MACROECONOMICS

MODULE EC104

Written by Giya.G, Abel.S and substantially revised and edited by Ndlovu.E DEPARTMENT OF ECONOMICS MIDLANDS STATE UNIVERSITY

2005 CHAPTER ONE INTRODUCTION Macroeconomics Macroeconomics is concerned with the study of the whole economy. Macroeconomics is concerned with the study of economy wide aggregates, such as the analysis of total output and employment, total consumption, total investment and national pr oduct. (Vaish,1995). It is concerned with the behaviour of the economy as a whol e- with booms and recessions, the economys total output of goods and services and growth of out[put, the rates of inflation and unemployment, balance of payments , exchange rates etc. Because it is closely related to real world issues, macroe conomics also involves many non-economic factors such as political, historic, cu ltural and sociological factors. (Dornbusch et al, 1998). Macroeconomic Problems These arise when the economy suffers from high unemployment, inflation, or a bal ance of payments deficit. Therefore the government sets itself certain macroecon omic objectives: Low unemployment Low inflation A balance of payments surplus Economic growth Macroeconomics and Microeconomics The line between macroeconomics and microeconomics is less sharp than it used to

be, but it is still there. What makes this module different is that we focus on the economy as a whole. Instead of talking about the demand and supply of (say) pizza, we talk a bout the demand and supply of output. Instead of talking about what determines the demand for workers in the pizz a industry, we talk about what determines the total demand for workers. BUSINESS CYCLE Business Cycles (or trade cycle) A business cycle is the more or less regular pattern of expansion (recovery) and contraction (recession) in economic activity around a growth trend (Dornbusch e t al, 1998). Business cycles can also be described as the periodic booms and slu mps in economic activities. The ups and downs in the economy are reflected by th e fluctuations in aggregate economic magnitudes, such as, production, investment , employment, prices, wages, bank credits etc. The upward and downward movements in these magnitudes show different phases of a business cycle (Dwivedi, 1996). Basically there are only two phases in a cycle, namely prosperity and depression . Considering the intermediate stages between prosperity and depression, the var ious phases of trade cycle may be enumerated as follows: 1) Expansion 2) Peak 3) Recession; 4) Trough 5) Recovery and expansion Phase of Business Cycles line of cycle Peak Growth Rates ty steady growth line prosperi depression expansion trough peak recovery trough Time Expansion or prosperity (or boom) This boom is characterised by increase in output, employment, investment, aggreg ate demand, sales, profits, bank credits, wholesale and retail prices per capita output and a rise in standard of living. The growth rate eventually slows down and reaches the peak. However: A boom increases spending on imports, causing balance of payments problems. Once high levels of employment have been reached, output cannot be increased any further and the boom causes inflation. Peak This is characterized by slacking in the expansion rate, the highest level of pr osperity, and downward slide in the economic activities from the peak. Recession The phase begins when the downward slide in the growth rate becomes rapid and st

eady. Output, employment, prices, etc. register a rapid decline, though the real ised growth rate may still remain above the steady growth line. So long as growt h rate exceeds or equals the expected steady growth rate, the economy enjoys the period of prosperity, high and low. When the growth rate goes below the steady growth rate, it marks the beginning of depression in the economy. Depression beg ins when growth rate is less than zero i.e. the total output, employment, prices , bank advances etc. decline during the subsequent periods. In other words there is a slump in the economy. [A slump reduces spending on imports, thus improving the balance of payments. Reduced total spending lowers inflationary pressure.] The span of depression spreads over the period growth rate stays below the secu lar growth rate or zero growth rate in a stagnated economy. Trough This is the phase during which the downtrend in the economy slows down and event ually stops and the economic activities once again register an upward movement. Trough is the period of most severe strain on the economy. Recovery When the economy registers a continuous and rapid upward trend in output, employ ment, etc, it enters the phase of recovery though the growth rate. When it excee ds this rate, the economy once again enters the phase of expansion and prosperit y. If economic fluctuations are not controlled by the government, the business c ycles continue to recur as stated above. Why worry about business cycles? Business cycles, cause not only harm to business but also misery to human beings by creating unemployment and poverty. Governments in many countries assume the role of a key player in employment and stabilization. Stabilization broadly mean s preventing the extremes of ups and downs or booms and depression in the econom y without preventing factors of economic growth to operate. Trade Cycles or business cycles- simplified diagram Government Macroeconomic Policies Macroeconomic Policy Objectives All governments like to achieve the following 4 major macroeconomic policy objec tives: (a) Full employment of labour force. (b) A stable price level. (c) B.O.P equilibrium ( surplus is desirable) (d) A satisfactory rate of economic growth. On full employment, of labour force it is not possible to achieve this in the st rictest sense. The use of official unemployment statistics as basis for setting policy objectives is also suspect. The list by government includes those defined as being unemployed by government rather than those who would be willing to tak e up paid employment should it become available. Some people on the register may be unemployable-aged, disabled, criminals and those not intending to work. Table below shows some of the policies the government can use to try to get full employment, stable prices etc. Policy Description Fiscal Changes in government expenditure and taxation Monetary Changes in the money supply and interest rates Prices and incomes Legal or voluntary limits on price and wage increases Regional Measures to help depressed areas Industrial Government planning of industry Commercial Quotas, tariffs, exchange controls or free trade

Exchange rate

Encouraging a depreciation or appreciation of sterling

Problems of Policy Timing The timing of policy events may be crucial to the efficiency and effectiveness o f policies. There are basically three forms of time lag to consider in relation to the behaviour of policy makers and operation of the economy. (a) Recognition lag- authorities perceive problems after some time. (b) Administration lag- it takes time to set up the necessary administrative machinery in motion. For example Parliament approves income tax measures after debate but monetary policy options take days or hours to implement. (c) Implementation lag- by the time the policy is implemented, new issues ha ve arisen hence new policies have to be implemented/formulated or adapt the poli cy instruments introduced. Chief Instruments of Economic Policy The two important subdivisions of economic policy are the monetary policy and th e fiscal policy. These two policies are applied as mutually complementary polici es to serve as instruments of governments economic policy which is applied to ach ieve certain social goals. Often the two overlap, because it is almost impossibl e to envisage any major fiscal or monetary measure which does not affect the oth er. A. Fiscal Policy. This is the policy of government with regard to level of government spending and tax structure. Government expenditure includes transfer payments, government current expenditures and budgetary balance (extent of borro wing). Taxation (i) provides the funds to finance expenditure. (ii) Can also be used for income redistribution. Taxes are subdivided into direct and indirect. ( i) Direct taxes these are levied directly on persons / corporates and include in come tax, corporate tax, poll tax and inheritance taxes, import duties. Typical uses for this instrument are a reduction in income inequalities, regulate aggreg ate demand, protection of domestic producers, reduce poverty, and provision of i nfrastructure and to adjust balance between aggregate demand and supply. Import duties are important sources of revenue in many African countries. Countries imp ose import tariffs for some or all of the following reasons: (a) Revenue, protec tion to local producers, (b) discriminate between essential and non-essential go ods and (c) B.O.P purposes. (ii)Indirect tax is levied on a thing and is paid b y an individual by virtue of association with that thing, e.g. local rates on pr operty, sales taxes and excise duties. Tax structure can be regressive proportio nal or progressive. Tax incentives may be given - investment allowances, tax hol idays, accelerated depreciation allowances, duty-free imports; no-tax concession s may be given by government for e.g. provision of roads, water and power. In so me African countries rural taxation- was used e.g. Cameroon, Mali and Sudan. Problems of Fiscal Administration (a) Tax evasion (b) Shortage of trained and experienced staff. (c) Corruption. (d) attitudes towards payment of taxes. (e) poor co-ordination of budgets with development plans. B. Monetary Policy- the manipulation of the volume of credit, interest rate s and other monetary variables. Monetary policy is a policy which employs centra l banks control over the supply, cost and use of money as an instrument for achie ving certain given objectives of economic policy. The policy is used to improve credit and saving facilities and to regulate macroeconomic balance of the econom y. All governments run deficits in that their total spending exceeds the value o f their tax and other current receipts. The deficit is financed by long-term bor rowing from abroad and from local residents. Sometimes the long-term borrowings will not cover the gap which means it has to be financed by other means. Governm ent usually fills the gap by short-term borrowing from the central and commercia l banks. This borrowing from the banking system (deficit financing) usually has

highly expansionary effects on money supply. In other words it increases the mon ey supply by the amount of the deficit but is likely also to result in secondary increases in money supply by increasing the cash base of the banking system and hence its ability to lend more to private borrowers. (N.B. Expansionary does no t mean inflationary). Monetary policy can be used for anti-inflationary purposes . Much industrial and commercial expansion is financed by bank credit (especiall y for working capital) so to restrict bank lending is liable to place a brake on new investment and economic expansion. It is possible for credit restrictions t o be pushed to the extent of forcing a deflation on the economy, with serious av oidable loses of output and employment. Some economists have argued in favour of the use of high interest rates to curb aggregate demand. The effect of a move a long these lines is to encourage the holding of larger money balances, reducing the pressure of demand for commodities. Critique of the interest rate Reservations to the interest rate issue have been raised: (a) Higher interest rates may discourage investment and thus impede the deve lopment of the economy. It can be counter argued that higher interest rates will raise the productivity of new investments because now only projects which promi se large returns will be undertaken. Hence it may be possible to sustain the ove rall rate of economy growth even from a reduced volume of investment. (b) A successful induction of people to substantially increase their money h oldings may due to the withdrawal of purchasing power from commodity markets may be deflationary. (c) Several studies have found the elasticity of demand for money with respe ct to the cost of holding it to be rather small. If this is the case, it would t ake a very large rise in interest rates to affect a significant increase in the demand for money. Limitations of the state in achieving Macroeconomic Policy Objectives (i) too many ministries, often with competing interests, too many public cor porations and too many boards of one kind or another. (ii) Too much corruption of civil service, civil servants badly motivated. (iii) Too much red tape. (iv) Too much political instability with governments often changed by militar y coups and other unconstitutional means. Governments are therefore preoccupied with tasks of maintaining their own popularity, authority and power. CHAPTER TWO NATIONAL INCOME ACCOUNTING National Income is the outcome or the end result of all economic activities. Eco nomic activities generate two kinds of flows (i) money flows- these are in excha nge for services of factors of production in the form of flows- these are in exc hange for services of factors of production in the form of wages, rent, interest and profits (i.e factor earnings) (ii) Product flows, are flows of consumer go ods and services and productive assets. All human activities which create goods and services that can be valued at market price are broadly the economic activit ies. Macroeconomics deals with a number of large totals or aggregates, which are used to conceptualize and measure key components of the economy. The most fundamenta l of these is the total output of goods and services, conventionally referred to as the national income. (Official data in most countries is now actually report ed on a "domestic" rather than a "national" basis. The distinction, which is uni mportant for most purposes, relates to the treatment of investment income receiv ed from non-residents and paid to non-residents. "Domestic income" is that produ ced within a country by all producers operating there, whether foreign or not. " National income" is that produced only by "nationals" of that country, whether t hey are producing it there or elsewhere.) There is nothing inconsistent in referring to total output as income. Although w hat is earned as income can be measured separately from what is produced, the tw o aggregates are necessarily the same in amount. Before going on to see why, not e that in either case such large totals can be expressed only in terms of money,

not physical products as such. It is impractical to try to measure output or in come in real, physical terms, simply because it is impossible to sum apples and oranges or any of the millions of goods and services which are produced and rece ived as income in a modern economy. Instead, physical quantities must be convert ed to a common measure and the measure used for this purpose is the national uni t of account, the dollar, pound, or other currency. The value of total output or income in an economy during some accounting period, usually a year or quarter of a year, is a significant statistic. It is generall y used as an indicator of the economys performance. Because a larger output or in come is equated with a rise in the economic well being of a countrys population, a higher output or income is considered desirable and a lower one undesirable. T he economys overall performance is tracked by the changing value of the total out put or income statistic. Similarly, comparisons of relative well-being among dif ferent countries are based on these statistics and a host of political and socia l as well as economic implications flow from their behaviour over time. The Circular Flow A modern economy can be simply modeled in the aggregate by thinking of it as com prising two key sectors, households which consume produced goods and services an d which supply labour and other productive services to firms, which use the labo ur and other productive services supplied by households to produce the goods and services the households consume. Households supply the services of productive f actors (land, labour, capital, etc.) and the firms convert these inputs into pro duced goods and services which return to the households. Owners of firms are, of course, also part of the household sector where they function in their other ca pacity as consumers of goods and services. The real flows of productive services and produced outputs have corresponding fl ows of money payments associated with them. Firms pay out wages and salaries in return for labour services, rents to owners of land and other natural resource i nputs, and interest and profits to suppliers of capital and entrepreneurial inpu ts. Householders consequently have money income with which to pay for the produc ed goods and services that flow to them from firms. Thus, there are money flows corresponding to the real flows, but they move, of course, in the opposite direc tion. Circular Flow of Income Services of factors of Production Goods and services

