MACROECONOMICS I

BCM 221
Lecturer: Ms E. SIYOTO

NOTE

The content of these lecture notes are

mainly based on the information contained in
the required text for this course: Mankiw
Gregory. Principles of macroeconomics. Third
edition.

Students are encouraged to obtain this book,

and other recommended macroeconomics
books, and study them to ease and broaden
their understanding of the course.

UNIT 1: THE STUDY OF

MACROECONOMICS

1.1 DEFINITION AND SCOPE OF

MACROECONOMICS
1.2 MACROECONOMIC INDICATORS
1.3 MACROECONOMIC POLICY GOALS

1.1 DEFINITION AND SCOPE OF

MACROECONOMICS

The field of economics is divided into two

broad categories: macroeconomics and
microeconomics.
Microeconomics is the study of the behavior
of individuals and individual firms in the
market for specific goods and services.
Macroeconomics is the study of the economy
as a whole, in which larger aggregates such
as aggregate demand, aggregate supply,
aggregate income, aggregate employment,
general price level are discussed.
4

1.1 DEFINITION AND SCOPE OF

MACROECONOMICS

Macroeconomics deals with important economic

issues and problems of the day.
Regarding what macroeconomists study, a number
of questions need to be answered.
Such as: why some economies have experienced
rapid growth while others are in poverty; why there
is high unemployment or inflation is some
economies while others are stable.
Macroeconomics considers many of the worldss
most pressing economic problems like persistent
unemployment, inflation, balance of payment
difficulties, economic stagnation and unequal
distribution of income and wealth.
5

1.2 MACROECONOMIC
INDICATORS
The most important indicators of
macroeconomics are:
The total economys output of goods and
services
The total demand for its output
Total employment and unemployment
The general price level
The balance of payments
The rate of economic growth

1.3 MACROECONOMIC POLICY

GOALS
We will consider four macroeconomic policy
goals.
1. Increasing national output
2. Reducing unemployment
3. Stabilizing prices
4. Maintaining foreign trade balance

INCREASING NATIONAL OUTPUT

The strength of the economy is judged, among

other things, by its ability to produce and provide
greater quantities, types and quantities of
output(goods and services) to domestic and
international markets.
Output refers to all goods and services produced in
an economy in a given period of time.
The goal of macroeconomics is to suggest ways and
means of achieving higher level and rate of growth
of output. And also suggest ways of reducing high
fluctuations (sharp increases and sharp falls) in
output, which is reflected in the business cycle.
8

INCREASING NATIONAL OUTPUT

The business cycle refers to periods of expansion and

contraction in real output.
During contractions, economic activities reduce,
output declines and unemployment rises.
During expansions, economic activities, production
and employment increase.
Even when an economy is showing an increase in
national output, it experiences such short-term
fluctuations.
When these fluctuations are sharp, they affect the
economy negatively. And thus the need to not only
increase output, but also minimize the degree of
fluctuations.
9

REDUCING UNEMPLOYMENT

Reducing unemployment is another major macroeconomic policy

goal because a high unemployment rate lowers the standard of
living in the economy and breeds many other economic and social
problems.

When output is depressed, demand for labor reduces and

unemployment increase. And when output is increased, more
labor is hired and employment increases.

While we observe a positive relationship between output

increases and employment, it is not always the case.

Sometimes output can be increased without a corresponding

increase in employment (eg, when production is made more
capital intensive). Thus the need to make the objective of
reducing unemployment distinct to ensure jobs are created.
10

STABILIZING PRICES

The third macroeconomic goal is to stabilize prices.

Because rapid price changes distort economic
decisions of firms and individuals.
Prices are the yardstick by which economic value is
measures.
Rapid changes in the price distort economic
agreements, and make others to gain, and others to
lose.
Economic agents want prices to be as stable or
predictable as possible so that they can correctly
anticipate the gain they may get from a certain
transaction.
11

STABILIZING PRICES

Price stability is also another factor influencing

foreign direct investment. Investors from abroad
would not want to invest in an economy whose
price is unstable, as they would not be sure about
their net profit at the end of the investment
period.
If prices generally rise, we say there is inflation.
The rate at which the price level changes is called
inflation rate.
An extreme case of inflation is hyperinflation, when
prices change by a thousand or million percentage.
If prices generally fall, we say there is deflation.
12

STABILIZING PRICES

When prices generally rise, business firms have an

incentive to hire more workers and increase
production and sales. Thus when prices rise,
employment increases and income and consumption
increases.
However, if the price increase is very high, the
purchasing power of money reduces and goods and
services become expensive and this negatively
affects peoples standard of living.
when there is deflation, the purchasing power of
households income increase. However, it discourages
firms from expanding their production and reduces
supply, output and employment and income.
13

STABILIZING PRICES

Thus even though prices have reduced,

individuals capacity to buy goods and services
is reduced due to the fall in their income.
Therefore, a small percentage of inflation rate
is necessary to encourage (induce) investment
and increase output, employment and income.
Usually, an inflation rate not exceeding 5% is
considered acceptable.
Governments as a result determine to monitor
the price level so that there are no sharp
increases or decreases.
14

MAINTAINING FOREIGN TRADE

BALANCE

Open economies interact with other economies

through trade and finance.
They import goods and services from other
economies, and export their output to other
economies.
They borrow money from and lend to other
countries.
When imports are greater than exports, the economy
faces a trade deficit.
When exports are more than imports, the economy
faces a trade surplus.
When exports and imports are equal, there is
balanced trade.
15

MAINTAINING FOREIGN TRADE

BALANCE

When a country exports, it earns foreign currency.

When it imports, it pays in terms of foreign currency.
If imports are greater than exports, then the nation
has not earned enough foreign currency to cover the
expenses to finance its imports.
The alternative is to either run down their foreign
currency reserves or borrow foreign currency from
abroad.
Running down foreign currency reserves is not
sustainable.
Borrowing from abroad leads to accumulation of
debt.
16

MAINTAINING FOREIGN TRADE

BALANCE

A huge accumulation of external debt causes nation to

sink in the debt trap and impose a negative impact on
its economic growth by discouraging investment,
reducing public funds that could have been used to
finance domestic development projects (since funds
are channeled to debt servicing).
Further, accumulation of debt reduces the sovereignty
of a country in pursuing its economic policies and
political freedom as lenders may put certain conditions
to postpone, reduce or cancel the payment of debt.
That is why maintaining a balanced trade (or even
having a trade surplus) is an important macroeconomic
goal.
17

UNIT TWO: MEASURING

ECONOMIC ACTIVITY

2.1 MEASURING GROSS DOMESTIC PRODUCT

2.2 COMPONENTS OF GDP
2.3 OTHER MEASURES OF INCOME
2.4 NOMINAL GDP, REAL GDP, AND GDP
DEFLATOR
2.5 GDP AND ECONOMIC WELL-BEING
2.6 DIFFICULTIES IN MEASURING ECONOMIC
ACTIVITIES

18

2.1 MEASURING GROSS

DOMESTIC PRODUCT
Gross domestic product (GDP) is the market value
of all final goods and services produced in the
economy in a given period of time.
GDP can be estimated in three equivalent ways:
1. As the final value of output produced during the
year under consideration. This is the product
approach to estimating GDP.
2. As income received by those who have supplied
factors of production during the year under
consideration. Payments to factors of production
include wages (for labor), rent (for land and
buildings), and profit (to firm owners). This is the
income approach to estimating GDP.

19

2.1 CONTINUED
3.

As the amount of expenditures on final goods and

services by the final users of the goods and services.
This is the expenditure approach to estimating GDP.
The product approach gives the value of the final
goods and services which were produced in the
economy during the year under consideration.
The expenditure approach gives the value of the
final goods and services which were bought by final
users in the same year.
The income approach gives the amount of incomes
which were earned by factors of production supplied
by individuals in the economy in the same year.

20

2.1 CONTINUED

All the three approaches are equivalent and

give the same estimate of GDP.
The equivalence of these approaches tells us
that in the economy,

21

2.1 MEASURING GROSS

DOMESTIC PRODUCT

Gross domestic product (GDP) is the market value of all final

goods and services produced in the economy in a given period of
time.
Lets break down the definition of GDP for better understanding.
GDP (AS THE MARKET VALUE )adds together many different
kinds of products into a single measure of the value of economic
activity (by using prices which reflect the value of the goods).
GDP (as the market value of ALL) tries to be comprehensive by
includes all items produced in the economy and sold legally on
the markets.
However, there are some products that GDP excludes because
measuring them is difficult. E.g. items produced and sold illicitly
like illegal drugs. It also excludes most items that are produced
and consumed at home because they do not enter the market.

22

2.1 CONTINUED

GDP (as a measure of FINAL goods and

services) includes only value of final goods.
The value of intermediate goods
(commodities that are used in the production
of final goods. E.g, wheat is an intermediate
good in producing bread) is not included
because it is already included in the value of
the final good.
Including intermediate goods would lead to
double counting(including a commodity more
than once in the measurement of GDP).
23

2.1 CONTINUED

However, when an intermediate good is

produced, and rather than being sold, its
added to a firms inventory to be used or sold
later, the intermediate good is taken to be a
final good for the moment, and its value as
inventory investment is added to GDP.
When the inventory of the intermediate good
is finally sold or used, the firms inventory is
reduced and GDP for that period is adjusted
accordingly (reduced).

