GREAT ZIMBABWE UNIVERSITY

ECONOMICS DEPARTMENT

PRINCIPLES OF MACROECONOMICS READING MATERIAL

Course Instructor: Saungweme Talknice
E-mail: tsaungweme@gzu.ac.zw
Mobile: +263 772 685 837 / 715 109 838

COURSE CONTENT

1. INTRODUCTION
• Definition and key concepts of Macroeconomics
• Macroeconomic objectives
• Determinants of Aggregate Demand and Aggregate Supply

2. NATIONAL INCOME ACCOUNTING

• Measuring macroeconomic activity
• Concepts of national income and price indices
• Measures of aggregate income
• Problems of measurement
• National income information and limitations

3. MONEY BANKING AND THE MACROECONOMY

• Characteristics of money and its functions
• Motives for holding money
• The classical quantity theory of money
• Monetary policy and its instruments

4. CONSUMPTION, SAVING AND INVESTMENT

• Consumption-Income relationship
• Saving-Investment Equilibrium
• Investment Theories

5. THE GOVERNMENT SECTOR

• Effects of Government on Aggregate Demand
• The Budget

6. INFLATION
• Definition and measurement
• Causes and types of inflation
• Effects of inflation
• Remedies and policy prescriptions
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 • Unemployment and inflation – the Philips curve

7. UNEMPLOYMENT
• Measurement of unemployment
• Causes and types of unemployment
• Effects of unemployment
• Policy prescriptions

8. INTERNATIONAL TRADE
• The pattern of international trade
• Terms of Trade
• Benefits of free trade
• Costs of international trade and trade policy
• Tariff and non-tariff barriers to trade

9. BOP
• Basic concepts
• BOP components
• Importance
• Empirical analysis

REFERENCES

Dornbusch R. and Fischer S. “Macroeconomics” 6th edition, Lexicon publishers, Johannesburg

Gwartney J. et al (2001), “Macroeconomics: Public and Private Choice” 3rd edition. Academic
press

1. INTRODUCTION

- Microeconomics is the study of how households and firms make decisions and how these
decision makers interact in the broader marketplace. In microeconomics, an individual chooses
to maximize his or her utility subject to his or her budget constraint.
- Macroeconomic events arise from the interaction of many individuals trying to maximize their
own welfare. Because aggregate variables are the sum of the variables describing individuals’
decisions, the study of macroeconomics is based on microeconomic foundations.

What is Macroeconomics?
- The study of aggregate economic variables in an economy e.g., national income, employment,
money supply, interest rates, exchange rates, prices, etc
- Study of the entire economy in terms of the total amount of goods and services produced, the
total income earned, the level of employment of productive resources, and the general behaviour
of prices.
- The study of how the economic aggregates grow and fluctuate, and the effects of government
actions on them.
- Macroeconomics involves the use statistical tools to analyse the interrelations among sectors
within the economy and how best to influence policy goals such as economic growth, price
stability, full employment and the attainment of a sustainable balance of payments.

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How to aggregate
- Use index numbers to represent macroeconomic variables, e.g., unemployment rate, trade-
weighted exchange rate, consumer price index.
- Index numbers are statistical measures that are used to give summary answers to changes in
macroeconomic variables. They measure the change that has occurred in some broad average
over some particular time period.
- Index numbers are calculated by assigning weights (weights are chosen to reflect the importance
of each price of output) to commodity prices and relate them to some chosen base period. The
value of the index is set equal to 100 in the base period.

- e.g., Prices and Inflation

- In microeconomics, we are more interested in the prices of individual goods and services;
however, in macroeconomics we are interested in how the price level changes over time.
- Price level refers to an index number computed from the prices of a broad group of goods and
services; i.e.it is a weighted average of different prices. The common index number of prices is
the Consumer Price Index (CPI).
- The price level is calculated from a defined basket of goods and services.
- We are rarely interested in the value of the price level per se, but in its percentage change over
two given periods.
- The rate of inflation, therefore, is the percentage rate of increase in CPI from one period to
another.

Macroeconomics objectives

- These objectives measure how well an economy is performing.

1. Economic growth – is measured by changes in GDP. GDP is defined as the total value of
final goods and services produced in the geographical boundary of an economy within a
given period of time. Economic growth is experienced when GDP increases year after year.

2. Price stability – the rate of inflation should not only be low, preferably one digit, but also
stable.

3. Full employment – the unemployment rate is a measure of the total number of

unemployed people as a proportion of the labour force. When unemployment levels
fluctuate, so does output, since output is produced using labour inputs. The extent to which
employment falls short of the full employment level explains the output gap. Output gap
is the difference between potential output and the actual output. Economic performance is
measured in terms of the general trend of output and in terms of whether the output gap is
decreasing or increasing. A. Okun, a leading analyst of the output gap, studied the
relationship between unemployment and output, i.e., real growth and unemployment rate.
Okun’s law says that the unemployment rate declines when growth is above the trend rate
of 2.25%. Specifically, 1% growth in real GDP above the trend rate, unemployment
declines by one-half percentage point. This relationship has been found to be applicable to
several countries tough with a different factor of proportionality between unemployment
and output. Full employment occurs when all the resources in an economy are being fully
utilised efficiently and effectively. An economy is said to be experiencing full employment
when it is operating on the frontier of the production possibility curve.

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 4. External balance (BOP) - BOP is a record of a country’s transactions with the rest of
the world. BOP surplus occurs when foreign currency receipts are greater than outflows,
whilst the reverse is a deficit. NB, neither a surplus nor deficit is health for the economy.

5. Equitable distribution of income – an economy should have an equitable distribution of

income so as to maximise social welfare. Social welfare, according to Pareto efficiency, is
maximised when someone cannot be better-off without making someone worse-off.

▪ Within macroeconomics analysis, the two types of economic fluctuations are of particular
important:

1. Long and sustainable deviations of unemployment from historical averages.

2. Continuing periods of intractable high unemployment e.g., the great depression in the
1930s, Western European Crisis (1975-1980), etc

▪ Notable observations/synchronised shift in crucial economic variables around a trend is

known as business cycle. According to Chidhakwa (2000), Business cycle refers to the
pattern followed by an economy and includes troughs, recovery, expansion, boom, and
recession/contraction.
▪ Business cycles represent short term fluctuations of output and employment lasting 3-4
years. A key feature of business cycles is that crucial macroeconomic variables like output,
prices, investments, monetary variables tend to move together in a systematic fashion. NB,
according to the Classical school (before 1930), the macroeconomics is self correcting.

AGGREGATE DEMAND AND SUPPLY

▪ Aggregate demand (AD) is the total amount of goods and services in the economy that
economic agents are willing to supply at a given price level. The AD can be shifted by
monetary and fiscal policies.
▪ Aggregate supply (AS) is the total amount of output that firms and households choose to
provide given the pattern of wages and prices in the economy. The supply function is given
by:

S x = f ( Px , Pf , K , T ) , that is AS is influenced by price of output, price of factors of

production, capital and technology.

▪ Households make decisions on how much labour to supply, whilst firms decide on how
much output to supply basing on both current and expected future prices.
▪ Shifts in either AS or AD will cause the level of output to change – thus affecting economic
growth - and will also change the price level (inflation). Through Okun’s law, changes in
output are linked to changes in the unemployment rate.

Economic Equilibrium Classical case Keynesian Case

P
AS AS
AS

AD1 AD1

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AD0
AD

Q
2. NATIONAL INCOME ACCOUNTING (NIC)

- The four key macroeconomic variables in any economy are economic growth,
unemployment, inflation and Current Account balance. There are obviously other issues
of concern that augment these ones.
- National income accounting is the set of rules and techniques for measuring the total flow
of output produced and the total flow of incomes generated in an economy.
- The NIC give regular estimates of GDP, the basic measure of the economy’s performance.
They also provide useful conceptual framework for describing relationships among three
key macroeconomic variables: output, income and spending.
- National income accounts are used in a country for the purposes of planning, decision-
making and forecasting. Income is derived from the output and when received it is spent.
The most popular identity in this area is depicted by National Income=National
Output=National Expenditure, (i.e., NI=NQ=NE). This implies that there are three
definitions of national income.

1. It is the income that is earned by all economic agents during a specific period, usually a
year.
2. It is the value of output produced by all economic agents during a given period, usually a
year.
3. It is the value of the expenditure incurred by all economic agents during a given period,
usually a year.

Ray Powel (1988) notes that all the identities used in NI accounting are ex post as they measure
what has actually happened in the economy as opposed to the wishes or intentions of the
citizens.

TERMS ASSOCIATED WITH NATIONAL INCOME

1) Gross Domestic Product [GDP]

- It is the total internal output. It also represents the value of the final output produced by all
enterprises within the boundaries of a nation irrespective of the owners of the means of
production. GDP consists of value of currently produced output. That is, it excludes
transactions in existing commodities, such as existing houses. In Zimbabwe, there are
Chinese firms, Nigerian firms, Zimbabwean firms etc and all their output will be the
national GDP.
- Chidhakwa (2000) says it is the money measure of the overall annual flow of goods and
services in an economy.
- GDP values goods at market prices, not at factor prices.

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 2) Gross National Product [GNP]

- It is the total national output. GNP is the value of final goods and services produced by
domestically owned factors of production within a given period of time. The income is
accumulated from Zimbabweans abroad and Zimbabweans in Zimbabwe. It is the output
produced by the people of a nation irrespective of where they are doing their business. In
Zimbabwe there are Zimbabweans who run businesses and there are also Zimbabweans
with businesses abroad and the total represents GNP. In other words, it is the total output
from factors of production owned by residents of a country.

3) Statistical Discrepancy

- In calculating national income, there may be material misstatements, omissions, errors,

and fraudulent misrepresentations, to an extent that national output totals will never be
accurate or equal to expenditure or income.

4) Nominal GDP VS Real GDP

- Nominal GDP is GDP at current prices while real GDP is GDP at constant prices or prices
adjusted to a chosen base year.

