STUDY SESSION ONE:

OVERVIEW OF MACROECONOMICS, CONCEPTS AND NOTIONS

1.0 Introduction

A nation has large number of people − labourers, artisan, housewives and core professionals alike
inhabiting its territory. They work in different fields of endeavours (industries) but for the common
purpose of sustaining the economy and to advance it course. Macroeconomics studies the overall
behaviours of individuals and firms. The basic thrust of macroeconomics is societal allocation of
productive resources. When resources are efficiently utilized, total quantities of goods and services
increase, consequently, reducing therate of unemployment and stabilizing general price level.

Learning Outcomes for Study Session One

At the end of this study, you should be able to:

1.1 define and use correctly all the key words printed in bold, (SAQ1)
1.2 give panoramic overview of macroeconomics; (SAQ2)
1.3 discuss general concerns of macroeconomics; and (SAQ3)
1.4 Explain basic concepts in macroeconomics.(SAQ4)

1.1 Panoramic overview of macroeconomics

The common concern of economics is to develop a system that will enable humans meet their
material needs i.e to improve their wellbeing.

Fortunately, society is blessed with productive resources, labour, managerial endowment, land and
mineral deposits which are used to produce goods and services. This production satisfies many of
our material needs and recurs through the organization mechanism called the economic system.

The blunt reality, however, is that the total of our material need is many times greater than the
productive capacity of our limited resources. Thus, the complete satisfaction of our material want
is seemingly impossible. The main concern of economics is how to allocate resources efficiently.
Economy is built on the assumption of rational self-interest. Individuals make rational /well-
informed decision i.e to achieve the greatest satisfaction or the maximum fulfilment of their goals.
Similarly, firms are assumed to behave like human beings but rather than allocate resources to
achieve maximum satisfaction, firms strive to maximize economic gains.

Macroeconomics endeavour, to study how the economy works as a system and built on principles
of microeconomics. The main focus of microeconomics is to examine the behaviour of individuals
and firms within given markets and industries respectively. This entails how resources are
allocated in order to maximize benefits − utility and income for households and firms respectively.
While microeconomics examines interactions in a particular market or industry, macroeconomics
views the entire economy from broad perspective, that is, behaviour of all households and firms in
the economy.

Therefore, understanding the principles and methods of microeconomics is crucial to the analysis
of macroeconomics. Microeconomics examines individual household and firm behaviour while
macroeconomics focuses on behaviour of all households and firms in the economy. Aggregate is
used to denote behaviour of all households and firms together. Similarly, aggregate consumption
and aggregate investment refer to total expenditure (consumption demand plus investment
demand).

Macroeconomics as a branch of economics deals in details with the performance, structure,

behaviour, and decision making of the entire economy. As a broad field of study, it studies
aggregated indicators such as national output known as Gross Domestic Product (GDP),
unemployment rates, and price indices to understand how the whole economy functions.
Macroeconomics examines national income and general price level rather than households
incomes and price in particular markets. In addition, macroeconomics does not analyze the demand
for labour in the manufacturing industry but instead total employment in the entire economy.

Macroeconomics is an important segment of our daily lives. During the period of macroeconomic
progress, rise, business profits increase and unemployment rate is low. However, if macroeconomy
is in recession, incomes fall, business profits decline and jobs are very scarce.
1.2 General Concerns of Macroeconomics

Macroeconomics focuses on the following parameters as a measure of performance of individual

economy using them as basis for comparing progress of different economies. These parameters
are as follows:

 Growth of output
 Total Employment
 General price level (inflation/deflation).

When businesses invest in technology and increase stock of capital goods, national output
increases. Generally, we measure national output using gross domestic product. When national
output increases, businesses are expanding and investing in new lines. Definitely, more hands will
be needed to produce additional output and the demand for labour increases. During such boom,
economy attains higher equilibrium until production reaches full employment or potential
productive capacity. Since, the quantities of commodities are high and there is no pressure on price
level to diverge from equilibrium point. General price level is stable.

Sustained increase in general price level (Inflation) distort economic performance. It reduces real
values of national output. One may be tempted to conclude that sustained decline in general price
(deflation) level should then be desirable. On the contrary, continuous fall in prices of commodities
impacts negatively on businesses revenue and level of profit. Firms cut investment demand which
causes further reduction in total output. Some business lines and factories are shutdown, workers
will be laid off, and unemployment rate increases. That is why macroeconomics strives to stabilize
general price level.

1.3 Basic concepts in macroeconomics

Certain concepts are instrumental to macroeconomic analysis and will be encountered consistently
in the course of its study. We briefly consider them in turn.
1.3.1 Consumption goods
Consumption goods are goods that can be used to satisfy human needs without further processing
or transformation. Such goods are not raw materials or semi-finished goods but goods that are
taken to commodity market where they can be purchased by final users. Households purchase
bread and butter to feed the family while car is demanded to provide comfort. Consumer goods
are divided into three namely: nondurable goods, durable goods and services. Non-durable goods
are consumed and exhausted within one year. These category of consumer goods cannot last more
than their year of production. E.g, bread, yam, etc Durable consumer goods are commodities which
cannot be exhausted within one year. Car, furniture, television set, refrigerator, etc, are all
examples of consumer durables goods. Consumer services are intangible products or actions that
are typically produced and consumed simultaneously. Examples include: teaching, barbing, etc

1.3.2 Capital Goods

These are seen as commodities used in producing other goods, rather than being bought by
consumers directly for satisfaction of their needs. Assets of organizations or firms used to produce
goods and services are known as capital goods. Examples of such goods are buildings, equipment,
machinery, among others. Capital goods are inexhaustible, that is, they are not used up within a
single year of production. Capital goods are used continually over a period of time. Their life span
is determined by the rate of depreciation technically known as capital consumption. Improvement
on capital goods extend their lifespan by reducing the rate of depreciation. Since capital goods are
used to create other goods, they are categorized as producer's goods.

1.3.3 Final goods

Final goods are consumed directly to create satisfaction rather than used for further production
process. These category of goods have been transformed from raw materials into finished products
having gone through necessary stages of production. Bread, butter, furniture, cars, telephones,
computer set, among others are examples of finished goods.

1.3.4 Intermediate goods

These are goods that cannot be consumed directly but rather are used to produce other
commodities. Basically, they are raw materials and partly finished goods. As inputs, they must
undergo transformation or production processes before they can be consumed as outputs. Wheat
is an intermediate good to a miller who transforms it into flour which is another intermediate good
to a baker. To this end, intermediate goods can pass through many industries which add value and
pass them on to another industry until the production process ends and thefinal goods are received.
That is why in national income accounting by output approach, we sum up value added to
intermediate goods at various stages of production in order to avoid error of multiple counting.

1.3.5 Stock and flow

Stock and flow have several contextual meanings in business and related fields. However, it is
expedient we clearly state what both concepts mean in economics as against other fields.
Stock
Stock refers to the value of goods and services at a particular period. Stock as an article can be
increased by addition of new items and reduced/depleted by subtracting new items from it. Hence,
flows change the level of stock. Stock can also be seen as measures of available resources for
production of output.
'Stocks' typically change in value with time. The value of stock this year may vary from its value
last year and vice versa. Nigeria population census showed that Nigeria had 88.9 million and 140
million people in 1991 and 2006 respectively. 88.9 million and 140 million are stock since they
represent population of people in Nigeria at different periods of time. The change to 2006
population figures is as a result of an inflow or increase of 51.1 million on the 1991 population
figure. Other examples of stock include: total asset, inventory level, number of houses in a
particular area, number of students in a school at particular period of time, value of existing
factories, among others.

Flow
In defining stock above, flow has been briefly introduced since both concepts are interrelated.
Flow simply refers to change in stock over a period of time. Change can result from two economic
activities, that is, inflows (increase to stock); and outflows (reduction in stock).
Hence, flows typically are measured over a certain interval of time. Flow is a measure of the level
of output like Gross Domestic Product (GDP). GDP includes the output of new cereals and tubers
during the production period but not the stock of cereals and tubers existing at a particular point
of time. Also GDP includes as investment the construction of new cement factories, opening of
more bank outlets and not the total existing cement factories and bank branches nationwide.
In addition, from our population figures above, the increase in population census from 1991 to
2006 census is due to increase in the number of births in a period of 15 years. 51.1 million people
in 2006 is a flow being added to 1991 figures which increase the stock to 140 million in 2006.
Simply put, we can say, stock is static in nature whereas flow is a dynamic concept.

1.3.6 Variable
Variable is a quantity which may assume value in a context of a particular situation. Example of
variables are Gross Domestic Product (GDP), Population census, price of commodity, among
others.

Endogenous variable
In economic model, endogenous variable is explained by the model. Any change in the state of the
economy will cause a change in the variable so it depends on the state of the economy. In our
national income model the national income (Y) depends on consumption expenditure (C),
investment expenditure (I), government expenditure (G) and net export written as follows:
Y = C + I + G + (X-M)
Where National income (Y) is an endogenous variable since the level of income will respond to
change in household purchase of consumption goods and services (C), firms purchase of capital
goods (I), government spending (G) and Net export (X-M).

Exogenous variable
An exogenous variable is the opposite of endogenous variable. Exogenous variable is not
explained by the economic model under consideration and is assumed not to depend on the state
of the economy. Using same national income model above, government expenditure (G) is an
exogenous variable because it does not change in response to change in level of income.

1.3.7 Comparative static analysis

We analyse the change to endogenous variable as a result of a change in exogenous variable with
the aid of comparative analysis. Comparative analysis examines two equilibria. The equilibrium
point before an exogenous variable is altered and new equilibrium results after the change.
So, it is a method of theoretical investigation of the results but not causes of a change in some
parameters in an economic model. For example, to determine the effects of an increase in price on
the level of output of a firm, a comparative statics examines the two relevant equilibrium outputs—
the equilibrium output under the old price system and the new equilibrium output that would result
from price changes. In effect, the comparative statics approach starts from an equilibrium position,
then alters one or more of the variables of the model and examines what has happened after the
system adjusts to a new equilibrium.

Almost every branch of economic theory has made effective use of comparative static analysis.
Two typical results of comparative statics are the macroeconomic conclusion, from the Keynesian
model, that a fall in the supply of money will reduce the (equilibrium) level of employment, and
the microeconomic result that a rise in price must decrease the (equilibrium) quantity of a
commodity demanded by a utility-maximizing consumer if the item is not an inferior good (a
commodity whose demand falls when income rises).

1.3.8 Dynamic analysis

Dynamic analysis considers the time path of the variables of the model during the adjustment
process. It considers a dynamic process (the time-consuming adjustment of the system to the
change in parameters) with focus on the end points. With dynamic analysis, we track the process
of change from one equilibrium point to another. Example of dynamic analysis includes the price-
lag model used to determine time path of price.

However, comparative static and dynamic analysis are related. Inherent in every theorem of
comparative statics is an adjustment process for which only dynamics can explain.

In formulating correspondence principle, Samuelson has shown that for comparative statics to
yield meaningful results, time path must converge toward equilibrium value.

1.3.9 Nominal and real value

Nominal value is the value of variable expressed in current market price. The total monetary value
of all goods and services produced in Nigeria in 2013 was put at $522.9 billion. This value
measured in 2013 general price level is nominal GDP. Similarly, income earned by factors of
production (wages and salaries, rent, profit and interest) in current period are expression of
nominal value. The major drawback to nominal value is its inability to categorically state the true
level of economic parameters. A nation’s nominal GDP figure may show increase year-on-year
while the quantities of commodities produced actually decline.

Real value

Real value measures the changes in quantities. It is a nominal value that has been adjusted to
remove the effect of general price level changes. Changes in nominal value of a bundle of
commodities can occur due to changes in quantities or prices, but changes in real values express
only changes in quantities.To remove the effect of prices changes, we divide nominal variable by
deflator.

Furthermore, real values are a measure of purchasing power. That is, quantities of goods and
services which income can buy. We arrive at real income after removing part of nominal income
that is due to increase in general price level (inflation).

The nominal/real value distinction also applies to cross sectional data varying by region. For
example, the total sales value of a particular good produced in a particular part of a country
different from national price can be adjusted to real value by repricing the goods at national-
average prices.

1.3.10 Function

It is a mathematical instrument but employed by economists to express how a change in

independent variable will affect level of dependent variable. Functions are built on economic
theory or laws.

Explicit function

This function expresses the true relationship between two variables. Consumption is a function of
income regarded as explicit function since it explains aggregate consumption at different levels of
income. It can be written as follows:

C = f(y)

Implicit function
This is a function that does not express the outright relationship between two variables. Not clearly
stating if y depends on x but both variables must be changed in order to maintain the “equal zero”
relationship. It explains among others ‘equal zero’ relationship between two variables.

It appears thus: g(x, y) = 0

G(x, y) = y – f(x) = 0

Summary of Study Session One

Macroeconomics is the study of aggregate income, output, and expenditure.

Sustained increase in production of goods and services engender abundant employment for job
seekers. More so, it facilitates price stability.

Consumption goods are bought by households to satisfy their needs while firms demand capital
goods to facilitate production process.

Intermediate goods transform into final goods by continuously adding value to intermediate
goods until production process is completed.

Stock as a measure of total quantity of item at a particular period of time is static while flow
measured at interval of time is dynamic. The change that occurs to stock at two different periods
of time is caused by flow.

Variable takes quantity which may change from time-to-time. It can be used to analyse other items
when the size of that quantity changes.

Variable is endogenous when it is explained by economy model but exogenous when the
economy model does not explain it’s behaviour.

Nominal value of a variable is measured at current market price and as such ignores effects of
price changes. Real value is the measure of exact quantities by eliminating changes in value
brought by price variation. Real value uses stable price as basis of measurement.

Function relates one variable to another. It explains what changes will occur to one variable when
the other is changed.
Self-Assessment Questions for Study Session One

S.A.Q.1.1

Explain how microeconomics differs from macroeconomics.

S.A.Q.1.2

Explain the impact of an increase in total output on general level of employment.

S.A.Q.1.3

Briefly explain with examples: consumption goods, Intermediate goods and final goods.

S.A.Q.1.4

What do you understand by the concepts of “stock” and “flow?”

S.A.Q.1.5

Comparative static analysis is instrumental to economic analysis. Discuss?

Answers to Self-study Questions for Study Session One

S.A.Q.1.1

The difference between microeconomics and macroeconomics is seen what both concepts examine
as well as their tools, approaches and methodologies. Microeconomics examines units (individual
household and firm) in the economy while macroeconomics studies the overall economic activities
in an economy. This captures the activities of all households and firms in the economy. Also,
microeconomics studies demand pattern in a particular market (say automobile) while
macroeconomics considers the total demand level or general employment level.

S.A.Q.1.2

Increase in the general level of output is a signal of economic boom or progress. Steady/persistent
rise in the demand for firms output by households and other firms bring about the need to raise
factor of production (especially labour) so as to meet increasing demand. Hence, firms/businesses
will increase their labour demand at least in the short run. Since, the increase in output occurs in
virtually all industries/sectors of the economy, overall or total level of employment increases
accordingly.
S.A.Q.1.3

Consumption goods are commodities that are consumed directly by the consumer. They do not
require further production processes before they can be used. These goods are not raw materials
or semi-finished goods; so, they are used to satisfy human needs and as such taken to commodity
market where they are sold and bought .Examples include housewife purchase of beverage, cheese,
etc and other items on the family menu list. Consumption goods also include consumer durable
like car. television set among others.

In addition, consumption goods can be further unbundled into three categories thus:

i. Non-durable goods;

ii. Durable goods; and

iii. Services.

Capital goods are used to manufacture other goods rather than consumed to meet needs directly.
Capital goods as factor of production are usually bought by firms/businesses rather than by
individuals. Capital goods include tools, machinery, equipment and other physical assets of an
organization. It must be noted that capital goods are inexhaustible within single year of production.
Usability or rate of wear and tear determines the life span of capital goods.

Unlike consumption goods, intermediate goods cannot be consumed directly to meet human
needs but must be processed or transformed before they can be consumed. Therefore, intermediate
goods are raw materials or partly finished products. Examples abound in various baskets of goods
of which we examine one. Mined iron ore is an intermediate good. It must be transformed into
steel by steel companies. Similarly, the steel company process it further and pass it on to an
automobile maker who uses it to manufacture vehicles. Other examples include timber, raw gold,
crude oil, etc

S.A.Q.1.4
Stock is the value which a variable has or assume at a particular period of time. The value of stock
at different periods of time differs, facilitated by various factors. The total number of students in a
university this year may be greater than that of last year based on increased enrolment rate among
other factors. The figure however can be otherwise. Hence, new addition increases stock level
while contraction reduces level of stock. Stock can also be seen as the total number of commercial
banks in Nigeria in year 2000.

Flow on the other side, is the change that occurs to stock over a period of time. Flow is measured
at a particular time interval, say, a year. When we estimate gross national output, the focus is on
items/commodities produced during the period in focus and not the stock of yesteryears.

Also, flow causes or triggers changes that occur to stock.

S.A.Q.1.5

Economic analysis cannot be carried out without the aid of comparative static analysis. In most
economic analysis, we compare events/results of two different periods in order to understand the
trend and factors responsible for change. To perform comparative static analysis, we observe an
equilibrium point and then change one or more exogenous variables. We then, observe the result
after new equilibrium is attained.

The importance of these tools cannot be overemphasized in economic analysis. Theoretically,

almost all branches of economic theory has made effective use of this tool from the Classical to
the Keynesian economic models.

In real life issues, businesses make use of comparative analysis when they increase the level of
capital stock, workforce, etc, in order to stimulate output and delivery. This they do by comparing
their financials at different periods. Even in government/public sector, comparative analysis is
carried out on performances of fiscal policies. In a nutshell, the use and efficacy of comparative
static analysis cut across both microeconomics as well as macroeconomics.

Reference

 Jhingan M.L 7th edition, Monetary Economics by Vrinda Publication (P) Ltd
  Debes, Mukherjee 2nd edition Essentials of Micro and Macroeconomics by New Central
Book Agency (P) Ltd
 Sampat, Mukherjee, 1st edition, Analytical Macroeconomics from Keynes to Mankiw by by
New Central Book Agency (P) Ltd
 Mishkin, Frederic S. 7th edition, The economics of money, banking, and financial markets
.

STUDY SESSION TWO

NATIONAL INCOME AND CIRCULAR FLOW OF INCOME

2.0 Introduction

Income received by households for the services rendered to firms is used to purchase firms
products thereby converting households’ receipt into firms’ revenue which is explained by circular
income flow. National income is all income received by factors of production (labour, land, capital
and entrepreneur) as rewards for their contribution to production process. National income can be
measured using Gross Domestic Product (GDP). The quantity of available productive resources
and technological advancement together with other factors determine national income. As a
veritable instrument in economic planning, national income enables us track nations level of
development, examine the living standard of the populace and compare gains made in different
economies.

Learning Outcomes for Study Session Two

At the end of this study session, you should be able to:

2.1 Define and use correctly all the key words printed in bold (SAQ1)

2.2 Define National Income (SAQ2)

2.3 Explain how income flow between households and firms in closed economy (SAQ3)

2.4 Explain some basic concepts in National Income Accounting (SAQ4)

2.5 Explain the three approaches in measuring National Income (SAQ5)

2.5 Identify the determinants of National Income Accounting (SAQ6)

2.1 National Income

Macroeconomics cannot be discussed without detailed study of national income. It is a very crucial
and fundamental concept. National income denotes overall monetary value of all final goods and
services produced within a particular geographical boundary (a country) during an accounting
period usually a year. National income deals with economic interactions among various income
generating units in the economy. In computing national income, we usually use circular flow of
income to buttress the methods and mechanism of computation.

The economy is assumed to have two main sectors- the business/firm sector and the household,
ignoring government and the rest of the world (external sector).
Households own the factors of production-land, labour, capital and entrepreneur (inputs to
production) so household can be considered as supplier of productive factors. On the other side,
firms/businesses employ factors of production in order to cause production of goods and services
hence, firms/businesses demand factor of production. Households supply mental and physical
effort (labour) to businesses for wages and salaries. Households own stake in firms so are firms’
ultimate owners and as such earn their profits/loss. Though businesses hold land and capital, they
are owned by households, so rent (reward for land) and interest (reward for capital) accrue to
households.

Let us use Table 2.1 to throw more light on activities between households and firms.

Table 2.1:Businesses by households and firms

AGENTS HOUSEHOLDS FIRMS

Factor Market Supply inputs to firms Use inputs to make output
Payment Earn factor incomes from businesses Employ factor services from households
Expenditure Purchase firms’ products Sell commodities to households

Households supply inputs to businesses which use them to make output as shown on row one. Row
two represents rewards to households in form of factor payment. Households receive factor
incomes in form of rents, wages and salaries, and profits. On row three, households spend their
rewards or factor incomes received from firms to purchase firms’ output, hereby giving businesses
the money to pay for inputs employed.

When we add all factors of production rewards earned by household in the economy, we arrive at
national income by income approach. Similarly, addition of all final goods and services produced
by firms/businesses gives national output by output approach. Output approach is technical
because we sum only value added to intermediate goods across industries. Inability to do this
brings about multiple counting of same item.

The total expenses or total spending of households on commodities produced by firms/businesses

is otherwise referred to as national expenditure and can represent national income by expenditure
approach. This pattern of interactions and chains of economic activities constitute circular flow of
income. Circular flow of income is a model or framework that explains the direction and movement
of resources (money) within an economy. It categorically state step-by-step movement of money
between individuals and businesses.

Circular income flow is built on the following assumptions.

1. Money flows between households and firms only.

2. All households’ income is spent.

3. Firms sell all goods and services produced.

4. Government spending/expenditure is ignored.

5. The economy is closed, that is, it does not transact with the rest of the world

If all income is spent, factor incomes equal households’ expenditure. In similar vein, value of
firms’ total output adjusts to total spending on goods and services if all goods are sold. The value
of total output equals value of household incomes.

Incomes = total output

The figure below shows exchanges between households and firms.

 Commodity market

Goods and services

Firms Households

Services of
productive factors

Factor Market

CIRCULAR FLOW OF INCOME IN A CLOSED ECONOMY

The inside circle explains the flow of real resources between the two sectors. With households
supplying factors which are is used up by firms to manufacture output. The outside circle explains
the corresponding payments for factors, goods and services.

Individuals spend their money on present and future consumption of goods and services. They buy
consumption goods, pay their bills, and buy assets (real estate) as well as financial instruments
(equities) against future consumption. Firms receive revenue from selling their products. In
addition, they contract financial facilities from banks and raise capital from the capital market to
enable them deepen their operations. Firms then use their revenue together with loan and capital
to pay for purchase of raw materials used for production, service factors inputs and pay wages and
salaries of labour employed. The result of this interaction is that total firms/businesses spending
become households’ total income and vice versa.

2.2 Basic concepts in national income accounting

There are basic variables embedded in national income definition when discussed further. These
variables include capital consumption (depreciation), taxation, and nationality of individuals
participating in production processes among others. Various concepts of national income thus arise
as follows:

Personal income

Personal income is the monetary reward that is earned by individuals for taking part in production
processes. Individuals receive wages and salaries for the services directly rendered to businesses.
Individuals receive interest on capital owned, rents on land and share business profits as
entrepreneurs. Personal income is national income less undistributed profits, profit tax, and social
security taxes.

Disposable

Disposable income is the income which individual can use for consumption. It is that part of
individuals income left after personal income tax has been deducted.

Yd = Yp – T

Where Yd is disposable income, Yp is personal income and T is income tax.

Gross domestic product

This is the total market value of all final goods and services produced by residents (citizens and
foreigners) of a country during a particular period usually a year. It is the measure of all economic
activities in indigenous currency.

Gross national product

Unlike gross domestic product (GDP), it is the measure of all monetary value of goods and services
produced by all citizens of a country irrespective of where they live and work. We arrive at GNP
when net factor income from abroad is added to the GDP. Thus GNP = GDP + net FIFA

Net factor income from abroad is the contribution of citizens abroad to GDP wherever they live
and minus contribution of foreigners here to our own GDP
Nominal and real gross national product

Nominal GNP is a measure of GNP at current market prices. However, real GNP is nominal GNP
adjusted against inflation. It is a measurement of goods and services by nationals at constant prices
usually taken as base year. That is, the year in which general price level is assumed stable. Real
GNP gives the true level of output/product since the effect of price increase has been factored out.
1990 and 2000 were popular base year used in measurement of GNP in Nigeria until recently
when 2010 was adopted.

Net national product (NNP)

It is the difference of GNP and capital consumption or depreciation.

NNP = GNP – depreciation

National income

It is the total resources that is used for production of goods and services during a particular period.
As earlier discussed, it measures earnings of all factors of production. National income is NNP
less indirect business taxes (IBT).

NI = NNP - IBT

Per capita income

Personal income is income per individual in an economy. It is calculated by dividing national

income by total population.

PCI = NI/P

GDP as a Flow

Clarification must be made that GDP does not measure economic wealth but rather value of current
produced output. As such, it considers the value of goods and services produced at particular period
and not total quantities of goods in existence. It considers the market value of yams, rice grown in
the economy during a year and not accumulations of such products existing at a particular time.
2.3 Measurement of national income

Basically, we use three methods or approaches in computing national income. They are:

1. Income approach

2. Output approach

3. Expenditure approach

2.3.1 Income Approach

This is the summation of income received by all the factors of production. It includes rents earned
by land, wages and salaries earned by labour, interest that accrue to capital and business profits
shared by entrepreneurs. This income is calculated at factor cost.

2.3.2 Output approach

This is a method of calculating national income by summing up the value of all net output of all
sectors in the economy. Net output is the net contributions of different sectors which refers to value
of final output less value of input that goes into production. Different sectors contribute to
production of certain product by adding value at different stages. To avoid multiple counting, we
take the ‘value added’ to inputs at different stages as against overall value of the product. We arrive
at national output by improving on intermediate goods which are semi-finished goods used up by
businesses. National income by output method is calculated at market price. Note that intermediate
goods are demanded by firms who used them up while final users buy final goods. Households
buy consumption goods while firms buy capital goods.

2.3.3 Expenditure approach

This is addition of total spending on goods and services produced in an economy. It is the sum of
consumption by households (C), businesses investment (I), government spending or expenditure
(G) and net contribution from transactions with the rest of the world technically referred to as net
met export, that is, total export of the economy minus her total import.
GDP = C + I + G + (X-M)

1.3.4 Factors that determine national income

 Stock of available productive resources.

 Kind of technology employed.
 Level of technical progress.
 The state of physical infrastructure.
 Conducive business environment
 Social and political stability
 Economic stability including stable banking and sound financial system

2.3.5 Reasons for computing national income

 National income is used to determine economic progress of a state.

 National income is used to measure the standard of living of the people.
 It is used to predict future event and plan ahead; it enhances development planning.
 It enables us discover why resources are under-utilized and why unemployment persist in
an economy.
 It is used for making international economic comparison.
 It can influence foreign investment.
 It is used to draw international aids and finances.
 It is used to determine individual economic competiveness.
 It directs state policy formulation and intervention.

2.4 Problems encountered in computing national income

Measurement of national income is faced with many challenges which can be viewed from
conceptual and statistical perspectives.

(1) Inappropriate pricing: As defined, national income calculation involves many commodities
which must be added up to arrive at aggregate value. Since these commodities are not likely to be
similar all through, the challenge is how to add up dissimilar commodities. The only way of getting
this done is by taking their market prices which is a common denominator. Prices have a lot of
imperfections and may not represent true commodities value. When determined by market forces,
imperfections distort market and when determined by the state based on social value, state
determined price is based on the whims and caprices of those who fixed it.

(2) Summation problems: National income is best estimated in real terms. In doing this, we use
index to adjust value. Hence the computation is faced with all difficulties of price index number.

(3) Information asymmetry/imperfect information: The reliability of information used for

national income accounting can be questioned in following ways:

(i) Undue delay: Pieces of information needed for national income estimation at times are not
available at the right time and such cannot be used to formulate effective policies. The information
can at best be used to readjust past estimate.

(ii) Infraction and poor recording: To estimate national income, several intelligent guesses have
to be made due to unavailability of pieces of information needed. Modern economy comprises
many sectors which make it quite difficult to gather relevant information across all sectors. The
situation is worse in a developing economy where book keeping and recording is very poor.
Therefore, households and firms may provide inappropriate information concerning their
consumption expenditure and investment expenditure.

Another source of worry for dependability of information in national income estimate is deliberate
attempt to hide relevant information. Households and firms may give wrong information about
their income and revenue in order to evade tax.

(iii) Problem of counting: National income estimate can be faulted on the basis of inconsistent
computational methodologies adopted.

(a) The activities of a house wife (household chores) are usually excluded from GDP. However,
when same services are performed by a house help, paid for in money terms; it becomes part of
GDP estimate. Another twist to this scenario is when a house wife renders the same services to
another household and gets paid while she employ another wife to perform the same services for
her with pay. Monetary value differs while real value remains unchanged. This is the reason why
GDP of most developed nations are very high because most household’s’ services are paid for in
monetary terms unlike developing or third world nation where such services are rendered by
household members.

(b) Consumption-producer goods: Public goods like road when constructed add to GDP that year
with additional repairs and maintenance contributing to national income in later years. However,
the value of road usage by individuals and firms are not paid in monetary terms and since GDP
measures monetary value, it is excluded from measurement. However, when same road is
constructed by private businesses or through Purchasing Power Parity arrangement of which toll
fee is levied on all users, there is an addition to national income. We then see how inconsistent
methodology can result in different national income estimates even when the items contribute the
same value. Similar contradictions exist in many consumer durable goods. A power generating set
is counted as part of national income when manufactured. In subsequent years, if the owner lease
it out for payment, the money received form part of his income and is included in the national
income as against when being used by the owner. In real terms, the items generate the same
consumption services but paid for in one instance and not in other.

(c) Net output captures only loss on fixed asset when in reality other productive resources are
consumed during production. The case is worse with reproducible resources which are not only
destroyed but possibilities of increasing their stock hindered. Examples include degradation of
land fertility, forest resources, pollution of water, discharge of harmful chemicals in the air and
soil and so on. Human health are not spared in this loss. Economic loss in the course of production
is then underestimated since net output ignores all such forms of loss but that on capital goods.

(d) What constitutes capital consumption remains one of the unresolved issues in national income
estimate. This is so as one school of thought views capital consumption in terms of acquisition
cost and technical life span which may be fixed while another school of thought sees it as cost of
replacement which may vary from year-to-year

(e) Exclusion of underground activities: Economic activities of smugglers, inland trade, oil thieves
, production of goods and services hidden from authorities in order to evade tax or face prosecution
are not included in national output estimate though they contribute to economic activities.

(f) Exact economic contribution: National income estimate includes corporate profits received by
entrepreneurs. Profit, however, may not be true representation of entrepreneur contribution to
output. Firms may make profit as a result of prevailing rate of profit in the economy. Thus: profit
may not be proportional to economic contribution of an entrepreneur.

Furthermore, public enterprises are not run for profit motive even if private firms that render the
same services earn profit. As a result, national income estimates can change simply because of
shifts in rate of profit without any corresponding change in real output.

Worked example

The data below represent economic activities in an economy

Items Amount
N’M
Personal consumption 80
Firms gross capital formation 40
Corporate income tax 22
Proprietor’s income 25
Government consumption 30
Profits 25
Wages and salaries 60
Export of goods and services 25
 Rental income 28
Import of goods and services 15
Capital consumption 7
Indirect business tax 20
Subsidies 5
Retained earnings/undistributed 9
corporate profits
Social security contribution 0
Transfer payment 0
Personal income taxes 11
Net foreign inflow -5
Interest 15
Calculate the national income (NI) approach using income and expenditure approach respectively.

Income approach: Wages and Salaries + Rental Income + Proprietor’s

Income + Interest

NI = 60 + 28 + 25 + 15

NI = 128

Expenditure approach: Personal consumption + Investment + Government Spending + Net Export

80 + 40 + 30 + (25-15)

GDP = 160
GNP = GDP – NFIFA; 160 – 5 = 155

NNP = GNP – Capital consumption

= 155 – 7

= 148

NI = NNP – IBT

NI = 148 – 20

NI = 128.

Summary of the Study Session Two

National income captures what factors of production earn in one year. It can be represented by
gross domestic product.

Gross domestic product (GDP) measures final monetary value of all goods and services produced
in a nation at certain period usually a year irrespective of who owns factors of production.

Gross national product (GNP) is the value of final goods produced by citizens of a nation only.
We add value of the citizens’ contribution (monetary) living outside the country to the GDP and
subtract the contributions of foreigners from the GDP to arrive at GNP.

Net national product (NNP) makes provision for capital consumption or depreciation of assets
caused by wear and tear in the course of production.

Income flows between two sectors (households and businesses) in the economy. Firms use revenue
from sales of their products to pay households for factors employed.

We encounter many challenges in national income accounting among which are double counting,
how value is determined, price inter-industry adjustment, measurement of capital consumption,
real contribution of labour among others.
National income (NI) is used nationally, regionally and globally as a tool for gauging economic
performance. It tells the economic size and strength of each nation.

Self-Assessment Questions for Study Session 2

S.A.Q.2.1
What is national income?

S.A.Q.2.2
Distinguish between GDP and GNP

S.A.Q.2.3
Explain the three approaches of computing national income

S.A.Q.2.4
Discuss the uses of national income.

S.A.Q.1.5
What are the determinants of national income?

Answers to Self-Study Questions for Study Session Two

S.A.Q.2.1

National Income is the total economic resources that are employed in order to produce goods and
services during a particular period. National income is measured by adding total rewards earn by
factors of production (labour, land, capital, entrepreneur) in an economy at certain period.

S.A.Q.2.2

Gross Domestic Product (GDP) measures the total market value of all final goods and services
produced by those living in a particular state or geographical boundary at a certain period. GDP
considers quantities of goods and services produced by the residents of the country irrespective of
their country of origin or nationalities.

Gross National Product (GNP) however considers or measures the total monetary value of final
goods and services produced by the citizens of the country living and working at home or abroad.
Hence, GNP is arrived at by adding the net economic contributions of foreigners to the GDP
estimate. This is done by adding the contribution of citizens abroad to the GDP estimate and
subtracting the contributions of foreigners living and working here from GDP figures.

We refer to this net contributions as net factor income from abroad (netFIFA) and it is the only
discrepancy between GDP and GNP.

S.A.Q.2.3

The three methods or approaches of measuring national income are as follows:

i. By income approach;

ii. By output approach; and

iii. By expenditure approach.

Income Approach

By adding the total income received by land, labour, capital and entrepreneur which are rent, wages
and salaries; interest and profits/losses respectively; we arrive at national income by income
approach. The validity of this method is emphasized based on the fact that households own factors
of production as well as businesses, so technically, households earn all income.

Output Approach

The second approach, that is, the output approach is the adding of all net output produced within
the given economy. Net output means the net contributions of different sectors/industries which is
the value of final output minus value of input that is used during production. This approach is very
technical because inability to properly track goods especially at intermediate stages can result in
multiple valuation/counting of such goods consequently over blowing national output figures.
Looking at bread/snacks production, the wheat which is the main input must undergo various
stages of transformation as intermediate/semi-finished goods. So taking the exact value of the
milled flour and final bread at different stages means that the same items have been counted more
than once.

