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2023/2024 A.Y Economics Lesson Note for Grade 11

UNIT 4
CONSUMPTION, SAVING AND INVESTMENT
The properties of MPC
1. MPC values lie between zero and 1. Zero means no change in consumption and 1 show
maximum (total) consumption of the new income.
2. MPC decreases with an increase in income. In other words, MPC of the poor is higher
than MPC of the rich. The poor people tend to consume a higher proportion of their
income relative the rich people.

Consumption Curve

Consumption curve illustration-1

• The consumption function is an increasing function of income. It is an upward-sloping
line. On the x-axis we measure the disposable income, and, on the y-axis, we measure the
level of consumption. We have assumed a constant MPC and hence, the consumption
function is a linear line.

Consumption curve illustration-2

• Consumption line does not pass through the origin. Its y-intercept is always positive
(given by C0) in the graph. The y-intercept is the amount of the autonomous
consumption.

1 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
Consumption curve illustration-3
• The slope of the consumption function is the MPC and the graph is drawn as flatter or
steeper liner depending on the magnitude of “c”. A steeper consumption function
represents a consumption function with higher MPC. Steep means ∆Y less than ∆C .A
flatter consumption function shows a smaller MPC. ∆Y greater than ∆C

Steeper Vs Flatter Curves

All of the following is true about a steeper consumption function

a) ∆C is greater than ∆Yd
b) ∆Yd is less than ∆C
c) MPC is relatively higher than flat curve
d) Poor people have a steeper consumption function curve
e) Rich people have a flat consumption function curve
f) Poor people tend to consume almost all of their Yd because they have small Yd
g) Rich people tend to consume a portion of their income and save some because
they have enough
Special attention
When disposable income changes MPC also changes causing a change in APC. The initial
source of change in the model is the change in disposable income. Consumption can be affected
through.
1. Change in MPC.
2. Change in disposable income
3. Change in the autonomous component
4.1.3 Determinants of Consumption Expenditure
The major determinants of consumption expenditure at individual and national levels are:
1. Money income: income is the primary determinant of consumption.
– An increase in income results in an increase of consumption expenditure. When
income decreases, consumption expenditure tends to decrease too.
2. Distribution of income: consumption expenditure per unit of income is more for poor
people than the rich people.

2 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
 3. Level of direct taxes:
– A higher level of direct taxes leads to a lower level of personal disposable
income, and thus to a decrease in consumption expenditure. This principle also
acts inversely.
4. Expectation about future income and prices:
– If prices and incomes are expected to rise in the future, present consumption will
increase. When people expect a fall in either income or prices, they tend to lower
current consumption.
5. Rate of interest:
– Increases in the rate of interest leads to a reduction of consumption expenditure
and an increase in saving. This is true because interest rate acts as cost of holding
money outside banks and financial institutions. This principle also acts inversely.
6. Level of wealth: A higher wealth level leads to higher consumption expenditure. This
principle also acts inversely.
4.2 Saving
 Savings is the difference between disposable income and consumption.
 The part of income which is not spent on consumption is called “savings”. Disposable
income can be used only for consumption or saving; that is, Yd= C + S .
 Hence, saving is the difference b/n income and consumption. People save what is left
after spending for consumption. S=Yd-C

Deriving the Saving function

Therefore,
S = Yd –C . …………………. Since C = Co + cYd, the saving function can be derived by
substituting the consumption function. Hence:
S = Yd – (Co + cY), distributing the minus sign, we have:
S = Yd −Co − cY, collecting the similar terms together
S = −Co + (1− c)Yd .
Note that the 0 −C is the amount of dis-saving associated with the autonomous consumption
discussed above. When people are consuming with zero income, they are either borrowing or
drawing on the wealth or previous savings.

Saving Versus Savings

Note that saving and savings are not the same. Saving refers to the act of depositing money while
savings refer to the already accumulated money. Saving is a flow concept (Continuous) while
savings is a stock (a point in time) concept.

4.2.1 Average Propensity to Save (APS)

• Average propensity to save is the ratio of total savings (S) to total income (Y).
• It is part of total income which is saved.
• It captures the tendency of the consumer to save on average.
• APS=S/Yd……………..but S=Yd-c

3 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
 • APS=Yd-c/Yd………..Yd/Yd-c/Yd
• APS=1-c/Yd……………but c/Yd=APC
• APS=1-APC
4.2.2 Marginal Propensity to Save (MPS)
• The MPS is the ratio of the change in saving to the change in disposable income.
• It is the slope of the saving function and is given by 1− c.

