Introduction To Macroeconomic

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Introduction to Macroeconomic
Entrepreneurship (Mount Kenya University)
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DEPARTMENT OF BUSINESS AND SOCIAL STUDIES
COURSE CODE: BBM 126
COURSE TITLE: INTRODUCTION TO MACROECONOMICS
Instructional Material for BBM- distance learning

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TABLE OF CONTENT
COURSE OUTLINE............................................................................................................................. 3
CHAPTER ONE: NATIONAL INCOME ANALYSIS.................................................................... 4
1.1 DEFINITION OF NATIONAL INCOME............................................................................................... 4
1.2 THE CIRCULAR FLOW OF INCOME AND EXPENDITURE .................................................................. 5
1.3 APPROACHES TO MEASURING NATIONAL INCOME ....................................................................... 5
1.4 DIFFICULTIES IN MEASURING NATIONAL INCOME ...................................................................... 11
1.5 FACTORS AFFECTING THE SIZE OF A NATIONAL INCOME............................................................. 11
1.6 REAL VS NOMINAL GNP: “DEFLATING” BY A PRICE INDEX ....................................................... 13
1.7 NATIONAL INCOME AND STANDARDS OF LIVING ........................................................................ 16
1.8 CONSUMPTION, SAVING AND INVESTMENT ................................................................................. 19
1.9 THE KEYNESIAN THEORY OF CONSUMPTION FUNCTION ............................................................. 20
1.10 DETERMINATION OF EQUILIBRIUM NATIONAL INCOME ............................................................ 25
1.11 FLUCTUATIONS IN NATIONAL INCOME AND THE BUSINESS CYCLES ......................................... 31
1.12 REVIEW QUESTIONS: ................................................................................................................ 33
1.13 REFERENCES ............................................................................................................................. 33
CHAPTER TWO: MONEY AND BANKING................................................................................ 34
2.1 MONEY ....................................................................................................................................... 34
2.2 THE QUANTITY THEORY OF MONEY ........................................................................................... 38
2.3 THE DEMAND FOR AND SUPPLY OF MONEY ................................................................................. 40
2.4 THE BANKING SYSTEM ............................................................................................................... 43
2.5 MONEY MARKETS ...................................................................................................................... 51
2.6 CAPITAL MARKETS ..................................................................................................................... 51
2.7 THEORIES OF INTEREST RATES DETERMINATION ........................................................................ 52
2.8 THE IS – LM MODEL .................................................................................................................. 59
2. 9 REVIEW QUESTIONS ................................................................................................................ 62
2.10 REFERENCES ............................................................................................................................. 62
CHAPTER THREE: PUBLIC FINANCE AND INFLATION ................................................... 63
3.1 OBJECTIVES OF GOVERNMENT .................................................................................................... 63
3.2 THE BUDGET .............................................................................................................................. 64
3.3 PUBLIC EXPENDITURE ................................................................................................................ 71
3.4 THE NEO-CLASSICAL VIEW ........................................................................................................ 76
3.5 TYPES AND CAUSES OF INFLATION ............................................................................................. 78
3.6 REVIEW QUESTIONS ................................................................................................................... 82
3.7 REFERENCES ............................................................................................................................... 83
CHAPTER FOUR INTERNATIONAL TRADE AND FINANCE................................................. 84
4.1 INTERNATIONAL TRADE ............................................................................................................. 84
4.2 THEORY OF COMPARATIVE ADVANTAGE.................................................................................... 85
4.4 TERMS OF TRADE........................................................................................................................ 93
4.5 INTERNATIONAL TRADE ARRANGEMENTS AND AGREEMENTS .................................................... 95
4.6 BALANCE OF PAYMENTS ........................................................................................................... 104
4.7 INTERNATIONAL LIQUIDITY ...................................................................................................... 109
4.8 INTERNATIONAL FINANCIAL INSTITUTIONS .............................................................................. 113
4.9 REVIEW QUESTIONS ............................................................................................................... 116
4.10 REFERENCES ........................................................................................................................... 116
SAMPLE PAPER 1 ......................................................................................................................... 117
SAMPLE PAPER 2 ......................................................................................................................... 118

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COURSE OUTLINE
BBM 126: INTRODUCTION TO MACROECONOMICS

Pre-requisites: BBM 115: Introduction to Microeconomics
Purpose: To enable learners understand and appreciate the importance of

economics national activities and equip them with skills that help them actively play
a practical role in economic development.
Course Objectives: By the end of the course unit the student should be able to:-
 Define and understand terminologies and meaning of key concepts used in
economics
 Describe basic economics problems faced by different types of economic
systems
 relate knowledge of Economic to other discipline such as commerce and industry
 Appreciate the relevance and importance of economics as a discipline
 Explore how they can contribute to the development of society
Course Content:
 Introduction to macroeconomics; relationship between micro and
macroeconomics.
 National income accounting; national income difficulties in estimation of
national income, uses of national income statistics
 Simple Keynesian model of income distribution, consumption, investment,
government an d foreign sector
 Consumption of savings functions, theories of investment, the multiplier and
accelerator effect, trade cycles
 Nature and development and functions of money ; the demand and supply of
money, price index, credit creation, financial institutions, interest rates, monetary
policies, equilibrium, in the money and product markets, money and capital
markets
 Government taxation and expenditure, national debt, fiscal and monetary
policies and macroeconomic objectives
 International trade theories; free trade and protectionism, terms of trade, balance
of payments, international liquidity, exchange rates, international institutions
 Teaching / Learning Methodologies: tutorials; group discussion;
demonstration; Individual assignment; Case studies
Recommended Text Books:

William A. Mceachern (2008), Macroeconomics: A Contemporary Introduction, 8th
Edition, South Western Educational Publishing
Rob Tisisnai et al. (1999), Introduction to Macroeconomics: mastering The Global
Community, University Access
Text Books for further Reading:

Koutsoyiannis A; (1994), Modern Macroeconomics, Macmillan Education Ltd

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CHAPTER ONE: NATIONAL INCOME ANALYSIS
Learning Objectives
At the end of the lesson the student should be able to:
 Explain fully the various concepts of national income.
 Appreciate the importance of compiling national income figures.
 Use national income figures to compare the standards of living over
time and between countries and know the problems involved.
 Explain fully why national output and employment fluctuate around their long
term trends
 Show how the country can manipulate its resources for faster growth using the
relationship between income, consumption and savings.
1.1 Definition of National Income

National Income is a measure of the money value of goods and services becoming
available to a nation from economic activities. It can also be defined as the total
money value of all final goods and services produced by the nationals of a country
during some specific period of time – usually a year – and to the total of all incomes
earned over the same period of time by the nationals.
Different Concepts of National Income
a) Gross Domestic Product

The money value of all goods and services produced within the country but excluding
net income from abroad.
b) Gross National Product

The sum of the values of all final goods and services produced by the nationals or
citizens of a country during the year, both within and outside the country.
c) Net National Product

The money value of the total volume of production (that is, the gross national product)
after allowance has been made for depreciation (capital consumption allowance).
d) Nominal Gross National Product

The value, at current market prices, of all final goods and services produced within
some period by a nation without any deduction for depreciation of capital goods.
e) Real Gross National Product

This is the national output valued at the prices during some base year or nominal GNP
corrected for inflation.
f) National Income Accounting

This refers to the measuring of the total flow of output (goods and services) and of the
total flow of inputs (factors of production) that pass through all of the markets in the
economy during the same period. To see exactly what national income includes, how
it is measured, and what it can tell us, we start with economic models: By economic
models we mean:
‘A simplification of a real world or a practical situation aimed at explaining

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that situation within a set of assumptions’
1.2 The Circular Flow of Income and Expenditure

This is an economic model illustrating the flow of payments and receipts between
domestic firms and domestic households. The households supply factor services to the
firms. In return, they get factor incomes. With factor incomes, they buy goods and
services from the firms. These flows can be illustrated diagrammatically as shown in
Figure 1.1.
The points at which flows from one sector meets the other sector and generate other
flows are called critical points. In the above diagram, the critical points are A, B and
C. At A, the flow of factor services from the households sector meets the firm sector
and generates the flow of factors incomes from the firms to the households. At B, the
flow of factor incomes meets the household sector and generates the flow of consumer
spending. At C, the flow of consumer spending meets the firms sector and generates
the flow of goods and services.
1.3 Approaches to Measuring National Income

The compilation of national income statistics is a very laborious task. The total
wealth of a nation has to be added up and there are millions of nationals. Moreover,
in order to double check and triple check the statistics, the national income
statistician has to work out the figures out in three different ways, each way being
based on a different aspect. The three aspects are:
a. The national output: - The creation of wealth by the nation’s industries. This is
valued at factor cost, so it must be the same as b) below.
b. The national income: - The incomes of all the citizens.
c. The national expenditure because whatever we receive we spend, or lend to the

banks to invest it, so that the addition of all the expenditure should come to the
same as the other two figures. Put in its simplest form we can express this as an
identity:
National output  National Income  National Expenditure.

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Figure 1.1 The Circular Flow of Income and Expenditure
i) Using Total Expenditure for Calculating National Income

The expenditure approach centres on the components of final demand which
generate production. It thus measures GDP as the total sum of expenditure on final
goods and services produced in an economy. It includes all consumers’ expenditure
on goods and services, except for the purchase of new houses which is included in
gross fixed capital formulation. Secondly we included all general government final
consumption. This includes all current expenditure by central and local government
on goods and services, including wages and salaries of government employees. To
these we add gross fixed capital formation or expenditure on fixed assets (buildings,
machinery, vehicles etc) either for replacing or adding to the stock of existing fixed
assets. This is the major part of the investment which takes place in the economy.
In addition we add the value of physical increases in the stocks, or inventories,
during the course of the year. The total of all this gives us Total domestic
expenditure (TDE). We then add expenditure on exports to the TDE and arrive at a
measure known as Total Final Expenditure. It is so called because it represents the
total of all spending on final goods. However, much of the final expenditure is on
imported goods and we therefore subtract spending on imports. Having done this
we arrive at a measure known as gross domestic product at market prices. To gross
domestic product at market price we subtract the taxes on expenditure levied by the
government and add on the amount of subsidy. When this has been done we arrive
at a figure known as Gross Domestic Product at factor cost. National Income
however is affected by rent, profit interest and dividends paid to, or received from,
overseas. This is added to GDP as net property income from abroad. This figure
may be either positive or negative. When this has been taken into account we arrive

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at the gross national product at factor cost. As production takes place, the capital
stock of a country wears out. Part of the gross fixed capital formation is therefore, to
replace worn out capital and is referred to as Capital Consumption. When this has
been subtracted we arrive at a figure known as the net national product. Thus,
summarising the above, we can say:
Y = C + I + G + (X – M)
Calculating national income from total expenditure
Country Y National Expenditure (in £millions) 1999
Expenditure of Consumers
Food 27,148
Alcoholic drink 13,372
Tobacco 6,208
Housing 27,326
Fuel and light 9,395
Clothing 12,114
Household goods and services 12,274
Transport and communications 31,475
Recreation 16,541
Other goods and services 23,356
Total 179,209
Less: Adjustment of non-profit making bodies (443)

178,766
178,766
Add: Expenditure of non-profit making bodies 3,661
182,427
Central Government expenditure 40,623
Local Government expenditure 25,236

Capital formation 49,559
Growth in stocks 267

Total Domestic expenditure at market prices 298,112
Deduct: Taxes on expenditure 49,865
248,247
Add: Net result exports-imports 3,186

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Subsidies 6,056
Net property income from abroad 1,948 11,190
259,437
Less: Estimated depreciation on capital assets 36,490
222,947m
(ii) Using Factor Incomes for Calculating National Income

A second method is to sum up all the incomes to individuals in the form of wages,
rents, interests and profits to get domestic incomes. This is because each time
something is produced and sold someone obtains income from producing it. It follows
that if we add up all incomes we should get the value of total expenditure, or output.
Incomes earned for purposes other than rewards for producing goods and services are
ignored. Such incomes are gifts, unemployment or relief benefits, lottery, pensions,
and grants for students etc. These payments are known as transfer income (payments)
and including them will lead to double counting. The test for inclusion in the national
income calculation is therefore that there should be a “quid pro quo” that the money
should have been paid against the exchange of a good or service. Alternatively, we
can say that there should be a “real” flow in the opposite direction to the money flow.
We must also include income obtained from subsistence output. This is the opposite
case from transfer payments since there is a flow of real goods and services, but no
corresponding money flow. It becomes necessary to “impute’’ values for the income
that would have been received. Similarly workers may, in addition to cash income,
receive income in kind; if employees are provided with rent free housing, the rent
which they would have to pay for those houses on the open market should, in
principle, be “imputed” as part of their income from employment. The sum of these
incomes gives gross domestic product GDP. This includes incomes earned by
foreigners at home and excludes incomes earned by nationals abroad. Thus, to Gross
Domestic Income we add Net property Income from abroad. This gives Gross
National Income. From this we deduct depreciation to give Net National Income.
Country Y National Income rewards to factors (in £ 1999

millions)
Incomes from employment
Wages and salaries 143,348
Pay in cash and kind of HM Forces 3,121
Employers’ contribution to National Health Insurance 10,632
Employers’ contribution to other funds 12,971
170,072
Income from self-employment 23,123
Other Incomes
Profits of companies 41,530

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Surpluses of public corporations 9,661
Surpluses of other public enterprises (-)

(109)
Rent 17,424
Imputed charge for consumption of capital 2,456
264,157
Less: Stock appreciation (4,326)
259,831
Add: net property income from abroad 1,948
261,779
Less: Residual error 2,342
Estimated depreciation on capital assets 36,490 (38,832)
222,947m
Table 1.1 Calculating National Income from factor Incomes
Note: The residual error is a small error (about 1%) in the collection of these
figures.
(iii) Using the National Output for Calculating National Income

A final method which is more direct is the “output method” or the value added
approach. This involves adding up the total contributions made by the various sectors
of the economy. “Value Added” is the value added by each industry to the raw
materials or processed products that it has bought from other industries before
passing on the product to the next stage in the production process. This approach
therefore centres on final products. Final products will include capital goods as well
as consumer goods since while intermediate goods are used up during the period in
producing other goods; capital goods are not used up (apart from “wear and tear” or
depreciation) during the period and may be thought of as consumer goods “stored up”
for future periods. Final output will include “subsistence output”, which is simply the
output produced and consumed by households themselves. Because subsistence
output is not sold in the market, some assumption has to be made to value them at
some price. We also take into account the final output of government, which provides
services such as education, medical care and general administrative services.
However, since state education and other governmental services are not sold on the
market we shall not have market prices at which to value them. The only obvious
means of doing this is to value public services at what it costs the government to
supply them that is, by the wages bill spent on teachers, doctors, and the like. When
calculating the GDP in this matter it is necessary to avoid double counting.

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Country Y National Product by industry (£ millions) 1999
Agriculture 5,535
Energy and water supply 29,645
Manufacturing 2,258
Construction 5,319
Distribution, hotels, catering, repairs 35,002
Transport 1,543
Communications 7,092
Insurance, banking and finance 31,067
Ownership of dwellings 15,761
Public administration, defence and social security 8,027
Public health and education services 4,021
Other services 6,415
Total domestic output 271,685
Deduct: Residual error 2,342

Adjustment for financial services 11,854
Estimated depreciation on capital assets 36,490 - 50,686
220,990
Add: Net property income from abroad 1,948
Aggregate net national product 222,947 m
Table 1.2 Calculating national income from national output
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1.4 Difficulties in Measuring National Income
National income accounting is beset with several difficulties. These are:
a. What goods and services to include

Although the general principle is to take into account only those products which
change hands for money, the application of this principle involves some
arbitrary decisions and distortions. For example, unpaid services such as those
performed by a housewife are not included but the same services if provided by
a paid housekeeper would be.
Many farmers regularly consume part of their produce with no money changing
hands. An imputed value is usually assigned to this income. Many durable
consumer goods render services over a period of time. It would be impossible to
estimate this value and hence these goods are included when they are first
bought and subsequent services ignored. Furthermore, there are a number of
governmental services such as medical care and education, which are provided
either 'free' or for a small charge. All these provide a service and are included
in the national income at cost. Finally, there are many illegal activities, which
are ordinary business and produce goods and services that are sold on the
market and generate factor incomes.
b. Danger of Double Counting

The problem of double counting arises because of the inter-relationships
between industries and sectors. Thus we find that the output of one sector is the
input of another. If the values of the outputs of all the sectors were added, some
would be added more than once, giving an erroneously large figure of national
income. This may be avoided either by only including the value of the final
product or alternatively by summing the values added at each stage which will
give the same result.
Some incomes such as social security benefits are received without any
corresponding contribution to production. These are transfer payments from the
taxpayer to the recipient and are not included. Taxes and subsidies on goods will
distort the true value of goods. To give the correct figure, the former should not
be counted as an increase in national income for it does not represent any growth
in real output.
c. Inadequate Information
The sources from which information is obtained are not designed specifically
to enable national income to be calculated. Income tax returns are likely to err
on the side of understatement. There are also some incomes that have to be
estimated. Also, some income is not recorded, as for example when a joiner,
electrician or plumber does a job in his spare time for a friend or neighbour.
Also information on foreign payments or receipts may not all be recorded.
1.5 Factors affecting the size of a National Income
The size of a nation’s income depends upon the quantity and quality of the factor
endowments at its disposal. A nation will be rich if its endowments of natural
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resources are large, its people are skilled, and it has a useful accumulation of capital
assets. The following points are of interest:
a) Natural Resources
These include the minerals of the earth; the timber, shrubs and pasturage
available; the agricultural potential (fertile soil, regular rainfall, temperature or
tropical climate); the fauna and flora; the fish; crustacea etc of the rivers and
sea; the energy resources, including oil, gas, hydro-electric, geothermal, wind
and wave power.
b) Human Resources
A country is likely to prosper if it has a large population; literate and numerate
sophisticated and knowledgeable about wealth creating processes. It should be
well educated and skilled, with a nice mixture of theory and practice. It should
show enterprise, being inventive, energetic and determined in the pursuit of a
better standard of living.
c) Capital Resources
A nation must create and then conserve capital resources. This includes not
only tools, plant and machinery, factories, mines, domestic dwellings, schools,
colleges, etc, but a widespread infrastructure of roads, railways, airports and
ports. Transport creates the utility of space. It makes remote resources
accessible and high-cost goods into low-cost goods by opening up remote areas
and bringing them into production.
d) Self-sufficiency
A nation cannot enjoy a large national income if its citizens are not mainly self-
supporting. If the majority of the enterprises are foreign –owned there will be a
withdrawal of wealth in the form of profits or goods transferred to the investing
nation.
e) Political Stability
Uses of national income figures
 We need national income statistics to measure the size of the "National cake'
of goods and services available for competing uses of private consumers,
government, capital formation and exports (less imports).
 National Income statistics are also used in comparing the standard of living of
a country over time
 And also the standards of living between countries.
 National Income Statistics provide information on the stability of performance

of the economy over time e.g. a steadily increasing income would be indicative
of increasing national income.
 If National Income Statistics are disaggregated it would enable us to assess the
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relative importance of the various sectors in the economy. This is done by

considering the contribution of the various sectors to Gross National Product
over time. Such information is crucial for planning purposes for it reveals to
planners where constraints to economic development lie. It therefore becomes
possible to design a development strategy that eventually would overcome
these problems. This central contribution could be in the form of employment
or the production of goods and services.
 By assessing exports and imports as a percentage of Gross national Product i.e.

using national statistics, it is possible to determine the extent to which a
country depends on external trade.
 National Income Statistics also help in estimating the saving potential and
hence investment potential of a country.
1.6 Real Vs Nominal GNP: “Deflating” by a Price Index

One of the problems that confront economists when measuring GNP is that they have
to use money as the measuring rod. These days however, inflation sends the general
price level up and up clearly this means that the yardstick stretches in their hands
everyday.
Economists repair most of the damage wrought by the elastic yardstick by using a
price index. The price index used to remove inflation (or “deflate’’ the GNP) is
called the GNP deflator. The GNP deflator is defined as the ratio of nominal GNP to
real GNP. It is constructed as follows:
GNP Deflator = Nominal GNP

Real GNP
Real GNP = Value at current Price

CPI
Where CPI is Consumer Price Index

The GNP deflator is useful because it includes prices on all goods and services in
GNP.
Per Capita Income

By National Income is meant the value of outputs produced within a year. Income
per capita is simply the National Income divided by the population of the country in
a year.
Income Per Capita = National Income

Population
It shows the standard of living a country can afford for its people. The level of
income per capita is determined by the size of a country’s population. The higher is
the rate of growth of population, the lower is the rate of growth of income per capita.
Per capita income is a theoretical rather than a factual concept. It shows what the
share of each individual’s National Income would be if all citizens were treated as
equal. In a real world situation there exists considerable inequality in the
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distribution of income especially in the third world countries
National Income and Welfare

The relationship between national income and welfare is best explained in terms of
economic growth (By economic growth is meant capacity expansion). The effect of
economic growth is an increase in the national income. This increase in National
Income has several effects on a country’s citizens.
1) Assuming a fair distribution of income, the average citizen would be in a

position to enjoy a higher living standard.
2) The ordinary households or persons could be able to afford luxury commodities.

NB: luxury differs in its definition from one country to another and the
determining factor being the level of income. e.g. clothing can be a luxury for
some people.
3) It enables the ordinary household to afford leisure which may be regarded as

luxury i.e. reducing working hours.
Points 1, 2 and 3 are based on assumption that there exists a fair distribution of the
National cake. This may not be the case in fact it is disastrous to rely on GNP, its
growth rate and GNP per capita as indicators of economic well being. GNP per
capita e.g. gives no indication of how National Income is actually distributed and
who is benefiting most from the growth of production. A rising level of absolute
and per capita GNP may camouflage the fact that the poor are not better than before.
In fact the calculation of GNP and especially its rate of growth is in reality largely a
calculation of the rate of growth, of the incomes of upper 20% who receive a
disproportionately large share of the National Product. It is, therefore, unrealistic to
use GNP growth rates as an index of improved economic welfare for the general
public.
Example: Assuming a 10 people economy and assuming 9 of them had no income

and the 10th person receives 100 units of income the GNP for this economy would be
100 units of income and per capita income would be 10 units. Suppose everyone’s
income increases by 20% so that GNP rises to 120 units per capita income would
rise to 12 units. However for the 9 people without income before and currently such
a rise in per capita income provides no cause for rejoicing since the one rich
individual still has the income. In this case we observe that GNP instead of being a
welfare index of a society as a whole is merely increasing the welfare of a single
individual.
This exchange though an extreme case is indicative of what happens in the real life
situation where incomes are very unequally distributed.
Costs of Economic Growth (Increase in National Income)
1. People living in industrial towns suffer from the effects of a polluted

atmosphere.
2. The manufacture of intoxicants together with urbanization and urban housing

problems leads to an increase in crimes. This creates for the state the additional
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costs of the maintenance of prisons and a large police force to maintain law and
order. Thus social welfare would be increased if the production and sale of
intoxicants are curtailed.
3. While the expansion of the National Income owes a great deal to scientific
research the application of research to new means of destruction add nothing to
social welfare.
4. It leads to employment of women in industry leading to children being left

without care or simply maternal care.
Arguments for and against Uneven Distribution of Income and Wealth
The basic economic argument to justify large income inequality was the assumption
that high personal and corporate incomes were necessary conditions for saving
which made possible investments and economic growth through mechanism such as
the Harrod-Domar Model. In this argument it is maintained that the rich save and
invests a significant proportion of their incomes while the poor spend all their
incomes on consumer items, and since GNP growth is assumed to be directly related
to the proportion of National Income saved then an economy characterised by highly
unequal distribution of income would save more and grow faster than one with more
equitable distribution of income. It was also assumed that eventually National per
capita income would be high enough to allow for a sizeable distribution of income
via Taxes and subsidies but until such time is reached, any attempt to redistribute
income significantly could only serve to lower growth rate and delay the time when
a large income cake would be cut up into smaller sizes for all population group.
Limitations of the argument (Against)

Unlike the historical experience of the now developed countries, the rich in
contemporary Third World Countries are not noted for the desire to save and invest
substantial proportions of their income in the local economy. Instead businessmen,
politicians and other elites are known to squander much of their income on imported
goods, luxury houses, foreign travel and investment in gold, jewellery and foreign
banking countries. Such savings and investments do not add to the National
Productive resources. Instead they represent substantial drains on these resources in
that the income so derived is extracted from the sweat and toil of common
uneducated unskilled labourers thus the rich do not necessarily save and invest a
significantly large proportion of their income than the poor.
A growth strategy based on sizeable and growing income inequalities may in reality
be nothing more than an opportunistic myth designed to perpetuate the vested
interests and maintain “status quo” of the economic and political elite of the 3rd
world, often at the expense of the great majority of the general population.
1) The low income and low levels of living for the poor which are manifested in
poor health, nutrition and education can lower their economic productivity and
thereby lead directly and indirectly to a slower growing economy. Therefore
strategies to lift the living standard and incomes of say the bottom 40% would
contribute not only to their material well being, but also to the productivity and
income of the economy as a whole.
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2) Raising the income level of the poor will stimulate an overall increase in the
demand for locally produced necessity products like food and clothing. Rising
demand for local goods provided a greater stimulus for local production i.e.
stimulates local production, employment and investment. This creates a
broader popular participation in that growth. The rich, on the other hand, tend
to spend more of their additional income on imported luxuries.
3) A more equitable distribution of income achieved through the reduction of mass

poverty can stimulate healthy economic expansion by acting as a powerful
material and psychological incentive to widespread public participation in the
development process. Wide income disparities and substantial absolute poverty
on the other hand can act as a powerful and psychological disincentive to
economic progress. In the extreme, it may create conditions for its ultimate
rejection by the masses of frustrated and politically exploitive people notably
the educated.
1.7 National Income and Standards of Living