5) Per Capital Income

- This is total national income divided by total population. The idea is to try and find out the
average income distribution amongst the citizens of an economy, not necessarily sharing
the income. The ratio is a good measure of general economic performance, though non-
deterministic on its distribution.

IMPORTANCE OF NATIONAL ACCOUNTS

➢ It enables economists and policy makers to:

1. Assess the health of the economy by comparing levels of production at regular intervals –
that is, national accounts are a tool of analysing the components (sectors), as well as the
overall performance of an economy
2. Track the long run course of the economy to see whether it has grown, has been constant,
or declined
3. Formulate policies that will safeguard and improve the economy’s health
4. Also important to politician for political mileage
5. Private business- on relation to inflation, investment

PROBLEMS ASSOCIATED WITH CALCULATING NI

i. Some firms supply wrong figures to reduce the amount of tax they are due to pay.

ii. Some goods may be produced, but not taken to the market, thus the value is not known.

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iii. Illegal services such as prostitution, thefts etc, are not recorded yet substantial amounts will
be involved e.g., Zimbabweans may steal cars worth Z$10 trillion from abroad into
Zimbabwe.

iv. The black market or underground economy is also excluded. Although estimates are made,
they are usually misleading.

v. Double counting which inflates the figures of the value of output. This is when value of
intermediate goods is counted, e.g., bread contains the value of wheat and flour and to add
the value of wheat to that of flour and then that of bread involves double counting. This
problem can be avoided by taking only values of final goods.

vi. Output produced for personal consumption is not recorded as it is not taken to the market
and is difficult to quantify or value.

METHODS OF CALCULATING NI

Since output=income=expenditure, there are therefore three methods of calculating NI, i.e. the
output, income and expenditure methods.

(a) THE OUTPUT METHOD

This represents the total value of output produced by all economic agents in an economy during
a specific period of time, usually a year. The major problem associated with this method is that
of double counting i.e. when the value of a product is counted twice. This occurs due to the
presence of intermediate goods, i.e. those goods, although finished, need to be processed to
produce final goods e.g. flour is an intermediate good for production of bread. The value of
flour is counted twice, firstly as flour and secondly in bread.

Simple example: sales of wheat = $ 50m

flour = $ 80m
bread = $ 120m
Total = $250m X
This is incorrect because the value of bread includes value of wheat that has been used to make
bread.

- To correct this, we measure the VALUE ADDED by each sector and add up the value
added to come up with the GDP figure.
- To avoid double counting we take care to include only final goods in GDP and to exclude
intermediate goods that are used up in making final goods.
- Value added = value of sales minus cost of intermediate inputs
- Intermediate inputs are inputs bought from other producers e.g., wheat not labour

Correction of the double counting method – Value addition method

Purchases ($m) Sales ($m) Value

added

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 wheat O 50 50
Flour 50 80 30
Bread 80 120 40
Total $120m

➢ In simple terms we can add up the output of all the sectors (industry) of in the economy
e.g. agriculture, mining, manufacturing, construction etc
➢ Simple example: Zimbabwe’s GDP 2005 (output method)

Industry $m % contribution to GDP

agriculture 15 283 ?

Mining 3846

Manufacturing 14668

construction 1943

Finance 6370

Public administration 3324

Education 3602

Health 4200

other 2795

Electricity and water 2409

Transport &communication 4200

Distribution , hotels 15630

Real Estate 1526

Other services 2795

GDP at Factor cost 76 660

Net taxes on production 834

GDP at market prices 85 585

Further, GNP and GDP at market prices suffer the distortions caused by subsidies and taxes.
Hence, to change these variables (GNP sand GDP) to factor prices, we simply subtract the taxes
and add the subsidies. This is because when the prices where being charged at the market, subsidies
were subtracted and tax added.

(b) THE INCOME METHOD

▪ Add up all incomes earned by factors of production in an economy over a given period

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 ▪ Production of a nation output generates income. Labour must be employed, land must be
rented, and capital must be used
▪ These include factor payment:-
1. Wages- payment for services for labour
2. Rent- incomes received by household and business that supply property resources. Also to
be included is imputed rent for the use of owner occupied housing
3. Proprietor's income- people earning a living but who are not employed by any one
organization e.g. consultants
4. Corporate profits- earnings of owners of corporation. Divided into three corporate income
taxes, dividends and retained earnings
N.B: GDP at factor cost- this is the sum of four components of factor income- wages, self
employment income, rent and profits.

Transfer incomes should be ignored. This is an income that is received from the government
but a person would not have provided any corresponding output, e.g. students’ grants,
unemployment benefit etc. Incomes from self provided activities should be included. The same
applies to income from black market activities. In reality however, there are serious problems
in estimating the level of ‘hidden economy’, and the poorer the economy the greater the size
of this sector and the more disastrous it is to ignore it.

Example of Income Approach:

Factor payments $m % contribution to GDP

Wages 30489

Rent 1432

Gross operating surplus 45545

Less imputed banking charges -1223

GDP at Factor cost 76242

Net other taxes on production 417

Net taxes on products (+ indirect 8925

taxes- subsidies)

GDP at market Price 85585

Net factor income from abroad -2931

Gross National Income 82654

(c) EXPENDITURE METHOD

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 ▪ This involves totalling of expenditure incurred on final goods and services by all
economic agents in an economy.

▪ GDP = C + G + I + X – M

1. Consumption (C)- also called personal consumption expenditure. It covers all expenditure
by household on durable goods (e.g. refrigerators), non durable goods( bread) and
consumer expenditure for services ( lawyers)
2. Government Expenditure (G)- is encompass all government purchases of goods and
services. Government purchases consumption goods like food for military and investment
type items such as computers
3. Gross private Investment (I)- these include all purchases of machinery, equipment and
tools by business enterprise, all construction and change in inventory. Gross investment
refers to all investment goods. It includes investment in replacement capital and in added
capital both those that replace machinery, equipment that were used up in producing
current output. Net Investment includes only investment in the form of added capital.
Amount of capital used up over the course of the year is called depreciation. Subtracting
depreciation from GDP gives us Net Domestic product (NDP)
4. Net exports (X – M) - is the difference between exports(X)and imports (M). Comes because
of international trade

Expenditure $m % contribution to GDP

Private consumption 113883 ?

Consumption of private non profit bodies 401

Government consumption 12605

Gross capital formation 21978

Gross fixed capital formation 18804

Total increase in stocks 3174

Net exports 163

GDP at market price 85585

Other aspects on National Accounts

1. Net National Product- which is found by subtracting depreciation (consumption of fixed

capital) from GDP
2. Gross National Product- is found by adding net factor income from abroad to GDP. Net
factor income is found by : factor income received from abroad minus factor income paid
abroad
3. Disposable income – is personal income less personal taxes. Personal income includes all
income whether earned or unearned (transfer payments) Personal taxes include income

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 taxes, personal property taxes and inheritance taxes. Disposable income can be used for
consumption or saving purposes
Nominal vs Real GDP

▪ Prices used to calculate GDP are nominal prices hence they change in response to inflation.
We are more interested in real income not nominal income, because we might think that
production of goods and services have increased while they are prices that are increasing.
▪ So, the practical issue is how we can compare market values of GDP from year to year if
the value of money itself changes in response to inflation or deflation.
▪ What matters to us is the quantity of goods that get produced and distributed to household
that affect their standard of living not the price of goods.
▪ So, economist should know how adjust from nominal to real GDP. The issue is to deflate
GDP when prices rise and inflate GDP when prices falls
▪ Nominal GDP (GDP at current prices)- measuring GDP for a particular year using the
actual market price of that year (PQ). It represents total money value of final goods and
services produced in a given year
▪ Real GDP (GDP at constant Prices)- GDP that has been deflated or inflated to reflect
changes in the price level. It removes price changes from nominal GDP. It is nominal GDP
(PQ) divided by the GDP deflator(P) or price index
▪ Real GDP (Q) = Nominal GDP/ GDP Deflator
= PQ/P

Adjustment Process

GDP price Index (deflator)]

▪ A price index is a measure of the price of a specified collection of goods and services,
called “market basket” in a given year as compared to the price of an identical (highly
similar) collection of goods and services in a reference year ( base year/ period)
▪ However, there are many method to come up with index numbers
▪ Mathematically: Price index in a given year is equal to

price of market basket in specific year

X 100
price of same basket in base year

MONEY, BANKING AND THE ECONOMY

MONEY
- Money is defined as anything that is generally acceptable as a medium of exchange and in
the settlement of transactions and debts.
- Note that while cheques are used in effecting transactions, they are not necessarily legal
tender.
- The development of money to fit into the system of trade was made both inevitable and
desirable due to the failure of the traditional barter system to stand the ever-increasing
volumes of trade between complete strangers living distances apart and also through the
development of specialization and division of labour.

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FACTORS MILITATING AGAINST THE BARTER/SWAPPING SYSTEM

a) There was need for what was called double coincidence of wants. This means that for Z
to get something from X, he had to have what X wanted and at the same time want what
X offered. In most real-world situations, it is regarded as rarely practical or possible.

b) It was difficult to store one’s wealth in some forms for a long period of time.

c) It was also very difficult to fix fair prices for the goods and services. Jack Nobbs, (1983)
notes that in a barter system with 100 types of goods supplied and demanded, about 4 950
relative prices or values would be required. He says:

An enormous amount of time wasted in haggling would still make it difficult to

ascertain the value of a sheep in terms of salt.

Adam Smith, an 18th Century economist wrote:

Every prudent man in every period of society, after the first establishment of the
division of labour, must naturally have endeavoured to manage his affairs in
such a manner as to have at all times by him…………..a certain quantity of some
one commodity or other, such as he imagined few people would be likely to refuse
in exchange for the produce of their own industry.

MONEY ATTRIBUTES

❑ Acceptability-it should be acceptable for use in the business transactions. Whoever receives
it in payment must be able to dispose of it in bill settlement without any problem. Acceptability
principle does not claim that all the pieces of paper and minted coins are worth their face value.
It merely emphasizes that people have developed confidence in their use.

