Chapter one:

Equilibrium income determination

What is income?

Income is the consumption and savings opportunity gained by an entity within a specified timeframe,
which is generally expressed in monetary terms. However, for households and individuals, "income is the
sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings received... in
a given period of time."

Income per capita has been increasing steadily in almost every country. Many factors contribute to people
having a higher income such as Education, globalization and favorable political circumstances such as
economic freedom and peace. Increase income also tends to lead to people choosing to work less working
hours. Developed countries defined as countries with a "developed economy" have higher incomes as
opposed to a developing countries tend to have lower incomes.

Economic definitions: In economics, "factor income" is the return accruing for a person, or a nation,
derived from the "factors of production": rental income, wages generated by labor, the interest created by
capital, and profits from entrepreneurial ventures.

1.1 Components (sources) of income

The detailed classification of sources of income (component (component groups A-F) was determined in
the following way. A basic distinction commonly made in discussing sources of income is between
earnings (income derived from the sacrifice of time and effort by the recipient) and unearned income
(incomes not requiring such sacrifice). In describing the functional distribution of income, economists
often further. Subdivide earnings into labor income (group A) and business income (group B), depending
on whether the work is performed for ‘pay, or as a self-employed entrepreneur. A distinction is also
drawn between property income (group C) and transfer payments (groups D-F) with in the ‘category of
unearned income.

These four categories define the classes often used in analyzing, the functional division of income.
However, such a broad classification is inadequate to distinguish among many income concepts. Thus, a
more detailed disaggregation lwas necessary. Little guidance was available for determining this finer
level of detail except that contained in the income definitions themselves. The categories chosen reflect
the focus of this study, as well as ‘the need for finer classification. Thus, transfer payments have been
grouped into public cash transfers, public transfers paid in kind, and private transfers. Within the public
transfer groups, individual program payments have been identified. In the labor and business income
groups, detail is determined according to more traditional criteria, such as distinguishing civilian from
military pay, business from farm income, or market from nonmarket activity. Sources of property
income, such as interest, dividends, and capital distinguished. Finally, private transfer income has been
distinguishing such items as alimony, gifts, bequests, trustily support provided by others. Gains, have
been disaggregated to income, and volume-The need to define components for income definitions which
differ conceptually in their accounting basis, accounting period, and recipient unit leads to the definition
of components’ which are mutually incompatible within a single incomes.
A. property income

B. Business Income employment

C. labor income

D. Public Cash Transfer Payments:

E.Public In-kind Transfers

F.Private Transfers in Cash or in Rind

Aggregate Expenditure and Equilibrium Output

In macroeconomics I we described real GDP, inflation, and unemployment, and we talked about how
they are measured. Now we begin the analytical part of macroeconomics. We begin with the simplest
case, focusing on households and firms. Once we understand how households and firms interact at the
aggregate level, we will introduce government.

Our goal in this chapter is to provide you with a simplified model that will let you see what happens to the
economy as a whole when there is an increase in investment. If suddenly all the managers of firms in the
economy decided to expand their plants, how would that affect households and aggregate output?
Because these are difficult questions, we start with a simple model and then build up chapter by chapter.

As we work through our model of the economy, we will focus, at least initially, on understanding
movements in real gross domestic product (GDP), one of the central measures of macro economic
activity. Because we are interested in tracking real changes in the level of economic activity, we focus on
real, rather than nominal, output. So, while we will typically use dollars to measure GDP, you should
think about this as dollars corrected for price level changes. We saw earlier that GDP can be calculated in
terms of either income or expenditures. We will use the variable Y to refer to both aggregate output and
aggregate income.
In any given period, there is an exact equality between aggregate output (production) and aggregate
income. You should be reminded of this fact whenever you encounter the combined term aggregate
output (income) (Y).

Aggregate output can also be considered the aggregate quantity supplied because it is the amount that
firms are supplying (producing) during a period. In the discussions that follow, we use the term aggregate
output (income) instead of aggregate quantity supplied, but keep in mind that the two are equivalent. Also
remember that aggregate output means “real GDP.”From the outset, you must think in “real terms.” For
example, when we talk about output (Y), we mean real output, not nominal output

Components of Aggregate Expenditure (AE)

A. Consumption and Savings Function

Consumption Expenditure Of the four components of aggregate demand, consumption expenditure C is

the largest contributing to between 60% and 70% of total expenditure. For this reason, we often start our
analysis with this particular component. This category of expenditure includes private spending on
durable goods (automobiles, electronic goods, appliances,), non-durable goods (food, clothing, books and
magazines,...), and services (housing, health-care, education, entertainment,...). Special attention must be
given to the service component of consumption expenditure for several reasons. First, services represent
the largest component representing at least 50percent of this type of spending. Second, services include
housing services measured directly by rents being paid from tenant to landlord, in the case of rental
housing, indirectly as imputed rent that an individual would pay to himself in the case of owner occupied
housing. In the latter case the homeowner acts as both tenant and landlord with no actual payment
changing hands but imputed expenditure being included in the services category to reflect the value of the
housing services received from the owner-occupied home. Third, services, unlike durable and some non-
durable goods are difficult to accumulate as inventory. Thus any changes in the demand for services (due
to changing preferences or the general level of economic activity) must be immediately matched with
changes in production. This is not always an easy task in any economy. Consumption expenditure
decisions are strongly influenced by household disposable (after-tax) income, household wealth, savings
needs and plans, confidence in the future direction of the economy, and interest rates (in the case of
durable-goods purchases).

Consumption is primarily a function of Yd (disposable income) or “after-tax” income. Although it is also

influenced by the rate of interest, expectations about future Yd, wealth effects etc.ifplot Consumption as a
function of Yd it will have a positive vertical intercept (‘autonomous consumption’) and a positive slope
but less than one (i.e, the slope of the consumption function is the coefficient on Yd in the Consumption
equation and represents the Marginal Propensity to Consume (MPC). Therefore, 0<MPC<1 if plot the
consumption function versus a 45 degree line (with the mathematical property that any point on the 45
degree line has the same vertical coordinate as horizontal coordinate, or x = y) then where Consumption
intersects the 45 degree line is referred to as “breakeven level of Yd”.

atYd<Yd breakeven, then C >Yd (the individual is ‘dissaving’ as savings <0)

atYd>Yd breakeven, then C <Yd and the individual is “saving”, Savings >0.

n the Savings function is derived from the consumption function (if the consumption function changes
then so does the savings function). For example, if

C = a + b (Y - T) where a>0, 0<b<1 and Yd= Y-T

then the implied savings function is:

S = - a + (1-b) (Y - T)where (1-b) = MPS (marginal propensity to save)

Note: MPC + MPS = 1

n Mathematical example:

if C = 1000 + 0.80 (Y -T) then the implied savings function is:

S = -1000 + 0.20 (Y - T)

where MPC = 0.80 and MPS = 0.20.

B. Investment Expenditure

Investment expenditure I represent a smaller share of the total but tends to be the most volatile component
leading to the cyclical behavior of aggregate demand. This category of expenditure includes fixed
nonresidential investment (factories, machines, transport equipment), fixed residential investment (new
houses and apartments), and business inventories. Often the volatility in investment results from
fluctuation in inventory levels due to changing expectation about business conditions. Fixed residential
and nonresidential investment refers to the creation of income producing assets. Assets that will generate
net-benefits (benefits - costs from housing services) in the case of owner-occupied housing or generate
profits as part of the production process. These net-benefits and profits depend on the expected revenue or
gross benefits generated by the asset as well as the costs of acquiring, maintaining and replacing these
assets. Demand for the production of the asset will directly affect the revenue generated. Strong demand
based on preferences, optimism, purchasing power, or demographics will lead to the desire for more
investment expenditure.

Acquisition costs include both the purchase price of the asset and the borrowing costs involved both
which are highly sensitive to changes in interest rates. Higher interest rates lead to higher borrowing costs
and thus lower net-benefits or profits such that the level of aggregate investment expenditure may be
reduced. Maintenance and replacement costs depend on the useful life of an asset and its rate of
depreciation. Assets that wear out very quickly or become obsolete in a short period of time have higher
costs with the same effect as rising interest rates. Because of the sensitivity of investment decisions to
changing interest rates, this category of expenditure is easily affected by monetary policies and activity in
the financial sector of an economy.

Investment function depends on interest rate, expected future profits. Not related to current GDP or Yd.
Therefore, if we plot the investment function in diagram with Investment expenditures on the vertical axis
and real GDP on the horizontal axis, the Investment (I) line is horizontal at I0. That is, we assume that:

I = I0.

C. Government Expenditure

Government expenditure G is a reflection of the fiscal needs and policies of the public sector in a given
economy. This type of expenditure might be in reaction to the demand for public goods and services by
private households and businesses through voting or other types of political activity. In addition,
government expenditure could be used as a deliberate policy tool to increase nominal incomes in the hope
of stimulating aggregate demand.
changes in government expenditures (G) or taxes (T) represents a “fiscal policy” decision of the federal
government. Therefore, a change in G is a policy choice and does not respond automatically to the level
of GDP (Y). So in a diagram, G is also assumed to be autonomous, G =
G0.

D. Exports:

Exports represent Ethiopian goods sold abroad. The level of exports will depend primarily on the
Ethiopian price level (P), foreign price level (Pf), the exchange rate (E) and foreign GDP (Yf). Therefore,
once again, X does not respond to the level of Ethiopian GDP so exports are autonomous. X = X0.

E. Imports:
Depends on relative prices (Ethiopian and foreign prices), the exchange rate (E), and Ethiopian GDP (Y).
As GDP (Y) increases, we buy more goods and services and some of these will be imported from the rest
of the world. Therefore,

Imports (M) = m Y where 0<m<1 and m=MPM (marginal propensity to import)

Aggregate Expenditure function (AE)

In building aggregate expenditure function we need to consider Autonomous and induced expenditure.

Autonomous expenditure: -The components of aggregate expenditure that do not change in response to
real GDP changes. Autonomous expenditure equals investment plus government purchases plus exports
plus the components of consumption expenditure and imports that are not influenced by real GDP.
Autonomous expenditures– expenditures that do not systematically vary with income.

Induced expenditure: -The components of aggregate expenditure that change when real GDP changes.
Induced expenditure equals consumption expenditure minus imports (excluding the elements of
consumption expenditure and imports that are part of autonomous expenditure). In other words, the parts
of consumption expenditure and [negative] imports that do change as a

Induced expenditures – expenditures that change as income changes result of changes in real GDP.

Autonomous expenditures is the sum of the autonomous components of expenditures:

AE
0 = C0 + I0 + G0 + (X0 – M0)

Induced expenditures is the sum of the induced components of expenditures.

We will begin with consumption expenditure ’C’ defined as being proportional to disposable income
(gross income less taxes paid) with this proportional relationship being defined by the marginal
propensity to consume ’b’: C = Co + b(Y-T), 0 < b < 1
Tax revenue ’T’ is defined to be some fraction of income via the tax rate ’t’:
T = tY, 0 < t < 1
For algebraic simplicity we will define the other expenditure categories; investment ’I’, government ’G’,
and net exports ’NX’ as being autonomous with respect to income (i.e., spending decisions remain
independent of the level of national income). We will combine these values with autonomous
consumption ‘C‘ and summarize this via a single variable’Ao ’ known as autonomous expenditure:
Ao= Co+ Io + Go+ NXo
Thus, the expenditure equation can be written as:
AE = Ao + b(1 - t)Yas shown in the diagram below:
Note: In the following diagram, the 45 degree line represents a one-to-one relationship
Between aggregate income and aggregate expenditure. Any point on this line
Would represent an equilibrium combination of these two variables:

And in equilibrium:

Ye: Y = Ao + b(1 - t)Y

1.2 DETERMINING EQULIBRIUM INCOME

Aggregate expenditure is the total amount the economy plans to spend in a given period. It is equal to
consumption plus planned investment
Equilibrium occurs when there is no tendency for change. In the macroeconomic goods market,
equilibrium occurs when planned aggregate expenditure is equal to aggregate output.

When AE = Y (planned spending = production) we have an equilibrium graphically this occurs anywhere
along the 45 degree line with AE on the vertical axis and real GDP (Y) on the horizontal axis.
Specifically, the equilibrium is where the given AE function intersects the 45 degree line. (see fig.-2
below

Figure 2 illustrates equilibrium expenditure.

Equilibrium occurs at the point at which the aggregate expenditure curve crosses the 45° line in part
(a).Equilibrium occurs when there are no unplanned changes in business inventories in part Equilibrium
expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals
real GDP.

Calculation of Equilibrium GDP (Y):

Suppose you are given the following equations:
 C = 1000 + 0.80 (Y- T)
I = 180
G = 100
X = 200
M = 0.20 Y
T = 100
To find equilibrium GDP, follow these steps:

Step 1: Calculate the AE equation by adding C, I G, X and M together and substitute the T value into
the consumption equation

AE = C + I + G + X - M

so AE = 1000 + 0.80(Y -100) + 180 + 100 + 200 - 0.20 Y

or AE = 1400 + 0.60 Y

Step 2: Impose the equilibrium condition, AE = Y

so 1400 + 0.60 Y = Y

and since the equilibrium condition has been imposed, the value of Y solved for is then equilibrium Y.

Step 3: Solve for equilibrium GDP

0.40 Y = 1400 so Y = 3500

1.3 The Expenditure Multiplier:

Term expenditure multiplier is: The expenditure multiplier is a key component of Keynesian economics
and the study of macroeconomics, illustrating how a relatively small change in expenditure like
investment can trigger larger changes in aggregate output. The value of the expenditure multiplier
depends on the marginal propensity to consume and other induced expenditures. Knowing the value of
the expenditure multiplier can also indicate the amount of policy-induced government expenditures are
needed to achieve a given level of aggregate output (presumably full-employment output).

The multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to
determine the change in equilibrium expenditure and real GDP.

The Basic Idea of the Multiplier

An increase in investment (or any other component of autonomous expenditure) increases aggregate
expenditure and real GDP.

The increase in real GDP leads to an increase in induced expenditure.

The increase in induced expenditure leads to a further increase in aggregate expenditure and real GDP. So
real GDP increases by more than the initial increase in autonomous expenditure.

Expenditures multiplier – a number that reveals how much income will change in response to a change in
autonomous expenditures.

The Size of the Multiplier

The size of the multiplier is the change in equilibrium expenditure divided by the change in autonomous
expenditure.

One of the components of expenditure multiplier is marginal propensity to expend.

Marginal propensity to expend (mpe) –the ratio of the change in aggregate expenditures to a change in
income.

It is composed of the various relationships between the components of aggregate expenditures.

Its value is greater than 0 and less than 1.

It is the slope of the aggregate expenditure curve.

formula for the expenditure multiplier is: multiplier = 1

1 - slope of AE function

The Multiplier and the Slope of the AE Curve

The slope of the AE curve determines the magnitude of the multiplier:

Multiplier = 1 ÷ (1 – Slope of AE curve) or

1
Multiplier 
1 - mpe
If the change in real GDP is Y, the change in autonomous expenditure is A, and the change in induced
expenditure is N, then

Multiplier = Y ÷A

Example: If the slope of the AE function is = 0.75 and the multiplier is = 4

Therefore, for everyone $1 increase in spending (whether it be from C, I, G, X) it will generate a $4

increase in equilibrium GDP. continuing the example from above where equilibrium Y = 3500, if full
employment GDP (Y*) = 4300 then in order to get to full employment GDP the government could
increase its spending by 200 (once subject to the multiplier, the overall increase in GDP is going to be
$800 bringing the new equilibrium GDP level to $4300 (=Y*)

Chapter 2

Consumption Spending

Consumption is one of the major components of the aggregate expenditure or national incomes of a given
country for goods and services.

It is the generic term for the use of goods and services to satisfy wants and needs. This activity may or
may not involve actual purchases or expenditures. Consumption is the fundamental process in the
economy that addresses the scarcity problem.

It is the amount from national income of a given country that is spent for consumption purpose or
satisfying the basic needs of the peoples of the nation within a specific periods of time. It is a primary
function of disposable income and, also is influenced by the rate of interest, expectations about feature
disposable income, wealth saving needs of households and individuals & the level of capital and other
related assets of the households.

Consumption Expenditures: This is the more specific term referring to actual expenditures on final
goods and services, or gross domestic product.

Personal Consumption Expenditures: This is the official measure of the consumption expenditures
component of aggregate expenditures used in the calculation of gross domestic product.

In the short run analysis consumption decision is crucial in its role in determining aggregated demand.
Fluctuations in consumption are a main element of booms and recessions, i.e. it can be a shock to the
economy. Consumption has its own vertical intercept and positive slope but less than one. i.e its MPC.
The marginal propensity to consume is the determinant in fiscal policy multiplier.

The Consumption Function is a relation that visually represents how consumers will spend each
additional dollar they make and how this each additional dollars of spending can affects the purchasing

capacity of the nation.figure 2.1 consumption f

unction

2.1. Keynes Consumption Function

Keynes made the consumption function central to his theory of economic fluctuations. Let’s see first what
Keynes thought about the consumption function. Keynes made his conjectures about the consumption
function based on introspection and casual empiricism. The three conjectures of Keynes are:

The marginal propensity to consume - the amount consumed out of the additional dollar of income - is
between zero and one. This conjecture is based on the fundamental psychological law, that people are
disposed as a rule and on average, to increase their consumption as their income increase, but not by as
much as the increase in their income. This psychological law can be translated in to the Keynesian
consumption functions:

C = a +bYd , a 0,

MPC= ΔC/ΔY= Δ(a +bYd )/ΔYd =b

Where C is real consumption and Y D is real disposable income, which equals GDP minus taxes (and other
adjustments)

ii) The ratio of consumption to income, called the average propensity to consume falls as income
increases. According to Keynes saving was a luxury, so he expected the rich to save a higher proportion
their income than the poor
i.e. APC = C/Y increase as YD decreases = a/Yd + b

C= a +bYD

iii) Income is the primary determinant of consumption, and interest rate does not have an important role.
This conjecture was in sharp contrast to the belief of the classical economists who held the view that a
higher interest rate encourages saving and discourage consumption.

Keynesian Consumption Puzzle

Earlier studies to test Keynes’s conjectures indicated that Keynesian consumption function is a good
approximation of how consumer behaves. Household data on consumption and income supported the
three conjectures of Keynes. Although the Keynesian consumption function met early successes, two
inconveniences soon arose. Both concern Keynes’s conjecture that the average propensity to consume fall
as income rises.

The first anomaly is related to Keynes statement that states as income in the economy grow overtime;
households would consume a smaller and smaller fraction of their income. If there might not be enough
profitable investment projects to absorb all savings as consumption decreases due to lack of adequate
demand when income increases. On the basis of Keynesian views, the economy would experience a
secular stagnation - a long depression of indefinite duration unless fiscal policy was used to expand
aggregate demand. However, in the period of high income, these higher incomes did not lead to large
increase in the rate of saving. Therefore, Keynes’s conjecture that the average propensity to consume
would fall as income rose appeared not to hold.

The second anomaly become into existence when economist Simon Kuznets constructed new aggregate
data on consumption and income i.e. he found consumption as stable function of income as given by: C =
cY He discovered that the ratio of consumption to income is fairly constant from decade to decade;
despite of large increase in income over the period. Again, Keynes’s conjecture that the average
propensity to consume would fall as income rose did not hold. This fact presented a puzzle.

Consumption, C

C = cYd

C = a + bYd

2.2. Short-run and Long-run Consumption Function

The findings of Keynes and Kuznets initially appeared contradictory, but later on it was found that the
two are not conflicting because Keynes’s hypothesis reflects the short run phenomenon while Kuznets
hypothesis reflects the long run phenomenon.

Short Run Consumption Function - C = a + bYd Keynes consumption function

The average propensity to consume decreases as the level of disposable income increases over time

APC = C/Yd = (a + bYd)/Yd = a/Yd + b

Short run consumption curves shift due to various reasons such as introduction of new technology,
migration and increase in population.

Long Run Consumption Function – C = cY Kuznets consumption function

Simon Kuznets taking the long time series data found that the value of c was more than what Keynes
found.

According to this finding the average propensity to consume does not change over time.

This can be shown as follows

APC = C/Yd = cYd/Yd = c

C= cYd

2.3. Theories of Consumption

There are different theories of consumption stated by different scholars. In this section we are going to
deal with five consumption theories or hypothesis which has different assumptions.

2.3.1. Keynesian absolute income hypothesis

According to Keynes, the decision to consume and save depends on the current income of the consumer
and similarly the total amount allocated between consumption and saving in the country depends on the
total income of the country. Thus both consumption and saving are the function of income. As we have
seen in Keynes consumption function, people are disposed, as a rule and on average, to increase their
consumption as their income increases but not by as much as the increase in their income. This is termed
as absolute income hypothesis

APC = C/Yd = (a + bYd)/Yd = a/Yd +b

It is the amount of consumption per unit of disposable income. As we see from the above, as the level of
disposable income increase, the APC declines.

Yd = C + S, C = Yd – S, Yd - S = a + bYd, Yd - a - bYd = S

S = -a+(1-b)Yd, 1 - b is the marginal propensity to save

APS = S/Yd =[-a + (1-b)Yd]/Yd

APS = -a/Yd +(1 - b)

As APC declines, APS increases when income increases.

2.3.2. Relative Income hypothesis

An alternative to the absolute income hypothesis was developed initially by Professor James S.
Duesenberry. Under relative income hypothesis consumption is not only a function of absolute income as
absolute income hypothesis views it, but also a function of income of a person relative to other people’s
income and relative to his past income

Income of the person relative to previous Income

People do not change their consumption as soon as their income changes. This is because people will not
automatically reduce their consumption as their income drops. If the income of a person drops, the
consumption level which was at equilibrium at point Co will not drop to Cᵢ, the person rather adjusts his
consumption along the short run consumption curve and consumes Cᵢˈ. This is because people try hard to
maintain their previous consumption. Similarly consumption doesn’t expand immediately as income
increases.In sum, not only the current income of the person, the previous income also affects
consumption.