Spending Incomes Because the flows of payments for produced goods and services and payments for f actor inputs are continuous, aggregate income/output in this simple model could be measured at any point, metering the flow anywhere in the circuit. If measured in terms of spending on produced goods and services, it would be natural to cal l this a measure of total spending or total expenditure. If measured in terms of outlays made for the services of productive factor inputs, it would be total in come (from the point of view of the owners of those factor inputs). Obviously th

e two totals would have to be the same. This is a greatly simplified model. One thing missing is the possibility of savi ng. If households do not spend all their income on produced goods and services, but hold some of it back as savings, every time income flows into the household sector the flow of payments made to producers will diminish. This is a "leakage" of income/spending from the system and the volume of the flow would diminishthe level of national income would fall. But if there are savings, there could also be new investment. If businesses borrowed income saved by households and used it to finance the building of new plant or for other business purposes, it would b e injected back into the income stream (in the form of payments to workers and o ther factor owners who supplied the necessary real inputs needed to produce the new capital). Banks and other financial intermediaries serve as the nexus throug h which savings are converted into investment spending and returned to the incom e stream. In the simple economy above we can write the identity of output produced and out put sold as Y C+I. That is all output produced is either consumed or invested. T he corresponding identity for the disposition of personal income is that the inc ome is allocated on C (Consumption) and part is saved (S). This implies that Y C +S. It also flows that C+I Y C + S. Subtracting C from both sides gives I Y - C S which shows that saving is also income less consumption and also investment is identically equal to saving. If another complication, government, is added to the simple model, another poten tial for a leakage of income from the system is introduced. Governments impose t axes (T) on households (and firms) and this results in a diversion of income fro m the private sector to government. This is another leakage and it too has a cor responding potential for injecting such income back into the stream, this time i n the form of government spending on produced goods and services. Taxation reduc es disposable income. Disposable income is given by Yd Y-T and also Yd C+S. Thus C+S Yd Y-T Finally, most real world economies are not closed loops. Instead they are "open" to the rest of the world, with leakages from domestic income/expenditure flows in the form of payments made for goods and services produced abroad ( imports, M ) and injections of income back into the domestic flows as a result of sales of goods by domestic firms to consumers abroad (exports, X). As already seen, there can also be important flows of savings and investment between one country and t he rest of the world. Circular Flow of Income Services of factors of Production Goods and services

Spending Incomes LEAKAGES/WITHDRAWALS S INJECTION

Savings Investments Taxation Government Expenditure Imports Exports From the diagram Y = C + I + G + (X-M) = C + S + T The important ideas to understand at this point are that national income or expe nditure can be thought of as a continuous flow which can be measured in differen t ways ( Product income expenditure on the product) and that this simple process is complicated by the possibilities of leakages and injections arising from pri vate saving and investing; government taxation and spending; and foreign trade a nd capital movements. THE NATIONAL ACCOUNTS All the economies today measure the volume of aggregate income, usually defined as Gross Domestic Product, in much the same way. Gross Domestic Product (GDP) Refers to the total monetary value of all goods and services produced within the geographic boundaries of a nation during a given year. The word domestic implies that only the income produced in that country is accounted for. The income that arises from investments and possessions owned abroad is thus not included in the GDP estimates. Calculation of GDP -calculated simply by valuing the outputs of all final goods and services at market prices ( i.e. actual prices at which they are bought and sold) and then adding t he total. N.B. The market value of all intermediate products- those used to prod uce the final output is excluded from the calculation of GDP since the values of intermediate goods are already implicitly included in the market prices of the final goods. Gross implies not all output was available for private/public consump tion and investment, part went to replace or maintain worn out capital equipment . Nominal and Real GDP Two measures of GDP are given: nominal GDP (also called current dollar GDP) and real (constant dollar) GDP. Nominal GDP measures the value of output at the pric es prevailing at the time of production, while real GDP measures the output prod uced in any one period at the prices of some base year. The growth rate of the e conomy is usually taken to be the rate at which real GDP is increasing. Whatever their minor differences, all national accounting conventions follow the basic pattern identified in the preceding discussion of the circular flow of in come and expenditure. There are always at least two main calculations, one which sums total expenditures on goods and services produced, the other of total inco me received as a result of producing those same goods and services. Because both are measures of the same thing they must, by definition, yield the same total. In national accounting in ex-post sense expenditure on production is always equa l to production and income. Product Income Expenditure on the product Why two measures if the total must be the same? One reason is that two estimates provide a check on one another with respect to accuracy. Another is that the tw o measures break down into different components, some of which are more useful f or certain purposes than others. GROSS NATIONAL PRODUCT (GNP) This is the most important and widely used measure of national income. It is the most comprehensive measure of a nations productive activities. It is defined as the value of all final goods and services produced during a specific period, usu ally one year (Dwivedi, 1996). In other words it refers to that part of the GDP

that is actually produced and earned by or transferred to resident nationals of that country. Earnings of foreigners which arise out of their domestic economic activities are thus excluded. For Zimbabweans working abroad their income is inc luded in the GNP of Zimbabwe. Where there is substantial foreign participation i n the economy and a large part of total domestic income is earned and repatriate d by foreigners and foreign companies as in many LDCs, GDP will be much larger t han GNP. As a result statistics of GDP growth may give a false impression of the economic performance of a particular developing nation. GNP is therefore a more appropriate measure of national income. NET NATIONAL PRODUCT (NET NATIONAL PRODUCT) Net National Product = Gross National Product Depreciation. Net National Product (NNP) is calculated by deducting from GNP the depreciation of existing capital s tock over the course of the period. The production of GNP causes wear and tear t o the existing capital stock, for example, machines wear out as they are used. I t is a more accurate measure of national product but in real life GNP is mostly because net investment (Gross Investment Depreciation) is difficult to measure e specially as rate of depreciation is not known (straight line, declining or redu cing balance?) or may be quite inaccurate. Depreciation estimates may also not b e quickly available. MEASUREMENT OF NATIONAL INCOME There are three methods or approaches for measuring total output, namely : 1). Expenditure 2). Income method 3). Value Added or Output approach A. The Expenditure Approach Measuring total output by the expenditure method involves breaking down total sp ending on all goods and services produced into four categories: (a) Expenditures by consumers on goods and services (abbreviated simply to the letter C); (b)Exp enditures by businesses on capital goods (total investment spending, I); (c) Ex penditure by government on goods and services, G); and (d) Net exports (the tota l value of exports minus the total value of imports, X-M). Because all spending done in the country falls into one or other of these four categories, we can say that total expenditure is the sum of C+I+G+(X-M). We now examine each of these four main components of total spending. Consumption (C) Consumption spending is the total of all outlays made by households on final goo ds and services. In all countries it is by far the largest component of total sp ending. It covers spending on an enormous range of items, including durable good s like television sets and cars, non-durable goods like food and clothing, and p ersonal services such as legal advice, hairdressing, and dental care. But it usu ally excludes spending on houses, which is customarily (and arbitrarily) treated as investment expenditure. C also excludes purchases of second-hand goods that were produced in some earlier accounting period so as not to double count the va lue of such output. Government Expenditure on Goods and Services (G) All governments payments to factors of production in return for factor services rendered are counted as part of the GDP. Much of the spending done by government s in the developed countries today takes the form of simple transfers of income from taxpayers to those eligible for the wide range of income supplements availa ble to assist the elderly, the sick and the unemployed, or as payments of intere st to holders of the public debt. Such transfer payments do not represent spendi ng on current production and consequently, are not counted in national income de termination. What is counted is government spending on goods and services, many of which are bought by the government on behalf of the public and which are ulti mately "consumed" by households: education, health care services, national defen ce, roads, water and sewage systems, postal services. Because so many of these g

oods and services are provided "free" or in other ways that bypass markets, it i s difficult to determine their value in the same way that the value of the other items entering into C would be determined. Consequently, national income accoun tants value government spending on the basis of what the government pays for the goods and services it requires. Another complication with government spending on goods and services is that such spending is often done on things like highways which are themselves capable of being used to assist in the production of other goods. Logically, such spending should be thought of as investment spending and included in the next category to be discussed. Some countries produce their accounts in such a form that governm ent spending can be separated into two categories, current spending on goods and services, and investment spending, but if the main concern is to understand the causes of year-to-year cyclical fluctuations in the level of national income ra ther than the causes of its longer term growth (which may be strongly affected b y the level of investment as opposed to current spending) it is convenient to st ick with the traditional categories of spending which emphasize the different mo tivations driving the spending decisions of ordinary consumers, private investor s and governments. Here, investment spending refers to private investment spendi ng unless otherwise stated. Investment (I) Investment is the production of goods that are not for immediate consumption. Th e goods are called investment goods (inventories and capital goods including res idential housing) The total investment in an economy is called Gross Investment.

We count the construction of new houses as part of GDP, but we do not add trade in existing houses. We do however, count the value of the estate agents commissi on in the sale of existing houses as part of GDP. The estate agent provides a cu rrent service in bringing buyer and seller together, and that is appropriately p art of current output. Total or gross investment Expenditure may be divided into two main categories: (i) Expenditure on capital goodspurchases of plant and equipment either to re place existing capacity that is wearing out or to increase capacity. This is oft en called fixed capital formation. (ii) Expenditure on inventories. Many businesses find it convenient or necess ary to hold certain supplies of goods on hand, in which case investment in inven tories may be considered voluntary. But business conditions are uncertain and so firms may also find themselves holding stocks because they miscalculated demand . In either case, firms are considered to be investing when they accumulate inve ntories. On the other hand, if their inventories decrease they are "disinvesting ." Inventory investment is highly volatile, changing greatly in amount and compo sition from year to year. Gross investment, then, is the total amount of (usually private) spending during the accounting period on capital goods (defined as structures, machinery and eq uipment, and inventories). Because capital by its nature consists of things that are used in the production of other goods and services, it is inevitable that i t will wear out or "depreciate." The amount necessary for replacement is called Depreciation or capital consumption allowance. Gross Investment Depreciation = N et Investment. Unless it is continually renewed, the stock of capital in the eco nomy will gradually be depleted. Handling depreciation is one of the more difficult parts of national income acco unting. Again, the best treatment depends on what the data are meant to be used for. If the concern is with the long-term growth of the economy, net investment (total investment during the accounting period minus depreciation) is the import ant concept because it measures the growth of the economys capital stock over tim e. But if the purpose is to understand short term, annual fluctuations in the le vel of total spending it is better to work with gross investment. Net Exports (X-M) A significant part of total spending in most countries goes toward the purchase

of goods produced abroad rather than domestically. As noted in discussing the ci rcular flow, such outlays represent spending which leaks from the domestic econo my to the rest of the world and is consequently treated as a negative entry in m easures of total domestic spending. But it is offset to a greater or lesser degr ee by the spending of non-residents on goods produced and exported to internatio nal markets. It is often convenient, therefore, to take domestic spending on imp orts and foreign spending on exports as a combined value, usually called net exp orts, a value which may be positive or negative in any accounting period dependi ng on which component, exports or imports, is larger. Summing these four expenditure components, C+I+G+(X-M), gives a single figure, t he total amount of spending done in the economy during the accounting period. It should be possible to arrive at exactly the same figure by summing all income r eceived in the economy during the accounting period. (GDP = Y = C+I+G+(X-M), B. Measuring Total Output by the Income Method As seen in discussing the circular flow, what the firms producing the national o utput see as costs of production, owners of productive factors see as income. Fa ctor costs and factor incomes are consequently the same thing viewed from differ ent perspectives. GDP = wages+ rents + interest + non-income charges Quantitatively, by far the most important and certainly the simplest factor cost s to measure are the payments made by employers for labour services. These payme nts are usually reported in the official statistics under a heading such as "Wag es, salaries, and supplementary labour income," with the latter term referring t o employee benefits such as pensions, workers compensation benefits, and employer contributions to unemployment insurance funds or other worker social security s chemes. Most other factor payments, however, are much more difficult to track. C onsider a farming operation. How should any net income derived from farming be c lassified? Part of it must be a return to the services of land the farmer is usi ng ( rent). Part must be a return to the farmers own input of labour (wages). Par t might be considered a return to setting up and operating the business(profit). These are difficult to separate. Because of such problems, the national account s typically use definitions of factor payments which owe more to convenience tha n to the logic of factor classification: net income of farm operators, corporati on profits, net income of unincorporated business, and interest and other invest ment income. Summing all these items yields the total amount received during the accounting period by the owners of productive factors. But if this figure for f actor costs or income is compared with the total arrived at by the expenditure m ethod, it falls considerably short of the amount expected. Indirect taxes and subsidies result in a discrepancy between the market price an d the factor cost of goods and services. The market price of most goods and serv ices includes indirect taxes, such as general sales tax, value- added tax and ex cise taxes with the result that the market price is greater than the price the s eller of the good or service receives. On the other hand, subsidies paid to prod ucers to keep the market price of certain goods and services lower than it would otherwise be, result in the producers income being greater than the market price . To calculate the GDP at factor cost, i.e. the amount received by the factors o f production that produced the goods and services concerned, we therefore have t o deduct indirect taxes from the GDP at market prices and add back subsidies. Th us: factor cost market price indirect taxes + subsidies. This point becomes imp ortant when relate GDP to the incomes received by the factors of production. C. Output Approach or the Value Added Method A third method is available for estimating the total output of the economy and i t is called the "value added method" because it simply sums the net value of the output produced by all the firms in the economy. GDP is the value of final good s and services produced. The insistence on final goods is simply to make sure th at we do not double count This approach measures GDP in terms of values added by each of the sectors of the economy. This is conceptually simple, but in practic e complex because of the need to avoid double counting. There are many interacti ons among firms in a modern economy. Many produce goods that are sold not to fin al users as consumer goods, but to other firms. Consider a firm producing power

