 300/d= 0.2 then d= 1500
 With 300 shs reserve it could support 1500 deposits so as to maintain
the minimum ratio of 0.2 (that is 300/1500= 0.2)
 From the initial deposit of 100 shs made by Juma to ABC
bank, it raised reserve assets and deposit liabilities by 100shs.
 The new reserve is now 300, however the deposit is only
1100
 In order for reserve ratio to meet its legal minimum
requirement, then amount of deposit should be increased
 By How much?
 r/deposit = 0.2 since 300/d= 0.2 then d= 1500
 It should however noted that loans is created by deposit.
 Therefore the difference between 1500 and 1100= 400shs is
the loan given out by the banks from its excess reserve ratio.
 In general if the reserve ratio is r, a bank can increase its
deposits by 1/r x any new reserves (1/0.2= 5=money
multiplier)
 The ABC Balance Sheet after making a 400 loan
Assets Liabilities
Reserve……………… 300 Deposits……………1,500
Loans………………..1300 Capital……………… 100
1600 1,600
 By increasing its loans by 400 shs, the bank restores its
reserve ratio of 0.2
The Case of many Banks
 Deposit creation is more complicated in a multibank system
than in a single bank system
 This is because when a bank makes a loan, the recipient of
the loan may pay the money to someone who deposits it not
in the original bank but in another bank.
 It can be assumed that every new borrower immediately
withdraws the borrowed funds from the lending bank and
pays someone who in turn deposits the money in another
bank or banks.
 Example:
 Suppose that Juma has deposited Tshs1,000,000.
 What effect would that have on M1? Assume that the

required reserve ratio is 20%.
 Step 1
‒ You take the Tshs1,000,000 and deposit it in the
checking account at Bank A.
‒ Bank A's reserves increase by Tshs1,000,000 and
demand deposits (D) increase by Tshs1,000,000.
‒ The bank is only required to keep 20% or Tshs 200,000
on reserve, so it has excess reserves of Tshs 800,000.
 Step 2
 They then loan out the Tshs 800,000 to somebody that
wants to buy a car.
 The bank has now created Tshs 800,000 in new money
(demand deposit).
 The process starts all over again. When the Tshs 800,000
gets spent it becomes Tshs 800,000 in new reserves at a
new bank - Bank B.
 The bank is only required to hold 20%, or Tshs 160,000, so
it lends out a new loan for Tshs 640,000, and increases the
demand deposits by Tshs 640,000.
 Step 3
 The person with the loan spends the Tshs 640,000 on
another car, or something else, and the process starts all
over again when the Tshs 640,000 gets into a new bank -
Bank C.
 The deposit expansion process continues until there is
Tshs 5,000,000 of new demand deposits and M1.
 So, starting with Tshs 1,000,000 of new money, the
money grew by 5x that amount.
Potential and Actual Deposit
 In reality, the actual deposit will be less that the full
potential amount, (for example, of 5), for two reasons:
1. Cash leakages - if people hold cash, outside the banking
system, the money supply will increase by less than the
full deposit.
‒ For example, if the person who got the loan for Tsh
800,000 spent only Tsh 700,000 and kept Tsh 100,000 in
cash for emergency, only Tsh 700,000 would go the next
stage instead of Tsh 800,000 , that would reduce the
deposit, that is deposit < 5.
2. Excess reserves – Actual reserves minus required
reserves are called excess reserves.
‒ If banks hold some excess reserves, the deposit will also be
less than 5
 Currency leakages and excess reserves will result in a
deposit that is less than its full potential.
 But since banks hold very few excess reserves, and since
people hold very little cash, the actual deposit would
usually be very close to the full deposit
 In the modern economies with credit cards, checks,
ATMs, there is little need to hold much cash.
Money Multiplier
 The most common mechanism used to measure increase in
the money supply is typically called the money multiplier.
 It calculates the maximum amount of money that an initial
deposit can be expanded to with a given reserve ratio – such a
factor is called a multiplier.
 As a formula, if the reserve ratio is r, then the money
multiplier m is the reciprocal, and is the maximum amount
of money commercial banks can legally create for a given
quantity of reserves.
 Therefore money multiplier (m) is equal to:
 1 / required reserve ratio (r).
 In our example is calculated as:
 Money multiplier = 1 / 0.2 = 5x,
 Meaning that for every Tshs 1 of new money created, the
money supply will eventually increase by 5x that amount,
or Tsh 5.
 If the reserve requirement were 0.1, the money multiplier
would be 1 / 0.1 = 10.
 It should be noted that the value of multiplier is not very
realistic, since banks do hold some excess reserves
(though not much) and, also because a sizeable fraction of
money loaned out does not get re-deposited into bank
accounts.
 For instance, about two-thirds of the U.S. currency that's
officially "in circulation" is not even held in this US;
 Many third-world countries, hold dollars as a hedge
against inflation in their own currency, since the dollar
right now is a much better store of value.
MONETARY POLICY
 The Central Bank (BOT) sets reserve requirements and
supervises the lending activities of commercial banks.
 The amount of money circulating in the economy influences
spending which, in turn, affects production, prices and
economic growth.
 In conducting monetary policy, the BOT seeks to target
money growth rates which promote stable prices, high
employment, and steady economic growth.
 Too much spending in the economy can lead to inflation or
higher prices if production cannot grow enough to keep up
with the aggregate demand for goods and services.
 Too little spending may dampen the economy and stimulate
a recession.
 Monetary policy can therefore be defined as a policy that
a national government uses to influence its economy.
 Using its monetary authority to control the supply and
availability of money, a government attempts to influence
the overall level of economic activity in line with its
political objectives.
 Usually this goal is "macroeconomic stability" - low
unemployment, low inflation, economic growth, and a
balance of payments.
 Monetary policy is usually administered by a Government
through "Central Bank. In Tanzania is BOT.
MONETARY POLICY….
 Operations of a Central Bank
 The Central Bank attempts to achieve economic stability
by varying the quantity of money in circulation, the cost
and availability of credit, and the composition of a
country's national debt.
 The Central Bank has 5 instruments available to it in order
to implement monetary policy:
 Open market operations
 Reserve requirements
 The 'Discount Window‘
 Financing of Budget Deficit
 Foreign exchange intervention

