Week 1

Macroeconomics is the study of the economy as a whole. Macroeconomics is concerned with such major aggregates as the household, business, and government sectors; in addition to measures of the economy such as inflation rates etc.

Macroeconomic Issues The macroeconomic issues that will be examined during this course are:

1) Economic Growth (change in the level of output)a) An outward shift in the PPC (production possibilities curve) due to an increase in

the quantity or quality resources.b) An increase of real output (gross domestic product) or real output per capita.

NB: Gross domestic product is the market value of all final goods and services produced within an economy for a given period.

2) Unemployment: The failure of an economy to fully utilise its entire labour force. 3) Inflation: A rise in the general level of prices in an economy.

4) The Balance of Payments: A summary of all the transactions that took place between the individuals, firms and government units of one nation and those of all other nations during a year.

5) Exchange Rates: The rate of exchange of one nation’s currency for another nation’s currency.

A foreign firm would look at some key macroeconomic indicators so as to inform its decision as to whether or not it should invest in a particular country.

These key macroeconomic indicators are:1. Real Gross Domestic Product (Real GDP)2. The unemployment rate3. The inflation rate4. The interest rate5. The exchange rate6. The level of the stock market

Economic Growth and Business Cycles

Economic Growth Economic growth has been defined generally as an increase in real GDP or real GDP per capita for a given time period. While both of the foregoing variables are important in giving an idea of an economy’s economic soundness they serve different purposes. The level of real GDP of an economy represents the economic, political and in some cases the military stature of a country, the United States which happens to be the world’s largest economy is a good example. On the other hand real GDP per capita – real GDP divided by the total population – serves as an indicator of a country’s standard of living.

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It is important to note that GDP was modified by the word ‘real’ as opposed to ‘nominal.’ It is conventional in economics that real variables be used so as to take out any illusory effects that nominal variables might readily present. Real GDP: The total amount of goods and services produced in a given time period, adjusted for price level changes.

Nominal GDP: The total amount of goods and services produced in a given time period, measured at current prices.

Factors determining economic growth Natural Resources – A large amount of resources is not sufficient to guarantee

economic growth. People must devise the methods to convert natural resources into usable forms. LDCs require this type of human resource before they are able to exploit the natural resources they possess.

Capital Accumulation – The more machines a nation has the more goods and services and therefore income it will be able to produce.

Rate of Saving – Without savings we cannot have investment, and without investment into capital stock there can be little hope of much economic growth. On a national level this means that higher savings rates eventually mean higher living standard, all other things held constant.

Technological Progress – Technology makes it possible to obtain more output from the same amount of inputs as before. The ability of a nation to initiate and sustain technology change depends on:

1. The scientific capabilities of the population2. The quality and size of the nation’s educational and training system and3. The % of income that goes into basic research and development each year.

Factors to Promote Growth Promote Savings Promote Mobility – Factors of production needs to be reallocated from industrial

sectors that are declining into those that are expanding. Promote Education and Training – We need specialize labour to operate and

develop specializes machinery. Promote Research & Development - Promote the Supply side – Increase the AS (Aggregate Supply)

Business CyclesA business cycle is the upward or downward movement of economic activity or real GDP that occurs relative to the long-term growth trend of the economy. These cycles vary in duration and intensity however; economists have identified four phases of a business cycle.

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Key: A – Peak B – Recession C – Trough D – Recovery 1Q;

Peak: At this point economic activity is at a temporary maximum. The economy is at the full employment level and real output is at or very close to the economy’s capacity. The price level is likely to rise during this phase. A peak is followed by a period of recession.

Recession: A period of decline in an economy’s total output usually lasting at least six months and marked by contractions in many sectors of the economy. The price level shows little or no change but if the recession is long enough – turns into a depression- then prices will start to fall. A recession is followed by a trough.

Trough: In this phase the recession or depression is at its lowest level, and can be short-lived or last very long. The trough is followed by the recovery or expansionary phase.

Recovery (expansion): As the word suggests the economy is on the road to growth. In this phase output and employment start to rise, as a result the price level will start to rise. This phase will continue until it reaches the plateau or peak and a new cycle will begin.

Homework1) Distinguish between actual and potential growth.Week 2

Lecture 1

Circular flow of income

Definition: The circular flow model, describes the interactions between the two basic agents in an economy, consumers and producers. This model shows the flow of resources, products, income and revenues between these two basic economic agents.  The circular flow of income is one of the most useful economic models. Universities and governments use a more complicated version in order to make economic forecasts. The

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model is simple to start with but is made more complex by adding additional sectors to it. The first version has only two sectors, households and firms. The basic circular flow of income model consists of six assumptions:

1. The economy consists of two sectors: households and firms. 2. Households spend all of their income (Y) on goods and services or consumption

(C). There is no saving (S). 3. All output (O) produced by firms is purchased by households through their

expenditure (E). 4. There is no financial sector. 5. There is no government sector. 6. There is no overseas sector.

In fig.1, firms use factors of production provided by households. Land, labour, capital and entrepreneurship are used by firms to produce a good or service. The firms pay households a reward for using these factors. Rent for land, wages for labour, interest for capital and profit for entrepreneurship. Collectively these rewards are called income and we use the letter Y to represent them. When households receive this income they use it to buy the goods and services from the firms. This we call expenditure and we use the letter E to signify it. Note that in this two sector model households spend all their income with firms. 

 Fig.1. is a very simple model. We can add to its complexity by adding another sector, the financial sector.

In fig. 2 households save some of their income and deposit it in banks and other financial institutions. Savings in economic is defined as income not spent.The banks lend money to firms who in turn invest in new machinery, factories, research and development etc. Note that investment in economics is defined as 'additions to the capital stock'. Capital you might remember is defined as 'man made goods used to produce other goods'. So in economic terminology, putting your money in a bank is not called investment it is saving. Fig. 2

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  Fig. 3 

  In fig. 3 we now add the government sector. Households in this model are required to pay taxes. When the government receives these taxes they then spend them (government spending) on building roads, paying soldiers, teachers and so on. Fig.4  

 

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In fig. 4 the overseas sector is added. This model is called an open model. The previous models all assumed that the economy was closed, i.e., no foreign trade occurred.   Fig. 5 

 Notice that those items leaking out of the circular flow on the left of the model (S, T and M) have been labelled withdrawals and those items on the right (I, G and X) injections.

Injections: This is an exogenous addition to the income of firms and households that does not result from current production. Injections lead to an expansion of an economy’s income. The expansions that result from injections is compounded through the multiplier effect. Injections consist of three broad areas viz. investment, government spending and exports. (Putting back into the economy)

Withdrawals: Any income that is not circulated currently in the circular flow of income and as such is not available for the purchasing of currently produced goods and services. Withdrawals help to contract the income of on an economy, and like injections its impact is exacerbated by the multiplier effect. Withdrawals consist of three broad categories viz. savings, taxation and imports. (Taking out of the economy)

NB: The multiplier effect will be examined in greater detail in later lectures.

Lecture 2Types of Market

Keynes identified three primary markets; these markets provide another way of looking at how households, firms, the government and the rest of the world interact with each other.

1) Goods & Services: The market for goods and services can be described as any medium where the independent actions of buyers and sellers are coordinated.

2) Money Market: The securities market dealing in short-term debt and monetary instruments. Money market instruments are forms of debt that mature in less than one year and are very liquid.

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A money market is a financial market for short-term borrowing and lending, typically up to thirteen months. This contrasts with the capital market for longer-term funds. In the money markets, banks lend to and borrow from each other, short-term financial instruments such as certificates of deposit (CDs) or enter into agreements such as repurchase agreements (repos). It provides short to medium term liquidity in the global financial system.

3) Labour Market: The labour market can be described as any medium through which individuals supply there labour time and firms demand that time for productive activity. The interaction of the supply and demand for labour time determines the wage rate.

The market in which workers compete for jobs and employers compete for workers.

Lecture 3Aggregate Demand and Aggregate Supply

Before venturing into aggregate demand and supply it is useful to first recap demand and supply within the context of microeconomics.

Demand: A relation showing the quantities of a good that consumers are willing and able to buy at various prices during a given period of time, ceteris paribus.

Supply: A relation showing the quantities of a good or service producers are willing and able to sell at various prices during a given time period ceteris paribus.

Aggregate Demand (expenditure) This is the sum of all nominal expenditures on goods and services for an economy i.e. consumption (C), investment (I), government expenditure (G) and exports (X) less imports (M). Put differently it is the demand for all final goods and services within an economy.

Aggregate Demand Curve: A curve showing the inverse relationship between aggregate output (income) and the price level. At each point on the curve the both the money and product markets are in equilibrium.In the Keynesian income-expenditure model Y = C + I + G + X – M Where; Y = income C = consumption I = investment G = Government X=exports

M = imports Personal consumption expenditures (C) or consumption - demand by

households Gross private domestic investment (I) - demand by business firms and some

individuals, for new factories, machinery, computer software, housing, other structures, and inventories. In addition, Investment is effected by the output and the interest rate (i). Investment has positive relationship with the output (Y) and negative relationship with the interest rate. For example, when Y goes up, the investment will increase.

Gross government investment and consumption expenditures (G) – spending by the government.

Net exports (X-M)) - i.e., net demand by the rest of the world for the country's output.

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Variations of the Keynesian income-expenditure modelY = C + I (private closed economy model) Y = C + I + G (closed economy model)

Y = C + I + G + X – M (open economy model)

Why does the aggregate demand curve slope down?In microeconomics we learnt that the demand curve for a particular good/service sloped downwards as result of the income and substitution effects. The following effects determine the downward slope of the aggregate demand curve:

1) Real-Balances Effect: A higher price level reduces the purchasing power of consumers thus reducing the total demand of the economy.

2) Interest Rate Effect: Assuming that the money supply is fixed an increase in the price level will cause consumers to demand more money to continue purchasing goods and services. Since the money supply is fixed, and the demand for money is increasing the price of money (interest rates) will naturally increase. Higher interest rates will decrease the demand, by firms, for investment loans and interest sensitive consumption would also decrease since consumers will save more. 3) Foreign Purchases Effect: When a country’s price level rises relative to the price level in countries to which it exports then the demand for exports by those countries will fall.

Determinants of Aggregate Demand

Autonomous consumption (autonomous consumer spending), which depends upon:

consumer nominal wealth consumer expectations and confidence concerning job security and future

income money supply autonomous taxes (e.g., sales and property taxes)

Planned investment spending (I), which depends upon:

real interest rates (i.e., changes in interest rates not caused by changes in the price level)

business profit expectations or the expected rate of return business taxes money supply

Government spending (G)

Net export spending (X-M) National income abroad b) Exchange rates

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A g g r e g a t e S u p p l y

Defining aggregate supply

Aggregate Supply (AS) measures the volume of goods and services produced within the economy at a given overall price level. There is a positive relationship between AS and the general price level. Rising prices are a signal for businesses to expand production to meet a higher level of AD. An increase in demand should lead to an expansion of aggregate supply in the economy.

