ASSIGNMENT 2

Graduate School of Business Leadership

Economics for Managers

Student numbers:
Module: MBL 4801

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 ASSIGNMENT 2: MACROECONOMICS

In the fulfilment of the requirements for

MBL 4801
In the subject
ECONOMICS FOR MANAGERS
at the

UNIVERSITY OF SOUTH AFRICA

We declare that the work we are submitting for assessment contains no section copied
in whole or in part from any other source unless explicitly identified in quotation marks
and with detailed, complete, and accurate referencing.

Aaron Mokabane..............................79465536

Conrad Booyse............................... 79502377

Craig Potgieter.............................. 71673695

Mpumelelo Thabethe........................79306829

Thembisile Mahlangu......................79306802

Walther Geyser.................................79319882

Victor Voorendyk...............................79240550

Frans Thathani..................................79466990

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ASSIGNMENT 2: MACROECONOMICS

Table of Contents

1. QUESTION 1 ...................................................................................................... 4

2. QUESTION 2 ...................................................................................................... 6

A. DATA LAGS: .................................................................................................. 7

B. RECOGNITION LAG: ..................................................................................... 8
C. LEGISLATIVE LAG: ....................................................................................... 8
D. IMPLEMENTATION LAG:............................................................................... 9
E. EFFECTIVENESS LAG .................................................................................. 9
A. MACROECONOMIC POLICY AND MODELLING ........................................ 11
B. UNEMPLOYMENT ........................................................................................ 12
C. INFLATION ................................................................................................... 12

3. QUESTION 4 .................................................................................................... 15

A. THE EQUILIBRIUM LEVEL OF INCOME (Y) OF THE AFRICAN COUNTRY

USING THE KEYNESIAN MODEL OF AN OPEN ECONOMY ............................ 15
B. IS THE ECONOMY IN A DEFICIT, SURPLUS OR BALANCED? ................ 17

4. REFERENCES.................................................................................................. 19

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1. QUESTION 1

Any country's economy is dynamic and interactive and is subject to a number of

varying forces within both the micro- and macroeconomic environment. Economies
can grow or decline and there are numerous factors and principles that play a role in
this respect. Some of these factors and principles will require specific clarification
and have been discussed below.
The Gross Domestic Product (GDP) of a country refers to the market value of the
final goods and services produced within a countrys borders during a given time
period (Parkin, 2013). A recession is a significant decline in economic activity,
spread across the economy that lasts for more than a few months. This decline is
usually visible in real GDP, real income, employment, industrial production outputs
and wholesale-retails sales (National Bureau of Economic Research, n.d.). Although
there are several reasons for recessions developing, a key trigger is inflation, which
in turn refers to a general rise in the prices of goods and services over a period of
time (Morah, 2017). Otherwise stated, inflation occurs where a growing quantity of
money outpaces the growth of potential GDP (Parkin, 2013). During recessions, and
more specifically when the economy develops into an inflationary environment,
consumer spending declines as an individual means of curbing expenditure, thereby
causing a drop in GDP.
Within a given economy, a relationship exists between the quantity of real GDP
demanded (expressed as the sum of real consumption expenditure, investment,
government expenditure and exports minus imports) and the price level (the average
level of prices and the value of money). This relationship is known as aggregate
demand (AD). Parkin suggests that there are three main factors influencing planned
expenditure (other than the price level) that in turn cause changes in aggregate
demand, namely (1) expectations; (2) Fiscal and monetary policy; and (3) the world
economy (Parkin, 2013). Governments influence the economy of their countries
through fiscal policies and they may, for example, elect to implement what is known
as an expansionary fiscal policy as a means of counteracting the effects of a
recession.
Such a fiscal policy in essence an expansionary aggregate demand measure
aims to increase aggregate demand through heightened government spending and/
or lower taxes, thereby leading to economic growth; however, it may also lead to