Income of the person relative to Others

.Duesenberry explained that there is strong tendency in our society for the people to emulate their
neighbour and to strive towards a higher standard of living. This is called demonstration effect. A family
with any given level of income will typically spend more on consumption if it lives in a community
which that income is relatively lower than if it lives in a community in which that income is relatively
high.
The relative income hypothesis holds that the average propensity to consume for the economy as a whole
will not change as long as the distribution of income does not change. During the period when the
economy is moving toward a new peak income level, there is no reason that the pattern of income
distribution should change. All spending units will enjoy a higher absolute level of income because the
income level of the whole economy has risen, but the relative position of each group will not necessarily
change. In short this theory holds that “there is psychological and family pressure on household living in
high income to spend more on consumption.

2.3.3. Modigliani’s Life-Cycle Hypothesis

In order to solve the consumption puzzle that is to explain the apparently conflicting pieces of evidence
that come to light when Keynes’s consumption function was brought to the data, different research have
been undertaken. Modigliani, who developed the life cycle hypotheses model, emphasized that income
varies systematically over people’s lives and that saving allows consumers to move income from those
times in life when income is high to those times when it is low.

The Hypothesis

One important reason that income varies over a person’s life is retirement. Most people plan to stop
working at about age 65, and they expect their incomes to fall when they retire. Yet they do not want a
large drop in their standard of living, as measured by their consumption. To maintain consumption after
retirement, people must save during their working years.

To see what this motive for saving implies for the consumption function considered, assume consumer
who expects to live another T years, has wealth of W, and expects to earn income Y until he/she retires R
years from now. What level of consumption will the consumer choose if he/she wishes to maintain a
smooth level of consumption over her life?

The consumer can divide up his/her lifetime resources among his/her T remaining years of life. We
assume that he/she wishes to achieve the smoothest possible path of consumption over his/her lifetime.
Therefore, he/she divides this total of W+RY equally among the T years and each year consumes

C = (W + RY)/T.

We can write this person’s consumption function as

C = (1/T)W + (R/T)Y
Assume that 1/T and R/T are constant and replaced by α and β respectively, then the economy’s
consumption function would be given as: C = αW + βY

Where the parameter  is the marginal propensity to consume out of wealth, and the parameter is the
marginal propensity to consume out of income.

For example, if the consumer expects to live for 50 more years and work for 30 of them, then T= 50 and
R= 30, so his/her consumption function is

C = 1/50W + 30/50Y = 0.02W + 0.6Y

This equation says that the consumption depends on both income and wealth. An extra birr 1 of income
per year raises consumption by birr 0.60 per year, and an extra birr 1 of wealth raises consumption by
birr0.02 per year. If every individual in the economy plans consumption like this, then the aggregate
consumption is much the same as the individual one. In particular, aggregate consumption depends on
both wealth and income.

To convert varying income to smooth linear consumption, people use saving and borrowing. At the early
stage, people earn less income, but consume higher than their income. In this case there is dis – saving
(borrowing). At middle age income is higher than consumption and there is saving at this stage. At later
stage income is lower than consumption and this would be possible through saving.

This life cycle model of consumer behaviour can solve the consumption puzzle. According to the life
cycle consumption function, the average propensity to consume is

C/Y = (W/Y) + β

Because wealth does not vary proportionately with income from person to person or from year to year, we
should find that high income corresponds to a low average propensity to consume when looking at data
across individuals or over short periods of time. But, over long periods of time, wealth and income grow
together, resulting in a constant ratio W/Y and a constant average propensity to consume. To make the
same point somewhat differently, consider how the consumption function changes over time. for any
given level of wealth, the life cycle consumption function looks like the one Keynes suggested. But this
function holds only in the short run when wealth is constant. In the long run, as wealth increases, the
consumption function shifts upward, This upward shift prevents the average propensity to consume from
falling as income increases. In this way, Modigliani resolved the consumption puzzle posed by Simon
Kuznets’s data.
2.3.4. Fisher’s Intertemporal Model of Consumption

When people decide how much to consume and how much to save, they consider both the present and the
future. The more consumption they enjoy today, the less they will be able to enjoy tomorrow. In making
this trade off, households must look ahead to the income they expect to receive in the future and to the
consumption of goods and services they hope to be able to afford.

The economist Irving Fisher developed the model with which economists analyze how rational, forward
looking consumers make intertemporal choices - that is, choices involving different periods of time.
Fisher’s model illuminates the constraints consumers face, the preferences they have, and how these
constraints and preferences together determine their choices about consumption and saving.

The Intertemporal Budget Constraint

Majority would prefer to increase the quantity or quality of the goods and services they consume. The
reason people consume less than they desire is that their consumption is constrained by their income. In
other words, consumers face a limit on how much they can spend - budget constraint. When they are
deciding how much to consume today versus how much to save for the future they face an intertemporal
budget constraint, which measures the total resources available for consumption today and in the future.

To keep things simple, we examine the decision facing a consumer who lives for two periods. Period one
represents the consumer’s youth and period two represents the consumer’s old age. The consumer earns
income Y1 and consumes C1 in period one, and earns income Y2 and consumes C2 in period two. Because
the consumer has the opportunity to borrow and save, consumption in any single period can be either
greater or less than income in the period.

This model uses optimization principle to the analysis of consumption. It is the basis for modern
optimization analysis. The model attempts to maximize utility given income constraint.

As Fisher saving is the future consumption for the owner, he/she is going to consume all saving in his life.
Consider how the consumer’s income in the two periods constrains consumption in the two periods. In the
first period, saving equals income minus consumption. That is, S = Y1 – C1

where S is saving. In the second period, consumption equals the accumulated saving, including the
interest earned on the saving, plus second period income. That is, C2 = (1+r) S + Y2
where r is the real interest. For example, if the interest rate is 5 percent, then for every birr 1 of saving in
period one, the consumer enjoys an extra Birr 1.05 of consumption in period two. Because there is no
third period, the consumer does not save in the second.

Note that the variable S can represent either saving or borrowing and that these equations hold in both
cases. If first- period consumption is less than first period income, the consumer is saving, and S is greater
than zero. If first period consumption exceeds first – period incomes, the consumer is borrowing, and S is
less than zero. For simplicity, we assume that the interest rate for borrowing is the same as the interest
rate for saving.

To derive the consumer’s budget constraint, combine the two equations above. Substitute the first
equation for S into the second equation to obtain

C2 = (1 +r) (Y1—C1) +Y2

(1+ r) C1 + C2 = (1+r) Y1+Y2

Now divide both sides by 1+ r to obtain: C1 + C2 = Y1 + Y2

This equation relates consumption in the two periods to income in the two periods. It is the standard way
of expressing the consumer’s intertemporal budget constraint.

Consumer Preferences

The consumer’s preferences regarding consumption in the two periods can be represented by indifference
curves. An indifference curve shows the combinations of first period and second period consumption that
make the consumer equally satisfied. The slope at any point on the indifference curve shows how much
second period consumption the consumer requires in order to be compensated for a 1 unit reduction in
first period consumption. This slope is the marginal rate of substitution between first period consumption
and second period consumption. It tells us the rate at which the consumer is willing to substitute second
period consumption for first period consumption. The indifference curves in figure 1.4 are not straight
lines and, as a result, the marginal rate of substitution depends on the levels of consumption in two
periods. When first period consumption is high and second period consumption is low, as at point W,
marginal rate of substitution is low the consumer requires only a little extra second period consumption to
give up 1 unit of first period consumption. When first period consumption is low and second period
consumption is high, as at point Y, the marginal rate of substitution is high: the consumer requires much
additional second period consumption to give up 1 unit of first period consumption.
The consumer’s preferences indifference curves represent the consumer’s preferences over first period
and second period consumption. An indifference curve gives the combinations of consumption in the two
periods that make the consumer equally happy. This figure shows two of many indifference curves.
Higher indifference curves such as Ic2 are preferred to lower curves such as 1c1. The consumer is equally
happy at points W, X, and Y, but prefers point Z to points W, X, or Y.

Optimization

Having discussed the consumer’s budget constraint and preferences, we can consider the decision about
consumption. The consumer would like to end up with the best possible combination of consumption in
the two periods, on the highest possible indifference curve. But the budget constraint requires that the
consumer also end up on or below the budget line, because the budget line measures the total resources
available to him.

How Changes in Income Affect Consumption?

So far we have seen how the consumer makes the consumption decision, let’s examine how consumption
responds to an increase in income. An increase in either Y 1 or Y2 shifts the budget constraint outward.
The higher budget constraint allows the consumer to choose a better combination of first and second
period consumption that is, the consumer can now reach a higher indifferent curve. Although not implied
by the logic of the model alone, this situation is the most usual. If a consumer wants more of a good when
his or her income rises, the good is normal good.

How changes in the real interest rate affect consumption?

Now we will use fisher’s model to consider how a change in the real interest rate alters the consumer’s
choice. There are two cases to consider the case in which the consumer is initially saving and the case in
which he is initially borrowing.The impact of an increase in the real interest rate on consumption can be
decomposed into two effects: an income effect and a substitution effect.

The income effect is the change in consumption that results from the movement to a higher indifference
curve. Because the consumer is a saver rather than a borrower (as indicated by the fact that first- period
consumption is less than first period income), the increase in the interest rate makes him better off (as
reflected by the movement to a higher indifference curve). If consumption in period one and consumption
in period two are both normal goods, the consumer will want to spread this improvement in his welfare
over both periods. This income effect tends to make the consumer want more consumption in both
periods.

The substitution effect is the change in consumption that results from the change in the relative price of
consumption in the two periods. In particular, consumption in period two becomes less expensive relative
to consumption in period one when the interest rate rises. That is, because the real interest rate earned on
saving is higher, the consumer must now give up less first period consumption to obtain an extra unit of
second period consumption. This substitution effect tends to make the consumer choose more
consumption in period two and less consumption in period one.

The consumer’ choice depends on both the income effect and the substitution effect. Both effects act to
increase the amount of second period consumption; hence, we can confidently conclude that an increase
in the real interest rate raises second period consumption. But the two effects have opposite impacts on
first period consumption. Hence, the increase in the interest rate could either lower or raise first period
consumption.

Life Cycle Consumption Hypothesis

Consumption (C) Consumption

Income (Y) Saving

Dissaving

Income
Borrowing

Time
2.3.5 Friedman’s Permanent Income hypothesis

Milton Friedman proposed the permanent income hypothesis to explain consumer behaviour. Friedman’s
permanent income hypothesis complements Modigliani’s life cycle hypothesis: both use Irving Fisher’s
theory of the consumer to argue that consumption should not depend on current income alone. But unlike
the life cycle hypothesis, which emphasizes that income follows a regular pattern over a person’s life
time, the permanent income hypothesis emphasizes that people experience random and temporary
changes in their incomes from year to year.

The Hypothesis

Friedman suggested that we view current income Y as the sum of two components, permanent income Y P
and transitory income YT. That is,

Y=YP + YT

Permanent income is the part of income that people expect to persist into the future. Transitory income is
the part of income that people do not expect to persist. But differently, permanent income is average
income, and transitory income is the random deviation from the average.

Friedman says, consumption should depend primarily on permanent income, because consumers use
saving and borrowing to smooth consumption in response to transitory changes in income. Suppose, if a
person received a permanent raise of birr 10,000 in a lottery, he would not consume it all in one year.
Instead, he would spread the extra consumption over the rest of his life. Assuming an interest rate of zero
and a remaining life span of 50 years, consumption would rise by only birr 200 per year in response to the
birr 10,000 prize. Thus, consumers spend their permanent income, but they save rather than spend most of
their transitory income. Friedman concluded that we should view the consumption function as
approximately C = YP

where  is a constant, which measures the fraction of permanent income consumed. The permanent
income hypothesis, as expressed by this equation, states that consumption is proportional to permanent
income.

Friedman’s hypothesis implies for the constant average propensity to consume.

APC = C/Y = YP/Y

According to the permanent income hypothesis, the average propensity to consume depends on the ratio
of permanent income to current income. When current income temporarily rises above permanent income,
the average propensity to consume temporarily falls; when current income temporarily falls below
permanent income the average propensity to consume temporarily rises. Now consider the studies of
household data. Friedman reasoned that these data reflect a combination of permanent and transitory
income. Households with high permanent income have proportionately higher consumption. If all
variation in income comes from the transitory component and households with high transitory income do
not have higher consumption. Therefore, researchers find that high income households have, on average,
lower average propensities to consume.

Similarly, consider the studies of time series data. Friedman reasoned that year to year fluctuations in
income are dominated by transitory income. Therefore, years of high income should be years of low
average propensities to consume. But over long periods of time - say, from decade to decade - the
variation in income comes from the permanent component. Hence, in long time series, one should
observe a constant average propensity to consume, as in fact Kuznets found.

Fig Permanent income and transitory income

YT , YP
YP

Time
CHAPTER 3. INVESTMENT AND SAVING
Investment spending is a central topic in macroeconomics for two reasons. First fluctuation in investment accounts
for much of the movement of GDP in the business cycle. Second, investment spending determines the rate at which
the economy adds to its stock of physical capital, and thus helps to determine the economy’s long-run growth and
productivity performance. Investment often refers to buying financial of physical assets. For example we say
someone “invests” in stocks or bonds, or a house when he or she buys the asset. The usage in macroeconomics is
more restricted: investment is the flow of spending that adds to the physical stocks of capital. Both investment and
GDP refers to spending flows.
Investment is the amount spent by businesses to add to the stock of capital over a given period. The capital stock
has been created by past investment and is always being reduced by depreciation so that investment spending is
needed just to keep the capital stock from declining.

The second distinction concerns the components of investment spending. We disaggregate investment spending into
three categories.
1). Business-fixed investments: It refers to business spending on machinery, equipments, and structures such as
factories.
2). Residential investments: This refers investment in housing (real state)
3). Inventory investment: It consists of increases in stocks of unsold goods or unused input materials. This kind of
investment is quite different from business fixed investment because inventory capital normally has a very short life
span. When inventories decrease from one period to the next, as sometimes happens even at an aggregate level,
inventory investment is negative. Another unique feature of inventory investment is that it often occurs
unintentionally. Unsold products are counted as inventory investment whether the firm bought them intending to
build up its inventory or simply ended up selling less than it expected to sell.

Decision Criterion: Marginal Efficiency of Capital (MEK)

 Concept of discounting and the MEK is the formalization of Keynes theory of investment.
 MEK- answer the question “is it profitable for a firm to make certain investment?”
 It involves the techniques of discounting future value of money.
FV (At + i) = At (1+r)i
Where – At = sum of money at time t
r= market interest rate

1 At  i
At  At  i 
PV =
(1 r ) i
(1  r ) i
Assume:
  Initial investment outlay = Ot
 Future running costs: Ct, Ct+1, Ct+2…..
 Future sale revenues: R1, Rt+1, Rt+2….

What factors determine the real rental price?

 From the equation for the equilibrium,
(a). The lower the stock of capital, the higher the real rental price of capital.
(b). the greater the amount of labor employed, the higher the rental price of capital.
(c). The better the technology, the higher the rental price of capital.

Rental Firms-The Cost of Capital

 Assume the rental firms operate-just like car-rental companies, merely buy capital goods and rent them out.
 What are the benefit and cost of owning capital?
Benefit = Revenue from renting the capital to production firms.

R
Revenue (real rental price) = P per unit of capital
Costs = Cost of owning capital is more complex to compute.
 Rental firms bear three costs for each period of time that it rents out a unit of capital.
 (1). Interest cost of capital: Interest on loan borrowed to buy a unit of capital.
Let: Pk = Purchasing price of a unit of capital (say Birr 400,000)
(i)= Nominal interest rate (10%)
iPk = interest cost of capital (Birr 400,000 x 0.1 = Birr 40,000)
Note:- interest cost would be the same even if the rental firm did not have to borrow.
 (2). Cost due to change in price of capital:
 If price of capital falls the firm loses due to fall in value of the firm’s asset.
 If the price of capital rises, the firm gains due to increase in the value of the asset.
-∆Pk = Cost of loss or gain due to change in Pk. (Note: It will be negative because we are measuring costs not
benefits).
 (3). Cost due to Depreciation: While the capital is rented it suffers wear and tear.
 = rate of depreciation
 Pk = monetary cost of depreciation (fraction of the capital asset value lost per period due to wear and tear.
 Total cost of renting out a unit of capital for one period is therefore;

Pk
Pk (i   )
Cost of capital= iPk -∆Pk +  Pk = Pk
Therefore, cost of capital depends on:
  Price of capital = Pk; interest rate (i), The rate at which capital prices are changing = ∆Pk; and

Depreciation rate = 
Numerical Example-Car Company
 Buy each car for $10,000 for rent
 Interest rate: i=10% per year
iPk = 0.1 x $10,000 = $ 1000 per year per car
 Car prices are rising at 6% per year
 So excluding wear and tear the company get capital gain of
∆Pk = 0.06 x $10,000 = $600 per year
The Company’s total unit cost of capital is: δ = 20%= 2000
Cost of capital = $1,000-$600 + $2000 = $2400
 The cost of the car-rental company of keeping a car in its capital stock is $2,400 per year
 For simplicity of interpretation, assume that price of capital good rises with the price of other goods

Pk


Pk

 .i = Nominal interest rate

.i – π = real rate of interest (r),
.i-π = r

Pk
Pk (i   )
Cost of capital =
Pk

Cost of capital = Pk(r+ )

 Cost of capital depends on the price of capital, on the real interest rate, and the depreciation rate.
 Finally, real cost of capital = The cost of buying and renting a unit of capital measured in units of the
economy’s output.
Pk
(r  )
 Real cost of capital = P
 The real cost of capital depend on:
 Relative price of a capital good = Pk/p
 The real interest rate = r

 And the depreciation rate = 

 Relative price of other goods in the economy = P
 Price of unit of capital = Pk
o The Determinants of Investment
 How rental firms take decision about whether to increase or decrease its capital stock?
 For each unit of capital:
 R
 Firm’s earns real revenue = P
Pk
(r  )
 Firm’s real cost = P

R Pk
 (r  )
 Firm’s Profit = P P
 But in equilibrium the real rental price equal the MPK

R Pk
MPK (1   )
 P ;therefore, profit rate = MPK- P
 Discounted Net return from investment
( Rt  Ct ) ( Rt  Ct ) (R  C
NPV  ( Rt  Ct )    ...  1 n n1 n
1 r (1  r ) 2
(1  r )
Where n is the last period over which the investment is expected to provide any output.
Rt and Ct may be zero if production does not begin immediately
i n
( Rt i  Ct i )

i 0 (1  r ) i
NPV =
 The profitability of NPV acceptable if it is > 0 otherwise rejects it.
 An alternative approach to the investment decision involves replacing the market interest rate r, by the unknown
m, and turning the inequality into equity.
i n
( Rt i  Ct i )
0 
 i 0 (1  m) i
 The equation is then solved for m and m is a discount rate that would make the investment neither profitable nor
unprofitable. Hence, m is a discount rate that makes the NPV =0
 Therefore, m is the yield on the investment-which Keynes called the “Marginal Efficiency of Capital” (MEK)
and the investment will be profitable if m ≥ r. Thus, MEK = m = Internal rate of return.

ra

I
a value of investment project
 Figure 3-1. Investment Function
Fluctuations in Investment spending
A. Movements in aggregate investment
1. Over the short-run business cycle, investment moves with output but its fluctuations are more pronounced than
those of output.
2. That is, investment rises rapidly at the beginning of expansions but it also falls sharply at the beginning of
recessions.
3. Economists, however, cannot determine if output movements are inducing investment to move or vise versa.
The amount of investment in the economy depends on actions in two markets.
The loanable funds market
a. Firms finance their investment purchases by borrowing funds from the loanable funds market. If firms internally
finance their investment, they must forgo the interest they would have otherwise earned on the resources used to
fund these purchases.
b. Investment demand determines the demand for loanable funds.
c. Savings decisions by private agents, governmental budget decisions, and the amount of direct foreign investment
determine the supply of loanable funds.
d. The interest rate clears this market.
r

r*

SLF DLF (demand for loanable fund)

LF Lonable fund

3.1.1. Investment Function and Shift Factors of Investment

Factors that shift the demand for capital
1. A rise (fall) in Y increases (decreases) the demand for capital which causes DK to shift rightward (leftward).
2. A rise (fall) in the real wage (W/P) means that the price of a substitute factor of production is higher (lower). This
leads to an increase (decrease) in the demand for capital, which causes DK to shift rightward (leftward).
3. A rise in DK to DK′ causes K to climb to K′
rK

rK
DK’
DK
 K* K’ Capital (K)

4. An increase (decrease) in RK to RK′ raises (lowers) the cost of K so firms reduce (expand) their level of K to K′.
This is represented by a leftward (rightward) movement along the DK curve.
Rental price of capital

Rk’

Rk

K’ K* Capital
The Neoclassical model of Business Fixed Investment
 To develop the model, imagine that there are two kinds of firms in the economy:
 Production Firms: Production goods and services using capital that they rent.
 Rental firms: Make all the investment in the economy. They buy capital and rent it out to
production firms.
 Of course, most firms in the actual economy perform both functions, they produce goods & services and also
invest in capital for future production.
(I). Production Firm: The Rental Price of Capital
 Assume a typical production firm who decides how much capital to rent by comparing the costs and benefits of
each unit of capital.
 Let: Rental Rate = R; Output price = P

R
 real cos t of a unit of capital
 P ; MPK = The real benefit of a unit of capital
 MPK declines as the amount of capital rises-Law of diminishing return to capital

R
 To maximize profit, the firm rents capital until: MPK = P
 The MPK determines the demand curve-and the demand curve slops downward

R
P S = Capital Supply

MPK = Capital Demand

 Capital stock (K)

 At any point in time, the amount of capital in the economy is fixed.

 So the supply curve is vertical
 The real rental price of capital adjusts to equilibrium the demand for capital and the fixed supply of capital.