Short-run aggregate supply curve

Aggregate supply is determined by the supply side performance of the economy. It reflects the productive capacity of the economy and the costs of production in each sector.

Shifts in the AS curve can be caused by the following factors:

changes in size & quality of the labour force available for production changes in size & quality of capital stock through investment technological progress and the impact of innovation changes in factor productivity of both labour and capital changes in unit wage costs (wage costs per unit of output) changes in producer taxes and subsidies changes in inflation expectations - a rise in inflation expectations is likely to

boost wage levels and cause AS to shift inwards

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In the diagram above - the shift from AS1 to AS2 shows an increase in aggregate supply at each price level might have been caused by improvements in technology and productivity or the effects of an increase in the active labour force.

An inward shift in AS (from AS1 to AS3) causes a fall in supply at each price level. This might have been caused by higher unit wage costs, a fall in capital investment spending (capital scrapping) or a decline in the labour force.

LONG RUN AGGREGATE SUPPLY 

Long run aggregate supply is determined by the productive resources available to meet demand and by the productivity of factor inputs (labour, land and capital). 

In the short run, producers respond to higher demand (and prices) by bringing more inputs into the production process and increasing the utilization of their existing inputs. Supply does respond to change in price in the short run.

In the long run we assume that supply is independent of the price level (money is neutral) - the productive potential of an economy (measured by LRAS) is driven by improvements in productivity and by an expansion of the available factor inputs (more firms, a bigger capital stock, an expanding active labour force etc). As a result we draw the long run aggregate supply curve as vertical.

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Improvements in productivity and efficiency cause the long-run aggregate supply curve to shift out over the years. This is shown in the diagram below

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Additional Readings1. Chapters 19, 20 & 23, Economics (John B. Taylor) © 19952. Chapter 22, Economics 10th Ed. ( Lipsey & Chrystal) © 2004 3. Chapters 8, 11 and 17, Economics 15th Ed. (McConnell & Brue) © 2002 NB: Students are free to read any principles of Economics text they might have.

Week 3

Lecture 1 & 2

Unemployment and InflationUnemployment and inflation have been described as the twin evils of economic instability, this week we will look at these two macroeconomic problems.

Unemployed - A person is said to be "unemployed" if he or she is looking for work, is willing to work at the prevailing wage, but is unable to find a job. Unemployment - refers to the condition of being unemployed, or to the number or proportion of people in the working population who are unemployed

Types of UnemploymentThere are three primary types of unemployment, frictional, structural and cyclical. Some economists include a seasonal unemployment as the fourth type.

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Frictional unemployment: Frictional employment – short term unemployment – is ever present in an economy and can be described as unemployment arising from changes such as when people change occupations or location, or are new entrants.

Structural unemployment: Like frictional unemployment, structural unemployment is ever present in an economy; however this type of unemployment is long term (say more than 6 months). Structural unemployment results from the structural imbalances that occur in an economy e.g. poor skills that cannot match current labour demand or changes in demand for a particular type of labour and insufficient work incentives. Instead of going through retraining individuals persist in their search for employment with obsolete skills in a market with limited demand. Structural unemployment has often been associated with technological unemployment, i.e., unemployment resulting from the increased use of labour saving machines. In some instances structural unemployment is very closely related to regional unemployment too. When an industry concentrated in one area declines as a result of changes in the pattern of demand, the whole area becomes full of workers with nothing to do.

Cyclical unemployment: Cyclical unemployment is concerned with the business cycle, therefore in periods where an economy is in a downturn cyclical unemployment will persist. The way to lessen cyclical unemployment would be to reduce the intensity, duration and frequency of ups and downs of business activity.

Seasonal unemployment: This type of unemployment is tied to sectors of the economy that have seasons e.g. (1) in the out of crop season some cane cutters are left without a job; (2) Construction workers in the US often can only work during the warmer months. They are seasonally unemployed during the winter. There is little we can do to reduce seasonal unemployment.

E c o n o m i c c o s t s o f u n e m p l o y m e n t

Most economists agree that high levels of unemployment are costly not only to the individuals and families directly affected, but also to local and regional economies and the economy as a whole. We can make a distinction between the economic costs arising from people out of work and the social costs that often result.

(A) Economic Costs of Unemployment – (1) Lost output of goods and services

Unemployment causes a waste of scarce economic resources and reduces the long run growth potential of the economy. An economy with high unemployment is producing within its production possibility frontier. The hours that the unemployed do not work can never be recovered. 

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But if unemployment can be reduced, total national output can rise leading to an improvement in economic welfare.

(2) Fiscal costs to the government

High unemployment has an impact on government expenditure, taxation and the level of government borrowing each year.

An increase in unemployment results in higher benefit payments and lower tax revenues. When individuals are unemployed, not only do they receive benefits but also pay no income tax. 

As they are spending less they contribute less to the government in indirect taxes. 

This rise in government spending along with the fall in tax revenues may result in a higher government borrowing requirement (known as a public sector net cash requirement)

(3) Deadweight loss of investment in human capital

Unemployment wastes some of the scarce resources used in training workers. Furthermore, workers who are unemployed for long periods become de-skilled as their skills become increasingly dated in a rapidly changing job market. This reduces their chances of gaining employment in the future, which in turn increases the economic burden on government and society.

(B) SOCIAL COSTS OF UNEMPLOYMENT

Rising unemployment is linked to social and economic deprivation - there is some relationship between rising unemployment and rising crime and worsening social dislocation (increased divorce, worsening health and lower life expectancy). 

Areas of high unemployment will also see a decline in real income and spending together with a rising scale of relative poverty and income inequality. As younger workers are more geographically mobile than older employees, there is a risk that areas with above average unemployment will suffer from an ageing potential workforce - making them less attractive as investment locations for new businesses.

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Key definitions

Labour Force: This consists of all those persons who are part of the working age population and are willing and capable of working. (Employed + unemployed)

Working age population: This is the population of persons who are over the legal working age (usually 16) and are not in an institution such as a jail or hospital.

The unemployed: Persons who are part of the labour force and are not gainfully employed.

The employed: Persons who have a job outside of the home or a paid job inside the home (freelance writer).

The unemployment rate: The ratio of unemployed persons to the labour force.

Unemployment rate = number of unemployed persons total labour force

The labour force participation rate: The ratio of the size of the labour force to the working-age population.

Labour force participation rate = size of labour force total working age population

The employment-to-population ratio: The ratio of employed workers to the working age population.

Employment-to-population ratio = number Employed workers total working age population

Full Employment

Full employment occurs when the economy is producing to its maximum sustainable capacity, using labour, technology, land, capital and other factors of production to their fullest potential. In a situation of full employment, some workers may still be unemployed if they are temporarily between jobs and searching for new employment (this is called ‘frictional unemployment’). 20th century British economist William Beveridge stated that an unemployment rate of 3% was full employment. Other economists have provided estimates between 2% & 7%, depending on the country, time period, and the various economists' political biases.

Why do people become unemployed?

1) Job losers: People who become unemployed since they lost their previous job.

2) Job leavers: People who become unemployed because they quit their previous job.

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3) New entrants: Persons who are unemployed because they just entered the labour force and have not yet found a job.

The labour market and the determination of unemployment and employment

Labour demand curve: A curve showing the inverse relationship between the quantity of labour a firm is willing to hire at different wage rates.

Labour supply curve: A curve showing the direct relationship between the quantity of labour workers are willing to supply at different wage rates.

Real wage: This is the nominal wage rate adjusted for inflation. Real wage = wage

Price level

Like the poor, the unemployed will always be with us.

Using the basic demand and supply of labour theory one would conclude that there should be no unemployment in an economy since the wage rate will always adjust to reflect changes in the supply and demand of labour. However, the fact is that the unemployed will always be with us. The two explanations that economists use to modify the simple demand and supply labour model are:

1) Job rationing: This model first assumes that the actual wage rate is higher than that of the equilibrium wage rate. Secondly, the number of persons that are employed are assumed to be the number of persons demanded by firms. Central to the understanding of this model are the explanations as to why wages do not fall when there is an excess supply of labour. The three explanations are:

1) Minimum wages2) Insiders versus outsiders3) Efficiency wages

Quantity of Labour

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2) Job search: This model hinges on the fact that labour markets are always in a state of flux. People enter and leave the labour force, move from different jobs, or lose jobs. The job search model is connected to frictional unemployment

Lecture 3: Inflation

Inflation: A situation in which there is a sustained rise in a weighted average of all prices. An alternative definition would be a relatively persistent general increase in the overall price level.

Deflation: As opposed to inflation, deflation is the decrease in the overall price level.

Hyperinflation: A very rapid increase in the overall price level e.g. the inflation rate rose by 5,000% in Germany in 1922.

Stagflation: A situation in which there are high levels of unemployment and inflation coupled with no growth.

Types of Inflation

Cost push inflation: This type of inflation occurs from the supply side of the economy and is caused by increases in the per-unit cost of production. ‘Supply shocks’ have been identified as the main culprit of cost-push inflation. A common example of a supply shock is the 1973-1974 oil price shock.

Per-unit production cost = total input cost Units of output

Demand pull inflation: Inflation of this nature occurs from the demand side of the economy, and is described as changes in the price level as a result of growing demand for goods and services after the economy would have reached its potential level of output. In

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a nutshell it’s a case of ‘too much money chasing few goods’. The term demand-pull inflation is mostly associated with Keynesian economics.

Costs of inflation

1) Inflation changes the distribution of income: During inflationary periods persons with fixed income tend to lose while those with flexible incomes do not. Most elderly persons who rely on a pension are fixed income earners. Flexible income earners, on the other hand, do not loose since their incomes are adjusted to cater for inflation rates.

Generally, persons with incomes that are not ‘indexed’ for inflation lose income during inflationary periods. 2) Effects on debtors and creditors: Debtors and creditors can either loose or gain as a result of inflation.

Example 1: John borrows $1000 from Jane at an interest rate of 5%, when John repaid Jane (principal plus interest) the inflation rate was 6%. Since the inflation rate was higher than the interest rate charged by Jane, John gains. In fact Jane did not even receive the real value of the principal amount that she lent John.

Example 2: Suppose both Jane and John have anticipated an inflation rate of 10% – they have factored in a 10% inflation rate in their transactions – and the actual level of inflation is only 5% then Jane would gain.

3) Administrative costs and inefficiencies: During inflationary periods the administrative costs accruing to firm increase since they have to constantly keep abreast with what the increases in the price level. In terms of inefficiencies, these arise as a result of lack of information which in turn can cause decision makers to make to misallocate resources.

4) Increased risk and slower economic growth: Investors love to invest in a country whose economy is relatively stable thus high inflation rates can send the wrong message

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to them. The uncertainty that surrounds an economy would not only drive potential investors away but it would also diminish the long term prospect for GDP growth.