❑ Homogeneity- it should be uniform to avoid confusion. This relates to the various

denominations money is in. All coins and papers that are assigned equivalent values should be
similar in appearance and quality. It should not be difficult to realise that an old $10 note is
the same as one new one from the RBZ.

❑ Portability-should be easy to carry and walk around with in pockets and wallets so as to avoid
inconveniencing the owner. It shouldn’t be bulky, otherwise a person carrying a goat for barter
trade is in less danger from robbers that one carrying a bag of money worth the same goat. In
fact this attribute is a direct attack on inflation.

❑ Cognisibility-should be easily recognizable. It should be easy to differentiate between fake

money and genuine money. This attribute is closely linked to that of homogeneity, but dwells
much on appearance of money. It also emphasis that money should be quickly identified and
its value ascertained.

❑ Durability-It should be strong and long lasting. This points to good quality on which money
is made. This is vital because the cost of replacing money is very high since it is normally

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 made in such a way as to avoid counterfeit money. It explains why Zimbabwe, and any other
developing country would hire a foreign company to produce its money.

❑ Stability- this is a desired feature of money, which emphasizes that money should maintain
its purchasing power. This builds confidence in the people who can then easily accept it. This
is achieved by controlling the level of money supply to that commensurate to output. No
wonder in National Income accounting, Income = Output. Severe diminishing in the value of
money (called inflation) will exert pressure on economic agents to revert to the horrible and
undesirable barter system.

❑ Liquidity-whatever is used as money should easily be convertible into something else at the
discretion of the holder. By this, it meets the convenience need money should provide. It is
plausible to note that this is also a function of money as it allows goods and services to be
bought and sold amongst economic agents.

❑ Divisibility-refers to partitioning of money into smaller units that make up the whole. There
should not be any cost or loss in value in so doing. For instance, a $10 note should be valued
the same with five pieces of $2 coins.

❑ Transferability-easily changes hands. This is linked to portability since what is portable can
easily be handed over to a new owner. In some societies (especially historical times), where
large pieces of stone are used as money like the South Sea in the 20th Century, transferability
is difficult because the money is not transferable.

❑ Legality-The reader is challenged and taken aback to primitive era when it simply needed
society’s agreement to accept something as money. Today, the government, through the
Central Bank, has to authorise and legalise the acceptance of special pieces of paper and metal
as money. It thus becomes an offence to refuse to accept the money.

FUNCTIONS OF MONEY

❑ Medium of exchange - Money allows people to exchange commodities they hold e.g. A
person exchanges his labour for money and his money for goods and services. This function
makes trade faster and smoother. Its basis is that money has value and is acceptable in
transactions.

❑ Unit of account - Money is used as a price tag for goods and services and is a yardstick by
which community measures the value for goods and services. It allows the use of the price
system and makes it easier to express the values of commodities in relative terms.

John Stuart Mill (J. Nobbs: 1983) said:

The relations of commodities to one another remain unaltered by money; the only new
relation introduced is their relation to money itself.

Because money can be expressed in distinctive numerical terms, depending on the value, it is a
good base of accounting.

❑ Store of wealth/wealth - Because of its durability, stability, and purchasing power, money
can be kept as wealth. The major threat to this function is inflation. If money loses its

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 purchasing power, the monetary system collapses as people refuse to accept it as legal tender.
It happened in Germany in 1923 after the 1st world war and in Zimbabwe between 2000 –
2009. It should be appreciated that the value of money should be fairly stable, at least in the
Short Run, to sustain this function. The gradual decline in the value of money in the Long run
should be insignificant to economic development and should not be sufficient enough to
discourage people from using it as such. The modern economic man is busy assessing the
ability of money to perform this function. The more it can do so, the more money he has in
hand and at the bank. The less it can do so, the less money he holds and the more he depends
on other forms of wealth like cars, houses, and other properties.

❑ Standard of deferred payment - Allows people to sign contracts for which payments will be
made later e.g., in a higher purchase. J. Nobbs (ibid) notes that today production is so indirect
that it could not take place unless it was financed in advance. This function, however, needs
to be supported by the legal system as it is bound to be abused by the economic agents who
have an upper hand over others. Creation of Credit Sale, hire Purchase, Lease Acts is in this
direction. Note also that if inflation skyrockets, creditors lose as debtors pay money of less
value compared to that they borrowed. In that period interest rates rise to guarantee the return.
Those living on fixed incomes like pensioners will cry foul.

❑ A liquid asset - Easily convertible into any other form of property. It satisfies the need for
convenience. Liquidity, known even to accountants varies with easy with which one thing (not
money) can be changed into another form in a transaction. Hence money is the most liquid
asset in accounting, ahead of bank balance, debts, and stock for trade. Many economists
(including to some extent Keynes) have no problem agreeing that the demand for cash balances
by households, firms and individuals is strongly dependent on interest rates. Hence this
demand is called liquidity preference and it is shown below.

Rate of interest
(r)

Liquidity preference curve

Money demanded (Md)

❑ Channel of purchasing power - Also called price rationing as it allows only holders to be
able to buy commodities. As it is used in a capitalist system, it causes inequitable distribution
of itself, as it is owned in large sums by a few individuals. However, to condemn it, its use and
the capitalist system outrightly on this basis is unfair. Even Karl Marx himself, the father of
Socialism, never cried for its abolition.

VARIOUS FORMS OF PAYMENT

1. Notes and coins

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 2. Cheques.

However, cheques can only be used under the following conditions:

• The drawer has been sanctioned to use the cheque system by the bank manager
• The payee has faith in the drawer and accepts the cheque
• The payee has a bank account or can easily ‘cash’ the cheque

A credit transfer allows a number of bills to be settled using one cheque.

3. Standing orders - Also called banker’s orders are where an account holder authorises his
bank to make fixed payments at regular intervals, say monthly. This involves a ledger
transaction only and no cheque is used. The drawer’s account is debited and the payee’s
account is credited by the same amount.

4. National Giro System (Provided by the Post Office) – is the old version of ZIPIT. That
is, a system of transferring money from one account to the other instantly.

5. Postal orders – this is also another method of sending of money using post offices., this
time through the mail and a fee is charged for such a service. Though not negotiable
instruments, they are reliable for small amount payments.

6. Bills of exchange - Found in international transactions. The exporter draws the bill and
posts it to the importer who signs it to accept liability to settle the stated amount at the
indicated date. Until then, it will be like any useless paper. This enables suppliers to send
goods to people who show keen interest their goods and who are prepared to pay. If they
fail or refuse to pay, that same document forms a legal documentary evidence in suing the
defaulter.

7. Promissory notes - No longer in frequent use. To some extent similar to bills of exchange
in that they represent a promise to pay at a later date. However, can be used in domestic
trade and issued to debtors by finance houses. These pay up the debt and draw up the
document to the debtor who signs to pay the amount plus interest in the future.

8. Credit cards - Various cards falling into different categories are issued by commercial
banks to enable holders to carry out transactions without having to carry large sums of
money.

9. Offsetting debts - Generally interpreted to mean cancelling a debt if one whom you owe,
owes you an equal amount. If he owes more than you owe him, you claim the margin. Use
of credit and debit notes in business supports this system.

MOTIVES FOR HOLDING MOBEY

The legendary British economist, John M. Keynes identified three major reasons why economic
agents, especially households and individuals, demand or save money. These are:

1) Transactionary motive savings- Done to cater for known future expenditure due to non-
synchronisation between time of receiving income and time of spending the income. For
instance, a person may receive income once at the end of the month and spreads the spending

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 throughout the month. Also known as keeping money to meet recurrent expenditure.
Inflation is strongly related to this in a positive way.

2) Precautionary motive saving - This is saving for unforeseeable uncertainties e.g., illnesses,
death etc. Also called saving for the rainy days. J. Nobbs call it ‘just in case’ saving. This
applies to all economic agents.

3) Speculative motive savings - Saving with the expectation that money will appreciate in value
through a rise in interest rate. When share prices are expected to fall this demand goes up.
More easily understood when one holds onto appreciating foreign exchange. Speculative
motive saving in general is counter-productive and may cause untold losses if the money held
onto loses value instead. Only rich individuals, households, and firms whose activity concerns
funds investment are interested in this motive.

THE CLASSICAL QUANTITY THEORY OF MONEY

- The quantity equation is an identity: the definitions of the four variables make it true. If
one variable changes, one or more of the others must also change to maintain the identity.
The quantity equation we will use from now on is the money supply (M) times the velocity
of money (V) which equals price (P) times the number of transactions (T):

M  V = P  T

- V is called the transactions velocity of money. This tells us the number of times a dollar
bill changes hands in a given period of time.
- Transactions and output are related, because the more the economy produces, the more
goods are bought and sold.
- If Y denotes the amount of output and P denotes the price of one unit of output, then the
dollar value of output is PY.

M  V = P  Y

- This version of the quantity equation is called the income velocity of money, which tells us
the number of times a dollar bill enters someone’s income in a given time.

◼ Monetary Policy and Its Instruments

The money supply is the quantity of money available in an economy. The control over the
money supply is called monetary policy.

- The role of central banks is to influence the size of a country’s money supply and in doing
so influence the national income and the price level.
- A central bank serves four main functions: it is a banker for commercial banks, a banker
for the government, the controller of the nation’s supply of money, and a regulator of
money markets.
- The central bank is the sole authority in an economy that issues the monetary policy to
achieve the aforementioned objectives of influencing national income and price stability.
- These objectives are called policy variables, whilst variables that it directly controls in
order to achieve the stated objectives are called policy instruments.

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 - NB. Whilst monetary policy influences both real output and price level in the short run,
it only affects price level in the long run.

❑ Policy Instruments – these are tools that the central bank uses to directly control aggregate
demand in an economy.
- The primary instruments used by central banks are:

1. Open Market Operations – involves the purchase and sale of government papers. To
expand money supply, the government buys treasury bonds and pays for them with
new money, whilst to reduce it, it sells treasury bonds and receives existing money
which it can destroy.
2. Reserve Requirements – this is the amount of money that banks are supposed to lodge
with the central bank. This directly affects money supply in an economy.
3. Discount Rate – is the rate at which the central bank charges to member banks who
need to replenish their reserves.