MPS = = = 1-c

Properties of MPS
1) MPS values lie between zero and 1. ;
a. Zero means no change in saving
b. 1 shows maximum possible or total saving out of the new income.
2) MPS increases with an increase in income.
a. In other words, MPS of the poor is less than MPS of the rich.
4.2.3 Determinants of Saving
• The major determinants of saving at the individual and national levels are:
1. Level of income:
– As income increases, saving also increases. But the rate of increase in saving is
less than the rate of increase in income. This is because, with an increase in
income, consumption increases, but by less than the increase in income.
2. Distribution of income:
– Saving increases when income inequality increases. This is because the tendency
to save is greater for rich people than poor people.
3. Expectation about future prices and income:
– If prices are expected to fall in the future, present consumption is less, and hence,
saving is more. An expected future increase in income reduces present saving,
and the inverse is also true.
4. Rate of interest:
– a higher rate of interest induces greater saving and the reverse
5. Level of wealth:
– A lower wealth level leads to a lower saving level. the reverse
6. Level of direct taxes:
– a higher level of direct taxes produces a lower level of personal disposable
income and reduced savings and the reverse
7. Individual nature:
– Saving is directly related to the nature of the individual. For example, a miser
(cheap) saves more than a spendthrift (Extravagant).

4 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
 4.3 The Relationship between Saving and Consumption
The relationship between MPC and MPS
• If MPS is given to be 0.6, MPC will be 1− 0.6 which equals to 0.4.
• Since any change in disposable income can change only consumption or saving
– Marginal propensity to consume + Marginal propensity to save = 1
• Symbolically,
– MPC (c)+ MPS (1-c) = 1
– Mathematically, this is adding c and 1-c .
– c +1− c =1
The Relationship between APC And APS
• In general, APS + APC = 1
• The proof is very simple.
• From our earlier discussion, we know that:
 Yd= C + S , i.e. income equals consumption plus saving.
• Dividing both sides of the equation by Y, we get:
 Yd/Yd= C/Yd + S/Yd
 1=APC+APS
A 450 reference line (“Expenditure equals income” line)
A 450 reference line shows equality between the value of the variable on the x-axis and the y-
axis. Hence, if we measure income on the x-axis and the total expenditure (C+S) on the y-axis,
the 450 reference line shows locus of points where Y = C + S .
Y = C + S is called the “expenditure equals income” line. Its significance is that each point on
this line shows that expenditure equals to income. Comparing the consumption function curve
with the 45° line for any point tells us whether consumption is equal to , greater than or less than
income level. When the consumption function crosses the income line it shows the point at
which income equals consumption, and hence, there is no saving. When income is above Y *d ,
consumption is less than income and there is positive saving. when income is less than Y *d ,
consumption exceeds income and there is dissaving.

5 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
 4.4 Investment
Investment: the amount of goods that are purchased or accumulated per unit of time and which
are not consumed at the present time.
 Putting savings into assets or objects that become worth more than their initial worth or
those that will help produce an income with time.
 In an economic outlook, an investment is the purchase of goods that are not consumed
today, but are used in the future to generate wealth.
 In a strict sense, investment should lead to an increase in stock of capital, finished goods
or raw materials.

4.4.1 Investment Types

• There are different ways of categorizing investment.
• It can be divided into two categories
 Gross and Net Investment
 Induced and autonomous
 Private and public investment depending on who makes the investment
Gross Investment or Gross capital investment is a company‟s capital investment before
deducting depreciation. Gross investment is the total amount that the economy spends on new
capital. This figure includes an estimate for the value of capital depreciation since some
investment is needed each year just to replace the used-up or worn-out plant and machinery.
Replacement Investment: The value of a piece of equipment decreases as we use it in the
production process and this is called depreciation of capital. Any investment that is made for the
purpose of compensating for such depreciation which is caused by production in a current year is
not real investment; rather, it is what is sometimes known as replacement investment.
Net Investment: is the gross investment minus the depreciation on the existing capital. If gross
investment is higher than depreciation, then net investment will be positive. A positive net
investment increases the productive capacity of the economy.