supply devices for computers. It buys components from suppliers, assembles them, and sells the finished product to another firm which incorporates it into a com puter. If the value of the power supplies was measured when they were produced a nd again as part of the price of the finished computer, total output would obvio usly be exaggerated. Dealing with this requires that the value of each firms outp ut be reduced by the amount of all payments made by that firm to obtain inputs. This involves considerable work, but the resulting data are often very useful be cause they yield a breakdown of national output on an industry-by-industry basis . In formula terms: Value Added = output of firm - output purchased from other firms. If we follow the course of this process, we will see that the sum of values adde d at each stage of process is equal to the final value of the item sold. Value a dded is also the basis for the Value added Tax (VAT). A problem associated with the value added approach is valuation of inventories o f goods produced but unsold. Unsold inventories are valued at market prices yet profits ( or losses) have not been realised; prices may fall or rise; goods may not be sold. This means that a rise in market prices causes a rise in value of t he existing inventories. To avoid this distortion a correction is made to elimin ate changes in the value of inventories due to price changes; that is stock appr eciation should be deducted from the value. The table below summarizes the relationships. For example from the third and fo urth columns NNP at market prices indirect taxes add subsidies = national income at factor cost. Net factor payments Depreciation Indirect taxes GDP at GNP less market at market subsidies prices prices NNP at market National Various* prices Income items at factor Personal Personal cost Income Tax Personal Disposable income * includes income that does not accrue to personal sector e.g. corporate taxatio n and corporate saving Uses of National Income Accounting 1. Assists government in planning the economy. The accounts will show growt h or stagnation in the economy, alerting policymakers to the sort of action whic h ought to be taken. Since national income accounts break the performance of the economy down into its component parts, they provide policymakers with specific information regarding the formulation and application of economic policy. 2. Permits us to measure the level of production in the economy over a give n period of time and to explain the immediate causes of that level of performanc e. 3. By comparing the national income accounts over a period of time, the lon g-run course which the economy has been following can be plotted. 4. To compare standards of living of different countries- the problem is th e countries being compared use different currencies. The simplest means of deali ng with the problem is to use the Exchange rates between countries to convert th e GNP of each nation to a common currency e.g. US$. Most international compariso ns use this method. The second method used is Purchasing Power Parity. (a) Excha

nge rate conversion- the method is simple and straightforward but this does not meet our needs fully. We are seeking to measure differences in standard of livin g among areas, but exchange rate reflects purchasing power of currencies for goo ds traded in international markets. Goods and services not traded on internation al market may not be correctly taken into account. (b) Purchasing power paritythe method involves determination of the relative purchasing power of each curre ncy by comparing the amount of each currency required to purchase a common bundl e of goods and services in the domestic market of the currencys country of origin . This information is then used to convert the GNP of each nation to a common mo netary unit. Estimates using Purchasing Power Parity method are a more accurate indicator of international differences in per capita GNP than exchange rate conv ersion method. 5. As a measure of welfare and national development, GNP per capita may be rising over a period of time implying a rise in economic welfare and economic de velopment. Criticisms include the following- output of weaponry may rise, crime may rise (use of more police), motor vehicle production (more pollution) may als o rise (showing increasing GNP) yet in terms the people are not better off or ev en worse off. Output may also have been of capital goods. GNP per capita gives n o indication of how national income is actually distributed and who is benefitin g from growth of production. A rising level of absolute and per capita GNP may o bscure the reality that the poor are no better off than before. As an index of i mproved economic welfare GNP growth rates are inadequate for the generality. Des pite its shortcomings, GNP provides a useful measure especially if it is accompa nied by indicators like life expectancy, infant mortality rates, education, lite racy and income distribution. 6. For soliciting international aid from other countries or multilateral or ganizations. 7. National income and product estimates by sector of origin of national pr oduct reveal contributions made by different sectors of the economy. PROBLEMS OF GDP MEASUREMENT GDP data are far from perfect measures of either economic output or welfare. Pro blems of GDP measurement are: (1) Badly measured outputs-some outputs do not go through the market, e.g. g overnment output (such as defence) is not sold in the market. Also there is noth ing comparable available that would make it possible to estimate the value of go vernment output. It is therefore valued at cost. Other non-market activities, in cluding do -it- yourself work and volunteer activities, are also excluded from G DP. (2) Unrecorded economy- many transactions that go through the market escape measurement. e.g. payment for a handymans services is not recorded in the GDP dat a as it is unlikely to be declared, illegal traffic in drugs. The main problem i s that the relative importance of such activities may have been changing. If suc h activities become more important over time , then measured real GDP will unde rstate the rate of growth of total economic activity. Why there might have been an increase in unrecorded transactions (i) rising tax rates (which make it more tempting not to declare sales or income,) and the growing importance of the so c alled informal activities outside the modern sector of the economy. (3) Data revisions- when they first appear, GDP data are not firm estimates. The reason is that many of the data are not measured directly, but are based on surveys and guesses. Considering the GDP is supposed to measure the value of al l production of goods and services in the economy, it is not surprising that not all the data are available within a few weeks after the period of production. T he data are revised as new figures come in, as the CSO and RBZ improve their dat a collection methods and estimates. Adjusting National Income Data to Allow for Price One difficulty with using money values to express is that the value of money may change over time. all prices, or a fall in all prices, the monetary Changes national accounting magnitudes If there is a general rise in unit either decreases or incre

ases in value. Trying to measure distance with a ruler that shrank or expanded s ignificantly between measurements would obviously be a frustrating and not very useful activity. Inflation, defined as a general rise in the price level, or def lation, a general fall in the price level, are common enough to make it necessar y to adjust national income data to remove the effect of changes in the purchasi ng power of the dollar or other monetary unit being used to measure the value of total output. This is done by developing indexes which show how the prices of t he goods and services produced in any one year have changed relative to the pric es of those goods and services in some other year. Setting up these indexes of p rices is not difficult in principle, although it can be an expensive, time-consu ming task in practice. Consider a simple example in which only a single commodit y is the subject of interest, mens shoes. In the following table the price of mens shoes in each year is compared with the price prevailing in one particular year . The base year in the example is year 2000, (this can be written as 2000=100) a lthough it could have been any one of the five years. The price in any particula r year is then divided by the price in the base year to get the ratio of prices shown in the third column. Because these ratios are usually expressed as percent ages, they are then multiplied by 100 to obtain the price index numbers shown in the last column. Year 1999 Price($) Price Ratio Price Index 2000 2001 20 40 20/40=0.5 50 100 2002 50 40/40=1 125 2003 60 80 50/40=1.25 150 200

60/40=1.5

80/40=2

These index numbers can now be used to adjust the data on the value of mens shoes produced in each year, thereby eliminating the effect of price changes from the series. Suppose the following production information is available.

Year 1999 2000 Output in Current $ Output in Constant$

2001 5 10

2002 20 20

2003 30 24

50 33.3

90 45

The current dollar values shown in the second column turn out to be quite mislea ding as an indicator of the real changes in output. Because prices were lower in Year 1999 than in the base year (Year 2000), the output in Year 1999 was unders tated, whereas, because prices in Years 2000, 2001, and 2003 were higher than in the base year, the current dollar production values overstated the volume of ou tput. The conversion to (Year 2000) constant dollars in the third column was don e by dividing the current dollar values of output for each year by the relevant index number (expressed as a percentage). Mens shoes are only one of thousands of commodities which are included in the tot al national income and, in practice, it is not feasible to develop price indexes for each item in this way. Instead, price indexes are built up for groups of co mmodities which are often defined in terms of who buys them. For example, a comm only used index measures changes in the amounts households spend on a selected b undle of goods and services. One of the problems with this kind of index is that it is very costly to determine which goods should be included in such a bundle. Surveys must be made of household buying habits to determine which goods househ olds are buying in significant quantities and the relative importance of various goods in typical household budgets. Because of this, years may elapse between r edefinitions of the goods which are included in the index which makes the inform ation the index provides of dubious value toward the end of the redefinition cyc le. When constructing large price indexes for adjusting national income data, most s tatistical agencies build up a general index from a large number of specific com modity group indexes, so that changes in expenditure patterns within the compone

nt groups will not seriously affect the outcome. This composite index is known a s a gross domestic product deflator. It can be used to convert any current dolla r value of gross domestic product to a constant dollar basis using the relation: Nominal GDP/Real GDP x 100 = GDP Deflator GDP price deflator is an index calculated from nominal and real GDP. Thus, if th e deflator is known to have a value of 125 and nominal (current dollar) gross do mestic income is 50 billion dollars, real gross domestic income is $40 billion. The measurement of per capita income All countries have adopted the conventions (the United Nations Standard National Accounts) for the calculations of Gross National Product (GNP) and Gross Domest ic Product (GDP), and GNP or GDP per capita is the commonest indicator of the le vel of development. Economic growth refers to an increase in either of these ind icators. There are however well known problems associated with the calculation o f national income in poor countries and its use as an indicator of development: 1. The necessary data are often incomplete, unreliable or not available 2. The accounting conventions are not necessarily appropriate; the services of women working in the household are excluded from national statistics yet in many poor countries, especially in sub Saharan Africa, women are often responsib le for running the family farm as well as working in the household. 3. In most poor countries, there is a large subsistence sector that is, far mers may well consume all or large proportion of what they produce, rather than sending it to the market where it would be counted for the purposes of calculati ng national income. Statisticians make an allowance for this non- marketed compo nent of output, and for rural capital formation that may not enter the national accounts house building, irrigation ditches but it is generally accepted that th e value of the activities is underestimated, thus biasing downwards the national income figures for poor countries. 4. Income may be overstated for developed economies because a number of ite ms that are included as income might better be seen as costs and hence excluded from income- the cost of travelling to work, for example, or the cost of heating the home in temperate climates. 5. Per capita (average) incomes tell us nothing about the distribution of i ncome. Two countries with similar per capita income distributions, with importan t implications for the welfare of their populations and the nature and character istics of the development process. Significant problems arise when international comparisons of income levels are m ade. Income data measured in national currencies have to be converted into a com mon currency, usually the US dollar, and an exchange rate must be chosen. If poo r countries artificially maintain overvalued exchange rates (that is, the price of foreign currencies in terms of their domestic currency is too low), this will overstate the income of the country expressed in US dollars. Offsetting this, h owever, is the fact that many goods and services in poor countries are not trade d and hence have no impact on the exchange rate. Many of these necessities of li fe in poor countries basic foodstuffs for example- are very low priced in dollar terms, and a haircut in Zimbabwe will cost less than one in Paris or London. According to World Bank data: Mozambique with an estimated GNP per capita of US 60 in 1992 was the poorest cou ntry in the world; Switzerland, with a GNP per capita of US$36080, was the richest Is the average Swiss citizen 600 times better off than the average Mozambican? T o put that question slightly differently, does it make sense to state that in Mo zambique, on average, people live on 16 cents a day? Clearly nobody in a developed economy could survive on such a low income. Given that the majority of Mozambicans do survive, it must be the case that the necess ities essential for survival cost less in Mozambique than for example in Switzer

land, and/ or $60 is not a meaningful estimate of per capita income in Mozambi que. This is not to deny that a huge gap exists between the average incomes of v ery rich and very poor countries, nor should it lessen our concern with such ine qualities. But it does mean that the gap on average is not as great as the stati stics would suggest and a number of attempts have been made to compute more mean ingful comparisons. Measurement of the Standard of Living The value of this year s national income is a useful measure of how well-off a c ountry is in material terms. However, inflation increases the money value of nat ional income but does not provide us with any more goods to consume. Real nation al income is found by applying the equation: Real national income = Money national income/Retail price index x 100. The standard of living refers to the amount of goods and services consumed by ho useholds in one year and is found (i) by applying the equation: Standard of living = Real national income/ Population = national income per capita A high standard of living means households consume a large number of goods and s ervices. Or (ii) by counting the percentage of people owning consumer durables such as cars, televisions, etc. An increase in ownership indicates an improved standard of li ving. Or (iii) by noting how long an average person has to work to earn enough money to b uy certain goods. If people have to work less time to buy goods, then there has been an increase in the standard of living. Interpretation of the Standard of Living An increase in the standard of living may not mean a better life-style for the m ajority if: Only a small minority of wealthy people consume the extra goods. Increased output of certain goods results in more noise, congestion and pollutio n. Leisure time is reduced to achieve the production increase. There is an increase in the amount of stress and anxiety in society. Common Misunderstanding 1. The various measures of the national product give us a tally of the nati ons income for a year. However this does not measure the nations wealth .The natio n has great stock of capital goods .The stock of national capital is the sum tot al of everything that has been preserved from all that has been produced through out our economic history. Interestingly, perhaps the greatest asset of modern ec onomies is the skill and education of the workforce. This is called human capital but is not included in measures of net capital stock owing to difficulty of meas urement. 2. If we are assessing someones wealth, one of the first things we would loo k at is how much money they had and whether they owned stock and shares. However these are excluded from the calculation of national wealth. Why? The answer is because we have already counted them in the form of real wealth such as building s and machines. Money and other financial assets are only claims upon wealth and hence are simply paper certificates of ownership. Similarly, varying the amount of money in the economy does not directly make it any richer or poorer.