4. CONSUMPTION, SAVING AND INVESTMENT

There is relationship between saving and consumption. Income not consumed is assumed to
have been saved:

◼ Y=C + I
◼ I=S
◼ Y–C =S
◼ Household have to decide how much of their current income will have to be consumed and
how much they have to put for future use. There are many theories which try to explain
the consumption and saving behaviour.

1. Life cycle hypothesis

2. Permanent income hypothesis
3. Absolute income hypothesis
4. Relative income hypothesis

- Decision on whether to save or consume your income is an intertemporal decision that is

we assume that households carefully take into account how their present decision will
affect their future consumption opportunities. This is an element of time preferences.

1. Life cycle savings model

▪ The basis of the model as originally formulated by Modigliani and Brumberg (1954) is that
individuals and households attempt to spread out consumption evenly over their lifetime
so that the decision to save are assumed to be a function of total lifetime earnings and the
stage reached in the earnings cycle. The life -cycle saving model has income-earning
households saving to finance consumption when they become old, non earning households.
▪ The model assumes individuals live for three periods, and that they only earn labour
income in the second period of their life. That is, it provides an incentive for
intergenerational borrowing.
▪ When young, individuals borrow to finance current consumption, because they know they
will be earning more later in their lives

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▪ During their working years, income rises to reach a peak at around middle age, and they
repay the debt incurred earlier and save for their retirement.
▪ When old, they consume the assets accumulated in the second period of their life.
▪ With liquidity constraints, the young can borrow at most a proportion of the present value
of their lifetime income.
▪ A typical pattern of behaviour will be dissaving in youth, positive savings in the middle
age and dissavings in the retirement, breaking even on death (on the assumption of no
bequests).
▪ The distinctive contribution of the life cycle hypothesis is its observation that income tends
to fluctuate systematically over the course of a person’s life and personal saving behaviour
is therefore crucially determined by one’s stage in the life cycle
▪ Notice that there are two periods of dissaving in an individual’s life the early years and
later years.

Consumption fuctionn
Income /consumption

saves
dissaves

dissaves
income

0 youth middle age retirement

time
(0-18 years) (18-60 years) 60 + years
2. Permanent income hypothesis

▪ This was developed by Milton Friedman (1975). Permanent income is the expected income
or average income that household should expect over a long time horizon. The model states
that household tends to smooth consumption over time. It means household will use capital
markets to borrow so as to smooth their consumption e.g. of a farmer who receives only
income during harvest time- objective will be trying then to smooth consumption.
According to this model, consumption responds to permanent income, which is a kind of
average of present and future incomes.

C2 Q
C1 + = Q1 + 2 , Q1  Q2
1+ r 1+ r

▪ Adaptive expectations are used to estimate future income.

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▪ This simply means people readjust (adapt) their estimates of permanent income each
period based on their previous estimates of permanent income and actual changes in output
▪ House decide their consumption basing on their permanent income not their current
income: C1 = Y p , where permanent income is given by:
Y2 Q
Y p : Y1 + = Q1 + 2
1+ r 1+ r
▪ To the extent that current incomes are lower than average income they will tend to dissave,
borrowing against their future income.
▪ If current income is higher they will tend to save the difference
▪ This can be shown diagrammatically as follows
▪ To find the permanent income we draw a 45- degree line from the origin to the budget
constraint ( the limit of consumer’s income imposes on the consumer's ability to obtain
goods and services
▪ It is represented as a line (budget line) which indicate combinations of of commodities that
a consumer can buy with a given income at a given set of prices.
▪ Permanent income lies at the intersection of these two lines (A), the only points with equal
output in both periods that lies on the budget constraint
▪ At point E, Q1 > Yp and Q2 > Yp
▪ In utility maximization , household tries to maintain a perfectly stable consumption path
so that it consumes the same every period
▪ In that case Cn is set exactly equal PI (C1 = C2 = YP
▪ The indifference curve (curve showing different combination of two products that yield
the same satisfaction/utility to a consumer) is tangent to the budget line at the same point
where budget line intersects the 45 degree line. Consumption is the same in both periods ,
and equal to permanent income.

Period 2

A Indifference curve
C2 = Qp

Budget constraint
Q2 E

C1 = Qp Q1 Period 1

3. Absolute income hypothesis

- It postulates that consumption depends on current disposable income

- Elasticity of consumption to income changes
- People adapt instantaneously to income changes

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What are the implications of these theories to developing countries?

❑ Determinants of Saving

1. Inflation
- Controversial- it is thru its impact on real interest rate that affect saving
- If real interest rates is negative people might not be motivated to save
- It may also influence saving through its impact on real wealth- if consumers attempt to
maintain a target rate of consumption to wealth, saving will rise with anticipated inflation.

2. Economic growth
- Positive relationship between economic growth and saving. Higher income lead to increase
in saving
- But other say it is negative- if income grows workers anticipate increase in future income,
so they increase consumption

3. Demographic factors
- Explained by life cycle hypothesis
- High savings expected if the age structure is composed of working age
- Bequests motives also lead people to save move
- Age structure therefore affects savings
- However in our case we have experienced company closures, retrenchments, drought-
affecting savings

4. Financial development indicators

- If a country has a well diversified banks it will have higher savings
- M2 / GDP measures financial depth (development) of a country
- M2 = M1 + time deposit
- M1 are notes and coins (not saving)
- Another indicator used is the number of banks

5. Foreign saving
- Open economies can actually borrow from other countries to smooth consumption
- This means that foreign savings can act as a substitute to domestic savings

❑ Investment
- Investment refers to the accumulation over time of real goods which will yield a future
flow of services (Levacic 1979).
- It is a forward looking activity with irreversible aspects therefore it tends to be a volatile
component of aggregate demand.
- It determines the rate of accumulation of physical capital and is thus an important factor in
growth of productive capacity.
- Investment in the national accounts includes: business fixed investment (purchases of
durable equipment structures), residential construction investment and changes in the
business inventories.
- With higher levels of investment a country can achieve higher economic growth.

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Theories of Investment

◼ Major investment theories are simple accelerator theory, liquidity theory, expected profit
theory, Tobin’s Q theory, and neoclassical theory.

1. The Fixed Accelerator model

- This model was first envisaged by Clark (1977).
- The basic idea behind this model is that the level of investment varies directly with the
rate of change of output and thus investment rises as output rises.
- More precisely , it suggests that the desired amount of capital (K*) is a constant fraction
(h) of output (Q) and presented as:

K* = h(Q)

- It also postulate a fixed relationship between the desired net capital stock (K*) and
expected output (Y*).
- Investment occurs when new capital equipment is being built and installed to increase
output. This model can be represented as:

I = a(Yt-Yt-1), where a is the accelerator coefficient

- This states that desired level of investment at any point in time is a function of the growth
rate of output which will in turn determine the level of investment.

Weakness of the model:

- model assumes that investment is always sufficient to keep the actual capital stock equal
to the desired capital stock –this is unrealistic because of the cost of adjusting the capital
stock and inevitable lags in the installation of capital
- it assumes full capacity at all times which is not the case in practice
- it does not include expectations as a factor which may raise or lower capital investment

The important point is that it brings one determinant of investment into light that is output
growth.

2. The Flexible accelerator model

- This tries to capture some of the weakness of the fixed accelerator model.
- It was developed by people like Goodwin, Hicks, and Kaldor.
- The simplest amendment to the accelerator model was to specify a partial adjustment
mechanism which describes gradual adjustment of capital stock (K) to the desired capital
stock (K*).

I =g(K*t+1-K)

- It simply states that actual and desired levels of capital stock are not always equal. Here
the determinants of desired level of capital are output, internal funds, cost of external funds.

3. Tobin’s q-theory
- Here the project/investment should pass the test of profitability.
- Tobin’s famous q-theory of investment starts from the idea that the stock market value of
a firm helps to measure the gap between K and K*+1.
- The Tobin’s hypothesis is that investment depends positively on the q –ratio her the q-ratio
is the stock market value of the firm divided by the replacement cost of the capital of the

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 firm‘s cost that one would pay to purchase the plant and equipment of the firm in the
output market.
- Thus the q-ratio is the ratio of the cost of acquiring the firm/investment through the
financial market versus the cost of purchasing the firm’s capital in the output market.
- If the q-ratio is greater than one then the firm has an incentive to invest because the rate of
return will be greater than the cost of capital which means that they can make profit.
- Similarly when q-ratio is less than one, then market is indicating that K*+1 is less than K,
so investment should be low.

❑ Determinants of Investment

1. Credit rationing (Availability)

-Changes in the volume of bank credit are suggested to have a positive impact on private
investment activity in developing countries.
- Agenor and Montiel(1996) argued that the typical absence of equity markets and the
prevalence of financial repression in developing world imply that neither Tobin’s Q theory
nor standard neoclassical flexible accelerator investment functions can be applied
uncritically in developing countries.
- Credit rationing influence the behavior of investment, the easier the access to source of
funds the higher the investment.
2. Inflation.
- High and persistent inflation undermines business confidence, while encouraging
consumption at the expense of saving mobilization and investment.
- Inflation is the general price increases.
- High and unpredictable inflation rate is an important indicator of macroeconomic
instability which can have an adverse impact on private investment by distorting the
information content of relative prices thus increasing the riskness of longer-term
investment.

3. Exchange rate
- The role of imported intermediate goods in developing nations suggest that the
specification of relative factor price in empirical investment functions cannot be restricted
to the wage rate and user cost of capital but must also take into account the domestic
currency price as well its availability.
- In the short run real devaluation will reduce private investment because it will raise the
cost of intermediate inputs on domestic currency terms, which will in turn reduce the level
of retained earnings, since demand will have been reduced due to rise in price.
- On the supply side, the expenditure-switching aspect of exchange rate policy on private
investment will increase the level of foreign prices measured in the domestic currency and
thus the price of traded goods relative to non traded goods in the domestic economy.

