AS MACROECONOMICS NOTES

TAYYABA SAMI KHAN

CHAPTER 1: THE CIRCULAR FLOW OF
INCOME AND NATIONAL INCOME
ACCOUNTING
Governments’ macro economic aims include maintenance of high and stable economic growth, low
unemployment, low inflation, avoidance of balance of payments deficit and exchange rate stability. One
way these four objectives are linked is through their relationship with aggregate expenditure (AE) which is
also called aggregate demand. This is the total spending on goods ans services made within the country
(domestically produced goods and services). This spending consists of four elements:

1- Consumer spending on domestically produced goods [Total consumer spending on all goods (C)
minus spending on imports (m)]
2- Investment expenditure by firms (I)
3- Government spending (G)
4- Expendture by residents abroad on this country’s exports (X)

Therefore:

𝐴𝐷 = 𝐴𝐸 = 𝐶𝑑 + 𝐼 + 𝐺 + 𝑋

Since Cd=C-M, we can say that:

𝐴𝐸 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀

To show how the four macroeconomic objectives are related in an economy, we make use of the ciruclar
flow of income. In the diagram 5.1, the economy is divided into two major groups: firms and households.
Each group has two roles. Firms are producers of goods and services, and are also employers of labor and
other factors of production. Households are consumers of goods and services; they are also suppliers of
labor and various other factors of production. In the diagram, there is inner flow and various outer flows of
income between these two groups.

Before we look at the various parts of the diagram, we need to make the distinction between money and
income. Money is a stock concept. At any given time, there is a certain quantity of money in an economy
(for example $1 billion at the beginning of 2018). But national income is a flow concept, therefore is
measured over a period of time.
The inner flow, withdrawals and Injections

The inner flow

Firms pay money to households in form of wages, salaries, dividends on shares, interest and rent. These
payments are in return for the services of factors of production (labor, capital and land) that are supplied by
households. Therefore, on the left hand side of the diagram, money flows directly from firms to households
in form of factor payments.

Households in return pay money to domestic firms when they consume domestically produced goods and
services. This is shown in the right hand side of the inner flow. There is a circular flow of payments from
firms to households to firms and so on.
 If households spend all their incomes on buying domestic goods and services, and if firms pay out all this
income they receive as factor payments, money just goes round and round between households and firms
and income remains unchanged.

In the real world, not all the income gets passed on round the inner flow; some is withdrawn. At the same
time, incomes are injected into the flow from outside. Let us examine these withdrawals and injections.

Withdrawals or Leakages (W)

Only part of incomes received by households will be spent on goods and services of domestic firms. The
remainder will be withdrawn from the inner flow. There are three forms of withdrawals or leakages:

1- Net saving (S): Saving is the income that households chose not to spend but to put aside for future. Savings
are normally deposited in financial institutions such as banks. This is shown in the bottom right of the
diagram. Money flows from households to banks.
2- Net Taxes (T): When people pay taxes (to either central or local government), this represents a withdrawal
of money from the inner flow in the same way as savings. Only in this case, people have no choice. Some
taxes such as income tax and employees national insurance contributions are paid out of household incomes.
3- Import expenditure (M): Not all consumption is of totally home produced goods. Households spend some
of their incomes on imported goods and services or on goods and services using imported components. This
expenditure on imports constitutes the third withdrawal from the inner flow as money flows abroad.

Total withdrawals are simply the sum of net saving, net taxes and import expenditure.

𝑊 = 𝑆+𝑇+𝑀

Injections (J)
Only part of the demand for firms’ output arises from consumers’ expenditure. The remainder comes from
other sources outside from the inner flow. These additional components of aggregate expenditure are called
injections (J). There are three types of injections:

1- Investment (I): This is the money that firms spend after obtaining it from various financial institutions-
either past savings or loans, or through a new issue of shares. They may invest in plant and equipment or
may simply spend the money on building up stocks of inputs, semi-finished or finished goods.
2- Government Expenditure (G): When the government spends money on goods and services produced by
firms, this counts as an injection. Examples of such government expenditure include spending on roads,
hospitals and schools. Note that government expenditure in this model does not include state benefits.
3- Export expenditure (X): Money flows into the circular flow from abroad when residents abroad buy our
exports of goods and services.