Additional Readings1. Chapters 22, Economics (John B. Taylor) © 19952. Chapter 32, Economics 10th Ed. ( Lipsey & Chrystal) © 2004 3. Chapters 8 Economics 15th Ed. (McConnell & Brue) © 2002 NB: Students are free to read any principles of Economics text they might have.

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Week 4

Unemployment and Inflation (cont’d)

Lecture 1Measuring Inflation

Consumer Price Index (CPI): A price index equal to the current price level of a fixed ‘market basket’ of consumer goods and services in a base year.

Formally, the CPI for a particular year is measured as the total price of a predetermined fixed set of goods and services divided by the total price of the same set of goods and services in the base year.

CPI = P1*A0 + P1*B0 or CPI = P1*A0 + P1*B0 × 100 P0*A0 + P0*B0 P0*A0 + P0*B0

EXAMPLE 1

2000 20052 units of X $25.00 $30.005 units of Y $50.00 $60.00

CPI2005 = 2*30 + 5*60 = 1.2 or CPI2005 = 2*30 + 5*60 × 100 = 120 2*25 + 5*50 2*25 + 5*50

GDP Deflator: This index attempts to show changes in the level of prices of all goods and services produced in the economy. Consequently, it is the most general indicator of inflation since it incorporates all domestic prices – not just for consumer good prices, but also the prices of investment goods, goods and services consumed by the government, and items made for export. It is simply nominal GDP divided by real GDP.EXAMPLE 2

Assume that the economy only produces two goods X & Y. In the base year (2000) 1,000 units of X and 2,000 units of Y are produced.

Nominal GDP (2000) = $15(1,000) + $5(2,000) = $25,000Nominal GDP (2005) = $30(1,300) + $10(2,600) = $65,000

Real GDP (2000) = $15(1,000) + $5(2,000) = $25,000Real GDP (2005) = $15(1,300) + $5(2,600) = $32,500

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GDP Deflator2005 = 65,000/32,500 = 2

Previously we learnt how to calculate the consumer price index and the GDP deflator; we will now use the level of the consumer price index to calculate the inflation rate.

The inflation rate over a given period can be calculated using the general function below.

Inflation Rate = CPI (present period) – CPI (past period) × 100

CPI (past period)

EXAMPLEUsing the information in the table below calculate the inflation rates from 2000 to 2004 and 2004 to 2005. The base year is 2000.

Basket Items 2000 2004 20052 of A $25.00 each $30.00 each $31.50 each 5 of B $50.00 each $60.00 each $63.00 each

CPI2000 = 2*25 + 5*50 = 1 or CPI2005 = 2*25 + 5*50 × 100 = 100 2*25 + 5*50 2*25 + 5*50

CPI2004 = 2*30 + 5*60 = 1.2 or CPI2005 = 2*30 + 5*60 × 100 = 120 2*25 + 5*50 2*25 + 5*50

CPI2005 = 2*31.5 + 5*63 = 1.26 or CPI2005 = 2*31.5 + 5*63 × 100 = 126 2*25 + 5*50 2*25 + 5*50

Using the formula the inflation rates are;

1) Inflation Rate (2000 -2004) = 120 - 100 × 100 = 20% 100

2) Inflation Rate (2004 -2005) = 126 - 120 × 100 = 5% 120

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Please note that the inflation from the base year, 2000, to the year 2004 could have been simply calculated by subtracting the CPI of 2000 from the CPI of 2004. However, the same exercise cannot be conducted when calculating the inflation rate from 2004 to 2005, since the answer will not be accurate.

EXERCISE

Using 2004 as the base year, calculate the inflation rates for the periods 2000-2004 and 2004-2005. Your answers must be the same as in the examples above.

Lecture 2Policies to tackle inflation

Macroeconomic Policy There are three general types of macroeconomic policies used by governments:

1. Fiscal Policy Fiscal policy or demand management policy is concerned with changes in government expenditure and taxation.

2. Monetary Policy Monetary policies are those policies conducted by a country’s central bank to control the money supply thus influencing interest rates. The monetary policy tools are:1) Open-market operations2) The reserve ratio3) The discount rate

3. Supply Side PolicySupply side policies are used to stimulate an economy’s aggregate supply. While fiscal and monetary policy focused primarily on changing aggregate demand, supply side policies seek to influence aggregate supply.

Macroeconomic Policies The two primary types of macroeconomic policies are fiscal and monetary policies. However, some economists include a third type of macroeconomic policy called ‘supply side policies.’ These three policies are used to ensure that there is price stability, full employment and economic growth in an economy.

Fighting Inflation through fiscal and monetary policiesContractionary fiscal and monetary policies are used to fight inflation by reducing the aggregate demand of the economy.

Contractionary Monetary Policy Reductions in the money supply which leads to higher interest rates (monetary policy).

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The effects of higher interest rates

Higher interest rates reduce aggregate demand by:

• Discouraging borrowing by both households and companies

• Increasing the rate of saving (the opportunity cost of spending has increased)

• The rise in mortgage interest payments will reduce homeowners' real 'effective' disposable income and their ability to spend. Increased mortgage costs will also reduce market demand in the housing market

• Business investment may also fall, as the cost of borrowing funds will increase. Some planned investment projects will now become unprofitable and, as a result, aggregate demand will fall.

• Higher interest rates could also be used to limit monetary inflation. A rise in real interest rates should reduce the demand for lending and therefore reduce the growth of broad money.

Contractionary Fiscal Policy

• Higher direct taxes (causing a fall in disposable income) • Lower Government spending • A reduction in the amount the government sector borrows each year (PSNCR)

These fiscal policies increase the rate of leakages from the circular flow and reduce injections into the circular flow of income and will reduce demand pull inflation at the cost of slower growth and unemployment.

Lecture 3The Unemployment & Inflation Trade Off

The relationship between unemployment and inflation has been modeled generally as an inverse one. In other words, the general consensus is that policy makers have to strike a balance between unemployment and inflation.

The Phillips Curve: A graph showing the inverse relationship between the inflation rate and the unemployment rate.

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NAIRU (Natural Rate of Unemployment)This stands for the non-accelerating inflation unemployment rate. It is the amount of unemployment which would prevail when inflation is stable and correctly anticipated. Consequently, the natural rate of unemployment can be regarded as the rate of unemployment that would exist in the absence of cyclical fluctuations in the economy.

Each economy will have its own natural rate of unemployment and it mat change with time. The level will depend upon the amount of frictional unemployment. If the labour market is functioning smoothly, with workers able to find out quickly about the availability of job vacancies, then, other things being equal, the natural rate of unemployment might be relatively low. If there are a large number of effective impediments to a smoothly functioning labour market, then the natural rate of unemployment might be high. Therefore, the more restrictions there are in the labour market, the higher the natural rate of unemployment. These restrictions might be minimum wage legislation, occupational training requirements, strict union membership requirements and so on. In addition geographical and occupational immobility are major factors in the NAIRU.

The expections-augumented Phillips Curve

Unemployment Rate

Pr i ce

Level

The Phillips Curve

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If inflation is stable at 6%, then the long-run equilibrium unemployment will be maintained at point A. However, if the actual rate of inflation then falls to only 3% per year, the economy will be at point D, where ther is excess unemployment – that is, unemployment over and above the normal long-run U* of 5%. Inflation is falling and unemployment is rising.

If the rate of inflation remains at 3%, expectations of inflation will adjust and in time unemployment will return to its normal long-run level of 5%. We will be at point B. But if then the rate of inflation rises again to 6%, we shall find ourselves at point C. There will be over full employment – that is, unemployment will be less than its long-run or normal level of 5%. At this point, inflation may stabilize with a return to A or it may continue to accelerate so that the economy moves onto an even higher curve.

Additional Readings1. Chapters 22, Economics (John B. Taylor) © 19952. Chapter 32, Economics 10th Ed. ( Lipsey & Chrystal) © 2004 3. Chapters 8 Economics 15th Ed. (McConnell & Brue) © 2002 NB: Students are free to read any principles of Economics text they might have.

WEEK 5Measuring National Output and National Income (National Income Accounting)

LECTURES 1&2Important Concepts & Calculating GDP/GNP

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GDP vs. GNP/GNIGross Domestic Product is concerned with the output within a country’s border while GNP is concerned with output by a nation’s citizens wherever they might be.

GNP = GDP + Net factor payments from abroad.

Market Price vs. Factor Price Gross domestic product was earlier described as the total market value of all final goods and services produced in an economy for a given period. However, GDP is not only given at market prices but also at factor cost.

GDP at factor cost = GDP at market prices - Indirect taxes net of Subsidies

Methods of Calculating GDPA country’s GDP can be calculated by using any of three approaches i.e. the product, expenditure or income approach. The latter two approaches are directly linked to the national income accounting identity GDP = Y = C + I + G + (X-M).

1. Product Approach This method of computing GDP is done by calculating the value of all final goods and services that are produced in an economy for a given period.

Central to the calculation of GDP using the product approach is the concept of ‘value added.’ (See table 1)

Value Added: The difference in value of goods as they leave a particular stage of production and the cost of those goods when they entered that stage.

Table 1: Value added in the production of a gallon of Gasoline

Stage of Production Value of Sales Value Added

(1) Oil Drilling $0.50 $0.50

(2) Refining $0.65 $0.15

(3) Shipping $0.80 $0.15

(4) Retail Sale $1.00 $0.20

Total Value Added   $1.00Source: Principles of Economics (CASE & FAIR)

2. Income Approach The income approach to calculating GDP involves the measuring of the payments to the factors of production during a given period.

Table 2: Components of US GDP (1997): The Income Approach

  Billions of US Dollars% of GDP

Gross Domestic Product 8079.9 100.0National Income 6649.7 82.3 Compensation of employees 4703.6 58.2

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Proprietors' Income 544.5 6.7 Corporate Profits 805.0 10.0 Net Interest 448.7 5.6 Rental Income 147.9 1.8Depreciation 867.9 10.7Indirect Taxes minus Subsidies 542.5 6.7

Net Factor Payments to the rest of the world 19.8 0.2Source: Principles of Economics (CASE & FAIR)

National Income: The total income earned by the factors of production of the country’s citizen’s.

Employee Compensation: Wages, salaries, and payments to pension funds and insurance.

Proprietors’ Income: The income of unincorporated businesses.

Corporate Profits: The income of corporate businesses.

Net interest: Interest paid by business.

Rental Income: The income received by property owners in the form of rent.

Indirect Business Taxes: Sales taxes, customs duties and license fees.

Subsidies: Government payments for which it receives no goods or services in return.

Net Factor Payments to ROW: Factor payments to the rest of the world minus factor payments from the rest of the world.

3. Expenditure Approach The expenditure approach is a method used to calculate GDP by adding up the expenditure on all final goods and services during a given period.

