DEBRE BERHAN UNIVERSITY

COLLEGE OF AGRICULTURE & NATURAL RESOURCE

SCIENCES
DEPARTMENT OF AGRICULTURAL ECONOMICS
MACROECONOMICS-II (AgEc 3011)

MARCH, 2022

DEBRE BERHAN, ETHIOPIA

1
 CHAPTER ONE

EQUILIBRIUM INCOME
DETERMINATION

2
 1.1. Introduction
 The Keynesian model of income determination that we develop in this unit is
very simple.

 We assume for the time being that prices do not change at all and that firms
are willing to sell any amount of output at the given level of prices.

 Demanders always get what they want. Even when the sum of consumer, firm,
and government demands is greater than what is produced in any given period,
firms can always meet demand by "going to the back room" and selling output
produced in previous periods—i.e., inventories. This means that the model is
demand-driven.

 This model is capable of explaining various economic phenomena effectively.

3
 1.2. The Components of Income
 GDP measures two things at once: the total income of
everyone in the economy and the total expenditure on the
economy’s output of goods and services.
 For an economy as a whole, income must equal expenditure
since every transaction has a buyer and seller.

 Generally, the GDP or income has four components:

consumption (C), investment (I), government purchases (G)
and net exports (NX).

 For a closed economy, three components of GDP are expressed

in the national income accounts identity: Y=C+I+G.

4
 Consumption:
 Households receive income (Y) from labor and ownership of
capital, pay taxes (T), and then decide how much of their after-
tax income to consume and how much to save.

 Income after payment of all taxes (Y–T) is disposable income.

 Disposable income= consumption (C) + saving (S).

S=Y-C…………………………………………… (1.1)

 Consumption depends directly on disposable income.

Thus, C = C(Y - T) =a+c(Y-T)…………………… (1.2)

5
 The slope of the consumption function is the marginal
propensity to consume (MPC) - the change in consumption
when disposable income increases by one dollar.

 The MPC is between zero and one: an extra dollar of income

increases consumption, but by less than one dollar.

 E.g., if MPC is 0.7, then households spend 70 cents of each

additional disposable income on consumer goods and services
and save 30 cents.

6
 Investment:
 Both firms and households purchase investment goods.

 Firms buy goods to add to their stock of capital and to replace

existing capital while households buy new houses.

 Investment demand depends on the interest rate, which

measures the cost of the funds used to finance investment.

 But, for now, we assume that investment is autonomous- i.e.

independent of any other variables like interest rate or income.
 It is simply a constant figure like 10 units and 100 units.

7
 Government Purchases:
 The government sector basically spends on goods and services
(G) and earns income through tax (T).
 All government spending on guns, books, roads and other
public works represent government purchases (G).

 The other types of spending are transfer payments (TR) to

households, such as welfare for the poor and social security
payments for the elderly, are not made in exchange for goods
and services and therefore, not included in the variable G.

 Transfer payments (TR) do affect the demand for goods and

services indirectly.

8
 Transfer payments are the opposite of taxes: they increase
households’ disposable income.
 We can now revise our definition of T to equal taxes minus
transfer payments.

 Disposable income, Y-T, includes both the negative impact of

taxes and the positive impact of transfer payments.
 If government purchases equal taxes minus transfers, G=T-TR,
then the government has a balanced budget.
 If G+TR>T, the government runs a budget deficit, which it
funds by borrowing in the financial markets.
 If G +TR< T, the government runs a budget surplus, which it
can use to repay some of its outstanding debt.

9
 1.3. Keynesian Cross and the Economy in Equilibrium
 In the simple Keynesian model, the three ‘fundamental
assumptions’ are:

1. The flow of output produced by an economy (GDP) in a given

time period is identically equal to income (Y) generated.

2. Output is demanded by consumers, firms, and the government.

3. The price level is constant, i.e., no inflation.

 The nominal values of Y, C, I, and G are also their real values.

10
 In The General Theory, Keynes proposed that an economy’s total
income was, in the short run, determined largely by the desire to
spend by households, firms, and the government.

 The more people want to spend, the more goods and services
firms can sell, and the more output to produce and the more
workers to hire.

 Thus, the problem during recessions and depressions, according

to Keynes, was inadequate spending.

 The Keynesian cross is an attempt to model this insight.

11
 We begin our derivation of the Keynesian cross by drawing a
distinction between actual and planned expenditure.

 Planned expenditure (AD) is the amount households, firms

and the government plan to spend on goods and services.
Aggregate demand of an economy (AD) is defined as the total
demand for goods and services at the given price level.

 Actual expenditure is the amount households, firms, and

government spend on goods and services, and it equals the
economy’s GDP.

 Actual expenditure differs from planned expenditure since

firms might engage in unplanned inventory investment when
their sales do not meet their expectations.
12
 When firms sell less of their product than they planned, their
stock of inventories automatically rises; conversely, when
firms sell more than planned, their stock of inventories falls.
 Thus, actual expenditure can be above or below planned
expenditure.

 Assuming closed economy, planned expenditure (AD) is the

sum of consumption (C), planned investment (I) and
government purchase (G).
AD = C + I + G ---------------------------------------- (1.4)

 Consumption is determined by disposable income (Yd) which

is total income (Y) minus taxes (T) i.e. Yd=Y-T.

13
 Then, C = a + c(Y-T), and 0<c<1, C=a+cYd
 Where, ‘a’ is the intercept of the consumption function
(sometimes called autonomous consumption)- level of
consumption when income is zero and ‘c’ is the MPC.

 Individual firms’ demands for capital goods can be aggregated

and represented by a planned investment function.
 To keep things simple, assume planned investment is
determined exogenously; i.e., fixed I=I̅ .

 The activity of a government exerts an influence on

economic activities and different economic variables in
different ways.

14
 E.g., when tax rate is increased, households disposable income
will fall and so their consumption- reduce the AD.
 Assuming fiscal policy fixed, G=G̅ and T=T̅ , equation (1.4),
can be written as:
AD=a+c(Y-T̅ ) +I̅ +G̅ …………………… (1.5)

 Equation (1.5) states that aggregate demand (planned

expenditure) is a function of income Y, since planned
investment I̅ , and the exogenous fiscal policy variables G̅ and
T̅ are fixed.

 Since both the AD and the consumption are the function of the
same variable, income, they vary in the same manner and have
the same slope given by MPC.
15
 The planned expenditure (AD) can be demonstrated
graphically in which the vertical axis represents the
components of aggregate demand and the horizontal axis
denotes the income/output.
 To derive the aggregate demand curve, the first step is
drawing the consumption function against income.

 The 2nd step is adding autonomous investment and government

spending. Since I and G are autonomous, they only affect
intercept of the consumption curve and the slope remains the
same.
 So, the new curve parallel to the consumption curve will be an
AD curve (see figure below). 16
 AD
AD  a  c(Y  T )  I  G

MPC C = a + c(Y- dิͿ

MPC

a+I+G

a Y

Figure 1.1: Aggregate Demand and Consumption

Function
17
 Note that the two curves differ only in their intercept.
 The intercept of consumption curve is ‘a’ whereas it is
‘a+I+G’ for the AD since I and G are constant by assumption.

 The two curves slope upward because higher income leads to

higher consumption and thus higher planned expenditure.

 The slopes of both lines are the MPC- proved by taking the
first order derivative of both functions.
d ( AD) d [a  c(Y  T )  I  G ]
  c  MPC
dY dY
d (C ) d [a  c(Y  T )]
  c  MPC
dY dY
18
 Equilibrium denotes a condition when actual expenditure (Y)
equals aggregate demand (AD).
 At equilibrium, AD intersects the curve given by Y= AD.
 The graphical representation of the equilibrium is known as
the "Keynesian cross" because of the crossing of AD curve
and the 450 line. In the figure 1.2, equilibrium occurs at Y*.

 The 45o line serves as a reference line that translates any

horizontal distance into an equal vertical distance.
 It compares a given level of GDP and AD on the vertical axis.

 Thus, anywhere on the 450 line, AD is equal to output (Y).

 If they are not equal, firms will adjust output.

19
 AD Y = AD

Y1

AD1
AD* A AD  a  c(Y  T )  I  G

AD2
Y2

450
Y2 Y* Y1 Income, output Y

Figure 1.2: Keynesian Cross and the Equilibrium

20
 At equilibrium level of output, AD equals GDP.
 E.g., at point A, both output and AD are equal, Y* = AD*.

 However, when there is any deviation from the

equilibrium, the equilibrium output would be achieved
through inventory adjustments.

 For example, suppose GDP is at a level greater than

equilibrium level, such as Y1 in figure 1.2 above, because of
the miscalculation of firms about the AD.
 In this case, AD1 is less than production (Y1)- firms are selling
less than they produce.

21
 Firms add the unsold goods to their stock of inventories.
 This unplanned rise in inventories induces firms to lay off
workers and reduce production, which in turn reduces GDP.
 This process continues until income falls to equilibrium.

 Similarly, suppose GDP is at a level lower than the

equilibrium level, such as the level Y2.
 In this case, AD2 is more than output Y2;- firms are selling
more than they produce (partly from stock of inventories).

 As firms see their stock of inventories fall, they hire more

workers and increase production.
 This process continues until income equals to AD.

22
Exercise:
Suppose the consumption function and the investment is given as
follows with no government intervention: C=100+0.75Yd;
I=150, Where, the investment (I) is autonomous.
a) Find the aggregate demand function.
b) Find the equilibrium level of income.
c) Find the equilibrium level of aggregate demand
d) Find the equilibrium level of consumption.
e) Draw the graph showing the consumption function and the
aggregate demand function with correct labeling.

23
 1.4. Fiscal policy and Multipliers
 The two major fiscal policy instruments in the commodity
market are government purchase and government tax revenue.

 Any change in these variables has a multiplied effect on real

factors such as output.

 The factors, which show the relationship between the changes

in the instrument and the effect, are known as multipliers.

 Thus, the corresponding multipliers are known as government

purchase multiplier and tax multiplier.
24
 1.4.1. Government Purchase multiplier
 High government purchases imply, for given level of
income, higher AD.
 If government purchases rise by ∆G, then the AD schedule
shifts upward by ∆G (figure 1.3 below).

 The graph shows that an increase in government purchases

leads to an even greater increase in income, i.e., ∆Y>∆G.
 As government expenditure increases by ∆G, then the AD
curve shifts upward parallel to itself by the same factor.

 As a result, the equilibrium output increases from Y1 to Y2

defined at points A and B, respectively.
 It is easy to compare the ∆G and the ∆Y.
25
 Since the line ‘Y = AD’ is a 45 0 line, the triangle ‘ABC’ is an
isosceles triangle with side AC and side BC being equal.
 The change in output (∆Y) is equal to the distance BC, since BC
is equal to AC.

 But, the ∆G is equal to distance BD.

 Thus, ∆Y exceeds ∆G by the distance DC.

 Hence, ∆G has a multiplier effect on output.

 The ratio ∆Y/∆G is called the government purchase multiplier-
the factor by which income rises in response to a unit increase in
government purchase.

 An implication of the Keynesian cross is that the government

purchase multiplier is larger than one.
26
 Y=AD
AD
AD2

∆Y AD1
∆G
D
AD2 = Y2
A

AD1 = Y1
∆Y
0
45
Y

AD1 = Y1 AD2 = Y2

Figure 1.3: Change in Government expenditure &

Aggregate Demand
27
 Why does fiscal policy have a multiplier effect on income?
 The reason is that higher income causes higher consumption.
 Because an increase in government purchase raises income, it
also raises consumption, which further raises income of
producers of the consumption goods, and so on.
 i. e. G  Y  C  Y  C Y…

 The process of the multiplier begins when expenditure rises by

∆G, which implies that income rises by ∆G, as well.

 This increase in income in turn raises consumption by MPC

times ∆G- raises AD and income once again.

28
 This second increase in income of MPC(∆G) again raises
consumption by MPC(MPC.∆G), which again raises AD and
income, and so on.

 We can, thus, write this process compactly as:

Y  G  MPCG  MPC 2 G  MPC 3 G  

 
Y  1  MPC  MPC 2  MPC 3   G............(1.6)

 Dividing both sides of equation (1.6) by ∆G, we obtain the

government purchase multiplier as:

Y / G  1  MPC  MPC 2  MPC 3  

29
The above expression is an infinite and decreasing geometric
series with common ratio ‘r’ given as:
Gn MPC MPC 2 MPC 3
r     ..............  MPC
Gn  1 1 MPC MPC 2

The sum of such geometric series is obtained using the formula:

G1
Sn 
1 r
Where, G1 is the first observation of the series.
Since G1 =1 and r = MPC, the sum of this series can be:
1
Y / G  ....................(1.7)
1  MPC

We can also derive the multiplier from our national income
identity or from the AD model. Y=a+ c(Y-T̅ ) +I̅ +G̅ )
30
 Assuming that T and I are constant and by taking total
differentiation of the above identity, we would get: dY=c(dY)
+dG
dY 1
 By a simple rearrangement, we obtain: 
dG 1 c
 This can be rewritten as: Y 
1
G
Where, c=MPC 1 c

 The value of MPC lies between zero and one i.e. 0<MPC<1.
 Hence, the value of expression (1-MPC) is positive and the
value of (dY/dG) is always positive and greater than one.
 Thus, a change in government expenditure (∆G) brings about a
larger change in output (∆Y).

31
 1.3.2. Tax multiplier
 The government increases the tax to increase government
revenue whereas it decreases the tax to motivate producers and
consumers.
 For instance, a decrease in tax by T immediately raises
disposable income (Y-T) by T and, therefore, consumption
by MPCxT.

 For any level of income Y, aggregate demand is now higher.

 As shown in the figure below, the AD schedule shifts upward
by MPCxT.

 The equilibrium moves from point A to point B.

32
 Taxes do also have multiplier impact on income.
 Starting with the national income identity, we can also prove
this multiplier effect as follows.
Y= a+c(Y-T) + I + G

 Assuming I and G to be constant, and differentiating the above

expression we obtain:
dY = c(dY – dT)+dI+dG,
 dY = cdY – cdT,  dY-cdY= – cdT, dY(1-c) = -cdT
 Dividing both sides by (1-c)dT, we obtain the tax multiplier.

dY c c
  0  Y   T
dT 1 c 1 c

33
 The sign of the tax multiplier is negative.
 But, in absolute terms the tax multiplier is greater than one
since the value of MPC is normally greater than 0.5 (c>0.5).

 Because for the majority of households, the larger proportion

of an increase in their income goes to consumption.

 Thus, in general, the multiplier implies that taxes and income

are inversely related and a unit decrease in tax leads to a more
than proportionate increase in income or output.

34
 The multiplier effect can also be demonstrated graphically
(see figure 1.4).
 A decrease in tax by T leads to upward shift in AD by
MPCxT.

 Consequently, income increases from Y1 to Y2, which is

measured by the distance AC in the figure below.

 The distance AC which is the measure of the change in income

is also measured by ∆Y (=Y2-Y1) and it is greater than T in
absolute terms.

35
 Figure 1.4: Impact of taxes on Aggregate Demand
Y=AD
AD AD2

B
AD2 = Y2 MPC*∆T

∆Y AD1

A
AD1 = Y1
C

∆Y
0
45
Y

AD1 = Y1 AD2 = Y2

36
 1.3.3. The Balanced Budget Multiplier
 Simultaneous change in government spending and tax have
different results in the change of output.
 Here, let’s see the impact of a combination of the two where an
increase in G is exactly equal to the change in T.
 Total change in income equals the sum of change in income
due to the change in government purchase and change in
taxes.
 Thus, we can substitute ∆T by ∆G since (∆T=∆G).
1 c
Y '  G  G
1 c 1 c
 1 c 
Y  
'
  G
1 c 1 c 
dY
  1  Y  G
dG
37
 Hence, when government expenditure and taxes increase by
the same amount, income changes by an amount equal to the
change in government purchase or the tax revenue and the
multiplier is equal to one.

 This multiplier is called the balanced budget multiplier.

 The impact of government expenditure on output is partly

negatively offset by the negative impact of tax.

 E.g., if both government expenditure and tax increase by 50

units simultaneously, then output will increase by 50 units.

38
Exercise:
Given consumption function (C), investment (I) and government expenditure
(G) as follows (the values are in millions birr): C=50+0.8Y d, I=100,
G=130 and if Yd =Y-T
a. Calculate the equilibrium level of output and consumption if the tax is
equal to T=80.
b. Calculate government purchase multiplier and interpret the result
c. Calculate government tax multiplier and interpret the result
d. Calculate the change in output and the new equilibrium output if
government expenditure increases by 50 units
e. Calculate the change in output and the new equilibrium output if
government increases tax by 10 units
f. Graphically demonstrate the changes owing to the two policy changes.
g. Calculate the change in output and the new equilibrium output if both
government purchase and government tax increases by 20 units
simultaneously.
39
 CHAPTER TWO

CONSUMPTION SPENDING

40
 2. CONSUMPTION SPENDING
2.1. Definition and Concepts of Consumption
 Consumption spending refers to the expenditures of
individual consumers and households.

 Consumption or consumers’ expenditure is the largest

component of desired aggregate expenditure (AD).
 AD = consumption of household sector (C) + investment
spending of business sector (I) + government spending (G) +
net of exports (NX)

 In practice, the demand for consumption goods increases with

income. The relationship between consumption and income is
described by the consumption function.
41
 2.2. Theories of Consumption
 A number of hypotheses developed to explain consumers’
behaviors, and short-run and long run consumption functions.

 Some of these theories or hypotheses are:

 Absolute income hypothesis (Keynesian Approach)
 Relative Income hypothesis (Duesenberry Approach)
 Intertemporal Model of Consumption (Fisher’s Approach)
 Life-Cycle Hypothesis and(Ando- Modigliani’s Approach)
 Permanent Income hypothesis (Friedman’s Friedman’s)

42
 2.2.1. Keynesian Consumption Function
 It states that when income increases, consumption also
increases linearly. i.e. the current real consumer spending is a
function of current real disposable income- known as absolute
income hypothesis.

 C=a+cYd; a>o, 0<c≤1………………………. 2.1

Where: C = Total real consumption of households
a = Autonomous real consumption of households
Yd = Real personal disposable income
c = Marginal propensity to consume (MPC)

43
 ‘a’ indicates that even if income is zero, a household will
consume by dis-saving (withdrawing saved amount) or obtain
from relatives, family, charity and so on.

 MPC- the proportion of income that goes to consumption.

 E.g., MPC of 0.75 indicates that 75 percent of the income will be

devoted to consumption and autonomous consumption of 500
birr indicates that even if income is zero, the households will
consume 500 birr.

 This condition can be specified as: C = 500 + 0.75Y d.

44
 I) Properties of Keynesian Consumption Function

a) The MPC is between 0 and 1 i.e. 0 < c ≤ 1

 A person with very low income may consume all income-
MPC is one (a very rare case).
 A person with very large income, consume only small
proportion of income.- MPC is close to, but greater than zero.
 Thus, the value of MPC is between zero and one.