Standard of living refers to the quantity of goods and services enjoyed by a person.
These goods may be provided publicly, such as in the case of health care or education
or they may be acquired by direct purchase. It also includes the less easily quantifiable
aspects of living such as terms and conditions of employment and general living
environment.
National Income figures can be used to measure the standard of living at a particular
point of time and over time. This is done by working out the per capita income of the
country. By per capita income we mean: the value of goods and services received by
the average man. Per capita income is obtained by dividing the National Income by
the Total population. If the per capita income is high, it can be deduced that the
standard of living is high.
Problems of using per capita income to compare standard of living over time
1) The composition of output may change. e.g. more defence-related goods may be
produced and less spent on social services, more producer goods may be made
and less consumer goods, and there may be a surplus of exports over imports
representing investment overseas. Standards of living depend on the quantity of
consumer goods enjoyed.
2) Over time prices will change. The index of retail prices may be used to express the
GNP in real terms but there are well known problems in the use of such methods.
3) National Income may grow but this says nothing about the distribution of that
income. A small group may be much better off. Other groups may have a static
standard of living or be worse off.
4) Any increase in GNP per capita may be accompanied by a decline in the general
quality of life. Working conditions may have deteriorated. The environment may
have suffered from various forms of pollution. These non-monetary aspects are
not taken into account in the estimates of the GNP.
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5) Finally the national income increases when people pay for services which they
previously carried out themselves. If a housewife takes an office job and pays
someone to do her housework, national income will increase to the extent of both
persons' wages. Similarly a reduction in national income would occur if a man
painted his house rather than paying a professional painter to do the same.
Changes of the above type mean that changes in the GNP per capita will only
imperfectly reflect changes in the standard of living.
Per Capita income and International Comparisons

Per capita income figures can also be used to compare the standards of living of
different countries. Thus if the per capita income of one country is higher than that of
another country, the living standard in the first country can be said to be higher. Such
comparisons are made by aid giving international agencies like the United Nations and
they indicate the relevant aid requirements of different countries.
But there are major problems in using real income per head (per capita income) to
measure the standard of living in different countries. First there is the whole set of
statistical problems and, secondly, there are a number of difficult conceptual problems
or problems of interpretation.
i. Inaccurate estimates of population: The first statistical problem in calculating

income per head particularly in less developed countries is that we do not have
very accurate population figures with which to divide total income.
ii. Specific items which are difficult to estimate: Another data problem, as already
mentioned, is that data for depreciation and for net factor income from abroad are
generally unreliable. Hence although we should prefer figures for “the’ national
income, we are likely to fall back on GDP, which is much less meaningful figure
for measuring income per head. Inventory investment and work-in-progress are
also difficult items to calculate.
iii. Non-marketed subsistence output and output of government: some output like
subsistence farming and output of government are not sold in the market. These
are measured by taking the cost of the inputs. In one country, however, salary of
doctors for instance, might be higher and their quality low compared to another
country. Although the medical wage bill will be high, the "real consumption” of
medical care in the former might be lower. Since “public consumption” is an
important element in national income, this could affect comparisons considerably.
Also in making international comparisons it is assumed that the complied national

income figures of the countries being compared are equally accurate. This is not
necessarily the case. If, for example, in one country there is a large subsistence
sector, a lot of estimates have to be made for self-provided commodities. The
national figures of such a country will, therefore, be less accurate than those of a
country whose economy is largely monetary or cash economy.
iv. Different degrees of income distribution: If the income of one country is evenly
distributed, the per capita income of such a country may be higher than that of
another country with a more evenly distributed income, but this does not
necessarily mean that most of its people are at a higher living standard.
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v. Different Types of Production: If one country devotes a large proportion of its

resources in producing non-consumer goods e.g. military hardware, its per capita
income may be higher than that of another country producing largely consumer
goods, but the standard of living of its people will not necessarily be higher.
vi. Different forms of Published National Income figures: The per capita income
figures used in international comparisons are calculated using the published
figures of national income and population by each country. For meaningful
comparisons, both sets of national income figures should be in the same form i.e.
both in real terms or both in money terms, the latter may give higher per capita
income figures due to inflation, and thus give the wrong picture of a higher living
standard. On the other hand, if both sets are in money terms the countries being
compared should have the same level of inflation. In practice, this is not
necessarily the case.
vii. Exchange Rates: Every country records its national income figures in its own
currency. To make international comparisons, therefore, the national income
figures of different countries must have been converted into one uniform
currency. Using the official exchange rates does this. Strictly speaking, these
apply to internationally traded commodities, which normally form a small
proportion of the national production. The difficulty is that these values may not
be equivalent in terms of the goods they buy in their respective commodities i.e.
the purchasing power of the currencies may not be the same as those reflected in
the exchange rate.
viii. Difference in Price Structures: Differences in the relative prices of different

kinds of goods, due to differences in their availability, mean that people can
increase their welfare if they are willing to alter their consumption in the direction
of cheaper goods. The people in poor countries probably are not nearly as badly
off as national income statistics would suggest, because the basic foodstuffs,
which form an important part of their total consumption, are actually priced very
low.
ix. Income in relation to Effort: The first conceptual problem in calculating

income per head is to look at goods and services produced in relation to the
human effort that has gone into producing them. Obviously if people work
harder, they will be able to get more goods; but they may prefer the extra
leisure. Indeed, the amount of leisure that people want depends in part on their
level of income. Strictly, therefore, we should take income per unit of labour
applied. It is largely because this would be statistically awkward that
economists prefer to take real income per head.
x. Differences in size: A problem which is both conceptual and statistical is due

to the transport factor. If two countries are of different sizes, the large country
may devote a large proportion of its resources in developing transport and
communication facilities to connect the different parts of the country. This
will be reflected in its national income, but the standard of living of its people
will not necessarily be higher than that of smaller country, which does not
need these facilities to the same extent.
xi. Differences in Taste: Another formidable difficulty is that tastes are not the
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same in all countries. Also in different countries the society and the culture
may be completely different thus complicating comparisons of material
welfare in two countries. Expensive tastes are to some extent artificial and
their absence in poor countries need not mean a corresponding lack of welfare.
Tastes also differ as regards the emphasis on leisure as against the employment
of the fruit of labour: if in some societies people prefer leisure and
contemplation, who is to say this reduces their welfare as compared to those
involved in the hurly-burly of life and labour in modern industry?
xii. Different climatic zones: If one country is in a cold climate, it will devote a
substantial proportion of its resources to providing warming facilities, e.g.
warm clothing and central heating. These will be reflected in its national
income, but this does not necessarily mean that its people are better off than
those in a country with a warm climate.
xiii. Income per head as index of economic welfare: We cannot measure material
welfare on an arithmetic scale in the same way as we measure real income per
head. For instance, if per capita income increases, material welfare will
increase; but we cannot say by how much it has increased, and certainly that it
has increased in proportion.
1.8 Consumption, Saving and Investment
Aggregate Demand
This refers to the total planned or desired spending in the economy as a whole in a
given period. It is made up of consumption demand by individuals, planned
investment demand, government demand and demand by foreigners of the nations
output.
i. The Consumption Function

The consumption function is the relationship expressed in mathematical or
diagrammatic form] between planned consumption and other independent variables,
particularly income.
The consumption function is one of the most important relations in Macro-economics.
Consumption is the largest single component of aggregate expenditure and if we are to
predict the effects of income and employment of variations in private investment and
in government spending, we must know how consumption varies in response to
changes in income. Thus it is important to take a closer look at the consumption.
Other Determinants
1. Rate of Interest Is contained in the argument of the classified economists

who argued that rational consumers will save more and consume less if the rate of
interest is high.
2. Relative Prices Influences the aggregate consumption. If relative prices are

high, the level of consumption will be low
3. Capital Gains Keynes observed that there is a possibility of windfall gains or

losses influencing consumption. He says consumption of the wealth owning group
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may be extremely susceptible to unforeseen changes in the money value of their

wealth. This is true of the stock minded speculative economy.
4. Wealth The possession of liquid assets influences the amount that you have to
save. It stems from the Diminishing Marginal Utility of Wealth. The larger the stock
of wealth, the lower its Marginal Utility and consequently the weaker the desire to add
to future wealth by curtailing present consumption. In this case, the more wealth an
individual has, the weaker will be the desire to accumulate still more savings at that
particular time.
5. Money Stock or Liquid Assets: Possession of liquid assets boosts consumption

in that they can be changed into cash and thus consumed.
6. Availability of Consumer Credit: Normally influences spending of the

consumer of durables.
7. Attitudes and Expectations of the Consumer A change in the consumer

attitudes will affect consumer behaviour. The expectations attained by the consumer
about income increases will affect the consumer behaviour. If in the face of price
increases they expect further price increases; they shall increase their purchases
further. N/B. These things might be true of an individual, but not the [aggregate]
society.
8. The money Illusion Some people look at money at the face value.
Consumption will be affected if customers are subject to money illusion. The
phenomenon of Money illusion occurs when despite proportional changes in the prices
of goods and services and then their money incomes which keeps real incomes
unchanged, consumers make a change in their real consumption pattern. It is know as
Pigou Effect which talks of real balance. With a change in nominal income, people
behave in the same way as though their real income has gone up.
Suppose price and Money Income increases by 10%, for the families which regard
their real income unchanged and do not suffer from money illusion they would take
their real incomes as unchanged and would only increase their consumption by 10%.
9. Distribution of Income If the Marginal Propensity to consume among the poor

is high, then redistribution of wealth from the rich to the poor leads to higher
consumption.
10. Composition of the Population: In sex and age.
1.9 The Keynesian Theory of Consumption Function

The theory was developed during the Great Depression which plagued Europe and
America. During this time, there was excess capacity and idle resources and no
effective demand i.e. people were unemployed and had no purchasing power. The
determination of aggregate demand, then, was of crucial significance in Keynes
analysis.
Definitions
i. Average Propensity to Consume:
The average Propensity to Consume [APC] is defined as the fraction of aggregate
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national income which is devoted to consumption. If consumption is denoted by C

and income by Y, then:
APC = C
Y
The Average Propensity to Consume decreases in Keynes model as income increases.
ii. Average Propensity to save The Average Propensity to Save [APS] is defined as the
fraction of aggregate national income which is devoted to savings. Thus if S denotes
savings then,
APS = S
Y
In a closed ungoverned economy, where income is spent or saved, APC = APS = 1
iii. Marginal Propensity to Save

The Marginal Propensity to Save is the fraction of an increase in income that is saved.
Thus, if ΔS denoted changes in savings, and ΔY change in income, then,
MPC = ΔC/ Δ y
An increase in income is partly consumed and partly saved. Thus
ΔC + ΔS = ΔY
Dividing through by ΔY, we get

Δc
/ ΔY + ΔS/ ΔY = 1
Therefore ΔC + ΔS = 1, and
S =1–C
ii. Investment
Investment is the process of increasing the productive capital stock of a country,

or can be defined as the production of goods not for immediate consumption.
The investment function is the relationship [expressed in mathematical or
diagrammatic form] between planned investment and the real interest rate.
Definitions
Induced Expenditure Also called endogenous expenditure is any expenditure that is
determined by, and thus varies with, economic variables within our theory.
Autonomous Expenditure: Also called exogenous expenditure, is any expenditure that

is taken as a constant or unaffected by any economic variables within our theory. For
instance, in the simple theory of the determination of national income, investment is
assumed to vary directly with national income.
Actual income and full employment income: Full employment income (Also called
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Potential National) is the national income that could be produced when the country’s
factors of production are fully employed. This concept is given the symbol YF.
Actual national income, symbolized by Y, can be below or equal to YF and, by
working resources overtime and otherwise harder than normal, it can occasionally rise
above YF.
Intended or planned Investment: Expenditure on investment depends on business

expectations on the chance of making profits and on the availability of funds for the
purchase of producer goods. Although business expectations re complex in nature, a
rough approximation is that the expectations on profits rise or fall in direct response to
movements in the GNP this year increases businessmen expect an increase in planned
consumption expenditures, and hence profits to increase next year.
iii. The Multiplier In his theory Keynes asserted that consumption is a function of
income, and so it follows that a change in investment, which we may call ΔI, meaning
an increment in I will change Y by more than ΔI. For while the initial increase in Y,
ΔY, will equal ΔI, this change in Y itself produce a change in C, which will increase Y
still further. The final increase in income thus exceeds the initial increase in
investment expenditure which is therefore magnified or “multiplied”. This process is
called the multiplier process.
The Operation of the “Multiplier”
The multiplier can be defined as the coefficient (or ratio) relating a change in GDP
to the change in autonomous expenditure that brought it about. This is because the
Multiplier can be defined as the coefficient (or ratio) relating a change in GDP to the
change in autonomous expenditure that brought it about. This is because a change in
expenditure, whatever its source, will cause a change in national income that is
greater than the initial change in expenditure.
For example, suppose there is an autonomous increase in investment which comes

about as a result of decisions by businessmen in the construction industry to increase
the rate of house building by, say, 100 houses, each costing £1,000 to build,
investment will increase by £100,000. Now this will be paid out as income to
workers of all kinds in the building industry, to workers in industries which supply
materials to the building industry, and others who contribute labour or capital or
enterprises to the building of the houses; these people will in turn wish to spend
these incomes on a wide range of consumer goods, and so on. There will thus be a
series of further rounds of expenditure, or Secondary Spending, in addition to the
initial primary spending, which constitutes further increases in GDP.
This is because those people whose incomes are increased by the primary increase in
autonomous expenditure will, through their propensity to consume, spend part of
their increase in their incomes. GDP increases through the Expenditure – Income –
Expenditure cycle.
How and where does the Multiplier Stop?

The multiplier concept can erroneously give the impression that an initial increase in
autonomous spending would lead to an indefinite increase in GDP. This does not
happen because each secondary round of increased expenditure gets progressively
smaller, which is explained by the fact that the Marginal Propensity to spend the
national income is less than one. This is the ratio which scales down each
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successive round of expenditure and causes the GDP to converge to a new

equilibrium level.
Suppose in our example, an average of three fifths of any increase in income is spent
by the people receiving it:
The Marginal Propensity to consume or save will be 3/ 5 or 2/ 5 respectively. Since

∆I = 1000,000, the increase in Y converge at the level 250,000. This is because for
any value z between 0 and 1, the series
1 + z + z2 z3 …..
tends to the value 1/ 1 -z. In our example we have the series (in thousands)
100 + 60 + 36 + 21.6 + ….
Or
100 { 1 + (3/5) + (3/5) + …..}
which thus equals:
1 1
100 = --------- = 100 ------- = 250
1 – 3/ 5 2
/5
This result can be generalized, using our notation, as
1 1
∆1 ----------------- = 1 -------------- = ∆Y
1 - ∆c/ ∆Y ∆s
/ ∆Y
Dividing by I, we obtain

∆Y 1 1
----- = ----------- = ------------
∆I 1 – ∆c/ ∆Y ∆s
/ ∆Y
The ratio, ∆Y/∆I, of the total increase in income to the increase in investment which
produce it, is known as the MULTIPLIER, K. If we write c for ∆C/∆T and s for
∆S/∆Y, we have
∆Y 1 1
k= ----------- = --------- = --------
∆I 1–c s
The multiplier is thus the reciprocal of the MPS (marginal propensity to save).
Relevance of Multiplier
The Keynesian Model of the Multiplier however is a Short Run Model, which puts
more emphasis on consumption than on savings. It is not a long run model of growth
since savings are the source of investment funds for growth. It is appropriate for
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mature capitalist economies where there is excess capacity and idle resources, and it is
aimed at solving the unemployment problem under those conditions – (i.e. problem of
demand deficiency with the level of investment too low, because of lack of business
confidence, to absorb the high level of savings at full employment incomes).
It is not a suitable model for a developing economy because:
i. In less developed economies exports rather than investment are the key injections
of autonomous spending.
ii. The size of the export multiplier itself will be affected by the economies
dependence on two or three export commodities.
iii. In poor but open economies the savings leakage is likely to be very much smaller,
and the import leakage much greater than in developed countries.
iv. The difference, and a fundamental one, in less developed countries is in the
impact of the multiplier on real output, employment and prices as a result of
inelastic supply.
The Acceleration Principle

Suppose that there is a given ratio between the level of output Y t at any time t, and the
capital stock required to produce it K t and that this ratio is equal to α, hence:
K t =αY t
The coefficient is the capital-output ratio, α, = K/ Y and is called the accelerator co-
efficient.
If there is an autonomous increase in investment, ∆I this through the multiplier process
will lead to increased employment resulting in an overall increase in income, ∆Y.
This may lead to further investment called Induced Investment in the production of
goods and services. This process is called acceleration.
The ratio of induced investment to the increase in income resulting from an initial
autonomous increase in investment is called the accelerator. Thus, if the included
investment is denoted by ∆I1 and the accelerator by β, then:
∆I1
----------------
= β, ΔI1 = βΔY
∆Y
Thus another way of looking at the accelerator is as the factor by which the increase
in income resulting from an initial autonomous increase in investment is multiplied
by the induced investment.
From the Keynesian model ∆Y = ∆1.1/ s we c an write
Δ11 = β, Δ11 .1/ s
Thus, the higher the multiplier and the higher the accelerator, the higher will be the
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level of induced investment from an initial autonomous increase.
1.10 Determination of Equilibrium National Income

National income is said to be in equilibrium when there is no tendency for it either to
increase or for it to decrease. The actual National Income achieved at that point is
referred to as the equilibrium National Income.
For there to be equilibrium, firm spending must be equal to firm’s receipts. If this
were not the case, the firms will receive less and lose money until there is no more
money in the system. Hence, for there to be equilibrium:
Factor Incomes = Consumer Spending
Income Models
1) The Spendthrift Economy: This assumes a circular flow of income in a closed
economy with no Government sector and no foreign trade. It also assumes the
existence of two sectors, namely the sector of households and the sector of firms.
Firms make the commodities that households consume. They purchase the services of
factors of production from the household that own them, paying wages, rent, interest
and profits in return, and then use the factors to make commodities.
It is assumed firms sell all of their output to households and receive money in return.
All of the money received is in turn paid out to households. Part goes to households
that sell factor services to firms, and the rest is profit paid out as Dividends to the
owners of the firm. In short, neither households nor firms save anything in the
spendthrift economy; everything that one group receives goes to buy goods and
services from the other group. Expenditure is the rule of the day!
The input Factor Household

The output Expenditure
Income Approach Approach
Wages payments
Factor Rent for goods
Goods and
Services interest and services Services
Profit purchased
Firms
Figure 1.2 The Spendthrift Economy
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Now, suppose we wish to calculate the Total Value of the economy’s output. We can
do this based on either side of the circular flow shown in the figure above. The
output-expenditure approach uses calculations based on the flows on the right hand
side of the figure, while the input-factor income approach uses calculations based on
the flows on the left-hand side of the figure.
2) The Frugal Economy: In the Frugal economy, households and firms look to the
future, and as a result undertake both Saving and Investment.
Saving is income not spent on goods and services for current consumption. Both
households and firms can save. Households save when they elect not to spend part of
their current income on goods and services for consumption. Firms save when they
elect not to pay out to their owners some of the profits that they have earned.
Distributed profits are profits actually paid out to the owners of firms, and
undistributed profits are profits held back by firms for their own uses.
Investment is defined as the production of goods not for immediate consumption. All
such goods a are called investment goods. They are produced by firms and they may
be bought either by firms or by households. Most investment is done by firms, and
firms can invest either in capital goods, such as plant and equipment, or inventories.
The total investment that occurs in the economy is called Gross Investment. The
amount necessary for replacement is called the Capital consumption Allowance and is
often loosely referred to as depreciation. The remainder is called net investment.
The current production of final commodities in the frugal economy can be divided into
two sorts of output. First, there are consumption goods and services actually sold to
households. Second, there are investment goods that consist of capital goods plus
inventories of semi-finished commodities still in the hands of firms. The symbols C
and I can be used to stand for currently produced consumption goods and currently
produced investment goods respectively.
In an economy that uses capital goods, as does the Frugal economy, it is helpful to
distinguish between two concepts of National Income (or National Product).
Gross National Income (or Gross National Product, GNP); It is the sum of the values
of all final goods produced for consumption and investment, and thus it is also the sum
of all factor incomes earned in the process of producing the National output.
Net National Income (or Net National Product, NNP) is GNP minus the capital
consumption allowance. NPP is thus a measure of the Net output of the economy
after deducting from gross output an amount necessary to maintain the existing stock
of capital intact.
Equilibrium National Income in a Frugal Economy

Saving and investment are examples of two categories of expenditure called
withdrawals and injections. A withdrawal is any income that is not passed on in the
circular flow. Thus if households can earn income and not spend it on domestically
produced goods and services, this is a withdrawal from the circular flow. Similarly, if
firms receive money from the sale of goods and do not distribute it as payments to
factors, this is a withdrawal from the circular flow.
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An injection is an addition to the incomes of domestic firms that does not arise from
the expenditure of domestic households or arise from the spending of domestic firms.
The effects of withdrawals and injections is to interfere with Equilibrium income.

Withdrawals by reducing expenditure exert a contractionary force on national income.
If, for example, households decide to increase their savings and correspondingly
reduce the amount they used to spend buying consumption goods from firms, this
reduces the incomes of firms, and reduces the payments they will make to factors of
production. Injections, by raising expenditure, exert an expansionary force on national
income. If, for example, firms sell machines to other firms, their incomes and
payments to household for factor services will rise without there having been an
increase in household expenditure.
Thus for equilibrium National Income to exist, firm spending should be equal to firm
receipts. Thus, denoting consumption by C, saving by S and Investment by I, there is
equilibrium if:
C+S=C+I
Or
S=I
i.e. there is equilibrium when savings are equal to investments.
H
- savings
F
+ Investments
Figure 1.3 Equilibrium National Income in a Frugal Economy
To measure the national income in a frugal economy, through the output and
Expenditure approach, the National Income Accountant includes production of goods
for inventories as part of total expenditure since the firm certainly spends money on
the factor services necessary to produce goods for its own inventories. The accountant
calculates the economy’s total output as the actual expenditure on final goods and
services sold, plus the market value of final commodities currently produced and
added inventories. This definition makes total expenditure the same thing as the value
of all final commodities produced and thus ensures that the measured value of
expenditure is identical with the value of total output in any economy.
3) The Governed Economy: The governed economy contains central authorities often
simply called “the government” – who levy taxes on firms and households and which
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engages in numerous activities such as defending the country, making and enforcing
the laws, building roads, running schools, and predicting weather.
When the government produces goods and services that households desire such as
roads and air traffic control, it is obviously engaged in a useful activity and is
obviously adding to the sum total of valuable output. The national income statistician
count as part of the GNP every government expenditure on goods and services,
whether it is to build a scud missile to promote police protection, or to pay a civil
servant to file and re-file papers from a now defunct ministry.
Definitions:
Transfer Payments: Are any payments made to households by the government that
are not made in return for the services of factors of production i.e. there is no Quid pro
Quo. Such payments do not lead directly to any increase in output and for this reason
they are not included in the nation GNP.
Disposable Income: This is the income which households actually have available to
spend or to save. To calculate disposal income, which is indicated by Ya, the
statistician must make several adjustments to GNP.
First, all those elements of the value of output that are not paid out to households must
be deducted: business savings represent receipts by firms from the sale of output that
are withheld by firms for their own uses, and corporation taxes are receipts by firms
from the sale of output that are paid over to the government. Secondly, personal
income taxes must be deducted from the income paid to households in order to obtain
the amount households actually have available to spend or save. Finally, it is
necessary to add government transfer payments to households. Although these are not
themselves a part of GNP, they are made available to households to spend and save,
and are thus a part of disposable Income. Thus disposal income is:
GNP minus any part of it that is not actually paid over to households, minus the
personal income taxes paid by households, plus transfer payments received by
households.
Real and nominal measures

Output, Expenditure and Income can be valued at current market price in which case
we speak, for example, of money or Nominal NNP, or NNP valued at current prices.
Changes from one year to another are then a compound of changes in physical
quantities and prices. Output, Expenditure and Income can also be valued at the prices
ruling in some base year. In this case,
each year’s quantity is priced at its base-year prices and then summed. We then
speak, for example, of GDP at constant prices, or REAL GDP. Changes in constant-
price GDP give a measure of real or quantity changes in total output.
Equilibrium Income
In this model, aggregate desired expenditure has three components: Consumption,
Investment and Government Expenditure:
E=C+I+G
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However, in the Governed Economy, taxes levied by the government are a second
withdrawal. If the government taxes firms, some of what firms earn is not available to
be passed on to households. If the government taxes households, some of what
households earn is not available to be passed on firms. Whatever subsequently
happens to money raised, taxes withdraw expenditure from the circular flow.
In the Governed Economy, however, government expenditure is a second injection.

Such expenditure creates income for a firm that does not arise from the spending of
households, and it creates income for a household that does not arise from the
spending of firms. Whatever the source of funds, government spending injects
expenditure into the circular flow.
Letting G stand for Government Expenditure, T for Taxes, J for injections and W for
withdrawals, we can say the National Income is in equilibrium when total
withdrawals, savings plus taxes, is equal to total injections, investment plus
government expenditure. The equilibrium condition for national income can thus be
written as:
W = J, or S + T = G + I
Government purchases G -
+ S
Personal
Income Taxes
- Taxes on
commodities
+
Taxes on I
Business - +
Government Purchases
From firms
Figure 1.4 The equilibrium for national income
Open Economy: None of the three economies considered so far are engaged in trade
with Foreign Countries. Such economies are often referred to as Closed Economies.
In contrast, open economies engage in significant amounts of foreign trade, so that
some of the goods produced at home are sold a broad while some of the goods sold at
home are produced abroad. The model is more applicable in real life.
A mathematical approach to national income equilibrium.