Net investment = Gross investment – Depreciation

Autonomous Investment: is the expenditure on capital formation, which is independent of the
 change in income
 rate of interest
 rate of profit
This is generally taken in the government sector. Autonomous investment is income inelastic (it
is not affected by changes in income level).Government makes autonomous investment because
of the welfare consideration.

6 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
Induced Investment; is investment which is made with the motive of earning a profit or income.
It depends directly upon profit expectations. It is income elastic. Factors which affect profits
influence induced investment.
 Prices
 wages
 interest changes
If national income goes up, induced investment also goes up – an increase in income induces
investment. This occurs because an increase in national income leads to an increase in the
demand for goods and services, which increases investor interest in meeting that demand, and
therefore leads to investment. Thus, we can say that induced investment takes place when a level
of income and demand in the economy goes up.

The Investment Functions

Induced investment is a positive function of income. The autonomous investment is a horizontal
line and is independent of the income or profit level. The induced investment varies directly with
profit or income. When income rises, more investment projects are profitable so more
investment.

Graph of Induced and Autonomous

Private Investment: is an investment, which is made by the private sector in the form of new
machinery, and equipment, the building of new factories, increases in inventories.

Public Investment:
Public investment is investment by the state, whether through central or local government or
through publicly owned industries or corporations.
The origin of public investment is associated with the need to provide certain goods,
infrastructure or services that are deemed to be of vital national interest and cannot be provided
by the private sector.
• Examples include investment to provide
 Police services and national defense, supply of electricity, clean water, and
sewage services, etc.
• Public investment can be divided into three broad classes:

7 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
  Physical Investment; refers to tangible investment in infrastructure (transport,
telecommunications and buildings)
 Human Investment; intangible investment is on education, skills, and knowledge.
 Consumption Investment; refers to investment in consumption of goods and
services (social security benefits and pensions).
Interest rates
• There are two types of interest rates that affect profitability of investment and hence
income.
• These are
 Nominal Interest Rate: refers to the interest rate before taking inflation into
account. It is not corrected for inflation. Nominal interest rates are the interest rate
that the bank pays. Almost all the interest rates that are reported in the newspaper
are nominal rates.
 Real Interest Rate: Real interest rate is an interest rate that has been adjusted to
remove the effects of inflation. Real interest rates reflect the real cost of
borrowing and capture changes in purchasing power. To calculate the real interest
rate, we subtract the actual or expected rate of inflation from the nominal interest
rate. If “i” denotes the nominal interest rate, “r” the real interest rate, and the
rate of inflation, then the relationship among these three variables can be written
as r = i-
For example, if the nominal interest rate is 15% and the inflation is 8%, the real
interest rate is 7%. (r=15%-8%=7%).If you save your money in a bank, you will
receive the nominal interest rate (Bank=15%) but because of the inflation, the real
gain is the amount of the real interest rate (in this case 7%).

4.4.2 Determinants of Investment

Interest Rate and Expectations about Future Sales
As interest rate rises (Increases), cost of investment project rises and businesses invested
less. So investment becomes less profitable and these would cause decline in the quantity
of investment demand.
Businesses invest because they expect to sell the goods they produce. If businesses
become optimistic about future sales, investment spending grows and aggregate demand
increases.
If businesses become pessimistic about future sales, investment spending contracts and
aggregate demand decreases

Business Taxes
Businesses naturally consider expected after-tax profits when making their investment decisions.
An increase in business taxes lowers expected profitability. With less profit expected, businesses
invest less. As investment spending declines, aggregate demand declines. A decrease in business
taxes, on the other hand, raises expected profitability and investment spending.

8 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
 Income
As national income rises, induced investment also goes up. The reason is that an increase in
national income leads to an increase in the demand for goods and services and in investors‟
interest in supplying them, which leads to increased investment.