24

2.1 CONTINUED

GDP (as the market value of all final GOODS

AND SERVICES) includes both tangible goods
like food, clothing, cars, and intangible
services like haircuts, housecleaning and
doctor visits.
GDP (as a market value of all final goods and
services PRODUCED) includes goods and
services currently produced. It does not
include transactions involving the sale of
goods produced in the past like second hand
clothes, used cars and other items produced in
the past periods.
25

2.1 CONTINUED

GDP ( as a measure of the final value of all

goods and services produced WITHIN A
COUNTRY) measures the value of production
within the geographical confines of a country,
regardless of whether the producer is of that
nationality or not.
GDP ( as a measure of the final value of all
goods and services produced within a country
IN A GIVEN PERIOD OF TIME) measures the
value of production that takes place within a
specific interval of time. Usually the interval
is a year or quarter.
26

2.2 COMPONENTS OF GDP

GDP, denoted as Y, is divided into 4 components:

consumption ( C) , Investment (I), Government purchases
(G) and Net exports (NX): Y=C+I+G+NX
Consumption is spending by households on goods and
services.
Investment is spending on capital equipments,
inventories, structures and households purchase of new
household.
Government spending is government spending on goods
and services. This excludes transfer payments because
there is no corresponding production.
Net exports equals purchases of domestically produced
goods by foreigners (EXPORTS) minus domestic purchases
of foreign goods (IMPORTS).
27

2.3 OTHER MEASURES OF

INCOME

There are other measures of income that differ

from GDP by including or excluding some things
found in GDP.
GROSS NATIONAL PRODUCT (GNP) is the total
income earned by the nations permanent
residents. It differs from GDP by including income
that our citizens earn abroad, and excludes the
income that foreigners are in our country.
NET NATIONAL PRODUCT (NNP) is the total income
of a countrys permanent residents, minus
depreciation. Depreciation is the wear and tear of
the economys stock of equipments and structures.
28

2.3 CONTINUED

NATIONAL INCOME (NI) is the total income earned

by a nations residents in the production of goods
and services. It differs from net national product
by excluding indirect business taxes, and
including business subsidies.
PERSONAL INCOME is the income that households
and non corporate businesses receive.
Unlike national income, it excludes retained
earnings (income that corporations have earned
but have not paid out to their owners). It also
subtracts corporate income taxes and
contributions for social insurance.
29

2.3 CONTINUED

In addition, personal income includes the

interest income that households receive from
holding government debt, and the income
households receive from government transfer
programs like welfare and social security.
DISPOSABLE PERSONAL INCOME is the income
that households and non-corporate
businesses have left after satisfying all their
obligations to the government. It equals
personal income minus personal taxes and
other non tax payments.
30

2.4 NOMINAL GDP, REAL GDP,

AND GDP DEFLATOR

GDP measure the total spending on goods

and services in all markets in the economy.
If total spending rises from one year to the
other, its either the economy is producing a
larger output or the prices have increased.
When studying changes in the economy,
economists want to separate these 2 effects.
In particular, they want a measure of the
quantity of goods and services produced that
is not affected by price changes.
To achieve this, we use real GDP.
31

2.4 CONTD

The production of goods and services valued

at current prices is called nominal GDP.
The production of goods and services valued
at constant prices is called real GDP.
By evaluating current production using prices
that are fixed at past levels, real GDP shows
how the economys overall production of
goods and services changes over time.
To see clearly how real GDP is constructed,
we consider a numerical example below.
32

2.4 CONTD

Suppose an economy that only produces bread and sugar.

To compute total spending in this economy, we multiply
the quantities of bread and sugar by their prices and sum
them.
We do this for each year, and the values we obtain are
nominal GDP values.
To obtain real GDP, we choose a base year.
We then use the prices of bread and sugar in the base
year to compute the values of goods and services for all
the years.
If real GDP rises, we know that its because production
has increased, and not prices, because prices will be
held fixed.
33

2.4 CONT

34

2.4 CONTD

Our calculations of nominal GDP show that total spending

rose from 200, to 600 to 1200.
Part of this increase is due to a rise in production, and
part of it is due to a rise in prices.
To see the change in production not affected by price
changes, we look at the real GDP.
Real GDP show that spending increased from 200, to 350
to 500.
This shows the change resulting from production only, not
price change.
Because real GDP measures the economys production of
goods and services, it reflects the economys ability to
satisfy peoples needs and desires. And its a better
measure than nominal GDP.
35

2.4 CONTD

GDP deflator is a measure of the price level

calculated as the ratio of nominal GDP to real
GDP times 100.
Because nominal and real GDP in the base year
are the same, the GDP deflator in the base year
is 100.
GDP for subsequent years measures the rise in
nominal GDP from the base year that cannot be
attributed to a rise in real GDP.
The GDP deflator measures the current level of
prices relative to the level of prices in the base
year.
36

2.4 CONTD

When the GDP deflator is 171, it means that

the price level increased by 71 % from 2011
to 2012.
The GDP deflator is one measure that
economists use to monitor the average price
level in the economy-inflation.

37

2.5 GDP AND ECONOMIC WELLBEING

GDP measures both the economys total

income and total expenditure on goods and
services.
Because most people would prefer to receive
a higher income and enjoy a higher
expenditure, GDP seems to be a good
measure of economic wellbeing.
However, some have disputed the validity of
GDP as a good measure of economic wellbeing.

38

2.5 CONTD

Their arguments are based on the claim that

GDP does not measure the things that make
life worthwhile
These among others include: the quality of
health & education, level of happiness,
strength of marriages, intelligence of public
debate, integrity of public officials, courage,
wisdom or devotion to the country.

39

2.5 CONTD

Yet we can see that a large GDP helps us to

lead a good life
Nations with a larger GDP can afford better
health care, better educational systems,
better leisure activities. Nations with a
larger GDP can easily foster intelligence,
integrity, courage, wisdom, devotion to the
country among its citizen.

40

2.5 CONTD

However, GDP is not a perfect measure of well

being.
Some things that contribute to a good life are
left out in the measure of GDP.
E.g leisure. If people started working more
hours and spending less time on leisure, more
goods and services would be produced and GDP
would increase.
Yet, this rise in GDP doesnt mean everyone is
better off. The loss from reduced leisure would
offset the gain from increased production of
goods and services.
41

2.5 CONTD

Further, because GDP uses market prices to value

goods and services, it excludes activities that take
place outside the market.
E.g, if a chef prepares and sells a meal at the
restaurant, its part of GDP, but when its prepared at
home, its not.
A paid maids services are included in GDP, but when
she marries the master, her services are not paid for
and thus not part of GDP
Child care provided in day care centers is part of
GDP, but child care provided by parents is not.
Volunteer work contributes to well-being but is not
is reflected in GDP.
42

2.5 CONTD

Another thing is that GDP excludes the quality

of the environment.
If firms were allowed to produce without
considering the pollution they create, GDP
would rise, yet well-being would fall.
Also, GDP says nothing about the distribution
of income.
A society with 100 people each earning 50,000
would have a GDP of 5 million, and so will a
society with 100 people where 10 earn 500,000
each and the 90 suffer with nothing at all.
43

2.5 CONTD

In the end, we can conclude that GDP is a

good measure of economic well being for
most, but not all purposes.

44

2.6 DIFFICULTIES IN MEASURING

ECONOMIC ACTIVITIES ,ESP IN LDCS

A good portion of the produce is not brought to the

market to be exchanged for money. Its either
consumed directly by the producers or exchanged
directly for other goods and services.
Difficulties to estimate income by industry due to
little specialization of functions and unscientific
classification of occupation.
Large number of producers do not keep any accounts
of their produce because most of them are illiterate.
Statistics for the computation of GDP are incomplete
and in some cases unreliable.
Difficulty regarding the method to use in estimating
national income.
45

UNIT 3: MEASURING THE COST

OF LIVING

3.1 THE CONSUMER PRICE INDEX

3.2 PROBLEMS IN MEASURING THE COST OF
LIVING
3.3 CPI vs GDP DEFLATOR AS MEASURES OF
OVERALL PRICE LEVEL
3.4 INFLATION AND ADJUSMENT TO INFLATION

46

3.1 THE CONSUMER PRICE

INDEX

The CPI is used to monitor changes in the

cost of living over time.
When the CPI rises, it means a typical family
has to spend more income to maintain the
same standard of living.
Inflation describes a situation where the
overall price level for an economy is rising.
The inflation rate is the percentage change
in the price level from the previous periods.
The CPI is one measure of inflation.
47

3.1 CONTINUED

The CPI is a measure of the overall cost of

goods and services bought by a typical
consumer.
To see how CPI is computed:
The first step is to fix the basket: determine
the quantities for each good & service an
average consumer would consume.
Secondly, we find the price for each good
and service

48

3.1 CONTINUED

Thirdly, we compute the cost of the basket.

We use data on prices to calculate the cost
of the basket at different times.
Only the price is allowed to change, while
the quantity of the food basket is held
constant.
By doing so, we are isolating the effects of
price change from the effect of any quantity
change that might be occurring at the same
time.

49

3.1 CONTINUED

The fourth step is to choose the base year

and compute the index. We choose one year
to be the base year against which all other
years are compared.
To calculate the index, the price of the
basket of goods and services in each year is
divided by the price of the base year, and the
ratio is multiplied by 100. the resulting
number is the CPI.