DETERMINATION OF EQUILIBRIUM NATIONAL INCOME Equilibrium is that position in which the opposing forces of change are in balan ce. In a two sector income equilibrium equation is Y = C + I where C = a + bY e. g. 50 + 0.75Y

According to Keynesian theory of income and employment, national income depends upon the aggregate effective demand. If aggregated effective demand falls short of the output at which all those able and willing to work are employed, unemploy ment in the economy will result. Consequently there will be a gap between econom ys actual and optimum potential output. On the contrary if the aggregate effectiv e demand exceeds the economys full employment output inflation will result. Equilibrium aggregate income and output is determined at that point at which tot al expenditure or aggregate demand function C + I + G + (X - M) cuts the 450 equ ality line (Expenditure = Income). N.B. Equilibrium does not mean full employmen t output. MULTIPLIERS When there is an increase in the level of injections, part of it will be receive d by a household as extra income. The households will probably act so that part of this extra income is then spent and part is saved. This extra consumer spendi ng then gives rise to a series of further incomes and expenditures. The overall increase in spending is much higher than the initial injection. This effect is k nown as the multiplier effect. The greater the proportion of the extra income th at is spent (the Marginal Propensity to Consume), the bigger the multiplier effe ct will be. The multiplier is defined as the ratio of the change in national inc ome to the change in expenditure that brought it about. The change in expenditur e might come from for example private investment (investment multiplier) or gove rnment expenditure (government expenditure multiplier) or exports (exports multi plier). If we let k be the multiplier; Investment Multiplier Investment Multiplier ki To clarify the investment multiplier supposing there is an injection of $120m to build factories and other capital goods. The impact of this investment will be more than the $120m initially invested. The $120m spent is thus income to those who supplied the equipment, resources etc. How much of this $120m which has been received as income will be spent depends on the keenness of the recipients to s pend it, in other words their marginal propensity to consume. Marginal Propensit y to consume (MPC) would thus be the fraction of the income likely to be spent. Of all income earned part will be spent, part will be consumed, ie. Y = C + S Consumption/ Income earned = MPC = Marginal Propensity to Consume Amount Saved or Amount earned or income = MPS (Marginal Propensity to Save) and therefore MPC + MPS = 1. Assuming a marginal propensity of 2/3, then $80m of the $120m will be spent in the next stage. In the next stage of the $80m income, $5 3m will be consumed. The greater the MPC the greater the income that is consumed hence the greater the amount spent at subsequent stages. To calculate the multi plier ki = 1/(1-MPC) = 1/MPS. From the example above ki = 1/(1-2/3) = 1/ (1/3)= 3. The greater the MPC the greater the multiplier. This means that the total increase in the national product brought about by the investment of an initial sum of $12 0m is $360m. This analysis assumes away taxation and also price increases due to high demand for goods and services. Imports have also not been taken into account. In realit y once demand increases prices may stabilize for a short while if factories have been operating at less than full capacity but when that happens, i.e. full capa city is reached prices start to rise. The rise will also depend on whether the e conomy is inward looking or outward looking in terms of raw material inputs. If inputs are imported this pushes up prices of the inputs and as a result increase in national output of $360m will not be realized because of the leakages. Incre ase in demand for finished products also causes a derived demand for material in puts hence cost of finished goods and ancillary services will rise. On the whole

there would be a decline in the quantities that would be purchased, due to incr eases in prices. Anticipated expenditure is thus not equal to actual expenditure realized. The tax structure may be increased especially as the tax base has bee n widened. Once the rate of tax has increased then disposable income diminishes hence this affects the amount of purchases vis--vis savings. Simple Investment Multiplier Importance of the multiplier for economic policy purposes stems from the assumpt ion that a given initial change in autonomous investment spending causes a magni fied change in the equilibrium income in the economy. Multiplier theory states t hat the increase in total income occasioned by any given increase in autonomous investment (or consumption) outlay is a certain multiple of the original increas e in autonomous expenditure and the magnitude of the increase in total income de pends upon the value of the MPC. The investment multiplier Ki and MPC are relate d in such a manner that the higher the MPC the higher the investment multiplier and vice versa. To derive we start with Y = C + I = C + and C = a + bY Substituting in the equilibrium equation ( Y = C + I ) this becomes Y = a +bY + Y(1-b) = a + Ki = 1/MPS MPS = 1 MPC The operation of the simple investment multiplier in the economy is thwarted by many leakages. Consequently the actual income generated consequent upon any give n increase in autonomous investment expenditure will be less than the product of the investment multiplier Ki and the given increase in autonomous investment I. In other words Y < . Ki . Examples of a leakages (imports); inflation (inc reased money spending fails to increase real consumption); savings (higher MPS l owers the multiplier while a lower MPS raises the multiplier. Regressive tax pol icy and other fiscal measures involving redistribution of income in favour of th e richer sections of the economy also reduce the size of the multiplier as do pa ying off debts, or if the increase is invested in securities. So far we focused on the simple investment multiplier where investment was treat ed as autonomous, i.e. not related to income changes. In reality increases in in come also causes increases in investment. Thus like consumption the changes in i nvestment in the economy are induced by change in the level of income. Induced i nvestment is positively related to the level of income such that an increase in income induces an increase in investment and net investment in any given time pe riod will be equal to the increase in aggregate demand. It is therefore more rea listic to treat total investment as being composed partly of the autonomous inve stment and partly of induced investment. Investment demand function in the form I =. IA + eY where A is autonomous investment and eY is the induced investment 0< e<1. Derivation Y=C+I and C= a + bY; and I =. IA + eY substituting gives This is the super multiplier. The inclusion of induced investment in the model r aises the value of the investment multiplier. Paradox of Thrift The inclusion of the induced investment in the model shows the interesting pheno menon of the paradox of thrift which reveals that an attempt on the part of the co mmunity to save more out of any given income will lead to an actual decrease in the amount it will succeed in saving. In short, the attempt to save more will be self-defeating. In fact the community may paradoxically end up with reduced tot al saving.

Government Expenditure Multiplier From the definition this multiplier is kg Government expenditure can influence economic activity in a country. It can infl uence national output and employment levels to name a few. The multiplier applie s equally to government expenditure as it does to investment. In a simple model on the determination of national income or output, aggregate demand is given by the formula Y=C+I+G, that is aggregate demand = Y = Consumption + Investment + G overnment Expenditure. If MPC =2/3 as before the change in national will be $360 m. This implies that an increase in employment for the factors used to produce t hat much in output will result. Knowledge of government expenditure multiplier would help the government in deci ding on what expenditure level would be necessary to reach the full employment l evel.

E=Y E=Y AD2 C,I,G AD1 Recessionary gap G Full employment Full employment 700 700 National Product National Product 1000 1000 AD1 C,I,G

In the diagrams, assuming that MPC=2/3, the multiplier is 3 an the present equil ibrium is such that the national product (aggregate demand) is at $700m and the full employment level is at $1000m then the government can increase its expendit ure to wipe the recessionary gap by spending only $100m. Government Spending-Investment Multiplier When investment (I) varies as income varies, then a change in government spendin g leads to a modified multiplier the government spending investment multiplier, kgi where MPI = marginal propensity to invest out of income. If MPC =2/3 and MPI =1/ 6 (MPS = 1 2/3=1/3) From this a change in government expenditure, hence aggregate demand of $120m le ads to a magnified change in income of $720m because of the multiplier factor. Y = kgi G = 6 x $120 = $720m. Government Expenditure Multiplier in a closed economy, with taxes If we assume a closed economy 1. - Government expenditure is exogenous 2. - The tax (T) depends on the tax rate (t), which is the function of income Budget Surplus or Deficit = G T; G is Government expenditure; T is Taxation

If G>T there will be a budget deficit. If G<T there will be a budget surplus. 3. where is disposable income 4. Disposable income equals total income less taxation. = 5. Investment is exogenous (independent of income) Expenditure (E) = Income (Y)

Government multiplier Alternative approach 1. 2. 3. 4. 5.

The higher the MPS and taxes the lower the amount consumed. The lower the MPS an d taxes the higher the expenditure rate and figure. Government Expenditure Multiplier in an open economy, with taxes 1. 2. 3. 4. 5. M=M0 +M1Y M = import function M1 = marginal propensity to import M0 = autonomous imports 6. 7. exports are exogenous because imports depend on the exchange rate. It also depends on the world price. The marginal propensity to i mport depends on the exchange rate. ( . Exports are exogenous in a small countr y because they are determined by other countries. 8. injections = leakages

Government purchases of goods and services when added to the level of private co nsumption and business investment demand cause an increase in the equilibrium in come in the economy. This is so because government purchases of goods and servic es not financed by an increase in taxes, increase the aggregate effective demand and consequently increase the equilibrium income in the same manner in which an increase in consumption and/or investment outlay raises the equilibrium income. Taxes on the other hand have the same impact on the economy as saving. An increa se in government taxes will, ceteris paribus, decrease the equilibrium income. G overnment purchases involve government expenditure on goods and services. Total government expenditure can be separated into government purchases of goods and s

ervices (G) and government transfer payments (R). Their impact on the economy is different. While G involve direct consumption of the purchased goods and servic es by government and therefore raise aggregate demand by the full amount of gove rnment expenditure. In the case of transfer payments (R), government pays money to individuals in the form of old age insurance, unemployment dole payments, etc . After including government sector in a 3 sector closed economy, equilibrium ag gregate income will be Y = C + I + G with no increase in the government taxes an d autonomous investment, the government purchases multiplier will be equal to th e simple investment multiplier. Derivation. This can be derived as follows: Y = C + I + G and C = a + bY; I = A w here A is autonomous investment. G = Go= autonomous government expenditure. This is the multiplier in the absence of government taxes and transfer payments with only autonomous investment. Government transfer multiplier. A government transfer multiplier operates like t he simple multiplier except that its value is generally smaller than the value o f the simple multiplier for either government purchases or investment. Normally different transfer payments would have different multipliers. For example, the t ransfer multiplier for interest payments would be smaller than that for the unem ployment compensation payments since interest payments are mostly received by hi gh income families owning government bonds. These families MPC is low while the u nemployment compensation payments are received by the low income and poor famili es whose MPC is generally high. Tax Multiplier. The tax multiplier would be negative because a tax would cause a negative change in the disposable personal income of the community. The disposa ble personal income Yd = Y T+R where R is transfers. (It is assumed that T and R are autonomously det ermined.) C = a + bYd and therefore C= bYd C= b (Y T+R) and C= bY bT+bR) The impact of taxes on consumption and therefore, on income is negative. Derivat ion is Y = C + I + G Substituting for Yd gives for the transfers multiplier. Lump sum tax multiplier Lumpsum tax is tax that is a fixed amount. The lumpsum tax multiplier ktx= - MPC/MPS. This has a negative sign because as tax increases consumption fa lls. If MPC = ; MPS = , then ktx= - MPC/MPS.= -(3/4)/ (1/4) = -3. If MPC = 2/3 ; MPS = 1/3 then ktx= - MPC/MPS = -(2/3)/ (1/3)= -2. Y = ktx.T T = Tax. With a tax cut of say $10m Y = ktx.T=-2 (-10) = $20m. Balanced Budget multiplier When a budget is balanced G=T hence G = T. If both G and T increase by $10m, incom e increases by $10m. The multiplier for a balanced budget kBB.=1 ; Y = kBB.x G = 1 x ($10m) = $10m this would be an expansionary budget. If there is a cut of say $10m , Y= kBB.x G= 1 x (-10) = -$10m and this is a contractionary bud get. Foreign trade multiplier. For an open economy, income and output will increase f rom one period to the next as total exports increase or its total imports decrea se because as a result of both these changes the economys net exports expand. Con versely, domestic economys income and output will fall over time as its total exp

orts decline or total imports rise as both these changes will tend to cause a fa ll in net exports. From this it follows that the effect of imports and exports o n economys equilibrium income and output originates from those factors that deter mine the economys imports and exports. Generally, a countrys total exports depend on the price of goods in the country r elative to their prices in other countries, tariff and trade policies prevalent in the country and availability of foreign currencies in the foreign exchange ma rkets, income in other countries, own imports of the country, etc. Some of the m ore important factors that determine a countrys exports are not directly related to conditions within that country. Consequently, it is assumed that gross export s of a country are autonomously determined, i.e. exports are determined by the e xternal factors. The volume of imports is determined by similar factors. Howeve r many of these factors are influenced by conditions within the country. Ceteris paribus, a countrys total imports are determined by the level of national income . In other words assuming given international price differences and unchanging t ariff, trade and foreign exchange restrictions a countrys imports are functionall y related to her national income. Assuming a linear relationship between national income and imports of the follow ing form which defines the import function as M = Ma + mY, where Ma is the auton omous spending on imports and m is the marginal propensity to import (MPM). In the four sector open economy the equilibrium income is given by the equation Y = C + I +G + (X-M) or by the equation S +T + M = I + G + X. Since our consump tion is defined by the equation of the consumption function C = a + b(Y-T) and i mports are defined by the import function equation M = Ma + mY, by substituting for the terms C and M the above equilibrium income can be written as Y = a + b(Y-T) + I + G +X (Ma + mY). This can be rewritten as Where 1/ (1-b+m) is the foreign trade multiplier for the economy in which export s are wholly autonomously determined while both consumption spending and import expenditure are linear functions of the level of national income. If taxes are a ssumed to be functionally related to the level of income so that the total tax f unction is T = d + tY, the equilibrium national income would then be Where 1/(1-b+bt+m) is the foreign trade multiplier for the system in which cons umption, imports and taxes are all linear functions of the level of domestic inc ome. Furthermore if we treat investment spending also linearly related to the le vel of income so that the investment demand function can be written as I = Ia + eY, the equation for the equilibrium aggregate income will become in which consumption, investment, imports and taxes are all linear functions of the level of national income. The foreign trade multiplier, also called the expo rt multiplier, operates in exactly the same manner, as does the ordinary investm ent multiplier. An increase in countrys exports causes an increase in the incomes of the exporters and factors employed in the export industries that in turn spe nd a part of their increased incomes on domestic goods. In short, the larger the marginal propensities to save and import, smaller will be the value of the fore ign trade multiplier and vice versa. is the foreign trade multiplier for the economy in which the consumption, invest ment, imports and taxes are all linear functions of the level of national income . A look at the multiplier brings home the fact that ceteris paribus the value o f the foreign trade multiplier is inversely related to the value of the marginal propensity to import m such that higher m is associated with lower foreign trad e multiplier and vice versa.