Equilibrium analysis also has applications in the area of national income. A simple
Keynesian national income model may be expressed as follows:
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Y = C + IO + GO …………………………………………………… (i)
C = a + bY ………………………………………. (ii)
(a > o, o < b < 1)
Y and C are both endogenous variables since they are determined within the model. I o
And G o, on the other hand, represent exogenously determined investment and
government expenditure respectively. Exogenously determined variables are those
whose values are not determined within the model. C = a + b Y represents a
consumption function where a and b stand for autonomous consumption and the
marginal propensity to consume, respectively.
If we substitute equation (ii) into (i) we obtain:
Y = a + bY + I o + G o
(1 – b ) Y = a + I o + G o
_
Equilibrium national income is represented by Y.
_
Y = a + I o + G o ………………………….. (iii)
1–b
The equilibrium level of consumption can be obtained by substituting equation (iii)

into equation (ii).
_ _
C = a + bY = a + b (a + I o + G o )
1–b
 a (1 - b) + b (a + I o + G o )
1–b
A numerical example
Assume a simple two sector model where Y = C + I C = a + bY and I = I o . Assume in
addition, that a = 85, b = 0.45 and Io = 55. This implies that Y = a + bY + I o = 85 +
0.45Y + 55
Y – 0.45Y = 140
0.55Y = 140
Y = 255
This simple model can be extended to include government expenditure and foreign
trade. It may take the following general form:
Y = C +I + G+ (X – M)
Where C = a +bY
And M = m o + mY
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M o represents autonomous imports and m represents induced imports (imports

dependent on _the level of income). Equilibrium national income in this case is
represented by
Y = a + Io + Go+ Xo - Mo
1 – b + mo
Numerical example.
Assume that I o = 360, G o = 260, X o = 320, M o = 120, a = 210, b = 0.8 and m = 0.2
The equilibrium level of national income can be computed as follows:
Y = 360 + 260 + 320 + 210 – 120 2,575

1 – 0.8 + 0.2
1.11 Fluctuations in National Income and the Business Cycles
Business Cycles The business cycle is the tendency for output and employment to
fluctuate around their long-term trends. The figure below presents a stylised
description of the business cycle. The continuous line shows the steady growth in
trend output over time, while the broken line indicate the actual output over the time
period.
Output
D
● ●E
C●
●B
●A
Time
Figure 1. 5 Business Cycles
Point A represents a slump, the bottom of a business cycle while point B suggests the
economy has entered the recovery phase of the cycle. As recovery proceeds the
output rises to a point C above the trend path; we call this a boom. Then as the line
dips via D towards the trend line with output growing less quickly during the recovery
and least quickly (perhaps even falling), during a recession.
Causes: There are a number of explanations of the business cycle but changes in the
level of investment seem to be the most likely. In the simplest Keynesian model an
increase in investment leads to a larger increase in income and output in the short run.
Higher investment not only adds directly to aggregate demand but by increasing
income adds indirectly to consumption demand. A process known as the multiplier.
The reasons for change in investment may be explained as follows. Firms invest when
their existing capital stock is smaller than the capital stock they would like to hold.
When they are holding the optimal capital stock, the marginal cost of another unit of
capital just equals its marginal benefit, this is the present operating profits to which it
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is expected to give rise over its lifetime. This present value can be increased either by
a fall in interest rates at which the stream of expected profits is discounted or by an
increase in the future profit expected. In practice, it is generally believed that changes
in expectations about future profits are more important than interest rate changes. If
real interest rates and real wages change only slowly, the most important source of
short term changes in beliefs about future profits is likely to be beliefs about future
levels of sales and real output. Other things being equal, higher expected future output
is likely to raise expected future profits and increase the benefits from a marginal
addition to the current capital stock. This kind of explanation is known as the
accelerator model of investment. In this theory it is assumed that firms estimate future
profits by extrapolation of past growth of output. While constant output growth leads
to a constant rate of growth of capital stock, it takes accelerating output growth to
increase the desired level of investment. Though the accelerator model is
acknowledged to be a simplification of a complex process its usefulness has been
confirmed by empirical research.
Just how firms respond to changes in output will depend on a number of things
including the extent to which firms believe that current growth in output will be
maintained in the future and the cost of quickly adjusting investment plans. The more
costly it is to adjust quickly, the more likely are firms to spread investment over a long
time period.
The underlying idea of the multiplier-accelerator model is that it takes an accelerating

output growth to keep increasing investment, but it must be noted that once output
growth settles to a constant level investment also becomes constant. Finally if output
falls then the level of investment must fall also.
The limits of the fluctuations around the trend path of output are referred to as ceilings
and floors. If we assume that the circular flow of income is in equilibrium at less than
full employment and there is an increase in investment, the effect of this will be to
raise national income by more than an equivalent amount because of the effect of the
multiplier. This will in turn produce a more than proportionate increase in investment
because of the effect of the accelerator which will produce a more than proportionate
rise in incomes and so on. This cumulative growth of income will continue until the
economy’s full employment ceiling is reached. The process then goes into reverse
with an accelerated decline in the absolute level of net investment, followed by a
multiplied reduction in income and so on. The bottom of ‘floor’, of the recession will
come when withdrawals once more equal the reduced level of injections.
It is argued that modern economies do not fluctuate as much as they did in the past
because of built in stabilizers which operate automatically and the use of discretionary
measures which are available to governments. The taxation system is said to act as a
stabilizer that operates automatically and the use of discretionary measures which are
available to governments. The taxation system is said to act as a stabilizer in the
following way: As income rises a progressive taxation system takes larger and larger
proportions of that increased income; when income falls revenue drops more than
proportionately. Other built-in stabilizers are unemployment benefits and welfare
payments because expenditures on these rise and fall with the unemployment rate.
Despite these built-in stabilizers and the actions of government in their use of
discretionary measures to stabilize the economy, the cycle is still with us as recent
experience has demonstrated.
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In conclusion, it must be added that the causation of business cycles is a complex

matter and the above is only one of a number of possible explanations.
1.12 Review Questions:

1. A hypothetical closed economy has a national income model of the form y = C +
I + G where C = 30 + 0.8Y and I and G and private investment and government
expenditure are exogenously determined t 50 and 80 units respectively. Compute
the national equilibrium level of income for this economy using aggregate income
equals aggregate expenditure and withdrawals and equal injection methods.
2. What are some of the limitations using Gross National Product as a measure of
economic performance?
3. With the help of a diagram explain the circular flow of income and expenditure
4. Briefly explain the following concepts
i) Gross domestic product
ii) Gross national product
iii) Net national product
iv) Nominal gross national product
v) Real gross national product
vi) National income accounting
5. Explain the approaches to measuring national income
6. Explain the difficulties in measuring national income
7. Describe factors affecting the size of a national income
8. Explain the problems of using per capita income to compare standard of living
over time
9. Briefly explain the Keynesian Theory of Consumption
10. Briefly define the following economic terms

i) Propensity to consume
ii) Marginal propensity to save
iii) Investment
iv) Actual income and full employment income
v) Autonomous Expenditure
vi) The Multiplier
1.13 References

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CHAPTER TWO: MONEY AND BANKING
Learning Objectives
At the end of the lesson the student should be able to:
 Explain why money is considered a dynamic force in modern economies.
 State clearly the functions of a central bank and commercial banks.
 Explain fully the process of credit creation by commercial banks.
 Explain fully the meaning of monetary policy and instruments of monetary policy.
 Explain the various theories that explain the demand for money.
 Explain the various theories of interest rate determination.
2.1 Money
The nature and function of money
The development of money was necessitated by specialization and exchange.
Money was needed to overcome the shortcomings and frustrations of the barter
system which is system where goods and services are exchanged for other goods and
services.
Disadvantages of Barter Trade
 It is impossible to barter unless A has what B wants, and A wants what B has.
This is called double coincidence of wants and is difficult to fulfill in practice.
 Even when each party wants what the other has, it does not follow they can
agree on a fair exchange. A good deal of time can be wasted sorting out
equations of value.
 The indivisibility of large items is another problem. For instance if a cow is

worth two sacks of wheat, what is one sack of wheat worth? Once again we
may need to carry over part of the transaction to a later period of time.
 It is possible to confuse the use value and exchange value of goods and services
in a barter economy. Such confusion precludes a rational allocation of
resources and promotion of economic efficiency.
 When exchange takes place over time in an economy, it is necessary to store

goods for future exchange. If such goods are perishable by nature, then the
system will break down.
 The development of industrial economies usually depends on a division of

labour, specialization and allocation of resources on the basis of choices and
preferences. Economic efficiency is achieved by economizing on the use of the
most scarce resources. Without a common medium of exchange and a common
unit of account which is acceptable to both consumers and producers, it is very
difficult to achieve an efficient allocation of resources to satisfy consumer
preferences.
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For these reasons the barter system is discarded by societies which develop beyond
autarky to more specialized methods of production. For such peoples a money
system is essential.
Money may be defined as anything generally acceptable in the settlement of debts.
The Historical development of money

For the early forms of money, the intrinsic value of the commodities provided the
basis for general acceptability: For instance, corn, salt, tobacco, or cloth was widely
used because they had obvious value themselves. These could be regarded as
commodity money.
Commodity money had uses other than as a medium of exchange (e.g. salt could be
used to preserve meat, as well as in exchange). But money commodities were not
particularly convenient to use as money. Some were difficult to transport, some
deteriorated overtime, some could not be easily divided and some were valued
differently by different cultures.
As the trade developed between different cultures, many chose precious metal’s
mainly gold or silver as their commodity money. These had the advantage of being
easily recognizable, portable, indestructible and scarce (which meant it preserved
its value over time).
The value of the metal was in terms of weight. Thus each time a transaction was
made, the metal was weighed and payment made. Due to the inconvenience of
weighing each time a transaction was made, this led to the development of coin
money. The state took over the minting of coins by stamping each as being a
particular weight and purity (e.g. one pound of silver). They were later given a
rough edge so that people could guard against being cheated by an unscrupulous
trade filling the edge down.
It became readily apparent, however, that what was important was public confidence
in the “currency” of money, its ability to run from hand to hand and circulate freely,
rather than its intrinsic value. As a result there was deliberately reduced below the
face value of the coinage.
Any person receiving such a coin could afford not to mind, so long as he was
confident that anyone to whom he passed on the coin would also “not mind”.
Debasement represents an early form of fiduciary issue, i.e. issuing of money
dependent on the “faith of the public” and was resorted to because it permitted the
extension of the supply of money beyond the availability of gold and silver.
Paper Money
Due to the risk of theft, members of the public who owned such metal money would
deposit them for safe keeping with goldsmiths and other reliable merchants who
would issue a receipt to the depositor. The metal could not be withdrawn without
production of the receipt signed by the depositor. Each time a transaction was made,
the required amount of the metal would be withdrawn and payment made.
It was later discovered that as long as the person being paid was convinced the
person paying had gold and the reputation of the goldsmith was sufficient to ensure
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acceptability of his promise to pay, it became convenient for the depositor to pass on
the goldsmith’s receipt and the person being paid will withdraw the gold himself.
Initially, the gold would be withdrawn immediately after the transaction was made.
But eventually it was discovered that so long as each time a transaction was made
the person being paid was convinced that there was gold, the signed receipt could
change hands more than once. Eventually, the receipts were made payable to the
bearer (rather than the depositor) and started to circulate as a means of payment
themselves, without the coins having to leave the vaults. This led to the
development of paper money, which had the added advantage of lightness.
Initially, paper money was backed by precious metal and convertible into precious
metal on demand. However, the goldsmiths or early bankers discovered that not all
the gold they held was claimed at the same time and that more gold kept on coming
in (gold later became the only accepted form of money). Consequently they started
to issue more bank notes than they had gold to back them, and the extra money
created was lent out as loans on which interest was charged. This became lucrative
business, so much so that in the 18th and 19th centuries there was a bank crisis in
England when the banks failed to honour their obligations to their depositors, i.e.
there were more demands than there was gold to meet them. This caused the
government to intervene into the baking system so as to restore confidence. Initially
each bank was allowed to issue its own currency and to issue more currency than it
had gold to back it. This is called fractional backing, but the Bank of England put
restrictions on how much money could be issued.
Eventually, the role of issuing currency was completely taken over by the Central
Bank for effective control. Initially, the money issued by the Central Bank was
backed by gold (fractionally), i.e. the holder had the right to claim gold from the
Central Bank. However, since money is essentially needed for purchase of goods
and services, present day money is not backed by gold, but it is based on the level of
production, the higher the output, the higher is the money supply. Thus, present day
money is called token money i.e. money backed by the level of output.
Over time, therefore, it became clear that for an item to act as money it must possess
the following characteristics.
 Acceptability If money is to be used as medium of exchange for goods and

services, then it must be generally accepted as having value in exchange. This
was true of metallic money in the past because it was in high and stable demand
for its ornamental value. It is true of paper money, due to the good name of the
note-issuing authority.
 Portability If an item is to be used as money, it must be easily portable, so that it

is a convenient means of exchange.
 Scarcity If money is to be used in exchange for scarce goods and services, then
it is important that money is in scarce supply. For an item to be acceptable as
money, it must be scarce.
 Divisibility It is essential that any asset which is used as money is divisible into
small units, so that it can be used in exchange for items of low value.
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 Durability Money has to pass through many different hands during its working
life. Precious metals became popular because they do not deteriorate rapidly in
use. Any asset which is to be used as money must be durable. It must not
depreciate over time so that it can be used as a store of wealth.
 Homogeneity It is desirable that money should be as uniform as possible.
Functions of money
a. Medium of exchange: Money facilitates the exchange of goods and services in

the economy. Workers accept money for their wages because they know that
money can be exchanged for all the different things they will need. Use of
money as an intermediary in transactions therefore, removes the requirement for
double coincidence of wants between transactions. Without money, the
world’s complicated economic systems which are based on specialization and
the division of labour would be impossible. The use of money enables a person
who receives payment for services in money to obtain an exchange for it, the
assortment of goods and services from the particular amount of expenditure
which will give maximum satisfaction.
b. Unit of account: Money is a means by which the prices of goods and services
are quoted and accounts kept. The use of money for accounting purposes
makes possible the operation of the price system and automatically provides the
basis for keeping accounts, calculating profit and loss, costing etc. It facilitates
the evaluation of performance and forward planning. It also allows for the
comparison of the relative values of goods and services even without an
intention of actually spending (money) on them e.g. “window shopping”.
c. Store of Wealth/value: The use of money makes it possible to separate the act
of sale from the act of purchase. Money is the most convenient way of keeping
any form of property which is surplus to immediate use; thus in particular,
money is a store of value of which all assets/property can be converted. By
refraining from spending a portion of one’s current income for some time, it
becomes possible to set up a large sum of money to spend later (of course
subject to the time value of money). Less durable or otherwise perishable
goods tend to depreciate considerably over time, and owners of such goods
avoid loss by converting them into money.
d. Standard of deferred payment: Many transactions involve future payment, e.g.

hire purchase, mortgages, long term construction works and bank credit
facilities. Money thus provides the unit in which, given the stability in its
value, loans are advanced/made and future contracts fixed. Borrowers never
want money for its own sake, but only for the command it gives over real
resources. The use of money again allows a firm to borrow for the payment of
wages, purchase of raw materials or generally to offset outstanding debt
obligations; with money borrowing and lending become much easier,
convenient and satisfying. It’s about making commerce and industry more
viable.
Only money, of all possible assets, can be converted into other goods immediately
and without cost.
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The Determination of the Value Money

Since money is primarily a medium of exchange, the value of money means what
money will buy. If at one time a certain amount of money buys fewer things than at
a previous time, it can be said that the value of money has fallen. Since money itself
is used as unit of account and a means of measuring the “value” of other things, its
own value can be seen only through the prices of other things. Changes in the value
of money, therefore, are shown through changes in prices.
2.2 The Quantity Theory of Money

In the 17th Century it was noticed that there was a connection between the quantity
of money and the general level of prices, and this led to the formulation of the
Quantity Theory of Money. In its crudest form is stated that an increase in the
quantity of money would bring about an appropriate rise in prices. If the quantity of
money was doubled, prices would double and so on. Algebraically, this could be
stated as:
P=aM
Where a is constant, P the price level, and M the supply of money. If the supply of
money doubled, to 2M, the new price level P will equal
a(2m) = 2(aM) = 2P
that is, double the old price level.
After being long discarded, the theory was revived in the 1920s by Professor Irving
Fisher, who took into account the volume of transactions, that is to say, the amount
of “work” that the money supply had to do as a medium of exchange. That is the
velocity
of circulation. Money circulated from hand to hand. If one unit of money is made
to serve four transactions, this is equivalent to four units of money, each being used
in only one transaction.
As modified by Irving Fisher, the quantity theory came to be expressed by the

equation
of exchange.
MV = PT
The symbol M represents the total amount of money in existence – bank notes etc,
and bank deposits.
The symbol V represents the velocity of circulation, i.e. the number of times during
the period each unit of money passes from hand to hand in order to affect a
transaction. Thus if the amount of money in the hands of the public during the year
was an average $1,000,000 and each dollar on average was used five times, the total
value of transactions carried out during the year must have been $5,000,000.
MV therefore represents the amount of money used in a period.
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On another side of the equation, P stands for the general price level, a sort of average
of the price or all kinds of commodities-producers’ goods as well s consumer’s
goods and services. The symbol T is the total of all transactions that have taken
place for money during the year.
The equation of exchange shows us that the price level, and, therefore, the value of
money, can be influenced not only by the quality of money but also by:
i. the rate at which money circulates, and

ii. the output of goods and services.
Thus prices may rise without any change taking place in the quantity of money if a
rise occurred in the velocity of circulation. On the other hand, prices might remain
stable in spite of an increase in the quantity of money if there was corresponding
increase in the output of goods and services.
Even in its revised form, however, the Quantity Theory has been subjected to the
following criticisms:
a. It is not a theory at all, but simply a convenient method of showing that there is
certain relationship between four variable quantities – M, V, P and T. it shows
that only the total quantity of money, as determined by the actual amount of
money in existence the velocity of circulation, is equal to the value of total trade
transactions multiplied by their average price. As such it is obviously a truism,
since the amount of money spent on purchases is obviously a truism, since the
amount of money spent on purchases is obviously equal to the amount received
from sales. Not only must MV be equal to PT, but MV is PT, since they are
only two different ways of looking at the same thing.
b. Even if the equation of exchange is only a truism, it would not be quite

correct to say that it demonstrates nothing. For example, it shows that it is
possible for there to be an increase in the quantity o f money without a general
rise in prices. It informs us, too, that if there is to be a change in one or more
of the variables of the equation, there must be a change in one or more of the
other variables. Cleary, it would be wrong to read into it more than this.
c. The four variables, M, V, P and T, are not independent of one another as the
equation of exchange implies. For example, a change in M is likely of itself to
bring a change in V or T or both. It is probable that a rise in pries will follow
an increase in the quantity of money, but this will most likely be brought about
because the increase in the quantity of money stimulates demand and
production.
d. A serious defect is to allow the symbol P to represent the general price level.
Price changes do not keep in step with one another. In its original form the
equation was criticized because it implied that an increase in the quantity
would automatically bring about a proportionate increase in all prices. A study
of price changes shows that some prices increased by many times while others
by fewer times. Clearly, then, there is no general price level, but instead, as
the index of Retail Price shows, a number of sectional price levels, one for
food, another for clothing, another for fuel and light, and so on.
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e. The Quantity Theory only attempts to explain changes in the value of money,
and does not show how the value of money is in the first place determined.
f. The Quantity Theory approaches the question of the value of money entirely
from the supply perspective.
2.3 The demand for and supply of money
i. Demand for money The demand for money is a more difficult concept than the
demand for goods and services. It refers to the desire to hold one’s assets as money
rather than as income-earning assets (or stocks).
Holding money therefore involves a loss of the interest it might otherwise have
earned. There are two schools of thought to explain the demand for money, namely
the Keynesian Theory and the Monetarist Theory.
The demand for money and saving The demand for money and saving are quite
different things. Saving is simply that part of income which is not spent. It adds to a
person’s wealth. Liquidity preference is concerned with the form in which that
wealth is held. The motives for liquidity preference explain why there is desire to
hold some wealth in the form of cash rather than in goods affording utility or in
securities. (See pp 18 – 26)
ii. The supply of money Refers to the total amount of money in the economy.
Most countries of the world have two measures of the money stock – broad money
supply and narrow money supply. Narrow money supply consists of all the
purchasing power that is immediately available for spending. Two narrow measures
are recognized by many countries. The first, M 0 (or monetary base), consists of
notes and coins in circulation and the commercial banks’ deposits of cash with the
central banks.
The other measure is M 2 which consists of notes and coins in circulation and the
NIB (non-interest-bearing) bank deposits – particularly current accounts. Also in the
M 2 definition are the other interest-bearing retail deposits of building societies.
Retail deposits are the deposits of the private sector which can be withdrawn easily.
Since all this money is readily available for spending it is sometimes referred to as
the “transaction balance”.
Any bank deposit which can be withdrawn without incurring (a loss of) interest
penalty is referred to as a “sight deposit”.
The broad measure of the money supply includes most of bank deposits (both sight
and time), most building society deposits and some money-market deposits such as
CDs (certificates of deposit).
Legal Tender Legal tender is anything which must be by law accepted in settlement
of a debt.
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Determinants of the money supply Two extreme situations are imaginable. In the
first situation, the money supply can be determined at exactly the amount decided on
by the Central Bank. In such a case, economists say that the money supply is
exogenous and speak of an exogenous money supply.
In the other extreme situation, the money supply is completely determined by things
that are happening in the economy such as the level of business activity and rates of
interest and is wholly out of the control of the Central Bank. In such a case
economists would say that there was an Endogenous money supply, which means
that the size of the money supply is not imposed from outside by the decisions of the
Central Bank, but is determined by what is happening within the economy.
In practice, the money supply is partly endogenous, because commercial banks are
able to change it in response to economic incentives, and partly exogenous, because
the Central Bank is able to set limits beyond which the commercial banks are unable
to increase the money supply.
Measurement of changes in the value of money

Goods and services are valued in terms of money. Their prices indicate their relative
value. When prices go up, the amount which can be bought with a given sum of
money goes down; when prices fall, the value of money rises; and when prices rise,
the value of money falls. The economist is interested in measuring these changes in
the value of money.
The usual method adapted to measure changes in the value of money is by means of
an index number of prices i.e. a statistical device used to express price changes as
percentage of prices in a base year or at a base date.
Preparation of Index Numbers

A group of commodities is selected, their prices noted in some particular year which
becomes the base year for the index number and to which the number 100 is given.
If the prices of these commodities rise by 1 per cent during the ensuing twelve
months the index number next year will be 101. Examples of Index Number are
Cost-of Living-Index, Retail Price Index, Wholesale Price Index, Export Prices
Index, etc.
Problems of Index Numbers

The construction of Index Numbers presents some very serious problems and, as
they cannot be ideally solved, the index numbers by themselves are limited in their
value and reliability as a measurement of changes in the level of prices. The
problems are:
a) The problems of weighting

The greatest difficulty facing the compiler of index number is to decide on how
much of each commodity to select. This is the problem of weighting. Different
“weights” will yield different results, as the following example illustrates. Assume
that there are only three commodities, A, B, C and the prices of which are
Kshs.50/=, Kshs.20/= and Kshs.10/=, respectively. By taking one unit of each that
is, without any weighting – the index number for the base year constructed as
follows:-
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Base Year
Commodity Price Weight Index

Kshs.
A 50 1 100
B 20 1 100
C 10 1 100
3 300
Assume that one year later the price of A is Kshs.45/=, B Kshs.25/= and C Kshs.
15/=.
Base Year

Kshs.
A 45 1 90
B 25 1 125
C 15 1 150
3 365
index for all items = 121.6
The index number in the second year is 121.6, showing an increase in price of 21.6
per cent over the base year. If the commodities A, B, C are all differently weighted
a different result will be obtained. For example, suppose that one will then be
compiled as follows:-
Base Year

Kshs.
A 50 1 100
B 20 4 400
C 10 20 2,000
25 2,500
Index for all items = 100
Second Year

Kshs.
A 50 1 90
B 20 4 500
C 10 20 3,000
25 3,590
Index for all items 143
By weighting C heavily this index shows a rise in prices of 43.6 per cent, although
individual prices show only the same change as before. By weighting commodity A
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more heavily, an index number can actually be compiled from the same date to show
a fall in prices.
b) The next problem is to decide what grades and quantities to take into account.
By including more than one grade an attempt is made to make a representative
selection. An even greater difficulty occurs when the prices of a commodity
remain unchanged, although the quantity has declined.
c) The choice of the base year. This would preferably be a year when prices are
reasonably steady, and so years during periods either of severe inflation or
deflation are to be avoided.
d) Index numbers are of limited value for comparisons over long periods of time
because:
 New commodities come on the market.