4. Public investment
- The studies have been carried out to determine the existence of “crowding in” or “crowding
out” of public investment on private investment.
- On the other hand, public investment that results in large fiscal deficits may crowd out
private investment through high interest rates and credit rationing.
- On the other hand, most developing countries have a large component of government
investment concentrated on infrastructure projects (transport, irrigation) which may be
complementary with private investment.

5. External debt (debt service ratio)

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 - Large external debt burdens have a strong disincentive effect on private investment.
- The existence of a large debt overhang in the form of a high ratio of external debt to GDP
reduces the future returns on investment because a high proportion of the forthcoming
returns must be used to repay the debt.
- In addition, debt service payments reduce the domestic resources available for investment.
- It is a major source of uncertainty: the size of future transfers to creditors is uncertain,
macroeconomic policy is uncertain, the exchange rate is uncertain.
- Many developing countries face liquidity constraints in international capital markets
because of large arrears in debt service obligation

6. Interest rate
- Neoclassical theory suggests that high interest rates raise the cost of capital, which reduces
the investment rate.
- In most African economies, nominal interest rates are high but real rates are often negative
due to high inflation rates (Ndikumana, 2000).
- In such a context, the interest rate can have a negative effect on investment only through
the saving channel (in the spirit of the McKinnon-Shaw hypothesis).
- Low or negative real interest rates, discourage saving, which reduce the amount of funds
available for investment.

7. Real (GDP) output

- Theoretically this relationship can be readily derived from a flexible accelerator model,
with the assumption that the underlying production function has a fixed relationship
between the desired capital stock and the level of real output.
- In the same vein private investment has been hypothesized as a positive function of income
per capital.
- Green and Villanuera (!991) assert that countries with higher per capita income could
denote more resources to domestic saving which could be used to finance investment
projects.

8. Taxation
- Corporate taxes have an important bearing on the firm’s investment decisions.
- The prospective after-tax return on capital is a decisive factor in evaluating investment in
a new venture or expansion of an existing enterprise.
- The higher the after-tax rate of return on capital the lower will be the risk of undertaking
the investment
- More precisely they can reduce the amount of retained earnings needed for further
investment.

THE GOVERNMENT SECTOR

▪ Government receipts
- The sources of government revenue are taxes, income from public enterprises and
donations.
- Taxes can be divided into direct and indirect. Direct taxes are levied on individuals or
corporate, e.g., payee and corporate taxes. Indirect taxes are levied on goods e.g. VAT,
input duty, etc.

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▪ Government Expenditures
-
- Government expenditure can either be in the form of consumption (e.g., wages and salaries
of civil servants, goods purchased for current consumption), investment (e.g., road
construction), transfer payments (e.g., pensions, war vet benefits) and interest on public
debt.
- Government expenditures can be divided into current and capital; mandatory and
discretionary.
- Mandatory expenditures are outlays that have to be made under entitlement programs, e.g.,
social security.
- Discretionary spending is governed by congressional appropriation process, e.g., defence
expenditures and foreign aid.

- Let B* be government’s stock of net financial assets and that it gets revenue from taxes
(T) – lump sum tax (lump sum tax is non-discretionary i.e. it does not affect the allocation
of resources or people’s decisions)

B * = B * −1 + rB G −1 + T − (G C + G I ) , where B* are government net assets, GC is

government consumption and GI is government investment.

- The government is always a net debtor, i.e. its expenses are greater than revenues. Let DG
be net debt, i.e.:
D G = −B G
Therefore, D = D −1 + rD −1 + (G + G − T ) , where D G −1 is debt from previous
G G G C I
-
periods, and rDG −1 is interest from previous debts.

Budget deficit (BD)

- Occurs when government expenditures exceeds its revenues.

BD = G C + rD G −1 + G I − T
- If BD is positive, then current expenditure will be in excess of revenues, and the reverse is
true
- The BD is also known as the public sector borrowing requirement
- The government can also borrow from the central bank, which is inflationary financing. In
this case, the central bank will be forced to print new money in order to pay government
debts – resulting in excess money

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 Government saving
S G = T − rD G −1 − G G + I
- If the government is saving it means it has a budget surplus and when it is not saving, then
it’s a sign of budget deficit.

6. INFLATION

- Inflation is 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.
- The Consumer Price Index (CPI) is one variable that is normally used to measure
inflation. It is the cost of a given basket of goods and services.
- Thus, 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 dollar. If the
supply of dollar (money) rises faster than the supply of goods and services in the country,
one would expect a decline in the value of dollar. Thus, an increase in money supply can
be a reason of inflation.

MEASUREMENT OF INFLATION

MEASURING INFLATION

1. THE GDP DEFLATOR

The calculation of real GDP gives a useful measure of inflation called the GDP deflator.
Nominal GDP reflects both the prices of goods and services and the quantities of goods
and services the economy is producing. By contrast, by holding prices constant at base-
year levels, real GDP reflects only the quantities produced. From these two statistics, we
can compute the GDP deflator, which reflects the prices of goods and services but not the
quantities produced. The deflator measures changes in prices that have occurred between
the base year and the current year.

No min al GDP
GDP Deflator = X 100
Re al GDP

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 2. CONSUMER PRICE INDEX
The consumer price index is used to monitor the changes in the cost of living over time.
When the consumer price index rises, the consumer has to spend more dollars to maintain
the same standard of living. The inflation rate is the percentage change in the price level
from the previous period. The consumer price index measures the overall cost of goods
and services that the consumer buys.

Formula for calculating inflation:

Pt − Pt −1
Inflation = X 100%
Pt −1

• (t-1) – previous period or Base time where prices are assumed fixed and deviation
from which is the inflation or deflation.

• (t) – current period or second period time after which prices are compared to the
base year prices and inflation calculated.

Important inflation concepts

I. Core/underlying inflation
This is inflation due to changes in economic variables like weather, Money supply, Interest
rates, Exchange rates etc. For example, a drought reduces output and raises the affected
commodity’s price.

II. Food Inflation

This is a general rise in the price of food items.

III. Non-food Inflation

This is a sustained increase in the price of other commodities and services other than food.

Overall CPI - Weight of Food CPI x Food CPI

Non − food CPI =
Weight of non − food CPI

IV. Monthly Inflation

This measures growth of CPI over a month. Given a growth of (Z%) per month, one would
be inquisitive to know what inflation would be after a year.

V. Quarterly Inflation
Measures the percentage growth of CPI in three months.

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VI. Seigniorage

Seigniorage is the revenue from printing money. When the government prints money to
finance expenditure, it increases the money supply. The increase in the money supply, in
turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax. As
prices rise, the real value of the money in your wallet falls. When the government prints
new money for its use, it makes the old money in the hands of the public less valuable.
Thus, inflation is like a tax on holding money. In countries experiencing hyperinflation,
seigniorage is often the government’s chief source of revenue—indeed, and the need to
print money to finance expenditure is a primary cause of hyperinflation.

TYPES OF INFLATION

1) Monetary Inflation

Milton Friedman said that, ‘Inflation over any substantial period is always and afterwards a
result of excessive growth in the quantity of money relative to output. All other monetarist
argue in the same way that inflation is due to unjustified money supply growth, i.e. not
commensurate with output growth/level.

According to Irving Fisher (1867-9147), in his book, ‘The purchasing power of money’
(Macmillan; 1911), there exists an equation of exchange that links money to prices. He stated
the equation as:

MV=PT………………………………………… 1

Where M = money stock, V = rate at which money changes hands, P = average price level
and T = volume of transactions carried out in any economy, say in a year.

The assumptions of equation 1 are that:

i) V is fairly stable, hence Money demand is also fairly stable
ii) T is fairly stable, i.e. there is full employment in the economy

Stability assumed for V and T means that a rise in M will lead to a rise in P. But empirical evidence
shows that V and T fluctuate even in the short run and are positively related to interest rates. The
reason is that when the interest rate and inflation are high, it is costly to hold on to money balances
(hence high V) as money loses value in one’s hands yet when invested on money markets, yields
are high. On the other hand, when interest rates and inflation are low, firstly, the money market is
not lucrative, and secondly, money does not lose value at a high rate in the bank, hence people can
afford to hold large cash balances (V is low).

It may be important to note some of the important factors resulting in growth of money supply:

 Excessive borrowing by the government from the RBZ/Central Bank

 Credit creation by banks
 Increase in Net Foreign Reserve inflows as seen from the following relationship:

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Excessive Money Supply dictates that people change from Investment into property and
financial assets e.g. bonds. It also means that as T cannot quickly adjust to demand caused by
increased money supply, price is bidded up leading to Demand-pull inflation.

▪ Demand Pull Inflation

According to monetarists, a rise in money supply will lead to an increase in aggregate demand,
but since output cannot be varied ion the short run, prices are likely to go up. Therefore, to the
monetarists, inflation is demand-pull inflation.

Demand Pull Inflation AS

Price
E1
AD1
Po E0
AD0

Quantity
Income/Money/Output
Comparing the two equilibria, E0 and E1, it is shown that an increase in income leads to an
increased demand for goods, but AS is stable. This leads to higher prices.

- Demand pull inflation occurs when the demand for goods and services continuously rises
faster than their supply, prices of goods and services shall rise too.
- Demand-pull inflation is likely when there is full employment of resources and when
SRAS is inelastic. In these circumstances an increase in AD will lead to an increase in
prices.
- AD might rise for a number of reasons – some of which occur together at the same moment
of the economic cycle

• A depreciation of the exchange rate, which has the effect of increasing the price of imports
and reduces the foreign price of exports. If consumers buy fewer imports, while foreigners
buy more exports, AD will rise. If the economy is already at full employment, prices are pulled
upwards.
• A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more
real disposable income causing demand to rise. A reduction in indirect taxes will mean that a
given amount of income will now buy a greater real volume of goods and services. Both factors
can take aggregate demand and real GDP higher and beyond potential GDP.
• The rapid growth of the money supply – perhaps as a consequence of increased bank and
building society borrowing if interest rates are low. Monetarist economists believe that the
root causes of inflation are monetary – in particular when the monetary authorities permit an
excessive growth of the supply of money in circulation beyond that needed to finance the
volume of transactions produced in the economy.
• Rising consumer confidence and an increase in the rate of growth of house prices – both
of which would lead to an increase in total household demand for goods and services
• Faster economic growth in other countries – providing a boost to exports overseas.