Expenditure Approach

The third approach or method, that is, by expenditure sum the overall spending of individuals,
firms and government/public as well as the net expenses on foreign made products. It includes
household consumption (C), businesses investment (I), government expenditure (G) ; and net
import (X-M)

S.A.Q.2.4
National income is widely used. It is used nationally, regionally and on the global stage. Below
are some of the uses:

 National income is a veritable tool for measuring economic progress.

 National income enables us determine the standard of living of the residents through the
per capita income measure as well as other measuring yardstick.
 It is used to predict future economic conditions and as such take advantages of expected
boom or make necessary investment decisions that will generate good returns.
 It can be used to determine the strength of regional economies, say West Africa sub-region.
With national income, a nation can command international attentions and assistance/aids.
 It shapes fiscal and monetary policies formulations and implementations.

S.A.Q.2.5
The determinants of national income among many others include:

i. The level of available productive resources.

ii. The type of technology in use goes a long way in determining national income. Modern
technology will stimulate production and increase national income while outdated
technology will do otherwise.
iii. The business climate can pull or push investment. A conducive business environment is an
impetus to investors while an unconducive business environment drives investment way.

iv. Social and political stability stimulates national income. During civil rule/democracy,
investors’ confidence is boosted for the period of the regime in power. This is quite different under
military regime when baton of power can change suddenly.

v. Financial sector stability is very crucial to national income determination.

Reference

 Jhingan M.L 7th edition, Monetary Economics by Vrinda Publication (P) Ltd
 Debes, Mukherjee 2nd edition Essentials of Micro and Macroeconomics by New Central
Book Agency (P) Ltd
 Sampat, Mukherjee, 1st edition, Analytical Macroeconomics from Keynes to Mankiw by by
New Central Book Agency (P) Ltd
 Mishkin, Frederic S. 7th edition, The economics of money, banking, and financial markets
.

STUDY SESSION THREE

NATIONAL INCOME, AGGREGATE DEMAND AND EQUILIBRIUM

3.0 Introduction

Households demand for consumption goods and firms purchase of capital goods constitute
aggregate demand. Firms produce goods for households and other firms and as such aggregate
demand equal total output at equilibrium. Households’ incomes not spent on consumption demand
leak out by finding their way out of circular income flow. Unspent income is then saved and
eventually flows to the economy in form of investment. Consumption function shows consumption
demand at different level of income. Marginal propensity to consume (MPC) and marginal
propensity to save (MPS) determine the proportion of change in income that will be consumed and
saved respectively. With multiplier concept, we discuss disproportionality of a change in
investment and output. In addition, multiplier explains how a unit change in investment will cause
more than a unit change in total output.

Learning Outcomes for Study Session Three

At the end of this lesson, you should be able to:

3.1 define and use correctly all the key words printed in bold (SAQ1)

3.2 define Aggregate Demand (SAQ1)

3.3 explain concepts of leakages and injections (SAQ2)

3.4 explain in details, consumption and savings functions (SAQ3)

3.5 explain how national income equal aggregate expenditure (SAQ4)

3.6 define multiplier (SAQ5)

3.1 National Income, Aggregate Demand and Output

Our circular flow of income in module 2 is built on assumption of household spending all income
to purchase output of firms with the expenses of individuals becoming the firms’ revenue. As such,
total income is the same as aggregate demand and total output bringing about equilibrium since
total expenditure equals total income. In the light of compelling realities, what then happens to
aggregate output when household does not spend all income on consumption? Will equilibrium
output contract, converge or maintain the same level before the emergence of such situation? What
are the economic processes and mechanism set in motion to adjust the system to equilibrium point?

The foregoing questions will form the fulcrum of our next discussion. The analysis and
clarifications will be based on two crucial basic concepts formulated and used by economists to
justify such scenario. Leakages and injections are no doubt two economic parameters built on
Keynesian model for adjusting aggregate output to change in consumption. Before full exploration,
it is crucial and expedient to critically explain what both concepts represent in this context.

3.2 Leakages

These are resources that are taken out of the income flow. The include unspent money by
household ‘s’ on consumption known as savings, compulsory charges by government or its agents
on households income and businesses’ profits referred to as taxes; and money spent on purchase
of services produced outside the economy but consumed (imports). Generally, leakages can be
represented in mathematical equation as follows:

L = S + T + IM

3.2.1 Savings

In a two sector-model which we are discussing, saving is the only leakage. Saving is household-
‘s’ earnings not used to buy foodstuff, pay bills and meet other households’ needs. Saving is excess
of income over consumption.

Households can save by not spending all income on consumption when income exceeds aggregate
demand. Household can also dissave i.e. borrow from friends or lenders to augment present
consumption if their earnings are insufficient to pay for their demand. Under either of the
situations, there is evident difference between income and aggregate demand or output.

In addition, saving is not money kept at home but unspent income that is put into financial
institutions. Having established these conditions, we use equation to express national income and
aggregate demand with left hand side representing national income while the right hand side stands
for aggregate demand.

Y=C+S (1)
Y = national income which also means aggregate output.

C = consumption, that is resources use for daily provisions.

S = savings, income not spent but kept with financial institutions.

3.2.2 Injections

Injections are resources that find their way into the economic system but not as a result of
households’ expenditure. To arrive at equilibrium, households must use all their income to buy
firms’ products and as such balance both sides of equation. We emphasized in study 2 that
household receipt in form of income earned for owning factors of production they lend to firms
becomes the firms’ revenue when the income is used to pay for the firms’ product.

New capital formation by firms known as investment (I), public spending as stabilization measures
in form of infrastructural intervention regarded as government expenditure (G) and receipt from
the rest of the world as payment for goods and services sold but produced in the economy (Export).
That is, three parameters: Investment, Government expenditure and Export represent injections in
expanded economic model.

I = In + G + Ex

Investment

Under this discussion however we consider investment as the only injection in two sector
economy. Investment is an addition to stock of productive resources. It can also mean new capital
goods (machinery, technology, inventories etc) purchase by businesses.

Having established what savings and investment connote, the next task will be to provide step-by-
step analysis on how what households’ save equals what firms invest in purchasing new capital
goods. The circular flow of income introduced in the last module will be used in doing this task
though with some modifications. The diagram is introduced thus:
Fig.3.1

Leakage and Injection

The numbers in the diagram above show flows of income, expenditure and output in a particular
year. During this year, interaction between households and firms is as follows: firms produce an
output worth of N10,000 for households consumption and N5,000 worth of capital goods for
investment by firms. Households save N5,000 which is a leakage from the circular flow while
firms invest N5,000 in additional capital goods as injections into the circular flow. Households
earn N15,000 which is the national income represented by GDP. So, the value of all final goods
and services produced in the economy during the year under consideration is N 15,000.

However, households spend only ₦10,000 on goods and services produced by firms. This implies
N15,000 flows to household in form of factor payment while only N10,000 flows back to the firms
in form of revenue from goods and services sold to households; leaving a balance of N 5,000
which flows out.

How does N5,000 that leak out of the circular flow find its way back into the flow so as to maintain
a balance? Who received the ₦5,000 and how will it be channelled into the circular income flow?

We know that excess of income over consumption is savings. Hence ₦5,000 is households’
savings. In furtherance to this conclusion, firms must spend ₦5,000 on new capital goods (new
buildings, plants, technologies) to support production and maintain balance of expenditure and
output. With the aid of equations, we explain adjusting mechanism that bring about this reality. In
the equation, consumption expenditure and savings make up total expenditure or output which
must equal national income at equilibrium.

Y=C+S (1)

If Y represent total final output (GDP), which equals household ‘s’ receipt (incomes), C denotes
households’ expenditure on consumption, and S represents savings; measuring GDP by
expenditure approach sum up all expenditure (consumption and investment) which can be written
as follows:

Y=C+I (2)

Setting equations (1) and (2) equal, we arrive at:

S=I

This is how we arrive at savings equals investment in our above explanation. In a two-sector
economy where government and external sectors are absent, actual savings must equal actual
investment even if desired savings differ from desired investment.

Households transfer their excess income over consumption to firms through banks. Households
save what is not spent with banks who in turn lend it to businesses. Indirectly, households are
lending their savings to firms while firms borrow such to buy new capital goods.

The concern of economists is to determine factors that influence the level of national output at any
point in time. The focus of analysis is on aggregate demand expenditure which changes from time
to time though the potential output cannot be changed within the short space of time. When
aggregate demand increases, firms increase their output to match up with the expansion. Limit on
productive capacity of machinery imposes constraint on output growth so output cannot expand
beyond certain limit. The alternative strategy is to buy bigger plants to balance up but the economic
reality is that installation of bigger plants cannot occur within a short period of time. Therefore,
output will keep expanding in response to growing aggregate demand when the potential output
level has not been attained. Upon attaining potential output level, increase in aggregate demand
will result in more money chasing few commodities so prices keep rising resulting in inflation.
Alternatively, continuous fall in aggregate expenditure makes firms cut output, close down some
business lines, downsize and lay off some employees. We call this situation recession which if it
continues for some time results in depression. The great depression of 1930s was as result of
protracted fall in aggregate demand or expenditure. Maintaining equilibrium is central to
macroeconomic policies design and implementation. We will now examine other concepts that are
salient to the study of aggregate expenditure and potential output.

3.3 Consumption Function

In a two sector-model where government is absent, household income is the same as disposable
income. But when there is government and taxes are imposed on incomes, disposable income is
household receipts minus taxes.

Yd = Y – T

The Yd, Y and T represent disposable income, national income and income taxes respectively.
Households then plan what to buy or save with their disposable income. So, disposable income is
the same as aggregate demand and aggregate demand is spent on consumption and investment.

AD = C + I

From the laws of demand, increase in income leads to an in increase consumption of commodities
that are not inferior implying that aggregate consumption rises with aggregate disposable income.
Consumption function explains in detail changes that take place to consumption when income
changes. Consumption function relates aggregate consumption to aggregate disposable income. In
other words, it shows the relationship between households consumption at different levels of
disposable income. Consumption function is represented in equation thus:

C = C0 + cY , (2)

where C0 is consumption not related to level of disposable income (autonomous consumption)

c is the proportion of additional income spent on consumption (marginal propensity to consume)

Y is the disposable income.

A college student that is neither working nor earning income buy books, foodstuff, pay transport
fare and other items. His income stream may be from his parents, uncles, etc. Such college students
expenditure is what economists term autonomous consumption (Co). Co is intercept unrelated to
income level. Autonomous consumption is positive when income is zero.

c defined as marginal propensity to consume (mpc) is the slope of consumption function and a
measure of proportional increase in consumption to change income. If income increases by N1, it
will increase by Nc.

Fig.3.2

C = C0 + cY
Consumption

C
A

C0

0
Income

Graphical Illustration of Consumption Function

Autonomous consumption pushes consumption curve above origin line (0).

3.3.1 Saving Function

When income is zero, autonomous saving is negative meaning that household‘s’ dissave, deplete
their asset or borrow to augment consumption.Since c-marginal propensity to consume (mpc) is a
fraction, that is greater than zero but less than 1, mps will be 1 minus marginal propensity to
consume (1-mpc) or (1-c)

Savings function shows desired savings at each level of disposable income.

S = -C0 + (1 – c)Y (3)

Addition of equation 2 and 3 gives desired consumption plus desired savings on the right hand
side and income on the left hand side of the equation respectively.

Fig.3.3

-C0 + (1 – c)Y

-C0

Graphical Illustration of Saving Function

3..3.2 Investment function

Investment demand is firms’ intention to add to stock of machineries, plants, assets and
inventories. Investment decision depends on what is expected to happen and not what had already
taken place. Firms use past data to forecast future demand conditions and when forecast result
shows positive signals of sustainable increase in aggregate demand, they add to their stock of
capital goods. There is no relationship between current level of income and investment so
investment demand is autonomous and induced. Hence, desired investment is constant,
independent of current output and income.
Fig.3.4

dI

dr

MEI

0 r

Graphical Illustration of Investment Function

MEI represents marginal efficiency of investment or internal rate of return.

MEI represents the interest elasticity of demand for investment (or capital goods) or the
responsiveness of investment to a change in interest rate.

3.4 Aggregate Demand

This represents household‘s’ planned expenditure plus business’ planned expenditure at each level
of income. Investment demand is constant, consumption is the only part that add to aggregate
demand as income level changes. Also, the slope of consumption function (mpc) is the slope of
aggregate demand. We can derive aggregate demand curve by adding investment demand to
consumption demand.

Fig.3.5
 AD = C + 1
C

AD

Aggregate Demand Curve

Equilibrium output

In the short run when prices and wages are fixed, actual output equals aggregate demand.At
equilibrium, firms sell all product while households buy all they wants. If aggregate demand
increases, output cannot be increased beyond short run equilibrium when short run equilibrium is
below potential output. Similarly, equilibrium occurs where planned savings equals planned
investment. Equilibrium income will make households save as much as firms will want/plan to
invest.

Planned investment is autonomous, and so represented with a horizontal line.

Planned savings = -C0 + (1-c)Y.

(1-c)Y slopes upward when income is greater than zero and mps is positive. Equilibrium output
automatically adjust planned savings to planned investment. Let us throw more light on how
equilibrium output adjusts savings to investment with the aid of the diagram below. The horizontal
axis represents income while vertical axis represents total output.

Fig.3.6
 450 line

AD
E*

Demand
Spending B

Y1 Y* Output

The 450 set the values of variable on vertical axis equal to that on horizontal axis. The point E*, at
which the AD schedule crosses the 450 line, is the only point at which AD is equal to income.
Hence E* is the equilibrium point at which spending equals actual output and actual income. If
output falls to Y1, income will be greater than output.

3.5 Multiplier

The slope of aggregate demand (AD) depends on marginal propensity to consume (mpc). For any
given mpc, autonomous expenditure equals (C0 + I). AD curve is vertical addition of investment
expenditure to consumption expenditure. In the short run, only investment expenditure shifts
aggregate demand curve.

The major concern is how much change will happen to equilibrium output if investment
expenditure changes by 1 unit? The change we are considering here is a reduction in investment
assuming the economy operates at full potential. The initial effect of a unit change in investment
is equivalent to a change in output and with marginal propensity to consume, further changes occur
making the effect larger.

This occurs as a result of multiplier effect which will always cause more changes in output.
Multiplier is defined as the ratio of change in equilibrium output to the change in investment
expenditure. Multiplier is always greater than 1 because mpc is greater than 0. In addition, changes
in aggregate spending trigger further changes in consumption demand.
Marginal propensity to consume (mpc) is directly related to multiplier. If marginal propensity to
consume is large, fall in income will cause great fall in consumption demand and vice versa.
Multiplier effect can be explained mathematically as shown below.

If C = C0 + cY; where C0-Autonomous consumption, c-mpc; C = 10 + 0.8Y

Suppose Y = N100, C = 10 + 0.8(100)

C = 10 + 80 = 90; consumption expenditure is ₦90

The difference of ₦10 is savings which eventually transform into investment expenditure which
is the same as investment demand by firms.

Using the above consumption function, we can say 1 unit reduction in investment demand leads
to 0.8 change in consumption. Firms then cut output by 0.8 which causes consumption demand to
change by 0.64. Since AD has fallen, firms respond by reducing output further to 0.51and so on.
The adjustment will continue until market settles at a new equilibrium where income equals output
and aggregate demand (consumption and investment demand).

In the number series below, the summation continues until the economy settles at a new
equilibrium:

Multiplier = 1 + 0.8 + 0.82+ 0.83 +…

In line with the foregoing, multiplier is seen as series of changes in output caused by changes in
autonomous expenditure from one equilibrium point to another.

Alternatively, since the size of multiplier depends on MPC, mathematical economists have
developed easier method of calculating multiplier using MPC.To find the multiplier by this
method, we subtract MPC from 1. The difference represent proportion of income not spent on
consumption and as such saved. Dividing 1 by (1-mpc) gives the multiplier. Thus,

Multiplier = 1/(1-MPC) or 1/(1-c)

Note that (1-c) = MPS

Worked example1:
If C = C0 + cY

C0 = 20, MPC = 0.8, I = 20 and Y = 200

Multiplier = 1/(1 – 0.8) = 1/0.2

Multiplier = 5

Worked example 2:

If C0 = 40, mpc = 0.6, I = 40, Y = 200

Multiplier = 1/(1-0.6) = 1/0.4

Multiplier = 2.5

From both conclusion, we can see how MPC size determines the size of multiplier.

Using example 2, if investment demand is reduced to 30, find the new equilibrium output?

Solution:

This means a cut of 10 from initial investment expenditure.

Multiplier = 2.5 since the MPC remains unchanged.

New equilibrium output = 200 – (2.5 X 10)

= 200 – 25

= 175.

Hence, 10 unit cut of investment expenditure will reduce output by 25 units.

Summary of Study Session Three

Aggregate demand is the total consumption and capital goods bought. It includes households’
expenditure on food, clothing, etc, and businesses acquisition of new plants, machineries, etc

National income equals aggregate demand and output at equilibrium.

Leakage is part of household income that is unspent and as such not received by firms as revenue
from products sold. Saving is unspent income that leaks out of the flow.

Injection is resources generated but not directly by households demand. It appears in form of
firms’ purchase of capital goods as investment in order to increase output.

In the event of rising aggregate demand, output level is increased when potential productive
capacity is not reached in the short run. In such instance, income and output increase and price is
stable.

If potential output is reached and aggregate demand continues rising, general price level increases
bringing about inflation.

When total output rises above aggregate demand, stock of inventory rises and when this continue,
firms will cut output. If it continues further, continuous declining in output culminate in
downsizing, involuntary unemployment and recession are the outcome. Prolonged recession then
plunges the nation into depression.

The multiplier examines the ratio of change in autonomous expenditure to total change in
equilibrium output level. It can be calculated using marginal propensity to consume since mpc is
a positive value between zero and one. Multiplier is always greater than one

Self-Assessment Questions for Study Session 3

S.A.Q 3.1

What do you understand by Aggregate Demand?

S.A.Q 3.2

Actual savings equals actual investment. Discuss.

S.A.Q 3.3
Capital goods demand causes a shift of AD curve. Discuss

S.A.Q 3.4

Explain the concept of Multiplier and the effect of a change in Investment on output.

S.A.Q 3.5

Explain the relationship between the multiplier and marginal propensity to consume.

Answers

S.A.Q.3.1

Aggregate demand can simply refer to the household‘s’ intended spending/expenditure on

consumption goods and firms planned investment expenditure at different levels of income. In a
two sector economic model where households spend their income on consumption and save the
unspent income. The unspent income which is savings through financial intermediaries is passed
unto firms or businesses which spend same on capital goods in order to increase the level of output.
The amount spent on consumption goods and savings differs at different income level so aggregate
demand responds to changes in income.

S.A.Q.3.2

Households save income that is not spent presently on consumption goods. Therefore, household
income is the summation of consumption expenditure and savings. Since aggregate demand is
household consumption expenditure plus firms investment spending, actual savings must adjust to
actual investment in order to maintain income balance. This can also be explained with
withdrawals-injections concepts. Saving is seen as withdrawal/leakage, that is, economic resources
that flows to households from firms but does not flow back to firms directly from households as
payment for firms commodities purchased. However, firms contract such economic resources to
continually produce the given level of output. Such resources are spent on purchase of capital
goods produced by other firms. Consequently, total output will consist of consumption goods and
capital goods. Since the value of output remains unchanged despite the nature (consumption and
capital) of the goods, the amount spent on capital goods by firms will be the same as the amount
not spent by households on consumption goods. Based on this notion as well as mechanism of
exchanges, actual savings equals actual investment even if intended/planned savings differ from
investment.
S.A.Q 3.3

Capital goods demand which is the demand by firms/businesses refers to investment expenditure.
Aggregate demand as total demand which equals total output and income at equilibrium comprises
household‘s’ consumption demand and capital goods demand. Using our consumption function
and curve, we know that consumption is made when income is zero refer to as autonomous
consumption and unrelated to level of income. So mpc determines extra unit of consumption that
will be made as a result of extra unit of income and it is the slope of consumption curve. What this
implies is that mpc cannot shift consumption curve and by extension aggregate demand curve since
aggregate demand is consumption plus investment demand. Investment demand being autonomous
demand and unrelated to level of income is the only variable that can shift aggregate demand
upward and downward. Investment demand is made based on future forecast.

In a nutshell, aggregate demand shifts upwards when firms increase their investment demand and
shifts downwards when firms cut investment demand when business environment is not very
promising.
S.A.Q 3.4

Multiplier is the ratio of change in the equilibrium level of output as a result of change in
autonomous spending. With the marginal propensity to consume (mpc) is greater than zero and
less than 1, a unit change in income will not bring about a unit change in equilibrium output.
Therefore, any change in autonomous spending will trigger series of changes in equilibrium output
beginning with a unit change and further changes until the new equilibrium output is attained.
Investment spending is an autonomous expenditure unrelated to level of income. The total effect
of a change in investment expenditure on equilibrium output level is determined by the mpc which
determines the multiplier size. With the size of the multiplier, when investment spending increases,
the total effect of this increase on equilibrium output level will be the investment expenditure times
the size of the multiplier and vice versa.
S.A.Q 3.5
Obviously, 1 less marginal propensity to consume (mpc) gives the marginal propensity to save
thus: (mps = 1-mpc). Based on this, the size of the marginal propensity to save (mps) determines
the multiplier size. This is how it works, since multiplier is got by dividing 1 by the mps that is,
(Multiplier = 1/mps) and mps must be less than 1. In line with this, there is an inverse relationship
between the Multiplier and mps. If mps size is large, multiplier size is small and vice versa.

References

 Jhingan M.L 7th edition, Monetary Economics by Vrinda Publication (P) Ltd
 Debes, Mukherjee 2nd edition Essentials of Micro and Macroeconomics by New Central
Book Agency (P) Ltd
 Sampat, Mukherjee, 1st edition, Analytical Macroeconomics from Keynes to Mankiw by by
New Central Book Agency (P) Ltd
 Mishkin, Frederic S. 7th edition, The economics of money, banking, and financial markets
.
 STUDY SESSION FOUR

GOVERNMENT EXPENDITURE, TAXES, FOREIGN TRADE AND MULTIPLIER

4.0 Introduction

Government expenditure affects equilibrium output level directly while net positive taxes inversely
affect equilibrium output level. Increase in government expenditure triggers continuous increase
in output until the economy fully settles at higher equilibrium. This perpetual change is caused by
the multiplier. Tax increase by the government however lowers equilibrium output while a tax cut
increases equilibrium output. Similarly, tax multiplier determines the ratio of change but tax
multiplier is usually lower than government spending multiplier with given marginal propensity
to consume (mpc). In the situation of equally increased government expenditure and taxes,
equilibrium output will increase by the size of government expenditure and tax as explained by
balanced budget multiplier which is identically equal to 1.Imports reduces marginal propensity to
consume domestically produced commodities since imports demand is included in aggregate
demand. Likewise, marginal propensity to import reduce the size of the multiplier.

Learning outcomes for study session four

At the end of this lesson, you should be able to:

4.1 explain government expenditure as injection as well as autonomous spending (SAQ1)

4.2 explain the impact of government expenditure on aggregate demand (SAQ2)

4.3 define government expenditure multiplier and how to find it (SAQ3)

4.4 define net taxes and explain how net positive tax affect income, aggregate demand and
equilibrium output (SAQ4)

4.5 Define tax multiplier (SAQ5)

4.6 Explain balanced budget multiplier; and (SAQ6)

4.1 Government Expenditure

Public sector inclusion in our economic model expands the economy. Public sector activities
manifest in two forms: as government expenditure and taxes. Government exists to cater for the
welfare of its citizens irrespective of where they live and work and as such, provides them with
basic necessities of life. In doing this, government develops a formidable workforce (civil service),
builds strong armed forces; establishes other institutions that will enable it perform its
constitutional obligations. Total government spending is referred to as government expenditure
which includes civil servants salaries and allowances, military and armed forces maintenance fee,
money spent on road construction, repair and maintenance, cost of building new power plants,
provision of pipe borne water, provision of sound healthcare, provision of quality education at all
levels, subsidies and transfer payments. Total government expenditure include spending of central,
states and local government. The table below shows the Nigeria government spending in 2008.

Items Capital Recurrent

(N’Million) (N’Million)

Administration 287100 731000

Table Economic Services 504400 313800 4.1
Nigeria
Social & Community services 152100 332900

Transfers 17300 739700

Total 960900 2117400

Government Expenditure For 2008

Source: CBN Statistical Bulletin: 2010

4.2 Government Expenditure and Aggregate demand

Government expenditure, as an additional spending on goods and services, adds to aggregate
demand. When added to consumption and investment demand, the aggregate demand function
shifts upward.

In studying the effect of government expenditure on aggregate output, we reproduce our aggregate
demand equation as written below:

AD = C + I + G

In the short run, government expenditure (G) is fixed, not affected by the level of income.
Therefore government expenditure is autonomous spending.

In line with this, we now have three autonomous expenditure namely: autonomous consumption
(C0), investment expenditure (I) and government expenditure (G).

4.3 Government Expenditure and Government Expenditure Multiplier

Government spending is autonomous and not directly related to the level of income. Many times
government intervention as expenditure is spontaneous and imperative. Spending on security,
environmental challenges, natural and man-made disaster are injections, meanwhile resources used
for public spending are not directly generated by households consumption demand.

In the event of zero tax rate, national income is the same as disposable income. With marginal
propensity to consume put at 0.8, the multiplier is the same as in two sector economy we studied
in module three. When government spending changes, output will change by the value of the
change in government expenditure times the multiplier. For instance, if government spends
additional N100 to mitigate the effect of fire outbreak, this spending will initially increase output
by N100. Since output has increased, more workers will be employed to produce additional output
at the same time increasing income. Now households have additional resources and will increase
their consumption demand and savings. Increase in aggregate demand, output and income will
continue further until the economy settles at a new equilibrium.

With the help of multiplier, we can determine the equilibrium output change which government
expenditure change will trigger. If mpc is 0.8, households continue to spend 80k of additional N1
of national income on consumption and save 20k. Then, multiplier is 5. Therefore, an increase of
N100 government expenditure will cause a change of ₦500 in equilibrium output level. This is
similar to how a change in investment demand affects output, income and consumption demand
explained in module three. This is so because investment expenditure (I) and Government
Expenditure (G) are autonomous spending. Similarly, the multiplier is the same as when
investment expenditure is altered. We only label this multiplier government expenditure multiplier
unlike in the previous module. The government expenditure multiplier is the ratio of the change in
the equilibrium level of output to a change in government expenditure. Based on this:
Government expenditure multiplier = 1/MPS

If the mpc is 0.8, government expenditure multiplier is 1/1 - 0.8 = 1/0.2 = 5.

Therefore, an increase of ₦100 in government expenditure will cause an increase of ₦500 in

equilibrium level of output.

4.4 Effect of Taxation on Income

On the contrary, government withdraws fund by imposing taxes on factors of production (labour,
land, capital and entrepreneur) incomes, corporate profits, profits on mineral resources exploration,
production of goods (value added tax) and consumption of goods. Generally, income tax is referred
to as direct tax while others are indirect tax. Tax reduces income available for consumption and
savings.

To cater for individuals not presently earning income, government makes transfer payments in
form of pension, unemployment benefits, etc, from generated tax revenue. Therefore, we find net
taxes by subtracting transfer payments from tax revenue. We do not include transfer payments in
GDP estimation because it is unearned income. Transfer payments affect aggregate demand only
by affecting other components such as consumption or investment.

As said in module three, in the absence of government, national income is the same as disposable
income (Y = Yd). In this section, government tax revenue must be subtracted from national income.
So households plan their consumption expenditure and savings on disposable income. National
income is now greater than disposable income when tax rate is greater than zero and positive. This
can be expressed as equation below:
Yd = Y - nT = (1 - t)Y

Where Yd= disposable income,

Y = national income,

nT = net taxes,

t = tax rate

If net taxes are proportional to national income, the total net tax yield or net tax revenue is tY.
Suppose net taxes are about 20 percent of national income, net tax rate (t) is 0.2. An increase of
N1 in national income will increase disposable income by 80k as government receives 20k as
additional net tax revenue.

Also, households’ consumption is proportional to their disposable income and not national income.
When autonomous consumption is zero, the proportion of households’ additional income that is
spent on consumption will be 0.8 or 80 percent of disposable income.

The consumption function is as follows:

C = 0.8Yd

Note that Yd is disposable income and not national income.

Relating consumption demand to national income, consumption function becomes:

C = 0.8Yd = 0.8(1-t)Y

An increase of ₦1 in national income will result in a change of 0.8(1-t)Y in consumption demand.

As seen that 0.8Y is greater than 0.8(1-t)Y when t is greater than zero (t > 0). Hence, positive net
tax rate reduces marginal propensity to consume out of national income.

Let us take our net tax rate to be 20 percent or 0.2 as earlier suggested, consumption demand out
of every ₦1 increase in national income then becomes N0.8(0.8) = ₦0.64. Spending N0.64 or 64k
of ₦1 additional national income on consumption implies a flatter consumption function than when
80k of each additional income is spent.

Fig 4.1

Consumption C = 0.8Y CC

CC1

C = 0.64Y

Income
Consumption Function Graph

In the absence of taxation, Y = Yd. The consumption function CC relates consumption expenditure
to national income which shows that households will spend 80k of ₦1 extra national income on
consumption expenditure when marginal propensity to consume is 0.8. However, with a
proportional net tax rate of 20 percent or 0.2, households will still spend 0.8 or 80 percent of
disposable income on consumption but disposable income is 80k as against ₦1 national income,
hence, households spend only (0.8X0.8) = 0.64 of national income on consumption expenditure.

Thus net taxes rotate the consumption function downwards from CC to CC1 as shown in the
diagram above.The real effect of positive net tax rate (t) is that it decreases marginal propensity to
consume.

4.5 Net Taxes and Tax Multiplier

Positive tax rate reduces mpc out of national income since taxes reduce money available for
consumption and savings. mpc out of national income is then written as follows:
MPCy = MPCd X (1-t)

Where: MPCy = marginal propensity to consume out of national income

MPCd = marginal propensity to consume out of disposable income

If MPC is 0.8 out of disposable income and net tax rate is 20 percent; mpc out of national income
is:

MPCy = 0.8 (1 - 0.2)

MPCy = 0.8 X 0.8

MPCy = 0.64

Hence, when national income increases by ₦1, households will spend 80k on consumption in the
absence of net positive tax rate. When net tax rate is put at 20 percent, households now spend 64k
out of ₦1 addition to national income.

Tax is burden which reduces income available for spending. Besides, it has an inverse relationship
with equilibrium output. How will a change in taxes affect equilibrium output? In a situation of
tax increase, consumption demand falls consequently reducing equilibrium output and income.
The reverse is the case when government cut tax rate. If government cuts tax by N100 and marginal
propensity to consume remains 0.8; N100 is seen as an additional income available to households.
However, households will not spend the entire N100 on consumption but only the proportion
defined by the mpc; households spend N80 not N100 additional income.

The change in equilibrium output level will be N400. Certainly, how we arrive at N400 must be
clarified. The multiplier influences the change in equilibrium output. The multiplier here is
regarded as tax multiplier, negative and lower than investment or government expenditure
multiplier.Tax multiplier is then defined as proportion of change in equilibrium output to a change
in taxes.Tax multiplier is negative because a tax increase reduces income and as such decreases
consumption expenditures and output; while a cut in tax will increase income and with higher
income, consumption expenditures and output rise. Tax multiplier can be written thus:

Tax multiplier = - MPC/MPS

For instance, with mpc of 0.8, mps is 0.2, tax multiplier is then – 4.

A tax cut implies a fall in government revenue to the amount of tax reduction which is –₦100
(negative amount). Since, tax multiplier is -4 (another negative figure); multiplication of both gives
a positive figure (-₦100 X -4). So, equilibrium output will change by ₦400.

The same analysis can be extended to aggregate demand to identify the effect of net positive tax
on equilibrium output and national income. Addition of investment expenditure to consumption
function shifts consumption demand upward to produce AD function. The diagram below explains
in details.

Fig. 4.2

450 line
AD
AD
E
AD1

E*

Y* Y Output

Aggregate Demand

Taxes shift AD1 function to the points where it crosses the 450 line. AD function crosses 450 line
at higher equilibrium output and income. When tax rate are lower, equilibrium output and AD
increases when AD and equilibrium output is below potential or full capacity output.

4.6 Balanced Budget Multiplier

With balanced budget multiplier, we examine the combined effect of net tax rate and government
expenditure. What will happen to equilibrium output level when an increase in government
expenditure is equally matched with net tax revenue? Or if government intends to increase
spending on key sectors of the economy but finance the spending with tax revenue it means that
government expenditure will increase without corresponding increase in deficit financing. To a lay
man, equilibrium output will remain at same level before such fiscal intervention.

We examine if the lay man view is correct or otherwise. If equilibrium output and national income
is N200 at zero tax rate, how will equilibrium output change supposing government increases its
expenditure by N40 and equally place 20 percent tax on income?

Increased government spending will positively and directly impact equilibrium output. However,
increased taxes will negatively impact output but will not counterbalance the effect of increased
government spending. Hence, total effect of this fiscal intervention on equilibrium output will
depend on how households will respond. We know that households will spend 80 percent of
additional disposable income and save 20 percent. However, tax increase will reduce disposable
income; reducing available resources for consumption and savings. Hence, additional ₦40
government expenditure will increase output by full amount while households will reduce
consumption demand by N32, that is, (0.8XN40); since marginal propensity to consume is 0.8.
Hence, only N8 worth output has been created. Consequently, change in equilibrium output level
will be N8 X 5 (investment multiplier) triggering a process that will result in ₦40 rise in
equilibrium output.
We can arrive at same result using alternative method, if mpc is 0.8 and multiplier is 5, an increase
of N40 in government expenditure will positively change output by N200 = (N40 X 5). On the
contrary, a tax revenue of N40 will negatively affect output by N40 X tax multiplier thus: N40 X
-4 = -N160; equilibrium falls by N160. On the balance, government expenditure increases
equilibrium output by N200 while taxes reduces equilibrium output by N160 leaving a positive
balance of N40 change in equilibrium output level. Obviously, the size of equilibrium output
change is the size of change in government spending or taxes.

The changes as discussed above is perpetuated by balanced budget multiplier which is defined
as the ratio of change in the equilibrium level of output to a change in government spending where
the change in government spending is equally matched by a change in taxes so as not to increase
deficit financing. The balanced-budget multiplier is identically equal to 1: the change in
equilibrium output resulting from the change in government expenditure and the equal change in
taxes are exactly the same size as the initial change in government expenditure or taxes. Balanced
budget multiplier can be derived by the addition of government expenditure multiplier and the
taxes multiplier as shown below.
Multiplier = 1/MPS + (-MPC/MPS)

Multiplier = MPC – 1/MPS

Multiplier = MPC/MPS = 1

With balanced budget multiplier, we can conclude that a rise in government spending with an equal
rise in taxes leads to higher equilibrium output. The table below provide further explanations and
clarifications on how G and T adjust equilibrium output.