MONETARY POLICY….
1) Open market operations
 Involves the buying or selling of Government securities by
the Central Bank in the open market.
 In most market economies this instrument remains the most
important and flexible tool on monetary policy.
 If the Central Bank were to buy financial securities, the
effect would be to expand the money supply and hence
lower interest rates, the opposite is true if financial securities
are sold.
 This is the most widely used instrument in the day to day
control of the money supply due to its ease of use, and the
relatively smooth interaction it has with the economy as a
whole.
 When the BOT sells securities on the open market,
reserves are withdrawn from the banking system which
decreases the total amount of excess reserves available to
use as a guideline for lending.
 This triggers a multiple contraction of the money supply
and by also decreasing demand deposit (checking
deposit).
MONETARY POLICY….
2) Reserve Requirements:
 Is a percentage of commercial banks', and other depository
institutions', demand deposit liabilities that must be kept on
deposit at the Central Bank as a requirement of Banking
Regulations.
 Though seldom used, this percentage may be changed by the
Central Bank at any time, thereby affecting the money
supply and credit conditions.
 If the reserve requirement percentage is increased, this
would reduce the money supply by requiring a larger
percentage of demand deposits of banks and depository to
be held by the Central Bank, thus taking them out of supply.
MONETARY POLICY….
 As a result, an increase in reserve requirements would
increase interest rates, as less currency is available to
borrowers.
 This type of action is only performed occasionally as it
affects money supply in a major way.
 Changing reserve requirements is not merely a short-term
corrective measure, but a long-term shift in the money
supply.
MONETARY POLICY….
3) The Discount Window
 Banks which are temporarily unable to meet their day-to-
day reserve requirements can borrow from the BOT’s
discount window
 The primary purpose of this policy tool is to provide a
safety net for the banking system by preventing a bank's
temporary deficiency in required reserves which may
cause a major financial crisis.
 Therefore the commercial banks, and other depository
institutions, are able to borrow reserves from the Central
Bank at a discount rate.
 This rate is usually set below short term market rates .
 This enables the institutions to vary credit conditions (i.e.,
the amount of money they have to loan out), there by
affecting the money supply.
MONETARY POLICY….
4) Financing of Budget Deficit
 This entails government financing its deficit through
borrowing from the central bank that increases the central
bank’s holdings of securities.
 This results to into an increase in reserve money, which is
equivalent to financing a deficit by issuing/ printing money
referred to as monetization of the deficit.
MONETARY POLICY….
5) Foreign Exchange Intervention
 This is done to defend foreign exchange rate and achieve a
desired amount of international reserves.
 It directly affects reserve money and hence has a direct
impact on overall liquidity in the economy and the stance
of monetary policy.
 For example; when the central bank purchases foreign
currency from a domestic resident and pays for it by
writing a check against itself (or equivalently by printing
money) it increases money supply.
 The central bank can also make direct purchases or sales
of foreign currency from or to commercial banks. This
will have effects on money supply thus increasing
liquidity of commercial banks.
INTERNATIONAL TRADE
LECTURE 5
Outline
 Why do countries trade?
 Benefits of International Trade
 Theories of international trade
 Terms of Trade
 Trade Policies
 Foreign Exchange Markets
 Balance of Payments
Trade - The exchange of goods and services.
 Trade can occur between individuals/firms of the same the
country (closed economy) or between individuals/firms of
different country (open economy).
 Retailers and wholesalers are the main agents of domestic
trade; exporters and importers for foreign trade
International Trade is the exchange of goods and services
among residents/ companies of different countries
Why do Countries Trade?
The Benefits of International Trade:
 The benefits of Specialization.
 Countries specialize in the production of goods and services
where they hold some advantage.
 Specialization enables firms to produce at higher level of
productive efficiency.
 There is an improvement in economic welfare if countries
specialize in the products in which they have advantages and
then trade the surplus, with surplus from other nations
 Trade allows firms to exploit scale economies by operating in
larger markets, which lead to lower average costs of
production that might be passed onto consumers
Why Countries Trade
 The Benefits of Competition:
 Increased competition among firms of different countries
encourages allocative and productive efficiency
 International competition stimulates higher efficiency - particularly
for domestic monopolies
 The Benefits of Choice:

 Free trade provides greater choice for consumer. Consumers gain
as a result of additional choices in consumption, for goods/services
not produced by domestic factors of production.
 Competition helps keep prices down. As a result of trade citizens
can buy goods/services at cheaper prices (world market prices)
 Imports can help to satisfy excess demand from consumers
Benefit of International Trade: Partial Equilibrium Analysis.
 The benefits of international trade can further be analysed using

the concepts of consumer and producer surplus.
 Consumer Surplus: The difference between the price that
consumers are willing to pay and the price that they actually pay.
 It is used as a measure of satisfaction or welfare of consumers.
 Producer Surplus: The difference between the price that producers
are willing to sell and the price that they actually sell. It is used to
measure welfare of producers.
 These two together are used to measure the welfare of the
product.
Benefits of International Trade: Partial
Equilibrium Analysis
Benefits of International Trade: Partial
Equilibrium Analysis
In a closed economy where the equilibrium market price
and quantity is Q1 and P0,
 The consumer surplus is shown by the area ABC.
 The producer surplus is shown by the area CB0.

 The total level of welfare would be equal to the area
AB0.
If the country engages in free trade, citizens of that

country can now buy goods and services at the world
price of Pw, which is lower than domestic price P0
Benefits of International Trade: Partial Equilibrium
Analysis
 At Pw domestic consumers consumer Q2, of which
Q0 is purchased from domestic producers and Q2-Q0
imported.
 As a result consumer surplus has increased to ADPw.
Consumers have gained CBFPw of consumer surplus
at the expense of domestic producers who have seen
their producer surplus fall to PwF0.
 Also consumers have gained FBG as they are now
able to buy good from more efficient foreign
producers.
Benefits of International Trade: Partial Equilibrium Analysis
 Consumers have additional gain of welfare of BGD,
which has resulted from simply buying more goods
because of the lower price.
 Overall, society has experienced a welfare gain of
BFD.
Why do nations trade
There are several theories that explain the reason
for this
Theories of IT help us to understand how international
trade increases the welfare of its citizens
we need to consider:-
 the basis and gains from trade . i.e. what is the
basis for trade and what are the gains from trade?
 the pattern of trade i.e. what commodities are
traded or which commodities are
exported/imported?
Theories of International Trade
 Basically, international trade is based on two theories:
 The theory of absolute advantage and,
 The theory of comparative advantage.
The Theory of Absolute Advantage (By
Adam Smith)
 A country has an absolute advantage in
producing a good if the cost of producing that
good in the country is lower than the cost of
producing it in another country.
Output per unit of labour