50

3.1 CONTINUED

Lastly we compute our inflation rate, which

is the percentage change in the price index
from the preceding period.
The inflation rate between two consecutive
periods is given as:

Inflation rate year 2

CPI year 2 CPI year1

CPI year1

100

Lets consider a numerical example. We

simply it by assuming only two goods are
consumed: bread and sugar.
51

3.1 CONTINUED

52

3.1 CONTINUED

The CPI is always 100 in the base year

CPI is 175 in year 2012 meaning the price of
a basket in 2012 is 175% of its price in the
base year.
In other words, a basket that costs k100 in
the base year costs k175 in 2012.
The CPI is 250 in 2013, indicating that the
price level in 2013 is 250% of the price level
in the base year.
In our example, the inflation rate is 75% in
2012 and 43% in 2013.
53

3.2 PROBLEMS IN MEASURING

THE COST OF LIVING

Three problems are widely acknowledged in

the use of CPI as a measure of cost of living:
Firstly, CPI does not take into account
consumers ability to substitute towards
goods that have become relatively cheaper.
When prices change, they do not change
proportionately. Some rise more than others.
Consumers substitute towards less expensive
goods.
Yet CPI is computed assuming a fixed basket.
54

3.2 CONTINUED

Secondly, it does not take into account the

increases in purchasing power of the income as
a result of the introduction of new goods.
When a new good is introduced, consumers
have a wider variety from which to choose.
Greater variety makes the currency more
valuable as consumers will need fewer
kwachas to maintain a given standard of living.
But because CPI is based on a fixed basket, it
does not reflect the increase in purchasing
power of the kwacha.
55

3.2 CONTINUED

Thirdly, it is distorted by unmeasured

changes in the quality of goods and services.
If the quality of the good rises, the value of
our kwacha rises, and vice versa.
As a result of these three problems, CPI
tends to overestimate annual inflation rate

56

3.3 CPI VS GDP DEFLATOR

GDP deflator is the ratio of nominal GDP to

real GDP.
Because nominal GDP is current output valued
at current prices, and real GDP is current
output valued at base-year prices, the GDP
deflator reflects the current level of prices
relative to the level of prices in the base year.
Economists use both the CPI and the GDP
deflator to monitor how quickly the prices are
rising. Usually, the 2 statistics give the same
result, yet there are 2 differences that may
cause them to diverge.
57

3.3 CONTINUED

Firstly, GDP deflator reflects prices of all

goods and services produced domestically,
whereas CPI reflects prices of all goods and
services bought by consumers.
This means a rise in the price of a good
domestically produced but not consumed by
a typical citizen would raise the GDP deflator
but not CPI.
Also, a rise in the price of imported goods
consumed by typical citizens would increase
the CPI but not the GDP deflator.
58

3.3 CONTINUED

Secondly, CPI compares the price of a fixed

basket of goods and services to the price of
the basket in the base year., whereas GDP
deflator compares the price of currently
produced goods and services to the price of
the same goods and services in the base year.
For CPI, the basket is rarely changed.
Whereas for GDP deflator, the group of goods
and services automatically change over time.
Despite these differences, the two statistics
still tell a similar story.
59

3.4 INFLATION AND ADJUSMENT

TO INFLATION

Measuring the overall price level in the economy

permits comparison between money units from
different points in time.
Take for example, if a teacher earned k1000 in
1993, (20 yrs ago). Is this salary lower or higher
than current teachers salaries (say K4000 ?
To answer such a question, we need to know the
level of prices in 1993 and the level of prices
now.
Part of the increase in income may just
compensate teachers for the increase in prices
today.
60

3.4 CONTINUED

To be able to compare teachers salaries in

1993 and today, we need to turn 1993
kwachas into todays kwacha.
The price index will determine the size of
this inflation correction.
Suppose the CPI in 1993 was 20, and the
price index now is 150. to calculate the
salary for 1993 in todays kwacha, we
multiply the salary in 1993 by the ratio of the
2013 price level to 1993 price level.

61

3.4 CONTINUED

Calculation

price level2013
salary2013 kwacha salary1993
price level1993
150
k1000
20
k 7500

We find that teachers in 1993 were getting a

higher salary (k7500) than current ones
(k4000).
62

3.4 CONTINUED

As just discussed, prices indexes are used to

correct for the effects of inflation when
comparing values for different times.
Correcting economic variables for the effect
of inflation is particularly important.
Take for instance interest rate
When you deposit your money for saving in
the bank, you will earn interest on your
deposit. When u borrow money from the
bank, you will pay interest on your loan.
63

3.4 CONTINUED

If u deposit k1000 in your bank, and the interest

rate is 10%. And the end of the year you will
earn k1100. will you be richer then than before?
You will have 100 more kwacha. The number of
your kwachas has risen by 10%. But if prices
have risen by 10% also, then your purchasing
power is still the same. If prices have increased
only by 4%, then the amount of goods and
services you can buy has increased by only 6%.
And if the price level has increased by 15%,
then your purchasing power has actually
reduced by 5%.
64

3.4 CONTINUED.

The interest rate that the bank pays is

nominal interest rate.
The interest rate adjusted for inflation is
called real interest rate.
Real interest rate= nominal interest rateinflation rate.
Real interest rate is the difference between
nominal interest rate and inflation rate.

65

UNIT 4: UNEMPLOYMENT

4.1 UNEMPLOYMENT, A MACROECONOMIC

PROBLEM
4.2 DEMAND AND SUPPLY IN THE LABOR
MARKET
4.3 CALCULATING UNEMPLOYMENT
4.4 NATURAL RATE OF UNEMPLOYMENT

66

4.1 UNEMPLOYMENT, A
MACROECONOMIC PROBLEM

A job loss means a lower standard of living now, future

anxiety about the future and reduced self esteem.
High unemployment levels in the economy reduces
wages and makes jobs insecure for the employed,
compromises working conditions, reduces bargaining
power of unions, reduces chances of finding employment
for those seeking it. It also reduces production in the
economy.
High unemployment levels also raises social vices like
crime.
Unemployment level of an economy is an obvious
determinant of an economys standard of living.
The more reason reducing it is a major macroeconomic
policy goal.
67

4.2 DEMAND AND SUPPLY IN

THE LABOR MARKET

Just like any market has a supply and

demand side, and a price level, so does the
labor market.
In the labor market, households supply their
labor services in exchange for pay, the real
wage.
Firms demand for labor to use in the
production of goods and services.
In equilibrium, demand and supply for labor
is equal, and the resulting wage is called
equilibrium wage.
68

4.2 CONTINUED

Demand for labor curve is a downward

slopping curve.
This is because there is a negative
relationship between the real wage firms pay
their workers, and the quantity of labor they
are willing to employ.
The real wage is a cost to the firm, and when
the real wage reduces, the cost to the firm
of hiring is reduced, and they are willing to
employ more labor. (the opposite is also
true).
69

4.2 CONTINUED

Supply of labor curve is a downward slopping

curve.
This is because there is a positive
relationship between the real wage
individuals receive and the amount of labor
they are willing to supply.
The real wage is a gain to an individual
supplying labor. And when the real wage
increases, their gain increases and they are
willing to supply more labor.

70

EQUILIBRIUM IN THE LABOR

MARKET

Real wage

labor supply

Equilibrium
real wage
labor demand
quantity of
labor
labor demand=
labor supply
71

4.3 CALCULATING
UNEMPLOYMENT
The adult population (often 16 years and above)
is divided into three groups:
The employed, The unemployed and Not in the
labor force
A person is employed if they work for a paying
job.
A person is unemployed if they are looking for a
job, temporary laid off, waiting to start working.
A person who fits neither of the two categories,
such as students, retirees, the old, the (sick &
unable to work), homemakers are not in the
labor force.

72

4.3 CONTINUED

A combination of the employed and

unemployed form the labor force.

The unemployment rate is the percentage of

the labor force that is unemployed.

The labor force participation rate is the

percentage of the total adult population that
is in the labor force.
73

4.4 NATURAL RATE OF

UNEMPLOYMENT

The economys natural rate of unemployment

is the amount of unemployment an economy
normally experiences. It has to do with the
long run trend of unemployment.
Cyclical unemployment is the year to year
fluctuations in unemployment around the
natural rate. It is closely associated with
short run ups and downs of economic
activity.

74

4.4 CONTINUED

In an ideal labor market, wages would adjust

to bring quantity of labor supplied and
quantity of labor demanded into balance and
ensure that all workers are fully employed.
However, the actual situation is not as the
ideal suggests.
There are always some workers without jobs
even when the economy is doing well.
This means unemployment rate does not fall
to zero, rather, it fluctuates around the
natural rate of unemployment.
75

4.4 CONTINUED
To understand the natural rate of
unemployment, we examine why actual labor
markets depart from the ideal of full
employment.
There are four ways to explain
unemployment in the long run:
The process of job search
Minimum wage laws
Labor unions and bargaining
Efficiency wage theory.