Table 4.2 Equilibrium In Aggregate Demand

Output Net Disposable Consumption Planned Government Aggregate Inventory Adjustment to

(Y) tax Income (Yd) demand Investment spending demand equilibrium
(T) (I)
C=20+0.8Yd G C+I+G Y- AD

200 40 160 148 20 40 208 -8 Output Rising

210 40 170 156 20 40 216 -6 Output Rising

220 40 180 164 20 40 224 -4 Output Rising

230 40 190 172 20 40 232 -2 Output Rising

240 40 200 180 20 40 240 0 Equilibrium

250 40 210 188 20 40 248 2 Output falling

260 40 220 196 20 40 256 6 Output falling

Y = AD. There is only one point of equilibrium where both output (Y) and aggregate demand equal
₦240 respectively. At no other output level can we have this result.

4.7 Net Export and Multiplier

We have analysed economic performance of self-reliant economy so far, that is, how changes in
certain parameters will alter equilibrium output level, income and aggregate expenditure.

In modern economy, no economy or nation can produce all her commodities (goods and services)
efficiently. So, every nation in a bid to be competitive deploys productive resources to concentrate
on commodities for which it has comparative advantages. There arises the need for nations of the
world to transact with one another. Based on this, a nation will sell (export) her excess commodities
to nations which need such and cannot produce them locally and at same time use the proceeds
from such sales to buy (import) goods and services needed by her citizens but produced elsewhere.

Exports as part of goods and services produced in the economy are included in the GDP estimation
while imports as commodities consumed but not produced in the economy are excluded though
spending on imports are part of final expenditure. GDP as sum of total expenditure in open
economy is defined as follows:

Y = C + I + G + (X-M); N-X being the net exports, that is, total exports – total imports

Exports demand depends on macroeconomic conditions of nations abroad. Exports demand are
unrelated to domestic income and output so, we treat export demand as autonomous demand.

Imports demand however is related to domestic income and can be treated as leakage because local
income used for buying foreign made goods add to output abroad; it rises with income but not by
total income change. Import is determined by the proportion of additional income which
households wish to spend on consumption of foreign made products; and is referred to as marginal
propensity to import (MPM).MPM is defined as the fraction of each extra naira of the national
income that domestic residents wish to spend on extra imports. Also, MPM is the slope of import
demand.
The gaps between export and import demand is the net exports demand and is included in the GDP
estimate. By including net exports in GDP estimate, aggregate demand is defined as follows:

AD = C + I + G + X – M > C + I + G; when X-M > 0

As output rises, import demand rises and desired net exports fall. However, import demand will
rise by the marginal propensity to import. Suppose 10k of extra ₦1 national income is spent on
imports, then MPM is 0.1. Marginal propensity to consume out of national income then becomes
marginal propensity to consume minus marginal propensity to import.

MPC = MPCy - MPM

From previous analysis where MPC is 0.64, now with MPM put at 0.1, marginal propensity to
consume out of national income is 0.64 - 0.1 = 0.54.

The figure above can be interpreted thus: 54k of extra ₦1 increase in national income will be spent
on domestic consumption. We have learnt how net positive tax rate reduces MPC, now imports
demands reduce MPC out of national income further.

Multiplier in open economy: this explains changes in equilibrium output level as a result of a
change in level of imports. Additional unit of income raises consumption demand for domestically
produced goods not by MPCy but by MPC - MPZ because of additional resources used to purchase
foreign made commodities.

The multiplier can be derived as follows:

Multiplier = 1/{1- (MPC’ - MPZ)}

With our earlier figures, mpc = 0.64 and mpz = 0.1, multiplier is therefore:

1/{1 – (0.64 - 0.1)}

1/1 – 0.54

1/0.46 = 2.17

Multiplier of 2.17 implies that extra ₦1 expenditure on imports will cause a change of N1X2.17
to the equilibrium output.
The marginal propensity to imports tends to lower the multiplier effect because demand for locally
produced goods and services falls as demand for foreign products increases.

Summary of the study session four

Government expenditure is the spending of the state in order to improve the living standard of
the people. It includes emoluments of civil servants, money used to provide basic infrastructure,
spending on security, among others.

Taxes are compulsory charges imposed on income earning factors.

When government expenditure changes by certain units, multiplier will cause further changes in
equilibrium output level more than the change in government expenditure.

Net positive taxes reduce households’ income, affect aggregate demand negatively and cause
decline in equilibrium output. Tax multiplier shows the ratio of change in net tax rate to a change
in equilibrium output.

With balanced budget multiplier, we learn how increase in government expenditure together
with a corresponding increase in tax rate will change equilibrium output by the size of government
expenditure or taxes. Hence, balanced budget multiplier is identically equal to 1.

The proportion of extra income spent on extra foreign made products is known as marginal
propensity to import (MPM). MPM reduces the size of MPC out of national income and at same
time the size of the multiplier.

In an open economy, savings, taxes and imports constitute leakages while investment
expenditure (I), government expenditure and exports represent injections.

Leakages must be equal to injections to ensure equilibrium output level.

Self-Assessment Questions for Study Session four

S.A.Q 4.1

Government expenditure affects equilibrium output directly, discuss?

S.A.Q 4.2

Explain how a tax cut will affect MPC and equilibrium output level.

S.A.Q 4.3

Balanced budget multiplier will cause a change in equilibrium output level that is equal to the size
of a change in government expenditure or Tax. Discuss?

S.A.Q 4.4

Explain how imports affect MPC and multiplier.

S.A.Q 4.5

Federal government of Nigeria has decided to construct second Niger Bridge to the tune of
₦1trillion. The government has also decided to fund the projects with tax revenue and has
mandated IFRS to review taxes upward to the tune of ₦1. Discuss how this policy will affect
equilibrium output level?

Answers

S.A.Q 4.1

Government expenditure as autonomous spending unrelated to the level of income is usually an

intervention in order to stimulate production of goods and services. The transmitting mechanism
is that government spending finds its ways into individual hands/pockets which in turn is used it
to pay for commodities bought from firms. Firms use the income generated from sales of its output
to purchase additional capital goods and pay other factors of production employed.

It can be established that, when government increases her spending, households will increase their
purchases of goods and services which will cause an increase in output of firms/businesses in order
to meet growing demand; and finally provoking an increase in equilibrium output level. So, there
is a positive relationship between government expenditure and equilibrium output.

S.A.Q 4.2
Tax as compulsory levy imposed on individual income and business profits by the government is
a burden on the payer because tax reduces amount available for consumption.Positive net tax rate
reduces MPC out of national income since the disposable income is less than national income. For
instance, if the MPC = 0.7 and net tax rate is 10% or 0.1. MPC out of national income will be
0.7(0.9) = 0.63 as against 0.7 when positive tax rate is zero. Simply put, positive tax rate reduces
MPC.

Tax has inverse relationship with equilibrium output. So an increase in tax rate will cause a decline
in equilibrium output while tax rate cut will increase output level. However, with MPC less than
1, tax cut does not influence equilibrium output as increase in government expenditure does. For
instance, if government cut tax by $500 and MPC is 0.7. Though additional $500 is made available
for spending, household will only spend $350 and not the entire $500.

Consequently, the change in equilibrium output level will be determined by the tax multiplier
which is always negative. Using the figure above, now that our MPC out of national income is
0.63, the multiplier will reduce based on the positive relationship between MPC and multiplier;
and the equilibrium output will not increase exactly as it does without positive tax rate or when
positive tax rate is zero.

S.A.Q 4.3

Balanced budget multiplier arises when government intends to increase her expenditure but plan
to finance same with tax revenue. The implication of this is that, tax rate will increase up to the
value of planned government expenditure. Hence, there will be combined effect on equilibrium
output level. A unit increase in government expenditure combined with a unit increase in tax will
cause a unit increase in equilibrium output level at new equilibrium. The adjusting mechanism is
this: government expenditure multiplier determines the total effects of increased government
expenditure while tax multiplier determines the total effect of tax rate change on equilibrium
output. The combined effect will be the same as the size of the increased tax cut or government
expenditure. The balanced budget multiplier is always 1. It is 1 in the sense that output level and
income are only equal at that level of output at new equilibrium point.
S.A.Q 4.4

Import refers to resources spent on foreign made products and as such constitute leakage. Extra
import depends on the proportion of extra income which individuals and firms intend to spend on
foreign made products. So, this is defined as marginal propensity to import (MPM). Extra income
has to compete with locally produced commodities and foreign made products so imports reduce
the MPC out of national income.

In a similar vein, imports demand reduces the size of multiplier because demand for locally
produced goods and services falls as demand for foreign products increases.

S.A.Q 4.5

One trillion naira that will be spent to construct the second Niger Bridge represents increase
government expenditure. Government, however, has decided to finance the project with increased
tax revenue rather than raise deficit financing as an alternative.

With this project, the contractors handling the will project increase their spending on raw materials,
labour and logistics. Since, individuals receives the payment as reward for the factors of production
which belong to them, individuals are more empowered to consume but not to the tune of ₦1
trillion alone but by ₦1 trillion times the multiplier. This will appear in form increase of aggregate
demand, that is, demand by households and businesses.

On the other side of the coin, increased tax signifies income decline which will eventually reduce
households and firms consumption. However, with marginal propensity to consume less than 1,
the tax multiplier is lower than government expenditure multiplier.

Though, government will not expend any amount directly to finance the project, the balanced
budget multiplier will trigger an increase worth N1 trillion in output level when the economy
settles at new equilibrium. Hence, the value of the firms total output, national income and
aggregate demand at new equilibrium will be ₦1trillion higher than it was before the project
implementation.

References
 Jhingan M.L 7th edition, Monetary Economics by Vrinda Publication (P) Ltd
 Debes, Mukherjee 2nd edition Essentials of Micro and Macroeconomics by New Central
Book Agency (P) Ltd
 Sampat, Mukherjee, 1st edition, Analytical Macroeconomics from Keynes to Mankiw by by
New Central Book Agency (P) Ltd
 Mishkin, Frederic S. 7th edition, The economics of money, banking, and financial markets
.

STUDY SESSION FIVE

 INVESTMENT ANALYSIS, ACCELERATOR THEORY AND AGGREGATE LEVEL
OF EMPLOYMENT

Introduction

Investment has a specific meaning in economics. It means addition to the existing productive
capacities (stock of fixed capital and inventories).They include fixed equipment’s, machinery,
building, raw materials, replacement due to depreciation, etc. Investment is a very key variable in
any economy thus, investment expenditure is one of the important components of the national
income and it requires serious attention because of the role it plays in the determination of the
equilibrium national income. It has a short-run and long-run effect on the national income.

Learning Outcome for Study Session Five

At the end of this study session, you should be able to

5.1 define and use correctly all the key words printed in bold, (SAQ1)
5.2 define Investment(SAQ2)
5.3 discuss the determinants of Investment (SAQ3)
5.4 explain accelerator theory and the term aggregate level of employment(SAQ4)
5.5 discuss the determinants of aggregate level of employment (SAQ5)

5.1 Definition of Investment

In literature, investment has been considered as the act of producing goods that are not for
immediate consumption, goods, inventory and residential housing. Investment, like saving, is the
amount of the economy’s product that is not consumed. Also, investment is that part of the
economy’s output that takes the form of new structures, producer’s new durables equipment and
change in inventories. Thus investment can be regarded as the addition to the stock of new capital
goods and to inventories which include raw materials, work in progress and stocks of unsold goods.
Also, investment may be gross or net. Gross investment in any period equals the amount of capital
used up during that period and, hence, there is no change in the stock of capital. If we deduct
depreciation or capital consumption allowance for the use of machines and equipment from total
investment (gross investment) in an economy what we obtain is net investment. When gross
investment exceeds depreciation allowance, the difference equals net investment, and, if the former
is less than the latter, then the difference equals negative net investment or disinvestment. Thus
net investment can be viewed as an addition to the existing stock of capital and it is considered to
be the most volatile component of GDP.
Investment Expenditure
Investment expenditure is the expenditure made by firms on goods produced not for their present
use but for their use in the future. In economics, investment expenditure comprises business fixed
investment (new factories and machinery), residential investment (new houses, apartments and
condominiums) and inventory investment (the change in the value of unsold goods). There are two
types of investment: autonomous investment and induced investment.
Autonomous Investment
Autonomous investment is that investment that occurs without the influence of national income.
It is considered as investment that is independent of national income. Its dominants’ include
interest rates, business sentiment, business costs, capital costs, corporate income tax, technological
advancements and the availability of credit. In examining the following diagram, the autonomous
investment function is a horizontal line that intercepts the investment axis.

Figure 5.1 Autonomous and induced investments

Induced investment
Induced investment is functionally related to the level of Gross Domestic Product. Induced
investment is that investment that is "induced" because of increased business activity. Induced
investment means that investment that is caused by increased levels of GDP and it is represented
by the upward slopping section of the graph in figure 5.1

5.2 Determinants of Investment

Several factors have been considered as determinants of investment but the following have have
identified as most important.:
1. Increased optimism among investors: These are the attitudes, beliefs or state of mind of
investors about the nature of economic events. Expectations play important role in
determining economic behaviour. A firm or an investor may select a price level of output
or investment alternative based on future expectations.
2. The price and productivity of capital goods. If the capital is cheap with high productivity
it can bring about high rate of investment and vice versa.
3. The availability of profits earned by firms for re-investment. Increase in net profit of firms,
can provide opportunity for re-investment by investors as this will provide cheap fund for
investment purposes.
4. A change in technology: A favourable technological change will shift the MEC schedule
to the right and increase the volume of investment even if the rate of interest remains
constant.
5. Government policy: Both fiscal and monetary policy of government affects the level of
investment to a great extent. Fiscal policies such as taxation can shape the direction of
investment. So also does the monetary policy such as preferential credit

Marginal Efficiency of Capital (MEC)

The MEC is the rate of discount which equates the present value of a series of cash flows obtainable
from an income-earning asset like a machine over its entire economic life to the cost of the
machine. It is the rate of return at which a project is expected to break even. For instance, when a
man buys an investment or capital-asset, he purchases the right to the series of prospective returns,
which he expects to obtain from selling its output, after deducting the running expenses of
obtaining that output, during the life of the asset.With series of annuities Q1, Q2, ... Qn , it is
convenient to call the prospective yield of the investment. Against the prospective yield of the
investment, we have the supply price of the capital-asset, means that not the market-price at which
an asset of the type in question can actually be purchased in the market, but the price which would
just induce a new manufacturer newly to produce an additional unit of such assets, i.e. what is
sometimes called its replacement cost.

The relation between the prospective yield of a capital-asset and its supply price or replacement
cost, i.e. the relation between the prospective yield of one more unit of that type of capital and the
cost of producing that unit, furnishes us with the marginal efficiency of capital of that type. More
precisely, we can define the marginal efficiency of capital as being equal to that rate of discount
which would make the present value of the series of annuities given by the returns expected from
the capital-asset during its life just equal to its supply price. This gives us the marginal efficiencies
of particular types of capital-assets. The greatest of these marginal efficiencies can then be
regarded as the marginal efficiency of capital in general.

Quantitative example:
If a businessman spends N10,000 on the purchase of a new grinding machine. We assume further
that this new capital asset continues to produce goods over a long period of time. The net return
(excluding meeting all expenses except the interest cost) of the grinding machine is expected to be
N1000 per annum. The marginal efficiency of capital will be 10%.
(1000/10000) Χ (100/1) = 10%

Formula:
The following formula is used to know the present value of series of expected income throughout
the life span of the capital assets.
Sp = (R1/1 + r) + (R2/1 + r2) + .......... .. = (Rn/1 + rn)

Where:
Sp = stands for supply price of the new capital asset.

R1 + R2 - Rn = stands for returns received on yearly basis.

R = It is the rate of discount applied each year.

Schedule:

According to Keynes, the behaviour of investment in respect of new investment depends upon the
various stock of capital available in the economy at a particular period of time. As the stock of
capital increases in the economy, the marginal efficiency of capital goes on diminishing. The MEC
curve is negatively sloped as shown in the table below
Table 5.1 Marginal Efficiency Table
Investment (N in billion) Marginal Efficiency of Capital

20 10%

25 9%

40 7%

70 5%

100 2%

CURVE
Fig 5.2 Volume of investment

In the above table, it is shown that when stock of capital is equal to N20 billion, the marginal
efficiency of capital is 10% while at a capital stock of N100 billion, it declines to 2%. This
investment demand schedule when depicted graphically in figure 30.7 gives us the investment
demand curve which goes on sloping downward from left to right.

MEC and Rate of Interest

The MEC and the rate of interest are the two important factors which affect the volume of new
investment in a country. An investor while making a new investment weighs the MEC of new
investment against the prevailing rate of interest. As long as the MEC is higher than the rate of
interest, the investment will be made till the MEC and the rate of interest are equalized.

For example, if the rate of interest is 7%, the induced investment will continue to be made till the
MEC and the rate of interest are equalized. At 7% rate of interest, the new investment will be N40
billion. In case the rate of interest comes down to 2%, the new investment in capital assets will be
N100 billion. In summary, if investment is to be increased in the country, either the rate of interest
should go down or MEC should increase.
5.3 The Accelerator Principle
The principle explains the relationship between investment and change in demand or change in
income. According to the theory, investment is related to change in national income. When
national income is increasing, it is necessary to invest in order to increase the capacity to produce
consumer goods to meet consumer demand. When income is falling, it is not necessary to replace
old capital as it wears out, let alone invest in new capital.

Table 5.2 Accelerator Principle’s Table

Year Annual Change in Required stock of Net investment, in-
sale sale capital. The K/Q is crease in the
5:1 required capital
1 10 0 50 stock 0

2 10 0 50 0

3 11 1 55 5

13 2 65 10
4
5 16 3 80 15

6 19 3 95 15

7 22 3 110 15

8 24 2 120 10

9 25 1 125 5
10 25 0
125 0
 As we can see in table 5.2, when change in sales is constant, change in investment is also constant
with fixed K/Q.Net investment occurs only when it is necessary to increase the stock of capital in
order to change output.
Limitations of accelerator Principle
1. An increase in sales may be expected to be temporary. To this effect, new investment may
not take place since overtime work or extra shifts would lead to expansion of the level of
output. Hence the accelerator principle is not justified.
2. The accelerator principle does not provide for the fact that investment at any point in time
can be restricted by a change in the capital invested.
3. The definition of investment by the accelerator principle emphasises capital widening, but is
silent on capital deepening as it assumes capital-output ratio to be fixed.

5.4 Aggregate Demand

The concept of aggregate demand (AD) refers to the total demand for goods and services in an
economy. AD is related to the total expenditure flow in an economy in a given period. It consists
of the following:

 Consumption demand by the households (C )

 Investment demand, i.e., demand for capital goods (I) by the business firms.
 Government expenditure (G)
 Net income from abroad (X – M)

Thus symbolically,

AD = C + I + G + (X-M)

Keynes's theory of aggregate demand

According to Keynes full employment is not a normal situation as stated in the Classical theory.
He argued that economy's equilibrium level of output and employment may not always correspond
to the full employment level of income. It is possible to have macroeconomic equilibrium at less
than full employment. If current level of aggregate demand (expenditure) is not adequate to
purchase all the goods produced in the economy (i. e a situation of excess supply) then output will
be cut back to match the level of aggregate demand.
Keynes's theory of the determination of equilibrium income and employment focuses on the
relationship between aggregate demands (AD) and aggregate supply (AS). According to him,
equilibrium employment (income) is determined by the level of aggregate demand (AD) in the
economy, given the level of aggregate supply (AS). Thus, the equilibrium level of employment is
the level at which aggregate supply is consistent with the current level of aggregate demand. The
theory believes that "demand creates its own supply" rather than the classical theory claim of
"supply creates its own demand".

Aggregate demand function

Aggregate demand or what is called aggregate demand price is the amount of total receipts which
all the firms expect to receive from the sale of output produced by a given number of workers
employed. Aggregate demand increases with increase in the number of workers employed. The
aggregate demand function curve is a rising curve as shown in Fig. 5.3
Figure.5.3: Aggregate Demand Function

It can be seen that total expected receipts is D1L1 at OL1 level of employment. Total expected
receipts increase to D2L2 with increase in the level of employment to OL2. OLf is the full
employment level. Initially the aggregate demand function (ADF) rises sharply as increase in the
number of employment leads to increase in society's expenditure, thereby, increasing producer's
expected sales receipts. There is not much increase in employment, income, expenditure and
therefore the producer's expected sales receipts as the economy reaches near full-employment. The
ADF curve becomes perfectly elastic (horizontal) as the economy reaches near full-employment.

Aggregate supply function

Aggregate supply is determined by physical and technical conditions of production. However,

these conditions remain constant in the short run. As such, given the technical conditions, output
in the short run can be increases only by increase employment of labour.
Aggregate supply or what is called aggregate supply price is the amount of total receipts which
all the firms must expect to receive from the sale of output produced by a given number of workers
employed. In other words, aggregate supply price is the total cost of production incurred by
producers by employing a certain given number of workers. Obviously, aggregate supply price
increases with increase in the number of workers employed. The aggregate supply function curve
is a rising curve and at full employment (OLf) it becomes perfectly inelastic (vertical) as shown in
Fig. 5.2.

Figure.5.4: Aggregate Supply Function

It can be seen that aggregate supply price or the cost of production is S1L1 at OL1 level of
employment. It increases to S2L2 with increase in the level of employment to OL2. Initially, the
aggregate supply function (ASF) rises slowly as labour is abundant thereby leading to slow
increase in the cost of production. Labour cost rises sharply as the economy reaches near full-
employment. The ASF therefore rises sharply and at full employment (OLf) it becomes perfectly
inelastic (vertical).
Determination of equilibrium level of employment

According to Keynes equilibrium level of employment (income) in the short run is determined by
the level of effective demand. The higher the level of effective demand, the greater would be the
level of income and employment and vice versa. This is shown in Fig.5.5: It shows the ADF and
ASF together. As discussed above, the ADF shows the amount of total receipts which all the firms
expect to receive from the sale of output produced by a given number of workers employed and
the ASF shows the amount of total receipts which all the firms must expect to receive from the
sale of output produced by a given number of workers employed. Entrepreneurs expand output as
long as there are opportunities to make profits.

Fig..5.5: Determination of Equilibrium Employment

It can be seen that up to OL level of employment, aggregate demand price is greater than
aggregate supply price (ADF > ASF). Producers expect greater returns than the cost of
production. As such, producers expand output up to OL level of employment. Thus, at any level
of employment up to OL, there would be expansionary tendency in the economy and therefore a
rise in the level of employment.

Beyond OL level of employment, aggregate demand price is less than aggregate supply price
(ADF < ASF). Producers expect less returns than the cost of production. As such, producers prefer
to cut down output. Thus at any level of employment beyond OL, there would be contractionary
tendency in the economy and therefore fall in the level of employment.

At OL level of employment aggregate demand price equals aggregate supply price (ADF = ASF).
Now there is no tendency towards economic expansion or contraction. Thus OL is the equilibrium
level of employment. Point 'E' is called the point of effective demand. It represents that level of
aggregate demand price that is equal to aggregate supply price and thus reaches short run
equilibrium position.

It can be seen that equilibrium point 'E' is established at less-than-full employment equilibrium
and there is LLf amount of involuntary unemployment in the economy. It is important to note that
according to Keynes, this unemployment is due to deficiency of aggregate demand. At full
employment level, there exists a gap between the full-employment level of aggregate supply price
and the corresponding level of aggregate demand price.

Role of fiscal policy in achieving full-employment equilibrium

According to Keynes, full-employment can be achieved by removing the gap between aggregate
supply price and aggregate demand price. However, he rejected the Pigouvian wage-cut solution
to pull the ASF downwards to achieve full-employment. This, according to him, would further
lower the aggregate demand, if the income of potential customers is reduced. The economy, in
short, will be caught in a vicious circle of high unemployment and low demand. On the other hand,
the policy to push the ADF upwards will push the economy into a virtuous cycle of high demand
and high employment. This is shown in Fig. 5.5
Summary of the Study Session Five

 In literature, investment has been considered as the act of producing goods that are not for
immediate consumption, goods, inventory and residential housing. Investment, like saving,
is the amount of the economy’s product that is not consumed.
 The MEC is the rate of discount which equates the present value of a series of cash flows
obtainable from an income-earning asset like a machine over its entire economic life to the
cost of the machine. It is the rate of return at which a project is expected to break even.
 The accelerator principle explains the relationship between investment and change in
demand or change in income. According to the theory, investment is related to change in
national income.
 According to Keynes full employment is not a normal situation as stated in the Classical
theory. He argued that economy's equilibrium level of output and employment may not
always correspond to the full employment level of income. It is possible to have
macroeconomic equilibrium at less than full employment.
 According to Keynes equilibrium level of employment (income) in the short run is
determined by the level of effective demand. The higher the level of effective demand, the
greater would be the level of income and employment and vice versa.

Self-Assessment Questions for study session five

(SAQ1) Which of the following would cause business investment spending to rise?

a. an increase in real interest rates from 5% to 8%

b. a decrease in the corporate profits tax rate from 48% to 34%

c. a reduction of the investment tax credit from 10% to 2%

d. sales falling in relation to capacity from 90% to 60%

(SAQ2) Investment

a. is a part of the demand in the economy.

b. is a part of the supply in the economy.
 c. is the inherited capital stock of the country
d. none of the above
(SAQ3) The unintended inventory changes are negative

a. when the economy is recovering from a recession.

b. when the sales are unexpectedly low.
c. when firms expect their sales to increase
d. none of the above

(SAQ4) Investment decisions depend on:

a. The cost of investment

b. The present value of expected profit from investment
c. The real investment rate
d. All of the above

(SAQ5) Firms should invest more when:

a. The price of an addition unit of capital the price of its stock

b. The price of an additional unit of capital exceeds the price of its stock
c. the price of its stock is less than real interest rate
d. The Tobin’s q is less than 1
e. The price of an additional unit of capital is less the price of its stock.

(SAQ6) The accelerator principle says that investment ever

a. Increase at increasing rate if output remains constant

b. Increase as output increase
c. Remains constant if output increases at an ever-increasing rate
d. Is always constant

(SAQ7) The total quantity of goods and services produced (or supplied) in an economy in a
given period is:
 a. Aggregate demand
b. Aggregate output
c. Aggregate investment
d. Aggregate expenditure

(SAQ8) Which of the following would cause the aggregate demand curve to shift to the right?

a. an increase in purchases by the federal government

b. an increase in real interest rates

c. an appreciation of the Naira

d. a decrease in the money supply

(SAQ9) Full employment output

a. is also the potential output of the economy.

b. is also the trend output of the economy.
c. Both (a) and (b) above
d. none of the above

Answers

Questions 1 2 3 4 5 6 7 8 9 10

Answers C A D D C B B A C

References
 Jhingan M.L 7th edition, Monetary Economics by Vrinda Publication (P) Ltd
 Debes, Mukherjee 2nd edition Essentials of Micro and Macroeconomics by New Central
Book Agency (P) Ltd
 Sampat, Mukherjee, 1st edition, Analytical Macroeconomics from Keynes to Mankiw by by
New Central Book Agency (P) Ltd
 Mishkin, Frederic S. 7th edition, The economics of money, banking, and financial markets
.
 STUDY SECTION SIX

THE CONCEPT OF EQUILIBRIUM NATIONAL INCOME

6.0 Introduction

Generally, equilibrium can be referred to as a state of balance or state of no change. By equilibrium

national income we mean that level of national income which remains unchanged at a particular
price level. This implies that, at equilibrium level of national income there is no tendency for
income / output to change. The theory was first developed by John Maynard Keynes, a British
economist, in his book published in 1936 under the title, General Theory of Employment, Interest
and Money.

Learning Outcome for Study Session Six

At the end of this study session, you should be able to:

6.1 define and use correctly all the key words printed in bold,
6.2 Explain circular flow of income
6.3 Solve for equilibrium in two sector model
6.4 Explain the concepts of saving, investment and consumption and relationships among the
concepts.
6.5 Explain simple concepts like the marginal propensity to consume and the marginal propensity
to save and their relevance to the growth of national income.
6.6 Determine the level of equilibrium level of income in four sector model.

6.1 Circular flow of income

In an attempt to explain the concept of national income equilibrium, it is important to look into the
workings of the economic system and the process of income generation, i.e. circular flow of
income. According to Keynes's analytical framework, the entire economy can be divided into four
sectors:
1. Household sector
2. Firms or the business sector
3. Government sect or
4. Foreign sector
For now, we shall start our discussion with the circular flow of income which is two sector model,
involving only the households and firms. This will serve as good foundation for four-sector model
which is obtainable in real life situation in any open economy. Assumptions of circular flow of
Income.
1. There are only two sectors — households and firms.
2. Households are the owners, and firms are the users of those factors of production.
3. Household incomes comprise factors' payments — wages, interest, rent and profits.
Households spend their total income on consumer and capital goods.
4. The economy is spendthrift, with no element of savings.
5. There is no foreign trade and no government expenditure

Diagrammatically, the circular flow of income may be shown as in figure 6.1.

Fig. 5.1 Circular flow of income

The figure is divided into two parts. The upper half represents the factor market in which
households sell and firms buy the services or factors of production. In the process, income factors,
i.e. wages, interest, rent and profit move from the firm and flow to the household. The lower part
of the figure represents the product or commodity market where firms sell and households buy the
commodities. In this process, household incomes flow to the firms and commodities flow to the
households. From the diagram, therefore, payments flow from firms to households in the form of
payments for the factors of production; and from households back again to firms in the form of
expenditure on goods and services within the economy.
Definition of Key terms
1. Actual Investment: Two very different groups of people are always at work making
decisions concerning spending, saving, and investment that affect each other. The income
households earn is spent and saved: Y = C + S. Producers produce an equivalent value of
goods and services in the form of consumption and investment: Y = C + I. By definition,
C + I = C + S. But the I (investment) in this last equation is actual investment. It's what
producers end up investing, not necessarily what they intended to invest. Sometimes they
end up with more actual investment than they intended (creating unwanted inventories)
and so cut output. At other times, their actual investment is less than what they intended
to produce, and as a result, they increase output. How they respond to their actual
investments and why they do it is what this chapter's about.
2. Aggregate expenditures: The total of what people spend on consumption, businesses
spend on investment, government spends on its purchases, and foreigners spend on net
exports is described as expenditure. Are these expenditures greater than, less than, or equal
to the total income earned in the economy?
3. Unwanted inventories: Suppose that consumers spend on consumption an amount less
than what producers produced for consumption. Some consumer goods remain unsold as
investories
4. Income multiplier: Changes in intended investment cause the equilibrium level of national
income to change. The relationship between these two changes is explained by the income
multiplier
5. Paradox of thrift: It says: The more people try to save, the more national income will fall,
leaving them with no more, and perhaps less saving in the end. The consumers' and
producers' behaviour that leads the economy to equilibrium also produces a rather
surprising consequence known as the paradox of thrift.

6.2 Two-sector model

Assumptions of the model

 1. It is two-sector economy where there is no government and foreign trade.
2. The consumption expenditures (C ) has the following equation: C= a +bY
3. The investment expenditure is autonomous i.e I= 𝐼0

In this two-sector model, the economy is closed with no government and foreign sectors. From
the above, it is clear that there are two elements of national income in this simple economy. They
are consumption and investment. Adopting usual notation, in such an economy national income
(Y) comprises of consumption (C) and investment (I).Recall, that an economy is said to be in
equilibrium when aggregate demand (expenditure) equals aggregate supply (output). In the case
of two sector models, economy only produces two commodities- consumption goods and
Investment goods. The addition of these two commodities represents the output (Y) of the society.
Also, expenditure in the model is basically on consumption and investment thus the addition of
consumption expenditure (C) and investment expenditure (I) represents the aggregate expenditure
in such society.
Equilibrium in two sector models

In the literature, there are two approaches to present equilibrium level of national income

1. AD = AS method
2. S = I (leakage and injection approach)

AD = AS approach

In two - sector economy, equilibrium level of income takes place, where AD = AS. Recall that
AD represents the aggregate expenditure in the society thus:

𝐴𝐷 = 𝐶 + 𝐼 …………………………………………………………………..(6.1)

Similarly, AS represents aggregate output in that society thus:

𝐴𝑆 = 𝑌……………………………………………………………………….(6.2)

From equation 5.1 and 5.2, equilibrium of national income can be represented thus:
𝑌 = 𝐶 + 𝐼…………………………………………………………………….(6.3)

Quantitative examples

Suppose the consumption is given by the consumption function

C= a +b Y……………………………………………………………………...........(6.4)

Where Y is income, a is autonomous consumption and b is marginal propensity to save.

Also, assuming that investment is autonomous given by

I= 𝐼𝑜 ……………………………………………………………………… ….........(6.5)

With this information, we can derive equilibrium for this hypothetical economy.

Solution

Recall that equilibrium condition is 𝑌 = 𝐶 + 𝐼 . Introducing the value of C and I in equation (5.4)
and (5.5) respectively will give

𝑌 = a + bY + 𝐼𝑜 ……………………………………………………………………(6.6)

𝑌 − bY = a + 𝐼𝑜

𝑌(1-b) = a + 𝐼𝑜

a + 𝐼𝑜
𝑌̅ =
(1-b)

1
𝑌̅ = (1-b) (a + 𝐼𝑜 )………………………………………………………………………(6.7)

1
Equation 5.7, provides solution to the problem where 𝑌̅ represent the equilibrium, (1-b) represents

the multiplier in the economy and (a + 𝐼𝑜 ) represents the autonomous variables. The solution in
equation 5.7 can produce a definite numeric value for our equilibrium income if the value of the
following parameters b, a and Io are known. Given that, b= 0.8, a= 5billion and I= N10 billion.

With this information, equilibrium Income (𝑌̅) in equation 5.7 becomes

 1
𝑌̅ = (1-0.8) (5 + 10)……………………………………………………………………..(6.8)

1
𝑌̅ = (15)
(0.2)

𝑌̅ = 5* (15)

𝑌̅ = 𝑁75 billion…………………………………………………………………………. (6.9)

S = I (Leakage and injection Approach)

According to this approach, total withdrawal and injections into the circular flow determine
equilibrium national income. In a two sector economy, withdrawal comprises only saving, while
injection comprises only investment. Equilibrium national income is determined at that point when
planned saving and planned investment are equal to each other. Diagrammatically, at the
intersection of the saving and investment line, equilibrium national income is determined.