Table 3: Components of US GDP (1997): The Expenditure Approach

  Billions of US Dollars% of GDP

Total Gross Domestic Product 8079.9 100.0Personal Consumption Expenditures (C) 5485.8 67.9Durable Goods 659.3 8.2Non- Durable Goods 1592.0 19.7Services 3234.5 40.0Gross Private Domestic Investment (I) 1242.5 15.4Non-Residential 846.9 10.5Residential 327.2 4.0Change in business inventories 68.4 0.8Government Consumption and Gross Investment (G) 1452.7 18.0Federal 523.8 6.5State and local 928.9 11.5Net Exports (X-M) -101.0 -1.3Exports (X) 957.1 11.8

Imports (I) 1058.1 13.1

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Source: Principles of Economics (CASE & FAIR)

Personal Consumption Expenditures (C): Consumption of goods and services by consumers.

Durable Goods: Goods that last a relatively long time e.g. a house.

Non-durable Goods: Goods that are consumed very quickly e.g. food.

Services: Education, medical, legal and other services.

Gross Private Investment (I): Total investment in capital goods such as plants, equipment and inventory by the private sector.

Non-residential Investment: Expenditures by firms for machines, tools, plants etc.

Residential Investment: Expenditures by households and firms on new houses and apartment buildings.

Change in business inventories: The amount by which firms inventories change during a period.

Government Consumption and Investment: Government expenditures on final goods and services.

Net Exports: Exports minus imports. This figure can either be negative or positive. Depreciation: The reduction in the value of an asset in a given period.

Gross Investment: The total value of all newly produced capital goods.

Net Investment: Gross investment less depreciation.

From GDP to Personal Disposable Income

Table 4: GDP, GNP, NNP, National Income, Personal Income, & Disposable Personal Income '97'

 US$ Billions

Gross Domestic Product 8079.9 Plus: Receipts of factor income from the rest of the world 262.2 Less: Payments of factor income to the rest of the world -282.0Equals: Gross National Product (GNP) 8060.1 Less: Depreciation -867.9Equals: Net National Product (NNP) 7192.2 Less: Indirect taxes minus subsidies -542.5Equals: National Income 6649.7 Less: Corporate profits minus dividends -484.7 Less: Social insurance payments -732.1 Plus: Personal interest income received from the government and consumers 319.9 Plus: Transfer payments to persons 1121.2Equals: Personal Income 6873.9

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Less: Personal taxes -988.7

Equals: Personal Disposable Income 5885.2Source: Principles of Economics (CASE & FAIR)

LECTURE 3

Limitations of Using GDP/GNP Statistics

1) GDP and Social welfareThere are a number of social and environmental concerns that are not reflected by merely looking at a country’s GDP. China, for example, has a large economy; however, its emission of pollutants is also on the increase causing damage not only to China’s environment but to other countries as well. It is likely that China will replace the United States as the world’s largest polluter.

The environment aside, the level of criminal activity, political instability and other social ills are also not reflected by GDP.

A crucial limitation of GDP is that it does not indicate the distribution of an economy’s income so it is possible that country A might have a larger GDP than country B, but country B’s income might be distributed more equitably among its citizens.

2) The underground economy By definition a country’s GDP should capture all productive activity in an economy for which persons receive an income. In reality this never happens since there will always be illegal transactions and/or unreported activities. The underground economy is therefore that part of the economy that is not counted by the authorities for one reason or the other.

Guyana’s underground economy

In 2003, Ebrima Faal, an economist at the IMF, did a paper on Guyana’s underground economy. In his paper, Faal attempted to estimate the size of the underground economy and its changes over the period 1964- 2000, in addition to its adverse effect on the tax system. Further, he attributed Guyana’s underground economy during the 1970’s and the 1980’s to the “pervasive regulations of the productive sectors and markets and the ensuing shortages.”

As a precursor to his estimation Faal made reference to studies done by Thomas (1989) and Bennett (1995) who estimated Guyana’s underground economy to be approximately 80-100% of GDP during 1982-1986 and 33.33% of GDP during 1979-1989 respectively. In Faal’s estimate, the underground economy as a percentage of GDP was approximately 40% during the 1970s, 76% in the 1980s and 47% in the 1990s.

In conclusion, Faal said, “the existence of a sizable underground economy of unrecorded domestic and international economic transactions suggests that the existing national accounts series are not adequate for meaningful economic analysis or for policy formulation. Efforts must be made by the authorities to establish credible estimates of

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the key components of the underground economy with a view of incorporating them in compilation of official statistics”.

ReferenceFaal, Ebrima, “Currency Demand, the Underground Economy and Tax Evasion: The Case of Guyana.” © IMF 2003, Working Paper

3) Per Capita GDP/GNP Since GDP does not give a good idea of the well being of the average citizen, per capita GDP or GNP figures are used. However, these figure themselves cannot give an idea of the distribution of an economy’s income but are useful for making international comparisons.

Additional Readings1. Chapter 7 Economics 15th Ed. (McConnell & Brue) © 2002 2. Chapter 7 Macroeconomics 4th Ed. (Colander) © 2001 3. Chapter 22 Principles of Economics 5th Ed. (Case & Fair) © 1999

NB: Students are free to read any principles of Economics text they

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WEEK 6KEYNESIAN ANALYSIS OF NATIONAL INCOME

The income-expenditure model revisited

a) National Income AE = Y = C + I + G + (X-M) C = Consumption I = Investment G = Government (X-M) = Net Exports

b) The Consumption Function C = a + bYD

C = Consumption a = autonomous expenditure b = marginal propensity to consume YD = Disposable Income

c) Saving, Consumption & Investment

National Saving = S = Y – C – G = I 1) Y = C + I (private closed economy model)If S = IY-C = IS = Y – C = I

2) Y = C + I + G (closed economy model)If S=I S = Y – C – G = I

3) Y = C + I + G + (X – M) (open economy model)

The consumption and savings functions

Disposable Income - Income actually available for spending is personal income less net taxes

The Consumption Function - The relationship between the level of income in an economy and the amount households plan to spend on consumption, other things constant. Households look at their level of disposable income and decide how much to spend. So spending depends on disposable income.  Marginal Propensity to Consume (MPC)The marginal propensity to consume gives the change in consumption, which results from a change in income. The MPC is therefore the slope of the consumption function

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(C = a + bYD). MPC = (Change in Consumption/Change in Income)

Average Propensity to ConsumeAPC = (Total Consumption/Total Income)

NB: The slope of a straight line is equal to ΔY/ΔX

S = -a + (1-b) Y Marginal Propensity to SaveThe marginal propensity to save gives the change in spending as a result of a change in income. MPS = (Change in Saving/Change in Income)

Average Propensity to SaveAPS = (Total Savings/Total Income)

NB: MPS + MPC ≡ 1

  Non-income (Autonomous) Determinants of Consumption Along the consumption function, consumption spending depends on the level of disposable income, other things constant. What factors are held constant, and how do they affect Consumption? 

Net Wealth

Net Wealth - The value of a household's assets minus its liabilities (debts owed). (Assets - home, cars, furniture, savings accounts, checking accounts; Liabilities - student loans, car loans, mortgage, credit card balances) Household wealth is assumed constant along a consumption function. 

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o An increase in net wealth makes a household more likely to spend and less likely to save at each level of disposable income.

o A decrease in net wealth makes a household less likely to spend and more likely to save at each level of disposable income.

 **Example, a fall in stock prices. What happens to net wealth if the value of stock declines? It falls. Households that own stock have a decrease in net wealth and are likely to spend less and save more. The consumption function shifts down. 

The Price Level  Some household wealth is held in dollar-denominated assets (bank accounts, cash). When the price level changes, so does the real value of dollar-denominated assets. A falling price level increases the real value of dollar-denominated assets, thereby encouraging greater consumption for goods and services. A higher price level discourages consumption demand as it lowers the real value of the dollar. 

The Interest Rate  Consumers make inter temporal decisions to consume (or save) over their lifetime. Interest is the reward to savers for current saving. When graphing the consumption function, we assume a given interest rate. If the current interest rate increases, consumers will save more, borrow less, and spend less because it increases the opportunity cost of consumption. This, in turn causes the consumption function to shift downward. Lower current interest rates increase consumption and lower savings. 

Expectations  Example: If people grow more concerned about job security and future expected income, they will reduce their consumption spending at all levels of disposable income. An expected tax cut that is viewed as permanent could increase current consumption. Expectations about future prices can also affect current consumption. Higher expected prices for real assets can increase current consumption. Higher expected prices of financial assets can lower consumption. (Remember that “investing” in financial assets is savings.)

The Demand for Investment Firms buy capital goods now in the expectation of a future return. Expected Rate of Return: This is the annual dollar earnings expected from the investment divided by the purchase price. Investment Demand for the Economy 

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The economy’s investment demand curve shows the inverse relationship between the quantity of investment demanded and the market rate of interest, other things equal.  Business expectations are held constant along this curve. If businesses become more optimistic, the demand for investment increases, and the entire curve shifts to the right. The price of capital goods is also held constant. If capacity constraints increase the cost of equipment, then less investment will occur at every interest rates because the marginal efficiency of investment decreases. Falling prices of capital goods (computers) increases the volume of investment. Planned investment and the Economy’s Level of Income Unlike consumption, Investment depends more on interest rates and on business expectations than on level of income. Investment Function – The relationship between the amount businesses plan to invest and the level of income in the economy, other things constant. The simplest investment function assumes that planned investment is autonomous investment is independent of level of income. The Autonomous Investment Function (Non income Determinants of Investment) 

The Market Interest Rate  

Business Expectations

Government Purchase’s FunctionThe Government Purchase Function: The relationship between government purchases and the level of income in the economy, other things constant. Government’s purchases are considered autonomous that do not depend directly on the level of income in the economy, because spending decisions are made by government officials.

Net Exports

Net Exports = Exports – Imports

The Net Export Function – The relationship between net exports and the level of income in the economy, other things constant. 

When incomes rise, persons spend more, and some of the increased spending goes to imported goods.

The amount of Guyana’s exports depends on the incomes of foreigners, not Guyana’s income. Hence, it is considered to be autonomous.

So, net exports tend to decline as income increases.

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  Non income Determinants of Net Exports Factors held constant along the net export function include the following:

Guyana’s price level Price levels in other countries Interest rates here and abroad Foreign income levels The Exchange rate between the dollar and foreign currencies

Week 7Aggregate Demand & National Income

The Keynesian 45 degree line This is a unique line showing all the points where aggregate expenditure is equal to income.

The Aggregate Expenditure function

AE = C + I + G + (X – M)

Where C = a + bYD a = autonomous expenditure b = MPC YD = Disposable Income

NB: When there is a government component the consumption function is often written in the following way catering for government taxation. The underlying assumption is that government spending is financed through taxation. C = a + b (Y – T) or C = a + bYD

Where T = taxes

Since it has been assumed that C is a function of income (Y) then the slope of the AE line is determined by the marginal propensity to consume (MPC) or the slope of the consumption function. However, if imports are also a function of income then the slope of the AE line will be determined by the marginal propensity to consume and the marginal propensity to import (MPC + (-MPI)). Since MPI is negative, the slope will be smaller than in the case where only consumption depends on income.