Equilibrium in the Financial Markets: The Supply and Demand for Loanable Funds

Before going to the detail aspects of investment let’s first shine over the saving functions look like. In closed
economy the variable S = I because countries uses only domestic capitals for investment, however, in open economy
there is addition of current account or net export (X-M).
S≡Y–C–G
GNP = Y = C + I + G
Sp (private saving) = Y – T – C
Sg (Government saving) = T –G; National Saving (S) = Sp + Sg
S = Y – C – G = (Y – T – C) + (T – G) = Sp + Sg
S = Sp + Sg = I + CA (NX)
Sp = I + CA (NX) - Sg = I + NX – (T-G) = I + NX + (G – T)

It is apparent that, the interest rate is the cost of borrowing and the return to lending in financial markets; we can
better understand the role of the interest rate in the economy by thinking about the financial markets. To do this,
rewrite the national income accounts identity as
Y − C − G = I.
The term Y − C − G is the output that remains after the demands of consumers and the government have been
satisfied; it is called national saving or simply saving (S). In this form, the national income accounts identity shows
that saving equals investment. To understand this identity more fully, we can split national saving into two parts—
one part representing the saving of the private sector and the other representing the saving of the government:
(Y − T − C) + (T − G) = I.
The term (Y − T − C) is disposable income minus consumption, which is private saving. The term (T − G) is
government revenue minus government
spending, which is public saving. (If government spending exceeds government revenue, the government runs a
budget deficit, and public saving is negative.) National saving is the sum of private and public saving.

To see how the interest rate brings financial markets into equilibrium, substitute the consumption function and the
investment function into the national income accounts identity:
Y − C(Y − T ) − G = I(r).
Next, note that G and T are fixed by policy and Y is fixed by the factors of production and the production function:
Y − C(Y − T ) −G – = I(r)
S = I(r).
The left-hand side of this equation shows that national saving depends on income Y and the fiscal-policy variables G
and T. For fixed values of Y,G, and T, national saving S is also fixed. The right-hand side of the equation shows that
investment depends on the interest rate.
Figure 3-7 graphs saving and investment as a function of the interest rate. The saving function is a vertical line
because in this model saving does not depend on the interest rate (although we relax this assumption later).The
investment function slopes downward: the higher the interest rate, the fewer profitable investment projects. From a
quick glance at Figure 3-7, one might think it was a supply-and demand diagram for a particular good. In fact,
saving and investment can be interpreted in terms of supply and demand. In this case, the “good’’ is Loanable
funds, and its “price’’ is the interest rate. Saving is the supply of Loanable funds— households lend their saving to
investors or deposit their saving in a bank that then loans the funds out. Investment is the demand for Loanable
funds—investors borrow from the public directly by selling bonds or indirectly by borrowing from banks. Because
investment depends on the interest rate, the quantity of Loanable funds demanded also depends on the interest rate.
The interest rate adjusts until the amount that firms want to invest equals the amount that households want to save. If
the interest rate is too low, investors want more of the economy’s output than households want to save. Equivalently,
the quantity of loanable funds demanded exceeds the quantity supplied. When this happens, the interest rate rises.
Conversely, if the interest rate is too high, households want to save more than firms want to invest; because the
quantity of loanable funds supplied is greater than the quantity demanded, the interest rate falls. The equilibrium
interest rate is found where the two curves cross. At the equilibrium interest rate, households’ desire to save
balances firms’ desire to invest, and the quantity of loanable funds supplied equals the quantity demanded.
Real Interest, r Saving, S

r*

Desired investment = I(r)

S* Investment, Saving, I, S

Saving, Investment, and the Interest Rate The interest rate adjusts to bring saving and investment into balance. The
vertical line represents saving— the supply of Loanable funds. The downward sloping line represents investment—
the demand for Loanable funds. The intersection of these two curves determines the equilibrium interest rate.

Changes in Saving: Effect of Fiscal Policy

An Increase in Government Purchases Consider first the effects of an increase in government purchases of an
amount ∆G. The immediate impact is to increase the demand for goods and services by ∆G. But since total output is
fixed by the factors of production, the increase in government purchases must be met by a decrease in some other
category of demand. Because disposable income Y − T is unchanged, consumption C is unchanged. The increase in
government purchases must be met by an equal decrease in investment. To induce investment to fall, the interest rate
must rise. Hence, the increase in government purchases causes the interest rate to increase and investment to
decrease. Government purchases are said to crowd out investment.

To grasp the effects of an increase in government purchases, consider the impact on the market for loanable funds.
Because the increase in government purchases is not accompanied by an increase in taxes, the government finances
the additional spending by borrowing—that is, by reducing public saving. With private saving unchanged, this
government borrowing reduces national saving. As below figure shows, a reduction in national saving is
represented by a leftward shift in the supply of loanable funds available for investment. At the initial interest rate,
the demand for loanable funds exceeds the supply. The equilibrium interest rate rises to the point where the
investment schedule crosses the new saving schedule. Thus, an increase in government purchases causes the interest
rate to rise from r1 to r2.

Real Interest rate, r S2 S1

A fall in saving

r2
∆r
r1
I(r)
 Investment, Saving, I, S
A Reduction in Saving A reduction in saving, possibly the result of a change in fiscal policy, shifts the saving
schedule to the left. The new equilibrium is the point at which the new saving schedule crosses the investment
schedule. A reduction in saving lowers the amount of investment and raises the interest rate. Fiscal-policy actions
that reduce saving are said to crowd out investment.

Changes in Investment Demand

So far, we have discussed how fiscal policy can change national saving. We can also use our model to examine the
other side of the market—the demand for investment. In this section we look at the causes and effects of changes in
investment demand. One reason investment demand might increase is technological innovation.
Suppose, for example, that someone invents a new technology, such as the railroad or the computer. Before a firm or
household can take advantage of the innovation, it must buy investment goods. The invention of the railroad had no
value until railroad cars were produced and tracks were laid. The idea of the computer was not productive until
computers were manufactured. Thus, technological innovation leads to an increase in investment demand.
Investment demand may also change because the government encourages or discourages investment through the tax
laws. For example, suppose that the government increases personal income taxes and uses the extra revenue to
provide tax cuts for those who invest in new capital. Such a change in the tax laws makes more investment projects
profitable and, like a technological innovation, increases the demand for investment goods.

Figure 3-10 shows the effects of an increase in investment demand. At any given interest rate, the demand for
investment goods (and also for Loanable funds) is higher. This increase in demand is represented by a shift in the
investment schedule to the right. The economy moves from the old equilibrium, point A, to the new equilibrium,
point B. The surprising implication of Figure 3-10 is that the equilibrium amount of investment is unchanged. Under
our assumptions, the fixed level of saving determines the amount of investment; in other words, there is a fixed
supply of Loanable funds. An increase in investment demand merely raises the equilibrium interest rate. We would
reach a different conclusion, however, if we modified our simple consumption function and allowed consumption
(and its flip side, saving) to depend on the interest rate. Because the interest rate is the return to saving (as well as
the cost of borrowing), a higher interest rate might reduce consumption and increase saving. If so, the saving
schedule would be upward sloping, rather than vertical.

Real Interest Rate, r S

r2 B
I(2)
 r1 A
I(1)

Investment, Saving, I, S
An Increase in the Demand for Investment: An increase in the demand for investment goods shifts the investment
schedule to the right. At any given interest rate, the amount of investment is greater. The equilibrium moves from
point A to point B. Because the amount of saving is fixed, the increase in investment demand raises the interest rate
while leaving the equilibrium amount of investment unchanged.

With an upward-sloping saving schedule, an increase in investment demand would raise both the equilibrium
interest rate and the equilibrium quantity of investment. Figure 3-11 shows such a change. The increase in the
interest rate causes households to consume less and save more. The decrease in consumption frees resources for
investment.

Real Interest Rate, r S(r)

r2
Raise in Interest rate I2
r1 An increase in Investment
I1

Investment, Saving, I, S
An Increase in Investment Demand When Saving Depends on the Interest Rate When saving is positively related
to the interest rate, a rightward shift in the investment schedule increases the interest rate and the amount of
investment. The higher interest rate induces people to increase saving, which in turn allows investment to increase.

Theories of Investment
There are several theories, which try to explain the investment and its determinant factors. These
theories of investment are Keynesian marginal efficiency of capital (MEC), Accelerator theory of
investment; Internal fund theory of investment; Tobin q – theory of investment; Neo-classical theory of
investment; and Inventory investment
Keynesian Marginal Efficiency of Capital (MEC)
Keynesian marginal efficiency of capital (MEC) is an alternative theory or approach in making investment
decision under profit oriented investment motive. In this approach, the comparison is between marginal
efficiency of capital (r) and market rate of interest (i). Marginal efficiency of capital (r) is the rate of
interest, which equates the cost of the project and the discounted value of the future income stream
associated with the project. To calculate the marginal efficiency of capital (r), we obtain the estimates of
the cost of the project (C) and the future income stream associated with the projects, P 1, P2… Pn. Where
the subscripts: 1, 2, 3…..n. represent the years (from now) in which the returns are received. These
values are substituted into the general formula of discounting process.

P1 P2 P3 Pn
C    ......  ......................................... 7
(1  r ) (1  r )
1 2
(1  r ) 3
(1  r ) n

In equation (7), we must solve for the unknown ‘r’. Then the investor must compare it with the market
rate of interest (i). If the marginal efficiency of investment (r) is less than the market rate of interest (i),
the project is not profitable. The investor can be better off by simply lending or saving at market rate of
interest (i) rather than investing. This is because the lower value of marginal efficiency of investment (r)
measures the rate of return on the money used in the investment.

If the marginal efficiency of investment (r) is greater than the market rate of interest (i), the project is
profitable. This means that the return on the money used for investment given by the marginal
efficiency of investment (r) is larger if we put or use the money for the investment than the return on it
if we save or lend at market interest rate (i). From the point of view of profit oriented private or
government investment, it is suggested by this theory that investment resource or money is better used
for investment activity than to save or to lend at market interest rate if the marginal efficiency of
investment (r) is greater than the market interest rate. This implies that the capital or the money will be
more efficient at margin if it is invested than if it is saved or lent at market or banks interest rate.
In the investment decision-making process, the market rate of interest plays a crucial role. If the rate of
interest is very high, then it may make investment projects very expensive and unprofitable. This is
because the marginal efficiency of capital is less than the cost of the investment, which is the market
interest rate. If market rate is low then it may make some previously unprofitable projects as profitable
because this is equivalent to lowering the cost of investment.

Accelerator Theory of Investment

The relationship between the change in the level of output and the volume of investment is
known as acceleration principle. This is because, addition to the capital good through the
investment is intended to accelerate or add to the output of the existing one. The capital-output
ratio is known as accelerator. This theory assumes that a particular amount of capital stock is
necessary to produce a given amount of output. For example, if a capital stock of 500 birr is
needed to produce 100 birr of output and if this keeps true over periods and different level of
capital, then we can say that there is a fixed relationship between the capital stock and output.
Let us assume that the ratio is given by a constant ‘λ’, we can explain the relation with the
following equations:
K
  t  K t  Yt ................................................. 8
Yt
Where, λ is the ratio of capital (K t) in time period‘t’ to the output ‘Y’ in time period‘t’. If λ is constant, the
same relationship is true for the previous year hence we can write the same relationship as follows:

K t 1  Yt 1 ........................................ .............. 9

By subtracting equation (9) from equation (8), we get:

K t  K t 1   (Yt  Yt 1 ) .............................. 10

The expression Kt - Kt-1 is the difference between the capital stock in time period ‘t’ and the capital stock
in time period ‘t-1’ is known as net investment. Net investment is equal to the capital output ratio
multiplied by the difference in the output in the two periods. By definition, net investment is equal to
the gross investment (I) minus capital consumption allowance or depreciation (D). This can be
incorporated in our equation as follows:

I t  D   (Yt  Yt 1 )  Y ................................. 11

Equation (11) gives the expression that net investment equals the accelerator coefficient (λ) multiplied
by the change in output. In other words, investment is a function of output. If output increases, the net
investment also increases. If in an economy a capital stock of 500 birr is needed to produce 100 birr of
output, then the value of λ is 5. If aggregate demand is 100 birr worth of output, then investment should
be 500 birr. This means that if aggregate demand is constant then net investment is zero. Because net

investment is given as follows:

I t  D   (Yt  Yt 1 )  Y

However, the aggregate demand is constant means Yt and Yt-1 are equal and Yt -Yt-1 = 0.

I t  D   (Yt  Yt 1 )  Y   (0)  I t - D  0 Net investment = 0

Suppose aggregate demand increases from 100 to 105 Birr worth of output, and then the investment

need is equal to (5x5=25) obtained as follows:

I t  D   (Yt  Yt 1 )  Y = 5(105 - 100) = 5(5) = 25

The change in capital is 25 and the new capital stock is Kt + Kt –1 = 500 + 25 = 525

Thus, the capital stock of the economy must be 525 Birr.

In its simplest form, the theory has a number of limitations.

First, the theory explains net investment but not gross investment because for the determination of
aggregate demand gross investment is the relevant concept.

Second, the theory assumes that a discrepancy between actual and desired capital stocks is eliminated
in a single period, which may not be true. That means there may always be deviation between the
desired level of capital and the actual level.

Third, this theory assumes that there is a fixed relationship between capital and output given by the
constant value λ. However, in real situation there is possibility of substituting capital to labour within a
limited range. If this concept of substitution is true then the concept of fixed capital – output ratio is not
valid.

The Internal Fund Theory of Investment

The central view of this theory is that investment depends on the level of profits. The managers have a
preference for financing investment internally. Firms can obtain finance to fund investment through
various sources such as retained earnings, depreciation expense, various types of borrowings, sales of
stocks etc. The first two sources are internal to the firm and others are external to the firm. If the firm
opts for external borrowing then it needs a series of fixed payments to return borrowings. During
recession, when economy does not perform well the firm may also not be performing well and firms
may not fulfill the commitment to pay. Similarly selling of stocks has a chance of losing control. For these
reasons, the proponent of internal fund theory argues that firms strongly prefer to finance investment
internally and that the increased availability of internal funds through higher profits generates additional
investment.

Hence, this investment theory implies that investment level is not determined by the level of interest
rate or cost of borrowing as suggested several government policy makers and central banks. According
to the proponents of this theory, regulating the level of interest rate does not help achieve the required
level of investment. This is because the major determinant of the level of investment is the level of
profit that investors can make.

Suppose policy makers are interested in increasing investment. Internal fund theory holds the view that
profits should be increased. Policy makers can do this by reducing corporate taxes and reduction of
income tax. This simply means that firms can invest and income earners can buy goods and services
produced by the firms. Thus, the policy action should not be reducing interest rate; rather it should be
reducing tax rates on investment and on sales of its products.
Tobin’s Q theory of Investment
The q-theory of investment creates linkage between investment and stock market. According to this theory, the price of the shares in any
company is the price of a claim on the capital in the company. The managers of the company are believed to be responding to the price of the
stocks by producing more new capital by investing. The investment is dependent on the share prices. If the share price is high, investment will
be high and vice versa.

‘Q’ is an estimate of the value of the stock that market places on (or market gives to) a firm’s assets
relative to the cost of producing those assets. In other words, q is the ratio of market value of the firm to
the replacement cost of capital. Mathematically,

Market value of the firm (x)

q ……………………………………………………(12)
Re placement cost (y)

Replacement cost is the cost that firm would get when it sells all its capital. When the value of q is high
(or x > y), firms will want to produce more assets, so investment will be high (the firm replaces its old
capital goods since the market values it at larger price). When the value of q is low (or x < y), firms will
want to produce less assets, so investment will be low (the firm will not replace the old capital goods
because its market valuation will be at lower value). Whenever q >1, firm should add physical capital
because it is profitable for the firm to do so because marginal product of capital is greater than its real
cost (MPk > Real cost). Thus, Tobin’s q theory is another form of explanation of the neoclassical model of
investment (see neoclassical theory of investment).

The investment decisions in this case are as follows:

If q > 1, investment continues until marginal q falls to 1 because investing in capital pays more
than its cost to acquire and install the investment goods.

If q <1, the firm should reduce the capital stock by disinvestments (saving some part) or letting
depreciation take its course.

Moreover, ‘q’ theory tries to address the following points which are considered in investment decision.

Lags and adjustment costs are inherent in selecting and implementing any capital investment project.
Investments which give product or return sooner are preferred to those investments which give results
after longer period.

Expectations about future costs and pay offs are also important. Expected higher cost of capital in the
future induces more investment currently. This is an attempt to avoid future higher expense.

There is risk and its evaluation by the market. Individuals are more reluctant to invest in risky
investment goods.
This theory implies that firms have choice to invest in real assets or financial assets. This means that the
choice is to purchase the capital good (or investment good) or to keep the finance or the money in the
form of saving depending on the above principles of investment conditions.

Neo-classical Theory of Investment

According to neo-classical theory of investment, investment is based on benefit and cost of the
investment activity to a firm or firms. This theory assumes that firms borrow capital at a rate (R) from
the owner of the capital and sell its product at price P. Then the cost of capital is equal to (R/P).

Real cost (R/P) has the shape of normal cost curves function, which is increasing or upward sloping.

In terms of benefit, we can get the productivity of the capital, which goes down with more
investment at margin. Real benefit is measured in terms of marginal productivity of capital (MP K).
The curve measuring this benefit is down ward sloping since marginal product of a factor of
production including capital declines as the level of employment of the factor increases.

The level of investment has to keep on increasing as long as the benefit of doing it is greater than
the cost of doing so or the cost of the investment activity. This implies that the invest level should
increase up to the level where the real cost of investment equals its marginal benefit given by
marginal product of the investment good or capital. This is represented by the point of intersection
between the cost (R/P) curve and the benefit (MP K) curve given by point ‘e’ in the following figure
(Figure 3.5). The firm employ capital up to ‘e’ where R/P = MPK Þ R = P (MPK)
Figure 3.5: Neo -classical optimal investment level

This implies that firms should invest up to the level when the marginal benefit is exactly equal to the
marginal cost of production. This is achieved at point ‘e’ where marginal benefit is equal to the marginal
cost of production. However, at point “a” the investors gains more by paying less and there is
justification to increase investment.
This theory implies also that it is better to focus on factors that affect benefit of investors such as
improving capital efficiency, lowering taxes on the investment products and of course keeping lower
market interest rate.

Inventory Investment
Inventories consist of raw materials, goods in the process of production, and, completed goods held by
firms in anticipation of the products’ sale. Inventory investment takes place when firms increase their
inventories. The central aspect of inventory investment lies in the distinction between anticipated
(desired) and unanticipated (undesired) investment. Inventory investment could be high in two
circumstances. First, if sales are unexpectedly low, firms would find unsold inventories accumulated on
their shelves; that constitutes unanticipated inventory investment. Second, inventory investment could
be high because firms plan to build up inventories; that is anticipated or desired investment.

Firms would invest in inventory for different reasons. Some of these are:

To smooth the level of production over time: The demand for goods may highly fluctuate and
producers or sellers fill the gap created through inventory investment. This is because; fluctuating or
changing production along with demand may be costly. And such the remedial measure is called product
smoothening.

To operate more efficiently: Goods on hand to show customers (for display) and keeping spare parts to
replace damaged machines would be efficiency improving.

To avoid stock out: That means to avoid running out of stock for sudden increase in demand. The
process is called stock out avoidance.

To help Production process: When production involves a number of steps, partially processed goods are
stored as inventory, called work- in -process.

Firms have a desired ratio of inventories to final sales that depends on economic variables. The smaller
the cost of ordering new goods and the greater the speed with which such goods arrive, the smaller the
inventory to sales ratio. The inventory-sales ratio may also depend on the level of sales, with the ratio
falling with sales because there is relatively less uncertainty about sales as their level increases. Finally,
there is the interest rate. Since firms carry inventories over time, the firms must tie up resources in order
to buy and hold the inventories. There is an interest cost involved in such inventory holding, and the
desired inventory-sales ratio should be expected to fall with increases in the interest rate.

Some Determinants of Investment in Less Developed Countries

Investment in developed country is a function of profit and interest rate = f (p, i). However, there are
other several determinants of investment in developing countries. Some of these factors are fiscal
policy, exchange rate policy, trade policy, level of financial deepening (financial intermediation) and
external debt. All of these factors exert their own impacts on profitability of investment in less
developed countries. But since they depend on their own market these impacts are less in developed
countries.

a)Inflation: Both actual and expected inflations affect the investment level.

Expected Inflation: If firms expect future inflation they move liquid asset to the real asset
(investment) called Tobin-Mundell effect. In principle, expected inflation encourages investment. In
less developed countries because of lack of capital market, people may change domestic currency to
foreign currency (resulting in capital flight). Or they invest in real assets like land. This means that in
less developed countries such as Ethiopia, expected inflation does not necessarily encourage
investment.

Actual Inflation: Actual inflation cause loss of confidence in currency and lead to capital flight.
Inflation leads to an increase in interest rate, which means higher capital price (expensive capital)
which again discourages investment.

b)Fiscal Policy

The major components of fiscal policies are taxation and government expenditure. Lower tax
encourages investment. Tax affects the investment through two channels: the direct and indirect
channels. The direct channel is that a reduced tax increases the profit, which in turn initiates the
investment. Higher tax indirectly encourages investment as it increases the government saving which in
turn make the loan cheaper for better investment.

Increased government expenditure leads to an increased interest rate, which has a crowd out effect on
private investment. That means, an attempt of government to improve investment through its own
involvement in the investment activity may require the government to borrow from banks or to cut
government saving. And this pushes the interest rate up and reduces private investment.

c)Exchange rate policy

One of the major policy instruments in relation to exchange rate policy is devaluation. Devaluation has
two major distinct implications for developing countries under different situations. These are:

If our target is domestic market, import becomes expensive. This implies that cost of production
increases and investment declines. So, finally this discourages investment in domestic market.