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inflation (or at least contribute towards inflationary pressures) as a result of the
higher demand in the economy (Pettinger, 2008). As a means of counteracting
these inflationary pressures stemming from the use of expansionary aggregate
demand measures during a recession, certain aggregate supply measures can be
instituted.
Similar to aggregate demand, aggregate supply (AS) refers to the relationship
between the quantity of real GDP supplied and the price level. Depending on the
time frame involved, aggregate supply can be viewed as long-run- or short-run
aggregate supply the former referring to the relationship between the quantity of
real GDP supplied and the price level when the money and wage rate changes at the
same time as the price level to maintain full employment; and the latter being the
relationship between the quantity of real GDP supplied and the price level when the
money and wage rate, the prices of other resources and potential GDP remain
constant.
The AS/AD model explains and illustrates economic growth and inflation as the first
being increasing long-run aggregate supply and the second as a persistent increase
in aggregate demand at a faster pace than that of the increase in potential GDP.
Aggregate supply changes when an influence on production plans (other than the
price level, such as changes in potential GDP and changes in the money-wage rate)
changes (Parkin, 2013).
It is important to fully contextualise and simplify in clear terms the issue at hand
with reference to the AS/AD model: Essentially, when an economy goes into a
recession, a government (on the local front) will aim to follow an expansionary fiscal
policy with the goal of increasing aggregate demand. Left uncontrolled, these well-
intended steps may gradually and over time lead, firstly, to an inflated increase in
price levels and, secondly, to a persistent increase in aggregate demand at a rate
that outpaces the growth of potential GDP. In order to contain the inflationary
pressures stemming from this situation, economic growth must be stimulated through
the imposition of complementary AS-measures, which will involve an increase long-
run aggregate supply.
Concerning aggregate demand, (Parkin, 2013) provides that when the price level
rises and other things remain the same, the quantity of real GDP demanded
decreases. When the price level falls and other things remain the same, the quantity

5
 of real GDP demanded increases. Potential GDP which has a direct impact on
aggregate supply in turn may increase due to an increase in the full-employment
quantity of labour; and/or the quantity of capital; and/or due to advances in
technology. Increases in potential GDP increase both long-run and short-run
aggregate supply.
In as far as these aggregate supply measures are concerned, it should be noted that
fluctuations in employment over the business cycle bring about fluctuations in real
GDP; however potential GDP would increase over time concurrent with the
expansion of the labour force. Where capital is concerned (and in this sense, capital
must include human capital), a larger quantity of capital will require a more
productive labour force, thereby also mean an increased potential GDP. The
technological advancement that has been so prevalent in the current day and age
has allowed firms to generate more from any given amount of production factors.
(Parkin, 2013) maintains that even with fixed quantities of labour and capital,
improvements in technology will lead to an increase in potential GDP.

2. QUESTION 2

Fiscal and monetary policies are used in most countries to influence the economy by
regulating unemployment, business cycles, inflation and the cost of money(also
referred to as stabilisation policies). The government and the central bank (South
African Reserve Bank) are guided by the economic climate at a particular time to
either use Fiscal or Monetary policy. Monetary policy is conducted by a common
central bank, while fiscal policy is implemented at the countrys government (Afonso
and Sousa, 2009). According to Smaland de Jager (2001), the vital goals of
monetary policy is to safeguard the value of the currency for obtaining balanced and
sustainable economic growth in the country, whereas fiscal
(Expansionary/Contractionary) policy is concerned with economic stability to achieve
economic goals (i.e. unemployment) by changing tax and government spending that
directly affect GDP (OpenStax, 2014). Stabilisation policies (Fiscal and Monetary)
are often administered with difficulties because of the time lags overall
responsiveness to changes in the economy (i.e. economists have inadequate
economic data).

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According to (Batini and Nelson, 2001), advances information processing and in the
financial market, sophistication does not appear to have substantially shortened the
lag. The empirical evaluation of dynamic general equilibrium models needs to be
extended to include assessment of these models ability to account for the monetary
transmission lags found in the data. Alike, fiscal policy application has time lags
hindrances in almost all stages of policy implementation (i.e. recognition lag, reaction
lag, and effect lag). Figure 1 below illustrates the types of lags associated with
Monetary and Fiscal policies. The effects of monetary policy are associated with
changes in interest rate, inflation, unemployment, the quantity of money and credit
(i.e. economic variables). Monetary policy can be changed several times each year,
but fiscal policy is much slower to be enacted (OpenStax, 2014).