 If the consumption function is in equation form, MPC is the

first order derivative of the function (dC/dYd) at that point.
 For instance, if C = 500 + 0.75Yd, then MPC is 0.75, meaning
that if income increase by 10 birr then 7.5 birr will be spent.

45
Table 2.1: Range of values of marginal propensity to
consume
Individual Autonomous Monthly Consumed Total The
(household) consumption disposable part of the consumption value of
income income MPC

A 100 200 176 276 0.88 =

(176/200
)
B 0 450 315 315 0.70 =
(315/450
)
C 130 100 100 230 1=
(100/100
)

46
 b) The average propensity to consume (APC) falls as income
(Yd) rises
 APC varies inversely with the level of income.

 This is because all extra income is not going to be consumed.

 At very low income a household may consume all income.

 However, when income increases, the household begins to

save part of its income.

 This makes the ratio of consumption to income (C/Yd), i.e.

APC smaller and smaller. (Table 2.2 below).

47
 c) Marginal propensity to consume is less than Average
propensity to Consume, (MPC<APC)
 Given C = 500 + 0.75Yd, Table 2.2 shows relationship between
MPC, APC and the level of saving.
 The greater the disposable income, the lower the APC is.

 In other words, households spend a smaller proportion of their

income as their income increases.

 Correspondingly, the fraction saved or the average propensity

to save (APS) must increase with income.
 MPC is less than the APC.

48
Table 2.2: Simple Keynesian Consumption schedule
Disposable Consumption APC MPC Saving
Income (Yd) (C) (= C/Yd) (= dC/dYd) (S =Yd - C)

50 87.5 1.75 - -37.5

100 125 1.25 0.75 -25
200 200 1.00 0.75 0
300 275 0.92 0.75 25
400 350 0.88 0.75 50

49
 Why is the MPC less than the APC?
 The answer to this question is that the existence of some
autonomous consumption.
 Or, in diagrammatic terms, because the consumption
function does not pass through the origin, the MPC is
measured by the slope of the consumption function while the
value of APC at a point is measured by the slope of the line
drawn from the origin to the point on the consumption
function. (see diagram below).

 The slopes of the lines L1, L2 and L3 measures the values of

APC at income levels Y1, Y2 and Y3, respectively.
 The APC declines as income increases while MPC more or
less remains constant.
50
Figure 2.1: MPC and APC

51
 When the consumption function starts from the origin (if
no autonomous consumption), consumption would be
proportional to income and the MPC and APC would be equal
(assuming a linear relationship).

 For example, C = 0.75Yd.

 Here, autonomous consumption is zero and MPC=APC=0.75.

 This is important since consumption is proportional to income

in the long run (Figure 2.2).

52
 Figure 2.2: Keynesian Consumption Function
C = Yd
Consumption(C)

C = a + cYd

450 Disposable income (Yd)

 Note that in the 450 consumption function (C = Yd), the implied

MPC is 1.
53
 d) At low levels of income dis-saving occurs (saving is
negative)
 During low income period, an individual has to withdraw
some of earlier savings to cover consumption expenditure-
termed as dissaving or negative saving (See Table 2.2 above).
 When the level of income increases, the person stops
withdrawal and eventually begin to save.

 In a two sector economy, income is either spent or saved.

 Suppose that there is efficient transfer of savings to

investment through borrowers by banks.
 Under this case, saving is equal to investment; i.e. I= S.

54
 Y=C+S and S = I, so we can write the aggregate demand or
income as Y=C+S but, C=a+cY.
 Thus,
Y  (a  cY )  S  S   a  (1  c)Y 2.2

 When Y = 0 then S = -a, people’s saving is negative.

 i.e. to consume, people should use their past savings.

 Marginal propensity to save (MPS) is equal to (1 – MPC).

 If some part of income is consumed then the remaining part
will be saved.

55
 Both the consumption and saving functions are positively
sloped because both increase as income increases even if the
rates may be different (see graph below).

 The consumption function has positive intercept meaning that

for a person to survive there must be positive consumption
even if income is zero.

 However, the saving function has negative intercept implying

that a person has borrowed or withdrawn earlier savings for
consumption during the period of zero income.

56
Figure 2.3: Relationship between Consumption and
saving function

57
 Example:
Given consumption function of a two sector economy as
C=40+0.8Y, find a) Saving function b) MPC c) MPS d)
Compare values of MPC and MPS
Solution:
a) Y = C + S S = Y – C but C=40+0.8Y
S = Y – (40 + 0.8Y)  S = – 40 + 0.2Y
b) MPC = dC/dY = 0.80- slope of the consumption function
c) MPS = dS/dY = 0.2- slope of the saving function
d) MPC + MPS = 0.8 + 0.2 = 1.
This implies that MPC = 1– MPS and MPS=1– MPC

58
 II) Keynesian Consumption Puzzle
 The early empirical studies confirm the Keynes’s
consumption hypothesis.
 However, after World War II, Keynes consumption function
was unable to predict the post war values.

 During this time, Simon Kuznet published data for the US

b/n 1869 and 1938, appeared to be linear, started from the
origin (as C=cY). ‘a’ was approximately zero and the value
of ‘c’ is more than the previous Keynesian estimates.

 Kuznet’s finding proved that APC is stable over time (from

decade to decade) as opposed to Keynes’ conclusion.
 Initially, these were supposed to be conflicting each other.
59
 But, later it was found that both findings were correct, but in
different time frames (in the short run and long run).
 Due to this, two consumption functions: short run (cyclical)
and long run (secular). (see graph below).
 In both the cases MPC is constant.

 In the case of the short-run function, the APC decreases as

income increases- Keynesian position whereas in the case of
the long-run, the APC is constant - Kuznet’s position.

 Keynesian consumption puzzle is the failure of Keynesians to

identify that the consumption function has different behaviors
in different time frames or it refers to the lack of clear idea or
agreement whether the value of APC is constant or declining.

60
Figure 2.4: The Short-run and Long-run
Consumption Function

61
 2.2.2. Relative Income Hypothesis
 Consumption is a function of current income relative to the
highest income previously attained and the income of the
household relative to the average income of the community.

 James. S. Duesenberry explained that people have strong

tendency to emulate their neighbors and to strive towards a
higher standard of living.

 If income falls from Y1 to Y2, then people move in the short

run consumption function (Figure 2.5 below) and consume C1.

 First reason: people try to maintain their previous standard

of living.
62
 When their income increases, then people will increase
consumption in the short run till the previous peak is reached.
 Then, they move on long run path to achieve the higher peak.

 Second reason: the decline in income makes him/her a

person with a relatively low income in the community and so
spends relatively more on consumption.

 Normally, when a family lives in a locality with higher income

groups then the family with lower income spends more by
seeing the spending pattern of other families in the same
locality.

63
 For instance, if a person with monthly income of 500 living in
a community with monthly incomes of 450, 560, 600, 900 and
980, spends 300 per month, he/she would spend more than 300
if she/he lives in community with monthly income of 870,
950, 1500, 1800 and 2300.

 This tendency arises in part from pressure on the family to

‘keep up with the joneses’ and in part from the fact that the
family observes the goods and services used by the neighbours
and try to purchase those goods which are superior goods due
to demonstration effect.

 For example, in a locality if somebody buys a colour

television then immediately one can see other families also
buying the same irrespective of their income.
64
 Figure 2.5: Relative income hypothesis and
consumption function
C=cY
C
SRC1

SRC2

C1

C2

Y
Y2 Y1

65
2.2.3. Fisher’s Intertemporal Model of Consumption
 When people decide how much to consume and how much
to save, they consider both the present and the future.

 In making this tradeoff, households must look ahead to the

income they expect in the future and to the consumption of
goods and services they hope to be able to afford.

 Irving Fisher developed the model to analyze how rational,

forward-looking consumers make intertemporal choices-
choices involving different periods of time.

 Fisher's model shows the constraints consumers face and

how they choose consumption and saving.
66
 People consume less than they desire b/c consumption is
constrained by their income, called a budget constraint.

 When they are deciding how much to consume today versus

how much to save for the future, they face an intertemporal
budget constraint, which measures the total resources
available for consumption today and in the future.

 For simplicity, assume a consumer who lives for two

periods.
 Period one- consumer's youth and period two- old age.
 The consumer earns income Y1 and consumes C1 in period
one, and earns income Y2 and consumes C2 in period two (all
variables are real terms- adjusted for inflation).
67
 Because the consumer has the opportunity to borrow and save,
consumption in any single period can be either greater or less
than income in that period.
 In the first period, saving equals income minus consumption.
S =Y1-C1…………………………(2.3)

 In the second period, consumption equals accumulated saving,

including interest earned, plus second-period income.
C2 = (1+r)S+Y2…………………….….. (2.4)
Where, r is the real interest rate.

 no third period, the consumer not save in the second period.

68
 The variable S represents both saving and borrowing.
 If C1 <Y1, the consumer is saving, and S>0.
 If C1>Y1, the consumer is borrowing, and S<0.

 For simplicity, assume that r is the same for borrowing and

saving.

 To derive the budget constraint, substitute equation (2.3) for

S into equation (2.4) to obtain:
C2 = (1 + r) (Y1 - C1) + Y2

 Rearranging terms: (1 + r) C1 + C2 = (1 + r) Y1 + Y2.

69
 Now divide both sides by (1+r) to obtain the consumer's
intertemporal budget constraint given below:
C Y
C1  2  Y1  2 ............................................(2.5)
1 r 1 r
 If the interest rate is zero, total consumption in the two
periods equals total income in the two periods.

 In the usual case in which the interest rate is greater than

zero, future consumption and future income are discounted by
a factor 1+r.

70
 Because the consumer earns interest on current income
saved, future income is worth less than current income.

 Similarly, because future consumption is paid for out of

savings that have earned interest, future consumption costs
less than current consumption.

 The factor 1/(1+r) is the price of second-period consumption

measured in terms of first-period consumption: the amount of
C1 that the consumer must forgo to obtain 1 unit of C2.

 At point A, C1=Y1 and C2=Y2, neither saving nor borrowing.

71
 At point B, saves all income, so C2 =(1+r)Y1+Y2.
 At point C, consume nothing in second period and borrows
against second-period income, so C1=Y1+Y2/(l+r).

 All points from B to C are also possible choices.

 If he chooses between A and B, he consumes less than his

income in the first period and saves the rest for second period.

 If between A and C, he consumes more than his income in the

first period and borrows to make up the difference.

72
Figure 2.6.Consumer's budget constraint

73
 The consumer's preferences regarding consumption in the two
periods can be represented by indifference curves.
 An indifference curve shows the combinations of first-period and
second-period consumption that make the consumer equally
happy.

 The slope at any point on the indifference curve is the marginal

rate of substitution (MRS) b/n first-period and second-period
consumption.
 It is the rate at which the consumer is willing to substitute second
period consumption for first-period consumption.

 The consumer is indifferent among combinations W, X, and Y.

 If the consumer's C1 is reduced, say from point W to point X and
then to Y, C2 must increase to keep him equally happy.
74
Figure 2.7: Consumer Preferences

75
 The consumer would like to end up with the best possible
combination of consumption in the two periods.

 The highest indifference curve that the consumer can obtain

without violating the budget constraint is the indifference
curve that is tangent to the budget line, point O.

 At this point, the slope of the indifference curve (MRS)

equals the slope of the budget line (1 + r).
 Therefore, at point O; MRS = (1+r).

 The consumer chooses consumption in the two periods so that

the marginal rate of substitution equals 1 plus the real interest
rate.
76
Figure 2.8: Optimization

77
 2.2.4. Modigliani Life Cycle Hypothesis (Ando -
Modigliani Approach)
 During the dawn of 1950s, F. Modigliani, Ando Albert and
Richards Brumberg explained the declining APC function
based on Fisher’s consumption model.

 They classified the society into different age groups- implying

that income varies systematically over these age groups.
 To convert systematically varying incomes into more or less
linear consumption, consumers use saving and borrowing.

 Thus, a typical individual might be expected to maintain

more or less constant or perhaps slightly increasing level of
consumption (See the figure below).

78
 According to Modigliani, current preference is better than
delayed preference.
 Thus, the consumption curve is upward sloping.

 The Modigliani’s model classified ages of individuals into

three paths (young, middle and old age) and so called life
cycle hypothesis.

 An individual is a net borrower in earlier years of his/her

life and saves during the middle age to repay young age
loans and to provide for old age consumption.

 Consumption is linear while income is non linear over time.

79
Figure 2.9: Life Cycle Consumption Hypothesis

80
 Individuals have no or very low income during their young
age, for instance, when they are in schools, and once complete
their training, will get relatively larger income.

 During old age people usually need recreation/ work lower

hours or eventually retires- implies get very low income.

 For better clarity, consider a consumer who expects to live

another T years, has wealth (initial assets- received through
gifts or bequests) of W, and expects to earn income Y until he
retires R years from now.
 The consumer can divide up his lifetime resources among his
T remaining years of life.

81
 We assume that he wishes to achieve the smoothest
possible path of consumption over his lifetime.
 Therefore, he divides this total of W+RY equally among the T
years and each year consumes C=(W+RY)/T.

 This person’s consumption function (C)=(1/T)W + (R/T)Y.

 Assume aggregate consumption is the same as the individual.
 The economy’s consumption function (C) = aW + bY, where,
a=1/T, and b=(R/T).

 Because wealth does not vary proportionately with income

from person to person or from year to year, high income
corresponds to a low APC when looking at data across
individuals or over short periods of time.
82
 But, over long periods of time, wealth and income grow
together, resulting in a constant ratio W/Y and a constant
APC.
 This hypothesis tries to justify consumption puzzle.

 Thus, the life cycle hypothesis supports the Keynes’s idea in

the short run, while it supports Kuznet’s idea in the long run.

 According to life cycle hypothesis, high-income groups are

the middle age group- there is higher savings relative to
consumption which simply means that there is lower APC.

 Furthermore, the hypothesis explicitly added wealth (asset) as

explanatory variable of consumption trend (function).
83
2.2.5. Permanent Income Hypothesis (Friedman Approach)
 In a book published in 1957, Milton Friedman proposed the
permanent- income hypothesis, which emphasizes that
people experience random and temporary changes in their
incomes from year to year.
 Thus, current income Y is the sum of permanent income
(YP) and transitory/ temporary income (YT). Y = YP + YT.

 Permanent income is the amount of income that a person

receives in constant collection base and with knowledge of the
amount of income to be collected in the nearer future.

 Transitory income is unanticipated income; may be positive

or negative.
84
 Permanent income is average income, and transitory income
is the random deviation from that average.
 For example, a farmer may receive more income than
anticipated if the weather condition is favorable and a person
can earn less due to illness or natural disasters such as flood on
farm products.

 If a household’s transitory income is positive, then its

actual income exceeds its permanent income.

 Friedman reasoned that consumption should depend

primarily on permanent income, because consumers use
saving and borrowing to smooth consumption in response to
transitory changes in income.
85
 For example, if a person received a permanent raise of Birr
10,000 per year, his consumption would rise by about as much
while a person won Birr 10,000 in a lottery would not
consume it all in one year- spread extra income over the rest
of his life.

 Assuming an interest rate of zero and a remaining life span of

50 years, consumption would rise by only Birr 200 per year in
response to the Birr 10,000 prize.

 Thus, consumers spend permanent income, but save

transitory income.

86
Figure 2.10: Permanent income and transitory
income

87
 Friedman concluded the consumption function as
approximately C=aYP, where ‘a’ is a constant that measures
the fraction of permanent income consumed.
P P
C
 Thus, APC = = a Y a Y
 T
Y Y Y  Y P 
 APC depends on the ratio of permanent income to current
income.

 When current income temporarily rises above permanent

income, the APC temporarily falls; when current income
temporarily falls below permanent income, the APC
temporarily rises.

88
 The value of APC is somewhat stable if there is change only
in the permanent component of income (YP).
 However, if there is an increase in the transitory component of
income (YT) (short run) the APC tends to decline.

 Thus, a fall in APC is a short run phenomenon because year-

to-year fluctuations in income are dominated by transitory
income. Therefore, years of high income should be years of
low APC.

 But over long periods of time-say, from decade to decade-the

variation in income comes from the permanent component.
 Hence, in long time-series, APC constant- fact Kuznets
found.
89
 END
OF
CHAPTER TWO!

90
thank you so much!

91
3. INVESTMENT AND SAVING
 3.1. The Meaning of Investment
 Investment can be defined depending on who invest, the size
of resources involved and the area of investment.
 Investment is the process of putting ones resource (money) in
a given system with expectation of some benefits (more
income, some products for sale or for consumption and
satisfaction).

 Investment includes spending on new plant and equipment

(business fixed investment), adding to the stock of inventories
(inventory investment); new housing (residential investment).
 Investment spending can be either gross investment or net
investment (after depreciation deducted).
92
 3.2. The Rationales and Decision Criteria for Investment
 The rationale/ purpose of investment is either a profit motive
or non-profit motives.

 Most of the private investors have profit motive

 Government and NGOs may involve in investment projects

because of non-profit motives such as welfare and national
growth issues.

93
 i) Profit Motives
 People like to invest money on new plants and equipments
because they believe that this helps them to make profit.

 However, the return to investment is spread over a number of

years. For example, a manager who has invested in a machine
to increase output can expect profits over a 10 years period.

 Thus, the decision to invest becomes complicated because

profits received today are worth more than the profits
received in the near future or sometimes in future.

 Whether to investment or not and to rank investment projects,

investors use different investment decision criteria such as
present value criterion and marginal efficiency criterion.
94
 a. Present Value (PV) Criterion
 Suppose an individual is to receive 1,100 Birr after one year
from today. If the market rate of interest is 10%, what is the
value of 1,100 Birr today?

 Solution: let ‘X’ be amount of money lent at 10% for one year
to get 1,100 birr by the end of the year. This means after one
year 10% of ‘X’ interest will be added on X to give us 1,100.
10 X
X  X (10%)  1,100  X   1,100  X  1000
100
 In this case, the present value (today’s value) of 1,100 Birr is
only 1,000 birr at 10% rate of interest.

95
 In the present value criterion, the present values of future
returns of different investment alternative are first calculated
and compared for decision.

 These values actually depend on the level of interest rates that

are maintained by the central banks.
 Accordingly, we can develop the general formula to calculate
the present value of the future income streams.

 If an individual has an initial amount P0 which he lends at

market rate of interest ‘i’, then he will have P1 at the end of one
year.
 Now again he lends his initial amount of P1 at ‘i’, then he will
get P2 amount at the end of two years and so on.
96
 Mathematically, this can be represented as follows:
First year  P1  P0  iP0  P0 (1  i )1 ............................ 1
Second year  P2  P1  iP1  P1 (1  i )1 ......................... 2

 Since P1= P0(1+i) , by substituting eqn (1) in eqn (2) we get:

P2  P0 (1  i )(1  i )  P2  P0 (1  i ) 2 ..................................3
 Similarly, he would have P0(1+i)3 at the end of the third year.
 Following this, we can have a general formula:
Pn  P0 (1  i) n .................................................................. 4
Where, Pn is the amount one gets at the end of ‘n’ years at market
rate of interest (i) if one invests P0 amount today or this year.