Other Factors Which Affect the Performance Of Existing Investments

The Ethiopian Central Statistical Agency (CSA) and the World Bank (WB) collect information
on the main challenges that firms face. The main factors include:
 lack of infrastructure (access to electricity, road, land, water and communication)
 Access to finance
 Rules and regulations( tax rules, customs duties)
 lack of raw materials
 Practices of the informal sector
 Lack of market for output
Ease of Doing Business (Eodb)
The World Bank encourages countries to solve these and other related challenges to improve the
business environment for firms. For example, the World Bank has an index called ease of doing
business (EoDB), a ranking system established to trace the improvement in the business
environment (An index is a composite number that is formed by combining several
indicators.)Currently 11 but aiming for 12 indicators

Current Indicators in Eodb

1. Process of starting a business 7. Engaging in international trade
2. Dealing with construction permits 8. Enforcing contracts
3. Obtaining an electricity connection 9. Resolving insolvency (Bankruptcy or
4. Getting access to credit failure)
5. Protecting minority investors 10. Employing workers
6. Paying taxes 11. Contracting with the government
EODB in Ethiopian context

Ethiopia‟s rank was 159th out of the 190 countries in the index in 2019. This shows that the
business environment is not good enough to attract and retain investors and the country needs to
improve. In order to attract new investments and improve the performance of the existing firms,
the Ethiopian government has introduced several reforms over the past few years, and these are
expected to improve the ease of doing business rank of Ethiopia.

4.4.3 Role of Investment in Economic Growth

Economic growth refers to an increase in the total output of a nation over time. Investment

 boosts economic activities

 adds to the stock of capital
 changes the capital stock

9 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
  Capital investment refers to a company‟s acquisition of assets such as real estate,
manufacturing plant, machinery, computers, vehicles and production equipment.
 Capital investments are long-term investments and they allow companies to generate
revenue for many years by adding or improving production facilities and boosting
operational efficiency.
 A business does not see an immediate increase in revenue when it makes investments in
capital goods. Changes in the capital stock shift the production possibilities curve and the
economy‟s aggregate production function.

Accelerator theory investment

Accelerator theory states that capital investment outlay is a function of output. If a firm
operates in an industry where demand is rising and there is excess demand for the goods in the
market, the firm is expected to respond to this situation. Firms respond by

 include expansion of production

 full utilization of the existing capacity to produce
 Selling their existing inventory
 investing more in capital goods
Investing more in capital goods means increasing investment spending. Thus, demand for
capital goods (investment) is driven by a change in demand for products being supplied by the
company. This triggers the accelerator effect, which states that when there is a change in demand
for consumer goods (an increase or decrease), there will be a higher percentage change in
demand for capital goods. When consumption spending increases, demand also increases and
this in turn will lead to an increase in investment demand. The accelerator effect happens when
an increase in national income (GDP) results in a proportionately larger rise in capital investment
spending. Investment demand is a function of changes in output or GDP in the economy, which
represents the total demand in the economy. This means that changes in demand or income
accelerates investment

Accelerator Coefficient

• Yt=GDP or output at time “t”

• Kt=capital stock at time “t”
• Itt=Level of investment at time “t”
• Kt-1=Capital stock at time “t-1”
• It=Kt-Kt-1
• Kt = Kt-1=
• It= -
• …….. Accelerator Coefficient
• It= ( )

10 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
 UNIT-5
TRADE AND FINANCE

Introduction
Trade refers to the process of buying, selling or exchanging of goods, and services. There are
two broad categories of trade:
 Domestic trade
 International trade
Domestic trade (also known as “home trade”) involves the flow of commodities by water, air,
and rail transport systems within a country or territory.
International trade refers to the exchange of goods and services between two or more
countries.

5.1 Overview of Domestic Trade

Domestic trade refers to the exchange of goods or services within an individual country or
territory. It is sometimes called “local trade” or “internal trade”. Domestic trade can be further
divided into retail trade and wholesale trade.
Retail trade: Retail trade involves selling goods and services for direct consumption. A retailer
is normally the final seller of a product. A retailor makes its purchases from wholesalers and
sales are made to the customers directly. Retailers have a credit arrangement with wholesalers to
buy the goods and can repay after their sales are made in cash. Retailers sell goods in small
quantities relative to wholesale trade and are distributed all over the country where consumers
live.
Wholesale Trade: wholesale trade involves agents other than a standard consumer. Wholesale
trade is the backbone of the domestic market.
Why do we need to engage in domestic trade?
• Allows different types of G/S to reach all parts of the country and Improves
 Standard of living of the people of the country
 Employment rate of the country
 Economic performance of a country
 Resource distribution and efficiency
 Encourages investment & development within the country
 Eliminates the country‟s dependence on foreign G/S.
 Political issues, international disagreements and wars have less effect on the
economy when a country has a strong domestic trade.
Domestic benefits over international trade
 First, transaction costs which are associated with making sales tend to be much lower for
domestic markets due to a lack of tariffs and customs duties.
 Second, transportation costs are also much lower, and goods can be put on the market
more quickly as they have a shorter distance to travel.