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2) Cost push inflation

This is whereby firms increase prices of commodities due to rising cost of inputs. May be due
to any one or several of the following:

 Imported inflation- a rise in prices of imported raw materials due to depreciation or

devaluation of the local currency.

 Wage spiral inflation- an increase in prices to compensate for a rise in wages, as

wages are a significant cost to the firm.

 Devaluation/Depreciation of the local currency-Many Zimbabwean businesses

borrow from off-show, i.e. from foreign financiers. Settling these debts with a
depreciated currency is costly.

 High local interest rates- Thus borrowing from the domestic market is costly.

*Rising costs of production have the effects that the producer will either cut on output or
increase price or do both. The following is an illustration of cost-push inflation:

AS1
Cost-push inflation
AS0

P1 ………….E1

Po ….……………… . E0

ADo

Q1 Q0 Income
It should however, be noted that other exogenous factors like drought, sanctions and
embargoes may equally lead to inevitable shortages which are in the end inflationary.

3) Supply shortage inflation

This is when aggregate supply is less than the level required to sustain economic growth. A
situation of shortage creates a stampede on the few available commodities leading to a wave
price increases.

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4) Cyclical inflation

This is inflation associated with the shortages experienced during economic depressions and
recessions. It thus follows changes in the business cycle.

5) Hyperinflation

This is whereby prices are rising so fast that money ceases to perform its functions. This may
be so critical as to lead to an abandonment of a currency or the issuance of a new one. If the
situation continues, the monetary system collapses. This happened in Yugoslavia and Germany
during the Great Depression, in Zimbabwe between the period 2003 and 2009.

CONSEQUENCIES OF INFLATION

1) Leads to high lending rates, as lenders want to cushion themselves as high inflation creates
uncertainty, which also increases risk.

2) Discourages borrowing by producers and makes it difficult for shrinking economies to

recover as cost of finance production is high.

3) Causes a shift from long term investment to investment in money and equity markets where
returns are more attractive.

4) Leads to currency depreciation and for Less Developed Countries (LDCs) like Zimbabwe,
which rely heavily on foreign borrowing and imported raw materials, cost of production is
likely to be high and this pushes up prices of finished goods.

5) Since from (4) above, domestic production becomes more expensive, if the commodities
are to be traded on the international market, they become less competitive. As a result, the
Balance of Payments situation is worsened as the country will not be able to raise enough
forex, as it requires.

6) High poverty levels, with many people falling below the Poverty Datum Line (PDL), that
is surviving at an amount below that which is expected to sustain them.

7) Causes moral decadence like prostitution as well as social deviance behaviors like
commission of crimes.

8) Causes unemployment because prices of labour (salaries and wages) become unsustainable
and firms fire labour.

9) Causes the breakdown of the monetary system as people prefer to hold onto physical
properties to hedge against spiralling prices.

10) Hits hard on people living on fixed incomes like pensioners, thus further straining the
government (Fiscus) as it has to make more transfer payments in the form of free or
subsidized food, health, shelter and education.

11) Harms the taxpayer as government increases taxes to get more money through its fiscal
policy. This is particularly so with the workforce exposed to a progressive tax system, as

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 was the situation in Zimbabwe. They are continuously pushed into higher tax brackets
creating a phenomenon called fiscal drag net. Their living standards plummet as their
incomes fall.

12) Rioting, industrial strikes, political upheavals can to some extent be attributed to high
inflation levels as cost of living rise to leave many trapped under the Poverty datum Line
(PDL). This was typical of the Zimbabwean situation during the period 2000 – 2009.

13) Redistributes income from lenders to borrowers. People who borrowed money during low
inflation time repays it when it is useless in terms of what it can purchase.

14) Causes high level of corruption, even to the extent of externalisation of foreign currency
and diversion of produce meant for local consumption to other countries.

15) Causes de-industrialization i.e. closures of firms which cannot operate in the prevailing
environment.

POLICY PRESCRIPTION AGAINST INFLATION

As the causes of inflation are diversified and intertwined, the suggested solutions below need to
be carefully studied. No one policy can cure an inflationary situation fuelled by a hoard of causes.
As such, emphasis is on policy combinations.

a) Management of Money Supply

The growth of MS should be managed to levels commensurate with increase in output. This
should be understood in the same way with as in the national income accounting where value
of output should equal incomes received. Open Market Operation system (OMOs) can be
adopted where excess liquidity is mopped up by selling certificates/treasury bills to cash
holders. But incessant borrowing by the government from the Central Bank makes control of
Money Supply difficult as this takes money back into the system.

b) Increasing the Statutory Reserve Requirement

Reserve requirements or required reserves are deposit monies banks are to keep and not use to
create more money. This reduces the money multiplier, which determines money growth.

c) Sterilization

This is merely neutralising net income flows from abroad by withdrawing a similar amount
from the economy if the net income is positive, and by adding a similar amount if it is negative.
In cases of a positive net income flow, OMOs may be used.

d) Moral suasion

This is not law, but an appeal by the Reserve Bank to the conscience of economic agents, or
more broadly, to economic stakeholders. The RBZ encourages people to understand the
importance and benefits of a low rate of inflation and hence an adoption of friendly economic
decisions that guard against inflation. Promotion of the Tripartite Negotiating Forums (TNFs)
in Zimbabwe is typical Moral suasion that intends to adjust wages to non-inflationary levels.

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e) Fiscal policy

This normally takes the form of reducing government expenditure on non-productive sectors
and an improvement on capital projects. It also calls for reduced government borrowing from
the domestic market as this crowds out private investors and dampen future growth
prospects. Fiscal policy also entails that taxes are levied in such a way as to leave sufficient
disposable incomes to stimulate consumption and this will stimulate production and reduce
inflation.

f) Reducing Supply-side bottlenecks

Involves upgrading the production base to shoot down demand-pull inflation. Adoption of
efficient production techniques also cut on cost of production and hence leading to a cut on
cost-push inflation. Increased low-cost production results in competitive exports and
generation of foreign reserves and this leads to a stabilised currency.

7. UMEMPLOYMENT
- Unemployment of labour is a situation whereby the number of people who are willing and
able to work is greater than that the labour market can absorb.
- Nb* General unemployment covers all forms of resources, which may be lying idle in an
economy. Labour is just one of those resources. However, unemployment of labour is the
most popular and hence in most cases when one mentions the word unemployment he will
be referring to the unemployment of labour.

Number of unemployed people

- Unemployment rate = X 100%
Labour force

- Unemployment and Inflation are usually called ‘evil twins’ considering the untold
suffering they are capable of causing on the ordinary people in society. They are sensitive
both as economic and as Political issues.

- According to an early economist, Philips, the two are negatively related. The diagram
below shows the trade-off between unemployment and inflation:

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TYPES OF UNEMPLOYMENT
1) Demand deficiency unemployment

This is when economic agents are not consuming enough for the firms to produce more and
employ more resources. This is so because the demand for any product is a derived demand.
The lobbying by the EU and South Africa for a ban in the use of asbestos will, if successful,
result in retrenchments at Shaban-Mashava mine in Zimbabwe where asbestos is mined. Close
to 100 000 people work in the production of asbestos in Zimbabwe. The influx of second hand
clothes in Zimbabwe also led to many retrenchments in the textile industry.

2) Frictional unemployment

Occurs when people changing from one job to another. Hence refers to temporary and
voluntary unemployment. It also results from imperfect or complete lack of coordination
between job seekers and job offers. It may also be due to high travel costs and social ties
restricting people in relocations. These costs are also known as search costs, especially when
they include the cost of going around looking for work.

3) Seasonal unemployment

Demand for resources to be employed including labour is determined by the period of the year
or season. It is very common in agricultural sectors and agro-based economies like Zimbabwe

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 experience this to a larger extent. Throughout the year farming policies which incorporate
irrigation schemes and winter farming tend to reduce the effects of seasonal unemployment.

4) Residual or hard core unemployment

This is when people are either unemployable due to lack of required skills or do not want to
work. May also be linked to or called voluntary unemployment which is due to sheer laziness
or to the fact that people would have inherited some wealth.

5) Structural unemployment

This is when there structural rigidities in the economy making it difficult to employ resources
to full employment levels e.g. during drought or when the capital employed limits on other
forms of resources to be employed. A good example is the Zimbabwe situation in 1991 when
ESAP was launched. The economy is agro-based and ESAP tended to reorient it to Industrial
and this caused severe job losses.

6) Technological unemployment

This is precisely when technological advancement ensures that labour is eliminated in the line
of production, as only a few will be required to operate the machines. The use of sprayers,
combine harvesters, weed chemicals will eventually lead to redundancy of agricultural labour.
The same with inclination in the use of computers.

7) Cyclical unemployment

This follows the business cycles and rates are high with recessions/contractions or troughs and
low with booms and recoveries.

8) The natural rate of unemployment

This occurs despite that all other macro factors are within sustainable levels e.g. inflation,
BOP, Money supply, Exchange rate, Interest rates etc.

EFFECTS OF UNEMPLOYMENT
1) High poverty levels associated with inability to buy basis commodities.

2) High moral decadence and crime rate, which in turn stifle economic growth and development.

3) Forced migration of some population units to neighbouring countries to look for work and
decent living.

4) Political instability as people are easily incited against the government of the day.

5) Unemployment is normally associated with unprecedented levels of suicidal deaths and

murders amongst the unemployed. In Britain in every one million, deaths, 15 000 are suicides.

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6) Personal psychological torture suffered by the unemployed and their families, relatives and
friends.

7) It creates a fiscal drag net where those who are employed are overburdened by high taxes to
sustain the government.

8) It represents a cost to the government, as it has to pay out transfer payments and
Unemployment Benefits.