Using this approach, equilibrium condition becomes S= 𝐼

Recall that saving (S) = 𝑌 − 𝐶 because when income is not consumed it is saved

S = 𝑌 − 𝐶…………………………………………………………. (6.10)

Substitute for C in equation (6.10)

S = 𝑌 − (𝑎 − 𝑏𝑌)

S = − 𝑎 + 𝑌 − 𝑏𝑌

S = − 𝑎 + (1 − 𝑏)𝑌

Assume that I =𝐼𝑜 , the equilibrium condition becomes

−𝑎 + (1 − 𝑏)𝑌=Io
So the equilibrium level of income is

(1 − 𝑏)𝑌=a+Io

a + 𝐼𝑜
𝑌̅ =
(1-b)

1
𝑌̅ = (1-b) (a + 𝐼𝑜 )………………………………………………………………………..(6.11)

Equation (5.11) and (5.7) are the same showing that the two approaches are basically the same
thing.

Given that, b= 0.8, a= N5billion and I= N10 billion we can derive consumption and saving
function from this information.

𝐶=5 + 0.8𝑌

Similarly,

𝑆=-5 + (1 − 0.8)𝑌

Recall equilibrium condition of 𝑆= I

-5 + (1 − 0.8)𝑌= 10

(1 − 0.8)𝑌= 10 + 5

(0.2)𝑌= 15

15
𝑌= = 𝑁75𝑏𝑖𝑙𝑙𝑖𝑜𝑛………………………………………………………….(6.12)
.2

Comparing equation (6.7) and (6.12), it is clear the equilibrium value of national income in the
two approaches are the same.

Effect of change in Autonomous variable

If there is any change in autonomous variables it will bring about higher change in the level of
equilibrium national income depending on the size of the multiplier. In our two- sector model
discussed above, there are basically two autonomous variables: autonomous consumption
represented by a and investment represented by Io .

Example 1

As a result of increasing level of confidence in our two sector model if investors choose to increase
their investment from N 10 billion naira to 15 billion, what is new the level of national income
equilibrium in our hypothetical economy?

Solution

The first thing to do in this instance is to determine the size of multiplier in the economy.

1
Recall: multiplier, 𝐾 = (1-b)

Also, recall 𝑏 = 0.8. ( marginal propensity to consume)

1
𝐾= (1-0.8)

1
𝐾= = 4 ……………………………………………………………………………(6.13)
(0.2)

The solution in equation (5.13) gives the size of the multiplier in the economy thus the change in
national income equilibrium can be arrived as follows:

𝐾 ∗ ∆𝐼 … … … … … … … … … … … … … … … … … … … … … … … … … … … … … … … … … . . (6.14)

where K is the multiplier and ∆𝐼 is change in level of investment

4 ∗ (15 − 10)

N 20 billion

The solution of equation (5.14) implies that increasing the level of confidence of investors which
brought about increase in investment from N10 billion to N 15 billion will increase the equilibrium
national income by N 20 billion naira and that will bring new level of equilibrium to (75 + 20 =
95) N 95 billion naira.

6.3 National income equilibrium in an open economy

In an open economy, the entire economy can be divided into four sectors:
1. Household sector
2. Firms or the business sector
3. Government sector
4. Foreign sector

The expenditure from each sector of the economy constitutes what we generally refer to as
aggregate expenditure (AE) in that economy. Household sector expenditure comes in form of
consumption, firms or the business sector comes in form of investment, government sector
expenditure comes in form of government spending and foreign sector comes in form of
expenditure on import and export. While consumption and investment have been discussed in the
previous study session, government expenditure and expenditure on import and export have not
been discussed. To make this section complete, we will need to discuss these two sectors.

Government expenditure

Government expenditures is the expenditure made by the government on goods and services either
within or outside the country. It includes expenditure on both consumer goods and capital goods.
It does not include government expenditure on transfer payments. Transfer payments are payments
made by the government to the recipients not in exchange for any goods or services and they
include social security benefits, unemployment benefits and interest payments on national debt.
The government can also influence aggregate expenditure by controlling consumption expenditure
through changing direct taxes or transfer payments. In addition to the effect on consumption
expenditure, a change in corporate income tax will also affect investment expenditure and hence
aggregate expenditure.

Foreign sector net exports (X - M)

Exports (X) are the expenditure made by foreigners on domestic goods and services. The
determinants of exports have been argued to include the following: foreign income (an increase in
foreign income will lead to a rise in exports and the converse is also true); domestic general price
level relative to foreign general price level (when the domestic general price level falls relative to
the foreign general price level, domestic goods and services will become relatively cheaper than
foreign goods and services, when this happens, exports will rise and the converse is also true);
exchange rate (when domestic currency depreciates, domestic goods and services will become
relatively cheaper than foreign goods and services, when this happens, exports will rise and the
converse is also true).

Imports (M)
Imports are the expenditure made by domestic residents on foreign goods and services. The
determinants of imports include. national income, domestic general price level relative to foreign
general price level and exchange rate.

Equilibrium
The equilibrium condition around which the open economic model is built is:

Y = C + Io + G + (X - M)

Where Y, C, and Io remain as defined in two sector model and Go represents government spending
(expenditure) while (X - M ) represents net export. Equilibrium still means what it did in two-
sector model, which is to say that aggregate expenditure equals to aggregate output (aggregate
demand and aggregate supply). But equilibrium in open economy does not in any way imply trade
balance.

Example 2

C = 10 + .8(Y - T)
S = - 10 + .2(Y - T)
I d = 23
G = 10
T = 10
M = .3Y
X = 15
To find equilibrium:

Y= C + Io + G + (X - M)
Y = 10 + .8(Y - 10) + 23 + 10 + (15 - .3Y)
Y = 50 + .5Y
0.5Y = 50
Y = 100
Technical Example
1. Consider the following simple model of an economy operating with fixed wages, prices,
and interest rates, and excess capacity (operating below the full-employment level):
C = 400 + 0.8Y
I = 500
where C is consumption, Yd is disposable income (equal to national income, Y, in the absence of
a government sector), and I is investment.

a. Solve for aggregate expenditure (AE) as a function of Y, and calculate the equilibrium level
of national income. Illustrate your equilibrium in a diagram with AE on the vertical and Y
on the horizontal axis.
b. What is the value of the multiplier?

Solution

Yd = Y

𝐴𝐸 = 𝐶 + 𝐼

AE = 400 + 0.8𝑌 + 500

AE = 900 + 0.8𝑌

In Equilibrium Y = AE, so:

 Y = 900 + 0.8𝑌

0.2𝑌 = 900

𝑌 = 4500

Recall: Multiplier=1/(1-MPC)=1/0.2=5

To illustrate the equilibrium we need to plot the AE function with Y on the horizontal axis and Y
on the vertical axis. Since AE is a linear function, all we need are two points through which the
line will go. If Y is 0, AE is 900. So, one point is (0, 900). From the above, calculation, we know
that if Y=4500, AE=4500. That means, at the point (4500, 4500), AE line will intersect the 45-
degree line (Y=AE line).

Fig.6.2

(2) Now, suppose we add a government sector with: T = 100+0.25*Y G = 980 where T is taxes
(net of transfers) and G is government spending on goods and services.
a. Calculate the new equilibrium level of national income. Illustrate in your diagram.
b. What is the new value of the multiplier? Is the government running a surplus or a deficit?
 Y = Y-T
Yd = Y - 100 - 0.25 * Y
Yd = Y(1 - 0.25) - 100
AE = C + I + G = 400 + 0.8((1- .25)Y - 100) + 500 + 980
AE = 900 - 80 + 980 + 0.8 * 0.75Y
AE = 1800 + 0.6 * Y

In equilibrium Y = AE, so:

Y = 1800 + 0.6Y
0.4Y = 1800
Y = 4500

Follow the same method explained in part (a) to show the equilibrium on the graph.
1 1
Multiplier = = = 2.5
(1 - (1 - t)MPC) 1  (1  0.25)0.8
Government budget balance:
Revenues (T) = 100 + 0.25* Y = 100 + 1125 = 1225
Expenditures (G) = 980
Therefore the budget has a surplus of 1225- 980 = 245
(3) Now suppose we expand the model to include a foreign sector with: M = 0.4Y X = 1800
a. where M is imports and X is exports. Calculate the new equilibrium level of national
income. What is the new value of the multiplier?
b. Does the country have a trade surplus or deficit? (what is the value of net exports?)

AE = C + I + G + (X - M) = 400 + 0.8((1- .25)Y - 100) + 500 + 980 + 1800 - 0.4 * Y

AE = 1800 + 0.6 * Y - 0.4 * Y + 1800
AE = 3600 + 0.2 * Y

In Equilibrium Y = AE, so:

Y = 3600 + 0.2Y
0.8Y = 3600
Y = 4500

1 1
Multiplier = = = 1.25
(1 - (1 - t)MPC) + MPI) (1 - (1 - 0.25)0.8) + 0.4)
Trade balance = exports – imports
Trade balance = 1800- 0.4 * 4500 = 1800- 1800 = 0
A country is running a balanced trade (no deficit/surplus)

Reasons for decreasing multiplier

Each successive model comes with increasing number of “leakages” for the system (originally
just to savings, then to taxes, then to imports). This means that after the initial effect of an increase
in autonomous spending, less is put back into the system to produce national income in each
“round” of the multiplier process. Therefore, the sum of all these increases (the multiplier) is
smaller.

Summary of the Study Session Six

 According to Keynes's analytical framework, the entire economy can be divided into four
sectors: household sector firms or the business sector, government and foreign sector
 In the literature, there are two approaches to present equilibrium level of National Income:
AD = AS method and S = I (leakage and injection approach)
 In two - sector economy, equilibrium level of income takes place, where AD = AS.
Recall that AD represents the aggregate expenditure in the society thus: 𝐴𝐷 = 𝐶 + 𝐼
 According to this approach, total withdrawal and injections into the circular flow
determine equilibrium national income.
 The equilibrium condition around which the open economic model is built is:
Y = C + Io + G + (X - M)
 If there is any change in autonomous variables, it will bring about higher change in the
level the of equilibrium national income depending on the size of the multiplier.
 Self-Assessment Questions for study session six
(SAQ1) Aggregate expenditure is equal to
a. spending by consumers on consumption goods
b. spending by businesses on investment goods
c. spending by government
d. spending by foreigners on net exports
e. the sum of a, b, c, and d
(SAQ2)The income multiplier is larger when
a. the marginal propensity to consume is larger
b. the marginal propensity to save is larger
c. spending by government is larger
d. the change in income is smaller
e. the marginal propensity to consume is smaller

(SAQ3)An example of the paradox of thrift is

a. consumers who attempt to save more but find they cannot go without basic consumption
goods
b. an increase in saving that leads to a lower equilibrium level of national income and the
same or lower saving
c. a high marginal propensity to save that is matched by a high marginal propensity to
consume
d. an increase in saving that leads to more investment, higher income, and higher
consumption
e. an increase in interest rates that leads to lower investment and lower saving

(SAQ4) Assuming there is no government spending and no foreign trade, then aggregate
expenditure is equal to consumption plus saving. (True/False)
(SAQ5) Spending by consumers on consumption goods is equal to consumption goods
production at the equilibrium level of national income. (True/False)
(SAQ6) When autonomous investment increases by N100, national income will increase by
N100. (True/False)
(SAQ7) A decrease in autonomous investment will have a smaller effect on national income than
an equal increase in autonomous investment. (True/False)

(SAQ8) Suppose that the consumption function is given by C = 500 + .8Y and investment is I =
500. The equilibrium level of income is
a. 2,500
b. 1,000
c. 5,000
d. 4,000
e. 7,500

Consider the following model of an economy. Output prices, factor prices and interest rates are
assumed constant. We have the following information, where
YD is disposable income and Y is national income.
Consumption: C = 50 + (0.8)YD
Taxes (net of all transfers) T= (0.3)Y
Investment: I = 100
Government Spending G = 350
Exports: X = 300
Imports: IM = (0.36)Y

(SAQ9)The equilibrium level of national income is:

a. 800
b. 1000
c. 1600
d. 1818
e. 4000
(SAQ10)In equilibrium, the government:
a. is running a deficit of 50.
b. is running a deficit of 110.
 c. has a balanced budget.
d. is running a surplus of 130.
e. is running a surplus of 50

Answers:

Questions 1 2 3 4 5 6 7 8 9 10

Answers E A B T T F F C B B

References

 Jhingan M.L 7th edition, Monetary Economics by Vrinda Publication (P) Ltd
 Debes, Mukherjee 2nd edition Essentials of Micro and Macroeconomics by New Central
Book Agency (P) Ltd
 Sampat, Mukherjee, 1st edition, Analytical Macroeconomics from Keynes to Mankiw by by
New Central Book Agency (P) Ltd
 Mishkin, Frederic S. 7th edition, The economics of money, banking, and financial markets
.
 STUDY SESSION SEVEN

THE CONCEPT OF INFLATION

7.0 Introduction

Inflation is a very old problem and the problem still persists till today in fact, some countries have
been reported to experience rates as high as 40 percent per month in recent times. Generally,
Inflation is described as a persistent rise in the general price level not in the price of a particular
commodity. And, It can result from either an increase in aggregate demand—demand-pull
inflation—or a decrease in aggregate supply—cost-push inflation. Why does inflation occur and
how do our expectations of inflation influence the economy. These and many more will be the
focus of this study session.

Learning Outcome for Study Session Seven

At the end of this study session, you should be able to:

7.1 define and use correctly all the key words printed in bold, (SAQ1)
7.2 explain the concept of inflation. (SAQ2)
7.3 determine inflation rate. (SAQ3)
7.4 explain types of inflation. (SAQ4)
7.5 identify the causes of inflation. (SAQ5)

7.6 explain the effect of inflation (SAQ6)

7.7 state the control of inflation (SAQ7)

7.1 Definition of Inflation

In economics literature Inflation has been considered as a phenomenon of continuous rise in the
general price level of goods and services. Inflation is not a rise in the prices of one or just few
goods, and it is also not a just one-time rise in the prices of most commodities. During inflationary
periods, prices of few goods may fall, but prices of most goods rise. Inflation can also be defined
as a decline in the value or purchasing power of money. Combining these two definitions, Inflation
can simply be defined as a process in which the price level is rising and money is losing value.
Inflation is a very important macroeconomic variable and several reasons have been put forward
as the likely cause depending on the school of thought involved. Majorly, inflation maybe as a
result of increasing money supply without corresponding increase in supply of goods and services
and a continuous fall in supply of goods and services due to continuous rise in the cost of
production. Thus, an increase in money supply can be a reason of inflation or increase in cost of
production.

7.2 Causes of Inflation

Inflation can result from either an increase in aggregate demand— demand-pull inflation—or a
decrease in aggregate supply—cost-push inflation.

7.2.1 Demand-Pull Inflation

Demand-pull inflation is an inflation that results from an initial increase in aggregate demand over
available output. But why does aggregate demand rise? Classical economists attribute this rise in
aggregate demand to increase in money supply. In other words, when people have more money to
buy things, but there aren't enough of the things people want to buy. Therefore, according to the
predictions of the supply and demand model, this will cause an increase in the price of the goods
suffering a shortage. This is due to the scarcity of the goods relative to the increase in the amount
of money in the hands of consumers who wish to purchase them (demand exceeds supply -->
shortage --> an increase in price). On the other hand, Keynesians argued that there can be
autonomous increase in aggregate demand or spending with no increase in money supply.
Figure 7.1 Aggregate Demand
From figure 7.1, AD1 is the initial aggregate demand curve that intersects the aggregate supply
curve AS at point E1. Thus, the price level is determined at OP1. As the aggregate demand curve
shift to AD2, price level rises to OP2. In conclusion, an increase in aggregate demand at the full
employment stage leads to increase in price level only, rather than the level of output.

7.2.2 Cost-Push Inflation

Cost -push inflation: This type of inflation occurs as a result of increase in the cost of production
which shifts the aggregate supply leftward. Cost of production may rise due to increase in the price
of raw materials, wages e.t.c. Cost -push inflation is caused by supply-side factor. For example, if
prices of some key inputs like oil rise, producers will have to either adjust output supply or translate
the higher costs into higher output prices. When output declines because of cost pressure on
producers, there will be a shortage in output markets and prices will rise as a result, ceteris paribus.
Prices may also rise as a result of uncertainty about future market condition.

Figure 7.2 Aggregate Supply

Intersection point (E1) of AD and SRA1 curves determined the price level, now there is a leftward
shift of aggregate supply curve to SRAS2. With no change in aggregate demand, this causes price
level to rise to OP2 and output to OY2.

7.3 Types of inflation

Inflation can be classified using the intensity or speed. Based on that, we have the following type
of inflation

 Creeping inflation: If the speed of upward thrust in prices is very low, then we have
creeping inflation. What speed of annual price rise is a creeping has not been stated by the
economists? But some economists have considered inflation rate of 2% to 3% as creeping
inflation.
  Walking inflation: If the rate of annual price increase lies between 3% and 4% then we
have a situation of walking inflation. It emerges principally due to failure to maintain
creeping inflation. But the two types of inflation (creeping and walking) can be regarded
as moderate inflation.
 Galloping and hyper-inflation: This is an extreme form of inflation when an economy
gets shattered. When inflation turns double or triple digit inflation percent a year, it is
considered as galloping inflation.

7.4 How inflation is measured and the inflation rate calculated

For measuring inflation, an aggregate representation of prices of commodities is needed. Such a
general price level is represented through a price index; GDP deflator is one such price index.
There are other price indices also, most notably the consumer price index (CPI) and the producer
price index (PPI).

GDP deflator

GDP deflator is the ratio of the value of aggregate final output at current market prices (nominal
GDP) to its value at the base year prices (real GDP). In effect, the basket of goods for the
construction of this price index includes all the final output produced within the geographic
boundaries of the country. GDP deflator can be considered the most comprehensive measure of
inflation since a wide array of goods and services are included in its construction. But it may not
reflect the full impact of inflation on consumer welfare because it does not include imported goods
and services that constitute a significant portion of what people buy.

GDP Deflator = Nominal GDP/ Real GDP

Note

 Nominal GDP is the sum value of all produced goods and services at current prices.
 Real GDP is the sum value of all produced goods and services at constant prices. The
prices used in the computation of real GDP are gleaned from a specified base year

The first step to calculating real GDP is choosing a base year.

Example

In year 1 Country N produced 5 bananas worth N1 each and 5 bags of cocoa worth N6 each. In
year 2 Country N produced 10 bananas worth N1 each and 7 bags of cocoa worth N6 each. . In
year Country N produced 10 bananas worth N 2 each and 9 bags of cocoa worth N6 each. Calculate
the GDP deflator for Country N in year 3 using year 1 as the base year.

In order to find the GDP deflator, we first must determine both nominal GDP and real GDP in
year 3.

Nominal GDP in year 3 = (10 X N2) + (9 X N6) = N74

Real GDP in year 3 (with year 1 as base year) = (10 X N1) + (9 X N6) = N64
The ratio of nominal GDP to real GDP is ( N 74 / N 64 ) = 1.156

We can estimate inflation rate from GDP deflator by multiplying our GDP deflator by 100.

1.156 × 100 = 115.6

This means that the price level rose approximately 16% from year 1, the base year, to year 3, thus,
the prevailing inflation rate in the economy is 16%. The formula and the procedures are the same
for any price index, the only difference among different price indices is the items that go into the
market basket.

Consumer price index (CPI)

We can described CPI is the cost of purchasing a market basket of consumption goods by a final
consumer during a given period of time usually a month, relative to the cost of purchasing the
same market basket in the base year. We can demonstrate the method of computing CPI with a
hypothetical example in Table 7.1 below.
Table 7.1: Construction of Price Index
Monthly Market 1985 1996 Cost of market basket Cost of market basket
Basket Prices(N) Prices(N) in 1985(N) in 1996(N)
60 gala 1.60 3.20 96.00 192.00
4 T-shirts 10.00 18.00 40.00 72.00
 2 jeans 24.00 24.00 48.00 48.00
1 compact disc 16.00 12.00 16.00 12.00
Total Cost of Basket 200.00 324.00
CPI 100 162

Let 1985 be the base year. When constructing a price index, its value is normalized to 100 in the
base year. Then, the value of price index in any year can be calculated as:
Cost of market basket in Year t
PI t  x100
Cost of market basket in Base Year

We can estimate CPI in 1996 as follow:

CPI = (324/200)*100 = 162,
This implies that the general price level increased by 62 percent during the 11-year period from
1985 to 1996. The above is a general formula for calculation of any price index. In CPI the
market basket consists of only the consumption goods, because the objective is to measure the
effect of inflation on households.

Problems with CPI as measurement of inflation

 Since the CPI represents the expenditure of the ‘average’ household, inevitably it will be
inaccurate for the ‘non-typical’ household.
 Single people have different spending patterns from households that include children,
young from old, male from female, rich from poor and minority groups.
 We all have our own ‘weighting’ for goods and services that does not coincide with that
assigned for the consumer price index.

Inflation measurement
Generally, inflation in any year (πt) is measured as the percentage change in price index from
the previous period:

PI t  PI t 1
(Equation 2) t  x100%
PI t 1
Calculation of inflation rate
Year Price Index Inflation Rate, %
1990 100 -
1991 110 {(110-100/100}×100=11%
1992 121 {(121-110)/110}×100=10%

7.5 Effects of inflation

 Transactions costs. People spend money more rapidly when they anticipate high inflation
and so transact more frequently, thereby incurring more transactions costs.
 Tax consequences. Inflation reduces the after-tax return from saving, which decreases
capital accumulation and long-term economic growth.
 Increased uncertainty. A high inflation rate increases uncertainty, which makes long- term
planning for investment more difficult and leads people to spend time forecasting inflation
rather than undertaking more productive activities.
 Inflation lowers the real wage rate and employers gain at the expense of workers.
 If the inflation rate is unexpectedly high, borrowers gain but lenders lose
7.6 Control of inflation
Causes of inflation are many and varied but its management can basically be traced to policies that
slow down the growth of AD ( demand management policy) and policies that boost the rate of
growth of aggregate supply AS ( supply side policy). Demand side policy can take the form of
either fiscal policy or monetary policy or both.

Fiscal policy:

 Controlling aggregate demand is important if inflation is to be controlled. If the

government believes that AD is too high, it may choose to ‘tighten fiscal policy’ by
reducing its own spending on public and merit goods or welfare payments
 It can choose to raise direct taxes, leading to a reduction in real disposable income
  The consequence may be that demand and output are lower which has a negative
effect on jobs and real economic growth in the short-term

Monetary policy:

 A ‘tightening of monetary policy’ involves the central bank introducing a period

of higher interest rates to reduce consumer and investment spending
 Higher interest rates may cause the exchange rate to appreciate in value bringing
about a fall in the cost of imported goods and services and also a fall in demand
for exports (X)

Supply side economic policies:

Supply side policies seek to increase productivity, competition and innovation – all
of which can maintain lower prices. The following measures constitute supply side
policies

 A reduction in company taxes to encourages greater investment;

 A reduction in taxes which increases risk-taking and incentives to work – a cut in
income taxes can be considered both a fiscal and a supply-side policy;
 Policies to open a market to more competition to increase supply and lower prices;
 The prices of some utilities such as water bills are subject to regulatory control – if
the price capping regime changes, this can have a short-term effect on the rate of
inflation.

Summary of the Study Session

 Inflation is not a rise in the prices of one or just few goods, and it is also not a just one-
time rise in the prices of most commodities. During inflationary periods, prices of few
goods may fall, but prices of most goods rise.
  Inflation maybe as a result of increasing money supply without corresponding increase
in supply of goods and services and a continuous fall in supply of goods and services
due to continuous rise in the cost of production
 Inflation can result from either an increase in aggregate demand— demand-pull
inflation—or a decrease in aggregate supply—cost-push inflation.
 Demand-pull inflation is an inflation that results from an initial increase in aggregate
demand over available output.

 Cost- push inflation occurs as a result of increase in cost of production which shifts the
aggregate supply leftward.

Self-Assessment Questions for Study Session Seven

(SAQ1) Inflation can defined as

a) persistant rise in general price level
b) persistant fall in general price level
c) an Increase purchasing power
d) . increase in Value of money

(SAQ2) What will be likely to cause inflation in an economy?

a) decrease in the cost of production
b) a decrease in total expenditure
c) An increase in productivity
d) An increase in the average wage level

(SAQ3) Demand pull inflation is caused by

a) Aggregate supply exceeds aggregate demand
b) Aggregate Demand exceeds aggregate supply
c) Aggregate demand and aggregate supply change in same direction.
d) Fall in equilibrium price
(SAQ4) Cost push inflation is caused by
a) An increase in the price of raw- materials, wage rate, rent
b) A reduction in aggregate demand
c) An increase Aggregate supply
d) An increase in factors of production

(SAQ5) Which of the following is the most obvious sign of inflation?

a) An increase in imports
b) A rise in the national debts
c) A rise in the rate of interest
d) A rise in retail prices
(SAQ5) Fiscal policy deals with
a) Import and export
b) Taxation and public expenditure
c) Public expenditure and money supply
d) Taxation and interest rate
(SAQ7) To reduce the rate of inflation, the government should
a) Increase public expenditure
b) Encourage consumer spending
c) Increase income tax
d) Reduce interest rate.
(SAQ8) If the price level was 100 in 1999 and 102 in 2000, the inflation rate was
(a) 102%.
(b) 20%.
(c) 2%.
(d) 0.2%.
(SAQ9) If the CPI was 132.5 at the end of 2003 and 140.2 at the end of 2004, the inflation rate
over these two years was
 a) 7.7 percent.
b) 5.4 percent.
c) 4.4 percent.
d) 5.8 percent.
(SAQ10) The technique currently used to calculate the CPI implicitly assumes that over time
consumers buy

a) relatively more of goods whose relative prices are rising.

b) relatively less of goods whose relative prices are rising.
c) the same relative quantities of goods as in a base year.
d) goods and services whose quality improves at the rate of growth of real income

Answers:

Questions 1 2 3 4 5 6 7 8 9 10

Answers A D B A D B C C A C

References

 Jhingan M.L 7th edition, Monetary Economics by Vrinda Publication (P) Ltd
 Debes, Mukherjee 2nd edition Essentials of Micro and Macroeconomics by New Central
Book Agency (P) Ltd
 Sampat, Mukherjee, 1st edition, Analytical Macroeconomics from Keynes to Mankiw by by
New Central Book Agency (P) Ltd
 Mishkin, Frederic S. 7th edition, The economics of money, banking, and financial markets
.
 STUDY SESSION EIGHT

THE CONCEPT OF UNEMPLOYMENT

8.0 Introduction

Just like GDP, unemployment ranks high as an indicator of economic wellbeing in any
country and unemployment rate is the most widely used indicator of the well-being of a labour
market and an important measure of the state of an economy in general .To the layman,
unemployment means a state of joblessness but economists consider it as the inability of those who
are in the labour force to find a job. It is a very serious macroeconomics problem that can influence
political outcomes in any country especially in developed countries. This study session will focus
majorly on definition, causes and types of unemployment.

Learning Outcome for Study Session Eight

At the end of this study session, you should be able to:

8.1 define and use correctly all the key words printed in bold (SAQ1)

8.2 explain the concept of unemployment. (SAQ2)

8.3 determine unemployment rate. (SAQ3)

8.4 explain types of unemployment. (SAQ4)

8.5 Identify the effect of unemployment. (SAQ5)

8.6 Explain Philips curve (SAQ6)

8.1 Definition of unemployment

Generally, unemployment could be defined as the percentage of the labour force that is without
job but is able and willing to work. Or the unemployed people are regarded as those who are not
currently employed and who indicate by their behaviour that they want to work at prevailing wages
and working conditions. According to the ILO guidelines, a person is to be considered unemployed
if he/she during the reference period simultaneously satisfies being:
(a) ‘without work’, i.e., was not in paid employment or self-employment as specified by the
international definition
(b) ‘currently available for work’, i.e., was available for paid employment or self-employment
during the reference period; and
(c) ‘Seeking work’, i.e., has taken specific steps in a specified recent period to seek paid
employment or self-employment
In summary, the most important part of the definition of unemployment is to know what it means
to be unemployed. Unemployment basically, reflects someone who is not working but is searching
for work.

8.2 Estimating Unemployment Rate

The most difficult part of measuring the unemployment rate entails determining who
is unemployed versus who is out of the labour. Because of this, we will need to define some
terms.

 Labour force: It is the total number of workers, both employed and unemployed.
Labour Force = Number of Employed + Number of Unemployed
 Employed. This category includes paid employees, both full-time and part-time,
people who worked in their own business, and those who were temporarily absent
from work because of illness or vacation.
 Unemployed. This category includes people who were not employed, were available
for work, and had tried to find a job within the previous four weeks, as well as those
who were temporarily laid off and waiting to be recalled.
 Not in the Labour Force. This category includes everyone else: students,
homemakers, retired people.

Unemployment rate is the percentage of the labour force that is unemployed.

numberof unemployed
Mathematically, unemployment Rate =  100
Labour force

Labour force participation rate as the percentage of the total adult population that is in the
labour force,
Labour Force
Labour force participation rate =  100
Adult Population

Example
Given the following hypothetical demographical statistics of country X, calculate the
unemployment rate and labour force participation rate for the country.
 Number of employed = 139.9 million.
 Number of unemployed = 14.3 million.
 Not in the labour force = 81.7 million.
 Labour force = 139.9 + 14.3 = 154.2 million
 Adult population=235.9 million
Solution
Unemployment rate = 14.3/154.2x 100 = 9.3 %

Labour force participation rate = {139.9 + 14.3}/{139.9 + 14.3 + 81.7}

= 154.2/235.9 = 65.4%

8.2.1 Shortfalls in the measurement of unemployment rate

 No measure of unemployment is ever completely accurate since there are some people out
of work but looking for a job who are not picked up by the official statistics.
 Official unemployment data misses out the “hidden unemployed” - an example is
discouraged workers who have been out of work for a long time and who have stopped
applying for jobs.
 Economically inactive – people who are not actively looking for work because they
need to look after elderly or infirmed relatives or some parents who are full-time carers
for their children and people who have taken early retirement.
 Under-employment: In many countries data may ignore the extent of under employment,
for example people who want full-time work but have to settle for a part-time job. In many
 lower-income countries, the quality of the labour market data may be poor causing
published figures to be inaccurate.

8.3 Types of unemployment

Before discussing different types of unemployment it is pertinent to discuss the concept of
natural rate of unemployment.
The natural rate of unemployment is an estimate of the unemployment rate that exists when the
economy is at full employment and this is the rate of unemployment that the economy will have
in the long run. We can think of it as the average long run rate of unemployment. The major
challenge is that many countries especially the developing countries do not have the estimate of
their natural rate of unemployment. For country like the US, the natural rate of unemployment
would be around 5% to 6%. Also, a nation is considered to be operating at full employment when
all unemployment is either frictional or structural. The difference between a nation’s natural rate
of unemployment and its actual unemployment rate is referred to as cyclical unemployment.

There are four types of unemployment.

 Seasonal unemployment: This is the unemployment that happens at the same time every
year due to seasonality. It is due to the low demand for certain types of labour during certain
seasons of the year. For instance, some agricultural workers are unemployed during the
off-harvest-season and some construction workers and lifeguards are unemployed during
winter. Seasonal unemployment always exists. The solution to seasonal unemployment is
the same as the solution to structural unemployment. In reality, it is difficult to decrease
seasonal unemployment significantly because a large part of it is voluntary. However,
seasonal unemployment is usually insignificant and hence, rarely a matter of social
concern.
 Cyclical unemployment: This is an unemployment that rises and falls over time. It is a
temporary deviation from the long run amount of unemployment. When you look at the
unemployment rate over time, the most prominent behaviour is for the unemployment rate
to rise and fall cyclically. It is the unemployment that deviates from the natural rate. Since
cyclical unemployment is temporary, it is a demand-deficient unemployment and it usually
 occurs due to a decrease in aggregate demand when the economy moves into a recession.
When aggregate demand falls, firms will decrease production and likewise the demand for
labour. Since real wages is inflexible downwards, demand-deficient unemployment will
occur. Downward inflexibility in real wages are often the result of trade unions trying to
protect the standard of living of their members, firms refusing to lower real wages to avoid
reducing the efficiency of their workers, or the existence of wage contracts.
 Frictional unemployment: This is the unemployment that occurs naturally and in the long
run. It is a type of unemployment that contributes to a natural rate of unemployment.
Frictional unemployment is due to lack of perfect information about the job market. Since
firms are not fully informed about the types of labour available and workers are not fully
informed about the types of job available, firms and workers need time to explore the job
market and this leads to frictional unemployment. Frictional unemployment always exists.
To reduce frictional unemployment, the government can increase expenditure on setting
up more job market intermediaries. However, if firms think they are better able to assess
prospective employees by themselves and hence reluctant to post their job vacancies in the
intermediaries’ job banks, having more job market intermediaries will not lead to a
significant fall in frictional unemployment.
 Structural Unemployment: This is unemployment that occurs in the long run and
contributes to the natural rate. Structural unemployment is due to a change in the structure
of the economy. The structure of the economy changes when some industries expand and
some industries contract and this could be due to technological advancements, changes in
comparative advantage or changes in the pattern of demand. When this happens, the
expanding industries will create jobs and the contacting industries will lose jobs. However,
as many of the workers who will lose their jobs in the contracting industries do not have
the relevant skills and knowledge to find jobs in the expanding industries, structural
unemployment will occur. Structural unemployment always exists.
To reduce structural unemployment, the government can provide education and training
directly, by setting up educational institutes, or indirectly, by giving subsidies or tax
incentives to firms to induce them to send their workers for education and training.
However, due to the effort that has to be expended on the part of the structurally
unemployed workers who are mostly low-skilled, such measures may not decrease
 structural unemployment significantly. If the cause of structural unemployment is the loss
of certain comparative advantages, subsidies and tariffs can be used to support declining
industries, so that they can phase out slowly. In this case, the workers in the declining
industries will have sufficient time to acquire the relevant skills and knowledge to find jobs
in other industries. However, these protectionist measures run counter to the objective of
free trade and they may provoke retaliation.

8.4 Effect of unemployment

 High unemployment will cause the economy to lose a large amount of output
 High unemployment will cause a large number of people to lose their income. Further, if
the unemployed remain unemployed for a long period of time, they may lose their skills
and knowledge.
 When unemployment is high, the employed will lose some of their income in the form of
a pay cut.
 High unemployment will cause firms to lose a large amount of profit.
 When unemployment is high, the government will lose a large amount of tax revenue.
 Society : High unemployment will lead to a high crime rate, high divorce rate, high suicide
rate and social unrest.

8.4 Fig.8.1 The Phillips Curve

Inflation

()

Unemployment (u)

1. Inverse relation between inflation and unemployment

The graph above shows an "inverse relation" between inflation and unemployment. When the
economy is weak and unemployment is high, inflation is low. When the economy is strong and
unemployment is low, inflation is high. This relationship was first studied in England by an
economist named Phillips. The inflation-unemployment graph is therefore called the "Phillips
Curve. We will use the Greek letter pi () to represent the inflation rate.

Facts of Phillips Curve

 Economists typically draw the graph with some "curvature," that is, the slope of the Phillips
Curve changes at different levels of unemployment.

 Note that the Phillips Curve cuts through zero on the inflation axis. This captures the fact
that deflation can happen, although it will normally be associated with high unemployment.