Total injections are the sum of investment, government expenditure and exports.

𝐽 =𝐼+𝐺+𝑋

The relationship between withdrawals and injections

There are indirect links between saving and investment, taxation and government expenditure, and imports
and exports. If more money is saved, there will be more funds available for banks and other financial
institutions to lend out. If tax receipts are higher, government is better able to increase expenditure. Finally
if imports increase, incomes of people abroad will increase which will enable them to purchase more of our
exports.

These links however, do not guarantee that S=I or G=T or M=X. Firms may wish to invest (I) more or less
than the households wish to save (S); governments can spend more than they receive in taxes or vice versa;
exports can exceed imports and vice versa. A major point here is that the decisions to save and invest are
made by different people; therefore they may plan to save or invest different amounts. As far as the
government is concerned, it may not choose to make T=G. It may choose to spend less than its receipts and
run a budget surplus (T>G) or it may choose to spend more than it receives in taxes and run a budget deficit
(T<G) by borrowing or printing money to make up the difference.

Therefore, planned injections (J) may not always lead to planned withdrawals (W).
The circular flow of income and the four macroeconomic objectives

Equilibrium in the circular flow

When injections do not equal withdrawals, a state of disequilibrium will exist. This will set in a process to
bring the economy back to the state of equilibrium where injections are equal to withdrawals. To illustrate
this, we can consider a situation where injections exceed withdrawals.

Withdrawals/Leakages and Injections approach: In a four-sector model, the only withdrawal is saving
and the only injection is investment. According to this approach, equilibrium in the circular flow of
income will occur when injections equal withdrawals. To illustrate this, we can consider a situation
where injections exceed withdrawals. The excess of injections over withdrawals will lead to a rise in
national income. But as national income rises, households will not only spend on goods, but also save (S),
pay more taxes and spend more on imports. In other words, withdrawals will rise. This will continue until
they have risen equal to injections. At that point, national income will stop rising and equilibrium has been
reached. On the other hand, if withdrawals exceed injections, more income is being taken out of the circular
flow of income than injected in. National income will fall. As national income falls, people spend and save
less, pay lesser taxes and import less, causing the withdrawals to decline. This will continue until they have
fallen equal to injections.
Perhaps there has been a rise in business confidence so that investment has risen. As we have seen, the
excess of injections over withdrawals will lead to a rise in national income. But as national income rises,
households will not only spend on domestic goods, but also save (S) more, pay more in taxes (T) and buy
more imports (M). In other words, withdrawals will rise. This will continue until they have risen equal to
injections. At that point, national income will stop rising and equilibrium has been reached.

Closed economy without government: Two sector model

In a two-sector model, we assume a closed economy (no international trade) without government.
Therefore, the only two economic agents in this model are consumers and firms. Consumers may spend
their income on domestic goods and save some of their income. Firms will produce goods and services and
carry out investment expenditures. Therefore, the only withdrawal in this type of an economy is savings,
and the only injection is investment. Consumers’ income will equal consumption and savings (there are no
taxes or imports) and aggregate expenditure in an economy will equal consumption plus investment (there
is no government spending and exports).

𝑌 =𝐶+𝑆

𝐴𝐸 = 𝐶 + 𝐼

𝑊=𝑆

𝐽=𝐼
Closed economy with government: Three sector model
In a three-sector economy, consumers, firms and government are the economic agents. Consumers now
spend on domestic goods, save and pay taxes out of their income. Firms produce goods and services and
invest. Government spends on providing goods and services and imposes taxes on income. Therefore, it is
a closed economy with government.

