Eco102 1

COURSE MANUAL
Introductory Economics II
ECO102
ECO102
University of Ibadan Distance Learning Centre

Open and Distance Learning Course Series Development
Version 1.0 v1
Copyright © 2009, 2013 by Distance Learning Centre, University of Ibadan, Ibadan.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or
transmitted in any form or by any means, electronic, mechanical, photocopying, recording or
otherwise, without the prior permission of the copyright owner.
ISBN: 978-021-365-1
General Editor: Prof. Bayo Okunade
Page layout and instructional design by EDUTECHportal, www.edutechportal.org
University of Ibadan
Ibadan Distance Learning Centre
University of Ibadan,
Nigeria
Telex: 31128NG
Tel: +234 (80775935727)
E-mail: [email protected]
Website: www.dlc.ui.edu.ng
Vice-Chancellor’s
Chancellor’s Message
The Distance Learning Centre is building on a solid tradition of over two decades of service in
the provision of External Studies Programme and now Distance Learning Education in Nigeria
and beyond. The Distance Learning mode to which we are committed is providing access to
many deserving Nigerians in having access to higher education especially those thos who by the
nature of their engagement do not have the luxury of full time education. Recently, it is
contributing in no small measure to providing places for teeming Nigerian youths who for one
reason or the other could not get admission into the conventional
conventional universities.
These course materials have been written by writers specially trained in ODL course delivery.
The writers have made great efforts to provide up to date information, knowledge and skills in
the different disciplines and ensure that the materials
m are user-friendly.
In addition to provision of course materials in print and e-format,
e format, a lot of Information
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available in audio format which you can also
download into your mobile phones, IPod, MP3 among other devices to allow you listen to the
audio study sessions. Some of the study session materials have been scripted and are being
broadcast on the university’s Diamond
Diamond Radio FM 101.1, while others have been delivered and
captured in audio-visual
visual format in a classroom environment for use by our students. Detailed
information on availability and access is available on the website. We will continue in our
efforts to provide
ide and review course materials for our courses.
However, for you to take advantage of these formats, you will need to improve on your I.T.
skills and develop requisite distance learning Culture. It is well known that, for efficient and
effective provision of Distance learning education, availability of appropriate and relevant
course materials is a sine qua non.
non. So also, is the availability of multiple plat form for the
convenience of our students. It is in fulfillment of this, that series of course materials
materi are being
written to enable our students study at their own pace and convenience.
It is our hope that you will put these course materials to the best use.
Prof. Isaac Adewole

Vice-Chancellor
Foreword
As part of its vision of providing education for “Liberty and Development” for Nigerians and
the International Community, the University of Ibadan, Distance Learning Centre has recently
embarked on a vigorous repositioning agenda which aimed at embracing a holistic and all
encompassing approach to the delivery of its Open Distance Learning (ODL) programmes.
Thus we are committed to global best practices in distance learning provision. Apart from
providing an efficient administrative and academic support for our students, we are committed
to providing educational resource materials for the use of our students. We are convinced that,
without an up-to-date, learner-friendly and distance learning compliant course materials, there
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availability of appropriate course materials in multiple formats is the hub of any distance
learning provision worldwide.
In view of the above, we are vigorously pursuing as a matter of priority, the provision of
credible, learner-friendly and interactive course materials for all our courses. We commissioned
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in an ICT age.
The development of the materials which is on-going also had input from experienced editors
and illustrators who have ensured that they are accurate, current and learner-friendly. They are
specially written with distance learners in mind. This is very important because, distance
learning involves non-residential students who can often feel isolated from the community of
learners.
It is important to note that, for a distance learner to excel there is the need to source and read
relevant materials apart from this course material. Therefore, adequate supplementary reading
materials as well as other information sources are suggested in the course materials.
Apart from the responsibility for you to read this course material with others, you are also
advised to seek assistance from your course facilitators especially academic advisors during
your study even before the interactive session which is by design for revision. Your academic
advisors will assist you using convenient technology including Google Hang Out, You Tube,
Talk Fusion, etc. but you have to take advantage of these. It is also going to be of immense
advantage if you complete assignments as at when due so as to have necessary feedbacks as a
guide.
The implication of the above is that, a distance learner has a responsibility to develop requisite
distance learning culture which includes diligent and disciplined self-study, seeking available
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This is why you are encouraged to develop your computer skills by availing yourself the
opportunity of training that the Centre’s provide and put these into use.
In conclusion, it is envisaged that the course materials would also be useful for the regular
students of tertiary institutions in Nigeria who are faced with a dearth of high quality textbooks.
We are therefore, delighted to present these titles to both our distance learning students and the
university’s regular students. We are confident that the materials will be an invaluable resource
to all.
We would like to thank all our authors, reviewers and production staff for the high quality of
work.
Best wishes.
Professor Bayo Okunade

Director
Course Development Team
Course Writer Abiodun O. Folawewo, Ph.D.
Content Editor Prof. Remi Raji-Oyelade

Production Editor Dr. Gloria O. Adedoja
Learning Design & Technologist Folajimi Olambo Fakoya
Managing Editor Ogunmefun Oladele Abiodun
General Editor Prof. Bayo Okunade
ECO102
ECO102 Introductory Economics II
Contents
About this course manual 1
How this course manual is structured .................................................................................................................... 1
Course Overview 3
Welcome to Introductory Economics II ECO102................................................................................................ 3
Course outcomes .............................................................................................................................................................. 3
Timeframe........................................................................................................................................................................... 3
How to be successful in this course ......................................................................................................................... 4
Need help?........................................................................................................................................................................... 5
Academic Support............................................................................................................................................................ 5
Activities .............................................................................................................................................................................. 5
Assessments ....................................................................................................................................................................... 6
Bibliography ....................................................................................................................................................................... 6
Getting around this course manual 8

Margin icons ....................................................................................................................................................................... 8
Study Session 1 9
The Field of Macroeconomics ..................................................................................................................................... 9
Introduction .......................................................................................................................................................... 9
Learning Outcomes ............................................................................................................................................ 9
Terminologies ...................................................................................................................................................... 9
1.1 What is Macroeconomics? .................................................................................................................... 10
1.2 The Distinction between Micro and Macroeconomics ............................................................. 11
Study Session Summary ............................................................................................................................................. 12
Assessment ...................................................................................................................................................................... 12
Bibliography .................................................................................................................................................................... 13
Study Session 2 13
National Income: Concepts and Measurement................................................................................................. 14
Introduction ....................................................................................................................................................... 14
Learning Outcomes ......................................................................................................................................... 14
2.1 Concepts of National Income............................................................................................................... 14
2.1.1 Gross Domestic Product (GDP).......................................................................................... 15
A. Market Value ........................................................................................................................ 15
B. Final Goods and Services ................................................................................................ 15
C. Produced within a Country during a given Period .............................................. 18
GDP at Factor Cost .................................................................................................................. 22
2.1.2 Gross National Product (GNP) ........................................................................................... 22
2.1.3 Net National Product (NNP) ............................................................................................... 23
2.1.4 Domestic Income ..................................................................................................................... 23
2.1.5 Personal Income ...................................................................................................................... 24
Contents ii
2.1.6 Per Capita Income / GDP Per Capita ............................................................................... 24

2.1.7 Disposable Income .................................................................................................................. 24
2.2 Measuring GDP .......................................................................................................................................... 25
2.2.1 The Value-Added Approach ................................................................................................ 25
2.2.2 The Income Approach ........................................................................................................... 26
2.2.3 The Expenditure Approach ................................................................................................. 28
2.3 National Income Measurement Problems ..................................................................................... 29
Assessment ...................................................................................................................................................................... 31
Study Session 3 Error! Bookmark not defined.

Aggregate Demand and Aggregate Supply ......................................................................................................... 32
Introduction ....................................................................................................................................................... 32
3.1 Aggregate Demand................................................................................................................................... 32
3.1.1 The Aggregate Demand Curve ........................................................................................... 32
3.1.2 Reasons for the Downward Slope of the AD Curve ................................................... 33
3.2 Aggregate Supply...................................................................................................................................... 34
3.2.1 The Aggregate Supply Curve .............................................................................................. 35
3.2.2 Aggregate Supply in the Short-Run ................................................................................. 35
3.2.3 Reasons for the Shape of the Short-Run as Curve ..................................................... 36
A. The Fairly Flat Shape ........................................................................................................ 36
B. The Nearly Vertical/Vertical Shape............................................................................ 37
3.2.4 The Long-Run Aggregate Supply Curve ......................................................................... 37
3.3 Shifts in the Aggregate Demand Curve............................................................................................ 38
3.3.1 Changes in Monetary Authority’s Policy Reaction Function ................................. 39
3.3.2 Change in Spending ................................................................................................................ 40
3.4 Shifts in the Aggregate Short-Run Supply Curve ........................................................................ 41
3.4.1 Economic Fluctuations .......................................................................................................... 41
Assessment ...................................................................................................................................................................... 41
Bibliography .................................................................................................................................................................... 42
Study Session 4 43
Money, Monetary Policy and Economic Activity ............................................................................................. 43
Introduction ....................................................................................................................................................... 43
4.1 The Meaning of Money ........................................................................................................................... 43
4.1.1 Definition of Money ................................................................................................................ 43
4.2 Functions of Money ................................................................................................................................. 44
4.2.1 Medium of Exchange .............................................................................................................. 44
4.2.2 Store of Value ............................................................................................................................ 44
4.2.3 Unit of Account/Unit of payment ..................................................................................... 45
4.3 Money and the Banking System ......................................................................................................... 45
4.3.1 The Banking System ............................................................................................................... 45
4.3.2 Money Supply and Control .................................................................................................. 45
Banks and Creation of Money ............................................................................................ 46
4.3.3 Money Supply with Currency and Deposit ................................................................... 47
4.3.4 Monetary Policy and its Instruments.............................................................................. 47
ECO102
Reserve Requirements.......................................................................................................... 47
Discount Window.................................................................................................................... 48
Open Market Operation (OMO)......................................................................................... 48
Bibliography .................................................................................................................................................................... 50
Study Session 5 51
Government and the Economy ................................................................................................................................ 51
Introduction ....................................................................................................................................................... 51
5.1 Government Spending............................................................................................................................ 51
5.1.1 Government Consumption Spending Expenditure on Goods and Services.... 51
5.1.2 Transfer Payment .................................................................................................................... 52
5.2 Government Revenue ............................................................................................................................. 52
5.3 The Budget Balance ................................................................................................................................. 53
5.3.1 Revenue and Expenditure functions ............................................................................... 54
5.4 Fiscal Policy and Aggregate Demand ............................................................................................... 54
Assessment ......................................................................................................... Error! Bookmark not defined.
Bibliography .................................................................................................................................................................... 59
Study Session 6 60
Open Economy Transaction ..................................................................................................................................... 60
Introduction ....................................................................................................................................................... 60
6.1 International Trade ................................................................................................................................. 60
6.1.1 Net Export................................................................................................................................... 60
Net Export Function ............................................................................................................... 61
6.1.2 Prices for International Transaction ............................................................................... 62
6.2 Equilibrium in the Open Economy .................................................................................................... 64
Assessment ...................................................................................................................................................................... 65
Bibliography .................................................................................................................................................................... 66
Study Session 7 67
Income Determination in the Long-Run ............................................................................................................. 67
Introduction ....................................................................................................................................................... 67
7.1 Production and Growth ......................................................................................................................... 67
7.2 Determinants of Labour Productivity.............................................................................................. 68
7.2.1 Human Capital .......................................................................................................................... 68
7.2.2 Physical Capital ........................................................................................................................ 69
7.2.3 Land and other Natural Resources .................................................................................. 69
7.2.4 Technology ................................................................................................................................. 70
7.2.5 Entrepreneurship and Management ............................................................................... 70
7.2.6 The Political and Legal Environment .............................................................................. 70
7.3 Public Policy and Economic Growth ................................................................................................ 71
7.3.1 Public Policy and Human Capital ...................................................................................... 71
7.3.2 Public Policy and Physical Capital Accumulation ...................................................... 72
7.3.3 Public Policy and Legal and Political Framework ..................................................... 72
7.3.4 Public Policy and Technological Improvement .......................................................... 73
Contents iv

Assessment ...................................................................................................................................................................... 74
Bibliography .................................................................................................................................................................... 74
References 85
About this course manual
About this course manual

Introductory Economics II ECO102 has been produced by University of
Ibadan Distance Learning Centre. All course manuals produced by
University of Ibadan Distance Learning Centre are structured in the same
way, as outlined below.
How this course manual is

structured
The course overview
The course overview gives you a general introduction to the course.
Information contained in the course overview will help you determine:
If the course is suitable for you.
What you will already need to know.
What you can expect from the course.
How much time you will need to invest to complete the course.
The overview also provides guidance on:
Study skills.
Where to get help.
Course assignments and assessments.
Activity icons.
Study Sessions.
We strongly recommend that you read the overview carefully before

starting your study.
The course content

The course is broken down into Study Sessions. Each Study Session
comprises:
An introduction to the Study Session content.
Study Session outcomes.
Core content of the Study Session with a variety of learning activities.
A Study Session summary.
Assignments and/or assessments, as applicable.
Bibliography
1
Your comments
After completing Introductory Economics II we would appreciate it if
you would take a few moments to give us your feedback on any aspect of
this course. Your feedback might include comments on:
Course content and structure.
Course reading materials and resources.
Course assignments.
Course assessments.
Course duration.
Course support (assigned tutors, technical help, etc.)
Your constructive feedback will help us to improve and enhance this
course.
2
Course Overview
Course Overview
Welcome to Introductory
Economics II ECO102
Eco 102, as an introductory macroeconomic course, addresses economic
problems on an economy-wide
economy wide level. Topics in focus include national
income, aggregate demand and supply, money and monetary policy and
international trade.
trade
Course outcomes
Upon completion of Introductory Economics II ECO102 you will be able
to:
discuss the scope of macroeconomic analysis.
point out the different components of national income and output.
highlight the basic ideas of aggregate demand and supply.
present the basic elements of money and monetary policy.
outline the rudiments of international trade through the basic
Outcomes concepts of exports and imports.
Timeframe
This is a 15 week course. It requires a formal study time of 45 hours. The
formal study
study times are scheduled around online discussions / chats with
your course facilitator / academic advisor to facilitate your learning.
Kindly see course calendar on your course website for scheduled dates.
You will still require independent/personal study time
time particularly in
How long? studying your course materials.
3
How to be successful in this

course
As an open and distance learner your approach to learning will be
different to that from your school days, where you had onsite education.
You will now choose what you want to study, you will have professional
and/or personal motivation for doing so and you will most likely be
fitting your study activities around other professional or domestic
responsibilities.
Essentially you will be taking control of your learning environment. As a

consequence, you will need to consider performance issues related to
time management, goal setting, stress management, etc. Perhaps you will
also need to reacquaint yourself in areas such as essay planning, coping
with exams and using the
the web as a learning resource.
We recommend that you take time now—before
now before starting your self-
self
study to familiarize yourself with these issues. There are a number of
study—to
excellent resources on the web. A few suggested links are:
http://www.dlc.ui.edu.ng/resources/studyskill.pdf
This is a resource of the UIDLC pilot course module. You will find
sections on building study skills, time scheduling, basic concentration
techniques, control of the study environment, note taking, how to read
techniques,
essays for analysis and memory skills (“remembering”).
http://www.ivywise.com/newsletter_march13_how_to_self_study.htm
l
This site provides how to master self-studying,
self studying, with bias to emerging
technologies.
http://www.howtostudy.org/resources.php
Another “How to study” web site with useful links to time
management, efficient reading, questioning/listening/observing skills,
getting the most out of doing (“hands-on”
(“hands on” learning), memory building,
tips for staying motivated, developing a learning plan.
The above links
links are our suggestions to start you on your way. At the time
of writing these web links were active. If you want to look for more, go to
www.google.com and type “self-study basics”, “self--study tips”, “self-
study skills” or similar phrases.
4
Course Overview
Need help?
As earlier noted, this course manual complements and supplements
ECO102 UI Mobile Class as an online course.
ECO102at
You may contact any of the following units for information, learning
Help resources and library services.
Distance Learning Centre (DLC) Head Office
University of Ibadan, Nigeria Morohundiya Complex, Ibadan-
Tel: (+234) 08077593551 – 55 Ilorin Expressway,
Expressway Idi-Ose,
(Student Support Officers) Ibadan.
Email: [email protected]
Information Centre Lagos Office

20 Awolowo Road, Bodija, Speedwriting House, No. 16
Ibadan. Ajanaku Street, Off Salvation
Bus Stop, Awuse Estate, Opebi,
Ikeja, Lagos.
For technical issues (computer problems, web access, and etcetera),

please send mail to [email protected].
Academic Support
A course facilitator is commissioned for this course. You have also been
assigned an academic advisor to provide learning support. The contacts of
your course facilitator and academic advisor for this course are available
at [email protected]
Help
Activities
This manual features “Activities,” which may present material that is
NOT extensively covered in the Study Sessions. s. When completing these
activities, you will demonstrate your understanding of basic material (by
answering questions) before
before you learn more advanced concepts.
concept You will
be provided with answers to every activity question. Therefore, your
Activities
emphasis when working
working the activities should be on understanding
understandin your
answers. It is more important that you understand why every answer is
correct.
5
Assessments
There are three basic forms of assessment in this course: in-text
in questions
(ITQs) and self assessment questions (SAQs), and tutor marked
assessment (TMAs). This manual is essentially filled with ITQs and
assessment
SAQs. Feedbacks to the ITQs are placed immediately after the questions,
Assessments while the feedbacks to SAQs are at the back of manual. You will receive
your TMAs as part of online class activities at the
the UI Mobile Class.
Feedbacks to TMAs will be provided by your tutor in not more than 2
weeks expected duration.
Schedule dates for submitting assignments and engaging in course / class
activities is available on the course website. Kindly visit your course
cours
website often for updates.
Bibliography
For those interested in learning more on this subject,, we provide you with
a list of additional resources at the end of this course manual;
manual these may
be books, articles or websites.
Reading
6
Getting around this course manual
Margin icons
While working through this course manual you will ll notice the frequent
use of margin icons. These icons serve to “signpost” a particular piece of
text, a new task or change in activity; they have been included to help you
to find your way around this course manual.
A complete icon set is shown below. We suggest that you familiarize
fam
yourself with the icons and their meaning before starting your study.
Activity Assessment Assignment Case study
Discussion Group Activity Help Outcomes
Note Reflection Reading Study skills
Summary Terminology Time Tip
8
Study Session 1 The Field of Macroeconomics
Study Session 1
The Field of Macroeconomics
Introduction
In this Study Session, you will examine the meaning of macroeconomics
as well as its subject matter. You shall be exposed to similarities and
differences between the macroeconomics and a related field,
microeconomics.
Learning Outcomes
When you have studied this session, you should be able to:
1.1 point how the importance of macroeconomics as a separate field of
study.
1.2 distinguish between microeconomics and macroeconomics.
macroe
Learning Outcomes
Terminologies
Macroeconomics The part of economics that examines large-scale
large
or general economic factors, such as interest
rates and national productivity.
Economy The wealth and resources of a country or region,

especially in terms of production and consumption
of goods and services. This of course consists of
all of the activities involved in the production
and distribution of these goods and services.
Policies A plan or course of action, by a government,

government
intended to influence and determine decisions and
actions in a bid to facilitate expediency and
achievement of long term goals.
Government An institutional framework of rule in a state, and it

consists of the legislature, executive and judiciary.
Microeconomics The part of economics that analyzes single factors

and the effects of individual decisions.
9
1.1 What is Macroeconomics?
Macroeconomics Macroeconomics is the study of the performance of the national