11 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
Problem and limitation of Domestic trade
 The limit to the selection of products which are available for sale.
 Countries may not meet the Demand of their people by relying only on their domestic
trade patterns.
 This is why today, all countries engage in international trade and would like to benefit
from international specializations and differences in endowments (Provision of
resources).
5.2 Basis of International Trade
• The immediate cause for trade among nations is the difference in the prices of G/S. There
are d/t reasons for the difference in the prices of a commodity among nations which may
include differences in
 Resource Endowments
 The Level of Technology
 Technical Skills or Know-how
Major Advantages of International Trade
• It makes the most efficient use of the world resource
• Each trading nation will gain as world output increases
• International trade relations help harmonize international political relations.
• Foreign competition tends to induce efficiency
• Domestic firms exploit economies of scale of production through expanding markets.
• Promotes learning through technology exchange.
• Cultural exchange and ties among countries develop
5.3 Basic Theories of International Trade
5.3.1 The Mercantilists’ View on Trade
Country‟s wealth is based on the holdings of precious metals like gold and silver. Nation should
accumulate gold and precious metals which were used as the medium of exchange at that time.
• Country should export more than its imports.
 Export is good B/c they generate revenue
 Import is bad B/c they imply payments
A country could achieve a favorable trade balance (a surplus of exports over imports).Advocated
government regulation of trade.
 Imposition of tariffs (Tax )
 Quotas (Restriction on amount) and other commercial policies to minimize
imports to protect a nation‟s trade position.
 This situation implied that international trade was a zero-sum game (a situation
where, if one party loses, the other party wins, and the net change in wealth is
zero.)
The two modern features of mercantilism: Features of mercantilism used till now
1. It was highly nationalistic, giving relative importance to the wellbeing of the home nation
rather than the foreign nation.

12 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
 2. Mercantilism favored the regulation and planning of economic activity as an effective
means of fostering the goals of the nation. This is also manifested in today‟s world in
different forms.
Critics of Mercantilism
• The static (not changing over time) view of the world economy by the Mercantilists
(Stocking precious metals as they were medium of exchange )
5.3.2 The Classical Trade Theories
• The idea of the mercantilists was refuted (disapproved) by some groups of thinkers called
the classical thinkers, who perceived that a nation‟s wealth is reflected in its productive
capacity (i.e. its ability to produce final goods and services), and not in its holdings of
precious metals.
• Adam Smith and David Ricardo were among the principal advocates of this economic
thought.
Adam Smith’s Principle of Absolute Advantage
In 1776, Adam Smith published his famous book, “An Inquiry into the Nature and Causes of
the Wealth of Nations”, in which he attacked the mercantilist view on trade and advocated free
trade as the best policy for all nations.
• Trade b/n two nations is based on absolute advantage
• Nations could benefit from international exchange of goods by concentrating on the
production of G/S that they could make most cheaply.
• Advocated a laissez faire (economic affairs of society are best guided by the decisions of
individuals).
• Laissez faire is French for “let people do as they choose to do ” or “allow to do”.
• Proper role of the government was to see that the market was free to function by
removing the barriers to effective operation of the market.
• Argued that mutually beneficial trade can be achieved based on what is referred to as
“absolute advantage”. This is sometimes called “absolute cost advantage”.
• The absolute cost advantage is the ability of one country to produce one of the two goods
at a lower cost relative to its trading partner.
• Import goods in the production of which they had an absolute disadvantage against the
exporting country.
• Export goods in the production of which they had an absolute advantage over the
importing country.
• Mutually beneficial trade is a positive sum game (a situation where all players can
receive a positive return (benefit) in their collaboration)
Assumptions of Adam Smith’s Principle of Absolute Advantage
1. There are only two countries and two goods.
2. Labor is the only factor of production, & it is homogeneous & fixed in amount.
3. The value or price of a good is equal to the amount of labor time which is used in the
production of the good. This is the labor theory of value. (argues that the economic value
of a good or service is determined by the total amount of “socially necessary labor”
required to produce it.)
4. Labor is mobile within a country, but immobile internationally
5. Labor is fully employed in both countries
6. The level of technology that is used to produce the goods is constant
7. Transportation costs are zero