 Changes in taste or fashion reduce the demand for some commodities and
increase the demand for others.
 The composition of the community is likely to change.
 Changes may occur in the distribution of the population among the various
age groups.
 The rise in the Standard of living.
e) Changes in the taxation of goods and services affect the index.
2.4 The Banking System

Consists of all those institutions which determine the supply of money. The main
element of the Banking System is the Commercial Bank (in Kenya). The second
main element of Banking System is the Central Bank and finally most Banking
Systems also have a variety of other specialized institutions often called Financial
Intermediaries.
The Central Bank
These are usually owned and operated by governments and their functions are:
i. Government’s banker: Government’s need to hold their funds in an account

into which they can make deposits and against which they can draw cheques.
Such accounts are usually held by the Central Bank
ii Banker’s Bank: Commercial banks need a place to deposit their funds; they
need to be able to transfer their funds among themselves; and they need to be
able to borrow money when they are short of cash. The Central Bank accepts
deposits from the commercial banks and will on order transfer these deposits
among the commercial banks. Consider any two banks A and B. On any given
day, there will be cheques drawn on A for B and on B for A. If the person
paying and the person being paid bank with the same bank, there will be a
transfer of money from the account or deposit of the payee. If the two people
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do not bank with the same bank, such cheques end up in the central bank. In
such cases, they cancel each other out. But if there is an outstanding balance,
say in favour of A, then A’s deposit with the central bank will go up, and B’s
deposit will go down. Thus the central bank acts as the Clearing House of
commercial banks.
iii. Issue of notes and coins: In most countries the central bank has the sole power
to issue and control notes and coins. This is a function it took over from the
commercial banks for effective control and to ensure maintenance of confidence
in the banking system.
iv. Lender of last resort: Commercial banks often have sudden needs for cash and
one way of getting it is to borrow from the central bank. If all other sources
failed, the central bank would lend money to commercial banks with good
investments but in temporary need of cash. To discourage banks from over-
lending, the central bank will normally lend to the commercial banks at a high
rate of interest which the commercial bank passes on to the borrowers at an
even higher rate. For this reason, commercial banks borrow from the central
bank as the lender of the last resort.
v. Managing national debt: It is responsible for the sale of Government Securities

or Treasury Bills, the payment of interests on them and their redeeming when
they mature.
vi. Banking supervision: In liberalized economy, central banks usually have a

major role to play in policing the economy.
Vii Operating monetary policy: Monetary policy is the regulation of the economy
through the control of the quantity of money available and through the price of
money i.e. the rate of interest borrowers will have to pay. Expanding the
quantity of money and lowering the rate of interest should stimulate spending in
the economy and is thus expansionary, or inflationary. Conversely, restricting
the quantity of money and raising the rate of interest should have a restraining,
or deflationary effect upon the economy.
a) Open Market Operations: The Central Bank holds government securities. It

can sell some of these, or buy more, on the open market, buying or selling
through a stock exchange or money market. When the bank sells securities to
be bought by members of the public, the buyers will pay by writing cheques on
their accounts with commercial banks. This means a cash drain for these banks
to the central bank, represented by a fall in the item “bankers” deposits’ at the
central bank, which forms part of the commercial banks’ reserve assets. Since
the banks maintain a fixed liquidity (or cash) ratio, the loss of these reserves
will bring about multiple contraction of bank loans and deposits.
By going into the market as a buyer of securities, the central bank can reverse
the process, increasing the liquidity of commercial banks, causing them to
expand bank credit, always assuming a ready supply of credit-worthy
borrowers.
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Conversely, if the central bank wanted to pursue an expansionary monetary

policy by making more credit available to the public, it would buy bonds from
the public. It would pay sellers by cheques drawn on itself, the sellers would
then deposit these with commercial banks, who would deposit them again with
the central bank. This increase in cash and reserve assets would permit them to
carry out a multiple expansion of bank deposits, increasing advances and the
money supply together.
b) Discount Rate (Bank Rate) This is the rate on central bank advances and is also
called official discount rate or “minimum lending rate”. When commercial
banks find themselves short of cash they may, instead of contracting bank
deposits, go to the central bank, which can make additional cash available in its
capacity as “lender of last resort”, to help the banks out of their difficulties. The
Central Bank can make cash available on a short-term basis in either of two
ways; by lending cash directly, charging a rate of interest which is referred to as
the official “discount rate”, or by buying approved short-term securities from
the commercial banks. The central bank exercises regulatory powers as a lender
of last resort by making this help both more expensive to get and more difficult
to get. It can do the former by charging a very high “penal” rate of interest, well
above other short-term rates ruling in the money market. Similarly, when it
makes cash available by buying approved short-term securities, it can charge a
high effective rate of interest by buying them at low prices. The effective rate
of interest charged when central bank buys securities (supplying cash) is in fact
a re-discount rate, since the bank is buying securities which are already on the
market but at a discount.
The significance of this rate of interest charged by the central bank in one way
or the other to commercial banks, as a lender of last resort, is that if this rate
goes up the commercial banks, who find that their costs of borrowing have
increased, are likely to raise the rates of interest on their lending to businessman
and other borrowers. Other interest rates such as those charged by building
societies on house mortgages are then also likely to be pulled up.
c) Variable Reserve Requirement

(Cash and Liquidity Ratios)
The Central Bank controls the creation of credit by commercial banks by

dictating cash and liquidity ratios. The cash ratio is:
Cash Reserves
Deposits
The Central Bank might require the commercial banks to maintain a certain
ratio, say 1/10. Hence:
Cash Reserves = 1
Deposits 10
Deposits = 10 x Cash Reserves
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This means that the banks can create deposits exceeding 8 times the value of its
liquid assets. The liquidity ratio can be rewritten as:
Cash + Reserves Assets = Cash + Reserves Assets

Deposits Deposits Deposits
= Cash Ratio + Reserve Assets Ratio
If the liquidity ratio is 12.5, then:
Cash + Reserved Assets =1

Deposits Deposits 8
Deposits = 10 x cash + 2.5 x Reserve Assets.
In most countries the Central Bank requires that commercial banks maintain a
certain level of Liquidity Ratio i.e. Cash reserves (in their own vaults and on deposit
with the Central Bank) well in excess of what normal prudence would dictate. This
level shall be varied by the Central Bank depending on whether they want to
increase money supply or decrease it.
This is potentially the most effective instrument of monetary control in less

developed countries because the method is direct rather than via sales of securities or
holding bank loans and advances. The effects are immediate. This method
moreover does not require the existence of a capital market and a variety of financial
assets. However, increased liquidity requirements may still be offset in part if the
banks have access to credit from their parent companies. A further problem is that a
variable reserve asset ratio is likely to be much more useful in restricting the
expansion of credit and of the money supply than in expanding it: if there is a
chronic shortage of credit-worthy borrowers, the desirable investment projects,
reducing the required liquidity. Ratio of the banks may simply leave them with
surplus liquidity and not cause them to expand credit. Finally, if the banks have
substantial cash reserves the change in the legal ratio required may have to be very
large:
d) Supplementary Reserve, Requirements/Special Deposit

If the Central Bank feels that there is too much money in circulation, it can in
addition require commercial banks to maintain over and above cash or liquid
assets some additional reserves in the form of Special Deposits. The
commercial banks are asked to maintain additional deposits in their accounts at
the central bank, deposits which cease to count among their reserve assets as
cover for their liabilities.
e) Direct control and Moral Suasion

Without actually using the above weapons, the central bank can attempt simply
to use “moral suasion” to persuade the commercial banks to restrict credit when
they wish to limit monetary expansion. Its effectiveness depends on the co-
operation of the commercial banks.
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f) General and Selective Credit Control

These are imposed with the full apparatus of the law or informally using
specific instructions to banks and other institutions. For instance, the central
bank can dictate a ceiling value to the amount of deposits the bank can create.
This is more effective in controlling bank lending than the cash and liquidity
ratio. It can also encourage banks to lend more to a certain sector of the
economy (e.g. agriculture) than in another (estate building). Selective controls
are especially useful in less developed investment away from less important
sectors such as the construction of buildings, the commercial sector, or
speculative purchase of land, towards more important areas.
B. Commercial Banks
A Commercial Bank is a financial institution which undertakes all kinds of ordinary
banking business like accepting deposits, advancing loans and is a member of the
clearing house i.e. operates or has a current account with the Central Bank. They are
sometimes known as Joint Stock Banks.
Functions of Commercial Banks

In modern economy, commercial banks have the following functions:
i. They provide a safe deposit for money and other valuables.
ii. They lend money to borrowers partly because they charge interest on the loans,
which is a source of income for them, and partly because they usually lend to
commercial enterprises and help in bringing about development.
iii. They provide safe and non-inflationary means for debt settlements through the
use of cheques, in that no cash is actually handled. This is particularly
important where large amounts of money are involved.
iv. They act as agents of the central banks in dealings involving foreign exchange
on behalf of the central bank and issue travellers’ cheques on instructions from
the central bank.
v. They offer management advisory services especially to enterprises which

borrow from them to ensure that their loans are properly utilized.
Some commercial banks offer insurance services to their customers e.g. The
Standard Bank (Kenya) which offers insurance services to those who hold savings
accounts with it.
Some commercial banks issue local travellers’ cheques, e.g. the Barclays Bank
(Kenya). This is useful in that it guards against loss and theft for if the cheques are
lost or stolen; the lost or stolen numbers can be cancelled, which cannot easily be
done with cash. This also safe if large amounts of money is involved.
Bank Deposit
Bank notes and coins together constitute the currency in circulation. But they form
only a part of the total money supply. The larger part of the money supply in
circulation today consists of bank deposits. Bank deposits can either be a current
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account or deposit account. These are created by commercial banks and the process
is called credit creation.
Credit Creation
The ability of banks to create deposit money depends on the fact that bank deposits
need to be only fractionally backed by notes and coins. Because the bank does not
need to keep 100 per cent reserves, it can use some of the money deposited to
purchase income-yielding investments.
Illustration
i. A Single Monopoly Bank
Consider first a country with only one bank (with as many physical branches as is
necessary) and assume that the bank has found from experience that it needs only to
hold 10% of cash s a proportion of total deposits – proportion of transactions that
customers prefer to settle by means of cash, rather than cheque. Now imagine the
balance sheet of the bank look like this:
Initial Position of single bank
Liabilities £1,000 Assets £1,000
Deposits 1,000 Cash 100

Loans 900
Total 1,000 Total 1,000
Deposits are shown as liabilities, since the bank can be called up to repay in cash
any amounts credited to customers in this way. Assets consist of cash held by the
bank, plus loans, which represents the obligations of borrowers towards the bank.
The cash ratio is the ratio of cash held (£100,000) to its liabilities ((£1,000,000), and
is 10 per cent in this case.
Suppose now a customer deposits (liabilities) in this initial position will be:
120 x 100 = 11.8%

1,020
This is unnecessarily high, nearly 12 per cent compared to the conventional ratio of
10 per cent. The bank can therefore safely make additional interest-bearing loans. If
it lends an extra £180,000, according deposits will rise from £1,020,000 to
£1,200,000, so that the 10 per cent ratio of cash to deposit is restored. The final
position is as shown below, and indicates that bank deposits have been created to the
extent of ten times the new cash deposit.
Addition of cash deposit raises cash reserves and cash ratio

Loans 900
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This is a stable position. Borrowers will make out cheques to other people in
payment for goods and services supplied. But these others must be customers of the
same bank, since there is only one bank. There will follow no more than a book
transaction within one bank, the bank deposits being transferred from one customer
to another. Total deposits, total cash, and the cash ratio will not be affected.
Comparing the initial position in the first table with the final position in the table
below, we can see that the increase in bank deposits, which we can call ΔD is 200
and the increase in cash held by the banks, which we can write as ΔC, is 20. Thus
ΔD is ten times ΔC, obviously because 1/r, where r is the cash ratio used, is 10.
Thus ΔD = ΔC
r
Restoration of conventional cash ratio by creation of additional bank deposits

Loans 1,080
ii. Many Banks

A single bank with a “monopoly” of credit creation is rarely found in real world.
What is usually found is where the bank receiving the new deposit is one of several
independent banks. In that case the bank will not seek immediately to expand
deposits to the number of times the cash ratio, by extending loans. It will know that
the borrowers will use the credit granted to them to pay for goods and services, or to
repay debts; and that therefore they will be making cheques out to other individuals
who by now have accounts in other banks. The bank can thus expect to lose cash to
other banks. Either the borrowers will withdraw cash directly, with which to pay
individuals who then deposit this cash with other banks, or if they pay by cheque
these cheques will be deposited with other banks, and the other banks themselves
will present them for cash at the first bank.
Suppose in our example above, (illustration 1), the bank made the extreme
assumption that none of the borrowers’ cheques would be paid to its own customers.
It will create only a relatively small amount of extra deposits, just sufficient to
restore its cash ratio. It will, in fact, make £18,000 worth of additional loans and
retain cash of £2,000. That will restore its cash ratio as shown below.
Initial round of credit creation by first bank
Liabilities (£1,000) Assets (£1,000) Cash ratio
Deposits Cash
Loans %
Original position 1,000 100 900 10.0
Add cash deposit +20 +20 - --
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Second position 1,020 120 900

11.8
Increase loans +18 - +18 --
Cash drain by cheques -18 -18 - -
-
Final position 1,020 102 918 10.0
Net change +20 +2 +18 --
However, the £18,000 lost in cash through cheques drawn by borrowers will be
received by other banks who in turn will find themselves with excess cash reserves,
and in turn create additional loans. There will thus be second generation of bank
deposit creation, each bank again retaining only 10 per cent of the new cash
received, and creating loans in the ratio of nine to one. This new drain of cash will
generate more deposits, and so on, each new round being nine-tenths of the value of
the previous one as follows (£’000s).
20 +18+ 16.20 + 14.85 + 13.12 + …

which can be written as
{1 + 9/10 + (9/10) 3 + (9/10) 4 +……..}
Each successive round of deposit creation is smaller than the previous one, so that
the series converges. Mathematically, the series will eventually add up to converge
to 200. This is because for any value of between 0 and 1 the series tends to the value
1/1 -z .
In an example z = 9/10, which is between 0 and 1, so on the formula applies. Hence
20{1 + 9/10) 2 + (9/10) 3 + ….} = { 1 } = 200

1 – 9/10
if we use ΔD to refer to the final increase or increment in bank deposits, ΔC too the
initial increase in cash received, and “r” to the cash ratio, then ΔD = 200, ΔC = 20,
r = 1/10.
Since 1 – r = 1 – 1/10 = 9/10, we have

ΔD = ΔC {1 + (1 – r) + (1 – r) 2 + (1 + r) 3 + …..}
ΔD = ΔC = ΔC
1 – (1 – r) r
Given the increase in cash received, the additional deposits created will depend on
the fraction of cash retained as backing. The ration ΔD/ΔC of deposits created to
increase in cash is referred to as the bank deposit multiplier.
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Limits on the process of bank deposit creation

On the demand side, there may be a lack of demand for loans, or at least of
borrowers who are sufficiently credit worthy. On the supply side, the volume of
bank deposits will not in general rise and fall as a result of changes in the amount of
cash held or deposited by the public, since the public’s currency requirements tends
to be fairly stable, and roughly proportional to the volume of transactions.
2.5 Money Markets

The expression “money markets” is used to refer to the set of institutions and
individuals who are engaged in the borrowing and lending of large sums of money
for short periods of time (overnight to three months). The money market is not
located in a place – it is rather a network of brokers, buyers and sellers.
Most money market transactions are concerned with the sale and purchase of near
money assets such as bills of exchange and certificates of deposit.
Function of Money Markets

The money markets are the place where money is “wholesaled”. As such the supply
of money and interest rate which are of significance to the whole economy is
determined there.
It is also used by the central bank to make its monetary policy effective.
2.6 Capital Markets

Markets in which financial resources (money, bonds, and stocks) are traded i.e. the
provision of longer term finance – anything from bank loans to investment in
permanent capital in the form of the purchase of shares. The capital market is very
widespread. It can also be defined as the institution through which, together with
financial intermediaries, savings in the economy are transferred to investor.
Interest and the Keynesian Liquidity Preference Theory

Interest is a factor income in that it is considered to be payment to or return on
capital in the sense that it is payment to those who provide loanable funds, which are
used for the purchase of capital assets. The payment of interest to the providers of
loanable funds may be justified on the following grounds:
 The lender postpones present consumption and enjoyment and interest is paid as
persuasion for him/her to make this sacrifice.
 There is risk of default in that the borrower may fail to pay back and interest is
paid as persuasion for the lender to undertake this risk.
 There is loss of purchasing power due to increases in prices over time, and
interest is paid as compensation for this loss.
 The borrower earns income from the investment, and the tender can justifiably
claim a share in that income.
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2.7 Theories of Interest Rates Determination

Interest rates, refers to payment, normally expressed as a percentage of the sum lent
which is paid over a year, for the loan of money. There are many rates of interest
depending on the degree or risk involved, the term of the loan, and the costs of
administration, namely, real, nominal and pure rate of interest.
Pure rate of interest is one from which factors like risk involved, the term of the loan
and the cost of administration has been removed. All rates of interest are related to
each other and if one rate changes so will others.
There are two theories as to how the rate of interest is determined – the loanable
funds and the liquidity preference theories.
a. The Loanable Funds Theory

Also called the classical theory of interest, was developed at the time of classical
economists like Adam Smith, David Ricardo and Thomas Malthus, who held the
view that economic activities were guided by some kind of invisible hand i.e.
through the self interest motive and the price mechanism, and that Government
interference was unnecessary and should be kept at minimum.
Interest SSssS
Rate %
Loanable Funds
Figure 2.1 Interest Rates Vs Loanable Funds
They therefore explained the rate of interest in terms of the demand for money and
supply of loanable funds. The demand comes from firms wishing to invest. The
lower the rate of interest the larger the number of projects which will be profitable.
Thus, the demand curve for funds will slope downwards from left to right.
The supply of loanable funds comes from savings. If people are to save they will
require a reward-interest – to compensate them for forgoing present consumption. If
the interest rate is high, people will be encouraged to save and lend. If the interest
rate is low, people will be discouraged from saving and lending. Hence, the supply
curve of loanable funds slopes upwards.
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Interest
Rate % S
Loanable Funds
Figure 2.2Interest Rates Vs Loanable Funds
The market rate of interest is therefore determined where the demand for and supply
of loanable funds are equal. Geometrically this corresponds to the point of
intersection between the supply curve and the demand curve for loanable funds.
D
S
Interest Rate%
D
S
L Loanable Funds
Figure 2.3Interest Rates Vs Loanable Funds
I is the equilibrium market rate of interest and L the equilibrium level of loanable
funds. Above i, there is excess of supply over demand, and interest rates will be
forced downwards. Below i there is excess of demand over supply and interest rates
will be forced upwards.
Changes in demand or supply will cause shifts in the relevant curves and changes in
the equilibrium rate of interest.
Although this theory has a certain amount of validity, it has been criticized on the
following grounds:
i. It assumes that money is borrowed entirely for the purchase of capital assets.
This is not true because money can be borrowed for the purchase of consumer
goods (e.g. cars or houses)
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ii. It assumes that the decision to borrow and invest depends entirely on interest.
This is not the case, for business expectations play more important role in the
decision to invest. Thus if business expectations are high, investors will borrow
and invest, even if the rate of interest is high and if business expectations are
low investors will not borrow and invest even if the rate of interest is low.
iii. It assumes that the decision to save depends entirely on the rate of interest. This
is not true for people can save for purposes other than earning interest, e.g. as
precaution against expected future events like illness or in order to meet a
certain target (this is called target savings) or simply out of habit.
b. The Keynesian Theory

Also called the Monetary Theory of Interest, was put forward by the Lord John
Maynard Keynes in 1936. In the theory, he stated that the rate of interest is
determined by the supply of money and the desire to hold money. He thus
viewed money as a liquid asset, interest being the payment for the loss of that
liquidity.
Keynes formulated derived from three motives for holding money, namely:
 Transactions;
 Precautionary; and
 Speculative.
Thus Keynes contended that an individual’s aggregate demand for money in any
given period will be the result of a single decision that would be a composite of
those three motives.
a. Transactions demand for money

Keynes argued that holding money is a cost and the cost is equal to the interest rate
foregone. People holding money as assets could also buy Government bonds to earn
interest. But money’s most important function is as medium of exchange.
Consumers need money to purchase goods and services and firms need money to
purchase raw materials and hire factor services. People therefore hold money
because income and expenditure do not perfectly synchronize in time. People
receive income either on monthly, weekly, or yearly basis but spend daily; therefore
money is needed to bridge the time interval between receipt of income and its
disbursement over time.
The amount of money that consumers need for transactions will depend on their
spending habits, time interval after which income is received and Income. Therefore
holding habit and Interval Constant, the higher the income level the more the money
you hold for transactions. Keynes thus concluded that transactions demand for
money is Interest Inelastic.
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Interest
Rate %
Liquidity
Preference
b. Precautionary Demand for Money

Individuals and businessmen require money for unseen contingencies, Keynes
hypothesized that individuals’ demand and institutional factors in society to be
considered in the short run.
Money demanded for these two motives is called active balances, because it is
demanded to be put to specific purposes. The demand for active balances is
independent of the rate of interest. Hence the demand curve for active balances is
perfectly inelastic.
Interest
Rate %
Liquidity
Reference
c. Speculative Demand for Money

Finally, money is demanded for speculative motives. This looks at money as a store
of value i.e. money is held as an asset in preference to an income yielding asset such
s government bond.
Keynes thus explained the Speculative motive in terms of the buying and selling of
Government Securities or Treasury Bills on which the government pays a fixed rate
of interest.
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According to Keynes, securities can be bought and sold on the free market before
the government redeems them, and the price at which they are sold does not have to
be equal to their face value. It can be higher or lower than the face value depending
on the level of demand for securities. He defined the market rate of interest as
Market rate of fixed government rate of interest on securities

Interest = Market price of securities
It follows therefore, that when the market price of securities is high the market
interest rate will be low. Also if the market price of securities ( high holders of
securities) will sell them now and hold money. Hence the demand for money is high
when the interest rate is low. On the other hand when the market price of securities
is low, the market rate of interest will be high. Also if the market price of securities
is low, it can be expected to rise. Hence people will buy securities at a low price,
hoping to sell them at higher prices. In buying securities, people part with money.
Hence the demand for money is low when interest rate is high. It follows, therefore,
that the demand curve for money for the speculative motive slopes downwards as
shown on the next page.
Interest
Rate % LI
Liquidity
Preference
Figure 2.4 Interest Rates and Liquidity Preference
It flattens out at the lower end because there must be a minimum rate of interest
payable to the people to persuade them to part with money. This perfectly elastic
part is called liquidity trap.
The total demand for money at any given interest rte is the sum of the demands for
the active balances and the speculative motive. Thus, the total demand curve for
money is obtained by the horizontal summation of the two demand curves.
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Interest Interest Interest

Rate % Rate % Rate %
La
L1 L
Active speculative Total
Balance Motive Demand
i1 i1 i1
i2 i2 i2
1 2 3 4 5
i3 i3 i3
L i 1 L31
Liquidity Liquidity Liquidity
Preference Preference Preference
1+2=4
Figure 2.5 Interest Rates and Liquidity
Note that the demand for money for active balances is constant at La at all rates of
interest. At interest rate i 1 , the demand for speculative motive is L i 1. Hence total
demand is (L a + L i 1)
At the interest rate i 2 and the total demand is (La + L 3 1) and so on. This gives rise to
the total demand curve LL.
Interest
Rate %
M
Liquidity Preference
Figure 2.6 Interest rates and liquidity preference

At any given time, the supply of the money is fixed, as determined by the monetary
authorities. Hence the supply of money is independent of the rate of interest and the
supply curve of money is perfectly inelastic as shown above.
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The equilibrium rate of interest is determined by the interaction of demand and

supply forces, and this corresponds to the point of intersection between the demand
curve and the supply curve.
Interest L
rate % M
i
L
Liquidity
Preference
Figure 2.7 Interest rates and liquidity preference
i is the equilibrium rate of interest. Above it there is excess supply over demand and
the interest rates will be forced downwards. Below it there will be excess demand
over supply and interest rates will be forced upwards. An increase in the supply of
money will cause interest rates to fall down because people will need less persuasion
to part with money. An increase in supply is indicated by a shift to the right of the
supply curve.
Interest L2
Rate % L1
M
i1
i2 L
Liquidity
Figure 2.8 Interest rates and liquidity
When supply increases from M1 to M2, interest rates fall from i1 to i2. Conversely,
fall in the supply of money (indicated by a shift to the left of the supply curve)
causes interest rates to rise because people will need more persuasion to part with
the money. Thus when supply falls from M2 to M1, interest rate will rise from i2 to
i1.
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An increase in the demand for money (indicated by an upward swing of the demand
curve will cause interest rate to rise.
Interest L
Rate % M1 M2
i1
i2
L
Liquidity
Figure 2.8 Interest rates and liquidity
An increase in demand from L1 to L2 causes interest rate to rise from i2 to i1. This
is because at the initial rate of interest the increase in demand creates excess of
demand over supply which causes interest rates to rise.
Conversely, when demand falls (indicated by downward swing of the demand curve)
interest rate falls as at the initial rate of interest there will be excess of supply over
demand. Thus, when demand falls from L2 to L1, interest rate falls form i1 to i2.
2.8 The IS – LM Model

IS – LM analysis aims to find the level of income and rate of interest at which both
the commodity market and money market will be in equilibrium.
There IS curve is locus of points representing all the different combinations of
interest rates and income levels consistent with equilibrium in the goods or
commodity market.
The IS curve is shown in the diagram below:
Interest
Rate
(i)
IS curve
0 National Income (Y)

Figure2.9 The IS curve
The IS curve is a linear function in the two variables Yand I.
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The LM curve is a locus of points representing all the different combinations of

interest rates and income levels consistent with equilibrium in the money market.
The LM curve is shown in the following diagram.
Interest
rate LM curve
(i)
0 National Income (Y)

Figure2.10 The LM Curve
The LM curve is also a function which is linear in the two variables I and Y.
IS – LM analysis aims at obtaining simultaneous equilibrium in both the commodity

and the money markets. Graphically, this situation can be represented as follows:
Interest
Rate IS – curve LM - curve
(i)
_
i
_
Y National income (Y)
Figure2.11 Equilibrium in both the commodity and money markets.
The equilibrium in the two markets is represented graphically by the intersection of

the IS and LM curves.
The commodity market for a simple two – sector economy is in equilibrium when
Y = C + I. The money market, on the other hand, is in equilibrium when the supply
of money (M s ) equals the demand for money (M d ). The demand for money is in
turn made up of the transaction – precautionary demand (M DT ) and speculative
demand for money (M DS ).
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Numerical example.
Assume that:
C = 178 + 0.6 Y
I = 240 – 300 i
M S = 550
M DT = 0.2 Y
M DS = 480 – 500i
Commodity market equilibrium (IS) exists where;
Y=C+I
= 178 + 0.6Y + 240 – 300i
Y – 0.6Y = 418 – 300 i
0.4Y + 300 i – 418 = 0
Monetary equilibrium (LM) exists where
M S = M DT + M DS
550 = 0.2y + 480 – 500 i
0.2Y – 500 i – 70 = 0
Simultaneous equilibrium in both markets requires that:
0.4Y + 300 i – 418 = 0 …………… (i)
0.2Y + 500i – 70 = 0 …………… (ii)
Multiply (i) by 5 and (ii) by 3 in order to eliminate i.
2 Y+ 1500 i – 2,090 = 0

0.6Y + 1500 i - 210 = 0
2.6Y _= 2,300
Y =2,300
= 885
substitute Y = 885 into (i) or (ii)
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0.4 (885) + 300i – 418 = 0
354 + 300i – 418 = 0
300 i = 64
i = 0.21
2. 9 Review Questions
1. State clearly the meaning of liquidity preference as applied to an individual

and a commercial bank.
2. How does a commercial bank reconcile the need for security, liquidity
profitability in distribution of the assets?
3. Briefly explain the historical development of money
4. Explain the quantity theory of money
5. Explain factors that determine the demand for and supply of money
6. Explain of the theories of interest rates determination
7. With the help of a diagram explain how equilibrium is achieved in IS- LM
curves
2.10 References


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CHAPTER THREE: PUBLIC FINANCE AND INFLATION
Learning Objectives:
At the end of the lesson the student should be able to:-
 State the various sources of government revenue

 State the various canons of a good tax system
 Discuss in detail the various functions of taxes
 Explain fully the various types of taxes and their merits and demerits
 See the effects of taxation on economic activities
 Explain how the tax system can be used to influence the direction the economy
can take
 Explain why inflation should be of concern to national governments
 Discuss exhaustively the various types and causes of inflation
 Prescribe some of the remedies for inflation.
3.1 Objectives of Government

Government policies are required in market economies to achieve certain goals.
There are broadly two types of government policies viz;
 Microeconomic policy objectives

 And macroeconomic policy objectives.
a. The Microeconomic objectives of government
These are the policies which are concerned with the allocation and distribution of
resources to maximize social welfare.
i. Allocation policies
The major objective of government is to achieve pareto efficiency in resource
allocation. An economy is said to be Pareto efficient when it must be
impossible to increase the production of another, or to increase the
consumption of one household without reducing the consumption of another.
Such situation results when the following three conditions are satisfied:
a) The given stock of resources must be allocated in the production of

goods and services in such a way that no re-location can increase the
output of one good without decreasing the output of any other.
b) The combination of goods and the proportions in which they are

produced must be in response to tastes and preferences of the
community – i.e. the goods produced must be the ones that the
community wants.
c) The distribution of goods and services must be in conformity with

consumers’ preferences, given their tastes and incomes.
ii. The distribution function /policy
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The overriding aim of the strategy is to promote equity – that is to achieve a