 We know from our earlier discussion that unemployment cannot really get to zero. Thus, the
Phillips Curve gets very steep as unemployment (u) gets very low. This means that prices
can begin to rise very fast in an overheated economy.

 At high levels of unemployment, further increases in (u) may have little effect on , so the
Phillips Curve gets flat.

Shifts of the Phillips Curve

 Unfavourable supply shocks and stagflation: If firms' costs rise, they are likely to pass
these costs on to their customers in the form of higher prices (again, this is the mark-up
pricing idea). Therefore, a "cost shock" will cause higher inflation, at least for a while.
Higher costs will raise inflation for a given level of unemployment. Therefore, the
Phillips Curve will shift upward.

Summary of the Study Session Eight

 Unemployment could be defined as the percentage of the labour force that is without
job but is able and willing to work. Or the unemployed people are regarded as those
who are not currently employed and who indicate by their behaviour that they want to
work at prevailing wages and working conditions.
 The most difficult part of measuring the unemployment rate entails determining
who is unemployed versus who is out of the labour.
  Unemployed. This includes people who were not employed, were available for work,
and had tried to find a job within the previous four weeks, as well as those who were
temporarily laid off and waiting to be recalled.
 The natural rate of unemployment is an estimate of the unemployment rate that exists
when the economy is at full employment and this is the rate of unemployment that
economy will have in the long run
 Phillips curve shows "inverse relation" between inflation and unemployment. When the
economy is weak and unemployment is high, inflation is low. When the economy is
strong and unemployment is low, inflation is high.

Self- Assessment Questions for Study Session Eight

(SAQ1) A type of unemployment in which workers are in-between jobs or are searching for
new and better jobs is called _______ unemployment:

a. frictional b. cyclical c. structural d. turnover

(SAQ2) Suppose the working age population in Tiny Town is 100 people. If 25 of these people
are NOT in the labour force, the ____ equals ____ a. unemployment rate; 25/100 x 100
b. unemployment rate; 25/125 x 100
c. labour force; 75
d. labour force; 25/100 x 100

(SAQ3) If a larger fraction of the adult population is working, household production

a. counted in real GDP increases.
b. not counted in real GDP increases.
c. counted in real GDP decreases.
d. not counted in real GDP decreases.

(SAQ 4) Cyclical unemployment

a. is due mainly to job leavers.
b. may increase or decrease during an expansion.
c. occurs when technology improvements change job requirements.
d. fluctuates over the business cycle.

(SAQ5) Consider a small economy where the total population is 10,000. The size of the labour
force is 8,000, while the number of people employed is 7,000. What is the unemployment rate in
this economy? a. 10% b. 12.5% c. 20% d. 30% e. 37.5%

(SAQ6) If the number of people classified as unemployed is 20,000 and the number of people
classified as employed is 230,000, what is the unemployment rate? a. 8% b. 8.7% c. 9.2% d.
12.5%

(SAQ7) The number of unemployed divided by the labor force equals

a. the inflation rate.
b. the labor force participation rate.
c. the unemployment rate.
d. the misery index.
(SAQ8) The main cause of cyclical unemployment is that

a. firms engage in race, gender and sex discrimination in their hiring practices.
b. some individuals do not have marketable job skills.
c. the level of overall economic activity fluctuates.
d. workers often voluntarily quit a job to look for a better job.
(SAQ9) If an individual who cannot find a job because his or her job skills have become
obsolete this is an example of

a. frictional unemployment.
b. structural unemployment.
c. cyclical unemployment.
d. seasonal unemployment
(SAQ10) According to the short-run Phillips Curve, there is a trade-off between
a. interest rates and inflation
b. the growth of the money supply and interest rates
 c. unemployment and economic growth
d. inflation and unemployment

Answers

Questions 1 2 3 4 5 6 7 8 9 10

Answers A C A D B D C C B D

References

 Jhingan M.L 7th edition, Monetary Economics by Vrinda Publication (P) Ltd
 Debes, Mukherjee 2nd edition Essentials of Micro and Macroeconomics by New Central
Book Agency (P) Ltd
 Sampat, Mukherjee, 1st edition, Analytical Macroeconomics from Keynes to Mankiw by by
New Central Book Agency (P) Ltd
 Mishkin, Frederic S. 7th edition, The economics of money, banking, and financial markets
.
 STUDY SESSION NINE

THE CONCEPT OF ECONOMIC GROWTH AND DEVELOPMENT

9.0 Introduction

In this study session, an attempt has been made to discuss the concept of economic growth and
development to learners in the study of macroeconomics. In the course of this study, you will
understand the major characteristics that distinguish developed countries from developing ones.
Likewise, the various measures utilized to assess economic growth and development will be
identified.

Learning Outcome for study session Nine

At the end of this study session, you should be able to:

9.1 define and use correctly the key words printed in bold (SAQ1)

9.2 define the concept and features of economic growth (SAQ2)

9.3 define the concept and features of economic development (SAQ3)

9.4 discuss the differences between economic growth and development (SAQ4)

9.5 explain the various indicators utilized to measure economic growth and development( SAQ5)

9.1 The concept of economic growth

The concept of economic growth and development has often been used interchangeably but they
don’t necessary mean the same thing. For clarity and the purpose of the learner, each term will be
discussed in different sub-heading. The terms economic growth can be defined in different ways.
Firstly, we can simply define economic growth as the increase in the capacity of an economy to
produce goods and services that are required to improve the welfare of the citizens in terms of the
number and diversity in a given period of time. It can be said to be: the steady process in which
the productive capability of the nation is increased overtime in order to bring about a rise in the
national income level (Todaro, 1977; Anyanwu, 1998). It is a positive change in the production
level of goods and services in a country over a given period of time. Similarly, we can say, it is an
increase in the capacity of an economy to produce goods and services, compared from one period
of time to another. From the above definitions, it is observed that emphasis have been placed on
the changes in physical production of goods and services; hence in explaining economic growth,
it is important to examine the behaviour of the people overtime. This is because economic growth
is an important concept as it brings about an improvement in the wellbeing of the whole society
overtime and this can only occur if the rate of population growth lags behind that of economic
growth overtime. Herein, emphasis is placed on changes in physical output of goods and services
and the impact of such changes on the material well-being of the people in the nation. Therefore,
we can generally say, the economic growth is a steady process of increasing the productive
capacity of an economy as well as an increase in national income, being characterized by high
rates of increase per capita income and total factor productivity, especially labour productivity.
Having examined the context of growth, there is the need to examine the factors that determine
economic growth of a nation.

ITQ for learning outcome 9.2

Briefly define the term economic growth?

ITQA for learning outcome 9.2

Economic growth can be defined as the increase in the capacity of an economy to produce goods

and services, compared from one period of time to another.

9.2.1 The determinants of economic growth

The process of economic growth is a highly intricate phenomenon and is influenced by diverse
factors such as economic and non-economic factors. The following are the important factors which
determine the economic growth of an economy.
• Natural Resources
The principal factor affecting the development of an economy is the natural resources. Among the
natural resources, we generally include the land area and the quality of the soil, forest wealth, good
river system, minerals and oil resources, good and bracing climate, etc. For economic growth, the
existence of natural resources in abundance is essential. A country deficient in natural resources
may not be in a position to develop rapidly. In fact, natural resources are a necessary condition for
economic growth but not a sufficient one. In less developed countries such as Nigeria, natural
resources are unutilised, underutilised or mis-utilised . This is one of the reasons for her slow
growth and development. There is little reason to expect natural resource development if people
are indifferent to the products or service which such resources can contribute. This is due to
economic backwardness and lack of technological factors.

• Capital formation

Among numerous factors, capital formation is another important factor for development of an
economy. Capital may be defined as the stock of physical reproducible factors of production.
Capital accumulation and capital formation, both of these terms carry the same meaning which
may be understood simply by the stock of capital. As we know, capital formation is cumulative
and self-feeding and includes three interrelated stages; (a) the existence of real savings and rise in
them; (b) the existence of credit and financial institutions to mobilise savings and to divert them
to desired channels; and (c) the use of these savings for investment in capital goods. Low
propensity to save in underdeveloped countries in Africa is due to low per capita income (PCI) of
the people, which may not be raised merely by voluntary savings. Hence, the rate of per capita
savings can be increased by emphasising forced savings which will reduce consumption and
thereby release savings for capital formation. Forced savings can be possible through the
implementation of a proper fiscal policy. In this regard, taxation, deficit financing and public
borrowing are better instruments in the hands of the state to collect savings and accumulate capital.
The capital formation possesses special significance, as it is a key to economic growth, particularly
in backward economies. It increases sectoral productivity in the economy on the one hand and
enhances ultimately national output by raising effective demand, on the other.

• Technological progress

The technological changes are most essential in the process of economic growth. There is no doubt
that technological progress is a very important factor in determining the rate of economic growth.
In fact, even capital accumulation is not possible without technical progress. A country may be
adding to its means of transportation and communications, its power resources and its factories.
The use of improved techniques in production and technological progress bring about a significant
increase in per capita income. Technological progress has something to do with the research into
the use of new and better methods of production or the improvement of the old methods.
Sometimes technical progress results in the availability of natural resources. But generally,
technological progress results in increase in productivity, e.g., green revolution. In other words,
technological progress increases the ability to make a more effective and fruitful use of natural and
other resources for increasing production.

Technological progress has very close connection with capital formation. In fact, both go hand in
hand. Without capital formation technical progress is out of the question because heavy investment
is required for making use of better and more efficient methods of production, although after they
are well established, capital cost per unit of output may fall.

Thus, technological progress has a very important role to play in the economic development of a
country. Specifically, no backward country can hope to march ahead on the road of economic
development without adopting newer and newer techniques of production and unless it is assisted
in its march by technological progress.

• Human resources

A good quality of population is very important in determining the rate of economic progress.
Instead of a large population a small but high quality of human race in a country is better for
development. Thus, for economic growth, investment in human capital in the form of educational
and medical, such other social schemes is very much desirable.

•. Population growth

Labour supply comes from population growth. But the population growth should be normal. A
galloping rise in population retards economic progress. Population growth is desirable only in an
under-populated country. It is, however, unwarranted in an overpopulated country like India and
Nigeria. In fact, a high population growth at the rate of 2.5 percent per annum is very much
detrimental to the economic growth of a country.

•. Social overheads
Another important determinant of economic growth is the provision of social overheads like
schools, colleges, technical institutions, medical colleges, hospitals and public health facilities.
Such facilities make the working population healthy, efficient and responsible. Such people can
effectively take their country economically forward.

• Organisation

In the process of growth, organisation is very important. It is organisation that emphasises

maximum use of the means of production in production. Organisation is complementary to capital
and labour and helps production to reach the maximum level. In the modern economic system, the
entrepreneur performs the duty of an organiser and bears all risks and uncertainties. Hence,
entrepreneurship is an indispensable part in the process of economic growth. Most of the
underdeveloped countries in the world are poor not because there is shortage of capital, weak
infrastructure, unskilled labour and deficiency of natural resources, but because of acute deficiency
of entrepreneurship.

It is, therefore, crucial in less developed countries (LDCs) such as Nigeria to create the climate for
promoting entrepreneurship by emphasising education, new researches, scientific and
technological developments. Apart from it, the state should also give priority to necessary imports
of machines, raw materials and equipment to provide facilities for wider markets, and to allow tax
rebates, special grants and loans to the new entrepreneurs for starting business or industries
particularly in the undeveloped areas of an economy.

• Transformation of traditional agricultural society

The transformation of traditional agricultural society into a modern industrial society, i.e.,
structural changes lead to enhancement of employment opportunities, higher labour productivity
and the stock of capital, exploitation of the newly developed resources and improved technology.
Mostly, LDCs such as Nigeria, Ghana, Togo etc. have a very large primary sector and very small
secondary and tertiary sectors. In such economies the structural changes involve the transfer of
population from the primary sector to the secondary and then to tertiary sectors. Agriculture being
the main occupation of the 70-80 percent population in the LDCs passes through several structural
changes. The number of dependents on agriculture sector progressively reduces with the expansion
of industrial or non-agricultural sector.
Similarly, the proportion of contribution of agriculture in the real national income also reduces
gradually. But net output in agricultural sector progressively increases in absolute terms, as it is
accompanied by a strong productivity movement, relating to the implementation of several
programmes like land reforms, expansion of banks, improved agricultural techniques and other
farm implements, availability of better marketing facilities, means of power and irrigation, and so
on.

•. Political stability

Political stability and strong administration are essential and helpful in modern economic growth.
It is because of political stability and strong administration that the countries like the U.K. the
U.S.A., Germany, France and Japan have reached the level of the highest economic growth in the
world. But in most of the poor countries there is political instability and weak administration which
have largely influenced economic development programmes. It is, therefore, essential for their
faster economic development to have a strong, efficient and incorrupt administration. In
conclusion, we can say that a clean, just and strong administration can put an economy on the way
to rapid economic development.

• Social and psychological factors

Modern economic growth process has been largely influenced by social and psychological factors.
Social factors include social attitudes, social values and social institutions which change with the
expansion of education and transformation of culture from one society to the other. The Industrial
Revolution of England and other Western European countries in the 18th century was largely
influenced by the spirit of adventure and the expansion of education which led to new discoveries
and inventions and consequently to the rise of the new entrepreneurs. Social attitudes, values and
institutions changed. Joint family system was replaced by the new single family system which
further led to the rapid economic development in these countries.

But the society in LDCs has been badly enveloped and guided by traditional customs, out dated
ideology, values, and obsolete attitudes which have not been conducive to their economic
development. Thus, there is need to change or modify these social and psychological factors for
the rapid economic development in these countries. But it is not an easy task, and moreover, any
rapid change may bring discontentment and resistance in the society, with the result that it may
adversely affect the economic growth in the economies. Only the selective social and
psychological changes can lead to economic growth in LDCs.

• Education

It is now fairly recognised that education is the main vehicle of development. Greater progress has
been achieved in those countries, where education is wide spread.

• Urbanisation
Another noneconomic factor promoting development is the process of urbanisation. In poor
agrarian economies, the structural change must begin with the change in the size of population in
rural and urban sectors.

• Religious factors

Religion plays a great role in economic growth. It may give rise to a peculiar sense of self-
satisfaction. For example, the Christian and Islam religions in Nigeria encourage faith in working
hard to achieve your aims. But the Hindu religion encourages faith in fate and prevents people
from working hard. They are educated to remain satisfied with their lot and to hate risk and
enterprise. Then our religion gives a higher place to spirit than matter.

In sum economic growth is the result of intensive efforts of both economic and non-economic
factors. However, the mere presence of one or more or all of these factors may not ensure that the
economy will be in a position to generate forces that bring about a fast economic growth. Some
further factors may also be required to work as a catalyst for growth. This function can well be
performed by the state.

9.2.2 Common characteristics of developing countries

Learners should be familiar with the classification of a number of countries in the world as
"Third World", "Less Developed Countries (LDCs)", "Under Developed Countries" "Developing",
or "Emerging". A developing nation is that in which the per capita income (PCI) is low when
compared with the PCI of Canada, Australia, Qatar, U.S.A. and the Western Europe." The LDCs
are among the poorest countries where the people live on the edge of existence. Some of the
features of these countries are briefly discussed below.
 i. Low per capita income: The per capita income in under-developed countries is extremely
low. The average annual income in less developed countries like Nigeria and Sudan is nearly
$2,800 per head as compared with $43,100 in Canada and $54,800 in Switzerland. Low per
capita income is an outstanding feature of an under developed economy and is a significant
measure of a country’s development.
ii. ii. Higher population growth rate: Developing countries, particularly low income
countries, are characterized by relatively high population growth rate and this is as a result
of declining death- rate and increasing birth-rate which have given rise to high natural growth
rate of population with the concomitant low per capita incomes and low rates of capital
accumulation. The population growth rate ranges between 2.5 – 3.5 percent in most
developing nations.
iii. Deficiency of capital equipment.
The insufficient amount of physical capital in existence is also a feature of all under-
developed economies. Hence, they are often called “poor capital” economies. One indication
of the capital deficiency is the low amount of capital per head of population. Not only is the
capital stock extremely small but the current capital formation is also very low. In most
under-developed countries, investment is only 5 percent to 8 percent of the national income,
whereas in the USA, Canada and Western Europe, it is generally from 15 percent to 18
percent. The low level of capital formation in LDCs is due to the weakness of inducement
to invest and low propensity and capacity to save. In under developed economy, at the root
of capital deficiency is the shortage of savings. The per capita income being quite low most
of it is spent in satisfying the basic necessaries of life, leaving a very low margin of income
for capital accumulation. Even with an increase in the level of individual income, this is not
usually followed by higher rate of saving because of the tendency to emulate the higher
levels of consumption prevailing in the advanced countries.
iv. Excessive dependence on agriculture and primary product exports: Most LDCs are
predominantly agricultural economy. A great majority of their population (about 60 % of the
labour force) are engaged in agriculture and allied occupations. This excessive dependence
on agriculture is due to the fact that non-agricultural occupation not grown at a rate
commensurate with the increase in population for lack of sufficient investment outside
agriculture. Agricultural practices are carried out by means of primitive technological tools−
 hoes, cutlasses, digger, etc., resulting in low production of goods and income. With the
exception of few oil- producing nations (non-OPEC and OPEC), most LDCs earn a greater
percentage (over 70 percent) of their foreign exchange (income) through exportation of
primary agricultural products.
v. Unemployment and under-employment: An important consequence of rapid population
growth without a corresponding increase in the level of economic activities is that there is
large scale unemployment in the urban areas and disguised unemployment in rural areas.
More and more people are thrown on land, since alternative occupations do not develop
simultaneously to absorb surplus population. It means that there are more persons engaged
in agriculture than are actually needed, so that the addition of such persons does not add to
the land’s productivity. Even if some of the persons are withdrawn from the land no fall in
production will follow from such withdrawal. Also, dependency burden is relatively high
and the occurrence of international brain drain is the order of the day.

vi. General poverty and low living standard: Poverty cannot be described but can only be
felt. Most of the less developed countries (LDCs) are facing the major problem of absolute
and relative poverty likewise low standard of living. Most of the people in developing
nations are ill-fed, ill-housed, ill-clothed and illiterate. In LDCs almost 1/3 of the population
are considered to be poor
vii. Low levels of productivity: Most developing nations are faced with the problem of low
level of labour productivity. Low level of productivity is due to economic backwardness of
people, lack of skill, illiteracy and ill-training. Work effectiveness and efficiency as well as
productivity are impaired by poor health and malnutrition which is the outcome of low
income.
viii. Dualistic Economy
Dualistic economy refers to the existence of advanced and modern sectors with traditional
and backward sectors. The Nigerian economy is characterized by a dualistic economy as
other developing countries on the following grounds: co-existence of modern and traditional
methods of production in urban and rural areas, co-existence of wealthy, highly educated
class with a large number of illiterate poor classes, and co-existence of very high living
standard with very low living standard.
ix. Prevalence of income inequality. Nations classified as LDCs, have the majority of the
wealth holding concentrated in the hands of few people, that is, less 20 of the aggregate
population. The gap between the poor and the rich is always on the increase, and the poorare
left in a hopeless situation.
x. Dependence on foreign economies: Third world countries are far from being economically
self-reliant. They import both finished and capital goods to make their economy grow; on
the other hand they have no products to export but raw material. Their economies are
particularly susceptible to fluctuations in the international prices of the few primary product
exports. The developed countries dictate the pattern and terms of trade that the LDCs should
undertake.
xi. Inappropriate use of natural resources: Mostly there is a shortage of natural resources in
developing nations and this is also a cause of their economic backwardness. Natural
resources are available in various poor countries but they remain un-utilized, under-utilized
or mis-utilized due to capital shortage, less efficiency of labour, lack of skill and knowledge,
backward state of technology, improper government actions and limited home market.
Though there are other features of LDCs not mentioned herein, but the above listed ones
should be able to give the learner, a clue of nations that fall within the realm of third world
countries.

ITQ for learning outcome 9.2

Highlight six features of less developed countries?

ITQA for learning outcome 9.2

• Prevalent of income inequality.

• Dependence on foreign economies

• Low levels of productivity

• High unemployment and under-employment rate

• Low Per Capita Income •

General Poverty and Low Living Standard.

9.3 The meaning of economic development
The term economic growth and development have been
interchanged and used by some authors to mean the
same thing, but in this subsection we have to differentiate
the two term. The term 'economic development' is generally used with many other
synonymous terms such as economic growth, economic welfare, secular change, social
justice and economic progress. As such, it is not easy to give any precise and clear
definition of economic development. But in view of its scientific study and its popularity,
a working definition of the term seems to be quite essential. Recall that, we defined
economic growth as the increase in the output of goods and services of a nation over a
given period of time usually a year. This definition does not take into consideration the
desirable structural changes in the nation’s economic arrangement. Accordingly, while
economic growth looks at the volume of output in the present year vis-à-vis the volume of
output in a given preceding year, it overlooks the distribution to and hence the wellbeing
of the people in the economy. On the contrary, the concept of economic development does
not look at output growth only but emphasises the distribution of the income of growth.
The concept of economic development denotes an entire transformation of a nation from a
less desirable to a more desirable one, bringing in its wake an overall improvement in the
welfare of the whole citizenry (Anyanwu, 1995). Another definition of development is
given by Umoh (1986) cited in Adebayo (1999) , ‘as a process by which a high degree of
self –reliant economic growth in a society, sustained over a long time, is associated with a
substantial reduction in poverty, unemployment and inequality’. Also, Development can
be defined as economic growth plus desirable cultural, social, economic and institutional
changes in the economy as a whole. This definition encompasses economic and non-
economic aspects of development. It stresses the expansion of development variables, and
also improving the quality of those variables. For example, capital is a development
variable. Not only the increased quantity of capital is needed but the improvement in its
 productivity is also required for development. Similar instances can be given in respect of
other development variables. The central point of the definitions given is that, quantitative
and qualitative changes in development variables are considered essential ingredients of
economic development. To buttress our discussion on the subject matter, we have to
examine Todaro’s (2006) views on the three broad objectives of development:
I. To increase the availability and widen the distribution of basic life-
sustaining goods such as food, shelter, health and protection.
II. To raise levels of living, including, in addition to higher incomes, the
provision of more jobs, better education, and greater attention to cultural
and human values, all of which will serve not only to enhance material
well-being but also to generate greater individual and national self-
esteem.
III. To expand the range of economic and social choices available to
individuals and nations by freeing them from servitude and dependence
not only in relation to other people and nation-states but also to the forces
of ignorance and human misery. We have to note the emphasis on
‘cultural and human values’, ‘self-esteem’ and freedom from ignorance;
it is important to remember that economic development is much more than
simply achieving economic growth. However, economic growth and
economic development are obviously closely related, as a nation cannot
attain economic development without attaining economic growth.

9.4 Differences between economic growth and economic development

A developed nation has the following features: well-developed means of transport and
communication, increase in capital resources, improvement in efficiency of labour, improvement
in the standards of education and expectation of life, better organisation of production in all
spheres, growth of banks and other financial institutions, urbanisation and a rise in the standard of
living, greater leisure and more recreation facilities, the widening of the mental horizon of the
people, and so on. In short, economic development must break the vicious circle of poverty and
bring into being a self-generating economy so that economic growth becomes self-sustained. The
main characteristics of developed nations are as follows.
 I. Low growth of population
The developed countries such as Canada, the U.S.A., the U.K. and other Western European
countries have low growth of population because they have low level of birth rate followed
by low level of death rate. Good health conditions, high degree of education and high level
of consumption of the people have led to maintenance of low growth of population
followed by low level of birth and death rates. The life expectancy in these countries is also
very high. The high rate of capital formation on the one hand and low growth of population
have resulted in high level of per capita income and prosperity in these countries.
Consequently, the people in these countries enjoy a higher standard of living and work
together in unity for more rapid economic and industrial development of the nations.
Besides this, the entire society, its structure and values are found to be dedicated to the goal
of rapid economic and industrial development. The position of individuals in the society is
decided by the ability of the persons and not by their birth, caste or creed. Dignity of labour
is maintained. The economic motive and strong desire to lead a better social life always
inspire people to contribute to the process of development.
II. High rate of capital formation: One key features of a developed nation is the high growth
rate of capital formation. Developed countries are generally very rich, as they maintain a
high level of savings and investment, with the result that they have huge amount of capital
stocks. The rate of investment constitutes 20 to 25 percent of the total national income. The
rate of capital formation in these countries is also very high.
Besides this, well-developed capital markets, high level of savings, broader business
prospects and capable entrepreneurship have led to a high growth of capital formation in
these economies.
III. Significance of Industrial Sector
Most of the developed nations in the globe have given much importance to the development
of the industrial sector. They have large capacities to utilise all resources of production, to
maximise national income and to provide employment for the jobless people. It is a well-
known fact that these countries receive the major share of their national income from the
non-agricultural sectors which include industry, trade, transport, and communication. For
instance, England generally receives nearly 50% of her national income from industrial
sector, 21% from transport and commerce, 4% from agriculture and 25% from other
 sectors. The same goes for the U.S.A., Japan and other West European countries. But in
Nigeria and other developing countries agriculture contributes, say, 35 to 40 percent, to
their national income.
IV. Use of high production techniques and skills;
High production techniques and skills have become an essential part of economic
development process in the developed countries. The new techniques have been used for
the exploitation of the physical human resources. These countries have, therefore, been
giving priority to the scientific research, so as to improve and evolve the new technique of
production. Consequently, these nations find themselves able to produce goods and
services of a better equality comparatively at a lesser cost. It is because of the use of high
production techniques and latest skills, that the countries like Germany Israel and Japan
could develop their economies very rapidly, though they have limited natural resources.
The main objective of rapid economic development, particularly in the developed
economies, is to achieve a level of stagnant economic growth, so that they may maintain
the existing economic status and exercise control over business cycle.

9.5 Indicators for measuring economic growth and development

We will now distinguish between the characteristics of a less developed countries (LDCs) and
developed ones as follows:

 High population growth rate is an important feature of most LDCs. Population growth in
underdeveloped countries neutralises economic growth. In advanced economies, the case
is different.
 Capital deficiency is the main cause of poverty of most developing nations, while affluent
capital accumulation is the main cause of stagnation of an advanced country.
 The central problem of underdeveloped economies is the prevalence of mass poverty which
is the cause as well as the consequence of their low level of development. Shortage and
scarcity are the main economic problems in these economies, whereas the affluent societies
of advanced countries have economic problems resulting from abundance.
 LDCs are distinguished from developed countries on the basis of per capita income. In
general, those countries which have real per capita incomes less than a quarter of the per
 capita income of the United States, or roughly less than 5000 dollars per year, are
categorised as under-developed countries.
 An underdeveloped economy, compared with an advanced economy, is underequipped
with capital in relation to its population and natural resources. The rate of growth of
employment and investment in such an economy lags behind the rate of growth of
population. The resources are not only employed but also underemployed. In technical
jargon, the production possibility frontier of a poor country is far ahead of the actual
production curve, whereas the gap between the potentiality and actual utilisation of
resources is narrow in a developed economy.
 Developing countries are poor in technology; advanced countries are advanced in
technology. In fact, the level of technology attained in production is a reliable indication
of the level of economic development. Employment of advanced technology goes along
with large capital resources, high attainments in the fields of scientific research, greater
availability of entrepreneurial skill and a good supply of efficient skilled labour. Thus,
development of technology is the basic objective of the backward economy whereas
development of technology no longer remains the overriding objective of an affluent
society.
 In developing economy, the fundamental problem is that of output, real income or the
standard of living, as these economies are characterised by low productivity, low income
and a poor standard of living. A vast majority of people in an underdeveloped country are
ill-clothed, undernourished and without adequate shelter. On the other hand, most of the
developed countries at present enjoy a high rate of mass-consumption. In their economies,
per capita real income has risen to a level at which a large number of people can afford
consumption transcending food, shelter and clothing.
 In an underdeveloped economy, the problem of under-employment is more important than
that of unemployment, whereas a developed economy may have a cyclical unemployment
problem. There is chronic unemployment in an underdeveloped economy. An advanced
economy may have unemployment occasionally due to business fluctuations and a low
marginal propensity to consume. Whereas an under developed economy is confronted with
the problem of disguised unemployment in the sense that even unchanged techniques in
agriculture could be removed without reducing agricultural output. Thus, in a developed
 economy, unemployment means waste of resources, while in an underdeveloped economy,
it is of disguised type.

ITQ for learning outcome 9.5

Identify two features that distinguish developed countries from developing countries?

ITQA for learning outcome 9.3

• In developing economy, the key problem is that of output, real income or the standard of living,

as these economies are characterised by low productivity, low income and a poor standard of living.

On the other hand, most of the developed countries at present enjoy a high rate of mass-

consumption. In their economies, per capita real income has risen to a level at which a large number

of people can afford consumption transcending food, shelter and clothing.

• Capital deficiency is the main cause of poverty in most developing nations, while affluent capital

accumulation is the main cause of stagnation in the developed nations.

9.7 Measurement of Economic Growth and Development

In discussing the concept of economic growth and development, five strands of the measure of
growth will be deciphered. These measures include: Gross Domestic Product (GDP), Gross
National Product (GNP), Growth in Per Capita Income (PCI), Physical Quality of Life index
(PQLI) and Human Development Index (HDI).

(i) Gross domestic product (GNP)

Recall, we define gross domestic product as a measure of the value of economic activity within a
country. Strictly defined, GDP is the sum of the market values, or prices, of all final goods and
services produced in an economy during a period of time. GDP in an economy is also seen as the
market value of all the final goods and services delivered in a country in a period of one year. GDP
is an important measure or indicator of economic progress in a country. There are, however, three
important distinctions within this seemingly simple definition: GDP is a number that expresses
the worth of the output of a country in local currency.It tries to capture all final goods and services
as long as they are produced within the country, thereby assuring that the final monetary value of
everything that is created in a country is represented in the GDP. It is calculated for a specific
period of time, usually a year or a quarter of a year. However, this method of measuring economic
performance has some flaws which are stated as follows:

• GDP does not take into account unpaid work (e.g. voluntary activities in the household) or
activity in the black/informal economy even though these may contribute positively to the welfare
of a society. An example of something excluded from GDP is the childcare services provided by
a mother to her own children.

• GDP does not take account of externalities and negative goods: For instance: if a building is
burned down and then rebuilt by a private company, GDP increases while economic well-being is
unchanged. The costs associated with cleaning up pollution are included in GDP – pollution can
therefore make a country appear better off in terms of GDP.
• GDP ignores non-income related dimensions of ‘development’ (e.g. ‘happiness’, human rights,
health, freedom.
• GDP ignores distribution of income.
(ii) Gross national product (GNP).
Like the GDP, GNP is another method of measuring economic activities in a society. GNP is the
sum value of all goods and services produced by permanent residents of a country regardless of
their location. The important distinction between GDP and GNP rests on differences in counting
production by foreigners in a country and by nationals outside of a country. For the GDP of a
particular country, production by foreigners within that country is counted and production by
nationals outside of that country is not counted. For GNP, production by foreigners within a
particular country is not counted and production by nationals outside of that country is counted.
Thus, while GDP is the value of goods and services produced within a country, GNP is the value
of goods and services produced by citizens of a country. Since the majority of production within a
country is by nationals within that country, GDP and GNP are usually very close . In general,
macroeconomists rely on GDP as the measure of a country's total output. Unfortunately, GNP is
not a perfect measure of social welfare and even has the same limitation as GDP in measuring
economic output. Such limitations include:
• Improvements in productivity and in the quality of goods are difficult to calculate. For example,
personal computer prices have dropped dramatically since their introduction, yet their capabilities
have vastly improved. • It does not
factor in other forms of measurement such as illegal markets, services, etc.
• GNP does not factor in a change in the population of a given nation.
• It does not reveal or factor in the negative externalities such as pollution. •
It tells nothing about the distribution of a society’s income.

(iii) GDP per capital (GDP PC)

It is a measurement of income which also factors in population. GDP per capita means that the
GDP divided by the size of the population, gives the amount of GDP that each individual gets, on
average, and thereby provides an excellent measure of standard of living within an economy.
Because GDP is equal to national income, the value of GDP per capita is therefore the income of
a representative individual. This number is connected directly to standard of living. In general, the
higher the GDP per capita in a country, the higher the standard of living. GDP per capita is a more
useful measure than GDP for determining standard of living because of differences in population
across countries. If a country has a large GDP and a very large population, each person in the
country may have a low income and thus may live in poor conditions. On the other hand, a country
may have a moderate GDP but a very small population and thus a high individual income. Using
the GDP per capita measure to compare standard of living across countries avoids the problem of
division of GDP among the inhabitants of a country. Like other measurements of economic
welfare, the GDP PCI has its own limitation as follows:

Criticisms of GDP PCI

 GDP PCI fails to measure changes in output due to changes in price lend.
 GDP PCI fails to take into account problems associated with basic needs like nutrition,
health, sanitation, housing, education, etc.
 It does not show whether any increase in income goes to the rich or the poor.
 International comparisons of real GDP PCI are inaccurate due to exchange rate
considerations of different currencies into one standard currency.
(iv) The physical quality of life index (PQLI)
The physical quality of life index (PQLI) refers to an effort to measure the quality of life or well-
being of a country. PQLI is the average of three statistics: basic literacy rate, infant mortality, and
life expectancy at age one, all equally weighted. It shares the general problems of measuring
quality of life in a quantitative way. The PQLI was developed in the mid-1970s by economist
Morris David Morris (1979). According to Morris D Morris: physical quality of life index (PQLI)
is a measurement of the most basic necessity of the people. It factors in a wide range of indicators
such as health, education, water conditions, nutrition and sanitation. PQLI is determined by taking
3 measurements: i.) Infant mortality rate (IMR), ii.) Life Expectancy at age one and iii.) Literacy
rate and averaging these three factors giving equal value to each.

Criticisms
•. It does not explain the changing structure of economics and societal development.

•. PQLI is a limited measure of basic needs.

•. Many societal and psychological factors like security, justice, human rights, etc are excluded.

• Arbitrary weights are given to each determining factors.

•. PQLI does not measure economic development and total welfare.

• There is no unanimity among the economists as to the number and type of items to b included
in such an index.
(v.) Human development index (HDI)
The PQLI was largely replaced with human development index (HDI) by the United Nations
Development Programme's (UNDP). HDI is a composite index of a long and healthy life,
knowledge and a descent standard of living. Human development is the process of enlarging
people’s choices and raising the level of well-being. Therefore, the United Nations Development
Program (UNDP) computes a human development index for each country each year. The human
development index (HDI), is composed of three indicators: life expectancy, education (adult
literacy and combined secondary and tertiary school enrolment) and real GDP per capita. To
calculate the HDI, involves i.) longevity, ii.) education (2/3) - educational attainment of adult
literacy, (1/3) gross enrollment ratio (GER) for primary, secondary and tertiary levels, and standard
of living and public power priority in terms of dollars. The HDI is given as (1.+2.+3.)/3 Thus, the
HDIs for each nation are grouped as : high HDI nations (.8+), medium nations HDI (.5-.8) and
low HDI countries (below .5). Also, this •measure is not free from crisis as follows:

Criticisms
• HDI may shift the focus away from the high inequality found in some countries.
• A crude index which tries to create one simple number for a complex realization about human
development and deprivation.