97
 The present value of income to be received after ‘n’ years
equals the amount an individual would have to lend at the
market rate of interest ‘i’ for ‘n’ years in order to receive the
given amount Pn.

 The present value given by ‘P0’ is obtained by solving for ‘P0’

from equation (4) above.
 The general formula for the present value of future income is:
Pn
P0  ........................................................ 5
(1  i ) n

 Thus, projects with larger present values are preferred.

98
 In investment projects, the streams of future incomes in
different times can be taken as sum of these discounted values
at the end of every year we pass through for the life of the
investment project.

 For simplicity, we discount every year and add the present

value of each income received in future.

 After discounting every year, we can obtain the general

formula of present value (PV) which is:
P1 P2 P3 Pn
PV     ......  .................6
(1  i ) (1  i )
1 2
(1  i ) 3
(1  i ) n

99
 Investment Criteria: The Decision to Invest
 The prospective investor must calculate the present value of
the income stream associated with the investment project and
compare with the cost of the project.

 If cost of project < present value of the future income then

profitable to invest.

 In real life, of course, the process is more difficult because of

uncertainty associated with the project.

100
 Exercise:
Given the present value of stream of returns and the required
amount of money for the investment by different parties (A, B and
C) as follows, decide whether each party has to make the
investment or not, if we consider the profit motive of investment.

Investing Present value of the The amount of Decision

parties estimated returns money required for (invest or
from the investment the investment (in not)
(in Birr) Birr)
A 8,000 10,000
B 80,000 70,000
C 6,000 6,000

101
 b. Marginal Efficiency Criterion
 Marginal efficiency criteria is about comparing a discount rate
that discounts the total stream of future returns to the value
equal to cost of the current investment.

 Marginal efficiency of capital (r) is the rate of interest, which

equates the cost of the project and discounted value of the
future income stream associated with the project.

 If the discount rate (r) is greater than the banks interest rate
(i), it means that the money investmented is increasing itself
by larger rate through returns from the investment products
than it brings if we save in banks or than the rate we should
pay if we borrow the money for the investment.
 Hence, lower bank interest rate (i) encourages investment.
102
 ii) Non–Profit Motives
 The most important non – profit motive is the welfare reason
or humanitarian issues.

 Individuals and NGOs spend their resources on investment to

benefit a community from the return.

 There is national or political obligation on the government of a

country to spend on some investment activities in providing
the society with some basic infrastructure.

 The later usually accounts for a considerable proportion of

government expenditure (G) in national income (GDP).

103
 3.3. Investment Demand and Saving Curve
3.3.1. Investment Demand
 Investment demand (I) has negative relationship with market interest rate
(r) for two major reasons.
 Higher interest rate makes:
 owners of capital (financial resource) prefer to save in banks to
receive the higher interest income than to invest in capital goods-
lower investment level.
 borrowing expensive, which again reduces the profit of the investor
to invest.

 From the Figure below, the level of investment is equal to I 1 when the
market interest rate is equal to r1 and the investment level declines to I2
when the interest rate increases to r2.
 The investment demand is I=f(r).
104
Figure 3.2: Investment demand curve

105
 Crowding effect
 Crowding effect represents the case where the government
action such as fiscal policy or government investment activity
itself reduces the investment in the private sector.

 The figure below indicates that when the government

investment increases, the government either cut its saving
(shifting saving curve from S1 to S2) as money moves to the
investment or the government increases borrowing.

 Both borrowing and reduction in saving pushes the interest

upward (from r1 to r2) making the borrowing expensive; so that
private investors cut investment spending from I1 to I2.
 This is also contributed to by increased private saving
attracted by higher interest income.
106
Figure 3.3: Crowding Out Effect increase in
government spending

107
3.3.2. Investment demand and Saving Relationships
 Investment spending is on the demand side where as saving is
on the supply side of investment and finance sectors.

 The level of saving is the major determinant of investment.

 The higher the saving, the lower interest rate will be and the
more the investment expenditure will be since opportunity cost
of investing money (foregone interest income) will be lower.

 Saving is known as supply of loanable fund whereas the

interest rate is known as the price of the loan.
 Thus, the larger the supply of the fund, the lower its price will
be and so the higher the demand (investment) will be.

108
 On the other hand, the level of interest rate affects saving and
investment in opposite direction; i.e. higher interest rate
discourages investment but it encourages more saving.

 This means investment is a negative function of interest rate

where as saving is a positive function of interest rate.
 Thus, saving curve is upward sloping as opposed to declining
investment function or curve.

 In a two sector model with assumption of banks’ efficient

transfer of saving to investment through loan, the value of
investment is equal to the value of saving- which is referred to
as equilibrium condition.

109
 Figure 3.4: Investment demand and saving curves

 The equilibrium level of investment and saving=I*; (I = S)-

point of intersection between saving and investment curves.

110
 During high government expenditure, the saving will be
relatively low. This would push the interest rate up and make
borrowing expensive and lower the investment.

 As a result, several economists and governments have been

recommending households to save as larger proportion of their
income as possible to encourage investment.

 However, there may be some exceptions.

 There is a level of saving in a country which leads to the
malfunctioning of investment sector of an economy.

 This is the situation where larger proportions of households

save the larger proportion of their income.
111
 This means consuming the smaller proportion of their income.
 Lower consumption level again implies lower demand for the
products of different investment activities and other national
products.

 This discourages further investment and reduces aggregate

demand and national output or national income.
Y↓= GDP↓= C↓+I ↓+G +X –M.

 This is what is known as the paradox of thrift or the

paradox of saving, where it affects the national income
negatively even if it is expected to improve national income by
encouraging investment.

112
 3.4. Theories of Investment
 Some of the theories, which try to explain the investment and
its determinants are:

– Keynesian marginal efficiency of capital (MEC),

– Accelerator theory of investment;
– Internal fund theory of investment;
– Tobin q – theory of investment; and
– Neo-classical theory of investment

113
 3.4.1. Keynesian Marginal Efficiency of Capital (MEC)
 In this approach, the comparison is between marginal
efficiency of capital (r) and market rate of interest (i).

 Marginal efficiency of capital (r) is the rate of interest, which

equates the cost of the project and the discounted value of the
future income stream associated with the project.

 To calculate r, we obtain the estimates of the cost of the

project (C) and the future income stream associated with the
projects, P1, P2… Pn. where the subscripts: 1, 2, 3…..n
represent the years (from now) in which the returns are
received.

114
 Then substitute into the general formula of discounting.

P1 P2 P3 Pn
C    ......  .................... 7
(1  r ) (1  r ) (1  r )
1 2 3
(1  r ) n
 In equation (7), we must solve for the unknown ‘r’.
 Then the investor must compare r with the market rate of
interest (i).

 If r is less than i, the project is not profitable.

 The investor can be better off by simply lending or saving at
market rate of interest (i) rather than investing.

115
 This is because the lower value of marginal efficiency of
investment (r) measures the rate of return on the money used
in the investment.

 If r is greater than i, the project is profitable.

 This means that the return on the money used for investment
given by the marginal efficiency of investment (r) is larger if
we use the money for the investment than the return on it if we
save or lend at market interest rate (i).

 This implies that the capital or the money will be more

efficient at margin if it is invested than if it is saved or lent at
market or banks interest rate.

116
 3.4.2. Accelerator Theory of Investment
 The relationship between the change in the level of output and
the volume of investment is known as acceleration principle.
 This is because, addition to the capital good through the
investment is intended to accelerate or add to the output of the
existing one.

 The capital-output ratio is known as accelerator.

 This theory assumes that a particular amount of capital stock
is necessary to produce a given amount of output.

 For example, if a capital stock of 500 birr is needed to produce

100 birr of output and if this keeps true over periods and
different level of capital, then we can say that there is a fixed
relationship between the capital stock and output.
117
 Let us assume that the ratio is given by a constant ‘λ’:
Kt
  K t  Yt ................................................. 8
Yt
Where, λ is ratio of capital (Kt) to output ‘Y’ in time ‘t’.
 If λ is constant, same relationship is true for the previous year:

K t 1  Yt 1........................................ .... 9

 By subtracting equation (9) from equation (8), we get:

K t  K t 1   (Yt  Yt 1 ) ..............................10

 The expression Kt - Kt-1 is the difference between the capital

stock in time period ‘t’ and capital stock in time period ‘t-1’ is
known as net investment.
118
 Net investment is equal to the capital- output ratio multiplied
by the difference in the output in the two periods.

 By definition, net investment is equal to the gross investment

(I) minus capital consumption allowance or depreciation (D):

I t  D   (Yt  Yt 1 )  Y......... ........................11

 Equation (11) gives the expression that investment is a

function of output.
 If output increases, the net investment also increases.

 If in an economy a capital stock of 500 birr is needed to

produce 100 birr of output, then the value of λ is 5.

119
 If aggregate demand is 100 birr worth of output, then
investment should be 500 birr. This means that if aggregate
demand is constant then net investment is zero.

 Because net investment is given as follows:

I t  D   (Yt  Yt 1 )  Y

 However, the aggregate demand is constant means Yt and Yt-1

are equal and Yt -Yt-1 = 0.

I t  D   (Yt  Yt 1 )  Y   (0)  I t - D  0

Net investment = 0

120
 Suppose aggregate demand increases from 100 to 105 Birr
worth of output, and then the investment need is equal to
(5x5=25) obtained as follows:
I t  D   (Yt  Yt 1 )  Y = 5(105 - 100) = 25

 The change in capital is 25 and the new capital stock is

Kt + Kt –1 = 500 + 25 = 525

 Thus, the capital stock of the economy must be 525 Birr.

121
 The limitations of theory are:
a) First, the theory explains net investment but not gross
investment because for the determination of aggregate demand
gross investment is the relevant concept.

b) Second, the theory assumes that a discrepancy between actual

and desired capital stocks is eliminated in a single period,
which may not be true.

c) Third, this theory assumes a fixed relationship between capital

and output given by the constant value λ. However, in reality
possible to substitute capital to labour within a limited range.

122
 3.4.3. The Internal Fund Theory of Investment
 The central view of this theory is that investment depends on
the level of profits.

 Firms can obtain finance to fund investment through internal

sources (such as retained earnings, depreciation expense), and
external sources (such as borrowings, sales of stocks, etc.).

 If the firm opts for external borrowing then it needs a series of

fixed payments to return borrowings.

 During recession, the firm may not perform well and the firm
may not fulfill the commitment to pay.
 Similarly, selling of stocks has a chance of losing control.

123
 The theory argues that firms strongly prefer to finance
investment internally and that the increased availability of
internal funds through higher profits generates additional
investment.

 Hence, this investment theory implies that investment level is

not determined by the level of interest rate.

 Suppose policy makers are interested in increasing investment.

 Internal fund theory holds the view that profits should be
increased.

 Policy makers can do this by reducing corporate taxes and

reduction of income tax.
124
 3.4.4. Tobin’s Q theory of Investment
 The q-theory of investment creates linkage between
investment and stock market.

 According to this theory, the price of the shares in any

company is the price of a claim on the capital in the company.

 The managers are believed to be responding to the price of the

stocks by producing more new capital by investing.

 The investment is dependent on the share prices.

 If the share price is high, investment will be high and vice
versa.

125
 ‘q’ is an estimate of the value of the stock that market places
on (or market gives to) a firm’s assets relative to the cost of
producing those assets.

 In other words, q is the ratio of market value of the stock or

asset to the replacement cost of capital.
 Mathematically,

Market value of the asset (x)

q …………(12)
Re placement cost (y)
 Replacement cost is the cost that firm would get when it sells
all its capital.

126
 The investment decisions in this case are as follows:
 If q>1, investment continues until marginal q falls to 1 because
investing in capital pays more than its cost to acquire and
install the investment goods- profitable because marginal
product of capital (MPk) is greater real cost.

 If q<1, the firm should reduce the capital stock by

disinvestments (saving some part) or letting depreciation take
its course- because of lower market value of old capital .

 Thus, Tobin’s q theory is another form of explanation of the

neoclassical model of investment.

127
 Moreover ‘q’ theory tries to address the following points.
1) Lags and adjustment costs are inherent in selecting and
implementing any capital investment project- investments
which give product or return sooner are preferred.

2) Expectations about future costs and pay offs are important-

expected higher cost of capital in the future induces more
investment currently- to avoid future higher expense.

3) There is risk and its evaluation by the market- individuals are

more reluctant to invest in risky investment goods.

 This theory implies that firms have choice to invest in real

assets or financial assets.
128
3.4.5. Neo-classical Theory of Investment
 According this theory, investment is based on benefit and cost
of the investment activity to a firm or firms.

 This theory assumes that firms borrow capital at a rate (R)

from the owner of the capital and sell its product at price P,
then the cost of capital is equal to (R/P).

 Real cost (R/P) is upward sloping curve.

 Real benefit is measured in terms of marginal productivity of
capital (MPK), which is downward sloping curve.

 The level of investment has to keep on increasing as long as

the benefit of doing it is greater than the cost of doing so.
129
 Invest level should increase up to the level where real cost of
investment equals its marginal benefit, represented by the
point of intersection between the cost (R/P) curve and the
benefit (MPK) curve given by point ‘e’ in Figure 3.5.

 The firm employs capital up to ‘e’ where R/P = MPK.

 Meaning marginal benefit is exactly equal to the marginal cost
of production, here at point ‘e’.
 However, at point “a” the investor gains more by paying less
and there is justification to increase investment.

 This theory suggests to focus on factors that affect benefit of

investors such as improving capital efficiency, lowering taxes
on investment and lower market interest rate.
130
Figure 3.5: Neo -classical optimal investment level

131
3.5. Determinants of Investment in Less Developed Countries
 Investment in developed countries is a function of profit and
interest rate I=f(, i).

 However, there are other several determinants of investment in

developing countries including inflation, fiscal policy,
exchange rate policy, trade policy, level of financial deepening
(financial intermediation) and external debt.

 These factors impact profitability of investment in LDCs but

impacts are less in developed countries (DC).

132
a) Inflation: Both actual and expected inflations.
 Expected Inflation: If firms expect inflation they move liquid
asset to real asset (investment) called Tobin-Mundell effect.
• However, in LDCs, because of lack of capital market, people
may change domestic currency to foreign currency (resulting
in capital flight) or invest in real assets like land, expected
inflation not necessarily encourage investment.

 Actual Inflation: causes loss of confidence in currency and

lead to capital flight- leads to an increase in interest rate
which means higher capital price (expensive capital) which
again discourages investment.

133
b) Fiscal Policy: taxation and government expenditure.
 Tax affects investment through direct and indirect channels.
 The direct channel is that a reduced tax increases the profit,
which in turn initiates the investment.

 Higher tax indirectly encourages investment as it increases the

government saving which in turn make the loan cheaper for
better investment.

 Increased government expenditure leads to an increased

interest rate, which has a crowd out effect on private
investment- reduces private investment.

134
c) Exchange rate policy: devaluation.
 Devaluation has two major distinct implications for LDCs:

1) If our target is domestic market, import becomes expensive.

 cost of production increases and investment declines- this
discourages investment in domestic market.

2) If our target is foreign market, we can’t know/predict the effect

on cost of production and on investment.
 As this increases market size, it may encourage investment.

135
d) Trade policy: inward looking and outward looking policy.
i. Inward looking (import substitution policy): may protect
investors from stiff competition of world producers.
 If a government gives incentives for investors for indefinite
time it may reduce efficiency of domestic producers and so
discourage investment.

ii. Outward looking (export promotion): low tariff

 If the firm is competitive at initial stages, a decrease in tariff
in importing country increase profit and encourage investment.
 However, for uncompetitive firm a decrease in import tariff
means cheap imports which crowds out the domestic ones and
discourages investment.

136
e) Financial Flows.
 In LDCs, there is foreign exchange constraint and producers
are dependent on imports.

 Moreover, there is closed capital account convertibility where

there is no free capital movement.

 This constrains import of capital goods which may be

important for investment.

 Such environment generally constrains investment.

137
f) Financial Intermediation (deepening): Some measurements:
1. Money- GDP ratio- High value indicates existence of
financial deepening.

2. Banks - (user) person ratio- High value is indicator of

financial deepening.

 High financial deepening means low cost of borrowing and

encourages investment.

 In LDCs, there are several other factors explaining investment.

138
g) Government debt: In LDCs, the government is over burdened
due to excess debt.
 Excess debt negatively affects investment in two ways.

i. Through debt financing/ Debt servicing: During the debt

period amortization and interest payment makes financial
resource unavailable for investment.

ii. Through debt stock: Under high debt stock, investors

expect higher tax by government to finance the debt in
future.
 A country with high debt stock is risky to invest in.
 Shortage of foreign exchange loans for new investment as well.

139
 4. THE MONEY MARKET
4.1. Types of Money
 Earlier, any commodity could be used for exchange for
another commodity which is called the barter system.

 Then after, different types of money have been evolved.

 Some of several types of money used for different purposes
over different periods are given as follows.

a) Primitive money: In the early phases of evolution of money,

arrowheads, hides, shells, bones, etc. were used as money.

140
b) Commodity money: are considered as money and at the same
time can be purchased and sold themselves as commodities.
 E.g., gold, silver and other precious metals.
 Commodity money has intrinsic value.

 The economy during the period or in a country which uses

gold as money is called Gold standard economy.

c) Fiat money or tender money: In the later stage, paper

currencies or legal money were developed and used as money.
 The money may not have material value at all or may have
lower material value than its face value.

141
d) Credit money or bank money: represents types of financial
documents such as credit cards that banks provide to people
and used in making transactions.
 This money also has no intrinsic value.

e) Electronic money (E-Money):- Recently, sitting at home or

office transactions can be made from anywhere around the
world with the aid of electronic money through computerized
communication technology.

 E.g., telecommunication prepayment card- typing the number

on your cell-phone or computer automatically confirms your
payment of the amount on the card.

142
4.2. Money Supply
 Money supply simply means the amount of money in
circulation in an economy.

 Any fluctuation in money supply brings changes in the

aggregate macroeconomic variables. E.g., larger money supply
may lead to larger inflation rate, lower interest rate, and lower
cost of borrowing or cheaper loan, lower saving and better
investment.

 The policy packages prescribed related to money supply is

known as monetary policy and the variables changed in
achieving the objectives are known as monetary policy
instruments.

143
4.2.1. The Components of Money Supply
 In a modern banking system, there are many assets which can
be termed as money and they have defined the components of
money supply.

 The levels/degrees of liquidity of these components of money

supply are different.

 For instance, Birr notes are more liquid than some financial
documents such as cheques owing to the fact that Birr can
easily be exchanged for other goods than the cheque.