Criticisms of the Multiplier Analysis 1. Simple multipliers analysis is faulty because it neglects the role of induced investment resulting from induced consumption in the determination of equilibri um income. 2. Multiplier analysis derives the multiplier on the assumption of constant MPC. Over the short period ( short-run) of a trade cycle, the marginal propensi ty to consume is not constant. 3. Assumes that labour and other fixed resources are idle or under-utilized in the economy. 4. Bottlenecks of particular kind of labour or at particular places may blo ck the expansion of employment and output in the economy. CHAPTER THREE MONEY AND BANKING THEORY Origins of Money The earliest method of exchange was barter in which goods were exchanged directl y for other goods. Problems arose when either someone did not want what was bein g offered in exchange for the other good, or if no agreement could be reached ov er how much one good was worth in terms of the other. Valuable metals such as gold and silver began acting as a medium of exchange. Go vernments then decided to melt down these metals into coins. By the seventeenth century people were leaving gold with the local goldsmith for safe keeping. Receipts of 1 and 5 were issued which could then be converted back into gold at any time. Soon these receipts were recognized as being as good as gold and were readily taken in exchange for goods. Goldsmiths became the first specialist bankers and their receipts began to circulate as banknotes. Only the Reserve Bank of Zimbabwe can issue banknotes in Zimbabwe. However, note s are not usually used to buy expensive items such as cars. The buyer is more li kely to write out a cheque, which instructs his bank to transfer money from his account into the account of the seller. Hence bank deposits act as money. Functions of Money Money is something which people generally accept in exchange for a good or a ser vice. Money performs four main functions: a medium of exchange for buying goods and services; a unit of account for placing a value on goods and services; a store of value when saving; a standard for deferred payment when calculating loans. Properties or Characteristics of Money Any item which is going to serve as money must be: acceptable to people as payment; scarce and in controlled supply stable and able to keep its value divisible without any loss of value portable and not too heavy to carry. Greshams Law- bad money drives out good money If there are two types of money, and one is more valuable than the other , the i nferior money gets used/ circulated and it drives the valuable / superior money out of circulation. People will hoard the good money and spend it. MONEY SUPPLY Definition The money supply is the total amount of assets in circulation, which are accepta ble in exchange for goods. In modern economies people accept either notes and co ins or an increase in their current account as payment. Hence the money supply i s made up of cash and bank deposits. Credit Creation

Some customers leave money in the bank earning interest. A bank can use these id le deposits to make loans to people who then buy goods. Shopkeepers receive extr a money, which they redeposit with the bank. Some of this redeposited money is l eft to earn interest and can be re-lent. The bank has therefore created money. I f all customers were to try to cash their deposits at once, there would not be s ufficient cash. The amount of money the bank can create therefore depends on the ratio of cash to liabilities that they hold. The higher this cash ratio the les s money the bank can re-lend or create. How do banks create money? Assume a single bank, Barclays bank Mr. Moyo deposits $20000 cash in the bank. By depositing $20000 in the bank, money changes its form from cash to deposit. Mrs. Maphosa wants to borrow money for business. Barclays Bank can lend because it knows Mr. Moyo will not withdraw all at once. But it knows it must keep some cash as a reserve say 10% therefore Barclays lend s $18000 to Mrs. Maphosa. By lending money to Mrs. Maphosa, the bank increases money supply to $38000 from just $20000. The bank is able to create money because people have confidence th at the cheques signed by the bank are honoured. If the reserve ratio is r then the basic definition of money multiplier (m) The change in total deposits (AD) =( 1/r x Deposit) When r = 0.1 and deposit = 20000, then The change in total deposits = D= From this calculation changes in deposits can be as high as $200000 from an init ial deposit of $20000. If the reserve ratio increases, it limits the change in d eposits because most of the deposits are kept as reserves and not lent. Limits to banks to create money will depend on: Amount of reserves (liquid) assets Reserve asset ratio Willingness of people to borrow Desire of people to hold cash. What is regarded as reserve asset must be defined by law. The following assets c an however be regarded as reserve assets: Cash balance with central bank Foreign exchange Treasury bills Gold etc. Definitions of money 1. = It is also called high powered money. 2. Demand deposits notes and coins in circulation with public. It is somet imes referred to as narrow money 3. Savings deposits with banks. It is sometimes referred to as broad money. 4. Other savings deposits etc. Determining Money Supply 1. 2. Where - reserve ratio - Reserve assets - Demand deposits - Currency ratio - Notes and coins in circulation in countries like Zimbabwe, the currency ratio is very high because many people keep notes and coins at home. This is because the banking system can at times be

inconvenient. 3.

4.

Where m is the money multiplier and is greater than 1 (m>1) the reserve ratio can be separated into required reserve ratio ess reserve ratio and exc

- Banks hold excess reserve ratio because 1. Most banks are prudent (prudential banks ) and sensible to see whether l ending is profitable. 2. Limited liability of banks to create since people may not be willing t o borrow due to high interest rates.

DEMAND FOR MONEY - refers to the amount of money held by the general public in an economy. The main reasons for holding money are: 1. Transactional reason/ motive 2. Speculative motive 3. Precautionary motive. MONETARY POLICY What is Monetary Policy? It is the use of money or its cost, the interest rate to fine tune some economic variables such as : Inflation Economic growth Investment Interest rates Balance of payments Objective of monetary policy In general monetary policy has two major objectives: 1. To reduce inflation (stability objective) 2. To boost economic growth (growth objective) Instruments / Measures/tools of monetary policy Monetary policy measures are used to increase or decrease the amount of money, d epending on the situation prevailing. Each instrument can be used in 2ways, either to increase or decrease the amount of money in circulation The following are some of common instruments: 1. Bank rate 2. Open market operations 3. Rediscount rate 4. Repurchase Agreement 5. Selective credit controls 6. Moral Suasion 7. Reserve requirements These instruments can be classified into the general or quantitative instruments

and the selective or qualitative instruments. General or quantitative instruments These include open market operations, changes in the minimum legal cash reserve ratio and changes in the bank or discount rate. These instruments influence the credit creating capacity of the commercial banks in the economy by operating dir ectly or indirectly on their excess cash reserves. Selective or qualitative instruments The instruments affect the types of credit extended by the banks. They affect th e composition rather than the size of the loan portfolios of the commercial bank s. The immediate object of imposing the selective credit controls is to regulat e both the amount and the terms on which credit is extended by the banks for sel ected purposes. The selective credit control instruments enable the central bank to restrict unhealthy expansion of credit for specific purposes; without at the same time airing credit expansion in general. Use of the Instruments/ Measures /Tools The instruments are contractionary or expansionary, depending on the liquidity s ituation. When there is too much money, monetary tools are used in contractionar y way. When there is less money, monetary tools are used in an expansionary way. Bank Rate/ Rediscount Rate When banks borrow from the Central Bank directly, they are charged a bank rate. When they borrow indirectly through the discount houses, they are charged redisc ount rates. This is the rate at which the central bank discounts first class bills. It is a benchmark for commercial bank lending rates. An increase in the bank rate increases lending rates and reduces the amount of m oney. A decrease in the bank rate reduces lending rates and increases the amount of mo ney. Open market operations This is buying and selling of government securities e.g. bonds (TBs). When there is too much money, the government sells securities. The government takes the mo ney and the public holds securities. To reduce money supply, the government sell s bonds to the public and pays with currency (notes + coins in circulation). Thi s reduces money available for spending. The success of the instrument depends on whether the public wants to buy bonds or not. To persuade people to buy bonds, the government raises interest. When there is inadequate money, the government buys securities. The government t akes the securities and the public holds money. Money is injected into the econo my. Selective credit controls When there are liquidity problems, the central bank and even banks have preferen tial treatment of clients. Credit is allocated to some selected sectors. For exa mple, credit can be allocated to export or productive sectors. Rationing of cred it- this involves imposing a ceiling upon its (Central Banks) discounts for any o ne bank or rejecting a proportion of each discount application whenever total de mand for loans exceeds the amount the central bank is prepared to discount on an y one day. Regulation of consumer credit The regulation of consumer credit is employed to regulate the terms and conditio ns under which bank credit repayable in installments could be extended for purch asing or carrying the consumer durable goods. The regulation of consumer credit is quite important in combating inflation by restricting the aggregate consumer demand for those goods which are in short supply in industrially developed count ries where consumer credit is largely used to finance domestic purchases. In cou ntries where there is no consumer credit and the banks do not participate in fin ancing the purchase of consumer durables to any significant degree, the method c annot be effective in curbing the inflationary pressures in the economy. Moral Suasion It involves direct solicit with the Central Bank. The central bank persuades fin

ancial institutions to be supportive of the prevailing monetary policy stance. W hen there is too much liquidity, institutions are persuaded to tighten their cre dit allocation systems. When there is a shortage of liquidity, institutions are persuaded to loosen their credit allocation systems. This measure is not mandat ory but persuasive and as a result it is difficult to influence the currency rat io c/D and consequently money supply. The instrument would succeed only if the commercial banks follow scrupulously th e leadership of the central bank. This will however depend on the strength of th e central bank and the prestige enjoyed by it among the member banks. In countri es with highly liquid monetary conditions and where the central bank cannot unde rtake open market operations on a massive scale to counteract the high bank liq uidity, it is advisable for the central bank to use moral suasion. Reserve Requirements When bank deposits are made, part of the money is kept as bank reserves and the rest is lent out as loans. The reserve requirement is the amount of money that i s kept as reserves. The percentage of money kept as reserves is called the reser ve requirements ratio. When there is too much money, the reserve ratio is increa sed to reduce credit creation. When there is a shortage the reserve ratio is red uced to increase credit creation so as to increase money supply. The government can regulate the required reserve ratio . Increasing required reserve ratio reduces the lending base. The instrument is no t without its limitations: If their cash reserves are swollen, commercial banks will not care at all for the increase in the minimum legal cash reserves ratio r equirement unless the increase is very high. They might also conduct their oper ations with a lower cash reserves ratio if they are optimistic about the future, while a fall in the minimum legal reserves ratio may fail to induce them to len d in depression. A counteracting force may arise from a change in the banking pr actices. If percentages of minimum legal cash reserves required to be kept with reserve banks differ for different kinds of deposits held by banks e.g. with a m inimum legal cash reserves ratio of 10% against the demand deposits and of 3% ag ainst the time deposits, a transfer of bank funds from the former to the latter would enable the banks to expand credit and to that extent would induce them to disregard the credit restriction policy enforced by the central bank. Publicity Central banks may employ the instrument of publicity in order to publicise the e conomic facts in the weekly statements of their assets and liabilities, monthly bulletins containing review of credit and business condition, and detailed annua l reports stating their operations and activities, the state of affairs of the m oney market and banking system and general review of the trade, industry, agricu lture, etc. in the country. By resorting to publicity, the central bank enlists public opinion in favour of its monetary policy and thereby combats opposition t o its policies among political, financial and business interests. However the me thod of publicity has the scope of useful application in industrially advanced c ountries where public opinion is enlightened. In the developing countries where people are mostly less educated and even those who are educated are not acquaint ed with the technique of banking the method of publicity is of little use in con trolling credit. CHAPTER FOUR UNEMPLOYMENT What is unemployment? Definition Unemployment is the pool of people above a specified age who are without work, a re currently available for work and are seeking work during a period of referenc e. Unemployment results when the available workplaces cannot adapt to the job se ekers. When the number of persons, who offer their working capacities, exceeds t he number of available workplaces, this leads to a lack in workplaces. Unemployment has become a serious economic problem. Majority of people can only make living by working for others. Many millions of people are both able and wil ling to work, but simply cannot find a job. Unemployment is an overwhelming conc

ern of policymakers and the general public. Unemployment often implies a waste o f human resources that could otherwise be producing goods and services to satisf y the needs of society. At the same time, it can mean extreme personal hardship for the Unemployed, and therefore it is an important social concern. Unemploymen t rate fluctuates widely over time within a given country, in line with the busi ness cycle. Unemployment increases during recession and declines during booms. Measurement of Unemployment When calculating the level of unemployment the government only counts those peop le who register as unemployed and claim benefit. A large number of people seekin g work either do not register or do not claim benefit and are now excluded from official figures. Unemployment rate is the number of unemployed people as a pro portion of the labour force. The labour force is all those with work or all thos e seeking work. The unemployment rate is the percentage of the labour force officially jobless. Full employment occurs when the number of notified job vacancies exceeds the num ber of registered people unemployed. Unemployment Trends Unemployment is a flow and not a stock. There are always inflows onto the unempl oyment register, and there are outflows off the register as people get jobs or j oin training schemes. If all inflows rise and all outflows except training fall then overall unemploym ent will rise. Young people, women, the over-fifties and ethnic minorities tend to be the hardest hit. Inner cities and manufacturing areas also tend to have ab ove-average unemployment. Natural rate of unemployment It is that rate which corresponds to macroeconomic equilibrium, in which expecte d inflation is equal to its actual level. It is that rate of unemployment to whi ch the economy will return after a cyclical, recession or boom. The natural rate of unemployment is sometimes called the the full employment rate of unemployment conveying the sense that unemployment is excessive only when act ual unemployment exceeds the natural level. We generally refer to the gap between actual unemployment and the natural rate a s cyclical unemployment. In other words, cyclical unemployment is the amount of unemployment that can be reduced by expansionary macroeconomic policies without setting off an endless rise in the rate of inflation. Types of unemployment We have to differentiate between a few types of unemployment: 1. Cyclical unemployment: if a country has an economical boom then people have j obs, if there is an economic recession people lose jobs. Cyclical unemployment i s unemployment above the natural rate. 2. Frictional unemployment: This arises because people are always flowing into a nd out of unemployment. New workers are constantly entering the labour force, an d existing workers frequently leave one job and look for another. During these t ransitions they spend time on their job searches e.g. you stop working in Decemb er and start your new work in March, these period between these months is called frictional unemployment 3. Structural unemployment: Structural unemployment can occur in factories when too old machines, cannot produce enough, sell less products, cannot pay their st aff, more unemployed people. It is unemployment that exists when the economy is operating at the natural rate. The natural rate of unemployment (Un) reflects m any different phenomena and forces such as union power, which raises real wages above full employment real wages. 4. Hidden unemployment: dismissed people dont ask for a new job, they also dont re gister for unemployment benefits, e.g. women after their maternity leave often s tay at home with their children. It can also include the discouraged, those nomi nally having jobs for which they are paid but in fact doing nothing; and those w ho can be withdrawn from rural areas because of their zero marginal product. 5. Seasonal unemployment: e.g. tourism-areas, construction sector, and agricultu