• There can be many indicators like IMR, nutrition, etc.

•. HDI measures relative rather than absolute human development.

• The use of weights to each of these items is arbitrary.

• Reliability of data pertaining to health education and literacy used by UNDP is open to question

Summary of the Study Session Nine

This study session has been able to discuss the concept of economic growth and development. In
the course of explaining the concept of economic growth, the factors that determine the growth of
a nation were briefly discussed. Also, the common features of less developed countries were
emphatically explained. Furthermore, the features of developed nations were discussed while the
differences between developing and developed economies were identified. Similarly, some
variables that are utilized to measure economic performance and well-being were explained and
the flaws of each method were highlighted.

Self – Assessment Question for study session Nine

(SAQ1) Which of the following characteristics are most likely to be found in developing
countries?

(a). high population growth rates.

(b). large number of people living in poverty.

(c). very traditional methods of agricultural production.

(d). all of the above

(SAQ2) The Human Development Index (HDI) summarizes a great deal of social performance in
a single composite index, combining

(a). disparity reduction rate, human resource development rate and the composite index.

(b). longevity, education and living standard.

(c). minimum schooling, adult literacy and tertiary educational attainment.

(d). human resource training, development and Research and Development (R&D).

(SAQ3) Longevity is a proxy for ___________ in the Human Development Index

(a). health and nutrition.

(b). living standard

(c). infant mortality

(d). purchasing Power Parity

(SAQ4) Which of these measures is not utilized to evaluate economic performance of a nation
….

(a). purchasing Poverty Parity.

(b). physical Quality of Life Index.

(c). human Development Index.

(d). gross Domestic Product

(SAQ5) The Physical Quality of Life Index (PQLI) combines three indicators. They are

(a). infant mortality, life expectancy and adult literacy rate.

(b). crime rate, clean environment and quality of housing.

(c). air pollution rate, water pollution rate and sanitation.

(d). health, education and environment.

(SAQ6) Infant mortality….

(a). is defined as the annual number of deaths of infant under 1 year old per 1,000 live births.
(b). reflects the availability of primary education, the rights of employment and social security.

(c). is life expectancy up to age 3.

(d). reflects the availability of hospitals and childcare facilities, and the parents’ wealth.

(SAQ7) Economic development refers to

(a) economic growth.
(b) economic growth plus changes in output distribution and economic structure.

(c) Improvement in the well-being of the urban population.

(d) sustainable increases in Gross National Product.

(SAQ 8) The poorest region of the world is

(a). the Middle East.

(b). Sub-Saharan Africa.

(c). Asia.

(d). Latin America.

(SAQ 9) Which of this continent is not classified as third-world regions?

a. Latin America.

b. Asia.

c. Africa.

d. Australia.

(SAQ10) The economics of development focuses primarily on the poorest ___________ of the
world's
 (a). Population.

(b). Two-thirds.

(c). One-third.

(d). 28 percent.

Answers.
Questions 1 2 3 4 5 6 7 8 9 10

Answers D B A A A A B B D A
References

Adebayo, A. (1999). Economics: A simplified Approach. Volume 2, Second Edition. African

International Publishing Ltd. ISBN: 978-2837-24-5.

Anyanwu, J. C. & Oaikhenan, H. E. (1995). Modern macroeconomics: Theory and application in

Nigeria. Joanee Educational Publishers Ltd. Onitsha. ISBN: 978 – 2784 – 16 -8

Jhingan, M. I. (2006). The Economics of development and planning. Vrinda Publications (P) Ltd.
ISBN 81-8281-089-2

http://www.myfinancialintelligence.com/banking-and-finance/sectoral-analysis-
nigeria%E2%80%99s-economy

http://www.aw-bc.com/info/todaro_smith/Chapter4.pdf

http://www.newagepublishers.com/samplechapter/000186.pdf

http://www.roiw.org/2004/585.pdf

http://ahsankhaneco.blogspot.com/2012/04/basic-major-and-common-characteristics.html

http://test.scoilnet.ie/Res/charlieotoole060899100743_2.htm

http://gerardlameiro.com/thoughts/characteristics-of-a-free-market

http://web.uvic.ca/~kumara/econ420/characteristics-dev.pdf

http://www.google.com.ng/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&uact=8&
ved=0CBwQFjAA&url=http%3A%2F%2Fwww.k-
state.edu%2Feconomics%2Fnafwayne%2FStudy%2520Guide%2520Dev_%2520Econ%2520M
ohan.doc&ei=lTtYVPOuO4PwOY7DgNgE&usg=AFQjCNHODTUi2sBc972_rABrr07_RzqfTA
&bvm=bv.78677474,d.ZWU

http://notesforpakistan.blogspot.com/2011/08/basic-characteristics-of-under.html

https://www.cia.gov/library/publications/the-world-factbook/rankorder/2004rank.html

http://studypoints.blogspot.com/2011/07/discuss-main-characteristics-of_8348.html
http://www.whatiseconomics.org/gross-domestic-product-or-gdp

http://www.tutor2u.net/blog/index.php/economics/comments/unit-2-macro-growth-and-
development-some-indicators

http://www.sparknotes.com/economics/macro/measuring1/section1.rhtml

http://www.harpercollege.edu/mhealy/g101ilec/intro/eco/ecomea/ecomeafr.htm

http://www.peoi.org/Courses/Coursesen/ecdev/ch/ch1b1.html
 STUDY SESSION TEN

SELECTED THEORIES OF ECONOMIC GROWTH

10.0 Introduction

In the preceding study session, the concepts of economics growth and development were
discussed. Recall it was noted that economic growth deals with the aggregate amount of good and
services produced in a given period of time usually a year. In this study session, we will be
examining some theories of economic growth starting with the classical, neoclassical and new
growth theories. In the course of the study, you will understand the basic tenets of each theory
reviews, similarly, an assessment of Nigeria economic growth performance will be examined.

Learning Outcomes for study Session Ten

At the end of this study session, you should be able to:

10.1 define and use correctly the key words printed in bold:

10.2 explain the meaning of theory

10.3 explain some selected growth theories

10.4 discuss the Nigeria economic growth performance

10.5 calculate annual growth rate of any given two year periods

10.1 Theories of Economic Growth

Basically, it has been identified that economic growth is one of the main macroeconomic goals of
any society and as such most nations try to maintain stable growth rate. However, the issues of
growth have not be placed on high esteem until two significance issues were confronting various
economies in the globe; one is the great depression of the 1930s and two; the devastating effect of
the 1939-45 second world war on war ravaged economies. These two crisis prompted nations to
design policies targeted to accelerate economic growth andmarked the landmark for the
development of various growth theories each attempting to explain the mechanisms of growth.
Some of these theories are: the Rostow’s stages of growth theory, Harrod-Domar model of
economic growth, Marxian growth theory and the neoclassical growth theory. Since we have
defined ‘growth’ in the previous section, we shall define theory herein as ‘a set of interrelated
constructs (concepts), definitions, and propositions that present a systematic view of phenomena
by specifying relations among variables, with the purpose of explaining and predicting the
phenomena’. It is a set of assumptions, propositions, or accepted facts that attempts to provide a
plausible or rational explanation of cause-and-effect (causal) relationships among a group of
observed phenomenon. Having connoted the meaning of theory, we have to examine some selected
growth theory for the leaners’ understanding of the terms.

10.3 Explanation of selected growth theories.

10.3.1 Classical theory of economic growth

The classical growth theory is presented by its proponents as one that identifies a parallel between
economic growth and population growth. Basically, this theory states that economic growth is tied
to increases and decreases in population growth due to the fact that any uncontrolled movement in
either way could have a detrimental effect on the economic growth of the nation under
consideration. The main reason for this assertion or belief is the position of the proponents of the
classical growth theory that economic growth can only continue for the period that the available
resources still form a sustainable balance with the population. When the population growth
becomes so much that it starts to put a strain on the resources, the economic growth will stall and
eventually start to regress in response.

The main proponents of the classicalists growth theory include: Adam Smith, David Ricardo, and
John Stuart Mill. They based their theory on the fact that resources that are meant to satisfy human
needs and that would promote economic growth are so limited that they cannot continue to function
at the optimum forever if the demand on them continues to grow. At a point, the demand will
eventually supersede the available resources, and the factors that powered the economic growth
will suddenly become overdrawn, causing an incremental reduction in the production capabilities
of any nation that is affected. As such, the main thrust of the classical growth theory is that the
population growth must be at a reasonably comparative level with the level of production in the
economy in order for that economy to continue to thrive. In what could be described as a self-
limiting theory, the proponents opined that the increased in division of labour and thus
specialization is made possible by increase in the growth rate of capital and this would result in
increases in both profit and wages. However, an increase in both profit and wages would in turn
boost off population growth which is the course of growth of capital and labour overtime and hence
result in diminishing returns consequent upon the immobility of the land. The setting in of
diminishing returns would lead to decline in profits as well as bring about a return of wages to
subsistence level leading in turn to decline in investment and hence growth, thus bringing about a
return of the economy to a stationary state (Anyanwu and Oaikhenan, 1995). The classical growth
theory, especially Ricardo growth model specifically emphasizes scarcity of land as an obstacle
that will hinder growth. However, one of the major flaws of the theory, is its inability to recognize
the role of total factor productivity/ technological progress in trigging growth.

10.3.2 Marxian theory of growth

One of the historical theories of economic growth that mixes reasoning from economics and
sociological perspectives is the Marxian theory. Marx view growth as a process of continuous
transformation of a society’s political life and social culture. Such transformation can be mapped
out to the society’s mode of production likewise the property rights of the society’s economic
power and prestige seeking class called the bourgeoisie. Marx theory of growth postulate that
growth is a function of the rate of accumulation of labour surplus value by the bourgeoisie who
belong to the capitalist class. Thus, labour surplus value is the rate of profit in excess of labour’s
true remuneration which has been taken from the worker (proletariats) by the owners of factor of
production (bourgeoisie or capitalists).

In other words, Marx believed that once the bourgeoisie /capitalist has set up the means of
production, all value is created by the labour involved in producing whatever is being produced.
In Marx's view, presented in his 1867 tome Das Kapital (Capital), a capitalist's profits come from
exploiting labour—that is, from underpaying workers for the value that they are actually creating.
For this reason, Marx couldn't abide by the notion of a profit-oriented organization. This situation
of management exploiting labour underlies the class struggle that Marx saw at the heart of
capitalism, and he predicted that that struggle would ultimately destroy capitalism. To Marx, class
struggle is not only inherent in the system—because of the tension between capitalists and
workers—but also intensifies over time. The struggle intensifies as businesses eventually become
larger and larger, due to the inherent efficiency of large outfits and their ability to withstand the
cyclical crises that plague the system. Ultimately, in Marx's view, society moves to a two-class
system of a few wealthy capitalists and a mass of underpaid, underprivileged workers. Marx
predicted the fall of capitalism and movement of society toward communism, in which “the
people” (that is, the workers) own the means of production and thus have no need to exploit labour
for profit. Clearly, Marx's thinking had a tremendous impact on many societies, particularly on the
Union of Soviet Socialist Republics (USSR) in the twentieth century. In practice, however, two
events have undermined Marx's theories. First, the socialist, centrally planned economies have
proven far less efficient at producing and delivering goods and services—that is, at creating the
greatest good for the greatest number of people—than capitalist systems. Second, workers'
incomes have actually risen over time, which undercuts the theory that labour is exploited in the
name of profit. If workers' incomes are rising, they are clearly sharing in the growth of the
economy. In a very real sense, they are sharing in the profitsThus his doctrine of surplus value is
regarded as the weakest point in his theory of economic growth. Critics argue that all factors of
production are needed to produce a commodity and workers alone cannot claim the entire volume
of the commodity.

While Marx's theories have been discredited, they are fascinating and worth knowing. They even
reveal some weaknesses in capitalism. For instance, large companies do enjoy certain advantages
over small ones and can absorb or undercut them. Furthermore, Marxian theory of economic
growth is applicable indirectly to developing countries. Although Marx did not think of the
problem of the developing countries, yet some of the variables of his analysis do exist in such
countries.

10.3.3 Rostow’s stages of Growth theory

This theory of historical process of economic growth is attributed to an American, W. W. Rostow

and it was propounded in 1960. Rostow opined that all nations of necessity must pass through five
(5) stages of growth. He based his model on 15 nations − most of which were European − and
suggested that it was possible for all countries to break the vicious cycle of poverty and develop
through these five linear stages that construct his model. These five stages are briefly discussed
below. The first stage is Traditional society: A subsistence economy based on basic agriculture.
The outputs are consumed by the producers instead of being exchanged and the only trade that
exists is the barter/exchange of items required for living (not done for profit). Agriculture is crucial
to daily life and is the only industry that exists. The work is very labour intensive as there is very
limited technology. Apart from the land for food production there is very limited exploitation of
raw materials and so the development of other industries and services is also restricted.

The second stage is Pre-conditions for take-off: Agriculture starts to become more
commercialised as mechanization occurs. Other industries start to emerge, although one will be
dominant (this is usually textiles), and resources start to be exploited. Likewise, as incomes,
savings and investment grow entrepreneurs emerge. Transnational corporations (TNCs) start to
invest and this further provokes the development of industries. This investment is known as FDI
= foreign direct investment.

The third stage is the: Take-off : This stage is characterised by industrialisation increases, with
workers switching from the agricultural sector to the manufacturing sector. Infrastructure
continues to be developed but growth is concentrated in a few regions of the country and in one or
two manufacturing industries. The level of investment reaches over 10 percent of Gross National
Product (GNP). The economic transitions are accompanied by the evolution of new political and
social institutions that support the industrialisation. The growth is self-sustaining as investment
leads to increasing incomes which in turn generates more savings to finance further investment.

The fourth stage is the Drive to maturity −Growth becomes self-sustaining as it is now supported
by technological innovation. The economy is diversifying into new areas. Technological
innovation is providing a diverse range of investment opportunities. The economy is producing a
wide range of goods and services and there is less reliance on imports. The population continues
to grow and rapid urbanisation starts to occur. Earlier industries start to decline as manufacturing
becomes dominant and a wider range of industries develop. Economic growth becomes more
evenly distributed throughout the country due to a process of filter through −this occurs via
Cumulative Causation.

The fifth stage is the Age of High Mass Consumption: The initially exploitative industries move
elsewhere and any remaining industries shift production to durable consumer goods. A rapid
expansion of tertiary industry occurs. One of the main shifts that occurs as a country moves through
the five stages of the Rostow model of development is within the employment sector and the
changes that occur here reflect those that happen within industry. In this stage of growth, an
economy is deemed to have matured, making it possible for the citizens to enjoy appreciable levels
of living standard. The more developed nations such as Germany, UK, USA, Norway, Sweden,
France, and Netherlands are most likely to fall under this stage of Rostow’s five (5) stages
classification. For the emerging nascent economies the second stage is probably more relevant to
their growth (and development) since it is at this stage that resistance to change in traditional values
and in the social, economic and cultural institutions is finally overcome and modern industries
begin to emerge.

Criticisms
Many development economists argue that Rostows's theory was developed with Western cultures
in mind and not applicable to less developed countries (LDCs). It addition, its generalised nature
makes it somewhat limited. It does not set down the detailed nature of the pre-conditions for
growth. In reality, policy makers are unable to clearly identify stages as they merge rather than
being mutually exclusive . Thus as a predictive model it is not very helpful. Perhaps its main use
is to highlight the need for investment. Like many of the other models of economic developments
it is essentially a growth model and does not address the issue of development in the wider context.

ITQ for learning outcome 10.3.3

Briefly discuss the first-two phases of the Rostow stages of growth.

ITQA for learning outcome 10.1

 The first –two phases of Rostow stages of growth are: The traditional society, the pre-condition
to take off and the take-off phase Stage one - Traditional Society. This phase is characterized
by subsistence activity where output is consumed by producers rather than traded. Agriculture
is the main source of income and barter system of trade is the order of the day. Thus, resource
allocation is determined very much by traditional methods of production.

Stage two - the preconditions for take-off ;

This stage is characterized by increases in specialisation which generates surpluses for
trading. There is an emergence of a transport infrastructure to support trade. As incomes,
savings and investment grow entrepreneurs emerge. External trade also occurs concentrating
on primary products.

10.3.4 The Harrod-Domar Growth Theory

The Harrod-Domar growth model was developed independently by Sir Roy Harrod in 1939 and
Evsey Domar in 1946. It is a growth model which states that the rate of economic growth in an
economy is dependent on the level of national savings and the capital output ratio. 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. In other words, the productivity of capital investment is also known
as the capital-output ratio. 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.
Therefore, the rate of growth of GDP is given as: (Y) = Savings (s) / capital output ratio (k)
This can be written as: y= s/k …………………(1)
where:
– y = is the economic growth rate
– s = S/Y is the ratio of saving (S) to income (Y),

– k = is marginal capital-output ratio

It is argued that in developing countries, savings rates are often low, if left to the free market
enterprises. Therefore, there is a need for governments to increase the savings rate in an economy.
Also, less developed countries (LDCs) often have an abundant supply of labour but they lack the
physical capital that promote economic growth and development. Boosting investment will help
accelerates economic growth which leads to a higher level of national income. Thus, one way of
enhancing investment is through developed countries stepping in and transfer capital stock to the
developing countries, which would increase the productive capacity and employment
opportunities. The resultant effect is higher incomes which allow more people to save.

From all indications, the growth model stresses the importance of savings and investment as key
determinants of growth. Let us give a simple analytical example of the model using the Capital-
Output ratio (COR).

• The
Capital-Output ratio (COR)
For instance, supposes in Nigeria N100 billion worth of capital equipment produces each N10
billion of annual output, a capital-output ratio of 10 to 1 exists. A 3 to 1 capital-output ratio
indicates that only N30 billions of capital is required to produce each N10 billions of output
annually.

Thus, if the capital-output ratio is low, an economy can produce a lot of output from a little capital.
If the capital-output ratio is high then it needs a lot of capital for production, and it will not get as
much value of output for the same amount of capital. This implies that, when the quality capital
resource is high, then the capital output ratio will be lower.

• Let us take a numerical example for instance: Suppose the savings rate in the economy is 10
percent and the capital output ratio is 2, then the country would grow at 5 percent per year. If the
savings rate in the economy is 20 percent and the capital output ratio is 1.5, then the country would
grow at 13.3 percent per year.

However, if the savings rate in the economy is 8 percent and the capital output ratio is 4, then the
country would grow at 2 percent per year. The calculation done so far is what Harrod called the
warranted growth rate.

The warranted growth rate is defined as the growth rate at which all savings are absorbed into
investment (for instance, N100 billions of savings = N100 billions of investment. In addition to
the example given, let us assume that, the saving rate is 10 percent and the capital output ratio is
4. In other words N10 billions of investment, increases output by N2.5 billion. In this case the
economy’s warranted growth rate is 2.5 percent (ten divided by four). This is the growth rate at
which the ratio of capital to output would stay constant at four.

Another term introduced alongside with the warranted growth rate by Harrod is the natural growth
rate (NGR). The natural growth rate is the rate required to maintain full employment. If the labour
force grows at 2 percent per year, then to maintain full employment, the economy’s annual growth
rate must be 2 percent (assuming no growth in productivity). This assumes no change in labour
productivity which is unrealistic.

To keep us on track, the Harrod-Domar growth theory posited that, the rate of growth in an
economy can be increased in one of two ways:

i. Increased level of savings in the economy (national savings)

ii. Reducing the capital output ratio (i.e. increasing the quality of capital inputs)

Criticisms of Harod-Domar model

  Developing countries find it difficult to increase saving. Increasing savings ratios may be
inappropriate when you are struggling to get enough food to eat.
 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.
 Harod based his model on looking at industrialised countries post-depression years. He
later came to repudiate his model because he felt it did not provide a model for long term
growth rates.
 The model ignores factors such as labour productivity, technological innovation and levels
of corruption. The Harod-Domar model is at best an oversimplification of the complex
factors which go into economic growth.
 There are examples of countries that have experienced rapid growth rates despite a lack of
savings, such as Thailand.
 It assumes the existence of a reliable finance and transport system. Often the problem for
developing countries is a lack of investment in these areas.
 Increasing capital stock can lead to diminishing returns. Domar was writing during the
aftermath of the great depression where he could assume there would always be surplus
labour willing to use the machines, but, in practice this is not the case.
 Research and development (R&D) needed to improve the capital/output ratio is often
underfunded
 Borrowing from overseas to fill a gap caused by insufficient savings causes external debt
repayment problems later.

Policy implication of the Harrod-Domar growth model.

One main policy analysis of the model is that the growth rate of an economy can be influenced by
policy makers by interfering with some components of the warranted growth rate. This implies
that by designing policies to stimulate the rate of savings (s) or legislating policies to reduce the
capital-output (k), for instance, investing in human capital, the productivity of capital might be
increased hereafter the growth rate of the economy can be considered a policy variable (Anyanwu
& Oaikhenan, 1995). In conclusion, the model suggested that if developing countries want to
achieve economic growth, their governments need to encourage savings, and support technological
advancements to decrease the economy’s capital output ratio.
10.3.5 The Neo-Classical growth Model

The Solow growth model, also called the neoclassical growth model, was developed by Robert
Solow in 1956. Robert Solow later received the nobel prize in economics in 1987 for his work on
this theory. The Solow growth model is an extension of the Harrod-Domar model. It states that
there are three factors: technology, capital accumulation and labour force that drive economic
growth. The growth model believes that a rise in capital accumulation and labour force will
increase the economic growth rate, but only temporarily because of diminishing returns. For
instance, suppose the Nigeria economy only has one worker. If you add one more worker, output
will increase dramatically. But if the economy has millions of workers, adding one more worker
will not cause output to increase as much. Eventually, the economy will grow at a steady rate, with
GDP growing at the same rate as the increase in labour force and productivity. After the steady-
state is reached and the resources in a country are used up, the economic growth rate can only be
increased through innovation and improvements in technology.

In other words Solow model believes that a sustained rise in capital investment increases the
growth rate only temporarily: because the ratio of capital to labour goes up. However, the marginal
product of additional units of capital may decline (there are diminishing returns) and thus an
economy moves back to a long-term growth path, with real GDP growing at the same rate as the
growth of the workforce plus a factor to reflect improving productivity. Thus, it is believed that
differences in the rate of technological change between countries are said to explain much of the
variation in growth rates that we see. The neo-classical model treats productivity improvements as
an ‘exogenous’ variable – they are assumed to be independent of the amount of capital investment.

Implications of this model

Just like the Harrod-Domar growth model, the model proposes that the way and speed of a society
growth are based on endogenous policy variables that are within the sphere of policy makers. Also,
the model predicts that the gap between the rich and poor countries will narrow, a concept called
the catch-up growth. The idea of catch-up growth is when a poorer country is catching up with a
richer country – often because of a higher marginal rate of return on invested capital in faster-
growing countries. This is because poor countries have less capital to start with, so each additional
unit of capital will have a higher return than in a rich country. This helps to explain why China’s
GDP grew at 9% on average over the last three decades, while the UK only grew at around 2%.
The theory also explains why Germany and Japan, despite losing in the Second World War,
managed to grow faster than the US and UK during 1950-1960 period. This is because many
capital stocks in those countries were destroyed during the war, so any new addition of capital
would have a high return and significantly increase economic development.

10.4 Evaluation of Nigeria’s economic growth

In assessing a nation economic growth, it is relevant to mention that the practical side of the growth
phenomenon work hand in hand with the theoretical side. However, the practical economic growth
gives us a clear picture of the measurement and evaluation of economic growth than the theoretical
issues. Against this background, we examine the concept of economic growth in the Nigeria
economy by examining the trends and pattern of growth rate of output over a periods of time.
Particularly, one way of assessing economic growth is to examine the behaviour of output growth
over specific period of time regardless of the composition of the output at that period of time.
Accordingly, we shall now examine the main growth rate indicators in Nigeria as depicted in
figure 10.1 and table 10.1 over the period 1981-2012.

Gross Domestic Product (GDP) Growth Rate

120

100

80
Percent (%)

60

40

20

-20
82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Years

Figure 10.1: Nigeria’s Economic Growth Rates

The table 10.1 shows three indicators of economic performance in the Nigeria society. The first is
the Gross Domestic Product (GDP) at current market prices. We define GDP at current market
prices as GDP at prices of the current reporting period. It is also known as nominal GDP. Similarly,
we say, the nominal GDP is GDP estimated at current market prices. Thus, nominal GDP will
include all of the changes in market prices that have taken place during the current year due to
inflation or deflation. The next term is the GDP annual growth rate. It is defined as a measure of
economic growth from one period to another in percentage terms. This measure does not adjust
for inflation; it is expressed in nominal terms. In practice, it is a measure of the rate of change that
a nation's gross domestic product goes through from one year to another. Gross national product
can also be used if a nation's economy is heavily dependent on foreign earnings.
The formula for annual growth rate of GDP is given as:
Economic Growth = GDP2 – GDP1 X 100.

GDP1 1

Where:
GDP2 = Gross Domestic Product (GDP) at the current year or period
GDP1 = Gross Domestic Product (GDP) at the based or past year

Table 10.1 Nigeria : indicator of economic growth in Nigeria

GDP at current GDP (annual GDP Per Year GDP at current GDP (annual GDP Per Capita
Year market price growth rate) Capita (US $) market price growth rate) (US $)

1981 94325.0 6.5 710.0 1997 4189249.8 3.9 1052.0

1982 101011.2 7.1 760.0 1998 3989450.3 -4.8 1048.4

1983 110064.0 9.0 550.0 1999 4679212.1 17.3 1041.9

1984 116272.2 5.6 450.0 2000 6713574.8 43.5 1038.9

1985 134585.6 15.8 530.0 2001 6895198.3 2.7 1046.8

1986 134603.3 0.0 520.0 2002 7795758.4 13.1 1062.5

1987 193126.2 43.5 540.0 2003 9913518.2 27.2 1065.4

1988 263294.5 36.3 540.0 2004 11411066.9 15.1 1073.3

1989 382261.5 45.2 540.0 2005 14610881.4 28.0 1076.2

1990 472648.7 23.6 520.0 2006 18564594.7 27.1 1030.3

1991 545672.4 15.4 580.0 2007 20657317.7 11.3 1223.5

1992 875342.5 60.4 860.0 2008 24296329.3 17.6 1286.3

1993 1089679.7 24.5 990.0 2009 24794238.7 2.0 1106.8

1994 1399703.2 28.5 102.6 2010 33984754.1 37.1 1235.9

1995 2907358.2 107.7 1050.0 2011 37409860.6 10.1 1176.6

1996 4032300.3 38.7 1026.0 2012 40544099.9 8.4 1205.8

Sources: CBN Annual report (various issues)

In addition, we have the ‘GDP per capita ' which is a measure of the total output of a country and
it is estimated by taking the gross domestic product (GDP) and dividing it by the number of people
in the country. The per capita GDP is especially useful when comparing one country to another
because it shows the relative performance of the countries. The relevant figures as depicted in
figure 10.1 and table 10.1 have shown an apparent growth in the Nigeria economy over the
reference period, except for some years where the nation experienced negative growth rate in GDP.
The other years experienced fluctuating positive growth rate which suggested that the nation’s
economy is slightly growing over the years. However, the economy has witnessed little or slow
development during this periods due to deteriorating infrastructure, bribery and corruption,
prolonged military regime, rising inflation and unemployment rate, militants and terrorists attacks,
hunger, low standard of living and inequitable distribution of income. These factors, among others,
have contributed to the slow growth and development of the Nigeria economy.

ITQ for learning outcome 10.4

 (i.) What is warranted rate of growth?

(ii) Suppose the Nigeria Real GDP for 2013 and 2014 were N12.7 trillion and N13.1 trillion,

calculate the annual growth rate of GDP?

ITQA for learning outcome 10.4

(i.) The warranted growth rate is defined as the growth rate at which all saving is absorbed into

investment (For example N20 billions of savings = N20 billions of investment.

(ii). The growth rate formula is given as:

G = GDP2 – GDP1 X 100.

GDP1

Therefore, we insert the values from the question (ii) into the formula as:

G = 13.1– 12.7 X 100.

12.7 = 0.03 or 3 percent

Summary of the Study Session Ten

This study session was able to examine some selected growth theories in detail. Some of the
theories reviewed were the Classical, Marxian, Rostow’s, Harrod-Domar and Solow growth
models. One common feature of these theories is: the roles attributed to labour and capital in
economic growth and development. Having explained various key issues in the stated theories, a
further step was to evaluate the Nigeria economic growth using some selected indicators (GDP at
market price, growth rate of GDP and GDP per capita income). In the course of assessing the
Nigeria economic growth, the learners were taught how to calculate the annual growth rate of GDP
in a given period of time. The section was concluded with a brief explanation of the trends of the
Nigeria growth rate indicator.

Self – Assessment Questions for study session Ten

(SAQ 1) The formula to calculate economic growth from 2013 to 2014 is given by

(a) [(GDP2014 + GDP2013)/ GDP2013]×100

(b) [(GDP2014 – GDP2013)× GDP2013]×100

(c) [(GDP2014 – GDP2013)/ GDP2013]×100

(d) [GDP2013 – GDP2014]×100

(SAQ2) If GNP Per Capita at constant prices for Nigeria is US$360 and US$364 in 2006 and
2007 respectively, the real economic growth from 2006 to 2007 is

(a) 4%

(b) 1.11%

(c) 0.011%

(d) 11%

(SAQ3) One criticism of Rostow's theory of economic growth is that:

(a). much available data contradicts his thesis about the takeoff stage.

(b). there is no explanation of why growth occurs after takeoff.

(c). his hypothesis of the stages of growth is difficult to test empirically.

(d). all of the above are correct.

(SAQ4) Criticisms of Rostow's stages of growth include:

(a) the difficulty of testing the stages scientifically.

(b) conditions for take-off are contradicted by historical evidence.

(c) characteristics of one stage are not unique to that stage.

(d) all of the above are correct.

(SAQ5) The Harrod-Domar growth model suggests that growth is

(a) directly related to savings and inversely related to the capital/output ratio.

(b) directly related to the capital/output ratio and inversely related to savings.

(c) indirectly related to savings and the capital/output ratio.

(d) directly related to savings and the capital/output ratio.

(SAQ6) Rostow's economic stages are

(a) the preconditions for take-off, the take-off, the drive to maturity, and the age of creative

destruction.

(b) the traditional society, the preconditions for take-off, the take-off, the drive to maturity,

and the age of high mass consumption.

(c) the preconditions for consumption, the replication, the drive to maturity, and the age of

high mass consumption.

(d) the learning curve, the age of high mass consumption, post-take-off, and the drive to

maturity.

(SAQ7) Which of the following was not a classical economist?

(a) Adam Smith.

(b) David Ricardo.

(c) John Stuart Mill.

(d) John Maynard Keynes.

(SAQ8) Adam Smith advocated

I laissez-faire.

II the invisible hand.

III free-trade policy.

IV competitive markets.

(a) I and II only

(b) II and III only

(c) I, II and III only

(d) I, II, III and IV

(SAQ10) A theory..

I is a systematic explanation of relationships between economic variables.

II explains causal relationships among variables.

III provides a basis for policy.

IV provides an explanation of all factors influencing economic growth.

a. I only.

b. I and II only.

c. I, II and III only.

d. IV only.

(SAQ10) The classical growth theory especially Ricardo growth model specifically emphasizes
scarcity of …………. as an obstacle that will hinder growth.

(a). Capital.

(b). Entrepreneur.
 (c). Land.

(d). Human resources.

Answers
Questions 1 2 3 4 5 6 7 8 9 10

Answers C B D D A B D D C C

References

Adebayo, A. (1999). Economics: A simplified Approach. Volume 2, Second Edition. African

International Publishing Ltd. ISBN: 978-2837-24-5.

Anyanwu, J. C. & Oaikhenan, H. E. (1995). Modern Macroeconomics: Theory and Application in

Nigeria. Joanee Educational Publishers Ltd. Onitsha. ISBN: 978 – 2784 – 16 -8

Jhingan, M. I. (2006). The Economics of Development and Planning. Vrinda Publications (P) Ltd.
ISBN 81-8281-089-2.

Mohan, R. (2005). Study Guide for Economic Development. Wayne Nafziger Economic
Development Cambridge University Press.

http://www.economicshelp.org/blog/498/economics/harod-domar-model-of-growth-and-its-
limitations/

www.tutor2u.net/blog/index.php

http://www.romeconomics.com/harrod-domar-model-explained/
http://www.bized.co.uk/virtual/dc/copper/theory/th9.htm

http://www.sjsu.edu/faculty/watkins/growthmodels.htm

http://www.slideshare.net/onlyforyouscribd/rostows-model-13497122

http://www.answers.com/Q/What_is_kerlinger_definition_of_theory

http://www.wisegeek.com/what-is-the-classical-growth-theory.htm

http://www.businessdictionary.com/definition/theory.html#ixzz3I85yR0of

http://www.ou.edu/uschina/gries/articles/IntPol/Rostow.1960.Ch2.pdf

http://202.202.111.134/jpk/data/gjzrzygl/web%20prepare20110608/paper/Rostow%20Developm
ent%20Model%201960.pdf

http://www.economicshelp.org/blog/498/economics/harod-domar-model-of-growth-and-its-
limitations/

http://www.sjsu.edu/faculty/watkins/growthmodels.htm

http://www.google.com.ng/url?sa=t&rct=j&q=&esrc=s&source=web&cd=6&cad=rja&uact=8&
ved=0CEYQFjAF&url=http%3A%2F%2Feconstudents.weebly.com%2Fuploads%2F8%2F7%2
F4%2F4%2F8744298%2Fkarl_marx.doc&ei=cSpZVOjRFsv3avyagvAF&usg=AFQjCNHATdR
bLhE0qIhigOy9t2Pik-WB9Q&bvm=bv.78677474,d.d2s.
http://www.infoplease.com/cig/economics/three-economists-their-theories.html#ixzz3I8KrjsT
 STUDY SESSION ELEVEN

THE CONCEPT OF DEVELOPMENT PLANNING

11.0 Introduction

The previous study session examined some theories of economic growth as well as assessing
economic growth performance in the Nigeria economy. In this study session, you will learn the
meaning, objective and types of development planning. In order to have a clear assessment and
understanding of the term: development planning, you will be taught the merit and demerit of
planning.

Learning outcome for study session Eleven

At the end of this study session, you should be able to:

11.1 define and use correctly the key words printed in bold:

11.2 have sound knowledge and understanding of the term development planning

11.3 explain the objective of development planning

11.4 discuss the types of development planning

11.5 highlight the advantages and disadvantages of development plans

11.1 The concept of development planning

In the previous sections, we explained the term ‘development’. For instance, we said that
‘development’ is a multi-sided process that encompasses political, social, economic and
educational advancement. Oftentimes, the concept is utilized in economic term, the justification
being that the type of economy is itself an index of other social features. Similarly, it can be defined
as the process of economic and social transformation that is based on complex cultural and
environmental factors and their interactions. Thus “development” encompasses the need and
means with which to provide better lives for people in poor countries. It includes not only
economic growth, although that is crucial, but also human development—providing for health,
nutrition, education, and a clean environment. From these definitions, we can see that development
cuts across all human spheres and ensures that human basic needs are meets.