Figure1 shows that it takes time to identify when a policy change is needed,
additional time to institute the policy change, and still more time before the change
begins to exert an impact on the economy (Latzko, 2014).

A. DATA LAGS:

Before any action is undertaken, the existence of any problem has to be identified.
The identification of a problem implies gathering and analysing economic data
(Jovanovski and Muric, 2012). The statistics figures needed to predict
macroeconomic patterns (GDP, GNP, CPI). Unemployment is obtained with time-
consuming process (i.e. time lags), usually, the information obtained through data
series is backdated and not coexistent. It must still be amended accordingly to
enable policy makers to make a right decision. Overall information collection about
existing state of the economy is with difficulties, as they might not be information
available months after the economy has already started changing its course. The

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success of both Fiscal and Monetary policy implementation is solely based on
correct predictions of data at various economic data analysis. Irregularities in data
information will result in an unsuccessful launch of policy where the course of
economy has already changed.

B. RECOGNITION LAG:

The time it takes the government and central bank to recognise that the economy is
in crisis is termed recognition lag. It is always difficult to predict downward trending
economy and will often take a couple of months before Economists can forecast an
economic downward trend, moreover, it will take a couple of months to further
predict the type of economic slowdown (e.g. recession or unemployment).According
to (OpenStax, 2014) during the early days of the Obama administration, no one
knew how deep in the hole the economy really was during the financial crisis of
2008-09. The rapid collapse of the banking system and automotive sector made it
difficult to assess how quickly the economy was collapsing. Had the recognition lag
been realised earlier, macroeconomics policies (Fiscal and Monetary) would have
been applied to minimise the then unforeseen recession effects.

C. LEGISLATIVE LAG:

The fiscal legislative action is prolonged by extensive government debates that

involve all government officials; moreover, the fiscal legislative law has to be as
transparent as possible and must be shared with the rest of the public. Long debates
about which law to pass delay the implementation of the policy. (Gruen et al., 1999)
says most of the considerable fiscal blow-outs in recent past were not concealed
from the public as they were arising. Therefore fiscal transparency is required to
accelerate a legislative law. Unlike fiscal policy changes, which occur only once a
year, monetary policy changes occur numerous times a year (i.e. three to four
times). This sets the monetary policy to have a short legislative lag compared to
fiscal which is characterised by long variable and uncertain time lags. Even though
monetary legislative laws characterised by lesser legislative lag as compared to
Fiscal, their transmission mechanism is characterised by long, variable and uncertain
time lags (South African Reserve Bank, 2004).

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 D. IMPLEMENTATION LAG:

The implementation lag for monetary policy tends to be relatively short. Policy
decisions are fast-tracked by special committee members that meet three or four
times a year. As soon as policy actions are taken, implementation process begins
almost immediately (often by the end of the day). Financial markets are associated
with fewer delays in decision makings; hence monetary policy completed in short
order. In contrast, the fiscal policy tends to have derailed implementation process.
Any changes in government spending or taxes must be debated and be the subject
perusal for all government agencies and bureaucracies before implemented.
Government administrations are slow in general as they seek to ensure that all
policies and procedures are followed accordingly. This tends to decelerate the time
needed to implement fiscal policy. In general, the monetary policy connection
between inflation and money growth can only fully convalesce once the lags
relationship is taken into account (Batini and Nelson, 2001).