When the government spends money on goods and services produced by firms, this counts as an injection.
Examples of such government expenditure include spending on roads, hospitals and schools. Note that
government expenditure in this model does not include state benefits.

Recall that injections are exogenous and consumption and withdrawals are endogenous. The injections in
the three sector model are investment (I) and government spending (G), while withdrawals in the three
sector model are Savings (S) and Taxes (T).

𝑌 =𝐶+𝑆 +𝑇

𝐴𝐸 = 𝐶 + 𝐼 + 𝐺

𝑊 =𝑆+𝑇

𝐽 =𝐼+𝐺
Open economy with government: Four sector model
In a four sector economy, it is now an open economy with consumers, firms and government as the
economic agents. Consumers now spend on domestic goods, save, pay taxes and purchase imports out of
their income. Domestic firms produce goods and services; invest in purchase of capital goods and export
goods and services to foreign countries. Government spends on providing goods and services and imposes
taxes on income. Therefore, it is an open economy with government.

When people from other countries spend on our economies goods and services, it results in higher export
revenue. Export revenue increase the income for domestic firms, therefore export is an injection in the
circular flow of income. When consumers in the domestic economy spend on goods and services produced
by firms abroad, they spend less on domestic goods. Therefore, import is a withdrawal from the circular
flow of income, since it reduces the amount of income that flows from domestic consumers to domestic
firms. Recall that injections are exogenous and consumption and withdrawals are endogenous. The
injections in the four-sector model are investment (I), government spending (G), and exports (X) while
withdrawals in the four sector model are Savings (S), Taxes (T) and Imports (M).

𝑌 =𝐶+𝑆 +𝑇+𝑀

𝐴𝐸 = 𝐶𝑑 + 𝐼 + 𝐺 + 𝑋

𝑊 =𝑆+𝑇+𝑀

𝐽 =𝐼+𝐺+𝑋
National income statistics

Meaning of national income

National income is either the total value of a country’s final output of all goods and services
produced in a year or the total value added of a country’s production of all goods and services,
both taking into account net property income from abroad and depreciation.

GNI (at market prices) = GDP (at market prices) + Net property income from abroad

GDP, GNI and NNI

National income can be measured in a variety of different ways using expenditure, income or
output data. As with national income, gross domestic product (GDP) can be measured either in
terms of the value of all final goods and services produced or in terms of the value added in the
production process. The key point is that both of these prevent double counting from taking place,
i.e. counting the same output twice. GDP deals with the output side of the economy. Gross national
income (GNI) and Net national income (NNI), however, are concerned with the sum of all income
earned by residents of the country. The difference between GNI and NNI is shown below:

NNI (at market prices) = GNI (at market prices) – depreciation

All three are often stated as per capita, for example GDP per capita is:
Adjustment of measures from market prices and basic prices
GDP and GNP figures can be shown as either market prices or basic prices. Market price is the
gross value of goods and services produced by an economy in a year including all taxes but
excluding any subsidies. The basic price, however, excludes taxes, but includes subsidies. It also
excludes transport costs if these are invoiced separately. The difference can be stated as:

GDP at basic prices = GDP at market prices – minus taxes + subsidies on products

Adjustment of measures from gross values to net values

The difference between gross and net measurements, such as GDP and net domestic product, is
depreciation.

Net domestic product = GDP – depreciation

Net national income = GNI – depreciation

Depreciation consists of the loss in value of a country’s capital assets including housing, vehicles,
machinery, etc. The depreciation is known as capital consumption.
CHAPTER 2: AGGREGATE DEMAND
AND AGGREGATE SUPPLY

Definition of Aggregate Demand

Aggregate demand (AD) is the total amount of goods and services demanded or total expenditure
on goods and services in an economy.