The part of economics economy as well as the policies that governments use to try to improve
that examines large-scale
that performance. A related field to macroeconomics is microeconomics.
While microeconomics studies the behaviour of individual decision-
or general economic
making units, households, typical business firms and the functioning of
factors, such as interest
individual industries in individual markets so as to derive useful
rates and national
conclusion on how markets work and how resources are allocated;
productivity. macroeconomics by contrast focuses on understanding the determinants
of such things as national unemployment rate, the overall price level, and
the total value of national output.
Economy The wealth
Macroeconomics, unlike microeconomics, looks at all economic units as
and resources of a
a whole; studies not household income but national income, not
country or region,
individual prices but the overall price level and how quickly or slowly it
especially in terms of is rising or falling, not the demand for labour in an industry but the total
production and employment in the economy.
consumption of goods and
services. This of course
consists of all of the
activities involved in the
production and
distribution of these
goods and services.
10
ITQ
Question
o What are the issues/problems that macroeconomics attempt to
resolve?
Feedback
• Macroeconomics as a field of economics attempts to resolve
issues or problem that relate, affect or concern the totality of
the economy as a whole, such as inflation, economic growth,
unemployment, and national income.
1.2 The Distinction between Micro and

Macroeconomics
It should be noted that there is not “water-tight” distinction between
microeconomics and macroeconomics as macroeconomics has
microeconomic foundation. First, this is because both are concerned with
the decisions of households and firms. In this regard, aggregation is
commonly used in macroeconomics to refer to ‘sums’, ‘total’, and
‘addition’. Therefore, when we speak of aggregate investment or
aggregate consumption; we mean total investment and total consumption
in the economy.
Secondly, although microeconomics and macroeconomics take different
perspectives on the economy, the basic tools of analysis are much the
same, and also macroeconomists apply the same core principles that are
used in microeconomics in their efforts to understand and predict
economic behaviour. In addition, macroeconomic behaviour is the sum of
all the microeconomic decisions made by individual households and
firms. If the movements of macroeconomic aggregates such as total
output or total employment reflect decisions made by individual firms
and households, we cannot understand the former without some
knowledge of the factors that influence the latter.
Macroeconomics is concerned mainly with four basic issues; that is, it
seeks to provide answer to the question of what is happening to:
1. Inflation or prices
2. Economic/ output growth
3. Unemployment
4. Balance of Payments
Government as policy maker would like to have low inflation, high
output growth, low unemployment and trade or external balance and uses
three kinds of policies to influence the economy. These are fiscal policy,
monetary policy and the growth or supply-side policies. Macroeconomics
deals with analysis of the outcomes of such policies on the economy.
11
While microeconomics focuses on the behaviour of individual units

(the households, the firms, the industries), macroeconomics focuses
on the aggregation of these behaviours in the economy.
Tip
ITQ
Question
o What differentiate macroeconomics from microeconomics?
Feedback
• The difference between macroeconomics and microeconomics
lies on the aspect of the economy each of them studies.
Macroeconomics examines the general or aggregate
performance of the economy, while microeconomics examines
the individual performance within thee economy,
economy i.e. individual
economic unit.
Study Session Summary

In this Study Session, you learnt that macroeconomics is the study of the
aggregate outcomes of economic behaviour. The word Macro is derived
from the Greek word makro, which means large and so we take an
economy wide perspective. Macroeconomics is not concerned with
economy-wide
Summary analysing how each individual person, household or business firm
behaves or what they produce or earn – that is the terrain of the other
major branch of economic analysis,
analysis, microeconomics. Macroeconomics
focuses on a selected few outcomes at the aggregate level and is rightly
considered to be the study of employment, output and inflation in an
international context.
Assessment
SAQ 1.1 (tests Learning Outcome 1.1)

Discuss the significance of macroeconomics as a field of economics.
economics
SAQ 1.2
1. (tests Learning Outcome 1.2)
Assessment
Make a distinction between macroeconomics and microeconomics
12
Bibliography
Read introduction to macroeconomics lecture notes by R. Kunst at
• homepage.univie.ac.at/robert.kunst/macro1.pdf
You may also study the pages at
• www.investopedia.com/terms/m/microeconomics.asp
Reading • www.whatiseconomics.org/microeconomics
13
Study Session 2
National Income: Concepts
Concepts and
Measurement
Introduction
In the previous Study Session, we noted that macroeconomics is the study
of the aggregate outcomes of economic behaviour. Macroeconomics
focuses on a selected few outcomes at the aggregate level, one of which
is national income. In this Study Session, we shall
shall examine various
concepts in National Income (NI) and the different approaches to
measuring it.
Learning Outcomes
2.1 highlight the differences
ces among various NI concepts.
2.2 measure NI.
2.3 present the problems associated with NI computation.
Learning Outcomes
2.1 Concepts of National Income

We all have an understanding of the concept of income on an individual
level and/or what our own income is. But how should we measure the
income of a whole economy? To find the nation’s income do we just add
up the incomes of the household, business, and government
government sectors? And
how does the rest-of-the-world
rest enter the picture?
National Income (NI) is a term that can be used interchangeably with
such terms as national output, national expenditure, and national
dividend. General, NI is the total value of all goods and services
produced annually in a country. It is the total amount of income earned
by a country from economic activities in a given year. It includes
payments made to all factors of production in the forms of wages,
interest, rent, and profits.
There
ere are several concepts pertaining to national income. Such concepts
include Gross Domestic Product (GDP), Gross National Income (GNP),
Net National Product (NNP), Net National Income (NNI), Disposable
Income (DI), Real Income (RI), GDP at factor cost, andan GDP at market
price and so on.
14
Study Session 2 National Income: Concepts and Measurement
Importance of National Income Analysis

1. National income data is useful for research purposes. Researchers
make use of national income data such as output, savings,
consumption, income, and employment data. They study and
analyse these data and use the trend to make appropriate policy
Reading Activity recommendations.
2. National income statistics enables us to know the distribution of
Allow 15 minutes income in a country. From wages, rents, profit data, we can see
income disparity of different sectors of the society and regard
distribution of income. It is only on the basis of these that the
government can adopt measures to remove income inequality and
restore regional equilibrium. In addition, with a view to removing
these personal and regional disequilibria, the decisions to levy more
taxes and increase public expenditure also rest on national
statistics.
3. National income data is useful for calculating a country’s per capital
income which reflects the welfare level of the country.
4. National income data is useful for planning: for economic planning,
data on a country gross income, output, saving, and consumption
from different sources are needed. Also, long-run and short-run
economic models are propounded by economists based on national
income data.
5. It tells us the aggregation of a nation’s output, income and product
resulting from the income of different individuals, product of
industries and transactions of international trade.
6. National income data form the basis of national policy, such as
employment policy
2.1.1 Gross Domestic Product (GDP)

The most frequently used measure of an economy’s output or national
income is the gross domestic product (GDP). GDP measures how much
an economy produces in a given period usually quarter of a year (3
months), half-yearly (six months), or a year. It is the market value of all
the final goods and services that are produced in a country during a given
period of time, usually in year by all factors of production located within
a country. In order to understand this definition, it is important that we
examine each of the key words in the definition. These key words are
“market value”, “final goods and services”, “produced within a country
during a given period of time.”
A. Market Value
National income/GDP is an aggregation of the market values of all the
goods and services produced in the economy in a given period. Goods
and services that are not sold in the markets such as unpaid house works
are not counted in GDP. Important exceptions to this regard are goods
and services provided by the government (they do not have market value)
which are included in GDP as the government’s cost of providing them.
B. Final Goods and Services

It should however be noted that not all goods and services that have a
market value are counted in GDP. GDP includes only those goods and
15
services that are the end product of the production process which are
called final goods and services.
Many goods are used in the production process. For example, in order for
a baker to produce a loaf of bread, grain must be planted and harvested,
the grains must thereafter be milled into fine flour, mixed with other
ingredients, and then baked into bread. Out of these three goods (grain,
flour and bread) that are produced during this process it is only bread that
is used by consumers, since the production of the bread is the ultimate
aim of the process, the bread is therefore called a final good.
It can therefore be seen that a final good or service is the end product of
the production process, or the product or service that consumers actually
use. The goods and services produced in the process of making the final
product (in our example, the grain and the flour) are called intermediate
goods and services.
Since we are only interested in measuring items that are of direct
economic value, only final goods and services are therefore included in
the calculation of GDP. Intermediate goods and services which are used
up in the production of final goods and services are not counted.
Some goods can either be intermediate or final. A special type of good

that is difficult to class as intermediate or final is a capital good.
Capital goods do not fit into the definition of final goods since their
purpose is to produce other goods. A capital good is a long-lived good
Hint which is itself produced and used in producing other goods and
services, e.g., factories, equipments and machines. Also, they are not
intermediate goods, because they are not used up during the production
process except over a very long period of time. Thus, for the purpose
of measuring GDP, economists have agreed to classify newly produced
capital goods as final goods so as to avoid double counting.
To illustrate the distinction between final goods and intermediate goods,

let us consider the following examples:
Illustration 1
Suppose that a bag of grain has a market value of
N5 (five naira, the price the milling company paid
for the grain). If the grain then is milled into flour,
which has a market value of N10.00 (the price the
baker paid for the flour). The flour is then made
into a loaf of bread worth N30.00 in the market.
In calculating the contribution of these activities
to GDP, we cannot add together all the values of
the grain, flour and bread, this is because the grain
and flour are only intermediate goods used in the production of
bread. So, the total contribution to GDP is N30.00 which is the
market value of the loaf of bread, the final product.
16
Illustration 2
A tailor charges N500.00 for each cloth that he

makes. The tailor pays her shop apprentice
N50.00 per cloth made in return for sweeping
the floor and other chores. For each clothe
sown, what is the total contribution of the
tailor and her apprentice to GDP?
Answer: The answer to this question is simply N500.00 which is the

market value of each cloth sown. This service is counted in GDP because it
is the final service, the one that actually has value to the final user. The
services the apprentice provided are intermediate services and have value
only because the services contributed to the production of the making of
the cloth; thus, they are not counted in GDP.
Illustration 3
A farmer produces N1,000 worth of cattle milk. He sold N300 worth of

milk to his friends and uses the rest of the milk to feed his livestock,
which he at the end sold to his friends for N1,500. What is the farmer’s
contribution to GDP?
Answer:
The milk the farmer produced serves as an intermediate good and part as
a final good. The N700 (N1,000 minus N300) worth of cattle milk that
was fed to the livestock is an intermediate good, thus, it is not counted as
part of GDP. Whereas, the N300 worth of cattle milk sold to his friend is
a final good. So, it is counted. Thus, final goods in the examples above
are the N300 worth of cattle milk and the N1, 500 worth of livestock that
the farmer sold to his friend. Adding N300 to N1, 500 makes N1, 800
which is the farmer’s contribution to GDP.
17
As earlier pointed out, intermediate goods are not counted in GDP to

avoid double counting. Double counting can also be avoided by counting
only the value added to a product by each firm in the production process;
the value added method would be explained later in the course of the
study.
ITQ
Question
o What are the items that constitute intermediate goods?
Feedback
• Intermediate goods are goods and services produced that are not
meant for immediate consumption, rather they are meant to
facilitate the production of other goods.
C. Production
Production within a Country during a given Period
The word ‘domestic’ used in the definition of gross domestic product tell
us that GDP is a measure of economic activities within a given country.
Therefore, only goods and services produced with the country’s borders
are counted.
• The GDP of Nigeria includes the market value of all goods and
services produced within the Nigerian borders even if they are
made in foreign-owned industries or are produced by foreigners.
Also, goods and services produced in Ghana by a Nigerian based
company like Globacom, etc. are not counted. In addition, only
goods and services produced during the current year, or the
portion of the value produced during the current year, are counted
as part of the current year’s GDP.
• Also, profits earned in Nigeria by foreign-owned companies are
counted in Nigeria’s GDP. For example, while the output of
foreigners working in Shell, Exxon, Mobil, etc are counted as
part of GDP, output produced by Nigerians abroad are not
counted.
Illustration 4
18
Suppose a 10 year old house is sold to Mr. A for N5 million and Mr. A pays
the real estate agent in charge of the sales a commission of one per cent
which is N50,000 (1/100 x N5 million).
The contribution of this economic activity to GDP is only N50, 000.
Generally, purchases and sales of existing assets such as old houses or used
cars, do not contribute to the current year’s GDP.
Since the house was not produced during the current year, its value (N5,
million) is not counted in this year’s GDP. This is so because the value of
the house has already been included in the GDP 10 years ago which was
the year the house was built. However, the N50, 000 will be included in
GDP because the N50, 000 fee paid to the real estate agent represents the
market value of the agent’s services in helping Mr. A to find and purchase
the house.
On the whole, the followings are not included in the calculation of GDP:
a. Goods and services that have no market value are not included in
GDP because it would be impossible to have a correct estimate of
their market prices. Such goods and services that have no market
value include those rendered free of charge. Examples include the
bringing up of a child by the mother, songs recited to friends by a
musician etc.
b. Intermediate goods and services are not included in GDP. This is
because many of the intermediate goods pass through a number of
production stages or processes before they are finally purchased or
consumed. If these products are now counted at every production
stage, they would be included many times in GDP leading to the
problem of double counting, and as a result, the GDP would increase
too much or be overstated. Therefore, to avoid double counting, only
the market value of the final products and not the intermediate
products should be included in GDP.
c. The transactions that do not arise from current year product or which
do not contribute in any form to production are excluded in GDP.
Thus, the sale and purchase of old goods, fairly used goods, and of
shares, bonds and assets of existing companies are all excluded in
GDP because they do not make any addition to national product, and
the goods are simply transferred.
d. Likewise, transferred payments (monies that you do not work for)
such as payments received under social security e.g., unemployment
insurance allowance, scholarship, bursary, gifts and bequests, old
age pension, and disability pension are also not included in GNP
because the recipients do not provide any service for them.
e. The profits earned or losses incurred on account of changes in
capital assets as a result of the fluctuations in market prices are not
included in GDP if and only if they are not responsible for the
current year’s production or current year’s economic activity. For
example if the price of a house increases due to inflation, the profit
earned by selling such a house will not be part of GDP, but if a
portion of the house is constructed anew during the current year, the
increase in the value of the house (after deduction of the cost of the
newly constructed portion) will be included in GDP. Similarly,
19
variations in the value of assets which can be ascertained beforehand

and that are therefore insured against uncertainties such as flood,
fire, etc, are not include
de in GDP. Note however that the depreciation
of machines, plants and other capital goods is not deducted from
GDP.
f. Income earned through illegal activities such as smuggling, drug
trafficking, children trafficking, prostitution etc are not included in
GDP.. Also, goods sold in the black market, are excluded although
they are priced (they have market value) and fulfil the needs of the
people but from the social point of view, they are not useful, and
thus, the income received from their sales and purchases is i always
not included in GDP.
There are several reasons for the exclusion of illegal activities and
black market transactions from GDP. First, it is uncertain whether or
not these products were produced during the current year or the
preceding years. Secondly, many of the products involved in
Hint smuggling are foreign made products and are smuggled into the
country; thus, are not included in GDP because they are not produced
within the border of the domestic country.
Nominal versus Real GDP

GDP of a country may rise or fall due to an increase or decrease in
prices. The rise or fall of the GDP may, however, not be real. That is,
GDP might not increase or fall in the real sense. To guide against
erring on this account, real GDP has to be calculated.
lculated. Real GDP is
calculated using the prices of goods and services that prevailed in a
base year rather than in the current year. Real GDP is nominal GDP
that has been adjusted for inflation. In other words, inflation has been
removed or taken care of in real GDP. Thus, comparisons of economic
activities at different times should be done using real GDP and not
nominal GDP because using nominal GDP to compare economic
Reflection
activities at two or more different points in time may give a misleading
answer.
Nominal GDP is the GDP measured in the current market prices of the
Nomin
goods and services. In other words, it is calculated using current year
prices. It can increase or decrease, but it does not tell us if the increase
or decrease is as a result of rise or fall in inflation or price level. It is
also called GDP at market or current prices.. On the other hand, real
GDP is called GDP at constant prices.
Real GDP is calculated using the prices of goods and services that
prevailed in a base year rather than in the current year; while Nominal
GDP is the GDP measured in the current market prices of the goods
and services.
services
Tip
20
ITQ
Question
o Examine the difference between nominal GDP and real GDP
Feedback
• Nominal GDP is the measured in terms of current market prices,
while real GDP is measured in terms of base year market prices
and not current prices.
Illustration 5
Let us assume that Nigeria produces only two commodities: beans and
cassava. The prices and quantities of these two goods in 1990 and 1991 are
presented in Table 2.1.
Table 2.1: Prices, Quantities and GDP in 1990 and 1991
Quantity of Prices of Quantity of Price of