ral sector. In the rural areas or farming areas, everyone is fully employed duri ng the rain season and harvesting periods but thereafter demand for labour is ve ry low. The unemployment is mostly where there is single cropping 6. Structural Unemployment. This occurs when economic readjustments are not fast enough during economic growth, so that severe pockets of unemployment occur in areas, industries and occupations in which the demand for factors of production is falling faster than is the supply. Policies that discourage movement among re gions, industries and occupations can raise structural unemployment. 7. Technological Unemployment- this comes about as a result of technological cha nge. Why unemployment is studied 1. The income aspect- income can mostly be earned if one is employed. Most econo mies gain from employment of their nationals. 2. The production aspect of employment- concern is on the labour utilisation. If labour is unemployed there is a waste of productive resources. 3. Recognition aspect- the type of employment determines social status and selfesteem. Studies found that people who had been unemployed for two or more years had self-esteem. Causes of Unemployment 1. Rapid growth of labour forces due to high population growth rate in developin g countries. Fast growth of labour force places a strain on the ability of the e conomy to generate new work opportunities on a sufficient scale to absorb rising numbers (economic dualism and rural- urban migration). 2. Education system also contributes the size of the educated labour force is gr owing more rapidly than the economy can absorb. 3. Shortage of saving and investment- investment per worker in developing countr ies is often less than that in developed countries. 4. Inefficient land tenure systems in many developing countries cause them not t o be able to utilise their expanding labour resources. 5. Inappropriate developmemnt strategies they pursued and technologies adopted. They engaged in import substitution strategies hence limited jobs. 6. Engineering bias, minimum wage laws, government salary structures, influence of trade unions, pay policies of multinational corporations all help to raise th e urban wages well above competitive market clearing levels. 7. Laws and conventions holding down interest rates, tax concessions for foreign investors similarly hold the price of capital well below levels which would ref lect their scarcity in the economy.

Consequences of unemployment /Costs of Unemployment Lost Output The opportunity cost of each unemployed person is their foregone output. Increased Benefit Payments Each extra person who becomes unemployed stops paying tax ( perhaps $4000) and s tarts receiving benefit (upwards of $5000). The government therefore has to rais e a additional funds to finance unemployment benefits for unemployed. As the fig ure falls the government pays out less unemployment benefits and receives more i n tax. The savings to the exchequer from this will be considerable. Lost Tax Revenue Growing unemployment means less direct and indirect tax revenue. When people los e their jobs they will stop paying income tax, and their spending will fall cons iderably reducing government receipts from VAT and other indirect taxes. Human Costs of Unemployment The long-term and youth unemployed feel increasingly isolated and removed (alien ated) from society. There will also be increased NHS costs as people s health of

ten suffers when they are unemployed, and there will be increased costs to socie ty in terms of crime. In our society where money means success the unemployed feel useless and conside r themselves a failure. Studies have shown that people who have been unemployed for some time develop a low self esteem.They are dissatisfied and depressed and this may lead to alcoholism drug problems and homelessness and even to crime. Especially for families its difficult because they do not have enough money to af ford their basics of life. So because of that that government has to help financ ially, but this causes high costs for working people who have to support the une mployed. High risk groups There are some high-risk groups, for example youths, women with little children after their maternity leave or elderly people aged 50 and over. Lots of those pe ople cannot find a (good) job. Young people are part of the high-risk group because in most cases they do not h ave any practical experience and there are lots of young people searching for th e same few jobs. That is why there is a high selection rate on the job market. F irms want to employ young people with lots of experience who want to work almost 24 hours a day and earn just a little pocket money. Women in general, but especially women with little children who want to work aga in after their maternity leave are another high-risk group. Their problem is tha t the probability of their needing time off to nurse sick children is very high, especially if they have little kids. Another problem is that those women have n ot worked for the time of their child nursing and there might be new trends, new developments or things like that. The last high-risk group is the large group of over 50 year old people. Their pr oblem is that they cost too much. If a firm employs younger workers they do not have to pay as much as they would for an older person. That is why they are fire d. And it is almost impossible for those people to find a new work place. Solution of unemployment Possible solutions: Early retirement Job-sharing New jobs (new economy) A general reduction of working hours Reduction of overtime It is very hard to find good solutions in the long run. Some ideas such as job-s haring or early retirement are in discussion. But my opinion on that is that bot h, job-sharing and early retirement are not the right way because if you share y our job you won t earn enough money to afford the basics of life for your family . Early retirement sounds nice but it means a huge amount of costs for all the oth er working people who have to pay for that. So this cannot be the right way, I s uppose. A good solution would be the attendance of further training courses, so that une mployed people are trained to find a new job and learn new skills. The only prob lem about that are the costs, which are very high and the question is who is goi ng to pay them. Population control- if there is population restraint the growth of developing co untry labour force will be in check. Overhaul of the education systems to change from their present academic, elitist , white-collar job orientation to vocational and technical training systems to p roduce artisans and technicians the countries desperately need. Sectoral priorities which particularly favour the development of small-scale agr iculture and the informal sector. Small-scale agriculture and the informal secto r are labour intensive, so their development will both generate more employment and raise productivities of those already working in them. Incomes policies designed to prevent formal sector wage levels from being raise d by institutional factors to levels well above the true economic value of unski lled labour. This involves attention to the governments own pay policies, its pol

icies towards the trade unions, towards multinational firms and towards minimum wage legislation. Rural development and decentralisation- this involves coordination of programmes for the improvement of agriculture, water, transport; access to goods and servi ces and appropriate land tenure- aim is to reduce rural- urban migration. Informal Sector:The development of the sector is attractive because it does not require complex and expensive infrastructure and has high potential for creating jobs. It uses mostly locally produced resources or raw materials. It can be a m ajor source of income generation both for rural and nonagricultural informal sec tions of the economy. It creates a platform for the exchange of locally produced goods and services. It provides strong base for local entrepreneurs. It is also a source of government revenue when these sectors grow and become registered. Problems of the informal sector in Zimbabwe Procedures to be followed in obtaining licences and project approval are discour aging and they (operatives in the sector) pay high rentals to landlords. Because of the high corporate tax, they would rather remain unregistered. If the y are taxed they face financial problems and hence cannot pay minimum wages. Lack of adequate transport and infrastructure to facilitate delivery of produce to the target market. Lack of technological support and managerial, technical and marketing skills. Lack of project planning and implementation. Inability to obtain loan and credit facilities hence due to lack of collateral s ecurity, 90% of microenterprises are automatically eliminated from getting finan cial assistance. However it must be pointed out that the development path whereby there is heavy emphasis on iunformal sector enterprise and small business development has limit ations, although it provides employment and income. The disadvantage of informal enterprise is it does not lead to development of high technology non traditiona l export.It does not invest in new technique, generate new skills and develop ne w products. Types, Causes, and Remedies for Unemployment Table below summarises the main causes and remedies for different types of unemp loyment. The average length of time workers remain unemployed is a critical measure of th e seriousness of the unemployment figures. If the average length of unemployment is short then the economy will be healthier and people will not lose their skil ls from long periods without work. Employment and training schemes that have been used in the 1980s and 1990s Scheme Description Restart Programme Interviews and training for the long-term unemployed Community Programme Local projects for the long-term unemployed New Workers Scheme A subsidy to employers taking on youth unemployed Job Search Scheme Return fare and allowances for job interviews Job Release Scheme Older workers retire early with an allowance and are rep laced by an unemployed person Job Splitting Scheme A subsidy to employers who encourage job sharing Youth Training Scheme Two-year work experience and training for school leavers Job Training Scheme Retraining scheme for unemployed adults Causes and remedies of unemployment Type Description Cause Remedy Frictional Workers temporarily between jobs Delays in applying inter viewing and accepting jobs Improve job information, eg computerised job cen tres Structural Workers have the wrong skills in the wrong place Declinin g industries and the immobility of labour Subsidies and improve the mobili ty of labour Cyclical All firms need fewer workers Low total demand in the economy Increased government spending or lower taxes Technological Firms replace workers with machines Automation and informati

CHAPTER FIVE INFLATION DEFINITIONS There are several definitions: (a)This is a persistent rise in the general level of prices or a persistent fall in the purchasing power of money. The value or purchasing power of money refers to the amount of goods or services a unit of money can buy. It should be noted that the definition implies that an increase in some particular price is not inf lationary if compensated by falls in other prices. (b) Inflation is the general and prolonged rise in the price level. (c) Inflation can also be defined as to the continual increase in prices. Inflation means the value of money is falling because prices keep rising. MEASURES OF INFLATION 1. Cost of living Index (*COLI)also called the retail price index or consumer price index. This is the most fre quently used measure and is based on observations of prices of a basket of goods s elected as a representative of the spending patterns of consumers within some sp ecified range of incomes. 2. Wholesale price indexis the index which measures prices of commodities commonly bought and sold by wh olesalers. This index has an advantage over the consumer price index in that it gives an earlier warning of an upsurge in prices than a retail index. It takes t ime for a rise to work its way through to the shops and markets. 3. The GNP deflatorThis is derived from comparisons of GNP estimates in current prices and in const ant prices. Prices of consumer goods, capital goods etc. are taken into consider ation when compiling this. Calculating the Retail Price Index The retail price index (RPI) can be used to measure inflation. The retail price index (RPI) is a monthly survey carried out by the government which measures pri ce changes. The following procedure is used: A basket of goods and services consumed by the average family is listed. For exa mple, food, clothing and transport are included in the basket. The price of items in the basket in the base (first) year is noted. Each item in the basket is given a number value (weighted) to reflect its import ance to the average family. For example, food has a higher weighting than transp ort. The price of goods in the basket is recorded every month compared with base year as a percentage (price relative) using the equation: Price relative = Current price/Base price x 100 The price relative of each item is then multiplied by its weighting. The new RPI is found using the equation: RPI = Total weightings x Price relative/Total weightings The value of the RPI in the base year is always 100. After twelve months the pri ce of good items in the basket may have risen by 25 per cent and that of housing

on technology Retraining International Overseas firms replace UK producers High-priced/low-quality UK goods Tariffs quotas or sterling depreciation Regional High unemployment in one area Local concentration of declining industries Regional aid, eg relocation grants Seasonal Unemployment for part of the year Seasonal variation in de mand Retraining Voluntary Workers choose to remain unemployed More money on the dole than from working Remove the low-paid from the liability to pay income tax

by 20 per cent while the cost of transport is unchanged. Table below shows how the RPI for year two might then be calculated. The RPI = Total weightings x Price relative/Total weightings = 12 100/100 = 121 Calculation of the retail price index Basket Weighting Price relative Weightings x price relative Food 60 125 7500 Housing 30 120 3600 Transport 10 100 1000 Total 100 12100 The rate of inflation is the percentage change in the RPI over the last twelve m onths and is calculated using the equation: Rate of inflation = (Current RPI - Last RPI)/Last RPI x 100 At the beginning of year two the rate of inflation is: (121 - 100)/100 x 100 = 21 per cent Problems in Using the Retail Price Index The RPI is narrow. Which items should be included in or excluded from the basket of goods? Different families have different tastes hence different weightings. How is an a verage family found? Not all regions in the country experience identical price changes. For a while new products ( eg mobile phones) may not be included in the index. Advantages and Effects of Inflation Not everyone suffers from inflation. Some parts of society actually benefit: The government finds that people earn more and so pay more income tax. Firms are able to increase prices and profits before they pay out higher wages. Debtors (borrowers) gain because they have use of money now, when its purchasing power is greater. Disadvantages of Inflation People on fixed incomes are unable to buy so many goods. Creditors (savers) lose because the loan will have reduced purchasing power when it is repaid. Domestic goods may become more expensive than foreign-made products so the balan ce of payments suffers. Industrial disputes may occur if workers are unable to secure wage increases to restore their standard of living. CAUSES OF INFLATION Supply oriented Explanations These explanations concentrate on the cost push and structuralist theories. Cost-push Inflation Cost Push Theory- this ascribes inflation to increases in cost, which are indepe ndent of the state of aggregate demand. For most manufacturers in developing cou ntries, the cost of imported goods is continuously rising because of world infla tion. This both directly raises the cost of living through higher prices for fin ished goods imports and indirectly through more costly imported materials used b y domestic producers. In addition, trade unions may force wages up more rapidly than increases in productivity, raising unit labour costs. Other groups e.g farm ers organizations, may also be strong enough to prevent their own position from being eroded, and the generally low degree of competition in modern industrial s ector allows manufacturers to pass cost increases on to consumers perhaps adding an enlarged profit margin for themselves. Cost-push Inflation occurs when a firm passes on an increase in production costs to the consumer. The inflationary effect of increased costs can be the result o f: Increased wages, leading to 1. a wage-price spiral, which occurs when price increases spark off a serie s of wage demands which lead to further price increases and so on;

2. a wage-wage spiral, which occurs when one group of workers receive a wag e increase which sparks off a series of wage demands from other workers. Wages m ay also rise due to the trade unions, which may force the wages to rise. This sq ueezes profits of firms and they raise price to meet target profits. Increased import prices which can be the result of: 1. a rise in world prices for imported raw materials; 2. a depreciation of the domestic currency. Increased indirect taxation Interest rate raises the costs of production and the general price levels. The c entral bank can respond by tightening money supply, which in itself raises inter est rates, which increases costs of production and increases prices. Pure cost inflation- aggregate demand held constant With increases in costs, manufacturers shift supply from S1 to S2 toi S3. This i mplies loss of output, more unemployment, and rise in price level from Py to Px. There is strong union resistance to reduction in wages, cost plus pricing polic ies of firm selling in oligopolistic and monopolistic markets where prices are d etermined by costs, not state of demand. The ability to pass increases to the pu blic makes producers less resistant to wage claims and other cost raising pressu res. S3 S2 Px S1

Py

D Qx Qy Cost Push with Demand Adjustments In the previous diagram there was increased unemployment, reduction in capacity utilisation and this may not be in the publics and governments interest. The gover nment would find itself under pressure to increase aggregate demand enough to pr event output and employment from falling (see diagram below).