If our target is foreign market, we can’t know/predict the effect on cost of production and on
investment. As this increases market size, it may encourage investment.
d)Trade policy: There are two major types of trade policy inward looking (called import substitution
policy) and outward looking (export promotion policy).

Inward looking (import substitution policy): Inward looking policy may be protecting investors from
stiff competition of world producers. If a government gives incentives for investors for definite time
(protects for definite time) it encourage investment. However, if the protection is for indefinite time
it may reduce efficiency of domestic producers and so discourage investment.

Outward looking (export promotion): There is always reciprocity (retaliation) in international trade.
This means the country imposes low tariff. If the firm is competitive at initial stages, a decrease in
tariff (low tariff in importing country) increase profit (p) and this in turn initiate or encourage
investment. However, for uncompetitive firm a decrease in import tariff means cheap imports which
crowds out the domestic ones and discourages investment.

e)Financial Flows.

In less developed countries, there is foreign exchange constraint and producers are dependent on
imports. Moreover, there is closed capital account convertibility where there is no free capital
movement. This constrains import of capital goods which may be important for investment. Such
environment generally constrains investment.

f)Financial Intermediation ( Financial deepening)

Some measurements of financial deepening are:

1)Money - GDP ratio. High value of this ratio indicates the existence of financial deepening.

2)Banks - (user) person ratio. High value of this ratio is also an indicator of financial deepening.
High financial deepening means low cost of borrowing and encourages investment. In less
developed countries, there are several other factors explaining investment. For instance,
infrastructure is assumed to be there in above discussion. But its absence and macroeconomic
instability, civil wars, etc complicate the cause effect relationship.

CHAPTER 4. THE MONEY MARKET

4.1. The Types of Money

What is Money? Money is currency and bank deposits on which checks may be written certainly qualify as money
or Money is the stock of assets that can be readily used to make transactions. These are widely accepted means of
payment that can be transferred between owners at low cost. Households and firms hold currency and checking
deposits as a convenient way of financing routine transactions as they arise. Assets such as real estate do not qualify
as money because, unlike currency and checking deposits, they lack the essential property of liquidity. Money takes
many forms and there are three types of money. In the U.S. economy we make transactions with an item whose sole
function is to act as money:
(1). Fiat Money: This type of money is paper currency (pieces of paper that function as a medium of exchange).
 It is decreed by governments as legal tender (meaning that legally it must be accepted as payment for debts)
 Cannot convertible into coins or precious metal. Because paper currency has the advantage of being much lighter
than coins or precious metal.
 Such type of money has no intrinsic value is because it is established as money by government decree, or fiat.

(2). Commodity money: This type of money that has intrinsic value. The most widespread example of commodity
money is gold. When people use gold as money (or use paper money that is redeemable for gold), the economy is
said to be on a gold standard. Gold is a form of commodity money because it can be used for various purposes—
jewelry, dental fillings, and so on—as well as for transactions. The gold standard was common throughout the world
during the late nineteenth century.
4.1.1. Nominal versus Real Quantity of Money

In economics we define the demand and supply in real terms, not in nominal terms. It is in line with the microeconomics
expression of demand and supply. Let's take an example of the demand and supply of hamburgers. We say that 5000
units of hamburgers are demanded at the price of $4. If we say that $20,000 worth of hamburgers are demanded, the
statement is not clear enough. If the price is $10, the demand for hamburgers in real terms is 2,000 units. We can dispel
any ambiguity by expressing the volume of demand and supply in real terms- here `real' means no change in response to
changes in prices. The nominal quantity of money (supply or demand) is the face value of the total amount of money,
and the real quantity of money is the face value divided by price level;
Real quantity of money = Nominal quantity of money / Price level:

m = M/P

At the equilibrium in the money market, the money supply in real terms is equal to the money demand in real terms:

ms= md.

It is of great importance to understand the operation of the above equation describing the equilibrium money market
condition. Unlike the usual demand and supply case, where the left-side supply is determined by the supplier(s) and the
right-side demand by the demander(s). The left-side can be determined by the interaction of the supplier and
demander(s). The above equation can be rewritten as
 M/P = md

ms = M/P as will be seen shortly.

In case the right-side md is constant, an increase in nominal money supply M by the monetary authority can lead to an
increase in the price level P: If the demanders have a very clear idea as to how much money they want to hold in real
terms, an increase in nominal money supply will simply lead to a rise of the price level. The above equation can be
rewritten as

M = P md.

When the left-side variable, that is, nominal money supply M increases, the price level will go up proportionally if the
real money demand is constant. What it implies is that the monetary authority or government determines only the
nominal money supply. The real money supply and the price level are both determined by the demanders of money.

4.2. Money Supply

The supply of money is a stock at their particular point of time, though it conveys the idea of a flow over time. The
term the supply of money: is synonymous with such terms as money stock', 'stock of money', 'money supply' and
'quantity of money'. The supply of money at any moment is the total amount of money in the economy.

Thus, the money supply is the quantity of money available in the economy. And there are four important actors, whose
actions determine the money supply – (i) the central bank, (ii) commercial banks, (iii) depositors, and (iv)
borrowers. Of the four players, the central bank is the most important. Its actions largely determine the money
supply.
Look at the following balance sheet

Balance Sheet of a Central Bank

Assets Liabilities

Government securities Notes in circulation

Advance to Banks Deposits

Foreign Securities & Currencies

The two liabilities on the balance sheet, notes in circulation and deposits of other financial institutions, are often
called monetary liabilities. The financial institutions hold deposits with the central bank either because they are
required to do so or to settle claims with other financial institutions. These deposits together with currency
physically held by commercial banks make up bank reserves. Reserves are assets for the commercial banks but
liabilities for the central bank. We will see later that an increase in reserves lead to increase in money supply.
Commercial banks hold reserves in order to meet their short-run liquidity requirements. This is called desired
reserve. Sometimes commercial banks are also required to hold certain fraction of their deposits in terms of
currency. These reserves are called required reserves.

The three assets of the central bank are important for two reasons. First, changes in the asset items lead to changes in
the money supply. Second, these assets earn interests (other than the foreign currency), while the liabilities do not.
Thus, they are source of revenue for the central bank. The currency in circulation (C) together with reserves (R)
constitute monetary base or high-powered money (MB). MB = C + R.

The central bank controls the monetary base through its purchase or sale of government securities in the open
market (open market operations), and through its extension of loans to commercial banks. It can also print new
currencies. It is through its control over monetary base, the central bank affects money supply.

4.2.1. Components of Money Supply

Definitions of terms:

What is the Demand Deposit? Before we discuss a time deposit, we must explore a traditional checking and savings
account called demand deposit. If you have an account at a bank, you probably have a demand deposit account. A
demand deposit is an account where you can deposit money and withdraw money at any time, by going to the bank
and completing a withdrawal slip or withdrawing your money from an ATM. Nevertheless, the bank has to give you
the money immediately. A demand deposit allows for access to your money when you need it, anytime. Since the
bank has no control when you will withdraw your money, they will pay you a small amount of interest based on
your account balance and the amount of time you leave the money in the bank. If you're interested in a higher
interest rate product, a time deposit may be for you.

What is Time (fixed) deposits? A time deposit is a depository account offered by a financial institution that pays
interest if the money remains in the account for a specified period of time.

What is saving Deposits? Savings deposits are accounts maintained by banks, savings and loan associations, credit
unions, and mutual savings banks that pay interest but cannot be used directly as money. These accounts let
customers set aside a portion of their liquid assets that could be used to make purchases. But to make those
purchases, savings account balances must be transferred to "transactions deposits" (or "checkable deposits") or
currency. However, this transference is easy enough that savings accounts are often termed near money. Savings
accounts, as such constitute a sizeable portion of the M2 monetary aggregate

What are the components of money Supply?

The narrow definition M1, consists of the assets which are most clearly held for transactions purposes. The broader
definitions M2 and M3 include other financial assets that can be used for transactions with minimum difficulty or
can be readily converted into a transaction asset. In addition to the three definitions of the money supply in common
use, the Federal Reserve also prepares and monitors two broadly defined money aggregates, L (for liquidity) and
total debt. The narrowly defined money stock, M1, consists of coins, currency, demand deposits, and other
checkable deposits (including travelers checks). Coins and currency (paper money) are clearly used for
transactions and should be included in even the most narrow measure of money. In addition, checkable deposits
(deposits at banks and other financial institutions that are subject to payment upon demand) are used and accepted
for most transactions. In fact, in the U.S. most transactions use checks. Some financial assets or instruments are not
used directly for transactions but are easily and readily converted into a form that can be used for transactions. These
near-money assets are included in the broader measures of the money supply. The broadly defined money supply,
M2, includes all of the items in M1 and some instruments that are very easily converted into a transactions balance
or can themselves be used for transactions with some restrictions. Thus, in addition to coins, currency, and
checkable deposits, M2 includes savings deposits (including money market deposit accounts—MMDA), small time
deposits (under $100,000) with a specific maturity, money market mutual funds (MMMF) and overnight
re purchase agreements. There are measures of the money supply that are still broader than M2. These measures
include financial instruments that are somewhat less easy to use for transactions than are the instruments in M2. For
example, M3 includes all items in M2 along with time deposits in excess of $100,000 term repurchase agreements,
and some Eurodollar deposits held by U.S. residents.

1) Exogeneity of Money Supply

The nominal quantity of the money supply is determined by the monetary authority, which usually is the central bank.

MS = M

As just mentioned, the monetary authority does not determine the real money supply as it does not control the price level.
The demanders of money or the general public determine the price level. To recap, the monetary authority determines
the nominal money supply not the real money supply.

How does the monetary authority determine the nominal quantity of money supply? The monetary authority determines
the money supply on the basis of a variety of variables. For instance, in the face of a high level of unemployment rate it
may increase money supply (of the next period). In this case the money supply is positively related to the
unemployment rate. Alternatively, the government may change money supply by accommodating money demand. In
the booming stage of business cycles where more money is needed to back up a higher volume of transactions, the
government may increase money supply. In that case the money supply is inversely correlated with the unemployment
rate.

The money supply must be positively correlated with government deficits if part of deficits is monetized or financed
through printing of paper money. If deficits are financed through issues of bonds or taxation, they are uncorrelated with
money supply. It is impossible to define any unchanging specific relationship between money supply and any variables.
so the nominal money supply is exogenously determined, meaning that it is a good approximation to say that the nominal
money supply is independent of any macroeconomic variables. Precisely speaking, the nominal money supply is also
affected by interest rates, and so forth. However, their impacts are so small as to be dominated by the government's
decision as to the money supply. At one point of time it is fixed, but over time it can be changed by the monetary
authority.

The real quantity of money supply (ms) is the nominal money supply divided by the price level;

ms = MS/P = M/P

As the money supply is independent of the interest rate, when drawn in the interest rate and real quantity dimension, the
money supply curve is vertical, being the same regardless of the level of the interest rate.

4.2.1. The High Powered Money- Multiplier Approach

 One of the two main approaches to the question of money supply is that of the High-Powered Money Multiplier.
 The approach essentially assumes that bank deposits and hence the money supply as a whole are determined by the
level of banks reserve.
 By definitions the money supply Ms is equal to notes and coins held by the non-bank private sector (C) plus the
private sectors bank deposits (D)
 Money Supply = Ms = C + D
 High power money (Monetary Bases) H, which is the liability of central banks consists of notes and coins held by
the public (C) plus notes and coins held by the banks plus the bank’s balance (deposits) at the central bank, and the
last two terms constitute the bank’s reserve (R).
H=C+R
Therefore, MS = C + D ............................................ (1)
H=C+R .............................................. (2)

R 
 Reserve Deposits Ratio = D π
 It is the fraction of deposits that banks hold in reserve
 The ratio of bank’s reserves to their deposit liabilities

C 
Currency-Deposit Ratio = D

 The amount of currency C people hold as a fraction of their holdings of demand deposit D.
 The ratio of the private sector holding of cash to its deposit reflecting the society’s preference over the type of
money to hold.
 Dividing 1 by equation 2
Ms C  D

H CR
 Divide the top and bottom of the right hand side of the equation by D and rearranging

C 1  C 1 
Ms D  D 
  C  R  H
H C R
D D Ms =  D D

 1
H
Ms =   ; Ms = hH

  1 
 
Where; h =     

 Money supply equals the stock of the high powered money times the high powered money multiplier h.
 That is, money supply is proportional to the high powered money (monetary base) and the factor of proportion is h.
 If the two ratios C/D and R/D are constant or at least stable (varying in narrow range) and predictable, h must also
be stable and predictable.
 In addition, if the stock of high powered money is fixed exogenous by the monetary authorities, then the money
supply must be determined by the stock of high powered money together with the multiplier.
 Change the money supply (monetary growth) can then legitimately be analysed in terms of the change in stock of
H and change in the multiplier h.

4.2.2. Creation of Money and Banking System

The fundamental idea that explains how banks create money is the fractional reserve system. Fractional reserve
simply means that banks have to keep in their vaults or at the Federal Reserve Bank only a fraction of what people
deposit in their banks, even though these people have the right to withdraw their deposits on demand (which is why
their deposits are called demand deposits). How can banks honor a promise to return deposits to people when their
deposits aren't there? The answer is that customarily people don't ask for their deposits, certainly not all, and not all
at one time. That's what banks count on and, most of the time, it works.

What do banks do with the deposits, if they're not there? That's the "creation" story. When a bank receives a new
deposit, it can loan out a portion of the deposit, keeping a fraction of the deposit on hand as reserves. How large that
fraction held in reserves must be is determined by the Federal Reserve System (the Fed). That's why they are called
required reserves. When the borrower who took out the loan spends it on, say, building a house, the house builder
now has the money and deposits it in his own bank. This second bank is now able to loan a portion of this new
deposit, keeping on hand a fraction as required reserves. Its own loan provides income for someone else who
deposits it in a third bank, and so on.

The process repeats and the money supply expands. This money creation process doesn’t go on forever because each
round of deposits is smaller as more reserves must be set aside. Stretching it out, the new deposits eventually
become close to zero. How much, then, does an initial deposit create in terms of total new deposits? The answer is
found by using the potential money multiplier which is 1/LRR, where LRR is the legal reserve requirement (in
percentage terms). The money supply is unlikely to expand to the extent indicated by the potential money multiplier
for two reasons. First, banks may prefer to hold reserves in excess of those required. These are called excess
reserves. Second, and more important, people may simply not borrow sufficiently to exhaust the full amount of the
available reserves. The money creation process can also run in reverse gear. When someone makes a withdrawal, it
means the bank's loans are more than its new and lower deposits can support. It must reduce its loans. But that
creates its own round-after-round sequence of loan and deposit reductions. Banks sometimes fail when a large
portion of the loans they made are not repaid. When people learn that someone else's bank is failing, they become
nervous about their own deposits and may choose to withdraw them. If many people behave this way, they may
cause a "run on the bank." If an exceptionally large number of withdrawals take place in a short period of time, loans
must be called in, reducing the money supply and real GDP. In the absence of intervention by a central bank like the
Fed, banking practice would tend to exacerbate the phases of the business cycle. During recession, a bank is less
likely to lend for fear of not being repaid. The money supply shrinks as outstanding loans are called in, causing the
interest rate to rise and the quantity of investment to fall, just when investment is needed the most. During
prosperity, banks are more inclined to lend, which causes the money supply to grow more rapidly than otherwise,
resulting in lower interest rates and more borrowing. With the economy near or at full employment, it creates an
upward pressure on the price level. The Fed can counteract these outcomes by using some of its monetary tools.

4.3. Monetary Policy Tools

The National Bank has three tools at its disposal to alter the money supply: open market operations, changing the
discount rate, and changing the reserve requirement.

(1). Open Market Operations: Open market operation refers to National Bank purchases and sales of bonds issued
by the government treasury. These transactions are with banks, public, and firms. When the National Bank buys
bonds in the bond markets it pays for the bond by creating new Bank deposits at the National Bank. These new Bank
deposits at the National Bank add to banks excess reserves, and can therefore form the basis of a multiple expansion
of the money supply through new loan creation by banks. To see how open market operation works, assume the
National Bank purchased $100 bonds from the First Local Bank (FLB) and banks required reserve ratio is R = 20%.

Since excess reserves have increased by $100, applying the money supply formula, total money supply will increase
by $100 x (1/0.2) = $500. To reduce the money supply, the National Bank does just the opposite. In summary: Open
market purchases increase reserves and allow the banks to increase the money supply. Open market sales reduce
reserves, thus reducing the banks ability to create money and therefore reducing the money supply.

(2).Changes in the Discount rate: The National Bank Reserve Discount rate is the interest rate on discount loans
that the National Banks makes to banks. Banks borrow discount loans from the National Bank when they do not
have enough reserve to meet the reserve requirements. Banks borrowings from the National Bank increase the level
of banks reserves and these additional reserves allow the banks to create more money. The National Bank can alter
the discount lending by changing the discount rate. When the National Bank lowers the discount rate it encourages
banks to borrow more from the National Bank, leading to more reserves in the banking system. These additional
reserves will eventually increase the money supply, because of the money multiplier principle, by a greater extent
than the increase in reserves. Conversely, an increase in the discount rate discourages banks borrowing from the
National Bank and reduces the money supply. Lowering the National Bank discount rate is expansionary monetary
policy, while raising the National Bank discount rate is contractionary monetary policy.

(3).Changes in Reserve Requirements: The last tool of changing the money supply is the required reserve ratio.
Required reserve ratio determines how much money the banking system can create with each dollar of reserves.
When the National Bank lowers the required reserve ratio money multiplier increases as well as excess reserves.
These changes can lead to increase in money supply. For example, assume the entire banking system has $1000 in
deposits and the required reserve ratio is 10% and banks are fully loaned up. That means the total reserve in the
banking system is $100. Now suppose the National Bank lowers the required reserve ratio to 8%, and hence, reduces
the total required reserve to $80. With this change banks find themselves with excess reserves of $20. If banks
decide to loan out the entire excess reserves the money supply can increase by as much as 20 x (1/0.08)=$250.
Conversely, an increase in required reserve ratio raises the reserve ratio, lowers the money multiplier, and decreases
the money supply. Lowering the required reserve ratio is expansionary monetary policy; raising the required reserve
ratio is contractionary monetary policy. There are two problems that the National Bank faces in trying to control the
money supply. The first problem is that the National Bank does not control the amount of money that households
want to hold as deposits in banks. The more money the households deposit in banks, the more reserves banks have,
and the more money banking system can create. And if households choose to hold more in cash and less in deposits,
banks lose reserves and money supply decreases. The second problem is that the National Bank does not control the
amount of money that banks choose to lend. If banks decide to hold more excess reserves and make fewer loans, the
amount of money supply will be smaller.

Major Functions of Money

I. Money as a Medium of Exchange

The most important function of money is to serve as a medium of exchange, a generally accepted means of payment.
To see why a medium of exchange is necessary, imagine how time-consuming it would be for people to purchase
goods and services in a world where the only type of trade possible was barter trade—the trade of goods or services
for other goods or services. Money eliminates the enormous search costs connected with a barter system because it
is universally acceptable. It eliminates these search costs by enabling an individual to sell the goods and services she
produces to people other than the producers of the goods and services she wishes to consume. A complex modern
economy would cease functioning without some standardized and convenient means of payment.

II. Money as a Unit of Account

Money's second important role is as a unit of account, that is, as a widely recognized measure of value. It is in this
role that we encountered money in Prices of goods, services, and assets are typically expressed in terms of money.
Exchange rates allow us to translate different countries' money prices into comparable terms. The convention of
quoting prices in money terms simplifies economic calculations by making it easy to compare the prices of different
commodities. The international price comparisons in which used exchange rates to compare the prices of different
countries' outputs, are similar to the calculations you would have to do many times each day if different
commodities' prices were not expressed in terms of a standardized unit of account.

III. Money as a Store of Value

Because money can be used to transfer purchasing power from the present into the future, it is also an asset, or a
store of value. This attribute is essential for any medium of exchange because no one would be willing to accept it in
payment if its value in terms of goods and services evaporated immediately. Money's usefulness as a medium of
exchange, however, automatically makes it the most liquid of all assets. As you will recall from the last chapter, an
asset is said to be liquid when it can be transformed into goods and services rapidly and without high transaction
costs, such as brokers' fees. Since money is readily acceptable as a means of payment, money sets the standard
against which the liquidity of other assets is judged.