E. EFFECTIVENESS LAG

Estimates time predictions required for the impact lag to be depleted ranges from six
months to two years in a monetary policy. Because of the time lag variations in the
policy execution, policy makers tend to be hind-sighted about the time frame within
which the policy can be effective. For the reason of the uncertain length of the impact
lag, efforts to stabilise the economy through monetary policy could be compromised
by destabilising the already course changed economy. Suppose, the Reserve Bank
attempts to close the recessionary gap with an expansionary policy but by the time
the policy begins to affect aggregate demand, the economy has already returned to
potential GDP. Figure 2 illustrate that the policy intended to rectify a recessionary
gap that could exacerbate the problem by creating an inflationary gap. A different
scenario could be that the intended contractionary policy to rectify this negative
status might have no effect on the aggregate demand until the gap is automatically
closed. Although the intention of this policy is to rectify the negative situation, the lag
between implementation and the positive swing could drop the economy into
recession. There is a perfect correlation between the increase of money supply by
the central bank and the decreasing of interest rates. Consumers and businesses
will only benefit from the low rates over a period of time before they will be capable

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of contributing to investment into the economy. These issues highlight the
importance of time from policy implementation to reaping the benefits thereof.
Research has shown that anticyclical monetary, debt management as well as fiscal
modifications are reliable for their predominant direct impact within a three to six
month period. This diminutive time period should, if started at the beginning of a
cyclical phase, not be destabilising.

Figure 2 shows, the delayed after-effect of fiscal response to the recessionary gap,
causing problems of inflationary gap thereby destabilising (Adopted from Sasha
Pashitin (2017).
Because of the time lags associated with Fiscal and Monetary policies, the
conditions of the economy might change before the impact of policies is felt, thus
destabilising the already neutralised economy. Monetarists argue against a lively
economic policy because of the prolonged time lags executions. The most widely
acknowledged deduction is that the reaction of prices, output, or balance of
payments variables that are primary goals of policy to modifications in monetary
policy (or for that matter the response to fiscal policy) is conducted over a "long"
period of time. This means that the reaction time took within the first month or
quarter, and even the first year is generally thought to be a small fraction of the
ultimate total or to saying that there is a "long" delay between the time that monetary
action is taken and the time that "most" of its effects are felt (Meltzer, 1966). Despite
the fact that inflation appears to take a somewhat shorter time, this is due to the
relative importance of the exchange rate pass-through via imported goods and
services. Therefore relatively long lags from the policy rate decisions to their effects
on the economy mean that monetary policy at any time needs to be foresighted on
inflation prospects for the period of 1-2 years rather than on the current inflationary

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advancements. Some economists argue that the effect of fiscal policy may only be
suitable for achieving long-term economic problems(i.e. Long-term interest rates and
GDP) (Afonso and Sousa, 2009) While the overall length of the policy lags may be
almost similar in both Fiscal and Monetary policy, the composition of these policies
differ (i.e. respectively meant to stabilise Government spending and money supply).

QUESTION 3

A. MACROECONOMIC POLICY AND MODELLING

Macroeconomic policy is aimed at tackling the challenges of unemployment, inflation

and cyclical instability (Black, Hartzenberg and Standish, 2001). Central Banks are
responsible for implementing country or region's macroeconomic policy. In the
aftermath of the 2008 financial crisis, the focus of most central bank in monetary
policy is on price stability and macroeconomic stability (Black et al 2001).
Each country develops an appropriate macroeconomic model as an economic tool
for implementing its macroeconomic policy. Macroeconomic models are important for
purpose of forecasting. Policy makers are interested in predicting the future direction
and this assists in shaping future policy (Pescatori and Zaman, 2011). Historically
there is three types of macroeconomic models structural, non-structural and large
scale model (Pescatori and Zaman, 2011). These three broad models have been
developed in the last forty to five years assisting policy makers to forecast the
direction of the economy. Each has their own weaknesses and strengths. Structural
models have been built largely on economic theory and its authors believed that you
learn more about economic processes by exploring the intricacies of economic
theory than from closely matching incoming data', (Pescatori and Zaman, 2011). The
non-structural models are a statistical time series models and represent the
correlations of historical data. The theory is fudged' to closely match economic data
in this model. The third type of a model is referred to as large scale models and are a
middle ground or a hybrid between structural and non-structural models, (Pescatori
and Zaman, 2011). They owe their origins to 1960s during the time when the
Keynesian economic theory was very popular and there advances in computer
technology.

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The goal of macroeconomic policy is to create a stable economic environment for
growth, employment creation and price stability through managing inflation. Both
inflation and unemployment are key variables to be considered in macroeconomic
modelling.