“fair” distribution of income and wealth. For this purpose, budgets are
usually designed to impose higher rates of taxation on higher incomes and to
try and secure a fair distribution of tax burdens in the community.
On the expenditure side of the budget, spending can be channelled into areas
(such as health, education, and social security benefits), which directly
benefit the lower income groups.
b. Macro-economic policy objectives

The major macro-economic policy objectives which the governments strive to
achieve are:
i. Full employment
One of the main objectives of all governments is the control of employment or
full employment. However economists are not agreed on what constitutes full
employment. But we can say full employment exists when everyone who wants
a job and is capable of doing a job is able to find one.
ii. The control of inflation

Since most monetarists believe that inflation has a negative effect upon
economic growth as it increases uncertainty and discourages savings,
maintaining stable prices usually is a major objectives of most governments.
These two foregoing objectives can be regarded as “good housekeeping”.
iii. High Growth rates

For most people, economic growth remains the prime objective of policy as it
allows everyone to enjoy a better standard of living.
iv. Balance of payments equilibrium

Most governments like to have an equilibrium position in the BOP accounts as there
are problems associated with both sides of disequilibrium.
v. Equitable distribution of income
3.2 The Budget

The budget is a summary statement indicating the estimated amount of revenue that
the government requires and hopes to raise. It also indicates the various sources
from which the revenue will be raised and the projects on which the government
intends to spend the revenue in a particular financial year. The budget in Kenya is
presented to parliament by the Minister of Finance around mid June. In the budget
the Minister REVIEW s government revenue and expenditure in the previous
financial year. The minister presents tax proposals i.e. how he intends to raise the
proposed revenue from taxation for parliament to approve.
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Functions of the Budget

The budget fulfils three main functions:
 To raise revenue to meet government expenditure
The government of a country provides certain services such as administration,
defence, law and order, environmental services and economic services. Also it
must meet the public debt. Sufficient revenue must be raised to pay for this.
 It is a means of redistributing wealth

In many countries, a situation has arisen where a small proportion of the
population own a more than proportionate share of the nations wealth, while the
majority of the population own only a small proportion of it. One method of
redressing such inequalities of wealth is through a progressive system of taxation
on income and capital. A progressive system is one whereby the wealthy people
do not only pay more tax than the poor, but also pay a greater proportion of their
income or wealth.
 To control the level of economic activity

The government uses the budget to implement fiscal policy, i.e. the regulation of
the economy through governments expenditure and taxes.
Types of Budgets
1. Deficit budget If the proposed expenditure is greater than the planned revenue
from taxation and miscellaneous receipts, this is a budget deficit. The excess of
expenditure over revenue will be met through borrowing both internally through the
sale of Treasury Bills and externally from other organisations.
2. Balanced budget If the proposed expenditure is equal to the planned revenue

from taxation and other miscellaneous receipts, this is a balanced budget. Usually,
balanced budgets are not presented, unless the expenditure is very limited. It would
mean the government would have to over-tax the population which can create
disincentives. It is to avoid this that the tax revenue is supplemented by borrowing.
3. Surplus budgets
If the proposed expenditure is less than the planned revenue from taxation and other
miscellaneous receipts, this is a surplus budget. Usually, surplus budgets are not
presented for they are deflationary and can create unemployment as the government
takes out of the economy more than it puts back.
Taxation is the process of imposing compulsory contribution on the private sector to

meet the expenses which are incurred for a common good.
Functions or Purposes of Taxation

The functions of taxation can be discussed from the activities of the government it is
meant to achieve.
These are:
a. Raise revenue The revenue is required to pay for the goods and services which
the government provides. These goods are of two types – public and merit goods.
Public goods, such as defence and police are consumed collectively and no one can
be prevented from enjoying them if he wishes to do so. These goods have to be
provided by governments. Merit goods, such as education and medical care, could
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be, and often are, provided privately but not necessarily in the amounts considered
socially desirable and hence governments may subsidize the production of certain
goods. This may be done for a variety of reasons but mainly because the market
may not reflect the real costs and benefits of the production of a good. Thus, the
public may be subsidized because the market does not take account of all the costs
and benefits of the public transport system.
b. Economic stability These are imposed to maintain economic stability in the

country. During inflation, the government imposes more taxes in order to
discourage the unnecessary expenditure of the individuals. During deflation, taxes
are reduced in order to enable the individuals to spend more money. In this way, the
increase or decrease helps to check the big fluctuations in the prices and maintain
economic stability.
c. Fair redistribution of income A major function of taxation is to bring about

some redistribution of income. First, tax revenue provides the lower income groups
with benefits in cash and kind. Second, the higher income groups, through a system
of progressive taxation, pay a higher proportion of their income in tax than the less
well-off members of the society.
d. Pay interest on National debt Taxes are also levied by the government to pay
interest on national debt.
e. Optimum allocation of resources Taxes are also imposed to allocate resources of

the country for optimum use of these resources. The amounts collected by the
Government from taxes are spent on more productive projects. It means the resources
are allocated to achieve the maximum possible output in the given circumstances.
f. Protection policy Taxes are also imposed to give protection to those commodities
which are produced in the country. The government thus imposes heavy taxes on the
import of such commodities from the other countries. In the view of these taxes, the
individuals are induced to buy local products.
g. Social welfare The government imposes taxes on the production of those

commodities which are harmful to human health e.g. excise duty on wines, cigarettes,
etc.
Principles of an Optimal Tax System

When taxes are imposed certain conditions must be fulfilled. These conditions are
known as Principles or canons of taxation. According to Adam Smith who first
studied the principles of taxation, these are equity, certainty, economy and
convenience.
Classification of Taxes
Taxes can be classified on the basis of:
a. Impact of the taxes It means on whom the tax is imposed. On the other hand,
incidence of the tax refers to who had to bear the burden of the tax. In this case the
taxes may be:
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 Direct or
 Indirect
b. Rates of tax The rate of tax is the percentage of the tax base to be taken in each
situation. In this case the taxes may be:
 progressive or
 proportional or
 regressive or
 digestive
Direct Taxes A direct tax is one where the impact and incidence of the Tax is on the
same person e.g. Income Tax, death or estate duty, corporation taxes and capital gains
taxes. It can also be defined as the tax paid by the person on whom it is legally
imposed.
 Impact of tax This means on whom the tax is imposed.
 Incidence of tax This means who has to bear the burden of the tax, i.e. who
finally pays the tax.
Merits of direct taxes

a. They satisfy the principle of equity as they are easily matched to the tax payers
capacity to pay once assessed.
b. They satisfy the principles of certainty and convenience to tax payers as they
know the time and manner of payment, and the amount to be paid in the case of
these taxes. Similarly, the government is also certain as to the amount of money
it shall receive from these taxes.
c. They satisfy the Canon Simplicity as they are easy to understand.
d. Because most of them are progressive, they tend to reduce income inequalities as
the rich are taxed heavily through income tax, wealth tax, expenditure tax,
excess profit, gift tax, etc. so long as they are alive; and through inheritance
taxes or death duties when they die. The poor and the income groups which are
below the minimum tax limit are exempted form these taxes. These taxes thus
reduce income and wealth inequalities because of their progressive nature.
e. Because the public are paying taxes to the government, they take an interest in
the activities of the state as to whether the public expenditure is incurred on
public welfare or not. Such civic consciousness puts a check on the wastage of
the public expenditure in a democratic country.
Demerits of direct taxes

a. Heavy direct taxation, especially when closely linked to current earnings, can act
as a serious check to productivity by encouraging absenteeism and making men
disinclined to work.
b. Heavy direct taxation will clearly reduce people’s ability to save since it leaves
them with less money to spend. Taxation may, therefore, act as a deterrent to
saving. Heavy taxation of profits makes it more difficult for business to build up
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reserves to cover replacement of obsolete or worn-out capital and thus investment.
c. Direct taxes possess an element of arbitrariness in them. They leave much to the
discretion of the taxation authorities in fixing the rates and in interpreting them.
d. They are not imposed on all as incomes earned on subsistence and non legal
activities are left out.
e. Cost of collection is generally high.
f. These taxes are easily evaded either by understating the source of income or by
any other means. Such taxes thus cultivate dishonesty and there is loss of revenue
to the state.
Indirect Taxes These are imposed on an individual mostly producers or traders but
they can be passed on to be borne by others usually the final consumers. They can
also be defined as taxes where the incidence is not on the person on whom it’s legally
imposed. They include excise duties, sales tax, Value Added Tax and others.
Advantages
a. They are less costly to administer because the producers and sellers themselves
deposit them with the government.
b. If levied on goods with inelastic demand with respect to price rises, it will result in
high revenue collection.
c. Indirect taxes reach the pockets of all income groups. Thus, they have a wide
coverage, and every consumer pays to the state exchequer according to his ability
to pay.
d. They can check on the consumption of harmful goods like wine, cigarettes and
other toxicants.
e. Can be used as a powerful tool for implementing economic policies by the

government. If the government wants to protect domestic industries from foreign
competition, it can levy heavy import duties. This will help to develop domestic
industries. If the government wants to encourage one industry on a priority basis,
it may not levy any taxes on its products but continue the taxes imposed on other
industries. The government may do so in order to encourage, a particular
technology or employment in a particular industry.
Disadvantages
a. Most indirect taxes are regressive as they are based are not based on ability to
pay. The rich and the poor are required to pay the same amount of tax on such
commodities as matches, kerosene, toilet soap, washing soap, toothpaste, blades,
shoes, etc.
b. They may lead to inflation as their imposition tends to raise the prices of
commodities, thereby leading to higher costs, to higher wages, and again to
higher prices. Thus a price-wage cost spiral sets in the economy
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c. They sometimes have adverse effects on production of commodities, and even

employment. When the price of a commodity increases with the levy of a tax,
its demand falls. As a result, its production falls, and so employment.
d. The revenue from indirect taxes is uncertain because it is not possible to

accurately estimate the effect of such taxes on the demand for products.
Progressive Tax A progressive income tax system is one where the higher the income,
the greater the proportion paid in taxes. This is effected by dividing the taxpayers’
incomes into bands (brackets) upon which different rates of tax are paid – the rates
being higher and the band of income. For example, in Kenya, the bands are as
follows:
Monthly Tax Rates

Income Bracket Tax
(K£ per month) (Kshs per Kshs 20)
1 – 325 2
326 – 650 3
651 – 975 4
976 – 1300 7
1301 – 1625 7
excess over 1625 7.50
Source: Income Tax Department, 1996
Examples of Progressive taxes in Kenya are Income Tax, Estate Duty, Wealth Tax and
Gift Tax.
Advantages
a. It is more equitable. The broader shoulders are asked to carry the heavier burden.
b. It satisfies the canon of productivity as it yields much more than it would under
proportional taxation.
c. It satisfies the canon of equity as it brings about an equality of sacrifice among

the taxpayers.
d. To some extent it reduces inequalities of wealth distribution.
Disadvantages
o The effect on incentives High progressive tax makes work and extra effort
become less valuable.
o The effect on the willingness to accept risk High marginal rates of tax are likely
to make entrepreneurs less willing to undertake risks.
o Effects on mobility Some financial inducement is usually required if people are

to be asked to change their location, or undergo training, or accept promotion.
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Progressive taxation by reducing differentials is likely to have some effect on a

person’s willingness to any of the above.
o Encourages tax avoidance and evasion.
o Outflow of high achievers to other countries with lower Marginal tax rates.
o It can lead to fiscal-drag where wage and price inflation cause people to pay
higher proportion of income as tax.
Proportional Tax Is where whatever the size of income, the same rate or same
percentage is charged. Examples are commodity taxes like customs, excise duties
and sales tax.
Its advantage is that it’s much simpler than progressive taxation.
Regressive Tax A tax is said to be regressive when its burden falls more heavily on
the poor than on the rich. No civilized government imposes a tax like this.
Digressive Tax A tax is called digressive when the higher incomes do not make a
due contribution or when the burden imposed on them is relatively less.
Another way in which digressive tax may occur is when the highest percentage is set
for that given type of income one which it is intended to exert most pressure; and
from this point onwards, the rate is applied proportionally on higher incomes and
decreasing on lower incomes, falling to zero on the lowest incomes.
Economic Effects of Taxation

a. A deterrent to work Heavy direct taxation, especially when closely linked to
current earnings, can act as a serious check to production by encouraging
absenteeism, and making men disinclined to work. However, indirect
taxation may actually increase the incentive to work, since the more money
is then required to satisfy the same wants, indirect taxes having made goods
dearer than they were before.
b. A deterrent to saving
Taxation will clearly reduce people’s ability to save since it leaves them with less
money to spend. Taxation may, therefore, act as a deterrent to saving. However,
this will not always be the case, as it will depend on the purpose for which people
are saving.
c. A deterrent to enterprise
It is argued that entrepreneurs will embark upon risky undertakings only when there
is a possibility of earning large profits if they are successful. Heavy taxation of
profits, it is said, robs them of their possible reward without providing any
compensation in the case of failure. As a result, production is checked and
economic progress hindered. It may be, too, that full employment provides
conditions under which even the less efficient firms cannot fail to make profits, and
so there may be greater justification for taxation of profits, and so there may be
greater justification for taxation of profits under such conditions.
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d. Taxation may encourage inflation

Under full employment increased indirect taxation will lead to demand for higher
wages, thereby encouraging inflation. A general increase in purchase taxes pushes
up the Index of Retail Prices, and so brings in its train demands for wage increase.
e. Diversion of economic resources

Only if there are no hindrances to the free play of economic forces will resources be
distributed among occupations in such a way as to yield that assortment of goods
and services desired by consumers. Taxation of commodities is similar in effect to
an increase in their cost of production. Thus, the influence of a change of supply has
to be considered, effect depending on their elasticity of demand. In consequence of
taxation, resources will more from heavily taxed to more lightly taxed forms of
production. This result may, of course, be desired on Non-economic grounds.
3.3 Public Expenditure

The accounts of the central government are centered on two funds, the Consolidated
Fund, which handles the revenues form taxation and other miscellaneous receipts
such as broadcasting license fees, interest and dividends, and the National Loans
Fund which conducts the bulk of the governments domestic borrowing and lending.
Each government ministry works out how much money it wants to spend in the
coming Financial Year which, in Kenya starts on 1st July in each year and ends on
30th June on the following year. This is known as preparing estimates. There are
two types of estimates, -estimates of Capital Expenditure and estimates of Recurrent
Expenditure.
Capital Expenditure refers to the money spent on government projects such as the
construction of roads, bridges, health facilities, educational institutions and other
infrastructure facilities. Recurrent expenditure refers to money spent by the
government on a regular basis throughout the Financial Year e.g. the salaries of all
civil servants, or the cost of lighting a government building.
Government departments also have to prepare estimates for the next financial year
for presentation to parliament. Any department which earns revenue for sales of
goods or services to the public shows this as an appropriations-in aid, which is
deducted from its estimated gross expenditure to show net expenditure, that is, the
actual amount required of the Exchequer.
The estimates also include Grants-in aid i.e. grants made by the central government
to local authorities to supplement their revenue from their levying of rates.
National Debt
Taxation does not often raise sufficient revenue for the Government Expenditure.
So, governments resort to borrowing. This government borrowing is called Public
debt or National debt, it thus refers to the government total outstanding debt. This
debt increases whenever the government runs a deficit for then it has to borrow to
pay for the excess of expenditure over taxes and other receipts.
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Public Debt is undertaken basically for two reasons:
a. Given the scarcity of our resources, it is necessary for the government to borrow
funds in order to speed up the process of economic development.
b. Export earnings of foreign exchange usually fall short of the needed outlays for
imports. In order to cover this foreign exchange deficit on transactions, it is
necessary for the government to borrow from abroad. In the short-run
therefore, the external debt is incurred to finance balance of payment deficits.
These deficits are incurred in the course of importing vital consumers and
producer goods and services.
Types of Public Debt
Public debts can be classified according to the purpose for which the money was
borrowed into;
a. Reproductive Debt: where a loan has been obtained to enable a government to

purchase some real assets, or Deadweight Debt where the debt is not covered by
any real assets.
b. National Debt: can also be classified into marketable and non-marketable debt.
Marketable debt can be bought and sold on the money market or stock
exchange. It can be divided into two types, short and long-term. The former
consists of Treasury Bills and the latter of Government Bonds (Stocks). Non-
marketable debt cannot be sold on the money market or stock exchange and
includes such items as National Savings certificates, various types of Bonds,
and deposits at the National Savings Bank.
Finally, National debt can also be classified into Domestic and external debt.
Domestic public debt is owed by the state mainly to its citizens or to domestic
institutions such as commercial companies, etc. It includes interest payments on
domestic institutions such as commercial companies, etc. Interest payments on
domestic debt are raised from the taxation of the community. Such interest
payments are transfer payments since the total wealth is not affected, irrespective of
the size of the debt. External debt is owed to foreign institutions and governments.
Kenya’s external debt is incurred with two types of lenders:
i. Bilateral Lenders
This is official lending between two governments. Chief among the lenders of
Kenya in this category are the U. S. A., Britain and Japan.
ii. Multi-lateral Lenders
This is lending from organizations comprising of many governments. By for the

leading lender is the World Bank (IBRD) – with two main lending affiliate bodies -
the International Development Association (IDA) – the international Finance
Corporation (IFC); and the International Monetary Fund, and since 1983, the
African Development Bank (ABD).
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Burden of the national debt

The extent of the burden on a nation of public debt, depends in the first place on
whether it is an external or an internal debt. The burden of the national debt to the
community can be approximated by the cost of serving it. The cost of servicing the
public debt can be calculated:
i. Per head of the population, or

ii. As a percentage of government revenue, or
iii. As a percentage of the national income.
Whichever method used, the National debt shall have the following burden on
society:
 If higher taxation is required to service a debt which might have disincentive

effects resulting in a lower level of output, then this is a burden.
 If the debt is held by foreigners, goods will need to be exported to pay the
interest and possible repayment of capital. This part of the debt will involve a
great burden.
Public Sector Borrowing Requirement (PSBR)

Public Sector Borrowing Requirement (PSBR) is the amount which the government
needs to borrow in any one year to finance an excess expenditure over income.
Effects of Government Borrowing on the Economy

If the government borrows from the general public, this may divert funds from more
productive uses.
Firms also require finance and it may be that individuals and financial institutions
prefer to lend to the government where the risk is less and possibly the returns are
greater. Thus the public sector may “crowd out” the private sector. This is known
as the “crowding out” effect.
A further harmful effect may occur. Government borrowing will tend to raise the
rate of interest. This increase in interest rates will make certain capital investments
less profitable resulting in a fall in investment, slower economic growth and a
reduction in the competitiveness of industries.
The increase in interest rates will also raise the cost of borrowing money for the
purchase of houses and other goods hence an increase in the cost of living leading to
inflationary wage pressure.
To avoid the above adverse effects, the government would borrow from the banking
system the use of Treasury Bills; But this would raise eligible reserve assets in the
banking system and thereby the money supply and the resultant inflation: This puts
the government in a dilemma.
The above pattern could be alleviated if the size of the PSBR was reduced. This
could be done by:
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Reducing government expenditures and/or increasing taxation: The first option is

the trend in recent years but increased taxation is said to have the effect of reducing
initiative and incentives.
Of late, employment has been put in the control of PSBR and ensuring that the
growth of money did not exceed the growth of output.
i. Fiscal policy refers to the manipulation of government revenue and expenditure

to achieve policy objectives associated with:
 Moderating resources allocation and adjusting price mechanisms in favour of

the satisfaction of public wants by encouraging socially optimal investments
as well as increasing rate of investments;
 Redistributing wealth income;
 Guiding the national economy in terms of growth and stability;
 Increasing employment opportunities;
 Counteracting inflation; and
 Improving the balance of payments.
The usefulness of fiscal policies if often limited by:
 Structural constraints in the economies; and
 Observed conflicts of objectives between long term growth and short term
stability; social welfare and economic growth; income distribution and growth
and personal freedom and social control.
Basically, fiscal policy can be applied in many ways to influence the economy. For
example the government can increase its own expenditure which it can influence by
raising taxes, by borrowing from non bank members of the public and/or borrowing
from the Central and Commercial bank. Borrowing from non - bank members of the
public often raises interest rates and reduces availability of credit to the private
sector forcing a reduction in the sectors of consumption and investment
expenditures. Borrowing from the Central Bank increases money supply and may
give rise to inflation and balance of payments problems.
Taxes can be used to change the consumption of demand in the economy and to
affect consumption of certain commodities.
ii. Monetary policies This is the direction of the economy through the variables of
money supply and the price of money. Expanding the supply of money and
lowering the rate of interest should have the effect of stimulating the economy, while
a policy designed to reduce price and wage inflation by requesting voluntary
restraint or by imposing statutory controls contracting the supply and raising the rate
of interest should have a restraining effect upon the economy. (See Lesson 5)
iii. Direct intervention The government can also intervene directly in the economy to
see that its wishes are carried out. This can be achieved thorough:
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a. Price and incomes policy This is where the government takes measures to
restrict the increase in wages (incomes) and prices thus can be statutory or voluntary.
b. Supply-side policies These are policies to influence the economy by the prod
Liquidity uctivity of the free market economy. For instance unemployment can be
controlled through supply side measures such as skills training, reducing social
security payments, lessening the disincentives presented by taxation, facilitating the
easier flow of finance to firms, removing firms, removing restrictive practices etc.
c. Regional policies
These are policies designed to help the less prosperous regions.
Policy conflicts
In their attempts to achieve the policy objectives, governments often face what are
called conflict of objectives. These arise partly because unlike private individuals,
governments strive to achieve a multiplicity of objectives.
For instance, a more equal income distribution certainly conflicts with efficiency in
the economic system (which reduces, the total output available for everyone).
Secondly, a fiscal policy which is meant to control unemployment may cause inflation
if it achieves full employment or policies to combat inflation might call for a cut in
public expenditure which in the short-run may lead to a higher rate of unemployment
and a less equitable distribution of income and wealth.
Also the policy of maintaining low council houses rents on equity grounds results in
long waiting list; this may be undesirable on efficiency grounds as it acts as a barrier
to labour mobility and this in turn may increase unemployment.
A fiscal policy meant to cure balance of payments may not just reduce demand for
imports but also reduces demand for domestically produced goods. This in turn can
have a knock on effect in the form of lower output and higher unemployment.
Difficulties in using fiscal policy

There are several problems involved in implementing fiscal policy. They include:
Theoretical problems
Monetarists and the Keynesians do not seem to agree on the efficacy of fiscal policy.
Monetarists claim that budget deficits (or surpluses) will have little or no effect upon
real national income while having adverse effect upon real national income while
having adverse effects upon the interest rates and upon prices.
The net effects of the budget

Unlike the simple Keynesian view that various types of budgets have different effects,
the empirical evidence is that the net effects of taxes and government expenditure are
influenced by the marginal propensities to consume of those being taxed and
governments expenditure.
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The Inflexibility of government finances

Much of the government’s finances are inflexible. One of the reasons for this is that
the major portion of almost any departments budget is wages and salaries, and it is not
possible to play around with these to suit the short-run needs of the government.
Discretionary and automatic changes

Discretionary changes are those which come about as a result of some conscious
decision taken by the government, e.g. changes in tax rates or a change in the pattern
of expenditure.
Automatic changes come about as a result of some changes in the economy, e.g. an
increase in unemployment automatically increases government expenditure on
unemployment benefits.
In fact it is the case that deficits tend to increase automatically in times of recession
and decrease in times of recovery. (These fiscal weapons which automatically
increase in times of recession and decrease in times of recovery are referred to as brick
stabilizers). It is possible for a government to compound the effects of a recession by
raising taxes in order to recover lost revenues. This, according to Keynesians, would
cause a multiplier effect downwards on the level of economic activity.
Policy conflicts
When devising its fiscal policy, the government must attempt to reconcile
conflicting objectives of policy. For example, there is commonly supposed to be a
conflict between full employment and inflation, i.e. that the attainment of full
employment may cause inflation.
Information
It is very difficult to assemble accurate information about the economy sufficiently
quickly for it to be of use in the short-run management of the economy.
Time lag
It normally takes time for a government to appreciate the economic situation, to
formulate a policy and them implement it. This leads to lagged responses some of
which may be long and difficult to predict.
For instance, there is an inside lag which is the time interval between the recognition
of an economic problem or the shock and the implementation of appropriate policy
measures. This is the time it takes to recognize that the shock has taken place and then
to formulate and implement an appropriate policy. In general, fiscal policy is thought
to have a longer inside lag than monetary policy.
Finally, there is an outside lag when the time interval between the implementation of
policy measures and the resultant effects on the intended targets.
3.4 The Neo-Classical View

The neo-classical view is that market forces are the best directors of the economy.
Positive attempts by the government it is argued inevitably make things worse. The
correct posture for fiscal policy, therefore, is simply to minimize the role of
government, thus leaving the largest proportion of the economy possible to be run by
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the market forces.
Problems of prices and Incomes policy
i. Confrontation The imposition of the prices and incomes policy, voluntary

or statutory, risks the possibility of confrontation with trade unions.
ii. Discrimination Incomes policies often tend to be more effective in the

public sector, thus restricting incomes then more than in the private sector.
iii. Distortion of market forces If all workers receive similar increases this will
tend to distort market forces in the labour market. Expanding sectors will find it hard
to attack labour while contracting sectors will hang on to labour for too long.
iv. Differentials Many incomes policies have been based on flat-rate increases,
e.g. £4 per week maximum increases, this increases the wage rate of lower paid
workers relatively more than those of the higher paid.
v. Wages drift This refers to the tendency for earnings to rise faster than wage
rates. This is because earnings are the compound of wages, overtime, bonuses, etc.
Incomes policy tends to worsen wages drift in those industries which are trying to
attract labour, i.e. industry will be tempted to comply with the incomes policy by
raising wage rates by only the stipulates account but increasing bonuses, fringe
benefits and so on.
Monetary policy
 The problems concerning the ability of monetary policy to influence the
economy, as for instance the doubts about the ability of lower interest rates to
stimulate investment, and employment.
 Mechanistic problems which may prevent the instruments from being

effective, as for example the existence of excess liquidity in the system
preventing open market operations from being effective.
Interest rates
 Decreasing the rate of interest may not encourage investment but increasing the
interest rate tends to lock up liquidity in the financial system.
 Governments may also be unwilling to put up interest rates because, as so many

voters are house buyers, this is extremely unpopular.
 With a large national debt to service, governments are less willing to raise
interests rates as this will raise their own expenditure.
 Finally, with so may foreign deposits in their monetary system (sector), each
percentage rise in interest rates means a drain of foreign currency on the balance
of payments.
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Liquidity and Multiple Contractions of Deposits