Beans Beans (N) Cassava Cassava (N)
Year
1990 20 5 30 4
1991 40 10 60 5
A. Calculating Nominal GDP

If we calculate GDP in each of the two years as the market value of
production, then,
1990 = (20 5) + (30 4)
= 220
1999 = (40 5) + (30 4)
= 700
These values (N220 and N700) are referred to by economists as GDP valued
at current year prices or nominal GDP. If we compare GDP for 1990 with
GDP for 1991, we might conclude that the GDP in 1991 is 3.3 times greater
than 1990 GDP, that is (700 > 220).
As shown from the example, if we want to use GDP in comparing economic
activity at different point in time, there is need to exclude the effects of price
changes that is, we need to adjust for inflation.
To adjust for inflation, economists usually use a common set of prices to
value quantities produced in different years. A particular year when prices
are normal or stable is called the base year is usually selected, and the price
from that year is then used in calculating the market value of output. Thus,
real GDP is calculated using the prices from a base year; rather than the
current year’s prices.
21
B. Calculating Real GDP

Still using the data contained in Table 2.2, and assuming 1990 as the base
year, the real GDP for years 1990 and 1991 can be calculated. Here, with
real GDP, we are interested in knowing by how much real output grew
between 1990 and 1991.
Answer:
To calculate real GDP for 1991, the quantities produced in 1991 must be
valued using the prices in the base year (1990)
1991 = (1991 1990
+ ((1991 1990 )
= (40 x 5) + (60 x 4)
The real GDP for 1990 equals year 1990 quantities valued at base year
prices. Since the base year is year 1990, therefore the real GDP for 1990
equals (year 1990 quantities valued at year 1990 prices which is the same
as nominal GDP for 1990. In general, in the base year, real GDP and Nominal
GDP are the same.
Now, having known how to determine the real GDP, we can now determine
how much real production has actually grown over the two years period.
Since real GDP was 220 in 1990 and 440 in 1991, we can clearly see that the
physical volume of production doubled between 1990 and 1991. This
conclusion makes good sense as we can see in Table 2.1 that he production
of both beans and cassava exactly doubled over the two years period. In
sum, using real GDP, we have eliminated the effects of price changes and
have gotten a reasonable measure of the actual change in physical
production over the two years period.
GDP at Factor Cost

In national income accounting, it is usual to also find terms like GDP at
factor cost. GDP at factor cost is the sum of the monetary value of all
goods and services produced by the factors of production or the income
accruing to the various factors of production in one year in a country.
2.1.2 Gross National Product (GNP)

Gross national product is the market value of all goods and services
produce by all the nationals (citizens) of a given country, irrespective of
whether they reside within the domestic country or abroad. It includes the
output or income of only the citizens of country resident in the domestic
country, as well as the output or income of the citizens of a country who
are abroad. The income of citizens of a country living abroad is termed
factor income from the rest of the world. Unlike GDP, it excludes the
output from foreigners residing in the domestic country. Thus, it subtracts
the income of the foreigners living in the domestic country that is called
payments of factor income to the rest of the world.
GNP therefore takes account of three components which are: the income
or output of citizens of a country residing in the country (GDP), the
income or output of citizens residing abroad (factor income from the rest
of the world) and excludes the income or output of foreigners residing in
the domestic country (factor income to the rest of the world)
22
GNP takes account of three components which are: the income or

output of citizens of a country residing in the country (GDP), the
income or output of citizens residing abroad (factor income from the
rest of the world) and excludes the income or output of foreigners
residing in the domestic country (factor income to the rest of the
Tip
world).
Because GNP considers only the output of nationals of a country, GNP is

GDP plus receipts of factor income from the rest of the world less the
payments of factor income to the rest of the world. Where the difference
between the receipts of factor income from the rest of the world and the
payments of factor income to the rest of the world is termed net factor
income from abroad (Nf).
(Nf) GNP is therefore GDP plus net factor income
from abroad:
GNP = GDP + (Nf).
ITQ
Question
o What is the difference between GDP and GNP?
Feedback
• GDP measures the value of goods and services produced within
a particular country by their citizens and non-citizen,
non while GNP
measures goods and services produced by their citizens both
home and away over a given period of time.
2.1.3
2.1 .3 Net National Product (NNP)
It can be recalled that GNP includes the value of the total output of a
country. In the production
production of these output or goods, capital goods such as
machineries, equipments etc are used. Some of these equipments wear
out, their component are damaged or destroyed, and others become
obsolete (out of fashion) through technological improvement. All these
are
re termed depreciation or capital consumption allowance.
allowance In essence,
fixed capital is subject to depreciation.
To calculate NNP, we subtract depreciation from GNP because the word
‘net’ refers to the exclusion of the part of total output that has
depreciated. Thus, net national product is gross national product minus
depreciated.
depreciation, that is,
NNP = GNP – D
2.1.4 Domestic Income

Domestic income Domestic income is similar to GDP but is particular about income earned
The sum of all income on the output produced. Domestic income is the income earned or
earned while producing generated by all the factors of production (land, labour, capital,
goods and services within a
nation's borders during a
entrepreneurship) within a given country from its own resources.
specified period
23
In some literatures, domestic income is referred to as Gross Domestic

H int Income (GDI). The sum of all income earned while producing goods
and services within a nation's borders.
Domestic income includes: (i) wages and Salaries earned by labour; (ii)
rent, including imputed house rents earned by land; (iii) interest on
capital; (iv) dividends,; (v) undistributed corporate profits including the
surpluses of public sector undertakings; (vi) other incomes consisting of
profits of unincorporated firms, partnerships, self-employed, and (vii)
direct taxes.
Domestic income does not include the income earned abroad and so, it is
the difference between national income and net income earned from
abroad.

= – ! " !
= –
Note however that net income earned from abroad can be positive or
negative. It is positive if income earned on exports is greater than the
payment made on imports. In this case, national income will be greater
than domestic income. Whereas, if payments made on imports exceed the
receipts from exports, net income earned from abroad will be negative,
thus domestic income will be greater than national income. Note that
domestic income can also be gross or net.
2.1.5 Personal Income

This refers to an individual's total earnings from wages, investment
enterprises, and other ventures. It is the total income received by the
individuals of a country from all sources in one year before it is subjected
to direct taxes.
2.1.6 Per Capita Income / GDP Per Capita

Per capita income is defined as the ratio of a country’s income to its
population, while GDP per capita is defined as the ratio of a country’s
GDP to the population of the country. Per capita GDP or per capita
income gives the value of the average income per person in the country.
If the value is high, it shows that the standard of living of an average
person is high, and if the value is low, it indicates that the standard of
living per head is low.
./0123/4 536278
?Per capita income =
920/4 :2;<4/0123
GDP
Per capita GDP =
Total Population
2.1.7 Disposable Income

Disposable income or personal disposable income is the actual income
which an individual spent on consumption. It is the income that remains
after direct taxes have been deducted from one’s personal income. Thus,
24
Disposable Income = Personal Income – Direct Taxes.
ITQ
Question
o Personal income minus taxes (direct) is best known as?
Feedback
• It is best known as Disposable income.
2.2 Measuring GDP

There are three basic approaches to the measurement of GDP. These are:
the value-added approach, the income approach and the expenditure
approach.
2.2.1 The Value-

Value-Added Approach
The value added by any given firm equals the market value of its product
or services minus the cost of the inputs the firm purchased from other
firms.
The summing-up of the value added by all firms (including the producers
Note for both intermediate and final goods and services) gives the same answer
as simply adding together the value of all final goods and service.
The major advantage of the value added approach is that it eliminates the
problem of dividing the value of a final good or services between two
periods and thus, prevents the double counting problems.
Illustration 6
Let us now illustrate the value added method by revisiting the example of
bread making as given in illustration 1. We have already determined that
the total contribution of this production process to GDP is N30.00, which is
the value of the bread. It can be shown that we can get the same answer
(N30.00) by summing up the value added. Suppose that bread baking is the
ultimate product of these three firms (Dangote Grain Company produces
grain; Lister Flour produces flour; and Agege Bread Making Firm produces
the bread).
Given the market value of the grain, the flour and the bread, what is the
value added by each of these three companies?
Answer:
Value added for any firm is the market value of its product or service minus
the cost of inputs purchased from other firms. So, for these three firms, their
value added can be calculated thus:
Dangote Grain Company:
Dangote Grain Company produces N5.00 worth of grain using no inputs
from other companies. Since it purchased no input from other companies,
therefore, the cost of inputs purchased is zero naira. Dangote’s value added
is therefore N5.00 [which is the market value of its product less the cost of
inputs purchased]. Thus, Dangote Grain Company’s Value added = N5.00 –
N0.00, that is, N5.00.
25
Lister Flours Company:

Lister Flour purchased N5.00 worth of (input) grain from Dangote and used
it to produce N15.00 worth of flour. The value added by Lister Flours
company is thus the market value of its product (N15.00) less the cost of the
inputs it purchased (N5.00), which gives N10.00. That is, N15.00 – N5.00 =
N10.00
Agege Bread Making Firm:
Finally, Agege bread making firm buys N15.00 worth of flour from Lister
Flours and used it to produce N30.00 worth of bread. So, the value added by
Agege bread making firm is the market value of its product minus the cost of
inputs it purchased from Lister Flours Company. That is, Agege Bread
Making Firm’s Value Added = 30.00 –15.00 = N15.00. The total value added
by all the firms is 5 + 10.00 + 15.00 = N30.00
The calculations are summarized in Table 2.2.
Table 2.2: Value Added in Bread Production
Market Value Cost of Purchasing Value

Company
of Products (N) Inputs (N) Added (N)
Dangote Grain 5 0 5
Lister Flours 15 5 10
Agege Bread 30 15 5
Note that the summation of the value added by each company gives the
same answer as the method of calculation of final goods and services that is
shown in illustration 1. Thus, summing the value added by all the firms in
the economy gives the total value of final goods and services, or GDP.
2.2.2 The Income Approach

The income approach to the calculation of GDP measures GDP in terms
of who receives it as income. According to this approach, national
income is the sum of eight income items which are:
i. Compensation of Employees: this is the largest of the eight items
and includes wages and salaries paid to households by firms and by
the government, as well as the various supplements to wages and
salaries such as contributions that employers make to pension funds
and social insurance.
ii. Proprietors’ Income: this is the income of unincorporated
businesses.
iii. Rental Income: is the income received by property owners such as
houses in the form of rent.
iv. Corporate Profits: this is the income of corporations.
v. Net Interest: is the interest paid by business (note that interest paid
by households and the government is not counted in GDP because it
is not assumed to flow from the production of goods and services).
vi. Indirect Taxes minus Subsidies: this includes taxes such as sales
taxes, licence fees, custom duties etc less subsidies that the
government pays for which it receives no goods or services in return
(note that subsidies are like negative taxes). The value of indirect
26
taxes minus subsidies is therefore the net income received by the

government.
vii. Net Business Transfer Payments: these are the net transfer
payments by businesses to others and are therefore the income of
others.
viii. Surplus of Government Enterprises: this is the income from
government enterprises.
An example of the income approach is given in Table 2.3.
Table 2.3 National Income (NI) Million Naira (N’m)

National Income
Compensation of Employees xxx
+ Proprietors’ Income xxx
+ Rental Income xxx
+ Corporate Profits xxx
+ Net Interest xxx
+ Indirect Taxes minus Subsidies xxx
+ Net Business Transfer Payments xxx
+ Surplus of Government Enterprises xxx
= National Income xxxx
However, it should be noted that NI is the total income of the country but
it is not quite the GDP. The NI is GDP less net factor income from
abroad (which is equal to GNP) less depreciation (which is equal to NNP)
less statistical discrepancy. This is illustrated in Table 2.4.
Table 2.4 National Income Million Naira

GDP, GNP, NNP and National (N’m)
Income
GDP xxx
Plus: Receipts of factor income from the rest of the world xxx
Less: Payments of factor income to the rest of the world xxx
Equals: GNP xxx
Less: Depreciation xxx
Equals: Net National Product (NNP) xxx
Less: Statistical Discrepancy xxx
Equals: National Income xxxx
The NI is the income of the country’s citizens and not the income of the
residents of the country and therefore, we need to move from GDP to
GNP. After subtracting depreciation from GNP, what we get is called net
national product (NNP). The NNP and NI are the same except for a
27
statistical discrepancy (data measurement error), which may lead to

differences between the two. If the government is absolutely accurate in
its data collection, this statistical discrepancy would be zero. However,
data collection is not perfect and the statistical discrepancy is the
measurement error in each period. Therefore, NI is NNP less statistical
discrepancy.
2.2.3 The Expenditure Approach

The expenditure approach considers GDP in terms of expenses incurred
on purchases of goods and services produced by a country. The
expenditure approach sums the expenditure from the four main economic
agents in the country which are the households, the firms, the government
and the rest of the world. There are four main categories of expenditure
and these are:
i. Personal Consumption Expenditure: this includes household
spending on consumer goods, it is denoted by C.
ii. Gross Private Domestic Investment (I): this includes spending by
firms and households on new capital such as plants and machineries,
equipment, inventory, and new residential structures.
iii. Government Consumption and Government Gross investment
(G): government also makes some purchases and consumes.
Government consumption can be on current expenditure (such as the
payment of salaries) or capital expenditure (which are like
investment).
iv. Net Exports (X – M): this is the net spending by the rest of the
world, or exports minus imports.
You should study further the components of GDP.
Table 2.4 National Income Million Naira

Components of the
Expenditure Approach Personal Consumption Expenditure 50
Durable goods 20
Nondurable goods 25
Services 5
Gross Private Domestic Investment (I) 100
Non-residential 40
Residential 45
Change in business inventories 15
Government Consumption & Gross Invest 80
Federal 49
State and Local 31
Net Exports (X – M) 30
Exports (X) 50
28
Imports (M) 20
Gross Domestic Product 200
The expenditure approach calculates GDP by adding together all these

four component of spending. In equation form, GDP = C + I + G +
(X − M)
ITQ
Question
o What are the methods of measuring national income?
Feedback
• There are three (3) methods of measuring national income, these
are:
i. Output approach
ii. Income approach, and
iii. Expenditure approach
2.3 National Income Measurement Problems

There are several problems that are encountered in the computation of NI,
some of these problems are:
1. Problem of double counting: the greatest difficulty in measuring
national income is that of double counting, which arises from the
improper distinction between final and an intermediate product.
There is always the possibility of a good or a service being
included more than once.
2. There is also the difficulty of defining “nation” in national income.
Although every nation has its political boundaries, the income
earned by nationals of a country in a foreign country beyond the
territorial boundaries of that country is also included in national
income.
3. The problem of measuring non-market or domestic activities:
national income is always measured in monetary value, but there
are a number of goods and services that are difficult to measure or
assess in terms of money and are therefore excluded. Such
activities include house works, child care, driving one’s car etc.,
they are excluded in GDP, though they amount to real production.
However, if one decides to send his/her children to the day-care, or
hire a cleaner or a chauffeur to drive his/her car, GDP will increase
because the salaries of day-care staff, cleaners and chauffeurs
would be counted in GDP whereas, the time spent by individuals in
doing the same activities is not counted. Excluding all such
activities will make national income to be less than what it should
actually be.
4. Income earned through illegal activities also makes national
income to be less, because they are excluded from GDP.
29
5. Measuring national income in monetary terms leads to the

underestimation of real national income. This is because national
income measured in monetary value does not include the leisure
forgone in the process of production of a commodity. For instance,
if two individuals earn the same amount as income but if one of
them works for longer hours than the other, it would be right to
state that the real income of this individual has been understated.
6. Some public services cannot be estimated correctly. For example,
how should police and military services be estimated? In days of
war, the forces are active but during peace, they rest in their
cantonment. Also, measuring the contribution of profits earned on
certain projects such as power project and irrigation to national
income in terms of money is a difficult task.
ITQ
Question
o The most common problem associated with national income
measurement is?
Feedback
• It is the problem of double counting resulting from inability to
differentiate between intermediate goods and final goods.
30

In this Study Session, you explored various concepts that are embedded
in national income. You also learnt how to calculate national income
using value-added
value added approach, income approach, and expenditure approach.
Lastly, you examined various problems facing the computation of
Summary national income.
Assessment
Write short notes on the following:
I. Gross Domestic Product (GDP),
Assessment II. Gross National Income (GNP),
III. Net National Product (NNP),
IV. Disposable Income (DI),
V. Personal Income (PI),
VI. GDP at factor cost, and
VII. GDP at market price.
SAQ 2.2
2 (tests Learning Outcome 2.2)
What
at are the methods of measuring GDP?
SAQ 2.3
Highlight some of the inherent problems associated with GDP
measurement.
Bibliography
http://tutor2u.net/economics/revision-notes/as-macro
http://tutor2u.net/economics/revision macro-national-
income.html retrieved August, 2013.
http://www.yourarticlelibrary.com/economics/3-important
http://www.yourarticlelibrary.com/economics/3 important-methods-for-
measuring
measuring-national-income/2792/ retrieved August, 2013.
Reading
31
Study Session 3
Aggregate Demand and Aggregate Supply
Introduction
One of the most important issues in macroeconomics and to the
government is the determination of the overall price level which in turn is
determined by the interaction of aggregate demand and aggregate supply.
Thus, it is important to study the behaviour of aggregate demand
dema and
aggregate supply. This Study Session examines concepts of aggregate
demand and supply.
Learning Outcomes
3.1 outline the nature of aggregate demand curve.
3.2 outline the nature of aggregate supply curve.
3.3 describe the causes of shift in aggregate demand..
Learning Outcomes 3.4 what are the factors responsible for a shift in aggregate supply.
supply
3.1 Aggregate Demand