B. UNEMPLOYMENT

The rate of unemployment can be defined as the number of unemployed job seekers
divided by the total number of unemployed persons, (Black et al 2001). There is
three types of unemployment cyclical, structural and frictional unemployment.
Cyclical unemployment is a product of period downswings in business cycles'(Black
et al, 2001). Structural unemployment results from a situation where skills profile of
unemployed persons does not match the skills demanded by employers' (Black et al,
2001). This can result from a situation where the unemployed are in different
geographic locations from where vacancies exist(Black et al, 2001). The third type is
called frictional unemployment. This is when people are voluntarily remaining
unemployed while they seek out and wait for suitable job vacancies (Black et
al,2001).

C. INFLATION

Inflation refers to the persistent rise in the general level of prices and is a process
where money loses its value of time (Reid et al, ). It is measured through two
indexes: consumer price index and producer price index (Black et al 2001). In
monetary environment decisions, wages and prices are coordinated between the
public and private sector. The central bank must maintain a stable inflation
environment (Reid et al, ). It is now common for most central banks to use inflation
targeting as a measure of limiting their ability to use discretion to decide monetary
policy. Inflation targeting has now become a the most durable nominal anchor for
monetary policy in the Post-War era (Rose, 2007).
Inflation does change from time to time and this can be explained in different ways.
The first type of inflation changes is referred to as demand-pull theories of inflation. It
is built on the proposition that where aggregate demand exceeds aggregate supply,
the general level of prices in an economy will rise to accommodate the excess
demand. The second type of increase is referred to as the cost-push theories of

12
inflation. It is a situation where the general level of price increase is as a result of
increases in production costs.
People make a plausible assumption about their expectation of inflation based on
recently observed inflation and this is referred to as adaptive inflation. A classic
example is that people are expecting inflation to rise at the same rate as the previous
year. In a case where the rate of unemployment is at a natural rate and there are no
external supply shocks on the economy, the prices will be projected to rise in the
year at the same rate as the previous year(Economics Discussion, 2017).
The causes of rising and falling inflation are varied. Cyclical unemployment
contributes to either upward or downward pressure on inflation. Inflation movements
are also caused by adverse supply shocks. The classic example is when there are
sharp rises in the world oil prices, this will cause inflation to rise and it is referred to
as cost-push inflation caused by an increase in production (Economics Discussion,
2017).
The trade-off relationship between inflation and unemployment
In Fig3 if the expected inflation rises the curve shifts upward and the policy makers
trade-off become less favourable inflation is higher for any level of unemployment.
The will be higher when the expected inflation is higher. Since people adjust their
inflation expectations over time, this trade-off between inflation and unemployment
holds only in the short-run.

Figure 3 Figure 4
In Fig 4 the government is pursuing a policy of maintaining full employment'. The
consequent policy pursued by the government is that of expansionary fiscal or
monetary policy. There is a shift in the graph from AD to AD'. In case the intervention
ended here, the price level will rise to P' and unemployment will be lowered. But

13
consequently fixed money wage and the rise in prices as a result of the policy, there
will be a fall in wages.

Figure 5 Figure 6
In Fig 5 if inflation increases in the rest of the world whilst our country is in
equilibrium, there will be an increase in exports and a consequent decrease in
imports and thus an increase in AD. This will result in the increase in prices, income
and unemployment and the fall in real wages. This is a classic case of importing
inflation from abroad.
In Fig 6 we assume that there is an excess demand for labour, this will result in two
scenarios: first the level of unemployment at this real wage is less and secondly, the
money wage will rise.
Recessions or high inflation are two scenarios that can exist. For a recession to
happen, high unemployment and low inflation can be expected. In this case, either
an expansionary monetary policy or an expansionary fiscal policy should be
implemented. In an expansionary model, the supply of money would increase, the
interest rate will go up, aggregate demand would move to the right resulting in the
income and price levels to increase.