S3 Pz price Py D2 S2 S1 D3 D1 Qx In the diagram, for every upward movement in the supply curve, government will i nduce a compensating increase in total demand (D1 to D3) so as to validate the cos t increase and prevent output from falling below Qx. The effect is to increase t he rate of inflation with price level going up to Pz. Structuralist Theory of Inflation This theory postulates that inflation will accompany economic development becaus e of disequilibria created by the structural changes that are necessary to the d evelopment process. As the economy develops, incomes rise and as the incomes ris e the composition of demand changes and so does the structure of output. There i s however no guarantee that the productive structure will prove sufficiently ada

ptive to the changing composition of demand to avoid the emergence of disequilib ria in product markets. Demand is greater than supply in some cases while supply is greater than demand in others. Foreign trade sector will be unable to earn e nough foreign exchange to meet the growing import needs of the economy. The fore ign exchange scarcities will also tend to push up prices. Domestic food production lags behind demand. Agricultural production is often in elastic with respect to price. Increased demand will have to result in large pri ce rises before output responds much. Food prices thus tend to move ahead of the general price level. This may induce higher prices in the industrial sector too as trade unions lodge wage claims to protect worker against effects of higher f ood prices. Export earnings lag behind import needs because of the slow expansion of world d emand for primary products exported by less developed countries. Artificial barr iers of developed countries make matters worse. Official aid flows fall far shor t of filling the gap between export earnings and import requirements. Import prices join agriculture prices in setting the inflationary pace dragging other prices up behind them. Devaluation of national currency or imposition of i mport controls both cause price rises. Import substitution strategy also causes inflation. If therefore developments within the economy are balanced, major dise quilibria in product markets and on balance of payments may be avoided thus resu lting in mild inflation. Demand-pull Inflation Demand-pull inflation occurs when there is too much money chasing too few goods because the demand for current output exceeds supply. Demand inflation is caused by an excess of aggregate demand for goods and servic es over available supplies at a given level of prices. The natural market respon se to such a situation is a rise in prices towards a market clearing equilibrium in which once more D=S. A new equilibrium may not be achieved because of propag ating forces which raise both demand and costs and thus push prices ever higher. Inflation is not an inevitable outcome of an increase in demand. It all depends on the price elasticity of supply. If the elasticity is large, a small price inc rease may call forth a large increase in output so that the inflation impact is slight. In the short run, the main determinants of the supply elasticity will be the ext ent to which suppliers are operating below productive capacity and the availabil ity of foreign exchange. If there is much surplus capacity, the principal effect of an increase in demand will be to induce greater output, rather than to initi ate an inflationary spiral. Similarly, if there is surplus foreign exchange, the effect will be to induce a larger volume of imports. For the economy as a whole , a large danger of demand inflation is when there is a foreign exchange constra int and the economy is operating at near full capacity. The possibility of deman d inflation is greater the nearer the economy is to being on its production poss ibility frontier. The monetarist school of inflation (led by Milton Friedman) tries to explain the origins of demand inflation.. The essence of the monetarist position is that i nflation is always and everywhere a monetary phenomenon. The greater the monetiz ation of the economy the greater the inflation. People whose economic lives are entirely monetized will be more strongly affected by inflation than those who st ill meet many of their needs for themselves. The consequence of an increase in the supply of money greater than an increase i n the demand for money will be a rise in the demand for products and hence will tend to cause inflation. People desire the convenience of holding money balance but if they6 desire they will spend the surplus on goods and services. Assuming the supply of money is under the control of the state and the demand fo r money is a function of the level of real income, the extent of monetization of economic activity and the net utility of holding money, there will be an increa se in demand if real income goes up. There will be a larger transactions demand for money. Barter transactions or subsistence production become monetised. The d emand for money will also rise if interest rates on bank deposits go up or if th e people expect slower inflation. NB. Monetarists are not contending that any in

crease that any increase in the supply of money is inflationary. An economy can increase the quantity of money without inflation to extent that i t is growing in real terms, that economic activity is becoming monetised and tha t the net utility of money is going up. In particular a rapidly developing econo my can absorb more non-inflationary money supply increases than a stagnant one. As long as money supply is expanded to meet non-inflationary needs, monetary str ingency may retard the pace of development. The figure below shows increased demand and increased prices as consumers compet e to buy up goods still available. A major source of inflationary pressure is the government which can print money to buy goods. The monetarist view of inflation can be stated in the equation: MV = PT Where M = the money supply, V = the number of times each unit of money changes hands (the velocity of circul ation), P - the average price of goods, and T = the number of goods bought (transactions). Monetarists believe that the values of V and T are fixed so that any increase in the money supply , must raise the level of prices (P), and this is inflationar y. There is always an associated price increase with money supply to balance the 2 sides of the equation. Remedies of Inflation There are many ways for businesses, consumers and government to halt or control inflation. The traditional Keynesian approach is to categorise inflation as bein g either demand pull or cost push in nature. Cost-push Remedies Introduce price and income policies to free price and wage increases. The polici es may be statutory or voluntary. Ceiling of wages or salary increases may be se t. There may also be interference in the exchange rate system to keep down price s of imported goods. Labour can help fight inflation by also trying to increase productivity and cooperating with management in controlling the wage- price spir al, that is, not setting excessive wage bids. Business can help fight inflation by trying to increase the productivity of workers. This would decrease costs. Indexation. This consists of periodic and automatic revision of incomes, financi al asset values, the exchange rates and other variables so as to compensate for the effects of inflation. Encourage an appreciation of domestic currency. Reduce indirect taxation. Demand-pull Remedies For the Keynesians, where inflation is demand pull, they advocate demand managem ent policies: Reduce government spending ( G). Increase income tax (T) to reduce consumer spending. Reduce peoples ability to borrow money by increasing interest rates and tightenin g credit regulations. Reduce non-essential government expenditure. (T-G) is the budget deficit which i s financed by issuing government paper (treasury bills,money) thereby contributi ng to the national debt. As G falls so will the deficit. Control the supply of money. Assuming a direct relationship between the supply o f money and aggregate income (Y=f(M)), a reduction in the money supply causes a preferable multiplied reduction in the aggregate demand. Interest rates can be r aised to depress capital investment and credit financial consumer purchase. (Thi s of course would have adverse effect if inflation is experienced before full em ployment is reached.). Construction should be postponed in so far as feasible because this reduces inve stment in buildings, machinery and inventories. This reduces aggregate demand. P roduction should also be geared towards reasonable demand and unnecessary stockp iling of raw materials and semi-finished products should be avoided.

However plausible these suggestions (or solutions) may be flimsy, for government before any economic issue can be decided the political half of the issue must b e solved. This often causes government to ignore the economic issues or try to s olve it in a roundabout, often unsuccessful manner. The business world is motiva ted by self interest hence in this situation of inflation, it seems risky to pos tpone expansion of the production facilities, to keep prices steady and profits low. The consumer on the other hand is confronted by the savings paradox. He knows th at more savings and less consumption would help fight inflation, but it is infla tion itself that is preventing the consumer from saving more, by inducing him to spend now rather than later. Some undesirable effects of Inflation (1) Unjustified wealth transfers occur from net money creditors to net money debtors. (2) When union wage contracts do not have inflation escalator clauses, and w orkers notice an actual decline in their real wages, they may frequently resort to strikes creating social instability. (3) Assuming a country has fixed rates of exchange and its domestic inflatio n rate is higher than the inflation rate in the countries with which it is tradi ng, it would be less competitive in the world markets. Its exports would be less and it imports more, leading to balance of payments problems. (4) Tax revenues of government are automatically increased because inflation pushes income earners into higher tax brackets (where tax system is progressive ). This may defeat the economic policy of reaching full employment because total spending decreases automatically. (5) The usefulness of money as a store of value may be reduced and people wi ll start to use money substitutes and will reduce their money balances and inves t more in real assets, like houses, education, automobiles, etc. (6) The operation of the credit market for example will be less effective by increasing the risk of borrowing and lending. Inflation-does anyone gain? 1. Government- where there is inflation, tax resource will be redistributed in favour of the government budget. Inflation benefits the budget by reducing t he real cost of servicing of the debt. 2. Farmers- where food production is relatively inelastic with respect to p rice. 3. Importers- where a fixed exchange rate is maintained they can raise pric es on local sales of imports and get a premium. Inflation- The losers 1. Creditors. 2. With a fixed exchange rate domestic producers of exports and of imports subst itutes will be losers. 4. Consumers of farmers products. 5. Economically inactive groups e.g. housewives. 6. Modern sector wage labour force. 7. Pensioners and others on fixed income. CAUSES FOR AND AGAINST INFLATION PROINFLATION CASE It is argued that inflation is necessary if there is to be growth in the economy . Inflation accompanies growth. It is also argued that inflation redistributes i ncomes in such a way as to raise saving and investment thus accelerating growth. According to the view, company profits and government budget are likely to bene fit from inflation at the expense of consumers especially urban wage labour forc e. Company profit margins rise and they often reinvest large proportion of incre ases in profits rather than paying them out to shareholders. Workers on the othe r hand consume almost all their income. Government also gains from inflation, it is argued, because of inflation tax on

money balance, i.e. on everyone. The public has to forego expenditure on goods a nd services. The reduction in spending releases real resources in the economy wh ich can then be used for investment. Some economists advocate for growth with inflation, in the belief that the infla tionary trend will be reversed with time. ANTIGROWTH WITH INFLATION ARGUMENTS It is argued that inflation penalizes saving because it reduces the purchasing p ower of income set aside. There is also a high propensity to borrow, as repaymen ts are cheaper. Investment/planning decisions are difficult under uncertainty, due to inflation. Inflation may lure firms into unproductive investment decisions because their a ccounts will most probably mislead them about their current profitability. Becau se depreciation of capital equipment is mainly based on historical costs, during inflationary times, firms tend to underestimate the depreciation and overestima te company profit. Many profits of manufacturing and trading companies in times of rapid inflation are often the result of stock appreciation hence the swollen profits are therefore illusory. Domestic inflation will raise the cost of producing exports. The profitability o f exports declines thereby undermining the balance of payments position of a cou ntry. CHAPTER SIX INTERNATIONAL TRADE Introduction Basic condition of the world community is one of mutual interdependence. All cou ntries of the world rely for their national well being on international trade an d payments. Foreign currency or foreign exchange is used for effecting payments. The rate at which one countrys currency is exchanged for another. for example Z$ 1800 / 1Rand is the exchange. Exchange Rates An exchange rate is the price of one currency in terms of another. For Zimbabwe, the dollar exchange rate means the number of pounds () can one dollar ($) buy. T he exchange rate is determined by the supply and demand for dollars) and is $2 p er pound in the diagram below: Demand for dollars British want to exchange pounds for dollars for two reasons: 1. To buy Zimbabwean goods and services; 2. To lend or invest in Zimbabwe. The diagram above shows the number of dollars demanded at each and every exchang e rate. This is the D curve. Supply of Dollars Zimbabweans want to exchange dollars for pounds for two reasons: 1. to buy British goods and services; 2. to lend or invest in Britain. In the diagram above S shows the number of dollars supplied by Zimbabwe at each exchange rate. Changes in the Exchange Rate (flexible exchange rate) A fall in the value of the dollar (depreciation) means one dollar now buys fewer pounds. The dollar depreciates if Britons demand fewer dollars (shown in the di agram below) or if Zimbabweans offer more dollars. Zimbabwean exports become che aper and its imports become dearer. Hence, a dollar depreciation improves the ba lance of payments. A rise in the value of the dollar (appreciation) means one dollar now buys more pounds. Zimbabwean exports become dearer and its imports become cheaper. Hence a