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The Multiplier

What is the Multiplier?

Multiplier: the ratio of the change in real GDP to the shift in the aggregate expenditure line. Multiplier = ΔY/ΔAE = 1/ (1 – MPC) = 1/ MPS

NB: The change in Aggregate expenditure can be derived from changes in any one of the components of the Aggregate expenditure function.

Deriving the Multiplier (Simple)Y = C + I + G (closed economy)

We know that C = a + bYD where YD = Y - T

Y = a + b(Y – T) + I + G

Y = a + bY – bT + I + G

and rearranging terms yields

Y – bY = a + I + G - bT

Y (1 – b) = a + I + G – bT

Solving for Y gives: Y = (a + I + G –bT)/ (1-b)

Y = [1/(1 – b)] (a + I + G + bT)

Therefore the Multiplier is 1/ (1-b)

We can also derive the tax multiplier from the above; the equation tells us that if T increases by $1, income will decrease by b/ (1 – b) dollars. Thus the tax multiplier is –b/ (1 – b); recalling again that b is the MPC; it is - MPC/MPS.

AE = C + I + G + (X – M)

450 Line

Aggregate Expenditure

Income/Real GDP

AE

Y0

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Example – Tax MultiplierSuppose the MPC is 0.6 and the tax cut is $100 million, then the increase in real GDP (aggregate income) will be ΔY = -b/ (1-b) TΔY = (-0.6/0.4) * -100ΔY = $150 million

Graph showing the multiplier effect as a result of a change in AE

The Multiplier & Net Exports

Recall X = Exports - Imports. Exports depend on income of foreigners but imports depend on domestic income. Like the demand for domestic goods, as income increases, demand for imported goods increases. Since net exports depend inversely on imports, assume the following function for net exports: X = e - fY.In this function 'e' and 'f' are positive constants and 'f' is called the marginal propensity to import (MPI).

Y = a + bY + I + G + e - fY Y –bY + fY = a + I + G + e

Y (1 – b + f) = a + I + G + e

Y = (a + I + G + e)/ (1 – b + f)

Y = 1/ (1- b + f) [a + I + G + e]

Y = 1/ (1 – MPC + MPI)

The Balanced Budget Multiplier

AE1

AE0

450 Line

Aggregate Expenditure

Income/Real GDP

AE0

AE1

Y0 Y1

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What would happen if the government increased spending and taxes by equal amounts, applying these multipliers?

-- (The result may surprise you. For most of us, our automatic response is to think that would somehow be a bad thing for the level of GDP, since higher taxes plainly lower our disposable incomes and leave less for our consumption. Or we might think that it would have zero effect on GDP, because the higher spending and the higher taxes would seem to offset each other. But, in the context of the multiplier model, both of those guesses would be wrong. Instead....)A: An equal increase in G and T would actually raise GDP, in the context of the multiplier model.

-- Why: Recall that the government-spending multiplier is

{spending multiplier} = 1 / (1-MPC),     and the tax multiplier is

{tax multiplier} = - MPC / (1-MPC).-- Add the two together and you get the multiplier for an equal increase in government spending and taxes. Equivalently, it is the increase in equilibrium GDP that results from a $1 increase in G and a $1 increase in T. We call it the BALANCED-BUDGET MULTIPLIER (BBM; or perhaps more accurately the tax-and-spend multiplier), and it is equal to the sum of those other two:

{BBM} = 1/(1-MPC) - MPC/(1-MPC)               = (1-MPC) / (1-MPC) (combining the two terms, which have a common denominator)               = 1

So the balanced-budget multiplier is 1, meaning that a given increase in G (say, $1 million) coupled with an equal increase in T ($1 million) would raise equilibrium GDP by that same amount ($1 million).

ExampleSuppose that government wants to fund a project, which costs $10 million dollars and decides to raise funds for the project by increasing its tax revenues by $10 million. What is the final impact on aggregate income? Assume MPC is 0.8.

Initial Change as a result of the tax increase and the tax multiplier effect [-b/ (1-b)] * TΔY = (-0.8/0.2) * 10 = - $40 million

Final change as a result of increased government spending and the multiplier effect [1/ (1-b)] * G

ΔY = (1/0.2) * 10 = $50 million

ΔY = 50 – 40 = $10

Therefore, as a result of the increase in taxes and subsequent increase in government spending, of the same magnitude, there is a net increase in the aggregate income or real

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GDP of $10 million. It should be noted that the net increase in aggregate income (real GDP) is exactly equal to the increase in taxes and the subsequent increase in government spending. This example clearly depicts the concept of the balanced budget multiplier.

Problem1) Solve for equilibrium income (Y = C + I + G) whenC = 85 + 0.5YD (YD = Y – T)T = -40 + .25Y I = 85 G = 60

Week 9

Aggregate Demand and Supply and the Aggregate Expenditures ModelThe aggregate demand and supply model coupled with the aggregate expenditures model tell the same story but from two different perspectives. In the case of the AD/AS model, an economy’s equilibrium position is established by the interaction of aggregate supply and demand. On the other hand, equilibrium in the aggregate expenditure model is established at the point where AE intersects with the 45-degree line. Since the 45 degree line is a locus of points where AE = Y = Real GDP, then aggregate expenditure must be equal to aggregate income or real GDP, at the point of intersection with the 45 degree line. Graphically, the similarity between the two models can be shown easily since they both have similar x –axes.

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Fig. 1: AE Graph & 450 line showing recessionary gap Fig. 3: AE Graph & 450 line showing Inflationary gap

Fig. 2: AD/AS Graph showing recessionary gap Fig. 4: AE Graph & 450 line showing Inflationary gap

When the equilibrium level of output is less than the natural rate, as shown in the Fig 1 & 2, a deflationary/ recessionary/output gap exists. In the figure the equilibrium level of output, Y1, is less than the natural level of output, YF. A deflationary/recessionary/output gap calls for an expansionary fiscal policy (an increase in government spending or reduction in taxes) or and expansionary monetary policy (increasing the money supply). Such an expansionary policy shifts the Ad curve to the right (or shift the AE curve upwards) and increases the equilibrium level of real GDP.

When the equilibrium level of output is greater than the natural rate, an inflationary/expansionary gap exists. This is illustrated in figures 3 & 4, where the equilibrium level of output, Y1, exceeds the natural level of output, Yf. When the economy experiences an inflationary gap, a contractionary fiscal policy (a decrease in government spending of an increase in taxes) or a contractionary monetary policy (reducing the money supply) is appropriate. These policies shift the AD curve to the left (or shift the AE line downwards).

Homework:1) Draw two diagrams (AD/AS curves and AE and 450 line) representing an economy at full employment equilibrium.

Acceleration Principle

AE

450 Line

Aggregate Expenditure

Income/Real GDP

AE

Y1 YF

AE

450 Line

Aggregate Expenditure

Income/Real GDP

AE

YF Y1

AD

ASe

Income/Real GDP Y1 YF

P r

I c

e

l eve

l

AD

AS Line

Income/Real GDP YF Y1

P r

I c

e

l eve

l

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Definition: The accelerator principle is the growth of output that induces continuing net investment. That is, net investment is a function of the change in output not its level.

The accelerator effect in economics refers to a positive effect on private fixed investment of the growth of the market economy (measured e.g. by Gross Domestic Product). Rising GDP (an economic boom) implies that businesses in general see rising profits, increased sales and cash flow, and greater use of existing capacity. This usually implies that profit expectations and business confidence rise, encouraging businesses to build more factories and other buildings and to install more machinery. (This expenditure is called fixed investment.)

The accelerator effect also goes the other way: falling GDP (a recession) hurts business profits, sales, cash flow, use of capacity and expectations. This in turn discourages fixed investment, making a recession worse.

The interaction between the Accelerator and the Multiplier

The accelerator and multiplier interact, affecting business as follows. We assume that the economy is moving towards full employment, national income is rising, and sales are expanding at an increasing rate. Because of the acceleration principle, this growth – meaning expected increases in sales – results in a relatively high level of planned investment. Furthermore, because of the multiplier, this relatively high level of planned investment provokes even greater increases in the equilibrium level of national income. Thus, the accelerator and the multiplier tend to reinforce each other, resulting in a strong upward movement in national income.

Eventually, however, the economy nears some level of full capacity. That is, since we have only a certain amount of labour, land and other factors of production, it is impossible to continue increasing national income at the rapid rate that was experienced during the expansion phase of the business cycle. At some point, supply constraints must become a problem and growth of all the components of the economy has to slow down. Sales will not increase forever at the same fast rate; they will begin to increase at a slower rate. This slowdown in the growth of sales means that the rate of growth of planned investment is going to turn down abruptly. However, because of the multiplier effect, the decrease in planned investment will lead to a magnified, or multiplied, decrease in the equilibrium level of income. The reduction in the rate of growth of national income will mean further reduction in the rate of sales growth, leading to further reduction in gross investment, and so on. Eventually, the economy will experience a recession and the cycle will start again.

Week 10

Fiscal Policy

Fiscal policy is one concept strongly advocated by Keynes. After all, Keynesian economists are those who support government regulation. Fiscal policy, then, is

41

government regulation of its own spending and taxes to influence a country's economy in order to achieve its economic objectives.

Nature of Fiscal Policy

Expansionary Fiscal Policy Restrictive Fiscal Policy Automatic Fiscal Stabilisers Fiscal Lags

1. Expansionary fiscal policy: occurs when the government deliberately increases its

deficit in order to stimulate the economy by increasing aggregate demand. In this

case government increase its spending, cut taxes or both.

If the government cut taxes it increases people’s disposable income (total income – Tax) and people will spend much of that extra income, so Consumption (C) increases.

An expansionary fiscal policy will cause the aggregate demand curve to shift out, causing the equilibrium real GDP to increased and equilibrium price level P to rise.

2. Contractionary fiscal policy: occurs when the government deliberately reduces its

deficit in order to slow down the economy ( reducing aggregate demand and the

price level/ inflation)

In this case the government can cuts spending (G) or raises taxes (T) or both, in order to decrease aggregate demand.

This will cause the aggregate demand curve to shift inwardly, causing equilibrium output and equilibrium price to decrease.

3. Automatic Fiscal Stabilisers: Automatic fiscal stabilisers are policies which ‘automatically’ promote a budget deficit during a recession or a budget surplus during an expansion. Example: Unemployment benefits, taxes on corporate profits and progressive income taxes.

4. Fiscal Lags: When government implements a particular fiscal policy there is usually a time lag before the effects of such a policy is felt.