Food Textile
Kenya 6 4
Tanzania 1 5
Kenya has an absolute advantage in Food product and
Tanzania in Textile
 The theory says that a country has an absolute
advantage over her trading partner if it is more
efficient in the production of one commodity but
less efficient in the production of a second
commodity compared to her trading partner.
 Both nations could gain by specializing in the
production of commodities of its absolute
advantage (food in kn, and textile in TZ) and
exchanging part of its output with other nation for
the commodity of its absolute disadvantage (food
in Tz and textile in Kn)
Theory of Comparative Advantage –
By David Ricardo
 Consider the case where Tanzania has absolute
advantage in the production of both food and
textile
 Is there possibility of specialization and gaining
through trade?
 Or should TZ Produce both food and textile and
sell to Kenya? If so what will Kenya give in
Output per unit of labour
exchange?
Food Textile
Kenya 2 1
Tanzania 3 9
Comparative Advantage
 According to Smith’s model there is no incentive to
trade, because TZ can at home produce both food
and textile cheaply
 The theory of comparative advantage says that
even if one nation is less efficient than the other
nation in the production of both commodities (has
an absolute disadvantage in production of both
commodities), there is still a basis for mutually
beneficial trade.
 The country should specialize in the production
and export of the commodity in which its absolute
disadvantage is smaller and import the commodity
in which its absolute disadvantage is greater.
or
 A country has a comparative advantage in the
production of a commodity if it can produce at a
lower opportunity cost than its trading partners.
Illustration 2
Consider the following output per unit of labor (in man-days)
employed in the production of food and cloth between North
and South:
Food (bags/ man- Cloth (yards/ man-day).

day)
Kenya 2 1
Tanzania 3 9
The opportunity cost of producing a commodity in term of the
other.
Food (bags/ man-day) Cloth (yards/ man-day).
Kenya 1/2 = 0.5 of cloth 2/1 = 2 of food
Tanzania 9/3 = 3 of cloth 3/9 = 0.3 food

 Kenya is a low (relative) cost producer of food and
Tanzania a low (relative) cost producer of clothing.
 Possible Trading Ratio (TOT) and Gains from Trade:

Gain from trade could be realised if international price
settles at a level that is between each country’s
opportunity cost: e.g.
 Kenya trades food to Tanzania for clothing at a rate
(TOT) greater than 1Food = 0.5clothing (opportunity
cost of food) but less than 1food =3clothing
(opportunity cost of food).
 Any intermediate trading ratio between the two
extreme would permit Kenya to acquire clothing
Assumptions Underlying the Theory of Comparative
Advantage (Ricardian Model)
 Two countries producing two goods using one factor of
production, usually labor
 Goods are assumed to be homogeneous (identical) across
countries and firms within the industry.
 Labor is homogeneous within a country but heterogeneous
(may have different productivities ) across countries.
 This implies that the production technology is assumed to
differ across countries
 Goods can be transported costless between countries
 Free movement of labour between industries within a country
but cannot move between countries.
 Labor is always fully employed.
 The labor and goods markets are assumed to be perfectly
competitive in both countries.
 Firms are assumed to maximize profit while consumers
(workers) are assumed to maximize utility.
What determines comparative advantage?
 Comparative advantage is a dynamic concept.
 For a country, the following factors are important in

determining the relative costs of production:
 The quantity and quality of factors of production
available
- If an economy can improve the quality of its labour force
and increase the stock of capital available it can
expand the productive potential in industries in which it
has an advantage.
 Movements in the exchange rate
- An appreciation of exchange rate can cause exports of

a country to increase in price. This makes a country
less competitive in international market.
 Long-term rates of inflation relative to other countries.
This will worsen her competitiveness and cause a
switch in comparative advantage.
 Trade policies such as tariffs and quotas (import
control) can be used to create an artificial comparative
advantage for a country's domestic producers.
TERMS OF TRADE
 The Terms of trade of a nation is the ratio of the
price of its exports to the price of its imports (for
two country case) or the ratio of the price index of
its exports to the price index of its imports (for
more than two country case).
 The terms of trade is a measure of the relative
prices of imports and exports
 The ratio is usually multiplied by 100 to express
the terms of trade in percentage.
 Types of terms of Trade.
 Commodity or Net barter Terms of Trade.
The ratio of the price index of the nation’s exports (Px)

to the price index of its imports (Pm) multiplied by 100.
CTOT = (Px/Pm) x 100.