Many of the instruments of monetary policy depend upon limiting liquidity, which has
a multiple effect upon bank’ deposits through their liquidity ratios. If however, banks
keep surplus liquidity this will protect them against such measures as open market
operations and special deposits.
The efficacy of open-market sales is also affected by who purchases the securities.
For open-market sales to be effective it is necessary that sales to be the general public,
if the securities are bought by the banks they will have little effect upon their liquidity
since most of them count as liquid assets.
The Velocity of Circulation

Theoretically it is possible for decreases in the money stock (M) to be offset by rises
in the velocity of circulation (V).
Other Problems
Funding may be effective in controlling liquidity, but it is expensive since the rate of
interest on long-term debt is usually much higher than on short-term debt.
Considerable funding of the debt might therefore have the undesirable consequences
of increasing long-term interest rates.
3.5 Types and Causes of Inflation

Meaning
The word inflation has at least four meanings.
 A persistent rise in the general level of prices, or alternatively a persistent falls in

the value of money.
 Any increase in the quantity of money, however small can be regarded as

inflationary.
 Inflation can also be regarded to refer to a situation where the volume of

purchasing power is persistently running ahead of the output of goods and
services, so that there is a continuous tendency of prices – both of commodities
and factors of production – to rise because the supply of goods and services and
factors of production fails to keep pace with demand for them. This type of
inflation can, therefore, be described as persistent/creeping inflation.
 Finally inflation can also mean runaway inflation or hyper-inflation or galloping

inflation where a persistent inflation gets out of control and the value of money
declines rapidly to a tiny fraction of its former value and eventually to almost
nothing, so that a new currency has to be adopted.
Measurement of Inflation
The rate of inflation is measured using the Retail Price Index. A retail Price Index
aims to measure the change in the average price of a basket of goods and services that
represents the consumption pattern of a typical household. It estimates the change in
the cost to consumers of a range of commodities that they typically buy. It is usually
prepared for different classes of consumers and for different areas. The index is
measured as follows:
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n
∑ P 1 iQoi
i=1
1=
n
∑ 1 PoiQoi
i
Where: I- is the cost of living index

∑ is the summation sign
n- is the number of commodities in the representative basket.
P1i - is the price of the commodity in the basket in the current period
Qoi- is the weight of the commodity in the consumer’s basket.
Poi -is the price of the commodity I in the base period
The calculation of the index requires:

 Selection of commodities to be included in the consumers basket
 Selection of the base period weights for each commodity
 Date on prices of the commodities in the current period and in the base period
Such an index then estimates the cost of living or the purchasing power of incomes.
If the index increases by 10% in a given period, wages would need to rise by 10%
for purchasing power to remain constant. It is in this regard that trade unions and
workers demand that wages should increase pari-passu with the cost of living index.
Causes of Inflation
At present three main explanations are put forward: cost-push, demand-pull, and
monetary.
Cost-push inflation occurs when he increasing costs of production push up the general
level of prices. It is therefore inflation from the supply side of the economy. It occurs
as a result of increase in:
a. Wage costs: Powerful trade unions will demand higher wages without
corresponding increases in productivity. Since wages are usually one of the
most important costs of production, this has an important effect upon the price.
The employers generally accede to these demands and pass the increased wage
cost on to the consumer in terms of higher prices.
b. Import prices: A country carrying out foreign trade with another is likely to
import the inflation of that country in the form of intermediate goods.
c. Exchange rates: It is estimated that each time a country devalues it’s currency by
4 per cent, this will lead to a rise of 1 per cent in domestic inflation.
d. Mark-up pricing: Many large firms fix their prices on unit cost plus profit basis.
This makes prices more sensitive to supply than to demand influences and can
mean that they tend to go up automatically with rising costs, whatever the state of
economy.
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e. Structural rigidity: The theory assumes that resources do not move quickly from
one use to another and that wages and prices can increase but not decrease. Given
these conditions, when patterns of demand and cost change, real adjustments
occur only very slowly. Shortages appear in potentially expanding sectors and
prices rise because slow movement of resources prevent the sector and prices rise
because of slow sectors keep factors of production on part-time employment or
even full time employment because mobility is low in the economy. Because
their prices are rigid, there is no deflation in these potentially contracting sectors.
Thus the process of expanding sectors leads to price rises, and prices in
contracting sectors stay the same. On average, therefore, prices rise.
f. Expectational theory: This depends on a general set of expectations of price and

wage increases. Such expectations may have been generated by continuing
demand inflation. Wage contracts may be made on a cost plus basis.
Demand-pull inflation is when aggregate demand exceeds the value of output

(measured in constant prices) at full employment. The excess demand of goods and
services cannot be met in real terms and therefore is met by rises in the prices of
goods. Demand-pull inflation could be caused by:
 Increases in general level of demand of goods and services. A rise in aggregate

demand in a situation of nearly full employment will create excess demand in
may individual markets, and prices will be bid upward. The rise in demand for
goods and services will cause a rise in demand for factors and their prices will be
bid upward as will. Thus, inflation in the pries of both consumer goods and
factors of production is caused by a rise in aggregate demand.
 General shortage of goods and services. If there is a general shortage of

commodities e.g. in times of disasters like earthquakes, floods or wars, the
general level of prices will rise because of excess demand over supply.
 Government spending: Hyper-inflation certainly rises as a result of government

action. Government may finance spending though budget deficits; either
resorting to the printing press to print money with which to pay bills or, what
amounts to the same thing, borrowing from the central bank for this purpose.
Many economists believe that all inflation is caused by increases in money
supply.
Monetarist economists believe that “inflation is always and everywhere a monetary

phenomenon in the sense that it can only be produced by a more rapid increase in the
quantity of money than in output” as Friedman wrote in 1970.
The monetarist’s theory is based upon the identity:
MxV=PxT
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And thus this was turned into a theory by assuming that V and T are constant. Thus,
we would obtain the formula
MV = PT
(See Lesson 5)
The Impact of Inflation and its Control Measures

Inflation has different effects on different economic activities on both micro and
macro levels. Some of these problems are considered below:
i. During inflation money loses value. This implies that in the lending-borrowing
process, lenders will be losing and borrowers will be gaining, at least to the extent
of the time value of money. Cost of capital/credit will increase and the demand
for funds is discouraged in the economy, limiting the availability of investable
funds. Moreover, the limited funds available will be invested in physical
facilities which appreciate in value over time. It’s also impossible the diversion
of investment portfolio into speculative activities away from directly productive
ventures.
ii. Other things constant, during inflation more disposable incomes will be allocated
to consumption since prices will be high and real incomes very low. In this way,
marginal propensity to save will decline culminating in inadequate saved funds.
This hinders the process of capital formation and thus the economic prosperity to
the country.
iii. The effects of inflation on economic growth have inconclusive evidence. Some
scholars and researchers have contended that inflation leads to an expansion in
economic growth while others associate inflation to economic stagnation. Such
kind of inflation if mild, will act as an incentive to producers to expand output
and if the reverse happened, there will be a fall in production resulting into
stagflation i.e. a situation where there is inflation and stagnation in production
activities.
iv. When inflation implies that domestic commodity prices are higher than the world
market prices, a country’s exports fall while the import bill expands. This
basically due to the increased domestic demand for imports much more than the
foreign demand for domestic produced goods (exports). The effect is a deficit in
international trade account causing balance of payment problems for the country
that suffers inflation.
v. During inflation, income distribution in a country worsens. The low income

strata get more affected especially where the basic line sustaining commodities’
prices rise persistently. In fact such persistence accelerates the loss of purchasing
power and the vicious cycle of poverty.
vi. Increased production

It is argued that if inflation is of the demand-pull type, this can lead to increased
production if the high demand stimulates further investment. This is a positive
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effect of inflation as it will lead to increased employment.
vii. Political instability

When inflation progresses to hyper-inflation, the unit of currency is destroyed and
with it basis of a free contractual society.
viii. Inflation and Unemployment

For many years, it was believed that there was a trade-off between inflation and
unemployment i.e. reducing inflation would cause more unemployment and vice
versa.
Measures to control inflation

An inflationary situation can effectively be addressed/tackled if the cause is first and
foremost identified. Governments have basically three policy measures to adopt in
order to control inflation, namely:
Fiscal Policy: This policy is based on demand management in terms of either raising
or lowering the level of aggregate demand. The government could attempt to
influence one of the components C + I + G (X – M) of the aggregate demand by
reducing government expenditure and raising taxes. This policy is effective only
against demand-pull inflation.
Monetary Policy: For many years monetary policy was seen as only supplementary to
fiscal policy. Neo-Keynesians contend that monetary policy works through the rate of
interest while monetarists’ viewpoint is to control money supply through setting
targets for monetary growth. This could be achieved through what is known s
medium term financial strategy (MTFs) which aims to gradually reducing the growth
of money in line with the growth of real economy – the use of monetary policy
instruments such as the bank rate, open market operations (OMO) and variable reserve
requirement (cash & liquidity ratios).
Direct Intervention: Prices and incomes policy: Direct intervention involves fixing
wages and prices to ensure there is almost equal rise in wages and other incomes
alongside the improvements in productivity in the economy. Nevertheless, these
policies become successful for a short period as they end up storing trouble further,
once relaxed will lead to frequent price rises and wage fluctuations. Like direct
intervention, fiscal and monetary policies may fail if they are relied upon as the only
method of controlling inflation, and what is needed is a combination of policies.
3.6 Review Questions

1. a) Outline the functions of taxation .
b) What are the possible disadvantages of a progressive income tax system?
2. State and explain Adam Smith’s canons of taxation. Give local example as
appropriate in each.
3. a) What is meant by inflation

b) What are the major causes of inflation?
c) Explain the economic problems that arise from a high rate of inflation.
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4. Explain the microeconomic objectives of government
5. Explain three types of budgets
6. What are the economic effects of taxation?
7. Explain the meaning of the term Fiscal policy
8. Describe the role of government in controlling market forces under the neo-
classical view
9. Breifly explain types and causes of inflation
3.7 References


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CHAPTER FOUR INTERNATIONAL TRADE AND FINANCE
Learning Objectives:
At the end of the lesson the student should be able to:-
Explain why countries engage in international trade,
 Understand how the theory of comparative advantage attempts to explain why
countries gain from international trade and its limitation,
 Explain the problems encountered by nations when they attempt to individually
maximize gains from trade through specialization,
 Enumerate the gains that accrue to a country from participating in international trade,
 Explain the reasons why countries put restrictions on international trade,
 Know the various methods a country can use to restrict international trade,
 Argue the case for free trade,
4.1 International Trade

Definition: It is the exchange of goods and services between one country and another.
International Trade can be in goods, termed visibles or in services, termed invisibles e.g.
trade in services such as tourism, shipping and insurance.
Reasons for the Development of International Trade

a. Some goods cannot be produced by the country at all. The country may simply not
possess the raw materials that it requires; thus it has to buy them from other
countries. The same would apply to many foodstuffs, where a different climate
prevents their cultivation.
b. Some goods cannot be produced as efficiently as elsewhere. In many cases, a

country could produce a particular good, but it would be much less efficient at it than
another country.
c. It may be better for the country to give up the production of a good (and import it
instead) in order to specialize in something else. This is in line with the principle of
comparative advantage.
d. In a free market economy, a consumer is free to choose which goods to buy. A

foreign good may be more to his or her liking. This is in line with the principle of
competitive forces and the exercise of choice.
e. Shortages: At a time of high domestic demand for a particular good, production may
not meet this demand. In such a situation, imports tend to be bought to overcome the
shortage.
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4.2 Theory of Comparative Advantage

In his theory put forward in a book published in 1817, David Ricardo argued that what
was needed for two countries to engage in international trade was comparative advantage.
He believed that 2 countries can still gain, even if one country is more productive then
the other in all lines of production. Using the Labour Theory Value, Ricardo’s
contribution was to show that a sufficient basis for trade was a difference, not in absolute
costs. He illustrated his theory with 2 countries and two commodities, I and II and A and
B respectively.
Country Cost of Producing One Unit

(in manhours)
A B
I 8 9
II 12 10
We can observe that country I has complete absolute advantage in the production of both
commodities since it can produce them with a lower level of resources. Country I is
more efficient than country II.
Ricardo believed that even then there could still be a basis for trade, so long as country II
is not equally less productive, in all lines of production. It still pays both countries to
trade. What is important is the Comparative Advantage. A country is said to have
comparative advantage in the production of a commodity if it can produce at relatively
lower opportunity costs than another country. (The law of comparative advantage states
that a nation should specialize in producing and exporting those commodities which it
can produce at relatively lower costs, and that it should import those goods in which it is
a relatively high cost producer). Ricardo demonstrated this by introducing the concept of
opportunity cost.
The opportunity Cost of good A is the amount of other goods which have to be given up
in order to produce one unit of the good. To produce a unit of good A in country I, you
need 8 man hours and 9 man hours to produce good B in the same country. It is thus
more expensive to produce good B then A. The opportunity costs of producing a unit of
A is equivalent to 8/9 units of good B. One unit of B is equal to 9/8 units of A.
In country II, one unit of A is equal to 12/10 of B and one unit of B = 10/12 units of A.
Therefore he felt that: -
Opportunity cost of producing one unit of:
A B
Country
I 9/8 (1.25) B 8/9 (0.89) A
II 10/12 (0.83) B 12/10 (1.2) A
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B is cheaper to produce in country II in terms of resources as opposed to producing it in

country I. The opportunity costs are thus lower in country II than in country I.
Consider commodity A valued in terms of B. A cheaper in country I than country II.
A country has comparative advantage in producing commodity if the opportunity cost of

producing it is lower than in other counties. Country I has a lower opportunity cost in
producing A than B and II has a lower opportunity cost in the production of B than A. In
country I, they should specialize in the production of A and Import B.
Limitations of Comparative advantage

This doctrine is valid in the case of a classical competitive market characterized by a
large number of informed buyers and sellers and homogenous products in each market,
with world market places serving as efficiency determinants for global allocation of
resources to their most suitable uses. Unfortunately, world markets and their prices are
largely inefficient showing influences of trade barriers, discrimination and market
distortions.
Individual countries systematically aim at maximizing their potential gains from trade
rather than with optimizing the allocation of world resources.
By pursuing gains from trade in the short run young nations may jeopardize long term
development prospects because:
i) It is important to protect infant industries to acquire new skills, technology and home
markets that are necessary in the early years of industrial development;
ii) Concentrating on short term comparative advantage may lead to internalizing wrong
externalities e.g. promoting use of illiterate peasants and primary sector production;
iii) Long term movements in commodity terms of trade disfavour primary commodities
as their prices rise more slowly than those of industrial manufactures (income
elasticity of demand for primary commodities is lower than for manufactures and as
world incomes rise demand for the latter rises more rapidly affecting their relative
world prices).
Gains from International Trade

The gains from International trade are to make the participating countries better of than
they would have otherwise been. This will be the result of a number of advantages
which a country can derive from international trade, namely:
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The vent-for-“surplus” product

Many countries have products which are surplus to their own requirements and it is only
by exporting these that they have value at all. Thus, the plantations of coffee in Kenya
are only of value because of the existence of international trade. Without it, the coffee
would mainly be unused and remain unpicked.
Many of the primary products that are exported would be of no use to the country.
Without trade, the land and the labour used for their production would be idle. Trade
therefore gives the country the opportunity to sell these products and to make use of the
available land and labour.
Importation of what cannot be produced

A country has to import what it cannot produce. Certain countries like Japan and Britain
could not manufacture goods without the importation of most of the raw materials. There
is thus necessity for international trade in respect of these essential materials.
Specialization according to absolute advantage

International trade allows a country to specialize in the production of commodities where
it more efficient than other countries. For instance, if we take a situation in which each
country in a simple two country model has an absolute advantage in producing either
fruits or beef but is able to produce the other commodity only if required (for simplicity
we assume constant returns to scale and full utilization of resources). Suppose that each
country has equal resources and devotes half its limited resources to citrus fruit and half
to beef and the production totals are:
Units of Citrus fruits Units of Beef
Country X 10 5
Country Y 5 10
World total 15 15
The relative or comparative costs of citrus production is lower in country X than in

country Y, but the situation is reserved in the case of beef production. Country X has an
absolute advantage in citrus fruit production and Y has an absolute advantage in beef
production. If each country specializes in the production of the commodity in which it is
most efficient and possesses absolute advantage, we get:
Country X 20 0
Country Y 0 20
World total 20 20
The gains from trade are obvious with five units m ore of fruit and five more of beef –
provided we assume that transport costs are not so enormous as to rule out gains made.
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Specialization according to comparative advantage

Even if one country can produce the two goods more efficiently at a lower comparative
cost than the other country, there could be gains to be made from International Trade.
This possibility is explained by the theory of comparative advantage. Suppose that
country X is more efficient in both citrus fruit and beef production. If each country
devoted half its resources to each, let us imagine the production totals are:
Country X 30 60
Country Y 20 10
World total 50 70
Country X possesses an absolute advantage in both industries but whereas X is only 50%
more efficient in the citrus fruit production, it is six times more efficient in beef
production. Even so, if country Y produces an extra unit of citrus fruit it need give up
only half a unit of beef. In contrast, country X must give up two units of beef to increase
production of citrus fruits by one unit. It is evident from this example that although a
country may have absolute advantage in the production of all products, it is possible for a
country such as Y to produce some products relatively cheaply at lower opportunity cost
than its trading partner X. When this occurs as in the simple example above then
economists describe X as possessing a comparative advantage in the production of citrus
fruit.
If each country specializes completely in the activity in which it possesses a comparative

advantage, the production totals are:
Country X 0 120
Country Y 40 0
World total 40 120
What is evident from these last calculations is that although the overall production of beef
has increased, the output of citrus fruit has fallen by ten units. Thus we cannot be sure
without some knowledge of demand and the value placed on the consumption of citrus
fruit and beef that a welfare system gain will result from specialization.
Competition
Trade stimulates competition. If foreign goods are coming into a country, this puts home
producers on their toes and will force them to become more efficient.
Introduction of new ideas

International trade can introduce new ideas into a participating country; it can stimulate
entrepreneurship and generate social change. This is especially the case in developing
countries where the development of expert industries can lead to the emergence of a
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commercial class desirous of change and opposed to any practice that hold back
economic advancement.
Technological advances can also be introduced into a country as companies start to base
their production in overseas countries.
Widening of choice to the consumer

It is undoubtedly a great benefit to be able to buy a wide range of goods that would not
otherwise be available. International trade offers to the consumer a wider choice. This
greater availability of goods may indeed prove to be of economic advantage. For in a
country, producers may only be prepared to take risks and invest their time and money in
a business if they can spend the resultant income on consumer goods. These may be
imported, especially if the country lacks consumer goods industries – as in may
developing countries. Thus, these imports of consumer goods provide the incentive for
productive effort within the country.
Creation and maintenance of employment

Once a pattern of international trade has developed, and countries specialize in the
production of certain goods for export, it follows not only has that trade created
employment in those sectors, but that the maintenance of that trade is necessary to
preserve that employment. In the modern world with its high degree of interdependence,
a vast number of jobs depend upon international trade.
Restrictions on International Trade

Despite the arguments of the “classical” theory of free trade, the twentieth century has
seen the gradual movement away from free trade, with governments increasingly
imposing restrictions on trade and capital flows. All have adopted, to varying extents,
various forms of restrictions to protect some of their industries or agriculture.
Reasons for Protection

Cheap Labour
It is often argued that the economy must be protected from imports which are produced
with cheap, or ‘sweated”, labour. Some people argue that buying foreign imports from
low wage countries amounts not only to unfair competition, but continues to encourage
the exploitation of cheap labour in those countries as well as undermining the standard of
living of those in high wage economies.
Infant Industry Argument

Advocates of this maintain that if an industry is just developing, with a good chance of
success once it is established and reaping economies of sale, then is it necessary to
protect it from competition temporarily until it reaches levels of producdton and cost
which allow it to compete with established industries elsewhere, until it can “stand on its
own feet”. The argument is most commonly used to justify the high level of protection
that surrounds the manufacturing industry in developing countries, as they attempt to
replace foreign goods with those made in their own country (“import substitution”).
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Structural Unemployment
The decline of the highly localized industry due to international trade causes great
problems of regional (structural) unemployment. If it would take a long time to re-locate
the labour to other jobs, then this can put the government, under considerable political
and humanitarian pressure, to restrict the imports that are causing the industry to decline.
Dumping
If goods are sold on a foreign market below their cost of production this is referred to as
dumping. This may be undertaken either by a foreign monopolist, using high profits at
home to subsidize exports for political or strategic reasons. Countries in which such
products are “dumped” feel justified in protecting themselves. This is because dumping
could result in the elimination of the home industry, and the country then becomes
dependent on foreign goods which are not as cheap as they had appeared.
Balance of Payments
Perhaps the most immediate reason for bringing in protection is a balance of payment
deficit. If a country had a persistent deficit in its balance of payments, it is unlikely to be
able to finance these deficits from its limited reserves. If therefore becomes necessary for
it adopt some form of restriction on imports (e.g. tariffs, quotas, foreign exchange
restrictions) or some means of boosting its exports (e.g. export subsidies).
Danger of over-specialising
A country may feel that in its long-term interests it should not be too specialized.
A country may not wish to abandon production of certain key commodities even though
the foreign product is more competitive, because it is then too dependent on imports of
that good. In the future, its price or supplies may diminish. It is for this reason that
countries wish to remain largely self-sufficient in food. An exporting country may not
wish to become overspecialized in a particular product. Such over specialization may
make sense now, but in the future, demand may fall and the country will suffer
disproportionally. It is for this reason that many developing countries choose not to rely
solely on their comparative advantage; they wish to diversify into other goods as an:
insurance policy”.
Strategic Reasons
For political or strategic reasons, a country may not wish to be dependent upon imports
and so may protect a home industry even if it is inefficient. Many countries maintain
industries for strategic reasons. The steel industry, energy industries, shipping, agriculture
and others have used this strategic defence argument.
Bargaining
Even when a country can see no economic benefit in protection, it may find it useful to
have tariffs and restrictions bargaining gambits in negotiating better terms with other
nations.
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Ways of Restricting International Trade

The most common means of restricting international trade is through import restrictions.
The main forms are:
Tariffs
This is a tax on each unit imported. The effect of the tax is to raise the price of imported
varieties of a product in relation to the domestically produced, so that the consumers are
discouraged from buying foreign goods by means of the price mechanism. Such a tax
may be ad valorem, representing a certain percentage of the import price, or specific that
is, an absolute charge on the physical amount imported as, for example, five shillings a
ton.
Quotas
The most direct way of offering protection is by limiting the physical quantity of a good
which may be imported. This can be done by giving only a limited number of import
licenses and fixing a quota on the total amount which may be brought in during the
period. The quota may be imposed in terms of physical quantities or in terms of the value
of foreign currency, so that a maximum of so many “shillings-worth” may be imported.
Foreign exchange restriction

Exchange controls work much the same way as physical controls. Foreign exchange is
not made available for all desired imports. It can be severely restricted to whatever the
government decides it wants to see imported. Alternatively, the exchange rate may be
fixed in such a way as to “overprice” foreign currency (compared to what would have
been the free market price), so that importers have to pay more for foreign currency (in
terms of domestic currency). This makes all imports dearer and thus gives protection
“across the board” to all domestic production for the home market.
Procurement policies by government

The government itself, together with state corporations, is an important purchaser of
goods; in its “procurement” policies, therefore, it can either buy goods from the cheapest
source, whether domestic or foreign, or it can give preference to domestic producers.
This could amount to a substantial advantage, or protection.
Other restrictions
Governments can devise health or safety requirements that effectively discriminate
against the foreign good. Also where the country has state import agencies they can
choose not to import as much as their citizens would require. The government can also
introduce cumbersome administrative procedures that make it almost impossible to
import.
Arguments against protectionism

Most of the arguments for protectionism may be met with counter arguments, but
underlying the economic arguments as opposed to the social, moral, political, strategic,
etc, is the free trade argument.
Free trade argument
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This, in brief, maintains that free trade allows all countries to specialize in producing
commodities in which they have a comparative advantage. They can then produce and
consume more of all commodities than would be available if specialization had not taken
place. By implication, any quotas, tariffs, other forms of import control and/or export
subsidies all interfere with the overall advantages from free trade and so make less
efficient use of world resources than would otherwise be the case.
Reduced output argument

It has been said that import controls will protect jobs initially, but not in the longer run.
If we in the home country limit imports, then other countries will have less of our
currency with which to buy our exports.
This will lead to a decline in sales and a loss of jobs in export industries. The overall
effect is likely to be a redistribution of jobs from those industries in which the country
has a comparative advantage to those in which it has a comparative disadvantage. The
net result will be that total employment is unchanged but total output is reduced.
The infant industries seldom grow up

The infant industry argument is sometimes met with the claim that infant industries
seldom admit to growing up and cling to their protection when they are fully grown up.
Most economists, however, appear to accept the infant industry argument as a valid case
for protection provided it is temporary.
Gains from comparative advantage

The argument for protection against low wage foreign labour is partly a moral argument
which is outside the scope of positive economics, but even the economic part of the
argument that it will drag down the living standards of high wage economies can be
shown to be invalid. It is true as noted above that the payment of low wages will allow a
country to export their goods cheaply and so possibly undercut those of high wage
countries. However, it must be noted that countries importing these cheap goods gain by
virtue of their low cost in terms of the goods required to be exported in return. This again
is another use of the comparative advantage argument.
No Validity in economics
The other arguments such as the need to avoid over dependence on particular industries
and the defence argument are really strategic arguments which are valid in their own
terms and for which economic science is largely irrelevant.
Retaliation
Advocates of free trade also believe that if one country imposes import restrictions, then
those countries adversely affected will impose retaliatory restrictions on its exports, so it
will not end up any better off. This could lead to a “beggar-my-neighbour” tariff war,
which no one can benefit from, and which contracts the volume of world trade on which
every country’s international prosperity depends.
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Inflation
If key foreign goods are not free to enter the country (or cost more), this will raise their
prices and worsen the rate of inflation in the country.
Inefficiency
It is argued that if home industries are sheltered from foreign competition there is no
guarantee that they will become more efficient and be able to compete in world markets.
4.4 Terms of Trade

The relation between the prices of a country’s exports and the prices of its imports,
represented arithmetically by taking the export index as a percentage of the import index.
In the comparative cost model, terms of trade were, defined as the international exchange
ratio between a country’s export good and its import good. This is the barter terms of
trade which measures the quantity of exports which have to be sacrificed to obtain a unit
of imports and is easily calculated when there are just two goods traded. But in practice,
countries trade hundreds of different goods and services and the concept of the terms of
trade becomes more complex. Estimates of the terms of trade are usually made by
calculating an index of import prices; this gives an index of the term of trade:
Terms of trade index = Export Price Index x 100