144
 Components of money supply popularly used in many
countries are:
 M1 = currency with the public + demand deposit with the
banking system or deposits in checking account + checks for
current conversion and use (e.g. travelers’ checks).
 M2 = M1 + deposit in saving account + money market mutual
funds.
 M3= M2+ time deposits with the banking system (long time
deposits) + financial securities (treasury bills, bonds, etc).
 M4 = M3 + total post office deposits

 M1 is sometimes defined as ‘narrow money’ whereas the other

components of money are defined as ‘broad money’.
 The components of money differ from one country to another.
145
4.2.2. Creation of Money and Banking System
 The process of money creation represents the process by which
a given amount of money increases itself through interaction
between central bank and commercial banks and households.

 Any typical central bank has three major monetary policy

tools through which it controls the money supply.

 These monetary policy instruments are reserve requirements,

open market operation and discount rate.

146
 1. Reserve Requirements
 Usually, households and owners of financial resources save or
deposit their money with commercial banks.
 The central bank (Fed) requires commercial banks to retain a
certain percentage of their deposits as a reserve in central
bank.

 For example, if the total deposit made in Ethiopian

commercial bank is 100 birr and the reserve requirement of
the central bank is 5%, then Ethiopian commercial bank has to
deposit 5 birr in the central bank of Ethiopia.

 The commercial bank can use the remaining 95 birr for giving
loans to the customers or borrowers.

147
 If central bank wants to expand money supply in the country,
then it should reduce the reserve requirement.
 For the above example, if the reserve requirement is 1% then
commercial bank should deposit 1 birr with the central bank.

 As a result, the commercial bank can use 99 birr for giving

loans. In this case, one can see previously the money supply
was only 95 birr assuming there is only one bank.

 However, as a result of reduction in reserve requirement,

money supply increased to 99 birr.
 Therefore, if the central bank wants to reduce money supply
for instance to reduce inflation, it has to increase the reserve
requirement.
148
 Reserve requirement and money creation process
 If a central bank wants to expand money supply, the bank buys
bonds and/or other financial securities from the public giving
them money in return (injects money into the economy).

 If the central bank buys bonds that worth Birr 100,000, at this
stage money supply increases by Birr 100,000. Let the reserve
requirement (rr) =10%. If the seller of bonds deposit all Birr
100,000 in bank B, 10% (100,000) = 10,000 will be kept with
Fed (out of circulation) and 90,000 remain in circulation.

149
 Further, if some other person borrows the 90,000 and deposits
in bank C for higher interest rate, 10% (90,000) = 9,000 will
be kept again with Fed and 81,000 remain in circulation. If
this process continues, the total money created is:

= 100,000 Birr (the seller of the bond is using or receiving

interest income on it) + 90,000 Birr (bank B is collecting
interest or using) + 81,000 Birr (used by bank C) + --- etc.

= 100,000 + 90,000 + 81,000 + ------

=100,000 + [100,000 – 0.1(100,000)] + {[100,000 (1- 0.1)] –
0.1[100,000 (1- 0.1)]} +...

150
= 100,000 + 100,000(1-rr) +100,000 (1 – rr) [1 – rr] + ----
= 100,000 [1+ (1 – rr) + (1 – rr)2 + ………….] ------- (1)

 The series: [1+ (1 – rr) + (1 – rr) 2 + … ] is a geometric series

with common ratio (1–rr).

 The sum of geometric series =1/[1-(1– rr)]=1/rr ------ (2)

 So substituting the relation (2) in (1) we obtain:

=100,000 [1/rr] = 100,000[1/0.1] = 1,000,000 Birr

 However, if the money expansion exceeds economic growth, it

leads to inflation.

151
 2. Open Market Operation

 Open market operation means the purchase and sale of

government securities by the central bank to maintain the
proper level of money supply in an economy.

 To increase money supply, the central bank can buy

government bonds from the public and gives money to the
public in return.

 Assume that the value of the bond is 1000 birr, then the
ownership of securities (bond) of central bank increases by
1000 birr.

152
 Paying 1000birr to the public indicates that the money supply
has increased in the economy.
 This is, however, only a single stage.

 The growth of money supply depends on the activities of the

individual who has received the money.

 If the individual goes to the bank again and deposit then again
the bank takes it as deposit and keeps a part as reserve
requirement and gives the rest amount in loan, then results
multiplier effect and ultimately supply of money increases.

153
 This process of increase in money supply resulting from open
market operation can be explained by changes in the different
stages:
Stage-I: The central bank buys bonds that worth 1000 birr.
 At this stage money supply increases by 1000 birr.
 Assuming reserve requirement of 10% and the seller of bonds
deposits all 1000 birr in commercial bank, then stage II begins.

Stage-II: Then, the bank will keep 10%(1000) = 100 birr as

reserve requirement with the central bank and the rest 900 birr
will be used for loan and go back to circulation in the
economy.

154
Stage–III: Let us assume another person takes the loan and
deposits in another bank.
 Then the bank will also follow the same procedure and keep
10% of the amount deposited as reserve requirement and use
the rest amount for giving loans. This process continues.

 The total money created in this process is:

=1000 + 900 + 810+…=1000/(1/0.1)=1000(10)=10,000 Birr

 Note that the role of the open market operation is to initiate

the initial amount of increase in money supply.

155
 The final result is the combined effect of the open market
operation and the commercial banking system.
 Thus, we can conclude that central bank can create high-
power money by simply buying assets, such as government
bonds and paying for them.

 However, if the money expansion exceeds economic growth or

level of growth in output, then it leads to inflation.

 On the other hand, the central bank can reduce the supply of
money by selling the government bonds.

156
 3. Changes in Discount Rate
 A commercial bank that runs out of reserves or money for its
operation such as making loans can borrow either from central
bank if reserve is in excess or other banks.

 The cost of borrowing from central bank is known as discount

rate.

 The willingness of commercial banks to borrow depends on

the discount rate.

 If discount rate is high, cost of borrowing will be high so that

commercial banks may not like to borrow.

157
 Thus, when the central bank wants to increase money supply,
it cuts the discount rate so that commercial banks will borrow.

 This borrowing takes the idle money with central bank back to
circulation and thereby increases money supply.

 When there is need of reducing money supply again, for

instance to control inflation, the central bank increases the
discount rate to discourage banks borrowing which would
decrease the money supply in circulation.

 If all instruments fail, then the central bank can increase

money supply by printing currency.

158
 The effectiveness of instruments:
 If there is smooth market operation, then open market
operation will be effective- the more free market the more the
effective the open market operation will be.

 Reserve requirement is more effective in highly monetized

economy (highly developed money markets) than less
developed countries. As there is high and quick circulation of
money among capital owners, investors, central banks and
commercial banks.

 Under shortage of liquidity, discount rate is effective. This

helps commercial banks to get money for their activities when
they face shortage of money supply.
159
 4.2.3. A simple Model of Money Supply
 A simple money supply model considers other parties than the
central bank such as households which affect money supply.
 This model involves three exogenous variables: monetary
base, reserve and demand deposits.

1. Monetary Base (B): is a total amount of money held by the

public as currency (C); and the amount kept by banks as
reserves (R) controlled by central bank.
 B = C + R -------------------- (3)

2. Reserve requirement: is the proportion of deposits that

commercial banks keep with central bank.
 Reserve – deposit ratio (R/D) = rr

160
3. Currency–deposit ratio (cr)= (C/D): represents the preference
of the public (consumers and producers) about how much money
to hold in the form of currency (C) and how much in the form of
demand deposits (D) in checking account from which they
withdraw when they need.

 The sum of the two represents the money supply in circulation

either in the form of currency or deposit in banks given by:
M = C + D -------------------------- (4)

 Taking the ratio of equation (4) to equation (3), we can obtain

more precise equation for money supply.
M C  D

B C  R
161
 Dividing numerators and denominators by ‘D’, we obtain:
C D
M
 D D  cr  1
B C R cr  rr
D D
 By multiplying both sides by ‘B’ we obtain: M   cr  1  B
 cr  rr 
cr  1 
 Letting   = m , the simple money supply is given as:
 cr  rr 

M = mB = m(C + R) -------------------------- (5)

Where, M = Money Supply and m is called money
multiplier.
 The meaning of the multiplier is that each birr of monetary
base produces ‘m’ birr of money.
162
 When B increases by a unit, money supply increases by ‘m’
factor or unit.
 The lower the reserve-deposit ratio (rr), the more loans banks
would make and the more money they would create from
every birr- increase in money supply.
 For instance, if currency-deposit ratio=0.4 (currency = 40% of
total deposit) and reserve requirement = 10 % of deposit then,

 cr  1   0.4  1 
m=    2.8
 cr  rr   0.4  0.1 
 This simple money supply function is given by M = 2.8B.
 The three major components of simple money supply model
(B, cr, and rr) are again affected by different actors.

163
 ‘B’ is affected by Fed (government) action through R.
 The value of ‘rr’ is also determined by the act of the
government (Fed).

 ‘cr’ is determined by the households behaviors- implies that

money supply is not determined by government decision alone
but also by households’ decision.

 For instance, if households decide to deposit more money,

money supply increases even if government takes no action.
 This is because, this makes the money circulate more and
multiply more.

164
 If we take open market operation: government purchase of
bonds expands monetary base (B), (gives money to the public)
while government sales of bonds (collects money from the
public) reduces monetary base thereby reduces money supply.

 The effect of open market operation is reflected in base money

(B) by affecting the value of C.
 Government sales of bonds reduces B=C+RCMs.

 Government purchase of bonds increases B as

B=C+RCMs.
 Even if these instruments give the Fed the power to control
money supply, they do not give the Fed full control over
money supply.
165
 4.2.4. Money supply, Near Money and Seigniorage
 Near money consists of assets that have acquired liquidity
(ability to purchase goods and services) such as bank cheques.

 Near money causes instability in money demand and finally

gives wrong signals about aggregate demand- may mislead
policymakers- solution is use of a broad definition of money.

 Seigniorage is the revenue from printing money.

 When the government or the central bank prints money, it

increases money supply.
 Such an increase in money supply usually causes inflation.

166
 4.2.5. Income Velocity of Money and Quantity Theory
 The income velocity of money is the number of times the
stock of money is turned over per year in financing the annual
flow of income.
 It is the ratio of GDP to nominal money stock.
V =YN/M  YN = MV ……………………... (6)
 Nominal income (YN) = (real income) (price level) = Y. P
YP = MV …………………………….….. (7)

 The classical quantity theory states that if both V and Y are

fixed, then it follows that the price level is proportional to the
money stock, given by the identity:
 P=VM/Y ………………………………. (8)

167
 This goes with the classical vertical supply function at full
employment level where an increase in money supply leads
only to an increase in price level (MsP).
 Such failure of money supply to affect real variables is called
monetary neutrality or money neutrality.

 However, if supply curve is not vertical (the Keynesian case),

an increase in money supply increase both price (P) and
income (Y) and therefore price level is not proportional to the
quantity of money.
 Of course, if the velocity(V) is constant, nominal GDP is
proportional to the money stock.
 In the long run, money supply and price level have such
positive trend relation or proportionality.
168
 4.3. The Demand for Money
4.3.1. Major functions of money
 Money has three major functions. These are:
1. Money as a Medium of Exchange (transaction purpose):-
Goods and services are sold in exchange for money and
bought in exchange with money.
2. Money as a Unit of Account (measuring outputs in terms of
money):- GDP is a function of money to provide common
measurement of the relative value of goods and services. With
this function, we can easily compare one kg of teff with three
loaves of bread.
3. Money as Store of Value (converting other assets into money
and keep for future):- The store of value is the ability of
money to hold value over time.

169
 4.3.2. Theories of Demand for Money
 Why we demand money?
 The answer for this question and the uses of money are
explained by various theories of money demand.

 The major categories of these theories are:

 Classical theory of money demand,
 Keynesian theories of money demand, and
 Portfolio theory of money demand.

170
 4.3.2.1. Classical theory of money demand
 For classical economists, who represent the early stage of
development of theories of money demand, people need or
demand money solely for transaction purpose called
transaction motive of money demand.

 Later, other dimensions of the money demand were discovered

and other theories were developed by Keynesians.

171
 4.3.2.2. Keynesian theories of Demand for Money
 This theory breaks down the demand for money into
transaction, precautionary and speculative demands.
i) Transaction demand: holding money to carry out ordinary
day-to-day transactions (selling and buying). Transaction
demand (Mt) and income (Y) are linearly related given in
equation form as: Mt=f(Y).

ii) Precautionary Demand for Money: arises due to uncertainty

of future receipts and expenditures.
 For instance, unexpected expenses include purchases of
something interesting you get on your way without your
intention; getting car trouble unexpectedly and paying for
mechanics for maintenance; losing your bag on your way and
purchasing new materials for use on your journey and so on.
172
 This demand for money can also be linked to income as high
income people are expected to keep more money than the
lower income group for precautionary purpose.

 Thus, precautionary demand is a function of income, Mp=f(Y).

 However, in the present world, credit cards, ATM and mobile
money are more popular than the precautionary demand.

 Since both transaction and precautionary demand for money

are functions of income and precautionary money is finally
used for transaction purpose, we can club together as: Mt=f(Y);
where Mt includes both transaction and precautionary demand.

173
iii) Speculative Demand for Money (Ms): arises due to certainty
of future rate of interests.
 People gain or loss due to the fluctuation of interest rates.
 For example, if the current rate of interest is 6% but a person
is expecting it to be 8% soon then he would keep more money
to take advantage of the current lower interest rate.

 Moreover, by waiting until the interest rate reaches 8%, bonds

with higher yields can be purchased at lower price.
 Since interest rate and bond prices are inversely related, the
person is able to purchase bonds at a lower price.

 Speculation demand depends on interest rate given by:

Ms=f(r); where ‘r’ is the rate of interest.
174
 A general Keynesian formula for demand for money is:
Md = Mt + Ms = k(Y) + h(r), since Mt = f(Y) and Ms = h(r)
Md = L(Y, r). …………………… (9)

 Money demand is positively related to income and

negatively related to interest rate. (see Figure below ).
 Therefore, from k(Y) and h(r) we can know the total demand for
money for every possible combination of Y and r.

 The declining line of the graph begins from the vertical broken
line since the transaction and precautionary demand for money
does not depend on interest rate.
175
 Figure 4.1: Total Demand for money

Interest rate (r)

Mt Ms

Md

0 Mt + Ms = Md (Total Money Demand)

176
 4.3.2.3. Portfolio Theory of Money Demand
 This theory emphasizes the role of money as store of value.
 People hold money as part of their portfolio of assets.

 Thus, the demand for money depends on the risk and return
offered by money and by other assets.
 For example, if holding other assets becomes highly risky then
people would prefer to keep money.

 For instance, in a country in civil war producers usually prefer

to keep money than other assets.
 If inflation is expected, people prefer real assets than money.

177
 The money demand would also depend on total wealth because
wealth measures the size of the portfolio to be allocated
among money and alternative assets.

 Thus, the demand for real money (Md/P) can be given by:
Md
 L (rs , rb ,  e , W ) ………………..(10)
P
Where, rs is expected return on assets, rb is expected return on
bonds, ∏e is expected inflation rate, and W is wealth.

 Since people hold money to avoid risk of losing money,

money demand falls as rs, rb, ∏e increases and wealth falls.

178
 As rs and /or rb increases, money demand falls because people
change their money to bonds and stocks to receive higher
interest rate.
 If the expected inflation rate e is high then demand for money
will be low as people change their money to real assets.
 If wealth is increasing then money demand is also increasing
as people prefer to buy luxurious goods.

 This theory is similar to Keynesian theory as we can take

interest rate (r) as an average of rs, rb, and e and we can
express the equation as: Md = L(r, y).
 The portfolio theory of demand is more plausible if we adopt a
broad money.

179
 4.4. Money Market Equilibrium
 Money market equilibrium is determined by interaction
between the level of money supply and money demand.

 Once we have a total demand for money (depends on income

and interest rate) and supply of money (a constant represented
by broken line) then we can find the equilibrium in money
market as shown in Figure 4.2.

 The equilibrium rate of interest is re whereas the equilibrium

demand for money is Mde determined at point ‘e’ where the
two functions intersect.

180
Figure 4.2: Money Market Equilibrium

Income (Y) MS = exogenous money supply

Interest rate (r)

Mt Ms
e
re

Md

0
Mde Mt + Ms = Md

181
 5. PRODUCT AND MONEY MARKET MODELS
 The IS and LM model, first developed by Sir John Hicks and
Alvin Hansen, has been used from 1937 onwards to
summarize a major part of Keynesian macroeconomics.

5.1. The Goods Market and the IS Curve

 The IS curve shows the combination of interest rates and
levels of output for which planned spending equals income.

 In the term IS, I stands for investment and S for saving since
these are the major determinants of the variables represented
by the IS curve.

182
 5.1.1. Deriving the IS curve
 In order to derive the IS curve, we assume that planned
investment is not autonomous; it is negatively related to
interest rate.

 This means that when interest rate is high, less investment will
be made- results in lower output.

 The three methods of deriving the IS curve are:

i) Deriving the IS curve from Keynesian cross
ii) Deriving the IS curve from investment and saving curves
iii) Deriving the IS curve Mathematically

183
 i) Deriving the IS curve from Keynesian cross
 To derive IS curve, add the investment as function of interest
rate and rewrite the AD equation as follows.
Y = a+b(Y-T) + I (r) +G ------------------------ (5.1)
Where, I=I(r) investment as a function of interest rate and
G = G0 autonomous government spending.

 Here, at different interest rates we can get different

equilibrium in the goods market.
 In other words, if interest rate is r1, then AD is equal to actual
expenditure at Y1 as mentioned in figure 5.1 below.
 If interest rate is r2 then the level of income is at Y2.

184
 By joining all points (different interest rates) in the lower part
of figure 5.1, we get a curve showing a negative relationship
between income and interest rate.

 This curve is known as IS curve which shows the combination

of interest rates and levels of output for which the planned
spending equals income.

 The higher the interest rate, the lower would be the level of
planned investment as cost of borrowing for investment will
be high. Or
 Individuals will prefer to save their money rather than making
investment in more productive activities or production.

185
 In the figure, investment is reduced from I1 to I2 as interest
rate increases from r1 to r2.

 Because of lower level of investment, the aggregate demand

curve shifts down ward leading to a shift in equilibrium from
point ‘A’ to new equilibrium at point ‘B’.

 Now the income is also lower because lower investment

spending leads to lower output and income.

 For this reason, the IS curve slopes downward.

186
Figure 5.1: Derivation of IS curve from AD and
actual expenditure curve or Keynesian Cross
Y=AD
AD
AD1 =a+b(Y-T) + I (r1) +G0
A

AD2 = a+b(Y-T) + I (r2)+G0

B

I2 I1
r

r2

r1

IS

Y2 Y1 Y
187
 ii) Deriving the IS curve from the Investment and
Saving curves
 Let’s say that for a given level of income there will be a given
level of saving, which is represented by the line S (Y1) in the
figure 5.2 below.