 Example.
In 1990 Px =100 and Pm = 100.

CTOT = (100/100) x 100 = 100%.
And in 2003 Px = 95 and Pm = 110.

CTOT = (95/110) x 100 = 86.36%.
 This means that between 1990 and 2003 the

nation’s terms of trade has deteriorated, from
100% in 1990 to 86.36% in 2003 (about 14%
decline)
 Income Terms of Trade
The income terms of trade measures the nation’s

export based capacity to import.
It measures the change in a country’s export
volume resulting from the change in export
prices.
ITOT = (Px/Pm) Qx
Where Qx = index of volume of exports .
 Example:
In 1990, Px = 100; Pm = 100; and Qx = 100.
The ITOT (1990) = (100/100) x 100 = 100%
And in 2003, Px = 95, Pm = 110, Qx = 120.

The ITOT (2003) = (95/110) x 120 = 103.63%
 This implies that between 1990 and 2003 the nation’s

capacity to import has (based on its export earnings)
increased by 3.63%.
 This shows that, even if the nation’s barter terms of trade
decline, it may still experience an improvement in its
income terms of trade when export volume (Qx) increases.
INTERNATIONAL TRADE POLICIES
(Trade Restrictions)
Despite the potential benefits of free trade, almost

all nations do erect trade barriers in the form of
Tariff or Quotas or both
Trade Policies
 Definition
- A series or a group of standing decisions by
authorities (Governments) to regulate exchange of
goods and services between a country and the rest of
the world
 The policies can be outward looking (free trade) or
inward looking (regulation to protect domestic
industry and market)
Trade Policies
 Governments have traditionally tried to manage trade

flows in two basic ways:
 Restricting imports
 Encouraging exports.
 Trade policies can come in many forms. Generally,
they consist of:
 Taxes or subsidies
 Quantitative restrictions or encouragements, on either
imported or exported goods, services and assets.
 Import Tariff.
- Tariff is a tax imposed upon each unit of a commodity
imported into a country, or
- An import tariff is a tax collected on imported goods.
There are two basic ways in which tariffs may be levied: specific
tariffs and ad valorem tariffs.
 A specific tariff is levied as a fixed charge per unit of

imports. E.g. the government levies a $5 specific tariff on
every TV imported into the country. Thus, if 1000 TVs are
imported, the government collects $5000 in tariff revenue.
The $5000 is collected whether the TV is a $400 Samsung
or a $500 Sony
Import Tariff
 An ad valorem tariff is levied as a fixed percentage of
the value of the commodity imported.
 E.g. the government levies 2.5% ad valorem tariff on
imported TVs. Thus if $100,000 worth of TVs are
imported, the government collects $2,500 in tariff
revenue. In this case, $2500 is collected whether
$50,000 Sony are imported or $50,000 Samsung.
 Tariffs restrict or discourage imports by making

imported goods relatively more expensive than
domestic goods.
 Effects of Tariff: (Partial Equilibrium Analysis )
Imposition of a tariff on imports raises the price by

the amount of the tariff imposed.
The table below summarizes the effects of the introduction of
the tariff:
Before After Change

Price Pw Pw1 Increase
Consumption PwD Pw1I Decrease
Production PwF Pw1H Increase
Government revenue Nil HKLI Increase
Imports (Balance of Trade) Q2-Q0 Q3-Q1 Decrease
Domestic Consumer surplus ADPw AIPw1 Decrease PwPw1ID is lost
Domestic Producer surplus PwF0 Pw1H0 Increase Pw1HPwF is gained

 Import Quotas
Import quotas are limitations on the quantity of
goods that can be imported into the country during a
specified period of time. Quota restricts the supply
of goods to the domestic market.
 An import quota is typically set below the free trade
level of imports. In this case it is called a binding
quota. If a quota is set at or above the free trade level
of imports then it is referred to as a non-binding
quota.
 Goods that are illegal within a country effectively
have a quota set equal to zero. Thus many countries
have a zero quota on narcotics and other illicit drugs.
 The effect of the quota is to raise the market price.
 This reduces the benefit to consumers causing a
loss of consumer surplus.
 With a tariff the effect was to increase government
tax revenue.
 However, for the case quota government earn no
revenue. The benefit goes to the importer or the
foreign exporter.
 The advantage of a quota is that its effect is more
definite than a tariff.
 With tariff the impact on the quantity imported will