76

JOB SEARCH

One reason why economies always experience

some level of unemployment is job search.
Job search is the process of matching workers
with appropriate jobs.
If all workers were well suited for all jobs, job
search would not be a problem.
But workers differ in their preference and
skills, and jobs differ in attributes, and
information about job candidates and job
vacancies is disseminated slowly among firms
and households in the economy.
77

JOB SEARCH

Since it takes time for workers to find jobs

that are best suited for them, during the
time individuals are seeking for jobs that
best suit them, they will be unemployed.
The unemployment that results from the
process of matching workers with
appropriate jobs is called frictional
unemployment.
Frictional unemployment is usually the result
of changes in the demand for labor among
different firms.
78

JOB SEARCH

Frictional unemployment is inevitable simply because

the economy is changing.
As consumers change their demand for goods and
services, Firms in industries whose goods and services
are demanded less have to cut on production and lay
off some workers.
These workers have to search for new jobs.
Firms in industries whose goods and services are
demanded more have to increase production and hire
more workers.
The firms have to decide which new workers to hire.
This result of this transition is a process of
unemployment.
79

JOB SEARCH

The faster information spreads about job

vacancies and worker availability, the faster the
economy can match workers and jobs and reduce
frictional unemployment.
Eg, the internet can help facilitate the matching
of workers and jobs.
Also, public policy, such as employment agencies
that give out information about job vacancies
can help reduce frictional unemployment.
Another way is through public training programs
which aim to help the transition of workers from
declining industries to growing industries.
80

MINIMUM WAGE LAWS

Structural unemployment results when the

number of jobs are insufficient for the number
of workers seeking employment.
Minimum wage laws is one factor for the
existence of structural unemployment.
Minimum wage laws stipulate the minimum
wage that firms can pay their workers.
When a minimum wage law forces the wage to
be above the equilibrium wage that balances
supply and demand, it raises labor supply and
reduces labor demand, causing surplus labor
and unemployment.
81

MINIMUM WAGE LAWS

Real wage
Minimum wage
We

surplus

Ld Le Ls

labor supply

labor demand
quantity
of labor

82

MINIMUM WAGE

We is equilibrium wage, where labor demand

equals labor supply.

If government passes a minimum wage that is

above equilibrium, as in the diagram, labor
supply will increase to Ls and labor demand
will reduce to Ld. The difference, Ls-Ld will
be surplus labor= unemployment.
Unemployment will arise because the
number of job vacancies is insufficient to
meet the demand.

83

UNIONS AND COLLECTIVE

BARGAINING

A union is a worker association that bargains with

employers over wages and working conditions.
The process by which unions and firms agree on
the terms of employment is called collective
bargaining.
When a union bargains with a firm, it asks for
higher wages, among other things.
If the firm and union do not reach an agreement,
the union would withdraw its labor, (strike),
which is costly to the firm as it reduces
production, sales and profits. As a result, the firm
would agree to raise the wage.
84

UNIONS AND COLLECTIVE

BARGAINING

If the union raises the wage above the

equilibrium wage, it will increase labor
supply and reduce labor demand which will
result in unemployment.

85

THE THEORY OF EFFICIENCY

WAGES

A fourth reason why economies experience

some level of unemployment, in addition to
job search, minimum wage laws and unionsis suggested by the efficiency wage theory.
According to this theory, firms operate more
efficiently if wages are above equilibrium
level.
It may be profitable for firms to pay higher
wages even when there is surplus labor.

86

THE THEORY OF EFFICIENCY

WAGES

Normally, profit maximizing firms want to keep

their costs as low as possible, and that includes
wages. So why would a firm choose to pay a higher
wage?
There are four explanations
One is that a highly paid worker can afford a more
nutritious diet and afford better health care, which
makes them healthy. And healthy workers are more
productive.
A high wage would reduce workers willingness to
leave their jobs, and since hiring and training new
workers is costly to the firm, firms would rather pay
a higher wage to reduce worker turnover.
87

THE THEORY OF EFFICIENCY

WAGES

A highly paid worker is more self motivated

to work hard, and thus more productive.
So firms would pay a higher wage to increase
worker effort.
The fourth reason is that a firm that pays
higher wages will attract workers with better
quality.
And the better the quality of workers, the
more productive they will be.

88

UNIT FIVE: ECONOMIC GROWTH

5.1 PRODUCTIVITY: ITS ROLE AND

DETERMINANTS
5.2 ECONOMIC GROWTH AND PUBLIC POLICY

89

UNIT FIVE: ECONOMIC GROWTH

Among the most important questions in macroeconomics

are: why are some countries rich and others poor? How
can rich countries be sure to maintain their high living
standards? What policies should poor countries pursue to
promote more rapid growth?
As discussed, GDP measures both total income earned in
the economy and total expenditure on the economys
output.
The level of real GDP is a good gauge of economic
prosperity. And the growth of real GDP is a good gauge of
economic progress.
By understanding the determinants of the level and
growth of real GDP, we can answer the above important
questions.
90

5.1 PRODUCTIVITY: ITS ROLE

AND DETERMINANTS

Productivity refers to the amount of goods

and services a worker can produce for each
hour of work.
A nation can enjoy a high standard of living if
it can produce a large quantity of goods and
services.
Thus to understand the large differences in
living standards across nations and over
time, we have to focus on productivity and
on what determines it.

91

5.1 THE ROLE AND DETERMINANTS

OF PRODUCTIVITY
1. physical capital
Workers are more productive if they have
tools with which to work with.
More tools allow work to be done more
quickly and more accurately.
The stock of equipment and structures that
are used to produce goods and services is
called capital.
An important feature of physical capital is
that it is a factor of production that was
produced from another production process.
92

5.1 DETERMINANTS AND ROLE

OF PRODUCTIVITY
2. Human capital

A second determinant of productivity is human

capital.

Human capital is the knowledge and skills that

workers acquire through education, training and
experience.

Human capital, like physical capital raises a

nations productivity (ability to produce goods and
services).

Like physical capital, human capital is also a

produced factor of production.

Producing human capital requires inputs like

teachers, libraries, schools, and student time.
93

5.1 DETERMINANTS AND ROLE

OF PRODUCTIVITY
3. Natural resources
A third determinant of productivity is natural
resources.
Natural resources are inputs into production
that are provided by nature. Such as land,
rivers and mineral deposits.
Natural resources can be either renewable or
non renewable.
Differences in natural resources are
responsible for some of the differences in
standards in living around the world.
94

5.1 CONTINUED
4. Technological knowledge
A fourth determinant of productivity is
technological knowledge. defined as
societys understanding of the best ways to
produce output.
Advancements in technological knowledge
would increase productivity.

95

5.2 ECONOMIC GROWTH AND

PUBLIC POLICY

We have determined that a nations living

standards is determined by productivity, and
that productivity is determined by physical
capital, human capital, natural resources and
technological knowledge.
The next question is: what can governments
do to raise productivity and living standards?

96

5.2 CONTINUED
1.
.

Saving and investment

Because capital is a produced factor of
production, an economy can alter its
amount of capital.
If today the economy produces more
capital goods, then tomorrow it will have a
larger stock of capital and be able to
produce more goods and services.
One way to raise productivity is to invest
current resources in the production of
capital.
97

5.2 CONTINUED

For society to invest more in capital, it must

consume less and save more of its current
income.
Society must sacrifice consumption of goods
and services now to enjoy higher
consumption in the future.
Encouraging saving and investment is one
way governments can encourage growth of
the economy.

98

5.2 CONTINUED
2. Investment from abroad
Investment from abroad takes different forms.
A capital investment that is owned and
operated by a foreign entity is called foreign
direct investment.
An investment that is financed with foreign
money but operated by domestic residents is
called foreign portfolio investment.
In both cases, foreign resources are being used
to increase the stock of domestic capital.

99

5.2 CONTINUED

Even if foreign investors take back some of

their earned income, investment from abroad is
still one way a nation can grow.
This is so because it increases the economys
stock of capital, productivity and wages.
In addition, investment from abroad is one way
poor countries can learn better technological
procedures.
Government policies that encourage investment
from abroad are therefore encouraged,
especially for less develop economies.
100

5.2 CONTINUED
3. Education
Education-investment in human capital is important
for a countrys long run economic success.
One way in which government policy can enhance
the living standards of its citizens is by providing
good schools and encourage the population to take
advantage of them.
Investment in human capital is of particular
importance for economic development because it
conveys positive externality. (an externality is the
effect of ones actions on the well being of a
bystander.)
101

5.2 CONTINUED

For example, an educated person can

generate new ideas that others can also use.
In this case, the return for schooling is even
greater for society than for the individual.
This argument justifies the large subsidies to
human capital investment that we observe in
the form of public education.

102

5.2 CONTINUED
4. Research and development
The primary reason why living standards are
better now than before is because there has
been technological advances.
Government policies that encourage research
and development of new technologies (such
as research grants) would ultimately lead to
an increased productivity and economic
growth.

103

5.2 CONTINUED
5. The control of population growth
A countrys population is an obvious
determinant of a countrys labor force.
The more reason countries with larger
populations produce a larger GDP than
countries with smaller economies.
But a more suitable measure of well being is
GDP per capita (GDP per person) as it shows
the quantity of goods and services available
for an typical individual in the economy.
104

5.2 CONTINUED

High population growth reduce GDP per person.