Effectiveness of Fiscal Policy

1. Crowding-out effect

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- When governments increase spending (expansionary fiscal policy) they create an increase in the demand for loans thus pushing interest rates up, which in turn ‘crowds out’ private investment.

Increased government borrowing tends to increase market interest rates. The problem is that the government can always pay the market interest rate, but there comes a point when corporations and individuals can no longer afford to borrow.

2. Timing Problems (lags)

- Recognition lags: it may take sometime before the authorities recognise that an economy is in recession

- Administrative lag: due to ‘red tape’ or bureaucratic hurdles policies are not always implemented in a timely manner

- Impact lag: the impact of fiscal policy is not immediately felt after implementation

Raising Revenue – Taxation

Taxation: the compulsory transfer of resources from the private sector to the government.

Tax Base: the three common tax bases are:

- Income- Consumption- Wealth

Tax Base: the measure or value upon which a tax is levied

Tax Rate

The amount of tax per unit of the tax base, and can be take the following forms. Proportional Tax: a tax whose burden is the same for all households Progressive Tax: a tax whose burden, expressed as a percentage of income, rises

as income rises Regressive Tax: a tax whose burden, expressed as a percentage of income, falls as

income rises

Calculating tax rates using the three methods above

Types of Taxes

1. General vs. selective

-General: tax the entire tax base

-Selective: impose a tax on a few products

2. Specif vs. ad velorem

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-Specific: tax per physical unit of a good.

-Ad Valorem: the tax is a percentage of a good value

3. Direct vs. indirect

- Direct: imposed directly on the individual or company

- Indirect: tax on commodity / transaction

Principles of Taxation

1. Benefit Principle: people pay tax relative to the benefit they receive from the

government.

2. Ability to pay Principle: people with equal capacity should pay the same tax. Underlying the ability to pay principle are the following:

-horizontal equity: people in the same circumstance pay the same tax

-vertical equity: people in better circumstances pay more tax.

The Budget

Budget Deficits and Surpluses

Balanced Budget: Govt. Spending = Govt. Rev. Balanced Deficit: Govt. Spending > Govt. Rev. Balanced Surplus: Govt. Spending > Govt. Rev.

Are budget deficits always bad?

Keynes disagreed with the notion that countries should always try to balance their budgets

The Budget Deficit/GDP ratio is an important indicator of the seriousness of the deficit

The Budget

Current Expenditure:

- Wages

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- Debt service

- Social sector spending

Capital Expenditure:

- Construction of infrastructure

Financing the Budget

Taxation Borrowing (external and internal) Grants

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Week 11

Role of Money in the Economy

Lecture 1

Definition: Money: money can be defined as anything that is generally accepted as a medium of exchange.

Functions of Money1. Medium of Exchange: anything that is readily acceptable as

payment.2. Unit of Account: serves as a unit of account to help us compare

the relative values of goods.3. Store of Value: a way to keep some of our wealth in a readily

spendable form for future needs.4. Method of Deferred Payment – Allows people to delay paying

for goods or settling debt, even though goods or services are being provided immediately.

Definitions of Money Supply The following definitions of money supply is based on U.S. definitions

Two Types of Money Commodity Money: something that performs the function of money and has

alternative, nonmonetary uses.– Examples: Gold, silver, cigarettes

Fiat Money: something that serves as money but has no other important uses.– Examples: Coins, currency, check deposits

Money in an EconomyMoney Stock is the quantity of money circulating in the economy

The different ways of measuring the money stock in an economy are:

M1: Currency (coins and paper money) in the hands of the public + all demand deposits in deposit taking financial institutions + travellers checks + other checkable deposits

In the US M1 is regarded as the narrowest form of money supply. The defining characteristic of this form of money is that it can be easily used to directly purchase goods and services.

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M2: M1 + Savings deposits + small time deposits (less than $100,000) + Money market deposit accounts + other short term investments

M3: M2 + large time deposits (more than $100,000.)

M2 + M3 are considered near or quasi money since they cannot be easily used to purchase a good or service.

NB: 1) In England the narrowest form of money supply is defined as M0 while the broadest is M4. 2) In Guyana the money supply is divided basically into two categories i.e. narrow and quasi money. Narrow money can be seen as M1 while narrow money and quasi money together makeup M2 (broad money).

The Central Bank and its Functions A country’s central bank is often seen as the bankers’ bank and is supposed to be independent of the government.Functions of the Central Bank1) Issuing Currency 2) Setting reserve requirements 3) Lending money to banks 4) Provides for Check collection or clearing between banks 5) Fiscal Agent to the government6) Supervision of Financial Institutions 7) Controlling the money supply

Lecture 2 The Credit Creation Process

The following tables depict how money can be created by commercial banks. RRR = 10%Bank A lends money to a customer to make a payment for let’s assume a car. That person then pays car care the money and car care has an account at Bank B so he deposits the money at bank B.

Balance Sheet Commercial Bank A

Assets Liabilities

Reserves $10 Deposits $100

Loans $90  

 

$100   $100

Balance Sheet Commercial Bank B

Assets Liabilities

Reserves $9 Deposits $90

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Loans $81  

 

$90   $90

Total money supply = $190

Required Reserves: That part or percentage of total deposits which banks by law must not make available for loans.

Required Reserve Ratio (RRR): The ratio of required reserves to total deposits.

Excess Reserves: That part of total deposits which banks can make available for loans.

The Money MultiplierThe money multiplier tells us the maximum amount of new demand-deposit money that can be created by a single initial dollar of excess reserves. This multiplier, m, is the inverse of the reserve requirement.

m = 1/R Where m = money multiplier and R = reserve requirement ratio

Maximum Checkable-Deposit Creation = Excess Reserves * Money Multiplier

ExampleAssuming that Jane Doe deposits $ 40.00 into her bank account what is the maximum possible money that can be created from that initial deposit. The RRR is equal to .2 or 20%.

Maximum money created = $32 * 1/.2 = $160

Please note that the entire initial deposit was not used to find the maximum money created.

Question: Assume that John deposits $100 into his GBTI bank account, and assuming that the bank does not lend any part of his deposit, would John’s action lead to an increase in the money supply?

Lecture 3 The Demand for MoneyThere are primarily two reasons why people demand money:

A. The Keynesian vies of Liquidity Preference 1) TRANSACTIONS DEMAND - this is money used for the purchase of goods

and services. The transactions demand for money is positively related to real incomes and inflation. As an individual's income rises or as prices in the shops increase, he will have to hold more cash to carry out his everyday transactions.  (Note:  the real demand for money is independent of the price level)

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2) PRECAUTIONARY BALANCES - this is money held to cover unexpected items of expenditure. As with the transactions demand for money, it is positively correlated with real incomes and inflation.

3) SPECULATIVE BALANCES - this is money not held for transaction purposes but in place of other financial assets, usually because they are expected to fall in price.  (choice between bonds and money) Keynes demonstrated that there was an inverse relationship between the price of a bond and the rate of interest. For example, suppose a bond is issued for £200 and its annual return (coupon) is £20. The annual rate of interest is 10%. If the market rate of interest falls to 5% the price of the bond will increase to £400. The rationale behind this is that in order to secure the same return of £20 in any other financial asset £400 would have to be invested.  Conversely, if the rate of interest increases, the price of bonds will fall. There is an inverse relationship between interest rates and the market prices of fixed interest government securities. Keynes argued that each individual has a a view about an 'average' rate of interest. If the current interest rate was above the average rate then a rational individual would expect interest rates to fall. Similarly, if current rates are below the average rate then obviously interest rates would be expected to rise.  At high rates of interest, individuals expect interest rates to fall and bond prices to rise. To benefit from the rise in bond prices individuals use their speculative balances to buy bonds. Thus when interest rates are high speculative money balances are low. At low rates of interest, individuals expect interest rates to rise and bond prices to fall. To avoid the capital loses associated with a fall in the price of bonds individuals will sell their bonds and add to their speculative cash balances. Thus, when interest rates are low speculative money balances will be high. There is an inverse relationship between the rate of interest and the speculative demand for money.

The total demand for money is obtained by summating the transactions, precautionary and speculative demands. Represented graphically, it is sometimes called the liquidity preference curve and is inversely related to the rate of interest.

Total Demand for Money

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A liquidity trap occurs when the economy is stagnant, the nominal interest rate is close or equal to zero, and the monetary authority is unable to stimulate the economy with traditional monetary policy tools. In this kind of situation, people do not expect high returns on physical or financial investments, so they keep assets in short-term cash bank accounts or hoards rather than making long-term investments. This makes the recession even more severe.

A liquidity trap is a situation where monetary policy becomes ineffective. Cutting the rate of interest is supposed to be the escape route from economic recession: boosting the money supply, increasing demand and thus reducing unemployment. But John Maynard Keynes argued that sometimes cutting the rate of interest, even to zero, would not help. People, banks and firms could become so risk averse that they preferred the liquidity of cash to offering credit or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policy makers.

MONEY DEMAND AND INCREASES IN REAL GDP

Consider a period of sustained economic growth in the economy. Rising real incomes and increasing numbers of people employed will increase the demand for money at each rate of interest. Therefore higher real national income causes an outward shift in the demand for money. This is shown in the diagram below

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FINANCIAL INNOVATION AND THE DEMAND FOR MONEY

The pace of change in financial markets is rapid and this affects our demand for money balances in order to finance our purchases. In recent years the demand for cash balances (M0) has declined relative to the demand for interest-bearing deposit accounts. Most people can finance their purchases using debit cards and credit cards rather than carrying around large amounts of cash. Financial innovation has reduced the demand for cash balances at each rate of interest - represented by an inward shift in the money demand curve. 

Week 12Balance of Payments and Exchange Rates

Lecture 1The Balance of Payments AccountBalance of Payments: A statistical statement which summarises all the external transactions a nation conducts with the rest of the world during a given period (a year in most cases). The Balance of Payments (BoP) account consists of information on the value of trade in goods and services, debt servicing, transfer payments etc.

Components of the Balance of Payments

US Balance of Payments 1999 (in Billions)

CURRENT ACCOUNT

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1) US goods exports 684

2) US goods imports -1030

3) Balance on goods -346

4) US exports of services 272

5) US imports of services -191

6) Balance on services 81

7) Balance on goods & services -265

8) Net investment income -18

9) Net transfers -48

10) Balance on Current Account -331

CAPITAL ACCOUNT

11) Foreign Purchases of assets in US 760

12) US purchases of assets abroad -438

13) Balance on Capital Account 322

OFFICIAL RESERVES ACCOUNT

14) Official reserves 9

0

The Current Account: This part of the Balance of Payments account basically consists of the value of exports less the value of imports plus net factor income and net transfer payments from abroad. In other words it is a list of short term flows of payments and transfers.

Visible Trade – Importing and exporting of merchandise (physical) goods i.e. you can feel and touch them they are tangible.