4.4.2. Theories of Demand for Money

4.4.2.1 The Classical Quantity Theory

 The classical quantity theory asserts that money determines only the price level, not real output.
 The central proposition is that, increases in money supply leads to increase in price.
 Root idea- no rational person holds money idle, for it produces nothing and yields no satisfaction. Rather- people
promptly use all the cash they receive from the sale of their goods and services to buy other goods and services.
 How promptly depend on- How productions are organized, how frequently incomes are paid and other institutional
and structural factors-independent of the quantity of money and level of prices.
 Given this assumptions, the theory showed how the quantity of money determines the level of money price without
direct impact on demand and supply of any individual product.
 The quantity theory can be stated in several ways-two closely related formulations are Transaction form and
Income form.
 (1). Transaction Form: MV = P1T
Where:
M = Quantity of money in circulation (notes, coins in circulation + checkable deposits in private circulation)
V = “Transaction Velocity of Money”
P1 = Average price level of all transactions-weighted price index or implicit deflator
 T = Physical volume of all transactions
 Assume- V is constant at its maximum feasible level.
P-Price is perfectly flexible
T- can always be at the maximum level permitted by the technology and the willingness to work at full
employment level because V is constant and, at any given time, T can be taken as constant
And P1 must be proportional to M;
MV = P1T
 Because money supply is controlled by the government and exogenous, the price is determined
endogenously by M, with T and V fixed. So, Z% increase in M leads to Z% increase in P1
 (2). Income Form: MC = P2Y
 Because there exists no acceptable measurement of the physical volume neither of transaction nor of the price
level of total transaction, the transaction form quantity has fallen out of use and replaced by income form.
Where: M= Quantity of money in circulation
Y = Real National Product- constant
P2 = Average price level of national product- National product deflator
C = Income velocity (circular velocity) of money-constant
 But because Y can be identified as real GDP and P2 as the GDP deflator, the income form quantity theory is used
more and more.
 MC = P2Y because V is constant at its maximum level, C will be constant as well. And Y is also fixed at the level
corresponding to the full employment of available resources.
 Price changes proportional to money
MC = P2Y

Velocity and the Demand for Money

 Income (circular) velocity is used to determine the demand for money proposition-that individuals demand for
money is proportional to his or her nominal income
 When this is aggregated and put in reduced form terms it becomes the proposition that the money supply is
proportional to national income
M = Md = or M = mP2Y
Where Md = demand for money,
M = supply of money
m = a constant fraction of P2Y which in the aggregate, members of the community desire to hold in the form of
money balance.
Remember that:
MC = PY
Md = mPY
 1
m 

C Reciprocal of income (circular velocity

Whatever factors determined the size of C must also determine the size of M

4.4.2.2. Keynes Theory of Demand for Money

 Keyne’s was concerned with the short-run in which income could be expected often to be below the full
employment level and in which variation in the circular velocity was of great importance.
 He put emphasis- on motives for holding money
(1). Transaction motive-depend on value of transaction that in turn depend income.
(2). Precautionary motive- against unforeseen payments or expenditure which vary primarily with income and
usually aggregated with transactions demand
 Keynes assumed both Transaction motive and precautionary motive vary with interest rate-opportunity cost of
holding money.
 But followers of Keynes dropped this idea and simply set demand proportional to national income. Therefore;
MT +P =mPY
MT+P = Transaction and precautionary demand for money

M T P
 mY
P (Real transaction and precautionary demand is proportional to real income)

(3). 3rd motives for holding money are speculative motive

 Hold money as alternative to holding bonds when they expect to make loss from holding bonds and relatively gain
from holding money.
 Amount of money hold for this purpose varies primarily with interest rates.
 Hence, it requires comparing relative rate of return from holding money or bonds.
 Note: This analysis mostly apply to government bonds-where holder is paid fixed “coupon” each year- and where
bonds are bought back on specific date in future.
Return on holding bond (foregone by holding money)= Coupon + any capital loss or gain from movement of market
price of the bond
 Hence we need to predict this movement in market price of bonds.
 The market price of bonds varies inversely with the rate of interest (r).
 Yield on bond is the coupon “C” divided by the price of the bond P b-plus and y change in price of the bond over the
period up to its redemption
 C
r
 Yield on bond =
Pb but coupon “C” is fixed. Therefore, yield on bonds can vary only with variation in the
price of the bond.
 When r rises or Pb must fall or rise. Bond price varies inversely with the interest rate r, and to predict bond price we
must predict r.
 Now, add the speculative demand for money to the transaction and precautionary demand-to obtain total demand for
money

M d M T  P M ' SPEC
   d  mY  Ir
 P P P
Total Demand for Money = Liquidity Preference
 Based on this, the proposition that there is proportional relationship between demand for money (M d) and national
income (in classical quantity theory) or between real money demand and real income disappeared.
 Total demand for money (including speculative demand) is referred to as “Liquidity Preference” and is unstable
due to fluctuation in the financial market confidence about future interest rate r.
 Note: Speculative demand for money can become infinite at some level of r = r*

M SPEC
 r P

r*

M
P

 At r* all speculators expect r to rise and bond prices to fall by an amount that exceeds the coupon return.
 Speculators want to hold money rather than bonds
 If monetary authorities want to increase the amount of money held they can do so by buying bonds. But this raises
the prices of bonds.

4.4.2.4. Modern Quantity Theory of the Demand for Money

 After Keynes the classical quantity theory was widely discredited because of its assumption of full employment.
 However, Friedman (1956) presented a “Restatement of Quantity theory” explicitly as theory of the demand for
money and without any assumption of full employment.
 The starting point for Friedman’s approach is the rejection of the Keynesian concern with the motives for holding
money and the Keynesian view of money as something unique and deserving of special treatment.
  Friedman set out to analyze what determines, not why, but how much money is demanded and to analyze the
demand for money in the same way as the demand for any other asset. Example; Economists do not ask why
people want pens, but analyze factors affecting how much pens are demanded.
 To apply this approach to the demand for an asset two modifications are required.
 1st The budget constraint which is relevant for decision making on how much of which asset to hold is not income
but wealth.
 2nd –The key variable affecting the choice between alternative assets is not their relative price but their relative rate
of return
 With these modifications the demand for an asset is predicted to be a function of the rate of return on the asset
concerned, rate of return on substitute’s assets, the rate of return on complementary assets, wealth and tastes.
From its definition some part of money consists of interest-bearing deposits and the rate of interest on such
deposits is an important element of “own” rate of return, the rate of return on money itself.
 Since permanent income is in principle a return on wealth and must therefore vary closely with wealth, permanent
income can be used instead of wealth as a budget constraint variable.
 With this simplifications Friedman’s modern quantity theory of money is reduced to the proposition that the real
demand for money is a function of wealth or permanent income and the interest rate. This brings the theory much
closer to the Keynesian theory of demand for money.
 Now in both cases the equation becomes

Md
 d  mY  Ir
P

2) Detailed Studies of Money Supply: Money Multiplier

Here we would like to show that while there are determinants of money supply their impacts on money supply is all
buried under the dominating factor, that is, the government decision of money supply. Roughly speaking, the money
supply is independent of all variables including interest rates.

CHAPTER 5.PRODUCT AND MONEY MARKET MODEL

5.1. Interest rate and AD-IS Curve
Introduction

The IS-LM curve model gives the equilibrium level of national income (Y *) in a larger setting. We have obtained
Y* from the Keynesian Cross Diagram. The equilibrium condition of the goods market will be condensed into a
curve of IS. We will introduce the money market; the equilibrium condition of the money market will give a one-
line curve of LM. The IS and LM curves are delineated with two explicit variables of national income and interest
rates.
 In the IS-LM Curve Model, the interactions between the goods (output) market and the financial market gives the
equilibrium Y* and the equilibrium interest rate i*. As this new Y* satisfies the equilibrium condition in the goods
market as well as the money market, it is an equilibrium of a broader scope and a higher order.

First, we will establish an inverse relationship between interest rates and investment in the goods market. This
eventually leads us to the IS curve or the various combinations of i and Y, which satisfy the equilibrium condition in
the goods market or make the demand equal to the supply in the goods market.

Second, we will establish an inverse relationship between interest rates and (real) money demand in the money
market. This leads us to the LM curve or the various combinations of i and Y, which satisfy the money market
equilibrium or make the demand equal to the supply in the money market.

Third, we will solve for the national income Y* and the interest rates i*, which satisfy the goods and money market
equilibrium conditions at the same time. Basically, they are obtained from the intersection of the IS and LM curves.

5.1.1. Investment Function

Marginal Efficiency of Capital Method

Investment is the demand for resources to be used for specific physical additions to the capital stock. An increase in
capital stock or investment is expected to yield ‘a stream of net income’ over time. We can find the rate of return,
which equates the present price tag of investment project on the left side of the equality and the stream of the
expected returns. This rate of return is called ‘Marginal Efficiency of Capital’ . As we start investing in the most
lucrative project and move onto less profitable projects, the Marginal Efficiency of Capital declines as the amount of
capital input increases.

The cost of the fund is the cost associated with the borrowing the fund. This is the ‘Marginal Cost of Fund’ . It is
generally equal to the interest rate paid on the interest bearing security, such as government bonds. In other words,
the marginal cost of fund is fixed, and thus can be delineated by a horizontal line in the graph.

Marginal Cost of Fund = Interest Rate

When the interest rate goes up, the amount of capital input or investment declines. Simply, think of the project
which is exactly making both ends, revenues and costs, meet in right now. If the interest rate and borrowing costs go
up, the project has loss and will be knocked off. The investment volume decreases by the amount of investment.

The (real) interest rate constitutes a cost of obtaining (financial) capital for additions to capital stock or investment.
A higher interest rate means a higher cost, a lower profitability and the lower rate of return on investment projects.
Some investment projects which used to be marginally profitable or managed to make both ends meet are no longer
profitable. So the desired investment will decrease as the interest rate increases. Thus,

I = I0 – d i,
I0 is the autonomous investment and d is the elasticity of investment with respect to interest rates. d > 0. Here d
measures the responsiveness to changes in investment to changes in the interest rate.

The larger the value of d, the more responsive the investment with respect to changes in interest rates. In other word,
the larger the value of d, the more interest-rate elastic the investment will be. A numerical example would be I =
100 – 5i: One percentage increase in interest rates will bring about a 5% decrease in investment.

(w.r.t. = with respect to)

5.1.2. IS Curve: Goods Market Equilibrium

The IS curve shows various combinations of national income and interest rates which bring out the equilibrium, or
the equality between demand and supply, in the goods market. Let’s plug the aforementioned modified investment
function into the aggregate expenditure function, and solve for Y* and i*.

1) Algebraic Derivation

Recall there are three different cases of AE (AD).

Case 1. All taxes are lump-sum or autonomous. T = T0.

(Assume NX = X- M = 0 for simplicity for now) Suppose that we are dealing with the aggregate expenditures with
only lump-sum taxes and no exports or imports (This is Case 1 in the last chapter of the Keynesian Cross Diagram).

The AD will be

AD = a + b(Y – T0) + I0 – di + G0

= b Y + (a - b T0 + I0 + G0 – di0 )

At equilibrium,

Y = AD

Y = b Y + (a – bT0 + I0 + G0 – di)

Y – b Y = a – bT0 + I0 + G0 – di

Solve for Y* and i*: We can rewrite this equation as a functional relationship between Y * and the interest rate i.

1
Y*  (a  bTo  I o  di  Go
1 b

1 1 b
i  (a  bTo  I o  Go  y)
d d

This is the algebraic expression of the relation between (i, Y) which represents equilibrium in the final goods
market.

 Note that the slope has a negative sign and thus the IS curve is downward sloping. This means that in
equilibrium, of the goods market, the interest rate and income move in the opposite direction; if interest rate
increases for some reason, in order to stay at the same equilibrium in the goods market, national income
should decrease.
 Also, we can draw the IS curve by putting i on the vertical axis and Y on the horizontal axis.
Intuitive Explanation of the IS curve.

We can also give the following intuitive explanation about the negative slope of the IS curve; Let us start from one
equilibrium: Y = YS = AD = C + I + G. Here let us change the interest rate an d examine the responsive changes in
Y. If i and Y turn out to be moving in the same direction, the slope of the IS curve will be positive, and vice versa.

Let us suppose that the interest rate decreases from i 0 to i1. If investment is inversely related to the interest rate, there
will be an increase in investment and thus an increase in the AE. This means that there will be an excess aggregate
demand (now Y < AE/AD’). How can we re-establish the equality between AE/AD and Y? The answer is by
increasing Y. In the equality of AE and YS, or the equilibrium of the goods market, when interest rates goes down
and national income goes up. The interest rate and national income should move in the opposite direction.

We can express the above relationship with a curve in a graph with Y* on the horizontal axis, and the interest rate i*
on the vertical axis. This curve is called the IS curve because, at equilibrium, AD = Y, which means C + I + G + X
– M = C + S + T. As C in both side cancels out, the equilibrium condition of the goods market can be expressed as I
+ G +X = S + T + M. The first letter of each side of the equality read ‘I’ and ‘S’. So along the IS curve, I + G + X =
S + T + M. So that is how the name, ‘IS curve’, came about.

Graphic Derivation of the IS curve.

Start with the Keynesian Cross- Diagram with which you are very familiar. Redefine the Investment function in the
AE/AD curve as being inversely related to the interest rate

 Suppose that the initial interest rate is i 0, it gives a certain investment level in AE/AD, which in turn gives
Y*. (see the initial equilibrium point at A in the graphs below)
 Now change the interest rate up to i 1. See the corresponding new Y *’  AE decreases:  the new
equilibrium point at B;
 Also, change the interest rate down to i 2, See the corresponding new Y*’’.  AE increases,  the new
equilibrium at C.
 These combinations of i and Y* will give an IS curve.
Comparative Statics of the IS Curve

What can cause a change in the IS curve?

(1)

Let us examine the second point: The more elastic the investment demand with respect to interest rate, the flatter the
IS curve. The more sensitive the investment demand is towards the interest rate, the flatter the IS curve will be.
Here the magnitude of d, or the elasticity of investment with respect to the interest rate, determines the slope of the
IS curve.

Numerical Examples: Suppose that we have the following two different investment functions, which have different
elasticity of investment with respect to the interest rate. The slope of the IS curve

In summary, the following factors determine the slope of the IS curve:

i) The larger the marginal propensity to consume (c1), the flatter the IS curve.
ii) The larger the elasticity of investment demand with respect to interest rate (d), the flatter the
IS.
iii) The lower the income tax rate (t1), the flatter the IS.
Case 1: Interest-rate Inelastic Investment eg) I = I0 – 0.5 i

Here, the investment demand is inelastic with respect to interest rate: A 1% increase in the interest rate i will bring
about a 0.5% decrease in the investment demand (Δ I 0). Therefore, for a given increase in the interest rate, there
occurs a relatively small decrease in AE = C + I + G , which will bring about a magnified but still small decrease in
Y through a multiplier effect in the cross diagram.

Case 2: Interest-rate elastic Investment eg) I = I0 – 10i

A 1% increase in interest rate will bring about a 10% decrease in investment (Δ I 0). Therefore there occurs a
relatively large decrease in AE = C + I + G (Δ AE), which will bring about a correspondingly large decrease in Y
through a multiplier (Δ Y) in the cross diagram.

Y=Y

Y*

2) Changes in the intercept of IS curve. Changes in the intercept of the IS curve will bring about Parallel Shifts of
the IS curve. Changes in C 0, I0, T0, G0 which constitute the intercept of the IS curve, will lead to the parallel shift of
the IS curve.

i) Δ G0, Δ C0, and Δ I0 shift the IS curve to the right by the actor of their (simple) multiplier 1/(1-c 1) (times the
changes in those variables). For instance, Δ G 0 will bring about a horizontal shift of the IS curve. The distance of
the horizontal shift is given by Δ G0 times 1/(1-c1).
ii) Δ T0 will shift the IS Cure to the left by the amount of its multiplier c1/(1-c1) times Δ T0.

5.2. The Money Market- LM Curve

LM curve shows the combinations of the interest rate and the income (i, Y) which satisfies the equilibrium in the
money market. The nominal quantity of the money supply is determined by the monetary authority, which usually is
the central bank.

MS = M

Money supply varies depending on the scopes of money: it may include only cashes (in circulation) in a narrow
scope, and may include cashes and all deposits in a broad scope such as M2. The different scopes of money supply
will be discussed in full in the separate chapter.

For instance, M = $20,000,000,000 or $20 billion.

The monetary authority does not have to determine the nominal money supply on the basis of any variables in any
given manner over time. Thus, we regard the nominal money supply as an exogenous variable, and regard it as
arbitrarily determined by the monetary authority. Mathematically, this means that the nominal money supply curve
is vertical, being independent of interest rates. As the money supply is independent of the interest rate, when drawn
in the interest rate and real quantity dimension, the money supply curve is vertical, being the same regardless of the
level of the interest rate.

Real Money Demand

First, note that the money market equilibrium should be defined in terms of real money supply and demand;

Nominal money supply is equal to nominal money demand at all times, i.e., at and out of equilibrium. The nominal
quantity of money demanded by the society as a whole is always equal to the nominal quantity of money supplied
by the government; MS = MD at all times. Suppose the government is handing out newly printed paper monies or
notes on the street. IS there anyone who would refuse them? Every dollar of money supply will be gladly
demanded.

Second, while an individual can control real money demand, the general public as opposed to the monetary
authority cannot control real money demand;

When an individual receives some new paper monies, her/his nominal (and real) balances increase. S/he may
succeed in decreasing the nominal money demanded or the real money balanced back to the initial level by spending
the excess money holdings. However, because her/his expenditures will become someone else’s receipts, some
other members are getting the increased money supply. So from an individual’s view point the nominal money
demanded may be controllable, while it is not controllable from the entire society’s viewpoint. What is true for
individuals is not necessarily true for the society as a whole. This is the ‘fallacy of composition’ commonly founded
in macroeconomics.

As individuals are busy getting rid of the excess of money holding over the desired level of demand (“I would like to
have $200 in my pocket, but as government gives me a new $100 bill, now I have the excess of money holding by
$100. I would like to go back to the desired level of money demanded, that is $200 by spending $100 away.”) The
increased money becomes a kind of ‘hot potato’. What does this mean in terms of the real money demand? The real
money demand, which is the nominal money demand (= the nominal money supply) divided by the price level, is
going back to the initial level. The increased speed of spending and expenditure will eventually push up the price
level. The general public are collectively changing the price level and thus controlling the real money demand.
Suppose MS = M = MD = $200 billion and P = 1.00 initially in the equilibrium; the real money demand is MD/P =
200/1 = 200 and should be equal to the real money supply at the equilibrium. This real money demand is at the
desired level at the equilibrium in light of all the determinants of the demand including the income level and the
interest rate.

Now the monetary authority increases the nominal money supply MS to $400 billion. First, all the increased nominal
money supply will be demanded. So the nominal money demanded is equal to the new nominal money supply; MD’
= MS’ = M’ = $400 billion.

In the short-run, the price does not change, and thus the actual amount of the real money holding will be m’ = m’’ =
M’/P = $400/1.00 = 400. This is much larger than the desired real money demand, that is, 200. As there are no
changes in the determinants of the real money demand, there should not be any change in the level of real money
balances the general public wishes to hold. There is an excess of real cash balances over the desired real money
demand; ‘actual’ real money balances > ‘desired’ real money balances.

As individuals with excessive money balances try to recover the desired real money balances by spending the excess
money receipt, the price level is going up to P’. At this new price level, the new ‘actual’ real money balances
(M’/P’) become equal to the desired level of real money balances.

Specifically, the price level will go up to the level of 2 (or the index number 200). The actual real money demand
will be 400/2 = 200, the same level as before any changes.

(2) Functional Form of Real Money Demand

The real money demand is given a functional form such as

md = L ( i, Y ).

The above equation defines the real money demand as a decreasing function of interest rates and an increasing
function of national income. What determines the desired level (quantity) of real money demand? Just as the
desired quantity of hamburgers is determined by the consumers’ income and the price of hamburger, the real
demand for money is determined by the income level of the economy that is the national income and the price of the
money, that is, the interest rate.

Let us examine the second point in the above statement: the price of money is the interest rate. In other words, the
opportunity cost of holding money balances is the interest rate. Money is one of many assets , which include bonds,
stock, equities and real assets. Money and other assets are substitutes. The major difference between money and
other assets is that money does not bring in any positive pecuniary returns. Actually it is very often subject to the
erosion of real value due to inflation, and other assets do have pecuniary returns. However money, or cash balances
in a precise term, renders a unique non-pecuniary service, which is known as ‘liquidity’. Money is the most
generally accepted medium of exchange and most ‘liquid’. So when you decide to hold assets in the form of cash
balances instead of any other, you are showing your preference for liquidity over pecuniary returns. This is the
reason why the money demand is called’ liquidity preference and the money demand function ‘liquidity preference
function.’

The interest rate represents the foregone pecuniary return or the economic sacrifice you have to take when you are
choosing cash balances over other assets, as your mode of holding assets; in other words, the interest rate is the
opportunity cost of holding cash balances. When the interest rate goes up, the cost of holding cash balances
increases and naturally you would like to hold less assets in the form of cash balances and more interest bearing
assets. This means that the demand for money is inversely related to the interest rate.

Now we have another major factor to be considered, which affect the real money demand; the income level. When
real income increases, in most cases, the demand for money increases in real terms, too. To name one reason, when
real income increases, there occur more transactions, and then more cash balances should be held to back up the
increased transactions.

We can give the liquidity preference function the following specific functional form;

Md = kY – h i + u,

where K is the elasticity of real money demand with respect to the national income; h is the elasticity of real money
demand with respect to interest rates; and u is the random component of real money demand.

The liquidity preference curve is negatively sloped when drawn with the interest rate on the vertical axis and the
amount of real money on the horizontal axis. The variables Y and u are the shift parameters of the real money
demand curve.

i 1

i0

L (Y, u )

md
(Note: Y and u are shifting parameters)
Also, we can draw a set of liquid preference curves for different levels of income; the higher the level of national
income, the larger the demand for real money balances. You may remember, from the class of Macroeconomics I,
that an increase in income shifts the demand curve to the right.

3) Money Market Equilibrium and LM Curve

As emphasized, the money market equilibrium should be defined in real terms; the money market is in equilibrium
when real money supply is equal to real money demand ex-ante. If the demand is larger than the supply, the price
will go up. With an increased price some people will give up their demand. The pri ce, which adjusts to equate the
supply and demand, is nothing but the interest rate. The money market interest is set at such a level as to make the
supply equal to demand ex-ante.

(1) Algebraic Solution

LM Curve: Money market equilibrium condition ms = md yields the following equations. Rearranging the equation
Ms
d
with ‘i’ on the left hand side and ‘Y’ on the right hand side, we get a LM Curve. Real money supply = P , m =
L(i,Y,u) = kY – hi + u

M
= kY - h i + u
P0
M
h i= - +k Y +u
P0
1 M k
i = (- + u )+ Y
h P0 h

↓ ↓
 intercept slope

We can draw a LM curve with the interest rate on the vertical axis and the national income on the horizontal axis.

The LM curve is upward-sloping, or in other words, it as a positive slope. (Along LM m  m )

s d

(3) Graphic Derivation of LM curve:

The real money demand and supply mainly curve up the relationship between the interest rate and the real money
balances. However, we are interested in getting the LM curve which curves up the relationship between Y and i *.
To get the relationship between the two, we have to change the value of Y and look at the responsive change in i * or
the money market equilibrium interest rate;

When Y increases from Y 1 to Y2 the real money demand curve shifts to the right. Here the Y variable is a shift
parameter I the real money demand function. When the real money supply remains unchanged, the increased real
money demand will push up the equilibrium price of the money in the market, that is, the equilibrium interest rate I
the money market. Previously Y1 corresponded to i1, and now a higher Y2 to i2.