 If the person’s income increases, then the person will have

excess money over and above his consumption and enable him
to save more.

 This will shift the saving line to the right and this higher
saving can be represented by the line S (Y2).

188
 This higher saving makes the loans cheaper measured in
terms of lower interest rate.

 Graphically, this is shown in the figure below as movement

from point A to point B where the saving and investment
curves intersect.

 In the lower part of the figure, the movement from point A to

point B owing to an increase in income leading to fall in
interest rate shows the inverse relationship between the two
variables given by the IS curve.

189
Figure 5.2: Deriving IS curve from Investment and
saving schedule
r S(Y1) S(Y2)

A
r1

B
r2

I(r)

I1 I2
r

r1 A

B
r2

IS

Y
Y1 Y2

190
 iii) Deriving the IS curve mathematically
 We can also derive the IS curve using the national income
accounts identity given as follows.
 Y = C + I + G ---------------- (5.2)
Where, I = I0 – i(r), here i is marginal propensity to invest.
C = a+b(Y-T), here b is marginal propensity to consume.
 The identity states that saving equals to investment.

 Now, substitute the investment function I=I0–i(r) and the

consumption function C=a+b(Y-T) for I and C, respectively.
 Y = a + b(Y -T) + I0 – i(r) + G
 By rearranging this identity, we obtain the following.
 Y – a-b(Y-T) - G = I0 – i(r) --------------------- (5.3)

191
 The left hand side of this equation states that supply of loan-
able funds depends on income and fiscal policy (T and G).

 The right hand side of the identity (5.3) states that the demand
for loan-able funds depends on the interest rate.

 Using the identity (5.3) we can prove that the IS curve shows
an inverse relationship between interest rate and output.

 Proof: First re-write the identity (5.3) as:

Y = a + b(Y-T) + I0 – i(r) + G ------------- (5.4)
 Taking the total differential of identity (5.4), we obtain:
 dY = b(dY - dT) - i(dr) + dG -------------- (5.5)

192
 Assuming taxes and government spending to be constant, (i.e.
dT=dG=0), we get: dY = bdY – idr =>dY – bdY = – idr
 (1 – b)dY = – idr dividing both sides by (1 – b)dr, we obtain:

dY i
  0, - - - - - - - - - - - - - - - - (5.6)
dr (1  b)
 Where ‘b’ is MPC and ‘i’ is ∆I/∆Y- a measure of change in
investment due to a unit change in output.
 The expression is less than zero because 0<b<1 and -i<0.

 dY/dr is the measure of a change in output that arises from a

unit change in interest rate and its sign shows that the two
variables are negatively related.

193
 5.1.2. Fiscal Policy and the IS Curve
 The impacts of the changes in the fiscal policy instrument is
reflected through shifts in the IS curve.

a) Increase in government expenditure and reduction in tax

 An increase in the government expenditure increases the AD
and producers increase production and receive more income.
 If the interest rate is unchanged, such an increase in income
is attained through a rightward shift in the IS curve.

 Reducing tax also increases income after tax for households

and firms- increases consumption and investment and so AD-
reflected by a rightward shift in the IS curve (figure 5.5).
 So, both are examples of expansionary fiscal policies.

194
 Figure 5.5: Rightward Shift in the IS curve
Rate of
interest

r*

IS2
IS1
Income (Y)

Y1 Y2

195
b) Decrease in government expenditure and increase in tax
 A decrease in G reduces government’s demand for goods and
services- producers have to cut their production or supply.

 Moreover, increasing tax means that relatively larger

proportion of household’s income goes to government-
households will be left with smaller income to consume.

 Thus, consumption will be lower and so will aggregate

demand and income- represented by a leftward shift in the IS
curve (figure 5.6).

 So, both are examples of contractionary fiscal policies.

196
 Figure 5.6: Leftward Shift in the IS curve
Rate of
interest

r*

IS1
IS2
Income (Y)

Y2 Y1

197
 5.2. The Money Market and the LM Curve
 LM curve is a curve that connects points of different
equilibrium level of output or income and interest rate in the
money market.

 The term ‘LM’ is derived from: ‘L’ for liquidity and ‘M’ for
money or money demand.

 The LM curve is upward sloping curve.

198
 5.2.1. Deriving the LM Curve
Deriving LM curve Mathematically
 The theory of liquidity preference explains how the supply and
demand for real money balance determines the interest rate.

 The theory of liquidity preference assumes a fixed supply of

real money balance ((M/P)S) given as (M/P)S= (M̅ /P̅ ).

 The money supply ‘M’ is an exogenous policy variable chosen

by the central bank and the price level ‘P’ is also exogenous
variable. (IS-LM considers short run when price is fixed).
 The supply of real balances doesn’t depend on interest rate
(Figure 5.7 below).

199
 Figure 5.7: Exogenous money supply
r
Money Supply

M/P M/P

200
 The theory of liquidity preference postulates that quantity of
real balances demanded depends on the interest rate- the
opportunity cost of holding money.

 The demand for real money balances is: (M/P)d=L(r).

 This inverse relationship between money demand and interest
rate can be shown as a downward sloping demand curve.

 As interest rate increases liquidity preference (the desire to

hold money) decreases.

201
Figure 5.8: Demand for real money balance

L(r)

M/P

202
 At the equilibrium interest rate (r*), the quantity of real
balances demanded equals the quantity supplied (see figure
below).

 If the interest rate is too high, the quantity of real balances

supplied exceeds the quantity demanded. i.e., If interest rate is
greater than r*, there will be excess money supply which
pushes the interest rate down.

 Conversely, if the interest rate is too low, so that the quantity

of money demanded exceeds the quantity supplied. This excess
demand for money pushes the interest rate up toward r*.

203
Figure 5.9: Equilibrium in the money market

204
 The Keynesian theory says that transaction and precautionary
demand for money are directly related to income alone i.e.
Mt = k(Y) -------------------------------------- (5.7)

 Speculative demand for money is a function of rate of interest.

Msp = L(r) ------------------------------------- (5.8)

 So, adding the two identities (5.7) and (5.8), the total demand
for money is:
Md = Mt+ Msp = k(Y)+ L(r)

205
 Since individuals and firms demand money for the demand for
real balance, the real money demand function is:

 Md 
  = k(Y) + L(r) - - - - - - - - - - - - - - - - - - - - - (5.9)
 P 

Where, Md/P is demand for real money balance; and ‘P’ is

price level

 Supply of money is assumed to be determined outside the

model (by the central bank) and represented as:
Ms= M̅ -------------------------------------- (5.10)

206
 The real money supply can be obtained by dividing the
nominal money supply by price level as follows.

MS M 
   - - - - - - - - - - - - - - - - - - - - - - - - - - - - - (5.11)
p P

 Here, M̅ represents the amount of money in circulation, and

price level (P) is assumed stable or constant.

 LM curve is represented by different combination of interest

rate and income for which the demand for and supply of real
money balance are equal.

207
  Md 
  = k(Y) + L(r) …..……Demand for real money balance
 P 
MS  M
  = …..…………Supply of real money balance
 P  P
 M d   M 
     - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - (5.12)
 P  P

 The identity (5.12) represents the equilibrium condition.

 Then, different values of interest rate and output or income
represent the LM curve.

 Graphically, we can derive the LM curve from income and

total demand for money.

208
 Deriving LM Curve from Income and Money Demand
 This method of deriving the LM curve uses the impact of an
increase in income on interest rate given the level of real
money supply.

 When income is high, expenditure is high, so people engage in

more transactions that require the use of money.

 Thus, the larger income implies the larger money demand.

 We now write the real money demand function as (5.9).

 Md   Md 
  = L(r, Y) or   = k(Y) + L(r)
 P   P 

209
 The quantity of real money balances demanded is negatively
related to interest rate and positively related to income.

 Now, consider what happens when income increases from Y1

to Y2 given in the figure 5.10 below.

 As the figure shows, the increase in income level shifts the

money demand curve outward or upward.

 If the supply of real money balance (M/P) remains constant, in

order to bring the equilibrium in the money market for money
balances, the interest rate must rise from r1 to r2.

210
 Therefore, the higher the level of income, the higher the
demand for real money balances, and the higher will be the
equilibrium interest rate.

 This can be plotted as a curve by putting the income level on

the horizontal axis and the interest rate on the vertical axis of
another plane.

 Then the LM curve can be drawn by connecting the points

representing the corresponding interest rate and income level-
the LM curve slopes upward (figure 5.10).

 So, LM curve is a positive relationship between the interest

rate and the level of income that arises in the money market.
211
 Figure 5.10: Derivation of the LM curve from
income and total money demand
LM
Ms r
r

r2
r2

r1 r1
L(r,Y2)
L(r,Y1)
Y
Y1 Y2
M/P M/P

212
 5.2.2. Monetary Policy and the LM Curve
 The LM curve is drawn for a given supply of real money balances.
 If supply of real balances change, the LM curve will shift.

 In order to show the direction of shift, let us assume that the

Central Bank has decided to decrease the money supply from M1
to M2.

 This causes the supply of real balances to fall from (M1/P) to

(M2/P), for M1>M2.
 Assuming the level of income and demand curve for the real
money balance are constant, a reduction in the supply of real
balances raises the interest rate (figure-5.11 below).

213
 This would ultimately shift the LM curve upward.
 It is also possible to see from the figure that at a lower interest
rate, the corresponding income level on the new LM curve ‘LM2’
is smaller.

 For instance, take any point to the left of point ‘A’ on the new LM
curve.
 Thus, it is clear that a reduction in the real money supply leads to
higher interest rate and a lower income level and it is a
contractionary monetary policy.

 On the other hand, an increase in the supply of real money balance

would shift the LM curve downwards or to the right- leads to lower
interest rate and higher output or income; and it is known as
expansionary monetary policy.
214
 Figure 5.11: Shift in LM curve
r LM2
r

r2
LM1
r2 A

r1
r1

L(r,Y)

Y Y
M2/P M1/P M/P

215
 5.3. Equilibrium in Goods and Money Markets: IS-LM (Closed Economy
Model)

 There is only one combination of ‘Y’ and ‘r’ at which the

supply of goods and services equals demand for the goods and
services in the goods market and the supply of real money
balance equals the demand for the real money balance in the
money market. i.e. a point where goods and money markets
are simultaneously in equilibrium.

 The equilibrium is defined at the point of intersection

between the IS and the LM curves (figure 5.12 below).

216
Figure 5.12: Equilibrium in the goods and money
markets
r
LM

r*

IS

Y
Y*

217
 Mathematically, the IS and the LM equations are calculated
from the components of the goods market and of the money
market using the equations (5.4) and (5.12), respectively.

 Thus, the two equations of the model are given below.

Y  a  b(Y  T )  I 0  i(r)  G .................IS
M   Md 
 
 P   P  = k(Y) + L(r) ……………………LM
 

 The model takes fiscal policy variables (G and T), monetary

policy instrument (M), and the price level (P) as exogenous
variables whereas income or output level (Y) and interest rate
(r) are endogenous variables.

218
 The IS curve provides the combination of r and Y in the
goods market, and the LM curve provides the combinations of
r and Y representing the money market.

 The markets are in equilibrium simultaneously at the interest

rate (r*) and the level of income (Y*). (figure 5.12 above)

 Any deviation from this equilibrium is believed to be

corrected by different corrective mechanisms.

 Classical economists believe that there is an automatic

adjustment by the markets themselves whereas Keynesians
believe that government corrective intervention is needed.

219
 5.3.1. Monetary and Fiscal Policy and Short Run IS–LM
Model
 The intersection of the IS curve and the LM curve determines
the equilibrium level of national income.

 National income fluctuates when one of these curves shift,

changing the short-run equilibrium of the economy.
 This analysis gives very important tool in the hands of policy
makers to alter the level of income.

 The major two of these are the fiscal policy and the monetary
policy as we will discuss them one by one as follows.

220
 5.3.1.1. Change in Fiscal Policy
 Suppose that we start in equilibrium and government spending
is increased by ΔG, then the IS curve shifts to the right.

 This will increase the level of income which ultimately

increases consumption following the multiplier principle.

 Again, income will increase as consumption of a person is

income of another person or sector.

 So income increases further and the intensity of the increase

depends on the value of the multiplier (Recall that the
rightward shift of the IS curve equals to (ΔG/ (1-MPC)).

221
 If we only had to worry about the goods market, this would be
the end of the story.
 But the increase in income, in turn, increases the demand for
money for transaction purposes- forces up the interest rate,
leading to a decline in investment.

 Thus, we observe short-run crowding out effect.

 So, in this two market cases, the increases in GDP may be less
than the simple Keynesian cross model’s because of the fact
that Keynesian model omits changes in the interest rate.

 Similarly, a decline in taxes shifts the IS curve out, causing

interest rates and GDP to rise.

222
 Mathematical derivation of the impact of the fiscal policy,
considering both the markets simultaneously, can be:
Y = a+ b(Y-T) + I0 - i(r) + G………………(5.13 )
(M/P) = k(Y) + L(r) ……………………… (5.14)

 Differentiating (5.13) we get: dY = b (dY- dT) + idr + dG

 Assuming the tax rate is fixed we get: dY = bdY + idr + dG,

1
 dY(1 - b)  idr  dG  dY  (idr  dG ) …….... (5.15)
1- b

223
 Differentiating [5.14] we get:

dM dp dM dp k
 M 2  Ldr  kdY  dr   M 2  dY ......(5.16)
P P LP Lp L

 Substituting (5.16) into (5.15)

1 idM iMdP
dY  (   dG)............................(5.17)
ik LP LP 2
(1  b  )
L
 Keeping M and P constant and simplifying the above identity:

dY 1
  0....................(5.18)
dG ik
1 b 
L

224
 This is because 1-b>0 since 0<b<1, and (ik/L)>0 since i<0,
L<0 and k>0. i.e. both the numerator and the denominator of
(ik/L) are negative.

 Thus, government expenditure has expansionary impact.

 But, the multiplier is smaller than the only goods market case.

 The other way round, substitute (5.15) into (5.16), and

assuming short run (P is constant), we get:
1 k  1 
dr  dM   (idr  dG ) 
L L 1  b 
l Ki kdG
dr  dM  dr 
L L (1  b) L (1  b)
225
 Collecting like terms, we obtain:

 ki  1 kdG
1  dr  dM 
 L(1  b)  L L(1  b)
L(1  b)  1 kdG 
dr   dM  .........................(5.19)
L(1  b)  ki  L L(1  b) 

 Next, let’s see the same for the monetary policy change.

dr k
 ....................................5.20
dG L(1  b)  ik

226
 5.3.1.2. Changes in Monetary Policy
 Consider the effects of an increase in the money supply.
 This shifts the LM curve rightwards.

 The increased money supply causes interest rates to fall.

 This fall in the interest rates encourages investment, leading,
ultimately, to an increase in GDP or income.

 The linkage from a change in the money supply to GDP is

known as the monetary transmission mechanism given by
the following chain of relation: M r I Y.

 The impact of the monetary policy can also be derived from

equation (5.17) above, keeping G and P constant.
227
 i
dY Lp
   0 - - - - - - - - - - - - - - - - - - - -(5.21)
dM ik
1 b 
L
 Both the denominator and the numerator are positive- increase
in money supply raises the level of income.
 The transmission mechanism in the context of the IS–LM
model is that an increase in the money supply lowers the
interest rate, which in turn stimulates investment and thereby
expands the demand for goods and services.

 Similarly, using equation (5.19), the impact of money supply

on the interest rate is given as follows.
dr L(1  b)  1 
  ...............................5.22
dM L(1  b)  ki  L 
228
 5.3.1.3. Interaction between Monetary and Fiscal Policy
 Monetary and fiscal policies may not be independent of each
other- a change in one may influence the other.
 Suppose that the fiscal authorities increase taxes.

 Other things being equal, this would reduce output and

interest rate in the short run (Case-1 in figure 5.14 below).
 Because an increase in tax shifts the IS curve to the left.

 If the monetary authority wants to keep interest rates stable,

however, it would respond to this change by decreasing the
money supply.
 This change shifts the LM curve to the left.

229
 The result would be larger decrease in output (Case 2 in figure
5.14 below).

 Alternatively, the monetary authorities might be trying to keep

output stable, by increasing the money supply, driving interest
rates down further (Case-3 in figure-5.14 below).

 The basic issue is that the ultimate effects on the economy

depend upon the combinations of policies chosen by the
monetary and fiscal authorities.

 Thus, coordination between the two policy making authorities

is very important.

230
Figure 5.14: Fiscal and Monetary policy interactions
LM2
Y r
LM
LM1
r1
r
r2
IS1
IS1
IS2 IS2
Y
Y2 Y1 Y Y2 Y1
Calse 1 Case 2
LM1
r

r1 LM2
Case 3
r2 IS1
IS2

231
 5.3.1.4. AD and the IS-LM Model
 Aggregate demand summarizes equilibrium in both the goods
and money markets.
 Recall that the IS–LM model is constructed on the basis of a
fixed price level.

 The real money supply changes if either the nominal money

supply or the price level changes.
 For a given value of the price level and the nominal money
supply, the position of the LM curve is fixed.

 Thus, changes in the price level are associated with change in

the equilibrium level of output and interest rates.
 The change in output and the price level represents the
relationship that is summarized by the AD curve.
232
 If the price level is high, the real money supply will be lower-
high interest rates owing to a leftward shift in the curve of real
money supply, and thus low investment and low output.
 If the price level falls, then the real money supply increases
(shifts to the right).

 Equilibrium in the money market implies that interest rates

must fall while goods market equilibrium implies that output
must rise, since investment rises owing to lower interest rate.

 Thus, AD curve is downward sloping; high values of the price

level are associated with low level of output, and vice versa.
 The AD curve can be derived from the changes in the IS and
the LM curves as given in the figure 5.15.
233
Figure 5.15: Aggregate Demand and IS - LM curve
Ms2 Ms1 LM (P2)
r
LM (P1)

r2
r2
r1
r1 IS
L(r,Y)

Y
M/P2 M/P1 M/P
Y2 Y1

P2

P1
AD

Y2 Y1

234
 The aggregate demand curve is a negative function of the
price level.
 Keeping G and M constant, this negative relationship can also
be proved by deriving (dY/dP) from the above relation given
by equation 5.17 as follows:
1 idM iMdp dY 1 iM
dY  (   dG )   (  )
ik 2
dP (1  b  ik ) LP 2
(1  b  ) LP LP
L L

dY  iM 2
 LP  0              [5.23]
dP ik
(1  b) 
L

 This identity also proves that the two variables are inversely
or negatively related meaning aggregate demand curve is a
downward sloping function of the price level.
235
Exercise:
 Given goods and money market structures of a given closed economy:
C(Y) =100 + 0.75Y; G = 80; I (r) = 25 - 0.0625r; Ms=M̅ (fixed) =
160; (M/P)d=Md=10+0.2y-0.05r, implies P=1. Assuming the economy
is in short run equilibrium, solve the following problems.
a) Estimate equations of the IS curve and the LM curve
b) Find the equilibrium output and interest rate
c) Find the multipliers dY/dG, dr/dG, dY/dM and dr/dM
d) What would be the impact of a unit increase in government
expenditure on both output and interest rate?
e) If money supply is increased by one unit, what would be the response
of (change in) output and interest rate?
f) Rather than using fiscal or monetary policies independently, if the
government prefer to use the composition of the two and expanded
money supply by 20 and increased government expenditure by 10
units, what would be the overall impact of these policies on output
and interest rate?