13 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
 8. Money is not used as a medium of exchange
9. The institutional setting is perfect competition

Limitations of the Theory of absolute advantage

1. initial assumptions that labor is the only factor of production and that it is homogeneous
could be challenged
2. Smith‟s concept of absolute advantage explains only a small part of the world trade, such
as those between developed and developing countries.
3. Finally, the principle of absolute advantage does not show what will happen if one
country has an absolute advantage in the production of both goods

David Ricardo’s Principle of Comparative Advantage

• David Ricardo (1772–1823) was a British Economist who is best remembered for his
theories of Rent and comparative cost.
• He introduced the concept of opportunity cost, which is defined as the next best
alternative forgone
Assumptions of Ricardo’s law of comparative advantage
1. There are 2 countries, 2 goods, and labor as the only factor of production.
2. The goods are homogeneous (identical) across firms and countries, and labor is
homogeneous within a country but heterogeneous (non-identical) across countries.
3. The factor of production is mobile between alternative uses and within a country, but
immobile internationally.
4. The labor theory of value is employed, i.e. the cost of a good is determined by the amount
of labor used to produce.
5. The level of technology is fixed with constant costs of production.
6. There is full employment.
7. The economy is characterized by perfect competition and free trade.
8. There are no government-imposed obstacles to economic activity, and
9. Transportation costs are zero.
Ricardo’s law of comparative advantage
• Even if a nation is more efficient (that is, has an absolute advantage) than another nation
in the production of both goods, there is still a basis for mutually beneficial trade.
• The more efficient nation should specialize in the production and export of the goods in
which its absolute advantage is greater and import the goods in which its absolute
advantage is smaller.
• Similarly, the less efficient nation should specialize in the production and export of the
goods in which its absolute disadvantage is smaller and import the goods in which its
absolute disadvantage is greater.

14 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
Criticisms David Ricardo's theory of comparative advantage
• He assumed labor was the only factor input which is homogeneous, but labor is one
among several factors of production and is not homogenous.
• Assumed constant returns to scale and thus, constant cost of production in both nations.
5.4 Balance of Payment Components
The concept of international trade, which we studied earlier, implies that a country has to deal
with three aspects of exchange: transactions involving
1. visible goods
2. Invisible goods
3. Finance(capital transfers)
 The BOP record of a country is a systematic record of all economic transactions of a
country with the rest of the world during a given period of time.
 It is a double entry system of record of all economic transactions b/n the residents of the
country and the rest of the world that is carried out in a specific period of time.
 Any transaction in BoP involves debit and credit items.
 Credit items in BoP accounts addition to home country.
 Debit items in BoP accounts minus to home country.
Main Items Registered As Credit (+)
• Exports
• Foreign directed investment inflow to the home country
• Receipts of interest and dividends by the home country from earlier investment abroad
Main Items Registered As Debit (-)
• Imports
• investments made in foreign countries by domestic nationals
• Payments of interest and dividends by the home country on earlier investments which are
made by foreign investors.
Accounts in BOP
• There are two main accounts in the balance of payment:
• The Current Account
 Trade Balance

15 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
  Net Services
 Net Transfers
• The Capital Account or (Financial Account)
5.4.1 The Current Account (CA)
• The current account includes transactions in
 Goods
 Services
 Investment Incomes
 Current Transfers
• The current account records inflows and outflows of foreign currency resulting from
flows of G/S and unrequited or unilateral transfer (foreign aid). It is composed of three
balances:
1) Trade Balance
2) Net Services
3) Net Transfers
1) Trade balance

Balance in the trading of merchandise goods by excluding trade in services. It is narrower than
the current account.
Trade balance shows that balance of export and import of goods by excluding current transfer
income and trade in services. The implication is that;
a. When the value of X is more than that of M, the country is said to have a trade
surplus or favorable (or positive) foreign trade.
b. When M values are more than X values, the country is said to have a trade deficit,
i.e. unfavorable (or negative) foreign trade.
c. When the value of X equals the value of M, we call it a trade balance.
2) Net services
The d/n b/n the X and M of services is called “net services”. There are many services that are
made use of in international trade, for example,
a. Shipping services
b. insurance services
c. banking services
The net receipt of such services is recorded as net services in BoP.
3) Net transfers
Transactions such as gifts, remittances, donations, etc., are unrequited or unilateral receipts and
payments, because residents of a country receive them „for free‟. Current account balance is the
sum of trade balance, net services and net transfers during a given period of time.