9) It also represents a loss of potential tax revenue to the government as people only pay tax when
employed.

10) It represents idle resources and lost productive potential. The loss was estimated by Economist
Okun’s Law, i.e. .....

SUGGESTED SOLUTIONS TO UNEMPLOYMENT

(a) Seasonal unemployment

In off-season, people should be geared for other forms of employment like fishing, winter
agriculture, arts etc. In general, therefore, development of micro-enterprises and
entrepreneurial skills is seemingly a permanent solution. However, the suggested solution is
questionable, as diversification of skills is in itself difficult to sustain in the real world.

(b) Cyclical unemployment

Re-alignment of macro-economic policies to avert recessions/contractions. Policies include

monitoring of money supply, interest rates, and inflation among others. The fiscal budget
should be more oriented towards investment and less on consumption spending.

(c) Technological unemployment

Adoption of labour-intensive technology is a policy consistent with developing economies like

Zimbabwe. However, most technology, if not all, is imported and users have no option.
Further, the choice of technology also depends on cost saving, and in the majority of cases,
labour-intensive machinery is more expensive than capital intensive over the lives of the
machines.

(d) Structural unemployment

Restructural exercises should be preceded or accompanied by informal sector entrepreneurial

development. This was overlooked by the authorities who adopted ESAP and results may have
a bearing on what the economy and people are today in Zimbabwe.

(e) Frictional unemployment

Improvement of transport and communication (especially in the form of advertising) networks

to reduce market imperfections. There is need to establish more information centres and
agencies that supply work information to those in need, especially to places that are remote.

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(f) Demand-deficiency unemployment

Dealing with the phenomenon requires a well framed long-term fiscal policy that stimulates
Aggregate Demand. Zimbabwe is among the world’s most taxing economies. As a result real
incomes fall progressively with consistent fall in output and eventual decline in employment
levels becoming certain.

8. INTERNATIONAL TRADE AND FINANCE

- International trade refers to the exchange of goods and services beyond a nation’s
boundaries.
- Closed Economy- is an economy that does not interact with other economies in the world.
An open economy is an economy that interacts freely with other economies in the world –
leading to international trade.

The Flow of Goods: Imports, Exports and Net Exports

- Exports are goods and services that are produced locally and sold abroad.
- Imports are goods and services that are produced abroad and sold domestically.
- Net exports are the value of a nation’s exports minus the value of its imports, also called
the trade balance.
- If net exports are positive, exports are greater than imports, indicating that the country sells
more goods and services abroad than it buys from other countries. In this case, the country
is said to run a trade surplus.
- If net exports are negative, exports are less than imports, indicating that the country sells
fewer goods and services abroad than it buys from other countries. In this case, the country
is said to run a trade deficit.
- If net exports are zero, its exports and imports are exactly equal, and the country is said to
have balanced trade.

REASONS FOR INTERNATIONAL TRADE

1. Climatic differences

Countries have got products that can be produced under some specific climatic conditions
while other products cannot be produced under those conditions.

2. Educational differences

Countries have different educational standards, hence international trade will allow for
education integration. This can be explained by the hiring of Cuban Doctors in the previous
years.

3. Cultural differences

International trade allows for cultural integration i.e. different countries may take advantage
of another’s culture for economic advantage.

4. Differences in factor endowments

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 Countries may have abundance of one factor and not the other. It has to import factors it cannot
sufficiently product for itself.

5. Differences in technology

Countries have got different levels of product and process technology, hence developing
nations stand to gain in any international trade in which they can purchase technology from
developed countries.

6. Law of absolute and comparative advantage

A country has an absolute in areas of production in which it is more efficient than the other.
Different countries have different areas of efficiency and a country like Zimbabwe has got an
advantage in the area of agriculture.

The absolute advantage argument states that if countries specialize in areas in which they have
absolute advantage, then world output would increase and would then trade to get things on
which they have a disadvantage in production.

The theory of comparative advantage, which was developed in the 1770s and developed in
the 1940s, deals with opportunity costs of production and countries are encouraged to
specialise in areas where they can produce commodities at a lower opportunity cost. It is
envisaged that world output would also grow when the theory of comparative advantage is
implemented.

Example:

Suppose there are two countries, A and B, and also that there are two products only, Food and
Cloth. If the countries allocate their efforts towards food production, they will produce the
following outputs in the ratio of their opportunity costs: A--------------------200 tons of food and
600 metres of cloth and B……………….500 tons of food and 300 metres of cloth.

ANALYSIS

a) Pre-trade situation

Without international trade, total food production would be 700 tons, while cloth would be
900 metres.

b) Trade situation

If countries would specialize in areas of advantage, ‘A’ would produce cloth only as it costs
less for her (just a tone of food for 3 m of cloth) to produce while it is cheaper for ‘B’ to
produce food as it costs less compared to A (3m of cloth only will give 5 tones while for ‘A’
we need 3m to produce only 1 tone f food). Therefore the totals with specialization will be:
1000 tons of food and 1 200m of cloth. It can be noted that world output has gone up.

ARGUMENTS AGAINST INTERNATIONAL TRADE

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1. The infant industry argument

The protectionist theory was propounded in the 1770s. An infant industry is one still incapable
of fair competition with established industries. This protection is sought from the government
since most of the most frightening rivals are foreign companies. International trade hence may
lead to closure of budding industries, mostly in developing countries.

2. Strategic industry argument

International trade may sometimes threaten existence of pivotal/strategic industries in a

country. Hence government has an obligation to protect such local industries from
competition, not because they are infants, but because the nation should not at any point
depend on another country for supply of a particular commodity. An example is the defence
industry and an industry for production of staple food.

3. Cultural issues argument

International trade usually leads to cultural distortions through ’culture importation’ in the
form of adopted food, dressing, and other materials treated as offensive in other countries like
pornographic print.

4. Terms of trade argument

Also used in the case of unfavourable Balance of Payment situation. Unfavourable terms of
trade exist when the value of imports exceeds the value of exports and this may in the end lead
to a depreciation or devaluation of the local currency. Therefore the government, in a bid to
maintain favourable TOT of BOP, will discourage importation of non-essentials, normally
through hiking their import duty.

5. Health argument

Certain products that do not meet set health standards are banned from entering the country.
Examples are importation of meat from disease infested areas e.g. where there is bird flu.

6. Unemployment argument

This can be linked to any other argument that may lead to closure of local industries. The
unemployment argument says that if international trade leads to closure of some industries,
effectively it leads to unemployment.

7. Anti-dumping argument

Dumping refers to the selling of a product in a foreign market at a far lower price than one at
which it is sold in the home country. This is normally done either when the seller wants to get
rid of excess output, when getting rid of reject output or merely to out- compete other firms in
the foreign countries. Because these commodities are lowly priced, this leads to closure of
local industries and all other disadvantages follow.

8. Revenue argument

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 Protectionism in the form of import duty/tariffs generates revenue for the government. Thus
the higher the import duty, the higher the revenue that can be raised.

Current global trends are aimed at removing all such distortions. For instance, the SADC
region intended to dissolve all forms of tariffs and other imperfections to trade such as quotas
by the end of the year 2000.

FORMS OF TRADE BARRIERS

Most people would think that protectionism or trade restriction takes the form of import
duty/tariffs, this is not correct. The following are some of the policy options in protectionism:

(a) Tariffs

These are the monetary taxes levied on imports and have the effect of raising the
international/world price of a commodity. They cause reduced importation and consumption
and, hence lead to welfare loss. Also called import duty. Import duty can be calculated as a %
of value of imports or per quantity.

(b) Quotas

This is a limitation of quantity one can import. Can also be in terms of value or quantity, but
in most cases takes the form of quantity. This is normally practiced when the government
wants individuals to import for use only e.g. only 20l of cooking oil per person.

(c) Sanctions

These are normally punishment deprivation of import rights to discourage the victim from
adopting a certain stance. This is normally abused by rich countries to punish less developed
countries that may have crossed their paths. This s a typically exclusive trade barrier as it is in
the form of punishment and tends to be more political than it is economic.

(d) Embargoes

This is a complete ban on the trade in some identified commodities, mostly to protect the
interests of the majority. Example is an embargo on the import of arms, or dangerous drugs.

(e) Voluntary agreements

Countries may negotiate and agree on the form, quantity or value of commodities to be traded
across their borders.

(f) Exchange control/allocation system

To import one needs to have foreign currency. The foreign currency is allocated to importers
by the Central Bank. The Central Bank weighs the importance of various imports and in the
allocation of foreign exchange favours those imports that are of importance to the country at
large.

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Balance of Payment (BOP)
The world economy has become increasingly interconnected:
▪ Globalization: markets exceed national boundaries; increased mobility of workers,
products, and information.
▪ Integration: people of different countries choose to function jointly in governance,
economic interests, currency, etc.
The possibility of such a global economy has been brought about by:
▪ Collapse of communism
▪ Lower transportation costs
▪ Advances in telecommunications (internet, etc.) related technological innovations
▪ Economic need
▪ These have led to reductions in trade barriers
- General barriers
- Integration and free trade zones—Europe, North America, etc.
- The relaxation of bank and capital market regulations
Economists typically separate the production and sale of goods and services from the exchanges
of financial assets.
▪ Real Sector: production and sale of goods and services.
▪ Financial Sector: transactions in global, foreign, or domestic financial assets.

NB: Measurement is difficult because trade may include services (invisibles) and electronic
commerce.

Definition of BOP:
BOP is a systematic record of all economic transactions international transactions between
residents of one country and the rest of the world. International transactions include exchanges of
goods, services or assets. “Residents” means businesses, individuals and government agencies,
including citizens temporarily living abroad but excluding local subsidiaries of foreign
corporations.

Importance of BOP
 BOP records all the transactions that create demand for and supply of a currency. This
indicates demand-supply equation of the currency. This can drive changes in exchange rate
of the currency with other currencies.
 BOP may confirm trend in economy’s international trade and exchange rate of the
currency. This may also indicate change or reversal in the trend.
 This may indicate policy shift of the monetary authority (RBZ) of the country.
 BOP may confirm trend in economy’s international trade and exchange rate of the
currency. This may also indicate change or reversal in the trend.
 This may indicate policy shift of the monetary authority (RBZ) of the country.