236
 5.3.2. The IS-LM Model in the long run
 Short run and long run (prices change) equilibriums are
different only from the point of view of Keynesian
economists.

 For classical economists the equilibrium is self-adjusting and

output is always at the full capacity (Y=Y̅ ), (figure 5.16).

 In the figure (5.16a), ‘eSR’ represents Keynesian equilibrium in

the short run- output is different from the capacity level
(Y≠Y̅) owing to stickiness of price and ‘eLR’ represents
Keynesian long run equilibrium.

 It is also a Classical equilibrium in both short and long run.

237
 If the equilibrium is at ‘eSR’ the economy is in short of
aggregate demand.
 Hence, fiscal policy or monetary policy that increases
aggregate demand (AD) should be at place.

 Long run adjustment can be represented by shifting ISLM

model as follows (figure 5.16b below).
 As price falls from P1 to P2, real money supply (M/P) increases
resulting in right ward shift of the LM curve, (LM1 to LM2).

 The interesting point of this is its policy implication.

 Now let’s see the implication of both fiscal and monetary
policies in the long run.

238
Figure 5.16a: Long run aggregate supply curve and
equilibrium
P AS

eSR

P1

eLR

P2
AD

Y1
Y̅

239
Figure 5.16b: ISLM model in the long run

LM1

LM2

r1

r2

IS

Y
Y1 Y̅

240
 5.3.2.1. Monetary policy in the long run
 As money supply increases, interest rate decreases which
again increases investment and increases aggregate demand
(AD shifts to the right).
 Increased aggregate demand again increases price.

 Increased price again leads to reduced real money supply

shifting the LM curve back to its original position (LM1);
where output is the same as before the policy change.

 The equilibrium simply moves from eSR to eLR in panel b.

 Thus, monetary policy is ineffective in the long run (no impact
on real output, Y) instead it only changes nominal variables
(Ms and P)- has an inflationary impact.
241
 Figure 5.17: Monetary policy in the long run
Panel (a)
Panel (b)
LM1
P Y
r

eLR
LM2 P2
r1
AD2

eSR
P1
r2

IS AD1

O Y̅ Y O Y̅ Y

242
 5.3.2.2. Fiscal policies in the long run
 As government expenditure increases (for instance) the IS
curve shifts to the right and aggregate demand (AD) curve
shifts upward to the right in panel b (see figure 5.18 below)
 Expansion of government expenditure increase aggregate
demand, which in turn leads to higher price level.
 Increased price level again reduces real money supply (M/P).

 This shifts the LM curve to the left until equilibrium is

maintained at the capacity level of output resulting in higher
interest rate.
 The equilibrium temporarily moves from point e1 to point e2
and then moves to point e3- in this case output is not affected.
 Thus, the ISLM model shows that fiscal policy is also not
effective in the long run.
243
 Figure 5.18: Fiscal policy in the long run
Panel (a) Panel (b)

r P
AS AS
as

LM2
e3
r3

LM1 P2
r2
e2
r1 e1 AD2

P1
IS2
AD1

IS1
Y̅ Y̅
Y 0
0 Y

244
5.3.2.3. Long run Proportionality between Prices and
Money Supply
 According to this theory, if the economy is not at full
employment, then the price level adjusts.

 In terms of the AD-AS diagram, the economy moves along the

AD curve and in terms of the ISLM, the LM curve shifts.

 There is adjustment to the long run equilibrium defined at a

point on the vertical aggregate supply curve.

 In the long run, output is equal to its potential level given at

the vertical aggregate supply curve, Y=Y̅.

245
 Thus, given change in output to be zero (dY = 0), the
differential of the IS equation will be given as follows.

 IS: dY (1-b) = idr + dG, substituting dY = 0, we obtain:

-idr = dG ---------------------------- [5.24]

 And the differential of LM equation will be:

dM dP
LM :  M 2  Ldr  kdY , but dY  0. Thus,
P P
dM dP dM dP
Ldr   M 2  dr  M 2
   [5.25]
P P LP LP

246
 Substituting the [5.25] into [5.24] and rearranging we obtain:

 dM dP    idM iMdP 
 i M 2 
 dG    2 
 dG
 LP LP   LP LP 

 iMdP  idM LP 2 i
 2 
 dG   dP  (dG  dM )
 LP  LP iM LP

dP LP 2 i P dP dM
 ( )   - - - - - - - - - - - - - - - (5.26)
dM iM LP M P M

 This implies that in the long run, a proportionate change in

price is equal to the proportional change in the money stock.
 This means that in the long run a percentage change in money
supply would only attribute to change in price level.

247
 5.4. Equilibrium in the goods and money markets: IS -LM
(Open Economy Model)
 In an open economy, a country’s spending in any given year
need not be equal to its output of goods and services.
 A country can spend more than it produces by borrowing from
abroad, or it can spend less than it produces and lend the
difference to foreigners.

 In an open economy GDP differs from that of a closed

economy because there is an additional injection i.e. export-
foreign expenditure on domestically produced goods.
 There is also an additional leakage, expenditure on imports
which represents domestic expenditure on foreign goods and
which raises foreigners’ income.

248
 An increase in exports increases the demand for domestic
goods and services while an increase in imports reduces it.
 Now, we assume that exports (X) and imports (M) are
autonomous; i.e. they are determined outside of the model.

 In an open economy, the relationship among the different

components of the AD can be:
AD = C + I + G + NX= C+I+G+X-M

 An export (X) increases the level of income and shifts the AD

curve upward whereas imports (M) reduce the level of income
and shift the aggregate demand curve downward (figure 5.19
below).
 The net effect depends on their relative values or on net export.
249
 Figure 5.19: Impact of Exports and Imports on the
Economy
Y=AD
Domestic Y=AD
Spending

AD AD0 = C+I+ G

AD1 = C+I+G + X

AD0 = C+I+ G AD1 = C+I+G +M

Y0 Y1 Y Y1 Y0 Y

A. Impact of Exports B. Impact of Imports

250
 5.4.1. Income Determination in Open Economy
 Equilibrium is defined at the point where aggregate demand
equals output or it is given by the national income identity.

 Since the level of import depends on the level of income and

demand of domestic consumers, the import function can be:
M = M0 + mY ------------------------------ (5.27)
Where; M = total import, M0 = autonomous import and
m=marginal propensity to import

 Consumption is also a function of income given as follows.

C = Ca + bY ------------------------------------ (5.28)

251
 Government expenditure and exports are assumed to be
exogenous. Exports- determined by foreign expenditure
decisions and foreign income.

 In equilibrium, the income equals AD given as follows:

Y = C + I + G + NX Y = C + I + G + X – (M)
Y = Ca + bY + I + G + X – (M0 + mY) ------- (5.29)

 Rearranging the identity, we get the following:

Y – [C(Y)+ I + G] = X – (M0 + mY)

252
 Y – AD(Y) = NX(Y) --------------------- (5.30)
Where, AD= C + I + G and NX is net export defined as,
NX(Y) = X – (M0 + mY).

 Equation 5.30 shows the equilibrium, where domestic balance

i.e. Y–AD(Y) is equal to the external balance i.e. NX(Y).

 The internal balance curve (Y–AD) is upward sloping since

its slope is given by (1–b) and hence positive- the larger the
income, the higher the AD for domestic spending will be.

253
 The external balance NX curve is downward sloping with the
slope of (–m) i.e. the larger the income, the larger the
consumption of imported goods will be, leads to smaller
external balance.

 The slope of the two curves can be derived as follows.

a) Slope of the domestic or internal balance

d Y  AD  d [Y  AD(Y )] d [Y  Ca  bY  I  G ]
(Y - AD) =    1 b
dY dY dY
b) Slope of the external balance
d NX  d [ NX (Y )] d [ X  M 0  mY ]
NX =    m
dY dY dY

254
 At the intersection of the two curves, the economy would be in
equilibrium as the internal balance is bridged up by the
external balance or vice versa (Figure 5.20).

 Y* and NX* are the equilibrium level of national income and

trade balance or net export, respectively.

 Note also that the external balance is also called the current
account balance when other components of the current
account are included in addition to import and export.

255
Figure 5.20: Internal balance and external balance
Y – AD Y – AD(Y)
NX

NX*

Y*
NX(Y)

256
 5.4.2. Open-Economy Multipliers
 The basic assumptions of open economy multiplier analysis:
i) Both domestic prices and the exchange rate are fixed;

ii) The economy is operating at less than full employment so that

increases in demand results in an expansion of output; and

iii) The authorities adjust the money supply to changes in money

demand by pegging the domestic interest rate so that the
money market will remain in the equilibrium.

 Some of the open economy multipliers are: import multiplier,

export multiplier, government purchase multiplier and current
account multiplier.
257
Import multiplier:
 is a measure of the impact of a unit change in the import on
the output or income.

 We can derive import multiplier using the major identities:

C = Ca + b(Y-T) consumption function; T = 0 (Tax is zero),
I=I0 (Autonomous investment); G = G0, X = X0
(Autonomous Exports); M = M0 + mY… import function

 In equilibrium, Y= C+ I + G +X – M,

 Substituting the consumption and import functions:

Y= Ca + b (Y-T) + I0 + G0 + X0 - (M0+ mY)

258
 Y= (Ca+bY)+ I0 + G0 + (X0 - M0 – mY) … since T = 0
Y-bY+mY = Ca + I0 + G0+ X0 - M0
Ca  I 0  G0  X 0  M 0
Y - - - - - - - - - - - - - - - - - - - - - - - - (5.31)
1 b  m

 Assuming G, I and X to be autonomous, import multiplier is:

dY= -dM / (1-b+m) dY / dM = -1/ (1-b+m)

 Import Multiplier = dY / dM =ke

 For autonomous change in import, the import expenditure
multiplier is : 1
ke  - - - - - - - - - (5.32)
1 b  m

259
 Example:
 If consumption is given by C = 100 + 0.75(Y-T); Tax (T) = 0;
Investment (I)=50; Government expenditure (G) = 100; Export
=50; Import (X) = 20+ 0.50Y; Find import multiplier.

Solution: Import multiplier = -1/ (1-b+m); where b = MPC, and

m = marginal propensity to import (MPI). In our case b = 0.75
and m= 0.50. The value of import multiplier = -1/(1-
0.75+0.50) = -4/3 = -1.33.

 From this, it is clear that as imports increase, the aggregate

income decreases by more than the increase in imports.

260
 Following the same procedure, we can derive other
multipliers. Or can derive multipliers from a common identity.
 Take eqn (5.29) and collect terms with income (Y) on one side.
Y = Ca + bY + I + G + X – (M0 + mY) =>
(1 –b + m)Y = Ca + I + G + X – M0

 1 
Y= (Ca + I + G + X - M0 )
1 b  m 
 Differentiating both sides, we get common identity.

1
dY  (dCa  dI  dG  dX  dM 0) - - - - - - - - - (5.33)
sm

261
 Different multipliers can be derived from above identity.
a) Import multiplier for an autonomous change in the import,

 dY   1   1 
  (1)   
 dM 0   1  b  m  1 b  m 

 Letting 1-b = s = marginal propensity to save.

 dY    1 
 = <0
 dM 0   s  m 
 Implies increase in autonomous import reduces the output.

262
b) Government purchase multiplier
dY  1   1 
= (1) =  >0
dG  1  b  m  sm

 This implies that an increase in the government expenditure

increases output.
 But, the multiplier is smaller than government purchase
multiplier in goods market with closed economy given by

 1   1 
 
  
1  b  1  b  m 

since 1 – b > 0 and m > 0.

263
c) Export multiplier

dY  1   1 
=  (1) =  >0
dX  1  b  m  s  m
 This implies that an increase in the export increases output.
 In this simple model, the multiplier effect of an increase in
exports is identical to that of an increase in government
expenditure.

 In practice, it is often the case that government expenditure

tends to be somewhat more biased to domestic output than
private consumption expenditure, implying that the value of
‘m’ is smaller in the government expenditure multiplier than in
the export multiplier.

264
d) Current Account Multiplier
 The policy variables have impacts on the external balance.

 A very simplified model of current account (CA) is given by:

 CA = X – M0 – mY ----------------------------- (5.34)

 Totally differentiating the equation (5.34), we obtain:

 d(CA) = dX – dM0 – mdY ------------------------- (5.35)

 Substituting equation (5.33) for dY in (5.35), we obtain:

m
dCA  dX - dM 0  (dCa  dI  dG  dX  dM 0 ) - - - - (5.36)
s  m

265
 From equation (5.36), we can derive the current account
multipliers.

i) Impact of government expenditure on CA balance is given by:

d (CA)  m m  ()
 (1) =  <0
dG sm s  m ()  ()
 That is, an increase in government spending leads to a
deterioration of the current account balance, which is some
fraction of the initial increase in government expenditure.

 This is because economic agents spend part of the increase in

income on imports.

266
ii) The effect of exports on the current account balance is:
d (CA) m s ()
 1   0
dX s  m s  m ()  ()
 Since (s/(s+m))<1, an increase in exports leads to an
improvement in the current account balance by smaller
proportion than the original increase in the exports.

 Part of the increase in income from the additional exports is

offset to some extent by increased expenditure on imports.

 That means exporters use imported raw materials and/or they

consume imported goods.

267
 5.4.3. Foreign Trade and IS -LM Model
 To obtain IS and LM curves, first assume prices, foreign
income and exports to be constant. Then we get equations:
Goods market: C = Ca + b(Y-T); T= (Tax is given/ constant);
I = I0 – i(r); G = G0, X= X0 (Autonomous Exports);
M=M0+ mY

 Substituting the above identities into AD function, we obtain:

AD = Ca + b (Y-T) + I0 – i(r)+ G + X0 - (M0 + mY) --- (5.37)

 IS curve is derived from national income identity:

Y = Ca + b (Y-T) + I0 – i(r)+ G + X0 - (M0 + mY) ---- (5.38)

268
 Graphically, the IS curve is derived from the points of
intersection between the AD curve and the 450 line given by
Y=AD (figure 5.21).

 IS curve may shift rightwards as income from abroad

increases, for instance, because higher export shifts the AD
curve upward and as a result IS curve shifts to the right.

 On the other hand, any decrease in exports shifts the AD

function downward and the IS curve to the left.

269
 Figure 5.21: Derivation of IS curve from AD and 450 line or
Keynesian Cross
Y=AD
AD
A
AD1 =a+b(Y-T) + I (r1) +G0+X0 -M

AD2 = a+b(Y-T) + I (r2)+G0+X0 -M

B

I2 I1
r

r2

r1

IS

Y2 Y
Y1

270
 The LM curve is derived from supply of and demand for
money taking into account impacts from the rest of the world.

 The balance of payment may have an impact on money supply

and ultimately on the LM curve.
 For example, Ethiopia imports more than exports hence there
is always deficit balance of payment.

 If this deficit is financed by increased borrowing from abroad,

then automatically money supply will increase.
 But, monetary authorities take appropriate measures to offset
changes in the money supply due to balance of payment
surpluses or deficits as it leads to a shift in the LM curve.

271
 Here, we introduce a third function showing a relationship
between income and interest rate because of external trade.

 Higher income leads to higher import demand since imports

are positive functions of income.
 The higher import leads to current account deficit and the
deficit is financed with capital inflow.

 So, there must be interest rate high enough to attract capital.

 Such positive relationship between income and interest rate is
represented by upward sloping curve known as Balance of
Payment (BOP) curve (figure 5.22 below).

272
 The BP curve consists of combinations of income and interest
rates which provide equilibrium in balance of payments.

 At income level Y0 and interest rate r2, the balance of payment

is in equilibrium while at income Y0 and interest rate r1, there
is a balance of payment surplus because, at income level Y0,
imports are unchanged because income remains the same.

 r1 is higher than the equilibrium rate and corresponding

capital inflow is greater than the equilibrium level.
 Consequently, the economy is in a balance of payment surplus.
 The economy has a balance of payment deficit at Y0 and r3.

273
 Figure-5.22: The BP curve
BP

r1

r2

r3

Y0

274
 Now, consider balance of payments equilibrium within IS and
LM context starting with initial equilibrium condition where
IS, LM and BP curves meet at interest rate r0 and income Y0.

 Since all the curves meet at this point, goods market, money
market and balance of payment is in equilibrium.

 At Y0 the economy may be in full employment but if the full

employment is at Y1 then unemployment is there in the
economy at Y0 level.

275
 So full employment and balance of payment can be achieved
through a mixture of fiscal and monetary policy so that IS and
LM curve can shift upwards to reach r1.

 Most appropriate policy could be expansionary fiscal policy to

shift IS curve and contractionary monetary policy to shift LM
curve to this level.

 In case of deficit the reverse policy should be applied.

 Yet, effectiveness of policies to increase interest rate and

attract foreign capital depends on elasticity of BP curve.

276
Figure-5.23: Internal and External Equilibrium
r
BP

LM0
r1

r0

IS0

Y0 Y1

277
 The elasticity of the BP curve, theoretically, varies between
perfectly inelastic and perfectly elastic cases.

 A perfectly inelastic BP curve is a vertical line (BP1 in figure

5.24).

 In this case, any level of increase in the interest rate will not
induce any capital inflow into the country- policies may be
totally ineffective.

 This reflects the condition of countries with little freedom or

high restriction on capital mobility.

278
 The other extreme case is the perfectly elastic BP curve (BP2
in the figure below), where a small increase in the interest rate
leads to a huge capital inflow.

 Thus, a small change in fiscal and monetary policy, which

leads to higher interest rate, is highly likely to be successful.

 The BP curve is highly elastic in countries with little

restriction on capital movement.

 Normally, the BP curve takes the position in between the two

extreme cases (e.g., BP3 in figure 5.24).

279
 Figure-5.24: Elasticity of BP Curve
r BP1

BP3

r0 BP2

280
 5.4.4. Problem of Internal and External Balance
 Although economic policy-makers generally have many
macroeconomic objectives, the discussion in the 1950s and
1960s was primarily concerned with two objectives.

 The principal goal was one of achieving full employment for

the labour force along with a stable level of prices which may
be termed internal balance objective.

 However, expanding output and employment through

expansionary fiscal policy to achieve full employment will
result in greater expenditure on imports and consequently will
lead to a deterioration of the current account balance.