Aggregate demand is the total demand for goods and services in the
economy. Aggregate
Aggregate demand is usually equal to planned expenditure.
Aggregate demand is national income denoted as Y and planned
expenditure is the addition of consumption expenditure (C),
( investment
(I)) and government consumption expenditure (G).
(
K = L + +
3.1.1
3.1. 1 The Aggregate Demand Curve
The aggregate demand curve shows the relationship between short-runshort
equilibrium output , ‘Y’, (which equals planned aggregate spending) and
price level, ‘P’
‘ ’ or inflation. The relationship is a negative one, implying
that an increase in price level will lead to a decrease in aggregate output
and vice versa. The name of the curve reflects the fact that short-run
short
equilibrium output is determined by total planned spending or demand in
the economy. The relationship between the short-run
sho run equilibrium output
and price level is shown in Fig 3.1 where the overall price level is on the
vertical axis and the aggregate output is on the horizontal axis.
It could be seen that the AD curve is downward-slopping;
downward slopping; depicting a
negative relationship
relationship between output and price level (or inflation). An
increase in the price level will reduce short-run
short run equilibrium output. The
AD curve can be either straight or curving. The AD curve shows a
32
Study Session 3 Aggregate Demand and Aggregate Supply
negative relationship between a short-run equilibrium output and price

level (inflation). Economists sometimes define the AD curve as the
relationship between aggregate demand and the price level rather than
inflation.
Fig 3.1 Diagram showing

the Aggregate Demand Curve
Note that the AD curve is not the sum of all the market demand in the
economy. It is not a market demand curve. It is different from an ordinary
demand curve in the sense that the logic behind the ordinary demand
curve is that when price of a commodity changes, ceteris paribus, the
prices of all other commodities will not change. However, in the case of
aggregate demand curve this logic does not follow, because when the
general price level changes every other prices like wages (price of
labour), commodity prices and interest rates will change. Given this, the
logic that explains why a simple demand curve slopes downward fails to
explain why the AD curve also has a negative slope.
3.1.2 Reasons for the Downward Slope of the AD Curve

The relationship between price level and output can be explained by the
followings:
1. The response of the monetary authority: when inflation is high,
the monetary authority (Central Bank of Nigeria (CBN), in the case
of Nigeria) responds by raising the interest rate. The increase in
interest rate reduces consumption and investment spending
(autonomous expenditure). The reduction in consumption and
investment spending in turn reduces short-run equilibrium output.
The higher inflation which led to a reduction in output makes
aggregate demand curve to be downward slopping.
2. The effect of money supply and demand on interest rate:
aggregate demand falls when the price level increases because the
higher price level causes the demand for money (Md) to rise. With
money supply constant, the interest rate will rise to re-establish
equilibrium in the money market. It is the higher interest rate that
causes aggregate output to fall. Thus, in the end, the increase in the
price level will lead to a fall in aggregate output, which gives a
negative relationship between the two.
3. The consumption link: consumption expenditure tends to rise when
interest rate falls and fall when interest rate rises, just as planned
33
investment does. The consumption link is another reason for the

downward slopping shape of AD curve. An increase in general price
level increases the demand for money, which in turn leads to an
increase in the interest rate. A rise in interest rate causes a decrease
in consumption as well as planned investment, which consequently
leads to a decrease in output or income.
4. The real wealth effect: consumption depends on wealth (that is,
holding of money, shares, housing, stocks, etc) other things being
equal, the more wealth households we have, the more they consume.
If household wealth decreases, the result will be less consumption
now and in the future. The price level has an effect on some kinds of
wealth. For example, an increase in the price level leads to decrease
in purchasing power and lowers the real value of some types of
wealth such as stocks, housing etc. however, the effect of a rise in
general price level on wealth depends on what happens to stock
prices and housing prices when the overall price level rises. If these
two prices rise by the same percentage as the overall price level. The
real value of stocks and housing will remain unchanged and this will
lead to a decrease in consumption, which leads to a decrease in
aggregate output. Thus, there is a negative relationship between the
price level and output through this real balance effect.
5. Uncertainty: during period of inflation, aggregate demand falls
because in uncertain economic environment both households and
firms may become more cautious and reduce their spending.
6. Foreign price of domestic goods: a final link between the price
level and total spending operates through the prices of domestic
goods and services sold abroad. The foreign price of domestic goods
depends in part on the rate at which the domestic currency
exchanges for foreign currencies. However, for constant exchange
rate between currencies, a rise in domestic inflation causes the prices
of domestic goods in foreign markets to rise more quickly. As
domestic goods become relatively more expensive to prospective
foreign purchasers, export sales decline. Since net exports are part of
aggregate expenditure, so we find that increased inflation tends to
reduce spending and cause the AD curve to slope downward.
ITQ
Question
o Why is aggregate demand curve different from a market demand
curve?
Feedback
• Aggregate demand curve (AD) is not the same thing with market
demand curve because in a market demand curve, a change in
the price of that commodity, all things been equal will not affect
the price of other commodity. But for an aggregate demand
curve, an increase in the price level affects other prices like
wages (price of labour), commodity prices and interest rates will
change.
34
3.2 Aggregate Supply

Aggregate supply is the total supply of goods and services in an
economy. Although economists have little disagreement about the logic
behind the aggregate demand curve, there is a great deal of disagreement
about the logic behind the aggregate supply curve and its shape.
3.2.1 The Aggregate Supply Curve

The aggregate supply (AS) curve shows the relationship between the
aggregate quantity of output supplied by all firms in an economy and the
overall price level. The short-run aggregated supply curve usually gives a
positive relationship between aggregate supply and the overall price
level. This implies that an increase in price level will lead to an increase
in aggregate supply and vice versa.
The aggregate supply curve is not a market supply curve, and it is not the
simple sum of all the individual supply curves in the economy. One of the
reasons for this is that most firms do not simply respond to prices
determined in the market but instead, they actually set prices (it is only in
perfectly competitive markets that firms simply react to prices determined
by market forces. In contrast, firms in imperfect competitive industries
make both output and price decisions based on their perceptions of
demand and costs). Price setting firms (imperfect competitive firms) do
not have individual supply curves and this is because these firms are
choosing both output and price at the same time and if supply curves do
not exist for these imperfect markets, we certainly cannot add them
together to get an aggregate supply curve
For the reason stated above, it is helpful to think of the AS curve as a
“price-output response” curve – that is, a curve that traces out the price
and output decisions of all the markets and firms in the economy under a
given set of circumstances.
3.2.2 Aggregate Supply in the Short-

Short-Run
Although it is generally opined that the AS curve has a positive slope, the
shape of the short-run AS curve is a source of much controversy in
macroeconomics. It is often argued that at very low levels of aggregate
output (for example, when the economy is in a recession, the aggregate
supply curve is fairly flat, and at high levels of output (for example, when
the economy is experiencing a boom), the curve is vertical or nearly
vertical. Thus, we have the AS curve sloping upward and becoming
vertical when the economy reaches its capacity or maximum output. Such
a curve is shown below in Fig 3.2.
35
Fig 3.2 The Short Run

Aggregate Supply Curve
In the short run, the aggregate supply curve has a positive slope. At low
levels of aggregate output, the curve is fairly flat, but as the economy
approaches full capacity, the curve becomes nearly vertical. At full
capacity, the curve is vertical.
In Fig 3.2, aggregate output is considerably higher at point B than at point
A but the price level at point B is only slightly higher than it is at point A.
Along these points, aggregate output is low and the resulting aggregate
supply curve is fairly flat. Between points C and D, there is no increase in
aggregate output because the economy is already in full capacity (that is
utilising all its available resources and producing at its maximum level of
output), but there is a large increase in the price level. Thus, point C is the
point where the economy begins to operate at full capacity. As the
economy approaches full capacity (point C), the curve becomes nearly
vertical but between points C and D when the economy is at full capacity,
the curve becomes vertical.
3.2.3 Reasons for the Shape of the Short-

Short-Run as Curve
Several reasons accounted for the shape of the short-run AS curve. Some
of the reasons associated with the shape of the AS curve are given below:
A. The Fairly Flat Shape

At low levels of output in the economy, firms are likely to be producing
at levels of output which are below their existing capacity constraints.
That is, they are likely to be holding excess capital and labour, and it is
also likely that there will be cyclical unemployment in the economy as a
whole in periods of low output.
Suppose now that there is an increase in aggregate demand when the
economy is operating at low levels of output. The firms will respond to
this increase in aggregate demand by increasing output (much more than
they increase price) with little or no increase in the overall price level.
This is because firms are already operating below capacity, so, the extra
cost of producing more output is likely to be small. This is because firms
can hire more labour from the ranks of the unemployed workers without
much, if any, increase in wage rates. This makes the aggregate supply
curve to be fairly flat at low levels of aggregate output.
36
In Fig 3.2, if the economy is operation at a low level of output such as at

point A that is below full capacity, and then, suppose now that there is an
increase in aggregate demand from point A to B, one can see from the
curve that the movement from point A to B makes the curve to become
fairly flat as the increase in aggregate demand results in an increase in
output with a small increase in overall price level. Thus, the aggregate
supply curve is likely to be fairly flat at low levels of aggregate output.
B. The Nearly Vertical/Vertical

Vertical/Vertical Shape
If aggregate output continues to expand, the firms and the economy as a
whole will begin to move closer and closer to full capacity. Firm’s
response to the increase in aggregate output is likely to change from
mainly increasing output to increasing prices. This is so because as firms
continue to increase their output, they will begin to bump into their short-
run capacity constraint. In addition, unemployment will be falling as
firms hire more workers to produce the increased output so the economy
will be approaching its full capacity.
As aggregate output rises, the prices of labour and capital will begin to
rise more rapidly, leading firms to increase their output prices. But at full
capacity (when all sectors in the economy are fully utilising their existing
factories and equipment and factors of production, where there is little or
no cyclical unemployment) when it is virtually impossible for firms to
expand any further, firms will respond to any further increase in demand
only by raising prices, since they are unable to expand output any further.
At full capacity and with output remaining unchanged, the aggregate
supply curve becomes vertical.
In Fig 3.2, moving from points C to D results in no increase in aggregate
output but a large increase in the price level, so, the economy is at full
capacity at point C. It can be seen that a little below point C, as the
economy approaches point C or as the economy approaches full capacity,
the aggregate supply curve becomes nearly vertical but at full capacity
which is at point C, the curve assume a vertical shape.
3.2.4 The Long-

Long-Run Aggregate Supply Curve
It is interesting to know that whether or not the economy is producing at a
level of output close to full capacity, there must be a time lag between
changes in input prices and changes in output prices for the aggregate
supply curve to slope upward. Therefore, if input prices change at exactly
the same rate as output prices, the AS curve will be vertical. For example,
all output and input prices increase by 10 per cent, no firm will find it
advantageous to change its level of output because the output level that
maximized profits before the 10 per cent increase will be the same as the
level that maximizes profits after the 10 per cent increase. Thus, if input
prices adjusted immediately to output prices, the aggregate supply curve
would be vertical.
It is precisely the above that leads to an important distinction between the
AS curve in the short-run and the AS curve in the long-run. As noted
earlier, for the AS curve to be vertical, input prices must change at
exactly the same rate as output prices and for the AS curve not to be
vertical, some costs must lag behind increases in the overall price level. If
37
all prices (both input and output prices) change at the same rate, the level
of aggregate output will not change.
In the short-run (a period when at least one input varies and the others are
fixed), at least changes in some costs lag behind changes in price level.
This is because the short-run is a period too short for input price to
quickly adjust to overall macroeconomic changes. Thus, in the short-run,
wage rates (price of labour) tend to adjust slowly to overall
macroeconomic changes and the AS curve cannot be vertical. In the
short-run, the wage rate may increase at exactly the same rate as the
overall price level if increase in the price level is fully anticipated.
However, most employees do not usually receive automatic pay rises as
the overall price level rises, and sometimes, increases in the price level
are unanticipated. Therefore, in the short-run, changes in costs lag behind
price level changes, but ultimately move with the overall price level.
In the long-run, however, which is a time sufficient for adjustments to be
made such that costs and price level change at the same rate, the AS
curve is best modelled as a vertical curve. In other words, in the short-
run, if the wage rates and other costs adjust fully to changes in prices, and
if all prices (both input and output prices) change at the same rate and the
level of aggregate output does not change, thus, the long-run AS curve is
vertical. The long-run AS curve is shown in Fig 3.3.
Fig 3.3 The Long-Run

Aggregate Supply Curve
ITQ
Question
o What makes Aggregate supply (AS) vertical in the long run?
Feedback
• Aggregate Supply (AS) will be vertical in the long run, if and
only if, input prices change at exactly the same rate as output
prices.
3.3 Shifts in the Aggregate Demand Curve

The aggregate demand curve in Fig 3.1 is based on the assumption that
the government policy variables G (government), T (taxes), and Ms
38
(money supply) are fixed. If any of these variables changes, the aggregate
demand curve will shift. In a nutshell, an expansionary policy will make
the aggregate demand curve to shift to the right and a contractionary
policy will shift the curve to the left. These shifters are discussed below:
3.3.1 Changes in Monetary Authority’s Policy Reaction

Function
These can be in the form of the monetary authority choosing an
expansionary or contractionary monetary policy either through changing
money supply or through changing the interest rate.
A. Change in money supply: an increase in the quantity of money
supply in the economy at any given price level will make interest
rate to fall thereby causing planned investment spending to rise. The
increased in planned investment spending will result into an increase
in output at the given price level. Thus, an increase in the quantity of
money supplied at a given price level will shift the aggregate
demand curve to the right and vice versa.
Fig 3.4 The Effect of a

Change in Money Supply on
the AD Curve
An increase in the money supply shifts the aggregate demand curve

to the right from AD0 to AD1, leading to an increase in output at
each possible price level, while a decrease in the money
supply shifts the curve to the left from AD0 to AD2, leading to a
decrease in output at each possible price level.
B. Change in the interest rate: for a given rate of inflation,
occasionally, the monetary authority may choose an expansionary or
contractionary monetary policy. At a very high inflation which has
refused to decline, the authority might embark on a contractionary
monetary policy by setting the real interest rate higher than normal
at each rate of inflation. When the interest rate is set higher than
normal at each given rate of inflation reduces investment and
planned expenditure and the short-run equilibrium output at each
rate of inflation. This makes the AD curve to shift to the left as
shown in figure 3.5a.
39
Fig 3.5 The Effect of the

Change of Interest Rate on
the AD Curve
Likewise, if the economy is experiencing an unusual severe recession, the

monetary authority may change its policies by setting the real interest rate
to be lower than normal, at the given rate of inflation. This behaviour will
lead to decrease in investment leading to higher levels of planned
expenditure and short-run equilibrium output. This causes the AD curve
to shift to the right as shown in Fig 3.5b.
3.3.2 Change in Spending

Many factors other than output or real interest rate can affect planned
expenditure or spending and can be referred to as exogenous changes in
spending. These factors include changes in the level of government
purchases, decrease in net taxes, changes in consumer confidence that
affect consumption spending, and new technological opportunities may
lead firms to increase their planned investment etc. Since these factors
increase output at each level of inflation, an exogenous increase in
spending will shift the AD curve to the right and vice versa. These are
explained below:
i. Change in net taxes: a change in net taxes also shifts the AD curve.
A decrease in net taxes results in a rise in consumption; and since
consumption is also a part of aggregate expenditure; this makes
planned aggregate expenditure to increase, leading to an increase in
output. A decrease in net taxes therefore shifts the aggregate demand
curve to the right. A direct opposite reasoning applies to an increase
in net taxes which shifts the aggregate demand curve to the left.
ii. Change in government purchases: an increase in government
purchase at each possible price level, [although some of the increase
will be crowded (wiped out) if the money supply is held constant],
will directly increase planned aggregate expenditure since
government purchases is a component of aggregate demand. This
leads to an increase in output. The reverse is the case for a decrease
in government purchases.
iii. New technological opportunities: this can also shift the AD curve
to the right. This is so because new technological opportunities may
make firms to increase their planned investment. The increase in
planned investment which is also a component of planned aggregate
40
expenditure will lead to an increase in aggregate expenditure and

thus, output will increase. This will shift the AD curve to the right.
iv. Changes in consumers’ confidence: changes in consumers’
confidence for a set of commodities will shift the AD curve. A
significant increase in consumers’ confidence in some commodities
will lead to an increase in aggregate expenditure and aggregate
output. Thus, increase in aggregate output will shift
s the AD curve to
the right. The reverse is the case for a decrease in consumers’
confidence.
3.4 Shifts in the Aggregate Short-

Short-Run Supply Curve
3.4.1 Economic Fluctuations
Output or GDP does not usually increase over time,
time but falls or rises due
to economic
economic fluctuation. The fluctuation (increase or decrease in GDP
over time) is termed economic fluctuation or business cycle. Business
cycle is divided into period of recession (or doom) and expansion (or
boom)
boom).
1. Recession: this is a persistent fall in outputt growth over a period
of three consecutive quarters.
2. Expansion: this is a continuous rise in output.
In this Study Session, you examined the nature of aggregate demand

curve You also examined the nature of aggregate supply curve.
curve. curve Finally,
you explored the short-run and long-run
run aggregate demand and supply.
Summary
Assessment
Explain the concept of aggregate demand curve.
3.2
Assessment Discuss the meaning of aggregate supply curve.
SAQ 3.3 (tests Learning Outcome 3.3)3.3
What brings about shift in aggregate demand curve?
What factors account for a shift in aggregate supply?
41
Bibliography
https://www.khanacademy.org/economics-finance-
domain/macroeconomics/aggregate-supply-demand-topic retrieved
August, 2013.
http://www.s-cool.co.uk/a-level/economics/aggregate-demand-and-
aggregate-supply/revise-it/aggregate-demand retrieved August, 2013.
Reading
http://www.s-cool.co.uk/a-level/economics/aggregate-demand-and-
aggregate-supply/revise-it/aggregate-demand retrieved August, 2013.
42
Study Session 4 Money, Monetary Policy and Economic Activity
Study Session 4
Money, Monetary Policy and Economic
Activity
Introduction
This Study Session focuses on money and its importance in the economy.
Money plays an important role in the economy; even though the role it
plays is controversial. On one hand, money allows those who have it to
buy goods and services, which imply that the more money one has, the
greater the amount of goods and services he/she can buy. On the other
hand, the amount of money does not guarantee the volume of goods and
services to be purchased. This is because the total amount of goods and
services available for
for everyone to buy depends on the total output
produced, and not on the amount of money. To this end, it is important to
understand the concept of money, why is money necessary in the first
place? How does money evolve and what are monetary policies and how h
can the usage of each one affect economic activity.
Learning Outcomes
4.1 discuss the concept of money.
4.2 highlight the functions
unctions of money in the economy.
4.3 outline how money is supplied into the economy..
Learning Outcomes
4.1 The Meaning of Money