Components of Aggregate demand

AD consists of consumption, investment, government expenditure and net exports, which is
exports – imports. This can be written as:

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

1. Consumption (C) is households/individuals’ expenditure on durables and non-durables. It

consists of that part of their income spent on goods and services. Buying a bicycle or going
to a restaurant for a meal are both examples of consumption.
2. Investment (I) is defined as firms acquisition of capital goods. It consists of spending on
an asset or capital good for future use. A firm building a new factory or offices or installing
a new computer system are all examples of investment.
3. Government expenditure (G) consists of all government spending on provision of goods
and services. It includes spending on pay for government employees, education and health
services and infrastructure.
4. Exports (X) are the sale of goods and services to foreign countries or people living abroad.
Exports bring money into a country and are an injection.
5. Imports (M) are the purchase of goods and services from abroad. Imports take money
away from a country and are a leakage.
Derivation of the Aggregate Demand Curve
The aggregate demand curve is negatively sloped, as higher the price level, lower the level of
equilibrium national income, keeping all other factors constant. The aggregate demand curve is
illustrated in figure 1:

Figure 1:

The reasons for the downwards sloping aggregate demand curve are mentioned below:

1. The wealth effect: A rise in the price level will reduce the amount of goods and services
that people’s wealth can buy. The purchasing power of savings held in the form of bank
accounts and other financial assets will fall. Hence consumption will fall, and aggregate
demand will fall.
2. The international effect: A rise in the price level will lead to a rise in price of exports and
imports will appear cheaper. As exports become expensive, quantity demanded of exports
will fall. On the other hand, imports appear cheaper and quantity demanded of imports will
rise. This causes net exports and aggregate demand to fall.
3. The interest rate effect: A rise in the price level will increase demand for loans to pay the
higher prices of goods and services. This, in turn, will increase the interest rate. A higher
interest rate, leads to a higher cost of borrowing. Firms and consumers will be able to
borrow less, leading to a reduction in consumption and investment. Subsequently, the
aggregate demand will fall.
Movement along and shift in Aggregate Demand Curve
Movement along the AD curve: We have seen that the AD curve plots the equilibrium national
income against the price level. Any change in price level will lead to a movement along the AD
curve. In figure 1, as the price level rises from P0 to P1, the level of equilibrium national income
declines from Y0 to Y1, keeping all other factors constant. This results in movement along the AD
curve from point a to point b.

Shifts in AD curve: Any force apart from changes in price level, which changes the total spending
in an economy will shift the AD curve. These changes include shifts in consumption, investment,
government expenditure and net exports. Increases in any of these will shift the AD curve
rightwards from AD0 to AD1 while decline in any of these will shift the AD curve leftwards from
AD0 to AD2. The shifts in AD curve are illustrated in in figure 2.

Examples that would cause an increase in aggregate demand include any factors which lead to an
increase in consumption, investment, government spending and net exports.

Factors leading to a rise in Consumption

1. A rise in consumer confidence: means that consumers are optimistic about the future.
They expect economic growth, rising employment and income levels. They will save less
and consume more, hence consumption expenditure rises.
2. A cut in income tax: will result in a rise in disposable income and a rise in the purchasing
power of consumers. Hence consumers will buy more goods and services and consumption
expenditure will rise.
3. An increase in wealth: If people in an economy are wealthier, their purchasing power will
rise. Also, there will be reduced need for saving, hence consumption expenditure will rise.
4. A rise in the money supply: Money supply is the total quantity of money in circulation in
the economy. If the central bank increases the money supply, the interest rate will decline.
Lower interest rates lead to reduced cost of borrowing. Consumers will take more loans;
hence consumption will rise. Also, lower interest rates lead to a decline in return on saving,
hence incentive to save will decline. People will reduce savings and increase consumption
expenditure.
5. An increase in population: will lead to a rise in the number of consumers in the economy,
hence consumption expenditure will rise.
 6. Price expectations: If households expect inflation to accelerate, they tend to purchase
more of the durable goods right now which they would have otherwise purchased later. In
such a scenario, purchases made currently are expected to be cheaper than purchase of the
same goods in future.