When population growth is rapid, it is more difficult
to equip each worker with sufficient capital. And a
smaller quantity of capital per worker tends to
reduce productivity and GDP per worker.
Countries with high population places a burden on
the education system and reduces the possibility of
investing in more human capital.
Policies aimed at reducing the rate of population
growth is considered one way in which less
developed countries can raise their standards of
living.
105

5.2 CONTINUED
6. FREE TRADE
International trade can improve the
economic well being of citizens.
This is due to various gains from trade.
E.g. by importing some goods and services
from other economies, the citizens of the
economy will enjoy the benefits of that good
in the same way as if it had produced it.
Therefore economies are encouraged to
pursue policies that limit restriction to trade
freely with other economies.
106

5.2 CONTINUED
7. property rights and political freedom
Another way in which policy makers can foster economic
growth is by protecting property rights and promoting political
stability.
Property rights refer to the ability of people to exercise
authority over the resources they own.
A firm will not produce something if it thinks its produce will
be stolen.
For this reason, courts are important to enforce property
rights, discourage theft and ensure buyers and sellers live up
to the terms of the contract.
A weak judicial system, corruption, etc discourage savings and
investment.
Political instability also casts a doubt on whether property
rights will be respected in the future.
107

UNIT SIX: SAVING, INVESTMENT

AND FINANCIAL MARKETS

6.1 Financial markets and intermediaries

6.2 National savings and its components
6.3 Market for loanable funds
6.4 government policy on saving and
investment.

108

6.1 FINANCIAL MARKETS AND

INTERMEDIARIES

Saving and investment are key ingredients to

long run economic growth.
When a country saves a large portion of its
income, more funds are available for
investing in capital, and higher capital raises
a nations productivity and living standards.
The financial system consists of those
institutions in the economy that help to
match one persons saving, with another
persons investment.

109

6.1 FINANCIAL MARKETS AND

INTERMEDIARIES

Financial markets are financial institutions

through which a person who wants to save can
directly supply funds to a person who wants to
borrow.
The two most important financial markets in
the economy are the bond market and stock
market.
Financial intermediaries are financial
institutions through which savers can indirectly
provide funds to borrowers.
Two of the most important financial
intermediaries are banks and mutual funds.
110

FINANCIAL MARKETS

The bond market

When a firm or government wants to borrow
to finance its investment, it can borrow from
the public through the sale of bonds.
A bond is a certificate of indebtedness.
It specifies the obligations of the borrower to
the holder of the bond.
It identifies the time at which the loan will
be repaid, called the date of maturity, and
the rate of interest that will be paid
periodically until the loan matures.
111

FINANCIAL MARKETS

The buyer of the bond (lender) gives their

money to the seller of the bond (borrower) in
exchange for this promise of interest and
eventual repayment of the money borrowed
(the principal).
The buyer of the bond can hold the bond until
it matures, or can sell it earlier to someone
else.
Different bonds mature at different times:
others take few months, others many months,
and others never mature (perpetuity)
112

FINANCIAL MARKETS

Bonds differ when it comes to interest rate

based on the credit risk-the probability that
the borrower may not pay some of the
interest of principal. The higher the credit
risk, the higher the interest rate.
Because the government is considered a safe
credit risk, their bonds usually have a low
interest rate.
The interest on most bonds is taxable
income.

113

FINANCIAL MARKETS

The stock market

Another way a firm can raise funds is to sell
stock in the company.
Stock represents ownership in the firm, and is
therefore a claim to the profits that the firm
makes.
If the firm is very profitable, stockholders enjoy
the benefits of those profits.
If the firm faces difficulties, stockholders share
the loss.
Stocks offer the holder higher risk and also
potential higher return.
114

FINANCIAL MARKETS

After a corporation issues stock by selling shares to

the public, these shares trade among stockholders
on organized stock exchanges.
The prices at which shares trade on stock
exchanges are determined by the supply and
demand for the stock in these companies.
Because stock represents ownership in a
corporation, the demand and price for a stock
reflects peoples perception of the future
profitability of the corporation.
When people are optimistic about a companys
future, they raise their demand for the stock and
bid up its price. (and vice versa).
115

FINANCIAL INTERMEDIARIES

Banks
A primary job of banks is to take in deposits
from people who want to save, and use the
deposits to make loans to those who want to
borrow.
Banks pay depositors interest on their
deposits, and charge borrowers slightly
higher interest on their loans.
The difference between these rates of
interest cover the banks costs and returns
some profits to the owners of the banks.
116

FINANCIAL INTERMEDIARIES

Mutual funds
A mutual fund is an institution that sells
shares to the public and uses the proceeds to
buy a selection, or portfolio, or various types
of stock, bonds or both.
If the value of the portfolio rises, the
shareholder benefits. If it falls, the
shareholder loses.
The advantage of a mutual fund is that it
allows people with small amounts of money
to diversify.
117

FINANCIAL INTERMEDIARIES.

Holding a single kind of stock or bond is risky in

that in case of misfortune, a shareholder loses
out completely.
But by buying shares in a mutual fund, a person
indirectly becomes a part owner or creditor of
various companies. And even if one company
fails, the others may still remain profitable.
Another advantage of mutual funds is that they
give ordinary people access to the skills of
professional money managers who pay close
attention to the developments and prospects of
the companies in which they invest
118

6.2 NATIONAL SAVING AND ITS

COMPONENTS

GDP, denoted as Y, is divided into four

components of expenditure: consumption(C),
Investment (I), government expenditure (G)
and net exports (NX).
We simplify our analysis by assuming a closed
economy, meaning there are no exports and
imports and net export is zero. Therefore our
national income identity is:

Y C I G
119

6.2 CONTINUED

If we subtract C and G from both sides of the

previous equation, we obtain:

Y C G I

The left side of the equation (Y-C-G) is the total

income in the economy that remains after paying
for consumption and government purchases.
This amount is called national savings, or just
savings, denoted as S. replacing S on the left
hand side of the equation we get:
S=I
Which states that savings equals investment.
120

6.2 CONTINUED

To understand the meaning of savings, let T

denote taxes collected by government.
Public savings is what remains of government
revenue after its spending. (T-G).
If tax revenue exceeds government spending,
then government has a budget surplus and
public savings is positive.
If government spending is more than tax
revenue, then government has a budget
deficit and public savings is negative.
121

6.2 CONTINUED

Private savings is what remains of

households income after paying taxes and
spending on consumption (Y-T-C).
Public savings plus private savings gives us
national savings.
S= (Y-T-C) + (T-G)
If we remove the brackets, we realise that
the T cancel out, and we remain with an
equation for savings as we had before:
S=Y-C-G=I
122

6.3 MARKET FOR LOANABLE

FUNDS

We simplify our analysis and assume that the

economy has one financial market called the
market for loanable funds.
All savers go to this market to deposit their
savings and all borrowers go to this market to
get loans.
Thus loanable funds refers to all the income
that people have chosen to save and lend out,
rather than consume.
In the market for loanable funds there is one
interest rate which is both the return to saving
and cost of borrowing.
123

SUPPLY AND DEMAND FOR

LOANABLE FUNDS

Like any market, the economys market for

loanable funds is governed by supply and
demand.
Supply of funds come from people who have
extra income they want to save and lend out.
This can be done directly e.g. through the
buying of a bond from a firm, or indirectly
through depositing funds in a bank, which
will in turn use the funds to make loans.
In any case, saving is a source of supply for
loanable funds.
124

SUPPLY AND DEMAND FOR

LOANABLE FUNDS

The demand for loanable funds come from

firms and households who wish to borrow to
make investments.
This can be families taking out mortgages to
buy homes, or firms borrowing to buy new
equipments or build factories.
In any case, investment is the source of
demand for loanable funds.
The interest rate is the price of a loan.
Its the amount borrowers pay for loans and
the amount lenders receive on their savings.
125

SUPPLY AND DEMAND FOR

LOANABLE FUNDS

Because a high interest rate makes borrowing

expensive, a high interest rate makes
quantity of loanable funds demanded to fall.
Because a high interest rate makes saving
more attractive, a high interest rate makes
the quantity of loanable funds supplied to
rise.
The demand curve for loanable funds is
downward sloping and the supply curve for
loanable funds is upward sloping.

126

EQUILIBRIUM IN THE MARKET

FOR LOANABLE FUNDS
interest rate
supply
r*
demand
loanable
L*

funds

127

EQUILIBRIUM IN THE MARKET

FOR LOANABLE FUNDS

In the market for loanable funds, the interest

rate adjusts to bring the supply and demand
for loanable funds in equilibrium.
In the diagram above, r* is the equilibrium
interest rate, and supply and demand for
loanable funds are equal at l*.
If interest rate was lower than the
equilibrium level r*, supply would be lower
than demand, and the resulting shortage of
funds would encourage lenders to raise the
interest rate they charge.
128

EQUILIBRIUM IN THE MARKET

FOR LOANABLE FUNDS

If the interest rate was higher than the

equilibrium level, the supply of funds would
be higher than the demand.
As lenders compete for scarce borrowers,
interest rate would be driven down until it
reaches equilibrium level.

129

6.4 GOVERNMENT POLICY ON

SAVING AND INVESTMENT
The amount of savings and investment
determine the amount of capital accumulation
in the economy, which in turn determine the
level and growth of output.
Government policies can affect the level of
savings and investment in different ways.
1.Taxes and savings
Tax laws have an affect on the level of saving.
e.g, a tax on income, including interest and
dividend income reduces the future payoff
from current savings and discourages savings.