Services – Intangible goods, i.e. you cannot feel or touch them. Transfers – Net earnings arising from overseas assets owned plus tranfers of

funds to and from Guyana.

The Capital Account: This account is concerned with the change in domestic assets owned by foreigners and foreign assets owned by citizens. Therefore, unlike the current account, the capital account lists all the long term flows of payments.

Official Reserves Account: This account gives an indication of how much money has to be used to pay for a balance of payments deficit (reduction of reserves). On the other hand, if there is balance of payments surplus then the reserves will be increased by the amount of the surplus.

NB: By definition the Balance of Payments accounts must always sum to zero. However, economists make the distinction between balance of payments deficits and surpluses to indicate the differences between the overall balances on the capital and current accounts.

Policies to reduce a deficit on the Current Account

Deflation – (1) Expenditure reducing policy – This cures a deficit by reduce the aggregate demand and therefore the demand for imports while at the same time seeking export markets for exporters.

Direct Controls (Import Controls) – Embargoes, Tariffs, Quotas. Devaluation – This makes exports cheaper and imports more expensive provided

that the demand for exports and imports are highly elastic (Marshall-Lerner Condition).

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Lecture 2

Exchange Rates

Exchange Rate: This is simply the price of one nation’s currency relative to the currency of another country. Naturally a country’s exchange rate can be expressed in terms of any other national currency; however, there are some major currencies which are commonly used, the United States dollar being the most common.

Determination of Exchange Rates

Every country has an exchange rate regime that determines its exchange rate. An exchange rate regime can be fixed, freely floating, or a combination of the two i.e. a managed or dirty float.

Flexible Exchange RateIn a flexible or floating exchange rate regime the market forces of demand and supply determine the exchange rate, and as such the government does not intervene. In today’s international exchange rate system there is no ‘pure’ flexible exchange rate regime, rather some countries have a ‘managed’ or ‘dirty float system’.

Factors affecting the Demand and Supply for a particular currency:

Before identifying the factors that affect the supply and demand for a particular currency it is useful to make the following generalisations:1) If the demand for a country’s currency increases (ceteris paribus), its value will appreciate and vice versa.

2) If the supply of a country’s currency increases (ceteris paribus), its value will depreciate and vice versa.

3) If a nation’s currency appreciates, some foreign currency depreciates relative to it.

Factors:Changes in Tastes: If a new line of cars is made in Japan and US consumers want those cars they will shift the supply curve of US dollars outwards while pushing the demand curve of the Japanese Yen upwards. Naturally the US dollar will depreciate against the Japanese Yen (ceteris paribus).

Relative Income Changes: Increased incomes in country X can lead to an increase demand for imports from country Y. Holding everything else constant such an increase in demand for imports can lead to a depreciation of country X’s currency relative to country Y.

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Relative Price-Level Changes: If the price level for Guyana increases while Trinidad’s remains constant then Guyanese consumers will demand more Trinidadian goods while the Trinidadians will demand less Guyanese goods, ceteris paribus. As a result of the foregoing there will be an increase in the demand for Trinidadian dollars by Guyanese. On the other hand there will be a decrease in the supply of Trinidadian dollars. The end result is a depreciation of the Guyanese dollar against the Trinidadian dollar.

Relative Interest Rates: If interest rates in country A increases relative to interest rates in country B, then the citizens of country B would invest in financial assets in country A. In order to obtain such assets they would have to buy country’s A currency. Such an action will cause country B’s currency to depreciate relative to country A’s currency.

Speculation: Assume that currency speculators in Trinidad expect that the price level in Barbados will increase significantly within the next 6 months thus causing the Trinidadian dollar to appreciate relative to the Barbadian dollar. The speculators will therefore sell Barbados dollars for Trinidad dollars, as a result of their actions Trinidad’s dollar will appreciate. This is an example of self-fulfilling prophecy.

Figures showing the appreciation of the Pound when demand or supply changes

Advantages of floating exchange rates

Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit. If an economy has a large deficit, there is a net outflow of currency from the country. This puts downward pressure on the exchange rate and if depreciation occurs, the relative price of exports in overseas markets falls (making exports more competitive) whilst the relative price of imports in the home markets goes up (making imports appear more expensive). This should help reduce the overall deficit in the balance of trade provided that the price elasticity of demand for exports and the price elasticity of demand for imports are sufficiently high.

A second key advantage of floating exchange rates is that it gives the government / monetary authorities flexibility in determining interest rates. This is because interest rates do not have to be set to keep the value of the exchange rate within pre-determined bands.

P1

P0

Q0Q1 Pounds

Dollar Price of Pounds Dollar Price of Pounds

PoundsQ0 Q1

P1

P0

D0

S0

S1S0

D1

D0

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  Fixed Exchange RatesIn a fixed exchange rate system, the government through the Central Bank would intervene when it sees it fit to maintain its predetermined exchange rate.

In order to maintain a fixed exchange rate a government can do either one of the following or a combination:1) Direct Intervention: Increase the supply of a particular foreign currency if demand for that currency seems to be increasing.

2) Trade Policies: A government can implement policies to reduce the demand for imports from a particular country if demand for that country’s currency seems to be increasing. Tariff increases is an example of such a policy.

3) Exchange Controls and Rationing: Governments can demand that all foreign currency that is received by exporters is sold to the government. The government in turn will be able to ration the amount of currency by reselling to select importers.

4) Moral Suasion: Commercial banks can be persuaded to keep the exchange rate at a certain level.

5) Domestic Macroeconomic Adjustments: Finally government can implement macroeconomic policies that will ensure the exchange rate does not depreciate or appreciate e.g. by manipulating interest rates, government spending and taxation.

Advantages of Fixed Exchange Rates (disadvantages of floating rates)  

Fixed rates provide greater certainty for exporters and importers and under normally circumstances there is less speculative activity - although this depends on whether the dealers in the foreign exchange markets regard a given fixed exchange rate as appropriate and credible. Sterling came under intensive speculative attack in the autumn of 1992 because the markets perceived it to be overvalued and ripe for devaluation.

Fixed exchange rates can exert a strong discipline on domestic firms and employees to keep their costs under control in order to remain competitive in international markets. This helps the government maintain low inflation - which in the long run should bring interest rates down and stimulate increased trade and investment.

Appreciation vs. Depreciation

Example 1In the example below the Guyana dollar has depreciated in value against the US dollar or the US dollar has appreciated in value against Guyana dollar.

US $1.00 = G $200.00 (December 2004)

US $1.00 = G $205.00 (May 2005)

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Example 2In the example below the Guyana dollar has appreciated in value against the US dollar or the US dollar has depreciated in value against Guyana dollar.

US $1.00 = G $200.00 (December 2004)

US $1.00 = G $190.00 (May 2005)

Additional Readings1. Chapter 16, Macroeconomics 4th Ed. (Colander) © 20012. Chapter 36, Principles of Economics 5th Ed. (Case & Fair) © 1999 3. Chapter 38 Economics 15th Ed. (McConnell & Brue) © 20024. Bank of Guyana: Annual Report and Financical Statement of Accounts (various years) NB: Students are free to read any principles of Economics text they might have

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Week 13

Monetary Policy

Monetary policy is the process by which the government, central bank, or monetary authority manages the money supply to achieve specific goals—such as constraining inflation, maintaining an exchange rate, achieving full employment or economic growth.

Nature of Monetary Policy

Expansionary monetary policy: occurs when the central bank increases the money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates. An expansionary monetary policy will lower the interest rate and increase the quantity of goods and services demanded for a given period.

1. Central Bank buys bonds, lowers reserve ratio or lowers interest rate 2. Excess reserves increase 3. Money supply rises4. Interest rate falls 5. Investment spending increases 6. Aggregate demand increases 7. Real GDP rises by a multiple of the increase in investment

Contractionary monetary policy: occurs when the central bank reduces the money supply. contractionary policy has the goal of raising interest rates to combat inflation (or cool an otherwise overheated economy). Interest rate rises and reduces the quantity of goods and services demanded for a given price level.

1. Central Bank sells bonds, increases reserve ratio or increases discount rate2. Excess reserves increases 3. Money supply falls 4. Interest rate rises 5. Investment spending decreases 6. Aggregate demand decreases 7. Inflation declines

Keynesian View

Change in the money supply affects aggregate demand because of the relationship between the rate of interest and planned investment.

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Monetarists View

Monetarist economists believe that monetary policy is a more powerful weapon than fiscal policy in controlling inflation. An increase in money supply increases aggregate demand, but the interest rate does not play a role in transmitting changes in the supply of money.

Instruments of Monetary Policy

The Central Bank attempts to achieve economic stability by varying the quantity of money in circulation, the cost and availability of credit, and the composition of a country's national debt. The Central Bank has three instruments available to it in order to implement monetary policy:

1. Open market operations 2. Reserve requirements 3. The 'Discount Window'

Open market operations are the buying or selling of Government bonds by the Central Bank in the open market. If the Central Bank were to buy bonds, the effect would be to expand the money supply and hence lower interest rates; the opposite is true if bonds are sold. This is the most widely used instrument in the day to day control of the money supply due to its ease of use, and the relatively smooth interaction it has with the economy as a whole.

Reserve requirements are a percentage of commercial banks', and other depository institutions', demand deposit liabilities (i.e. chequing accounts) that must be kept on deposit at the Central Bank as a requirement of Banking Regulations. Though seldom used, this percentage may be changed by the Central Bank at any time, thereby affecting the money supply and credit conditions. If the reserve requirement percentage is increased, this would reduce the money supply by requiring a larger percentage of the banks, and depository institutions, demand deposits to be held by the Central Bank, thus taking them out of supply. As a result, an increase in reserve requirements would increase interest rates, as less currency is available to borrowers. This type of action is only performed occasionally as it affects money supply in a major way. Altering reserve requirements is not merely a short-term corrective measure, but a long-term shift in the money supply.

Lastly, the Discount Window is where the commercial banks, and other depository institutions, are able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term market rates (T-bills). This enables the institutions to vary credit conditions (i.e., the amount of money they have to loan out), there by affecting the money supply. It is of note that the Discount Window is the only instrument which the Central Banks do not have total control over.

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Money

Money supply

Liquid assets held by individuals and banks. The money supply includes coins, currency, and demand deposits (chequing accounts). Some economists consider time and savings deposits to be part of the money supply because such deposits can be managed by governmental action and are nearly as liquid as currency and demand deposits. Other economists believe that deposits in mutual savings banks, savings and loan associations, and credit unions should be counted as part of the money supply.

The Quantity Theory of Money

Economists regularly use the term money supply without defining it.  A notable example is the equation of exchange in the quantity theory of money. 

MV = PT

This relates the money supply, M, and the velocity of money, V, to the average price level, P, and the total number of transactions, T, in a given time period.  The equation is simply an identity, meaning it is true by definition.  Yet it is often used to "prove" that the average price level increases with the quantity of money.  An identity says nothing about causal relations.  The only thing we know is the product MV, which equals the national income, PT, which itself is only roughly measurable.  The quantity of money, M, remains undefined and unknowable.