BOP Accounting (Double entry)

If a transaction earns foreign currency for the nation, it is a credit and is recorded as a plus item. If
a transaction involves spending of foreign currency, it is a debit and is recorded as a negative item.
◼ Credit transactions result in receipt of payment from foreigners, e.g.
➢ Merchandise exports (valued f.o.b.)
➢ Transportation and travel receipts
➢ Income received from investments abroad
➢ Gifts received from foreign residents
➢ Aid received from foreign governments

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 ◼ Debit transactions involve to payments to foreigners
➢ Merchandise imports
➢ Transportation and travel expenditures
➢ Income paid on investments of foreigners
➢ Gifts to foreign residents
➢ Aid given by home government
➢ Overseas investments by home country residents
NB: Each credit transaction has a balancing debit transaction, and vice versa, so the overall
balance of payments is always in balance.

Various components of BOP

◼ A Current Account
◼ B. Capital Account
◼ C. IMF
◼ D. SDR Allocation
◼ E. Errors & Omissions
◼ F. Reserves and Monetary Gold

A: Current Account (CA)

Current Account (all real transfers)
➢ Merchandise trade
➢ Service trade
➢ Transfers

In other words, CA reflects the net flow of goods, services and unilateral transfers (gifts). The net
value of the balances of visible trade and of invisible trade and of unilateral transfers defines the
balance on current account.

The current account is that balance of payments account in which all short-term flows of payments
are listed:
 Goods and services balance (exports – imports)
➢ Merchandise trade balance (exports – imports)
➢ Services balance (exports – imports)
 Net Investment income
 Unilateral transfers
➢ Private transfer payments
➢ Governmental transfers

Services are:
➢ Travel and tourism
➢ Trade transportation
➢ Insurance
➢ Education
➢ Financial, technical, and marketing services
➢ Telecommunication
➢ Use of property rights (royalties)
➢ Other professional and consulting services

Investment income:
 Payment to holders of foreign financial assets, including:
➢ Interest on bonds and loans

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 ➢ Dividends and other claims on profits by owners of foreign businesses
➢ Payments made to temporary (nonresident) workers

Unilateral Transfers:
➢ Official government grants in aid to foreign governments
➢ Charitable giving (e.g., famine relief)
➢ Migrant workers transfers to families in their home countries

B: Capital and Financial Account (KA)

KA refers to transfers of ownership and financial assets and liabilities:
➢ Changes in private assets
➢ Changes in holdings of official international reserves
➢ Statistical Discrepancy

The capital account records all international transactions that involve a resident of the country
concerned changing either his assets with or his liabilities to a resident of another country.
Transactions in the capital account reflect a change in a stock – either assets or liabilities.
The capital and financial account is that balance of payments account in which all cross-border
transactions involving financial assets are listed. This includes transactions between foreign and
domestic residents, and foreign and domestic governments.
 All purchases or sales of assets, including:
➢ Direct investment
➢ Securities (debt)
➢ Bank claims and liabilities
➢ Official reserves transactions
➢ When Zimbabwean citizens buy foreign securities or when foreigners buy Zimbabwean
securities, they are listed here as outflows and inflows, respectively.

Foreign Direct Investment: Is any flow of lending to, or purchases of ownership in, a foreign
enterprise that is largely owned by residents of the investing country, i.e.
➢ Securities (stocks and bonds)
➢ Loans
➢ Bank deposits
➢ Minority ownership positions

 FDI is the purchase of assets to establish financial control of a foreign entity. Generally
ownership of 10% or more of a company’s outstanding stock is considered FDI.
 Portfolio investment involves little management control or interest, and is solely for
financial gain.

C: The Reserve account

The reserve account comprises of three accounts: IMF, SDR, & Reserve and Monetary Gold. The
IMF account contains purchases (credits) and re-purchase (debits) from International Monetary
Fund. Special Drawing Rights (SDRs) are a reserve asset created by IMF and allocated from time
to time to member countries. It can be used to settle international payments between monitary
authorities of two different countries.
Official Reserve Assets: These are primarily financial assets denominated in a foreign currency
that is widely accepted in international transactions.
 Governments can influence exchange rates by buying and selling official reserves.

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  The buying and selling of official reserves is recorded in the “official transactions”
account. Also referred to as “changes in holdings of official international reserves” or
“official settlements balance”.
 It is the part of the balance of payments accounts that records the amount of its own
currency or foreign currencies that a nation buys or sells.

E: Errors and Omissions (Statistical discrepancies)

It is the net result of errors and omissions on both the credit and debit sides. Errors arise from:
➢ Under-reporting merchandise imports
➢ Under-reporting investment incomes
➢ Under-reporting capital exports
➢ Basically, people succeed in hiding their imports, foreign investment incomes, capital
flight from their governments for tax and other purposes.
Account Overview
Current Account Capital Account

Merchandise trade Changes in Zimbabwe assets abroad, net

exports other Zimbabwe govt assets
imports Zimbabwe private assets
Trade Balance All changes, net
Services
military trans. (net)
other services, net Changes in foreign assets in the Zimbabwe,
Service Balance net foreign private assets
Balance on goods & services All changes, net

Investment income, net

Changes in holdings of official international
Unilateral transfers reserves, net
Zimbabwe government grants
Zimbabwe govt pensions, and
other transfers
Private remittances and Statistical discrepancy
other transfers
All transfers, net

Balance on current account Balance on capital account

Current Account:
 The difference between the import and export of goods is sometimes called the balance of
merchandise trade. Although the popular press often uses this measure, the merchandise
trade balance is not a good summary because services are an important component of trade.
 The balance on goods and services includes trade in services. This includes visible and
invisible trade.
Current Account Surplus and Deficit
 A current account surplus means exports of goods and services, investment income and
transfers exceed imports and outflows.
 A current account deficit means imports of goods and services, and outflows are greater
than exports and inflows; must be financed by borrowing (capital account inflows).

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Linkage to NIPA and the Domestic Economy
Current Account (CA) surplus equals net foreign investment (If ). CA = If .
o If If > 0, the country has net foreign investment, so the country must be investing
part of its saving abroad, and S = Id + If .
o That means If = S – Id .
o Recall that Y = C + Id + G + (X – M).
o Also, CA = X – M.
o Domestic Expenditures E = C + Id + G, and
Y – E = X – M = CA
o C + Id + G is sometimes referred to as absorption.
Meaning of Overall Balance
 The current account and the capital account measure the private and non-U.S. government
supply of and demand for dollars.
 Official Settlements Balance:
B = CA + KA
 Because the balance of payments must sum to zero, any imbalance in the official
settlements balance must be financed (paid for) by official reserves flows:

 B + OR = 0

BOP Surplus and Deficit

 The Official Settlements Balance (B ) is sometimes referred to as the net sum of the items
above the line or autonomous transactions, and
 The Official Reserves Transactions (OR ) are referred to as the sum of the items below the
line, also called nonautonomous or accommodating transactions.
➢ When B = 0, there is said to be a BOP equilibrium, and if B  0, a BOP
disequilibrium.
➢ When B > 0, there is said to be a BOP surplus.
➢ When B < 0, there is said to be a BOP deficit.
 In terms of the supply and demand of a nation’s currency, there is:
➢ A balance of payments surplus if quantity demanded for a currency exceeds
quantity supplied, putting upward pressure on the value of the nation’s currency.
➢ A balance of payments deficit if quantity supplied of a currency exceeds quantity
demanded, putting downward pressure on the value of the nation’s currency.
Official Transaction Account
 Most of the Official Reserves flows are official interventions by the country’s monetary
authorities in the foreign exchange markets.
 When a government buys its own currency to hold up the currency’s price, we say that the
government has supported its currency.
➢ It is holding the exchange rate higher than that rate otherwise would have been.
 When it sells its currency, it is attempting to depress the value of its currency.
➢ It is forcing the exchange rate to be lower than that rate would otherwise have been.
 Because they are an accounting identity, the current, capital, and official transactions
accounts must sum to zero—in total, the balance of payments balances.
 The supply of currency, including government’s, must equal the demand for currency,
including government’s.

Important implications of BOP:

 If CA is in surplus, the nation must be a net exporter of capital.
 If CA is a deficit, the nation is a major capital importer.

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  When National Savings > National Income, the excess must be acquired through foreign
trade.

Solutions for Improving CA deficits:

 Raise national income (output) relative to domestic investment (I).
 Increase (S) relative to domestic investment (I).

Government Budgets and Current Account Deficits

CURRENT ACCOUNT BALANCE: CA = Saving Surplus - Government budget deficit
CA Deficit means the nation is not saving enough to finance (I) and the deficit.
CA Surplus means the nation is saving more than needed to finance its (I) and deficit.
Possible solutions: Currency depreciation; Protectionism
Depreciations are ineffective because:
➢ It takes time to affect trade.
➢ J-Curve Effect states that a decline in currency value will initially worsen the deficit
before improvement.
Protectionism
A. Trade Barriers used:
1. Tariffs
2. Quotas

B. Results: Most likely will reduce both X and M.

C. Foreign Ownership - one protectionist solution would place limits on or eliminate foreign
ownership leading to capital inflows.
D. Stimulate national saving change the tax regulations and rates.

SUMMARY: CURRENT-ACCOUNT
DEFICITS- neither bad nor good inherently
➢ Since one country’s exports are another’s imports, it is not possible for all to run a
surplus
➢ Deficits may be a solution to the problem of different national propensities to save
and invest.

Some definitions:
1. Basic balance
- consists of current account and long-term capital flows.
- emphasis long-term trends
- excludes short-term capital flows that heavily depend on temporary factors

2. Net Liquidity Balance:

Measures the change in private domestic borrowing or lending requires to keep payments
equal without adjusting official reserves.

3. Official Reserve Transactions Balance

Measures adjustments needed by official reserves.

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