130

GOVERNMENT POLICY ON
SAVING AND INVESTMENT

A tax policy that would encourage savings,

e.g. a reduction of tax on income saved,
would increase the quantity of loanable
funds supplied at each interest rate, and will
shift the supply curve of loanable funds to
the right.
At the new equilibrium, the increase in
supply of loanable funds would reduce
interest rate. A reduced interest rate would
encourage demand for funds and investment
would increase.
131

TAXES AND SAVINGS

Interest rate
s1

s2

r1
r2
demand
l1

l2

loanable
funds
132

GOVERNMENT POLICY ON
SAVING AND INVESTMENT
Taxes and investment
Lets suppose an investment tax credit that
reduces the tax for a firm investing in new
capital.
This policy would increase the incentive to
invest and increase the demand for loanable
funds at every interest rate and the demand
curve would shift to the right.
At the new equilibrium point, the increased
demand for loanable funds would increase the
interest rate, which in turn increases the
amount saved.
133

TAXES AND INVESTMENT

Interest rate

supply

r2
r1
demand,D1 D2
L1

L2

loanable funds

134

GOVERNMENT POLICY ON
SAVING AND INVESTMENT
Government budget deficit and surplus
A budget deficit is the excess of government
spending over revenue.
Governments finance budget deficits by
borrowing in the bond market.
An accumulation of past government
borrowing is called government debt.
Government deficit or surplus has effect on
the economys allocation of resources and on
long term growth.
135

GOVERNMENT BUDGET DEFICIT

National savings, which is the supply of loanable

funds, is composed of public and private
savings.
A change budget deficit, affects national
savings and the supply of loanable funds.
When a government runs a budget deficit,
public savings are negative and national savings
are reduced.
Thus, when the government finances its budget
deficit by borrowing, it reduces the supply of
loanable funds available to finance investment
by firms and households.
136

GOVERNMENT BUDGET DEFICIT

The supply curve for loanable funds shifts to the

left.
At the new equilibrium point, the reduction in the
supply for loanable funds increases the interest rate.
The higher interest rate discourages borrowing for
investment.
The fall in investment due to government borrowing
is called crowding out.
A government budget surplus has the opposite
effect: it increases the supply for loanable funds,
reduces interest rate, stimulates investment, and
greater capital accumulation and economic growth.
137

EFFECT OF GOVERNMENT
BUDGET DEFICIT.
Interest rate

supply,S2

S1

r2
r1

l2

l1

demand
loanable
funds

138

UNIT 7: MONEY AND PRICES

7.1 money and its uses

7.2 commercial banks and the creation of
money
National banks, money supply and prices

139

7.1 MONEY AND ITS USES

Definition of money
Money is the set of assets in the economy
that people regularly use to buy goods and
services from each other.
Functions of money
Money has three functions in the economy: a
medium of exchange, unit of account and
store of value.
These functions of money distinguish money
from other assets in the economy like bonds,
stocks, real estates, etc.
140

MONEY AS A MEDIUM OF
EXCHANGE

A medium of exchange is an item that buyers

give sellers when they purchase goods and
services.
Imagine a society with no item widely
accepted in exchange or goods and servicespeople would have to rely on barter-the
exchange of one goods or services for
another.
An economy that relies on barter would have
trouble allocating its scarce resources
efficiently.
141

MONEY AS A MEDIUM OF
EXCHANGE

In a barter economy, trade requires a double

coincidence of wants-the unlikely occurrence that
two people each have a good or service that the
other wants.
E.g. If you are an economics lecturer in need of
maize, you must find a farmer willing to exchange
the maize with learning economics.
Such a system is very laborious and time consuming.
Further, a barter system poses a challenge due to
indivisibility of certain goods- e.g. 5 chickens may be
exchanged for half a goat. But a goat cannot be
divided into two, & trade would not occur.
The existence of money makes trade easier.
142

MONEY AS A UNIT OF ACCOUNT

A unit of account is the yardstick people use

to post prices and record debt.
E.g. the price of an orange is K2, its quoted
in terms of money, not other goods (like: the
price of an orange is 2 lemons).
If you borrow money, the size of your future
loan repayment is measured in kwacha
terms.
If we want to measure and record economic
value, we use money as the unit of account.
143

MONEY AS A UNIT OF ACCOUNT

In a barter system, where there is lack of a

common measure of value, the value of each
good and service is required to be stated in as
many quantities of other goods and services.
E.g. 1 orange = 2 lemons, or 4maize, or
If an economy has 100 goods and services,
then there is need for 4950 exchange rates
needed.
This makes accounting difficult, and
calculating and interpreting profits and losses
hard.
144

MONEY AS A STORE OF VALUE

A store of value is an item that people can use to transfer

purchasing power from the present to the future.
If you sale a good today and receive money, you can hold
on to it and use it at a later stage to buy something else.
There are other assets that can store value in an
economy, like stocks, bonds, bank deposits (even a
house, cattle and chickens).
However, some assets are not very liquid- they cannot be
easily transferred into a medium of exchange.
Money is the most liquid asset, but not a very good store
of value because when prices fall, the value of your
money falls. also, it can be lost, stolen and does not earn
interest.
145

MONEY AS A STORE OF VALUE

In a barter system, it is difficult to store

value
If you store your value by buying a radio,
years later it may become obsolete.
Some items are perishable and others
depreciate, posing a challenge in using them
as a store of value.

146

7.1 MONEY AND ITS USES

Kinds of money
Commodity money- this is money that takes
the form of a commodity with intrinsic value,
which means the item would have value even
if it were not used as money. E.g. cigarettes,
gold (as it can be used to make jewelry).
Fiat money-this is money without intrinsic
value.
fiat money is established as money by
government decree.
147

7.1 MONEY AND ITS USES

Money stock
Money stock is the quantity of money circulating in
the economy.
Included in the quantity of money is currency, the
notes and coins in the publics hands which are
clearly widely accepted as a medium of exchange.
But currency is not the only asset acceptable for the
exchange of goods and services.
Wealth in your checking account can also buy goods
and services.
Therefore demand deposits- the balances in your
bank account that you can access simply by writing a
check is part of the money stock.
148

7.1 MONEY AND ITS USES

Money stock
There are various measures of the money
stock in the economy.
And they include not just currency, but also
the deposits in the banks and other financial
institutions that can be readily accessed and
used to buy goods and services.

149

7.2 COMMERCIAL BANKS AND

THE CREATION OF MONEY

The amount o money includes both currency

and demand deposits.
Since demand deposits are held in the banks,
the behavior of banks can influence the
quantity of demand deposits, and as such the
money supply.
We start with a simple analysis, where
currency is the only source of money in
society.
Suppose the total quantity of currency is
k100, then the supply of money is k100.
150

7.2 COMMERCIAL BANKS AND

THE CREATION OF MONEY

Now suppose someone opens a bank, called

bank one. And accepts deposits but does not
make loans, (100 % reserve banking)
Reserves are deposits that banks receive but
do not loan out.
If the economys entire money k100 is
deposited in the bank, Bank ones financial
position will be:

151

7.2 CONTINUED

On the left hand side we have bank assets,

reserves it holds in vaults. On the right side
we have liabilities, the amount the bank
owes depositors.
The money supply in this economy is k100.
It has just changed from currency to
deposits.
Thus is banks hold all deposits in reserves,
they do not affect the money supply.

152

7.2 CONTINUED

In reality, banks do not hold all money in

reserves, they make loans and leave only a
fraction of their deposits as reserve.
The reserve ratio is the fraction of deposits
the bank hold as reserves.
Suppose bank ones reserve ratio is 10%. Its
financial situation will be:

153

7.2 CONTINUED

The money supply in the economy has now

changed. Individuals have deposits of k100, and
now borrowers hold k90 as currency.
Money supply increases to k190.
Thus, when banks hold only a fraction of their
deposits as reserves, they create money.
Note that the bank creates money, but not
wealth, because as the bank creates as asset of
money, it also creates a corresponding liability
for the borrowers.
At the end of the process, the economy is more
liquid, but not wealthier.
154

7.2 CONTINUED

The money multiplier

The creation of money does not end with
bank one.
Suppose the borrower from bank one buys
something from someone who deposits the
money in bank two. The T account for bank
two will be:

155

THE MONEY MULTIPLIER

After the deposit of k90, with a reserve ratio

of 10%, bank two keeps k9 as reserves and
makes loans of k81.
So bank two creates an additional k81
quantity of money.
If this k81 is further deposited in bank three,
bank three will have k81 deposits, k8.1
reserves and k72.9 loans. It would have
created an additional k72.9 quantity of
money.

156

THE MONEY MULTIPLIER

The process goes on and on. Each time money

is deposited and loaned out, the bank creates
money.
The total amount of money created in the
economy will be: k100 original deposit. K91
created by bank one, k81 created by bank two,
k72.9 created by bank three. And so on and
so forthuntil the total quantity is k1,000.
The amount of money the banking system
generates with each kwacha of reserves is
called the money multiplier.
157

THE MONEY MULTIPLIER

In this economy, k100 of reserves generated k1000. and

the money multiplier is 10.
The money multiplier is determined by the reserve ratio.
The money multiplier is the reciprocal of the reserve
ratio: 1/reserve ratio. (1/R)
If the reserve ratio is 10%=0.1, the money multiplier is
1/0.1= 10. meaning k100 of reserves will create 100
times 10=1000 money.
If the reserve ratio is 5%=0.05. the money multiplier will
be 1/0.05= 20. and reserves of 100 will generate 100
times 20=2000 money.
The higher the reserve ratio, the smaller the multiplier
and the less the money created.
158

7.3 NATIONAL BANKS AND THE

MONEY SUPPLY.