16 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
 5.4.2 The Capital Account (KA)

• It includes transactions in financial instruments and central bank reserves.

• The capital account records transactions concerning the movement of financial capital
into and out of a country.
• Capital comes into (inflow) a country by (+ Credited)
• borrowing
• Sales of overseas‟ assets and investments in a country by foreigners.
• Capital that leaves (out flow) the country due to (-Debited)
• lending
• buying of overseas‟ assets
• Purchases of domestic assets which are owned by foreigner residents.
• The balance may be positive (surplus) or negative (deficit).
Why control international trade flows
• Overall balance of payment (BoP), therefore, is the sum of current account balance (CA)
and capital account balance (KA).
BoP=CA + KA
• When a country is in current account deficit, it must pay the differences between imports
and exports from
• a surplus in the capital account surplus
• Official reserve accounts.
• This is why countries enter into a situation where they have to restrict or control
international trade flows.
Balance of Payment Statement

• By adding the balance on the KA and the CA, we get the complete balance of the
payments account.
• When receipts and payments are equal, the balance of payments is said to be in balance.
• If the total BoP receipts are more than the payments, the excess goes to a third account,
the Foreign Exchange Reserves.
• In addition to this, when payments exceed receipts, there is a depletion of foreign
exchange reserves.
5.5 Trade Policies and Strategies

• Trade policies refer to actions and arrangements that are taken by a country to encourage
or restrict international trade.
• Trade restriction is a policy that is introduced by countries on the trade of G/S B/n two or
more countries to limit the volume of trade and associated transactions.
• There are two broad measures which are used to restrict trade flows
• Price related; Imposition of a tariff
• Quantity related; import quota

17 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
 Tariff and Quota
Tariff restrictions: are in the form of taxes on the import of goods, called “custom duty” or
“import duty”. Such taxes raise the price of imported goods. Note that tariff increase government
revenue.
Quantitative restriction (Import quota): these restrictions take the shape of fixing the
maximum quantity of goods that are permitted to be imported. This naturally limits the quantity
of imports.
Reason for trade restrictions

• There are several reasons for restricting trade including to/for

 Protect domestic jobs (job protection argument)
 Protect small and infant industries (infant industry argument)
 Maintain the domestic standard of living
 Equalize production costs
 National security
 Cultural and sociological considerations
Strategies for Enhancing Macroeconomic Performances Import Substitution (IS) and
Export Promotion (EP)

Import substitution is a trade and economic policy that advocates replacing imports with
domestic production.
Export promotion refers to the act of policy measures which actually or potentially enhance
exporting activity at the company, industry, or national level.

5.6 Exchange Rate Determinations

• The foreign exchange market is a market place that determines the exchange rate for
global currencies.
• It is sometimes called “forex market” or “currency market”.
• The demand for foreign currencies is due to
 tourist visits to another country
 import demand for goods from other nations
 demand to invest abroad
• The SS of a nation‟s foreign currency arises from earnings such as
 Earnings from tourist expenditure
 Export earnings
 Foreign direct investment

18 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
 5.6.1 Nominal and Real Exchange Rate

• The nominal exchange rate is the number of units of the domestic currency that can
purchase a unit of a given foreign currency. There are two ways of expressing the
exchange rate. (if 1USD=45ETB)
The price of one unit of foreign currency in terms of domestic currency (45/1=45)
The price of one unit of domestic currency in terms of foreign currency.
(1/45=0.0222)
Real Exchange Rate:The real exchange rate is the ratio of the price level abroad and the
domestic price level, where the foreign price level is converted into domestic currency units via
the current nominal exchange rate.