M
ms 
i P M
i LM ( , u)
P

i2

i
md (Y2 , u)
i1

m d (Y1 , u ) Y

ms / md Y1 Y2 Y
So a higher level of income means a higher level of interest rate. Y and i are moving in the same direction. The LM
curve should be upward sloping.

4) Comparative Statics of LM curve

(1) Change in the Slope of LM curve.

i) Elasticity of real money demand with respect to Income, or income elasticity of real money demand (K): The
larger the income elasticity of real demand, the steeper the LM curve.

For instance, when Δ Y = 1% for the following two cases:

Case I with K = 1: md = Y – 20 i+ u

M
ms 
i P M
i LM ( , u)
P

i2

i
md (Y2 , u)
i1

m d (Y1 , u ) Y

ms / md Y1 Y2 Y

Case II with K = 0.5: md = 0.5 Y – 20 i + u

 M
ms 
i P i
M
LM ( , u)
P

i2
i1

md (Y2 , u)
m d (Y1 , u ) Y
ms / md Y1 Y2 Y

ii) Elasticity of real money demand with respect to Interest rate, or Interest rate elasticity of real money demand
(h): the elasticity of real money demand with respect to the interest rate, or in short interest elasticity of money
demanded.
In general, the larger the value of h, or the more (interest rate) elastic the real money demand, the flatter the real
money demand. In the following two cases, assuming that K = 0.5 and u = 20 for both in the money demand
function md = K Y – h i + u,

Case 1 with h=0.5; Inelastic money demand, md = 0.5 Y – 0.5i = 200

M
ms 
i P M
i LM ( , u)
P

i2

i
md (Y2 , u)
i1

m d (Y1 , u ) Y

ms / md Y1 Y2 Y

Case II with h =20; Elastic money demand, md = 0.5 Y – 20 i +200

 M
ms 
i P i

M
LM ( , u)
P
i2
i1
md (Y2 , u)
m d (Y1 , u )
Y
ms / md Y1 Y2 Y

In the above graphs, we can see that with a flat m d curve with a large interest-rate elasticity, a very small drop in the
interest rate will bring about a very large increase in md. We may also review some extreme cases.

(2) Shift of the LM curve.

i) Change in nominal Money Supply; Δ MS

The LM curve shifts to the right when the monetary authority increases the nominal money supply: An increase in
nominal money supply leads to the increase in real money supply when the price level is fixed.


ms ms LM (
M
, u)
i P
i 
M
LM ( , u)
P

md (Y2 , u)

m d (Y1 , u )

ms / md Y1 Y2 Y

5.3. Equilibrium in the Goods and Money Market: IS-LM Curve (Closed Economy Model)

The intersection of the IS and LM Curves give the equilibrium national income and the interest rate that satisfy the
market clearing condition in both goods markets and money markets; ex-ante all the goods produced are demanded,
and real money supply is equal to the real money demand.

1) Graphic Solution
5.5. Policy Effects in IS-LM Model

1) Fiscal Policies

Government expenditures may be financed either by taxes or by deficits. In the latter, the deficits should be made up
by issuing bonds. Perversely, a bond-financed increase in government expenditures has a larger impact on national
income than a tax-financed increase in government expenditures. This in equivalence in terms of financing is a
main feature of the conventional IS-LM model. We will later discuss the problem of this view and present an
alternative view developed by Barro-Richardo. For now, we are simply having a review of fiscal policies in the IS-
LM model.

(1) A Bond-Financed Increase in Government Expenditure: ∆G = ∆B

When government increases its expenditure without increasing tax revenues, there occur deficits. The government
has to make up for deficits by borrowing funds. The certificates of borrowing by the government are bonds. So
deficit-financing is the same as bond-financing. There is no corresponding increase in taxes when government
expenditures increase.

In the Keynsian Cross-Diagram, ∆G 0 shifts the AE curve up by ∆G 0 and the Y (note that there is no longer * on Y
because this Y is just an equilibrium in the goods market as opposed to the Y * which is the equilibrium in the goods
and money markets) increases by ∆G0 times 1/(1-c1).

Accordingly, in the IS-LM curve model, there occurs a parallel shift of the IS curve to the right by ∆G 0/(1-c1). This
results into the increase in Y* by ∆G0 times 1/(1-c1 + Kb/h) which is smaller than ∆G0 (1-c1).
 A- The Horizontal distance of IS curve shift
B- ∆Y*
C- ∆i*

The increase in Y*, shown as the rightward movement of Y *in the graph, is smaller than the rightward shift of the IS
curve. The reason is that ∆G0 leads to ∆Y*and this increased income increases real money demand. An increase in
real money demand pushes up the interest rate when real money supply is fixed. A higher interest rate decreases
investment and through the multiplier, income falls. This mechanism partially offsets the initial increase in the
income due to ∆G0. This is called ‘Crowding Out’. The increased government expenditure crowds out the private
investment by raising the interest rate.

(2) A Tax-Financed Increase Government Expenditure: ∆G = ∆T

When government is increasing its expenditure with revenues raised through taxation, it is engaged in balanced
budget operation. In the Cross Diagram, ∆G = ∆T leads to a rightward shift of Y or the goods market equilibrium
national income by ∆G times 1.

Accordingly, in the IS-LM curve model, the IS curve shifts to the right by ∆G. This results into the rightward shift
of Y*, goods and money market equilibrium national income by ∆G times (1- c1)/(1- c1 + Kb/h) which is less than

∆G. Also the interest rate goes up.

2) Monetary Policies (Shift in LM Curve)

We now examine the effects of monetary policy. Recall the change in money supply alters the interest rate that
equilibrates the money market for any given level of income and, thereby, shifts the LM curve. The IS_LM model
shows how a shift in the LM curve affects income and interest rate.

Consider an increase in the money supply. An increase in M leads to an increase in real money balances M/P,
because the price level P is fixed in the short-run. The theory of liquidity preference shows that for any given level
of income, an increase in real money balances leads to a lower interest rate. Therefore, the LM curve shifts
downward, as below figure. The equilibrium moves from point A to point B. The increase in the money supply
lowers the interest rate and raises the level of income.

r. IS LM1

LM2

r1 A

r2 B

Y1 Y2 Y-Income (output)

Once again, to tell the story that explains the economy’s adjustment from point A to point B, we rely on the building
blocks of the IS-LM model the Keynesian cross and the Liquidity Preference Theory. When the national bank
increases supply of money, people have more money than they want to hold at the prevailing interest rate. As a
result, they start depositing extra money in banks or use it to buy bonds. The interest rate r then falls until people
are willing to hold all the extra money that the bank has created; this brings the money market to a new equilibrium.
The lower interest rate, in turn, has ramification for the goods market. A lower interest rate stimulates planned
investment, which increases planned expenditure E, production, and income Y.

CAPTER .6

BALANCE OF PAYMENT AND EXCHANGE RATE

Any economy is linked to the rest of the world through two broad channels: trade (in goods and
services) and finance. The trade linkage means that some of a country’s production is exported to
foreign countries, while some goods that are consumed or invested at home are produced abroad and
imported. There are also strong international links in the area of finance. The residents, whether
households, banks, or corporations, can hold the nations assets such as treasury bills or corporate
bonds, or they can hold assets in foreign countries say in Canada or in Germany. Most households, in
fact, hold almost exclusively assets, but that is certainly not true for banks and large corporations.

6.1.Balance of Payments
We know that international trade is important for every nation as nations are not self-sufficient in the
production of all the goods and services. Also the labours are not only working in their country but also
moving to other countries for their living. Governments of different countries participate in various
socio-economic programs. All these activities require transactions of resources from one country to
another; hence, it is important to record all these activities. Balance of payment exactly does the same
thing by recording all the transaction between the home country and the rest of the world.

6.1.1.Balance of Payments: Definitions and Concepts

We frequently hear that developing and less developed countries suffer from adverse balance of
payments (BOP). Persistent balance of payments (BOP) deficits have forced countries to implement
harsh policy measures such as currency devaluation, imposition of tariffs, exchange controls,
contractionary monetary and fiscal policies and so on. Even the developed countries have been no
exception to this tendency. Policies like import substitution and export promotion to achieve external
balance (or balance of payments equilibrium) have led to serious problems of growth and trade for the
countries of the world.

The balance of payment (BOP) of any country is ‘a systematic record of all economic transactions
between the residents of a given country and of the residents of the rest of the world in an accounting
period (normally one year)’. Despite the efforts by international organizations to secure uniformity of
classification and presentation, the BOP accounting format differs among different countries.

6.1.2.Accounting method and components of BOP

The BOP transactions include the all the foreign receipts of and payments by a country during a given
year. The receipts include all the earnings and borrowings of foreign exchange, and they are recorded as
credit items. The payments include all the spending and lending of foreign exchange, and they are
recorded as debit items. All the foreign receipts are financial inflows and all the foreign payments are
financial outflows in a year. In the purely accounting or bookkeeping sense the BOP must always
balance, because the BOP is a schedule of debit and credit transactions, which must necessarily be
equal. While the equality of debits and credits (i.e. accounting balance) is inevitable, it does not
necessarily follow that the BOP equilibrium is guaranteed. Accounting balance is consistent with BOP
disequilibrium i.e. deficits and surpluses exist in the BOP. The value of transaction and resources flowing
into a country and recorded as credit items can be different from values of transaction and resources
flowing out of the country and recorded as debit items. This depends on the country ’s economic and
political position in the world.

Major accounts of balance of payment

The BOP statements basically include the following six major accounts: Goods account, Services account,
unilateral transfers account, Long-term capital account, Short term capital account and International
liquidity account.

1.Goods account

Goods account includes the value of merchandise exports and the value of merchandise imports. They
may be final consumer goods, intermediate capital goods or raw materials. These items of foreign
exchange earnings and spending are called as ‘visible ’ items in the BOP. If the receipts from exports of
goods are equal to the payments for the imports of goods, we describe the situation as ‘goods balance ’.
Otherwise, there would be either a positive or a negative goods balance depending on whether we have
receipts exceeding payments (positive) or payments exceeding receipts (negative). Positive goods
balance is regarded as ‘favourable’ for a country and negative goods balance is regarded as
‘unfavourable’ since the country pays more than it receives.

2.Service account

The service account records all the services exported and imported by a country in a year. Services are
intangible or invisible. Accordingly, services transactions are regarded as ‘invisible ’ items in the BOP.
They are invisible in the sense that service receipts and payments are not recorded at the port of entry
or exit like merchandise imports and exports receipts. Except for this, there is no meaningful difference
between goods and services receipts and payments. Both constitute earnings or spending of foreign
exchange.

Goods account and service account together constitute the largest and economically the most
significant components in the BOP of any country. Favourable goods and services balance brings foreign
reserve into the country, where as unfavourable goods and services balance takes foreign reserve out of
the country.

3.Unilateral transfer account

This account includes all gifts, grants and reparation receipts and payments to foreign countries.
Unilateral transfer consists of two types of transfers: (a) government transfers and (b) private transfers.

Foreign economic aid or assistance and foreign military aids or assistances received by the home
country’s government (or given by the home government to foreign government) constitute
government to government transfers. The United States aid to Ethiopia, for example, is a government
transfer constituting a credit item in Ethiopia ’s BOP (but a debit item in the BOP of USA). These are
government to government donations or gifts. These flows depend on political and institutional factors
as the government donations (or aid or assistance) given to governments of other countries is due to
economic or political or humanitarian reasons. Private transfers, on the other hand, are funds received
from or remitted to foreign countries on person to person basis. An Ethiopian settled in the United
States, Canada, Australia or anywhere in the world outside Ethiopia remitting $100 a month to his aged
parents in Ethiopia, is a unilateral (private) transfer inflow item in the Ethiopian BOP.

4.Long-term capital account

Long term capital account includes the amount of capital that has moved into or out of the country in a
year. Any capital that has moved in or out of the country for a period of one year or more is regarded as
long-term capital movement. The long term capital account includes the following categories:

a.Private direct investment: these investments are done by the citizen’s and domestic firms of home
country in foreign countries (debit) and by foreigners or foreign firms in the home country (credit). This
type of capital movement is induced by differences in profit rate between the home country and the
rest of the world.
b.Private portfolio investment: these investments are done by home country citizens and firms in
foreign securities or stocks or bonds or shares (debit) and by foreigners in home country securities,
stocks, bonds, shares, etc. (credit). This type of movement in and out of a country is induced by
differences in interest rate, dividends or rate of return on capital between the home country ’s financial
assets and those of the foreign nations. In Ethiopia, this is hardly done as there is no stock market in
Ethiopia.
c.Government loans to foreign governments: these loans are given by home country’s government
(debit) and to the home government by foreign governments (credit). If the foreign multinational
corporations are investing heavily in our country, we receive capital inflow in the form of direct private
investment. It has a favourable effect on our bop. But when the foreign investors in our country start
repatriating profits to their home country, there will be a capital outflow from our country to foreign
countries. This goes into our service account as investment income outflow or capital service (debit).
Capital lending countries would experience deficits on long term capital account; and capital borrowing
countries, for instance, less developed countries (LDCs), experience surpluses in their long-term capital
account.

It is important to note that the long term capital account includes new capital flows into and out of the
country. The capital services item in the service account would include the amount of foreign receipts
and payments. It is, therefore, possible for a creditor nation that is investing heavily overseas to incur
debit or deficits in the long term capital account in the current year while at the same time running
capital service item credits or surpluses in service account of equal or even larger magnitude than
capital account outflows. A borrowing country, on the other hand, receiving credits at present and
therefore, enjoying surpluses on long term capital account must soon expect to lose a sizeable sum as
capital service obligations and, therefore, be ready to suffer deficits on service account. LDCs often
experience investment income outflows (capital service account debits) exceeding new long term capital
inflows. The United States, a mature creditor country, regularly earns more from its past investments
than it ‘loses’ in the form of new capital investment outflow. In this sense it is necessary to note that the
long term capital account bears a special relationship to one of the items (investment income item) in
the service account.

5.Short term capital account

Bank deposits and other short term payments and credit arrangements fall into this category. Short
term capital items fall due on demand or in less than one year, as opposed to long term capital flows
which have maturity after one year or thereafter. The vast majority of short term capital transactions
basically represent bank transfers to finance trade and commerce. It is interesting to note that when
Ethiopian exporters export coffee worth $5 million to an importer in Germany, it generates a credit of $5
million to the Ethiopian merchandise account, but if the Germany importer pays this sum of $5 million
into the bank account of the Ethiopian exporter held in Berlin bank, the sum of $5 million would be held
as a debit in Ethiopia’s short term capital account. The latter constitutes a short term capital out flow of
$5 million from Ethiopia to the Germany.

It is also interesting to note that it is often hard to keep track of all the short term capital movements in
and out of a country. They can at best be approximate estimates. Indeed in some countries the separate
category of short term capital account does not exist. These transactions are simply included in an
account under the general term ‘Errors and Omissions including short term capital account ’. In some
countries short term capital transactions are included in the ‘Unrecorded Transactions ’ as a separate
BOP account in its own right. This Unrecorded Transactions account or Errors and omissions account
include, besides short term capital movements, the following items as well.

a.Statistical and recording errors

b.Smuggling

c.Illegal and secret capital movements

d.Imperfect estimation procedures errors

All of these items, like short term capital movements are estimates and are treated as errors and
omissions in the BOP accounting. Often it represents a difference in the sums of recorded credit and
debit transactions in the first four accounts of BOP, namely goods account, service account, unilateral
transfers account and long term capital account. The fifth account in the BOP schedule may therefore be
called either as short term capital account or as errors and omissions including short term capital or
simply as unrecorded transactions account.

6.International Liquidity Account

The six and final BOP account is the international liquidity account which simply records net changes in
foreign reserves. Essentially this account lists internationally acceptable means of settling international
obligations. International liquidity account is best understood as follows:

Table 6.1: Balance of Payment account ($ millions)

Items A: surplus case B: deficit case
Credit Debit Credit Debit
Goods account 1,500 800 800 1,500
Services account 500 1,400 1,400 500
Unilateral transfers account 100 120 120 100
Long term capital account 900 400 400 900
Errors & omissions (including short 500 630 630 500
term capital) account
International liquidity account --- 150 150 ---
Balance of payment 3,500 3,500 3,500 3,500
In panel A of the table, the total receipts are $3,500 million and total payments are $3,350 million. There
is a net BOP surplus amounting to $150 million, which is entered into international liquidity account as
debit. The logic of accounting for this sum of $150 million as debit or payment is that, this sum
represents either:

a.Purchase or import of gold worth $150 million; or

b.Net addition to accumulation of foreign reserves of $150 million; or

c.Capital lending in the sum of $150 million to other countries on short term or long term basis.

The international liquidity account in this case represents the BOP surplus magnitude and only shows
how the BOP surplus is entered or accounted for in the balance sheet. A debit entry in the international
liquidity account shows that there is a surplus in the BOP of the country for that year.

Panel B has the exact opposite picture. The sum of debit (payments) ($3,500 million) exceeds the sum of
credit (receipts) ($3,350 million) by $150 million which represents the net deficit in the BOP due to the
first five accounts in the table. The question one can ask here is how was is deficit of $150 million
financed? The answer is that it will be financed in one of the following three ways:
a.Selling or exporting gold worth $150 million; or

b.Drawing down upon the past accumulated foreign reserves equal to the sum of $150 million; or

c.Borrowing capital in the sum of $150 million on short term or long term basis from friendly countries
or international institutions such as the international monetary fund.

The international liquidity account in this case, then, represents the BOP deficit sum of $150 million. This
amount is entered as credit item to indicate how the sum of $150 million was brought into finance the
deficit of that magnitude arising out of the first five accounts in the BOP schedule. A credit entry in the
international liquidity account shows, therefore, that the country had a deficit in its BOP of that
magnitude in that particular year.

Let us take a look at the following sample of BOP schedule using some hypothetical numbers in each of
the six accounts. In table 6.2 below, the six accounts are numbered from 1 to 6, whereas the major BOP
concepts are serialized as A, B, C, D, E and F.

Table 6.2: Balance of payments schedule-a sample

Major accounts Credit Debit Net surplus (+)

(Receipts) (payments) or deficit (-)

Goods account 200 180 +20

Service account 100 250 -150

Balance of trade (1+2) (300) (430) (-130)

Unilateral transfers account 300 120 +180

Balance of payments on current account (600) (550) (+50)

(1+2+3)
Long term capital account 150 120 +30

Basic balance (1+2+3+4) (750) (670) (+80)

Short term capital account 50 40 +10

Balance of payments on capital account (4+5) (200) (160) (+40)

Overall balance of payments (B+D) (800) (710) (+90)

 International liquidity account /net changes in 90
external reserves
Balance of payments accounting balance (800) (800) (0)

A.Balance of trade
Balance of trade may be defined as the difference between the value of goods and services sold to
foreigners by the residents and firms of the home country and the value of goods and services
purchased by them from foreigners. In other words, the difference between the value of goods and
services exported and imported by a country is the measure of balance of trade. If the two sums are
exactly equal to each other, we say that there is balance of trade equilibrium or balance; if the former
exceeds the latter, we say that there is balance of trade surplus; and if the latter exceeds the former,
then we describe the situation as one of balance of trade deficit. Surplus is regarded as favourable and
deficit as unfavourable. In table 6.2 above, there is a balance of trade deficit equal to $130 million.

B.Balance of payments on current account

Balance of payments on current account includes the sum of three balances viz. merchandise balance,
service balance and unilateral transfers balance. In other words, it comprises trade balance (in Meade ’s
sense) and transfers balance. In table 6.2 above, the positive unilateral transfers balance of $180 million
is added on to the negative trade balance of $130 million which will give us a current account BOP
surplus of $50 million.
Balance of payments on current account is also referred to as Net Foreign Investment because the sum
represents the contribution of foreign trade to GNP. It is also worth remembering that BOP on current
account covers all the receipts on account of earnings (or opposed to borrowings) and all the payments
arising out of spending (as opposed to lending). There is no reverse flow entailed in the BOP current
account transactions. This is in sharp contrast to the balance of payments on capital account.

C.Balance of payments of capital account

For a long time, economists had assumed that factors of production do not move across international
boundaries. The classical economists build models of trade assuming that only goods and services move
across international boundaries. Perhaps, for this reason, we do not have a well developed theory of
international capital movement. International capital movements in and out of countries are a fact of
life and very much a reality in today’s world with many multinational banks, multinational corporations
with their global operations, inter-governmental aid, grants and loans and international institutional
arrangements for borrowing and lending of money between the countries.

All transactions involving inward or outward movement of capital and investment (be it long term or
short term, direct or portfolio, private or government, individual or institutional, tied or untied, interest
bearing or non-interest bearing, soft or hard) are included in the capital account of BOP of the reporting
country. In simple terms, the BOP capital account comprises the long-term and short term capital
accounts.

Less developed countries (LDCs) are usually net borrowers of foreign capital and recipients of foreign
investment, and to that extent they would ‘enjoy ’ favourable BOP trends. This is undoubtedly true. But
sooner or later this foreign capital and investment will leave the LDCs and go back. Whether they do or
do not go back to their home country, what is most certainly true is that the returns on that capital and
investment in the form of profits, interest, dividends and royalties would be repatriated from the ‘host ’
countries to the ‘home’ countries, in this case from LDCs to developed countries (DCs).

However, the significance of the balance of payment (BOP) deficits and surpluses arising out of
transactions in capital account can, therefore, be seen only with a time perspective and future
perspective clearly in mind. Only then, can the significance of capital account in the BOP be fully
understood.