The role of the central bank

The national bank, or central bank is an
institution designed to oversee the banking
system and regulate the quantity of money in
the economy.
The central bank regulates banks and ensures
the smooth running of the banking system.
It also acts as a banks bank. It makes loans to
the banks, and acts as lender of last resort for
banks with financial troubles.
The central bank controls the quantity of money
made available in the economy (money supply).
159

7.3 NATIONAL BANKS AND THE

MONEY SUPPLY.

Tools for monetary policy

Decisions by policy makers concerning the
money supply constitute monetary policy.
The central bank has three tools for
monetary policy.
(1) open market operations
(2) reserve requirements
(3) the discount rate.

160

OPEN MARKET OPERATIONS

The central bank conducts open market

operations when it buys or sells government
bonds to the public.
To increase money supply, the central bank buys
bonds from the public in exchange for currency,
in this way increasing the money supply.
To reduce money supply, the central bank sells
government bonds to the public.
The public pays for the bonds with its holding of
currency and bank deposits, directly reducing
the amount of money in circulation.
161

RESERVE REQUIREMENTS

Reserve requirements are regulations on the

minimum amount of reserves the bank can
hold against its deposits.
Reserve requirements influence how much
money banks can create.
An increase in the reserve requirement
means banks mush hold more reserves and
make few loans, and this reduces the money
multiplier and the amount of money created.

162

THE DISCOUNT RATE

The discount rate is the amount of interest

rate on the loans the central bank makes to
commercial banks.
A bank borrows from the central bank when it
has too few reserves to meet reserve
requirements, or it has more withdrawals from
depositors it cant meet, or its facing financial
difficulties.
When the discount rate is increased, banks are
discouraged from borrowing and will be forced
to keep more reserves, thus reducing the
amount of loans and creation of money.
163

MONEY GROWTH AND

INFLATION

The classical theory of inflation

We defined inflation rate as the percentage
change in the overall price level.
If over time we observe the price of a good rise,
its less likely that the value of the good has
increased, but that the value of the money used
to purchase the good has reduced and now
consumers have to spend more on the same good.
Suppose p is the price level as measured by CPI
or GDP deflator, and measures the number of
kwachas required to buy a basket of goods and
services.
164

MONEY GROWTH AND

INFLATION

Then the quantity of goods and services that

can be bought by k1 is 1/p.
This means 1/p is the value of money
measured in terms of goods and services.
If the price level increases, the value of
money falls.
Just like any good in a market, the value of
money is determined by the supply and
demand for money.

165

SUPPLY AND DEMAND FOR

MONEY

In the preceding discussion, we have determined how

money supply is determined by the central bank and
the banking system.
The demand for money is determined by many factors.
But the most important factor determining how much
money people chose to hold is the average price level.
People hold money because it is a medium of
exchange, used in transacting.
The higher the price, the more money a typical
transaction requires and the money people choose to
hold.
That is, the higher the price level, the lower the value
of money and the more the money demanded.
166

SUPPLY AND DEMAND FOR

MONEY

In the long run, the price level adjusts to bring

supply and demand for money to equilibrium.
If the price level is above equilibrium, people
will want to hold more money than the central
bank has made available. So the price level
must fall to balance supply with demand for
money.
If the price level is above equilibrium, people
will want to hold less money than the central
bank has supplied. And the price level must
rise to balance supply and demand.
167

SUPPLY AND DEMAND FOR

MONEY
Value of
Money,1/P

money
supply

price
level, P

low price level

Eq money
Value, 1/p

eq price level,p
money
demand high price level
eq quantity

quantity of
money

168

SUPPLY AND DEMAND FOR

MONEY

The supply of money curve is vertical

because quantity of money supplied is fixed
by central bank.
The demand curve for money is downward
sloping because when the value of money is
low (and the price is high) people demand a
larger quantity of money to buy goods and
services.

169

EFFECTS OF MONETARY POLICY

If the central bank was to increase money

supply, the money supply curve would shift
to the right.
The value of money decreases and the price
level increases.
This is the quantity theory of money, which
suggests that the quantity of money in the
economy determines the value of money, and
the growth in the quantity of money is the
primary cause of inflation.

170

EFFECTS OF MONETARY POLICY

Value of
Money,1/P

MS1

MS2

price
level, P

low price level

Fall in
moneyValue
rise in price
MD
M1

M2

quantity of
money

171

UNIT 8: SHORT TERM ECONOMIC

FLUCTUATIONS

8.1 recessions and expansions

8.2 Aggregate demand and aggregate supply
8.3 Causes of economic fluctuations
8.4 influence of monetary and fiscal policy
on aggregate demand.

172

8.1 RECESSIONS AND

EXPANSIONS

Economic activity fluctuates from year to

year.
The business cycle refers to irregular
fluctuations in real GDP.
In most years, the production of goods and
services rises. Because of increases in the
labor force, increases in capital stock,
advancement in technological knowledge,
the economy can produce more and more.
this phase of the business cycle is called the
expansion phase.
173

8.1 RECESSIONS AND

EXPANSIONS

However, in some years, this normal growth

does not occur. Firms find themselves unable
to sell all their output, they cut back on
production, some workers are laid off, and
factories are left idle. And real GDP declines.
Such a period of failing incomes and rising
unemployment is called a recession if its
mild, and a depression if it is severe.

174

8.2 AGGREGATE DEMAND AND

AGGREGATE SUPPLY

We analyze fluctuations in the economy using

the model of aggregate demand and supply.
We plot the price level on the vertical axis,
where price is measured using the GDP
deflator or CPI.
On the horizontal axis we have the total
quantity of goods and services produced in
the economy, as given by real GDP.
According to this model, the price level and
quantity of output adjusts to bring aggregate
demand and aggregate supply into balance.
175

THE AGGREGATE DEMAND

CURVE

The aggregate demand (AD) curve shows us the

quantity of all goods and services demanded in
the economy at any given price level.
The AD curve slopes downwards, meaning that
other things being equal, the fall in the overall
price level will increase the quantity of goods
and services demanded.
Aggregate demand is divided into four
components: consumption (C), investment (I),
government spending (G) and net exports (NX)
AD=C+I+G+NX
176

COMPONENTS OF AGGREGATE
DEMAND

Consumption consists of all goods and

services bought by households.
We have non durable goods that last a short
time like food and clothing. We have durable
goods that last a long time like cars and TVs.
We have services which include work done
for consumers by individuals and firms like
hair cuts and doctor visits

177

COMPONENTS OF AGGREGATE
DEMAND

Investment consists of goods bought for

future use.
We have business fixed investment which is
the purchase of new plant and equipment by
firms. Residential investment is the purchase
of new housing by households and landlords.
Inventory investment is the increase in the
firms inventory of goods

178

COMPONENTS OF AGGREGATE
DEMAND

Government purchases are goods and

services bought by the government. This
includes items like military equipment,
highways, and services that government
workers provide.
It does not include transfer payments to
individuals such as social security and
welfare because transfer payments
reallocate existing income and are not made
in exchange for goods and services.

179

COMPONENTS OF AGGREGATE
DEMAND

Net exports takes into account trade with

other countries. It is the value of goods and
services exported to other countries, minus
the value of imports.
For our analysis, we will simplify our
economy to a closed economy.
That means we will exclude the external
economy, and aggregate demand for our
output will not have net exports.
AD=C+I+G+NX
180

CONSUMPTION

Households receive income from their labor

and ownership of capital. They pay taxes to
the government, and then decide how much
of their after tax income to consume and
save.
The income that households receive equal to
the national output Y.
The amount of taxes households pay to the
government is T
Income after all payments of taxes, Y-T is
called disposable income.
181

CONSUMPTION

Households divide their disposable income

between saving and consumption.
We assume that the level of consumption
spending directly depends on the level of
disposable income.
The higher the disposable income, the higher
the level of consumption.
We also assume that consumers consume a
certain amount even when income is zero.
We call this amount of consumption that does
not depend on income as autonomous
consumption.
182

CONSUMPTION

the marginal propensity to consume (MPC) is the

amount by which consumption changes when
disposable income increases by one unit.
The MPC is between zero and one. That means an
increase in income of k1 will increase
consumption, but by less that k1. they will save a
portion of it.
E.g. if MPC is 0.8. it means an increase in income
of k1 will increase consumption by k0.8, and the
other portion of k0.2 will be saved.
The slope of the consumption function is the MPC
and the intercept is the autonomous consumption.
183

CONSUMPTION FUNCTION
consumption

consumption function
C= a+ b(Y-T)
slope=b=MPC

Intercept=a
disposable
income

184

INVESTMENT

The quantity of investment goods demanded (I)

depends on the interest rate (r ).
I=I(r)
The interest rate measures the cost of the funds
used to finance investment.
The investment function is downward sloping.
If the interest rate rises, most investment
projects are not profitable and the amount of
investment goods demanded falls.
If the interest rate falls, the cost of borrowing
reduces and more goods are demanded for
investment.
185

INVESTMENT FUNCTION
Real interest rate

investment function. I (r )
quantity of
investment
186

GOVERNMENT PURCHASES

The level of government spending is

determined outside our model, it is taken as
a given variable.
It is fixed by government policies.

187

AGGREGATE DEMAND CURVE

We have looked in detail at the components

of AD.
And we determined that the AD curve slopes
downwards.