Thus, we have to look at the concept of plan and planning for a clearer understanding. Planning
can de defined as the process of setting goals, developing strategies, and outlining tasks and
schedules to accomplish the goals. Planning is usually interpreted as a process to develop a
strategy to achieve desired objectives, to solve problems, and to facilitate action, while the term
‘plan’ is a statement of intent or vision. It sets out how we would like to see a place such as state
and country developed over a specified time period. It is also a road map: since the state or country
has a vision and a goal, the question is how do we get there? Thus, the role of the planner is to
identify a desirable future and to prepare a course of action to achieve this goal (Mitchell, 2002).
To make this topic more robust both plan and planning will be utilized with the concept of
development. Having defined the terms ‘development’ and planning’ let us put both terms together
and give a full explanation for the learners’ understanding.

Development planning is viewed in different contexts. As noted by Adebayo (1999), ‘development

planning is a conscious effort on the part of the central government of a nation to maximise the
economic and social welfare of the people through efficient allocation of resources’. Likewise,
development planning is refered to as the strategic measurable goals that a person, organization,
community or nations plans to meet within a certain period of time. 'Development plan describes
the various planning policy documents that provide planning guidance for a particular area of the
country. This can be at a state, region or Nation. The development plan documents set out the state
or nations adopted policies and proposals for the use of finance and land and take the form of often
quite detailed publications, containing formal policies and explanatory texts, together with detailed
maps of the area, showing the various allocations or restrictions upon income, land and other
pertinent information. Usually the development plan includes time-based benchmarks. It generally
also includes the criteria that will be used to evaluate whether or not the goals were actually met.
The development plan sets out the overall strategy for the proper planning and sustainable
development for the nation for a specified period of years. In sum, the aim of this plan is to provide
an efficient and effective use of revenue and land in the public interest in order to meet the
identified needs of the area, whilst also having regard to national and regional planning guidance.
Other reasons why development plans are prepared are:
• To anticipate the development needs of an area;

• To identify relevant development issues;

• To identify opportunities for and constraints to development;

• To identify areas which are suitable/unsuitable for different types of development;

• To make proposals for the way in which the area should develop over time; and

• To establish policies and standards to guide development.

• For areas which are already experiencing significant development pressures or some of the
negative effects of growth and development in an effort to find solutions to these problems and to
manage future growth. After
the second World War, it has become an accepted practice among the governments of the
developing countries such as Nigeria to publish their “development plans.” In Nigeria, the National
Planning Commission (NPC) in corroboration with the Federal Ministry of Finance is responsible
for the formulation of development plans. These plans are usually a medium-term plan which is
for a five-year period. The aim is to select a period long enough to include projects spanning a
number of budget years but not so long as to delay periodic assessment of the development effort
stretching over a series of plans. The development plan attempts to promote economic
development in four main ways: (i) by assessing the current state of the economy and providing
information about it; (ii) by increasing the overall rate of investment; (iii) by carrying out special
types of investment designed to break bottlenecks in production in important sectors of the
economy; and (iv) by trying to improve the coordination between different parts of the economy.
Of these, the first and fourth are perhaps the most important and the least understood function of
economic planning. The other two functions of planning cannot be efficiently carried out without
ample and reliable information, or without effective economic coordination between the different
government departments and agencies within the public sector and the private sector. In most
developing countries, information about the economy is scarce, and planning has provided the
impetus to acquire and analyse the necessary data in order to provide a better understanding of the
functioning of the economy. In order to improve coordination, it is necessary to spread reliable
economic information to indicate the future course of the government’s economic intentions and
activities so that the people concerned, both in the public and the private sectors, may make
appropriate plans of their own to bring them in line with the government’s plan. In fact, this may
be regarded as the main reason for publishing development plans, although this point is not always
clearly appreciated by the governments that issue them.

11.3 Features of a development plan

The development plan of any economy should possess some of the following characteristics:

I. It should be goal-oriented, by implication it must be able to achieve desired objective of

the nation. Thus, the goals established should have general acceptance otherwise
individual efforts and energies will go misguided and misdirected.
II. It should be futuristic in nature. Development planning should not be for the present only
but should be done for future purposes. It entails peering into the future, analysing and
predicting it. Thus, we can deduce that planning is based on forecasting.
III. It should involve a continuous process. Every development plan does not have an ending
functions because in each day needs of different kinds normally arise. Also as a result of
the dynamic environment of socio-economics and political issues planning become a
continuous process. Plans are also prepared for specific period of time and at the end of
that period, plans are subjected to revaluation and review in the light of new requirements
and changing conditions.
IV. It involves choice and decision making. Development planning essentially involves the
planners making choices among various alternatives. Thus, if there is only one possible
course of action, there is no need planning because there is no choice. Thus, decision
making is an integral part of planning. Since, the development planners are surrounded by
a number of alternatives, they have to pick the best depending upon the requirements and
resources of the nations.
 V. It is premeditated for efficiency. Every national planning should leads to accomplishment
of objectives at the minimum possible cost. Also, it should avoid wastage of resources
and ensure adequate and optimum utilization of resources. It must be time, money and
effort saving.
VI. It should be pervasive in nature. Development planning requires all levels of management
and all departments in the National planning commission. The scope of planning is differs
from one level to another in the commission.
VII. It should be flexible. As noted earlier, every plan should be done to incorporate the future,
since the future is unpredictable, economic planning must provide enough room to cope
with the changes in customer’s demand, competition, government policies, etc. Under
changed circumstances, the original plan of action must be revised and updated to make it
more practical.

11.4 Types of development planning

The idea of planning will be clear by drawing a distinction between the types of development
planning in different economies. Some of the forms of developmental planning are highlighted
below:

i. Rolling and fixed plans:

ii. Perspective Planning and Annual Planning:

iii. Indicative planning and imperative planning:

iv. Democratic planning and totalitarian planning:

v. Centralised and decentralised planning.

I. Rolling and fixed plans: In a rolling plan, every year three new plans are made and
acted upon. First, there is a plan for the current year which includes the annual budget and
the foreign exchange budget. Second, there is a plan for a number of years, say three, four
or five. Third, a perspective plan for 10, 15 or 20 or even more years is presented every
year in which the broader goals are stated and the outlines of future development are
 forecast. The annual one-year plan is fitted into the same year’s new three, four or five
year plan, and both are framed in the light of the perspective plan. In contrast to the rolling
plan, there is a fixed plan for four, five, six or seven years. A fixed plan lays down definite
aims and objectives which are required to be achieved during the plan period. For this
purpose, physical targets are fixed along with the total outlay. Physical targets and
financial outlays are seldom changed except under emergencies. Development planning
in Nigeria between 1960 and 1985 was in four phases referred to as the First, Second,
Third and Fourth National Development Plans. Each one plans has different time interval,
for instance the first was to cover a period of six years (1962-68). In countries such as
India, planning is (Five-Year) and Russia (Seven-Year) which is of the fixed type.
II. Perspective planning and annual planning: Perspective planning is seen as a long-term
planning in which long range targets are set in advance for a period of 15, 20, or 25 years.
A perspective plan, however, does not imply one plan for the entire period of 15 or 20
years. In reality, broader objectives and targets are to be achieved within the specified
period of time by dividing the perspective plan into several short-period plans of 4, 5 or 6
years. Not only this, a five year plan is further broken up into annual plans so that each
annual plan fits into the broad framework of the five-year plan. Plans of either kind are
further divided into regional and sectorial plans. Regional plans pertain to regions, districts
and localities and sectorial plans pertain to plans for agriculture, industry, foreign trade,
etc.
III. Imperative Planning and Indicative Planning: The imperative planning is a kind of plan
whereby all economic activities and resources of the economy operate under the direction
of the state. There is complete control over the factors of production by the state. The
entire resources of the country are used to the maximum in order to fulfil the targets of the
plan. There is no consumers’ sovereignty in such planning. What and how much to
produce – such decisions are taken by the managers of firms and factories on the direction
of the planning commission or a central planning authority. Since the government policies
and decisions are rigid, they cannot be changed easily.
IV. The indicative planning is the French system of planning which is based on the principle
of decentralization in the operation and execution of the national plans. This type of
planning is not imperative but flexible. In indicative planning the private sector is neither
 rigidly controlled nor directed to fulfil the targets and priorities of the plan. Even then, the
private sector is expected to fulfil the targets for the success of the plan. The state provides
all types of facilities to the private sector but does not direct it, rather indicates the areas
in which it can help in implementing the economic plan.
V. Democratic planning and totalitarian planning: In democratic planning, the philosophy
of democratic government is accepted as the ideological basis. People are associated at
every step in the formulation and implementation of the plan. Cooperation of different
agencies, and voluntary groups, and associations plays a major role in the execution of the
plan. Democratic planning respects the institution of private property. Price mechanism is
allowed to play its due role. The government only seeks to influence economic and
investment decisions in the private sector through fiscal and monetary measures. The
private sector operates side by side with the public sector. Democratic planning aims at
the removal of inequalities of income and wealth through peaceful means by taxation and
government spending on social welfare and social security schemes. Individual freedom
prevails and people enjoy social, economic and political freedoms.
In totalitarian or authoritarian planning
there is central control and direction of all economic activity in accordance with a single
plan. There is planning by direction where consumption, production, exchange, and
distribution are all controlled by the state. In totalitarian planning, the planning authority
is the supreme body. It decides about the targets, schemes, allocations, methods and
procedures of implementation of the plan. There is absolutely no opposition to the plan.
People have to accept and rigidly implement the plan.

VI. Decentralised and Centralised planning. The decentralized planning refers to the
execution of the plan from the grass roots. Under it, a plan is formulated by the central
planning authority in consultation with the different administrative units of the country.
The central plan incorporates plans under the central schemes, and plans for the states
under a federal set-up. The state plans incorporate district and village level plans. Under
decentralized planning, prices of goods and services are determined by the market
mechanism despite government control and regulation in certain fields of economic
activity. On the other hand, in centralized planning, the entire planning process is under a
 central planning authority. The authority formulates a central plan, fixes objectives,
targets, and priorities for every sector of the economy. The principal problems of the
economy – what and how much to produce, how and for whom to be produced, etc, are
decided by this authority. The entire planning process is based on bureaucratic control and
regulation. Naturally, such planning is rigid. There is no economic freedom and all
economic activities are directed from above.

(i.) Name fives types of development plan?

Five types of development plans are:

(i.) Rolling Plans:

(ii.) Fixed Plans

(iii) Annual Planning

(iv.) Perspective Planning

11.5 Advantages and disadvantages of development planning

• Advantages

I. Planning encourages innovation. In the process of planning, planners have the

opportunities of suggesting ways and means of improving the performance of the nations.
Thus, development plan is basically a decision making function which involves creative
thinking and imagination that ultimately leads to innovation of methods and operations for
growth and prosperity of the economy.
 II. Planning minimizes uncertainties. When the government carries out development plans
they help in reducing uncertainties of the future as it involves anticipation of future events.
Although the future cannot be predicted with certain degree of accuracy but planning made
by the government helps the economy to anticipate future and prepare for risks by
necessary provisions to meet unexpected turn of events.
III. Development planning facilitates management by objectives. That is, planning begins with
determination of objectives and it highlights the purposes for which various activities are
to be undertaken. In fact, it makes objectives clearer and more specific.
IV. It helps in achieving economies. Effective planning secures the economy since it leads to
orderly allocation of resources to various sectors of the economy and different part of the
nation. It also facilitates optimum utilization of resources which promotes economic
operations.
V. It facilitates effective controls. Development planning facilitates existence of certain
planned goals and standard of performance. Planning provides pre-determined goals
against which actual performance is compared. In fact, planning and controlling are two
sides of the same coin. If planning is root, controlling is the fruit.

Disadvantages

i. It is time consuming. The period of computing development plan is time

consuming since it involves collection of data, its analysis and interpretation
thereof. This entire process takes a lot of time specially where there are a
number of alternatives available.
ii. Sometimes, development planning can be misdirected. It may be used to serve
some sectors or ethnic group interests rather than the interest of the whole
citizenry. Attempts can be made to influence setting of objectives, formulation
of plans and programmes to suit one’s own requirement rather than that of the
whole economy.
iii. It is expensive to undertake. The data collection, analysis and evaluation of
different information, facts and alternatives involve a lot of expense in terms of
time, effort and money.
 iv. It can be rigid in its implementation. Most development plans have the tendency
to make administration inflexible. Planning implies prior determination of
policies, procedures and programmes and a strict adherence to them in all
circumstances.
v. Probability in planning. It is based on forecasts which are mere estimates about
the future. These estimates may prove to be inexact due to the uncertainty of
the future. Any change in the anticipated situation may render plans ineffective.
Plans do not always reflect real situations in spite of the sophisticated
techniques of forecasting because future is unpredictable. Thus, excessive
reliance on plans may prove to be fatal.

Summary of the Study Session Eleven

In this study session 11, the concept of development, planning and plan were explained.
Furthermore, emphasis was said on the concept of development planning and the reasons why
development plan is prepared. Likewise, some features of a good development plan were
identified. Against this backdrop, different types of development plans were explained while the
advantages and disadvantages of economic planning were briefly discussed.

Self – Assessment Questions for Study Session Eleven

(SAQ 1). ….. is seem as a plan in which long range targets are set in advance for a period of 15,
20 or 25 years

(a) Annual planning

(b) Perspective planning

(c) Rolling planning

(d) Fixed planning

(SAQ 2) Government's use of coordinated policies to achieve national economic objectives is

a. commanding heights.

b. entrepreneurial programs.

c. public physical policy.

d. development planning.

(SAQ 3) All of the following are features of development plan except ….

(a). It should be goal-oriented

(b). It involves a continuous process

(c) It involves choice and decision making.

(d) None of the above

(SAQ 4) The merits of development planning include the following except……

(a) sometime development planning can be misdirected.

(b) it facilitates effective controls.

(c) it helps in achieving economic development

(d) planning encourages innovations

(SAQ 5) Which of the following is not a public policy to promote the private sector?

(a). investigating development potential through scientific and market research, and natural resources
surveys.

(b). providing adequate infrastructure for public and private agencies

(c). creating markets, including commodity markets, security exchanges, banks, credit facilities, and
insurance companies.
(d). increasing market monopolies and oligopolies to help producers.

(SAQ6) A plan that every year three new plans are made and acted upon is…
(a). fixed plan.

(b). rolling plan.

(c). inductive plan

(d). annual plan.

(SAQ 7) Planning in many LDCs has failed because detailed programs for the public sector have
not been worked out and…

(a). governments depend primarily on their colonial masters.

(b). excessive controls are used in the private sector.

(c). the brain drain cost government substantially.

(d). monopolies dominate in the agricultural sector.

(SAQ8) Which of these reasons is not why development plans are prepared:

(a) to anticipate the development needs of an area;

(b) to identify relevant development issues;

(c) to identify opportunities for and constraints to development;

(d) none of the above

(SAQ 9)The indicative planning is the French system of planning which is based on the principle
of decentralization in the operation and execution of the national plans.

(a) centralised planning

(b) totalitarian planning

(c) democratic planning

(d) indicative planning

(SAQ 10)One demerit of development planning is……

 (a) Sometime development planning can be misdirected.

(b) It facilitates effective controls.

(c) It helps in achieving economies

(d) Planning encourages innovations

Answers
Questions 1 2 3 4 5 6 7 8 9 10

Answers B D D A D B B D D A

References

Adebayo, A. (1999). Economics: A simplified Approach. Volume 2, Second Edition. African

International Publishing Ltd. ISBN: 978-2837-24-5.

http://www.ehow.com/about_5095844_definition-development-planning.html

http://www.businessdictionary.com/definition/development.html#ixzz3J3rG97Rn

http://www.trcollege.net/study-material/24-economics/43-meaning-and-types-of-planning

www.managementstudyguide.com/management_level.htm

http://www.planning-applications.co.uk/development%20plans.htm#what

http://www.planning-applications.co.uk/development%20plans.htm#what

http://www.britannica.com/EBchecked/topic/178458/economic-planning/30579/Planning-in-
developing-countries-approaches

http://www.planning-applications.co.uk/development%20plans.htm#what

http://www.ehow.com/about_5095844_definition-development-planning.html
http://www.businessdictionary.com/definition/development.html#ixzz3J3rG97Rn
http://www.globalization101.org/introduction-what-is-development-2/

http://www.investorwords.com/3710/planning.html#ixzz3J3xRSYQ2

www.investorwords.com/4405/schedules

http://www.oas.org/pgdm/document/BITC/papers/dthomas.htm

http://www.google.com.ng/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&cad=rja&uact=8&
ved=0CDAQFjAB&url=http%3A%2F%2

www.environ.ie%2Fen%2FPublications%2FDevelopmentandHousing%2FPlanning%2FFileDo
wnLoad%2C14468%2Cen.pdf

www.cms.fu-
berlin.de/geo/fb/elearning/geolearning/en/watershed_management/introduction_wm

/natural_resource_management_planning/definitions_planning_management/index.html

http://www.basis.ie/home/home.jsp?pcategory=13260&ecategory=13263&doclistid=13269&sect
ionpage=10339&language=EN&page=&link=link001&doc=10949&logname=Development%20
Plans%20and%20Development%20Control&urlcode=

STUDY SESSION TWELVE

FISCAL POLICY

12.0 Introduction

Fiscal policy affects output in the short run–through its effect on aggregate demand–and in the
long run–through its effect on investment. Fiscal policy is limited by the government budget
constraint, which links the deficit to the increase in debt. Given the budget constraint, prudence
suggests that governments should run fiscal surplus during booms to balance deficits during
recession. Such a policy allows the government to stimulate the economy during recession, but
avoids the dangers inherent in accumulating a large debt.
Learning Outcome for Study Session Twelve
At the end of this study session, you should be able to:

12.1 define and use correctly all the key words printed in bold (SAQ1)

12.2 explain the term fiscal policy. (SAQ2)

12.3 explain basic terms in fiscal policy (SAQ3)

12.4 explain the relationship interest rate and fiscal policy. (SAQ4)

12.5 state the effects and explain the mechanism of each fiscal policy tool. (SAQ5)

12.1 Definition of fiscal policy

Before providing the definition of fiscal policy, it is proper to put the definition of federal budget
into perspective. Federal budget is the annual statement of the federal government’s expenditure
and tax revenue and surplus or deficit of the government .The government has a budget surplus
if tax receipts exceed expenditure; a budget deficit if expenditures exceed tax receipts; and a
balanced budget if tax receipts equal expenditure. Generally, Fiscal policy is the use of the federal
budget to smooth the business cycle and encourage economic growth. Specifically, Fiscal policy
is the use of government taxation and expenditure policies to achieve macroeconomic objectives,
such as full employment, sustained long-term economic growth, and price level stability. Fiscal
policy is passed by the legislative branch and signed into law by the executive branch. Fiscal policy
can either be expansionary or contractionary depending on macroeconomic objectives of
government. Expansionary fiscal policy uses higher government spending and/or lower rates of
taxation to increase aggregate economic activity while contractionary fiscal policy uses lower
government spending and/or higher rates of taxation to reduce aggregate economic activity.
12.2 Basic Terms in Fiscal Policy
I. Automatic expenditure is expenditure that happens automatically. In other words, the
government doesn't have exact control over the level of this type of expenditure. The most
obvious example of this is spending on benefits. The government sets regulations for who
is entitled to benefits, and it sets the level of the benefits. However, the one thing that it
cannot dictate is the number of people who may then be entitled to them as this will often
depend on the state of the economy. As the economy goes into recession and people lose
their jobs, more people will be entitled to benefits. This will mean that government
 expenditure will rise not because the government chose to spend more, but simply because
of the state of the economy. This spending is therefore automatic spending. These
automatic fiscal mechanisms are often referred to as automatic stabilizers
II. Discretionary spending is, by contrast, the spending the government chooses to make. In
a time of recession, it may choose to spend more to try to boost the level of aggregate
demand and therefore equilibrium output. At other times, it may choose to lower the level
of expenditure to avoid 'crowding out' private sector spending. Either way, it is operating
a discretionary fiscal policy.
III. Fiscal policy Multiplier: While expansionary and contractionary fiscal policy both
directly affect the national income, the ultimate change in output is not always equal to the
policy change. That is, there are factors that increase or decrease the efficacy of fiscal
policy. These factors are called multipliers. In particular, there are two types of multipliers,
namely tax multipliers and government spending multipliers.
Tax multipliers are based on the population's willingness to consume. The marginal
propensity to consume, or MPC, is a measure of that willingness. It is defined as the amount
of additional naira of income that a consumer will spend on goods and services. The MPC
can have a value between 0 and 1. A small MPC represents a large amount of savings and
a small amount of consumption. A large MPC represents a small amount of savings and a
large amount of consumption. When a tax decrease occurs, consumers will spend part of
the money and save part of it. Therefore, the actual change in national income as a result
of a change in tax policy is equal to [(+ or -) change in taxes * - MPC] / (1 - MPC). The
resulting number is called the tax multiplier.
There is also a multiplier for government spending. This multiplier is derived in a different
way. When the government increases purchases, it directly increases output, or national
income. But, there is a greater effect than just the actual amount of increase in government
purchases. When the government spends more, the populace receives more. That is,
because the population is the target of increased government spending, personal incomes,
and thus consumption, increases. Once again, the size of this increase is based on the MPC.
The total change in output as a result of a change in government purchases is equal to
(change in government purchases) / (1 - MPC). This number is called the government
spending multiplier.
 Let us work a couple of examples. The first one will deal with tax policy. What is the total
change in output from a tax cut of N20 million if the MPC is 0.8? To solve this, simply
plug these numbers into the tax multiplier, that is [(change in taxes) × MPC] / (1 - MPC).
This becomes [(N20 million) × -0.8] / (1 - 0.8) = N80 million. This means that a N20
million tax cut will yield an N80 million increase in output. What is the process of this
equation model? Simply put, when consumers have more disposable income, they spend
some and save some. The money that they spend goes back into the economy and is saved
and spent by somebody else. This process continues, and eventually the final change in
output created by a tax cut is significantly larger than the initial tax cut itself.
The second example we will work with deals with government spending policy. What is
the total change in output from an increase in government spending equal to N20 million
if the MPC is 0.8? To solve this, simply plug these numbers into the government spending
multiplier: (change in government purchases) / (1 - MPC). This becomes (N20 million) /
(1 - 0.8) = N100 million. A N20 million increase in government spending will cause a
N100 million increase in output. When government spending increases, the populace, as
the recipient of this spending, has more disposable income. When consumers have more
disposable income, they spend some and save some. The money that they spend goes back
into the economy and is saved and spent by somebody else. This process continues.
Eventually the final change in output created by a tax cut, as in the previous example, is
significantly larger than the initial tax cut itself.

IV. Crowd out effect: When increased interest rates lead to a reduction in private investment
spending such that it dampens the initial increase of total investment spending, it is called
crowding out effect. A situation when increased interest rates lead to a reduction in private
investment spending such that it dampens the initial increase of total investment spending
is called crowding out effect. For instance, if government adopts an expansionary fiscal
policy stance and increases its spending to boost the economic activity, this leads to an
increase in interest rates. Increased interest rates affect private investment decisions. A high
magnitude of the crowding out effect may even lead to lesser income in the economy. With
higher interest rates, the cost for funds to be invested increases and affects their
accessibility to debt financing mechanisms. This leads to lesser investment ultimately and
 crowds out the impact of the initial rise in the total investment spending. Usually the initial
increase in government spending is funded using higher taxes or borrowing on part of the
government.

12.3 Interest rates and fiscal policy

Fiscal policy has a clear effect upon output. But there is a secondary, less readily apparent fiscal
policy effect on the interest rate. Basically, expansionary fiscal policy pushes interest rates up,
while contractionary fiscal policy pulls interest rates down. The rationale behind this relationship
is fairly straightforward. When output increases, the price level tends to increase as well. This
relationship between the real output and the price level is implicit. According to the theory of
money demand, as the price level rises, people demand more money to purchase goods and
services. Given that there is no change in the money supply, this increased demand for money
leads to an increase in the interest rate. The opposite is the case with contractionary fiscal policy.
When output decreases, the price level tends to fall as well. Again, this relationship between the
real output and the price level is implicit. According to the theory of money demand, as the price
level falls, people demand less money to purchase goods and services. Given that there is no
change in the money supply, this decreased demand for money leads to a decrease in the interest
rate. This is how fiscal policy affects the interest rate.

Summary of the Study Session Twelve

 Fiscal policy is the use of the federal budget to smoothen the business cycle and encourage
economic growth. Specifically, fiscal policy is the use of government taxation and
expenditure policies to achieve macroeconomic objectives, such as full employment,
sustained long-term economic growth, and price level stability.
 Fiscal policy can either be expansionary or contractionary depending on macroeconomic
objective of government. Expansionary fiscal policy uses higher government spending
and/or lower rates of taxation to increase aggregate economic activity while contractionary
fiscal policy uses lower government spending and/or higher rates of taxation to reduce
aggregate economic activity.
 Automatic expenditure is expenditure that happens automatically. In this case, the
government does not have exact control over the level of this type of expenditure.
  Discretionary spending is by contrast, the spending that government chooses to make. In a
time of recession, it may choose to spend more to try to boost the level of aggregate demand
and therefore equilibrium output
 Fiscal policy multiplier: While expansionary and contractionary fiscal policies both
directly affect the national income, the ultimate change in output is not always equal to the
policy change. That is, there are factors that increase or decrease the efficacy of fiscal
policy. These factors are called multipliers.

Self- Assessment Questions of study session Twelve

(SAQ 1) Fiscal Policy is controlled by

a. The Federal Reserve Board

b. Legislature and the President
c. The Supreme Court
d. Private banks

(SAQ 2) The purpose of fiscal policy is to

a. Alter the direction of the economy

b. Change people's attitudes toward government
c. Educate people as to the importance of economics
d. Offer insight into the way things work

(SAQ 3) Fiscal policy is purposeful movements in ____________ designed to direct an

economy.

a. Interest rates
b. Legal structures
c. Government regulations
d. Governmen spending and taxes

(SAQ 4) Discretionary Fiscal Policy differs from Nondiscretionary Fiscal Policy in that
a. The former deals with interest rates and the latter deals with tax policy
b. The former is built into the system whereas the latter requires timely decisions
c. The former requires timely decisions whereas the latter is built into the system
d. The former deals with tax policy and the latter deals with interest rates

(SAQ5) Discretionary Fiscal Policy differs from Nondiscretionary Fiscal Policy in that

a. The former deals with government spending and the latter deals with tax policy
b. The former is chosen by Congress while the latter is chosen by the President
c. The former is always stabilizing, while the latter is never stabilizing
d. The former often takes years to enact, while the latter takes effect automatically
(SAQ 6) Short-run contractionary Fiscal Policy would result in

a. Aggregate demand moving to the right

b. Aggregate supply moving to the right
c. Aggregate demand moving to the left
d. Aggregate supply moving to the left
(SAQ 7) Short-run expansionary Fiscal Policy would result in

a. Aggregate demand moving to the right

b. Aggregate supply moving to the right
c. Aggregate demand moving to the left
d. Aggregate supply moving to the left
( SAQ 8) An example of nondiscretionary fiscal policy would be

a. The existence of the progressive federal income tax

b. A federal jobs program adopted to stimulate consumption
c. A tax cut adopted to stimulate consumption
d. An interest rate cut implemented to stimulate consumption

(SAQ 9) An example of discretionary fiscal policy would be

a. The operation of the welfare state

 b. The operation of the progressive federal income tax
c. CA tax increase adopted to control inflationary pressures
d. An interest rate increase implemented to control inflationary pressures
(SAQ 10) If Nigerian interest rates rise, the exchange rate value of the dollar ________ and
net exports ________.

a. rises; increase
b. rises; decrease
c. falls; increase
d. falls; decrease
e. rises only if the U.S. interest rates fall concurrently; decrease

Answers:

Questions 1 2 3 4 5 6 7 8 9 10

Answers B A D B C A C A D D

References

 Jhingan M.L 7th edition, Monetary Economics by Vrinda Publication (P) Ltd
 Debes, Mukherjee 2nd edition Essentials of Micro and Macroeconomics by New Central
Book Agency (P) Ltd
 Sampat, Mukherjee, 1st edition, Analytical Macroeconomics from Keynes to Mankiw by by
New Central Book Agency (P) Ltd
 Mishkin, Frederic S. 7th edition, The economics of money, banking, and financial markets
.
 STUDY SESSION THIRTEEN

INTRODUCTION TO MONETARY POLICY

13.0 Introduction

Monetary policy involves control of the quantity of money in the economy. It is how central
bank manage the money supply to guide healthy economic growth. The money supply
is credit, cash, checks, and money market mutual funds. The most important of these is credit,
which includes loans, bonds, mortgages, and other agreements to repay. It includes all measures
employed by governments through central banks to influence economic activity, specifically by
manipulating the money supply and interest rates.

Learning Outcome for Study Session thirteen

At the end of this study session, you should be able to:

13.1 define and use correctly all the key words printed in bold (SAQ1)

13.2 explain the term monetary policy. (SAQ2)

13.3 Explain objectives of monetary policy in the Nigerian. (SAQ3)

13.4 Identify and explain the instruments of monetary policy tools in Nigeria. (SAQ4)

13.2 Definition of monetary policy

According to Harry Johnson, Monetary policy is a policy employing the central banks control of
the supply of money as an instrument for achieving the objectives of general economic policy."
According to A.G. Hart, "a policy which influences the public stock of money, substitute of public
demand and liquidity position is known as a monetary policy." Generally, monetary policy has
been recognised as a deliberate action of the monetary authorities to influence the quantity, cost
and availability of money credit in order to achieve desired macroeconomic objectives of internal
and external balances. The action is carried out through changing money supply and/or interest
rates with the aim of managing the quantity of money in the economy. Monetary policy can either
be expansionary or contractionary, depending on the overall policy thrust of the monetary
authorities. Monetary policy is expansionary when the policy adopted by the central bank increases
the supply of money in the system and contractionary, when the actions reduce the quantity of
money supply available in the economy or constrains the growth or ability of the deposit money
banks to grant further credit.

The primary objective of monetary policy is the realization of stable non-inflationary growth. This
gives the citizens confidence in the future value of their money, so that they can make sound
economic and financial decisions. Low and stable inflation also helps to prevent inflationary boom
and bust cycles that could result in recession and higher unemployment. In recognition of the
importance of money in economic life policy makers and other relevant stakeholders have paid
special attention to the conduct of monetary policy. To this end, separate Institution of government
has been shadowed with the responsibility of coordinating monetary policy. In the case of the
United State of America it is referred to as Federal Reserve while United Kingdom refers to the
institution as Bank of England. The Central Bank of Nigeria is the organ that is responsible for the
conduct of monetary policy in Nigeria.
13.1.1 Objectives of monetary policy
After the Keynesian revolution in economics, many people accepted the significance of monetary
policy in attaining the following objectives.

1. Rapid Economic Growth

2. Price Stability
3. Exchange Rate Stability
4. Balance of Payments (BOP) Equilibrium
5. Full Employment
6. Neutrality of Money
7. Equal Income Distribution

These are the general objectives especially in developing countries which every central bank of a
nation tries to attain by employing certain tools (Instruments) of a monetary policy. Let us now
see objectives of monetary policy in detail:

 Rapid economic growth: It is the most important objective of a monetary policy. The
monetary policy can influence economic growth by controlling real interest rate and its
resultant impact on the investment. If the central bank opts for a cheap or easy credit policy
 by reducing interest rates, the investment level in the economy can be encouraged. This
increased investment can speed up economic growth. Faster economic growth is possible
if the monetary policy succeeds in maintaining income and price stability.
 Price stability: All the economics suffer from inflation and deflation. It can also be called
as Price Instability. Both inflation and deflation are harmful to the economy. Thus, the
monetary policy having an objective of price stability tries to keep the value of money
stable. It helps in reducing the income and wealth inequalities. When the economy suffers
from recession the monetary policy should be an 'easy money policy' but when there is
inflationary situation there should be a 'tight money policy'.
 Exchange rate stability: Exchange rate is the price of a home currency expressed in terms
of any foreign currency. If this exchange rate is very volatile leading to frequent ups and
downs in the exchange rate, the international community might lose confidence in the
economy. The monetary policy aims at maintaining the relative stability in the exchange
rate. The RBI by altering the foreign exchange reserves tries to influence the demand for
foreign exchange and tries to maintain the exchange rate stability.
 Balance of payments (BOP) equilibrium: Many developing countries suffer from the
disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to
maintain equilibrium in the balance of payments. The BOP has two aspects i.e. the 'BOP
surplus' and the 'BOP deficit'. The former reflects an excess money supply in the domestic
economy, while the later stands for stringency of money. If the monetary policy succeeds
in maintaining monetary equilibrium, then the BOP equilibrium can be achieved.
 Full employment: The concept of full employment was much discussed after Keynes's
publication of the "General Theory" in 1936. It refers to absence of involuntary
unemployment. In simple words 'full employment' stands for a situation in which
everybody who wants jobs get jobs. However, it does not mean that there is a zero
unemployment. In that sense, the full employment is never full. Monetary policy can be
used for achieving full employment. If the monetary policy is expansionary then credit
supply can be encouraged. It could help in creating more jobs in different sectors of the
economy.
 Neutrality of money: Economists such as Wicksted and Robertson have always
considered money as a passive factor. According to them, money should play only a role
 of medium of exchange and not more than that. Therefore, the monetary policy should
regulate the supply of money. The change in money supply creates monetary
disequilibrium. Thus monetary policy has to regulate the supply of money and neutralize
the effect of money expansion. However, this objective of a monetary policy is always
criticized on the ground that if money supply is kept constant, then it would be difficult to
attain price stability.
 Equal income distribution: Many economists used to justify the role of the fiscal policy
is maintaining economic equality. However, in recent years economists have given the
opinion that the monetary policy can help and play a supplementary role in attainting an
economic equality. Monetary policy can make special provisions for the neglected supply
such as agriculture, small-scale industries, village industries, etc. and provide them with
cheaper credit for longer term. This can prove fruitful for these sectors to come up. Thus
in recent period, monetary policy can help in reducing economic inequalities among
different sections of society.