 Real exchange rate= Nominal exchange rate* (Foreign Price/Domestic Price)

 Symbolically; RER=e(P*/P)
 Where, in our example,
 “e” is the nominal ETB-USD exchange rate
 P* is the average price of a good in the foreign market
 P is the average price of the good in Ethiopia
Determining the Price of Foreign Currency
• There are two different methods of determining the price of foreign currency (exchange
rate):
• Fixed Exchange Rate System
• Flexible Exchange Rate System
5.6.2 Fixed Exchange Rate Systems
A fixed exchange rate is a situation where the price of one currency in terms of another
currency is fixed by a government or national bank. In a fixed exchange rate system, exchange
rate is determined by the national bank of a country at the point where the demand for foreign
currency equals its supply.
• Advantages
 Stability of the value of local currency
 Provision of greater certainty for exporters and importers
 The government maintains low inflation.
• Devaluation refers to an increase in the foreign exchange rate while revaluation is the
opposite.
• Devaluation of a local currency is generally expected to encourage export earnings and
discourage imports. With devaluation, imports become expensive while exports become
cheaper in the international market.

19 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
5.6.3 Floating Exchange Rate Systems

 A floating or flexible exchange rate is a regime where the price of the domestic currency
is set by the foreign exchange market based on the interaction between supply and
demand of the currencies.
 Floating exchange rates is more common in the real world. A floating exchange rate does
not mean that countries do not try to intervene. This is usually the case of managed
floating where a government or central bank manipulates its currency‟s price, in order to
maintain a currency price which is favorable for international trade.
 A change in the value of exchange rate under a flexible exchange rate regime constitutes
appreciation or depreciation. Appreciation refers to a decrease in the foreign exchange
rate while depreciation is the opposite. If the exchange rate between USD and ETB
increase from its value of 45 to 50, we say that there is depreciation of ETB, if the
exchange rate decreases to 30, for instance, we say the Birr has appreciated.

5.7 Regional Integration and Globalization Practices in the Ethiopian context

Regional integration is the process by which two or more countries agree to cooperate and work
together to achieve peace, stability and wealth. Regional integration is sometimes called
“economic integration”.

5.7.1 Advantages of Economic Integration

 Trade Benefits
 Employment Benefits
 Improved Political Cooperation
Disadvantages of Economic Integration

 Trade Diversion
 Reduced Employment
 Reduced National Sovereignty
Types of Regional Economic Integrations

Free trade area: this most basic form of economic cooperation in which member countries
remove all barriers to trade between themselves. They are free to independently determine their
own trade policies with non-member nations. An example is the North American Free Trade
Agreement (NAFTA).

Customs union: this form of regional integration builds on the agreement under free trade area
and restricts member countries to trade with non-member countries in a similar manner. Hence,
barriers to trade are removed between member countries and members agree to use a common
trade policy against non-member countries.

20 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11
Common market: this type of regional integration allows for the creation of economically
integrated markets between member countries. Trade barriers, including any restrictions on the
movement of labor and capital between member countries, are removed. Like customs unions, in
common market there is a common trade policy for trade with nonmember nations. In this
regional integration, the primary advantage to workers is that they no longer need a visa or work
permit to work in another member country of a common market. An example is the Common
Market for Eastern and Southern Africa (COMESA).

Economic union: Under economic union, countries enter into an economic agreement to remove
barriers to trade and adopt common economic policies. An example is the European Union (EU).

5.7.2 Globalization Practices in Ethiopian Context

• Globalization refers to the increasing interdependence of world economies, population

and cultures.

• The main drivers could be the

growing scale of cross-border trade of commodities and services,
the flow of international capital
The wide and rapid spread of technologies.
• benefits of globalization

access to new markets and technology

exposure to a new way of life and culture
improved standard of living
allow companies to find lower-cost ways to produce their products
increases global competition
technological up-grading in developing countries
Last comer country benefit by jumping directly on a relatively new technology.
Downsides of Globalization

• The downsides of globalization include

loss of cultural identity
Exploitation of employees in foreign countries which is also a problem in
Ethiopia.
Ethiopian economy

Globalization has affected the Ethiopian economy positively for the past few years in a similar
fashion to that stated above. Ethiopia has managed to attract world class investors and
technologies and the cities and urban life has substantially changed due to access to technology
and information. The economy has registered a rapid growth rate over several years and Addis
Ababa has flourished as the capital city of the African continent (i.e. the Headquarters of
Organization of African Union).

21 “ፈጣሪ የተወደዱ ልጆቻችንን፣ሀገራችንን እና ህዝባችንን ይጠብቅልን!”

Economics Lesson Note for Grade 11