281
 As authorities had agreed to maintain fixed exchange rates,
they were interested in running equilibrium in the balance of
payments.
 This later objective can be termed external balance objective.

 Figure 5.25 below shows this problem of maintaining both

internal and external balance simultaneously.

 As a result of expansionary fiscal policy the [Y-AD(Y)] curve

shifts from [Y–AD(Y1)] to [Y–AD(Y2)] and the new
equilibrium point is achieved with a higher output (Y**) but
the current account balance has deteriorated simultaneously.

282
 Figure 5.25: Internal and external balance
Y-AD[Y1]
Y-AD[Y]
NX[Y]

Y-AD[Y2]

NX*

NX**

Y
NX[Y]
Y* Y**

283
 The multipliers also tell us the same thing i.e.
dY 1
 0
dG ( s  m)
d (CA) s
where as dG  ( s  m)  0
 Hence, use of one instrument to achieve two targets, internal
and external balance, is most unlikely to be successful.

 The idea that a country generally requires as many instruments

as its target was elaborated by the Nobel Prize winner
economist Jan Tinbergen (1952), and is popularly known as
Tinbergen’s instruments – targets rule.

284
 To maintain the external balance, devaluation would be a
good candidate as it can improve the current account balance
by making imports expensive in the domestic market and by
making exports cheaper in the foreign market.

 As the figure below shows, devaluation shifts the NX curve

upward from NX1 to NX2, and equilibrium can be maintained
at a higher level of output and better current account balance.

 Thus, export increases as import decreases both of which

improve the current account balance.

285
Figure 5.26: Devaluation and the internal and
external balances
Y - AD[Y]1
Y - AD[Y]
NX[Y] Y - AD[Y]2

NX***

NX*

NX2
NX**
Y

Y* Y** Y***
NX1

286
 However, the effectiveness of devaluation in yielding the
above solution depends on the Marshall-Lerner condition.

 Marshall–Lerner condition (MLC) is a measure or

mathematical relation developed to evaluate effectiveness of
devaluation policy considering the response of the two major
variables, import and export to the change in exchange rate.

 The MLC is derived as follows.

 A simplified current account balance (CA) expressed in terms
of domestic currency is given by the following identity (5.39).

287
 CA = X – eM ----------------------- [5.39]
Where, e is the nominal exchange rate, CA is current account
balance, X is export, M is import expenditure

 Totally differentiating equation [5.39] we obtain,

d(CA) = dX – edM – Mde

 Dividing both sides by ‘de’, we get

d (CA) dX edM
   M - - - - - - - - - - - - - - - - - - - - - - - [5.40]
de de de
 At this point, we introduce two definitions.

288
a) The price elasticity of demand for exports ‘ŋx’ is defined as
the percentage change in exports owing to a percentage
change in price as represented by the percentage change in
the exchange rate.

 This is given as:

dX e
x  . - - - - - - - - - - - - - - - - - - - - - [5.41]
de X
 Rearrange and solve for:
dX X
 x - - - - - - - - - - - - - - - - - - (5.42)
de e

289
b) The price elasticity of demand for imports ‘ŋm’, is defined as
the percentage change in imports due to a percentage change
in import price as represented by the percentage change in the
exchange rate.

 It is given as follows.
dM e
m   . - - - - - - - - - - - - [5.43]
de M
 Rearrange and solve for:
dM M
  m - - - - - - - - - - - - - - - - - - - - - - - - [5.44]
de e

290
 Substituting [5.42] and [5.44] into [5.40] we obtain:
d (CA) X
  x   m M  M - - - - - - - - - - - - - - - - - - - - - [5.45]
de e
 Multiplying [5.45] by 1/M throughout we get:
d (CA) X
 x   m  1 - - - - - - - - - - - - - - - - - - - - - - - - [5.46]
de.M eM
 Assuming that we initially have balanced trade X = eM and
hence X/eM = 1 and rearranging [5.46] yields:
d (CA)
 M ( x   m  1) - - - - - - - - - - - - - - - - [5.47]
de
 Equation [5.47] is known as the Marshall-Lerner Condition
and it says that devaluation will improve the current account.

291
 That is, d(CA)/de>0 only if the sum of the foreign elasticity of
demand for exports and the home country elasticity of demand
for imports is greater than unity (ŋx+ŋm >1).

 If (ŋx+ŋm<1) then devaluation will lead to a deterioration of

the current account balance- requires much research.

 Economists are divided up into two camps popularly known as

elasticity optimists who believed that the sum of these two
measures of elasticity tended to exceed unity and others
believe that it is not unity.

292
 It was argued that devaluation may be better for industrialized
countries than for developing countries.

 Many developing countries are heavily dependent upon

imports so that their price elasticity of demand for imports is
likely to be very low while for industrialized countries that
have to face competitive export markets, the price elasticity of
demand for their export may be quite elastic.

 The implication of MLC is that devaluation may be a cure for

some countries balance of payment deficits but not for others.

293
 Even for countries for which that devaluation is a solution for
the Balance of Payment deficit, the initial J-curve effect (see
figure 5.27) may not be precluded.

 The J-curve shows that the deficit may initially rise but after
a lag of sometime the trend would be reversed so that the BOP
would be in surplus.

 The J-curve effect arises mainly as elasticities are lower in the

short run than in the long run.
 So, the MLC may hold only in the medium to long run.

294
 Figure 5.27: The J-Curve
Current Account

The J - Curve

Surplus

Time

Deficit

295
 The idea underlying the J-curve effect is that in the short run,
export and import volumes do not change much, so that
devaluation leads to deterioration in the current account.
 However, after a time lag, export volumes start to increase and
import volumes start to decline; consequently the current deficit
starts to improve and eventually moves into surplus.

 The two most important reasons for slow responsiveness of

export and import volumes in the short run are:
 a time lag in consumers’ responses, the time it takes for
consumers in both the devaluing country and the rest of the
world to respond to the changed competitive situation and
 a time lag in producers’ responses, the time it takes for
domestic producers to expand production of exportable goods.
296
6. BALANCE OF PAYMENT AND EXCHANGE RATE
 Any economy is linked to the rest of the world through two
broad channels: trade (in goods and services) and finance.

 The trade linkage means that goods are exported to foreign

countries and imported from abroad.

 The international links in finance means that the residents,

whether households, banks, or corporations, can hold the
nations assets such as treasury bills or corporate bonds, or
they can hold assets in foreign countries say in Canada or in
Germany.

297
 6.1. Balance of Payments
6.1.1. Concepts and Components of Balance of Payments
 The balance of payments (BOP) of any country is ‘a
systematic record of all economic transactions between the
residents of a given country and the residents of the rest of the
world in an accounting period (normally one year)’.

 The BOP transactions include all the foreign receipts of and

payments by a country during a given year.

 The receipts include all the earnings and borrowings of

foreign exchange, and they are recorded as credit items.
 The payments include all the spending and lending of foreign
exchange, and they are recorded as debit items.

298
 All the foreign receipts are financial inflows and all the
foreign payments are financial outflows in a year.
 In the purely accounting or bookkeeping sense the BOP must
always balance, because the BOP is a schedule of debit and
credit transactions, which must necessarily be equal.

 While the equality of debits and credits (i.e. accounting

balance) is inevitable, it does not necessarily follow that the
BOP equilibrium is guaranteed.
 Accounting balance is consistent with BOP disequilibrium i.e.
deficits and surpluses exist in the BOP.

 The BOP accounting format differs among different countries.

299
 Major accounts of balance of payment
 The BOP statements basically include six major accounts:
 Goods account,
 Services account,
 Unilateral transfers account,
 Long-term capital account,
 Short term capital account and
 International liquidity account.

300
 1) Goods account
 Goods account includes the value of merchandise exports and
the value of merchandise imports.
 They may be final consumer goods, intermediate capital goods
or raw materials. These items of foreign exchange earnings
and spending are called as ‘visible’ items in the BOP.

 If the receipts from exports equals to the payments for

imports, we describe the situation as ‘goods balance’.

 Otherwise, there would be either a positive or a negative

goods balance depending on whether receipts exceeding
payments (positive) or payments exceeding receipts (negative).
 Positive goods balance is regarded as ‘favourable’.

301
 2) Service account
 The service account records all the services exported and
imported by a country in a year.
 Services transactions are regarded as ‘invisible’ items in the
BOP.

 They are invisible in the sense that service receipts and

payments are not recorded at the port of entry or exit like
merchandise imports and exports receipts- the main difference
between goods and services receipts and payments.

 Favourable goods and services balance brings foreign reserve

into the country, where as unfavourable goods and services
balance takes foreign reserve out of the country.

302
 3) Unilateral transfer account
 This account includes all gifts, grants and reparation receipts
and payments to foreign countries.
 Unilateral transfer consists of two types of transfers: (a)
government transfers and (b) private transfers.

 Foreign economic aid or assistance and foreign military aids

or assistances received by the home country’s government (or
given by the home government to foreign government)
constitute government to government transfers.

 Private transfers, on the other hand, are funds received from

or remitted to foreign countries on person to person basis.

303
 4) Long-term capital account
 Long term capital account includes the amount of capital that
has moved into or out of the country in a year or more.
 The long term capital account includes: Private direct
investment, Private portfolio investment and Government
loans to foreign governments.

a) Private direct investment: these investments are done by the

citizen’s and domestic firms of home country in foreign
countries (debit) and by foreigners or foreign firms in the
home country (credit).
• This type of capital movement is induced by differences in
profit rate between the home country and the rest of the world.

304
b) Private portfolio investment: these investments are done by
home country citizens and firms in foreign securities or
stocks or bonds or shares (debit) and by foreigners in home
country securities, stocks, bonds, shares, etc. (credit).

 This type of movement in and out of a country is induced by

differences in interest rate, dividends or rate of return on
capital between the home country’s financial assets and those
of the foreign nations.

305
c) Government loans to foreign governments: these loans are
given by home country’s government (debit) and to the home
government by foreign governments (credit).

 Capital lending countries would experience deficits on long

term capital account; and capital borrowing countries
experience surpluses in their long-term capital account.

 A borrowing country, receiving credits at present and enjoying

surpluses on long term capital account must soon expect to
lose a sizeable sum as capital service obligations and,
therefore, be ready to suffer deficits on service account.

306
 5) Short term capital account
 Bank deposits and other short term payments and credit
arrangements fall into this category.

 Short term capital items fall due on demand or in less than one
year, as opposed to long term capital flows which have
maturity after one year or thereafter.

 The vast majority of short term capital transactions basically

represent bank transfers to finance trade and commerce.

 When Ethiopian exporters export coffee worth $5 million to an

importer in Germany, it generates a credit of $5 million to the
Ethiopian merchandise account.

307
 But if the Germany importer pays this sum of $5 million into
the bank account of the Ethiopian exporter held in Berlin
bank, the sum of $5 million would be held as a debit in
Ethiopia’s short term capital account.

 The latter constitutes a short term capital out flow of $5

million from Ethiopia to the Germany.

 It is also interesting to note that it is often hard to keep track of

all the short term capital movements in and out of a country.
 They can at best be approximate estimates.

308
 In some countries short term capital transactions are included
in the ‘Unrecorded Transactions’ as a separate BOP account.

 Unrecorded Transactions account or Errors and omissions

account include statistical and recording errors, smuggling,
illegal and secret capital movements and imperfect estimation
procedures errors besides short term capital movements.

 The fifth account in the BOP schedule may therefore be called

either as short term capital account or as errors and
omissions including short term capital or simply as
unrecorded transactions account.

309
 6) International Liquidity Account
 The final BOP account is the international liquidity account
which simply records net changes in foreign reserves.

 Essentially, this account lists internationally acceptable means

of settling international obligations.

 International liquidity account is best understood as follows:

310
 Table 6.1: Balance of Payment account ($ millions)
Items A: surplus case B: deficit case
Credit Debit Credit Debit
1. Goods account 1,500 800 800 1,500
2. Services account 500 1,400 1,400 500
3. Unilateral transfers account 100 120 120 100
4. Long term capital account 900 400 400 900
5. Errors & omissions 500 630 630 500
(including short term
capital) account
6. International liquidity --- 150 150 ---
account
7. Balance of payment 3,500 3,500 3,500 3,500
311
 In panel A of the table, the total receipts are $3,500 million
and total payments are $3,350 million. There is a net BOP
surplus amounting to $150 million, which is entered into
international liquidity account as debit.

 The logic of accounting $150 million as debit or payment is

that, this sum represents either: a) Purchase or import of gold
worth $150 million; or b) Net addition to accumulation of
foreign reserves of $150 million; or c) Capital lending in the
sum of $150 million to other countries on short term or long
term basis.

 A debit entry in the international liquidity account shows that

there is a surplus in the BOP of the country for that year.

312
 Panel B has the exact opposite picture.
 The sum of debit ($3,500 million) exceeds the sum of credit
($3,350 million) by $150 million which represents the net
deficit in the BOP due to the first five accounts in the table.

 How was deficit of $150 million financed?

 It will be financed in one of the following three ways: a)
Selling or exporting gold worth $150 million; or b) Drawing
down upon the past accumulated foreign reserves equal to the
sum of $150 million; or c) Borrowing capital in the sum of
$150 million on short term or long term basis from friendly
countries or international institutions such as the IMF.

313
 The international liquidity account in this case, then,
represents the BOP deficit sum of $150 million.

 This amount is entered as credit item to indicate how the sum

of $150 million was brought into finance the deficit of that
magnitude arising out of the first five accounts in the BOP
schedule.

 A credit entry in the international liquidity account shows,

therefore, that the country had a deficit in its BOP of that
magnitude in that particular year.

314
Sample BOP schedule
 Let us take a look at the following sample of BOP schedule
using some hypothetical numbers in each of the six accounts.

 In table 6.2 below, the six accounts are numbered from 1 to 6,

whereas the major BOP concepts are serialized as A, B, C, D,
E and F.

315
 Table 6.2: Balance of payments schedule-a sample
Major accounts Credit Debit Net surplus (+)
(Receipts) (payments) or deficit (-)
200 180 +20
1. Goods account
100 250 -150
2. Service account
(300) (430) (-130)
A. Balance of trade (1+2)
300 120 +180
3. Unilateral transfers account
(600) (550) (+50)
B. Balance of payments on current account (1+2+3)
150 120 +30
4. Long term capital account
(750) (670) (+80)
C. Basic balance (1+2+3+4)
50 40 +10
5. Short term capital account
(200) (160) (+40)
D. Balance of payments on capital account (4+5)
(800) (710) (+90)
E. Overall balance of payments (B+D)
90
6. International liquidity account /net changes in
external reserves
(800) (800) (0)
F. Balance of payments accounting balance

316
 A) Balance of trade
 Balance of trade is the difference between the value of goods
and services exported and imported by a country.
 If the two sums are exactly equal to each other, we say that
there is balance of trade equilibrium or balance; if the former
exceeds the latter, we say that there is balance of trade
surplus; and if the latter exceeds the former, then we describe
the situation as one of balance of trade deficit.

 Surplus is regarded as favourable and deficit as unfavourable.

 In table 6.2 above, there is a balance of trade deficit equal to

$130 million.

317
 B) Balance of payments on current account
 It includes the sum of three balances viz. merchandise balance,
service balance and unilateral transfers balance.
 In table 6.2 above, the positive unilateral transfers balance of
$180 million is added on to the negative trade balance of $130
million, giving current account BOP surplus of $50 million.

 Also referred to as Net Foreign Investment.

 BOP on current account covers all the receipts on account of
earnings (or opposed to borrowings) and all the payments
arising out of spending (as opposed to lending).

 There is no reverse flow entailed in this account transactions

which is a sharp contrast to the BOP on capital account.
318
 C) Balance of payments of capital account
 All transactions involving inward or outward movement of
capital and investment are included in the capital account of
BOP of the reporting country.
 It comprises the long-term and short term capital accounts.

 Less developed countries (LDCs) are usually net borrowers of

foreign capital and recipients of foreign investment, and to
that extent they would ‘enjoy’ favourable BOP trends.

 But sooner or later this foreign capital and investment will

leave the LDCs and go back/ repatriated in the form of profits,
interest, dividends and royalties from the ‘host’ countries to
the ‘home’ countries, i.e. from LDCs to DCs.
 Significance of deficits and surpluses here depends on time.
319
 D) Basic balance
 Basic balance in the BOP comprises the BOP on current
account plus long term capital account.
 The short term capital account balance is not included in the
basic balance for two main reasons:

A. Short term capital movements, unlike long term capital

flows, are relatively volatile, and move in and out of a
country in a period of less than a year. It would, therefore,
be improper to treat them on the same footing as current
account BOP, which are extremely durable in nature.
B. In many cases, countries do not have a separate short term
capital account; in these countries, short term capital
transactions constitute a part of the ‘errors and omissions
account’.
320
 E) Overall balance of payment
 This is the sum of balance on current account and on capital
account put together.
 It includes all international monetary transactions of the
reporting country vis-a-vis the rest of the world.

 Since it is highly aggregative, the overall BOP cannot be of

much significance, because the aggregate credit and debit
figures do not reveal the behaviour of change of the
components which constitute the aggregate.

 Take, for instance, the question of surplus and deficit.

321
 Can we say that a surplus in overall BOP is a good sign or a
deficit in the overall BOP is a bad sign? The answers can be:
i. If the overall surplus in the BOP was caused by current
account surplus but not capital account surplus, then the
surplus may be a good sign for the country.
ii. If the overall deficit in the BOP was caused by current
account deficits rather than capital account deficits, then the
deficit may be considered as a bad sign for the reporting
country.

 In other words, if there is an overall BOP surplus/ deficit, we

will have to first locate whether the surplus/ deficit originated
in current account or capital account or both.

322
 6.1.2. Balance of payments settlement and adjustment
 Suppose that we have a deficit (or surplus) in the current and
capital account of our country’s BOP.
 We can ‘settle’ this deficit (or surplus) arising out of
imbalance in the autonomous transactions by accommodating
payments (or accommodating receipts) so as to produce a BOP
balance in the accounting sense.

 This is a process of BOP settlement.

 This merely and temporarily overcomes the BOP problem with

the help of necessary accommodating transactions.

323
 If, on the other hand, we control the deficit (or surplus) by
controlling the forces which were causing this deficit (or
surplus) then we have undertaken what may be called as BOP
adjustment.

 BOP adjustment takes place only when we have produced

‘balance’ in autonomous transactions i.e. when autonomous
credit receipts are equal to autonomous debit payments.

 Adjustment is more desirable and difficult than settlement.

324
 6.1.3. Balance of Payments and Economic Policy
 It is believed that BOP surpluses do not usually create great
problems, so we are not especially concerned with surplus
countries.
 For economic policy purposes, one is especially concerned
with BOP problems of deficit countries.

 If a country is already pursuing a tight monetary and fiscal

policy and has tariffs and import controls, but yet it has a
serious deficit, it may be very difficult for such a country to
get rid of a deficit.
 We can then talk about actual and potential deficits.