Import Price Index
Thus, the price indices are essentially weighted averages of export and import pries. If
these are set at 100 in the same base year, say, 1990, then the terms of trade index is also
100. If, for instance, import prices fall relative to export prices, the terms of trade will
rise above 100, the terms of trade then being said to be more favourable to the country
concerned since it means that it can obtain more goods from abroad than before in
exchange for a given quantity of exports. On the other hand, if the terms of trade become
unfavourable, the terms of trade index will fall below 100.
A rise in terms of trade index is usually described as an “improvement” or as

“favourable” on the grounds that a rise in export prices relative to import prices
theoretically means that a country can now buy the same quantity of imports for the
sacrifice of less export (or it can have more imports for the same volume of exports).
Similarly, a fall in the terms of trade index is a “deterioration” or is an “unfavourable”
movement.
Factors affecting the long run trend of the Terms of Trade for developing countries
Most Third World countries have been faced by a fall in their terms of trade over the long
run. There are a number of factors which contributed to this result, namely: -
The income-elasticity of demand for primary products

These countries export primary products like basic foodstuffs which may be considered
to be “necessities” on which a decreasing proportion of income is likely to be spent as
these incomes rise. Countries relying on basic foodstuffs and other primary product
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exports may therefore find their exports growing more slowly than those of individual
countries exporting manufactured goods.
The discovery of synthetic materials

Over a whole range of items, the substitution of synthetic man-made products has
reduced the market for particular primary products. The long term trend in the market
shares of natural and synthetic products is likely to be influenced by a “ratchet” effect.
When prices of natural products are high, due to cyclical fluctuations or temporary
shortages, research into possible synthetic substitutes will be encouraged. When prices of
natural products revert to more normal levels, these products may have permanently lost
a further part of the market.
Raw material – saving innovations

This is likely to apply to technical change aimed at economizing the use of raw material’s
in industry. Periodic high prices will stimulate the search for and application of raw
material saving process. Technical change aimed at a progressive reduction in costs per
unit of output directly by permitting industrial output (and thus income) to expand in
greater proportion than the demand for materials.
Agricultural protection and import substitution in developed countries

The protectionist policies within the industrial countries which aim to raise the incomes
of farmers and other primary producers like fishermen by placing tariffs or quotas on
competing imports have also affected the terms of trade for developing countries. As a
result, many industrial countries have become almost self-sufficient in producing grains,
sugar (from beet), livestock products, and even tobacco and wines. Sometimes the
policies have been directed at saving foreign exchange as well as maintaining domestic
incomes and employment, and have not only been confined to primary products. Indeed,
restrictions on access to markets for manufactured goods by developing countries at
large, or potentially large, export industries like India’s textiles have forced developed
countries to sell more primary products instead. Thus even without tariffs or quotas,
therefore, the expansion in primary product exports is likely to result in a decline in their
commodity terms of trade in the many cases where the exports are likely to result in a
decline in their commodity terms of trade in the many cases where the price-elasticity of
demand in industrial countries is very low. When in addition, these primary products
face tariff or quota restrictions, the deterioration in the terms of trade will be greater.
Diminishing returns in agriculture and limited natural resources

Whatever the income-elasticity of demand for primary products, continuous expansion of
industrial output means a continually increasing requirement of raw materials. If the
supply of land suitable for various agricultural products is limited, the law of diminishing
returns may apply, leading to increasing scarcity of such products, and a rise in their
prices.
Technical progress in manufacturing

Although technical progress in the industrialized countries should, through the market
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mechanism, have been shared between the industrial producers and the producers of
primary products, according to Raoul Presbich, this desirable development has been
frustrated. On the one hand, industrial monopolistic practices and trade union action
producing cost-push inflation in the developed countries have persistently raised money
wages in these countries and, with these, the prices of manufactured goods. In contrast,
competition among primary producers, and the ineffectiveness of trade unions in the
agricultural sectors of these economies, has kept down the prices of raw materials. In
fact the benefits of any cost-reducing innovation in these countries is likely to be passed
on, as a result of competition, to industrial consumers in the form of reduced prices.
4.5 International Trade arrangements and Agreements
International Commodity Agreements (ICAS)

International Commodity Agreements (ICAS) represents attempts to modify the
operation of the commodity markets so as to achieve various objectives such as price
stabilization of price enhancement. Support for such intervention stems from apparent
weaknesses in the operation of market forces in achieving an efficient allocation of
resources, appropriate levels of privately held stocks in some commodities and an
equitable distribution of income from their export as between exporters and importing
countries. ICAS are to be distinguished from producers’ or exporters’ cartels by the
feature of consumer agreement to the scheme and representation on the governing body.
Objectives of ICAs
Most schemes have as their main objective to stabilize and/or increase the world price of
commodity, producers’ incomes, foreign exchange earnings of exporting countries and
governing revenues from taxes on the commodity. More stable prices are desired
because wildly fluctuating prices may cause hardship and are likely to increase the costs
of both producers and consumers through increasing uncertainty and producing
exaggerated responses in production and consumption. Where these responses are lagged
one or more seasons behind the price change they can be particularly damaging in
producing ‘cobweb’ cycles. High current prices for coffee, for example, may stimulate
planting of new coffee trees that will only bear fruit five or more years hence when the
prices may become, as a result very depressed. More stable earnings for producers
becomes a particularly important objective when the producers are small farmers with
low incomes and little or no reserves, though most countries have national measures such
as marketing boards which try to stabilize producers’ earnings. Greater stability in export
revenues should reduce uncertainty in economic planning and where taxes are geared to
export revenues, as is the case for many primary exports, this objective is reinforced.
The aim of raising prices, incomes or export earnings above the levels that would prevail
without intervention has to be seen as a form of disguised economic aid or as
compensation for declining terms of trade. The charters of several ICAS also include the
aim of expanding the markets for their primary products by developing new uses,
reducing trade barriers and increasing sales promotion.
As is often the case in economics, many of these objectives are mutually incompatible. A
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world price stabilized within narrow limits could cause greater instability in export
earnings for some commodities, whereas a raised price may involve lower incomes and
will certainly militate against expanded markets. Obviously these possibilities depend on
assumptions about elasticities of demand and supply for specific commodities, but are in
fact more than likely. For example, where demand shifts are the main cause of
fluctuations but demand is price elastic, an export quota agreement will destabilize
export earnings. Similarly, where supply variations are the basic cause, holding price
stable though a buffer stock can destablise income if the price elasticity of demand is
greater than 0.5. a stable price can also involve lower total export earnings. But recently
research shows these results are less likely than was previously considered to be the case,
particularly if the bank within which a buffer stock seeks to confine price movements is
fairly wide. In practice the conflict between price stabilization and stabilization of export
earnings for most countries’ export earnings is unlikely.
The UN’s Integrated Programme for Commodities

Most of the political pressure for ICAs comes from spokesmen for the developing
countries. This is reflected in countless resolutions in UNCTAD and in the grandiloquent
mid-70s demands for ‘ A New International Economic Order’, basically a collection of
old ideas in a fashionable package. Stabilization and support for primary commodity
prices remains the main objective and ICAs the main mechanism for achieving it. The
only novel features in the UNCTAD proposals for an integrated programme were the
suggestion for a Common Fund for financing international stocks and the simultaneous
negotiation of a broad group of ICAs. The UNCTAD report stressed, ‘That years of
studies, discussions and consultations in various forums have succeeded in establishing
international arrangements for only a few commodities, hardly any of which have proved
to be effective or durable.’ Instead of drawing the conclusions that such a dismal record
might indicate basic flaws in these forms of market intervention UNCTAD demanded
urgent negotiations for creating a package of up to eighteen ICAs with buffer socks and a
Common Fund without wasting further time in research or consultation.
But of these eighteen commodities three already had existing price control agreements
(tin, coffee and cocoa); two had existing and successful producer price raising schemes
(bauxite and phosphates); four were unsuitable for buffer stocks scheme either because of
the absence of organised markets or perishability (iron ore, bauxite, meats, bananas).
Price enhancement for copper, cotton, iron ore, vegetable oils and oil seeds, sugar and
meats was unlikely and inequitable because developed countries produced a large
proportion of them, and for rubber, jute, hard fibres and cotton because of the ready
availability of synthetic substitutes. A rather similar appraisal can be found in
Rangarajan’s book where he says, of the 18 commodities in the list, “the stock
mechanism is suitable for four, of which tow already have operating mechanisms and one
does not need to be stocked in the near future… it is difficult to avoid the conclusion that
the stock mechanism was first chosen as a saleable proposition and the Integrated
Programme then fitted around it.”
If it is accepted the ICAs are a good thing then there is a case for a simultaneous
approach and for the creation of a common fund for stocks. The attraction of dealing
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with a large group of commodities simultaneously is that it can have something in it for
everyone. Countries which have interests in some commodities as consumers but in other
as producers can offset gains from one agreement against losses on another. Against this
can be set the sheer complexity of the task and tremendous demands that would be
created for the simultaneous price increase (since that is the most likely effect of the start
of the large number of stockpiles recommended) in a wide range of important imports in
unlikely to raise much enthusiasm on their form for such proposals, it may be possible to
give a little disguised aid in the form of an agreement on sugar or coffee without the
electorate noticing what is afoot, but if similar transfers through raised prices are intended
for ten or more commodities strong opposition form consumers is very likely.
A common fund for buffer socks offers several advantages. First, if the market behaviour
for some commodities is out of phase with movements in prices of others, some buffer
stocks could be selling at the same time as others buying. These offsetting movements
could reduce the overall size of the required fund as compared with the aggregate of
individual commodity funds required to achieve the same policy objectives. If, however,
the main cause of instability was cyclical – fluctuations in demand which caused all
commodity prices to rise and fall together –this economy in funds would be zero or
negligible.
A large single fund might obtain finance on better terms than would several smaller ones.
Lending risks would be pooled and reduced, and dealing in large sums of money would
yield some economies of scale. UNCTAD envisages the buffer stocks as representing
investments which could attract funds on a near commercial basis from OPEC members,
but this is a very doubtful proposition. It depends on either rather wide swings between
purchase and sale prices or very accurate predictions on the part of the stock managers.
The combination of administrative, brokerage, storage and deterioration costs in stocks
tends to absorb a very large part the gross margins between purchase and sale prices
making it unlikely that the fund could support high interest charges.
Negotiations for a Common Fund (CF) were eventually concluded in1979. It was set up
with ‘two windows’. The first is intended to help finance international buffer stocks and
international buffer stocks and internationally co-ordinated national stocks. Its send
window will finance such measures as research and development, marketing and
diversification. The financial structure of the CF is envisaged as government
contributions of $470 million of which $400 million is for the first, and $70 million for
the second window. Of the $400 million, $150 million is to be contributed in cash, $150
million on call and $100 million as on call for backing the Fund’s borrowing.
UNCTAD’s earlier estimate of $6 billion for stocking the ten ‘core’ commodities
(thought by may to be an underestimate) may be directly comparable to this because of
differences in the financial arrangements, but the obvious disparity in size is so huge as to
suggest that the CF is unlikely to have any significant impact upon commodity trade
instability.
In any case it has often been marked that the main obstacle to ICAs has seldom been lack
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of finance. Negotiations have almost always broken down over the issues of the target
price and the allocation of quotas. Even if they could be set up it is not known whether
ICAs could succeed in moderating fluctuations in the export prices and revenues of
developing countries. Past experience does not justify optimism. Nor does the evidence
of theoretical and empirical research, including simulation studies, suggest that the task
of keeping actual prices within, say, plus or minus 15 per cent of a target price which
keeps in touch with long-term trends in supply and demand, is anything but extremely
difficult in technical terms, let alone in the real world of clashing interests between
producers and consumers and among producing nations.
Compensatory Financing
Two other schemes for alleviating the effects of commodity trade instability have been
operating for a number of years. These are the IMF’s Compensatory Financing Facility
(CFF) started in 1963 and the EEC’s STABEX scheme which was established by the
Lome convention between the Community and forty-six African, Caribbean and
compensating countries for shortfalls in export earnings which result from fluctuations in
commodity markets. No attempt is made to intervene in the markets to influence
shortfall and the loans normally have to be repaid within a few years. The IMF’s CFF
defines a shortfall as the gap between the current years’s and forecasts for the subsequent
years. Initially drawings were limited to 25 per cent of the member’s quota in the IMF,
were not additional to ordinary drawings and required the member to co-operate with
Fund in finding a solution to its balance - of- payments difficulties. Partly because of
these limitations and partly because the 1960s were a period of relative stability the CFF
was little used. Over the years the scheme was liberalized. Major changes were made
in1975 in the wake of the oil crisis. The limit on drawings was raised to 75 per cent of
quota and could be additional to ordinary drawings. The permitted that the amount of
outstanding drawings in any twelve-month period was raised from 25 to 50 per cent of
quota. Because the calculation of the shortfall is necessarily delayed until after the end of
the current year countries were permitted to draw on their ordinary quota in anticipation
of a shortfall and then convert this to a CFF drawing at anytime up to eighteen months
later. Up to eighteen months later. Shortfalls have to be for reasons outside the country’s
control and the member still has to co-operate with the IMF in finding a solution. A rule
which prevented a country from borrowing if its current exports were 5 per cent or more
than the average of the two previous years was eliminated. This proved crucial in the
inflationary years of the 1970s.
After the 1975 reforms drawings shot up. In the subsequent sixteen months drawings by
forty-nine member countries reached SDR2.4 billion or twice the amount in the previous
thirteen years. By April 1980 the drawings by the non-oil Less Developed Countries
(LDCs) had amounted to 4.6 billion SDRs and their net outstanding credits were 2.5
billion SDRs.
Nevertheless, it has been criticized for providing far too little assistance to the LDCs.
UNCTAD secretariat calculations show that drawings against the CFF by the LDCs have
on average not exceeded 12.5 per cent of shortfalls. Even in 1976 – the year of maximum
drawings –it was only 12.7per cent.
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It may well be time for the CFF to meet a much larger proportion of export shortfalls, and
most suggested reforms point that way, but several factors should be borne in mind.
First, the IMF assumes that most countries will use their own reserves, borrowing from
other official sources and commercial sources as well as drawing upon the CFF.
Secondly, the 1976 drawings were in relation to the shortfalls of 1975 which was a quite
exceptional year. Primary commodities hit their peak in 1974 and their trough in 1975,
recovering substantially in 1976 and 1977. Many LDCs should have accumulated
reserves from the preceding commodity boom in 1973/4 and the IMF had created several
emergency funds to assist in this world crisis. For example the Oil Facility and the Trust
Fund. The NOLDCs did draw on these.
The CFF scheme is, in principle, a much easier system to operate than ICAs. It is much
more comprehensive in that it covers all merchandise exports (and could easily include
invisibles as well) and it is much less demanding of political necessity to obtain
agreements. Or technical skill in forecasting future prices of individual commodities and
designing optimal stocking policies than is the case for ICAs. CFF-type schemes emerge
in favourable light from simulation exercises and, in practice, the IMF scheme seems to
have worked in the right directions even if the amounts of compensation have seemed
small in relation to the recent problems of the LDCs.
Increases the LDCs’ Fund quotas, the inclusion of invisibles, and calculation of shortfalls
in real terms (allowing for changes in the prices of imports) are all possible reforms
which could increase the value the CFF to LDCs.
c. STABEX
The STABEX scheme was designed to stabilize earnings from exports of the African,
Caribbean and Pacific (ACP) countries to the Community. It covered seventeen
agricultural commodities and iron ore. The original forty-six ACP countries later rose to
fifty-two so that it involves substantial number of developing countries, many of them
rather small, poor and vulnerable. But the commodities whose earnings are intended to
be stabilized amount to only 20 percent of the export earnings of the ACP countries. In
1976, its first year of operation, seventeen ACP countries drew SDDR 72 million. In the
same year ACP counties drew SDR124 million from the IMF scheme and LDCs total
drawings for 1976 were SDDR 1,575 million.
The total sum allocated to STABEX for the whole period 1976 – 80 was only about $420
million and conditions for eligibility were quite stringent. The exports had to be crude or
in very elementary processed form. Individually they had to account for at least 7.5
percent of the country’s total merchandise exports to all destinations. The shortfalls,
calculated in nominal terms, had to be at least 7.5 percent below the average earnings
from the product the ECC over the previous four years. For the least developed, land-
locked or island economies these two conditions are dropped to 2.5 per cent.
The terms for repayment are liberal. Compensation payments to the least developed
countries are in the form of grants and for the others the loans are interest free and
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repayable as and when export earnings recover. The STABEX can be criticized for
discriminating between ACP and other LDCs and for being too limited in coverage and
funds. This has the effect of making it liable to political influence when decisions have
to be made on rationing funds between intending borrowers. The idea of making
compensation payments grants to the least developed countries is widely commended as
an appropriate change for adoption by the IMF\CFF. But is it sensible to confuse
transfers intended to promote development with assistance intended to deal with
temporary financial imbalances? The criteria for allocating funds for each of these
purposes should be quite different. Of course situations may arise where what was
intended as a short-term loan has to be re-phased. Instead of exports rising in the next
three years they may drop still further or there may be drop and still unforeseen events
need special ad hoc arrangements and that basically is the attitude of the IMF.
A complementary facility for commodity-related shortfalls in export earnings

This is the most recent proposal of the Group of 77 at UNCTAD in June 1979. There
they requested that the UNCTAD secretariat in consultation with the IMF staff carry out
a detailed study for a complementary facility’ to compensate for shortfalls in each
commodity, taking account of its financial requirements, possible sources of financing, its
financial feasibility, institutional arrangements and the modalities and considerations that
would provide adequate compensation in real terms to developing countries …’ it is
intended that this should be additional to improvements in the CFF to the IMF and other
IFC arrangements. Most of the OECD nations voted against this resolution or abstained.
If the major worry of the LDCs is fluctuations in their export earnings (and this is what
has usually been maintained) the CFF approach offers much greater prospects of success.
There is scope for reforming and expanding it, but not in the direction of turning it into a
mechanism for long-term transfers of resources to LDCs. The criteria for long-term
assistance out to differ significantly from the relatively automatic provision of short-term
finance to meet balance-of-payments problems induced by export instability.
Economic integration
It refers to the merging to various degrees of the economies and economic policies of two
or more countries in a given region.
 Free Trade Area:

Exist when a number of countries agree to abolish tariffs, quotas and any other physical
barriers to trade between them, while retaining the right to impose unilaterally their own
level of customs duty, etc, on trade with the rest of the world.
 Customs Market
Exists where a number of countries decide to permit free trade among themselves without
tariff or other trade barriers, while establishing a common external tariff against imports
from the rest of the world.
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 Common Market
Exists when the countries, in addition to forming a custom union, decide to permit factors
of production full mobility between them, so that citizens of one country are free to take
up employment in the other, and capitalist are free to invest and to move their capital
from one country to another.
 Economic union
Is where the countries set up joint economic institutions, involving a degree of
supranational economic decision-making.
 Common Monetary System

Is where countries share a common currency, or ensure that each national currency can be
exchanged freely at a fixed rate of exchange, and agree to keep any separate monetary
policies roughly in line, to make this possible.
Benefits of integration
The formation of an economic integration could be beneficial in the light of the following
aspects:
 Enlarged market size: Regional economic blocks provide larger markets than
individual countries. Such increase in size of the market permits economies of
scale, resulting in lower production costs and expansion of output. In fact,
member countries are better placed to bargaining for better terms of trade with
non-member countries.
 Industrialization: the size of the domestic market of one member country may not
be sufficiently large to justify the setting up of an industry, whereas the market
provided by many countries (regional market) is much more likely to be an
incentive for establishment of new manufacturing industries, thus what
economists consider as potentially derived industrial development.
 Infrastructural facilities: Jointly financed infrastructural facilities such as in the

field of transport (e.g. railway systems, ports and habours, and airlines. The East
African Co-operation (EAC), for instance, would reduce costs by setting up one
Development Bank to serve all the three countries rather than each country
maintaining its own.
 Specialisation: Each member country concentrates on production of those goods

which it can produce more efficiently. Surpluses are exchanged and resources
utilisation is increased - comparative advantage.
 Increased employment opportunities and subsequent reduction in income

inequalities: Free mobility of labour leads to people moving from areas where
incomes are low to areas of high labour incomes. This becomes even more
beneficial if such incomes are invested back in respective countries. Furthermore,
firms will have to pay highly in order to retain factor services (economic rent),
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thereby enhancing productivity.
 Improvement of balance of payments (BOP): increased market implies more

exports than before and given fairly low priced imports (from member countries)
relative to imports from non-member countries, balance of payments position is
most likely to improve. Foreign exchange savings also arise from this situation
i.e. hard currencies such as the US dollar will only be required to import what
cannot be produced from within the region.
 Competitive business environment: Absence of trade barriers allows for free flow
of goods and services which develops an upward pressure on competition and the
driving force for relatively lower prices for higher quality products. This helps
reduce or even eliminate monopoly practices, since firms can only acquire and
maintain a market base by producing as efficiently as possible. Overall, there is
increased variety of goods and services their consumption of which enhances
living standards/development.
 Indigenisation of economies: Regional governments play their part by creating

the right incentives for the growth of the private sector which is the prime-mover
of economic activities in liberalized situations. The private sector participation
should not be limited to business activities but should extend to the formation of
regional professional and business associations in order to advise on the influence
future co-operation policies (e.g. the East African Business Council.) This creates
more awareness among potential investors to take advantage of investment
opportunities available within the region to create wealth. This way, over-
reliance on private foreign investments and other forms of capital inflows (such as
conditional Aid from IMF and World Banks) tends to be reduced.
The African continent regional integrations have not gone far in realizing the intended
objectives due to:
Minimal or lack of practical commitment hence the low implementation of policies and
agreements. Policy-induced factors such as inward looking policies of individual
countries could result in the protection of less or uncompetitive domestic producers
against imports irrespective of resources, and stringent trade and payments controls
instituted to deal with the persistent balance of payments problems have adversely
affected the volume of trade among African countries.
 Indispensable high capital import content: Most African countries are not in a
position to sufficiently produce capital goods and other inputs for the production
of goods hence continued vulnerability to foreign influence and dominance. This
is traced to widespread poverty and minimal technical progress.
 Neo-colonialism and dependence mentality: The psychological influence arising

from massive and persuasive advertising by the developed world has largely role-
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modelled the consumption pattern (tastes and preferences) of the African People.
Preference has been given to products which do not originate from within the
region. This then forces regional member countries to import such products in
order to meet their domestic demand.
 Trade-diversion: countries previously importing cheap goods from outside the

region switch to importing the same goods from other member countries. This is
brought about by the removal of tariffs and other trade restrictions on the
movement of goods between member states, while the tariffs on goods from
outside remain. Depending on price/cost difference(s) such expenditure –
switching may increase production cost accompanied by negative welfare
implications.
 Government loss of tax revenue: Removal of tariffs (import duties) leads to

reduced tax revenue to the government. With free trade, in countries where
import duties constituted a high proportion of tax revenue; the government’s
spending programmes will be distorted.
 Unequal distribution of trade benefits/gains: Although all countries gain to a

certain extent, one member country may benefit more than the others. This often
arises due to high subsidization of production so that one country may succeed in
attracting a more than proportionate share of new industrial development. In
particular, incomes and employment opportunities will increase more than
proportionately due to the multiplier effect.
 Product similarity and duplication: Because of product similarity (especially

primary products), regional member countries have not lived to substantial
benefits as would be required; what one country produces is equally produced by
others so that the overall relative market share remains distinctively small.
 Widespread internal conflicts and general political instabilities: the most

immediate result of such an atmosphere is suspicion and increase of protectionist
strategies which no doubt hinders the free movement of goods and people. This
then negates the intention of an economic integration. Owing to the current
political and economic reforms sweeping across the economies of the developing
would, it’s quite evident that much cannot be done without any form of collective
effort. Economic integration aspect(s) could receive the seriousness deserved
now or in the immediate future. In fact, some which had collapsed or remained
insensitive are getting revived e.g. the East African Co-operation.
The disadvantages of economic integration
i. The “trade-diversion” effect has already been mentioned. Countries

previously importing cheap goods from outside the free trade area switch to
importing the same goods from other member countries. This is brought about
by the removal of tariffs on goods moving between member states, while the
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tariffs on goods from outside remain. The result is a less efficient use of
resources. Further more, the goods produced in the other member states are
often of inferior quality to those formerly imported from outside.
ii. Government suffer a loss of tax revenue from the setting up of a free trade
area. Before a lot of tax revenue was received from import duties on goods
brought into the country from overseas. If goods are imported from other
member states when the free trade area is up, import duties are no longer
payable and tax revenue, the effect on a government’s spending programme
will be substantial.
iii. The benefits arising from a free trade area may be unequally distributed.
Even though all countries gain to a certain extent, one may benefit more than
the others. If one country succeeds in attracting a more than proportionate
share of new industrial development, it will enjoy more than proportionate
economic benefits. In particular, incomes and employment opportunities will
increase more than proportionately because of the multiplier effect.
4.6 Balance of Payments
The Balance of Payments of a country is a record of all financial transactions between

residents of that country and residents of foreign countries. (Residents in this sense does
not just refer to individuals, but would also include companies, corporations and the
government). Thus all transactions are recorded whether they derive from trade in goods
and services or transfer of capital.
Like all balance sheets, the balance of payments is bound to balance. For if the country
has “overspent”, then it must have acquired the finance for this “overspending” from
somewhere (either by running up debts or using its reserves), and when this item is
included in the accounts they will balance. It follows therefore that when reference is
made to a balance of payments “deficit” or “surplus”, this only looks at a part of the total
transactions, e.g. that part involving trade in goods and services, which is termed the
“Balance of Payments on the current account”
If the value of exports exceed the value of imports the balance of payments is said to be
in Trade Surplus. This is regarded as a favourable position because a persistent trade
surplus means lower international debts. Also, a trade surplus is regarded as a sign of
success in the country’s trade with other countries and is, therefore, politically desirable.
On the other hand, if the value of imports exceed the value of exports, the balance of
payments is in trade deficit. This is an unfavourable position because a persistent balance
of payment trade deficit means the country’s foreign exchange reserves are being run
down and so is its ability to pay for its imports and settle its international debt. Also
persistent balance of payments trade deficit is regarded as a sign of failure in the
country’s trade with other countries and is therefore politically undesirable
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Structure of the Balance of Payments
The balance of payments is divided into three accounts:
a. The Current Account