BD.asic balance
Basic balance in the BOP comprises the BOP on current account plus long term capital account. The
short term capital account balance is not included in the basic balance for two main reasons:

A.Short term capital movements, unlike long term capital flows, are relatively volatile and
unpredictable. They move in and out of a country in a period of less than a year or even sooner than
that. It would, therefore, be improper to treat short term capital movements on the same footing as
current account BOP transactions which are extremely durable in nature. Long term capital flows are
relatively more durable and, therefore, they qualify to be treated alongside the current account
transactions to constitute basic balance.

B.In many cases, countries do not have a separate short term capital account for reasons discussed
earlier in this chapter; in these countries, short term capital transactions constitute a part of the
‘errors and omissions account’. Hence, the justification in excluding short term capital flows from the
definition of ‘basic balance’.

E.Overall balance of payment

This is the sum of balance on current account and on capital account put together. It includes all
international monetary transactions of the reporting country vis-a-vis the rest of the world. It is highly
aggregative, and like any other highly aggregated variables, the concept (or the sum entered as credit
and debit under this item) cannot be of much significance. Because, the aggregate credit and debit
figures do not reveal the behaviour of change of the components which constitute the aggregate. Take,
for instance, the question of surplus and deficit. Can we say that a surplus in overall balance of
payments is a good sign or a deficit in the overall balance of payments is a bad sign? We cannot give
sensible answers to these questions simply by reading the entries in the credit and debit columns of the
overall BOP row. We must not only know the extent of BOP overall surplus or deficit but also the
location of those surpluses or deficits. The answers can then be given something like these:

a.If the overall surplus in the BOP was caused by current account surplus but not capital account surplus,
then the surplus may be a good sign for the country.

b.If the overall deficit in the BOP was caused by current account deficits rather than capital account
deficits, then the deficit may be considered as a bad sign for the reporting country.

In other words, if there is an overall surplus, we will have to first locate whether the surplus originated
in current account or capital account or both. The same will have to be done in case of a deficit in the
overall BOP. Therefore, the overall BOP figures by itself, whether they indicate a surplus or a deficit, do
not reveal the real situation. For this reason, not much economic significance can be attached to the
overall BOP concept. The current and capital account breakdown is very useful and are given more
weight.

6.1.3.Balance of payments settlement and adjustment

Suppose, we have a deficit (or surplus) in the current and capital account of our country ’s BOP, then we
can ‘settle’ this deficit (or surplus) arising out of imbalance in the autonomous transactions by
accommodating payments (or accommodating receipts in case of a surplus) so as to produce a BOP
balance in the accounting sense. In this case, therefore, what we have undertaken is a process of BOP
settlement. We have, in this case, merely and temporarily overcome the BOP problem with the help of
necessary accommodating transactions.

If, on the other hand, we control the deficit (or surplus) by controlling the forces which were causing this
deficit (or surplus) then we have undertaken what may be called as BOP adjustment. BOP adjustment is
said to have taken place only when we have produced ‘balance ’ in autonomous transactions i.e. when
autonomous credit receipts are equal to autonomous debit payments. In brief, when accounting balance
is produced with the help of accommodating transactions there is said to be BOP settlement; and when
this balance is produced without the help of accommodating transactions, there is said to be BOP
adjustment. Adjustment is more desirable and more difficult than settlement.
6.1.4.Full Employment Equilibrium or True Balance
When the sum of accommodating transactions is zero, there is ‘equilibrium ’ in the balance of payments
(as well as a ‘balance’ in BOP). It is, however, possible that such ‘equilibrium’ has been produced by:

a.Imposing trade and payment restrictions such as import tariffs, import quotas, export duties,
restrictions on foreign travel exchange controls, exchange rate support policies and other monetary and
fiscal policy applications; and

B.By causing internal imbalance i.e. by causing inflation, or unemployment in the economy. If the BOP
‘equilibrium’ is produced by causing (a) or (b) or both, then it is not to be considered as ‘true ’ balance or
‘full employment’ equilibrium.

6.1.5.Balance of Payments and Economic Policy

Different countries use different national accounting systems. This is reflected also in the construction of
balance of payments. There is agreement on the broad features, but differences in detail do exist. Our
aim is to understand how basic questions of economic analysis and policy can be explained by the use of
BOP statistics and to know what factors one has to take into account to be able to interpret a country ’s
BOP situation in any meaningful sense.

Having understood the sense in which the BOP is always in ‘balance ’ and the sense in which the BOP
might be in ‘disequilibrium’ one can talk about suggested economic policy in relation to a given BOP
situation of a country. For example, if a country has a deficit and an accommodating capital inflow, it
must in general try to implement policy measures aimed at reducing the deficit; but a country with a
surplus in its BOP and an accommodating capital outflow need not take immediate measures. It is
believed that surpluses do not usually create great problems, so we are not especially concerned with
surplus countries. For economic policy purposes, one is especially concerned with BOP problems of
deficit countries.

To understand the nature of a deficit, one has to judge it against the background of the general
economic policy of a country and the policy options the country has at its disposal. If a country is already
pursuing a tight monetary and fiscal policy and has tariffs and import controls, but yet it has a serious
deficit, it may be very difficult for such a country to get rid of a deficit. We can then talk about actual and
potential deficits. The actual deficit which has appeared on the surface is in that case, much smaller than
the potential deficit that could have surfaced but has indeed been suppressed by tight domestic and
foreign trade economic policies of the country. The possibility or scope of pursuing a more restrictive
policy to close the actual deficit may no longer exist for a country, because it already has reached its
upper limit.
Furthermore, if the economy is already experiencing politically unacceptable levels of high
unemployment, it will be almost impossible to try to cut down BOP deficits by pursuing still
contractionary monetary, fiscal and other policies. In such tight situations only international capital
flows can play a vital role in equilibrating the BOP. Once again the nature of capital flows is very crucial.
We have already said that accommodating capital inflows, especially, if they are continued over several
years, are a sure warning signal. It is left to the ingenuity of the country ’ planers and policy makers to
adopt ways and means of converting accommodating capital imports of short-term nature into planned
long term autonomous capital imports. If that can be done, the country need not change its economic
policy. It can proceed without having to worry about the BOP situation for the next 15-20 years.

6.2.Exchange Rate
The application of national currency is limited to the geographic boundaries of the country under
consideration. For instance, Ethiopian Birr is not acceptable if we move out from Ethiopia because it is
not internationally accepted currency. But at the same time Ethiopia is actively participating in imports
and exports. So, it is necessary for Ethiopia to establish a price for its currency in terms of other
internationally accepted currencies. The price of Ethiopian currency in terms of foreign currencies is
known as exchange rate.

6.2.1.Definition and Exchange Rate Determination

Any nation around the world uses many products produced by some other countries since no country is
efficient enough in producing all the goods and services of its own. This is the primary reason for
international trade and the purchase of foreign product is made with the use of foreign currencies. This
means, in order to make international trade possible we need to use or employ the currencies which are
internationally accepted. Some of these currencies are US dollar, Pound of UK, European Euro, Japanese
Yen and so on. For other user nations, these currencies are known as foreign currencies or foreign
exchange.

In order to convert domestic currency to foreign currency there must be a price established between the
two currencies. The price or foreign exchange rate can be defined as the amount of domestic currency
(let’s say Birr) that must be paid per unit of foreign currency (may be US$).

There are two major exchange rate policies. These are fixed exchange rate regime and floating or
flexible exchange rate regime. There are also different theories that explain how this price or exchange
rate is determined.
Sometimes a type of exchange rate policy which lies between the two extreme conditions is followed by
nations. This exchange rate policy is partly free/flexible and partly fixed. This type of exchange rate
policy is known as dirty exchange rate regime.

6.2.1.1.Fixed Exchange rate Policy/Regime

Fixed exchange rate policy is followed by a number of countries around the world. During the Imperial
period (Hailesilassie government) and during the Derg period, Ethiopia had been one of these countries
who followed fixed exchange rate regime. During those periods Ethiopian exchange rate defined in
terms of United States (US) Dollar was 2.07 Birr (2.07 Birr per one United States (US) Dollar). The
determinant or the determination of the level of exchange rate is made based on the government
political and economic decisions.

There are several reasons why nations follow fixed exchange rate policy. The major reason is to protect
the value or the strength of their currency in the foreign market. These countries are those countries
which are weak in the international trade. Their export capacity is very low and this implies that their
foreign exchange earnings are low. This means again that the capacity of the country to finance the
necessary import (for the government and the public) is very low. Thus, the necessary foreign exchange
will be obtained through purchases of the foreign currency with the domestic currency. In this regard it
is helpful if the foreign currency price (exchange rate) is kept or fixed at low level. Otherwise, the
demand for the domestic currency by the international community decrease as the export supply of the
country to them is limited. This limited demand of the domestic currency again leads to a decline in the
value of the currency given by higher exchange rate (domestic currency per foreign currency) known as
exchange rate depreciation. Thus, these countries in most cases try to keep their exchange rate fixed.

It is important to note that in the countries which follow fixed exchange rate regime, there are specific
groups of individuals, firms and institutions who are officially allowed to get foreign exchange being in
the country. This means that other people and institutions cannot get foreign exchange or foreign
currencies from official financial institutions such as commercial banks. In this case such demand for the
foreign currencies and supply of foreign currencies may be exchanged in the black market (parallel
market) transactions.
Black market represents the act of transactions by individuals at home or private centers devoid of the
government acknowledgement or license. These people supply or provide the foreign currency that they
personally access from relatives, individuals and small entities involved in similar activities. The
exchange rate in the black market is different from the official one and is normally floating. Since the
exchange market does not clear under fixed exchange rate policy, the differences (excess or deficit) in
the demand for and supply of the foreign exchange are usually managed or filled by the supply and
demand in the parallel market.
6.2.1.2.Floating or Flexible Exchange Rate Regime
Floating or flexible exchange rate policy is the case where the price of the foreign currencies in terms of
domestic currency (domestic currency per foreign currency) is left for the market factors to determine.
Depending on the level and intensity of the determinant factors, the value of the exchange rate is
allowed or left free to change or float. Several theories of exchange rate determination are categorized
under this type of exchange rate policy. This is because, there are different factors emphasized by
different theories as determinants of the level of exchange rate.

According to Purchasing Power Parity theory, first coined by Gustav Chassell, the exchange rate is
determined by the relative purchasing powers of the two currencies reflecting parity between them. For
instance, if the price of a product is 2 birr in Ethiopia and the price of the same product is 20 cents in
USA then the exchange rate between two currencies is (2Birr=20US cents) or (1 US$ = 10 Birr). In this
way it is difficult to find the exchange rate as there are thousands of products produced by these two
countries and which standard products to take is very difficult to find. In other words, this is a very
simplistic to explain the forces that determines exchange rate.

According to the demand and supply theory, the level of exchange rate is determined or explained by
demand for and supply of the domestic currency and/or foreign exchange or currency. The demand for
foreign exchange can be explained by the fact that nations need foreign currency to buy foreign goods
and services, to make unilateral transfers to individuals or firms outside the country, to save their
money or make deposits in foreign banks and to make long and short term loans to foreign residents,
firms or governments and so on. The supply of foreign exchange means the earnings of foreign
currencies from exports of various goods and services, receiving unilateral transfer payments from
abroad, short term and long term capital imports or inflows in the form of foreign direct investment or
foreign deposits made in the country, borrowing from abroad, aids received from abroad, and so on.
Note that all these components of supply of foreign exchange are recorded in credit transactions of the
current and capital account of the balance of payment schedule.

However, it is also important to note that supply of foreign exchange may not be always be equal to the
demand for foreign exchange. The reason is that components of supply and demand are made of
entirely different components. But in case if demand for foreign exchange and supply of foreign
exchange are equal then we say that there is balance of payment equilibrium and the exchange rate
determined by demand for and supply of foreign exchange at this point is known as equilibrium foreign
exchange rate. In figure 6.1, one can see that the supply and the demand curves intersect at point ‘e ’
representing equilibrium exchange rate given by ‘ER e’ where demand for foreign exchange is exactly
equal to the supply of foreign exchange. This exchange rate is also known as market clearing foreign
exchange rate.

Figure 6.1: Exchange rate determination under floating exchange rate regime

All other exchange rates are not market clearing ones. For instance, in the figure below, when exchange
rate is at ‘ER1’ the supply of the foreign exchange (FE2)exceeds the demand for the foreign exchange
(FE1); i.e. FE2> FE1. Under this situation, if exchange rate is free to adjust or left floating, then the
exchange rate will fall down until it reaches the equilibrium. This is because the suppliers of the foreign
currency will be ready to sell their foreign exchange at lower price (exchange rate) so that they will get
rid of the excess supply which they possibly make to get the domestic currency. For instance, if several
tourist visitors come to a country with their foreign currency, it means higher supply of the foreign
exchange for the country and at the same time these visitors would be ready to receive less domestic
currency per their own country currency (foreign currency).

On the other hand, if exchange rate is at ‘ER 2’, there will be an excess demand of foreign exchange (FE 2)
over supply of the foreign exchange (FE 1). Under flexible or floating exchange rate policy/regime, the
price of the foreign exchange (exchange rate) increases till it reaches the equilibrium. This is because the
individuals or entities with excess demand for the foreign exchange would be ready to pay more
domestic currencies to get a unit of the limited foreign currency.

6.2.2.Exchange Rate Fluctuations and External Balances

Different terms are used to explain fluctuations in the exchange rate under different exchange rate
policies. Under floating exchange rate regime, exchange rate itself adjusts downward or upward
depending on the demand for and supply of foreign exchange. If the demand for the foreign currency is
in excess of its supply at the prevailing exchange rate, then there will be upward pressure on the
exchange rate as the demanders will be ready to pay more of the domestic currency to get limited
foreign currency. Thus, exchange rate increase and continue to increase until the equilibrium is reached.
Such an increase in the exchange rate due to the market forces is known as depreciation of the
domestic currency. The value of the domestic currency relative to the foreign currency is reduced. The
change in the opposite direction (a decrease in the exchange rate) owing to market forces such as an
excess supply of foreign currency over its demand is known as appreciation of domestic currency. The
value of the domestic currency relative to the foreign currency is increased in this situation. In general,
an increase in demand for a currency relative to its supply leads to appreciation (an increase in relative
value) of the currency; whereas a decrease in demand for a currency relative to its supply leads to
depreciation (a decrease in relative value) of the currency. Similarly, an increase in supply of a currency
relative to its demand leads to depreciation (a decrease in relative value) of the currency; whereas a
decrease in supply of a currency relative to its demand leads to appreciation (an increase in relative
value) of the currency.

If official exchange rate is increased through political or economic decision of the government of a
country which follows a fixed exchange rate policy, such a change is known as devaluation of domestic
currency. In this case the value of the domestic currency relative to the foreign currency is reduced. If an
opposite change is made (exchange rate, domestic currency per foreign currency, is reduced) by the
government decision, this change is known as revaluation of domestic currency. In this case, the value
of the domestic currency relative to the foreign currency is increased.

Devaluation is often recommended by several economic policy makers and international institutions as a
solution for the problem of deficit in the current account balance and/or deficit in the overall balance of
payment for several developing countries around the world. This means that devaluation improves the
current account balance and/or the overall balance of payment whether the initial balance is negative
(deficit) or positive (surplus). The improvement mechanism is explained as follows.

Devaluation and depreciation have the impacts of improving the external balances by making export of
the country cheaper and by making import by the country costly. But, on the contrary, revaluation of a
domestic currency and exchange rate appreciation have the impacts of deteriorating the external
balances by making export of the country more costly and by making import by the country or its
citizens cheaper than before.
Suppose that Ethiopian birr is pegged with US Dollar and the initial exchange rate of two Birr per one
US$ is devalued and the exchange rate is changed to eight Birr per one US$. Then, one can easily see
that now for Ethiopians foreign goods and services are more costly than before the devaluation and
Ethiopians are expected to spend less on foreign goods and services (reducing import). This is because
to import or to purchase a foreign commodity of 10 US$ value, Ethiopians have to pay 80 Birr after
devaluation as opposed to only 20 US$ they use to pay before the devaluation. But, for the foreigners
the Ethiopian goods and services become less costly than before devaluation and they are expected to
purchase Ethiopian goods and services more than before. This is simply because they can get larger
amount of Birr for less number of their currency to purchase Ethiopian products (mainly export and so
increasing export).

However, whether a country will gain or not due to devaluation depends on the responsiveness or
elasticity of imports and exports given by Marshall Lerner conditions. The Marshall Lerner condition
(MLC) is given by the following identity.

Where, d(CA)= change in current account balance M=import value

de=change in exchange rate (devaluation), ŋx=export elasticity; ŋm=import elasticity

The detail of the derivation of the identity is covered in the previous unit.

The success of devaluation policy in improving the external balance depends upon the sum of elasticity
of import demand and elasticity of export supply of the country. Thus, there are three different possible
outcome of devaluation given as follows.

a.If the sum of elasticity of demand for imports and elasticity of supply of exports is greater than one,
(ŋx + ŋm> 1), then devaluation would improve trade balance and so the overall balance of payment.

B. If the sum of elasticity of demand for imports and elasticity of supply of exports is equal to one
(ŋx+ŋm= 1), then with devaluation, trade balance or overall balance of payment remains unchanged.

C.If the sum of elasticity of demand for imports and elasticity of supply of exports is less than one,
(ŋx+ŋm< 1), then devaluation would worsen a problem of trade balance and so that of overall
balance of payment.

In developing and underdeveloped countries the sum of elasticity of demand for imports and elasticity
of supply of exports is normally less than one, (ŋx + ŋm< 1). This is for the reason that developing
countries composition of imports is highly inelastic items such as petroleum and capital intensive goods
which have no substitutes in less developed countries. Whatever may be the price they have to pay for
the import, a fixed or a closer quantity should be imported for continuations of domestic production and
other crucial social and economic activities. This implies that the amount of the resource that has to be
paid to foreigners will be even higher and this in turn leads to deterioration of the external balance. On
the other hand, the exports are basically primary goods which require long time (may be years) to
expand their production and have less demand in the international market. Even if expected gain in the
export may be positive, this positive gain is taken by higher import expenditure and hence the net gain
from devaluation would be deterioration of the external balance.

CHAPTER 7. GRWOTH MODEL

7.1. Meaning of Economic Growth

Economic development is a process that generates economic and social, quantitative and, particularly, qualitative
changes, which causes the national economy to cumulatively and durably increase its real national product.

In contrast and compared to development, economic growth is, in a limited sense, an increase of the national income
per capita, and it involves the analysis, especially in quantitative terms, of this process, with a focus on the
functional relations between the endogenous variables; in a wider sense, it
involves the increase of the GDP, GNP and NI, therefore of the national wealth, including the production capacity,
expressed in both absolute and relative size, per capita, encompassing also the structural modifications of economy.

We could therefore estimate that economic growth is the process of increasing the sizes of national economies, the
macro-economic indications, especially the GDP per capita, in an ascendant but not necessarily linear direction, with
positive effects on the economic-social sector, while development shows us how growth impacts on the society by
increasing the stlife. Typologically, in one sense and in the other, economic growth can be: positive, zero, negative.
Positive economic growth is recorded when the annual average rhythms of the macro-indicators are higher
than the average rhythms of growth of the population. When the annual average rhythms of growth of the macro-
economic indicators, particularly GDP, are equal to those of the population growth, we can speak of zero economic
growth. Negative economic growth appears when the rhythms of population growth are higher than those of the
macro-economic indicators. Economic growth is a complex, long-run phenomenon, subjected to constraints like:
excessive rise of population, limited resources, inadequate infrastructure, inefficient utilization of resources,
excessive governmental intervention, institutional and cultural models that make the increase difficult, etc.
Economic growth is obtained by an efficient use of the available resources and by increasing the capacity of
production of a country. It facilitates the redistribution of incomes between population and society. The cumulative
effects, the small differences of the increase rates, become big for periods of one decade or more. It is easier to
redistribute the income in a dynamic, growing society, than in a static one.

7.1.1. Some Facts about Economic Growth

A. Output Growth, Factor Input, and Production
Fact #1. Output per worker (or average labor productivity) tends to grow over time, albeit wide differences across
countries.
Fact#2. The rate of growth of factors of inputs (capital and labor) does not fully account for the rate of growth of
output-there are also other factors explaining growth.
Fact#3. The mean growth rate of output is unrelated to the initial of per capita income across countries- (example;
some Asian countries are growing faster than most high income industrialized countries).
Fact#4. Population growth rates are negatively related with both the level and the rate of growth of income per
capita across countries- (Example; Sub-Saharan Africa).
B). Saving, Investment, and Growth
Fact#5. Saving rates are positively related to the level and the growth rate of income per capita-saving rates are
higher in high income and fast growing countries than low income countries.
Fact#6. Both the rate of growth of investment and the share of investment in output are positively related to the rate
of growth of income per capita.
C). Poverty and Growth
Fact#7. Durable reductions in poverty rates require maintain sustained rates of economic growth over time.

7.2. Theories of Economic Growth

As we have noted in the introduction part of this unit, generally, we see vast differences in standards of living
overtime. The world is much richer today than it was 100 years ago or even 60 years ago. In other words, the
differences are the results of historical differences in countries’ growth records: some countries had been growing
faster than others (e.g. Asian Tigers); while others have difficulty simply in obtaining positive growth rates (South
America and Sub-Saharan Africa). For instance, the real GDP of the US today is more than three times its 1950
level, and real GDP per person is more than twice its 1950 level. This implication of these differences in the real
income means large differences in: well-being (nutrition, literacy, infant mortality, life expectancy, and other),
socio-economic and political dependence and vulnerability to socio-economic shocks. Therefore, our goal in this
unit is to understand and explain what causes the difference in the level of real per capita income and the rate of
growth of real per capita income across countries and overtime. Thus, in order to answer these temporal and spatial
differences, which are also called the central questions of economic growth theory.