325
 The actual deficit which has appeared on the surface is in that
case, much smaller than the potential deficit that could have
surfaced but has indeed been suppressed by tight domestic and
foreign trade economic policies of the country.

 The possibility of pursuing a more restrictive policy to close

the actual deficit may no longer exist for a country, because it
already has reached its upper limit.

 Furthermore, if the economy is already experiencing

politically unacceptable levels of high unemployment, it will
be almost impossible to try to cut down BOP deficits by
pursuing contractionary monetary, fiscal and other policies.

326
 In such tight situations only international capital flows can
play a vital role in equilibrating the BOP.
 Once again the nature of capital flows is very crucial.

 Accommodating capital inflows, especially, if they are

continued over several years, are a sure warning signal.
 It is left to the ingenuity of the country’s planers and policy
makers to adopt ways and means of converting
accommodating capital imports of short-term nature into
planned long term autonomous capital imports.

 If that can be done, the country need not change its economic
policy. It can proceed without having to worry about the BOP
situation for the next 15-20 years.
327
 6.2. Exchange Rate
 6.2.1. Definition and Exchange Rate Determination
 In international trade, we need internationally accepted
currencies. So, we need to convert domestic currency to
foreign currency.

 The price or foreign exchange rate can be defined as the

amount of domestic currency (say Birr) that must be paid per
unit of foreign currency (may be US$).

 There are two major exchange rate policies: fixed exchange

rate regime and floating or flexible exchange rate regime.
 Sometimes, a partly flexible and partly fixed, known as dirty
exchange rate regime is used.

328
 Fixed Exchange rate Policy/Regime
 During the Imperial period (Hailesilassie government) and
during the Derg period, Ethiopia had been one of the countries
who followed fixed exchange rate regime and it was about 2.07
Birr per one United States Dollar.

 The determination of the level of exchange rate is made based

on the government political and economic decisions.

 There are several reasons why nations follow fixed exchange

rate policy.
 The major reason is to protect the value or the strength of their
currency in the foreign market for those countries which are
weak in the international trade.
329
 Their export capacity is very low and this implies that their
foreign exchange earnings are low and again that the capacity
of the country to finance the necessary import (for the
government and the public) is very low.

 Thus, the necessary foreign exchange will be obtained through

purchases of the foreign currency with the domestic currency
at low level fixed rate.

 Otherwise, the demand for the domestic currency by the

international community decrease as the export supply of the
country to them is limited and again leads to a decline in the
value of the currency given by higher exchange rate known as
exchange rate depreciation.

330
 Thus, countries try to keep their exchange rate fixed.

 In the countries which follow fixed exchange rate regime,

there are specific groups of individuals, firms and institutions
who are officially allowed to get foreign exchange while other
people and institutions cannot get foreign exchange from
official financial institutions such as commercial banks.

 In this case such demand for the foreign currencies and supply
of foreign currencies may be exchanged in the black market
(parallel market) transactions.

331
 Black market represents the act of transactions by individuals
at home or private centers devoid of the government
acknowledgement or license.

 These people supply the foreign currency that they personally

access from relatives, individuals and small entities involved
in similar activities.

 The exchange rate in the black market is different from the

official one and is normally floating.

332
 Floating or Flexible Exchange Rate Regime
 Floating or flexible exchange rate policy is the case where the
price of the foreign currencies in terms of domestic currency
(domestic currency per foreign currency) is left for the market
factors to determine.

 Depending on the level and intensity of the determinant

factors, the value of the exchange rate is allowed to change.

 There are several theories under this type of exchange rate

policy that emphasized different factors for determining the
level of exchange rate.

333
 According to Purchasing Power Parity theory, first coined by
Gustav Chassell, exchange rate is determined by the relative
purchasing powers of the two currencies reflecting parity
between them.
 For instance, if the price of a product is 2 birr in Ethiopia and
the price of the same product is 20 cents in USA then
exchange rate is (2Birr=20US cents) or (1 US$ = 10 Birr).

 In this way it is difficult to find the exchange rate as there are

thousands of products produced by these two countries and
which standard products to take is very difficult to find.
 According to the demand and supply theory, the level of
exchange rate is determined by demand for and supply of the
domestic currency and/or foreign currency.

334
 The demand for foreign exchange can be explained by the fact
that nations need foreign currency to buy foreign goods and
services, to make unilateral transfers to individuals or firms
outside the country, to save their money or make deposits in
foreign banks and to make long and short term loans to foreign
residents, firms or governments and so on.

 The supply of foreign exchange means the earnings of foreign

currencies from exports of various goods and services, receiving
unilateral transfer payments from abroad, short term and long
term capital imports or inflows in the form of foreign direct
investment or foreign deposits made in the country, borrowing
from abroad, aids received from abroad, and so on.
335
 All these components of supply of foreign exchange are
recorded in credit transactions of the current and capital
account of the balance of payment schedule.

 However, supply of foreign exchange may not be always be

equal to the demand for foreign exchange because components
of supply and demand are made of entirely different
components.

 But if demand for foreign exchange and supply of foreign

exchange are equal then there is balance of payment
equilibrium and the exchange rate determined by demand for
and supply of foreign exchange at this point is known as
equilibrium foreign exchange rate.

336
 In figure 6.1, the supply and the demand curves intersect at
point ‘e’ representing equilibrium exchange rate given by
‘ERe’ where demand for foreign exchange is exactly equal to
the supply of foreign exchange, is also known as market
clearing foreign exchange rate.

 All other exchange rates are not market clearing ones.

 For instance, in the figure below, when exchange rate is at

‘ER1’ the supply of the foreign exchange (FE2) exceeds the
demand for the foreign exchange (FE1); i.e. FE2> FE1.

337
Figure 6.1: Exchange rate determination under
floating exchange rate regime
Exchange rate
Sf = supply of foreign exchange
(Birr/$)

ER1
e

ERe

ER2
Df = demand for foreign exchange

FE1 FEe FE2, Quantity of foreign exchange (eg: USD)

338
 Under this situation, if exchange rate is free to adjust, then the
exchange rate will fall down until it reaches the equilibrium.

 This is because the suppliers of the foreign currency will be

ready to sell their foreign exchange at lower price so that they
will get rid of the excess supply.

 For instance, if several tourist visitors come to a country, it

means higher supply of the foreign exchange and at the same
time these visitors would be ready to receive less domestic
currency per their own country currency (foreign currency).

339
 On the other hand, if exchange rate is at ‘ER2’, there will be
an excess demand of foreign exchange (FE2) over supply of
the foreign exchange (FE1).

 Under flexible or floating exchange rate regime, the price of

the foreign exchange increases till it reaches the equilibrium.

 This is because the individuals or entities with excess demand

for the foreign exchange would be ready to pay more domestic
currencies to get a unit of the limited foreign currency.

340
6.2.2. Exchange Rate Fluctuations and External Balances
 Different terms are used to explain fluctuations in the
exchange rate under different exchange rate policies.

 Under floating exchange rate regime, if the demand for the

foreign currency is in excess of its supply at the prevailing
exchange rate, then there will be upward pressure on the
exchange rate as the demanders will be ready to pay more of
the domestic currency to get limited foreign currency.

 Thus, exchange rate continues to increase until the equilibrium

is reached.
 Such an increase in the exchange rate due to the market forces
is known as depreciation of the domestic currency.
341
 The value of the domestic currency relative to the foreign
currency is reduced.

 A decrease in the exchange rate owing to market forces such

as an excess supply of foreign currency over its demand is
known as appreciation of domestic currency.

 The value of the domestic currency relative to the foreign

currency is increased in this situation.

 If official exchange rate is increased through political or

economic decision of the government of a country which
follows a fixed exchange rate policy, such a change is known
as devaluation of domestic currency.
342
 In this case the value of the domestic currency relative to the
foreign currency is reduced.

 If an opposite change is made by the government decision, this

change is known as revaluation of domestic currency.
 In this case, the value of the domestic currency relative to the
foreign currency is increased.

 Devaluation is often recommended by several economic

policy makers and international institutions as a solution for
the problem of deficit in the current account balance and/or
deficit in the overall BOP for several developing countries
around the world.

343
 This means that devaluation improves the current account
balance and/or the overall BOP whether the initial balance is
negative (deficit) or positive (surplus).
 The improvement mechanism is explained as follows.

 Devaluation and depreciation have the impacts of improving the

external balances by making export of the country cheaper and
by making import by the country costly.

 But, on the contrary, revaluation of a domestic currency and

exchange rate appreciation have the impacts of deteriorating
the external balances by making export of the country more
costly and by making import by the country or its citizens
cheaper than before.
344
 Suppose that Ethiopian birr is pegged with US Dollar and the
initial exchange rate of two Birr per one US$ is devalued and
the exchange rate is changed to eight Birr per one US$.

 Then, now for Ethiopians foreign goods and services are more
costly than before the devaluation and Ethiopians are expected
to spend less on foreign goods and services (reducing import).

 This is because to import or to purchase a foreign commodity

of 10 US$ value, Ethiopians have to pay 80 Birr after
devaluation as opposed to only 20 Birr they used to pay before
the devaluation.

345
 But, for the foreigners the Ethiopian goods and services
become less costly than before devaluation and they are
expected to purchase more Ethiopian goods and services.

 This is simply because they can get larger amount of Birr for
less number of their currency to purchase Ethiopian products
(mainly export and so increasing export).

 However, whether a country will gain or not due to

devaluation depends on the responsiveness or elasticity of
imports and exports given by Marshall Lerner conditions.

346
 The Marshall Lerner condition (MLC) is given by:
d (CA)
 M ( x   m  1) - - - - - - - - - - - - - - - - - - - (6.1)
de
Where, d(CA)= change in current account balance, M=import
value, de=change in exchange rate (devaluation), ŋx=export
elasticity; ŋm=import elasticity

 The derivation of the identity is covered in the previous unit.

 The success of devaluation policy in improving the external

balance depends upon the sum of elasticity of import demand
and elasticity of export supply of the country.

347
 Thus, the three different possible outcomes of devaluation are:
1) If the sum of elasticity of demand for imports and supply of
exports is greater than one, (ŋx + ŋm> 1), then devaluation
would improve trade balance and the overall BOP.

2) If the sum is equal to one (ŋx+ŋm= 1), then with devaluation,

trade balance or overall BOP remains unchanged.

3) If the sum is less than one, (ŋx+ŋm< 1), then devaluation

would worsen a problem of trade balance and so that of
overall balance of payment.

348
 In developing countries the sum of elasticity of demand for
imports and elasticity of supply of exports is normally less
than one.
 This is for the reason that developing countries composition of
imports is highly inelastic items such as petroleum and capital
intensive goods which have no substitutes.
 This leads to deterioration of the external balance.

 On the other hand, the exports are basically primary goods

which require long time (may be years) to expand their
production and have less demand in the international market.
 Hence, the net gain from devaluation would be deterioration
of the external balance.

349
 7. Economic Growth and Development

7.1. Meanings of Economic Growth and Development

 The difference between economic development and economic
growth relates to the nature and causes of change.

 According to Kindleberger, economic growth means more

output while economic development implies both more output
and changes in the technical and institutional arrangement by
which it is produced and distributed.

 The concept of development should embrace the major

economic and social objectives and values that society
strives for.

350
 Goulet distinguished three basic values of development, as,
life sustenance (ability to meet basic needs), self respect and
freedom from the evils of want and ignorance.

 Generally, economic growth is related to a quantitative

sustained increase in the country's per capita output or
income accompanied by expansion in its labor force
consumption, capital and volume of trade.

 Economic development is wider concept than economic

growth. It is taken to mean growth plus change.
 It is related to qualitative change in economic wants,
institutions or the upward movement of the entire social
system. 351
 7.2. Measurements of Economic Development
 Economic development is measured in four ways:

1. GNP- Gross National Product: refers to the country's total

output of final goods and services.

 GNP does not reveal the changes in growth of population.

 It does not reveal -the costs to society of environmental
pollution.

 It tells us nothing about the distribution of income in the

economy.

352
 GNP makes no effort in including the non marketable
products (bringing up children, production of home materials,
home bakery, etc).

 Another difficulty in calculating GNP is of double counting

which arises from the failure to distinguish properly between
final and intermediate products.
 a good or a service being included more than once- the
GNP would work out to be many times the actual.

353
2. GNP per capita-it is the GNP divided by the total population of
the country.

 The real GNP per capita fails to take problems associated with
basic needs like nutrition, health, sanitation, housing, water and
education.

 The improvement in living standards by providing basic

needs cannot be measured by increase in GNP per capita.

 The real GNP per capita is the most widely used measure of
economic development.
354
3. Welfare- economic development is regarded as a process
whereby there is an increase in the consumption of goods and
services of individuals.

 Welfare as measurement of development is not free from

limitations like the difficulty in the valuation of the output.

 This measure is the secular improvement in material well

being.

355
4. Social Indicators- economists include a wide variety of items
in social indicators: some are inputs such as nutritional
standards or number of hospital beds or doctors per head of
population while others may be output corresponding to
these inputs such as improvements in health in terms of infant
mortality rates, sickness rates, etc.
 often referred to as the basic needs for development.

 The merit of social indicators is that they are concerned with

ends being human development. The social indicators
include health, food, water, sanitation, housing and the like.

356
Human Development Index (HDI)
 Since 1990, the UNDP has been presenting the measurement
of human development in terms of HDI in its annual report.

 The HDI is a composite index of three social indicators: life

expectancy, adult literacy and years of schooling and real
GDP per capita.

 Thus, the HDI is a composite index of achievement in three

fundamental dimensions: a long and healthy life, knowledge
and a decent standard of living.

357
 The HDI value of a country is measured by taking three
indicators:-
 Longevity: as measured by life expectancy at birth, the range
is 25 to 85 years.

 Education attainment: as measured by a combination of

adult literacy (2/3 weight) and combined primary, secondary
and tertiary enrollment ratios (1/3 weight), the range for both
is 0% to 100%.

 Standard of living: as measured by real GDP per capita based

on Purchasing Power Parity (PPP), the range is $100 to
$40,000.

358
 For any component of the HDI, the individual indices can be
computed according to the general formula:
Actual value - Minimum value
Index 
Maximum Value - Minimum value

 The HDI is not free from certain limitations such as: the three
indicators are not the only indicators of human
development, the attachment of weights to each of these
items is arbitrary and others.

359
Exercise:
 Life expectancy at birth for country X is given to be 58 years.
 The combined primary, secondary and tertiary education
attainment is given to be 50%, for the same country the real
per capita GDP is $900.
 The adult literacy is given to be 30%. Calculate,
a) Life expectancy index b) Education index
c) GDP index d) HDI

360
 7.3. Characteristics of Underdeveloped Country
General poverty: An underdeveloped country is poverty ridden.
 Poverty is reflected in low GNP per capita.
 It is not relative poverty but absolute poverty that is more
important in assessing underdeveloped countries.

 Absolute-poverty is measured not only by low income but also

by malnutrition, poor health, clothing, shelter, and lack of
education.

 Thus, absolute poverty is reflected in low living standards of the

people.
 In such countries, food is the major item of consumption and
about 80% of the income is spent on it as compared with 20% in
advanced countries.
361
 The vast majority of the people in LDCs are ill fed, ill-
clothed, ill-housed and ill educated.

Agriculture, the main occupation: In underdeveloped countries

two-thirds or more of the people live in rural areas and their
main occupation is agriculture.

 This heavy concentration in agriculture is a symptom of

poverty.

 Agriculture, as the main occupation, is mostly unproductive.

 It is carried on in an old fashion with obsolete and outdated
methods of production.

362
A dualistic economy: Almost all underdeveloped countries have
a dualistic economy.
 One is the market economy which is modern and the other
subsistence economy which is backward and mainly
agriculture-oriented.

 There is also financial dualism consisting of the unorganized

money market charging very high interest rates on loans and
the organized money market with low interest and abundant
credit facilities.

363
Underdeveloped natural resources: The natural resources of an
underdeveloped country are underdeveloped in the sense that
they are either unutilized or underutilized.

 A country may be deficient in natural resource, but it cannot

be so in the absolute sense.

 Although a country may be poor in resources, it is just

possible that in the future it may become rich in resources as a
result of the discovery of presently unknown resources or
because new uses may be found for the known resources.

364
Demographic features: Almost all the underdeveloped countries
possess high population growth potential characterized by high
birth rate and high but declining death rate.

 The advancement made by medical science has resulted in the

discovery of marvelous drugs and the introduction of better
methods of public health and save reduced mortality and
increased fertility.

 An important consequence of high birth-rate is that a larger

proportion of the total population is in young age groups.

365
 A large percentage of children in the population entail a
heavy burden on the economy which implies a large number
of dependents who do not produce at all but do consume.

 With many dependents to support, it becomes difficult for

the workers to save for purposes of investment in capital
equipment.

 It is also a problem for them to provide their children with

the education and basic necessities of life that are essential
for the country's economic and social progress in the long run.

366
Unemployment and Disguised Unemployment:
In underdeveloped countries there is vast open unemployment
and disguised unemployment.

 The unemployment is spreading with urbanization and the

spread of education.
 But the industrial sector has failed to expand along with the
growth of labor force thereby increasing urban unemployment.

 Then there are the educated unemployed who fail to get jobs
due to structural rigidities and the lack of manpower
planning.

367
 Underemployment or disguised unemployment is a notable
feature of underdeveloped countries.

 A person is said to be disguised unemployed if his

contribution to output is less than what he can produce by
working for normal hours per day.

Economic Backwardness: In under developed countries

particular manifestations of economic backwardness are low
labor efficiency, factor immobility, and limited specialization in
occupation and in trade, economic ignorance, values and social
structure that minimize the incentive for economic change.

368
Lack of enterprise and initiative: Entrepreneurial ability is
inhibited by the social system which denies opportunities for
creative facilities.

 The force of custom, the rigidity of status and the distrust of

new ideas and of the exercise of intellectual curiosity, combine
to create an atmosphere inimical to experiment and
innovation.

 The small size of the market, lack of capital, absence of

private property, absence of freedom of contract and of law
and order hamper enterprise and initiative.

369
Insufficient capital equipment: Underdeveloped countries are
characterized as capital poor or low saving and low-investing
economies.

 There is not only an extremely small capital stock but the

current rate of capital formation is also very low.

 In most underdeveloped countries gross investment is only

(5-6)% of GNP where as in advanced countries it is about (15-
20)%.

370
Technological Backwardness: Their technological backwardness
is reflected in:
 the high average cost of production despite low money
wages, and
 the predominance of unskilled and untrained workers and
others.

Foreign Trade Orientation: Underdeveloped economies are

generally foreign trade oriented.
 This orientation is reflected in exports of primary products
and imports of consumer goods and machinery.
 The percentage share of fuels, minerals, metals, and other
primary products in the merchandise exports of the majority of
LDCs is on the average about 80 percent.
371