dollar appreciation worsens the balance of payments. Benefits of Trade Participation in the international economy can improve living standards and the rate of economic development. This is in 3 ways: 1. Trade provides countries with an escape from confines of their national econo mies. It creates more profitable investment opportunities and this leads to acce lerated growth. 2. By giving access to the products of other nations, it avoids the need to stri ve for self sufficiency within national boundaries- technology developed elsewhe re is available. 3. Capital flows, an integral feature of world trade and payments give developin g countries access to the savings of richer nations, to augment their own. Capit al is obtainable from private sources as well as from aid from foreign governments and agencies eg. World Bank. Reasons for Trade Domestic Non-availability International trade is the exchange of goods and services between countries. An import is the Zimbabwean purchase of a good or service made overseas. An export is the sale of a Zimbabwean-made good or service overseas. A nation trades because it lacks the raw materials, climate, specialist labour, capital or technology needed to manufacture a particular good. Trade allows a gr eater variety of goods and services. Principle of Comparative Advantage The principle of comparative advantage states that countries will benefit by con centrating on the production of those goods in which they have a relative advant age. For instance, France has the climate and the expertise to produce better wine th an Brazil. Brazil is better able to produce coffee than France. Each country ben efits by specialising in the good it is most suited to making. France then creates a surplus of wine which it can trade for surplus Brazilian c offee. Protectionism Advantages of Protectionism Protectionism occurs when one country reduces the level of its imports because o f: Infant industries. If sunrise firms producing new-technology goods (eg computers ) are to survive against established foreign producers then temporary tariffs or quotas may be needed. Unfair competition. Foreign firms may receive subsidies or other government bene fits. They may be dumping (selling goods abroad at below cost price to capture a market). Balance of payments. Reducing imports improves the balance of trade. Strategic industries. To protect the manufacture of essential goods. Declining industries. To protect declining industries from creating further stru ctural unemployment. Disadvantages of Protectionism Prevents countries enjoying the full benefits of international specialization an d trade. Invites retaliation from foreign governments. Protects inefficient home industries from foreign competition. Consumers pay mor e for inferior produce. Protection Methods Methods of trade restriction Tariffs For every unit of import a charge is put and this fixed amount for every unit of import is the tariff. Tariffs (import duties) are surcharges on the price of im ports. The diagram below uses a supply-and-demand graph to illustrate the effect of a tariff.

Note that the tariff raises the price of the import; reduces the demand for imports; encourages demand for home-produced substitutes; raises revenue for the government. A tariff can be specific or advalorem. A specific tariff is a fixed amount for e very amount of imports. An advalorem tariff is the charge per value of import. Quotas Quotas restrict the actual quantity of an import allowed into a country. Note th at a quota: raises the price of imports; reduces the volume of imports; encourages demand for domestically made substitutes. A quota is a non tariff restriction. Another example of a non tariff restriction is an embargo. An embargo is a complete ban on imports. Other Protection Techniques 1. Administrative practices can discriminate against imports through custom s delays or setting specifications met by domestic, but not foreign, producers. 2. Exchange controls (currency restrictions) prevent domestic residents fro m acquiring sufficient foreign currency to pay for imports. 3. Prior to imports deposits. Before you import you are supposed to put asi de an import value. This reduces the amount of import. 4. Technical specifications on imported goods. The government put standards on the goods imported causing rejection of some. CHAPTER SEVEN BALANCE OF PAYMENTS Definition of the Balance of Payments 1. Is a systematic record of the economic transactions between residents of the exporting country and residents of the foreign countries during a certain period of time or 2. Is the difference between the total earnings on both invisible and visible it ems and total expenses. In order to know the position as regards international p ayments, government compile records of transactions. This record of transactions is thus called the Balance of Payments (BOP). 3 The balance of payments is a record of one country s trade dealings with the r est of the world. Any transaction involving Zimbabwean and foreign citizens is c alculated in dollars Dealings which result in money entering the country are credit (plus) items whil e transactions which lead to money leaving the country are debit (minus) items. Components of the Balance Of Payments The balance of payments can be split up into three sections: 1. the current account which deal with international trade in goods and ser vices; 2. transactions in assets and liabilities which deals with overseas flows o f money from international investments and loans; 3. Monetary Account which deals with foreign currency reserves and transact ions with multilateral bodies. Current Account The current account consists of international dealings in goods (visible trade) and services (invisible trade). It records all transactions in goods and service s, ie. visibles and invisibles. Receipt of interest , profits and dividends on l oans and investments in foreign countries; earnings from tourism and transportat ion and remittances home of income earned by nationals working abroad are includ ed in this account as invisibles. Example of current account 1985 Debits $m Credits $m Balance m Visible imports 80 140 Visible exports 78 072 -2 068 Invisible imports 75 007 Invisible exports 80 027 5020 By referring to above table you can see that in 1985: Zimbabwe bought $80 140 million worth of goods made overseas.

 Zimbabwe sold $78 072 million worth of goods overseas. The difference between visible exports and imports is known as the balance of t rade or visible balance. The amounted to -$2 068 million. Zimbabwe bought $75 007 million worth of foreign-produced services. Zimbabwe sold $80 027 million worth of services overseas. The difference between invisible exports and imports is called the invisible bal ance. This amounted to $5 020 million. Adding the balance of trade and balance on invisibles together gives the balance on the current account. A deficit on the current account means that more goods and services have been imported into the country than have been sold abroad. A s urplus on the current account means more goods and services have been exported t han imported. Transactions in Assets and Liabilities/ Capital account The transactions in assets and liabilities section of the balance of payments sh ows all movements of money in and out of the country for investment. This may be direct investment - investment in productive capacity (when firms invest in oth er countries to increase capital in these countries), or portfolio investment investment in shares ,bonds or other assets in foreign countries. Changes in ass ets will be outflows from Zimbabwe, as Zimbabwean investors invest money oversea s. These flows will be debits to the Zimbabwes Balance of Payments. Changes in li abilities will be credits to the Zimbabwean Balance of Payments as overseas inve stors invest money into the country (Zimbabwe) Monetary Account This is also called the official financing account. It records changes in the co untrys official foreign currency/exchange reserves (consisting usually of a mixtu re of gold and foreign currencies) plus transactions with the IMF and other fina ncial institutions. Balance of Payments Problems Balance of payments deficit This is of concern especially in developing countries because it affects the abi lity of those countries to trade with other countries. A balance of payments def icit is a major problem if it is persistent. This can be the result of excessive purchases of foreign goods and services or excessive Zimbabwean investment over seas. Faced with existing or projected balance of payments deficits on the combi ned current and capital accounts a variety of policy options are available: Correcting a Balance of Payments Deficit 1. Long term capital from the rest of the world. This has the disadvantage of ex ternal indebtedness. 2. Using foreign currency reserves- this is a short term measure because most no n-oil producing developing countries have very few months in which to exhaust th is. 3. Attracting additional inflows of short-term capital by raising interest rates . Lack of stability in developing countries means that there is no guarantee fun ds will remain in the countries, i.e. there is capital flight. 4. Import substitution- this is the local production of previously imported good s. This requires the importation of capital equipment and protection of the infa nt industry by imposing tariffs or bans on imported goods. 5. Exchange control this is designed to control foreign currency reserves. The f oreign currency is rationed so that the most pressing needs of the country will be given top priority when the funds are allocated., eg. capital goods and essen tial raw materials. Measures also include import licensing as well as creating a state monopoly tasked to import essentials. 6. Use of multiple exchange rates- different rates for currencies/ transactions. Essentials such as exports, tourism and essential inputs for industry would hav e a separate rate(s) of exchange to encourage them while for nonessentials they would be discriminatory . In other words there is a multi-tiered market for for eign exchange. 7. Disguised depreciation- this is a policy whereby there is a deliberate effort

by government to make imports more expensive. This includes raising import duti es, taxing invisibles, taxing remittances abroad, subsidise exports, charging hi gh fees on sales of foreign currency. This policy is deflationary and also has l oopholes. 8. Devaluation- reducing the external value of a currency. This increases t he volume of sales abroad. 9. Promoting ting export expansion- drawbacks of duty, export incentive sch emes. 10. Encouraging more private investment and seeking more foreign assistance. Much of the foreign aid comes in the form of loans which have to serviced. Inte rest has to be paid on the loans. The principal has also to be repaid in future. Balance of Payments Surplus This is also a cause for concern because if it is persistent, partners may retal iate by introducing import controls etc. A surplus implies an overvaluation of c urrency and this leads to exports becoming less competitive on the world market. It could also be inflationary because , it is argued by monetarists that it lea ds to an increase in money supply. A persistent surplus could mean a depression of domestic living standards. Correcting a Balance of Payments Surplus An unwanted balance of payments surplus can be the result of excessive foreign i nvestment in Zimbabwe. This will place a future strain on the invisible balance. A reduction in interest rates ( an outflow of funds on the capital account) or the scrapping of protectionist measures (restrictive exchange controls) will cor rect the surplus. CHAPTER EIGHT ECONOMIC GROWTH Definition Economic growth refers to an increase in a country s ability to produce goods an d services. The advantage of economic growth is that an increase in real nationa l income allows more goods for consumption or for investment. It is also defined as a long term rise in capacity to supply increasingly diverse economic goods to its population, this growing capacity based on advancing tech nology and the institutional and ideological adjustments that it demands. by Prof essor Kuznets. From this definition advancing technology provides the basis or p reconditions for continuous economic growth. Measurement of Economic Growth It can be measured by the change in GDP or GNP over time. It can be measured at current prices, also called nominal GDP (GNP). Real GDP is at constant prices. T he best indicator of growth is real GDP per capita. Factors affecting Economic growth 1. Capital accumulation i.e. Accumulation of machinery, equipment and tools etc. These lead to increased capacity of plants. Capital accumulation also incl udes investment in human resources. 2. Population and labour force growth- a larger labourforce means more prod uctive manpower while a larger overall population increases the potential size o f domestic markets. The growing supply will have a positive impact if the econom ic system can absorb and productively employ these added workers. 3. Technological progress- this is the most important source of economic gr owth. In its simplest form technological progress can be said to result from new and improved ways of accomplishing traditional tasks. The productive resources, if used efficiently can increase economic growth. 4. Weather. Because of the importance of rain-fed agriculture and agro-indu stry in certain countries such as Zimbabwe, weather is also an important determi nant of economic growth in the medium term. Developing Countries A developing country or less developed country (LDC) is one that is not yet full y industrialised and tends to have the following features: Agriculture is more important than manufacturing. There is limited specialisation and exchange.

 There are not enough savings to finance investment. Population is expanding too rapidly for available resources. Population growth i s equal to or more than the rate of GNP growth in some countries. There are high and rising levels of unemployment and underemployment. There are low incomes. In the income distribution, the gap between the rich and poor is generally greater in less developed than in developed countries. Inadequate housing. There are low levels of productivity. This may be due to the absence or severe l ack of complementary factor inputs such as physical capital and or experienced m anagement. In education there are low levels of literacy, significant school dropout rates, inadequate and often irrelevant curricula and facilities. There is poor health. Most LDC people suffer from malnutrition and ill-health an d high infant mortality and have a lower life expectancy than in developed coun tries (DCs) A low standard of living. A large portion of the population is living below the Poverty Datum Line. A developed country is more fully industrialised and has a high standard of livi ng. Barriers to Economic Growth A country can increase production if it increases the amount of resources used o r makes better use of existing factors. Economic growth is more difficult if: A country lacks the infrastructure (underlying capital) to produce goods more ef ficiently. There are three types of infrastructure: 1. basic including electricity, road and telephone networks; 2. social including schools, hospitals and housing; 3. industrial including factories and offices. A country lacks the machines or skilled labour needed to manufacture modern good s or services. A country lacks the technical knowledge. Workers are not prepared to accept specialisation and the division of labour. Population growth is too rapid. A country has too large a foreign debt. Disadvantages of Economic Growth Increased noise, congestion and pollution. Towns and cities may become overcrowded. Extra machines can be produced only by using resources currently involved in mak ing consumer goods. A traditional way of life may be lost. People may experience increased anxiety and stress. ECONOMIC DEVELOPMENT is a multidimensional process involving the reorganization and reorientation of t he entire economic and social systems. In addition to improvements in incomes an d output, it typically involves radical changes in institutional, social and adm inistrative structures as well as in popular attitudes and sometimes even custom s and beliefs (Michael Todaro- Economics for a Developing world.) Economic development is also defined in terms of the reduction or elimination of poverty, inequality and unemployment within the context of a growing economy. Development must have the objectives of -: increasing the availability and wider distribution of basic- food, shelter, health and protection; raising the levels of living (higher incomes, higher employment, better education and increased at tention to cultural values). Indicators of Economic Development. The traditional view of economic development is GNP Another common economic index of development is the r capita GNP. Rapid industrialization was viewed as g GNP, this often at the expense of agriculture and nefit through the trickle down effect. is an index of development. use of rates of growth of pe a way of having an increasin rural areas these were to be

Obstacles to Economic Development in developing countries Overpopulation- high population growth. Low savings rate- has hampered industrial development. Limited range of exports. Urbanization- this compounds population problems through congestion. Overcrowdin g promotes pollution, unemployment, disease and food shortages. Lack of an infrastructure. Because LDCs generally do not have infrastructures, i ndustrial firms will not normally locate plants there. Products manufactured for mass consumption simply cannot be distributed and used without transportation a nd communication facilities- few schools, roads, dams and bridges. Solutions for Economic Underdevelopment Foreign aid Exportation of a major resource e.g. oil. Industrialization and protective tariffs and quotas. Industrialization and the export of manufactured goods.