7.2.1. Harrod-Domar Model of Economic Growth

Rostow's stages of growth can be seen as the precursor of the Harrod-Domer model. According to Rostow's theory
there are five stages of development which are:

1. The traditional society

2. Preconditions for takeoff

3. Takeoff

4. The drive to maturity

5. The age of high mass-consumption

It is the take off stage where Rostow predicted that the rate of savings and investment would rise from 5% of the
national income to 10%. Hence, this is the stage an economy will take off to the path of high growth. But Rostow
did not have a proper theory identifying the path leading to take off. Thus, based on the Rostow take off stage, the
Harrod-Domar model was developed independently by Sir Roy Harrod in 1939 and Evsey Domar in 1946. This time
was remembered by when industrialized countries being plunged into deep recessions, with a high unemployment
rate and a sharp decline of gross domestic product hence, both authors developed their models independently, but
the assumptions and results are, nevertheless, basically the same. The dominating perspective was the linear-stages
approach to development according to which all countries have to pass the same stages as the rich countries in
Europe. These were made explicit in Rostow’s stages-of-growth model, where all societies starts as traditional
agrarian economies that find a development strategy for a “takeoff” into self-sustaining growth.

It is a growth model which states the that the rate of growth of GDP is determined by the savings ratio (the
marginal propensity to save) in the economy and the capital output ratio (the amount that has to be spent on capital
to produce £1 worth of national output e.g. if the ratio was 3:1, £3 would have to be spent on capital to produce £1
of output). If there is a high level of saving in a country, it provides funds for firms to borrow and invest.
Investment can increase the capital stock of an economy and generate economic growth through the increase in
production of goods and services. The capital output ratio measures the productivity of the investment that takes
place. If capital output ratio decreases the economy will be more productive, so higher amounts of output is
generated from fewer inputs. This again, leads to higher economic growth.
Rate of growth (Y) = Savings (s)/ capital output ratio (k).
The model suggests that the economic rate of growth depends on the level of savings, and the productivity of
investment (i.e. in order to grow, economies must save and invest a certain portion of their GDP).

In these theories increased domestic saving in combination with transfers of capital from the rich countries
either privately or as foreign aid to accelerate investments was considered as an important condition for
“takeoff” and regular growth. Thus, today many governments in developing countries base their development
policies on an aggregate growth model inspired by the Harrod-Domar growth model.

The logic behind using this model is that capital formation is the main obstacle to development. Labor is excluded as
this factor has been considered as abundant in developing countries. It is a difference with regard to innovation and
technological change which is a scarce factor in most poor countries in Africa. This factor can be incorporated into
the Harrod-Domar model as a reduction in k over time. That is, as time passes, less savings and investments are
needed to produce a given income.

Assumptions

 In this model production function is the fixed coefficient production function meaning that the capital-
output ratio is a constant.
K
v
Y where v is constant and we can write as:
K
v
Y
K K
 Y and Y
From the relationships v v we can derive that
Y K v K
g  x 
Y v K K
This means that the rate of growth of output is exactly equal to the rate of growth of capital. Example of the use of
formula: Assume that a LDC’s national capital-output ratio is 3, and that aggregate saving ration is 6% of GDP, then
the growth rate of the LDC is 2% per year: ΔY/Y = 6%/ 3, ΔY/Y = 2%. If the national saving increase from 6% to
15%, then GDP can increase from 2% to 5%: ΔY/Y = 15%/ 3, ΔY/Y = 5%

Limitations of H-D Model

 Increasing the savings ratio in developing countries is not always easy. The majority of developing
countries have low marginal propensities to save. Extra income gained is often spent on new assets rather
than saved.
 Many developing countries lack a sound financial system. Increased saving by households does not
necessarily mean there will be greater funds available for firms to borrow to invest. (Institutional factors)
 Efficiency (improving capital/output ratio) gains are difficult to achieve in developing countries often due
to a poorly educated work force. New capital is often inefficiently used by labour.
 Research and Development needed to improve the capital/output ratio is often underfunded in developing
countries.

7.2.2. The Solow Growth Model

 The Solow growth model was developed in 1950s by Prof. Robert Solow MIT who awarded for Noble
prize
 According to Solow economic growth is initially rapid but slows down from period to period and reaches
the steady states where the economy stops growing.
 The assumptions of constant return to scale (CRS) showing capital accumulation alone cannot be guarantee
for sustained economic growth unless there would be continuous stream of technological improvements.
Because investment shrinks from one period to the next until the economy reaches the steady state.
 Thus, continuous stream of technological improvements is necessary to sustained growth assuming saving
equals to investment i.e. S = I.
 Eventually, the dynamic model of Solow showed saving, population growth and technological progress
affects the level of an economy’s output and its growth over time.
7.2.2.1. Model of Capital Accumulation
 The Solow growth model shows how growth in the capital stock, growth in labor force, and advances in
technology interact in the economy, and how they affect nation’s output. For this analysis let’s see first step to
examine how the supply and demand for goods determines the accumulation of capital.
 To do this, we hold the labor force and technology fixed.
 Later we relax these assumptions, first by introducing changes in the labor force and then by introducing
changes in technology.

7.2.2.1.1. The Supply and Demand for Goods

The supply and demand for goods plays a central role in the Solow model, just as it did in a static model of the
economy. In a static analysis, the supply of goods determines how much output is produced at any given point in
time, and the demand determines how this output is allocated among alternatives uses.

A. The Supply of Goods and the Production Function

 The supply of goods in the Solow model is based on the familiar production function: i.e. Y = F (K , L) (output
depends on the capital stock and the labor force).
 The Solow growth model assumes that the production function has Constant Return to Scale in its two
arguments, capital and labor.
 Recall that a production function has constant returns to scale if
zY = F (zK , zL) (for any positive number z)
 To keep the analysis simple, we express all quantities relative to the size of the labor force.
 Production functions with constant returns to scale are convenient for this purpose because output per worker
depends only on the amount of capital per worker.
1
 To see that this is true, set z = L in the equation above to obtain:
Y K
 F ( ,1) Y K
L L This equation tells us output per worker L is a function of Capital per worker L.
 We use lowercase letters to denote quantities per worker:
Y
y is output per wor ker, and
 Thus, L
K
k is capital per wor ker .
L

 Therefore, we can write the production function y  f (k )

Where we define f (k )  F (k ,1) . This production function relates capital per worker to output per worker.

Output per worker Y y= f(k)

 MPK

0 Capital per worker k

Figure 6.2.1. Production Function

 The production function shows how the amount of capital per worker k determines the amount of output per
worker y = f(k).
 The slope of the production function is the Marginal Product of Capital: if k increases by 1 unit, y increases by
MPK units.
 This amount is the marginal product of capital MPK. Mathematically, we write
f ( K )
MPK = f(K + 1) – f(K) = K
 The production function becomes flatter as K increases, indicating diminishing marginal product.

B. The Demand for Goods and the Consumption Function

 The demand for goods in the Solow model comes from consumption and investment. In other words, output
per worker y is divided between consumption per worker c and investment per worker i.
y=c+i
 This equation is the National Income Identity accounts for the economy).
 It differs from the usual National Income Identity because it omits government purchases and net exports
(because assumes closed economy).
 The Solow model assumes that each year people save a fraction S of their income and consume a fraction of (1-
S). We can express this idea with a consumption function with the simple form
c = (1-S)y,
where S, the saving rate, is a number between 0 and 1. Rearranging the above equation we can obtain:
y = (1-S)y + i and;
i= sy

C. The Evolution of Capital and the Steady State

 Two forces cause the capital stock to change
 (1). Investment: The capital stock rises as firms buy new plants and equipments
  (2). Depreciation: The capital stock falls as some of the old capital wears out.
 To understand how the capital stock changes, we must understand the determinants of investment and
depreciation.
 (1). INVESTMNET: We noted previously that investment per worker is a fraction of output per worker (sy).
By substituting the production function for y, we can express investment per worker as a function of the capital

stock per worker i.e. i sf (k ) .

Output per worker Y f(k)

Sf(k)
c*= Consumption per worker

y*
i* = investment per worker

0 Capital per worker K

Figure 6.2.2. Output consumption & Investment

 In the above figure we can see that the saving rate S determines the allocation of output between consumption
and investment for every value of K.
 At any level of capital K, output is f(k), investment is sf(k), and consumption is:
c  f (k )  sf (k )
 The higher the level of capital K, the greater the levels of output f(k) and investment i.
 This equation incorporates both the production and consumption function and relates the existing stock of
capital K to the accumulation of new capital i.

 (2).DEPRECIATION: To incorporate depreciation into the model, we assume that a certain fraction  of the
capital stock wears out each year- we call  the depreciation rate.
  k- the amount of capital that depreciation each year.
 Depreciation is therefore proportional to the capital stock.

Depreciation ( k ) k
 1 K
Capital per worker
Figure 6.2.2.1. Depreciation
 We can express the impact of investment and depreciation on the capital stock with the following adjustments
equation:
Change in Capital Stock = Investment – Depreciation
K i  k ( the ∆K is the change in capital stock between one year and the next year).

D. The Steady State Level of Capital

 The higher the capital stock, the greater will be the amounts of output and investment, and also the greater will
be the amount of depreciation.
 The below figure shows that there is a single capital stock at which the amount of investment of investment
equals the amount of depreciation.

Investment & Depreciation k

sf(k)
k 2

I*= k
k1

K1 K* K2

Capital stock increases

Steady state level of capital per worker
Capital stock decreases
Figure 6.2.2.4. Investment, Depreciation & the steady state

 If the economy has the capital stock, the capital stock will not change over time because the two forces acting to
change it- investment and depreciation-just balance
 That is, at this level of the capital stock, ∆k =0
 We call this the STEADY STATE level of capital and designate it as K*.

 Since the saving rate s is constant and saving equals investment, the amount of investment is sf (k ) .

 Since capital depreciates at a constant rate  , the amount of depreciation is k .

 The steady state level of capital K* is the level at which investment equals depreciation; at K* the two curves
cross.
 Below K* investment exceeds depreciation, so the capital stock grows.
 Above K* investment is less than depreciation, so the capital stock shrinks.

E. Approaching the Steady State

 The steady state represents the long-run equilibrium of the economy.

 The economy ends up with the steady state level of capital, regardless of the level of capital with which it
begins.
 Suppose that the economy starts with less than the steady-state level of capital, such as level K1 in figure
above.
 In this case, the level of investment exceeds the amount of depreciation
 Over time, the capital stock will rise and will continue to rise-along with output-until it approaches the steady-
state K*.
 Similarly, suppose that the economy starts with more than the steady-state level of capital, such as level K2 . In
this case, investment is less than depreciation: Capital is wearing out faster than it is being replaced.
 The capital stock will fall, again approaching the steady-state.
 Once the capital stock reaches the steady-state, investment equals depreciation and the capital stock neither
increases nor decreases.
 Numerical Example;
1 1
Y K 2L 2

 To derive the per worker production function f (k ) and divide both sides of the production function by L.
1
Y K 2
 
 Rearranging to obtain: L L

y Y and k  K
 Since L L this becomes
1
y k 2
This equation can also be written as

y k
 Output per worker is equal to the square root of the amount of capital per worker.
 Now assume that:
 30% of output is saved (S= 0.03)
 About 10% of the capital stock depreciates every year

(  =0.1, and
 The economy starts off with 4 units of capital per worker (k= 4).

Thus, we can now examine what happens to this economy over time.
 Approaching the Steady State: A Numerical Example
Assumptions: y=√k; S= 0.3; δ=0.1; initial K = 4.0
Year K y c i Δk ∆k
1 4.000 2.000 1.400 0.600 0.400 0.200
2 4.200 2.049 1.435 0.615 0.420 0.195
3 4.395 2.096 1.467 0.629 0.440 0.189
4 4.584 2.141 1.499 0.642 0.458 0.184
5 4.768 2.184 1.529 0.655 0.477 0.178
10 5.602 2.367 1.657 0.710 0.560 0.150
25 7.321 2.706 1.894 0.812 0.732 0.080
100 8.962 2.994 2.096 0.898 0.896 0.002
.
∞ 9.000 3.000 2.100 0.900 0.900 0.000
 Following the progress of the economy for many years is one way to find the steady-state capital stock, but
there is another way that requires fewer calculations. Recall that
k  sf (k )  k .
 This equation shows how k evolves over time. Because the steady-state is (by definitions) the value of k at
which ∆K =0, we know that:
0  sf ( k *)  k *,

K* S

Or, equivalently, f ( K *) 
 This equation provides a way of finding the steady-state level of capital per-worker, K*. substituting in the
numbers and production function from our example, we obtain;
K* 0.3

K* 0.1 then now square both sides of this equation to find K* = 9. The steady state capital stock is
9 units per worker.

7.2.3. The Golden Rule Level of Capital

 We have examined the link between the rate of saving and the steady-state levels of capital and income
 Now we can discuss What amount of capital accumulation is optimal?
 Later, we describe how government policies influences a nations saving rate.
 But first, we present the theory behind these policy decisions.
 To keep our analysis simple, lets assume that a policymaker can set the saving rate at any level.
A. Comparing Steady State
 When choosing a steady state, the policymaker’s goal is to maximize the well-being of the individuals who
make up the society.
Individuals themselves do not care about the amount of capital in the economy, or even the amount of output
They care about the amount of goods and services they can consume. They care about Consumption level.
 Thus, a benevolent policymaker would want to choose the steady state with the highest level of consumption.
The steady state with the highest consumption is called the Golden Rule level of capital accumulation and is
denoted K*gold .
How can we tell whether an economy is at the Golden Rule Level?
To answer this question, we must determine steady-state consumption per worker.
Then we can see which steady state provides the most consumption
To find the steady state consumption per worker, we begin with the national income accounts identity
y= c + i
Rearranging c = y – i
 Since we want find steady-state consumption, we substitute steady-state values for output and investment

 Steady-state output per worker is f (k *) , where K* is the steady-state capital capital stock per worker.

 Substituting f (k *) for y and K * for i we can write steady-state consumption per worker as
c *  f (k *)  K *
 Steady-state consumption is the gap or difference between steady-state output and steady-state
depreciation.
 It shows that increased capital has two effects on steady-state consumption.
 It causes greater output, but more output must be used to replace depreciating capital.

Steady-state output & k *

Depreciation f (k *)

C* gold

K*gold K*
Steady state capital per worker
 This figure shows that there is only one level of the capital stock-the Golden Rule level K gold -that
maximizes consumption.

7.2.4. Population Growth

 The basic Solow model shows that capital accumulation by itself, cannot explain sustained economic growth.
 High rates of saving leads to a high growth rate, but the economy eventually approaches a steady state in
which capital and output are constant.
  Therefore, Solow model incorporates the other two sources of economic growth population growth and
technological progress.
 In this section we add population growth to the model
 Instead of assuming that the population is fixed as we did in the first part, we now suppose that the population
and the labor force grow at a constant rate n.
 For example, if the population growth rate is about 1% per year, so n=0.01
The steady state with Population Growth
 How does the population growth affect the steady state?
 To answer this question, we must discuss how population growth along with investment and depreciation,
influences the accumulation of capital per worker.
 As we noted before, investment raises the capital stock, and depreciation reduces it.
 But now there is a third force acting to change the amount of capital per worker, the growth in the number of
workers causes per worker to fall.

kK y Y
 We assume to let lowercases letter stand for quantities per.Thus L is capital per worker, and L
is output per worker. Keep in mind; however, that the number of workers is growing over time.
 The Change in the capital stock per-worker is:
K  i  (  n) K
 This equation shows how investment, depreciation, and population growth influence the per-worker capital
stock. Investment increases K, whereas depreciation and population growth decreases k. We save this
equation earlier chapter for the special case of a constant population (n=0).

 We can think the term (  +n)k as Break-even investment: The amount of investment necessary to keep the
capital stock per worker constant.

 Break-even investment includes the depreciation of existing capital, which equals  k. It also includes the
amount of investment necessary to provide new workers with capital. The amount of investment necessary
for this purpose is nk, because there are n new workers for each existing worker, and because K is the amount
of capital per worker.
 Our analysis with population growth now proceeds much as it did previously. First, we substitute
sf (k ) for i . The equation can then be written as:

 ∆K = sf ( k )  (  n) k .

Investment i & (  n) k Break-even

Break-even i Investment

sf (k ) investment
 K* Capital per worker

Figure 6.3. Population Growth in the Solow Growth Model

 In the steady state, the positive effect of investment on the capital stock per worker exactly balances the

negative effects of depreciation and population growth. That is K*, K  0 and i*  k *  nk * .

 Once the economy is in the steady state, investment has two purposes. Some of it ( K * ) replaces the
depreciated capital, and the rest (nK*) provides the new workers with the steady state amount of capital.

The Effect of Population on Growth

 Population growth alters the basic Solow model in three ways.

 1st it brings us closer to explaining sustained economic growth
 In the steady state with population growth, capital per worker and output per worker are unchanging.
 But because the number of workers is growing at rate n, total capital and total output are also growing at the
rate n.
 Hence, population growth cannot explain sustained growth in standards of living, because output per worker is
constant in the steady state. But population growth can explain sustained growth in total output
 2nd Population growth gives us another explanation for why some countries are rich and others are poor.
Consider the effects of an increase in population growth in the following figure. Below figure shows that an
increase in the rate of population from n1 to n2 reduces the steady-state level of capital per worker from K*1
to K*2. Because K* is lower, and because y*=f(k*), the level output per worker y* is also lower. Thus, the
Solow model predicts that countries with higher population growth will have lower levels of GDP per person.
 3rd , population growth affects our criterion for determining the Golden Rule (consumption maximizing) level
of capital. To see how this criterion changes, note that consumption per worker is: c= y-i

 Because steady-state output is f (k *) and steady-state investment is

(  n)k * . We can express steady-state consumption as:

c*  f (k *)  (  n)k *
Using an argument largely the same as before, we conclude that the level of K* that maximizes consumption is
the one at which;
MPK    n
Or equivalently, MPK    n
  In the Golden Rule Steady state the marginal product of capital net of depreciation equals the rate of
population growth.

Investment, i & (  n 2 )k

Break-even, i (  n1 )k

sf (k )  Invst

K*2 K*1

Figure 6.4. The Impact of Population Growth

 According to Solow Growth Model countries with high population have lower GDP. However, this conclusion is
not lost on policymakers.
 Those trying to pull the world’s poorest nations out of poverty, such as the advisers sent to developing nations by
the World Bank, often advocate reducing fertility by increasing education about birth-control methods and
expanding women’s job opportunities. Toward the same end, China has followed the totalitarian policy of
allowing only one Child per couple. These policies to reduce population growth should, if the Solow model is
right, raise income per person in the long run.

7.2.5. Technological Progress in the Solow Growth Model

 We now incorporate technological progress, the third source of economic growth, into the Solow model.
 So far, our model has assumed an unchanging relationship between the inputs of capital and labor and the
output of goods and services.
 Yet the model can be modified to allow for exogenous increases in society’s ability to produce.

A. The Efficiency of Labor

 To incorporate technological progress, we must return to the production function that relates total capital K
and total labor L to total output Y.
 Thus, the production function has been
Y = f(K, L).
 We now write the production function as
Y = F (K,L x E),
Where E is a new variable called the efficiency of labor
  The efficiency of labor reflects society’s knowledge about production methods: as the variable technology
improves, the efficiency of labor rises
 The efficiency of labor also rises if there are improvements in the health, education, or skills of the labor
force.
 The term L x E is the labor force measured in Efficiency Unit.
 It takes into account the number of workers L and the efficiency of each worker E.
 This new production function states that total output Y depends on the number of units of capital K and on
the number of efficiency units of labor L x E.
 The simplest assumption about technological progress is that it causes the efficiency of labor E to grow at
some constant rate g.
 For example, if g = 0.02, then each unit of labor becomes 2% more efficient each year: output increases as if
the labor force had increased by an additional 2%.
 This form of technological progress is called labor-augmenting, and g is called the rate of labor-augmenting
technological progress.
 Since the labor force L is growing at rate n, and the efficiency of each unit of labor E is growing at rate g, the
number of efficiency units of labor L x E is growing at rate n + g.

B. The Steady-state with Technological Progress

 Expressing technological progress as labor-augmenting makes it analogous to population growth.
 In the past section we analyzed the economy in terms of quantities per worker and allowed the number of
workers to rise over time.
 Now we examine the economy in terms of quantities per efficiency unit of labor and allow the number of
efficiency units to rise.
 To do this, we need to reconsider our notation. We now let:
K
k
LxE stands for capital per efficiency unit, and
Y
y
LxE stands for output per efficiency unit.

With these definitions, we can again write y  f (k )

 If we hold the efficiency of labor E constant at the arbitrary value of 1. Then these new definitions of k and y
reduces to our old ones.
 When the efficiency of labor is growing, however, we must keep in mind that K and y now refer to quantities
per efficiency unit of labor (not per worker).
 Our analysis of the economy proceeds just as it did when we examined population growth.
 The equation showing the evolution of k over time now changes to
k  sf (k )  (  n)k
  As before, the change in the capital stock ∆K equals investment sf (k ) minus break-even investment
K
k
(δ+n+g)k. Now, however, because L.E , break-even investment includes three terms: to keep K
constant, δk is needed to replace depreciating capital, nk is needed to provide capital for new workers, and
gk is needed to provide capital for the new “effective workers” created by technological progress.

Investment, i & (δ + n + g)k

Break-even, i sf (k ) -investment

K- Capital per worker

K*

Figure 6.4. Technological Progress & the Solow Growth Model

C. The Effects of Technological Progress

 The following table shows how four key variables behave in the steady state with technological progress.
 Capital per efficiency unit k is constant in the steady-state.
 Since y=f(k), output per efficiency unit is also constant. Remember, though, that the number of efficiency units
per worker is growing at rate g.
Y
 y.x E )
(
 Hence, output per worker L also grows at rate g.
 Total output ( Y = y x(E x L) ) grows at rate n + g
 Table 6.4. Steady-state Growth Rates with Technological Progress

Variables Symbol Steady-state

growth rate
Capital per Effective worker K 0
k
LxE
Output per effective worker Y 0
y  f (k )
LxE
Output per worker Y g
 y xE
L
Capital per worker K g
 k xE
L
Total output Y= y x (L x E) n+g

With the addition of technological progress, our model can finally explain the sustained increarse.