4.1.1 Definition of Money
Money can be defined as any item that is generally accepted as medium
of exchange in an economy. When we say a medium of exchange, we are
referring to anything that
that will be widely or generally accepted in a
community, a society or specifically a country, in exchange for goods and
services. This definition incidentally, is the primary function of money.
In a loose language, money can be defined as anything/object that th is
accepted either by law, constitution or decree, and generally recognized
by a sovereign country as a means through which goods and services can
be exchanged.
43
4.2 Functions of Money

Money performs many functions, but the most important ones are listed
below:
• Medium of exchange
• Store of value
• Unit of payment
4.2.1 Medium of Exchange

Consider a country where there were three people but no money. How
would each person get what he needs? Perhaps he will have to possess
what one of the rest needs, and at the same time that person will posses
what he needs. This was exactly the means of exchange in the olden days.
In such a system it is clear that exchange becomes cumbersome as
population increases and this may even lead to frustration! In economic
parlance, this exchange system implies that each transaction requires a
double coincidence of wants; anyone who specialized in producing one
commodity will have to spend a great deal of time searching for
satisfactory transactions. This was a serious problem.
The use of money as a medium of exchange lessens this problem. In an
economy where money serves as a means of exchange (payment), sellers
can sell/exchange their output for money, and subsequently use the
money to buy whatever they wish from others. Also, buyers can
purchase/exchange what they want and enjoy the worth of their money.
The implication of monetised economy is that it requires exchange of
goods and services for money and of money for goods, but not goods for
goods as in the case of barter economy.
UES ITQ
Question
o What was the main problem associated with barter system?
Feedback
• Barter system is mostly associated with the problem of double
coincidence of wants.
4.2.2 Store of Value

Assuming that there is no money, it means payment has to be made
through barter system. When paying with simple commodities, the value
of the good one has received may change without any external influence.
In the money economy, the value of money will not change unless prices
change. Therefore, money, apart from being a means of exchange, is also
a store of value. It guarantees that other things being equal; the value of
what is received now will be the same until the time of exchanging it for
a desirable good or service.
44
4.2.3 Unit of Account/Unit of payment

The use of money as unit of payment means that it is a means of
counting. When we look at a shoe and a flower we can say that six
flowers can be exchanged for one shoe. When there is another
commodity, say, a toothbrush, we can count all goods in terms of one of
the goods, say flowers. Hence, three toothbrushes can be exchanged for
one shoe. You can imagine how difficult it all becomes when we have
many goods. Using money as a numeraire (means of counting) provides
a way of circumventing such problems. It means that we measure all
goods in terms of money units. By implication, we assume that money in
itself is not a good like, say flowers, which are desirable in themselves.
In a nutshell, money as a unit of account allows us to compare the prices
of different goods, and attach monetary value to the goods.
4.3 Money and the Banking System

4.3.1 The Banking System
The banking system consists of commercial banks, merchant banks,
development banks, and community banks. However, commercial banks
form the largest component of banking system in any economy, and there
are 25 of them in Nigeria. Commercial banks are business organisations
owned by private individuals. Commercial banks accept deposit from
individuals, businesses and government and use those deposits to make
loans. That is, commercial banks are financial intermediaries, by
extending credit to borrowers with the fund raised from savers.
Banks on one hand help savers by eliminating their need to gather
information about potential borrowers and by directing their savings
toward high return and more productive investments. On the other hand,
they help borrowers by providing access to credit that might otherwise
not be available.
Another important function that the banks perform is making payments
by depositors easier. Most banks deposits allow the holder to write a
cheque against them or draw on them using withdrawal forms or ATM
cards.
ITQ
Question
o How do commercial banks perform the role of financial
intermediaries?
Feedback
• Commercial banks perform the role of financial intermediaries
by allocating money from the surplus consumption units to the
deficit consumption unit.
45
ECO102 Introductory
ry Economics II
4.3.2 Money Supply and Control

In any economy,
economy the Central Bank is the apex bank and it represents the
monetary authority. The Central Bank regulates the activities of other
banks and financial institutions in the economy. Central Bank is
responsible for supplying money into the economy. The money supplysup
effort of the Central Bank is usually complemented by creation of money
by commercial banks.
Banks and Creation of Money

If the economy’s supply of money consists of entirely of currency, then
money supply is the value of currency created and circulated
circulat by the
government. However, cheques give the banks permission to transfer
cash from the account of the person paying by cheque to the account of
the person to whom the cheque is issued. With a system of payments
based on checks, the cash never leave the banking system, although they
flow from one bank to another as a depositor of one bank makes a
payment to a depositor in another bank.
The assets of commercial banking system are the cash in the vaults of all
individual banks, the habitation are the deposits
deposits of the banks’ customers.
Cash or similar assets held by banks are called bank reserves. If all banks
reserve of 100% of bank their deposits this is called 100 percent reserve
banking. Banking reserves are not counted as part of the money supply,
bank deposit
deposit balances, which can be used in making transactions, are
counted as part of money supply. It is possible that not all bank deposits
are treated as bank reserve. That is, it is only a proportion of the deposit
that makes up bank reserve. This is called
calle reserve-deposit
deposit ratio and it is
calculated thus
Bank reserve
reserve
Reserve I deposit ratio
Deposits
From the above, bank deposits can be solved for. To do so, cross multiply
the above equation and divide through by reserve-deposit
reserve ratio. This
yields the following
followin
Bank reserves
Bank deposits
Desired reserve I Deposit ratio
Deposit
Let deposits be 1,000,000, while reserve-deposit
reserve deposit ratio desired by banks be
0.10 (10% of total deposit). Then, bank deposit can be calculated thus:

1,000,000
Bank deposit 10,000
000,000
0.1
It is clear from the above that the higher the reserve-deposit

reserve ratio, the
smaller the bank deposit. Conversely, the smaller the reserve-deposit
reserve
ratio the larger the bank deposits.
Tip
46
ITQ
Question
o What determines the extent to which commercial banks can
create money within an economy?
Feedback
• The extent to which commercial banks can create money in an
economy depends on the value of reserve-deposit ratio.
4.3.3 Money Supply

Supply with Currency and Deposit
In most cases, citizens keep part of their money hidings in form of bank
accounts and hold the rest in the form of cash. Let us assume that 500,000
is held as cash while 500,000 is deposited. Then bank deposit is now
500,000
= 5,000,000
0.1
The money supply is the sum of currency in the hands of the public
(currency in circulation) and bank deposits. Since bank deposit is
5,000,000 and currency in circulations 5,000,000, money supply is
5,000,000 + 500,000 = 5,500,000
Hence, the general relationship that captures money supply with currency
and deposits can be conceptualized. First we can write out the fact that
the money supply equals currency plus bank deposits.
Money supply = currency in circulation + Bank deposits
Currency in circulation + Bank reserves

Money supply =
Desired − Deposits ratio
4.3.4 Monetary Policy and its Instruments

The apex bank of a country has the primary responsibility of making
monetary policy. Monetary policy involves decisions about the
appropriate size of the nation’s money supply. In the case of Nigeria,
central Bank of Nigeria (CBN) is the only bank that makes monetary
policy.
There are three monetary policy instruments that can be used to control
money supply. These are reserve requirements, discount ratio and open
market operations (OMO).
Reserve Requirements
Recall that the economy’s money supply depends on three factors: the
amount of currency held by the public, the supply of bank reserves and
the reserve-deposit ratio. Also, note that increase in reserve-deposit ratio
reduces bank deposit and hence, money supply. A higher reserve-deposit
ratio implies that banks lend out a smaller share of their deposits in a
particular period, thereby limiting the overall expansion of loans and
deposits.
47
Commercial banks are free to set the reserve-deposit ratio they desire to
maintain. However, CBN has the statutory authority to set minimum
values of the reserve-deposit ratio for commercial banks. Reserve
requirement is the minimum values of the ratio of bank reserves to bank
deposits that commercial banks are allowed to maintain. This reserves
requirement is set by the CBN.
Discount Window
The second instrument used by the central bank to control reserves and
the money supply is the use of discount window. In some cases,
individual commercial banks can be short of reserves from the central
bank. Lending of reserves by the Central Bank to commercial banks is
referred to as discount window lending. When the Central Bank lends out
to any commercial banks, it charges interest. The interest rate charged is
called the discount rate. When the central bank lends out from it reserves
to commercial banks reserve, this will ultimately increase bank deposits
and hence money supply.
Central Bank can control money supply by charging the discount rate.
For instance, if the central bank intends to increase money supply, it can
reduce discount rate so that commercial banks find it easy to borrow
money from actual bank reserve. Conversely, Central Bank decreases
money supply by raising discount rate.
Note that this instrument is also an indirect way of controlling money
supply in the sense that a change in discount rate will lead to a change in
bank deposit and hence, money supply. That is:
Discount rate bank deposit money supply
Open Market Operation (OMO)

Open market operation (OMO) is an important monetary instrument used
by the central bank to control money supply. Assuming that the Central
Bank wants to raise money supply, using OMO, the process goes thus;
the Central Bank buys financial assets, that is, government bond from the
public. To simplify things, let us assume that the central bank pays for the
purchases with newly printed money. If the public who own the financial
instrument already holds the currency, it will deposit the cash they
receive in commercial banks. This increases the reserves of commercial
banks by the amount equal to the value of the bonds purchased by the
Central Bank. The increase in bank reserves will lead in turn, through the
process of lending and redeposit discussed earlier to an expansion of bank
deposits and the money supply.
Conversely, if the Central Bank wants to reduce money supply, it will sell
financial assets to the public, receives money equal to the value of the
bond sold. This payment will be made by withdrawing money from
commercial banks. This will lead to decrease in money supply. The
Central Banks’ sale (purchase) of government bonds from the public,
with the result that bank reserves and the money supply are decreased
(increased) is called an Open Market Operations. The sale of instrument
is called Open Market Sale, while the purchase of instrument is called
Open Market Purchase. It turns out that OMO appears to be the
48
commercial and flexible tool that the Central Bank has for affecting the
money supply.
ITQ
Question
o What are the commonest monetary policy instruments used by
the Central bank to regulate the volume of money in an
economy?
Feedback
• The three commonest policy instruments employed by the apex
bank to regulate the amount of money in circulation are:
i. Open market operation (OMO)
ii. Discount rate, and
iii. Reserve ratio or Liquidity ratio

In the course of this Study Session, you examined the concept and
functions of money. You also learnt how money is supp
supplied into the
economy
economy.
Summary
49
Assessment
SAQ 4.1 (tests
( Learning Outcome 4.1)
Define the term “money”.
SAQ 4.2 (tests
Assessment What are the functions performed by money in an economy?
SAQ 4.3 (tests
Discuss the processes by which money is made available in an economy
Bibliography
http://economicsandliberty.wordpress.com/what-is-money/
http://economicsandliberty.wordpress.com/what money/ retrieved
August, 2013.
http://www.preservearticles.com/201104115268/4-essential
http://www.preservearticles.com/201104115268/4 essential-functions-of-
Reading money.html retrieved August, 2013.
50
Study Session 5 Government and the Economy
Study Session 5
Government and the Economy
Introduction
Government affects economic activities through its spending and revenue
decisions. In this Study Session, we will examine various classes of
government spending and the reason for such spending. We will assume
that government is not a producing agent, and thus, it is important to
examine how government finance its spending outlay. We willwil examine
the various sources of government revenue. It will also be important to
examine what happens when government spending is higher than
government revenue. The Study Session will end by looking at various
fiscal policy instruments that government can
can use to control economic
activity.
Learning Outcomes
5.1 identify the different
nt forms of government spending.
5.2 discuss how government
vernment revenues are generated.
5.3 explain the term “budget”
Learning Outcomes 5.4 describe how government revenue and expenditure activities affect
aggregate demand.
5.1 Government Spending

Government spending is the spending activities carried out by the
government of a country. There are essential services that government
provides. These include national defence, provision of education, health,
public roads, policing, internal and external securities, and possibly
provision of social security’s – unemployment benefits, pension schemes
and so on. These set of government spending can be categorized into two
viz:
5.1.1 Government Consumption Expenditure on Goods

and Services
This takes the form of the expenditure on public health, public education,
street light, public roads, and purchases of material for public office use,
purchase of labour services and so on.
51
5.1.2 Transfer Payment

Transfer payments are government expenditure that is not made in return
for currently produced goods and services. If government makes a
payment to old-age pensioners, or pays pensioners’ gratuity, the
government is not purchasing any currently produced goods or services
from the retired people. The payment itself adds neither to employment
nor to total output. Other examples of transfer include unemployment
benefit, student grants, and interest paid on the national debt.
Government spending is spelt out in the budget, and so it is assumed to be
predetermined. This means that government expenditure/spending is
autonomous.
ITQ
Question
o Government expenditures can be categorised into how many
groups?
Feedback
• Government expenditure can be categorized into three main
groups, these are:
i. Current expenditure (Government Consumption Spending
Expenditure)
ii. Capital expenditure, and
iii. Transfer payments
5.2 Government Revenue

How does the government finance its predetermined expenditure? Of
course from the revenue it can generate. The sources of government
revenue are:
a. Sales of government bonds or treasury bills.
b. Borrowing from the rest of the world.
c. Taxes.
Government can source for fund through the sale of government
securities called Treasury Bills (T-bill). Government sells the treasury
bills to the private individuals who have more than enough money to
hold. Thus, they buy government security and pay with cash.
Government can also decide to raise fund by borrowing from
international institutions like African Development Bank (AfDB),
International Monetary Fund (IMF), World Bank (WB) and so on.
Finally, government can generate revenue by imposing taxes. Taxes can
be indirect or direct. Indirect taxes are taxes that do not depend on level
of income. Such taxes include tariff, poll tax, sales tax and value added
tax,. This type of tax can also be called lump-sum tax.
Direct taxes are taxes levied on the level of income. There are three of
such. These are proportional tax, progressive tax and regressive tax..
52
Proportional tax is a flat rate of tax which is paid by every worker. It is a

share of one’s income that must be set aside as tax. The higher one’s
income, the greater the tax paid. We can write proportional tax as
follows:
W (K)
where the LHS implicitly describes tax as a function of income. The RHS
say that tax (t) takes a proportion of income Y. Thus, increase in income
will increase the amount of T(Y).
Progressive tax on the other hand is a system where the rate of tax itself
depends on the income earned. In this case, rate of tax is no more the
same across income category. In fact, the higher the income, the higher
the tax rate. Discussion about the appropriate tax to adopt is beyond the
scope of this study. However, it is useful to have this basic understanding
of what distinguishes them.
In terms of modelling the economy, knowing the position of the tax
function in the demand for consumption should allow a straight forward
incorporation of any form of tax functions. In the case of Nigeria, it is
reasonable to incorporate both lump – sum tax and proportional tax in the
tax function because government generates revenue both from lump –
sum tax and proportional tax.
ITQ
Question
o What are the sources of government revenue?
Feedback
• Sources of government revenue include:
i. Taxation
ii. Borrowing, and
iii. Selling of bonds and bills
5.3 The Budget Balance

Budget is a document that explicitly describe the spending decision of
the government vis-à-vis the projected revenue and the source. Budget
balance is the difference between total government expenditure, that is,
taxes minus government expenditure. If government expenditure is
denoted by G and government revenue by T, then budget balance can be
written as:
W or W– = 0
In most cases, revenue may be greater than expenditure, in which case the
government is running budget surplus. If government owes some debts, it
can reduce the debt by the surplus. In another case, expenditure may be
greater than revenue. This implies that government intends to spend more
than it can generate revenue. The case where the government expenditure
is greater than revenue is a case of budget deficit. This implies that the
53
government must add to the national debt, since it must borrow to cover
its deficit (with sale of government bonds discussed earlier)
5.3.1 Revenue and Expenditure functions

Government expenditure is treated asas autonomous because it is assumed
that government has decided on how much it wishes to spend and hold to
these plans whatever the level of income (GDP). Tax rate, in some sense,
is also autonomous because government sets its tax rates and does not
vary them
them as GDP varies. Thus, tax revenue is endogenous: as GDP rises,
with given tax rates, the tax revenue will rise. The other part of tax
function is purely exogenous. The Table 1 below indicates that
government ran budget deficit in the first two rounds of income after
which it began to run budget surplus.
Table 5.1 Tax Revenue, GDP (Y)

( Government Net Taxes Budget Balance
Government Expenditure Expenditure
T = 10 + 0.1 Y (T-G)
and Budget Balance
2000 500 210 -200
4000 500 410 -90
9500 500 960 460
10000 500 1010 510
15000 500 1510 1010
20000 500 2010 1510
How does government expenditure and tax revenue affect economic

activity?
Reflection
ITQ
Question
o When does government runs a balanced budget?
Feedback
• A balanced budget implies a situation when government
proposed expenditure is equal to its expected revenue.
5.4 Fiscal Policy and Aggregate Demand