13.1.1 Objective of Monetary policy in Nigeria

The objectives of monetary policy may vary according to the level of development of the economy
involved, but invariably, they include the attainment of price stability, maintenance of external
payments equilibrium, as well as promotion of employment and output growth, and sustainable
economic development. Irrespective of the type of economy, these objectives are critical for the
attainment of internal and external balance and ultimately the promotion of long-run economic
growth. Where the stability of the financial system is threatened, these short and long term
objectives could be subordinated to the overriding objective of achieving financial stability.
In pursuit of the provisions of the CBN Act 2007, the primary objective of monetary policy has
remained the maintenance of monetary and price stability. Generally, the monetary policy of the
CBN is anchored on four main pillars:
 Inflation as a monetary phenomenon;
 The public‘s expectation of future inflation (this is crucial in the setting of current wages
and prices). A corollary to this is that there is no long-run trade-off between unemployment
and inflation; to anchor expectations;
  Proactive and rule based monetary policy (for instance, under the Taylor rule, for monetary
policy to stabilize prices, the nominal interest rate must be raised by more than the level of
inflation); and
 The need for monetary policy to be undertaken outside the control of the political
authorities i.e. the independence of the central bank to conduct monetary policy

13.2 Who conducts monetary policy in Nigeria?

The Central Bank of Nigeria through the Monetary Policy Committee (MPC) conducts monetary
policy. The MPC is statutorily charged with the responsibility for the conduct of the monetary
policy of the Bank. The MPC uses the instruments of monetary policy available with the Bank to
effect changes in the liquidity of the deposit money banks to affect the supply of money. Often the
MPC takes monetary policy decisions through tinkering with the monetary policy rate (MPR) in
order to affect short-term interest rates. The CBN does this by altering the target for the overnight
interest rate —the rate financial institutions charge each other for overnight loans. A change in the
target rate leads to changes in other interest rates, thereby affecting everyone‘s spending and
borrowing decisions. The target rate is set periodically and reassessed at the subsequent MPC
meeting.
The CBN Act, 2007 provides for the constitution of a Monetary Policy Committee (MPC). The
Committee comprises 12 members with the Governor as the Chairman, four Deputy Governors,
two members of the Board of Directors of the Bank, three members appointed by the President
and two members appointed by the Governor. Other committees set up to facilitate the success of
monetary policy are Monetary Policy Technical Committee (MPTC) which meets prior to the MPC
meetings, to review and make final inputs to the economic report for the MPC, Monetary Policy
Implementation Committee (MPIC) meets weekly to review and monitor policy implementation.
The Fiscal Liquidity Assessment Committee (FLAC) and Liquidity Assessment Group (LAG)
have the mandate to design and regularly update the framework for obtaining information for
forecasting fiscal liquidity, and LAG take decisions on intervention in the financial markets − the
domestic money and foreign exchange markets respectively.

14.3 What are the instruments of monetary policy in Nigeria?

Fiduciary or paper money is issued by the Central Bank on the basis of computation of estimated
demand for cash. Monetary policy guides the Central Bank’s supply of money in order to achieve
the objectives of price stability (or low inflation rate), full employment, and growth in aggregate
income. This is necessary because money is a medium of exchange and changes in its demand
relative to supply and necessitates spending adjustments. To conduct monetary policy, some
monetary variables which the Central Bank controls are adjusted− a monetary aggregate, an
interest rate or the exchange rate −in order to affect the goals which it does not control. The
instruments of monetary policy used by the Central Bank depend on the level of development of
the economy, especially its financial sector. The commonly used instruments are discussed below.

 Reserve Requirement: The Central Bank may require deposit money banks to hold a
fraction (or a combination) of their deposit liabilities (reserves) as vault cash and or
deposits with it. Fractional reserve limits the amount of loans banks can make to the
domestic economy and thus limit the supply of money. The assumption is that deposit
money banks generally maintain a stable relationship between their reserve holdings and
the amount of credit they extend to the public.
 Open Market Operations: The Central Bank buys or sells ((on behalf of the fiscal
authorities (the treasury)) securities to the banking and non-banking public (that is in the
open market). One such security is treasury bills. When the Central Bank sells securities,
it reduces the supply of reserves and when it buys (back) securities −by redeeming them−it
increases the supply of reserves to the deposit money banks, thus affecting the supply of
money.
 Lending by the Central Bank: The Central Bank sometimes provide credit to deposit money
banks, thus affecting the level of reserves and hence the monetary base.
 Interest Rate: The Central Bank lends to financially sound deposit money banks at a most
favourable rate of interest, called the minimum rediscount rate (MRR). The MRR sets the
floor for the interest rate regime in the money market (the nominal anchor rate) and thereby
affects the supply of credit (which affects the supply of reserves and monetary aggregate)
and the supply of investment (which affects full employment and GDP).
 Direct Credit Control: The Central Bank can direct deposit money banks on the maximum
percentage or amount of loans (credit ceilings) to different economic sectors or activities,
 interest rate caps, liquid asset ratio and issue credit guarantee to preferred loans. In this
way the available savings is allocated and investment directed in particular directions.
 Moral Suasion: The Central Bank issues licenses or operating permit to deposit money
banks and also regulates the operation of the banking system. It can, from this advantage,
persuade banks to follow certain paths such as credit restraint or expansion, increased
savings mobilization and promotion of exports through financial support, which otherwise
they may not do, on the basis of their risk/return assessment.
 Prudential Guidelines: The Central Bank may in writing require the deposit money banks
to exercise particular care in their operations in order that specified outcomes are realized.
Key elements of prudential guidelines remove some discretion from bank management and
replace it with rules in decision making.
 Exchange Rate: The balance of payments can be in deficit or in surplus and each of these
affects the monetary base, and hence the money supply in one direction or the other. By
selling or buying foreign exchange, the Central Bank ensures that the exchange rate is at
levels that do not affect domestic money supply in undesired direction, through the balance
of payments and the real exchange rate . The real exchange rate when misaligned affects
the current account balance because of its impact on external competitiveness. Moral
suasion and prudential guidelines are direct supervision or qualitative instruments. The
others are quantitative instruments because they have numerical benchmarks.

Summary of the Study Session Thirteen

 Monetary policy has been recognised as a deliberate action of the monetary authorities to
influence the quantity, cost and availability of money credit in order to achieve desired
macroeconomic objectives of internal and external balances. The action is carried out
 through changing money supply and/or interest rates with the aim of managing the quantity
of money in the economy.
 Monetary policy can either be expansionary or contractionary, depending on the overall
policy thrust of the monetary authorities. Monetary policy is expansionary when the policy
adopted by the central bank increases the supply of money in the system and
contractionary, when the actions reduce the quantity of money supply available in the
economy or constrains the growth or ability of the deposit money banks to grant further
credit.
 The primary objective of monetary policy in Nigeria remains the maintenance of monetary
and price stability and it is anchored on four main pillars: Inflation control, the public‘s
expectation of future inflation proactive and rule based monetary policy, and independence
of the central bank to conduct monetary policy
 The instruments of monetary policy used by the Central Bank depend on the level of
development of the economy, especially its financial sector. The commonly used
instruments are; reserve requirement, interest rate, bank rate ,direct credit control, moral
suasion, e.t.c

Self- Assessment Questions

(SAQ 1) When a central bank sells securities in the open market, which of the following set of
events is most likely to follow?

a. An increase in the money supply, a decrease in interest rates, and an

increase in aggregate demand
b. An increase in the money supply, an increase in interest rates, and a
decrease in aggregate demand
c. An increase in interest rates, an increase in the government budget deficit,
and a movement toward trade surplus
d. A decrease in the money supply, an increase in interest rates, and a
decrease in aggregate demand
e. A decrease in the money supply, a decrease in interest rates, and a
decrease in aggregate demand
(SAQ 2) The Bank rate is the interest rate that

a. the CBN charges the federal government on its loans

b. banks charge one another for short-term loans
c. banks charge their best customers
d. equalizes the yield on government bonds and corporate bonds

( SAQ 3) An increase in the money supply is most likely to have which of the following short-
run effects on real interest rates and real output?

Real Interest Rates Real Output

a. Decrease Decrease

b. Decrease Increase

c. Increase Decrease

d. Increase No change

(SAQ 4) In the Keynesian model, an expansionary monetary policy will lead to

a. lower real interest rates and more investment

b. lower real interest rates and lower prices
c. higher real interest rates and lower prices
d. higher real interest rates and higher real income
(SAQ 5) Under which of the following conditions would a restrictive monetary policy be most
appropriate?
a. High inflation
b. High unemployment
c. Full employment with stable prices
d. Low interest rates
(SAQ 6) One way in which the CBN works to change money supply is by changing the

a. Number of banks in operation

b. Velocity of money
c. Price level
d. Prime rate
(SAQ 7) Open market operations refer to which of the following activities?

a. The buying and selling of stocks in the New York stock market
b. The loans made by the Federal Reserve to member commercial banks
c. The buying and selling of government securities by the Federal Reserve
d. The government’s purchase and sales of municipal bonds
(SAQ 8 ) Open market purchases raise the ___________ thereby raising the ___________.

a. money multiplier; money supply

b. money multiplier; monetary base
c. monetary base; money supply
d. monetary base; money multiplier

(SAQ 9) The CBN uses three main policy tools to manipulate the money supply: open market
operations, which affect the _________; changes in the discount rate, which affect the
____________ by influencing the quantity of discount loans; and changes in reserve
requirements, which affect the __________.

a. money multiplier; monetary base; monetary base

b. monetary base; money multiplier; monetary base
c. monetary base; monetary base; money multiplier
 d. money multiplier; money multiplier; monetary base

( SAQ 10) If the Federal Reserve wants to drain reserves from the banking system, it will

a. purchase government securities.

b. lower the discount rate.
c. sell government securities.
d. raise reserve requirements

Answers:

Questions 1 2 3 4 5 6 7 8 9 10

Answers D A B A A A C C C C

References

 Jhingan M.L 7th edition, Monetary Economics by Vrinda Publication (P) Ltd
 Debes, Mukherjee 2nd edition Essentials of Micro and Macroeconomics by New Central
Book Agency (P) Ltd
 Sampat, Mukherjee, 1st edition, Analytical Macroeconomics from Keynes to Mankiw by by
New Central Book Agency (P) Ltd
 Mishkin, Frederic S. 7th edition, The economics of money, banking, and financial markets
.
 STUDY SESSION FOURTEEN

DETERMINATION OF INTEREST RATE

14.0 Introduction

In economic theory, interest is the price paid for inducing those with money to save it rather than
spend it, and to invest in long-term assets rather than hold cash. Rates reflect the interaction
between the supply of savings and the demand for capital; or between the demand for and the
supply of money. Interest rates affect personal decisions such as whether to consume or save,
whether to buy a house, and whether to purchase bonds or put funds into a savings account. Interest
rates also affect the economic decisions of businesses and households, such as whether to use their
funds to invest in new equipment for factories or to save their money in a bank.
Learning Outcome for Study Session Fourteen
At the end of this study session, you should be able to:

14.1 define and use correctly all the key words printed in bold (SAQ1)

14.2 explain the term interest rate. (SAQ2)

14.3 explain the concept of money supply and demand. (SAQ3)

14.4 discuss some interest theories (SAQ4)

14.5 discus how interest rate is determined. (SAQ5)

14.1 Definition of Interest Rate

Generally, interest rate is the price that people pay for borrowing money. It is also the price that
businesses or people receive for lending money. To the economist, interest is above all a price,
paid for the use of credit or money and it follows that the theory of interest-rate determination is a
sub-set of price-determination theory. Based on this, classical economists believe that rate of
interest is therefore determined by the interaction between the demand for investment capital (the
fisherman making a net) and the supply of savings (the friend’s surplus fish). Also, John Maynard
Keynes believed that interest rates were generally set in the market for loans. Other factors,
however, were important: in particular, the "liquidity preference" of savers.
14. 2 Determination of Interest Rate

Several theories exist in economics literature as regard the determination of interest rate but we
will limit our discussion to loanable fund theory and liquidity preference.

14.2.1 Loanable fund theory of Interest

The loanable funds theory explains the determination of interest in terms of demand and supply of
loanable funds or credit. The theorists assert that, the rate of interest is the price of credit, which is
determined by the demand and supply for loanable funds (Loanable fund is the sum total of all
the money people and entities in an economy have decided to save and lend out to borrowers as
an investment rather than use for personal consumption).

Demand for loanable funds.

There are three sources of demand for loanable funds which are; government, businessmen and
consumers who need them for purposes of investment, hoarding and consumption. In case of
government, funds borrowed are utilized for constructing public works or for other exigencies.
While in the case of businessmen funds borrowed are used for the purchase of capital goods and
for investment purposes.
Supply of loanable funds
The supply of loanable funds comes from savings, dishoarding and bank credit. Private, individual
and corporate savings are the main source of savings. Though personal savings depend upon the
income level, yet taking the level of income as given, they are regarded as interest elastic. The
higher the rate of interest, the greater will be the inducement to save and vice versa. Corporate
savings are the undistributed profits of a firm which also depend on the current rate of interest to
some extent.
Equilibrium
The law of supply and demand is applicable in the market for loanable funds. We can consider the
interest rate a lender earns or a borrower must pay as the price for the loan. Supply, as we have
stated above, is simply the amount of savings in the market that provides the money to fund the
loans. Demand is the level of investment seeking financing. As the interest rate on loanable funds
increases, it becomes more expensive to borrow and the quantity of funds demanded will decrease.
On the other hand, as the interest rate for loanable funds increase, the supply of loanable funds
also increases because higher interests rates makes saving more financially attractive.

Eventually, the interest rate for loanable funds will reach equilibrium where demand for loanable
funds equal the supply of loanable funds offered for investment and the is the prevailing interest
rate in the economy. If the interest rate is lower than the interest rate at equilibrium, then the
amount of loanable funds available is less than the demand for them. As a result, lenders will
increase the interest they charge on loans until the rate reaches the equilibrium point as the supply
of funds increases due to increasing interest rates, and the demand decreases because of the
increased lending costs.

Fig. 14.1 Supply and demand of loanable fund.

14.2.1 Liquidity Preference Theory of Interest Rate.

Thus according to Keynes interest is the price paid for surrendering ones liquid assets. The greater
the liquidity preference the higher shall be the rate of interest. The liquidity preference constitutes
the demand for money. According Keynes, the rate of interest is determined by the supply of and
demand for money. The rate of interest on the demand side is governed by the liquidity preference
of the community which arises due to the necessity of keeping cash for meeting. The theory states
that interest rates change to equate the demand for money with the supply. If demand for money
rises — that is, if people decide they would prefer cash to interest-bearing securities — they sell
them, and bond prices fall: i.e. interest rates rise. Likewise, if the supply of money rises, people
will move into bonds, the price of which will rise and interest rates will fall.

Total Demand for Money

Money under the above three motives constitutes the demand for money. An increase in the
demand for money leads to a rise in the rate of interest, a decrease in the demand for money
leads to a fall in the rate of interest. According to Keynes, the first two motives for liquidity
preference namely the transaction and precautionary are interest inelastic. That is why the
speculative motive is important in the sense that speculative motive is interest elastic.
Supply money

Supply of money: The supply of money refers to the total quantity of money in the country. Though
the supply of money is a function of the rate of interest to a certain degree, yet it is considered to
be fixed by the monetary authorities. Hence the supply curve of money is taken as perfectly
inelastic represented by a vertical straight line.

Determination of the Rate of Interest:

Like the price of any product, the rate of interest is determined at the level where the demand for
money equals the supply of money. In the following figure, the vertical line QM represents the
supply of money and L the total demand for money curve. Both the curve and the vertical line
intersect at E2 where the equilibrium rate of interest OR is established and this is the prevailing
interest rate in the economy.
14.3 Nominal and Real Rates
The nominal interest rate is the interest rate that banks list as their lending rate. The real interest
rate is the nominal rate minus the inflation rate. If a bank charges an interest rate of 10%, and the
inflation rate is 6%, then the bank generates an interest of 4% in real terms. At a simple level of
analysis, since money represents purchasing power, the interest rate represents the equilibrium
reward at which people are willing to lend real resources from one period to another (machinery,
units of land, corn etc.). Thus, if at the margin, a saver is willing to defer the use of one unit of
resources this period, and instead transfer it to an agent (who wishes to invest in a project), in
return for 1.05 units next period, we would say that the real interest rate is 5%. The rate is referred
to as a real rate, since the payment next period is stipulated in real resource units.

Mathematically, the difference is relatively simple: the real rate is the nominal rate minus the rate
of inflation. Thus in an economy with a 4% rate of inflation, the real rate of return on an asset
paying a nominal 6% is 2%. Where there is deflation in an economy, the real rate will of course
be higher than the nominal. The implications for economic behaviour are important. Most
economies will necessarily operate on the basis of positive real rates, since most people will prefer
to spend their money on current consumption rather than lose it investing. More important is the
effect of inflationary expectations. If savers believe that future inflation will be at a certain level,
they will demand nominal interest rates over the period in question which will provide positive
real rates — whether the anticipated inflation occurs or not. This is a key element in the
determination of long-term interest rates.
14.4 Short- and Long-run Rates

The differences between the interest rates charged on assets with different maturities is also crucial.
It is common to talk about "short-term" and "long-term" rates. In reality, there exists at any one
time a multiplicity of rates, applicable to assets along a spectrum of maturity. They range from the
interest paid on "overnight" money to rates on securities maturing in thirty years.

Short-term rates are those generally associated with treasury bills or comparable instruments that
have a three-month maturity. However, in the markets there exists a whole range of instruments:
those with maturities of one month, three months, six months and twelve months are normally
classified as short-term . Also, overnight rates are the rates at which a country’s central bank
lends to selected banks or other financial intermediaries (the so called discount-rate of a central
bank) and the rates at which inter-bank money dealings take place (the so-called call money rates).
From the name "overnight" it is evident that these rates concern transactions that take place
overnight, in one or two days, or at a maximum in a week. They also constitute part of short-term
rate. Long-term rates are the rates most usually defined as those associated with bonds with a
maturity of ten years. However, instruments with a five-year or a thirty-year maturity exist, and
both fall into the category of yielding long-term rates.

14.5 Interest Rates and Risk

Long term rates, then, are likely to be higher than short term rates because the greater the term to
maturity, the greater the uncertainty. Savers will normally require a rate of interest in excess of the
expected rate of inflation: i.e. positive real rates. A comparison of the rates of interest on ordinary
bonds with those on index-linked bonds of a similar maturity gives an indication of what real rates
are demanded, and hence what inflation rate is expected . The degree of risk involved in holding a
particular asset is therefore a key determinant of interest rates.

14.5 Central Bank’s key interest-rates

The Central Bank majorly uses three main money market interest-rates:

 Marginal Refinancing Rate (MRR) :The MRR is the rate used when the CB undertakes
refinancing operations, and is at a fixed-rate.
  Deposit Rate (DER): The DER is the pre-specified interest-rate given by the ECB to
counterparties (14), on their own initiative, which make overnight deposits at the ECB
 Marginal Lending Rate (MLR): MLR is the pre-specified interest-rate charged by the
ECB when counterparties, on their own initiative, use the Central Bank’s service of
providing overnight credit. In normal circumstances, the DER provides the floor for the
overnight market rate, while the MLR similarly provides the ceiling.

14.6 Interest rate as monetary policy instruments

In the conduct of monetary policy, a Central Bank has at its disposal a number of instruments,
most of which depend upon setting or influencing interest rates. First, the discount and other
rates set by the Central Bank will feed through into the financial system. The Bank is the "lender
of last resort" in an economy, and can determine the short-term rate floor and ceiling. Decisions
on interest rates by a Central Bank also act as signal to the financial system, which tend
automatically to move their rates in the same direction.

This is because the Central Bank can re-enforce its interest rate "stance" by other means. A Central
Bank is usually the monopoly supplier of cash to the financial system of an economy. It can
therefore set interest rates by the way in which it makes that supply. It can make fixed amounts
available at a fixed rate of interest, "rationing" the supply between the bidders according to some
key. Or it can auction a fixed amount, which is allocated to the institutions offering the highest
rate of interest. The buying or selling of treasury bills or bonds - open market operations─ will
have the effect of raising or lowering their price: i.e. of lowering or raising the interest rate.

Further instruments which can directly affect the degree of liquidity in a financial system, and
hence interest rates, include changing minimum reserve requirements. These are legal
obligations placed upon banks to hold a certain amount of liquid assets, like treasury bills. The
Central Banks can also remove liquidity from a system by requiring financial institutions to make
special deposits with the Central Bank. This mechanism can be useful, for example, when it is
necessary to "sterilise" money which has been issued (i.e. created) to support a currency in the
foreign exchange markets. The setting of short term interest rates by the monetary authorities of a
particular economy is, therefore, in part a matter of direct decision, and in part the exercising of
"leverage" within the financial system

Summary of the Study Session Fourteen

 In economic theory, interest is the price paid for inducing those with money to save it
rather than spend it, and to invest in long-term assets rather than hold cash. Rates reflect
the interaction between the supply of savings and the demand for capital.
 Short-term rates are those generally associated with treasury bills or comparable
instruments that have a three-month maturity and Long-term rates the rates are most
usually defined as those associated with bonds with a maturity of ten years.
 The nominal interest rate is the interest rate that banks list as their lending rate and the real
interest rate is the nominal rate minus the inflation rate
 Several theories exist in economics literature as regards the determination of interest rate,
such as classical theory, loanable theory and liquidity preference theory of interest rate.

Self- Assessment Questions for Study Session Fourteen

(SAQ1) If the current market interest rate for loanable funds is below the equilibrium
level, then the quantity of loanable funds
a. demanded will exceed the quantity of loanable funds supplied and the interest rate
will rise.

b. supplied will exceed the quantity of loanable funds demanded and the interest rate
will rise.

c. demanded will exceed the quantity of loanable funds supplied and the interest rate
will fall.

d. supplied will exceed the quantity of loanable funds demanded and the interest rate
will fall
(SAQ 2) What would happen in the market for loanable funds if the government were to
decrease the tax rate on interest income?
a. The supply of and demand for loanable funds would shift right.

b. The supply of and demand for loanable funds would shift left.

c. The supply of loanable funds would shift right and the demand for loanable funds
would shift left.

d. None of the above is correct.

(SAQ 3) If the quantity of loanable funds supplied is greater than the quantity demanded,
then
a. there is a shortage of loanable funds and the interest rate will fall.

b. there is a shortage of loanable funds and the interest rate will rise.

c. there is a surplus of loanable funds and the interest rate will fall.

d. there is a surplus of loanable funds and the interest rate will rise.

(SAQ 4) If at some interest rate the quantity of money demanded is greater than the
quantity of money supplied, people will desire to
a. sell interest bearing assets causing the interest rate to decrease.

b. sell interest bearing assets causing the interest rate to increase.

c. buy interest bearing assets causing the interest rate to decrease.

d. buy interest bearing assets causing the interest rate to increase

(SAQ 5) The real interest rate is defined as:

a. the actual interest rate plus the rate of inflation
b. the actual interest rate minus the rate of inflation
c. the actual rate people pay rather than the advertised rate
d. none of the above
( SAQ 6) Assume the nominal interest rate is 12 percent, the expected inflation rate is 5
percent, and the marginal income tax rate is 25 percent. Then the after-tax real interest
rate is:
a. 7 percent
b. negative 2 percent
c. 4 percent
d. none of the above

(SAQ 7) In which of the following situations would you rather be borrowing?

a. the interest rate is 20% and expected inflation rate is 15%
b. the interest rate is 4% and expected inflation rate is 1%.
c. the interest rate is 13% and expected inflation rate is 15%
d. the interest rate is 10% and expected inflation rate is 15%

(SAQ 8) Suppose that the real interest rate remains constant at 3 percent while expected
inflation increases from 4 percent to 6 percent. Then the nominal interest rate:
a. increases from 4 percent to 6 percent
b. increases from 7 percent to 9 percent
c. increases from 1 percent to 3 percent
d. does none of the above

(SAQ 9) Higher expected inflation should

a. decrease the nominal interest rate and decrease the real interest rate
b. decrease the nominal interest rate and increase the real interest rate
c. increase the nominal interest rate and decrease the real interest rate
d. increase the nominal interest rate, but its effect on the real interest rate is unclear

(SAQ 10) When the growth rate of the money supply is increased, interest rates will rise
immediately if the liquidity effect is _____ the inflationary expectations effect.
a. equal to
b. larger than
c. smaller than
 d. all of the above

Answers:

Questions 1 2 3 4 5 6 7 8 9 10

Answers A D C A B A B B C B

References

 Jhingan M.L 7th edition, Monetary Economics by Vrinda Publication (P) Ltd
 Debes, Mukherjee 2nd edition Essentials of Micro and Macroeconomics by New Central
Book Agency (P) Ltd
 Sampat, Mukherjee, 1st edition, Analytical Macroeconomics from Keynes to Mankiw by by
New Central Book Agency (P) Ltd
 Mishkin, Frederic S. 7th edition, The economics of money, banking, and financial markets
.
 STUDY SESSION FIFTEEN

FISCAL AND MONETARY POLICIES MIX.

15.0 Introduction

A government's combined use of fiscal policy and monetary policy to attempt to manage the
economy is referred to as fiscal and monetary policy mix. Monetary and fiscal policies affect each
other, and the right policy mix is supposed to achieve desirable macroeconomic outcomes such as
price stability, credit availability, economic growth and financial stability. An example of a policy
mix would be tight monetary policy combined with easy fiscal policy.

Learning Outcome for Study Session Fifteen

At the end of this study session, you should be able to:

15.1 define and use correctly all the key words printed in bold (SAQ1)

15.2 explain the term policy mix. (SAQ2)

15.3 explain policy mix in the Nigerian context. (SAQ3)

15.4 describe the relationship between monetary policy and fiscal policy. (SAQ4)

15.1 Definition of fiscal and monetary policies mix (policy mix)

Generally, policy mix is the combination of a country's monetary policy and fiscal policy. More
technically, it can be defined as contemporaneous joint state of monetary and fiscal policy. These
two policy options influence growth and employment through several channels, and are generally
determined by the central bank and the government of a particular country. Ideally, the policy mix
should aim at maximizing growth and minimizing unemployment. However, the central banks and
governments are sometimes theorized to have different time horizons, with the elected
governments having a shorter time range. Both can have other objectives and must apply some
constraints, diverting them from these primary objectives: obeying a deficit rule, securing the
financial sector, courting popularity, etc .There are essentially four types of possible outcomes for
the mix of policies in an economy in which monetary and fiscal decisions are made independently:
  Loose fiscal policy / easy monetary policy
 Loose fiscal policy / tight monetary policy
 Tight fiscal policy / easy monetary policy
 Tight fiscal policy / tight monetary policy

From a purely theoretical perspective, the coordinated stances of loose fiscal / easy money and
tight fiscal / tight money are most effective when they are applied counter -cyclically. As the
standard IS/LM framework reveals, simultaneous expansionary fiscal and monetary policies
would be most beneficial for an economy experiencing a recession: the simultaneously loose fiscal
and easy money policies produce a large increase in output at the expense of little or no increase
in real interest rates. Similarly, a coordinated contractionary mix would work best in reducing a
positive output gap. Policy divergence, however, can produce mixed results depending on the
relative strength of one policy’s effects on another. While a loose monetary, tight fiscal posture
has been rarely observed empirically, a loose fiscal, tight monetary posture almost always raises
the equilibrium level of real interest rates, potentially resulting in crowding out effects on
investment demand and moderating any expansionary attempts of the government.
15.2 Effect of Monetary and Fiscal Policy in IS-LM model
We can use the IS-LM model to show the effects of monetary and fiscal policy. Expansionary
monetary policy uses the money supply to influence the levels of output. One way the central bank
increases the money supply is through open market operations. The central bank buys bonds to
increase the money supply. As shown in the monetary policy graph, this shifts the LM curve
downwards. The demand for bonds pushes their price up. This leads to a decrease in the interest
rate from r1 to r2.Lower interest rates attract investment which in turn increases income from Y1 to
Y2
.
Fig. 15.1 Monetary policy Fig.15.2 Fiscal policy
Expansionary fiscal policy uses government spending or tax reduction to influence the levels of
output. As shown in the fiscal policy graph, by increasing government spending the IS curve shifts
to the right. This leads to an increase in income from Y1 to Y2 and unlike monetary policy, the
interest rate increases from r1 to r2. This brings us to the debate between Keynesians and
Monetarists over the use of fiscal and monetary policy.

Monetary Fiscal Policy Mix, Or Simply, the Policy Mix

15.3 Fiscal and Monetary Policy - Comparison

Impact on the composition of output

Monetary policy is seen as something of a blunt policy instrument – affecting all sectors of the
economy although in different ways and with a variable impact. Fiscal policy changes can be
targeted to affect certain groups (e.g. increases in means-tested benefits for low income
households, reductions in the rate of corporation tax for small-medium sized enterprises,
investment allowances for businesses in certain regions) Consider too the effects of using either
monetary or fiscal policy to achieve a given increase in national income because actual GDP lies
below potential GDP (i.e. there is a negative output gap)

Monetary policy expansion

Lower interest rates will lead to an increase in both consumer and fixed capital spending both of
which increases current equilibrium national income. Since investment spending results in a larger
capital stock, then incomes in the future will also be higher through the impact on LRAS.

Fiscal policy expansion

An expansion in fiscal policy (i.e. an increase in government spending) adds directly to AD but if
financed by higher government borrowing, this may result in higher interest rates and lower
investment. The net result (by adjusting the increase in G) is the same increase in current income.
However, since investment spending is lower, the capital stock is lower than it would have been,
so that future incomes are lower.

15.3.1 Differences in the effectiveness of monetary and fiscal policies

When the economy is in a recession (when business and consumer confidence is very low and
perhaps where deflationary pressures are taking hold) monetary policy may be ineffective in
increasing current national spending and income. The problems experienced by the Japanese in
trying to stimulate their economy through a zero-interest rate policy might be mentioned here. In
this case, fiscal policy might be more effective in stimulating demand. Other economists disagree
– they argue that short term changes in monetary policy do impact quite quickly and strongly on
consumer and business behaviour. Consider the way in which domestic demand in both the United
States and the UK has responded to the interest rate cuts introduced in the wake of the terror attacks
on the USA in the autumn of 2001
However, there may be factors which make fiscal policy ineffective aside from the usual crowding
out phenomena. Future-oriented consumption theories hold that individuals undo government
fiscal policy through changes in their own behaviour – for example, if government spending and
borrowing rise, people may expect an increase in the tax burden in future years, and therefore
increase their current savings in anticipation of this

15.3.2 Differences in the Lags of Monetary and Fiscal Policies

Monetary and fiscal policies differ in the speed with which each takes effect, the time lags are
variable

 Monetary policy rates can be changed each month and emergency rate changes can be
made in between meetings of the MPC, whereas changes in taxation take longer to
organize and implement.
 Because capital investment requires planning for the future, it may take some time before
decreases in interest rates are translated into increased investment spending. The impact of
increased government spending is felt as soon as the spending takes place and cuts in direct
and indirect taxation feed through into the economy pretty quickly. However, considerable
time may pass between the decision to adopt a government spending programme and its
implementation. In recent years, the government has undershot on its planned spending,
preferably because of problems in attracting sufficient extra staff into key public services
such as transport, education and health.

Evaluation:

 Fiscal policy is weak (ineffective) when investment is very sensitive to interest rates and
when consumers pierce the veil and attempt to offset the actions of the government (e.g.
saving a tax cut, or increasing their saving when higher government spending leads to
expectations of higher taxes in the future)
 Monetary policy is weak (ineffective) when consumers are willing to hold large
quantities of money rather than spend them even when interest rates are very low

15.4 Monetary and fiscal policy in Nigeria

Fiscal and monetary policies are inextricably linked in macroeconomic management as
developments in one sector directly affect developments in the other. Moreover, there is a
consensus among economists such as Ajayi (1974); Cardia (1991); Ajisafe & Folorunso (2002)
and Adefeso & Bolaji (2010) that monetary and fiscal policies are either jointly or individually
affecting the level of economic activities in Nigeria but the degree and relative potency differs.

Summary of the Study Session Fifteen

Policy mix can be defined as contemporaneous joint state of monetary and fiscal policy. There are
essentially four types of possible outcomes for the mix of policies in an economy in which
monetary and fiscal decisions are made independently: loose fiscal policy / easy monetary policy,
loose fiscal policy / tight monetary policy, tight fiscal policy / easy monetary policy and tight fiscal
policy / tight monetary policy.

Self- Assessment Questions Study Session Fifteen

(SAQ 1)The policy mix that would cause the interest rate to increase and investment to decrease,
but have an indeterminate effect on aggregate output, is a mix of
A. Expansionary fiscal policy and expansionary monetary policy

B. Contractionary fiscal policy and expansionary monetary policy

C. Expansionary fiscal policy and contractionary monetary policy

D. Contractionary fiscal policy and contractionary monetary policy

(SAQ 2) In the IS-LM model, an easy monetary in conjunction with a tight fiscal policy

A. Increases exports and decreases imports

B. Decreases exports and increases imports
C. Encourages foreign capital inflows
D. Both b and c

(SAQ 2) Fiscal policy affects the goods market through

A) changes in money supply.

B) changes in taxes and money supply.

C) changes in government spending and money supply.

D) changes in taxes and government spending.

(SAQ 3) A policy mix of an expansionary fiscal policy and a contractionary monetary policy would
cause
A) output to decrease and interest rates to decrease.

B) output to decrease and interest rates to increase.

C) output to decrease and interest rates to either increase, decrease, or remain unchanged.

D) output to either increase, decrease, or remain unchanged and interest rates to increase.

(SAQ 4) A policy mix of an expansionary fiscal policy and an expansionary monetary policy
would cause output to ________ and interest rates to ________.

A) increase; increase

B) increase; increase, decrease, or remain unchanged

C) increase, decrease, or remain unchanged; increase

D) decrease; increase

(SAQ 5) The policy mix of a contractionary fiscal policy and a contractionary monetary policy
would cause output to ________, and interest rates to ________.

A) decrease; increase, decrease, or remain unchanged

B) decrease; decrease
C) decrease; increase

D) increase, decrease, or remain unchanged; decrease

(SAQ 6) The policy mix that would cause the interest rate to increase and investment to decrease,
but have an indeterminate effect on aggregate output, is a mix of

A) expansionary fiscal policy and expansionary monetary policy.

B) contractionary fiscal policy and expansionary monetary policy.

C) expansionary fiscal policy and contractionary monetary policy.

D) contractionary fiscal policy and contractionary monetary policy

(SAQ 7) The policy mix that would cause the interest rate to decrease and investment to increase,
but have an indeterminate effect on aggregate output, is a mix of

A) contractionary fiscal policy and expansionary monetary policy.

B) expansionary fiscal policy and contractionary monetary policy.

C) expansionary fiscal policy and expansionary monetary policy.

D) contractionary fiscal policy and contractionary monetary policy.

Answers:

Questions 1 2 3 4 5 6 7 8 9 10

Answers C D D C C C A

References

 Jhingan M.L 7th edition, Monetary Economics by Vrinda Publication (P) Ltd
 Debes, Mukherjee 2nd edition Essentials of Micro and Macroeconomics by New Central
Book Agency (P) Ltd
 Sampat, Mukherjee, 1st edition, Analytical Macroeconomics from Keynes to Mankiw by by
New Central Book Agency (P) Ltd
 Mishkin, Frederic S. 7th edition, The economics of money, banking, and financial markets
.