depend upon the price elasticity of demand of
imports.
 However with a quota the country can determine
the precise amount to be imported.
 Reasons for the trade restrictions
 To protect domestic (infant) industries from

foreign competition.
 To reduce imports in order to reduce balance of
payments deficits.
 To raise government revenue.
 Improve international terms of trade
 To protect national health.
 A government sometimes bans all imports of a particular
good when it has reason to believe it could harm public
safety or health. For example, a number of countries
recently prohibited all imports of poultry products from
some countries in order to protect their livestock and
citizens from bird flue
 Governments also restrict imports and exports for political
reasons.
 Countries wishing to punish or influence the behavior of
another country for human rights violations or for an act
of aggression, for example, will sometimes restrict
imports from goods producing in the “misbehaving”
country. In times of war, adversaries will often prohibit all
imports from each other, a measure known as an
embargo.
Consequences of Trade Restrictions
 Trade restrictions can impose significant costs to the government or
consumers
 Tariffs or quantitative restrictions protect domestic industries and
workers from foreign competition by raising the prices domestic
consumers must pay for imported goods.
 some argue that import restrictions should be viewed as a tax on
domestic consumers—the cost of protecting the jobs of workers in
vulnerable industries is borne by taxpayers or consumers. That
cost exceed the potential cost of retraining and finding new jobs
for those workers.
 Import restrictions and export subsidies discourage the firms and
industries benefiting from such policies from making the changes
necessary to challenge foreign competition.
 Once the protected companies have received government
support in the form of import restrictions or export subsidies, they
may have less incentive to improve their efficiency and
management, eventually even becoming dependent on
government support for their survival.

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Macroeconomics

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MACROECONOMICS

 In contrast, macroeconomics is the study of the

 The major theoretical issues that arise out of

Therefore macroeconomics provides analytical

 If firms produce more than what customers can buy;

 Conversely if customers demand more than it is

 This can be explained by what is known as a

 The circular flow of income is a simple model of

 In exchange for the services the business sector pays

 Thus, there is a flow of earnings or income to the

The leakage that the Government sector provides is through

 Including intermediate goods and final goods will

 Same principles as above but need to make

Compensation of Employees COE 1,093,800

Net Operating Surplus NOS 2,215,100

Gross Domestic Product GDP 4,022,700

Net Factor Income from the NFIRW 267,500

Gross National Product GNP 4,290,200

Ice Cream 100 100

Ice Cream 50 100

Ice Cream 5,000 10,000

 In practice, calculating real GDP using the previous approach

Inflation Rate, Philippines

Per capita GDP at

(1) GDP at current

(2) GDP deflator (base

(3) GDP at constant

(6) Population (million

Source: NSCB (1998), Philippine Statistical Yearbook.

 Convert a country’s GNP to US dollars, or

Aggregate Income (Y)

Income (In Billions Tshs)

1) Autonomous consumption (a), which is

DI= Disposable Income

Boom Average Growth

1. The cost of collection must be low relative to the yield.

3. Administration and Compliance Costs

 Proportional tax - a tax where the percentage of

3) The final use for fiscal policy is as a tool of supply-side

(Most exclusive function)

3. Stable and able to keep its value

6. Portable and not too heavy to carry

7. Money should be durable

 Depending on the costs and benefits associated with each

 What effect would that have on M1? Assume that the

 The 'Discount Window‘

 Financing of Budget Deficit

 Foreign exchange intervention

 The Benefits of Choice:

 The benefits of international trade can further be analysed using

 The producer surplus is shown by the area CB0.

If the country engages in free trade, citizens of that

Output per unit of labour

Food (bags/ man- Cloth (yards/ man-day).

Food (bags/ man-day) Cloth (yards/ man-day).

Kenya 1/2 = 0.5 of cloth 2/1 = 2 of food

Tanzania 9/3 = 3 of cloth 3/9 = 0.3 food

 Possible Trading Ratio (TOT) and Gains from Trade:

 Comparative advantage is a dynamic concept.

 For a country, the following factors are important in

- An appreciation of exchange rate can cause exports of

The ratio of the price index of the nation’s exports (Px)

CTOT = (Px/Pm) x 100.