Keynesian economic model opines that recession occurs as a result of low
spending brought about by low income. Hence, to fight recession that is
caused by low demand, government should find ways of reducing or even
eliminating this recession. Policies that are used to affect aggregate
demand with the objective of eliminating output gaps are called
stabilization policies.
54
There are two types of stabilization policies: monetary policies and

fiscal policies. Monetary policy has been dealt with earlier (Study
Sessions Three and Four). Fiscal policies refer to decisions about the
government’s budget. The fiscal policy instruments used by the
government to stabilize the economy are government expenditure policy
and government tax policy.
Keynes argued that changes in government spending were probably the
most effective instrument for offsetting recession. According to him,
government purchases of goods and services are a component of
aggregate demand, so aggregate demand is directly affected by changes
in government purchases. In a case of output gap (recession or
depression) where there is too much AD or too little AD, the government
can be helpful in reducing or filling the gap. For simplicity, let us assume
that aggregate demand (AD) function is given by
" L+ +
Where C, I, G are planned private consumption, planned private
investment and planned government expenditure. Let G = 300, T = 250.
Also let C = 620 + 0.8Yd, I = 250, where Yd is after-tax disposable
income. This implies that Yd = (Y-T). Substituting all these information
into AD function we have
" 620 + 0.8K [ 250 + 300
But K [ = K − W
Therefore,
AD = [620 + 0.8 (Y – 250)] + 220 + 300
= 620 + 0.8Y – 200 + 220 + 300
AD = 940+ 0.8Y
This is what is called Aggregate Demand function.
According to the short-run equilibrium output, AD = Y
Thus we have
Y = 940 + 0.8Y
Y – 0.8Y = 940
Y (1- 0.8) = 940
0.2Y = 940
Y = 940/0.2 = 4700
What this implies is that for the economy to be at equilibrium, planned
aggregate expenditure must equal to aggregate output/income. The
equilibrium output can be graphically plotted as follows:
55
Fig 5.1
To appreciate the importance of government spending, assuming that

private consumption dropped by 10 units. So the new specification
becomes
" L+ +
I = 220, T = 250, C = 610 + 0.8, G = 300
Substitute for each of the four components into the AD function
AD = 610 + [0.8 (Y – 250)] + 220 + 300
= 610 + 0.8Y – 200 + 220 + 300
= 830 + 0.8Y
since AD = Y, then we have
Y = 830 + 0.8Y
Simplifying this, we have
Y = 830/0.2 = 4150
Fig 5.2
Due to consumer willingness to reduce consumption by 10 units,

equilibrium AD fell by 550. We conclude that the fall in consumer
spending has led to a recession. This is shown graphically above. Now let
government intervene by increasing its expenditure by 10 units, so that G
= 310.
As before the first step is to write the relationship between aggregate
demand AD and output Y.
" L+ +
trailing the steps given earlier,
56
AD = 610 + (0.8 (Y – 250)) + 220 + 310

= 940 + 0.8Y
since AD = Y
then Y = 4700
This value is the same for the assumed potential output. Thus, in this
simple example, the increase in government purchases eliminates the
necessary output gap. This simple example shows that through changes in
government expenditure, which is one of the fiscal policy instruments of
government, output gap can be affected.
Through its policy, government also determines the level of tax
collections and transfer payments. From the Keynesian’s point of view,
changes in the level of taxes or transfer can be used to affect aggregate
demand and thus to reduce or eliminate output gap. Meanwhile, the effect
of tax policy on aggregate demand is indirect. Changes in taxes affect
aggregate demand by first of all changing private disposable income. For
instance, a reduction in tax or an increase in transfer payments will
increase disposable income. What this turns out to mean is that more
money is available for consumption by the private sector. It thus appears
that changes in taxes and transfer will affect aggregate output to the
extent that consumers/private sector change the level of spending.
Let us continue to use our earlier example to demonstrate how tax cut or
increase in transfer payment can be used to reduce or eliminate output
gap. Assume that government decides not to increase expenditure to close
the gap created by the reduction in private consumption of 10 units.
Suppose that fiscal policymakers decide to restore potential AD by
changing the level of tax collections. Note that reducing tax by 10 units
cannot fully eliminate the gap as it does for government expenditure. This
is so because if tax is reduced by 10 units, only 8 units will be spent,
since marginal propensity to consume (MPC) is 0.8. So consumption
spending increases by only 0.8 times the amount of the tax cut. To
eliminate the output gap completely, tax has to be reduced by 12.5 units
so that the new tax revenue is 237.5. How? To get the value, we divide 10
(the unit by which aggregate demand is reduced) by 0.8 (the MPC). The
answer you get (12.5) is the amount by which tax must be reduced. We
can then write out our new consumption function as follows
C = 610 + 0.8 (Y – 237.5)
Using the values for I and G, AD function becomes
AD = [610 + 0.8 (Y – 237.5)] + 220 + 300
AD = 940 + 0.8Y
At equilibrium, AD =Y
Hence Y = 960 + 0.8Y
Simplifying, Y = 4700
which give the potential output, we therefore conclude that a tax cut of
12.5 will eliminate the necessary gap and restore full employment in this
example.
57
Thus far, we have demonstrated that fiscal policy affects economic

activity. When the economy is in recession, government fiscal policy can
be used to help the economy out of recession. Conversely, if the economy
is perceived to be very strong, when aggregate demand appears to be
greater than full employment output, fiscal policy can be used to reverse
the situation.
However, it must be noted that practically, this does not produce
immediate result as demonstrated in our example. One significant reason
for this is that in true life situation, changes in fiscal policy go through
lengthy legislative process. What must be understood here is that fiscal
policymakers can use any of the instruments discussed to change
economic activities.
ITQ
Question
o What are the major tools of stabilization policy?
Feedback
• The major tools of stabilization policy are:
- the monetary policy and
- fiscal policy.
58
Study Session 5 Government and
an the Economy

In this short Study Session, we highlighted different
nt forms of government
spending. We also discussed how government
vernment revenues are generated,
and how government revenue and expenditure activities affect aggregate
demand
demand.
Summary
Assessment
SAQ 5.1
Discuss the various forms of government spending.
spending
SAQ 5.2
5 (Tests Learning Outcome 5.2)
Assessment
What are the sources of government revenue?
SAQ 5.3
5 (Tests Learning Outcome 5.3)
How will you explain
e the term “budget”?
SAQ
AQ 5.3 (Tests Learning Outcome 5.4)
In what way do government revenue and expenditure activities affect
aggregate demand?
demand
Bibliography
http://www.wisegeek.org/what-is-government-revenue.htm
http://www.wisegeek.org/what revenue.htm retrieved
August, 2013.
http://www.medwelljournals.com/fulltext/?doi=ibm.2009.54.60
http://www.medwelljournals.com/fulltext/?doi=ibm.2009.54.60 retrieved
Reading August, 2013.
http://www.revenuewatch.org/countries/africa/nigeria/overview retrieved
August, 2013
59
Study Session 6
Open Economy Transaction
Transaction
Introduction
Up to this moment, nothing has been said about the transaction that exists
between countries. This was deliberate in order to enable you grasp the
basic mechanics of output determination analysis. In this Study Session,
we will relax the assumption of no foreign trade, and examine its
implication on national output determination.
Learning Outcomes
6.1 discuss what international trade stands for.
6.2 explain how an economy attains equilibrium in an open economy.
Learning Outcomes
6.1 International Trade

There are two ways by which international transactions take place. These
are through export and imports. Sales of domestic goods to the rest of the
world (or outflow of goods to the rest of the world) are called exports,
while the purchase of foreign goods
goods (or inflow of goods and services
from the rest of the world) is called imports.
There are series of theories propounded for the justification of engaging
in international transactions. These include theories like comparative
advantage, new world trade theory
theory and so on. The analysis of each of
these theories is beyond the scope of this course. Therefore, we will take
it as given that each country knows why and what to export and import,
and from where.
6.1.1 Net Export

Export and import activities of a country are recorded in a book called
current accounts.
accounts. A country’s current accounts is said to be balanced
when the value of its purchases of foreign goods and services is equal to
the value of goods and services sold to foreign countries, that is, when
exports
xports equals imports. When export is greater than imports, we say the
country has current account surplus. Conversely, when export is less than
imports, we say the country has current account deficit. The difference
between export and import demand is called net export.
export We can then
extend the aggregate demand to include net export component as follows:
60
Study Session 6 Open Economy Transaction
AD = C + I + G + (X-M)
The term in the bracket gives the value of net export demand.
ITQ
Question
o What are the components of international trade?
Feedback
• There are two components of international trade, these are:
are
i. import, and
ii. export.
When an economy is running current account deficit (that is, when net
export is negative), the value of aggregate demand will fall. If the
economy is running current account surplus, a situation where net export
is positive, the value of aggregate demand will rise. It then follows that
any factor that affects net export will automatically affect aggregate
Tip demand. If this is the case, then it is important to examine e the
determinants of net export.
Net Export Function

Exports depend on spending decisions made by foreign consumers or
overseas firms that purchase domestic goods and services. The spending
decisions are guided by the level of income, price level, taste and fashion
of the foreign consumers. We will therefore assume that exports are
determined by factors outside the control of the home economy. This
allows us to treat it as an exogenous variable.
Imports on one hand depend on the spending decisions
de of domestic
consumers and on the other hand domestic firms using foreign raw
materials, capital goods and intermediate goods. The latter is treated to
be exogenous because in most cases firms know the amount of
intermediate goods or capital goods they will need for their production.
In fact, we can say that this set of goods is basic for production to take
place. We will then assume that this aspect of import is also exogenous.
Another aspect of import demand is the one that changes as income
changes.
nges. When income rises, this aspect of import demand rises as well
and when income falls, it falls. Therefore, we have two components of
import demand, the one that is fixed, and the one that varies with income.
Because export is exogenous while a part of import is an increasing
function of income, net exports are negatively related to national
income/national output. Let X0 represent planned export demand, Mo
represents imported basic investment good, while M1 represents an aspect
of import that changes with income, that is, marginal propensity to
import. Finally let M represent total import demand so that M equals M0
plus M1Y, where Y is national income. Therefore, net export function can
be written algebraically
algebrai as follows:
61
X0 – M
X0 – (M0 + M1Y)
X0 – M0 – M1Y
Consider a set of income level say Y = 1000, 1500, 2000, 2500, and 3000.
Let planned export demand equals 800 and let marginal propensity to
import equals 0.2. Finally, let exogenous import equals 250. We can
construct net export table as follows:
Table 6.1 Net Export GDP (Y) Export M0 = M1 = M= Net

Schedule (X0) 250 0.2Y M0 + M1 Export
1000 800 250 200 450 350
1500 800 250 300 550 250
2000 800 250 400 650 150
2500 800 250 500 750 50
3000 800 250 600 850 -50
The table shows that export demand was higher than import demand (net
export being positive) up to the point when income was 2500. If we
graph import function, you will find out that import is an increasing
function of income. As income rises, import demand also rises. Lastly,
note that as income is increasing, with fixed export demand, net export is
falling. This implies that net export is inversely related to income.
ITQ
Question
o Why is import and export treated as exogenous?
Feedback
• Both import and export are treated as exogenous because they
are both determined by factors outside the control of the home
economy.
6.1.2 Prices for International Transaction

Exports and imports are both affected by international prices. When
imported goods and services are purchased from abroad, though we pay
in local currency in the local market, importers actually purchase those
imported goods with the currency of the foreign country from which such
goods are purchased.
For simplicity, let us assume that a unit of good worth $2 is to be
imported to Nigeria from the United States. Importer will need to pay the
US producers in dollars before such goods could be purchased. This
means that some naira has to be exchanged for dollars. The rate at which
the naira is exchanged for the dollar is called exchange rate. In
62
particular, exchange rate is the quantity of domestic currency that can be

exchanged for a unit of foreign currency in order to allow international
transactions to take place. Let the unit price of Nigeria currency be N
(naira), while that of the US is $, then exchange rate of naira to dollar will
be:
ER = naira/dollar or N /$
To compute the amount of naira needed when we want to buy $10 worth
of US products given that ER is N50, we proceed thus:
ER = naira/dollar
50 = N /10 = 50 x 10
After simplifying, we see that the amount of naira needed is N500.00.
Let us assume that exchange rate now falls to 25, and then the amount
needed to purchase a $10 US product is N250.00.
What this implies is that as exchange rate falls, import demand becomes
cheaper and as it rises, import demand becomes more expensive. A fall in
exchange rate (when domestic currency falls relative to foreign currency)
is called exchange rate appreciation. A rise in exchange rate (when
domestic currency rises relative to foreign currency), is called exchange
rate depreciation.
What is the implication of exchange rate on export demand? Consider a
US consumer that intends to buy Nigeria products worth N1000.00, how
much dollars does he need for the transaction? Given that exchange rate
is 50, we proceed thus:
50 = 1000/$
$ = 1000/50 = $20.
This means that the consumer needs $20. Now let the exchange rate be
25
25 = 1000/$ = $40
That is, the foreign consumer need $40 (an extra $20) to purchase the
same basket of good. What this implies is that all other things being
equal, appreciation of domestic currency relative to foreign currency
makes export expensive and makes import cheaper. Conversely, if other
things remain the same, depreciation makes export cheaper and makes
import expensive. Hence, any factor that changes exchange rate will
cause net export to change. If exchange rate appreciates, export falls,
import rises and net export function shifts downwards and to the left,
such that aggregate demand falls. If exchange rate depreciates, export
rises, import falls and net export function shifts upwards and to the right
such that aggregate demand rises.
Another factor that can affect trade flows is the changes in domestic price
level relative to foreign price level. Consider first a rise in domestic
price. On the one hand, foreigners will now see domestic-produced
goods as more expensive relative to both goods produced in their country
and to goods imported from other countries. On the other hand, domestic
residents will see imports from foreign countries become cheaper relative
to the prices of home-produced goods. As a result, they will buy more
63
foreign goods, and imports will rise. Both of these responses will cause
the net export function to shift downwards. As it shifts downward,
aggregate demand falls. Thus, increase in domestic price will cause net
export to fall.
Consider a situation whereby domestic price level falls relative to foreign
price level. Domestic good exported will look cheaper in foreign country
relatively to home-produced goods, and to goods imported from say other
countries. As a result, home country exports will rise. On the other hand,
the same change in relative prices – home-made goods become cheaper
relative to foreign-made goods – will cause domestic country’s import to
fall. Thus, the net export function will shift upwards in exactly the
opposite way to the previous situation.
Thus far, we have established the fact that changes in foreign GDP,
changes in exchange rate, and international differences in inflation rates
cause net export function to shift. What is the implication of these factors
on the equilibrium aggregate output/aggregate income? This is the
question we provide answer to in the next section.
ITQ
Question
o What does the word “exchange rate” connotes?
Feedback
• Exchange rate is the rate at which a country’s currency is
exchanged for another country’s currency.
6.2 Equilibrium in the Open Economy

The aggregate demand will now include net export (X-M) component.
However, equilibrium output is still the level of output at which desired
aggregate demand equals national output/income.
To establish equilibrium in an open economy, let us rewrite our aggregate
demand function and incorporate net export component. To put the
matter very simple, let us assume that planned aggregate demand is given
by:
AD = C + I + G + NX
Let C = 610 + 0.8Y; I = 220; and G = 300; NX = 10 and T = 250
Note that planned private consumption has fallen by 10-unit but this has
been taken care of by NX which is 10. Equilibrium output can be
achieved as follows:
AD = 610 + 0.8 (Y – 250) + 220 + 300 + 10
= 610 + 0.8Y – 200 + 220 + 300 + 10
= 940 + 0.8Y
at equilibrium, AD = Y
64
hence, Y = 940/0.2 = 4700.

This implies that the equilibrium has been restored but in this case
through net export surplus.
From this simple example above, it is clear that positive net export
(current account surplus) can be used to recover the economy from
(current
recession, while negative net export (current account deficit) can also
plunge the economy into recession. In particular, exchange rate policy,
domestic inflation and foreign inflation have implication
implica on the output
performance of the domestic economy. A rise in domestic inflation can
plunge the economy into recession through a fall in net export. While a
fall in domestic inflation will help economy recover from recession
through increase in net export.
export. Specifically, this analysis implies that an
economy that is in recession can recover by reducing import demand and
increasing export supply which can be achieved through exchange rate
manipulation or reduction in domestic price level.
ITQ
Question
o Under what condition will an economy be at equilibrium?
Feedback
• An economy, either closed or open will be at equilibrium when
its desired aggregate demand equals national output/income.