This records all transactions involving the exchange of currently produced goods and
services and is subdivided into
i Visibles:
A record of all receipts from abroad the export of goods and all expenditures abroad
on the import of goods. When these are compared, this is known as the “balance of
trade” (though it would be properly called the “balance of visible trade”).
ii. Invisibles:
A record of all receipts from abroad in return for services rendered and all
expenditure abroad for foreign services. It also includes receipts of profits and
interest earned by investments abroad, and similarly profits and interest paid
abroad to foreign owners of capital in the country are included in Expenditure.
The comparison of all the debits (Expenditure abroad) and credits (receipts from
abroad) arising from visibles and invisibles is known as the “balance of
payments on current account” and is the best indicator of the country’s trading
position.
If the value of exports exceeds the value of imports the balance of payments is
said to be in trade surplus. This is regarded as a favourable position because a
persistent trade surplus means the country’s foreign exchange reserves are rising
and so its ability to pay for its imports and settle its international debts. Also a
trade surplus is regarded as a sign of success in the country’s trade with other
countries and is, therefore, politically desirable.
On the other hand, if the value of imports exceeds the value of exports, the
balance of payments is in trade deficit. This is an unfavourable position because
a persistent balance of payments trade deficit means that the country’s foreign
exchange reserves are being run down and so is its ability to pay for its imports
and settle its international debts. Also a persistent balance of payments trade
deficit is regarded as a sign of failure in the country’s trade with other countries
and is therefore politically undesirable.
b. Capital account
This records all transactions arising from capital movements into and out of the country.
There are a variety of such capital flows recorded, namely:
i. Long term capital:

This consists of:
a. Government to Government borrowing and lending
b. Government borrowing from international organizations
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c. Investment by foreigners at home in such projects as factories, mines and

plantations and by nationals abroad in similar projects.
d. The buying of shares by foreigners in home companies and by nationals in
foreign companies.
ii. Short term capital (“hot money”)

Refers to changes in bank balances held by foreigners in home banks and by
nationals in foreign banks.
If money comes into the country (e.g. deliberate borrowing abroad by a
domestic company or foreign investment in the country), it is recorded as a
credit item, while investments abroad etc is recorded as a debit item.
When the current account and the capital account are combined, and we compare
the total debits and credits, this is termed the balance for official financing (it used
to be termed the “total currency flow”). This shows the final net outflow, or
inflow arising from current and capital transactions.
c. The Monetary account

Also called official financing, this comprises the financial transactions of the
government (handled by the central bank) needed to offset any net outflow of money
on the current and capital accounts i.e. total currency flow. It comprises of:
i. Use of the foreign exchange reserves, i.e. increasing or decreasing them.
ii. Borrowing from the IMF i.e. borrowing or paying back.
iii. Central bank transactions with other countries central banks i.e. borrowing or
lending.
d. The balancing item
Since for ever position entry in the current and capital accounts there is a
corresponding negative entry in the monetary account, and for every negative entry
in the first two accounts there is a corresponding positive entry in the monetary
account, it follows that the balance of payments must balance i.e. the sum of the
balances of all the three accounts must add up to zero.
In practice, this is usually not the case because there are so many transactions that
take place, and due to human errors some may be recorded correctly in one account
but incorrect in another account with the result that the sum of the tree balances may
not be zero. The actual discrepancy in the records can be calculated. The balancing
item represents the sum of all errors and omissions. If it is positive, it means that
there have been unrecorded net exports while a negative entry means that there have
been unrecorded net imports.
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Equilibrium and disequilibrium in the balance of payments

If on the current account, the value of exports is equal to the value of imports, the
balance of payments is said to be equilibrium. If the two values are not equal, the
balance of payments is in disequilibrium. This could be due to a trade surplus with the
value of exports exceeding that of imports or due to a trade deficit with the value of
imports exceeding that of exports.
In either case, balance of payments disequilibrium cannot last indefinitely. For if this is
due to a trade deficit, the country will try and move it. This is because a persistent trade
deficit i.e. a fundamental disequilibrium poses several problems for an economy, namely:
 In short run a deficit allows a country’s peoples to enjoy higher standard of living
form the additional imports that would not be possible from that country’s output
alone in the longer term the decline of the country’s industries in the face of
international competition will inevitably result in lower living standards.
 A persistent trade deficit means that the country’s foreign exchange reserves are
being run down and so it its ability to pay for its imports and settle international
debts.
 Also, a persistent balance of payments trade deficit is regarded as a sign of failure

in the country’s trade with other countries, and is therefore not politically desirable.
Policies to cure balance of payment deficits

The measures available to tackle balance of payments deficits include short term
measures such as deflation, import controls, devaluation of a fixed exchange rate or a
managed downward float of the exchange rate in the short-run and foreign exchange
controls and long term measures such as Export promotion and Import Substitution.
Short-term policies
Deflation is a policy of reducing expenditure with the intention of curing a deficit by

reducing the demand for imports. This reduction of expenditure may be achieved by the
use of either fiscal or monetary policy. In addition to reducing demand for imports
however, deflationary measures may also have expenditure switching effect upon the
balance of payments. The depression of demand may cause the domestic inflation rate to
fall relative to that of competitor countries and thus increase the price competitiveness of
exports. Consumers in other countries may then switch their demand towards the
country’s exports, whilst its own residents switch away from imports, preferring instead
to buy home produced substitutes. The difficulty posed by deflation is that it not only
reduces demand for imports but also reduces demand for domestically produced goods.
This in turn can have a knock on effect in the form of lower output and higher
unemployment.
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Import controls have immediate effect on the balance of payments. Quotas and
embargos directly prevent or reduce expenditure on imports, while import duties or
tariffs discourage expenditure by raising the price of imports, while import duties or
tariffs discourage expenditure by raising the price of imports. Import controls also have
their limitations and problems. They do not tackle the underlying cause of this
disequilibrium i.e. the lack of competitiveness of a country’s industry and what is more
they are likely to invite retaliation to the long-term detriment of themselves as well as
their trading partners. It is also the case that trade agreements such as GATT limit the
opportunities for member countries to make use of import controls and the use of
subsidies to encourage exports.
A third option is that of devaluation. Devaluation of a fixed exchange rate or the

downward float of a managed exchange rate is mainly expenditure switching in its effect.
The cure works in a similar manner to the freely floating adjustment mechanism under a
floating exchange rate system. In the case of a fixed exchange rate system devaluation
consists of an administered reduction in the value of the currency against other
currencies. In a managed system the authorities can engineer a downward float by
temporarily reducing their support. In both cases the effect is to increase the price of
imports relative to the price of exports and so switch domestic demand away from
imports and towards home produced goods.
Certain conditions have to be met for devaluation to have this effect on boosting
exports/curbing imports. They are:
a. Competing countries must not devalue at the same time, otherwise there would be no
competitive advantage gained (exports would not become any cheaper in comparison
with products of those countries).
b. The demand for exports (or for imports) must be price elastic, i.e. the sales must be
affected by the change in price. Thus, when the domestic currency falls in value, the
demand for exports should rise by a larger proportion in order to earn more foreign
exchange.
c. There must be appropriate domestic policy.
i. The extra exports must be available. If there were full employment in the
economy, the home demand would have to be curbed to make room for the extra
export production.
ii. Inflation must not be allowed to erode the competitive advantage secured by
devaluation.
A devaluation of the currency is not a soft option. There are a number of problems that
will be involved, and these must be outlined:
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a. To the extent that home demand has to be cured to make room for the extra exports,
the domestic standard of living is reduced. This is only because, before it took place,
the country was “living beyond its means”, but it does come as a shock to find the
domestic “squeeze” accompanying devaluation. Yet if it does not take place, then the
strategy will not have worked; the exports may not rise to meet the higher demand
from abroad.
b. The larger cost of importing goods raises the domestic cost of living. This is not just
inflationary in itself, but can trigger off pay claims which if settled will further
worsen inflation.
c. It does not boost exports immediately. There is a period during which the balance of
payments gets worse as the country faces a higher import bill. It is only when
exports start rising (and there is a considerable time lag involved) that the situation
improves.
d. It does not tackle the long-run problem of why exports were not doing well. The
problem may be more in inefficiency and other non-price factors than in the price of
the exports themselves. In which case devaluation would make little difference to
the basic problem.
A fourth option is to use exchange control. When this is used to deny foreign exchange
to would be importers, its effects are identical to those of the various import restricdtions
already discussed. There are various forms of exchange control that can be imposed by a
government and enforced by legislation. They all involve restrictions on the actions of
holders of its currencies and residents of the country who may hold foreign currency.
ii. Long-term policies

One long term option of tackling balance of payments deficit is export promotion. In the
long run this is the best method of improving a balance of payments. If the general level
of efficiency in an economy can be raised, then exports will benefit. Efficiency can be
promoted by mergers in exporting firms (thereby reaping economies of scale), research
and economic growth – for it is felt that once an economy is growing it is generating the
necessary dynamism and technological improvement that will feed through into a better
export performance.
A second long-term option is import substitution. The replacement of imports by home

products can be achieved by economic planning. If the defects of home products can be
analysed, and the likely future trends in demand can be forecast, then domestic firms can
take the necessary action both to improve their product and to expand their capacity.
Government support for certain industries can also be helpful here.
4.7 International Liquidity

International liquidity is the name given to the assets which central banks use to
influence the external value of their currencies. It can also be defined as the means
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available for settling international indebtedness. There are five main types of
international liquidity:
 Gold
 Convertible national currencies
 Borrowing facilities
 International reserve assets
 Currency swaps
Gold
Although currently no country uses gold as its national currency, gold has a long history
of use as commodity money and has almost universal acceptability. Gold is still regarded
as money in international transactions and is an international reserve currency i.e.
countries can hold their foreign exchange reserves in terms of gold and it is acceptable in
international payments and is convertible.
The great advantage of gold as an international currency is the confidence people have in
its ability to maintain its exchange value. This stems mainly from the knowledge that
world supplies of gold cannot easily and quickly be augmented.
Nevertheless, it is clearly wasteful to employ vast resources of men and capital to

produce gold merely in order to store it away in central banks. Besides, it is scarce i.e.
not each country has it.
Convertible National Currencies

Currencies are convertible when holders can freely exchange them for other currencies.
There are several advantages in using a particular national currency as an international
standard of value and as an international reserve asset. Unlike gold its costs of
production and storage are negligible and the reserve asset is in the same form as the
currency used by traders and investors. The supply can easily be increased or diminished
to meet the needs of world trade.
The problem with this facility is that for the other countries to hold convertible currency,
the country to which it belongs must be in constant trade deficit because it must import
form other countries and pay them in its currency. But a prolonged deficit will cast doubt
on the ability of that country to maintain the exchange value of its currency. Another
problem is that if the country to which the currency belongs devalues the currency, the
other countries holding it will lose purchasing power in international transactions.
Borrowing Facilities
If a country’s currency is not convertible, it can borrow from countries whose currencies
are convertible and use the convertible currencies to make its international payments.
The difference from gold and national convertible currencies is that they are conditional –
they have to be repaid. Borrowing facilities as a source of liquidity have the advantage
that they can be expanded to meet the growing demands. However, the draw-back is that
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it makes the borrowing country indebted to the lending country, which is sometimes
politically undesirable because of the “strings” which may be attached to the loans.
Special Drawing Rights (SDR)

These are international reserve currencies created by the International Monetary Fund
(IMF) to overcome the problems of using gold and national currency reserve. These
represent an entirely new form of reserve assets. The SDR are simply entries in the
books of the IMF and do not require expenditure of resources to create them unlike gold.
Also their use does not put any country under strain unlike the use of national reserve
currencies. Initially, the unit of the SDR was pegged to the American dollar, but when
the dollar was floated the unit of SDR became a weighted basket of 16 currencies of the
world’s major trading nations, the weight used in each case being the proportion of
World Trade taken up by that country. Later the unit of SDR was reduced to a weighted
basket of the exchange values of five major currencies (the US dollar, the Deutschemark,
the French franc the Japanese yen and the Pound sterling). The value obtained is then
expressed in dollars.
SDRs are issued by the IMF to member countries in proportion to their quotas and
represent claims or rights which are honoured by other members and by the IMF itself.
By joining the scheme, a member accepts an obligation to provide currency, when
designated by the Fund, to other participants in exchange for SDRs. It cannot, however,
be obliged to accept SDRs to a greater total value than three times its own allocation.
Participants whose holdings are less than their allocation pay interest on the difference
between their allocation and their actual holdings, and members holding SDRs in excess
of their allocation receive interest.
Each member of the IMF is entitled to an allocation of SDR, which it can use to pay for
its imports or settle international debts. If both the paying country and the country being
paid are members of the IMF, then in the books to IMF, the allocation of the paying
country will go down and that of the country being paid will go up. If the country being
paid is not a member of IMF, then the country paying can use its allocation of SDR to
purchase gold or convertible currency from the IMF or another member of the IMF,
whose allocation of SDR will correspondingly increase.
Currency Swaps
If the currency of one country is not convertible, the central banks o f the two countries
can exchange their currencies, and the country with the non-convertible currency can use
the convertible currency of the other country. These are called currency swaps. The
country with the non-convertible currency will later purchase back its own currency using
gold or convertible currency.
Foreign Exchange Markets

It is the place where buyers and sellers meet to negotiate the exchange of different
currencies e.g. forex bureaus.
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Exchange Rates
These are the rates at which one currency can be exchanged for another or the price of
one currency in terms of another
Factors determining the Exchange Rates

The exchange rate for any particular country is basically the result of the interaction of
export demand and import supply.
$/£
4 S£
3 D£
Exchange Rates
2 £1 = £1.3
1 S£ D£
0
Figure 4.1 Quantity of £s traded on Foreign Exchange Market
The demand curve lies has the USA desire to buy U.K. exports. Below the supply curve
is the UK desire to buy USA’s export. An increase in demand for UK exports will mean
foreigners are now offering more money so that demand for increases. The price of
foreign currency will decline and the pound will have to appreciate.
S£
D1
D
3 E1
2 E
Exchange Rates 1 D1
D
S£
0 A B
Figure 4.2 Quantity of £s traded on Foreign Exchange Market
An appreciation in the exchange rate cold be caused by either:-
a. an increase in demand for exports

b. a decrease in demand for imports
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If foreign currency becomes more expensive, the domestic currency is said to have
depreciated. Depreciation is the rate of exchange could be caused by;
a. An increased demand for imports;

b. A decreased foreign demand for exports
Other factors influencing Exchange Rates
i. Inflation: Other things being equal, a country experiencing a high rate of inflation
will experience a lower demand for its goods while its trading partners goods whose
rate of inflation is low will now appear cheaper to citizens who will thus buy more.
Thus demand for its currency will decrease while the demand for its trading
partners’ currencies will increase, and both the factors will cause depreciation in the
external value of its currency. If on the other hand, a domestic rate of inflation is
lower than that of its trading partners these factors will be expected to work in
reverse.
ii. Non-trading factors: Exchange rates re also influenced by invisible trade, interest
rates, capital movement speculation and government activities.
iii. Confidence: A vital factor in determining the exchange rate is confidence that most
large companies “buy forward” i.e. they buy foreign currency ahead of their needs.
They are thus very sensitive to factors which may influence future acts such as
inflation and government policy.
Thus, the exchange rate at any particular moment is more likely to reflect the anticipated
situation on country rather than the present one.
Effects of Fluctuations in Exchange Rates

When a country’s currency depreciates, exporting firms may have competitive advantage
but businesses which rely on imports for raw materials or components will find costs
rising. This may make them less competitive on both domestic and foreign markets.
If the domestic currency appreciates then imports will become cheaper to domestic
customers and exports more expensive to foreign customers. this will result in a full
demand for the businesses goods abroad and increase competition from imports in the
home markets.
4.8 International Financial Institutions

In July 1944, a conference took place at Bretton Woods in New Hampshire to try to
establish the pattern of post-war international monetary transactions. The aim was to try
to achieve free convertibility, improve international liquidity and avoid the economic
nationalism which had characterized the inter war period.
The result was that two institutions were established: in 1946, the International Bank for
Reconstruction and Development (IBRD); and in 1947 the International Monetary Fund.
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The International Monetary Fund

The International Monetary Fund is a kind of an embryo World Central Bank. Its
objectives are:
i. To work towards the full convertibility of currencies by encouraging the growth of

world trade.
ii. To stabilize exchange rates between currencies.
iii. To give short-term assistance to countries having balance of payments problems.
To achieve these objectives, the following conditions would have to be fulfilled: -
i. Countries should not impose restrictions in their trade with each other. This should
encourage the growth of world trade and lead to full convertibility of currencies.
ii. Countries should adopt the peg system of exchange rates, in which each country
quotes the exchange rate of its currency in gold and thus the exchange rates between
currencies can be determined. The quoted exchanged rate is allowed to fluctuate to
within 1% up and down, and the country can devalue or revalue its currency by up to
10%. This was meant to stabilize exchange rates between currencies.
iii. Each member state of the I.M.F should contribute to a fund to enable the I.M.F to
give short-term assistance to countries having balance of payments problems. The
quota contribution of the member state depends on the size of its G.D.P and its share
of world trade. The member state contributed 25% of its quota in gold or convertible
currency and the remaining 75% in its own currency.
iv. A member state in balance of payments problems can borrow from the I.M.F on a
short-term basis. 25% of the country’s quota contribution is automatically available
to it as stand-by credits. Beyond this the country can borrow on terms dictated by
the I. M. F. the country borrows by purchasing gold or convertible currency using it
own currency. The country’s borrowing facility expires when the I.M.F. holds the
country’s currency twice the value of its quota contribution. In paying back to the
I.M.F. the country will repurchase back its currency using gold or convertible
currency until the I.M.F holds 75% of the country’s quota contribution in the
country’s currency.
v. The I.M.F. reserves the right to dictate to the country borrowing from it how to
govern its economy.
To what extent has the IMF achieved its objectives?

The objective of achieving full convertibility of currencies has not been achieved. In the
first place countries impose restrictions in their trade with each other, and this has not
helped the growth of world trade. Secondly, the export capabilities of different countries
are different and it is difficult for all currencies to be convertible in particular the range of
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exports for developing countries very limited and so is the demand for them. This makes
their currencies weak and unconvertible.
The objective of stabilizing exchange rates has not been achieved. This is because
outside the stated limits the adjustable peg system of exchange rates has the same
limitations as the gold standard in that it is deflationary and can put strains on the
country’s foreign exchange reserves in times of a trade deficit and it is inflationary in
times of a trade surplus.
While the IMF does give short-term assistance to member states in balance of payments
problems, it is strictly on a short-term basis and it does not go to the root cause of the
deficit. A more useful form of assistance would be one that would go into projects that
would increase the productive potential of the country, making it less dependent on
imports and increasing its export potential. Such assistance would have to be on long-
term basis, but this is not within the objectives of the I.M.F., which gives assistance to
finance a prevailing deficit.
External Debt Problem

External debt refers to debt owing by one country to another. External debt is a more
serious problem than internal debt because the payment of interest and repayment of the
capital sum form debit items in the balance of payments.
The cause of third world debt is the unwise borrowing and lending during the 1970s. The
oil crisis made conditions extremely difficult for many third world countries. For the
same reason the Euro currency markets were awash with money and real interest rates
were low. Therefore poor countries need to borrow and banks were anxious to lend
where they could get better return than on the domestic market. The bulk of this lending
was by commercial banks and not by international institutions such as the IMF and World
Bank. This has the consequence that, while the international institutions could write-off
the debt, it is very difficult for commercial ones to do so.
The problem turned into a crisis in the early 1980s. As the world fell into recession this
hit the debtor nations particularly hard. Many developing economies are highly
dependent on the export of primary products and the price of these dropped dramatically.
At the same time real interest rates rose sharply and most of the debt was at variable
interest. The debtor nations were caught in a vice between falling income and rising
costs. When this happened the banks which had been so anxious to lend in the 1970s
were no longer willing to do so.
This meant that the debtor nations had to turn to international agencies for help.
However, the international agencies do not have sufficient funds to substantially affect
the situation. For such help as they were able to give, they demanded very stringent
conditions. These deflationary conditions have often impoverished further the debtor
nations.
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Much of the money that was borrowed was not used for development purposes but
simply balance the books for the nations’ overseas payments. Little found its way into
the sort of projects which development economies would suggest.
Many measures have been suggested for instance by the World Bank. Among them has
been suggestion for reducing interest rates on non-concessional debt, rescheduling with
longer grace periods and maturities or outright conversion of bilateral loans to grants.
International Development Association (IDA) has converted its repayments to be used to
reduce International Bank for Reconstruction and Development (IBRD) debt owed by
low income third world countries.
4.9 Review Questions

1. What problems do African regional integration bodies /organizations face?
2. What factors affect the long-run trend of the terms of trade for developing countries?
3. Explain reasons for the development of international trade
4. Explain the theory of comparative advantage and its limitations
5. Explain the reasons for protectionism policy
6. Describe ways of restricting international trade
7. What are the benefits of integration?
8. Describe five main types of international liquidity

9. Explain the following terms as used in international trade
i) Economic integration
ii) Free trade area
iii) Customs market
iv) Common market
v) Economic union
vi) Common monetary system
4.10 References

116

lOMoARcPSD|16863312
Sample Paper 1
Mt Kenya University
SCHOOL OF APPLIED SOCIAL SCIENCES 2010/2011
DEPARTMENT OF BUSINESS & SOCIAL STUDIES
BACHELOR OF BUSINESS MANAGEMENT
UNIT CODE: BBM 126 UNIT NAME: INTRODUCTION TO MACROECONOMICS
2 HRS
Answer question One which is compulsory and any other Two questions.
QUESTION ONE
a) State the canons of public expenditure (4marks)
b) What are the determinants of consumption (4marks)
c) State any two reasons why macroeconomics is important (4marks)
d) ‘Inflation is such a bad disease that any country would wish to rid off’. Explain
(4marks)
e) State and explain any two factors that cause the shifts in the balance of payments curve.
(4marks)
f) What are the policies that can be used to curb unemployment in Kenya (5marks)
g) State the functions of money (5marks)
(30 marks)
QUESTION TWO
a) National income accounting is very paramount to any country that is conscious a bout its
growth and development. Discuss the national income difficulties in estimation of
national income (10marks)
b) Discuss some of the options that can be used by Kenyan government in dealing with
excess money in circulation (10 marks)
QUESTION THREE
a) State and explain the methods that can be used by a country to correct the trade deficit
(10 marks)
b) Some times countries that are developing can resort to taking up measures to protect
their young industries against foreign multinational. Discuss the forms of protection that
can be used by such a country (10marks)
QUESTION FOUR
a) State and explain the types of investments that can be witnessed in any economy like
Kenya (10 marks)
b) What are the determinants of investments (10 marks)
QUESTION FIVE
a) Briefly explain the main components of balance of payments (10 marks)
b) What are the roles of central bank to any country like Uganda (10marks)
117

lOMoARcPSD|16863312
Sample Paper 2
Mt Kenya University
SCHOOL OF APPLIED SOCIAL SCIENCES 2010/2011
DEPARTMENT OF BUSINESS & SOCIAL STUDIES
BACHELOR OF BUSINESS MANAGEMENT
UNIT CODE: BBM 126 UNIT NAME: INTRODUCTION TO
MACROECONOMICS
2 HRS
Answer question One which is compulsory and any other Two questions.
QUESTION ONE
a) Investment is very important for any country that wants to move forward what are the
determinants of investments. (4 marks)
b) National income accounting is very important to a country like Kenya but it’s not a good
measure of material will being. Explain. (4 marks)
c) Explain in detail the Keynesian’s transactions native for demand for money. (3 marks)
d) State the assumptions of the multiplier formula. (3 marks)
e) What are the sources of public revenue for a country? (4 marks)
f) A developing country like Kenya must protect the local industries against competition
against from multi-naturals. What are the forms of protection that can be used (8 marks)
g) State the goals of macroeconomic policy (4 marks)
(30 marks)
QUESTION TWO
a) Discuss any two approaches of measuring the national income (10 marks)
b) What are the uses of national income statistics (10 marks)
QUESTION THREE
(a) Discuss the Keynesian theory of demand for money (15 marks)
(b) State the principles of taxation (5 marks)
QUESTION FOUR
In the recent years Kenya has been experiencing inflation tendencies that have eroded the value
of money thereby making people worse off.
(i) Discuss by use of examples the various types of inflation. (10 marks)
(ii) Any country that fails to control inflation is doomed to fail. What are the remedies that can be
recommended for any economy to apply and bring inflation under control (10 marks)
QUESTION FIVE
(i) With the examples, explain the causes of unemployment (5marks)
(ii) Compare and contrast between free trade and protectionism (10 marks)
(iii) Economic will carry out the operations under either micro-economics or macro-economics.
What is the difference between the two? (5 marks)
118

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Entrepreneurship (Mount Kenya University)

Studocu is not sponsored or endorsed by any college or university

P.O. Box 342-01000 Thika

DEPARTMENT OF BUSINESS AND SOCIAL STUDIES

COURSE CODE: BBM 126

COURSE TITLE: INTRODUCTION TO MACROECONOMICS

Instructional Material for BBM- distance learning

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BBM 126: INTRODUCTION TO MACROECONOMICS

Purpose: To enable learners understand and appreciate the importance of

Recommended Text Books:

Text Books for further Reading:

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CHAPTER ONE: NATIONAL INCOME ANALYSIS

1.1 Definition of National Income

Different Concepts of National Income

a) Gross Domestic Product

b) Gross National Product

c) Net National Product

d) Nominal Gross National Product

e) Real Gross National Product

f) National Income Accounting

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that situation within a set of assumptions’

1.2 The Circular Flow of Income and Expenditure

1.3 Approaches to Measuring National Income

b. The national income: - The incomes of all the citizens.

c. The national expenditure because whatever we receive we spend, or lend to the

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Figure 1.1 The Circular Flow of Income and Expenditure

i) Using Total Expenditure for Calculating National Income

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Calculating national income from total expenditure

Country Y National Expenditure (in £millions) 1999

Alcoholic drink 13,372

Fuel and light 9,395

Household goods and services 12,274

Transport and communications 31,475

Other goods and services 23,356

Less: Adjustment of non-profit making bodies (443)

Local Government expenditure 25,236

Growth in stocks 267

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(ii) Using Factor Incomes for Calculating National Income

Country Y National Income rewards to factors (in £ 1999

Pay in cash and kind of HM Forces 3,121

Employers’ contribution to National Health Insurance 10,632

Employers’ contribution to other funds 12,971

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Surpluses of public corporations 9,661

Surpluses of other public enterprises (-)

Imputed charge for consumption of capital 2,456

Table 1.1 Calculating National Income from factor Incomes

(iii) Using the National Output for Calculating National Income

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Country Y National Product by industry (£ millions) 1999

Energy and water supply 29,645