Monetary policy and Exchange Rate

Under a fixed exchange rate system, monetary policy becomes more difficult – any change in the interest rate is liable to lead to inflows or outflows of currency, and put pressure on the currency e.g. the government tries to control the money supply which leads to higher interest rates which encourage inflows on the capital account. These inflows increase the money supply again.

MSOInterestRate (r) MS1

MS2

Ro

R2

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MD

R1

In a floating exchange rate an expansion of the money supply will reduce interest rates, which will boost spending within the economy. It will also lead to outflows of currency of the capital account. This will lead to a fall in the value of the currency, which will boost exports leading to further increase in aggregate demand. Alternatively, a tight (contractary) money policy increases interest rates and reduces aggregate demand. Higher interest rates lead to capital inflows and appreciation of the dollar. This further reduces aggregate demand.

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Week 14 International Trade and International Organisations

Lecture 1:International Trade

Why do nations trade? Essentially international trade enables countries to specialise in the production of particular goods and services, enhances the efficient allocation and productivity of their resources and increases the availability of consumer goods and services. In other words, international trade provides countries with the opportunity to produce and specialise in the production of those goods and services for which they can produce with the greatest relative efficiency and at the same time exchange those goods for goods, which they cannot produce at a relatively efficient level.

The fundamental reasons why nations trade are: 1. Countries have different quantities and types of natural, human and capital resources at their disposal.

2. Countries differ in terms of their efficient production of particular goods or services. In other words while two countries might be endowed with the same resources one might be more efficient at using those resources for the production of a particular good.

3. Goods and services can be similar but at the same time differentiated in terms of quality and other non-price attributes e.g. brand. Absolute Advantage: This is a situation where one country is more efficient at producing a particular good or service relative to another country. In other words if country X and country Y had the same amount of resources available to produce sugar, but country X produces more sugar then country X has an absolute advantage in producing sugar relative to country Y.

Adam Smith proposed the concept of absolute advantage in his book ‘The Wealth of nations’ (1776). In it he argued against the widely held Mercantilist view that trade is a

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zero sum game i.e. one country’s gains will result in another’s loss. Due to this notion, the Mercantilist’s felt that it was in a country’s best interest to export more than it imports.

On the other hand, Adam Smith argued that a country should produce those goods for which it has an absolute advantage and import those goods for which it does not have an absolute advantage, thus maximising the total combination of goods it has for consumption.

Example

ABSOLUTE ADVANTAGE AND THE GAINS FROM TRADE

Table 1: Production and Consumption without Trade

COUNTRY COCA RICETotal Resources

  Output (tons) Resources Output (tons) Resources  

Ghana 10 10/ton 5 20/ton 200

           

South Korea 2.5 40/ton 10 10/ton 200

           

TOTALS 12.5   15    

Table 2: Production and Consumption with Trade

COUNTRY COCA RICETotal Resources

  Output (tons) Consumption Output (tons) Consumption  

Ghana 20 14 0 6 200

           

South Korea 0 6 20 14 200

           

TOTALS 20 20 20 20  

Source: Hill, Charles W.L. 2 nd Ed. ‘Global Business.’ Irwin McGraw Hill © 2001.

In the example above Ghana can produce 10 tons of Coca with 100 units of resources while South Korea can only produce 2.5 tons of Coca with the same number of resources, therefore Ghana has an absolute advantage in producing Coca. On the other hand, South Korea clearly has an absolute advantage in producing Rice

Comparative Advantage: The situation where a country can produce good X more efficiently relative to good Y, while good Y can be produced more efficiently relative to good X or at a lower opportunity cost in another country. Therefore, it is possible that a country can have an absolute advantage in the production of two goods but have a comparative advantage in only one of them.

Following on the heels of Adam’s Smith absolute advantage theory was the theory of comparative advantage. David Ricardo in his book ‘Principles of Political Economy’ (1817) argued that a country can still gain from trade even if it has an absolute advantage

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in both goods. Previously, Adam Smith had suggested that in such a case a country will not have an incentive to trade.

Example

Consider the data in the following table:

Pre-Specialisation Good X Good YCountry A 1 4Country B 2 3Total Output 3 7

The opportunit costs of production are as follows:

Opportunity cost of 1X Opportunity cost of 1YCountry A 4Y ¼ XCountry B 1.5Y 2/3XIf each country specializes in the production of the good in which it has comparative advantage, A will make Ys because the opportunity cost is 1/4X rather than 2/3X. B will make X because the opportunity cost is 1.5Y rather than 4Y.

If all resources are now diverted into these goods, then, assuming constant returns to scale, the output will double (because there are twice as many resources in the production of these particular goods) i.e.

Good X Good YCountry A 0 8Country B 4 0Total Output 4 8Without trade the economies made 3Xs and 7Ys; with trade they make 4Xs and 8Ys, i.e there are more of both goods. Trade allows countries to benefit from more goods and services by specializing in the goods and services where they have comparative advantage. International trade is always beneficial if there is a difference in the opportunity cost ratios between two countries.

Assumptions underlying the concept of comparative advantage

Perfect occupational mobility of factors of production - resources used in one industry can be switched into another without any loss of efficiency

Constant returns to scale (i.e. doubling the inputs in each country  leads to a doubling of total output)

No externalities arising from production and/or consumption Transportation costs are ignored

If businesses exploit increasing returns to scale (i.e. economies of scale) when they specialise, the potential gains from trade are much greater. The idea that specialisation should lead to increasing returns is associated with economists such as Paul Romer and

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Paul Ormerod

What determines comparative advantage?

Comparative advantage is a dynamic concept. It can and does change over time. Some businesses find they have enjoyed a comparative advantage in one product for several years only to face increasing competition as rival producers from other countries enter their markets. 

For a country, the following factors are important in determining the relative costs of production:

The quantity and quality of factors of production available (e.g. the size and efficiency of the available labour force and the productivity of the existing stock of capital inputs). If an economy can improve the quality of its labour force and increase the stock of capital available it can expand the productive potential in industries in which it has an advantage.

Investment in research & development (important in industries where patents give some firms significant market advantage).

Movements in the exchange rate. An appreciation of the exchange rate can cause exports from a country to increase in price. This makes them less competitive in international markets.

Long-term rates of inflation compared to other countries. For example if average inflation in Country X is 4% whilst in Country B it is 8% over a number of years, the goods and services produced by Country X will become relatively more expensive over time. This worsens their competitiveness and causes a switch in comparative advantage.

Import controls such as tariffs and quotas that can be used to create an artificial comparative advantage for a country's domestic producers- although most countries agree to abide by international trade agreements. 

Non-price competitiveness of producers (e.g. product design, reliability, quality of after-sales support)

Arguments for Free Trade:1) Increased Choices2) Increased Output of goods 3) Increased Competitiveness4) Better bilateral relations between nations

Arguments against Free Trade:1) Self-Sufficiency 2) Increased Domestic Employment 3) Diversification for Stability 4) Infant Industry 5) Anti-dumping Protection 6) Cheap Foreign Labour

TRADE CONCEPTS 64

Tariff: a tax on an imported good.

Non-tariff Barrier: all barriers other than protective tariffs that nations erect to impede international trade e.g. import quotas, licensing requirements, sanitary and phytosanitary measures.

Import Quota: a limit imposed by a nation on the quantity (or total value) of a good that may be imported during some period of time.

Voluntary export restriction: voluntary limitations by countries or firms of their exports to a particular country to avoid enactment of formal trade barriers by the importing country.

Trade Embargo: a restriction on the export or import of a good(s).

Regional economic integration: agreement between countries in a geographic region to reduce tariff and non-tariff barriers to the free flow of goods and services and factors of production.

Trade Creation: A situation in which high-cost domestic producers are replaced by low-cost foreign producers within the regional free trade area.

Trade Diversion; As a result of regional integration, low-cost foreign suppliers outside the region are replaced with high-cost foreign suppliers within the region.

Trading Blocks

The European Union (EU) - is a union of twenty-seven independent states based on the European Communities and founded to enhance political, economic and social co-operation. Formerly known as European Community (EC) or European Economic Community (EEC). Date of foundation: 1st November, 1993. The EU is the largest political and economic entity on the European continent, with around 493 million people and an estimated GDP of US$14.2 trillion. The Union has a single market consisting of a customs union, a currency called the euro (adopted by 13 member states), a Common Agricultural Policy, a common trade policy,[2] and a Common Fisheries Policy.[3] The Schengen Agreement abolished passport control and customs checks for most member states within EU's internal borders, creating, to some extent, a single area of free movement for EU citizens to live, travel, work and invest

International Monetary Fund - The IMF is the world's central organization for international monetary cooperation. It is an organization in which almost all countries in the world work together to promote the common good.

The IMF's primary purpose is to ensure the stability of the international monetary system—the system of exchange rates and international payments that enables countries (and their citizens) to buy goods and services from each other. This is essential for sustainable economic growth and rising living standards.

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To maintain stability and prevent crises in the international monetary system, the IMF reviews national, regional, and global economic and financial developments. It provides advice to its 184 member countries, encouraging them to adopt policies that foster economic stability, reduce their vulnerability to economic and financial crises, and raise living standards, and serves as a forum where they can discuss the national, regional, and global consequences of their policies.

The IMF also makes financing temporarily available to member countries to help them address balance of payments problems—that is, when they find themselves short of foreign exchange because their payments to other countries exceed their foreign exchange earnings.

And it provides technical assistance and training to help countries build the expertise and institutions they need for economic stability and growth.

The World Bank Group (WBG) was established in 1944 to rebuild post-World War II Europe under the International Bank for Reconstruction and Development (IBRD). Today, the World Bank functions as an international organization that fights poverty by offering developmental assistance to middle-income and low-income countries. By giving loans and offering advice and training in both the private and public sectors, the World Bank aims to eliminate poverty by helping people help themselves. Under the World Bank Group, there are complimentary institutions which aid in its goals to provide assistance.

The World Trade Organization (WTO), established on 1 January 1995, is the legal and institutional foundation of the multilateral trading system. It provides the principal contractual obligations determining how governments frame and implement domestic trade legislation and regulations. And it is the platform on which trade relations among countries evolve through collective debate, negotiation and adjudication.

Main functions - The essential functions of the WTO are:

- administering and implementing the multilateral and plurilateral trade agreements which together make up the WTO;

- acting as a forum for multilateral trade negotiations;

- seeking to resolve trade disputes;

- overseeing national trade policies; and

- cooperating with other international institutions involved in global economic policy-making.

Caricom

CSME

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Additional Readings1. Chapter 35 Principles of Economics 5th Ed. (Case & Fair) © 1999 2. Chapter 37 Economics 15th Ed. (McConnell & Brue) © 2002 NB: Students are free to read any principles of Economics text they might have

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