In this Study Session, we discussed the meaning of international trade.
We explored the importance of international transactions in the
determination of national income and analysed exchange rate.
Summary
Assessment
SAQ
Discuss briefly the term “international trade”.
SAQ
Assessment
Under what condition will a country attain equilibrium in an open
economy?
65
Bibliography
http://www.suu.edu/faculty/hamlin/MGMT3050/ppt/Wild_IB5e_PPT_Ins
tructor_05.ppt retrieved August, 2013.
http://faculty.washington.edu/jwh/349lec03.htm retrieved August, 2013.
Reading
66
Study Session 7 Income Determination in the Long-Run
Long
Study Session 7
Income Determination in the Long-
Long-Run
Introduction
You will recall that all our analysis up to this point centres on how
cyclical fluctuations can be taken care of. As noted, cyclical fluctuation –
the ups and downs of the economy – is a short-runrun phenomenon. We will
explore income determination in the long-run
long run in this Study Session.
7.1 discuss the concept of productivity.
7.2 discuss the determinants of labour productivity.
Learning Outcomes
7.1 Production and Growth

Productivity is defined as the amount of goods and services that can be
produced per person. This is also called GDP per person. GDP per
person or productivity can be perceived as a product of two terms:
average labour productivity and the share of the population that th is
working. To fix ideas about what productivity is, let Q represent
aggregate output (or national income) measured by real GDP, let L
represent the number of employed workers and let N represent the total
population. Real GDP per person by definition can be written as:
Q/N
Average labour productivity or output per employed worker equals Q/L,
while the share of working population from total population is L/N. The
relationship between these three variables is:
Q/N = Q/L* L/N
That is the basic relationship is that real GDP per person equals average
labour productivity multiplied by share of population employed. If we
think of output produced per person being equal to output consumed per
person, then, the above expression implies that the quantity
quantit of goods and
services that each person can consume depends on:
a. how much each worker can produce; and
b. the number of people working (the share of working people from
total population)
The higher each worker can produce, the greater is GDP per person and
thee more abundant goods and services are available for consumption.
Also, the more we have people working in the economy, the more there
will be goods and services available for consumption. That is, real GDP
67
per person can grow only to the extent that there is growth in workers’
productivity (each worker producing more) and/or the fraction of the
population that is employed.
It turns out that the long-run increase in output per person arises primarily
from increases in average labour productivity. Therefore, it is important
to examine the determinants of average labour productivity.
ITQ
Question
o What determines the long run output per person?
Feedback
• Output per person in the long run is determined by average
labour productivity.
7.2 Determinants of Labour Productivity

Some traditional economists argue that workers’ productivity depends on
the willingness of workers to work hard. According to this line of
thought, a culture that promotes hard work certainly tends to increase
workers’ productivity. However, empirical evidence shows that hard
work alone cannot account for large variations in average labour
productivity that is observed across countries over time. For example,
average labour productivity in the United States is 100 times what it is in
Bangladesh, even though Bangladeshis work harder than Americans!
Also, average labour productivity in Nigeria today is more than 100 times
what it was 50 years ago even though workers then worked harder than
workers of nowadays.
Modern economists have probed into this issue and came out with six
possible factors that determine labour productivity. The factors are:
human capital, physical capital, land and other natural resources,
technology, entrepreneurship and management, and the political and legal
environment.
Human Capital
Human capital comprises of talents, education, training and skills.
Workers with a large stock of human capital appear to be more
productive than workers with less. Human capital helps to develop one’s
skill level which can be used to produce more than when such skill is
lacking. For example, a secretary who knows how to use a word
processing program will be able to type more document than one who
does not. Also, an auto-mechanic equipped with skill of computerized
diagnostic equipments will be able to detect engine fault and be able to
fix the problem more quickly than less well-trained mechanics.
It must be noted that human capital acquisition is not without cost. For
instance, one needs to create time, energy and money for the acquisition
of such skill. All these are opportunity costs to be considered. However,
68
the benefit of such acquisition is the increase in wages that will be earned
after the acquisition of such skill. It turns out that what motivates
workers to want to acquire extra skill is the difference between wages of
the skilled and unskilled workers. If the difference is positive, workers
tend to acquire more skill and this invariably increases their productivity
and hence output.
ITQ
Question
o What accounts for the tendency of people to acquire more skills
so as to improve their productivity?
Feedback
• The urge to acquire more skills by people is driven by the
difference between wages of the skilled and unskilled workers.
If the difference is positive, workers tend to acquire more skill
and vice versa.
Physical Capital
Workers’ productivity also depends on the available equipments,
machines and tools. The most skilled Building Engineer cannot build a
50-storey glass building without sophisticated building and engineering
equipment. A most talented musician will not be able to develop his
potential with limited musical instruments. These examples illustrate the
importance of physical capital such as factories and machines in the
production of goods and services. In a nutshell, more and better capital
allows workers to produce more efficiently and effectively.
However, continuous increase in physical capital may not lead to
continuous increase in output. When labour and other input are held
constant, the greater the amount of capital already in use, the less an
additional unit of capital adds to production. That is, physical capital is
subject to diminishing returns. Diminishing returns to capital tells us how
to stimulate economic growth. First, increasing the amount of capital
available to the workforce will tend to increase output and average labour
productivity. The more adequately equipped workers are, the more
productive they will be. Second, the degree to which productivity can be
increased by an expanding stock of capital is limited. Because of
diminishing returns to capital, an economy in which the quantity of
capital available to each worker is already very high will not benefit
much from further expansion of the capital stock.
Land and other Natural Resources

Other factor inputs necessary for increasing workers’ productivity are
land, energy, and raw materials. In general, an abundance of natural
resources increase the productivity of the workers who use them. For
instance, fertile land is essential to agriculture. A farmer can produce as
much large crop in a land-rich country like United States and Nigeria
69
than in a country where the soil is poor or arable land is limited in supply
as in Iraq.
That a country lacks some natural resources does not mean that it cannot
increase its production. As long as natural resources like crude oil,
petroleum, metals, and chemicals can be obtained through trade,
countries with limited natural resources can raise production by obtaining
necessary natural resource inputs through international market.
Technology
Ability to develop and use new technologies will go a long way to
increase output per person. Technology is defined as a scientific means of
producing large amount of goods and services within a short period of
time and or per unit of labour. In the olden days, the horse driven wagon
was the primary means of transportation. This method, no doubt, is not
only costly but also very slow. In the nineteenth century, technological
advances such as steam engine supported the expansion of river-borne
transportation and the development of national rail network. Nowadays,
the invention and development of international network of an extensive
infrastructure of roads and airports have produced increasingly rapid,
cheap, and reliable transport. Rapid technological transition has also
occurred in construction, financial institutions and telecommunications.
Technological change has also contributed immensely to the sectoral
revolution of the economy.
Entrepreneurship and Management

Management
The productivity of workers depends in part on the people who help to
decide what to produce and how to produce it. Entrepreneur is defined
as people who create new economic activities. Entrepreneurs tend to be
creative and always introduce new products, new services, new
technological processes and new production techniques. To this extent,
entrepreneurs are critical to dynamic, matured and improved economy.
In fact, the more people are enterprising, the healthier the economy
becomes. Not only that, since entrepreneurs created new enterprises, it
means the more they are present in the country, the greater new things are
discovered, made use of and the more output grows.
The Political and Legal Environment

All the factors mentioned above describe the roles played by the private
sector in increasing average productivity of labour. If an economy
operates a mixed economic system, it follows that government also has a
role to play in improving productivity. One important contribution of
government to productivity is to provide political and legal environment
that encourages people to behave in economically productive ways
whereby they are taught to work hard, save and invest wisely, acquire
useful information and skills, and provide goods and services that the
public demands.
Another important contribution of government to productivity and growth
is in the area of providing well-defined property rights. By property
70
rights, we are referring to the provision of clear rules for determining who
owns what resources and how those resources can be used
Government should also ensure political stability. It has been
unanimously agreed upon that political instability is inimical to economic
growth. This is true because investors and savers may not be willing to
invest or save in a country fraught with financial uncertainty brought
about by unstable government policy or unstable political terrain,
particularly if the struggle for power involves civil unrest, terrorism and
the likes.
On the other hand, a political system that supports and operates free and
open exchange of ideas will create incentives for investment to thrive,
will speed the development of new technologies, and will ascertain
protection of lives and properties. With these in place, production will
take place dramatically, output will increase steadily and economic
growth will be achieved.
7.2.1
7.2.1 Public Policy and Economic Growth
The primary objective of an economy is to be able to increase production
in a continuous manner such that goods and services can be available for
consumption and possibly for exports. There are some policy measures
that government can apply in order to make this fundamental objective
realizable. Based on the discussion of the factors that necessitate growth
in labour productivity, the policy measures that can be taken include
policies to increase human capital, policies to promote physical capital
and policies to improve legal and political framework.
Public Policy and Human Capital

We have demonstrated the importance of human capital development in
economic growth. Governments of most countries try to increase human
capital of their citizens by supporting education and training programs.
In Nigeria, government provides public education by making schooling
free for students up to JSS III. Also, government encourage people to
attain tertiary education by subsidizing the financial outlays of tertiary
education. Government also provides scholarships to outstanding
students through Educational Trust Fund (ETF) in furtherance of their
education. In some advanced countries like the United States,
government funds job training for unskilled youths and retraining for
workers whose skills have become obsolete. In Nigeria, the National
Industrial Training (NIT) was set up by the government to provide basic
skills for some intending Nigerians. This is in a view to making them
highly skilful so that their productivity can increase.
71
ITQ
Question
o In what way can government promote human capital
development?
Feedback
• Government can facilitate development of human capital
through its support toward education and training programs.
Public Policy and Physical Capital Accumulation

Average labour productivity increases when workers can utilize a
sizeable and modern capital stock. To support the creation of new capital,
government can encourage high rate of saving and create conducive
environment for investment in the private sector. In the United States,
one of the policy measures to encourage saving is the US tax code. In
this case, a household that opens an Individual Retirement Account (IRA)
is able to save for retirement without paying taxes on either the funds
deposited in the IRA or the interest earned on the account. The intent of
IRA legislation is to make saving more financially attractive to American
households. A similar scheme like that of the US also exist in Nigeria,
this is called Pension Scheme legislation. This government policy
requires all Nigerian workers to save part of their monthly earnings in
their pension account. The essence of this is to inculcate the habit of
saving, and also to divert money to its most efficient use (investment).
Government can also contribute to capital formation through public
investment. Public investment includes the building of roads, rural and
urban electrification, and creation of bridges, dams, irrigation, energy,
and communication networks. In the area of transportation, construction
and or rehabilitation of motor roads, rail, roads, sea ports and airways are
some ways through which public policy affect physical capital
accumulation.
That Nigeria has developed to the use of computers and communications
for business transaction is not new. It must be noted that the involvement
of Nigeria in e-business is not unconnected with government funding. In
fact, many research studies have confirmed that government investment
in the provision of infrastructure, the capital that supports private-sector
economic activities, is a significant source of growth.
Public Policy and Legal and Political Framework

Government provides framework within which the private sector operates
productively. In our earlier discussion, we mentioned the fact that the
establishment of property rights, a well functioning legal system and
political stability are crucial to labour productivity and hence growth.
Hence, government policymakers should, as a matter of importance, also
consider the potential effects of tax and regulatory policies on activities
that increase productivity, such as investment, innovation and risk taking.
72
Long
Public Policy and Technological Improvement

As demonstrated earlier, average labour productivity rises with
technological improvement. Technology
Technology is being produced through
research and development (R&D). Individual firms whose intention is to
maximize profit will set up its private research and development section.
For instance, Cadbury Nigeria Plc has a R&D department that helps with
the development of new technique of producing old products and the
invention of new products. However, government policy can also be
useful in national development. This is so because society in general,
rather than individual may receive much of the benefit from basic
research.
Nigeria government has a policy that supports basic R&D. There are
many research institutes that are established and financed by the
government of Nigeria. Among them are National Institute of Economic
and Social Research (NISER), National National Institute of Horticulture
(NIHORT) and so on. All these are aimed at providing general
discoveries that will help private firms strive.
ITQ
Question
o What is the essence of embarking on various Research and
Development programs by government?
Feedback
• Government embarks on Research and Development programs
with the aim of enhancing technological improvement toward
increasing the productivity of labour.

In this Study Session, you learnt that the economy’s full potential is
achieved in the long-run.
long Specifically, long-run
run is a period sufficient to
allow time for the automatic adjustment mechanisms to return economic
activity to equilibrium after it has been disturbed by an exogeneous
Summary shock. We began by examining
examining the causes and consequences of
economic growth. A key conclusion from the analysis is that
improvements in average labour productivity are the primary source of
rising living standards. Lastly, we examined the consequence of public
policy on economic growth.
73
Assessment
SAQ
Q 7.1 (tests Learning Outcome 7.1)
How will explain
e the concept of productivity?
SAQ
Q 7.2 (tests Learning Outcome 7.2)
Assessment What are the factors that determine labour productivity?
Bibliography
Economics Prentice Hall, 6th
Karl E. Case and Ray C. Fair, Principles of Economics,
ed.
Robert. H. Frank and Ben S. Bernanke, (2007) Principles of Economics,
Reading McGraw
McGraw-Hill Irwin, 3rd ed.
http://economics.adelaide.edu.au/downloads/services-
http://economics.adelaide.edu.au/downloads/services
workshop/Definition
workshop/Definition-Importance-And-Determinants- -Of-Productivity.pdf
retrieved August, 2013.
http://econ.la.psu.edu/~bickes/income.pdf retrieved August, 2013.
http://econsiseasy.blogspot.com/2006/08/keynesian-model
http://econsiseasy.blogspot.com/2006/08/keynesian model-of-
income.html retrieved August, 2013.
http://home.cogeco.ca/~pcreighton/Economics/Module%2014.htm
retrieved August, 2013.
http://www.ijhssnet.com/journals/Vol_3_No_4_Special_Issue_February_
2013/21.pdf retrieved August, 2013.
74
Feedback on Self Assessment Questions
SAQ 1.1
The importance of macroeconomics to any nation cannot be
overemphasised. Below are some of the significance of macroeconomics
to any nation:
1) It helps to understand the functioning of a complicated modern
economic system. It describes how the economy as a whole
functions and how the level of national income and employment
is determined on the basis of aggregate demand and supply.
2) It helps to achieve the goal of economic growth, higher level of
GDP and higher level of employment. It analyses the forces
which determine economic growth of a country and explain how
to reach the highest state of economic growth and sustain it.
3) It helps to bring stability in price level and analyses fluctuations
in business activities. It suggests policy measures to control
inflation and deflation.
4) It explains factors which determine balance of payment. At the
same time, it identifies causes of deficit in balance of payment
and suggests remedial measures.
5) It helps to solve economic problems like poverty, unemployment,
inflation, deflation etc, whose solution is possible at macro level
only, i.e. at the level of the whole economy.
6) With detailed knowledge of functioning of an economy at the
macro level, it has possible to formulate correct economic
policies and also coordinate international economic policies.
SAQ 1.2
Macroeconomics: is about the performance of the economy in general. It
deals with the larger aspects of a nation's economy, such as the sectors of
agriculture, industry, and service. It is a branch of economics that deals
with the performance, structure, behaviour and decision-making of the
entire economy, be that a national, regional, or the global economy.
Macroeconomists study aggregated indicators such as GDP,
unemployment rates, and price indices to understand how the whole
economy functions. Macroeconomists develop models that explain the
relationship between such factors as national income, output,
consumption, unemployment, inflation, savings, investment, international
trade and international finance.
It aims to (a) speed up the economy's growth rate and increase total
production; (b) increase the rate of employment; (c) keep the prices of
commodities stable so that they remain affordable; and (d) have sufficient
reserves for foreign exchange for importing goods and paying off loans.
Economists help in solving problems like unfair wages, rapid population
growth, people migration to city centers, high crime incidence, and loss
of human resources due to overseas migration.
75
Microeconomics: is about smaller and more specific things such as how

families and households spend their money. It is a branch of economics
that deals with the personal decisions of consumers and entrepreneurs. It
is a branch of economics that studies how the individual parts of the
economy, the household and the firms, make decisions to allocate limited
resources, typically in markets where goods or services are being bought
and sold. Microeconomics also deals with the effects of national
economic policies (such as changing taxation levels) on individuals and
firms.
Its primary concern is to help consumers and investors make their lives
better by increasing their earnings and satisfying their needs despite
limited resources. Also included in its study are the consumers' decisions
on what products to buy and how the cost of commodities is determined.
SAQ 2.1
1. Gross Domestic Product (GDP): This represents the market
value of the final goods and services produced in the country
during a particular period. Thus, GDP measures how much of
goods and services an economy produces in a given period
usually quarter of a year (3 months), half-yearly (six months), or
a year. Here, only final goods and services are included while
intermediate goods are excluded.
2. Gross National Product (GNP): This represents the totality of
market value of all goods and services produce by all the citizens
of a given country, irrespective of whether they reside within the
domestic country or abroad. GNI describes the output or income
of only the citizens of country resident in the domestic country,
as well as the output or income of the citizens of a country who
are abroad. Thus, gross national product equals GDP plus factor
income from abroad.
3. Net National Product (NNP): This describes the output or
income of only the citizens of country resident in the domestic
country, as well as the output or income of the citizens of a
country who are abroad minus depreciation. Depreciation here
connotes wearing out of some equipment, damaged or
condemned equipment as well as those that are obsolete. Thus,
NNP= GNP₋ depreciation.
4. Domestic Income (DI): This describes the income received on
output produced within the country. It is the income received by
the owners of factors of production within a given country.
Domestic Income is somehow similar with Gross Domestic
Product (GDP) but DI is much particular about income receive or
earn on goods and services produced domestically.
5. Personal Income (PI): This describes total earnings of
individual's from various activities such as wages, investment
enterprises, and other ventures before taxes (direct tax). It is the
total income received by the individuals of a country from all
sources in one year before it is subjected to direct taxes.
6. GDP at factor Price: This explains the sum of the monetary
value of all goods and services produced by the factors of
production or the income accruing to the various factors of
production in one year in a country. GDP at factor price describes
76
the value of output in terms of the resources used to produce

them.
7. GDP at market Price: This represents the sum of gross added
value of the various institutional sectors of the various branches
of activity plus taxes minus the subsidies on products (which are
not attributed to the sector and branches of activity.
SAQ 2.2
SAQ 2.3
There exist several plaguing the computation of NI, though we don’t
know exactly what you may think of but you may consider some of the
following problems:
1. Problem of double counting.
2. There is also the difficulty of defining “nation” in national
income.
3. The problem of measuring non-market or domestic activities.
4. Income earned through illegal activities also makes national
income to be less, because they are excluded from GDP.
5. Problem of measuring national income in monetary terms which
leads to the underestimation of real national income.
6. Some public services cannot be estimated correctly.
SAQ 3.1
The aggregate demand curve is a curve showing the relationship between
short-run equilibrium outputs, ‘Y’ and the price level, ‘P’ or inflation. It
is a curve that represents the total quantity of all goods services
demanded by the economy at different price levels. AD curve like the
demand curve for individual goods is downward sloping, implying that
there is an inverse relationship between the price level and the quantity
demanded of real GDP.
The reasons for the downward sloping of aggregate demand curve are
different from the reasons given for the downward sloping demand
curves for individual goods and services. Some of the reasons for
downward sloping of aggregate demand curve include:
• Response of the monetary authority.
• Effects of money supply and demand on interest rate.
• The consumption link
• Effect of the real wealth
• Uncertainty
• Foreign price of domestic goods etc.
SAQ 3.2
The aggregate supply (AS) is a curve that shows the relationship between
the aggregate quantity of output supplied by all firms in an economy and
the overall price level. Aggregate supply depicts the quantity of GDP that
is supplied by the economy at different price levels. The reasoning used
to construct the aggregate supply differs from the reasoning used to
construct the supply curve for individual goods and services.
77
The supply curve for an individual good is drawn under the assumption
that input prices remain constant. As the price of good X rises, sellers per
unit cost of providing good X do not change, and so sellers are willing to
supply more of good X-hence, the upward slope of the supply curve for
good X. The aggregate supply curve, however, is defined in terms of the
price level. Increases in the price level will increase the price that
producers can get for their products and thus induce more output. But an
increase in price will also have a second effect; it will ill eventually lead
to increase in input prices as well, ceteri paribus, will cause producers to
cut to cut back. Thus, the AS curve in the short run is sloping upward and
becoming vertical when the economy reaches its capacity or maximum.
However, the AS curve remains vertical in the long run.
Several factors are responsible for the behaviour of the aggregate supply,
some of these factors include:
• The fairly flat shape
• The nearly vertical/ vertical shape
SAQ 3.3
Several factors are responsible for the shift of the aggregate curve from
its original position to a new position entirely. A change in any of the
components of the aggregate demand will definitely lead to a shift in the
aggregate demand curve. Thus, a change in any of the macroeconomic
variable like G (government), T (taxes), and Ms (money supply) will
result in a shift of the AD curve. However, these changes can be grouped
into two, namely:
• Changes in Monetary Authority’s Policy Reaction Function, and
• Change in Government Spending.
Changes in Monetary Authority’s Policy Reaction Function
Monetary regulatory authority may choose either an expansionary or
contractionary monetary policy through changing money supply or
through changing the interest rate.
Change in money supply: When there is an increase in the quantity of
money supply in the economy at any given price level, interest rate will
fall thereby causing planned investment spending to rise. The increased in
planned investment spending will result into an increase in output at the
given price level, and this makes the aggregate demand curve to shift to
the right.
Change in the interest rate: When the interest rate is set over above the
normal price level, it reduces investment and planned expenditure. Thus,
this makes the AD curve to shift to the left
Change in Government Spending
This may take various forms which include:
Change in net taxes: a change in net taxes shifts the AD curve. A
decrease in net taxes results in a rise in consumption which brings about
increase in the planned aggregate expenditure, leading to an increase in
output.
78
Change in government purchases: an increase in government purchase