Price
level
AD curve
quantity of output
188

WHY THE AD CURVE SLOPES

DOWNWARDS
Why does a fall in the price level lead to an
increase in quantity demanded? To answer
this question we refer to the components of
AD.
1. The price level and consumption: the
wealth effect
. when prices fall, the real value of your
money increases. This makes consumers
feel more wealthy, which encourages them
to spend more. Increase in consumption
increases aggregate demand.

189

WHY THE AD CURVE SLOPES

DOWNWARDS
2. The price level and investment: the interest
rate effect
When the price level falls, the less the money
households need to hold to buy goods and
services.
When prices fall, households reduce their
holding of money by lending some of it.
The increase in the supply of loanable funds will
drive down the interest rate.
A fall in interest rate will encourage investment.
An increase in investment demand increases AD.
190

WHY THE AGGREGATE DEMAND

CURVE MIGHT SHIFT

the AD curve slopes downwards, showing that

a fall in the price level will increase the
quantity of goods and services demanded.
However, the quantity of goods and services
demanded at a given price can change, thus
shifting the AD curve.
Many factors can shift the AD curve, as
discussed below.

191

WHY THE AGGREGATE DEMAND

CURVE MIGHT SHIFT
1.Shifts arising from consumption
Any event that increases consumption at a given
price level will shift the AD curve.
E.g. if suddenly people became more concerned
about saving for retirement and increased their
saving and reducing their consumption, quantity
demanded will reduce at any price level and the
AD curve will shift to the left.
When government reduces taxes, people are
encouraged to spend more, increasing quantity
demanded and shifting AD curve to the right.
192

WHY THE AGGREGATE DEMAND

CURVE MIGHT SHIFT
2.Shifts arising from investment
An event that makes firms invest more at a
given price level, such as optimism about the
future, will shift the AD curve to the right.
An event that makes firms invest less at a
given price level, such as pessimism about
the future, will shift the AD curve to the left.
An investment tax credit will increase
investment demand at any price and will
increase AD, shifting the AD curve to the
right.
193

WHY THE AGGREGATE DEMAND

CURVE MIGHT SHIFT
3. Shifts arising from government purchases
If the government increased its spending,
say, on military, education, infrastructure,
etc., this will increase the quantity of goods
and services demanded in the economy, and
will shift the AD curve to the right.

194

THE AGGREGATE SUPPLY CURVE

The aggregate supply curve shows the quantity of

goods and services that firms produce and sell at
each price level.
The aggregate supply curve is vertical in the long
run and upward sloping in the short run.
In the long run, an economys production of goods
and services depends on the supplies of labor,
capital, natural resources and technological
knowledge.
Because these determinants of real GDP are not
influenced by the price level in the long run, the
long run aggregate supply (LRAS) curve is vertical.
195

THE AGGREGATE SUPPLY CURVE

Price level
long run
aggregate supply

quantity of output
natural
rate of output
196

WHY THE LONG RUN AGGREGATE

SUPPLY CURVE MIGHT SHIFT

1. shifts arising from labor

Suppose the economy experiences an
increase in immigration from abroad and this
leads to a greater number of workers, then
quantity of goods and services supplied will
increase, the LRAS curve will shift to the
right.
But if many workers were to leave the
economy to work abroad, the quantity of
goods and services produced would reduce
and the LRAS curve would shift to the left.
197

WHY THE LONG RUN AGGREGATE

SUPPLY CURVE MIGHT SHIFT

2. shifts arising from capital

An increase in the economys capital stock will
increase productivity and the quantity of goods and
services supplied. The LRAS curve will shift to the
right. And vice versa.
3. shifts arising from natural resources
A change in natural resources, e.g. a discovery of a
new mineral deposit will increase supply of output
and the LRAS curve will shift to the right.
Conversely, a negative natural factor like change in
weather patterns that makes farming difficult will
reduce output and shift the LRAS curve to the left.
198

WHY THE LONG RUN AGGREGATE

SUPPLY CURVE MIGHT SHIFT

4.shifts arising from technological knowledge

An advancement in technological knowledge
will increase productivity, increase output
and shift the LRAS curve to the right.

199

WHY THE SHORT RUN AGGREGATE

SUPPLY CURVE SLOPES UPWARDS

In the short run, an increase in the overall

price level will raise the quantity of goods
and services supplied. (and vice versa).

Price level

short run
aggregate supply

quantity supplied
200

WHY THE SHORT RUN AGGREGATE

SUPPLY CURVE SLOPES UPWARDS
1.The misperception theory
An unexpected low price level will lead suppliers to
think their relative prices (return from selling output)
have fallen and will be led to reduce output supplied.
2. The sticky wage theory
An unexpected low price level will raises the real
wage, which causes firms to hire fewer workers, and
produce a smaller output
3.The sticky price theory
An unexpected low price level leaves some firms with
higher-than-desired prices, which depresses their
sales and leads them to cut back on production.
201

WHY THE SHORT RUN AGGREGATE

SUPPLY CURVE MIGHT SHIFT
The factors that shift short run aggregate
supply curve are the same as those that shift
the long run aggregate supply curve:
Shifts arising from changes in labor
Shifts arising from changes in capital
Shifts arising from changes in natural
resources
Shifts arising from technology.

202

8.3 CAUSES OF ECONOMIC

FLUCTUATIONS

Causes of fluctuations in the short run can be

explained by two causes: shifts in aggregate
demand, and shifts in aggregate supply.
We start our analysis by considering an economy
in equilibrium.
Equilibrium output and equilibrium price level
are determined at the point of intersection of
the aggregate demand curve and the long run
aggregate supply curve.
At this point, output is at its natural rate, and
short run aggregate supply curve passes through
this point as well (as shown in the graph below).
203

LONG RUN EQUILIBRIUM

price level

LRAS

SRAS

Eq price
level
aggregate demand
quantity
natural rate
of output
of output
204

8.3 CAUSES OF ECONOMIC

FLUCTUATIONS
1.EFFECTS OF A SHIFT IN AGGREGATE DEMAND
Suppose due to any of the reasons earlier discussed,
aggregate demand (AD) reduced.
The aggregate demand curve would shift to the left.
As shown in the next graph, in the short run, the
effect of this shift will be that the economy will
move along the initial SRAS curve, AS1. moving from
point A to B.
As the economy moves from point A to B, output falls
from Y1 to Y2, and the price level falls from P1 to
P2. And firms reduce their employment of labor.
These changes indicate that the economy is in
recession.
205

EFFECTS OF A SHIFT IN
AGGREGATE DEMAND
price level

p1
p2

LRAS

SRAS 1

A
B
AD1 AD2
y2 y1

quantity
of output

206

EFFECTS OF A SHIFT IN
AGGREGATE DEMAND

Over time, as perceptions, prices and wages

adjust, the short run aggregate supply curve
shifts to the right.
In the long run, the economy will be restored
back to its natural rate of output., but the
price will have reduced to p3.
The new aggregate demand curve, the new
short run aggregate supply curve, and the
long run aggregate supply curve once again
intersect and the economy is in long run
equilibrium.
207

EFFECTS OF A SHIFT IN
AGGREGATE DEMAND
price level

LRAS

SRAS 1
SRAS 2

p1
p2
P3

A
B
C
AD1 AD2
y2 y1

quantity
of output

208

8.3 CAUSES OF ECONOMIC

FLUCTUATIONS
2. EFFECTS OF A SHIFT IN AGGREGATE SUPPLY
Suppose the economy initially is in equilibrium
at point A. with equilibrium price p1, and
equilibrium output Y1.
If there is a reduction in quantity supplied, so
that the short run aggregate supply curve shifts
to the left.
The economy will move along the aggregate
demand curve from pint A to B.
Prices will increase from p1 to p2 and output
fall from y1 to y2, a situation referred to as
stagflation.
209

EFFECTS OF A SHIFT IN
AGGREGATE DEMAND
price level

LRAS

SRAS 2
SRAS 1

p2
P1

B
A
AD1
y2 y1

quantity
of output

210

EFFECTS OF A SHIFT IN
AGGREGATE DEMAND

In the long run, as perceptions, prices and

wages adjust, the short run aggregate supply
curve shifts back to SRAS1.
The economy will move back to point A.
Output will get back to its natural rate.
where again the AD, LRAS and SRAS curves
intersect.

211

8.4 INFLUENCE OF MONETARY

AND FISCAL POLICY ON
AGGREGATE DEMAND.

Fiscal policy refers to the deliberate

manipulation of government income and
expenditure to influence output, income,
prices and employment.
The fiscal instruments are government
spending and taxes.
Suppose the economy experiences excessive
demand, so that the economy wants to spend
more than it has produced, the government
can take the following steps:
212

8.4 CONTD

Increase tax rates to reduce disposable

income and hence consumption spending.
Reduce its own demand of goods and
services.
If the economy experiences deficient
demand, so that the economy is producing
more than it can demand, the government
can:
Reduce taxes to encourage spending
Increase its own expenditure.
213

8.4 CONTD

Monetary policy involves the management of

a nations money, credit and banking system.
By changing the money supply, the
government can influence economic
variables like interest rate, prices , exchange
rates.
E.g. by reducing money supply, people will
have less money to spend on goods and
services, which will lead to a fall in prices.
Increase in money supply can also reduce
interest rate and encourage investment.
214