Figure 7 Figure 8

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 Figure 7 indicates high unemployment and low inflation.Figure 8 indicateshigh
inflation that will result in hyperinflation as the price level of money increases.
High inflation will result in low unemployment. In this case, contractionary monetary
and fiscal policy should be applied. Implementing contractionary monetary policy will
result in the supply of money would decrease, the interest rate will go up, aggregate
demand would shift left resulting in the income and price levels to go
down.Implementing contractionary fiscal policy will result in Government spending to
decrease; the aggregate demand would shift to the right, resulting in the income and
price levels to go down.

3. QUESTION 4

A. THE EQUILIBRIUM LEVEL OF INCOME (Y) OF THE AFRICAN

COUNTRY USING THE KEYNESIAN MODEL OF AN OPEN ECONOMY

Autonomous consumption: a = US$250million

Investment: I = US$150million,
Government expenditure: G = US$300million
Marginal propensity to consume (MPC): b = 0.8
Tax rate (t): t = 0.25
Imports goods: M = US$420million per annum
Exports are 0.7 of the imports X = 0.7(420) = US$294million per
annum
The Aggregate Expenditure slope AE will be equal to MPC.
Calculating the slope for AE:
SLOPE AE = MPC= 0.8 = 4/5
Calculating Saving S:
MPC + MPS=1
= 1 = 0.2
Marginal propensity to save:
MPS = 0.2 with a slope of 1/5
Consumption Expenditure C:
Ye=1(1-b)(a+I) = 1(1-.8)(250+150) = 5(400)= 2000
Total private consumption
C= a + bYe = 250 + 4/5(2000) = 250 + 1600 = 1850 (for National Income)

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For a closed economic model and at a tax rate of 25%
Ye=11-(b(1-t))(a+I + G) = 11-(4/5(1-1/4))(250+150 +300)
= 2.5(700) = 1750
Thus, the total private consumption expenditure will be:
C= a + b(1-t) Ye = 250 +4/5(3/4) 1750 = 250 + 1050 = 1300
The equilibrium level of income (Y) of the African country for an open economic
model:
= 1 1 [[1 ]](C + I + G + X -M)
Note, when using the Keynesian model: I, G, X and M are all been treated as
autonomous (Parkin, 2013)
Calculating the Multiplier:
Multiplier = 1 1 [[1 ]]
= 1 1 [0.8[1 0.25]]
= 2.5
(C + I + G + X -M) = (250 + 150 + 300 + (420 294)
= 826
The equilibrium level of income:
(Y) = 2.5(826) = 2065
Autonomous Expenditure:
Net taxes are assumed to be constant and not vary with income.
A = a bTa + I + G + X
Aggregate Expenditure:
A E= C + I + G + (X M)= 826

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 B. IS THE ECONOMY IN A DEFICIT, SURPLUS OR BALANCED?

According to (Mankiw, 2008), a country will be in an economic surplus when the

income is greater than the spending. This means that the income Y= C + I + G + (X
M) will be more than the spending C + I + G. Saving S = Y C G must be more
than the investment and the capital outflow more than zero due to savings also going
abroad.
(Mankiw, 2008), further explains that for a country in deficit the exports will be less
than the imports, creating a negative. The incomeY= C + I + G + (X M) will be less
than the spending C + I + G. Saving S = Y C G will be less than saving. A
negative outflow will result due to asset investing abroad.
Lastly, (Mankiw, 2008), indicates that a country will be in an economic balance when
there exist a balance in all of these cases and Net exports and capital outflow is
zero.
Deficits: Exports < Imports, Net Exports < 0, Y < C + I + G, savings < Investments,
Net Capital Outflow < 0
Balanced: Exports = Imports, Net Exports = 0, Y = C + I + G, savings = Investments,
Net Capital Outflow = 0
Surplus : Exports > Imports, Net Exports > 0, Y > C + I + G, savings > Investments,
Net Capital Outflow > 0

17
In this African country, the following calculations indicate that the economy is in
surplus:
1. The incomeY= C + I + G + (X M) = 826
2. Savings > Investments :
a. Saving S = Y C G = 826 250 300 = 276
b. Investment = $150.
3. Exports > Imports = 420 > 294

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