at each possible price level, been part of aggregate demand, will directly
increase planned aggregate expenditure. This leads to an increase in
output. The reverse is the case for a decrease in government purchases.
New technological opportunities: Introduction of new technological
opportunities makes firms to increase their planned investment. The
increase in planned investment been a component of aggregate demand
will lead to an increase in aggregate expenditure and thus, output will
increase. This will shift the AD curve to the right.
Changes in consumers’ confidence: An important increase in
consumers’ confidence in some commodities will lead to an increase in
aggregate expenditure and aggregate output. Thus, increase in aggregate
output will shift the AD curve to the right. The reverse is the case for a
decrease in consumers’ confidence.
SAQ 3.4
Unlike the aggregate demand, aggregate supply otherwise known as GDP
or Output or does not usually increases over time, but falls or rises due to
economic fluctuation. This fluctuation is termed economic fluctuation or
business cycle. Business cycle is divided into period of recession (or
doom) and expansion (or boom).
• Recession: this is a persistent fall in output growth over a period
of three consecutive quarters.
• Expansion: this is a continuous rise in output.
SAQ 4.1
Money can be defined as anything that is generally acceptable as medium
of exchange for making payment, settlement of debts and other business
obligations. Money can also be defined as a good that acts as a medium
of exchange in transaction. To some, money is defined as any object or
record that is generally accepted as payment for goods and services and
repayment of debt in a given socio-economic context or country.
SAQ 4.2
The role and importance of money in any economy cannot be over-
emphasised. Money performs several functions that are not only peculiar
but inevitable in every society. Some of the functions performs by money
are discussed below
Medium of exchange
When money is used to intermediate the exchange of goods and services,
it’s performing a function as a medium of exchange. It thereby avoids the
inefficiencies of a barter system such as the problem of “double
coincidence of wants”.
Unit of Account
A unit of account is a standard numerical unit of measurement of the
market value of goods, services, and other transactions. Also known as a
“measure” or “standard” of relative worth and deferred payment, a unit of
account is a necessary prerequisite for the formulation of commercial
agreements that involve debt. To function as a unit of account, whatever
is being used as money must be;
79
• Divisible into smaller units without loss of value.

• Fungible: that is, a unit or piece must be perceived as equivalent
to any other.
• It must carry or bear a specific weight, measure, and size.
Store of Value
To act as a store of value, money must be able to be reliably saved,
stored, and retrieved- and be predictably usable as medium of exchange
when it’s retrieved. The value of money must remain stable overtime.
Standard of deferred payment
A “standard of deferred payment” is an accepted way to settle a debt- a
unit in which debts are denominated, and the status of money as legal
tender, in those jurisdictions which have this concept, states that it may
function for the discharge for debts.
Measurement of value
Money acts as a standard measure and common denomination of trade.
It’s thus a basis for quoting and bargaining of prices. It’s necessary for
developing efficient account systems. But , its most important usage is a
method for comparing the value of dissimilar objects.
SAQ 4.3
In any economy, the Central Bank is the apex bank and it’s the only bank
that has the power to issue currencies within the economy. The Central
Bank regulates the activities of other banks and financial institutions in
the economy. Central Bank is responsible for supplying money into the
economy. The money supply effort of the Central Bank is usually
complemented by creation of money by commercial banks.
Commercial banks ability to create money is not like that of the central
bank. Thus, commercial banks create money such a way that they
generate money from the surplus consumption units and make them
available to the deficit consumption unit. Surplus consumption unit
characterises those set of people that have money over and above their
present financial up-keepings and decided to keep their excesses with the
commercial banks. Deficit surplus consumption unit on the other hand,
are those who to have enough or required amount of money to keep up
with their present financial obligations.
How Commercial banks create Money
When commercial banks collect money from the members of the public
as deposits, it’s not all the money received as deposits that remain in their
custody as cash otherwise known as bank deposit balances (Reserves).
However, some parts of the deposits received from the members of the
public are given out to people as loans that yield some interests for the
bank. Thus, not all bank deposits are treated as bank reserve. That is, it is
only a proportion of the deposit that makes up bank reserve. This is called
reserve-deposit ratio and it is calculated thus
Bank reserve
Reserve − deposit ratio =
Deposits
80
From the above, bank deposits can be solved for. To do so, cross multiply
the above equation and divide through by reserve-deposit ratio. This
yields the following
Bank reserves
Bank deposits =
Desired reserve − Deposit ratio
Let deposits be 2,000,000, while reserve-deposit ratio desired by banks be
0.10 (10% of total deposit). Then, bank deposit can be calculated thus:
2,000,000
Bank deposit = = 20,000,000
0.1
SAQ 5.1
Government spending represents expenses or costs carried out by the
government of a country. These include expenditure on provision of
goods and services, internal and external securities, provision of social
security’s – unemployment benefits, pension schemes etc.
There are various forms of government spending, these include:
Current Expenditure: This form of government spending takes care of
expenditure on public health, public education, street light, public roads,
and purchases of material for public office use, purchase of labour
services and so on. It is otherwise known as government consumption
expenditure on goods and services.
Capital Expenditure: This form of spending deals with expenses that
creates future benefits. A capital expenditure is incurred when the
government spends money either to buy fixed assets or to add to the value
of an existing fixed assets with a useful life extending beyond the taxable
years. Examples are expenditures on Capital projects like, construction of
Refineries, Dams Electricity etc.
Transfer payments: This represents government expenditure that is not
made in return for currently produced goods and services. This covers
activities like the payment of old-age pensioners, pensioners’ gratuity,
unemployment benefit, student grants, and interest paid on the national
debt the government is not purchasing any currently produced goods or
services from all these activities, hence they are recognised as “transfer
payments”.
SAQ 5.2
There are three (3) major sources of government revenue, these are:
• Taxation
• Borrowing, and
• Selling of bonds and bills.
Taxation: This is a compulsory payments made by individual, firms and
corporate organizations to government to settle its expenses. Taxes can be
indirect or direct. Indirect taxes are taxes that do not depend on level of
income. Such taxes include tariff, poll tax, sales tax and value added tax,.
This type of tax can also be called lump-sum tax.
Direct taxes are taxes levied on the level of income. There are three of
such. These are proportional tax, progressive tax and regressive tax.
Proportional tax is a flat rate of tax which is paid by every worker. It is a
share of one’s income that must be set aside as tax. The higher one’s
81
income, the greater the tax paid. Progressive tax on the other hand is a
system where the rate of tax itself depends on the income earned. In this
case, rate of tax is no more the same across income category. In fact, the
higher the income, the higher the tax rate. However, it’s worthy to note
that the bulk of government revenue comes from taxation.
Borrowing: Government also generate lots of money through borrowing.
This can either be internal or external borrowing. Internal borrowings are
borrowing made by government from individuals and corporate
organizations within the economy. External borrowings are borrowing
made by government outside its own economy. This form of borrowing
involves borrowing from international organizations like World Bank,
International Monetary Fund (IMF), African Development Bank (AFDB),
United Nations etc.
Selling of bonds and bills: Government can also source for fund through
the sale of government securities such as Treasury Bills (T-bill) and other
government bonds. Government sells the treasury bills to the private
individuals who have more than enough money to hold. Thus, they buy
government security and pay with cash. This is also a means of regulating
the amount of money in circulation.
SAQ 5.3
A budget can be defined as a financial statement of a proposed
expenditure and the expected revenue of government over a given period
of time which can be monthly, quarterly, or yearly basis. The term
“budget” simply refers to a financial statement made by the government
explaining the details in terms of planned expenditure to be expended by
government as well as the expected revenue (income) over a given period
of time.
Therefore, budget balance is the difference between total government
expenditure, that is, taxes minus government expenditure. Budget can
either be surplus, deficit or balanced budget. Surplus budget implies a
situation whereby government expected revenue is greater than its
expected income. On the other hand, deficit budget explains a situation
whereby government proposed expenditures outweigh its expected
revenue. However, when these two are equal, we say the government
plans a balanced budget.
SAQ 5.3
There are two forms of stabilization policies; these are the monetary
policy and the fiscal policy. Thus, the fiscal policy instruments used by
the government to stabilize the economy are government expenditure
policy and government tax policy. Changes in government spending were
probably the most effective instrument for offsetting recession, according
to John Keynes. Remember, that the components of aggregate demand
are consumption, investment, government expenditure for a closed
economy. Government purchases of goods and services are a component
of aggregate demand, so aggregate demand is directly affected by
changes in government purchases. Thus, the increase in government
purchases eliminates the necessary output gap. Also, through changes in
82
government expenditure, which is one of the fiscal policy instruments of

government, output gap can be affected.
In the same way, government also determines the level of tax collections
and transfer payments. From the Keynesian’s point of view, changes in
the level of taxes or transfer can be used to affect aggregate demand and
thus to reduce or eliminate output gap. Meanwhile, the effect of tax
policy on aggregate demand is indirect. Changes in taxes affect aggregate
demand by first of all changing private disposable income. For instance, a
reduction in tax or an increase in transfer payments will increase
disposable income. What this turns out to mean is that more money is
available for consumption by the private sector. It thus appears that
changes in taxes and transfer will affect aggregate output to the extent
that consumers/private sector change the level of spending.
SAQ 6.1
International trade is a trade between two or more countries. It’s a trade
across the borders of a country. International trade can also be described
as a form of relationship between two or more countries such that goods
and services are being traded in the form of exchange through the use of
money. Several reasons account for why there is need for international
trade. Some of these reasons are highlighted below:
• No country is self- complacent or self-satisfied with the goods
and services produced only in his country.
• Resources, both natural and human resources are not evenly
distributed. Hence, the variation in goods and services each
country can produce.
• Levels of technology are not the same across countries.
• No country can produced all the goods and services needed for
survival.
There are two strains or components of international trade. These are
export and imports. Sales of domestic goods to the rest of the world (or
outflow of goods to the rest of the world) are called exports, while the
purchase of foreign goods (or inflow of goods and services from the rest
of the world) is called imports. There are series of theories propounded
for the justification of engaging in international transactions. These
include theories like comparative advantage, new world trade theory and
so on. Terms used in international trade include terms of trade, balance of
trade and balance of payment.
SAQ 6.2
An open economy is an economy that allows for inflow and outflow of
goods and services. It is an economy who relates with the rest of the
world by exchanging their goods and services with other economies in
the world. To attain equilibrium in an open economy, the aggregate
demand which were Consumption, Investment and Government purchase
in a closed economy will now include net export (X-M) component.
However, equilibrium output is still the same level of output at which
desired aggregate demand equals national output/income.
To establish equilibrium in an open economy using the previous example
in the text, let us rewrite our aggregate demand function and incorporate
83
net export component. To put the matter very simple, let us assume that
planned aggregate demand is given by:
AD = C + I + G + NX
Let C = 610 + 0.8Y; I = 220; and G = 300; NX = 10 and T = 250
Note that planned private consumption has fallen by 10-unit but this has
been taken care of by NX which is 10. Equilibrium output can be
achieved as follows:
AD = 610 + 0.8 (Y – 250) + 220 + 300 + 10
= 610 + 0.8Y – 200 + 220 + 300 + 10
AD = 940 + 0.8Y
at equilibrium, AD = Y, thus, 940+0.8Y= Y
collect like terms such that Y–0.8Y = 940
Y(1–0.8)= 940
Y(0.2) = 940
0.2Y= 940
hence, Y = 940/0.2 = 4700.
This implies that the equilibrium has been restored but in this case
through net export surplus.

How will explain the concept of productivity?
Answer:
Productivity is the ratio of output to input in production. It is an average
measure of the efficiency of production. Productivity can also be defined
as a measure of efficiency of a person, machine, factory system etc in
converting inputs into output. Common to these two definitions is the
term efficiency of production. Thus, efficiency of production mans
production’s capability to create income which is measured by the
formula real output value minus real input value. Thus, productivity is
about the effective and efficient use of all resources which include time,
people, knowledge and mineral resources.
SAQ 7.2
Several factors serve as determinants of labour productivity. These
factors include:
• Human Capital
• Physical Capital
• Land and other Natural Resources
• Technology
• Entrepreneurship and Management
• The Political and Legal Environment
84
You may see section 7.2 for further details on how these factors help to
promote and ensure the efficiency of labour and improve labour
productivity.
85
References
Dasoupta; Partha, Amartya Sen and Stephen Bardin, (1972). Guideline for Project
Evaluation, UNIDO, New York: Vienna, Series No.2.
Ekpenyong, B.E. (1993). Fundamentals of Project Analysis-An Integrated Approach,
Heinemann Educational Books (Nigeria) Plc.
Inanga, E.L. (1985). Principles of Accounting, Heinemann Educational Books Ibadan
(Nig.) Ltd., Nigeria.
Karl E. Case and Ray C. Fair, Principles of Economics, Prentice Hall, 6th ed.
Kayode, M.O. (1979). The Art of Project Evaluation, Ibadan: University Press, Ibadan.
Little, I.M.D and J.A. Mirrless (1980). Project Appraisal and Planning for Developing
Countries, London: Heinemann Educational Books.
OECD (Organisation for Economic Co-operation and Development) 2001, OECD
Productivity Manual: A Guide to the Measurement of Industry – level and
Aggregate Productivity Growth, OECD, Paris.
Olaoye, C.O., 2006. Analysis of Government Finance. 1st Edn., Clemart Publishing,
Kwara State.
Parham, D. and Zheng, S. 2006, ‘Aggregate and Industry Productivity Estimates for
Australia’, Australian Economic Review, vol. 39, no. 2, pp. 216 – 226
Robert. H. Frank and Ben S. Bernanke, (2007) Principles of Economics, McGraw-Hill
Irwin, 3rd ed.
Smith, Charles (2007). International Trade and Globalisation, 3rd edition. Stocksfield:
Anforme.
86

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COURSE MANUAL

University of Ibadan Distance Learning Centre

General Editor: Prof. Bayo Okunade

Page layout and instructional design by EDUTECHportal, www.edutechportal.org

Prof. Isaac Adewole

Professor Bayo Okunade

Content Editor Prof. Remi Raji-Oyelade

Getting around this course manual 8

2.1.6 Per Capita Income / GDP Per Capita ............................................................................... 24

Study Session 3 Error! Bookmark not defined.

Study Session Summary ............................................................................................................................................. 73

About this course manual

How this course manual is

We strongly recommend that you read the overview carefully before

The course content

How to be successful in this

Essentially you will be taking control of your learning environment. As a

Information Centre Lagos Office

For technical issues (computer problems, web access, and etcetera),

Getting around this course manual

Activity Assessment Assignment Case study

Discussion Group Activity Help Outcomes

Note Reflection Reading Study skills

Summary Terminology Time Tip

Economy The wealth and resources of a country or region,

Policies A plan or course of action, by a government,

Government An institutional framework of rule in a state, and it

Microeconomics The part of economics that analyzes single factors

1.1 What is Macroeconomics?

Macroeconomics Macroeconomics is the study of the performance of the national

1.2 The Distinction between Micro and

While microeconomics focuses on the behaviour of individual units

Study Session Summary

SAQ 1.1 (tests Learning Outcome 1.1)

2.1 Concepts of National Income

Importance of National Income Analysis

2.1.1 Gross Domestic Product (GDP)

B. Final Goods and Services

Some goods can either be intermediate or final. A special type of good

To illustrate the distinction between final goods and intermediate goods,

A tailor charges N500.00 for each cloth that he

Answer: The answer to this question is simply N500.00 which is the

A farmer produces N1,000 worth of cattle milk. He sold N300 worth of

As earlier pointed out, intermediate goods are not counted in GDP to

variations in the value of assets which can be ascertained beforehand

Nominal versus Real GDP

Table 2.1: Prices, Quantities and GDP in 1990 and 1991

Quantity of Prices of Quantity of Price of

A. Calculating Nominal GDP

B. Calculating Real GDP

GDP at Factor Cost

2.1.2 Gross National Product (GNP)

GNP takes account of three components which are: the income or

Because GNP considers only the output of nationals of a country, GNP is

2.1.4 Domestic Income

In some literatures, domestic income is referred to as Gross Domestic

2.1.5 Personal Income

2.1.6 Per Capita Income / GDP Per Capita

2.1.7 Disposable Income