Factors leading to a rise in Investment

1. A rise in business confidence: means that firms are optimistic about the future. They
expect economic growth, rising employment, incomes and rising consumer demand. Firms
will prepare to fulfill the rising demand by increasing investment expenditure.
2. A cut in corporation tax: Corporation tax is a tax on firm’s profits. A cut in corporation
tax would mean that firms will have a higher level of after-tax profits/retained earnings.
Investment will rise as there will be more funds available to the firms.
3. Advances in technology: The development of new techniques for producing existing
products is called process innovation. These new techniques require new equipment. For
example, the advent of robots has drastically changed assembly-line processes. The
installation of robots has led to large quantities of recent investment expenditure in
manufacturing industries.
4. A fall in interest rates: Lower interest rates lead to reduced cost of borrowing. Firms will
take more loans; hence investment expenditure will rise.
5. Cost and productivity of capital goods: The amount of money the firm has to pay to buy
any piece of capital that it purchases as well as the productivity of capital will affect the
profitability of the investment decision. A new process that reduces the cost of capital
goods will make any given investment more profitable because the interest costs involved
will be reduced. For example, a machine costing $1000 will have an interest cost of $100
at the rate of 10 percent. However, if the cost of capital falls to $800, then interest cost will
also fall to $80, making investment more attractive.
Any new invention which makes capital equipment more productive will make investment
more attractive. Higher productivity will lead to lower cost of capital and tend to increase
desired investment expenditure.
Factors leading to a rise in Government spending

1. A desire to stimulate economic activity: If the economy is in a recession, the government

may increase spending on provision of education, health and etc. This will create more
jobs, increasing income and consumption levels, stimulating the economic activity.
2. A desire to win political support: Sometimes governments tend to increase the
government spending just before the election in order to win political support.
3. A rise in tax revenue: If government’s tax revenue increases, there will be a higher level
of funds available for spending on health, education, infrastructure and etc. Hence
government spending will rise.

Factors leading to a rise in net exports

1. A fall in the exchange rate: Exchange rate is the price of one currency in terms of another.
Considering UK as the domestic economy, a fall in sterling exchange rate will reduce the
price of UK exports and increase the quantity demanded of UK exports. A fall in sterling
exchange rate will also raise the price of imports for UK consumers; therefore, demand for
imports will fall in UK. If the demand for imports and exports is price elastic, export
revenue will rise and import expenditure will fall, causing net exports to rise.
2. A rise in the quality of domestically produced products: Technological advancement or
training of workers in the domestic economy may lead to better quality goods being
produced in the domestic market. This will increase the international competitiveness of
domestic goods, causing the demand for exports to rise. Since domestic goods are of a good
quality, domestic consumers will prefer buying local goods and demand for imports will
fall. This will cause the net exports to rise.
3. An increase in incomes abroad: Considering UK as the domestic economy, if the trading
partner of UK is experiencing a recession, the incomes in the foreign economy will decline.
Their consumers will then be able to purchase fewer exports from UK, hence net exports
for UK will decline.
Figure 2:

Aggregate Supply
Aggregate supply is the total output (real GDP) that producers in an economy are willing and able
to supply at a given price level in a given time period. Regarding aggregate supply (AS),
economists sometimes distinguish between short-run aggregate supply (SRAS) and long-run
aggregate supply (LRAS).

Short-run aggregate supply is the output that will be supplied in a period of time when the prices
of factors of production (inputs, resources) have not had time to adjust to changes in aggregate
demand and the price level.

In contrast, long run aggregate supply is the output that will be supplied in the time period when
the prices of factors of production have fully adjusted to changes in aggregate demand and the
price level.
The short run aggregate supply curve
The short-run aggregate supply curve slopes up from left to right as shown in Figure 3. As the
price level rises, producers are willing and able to supply more goods and services. There are three
possible reasons for this positive relationship:

1. The profit effect: As the price level (that is, the price of goods and services) increases, the
price of factors of production such as wages do not change. So the price level rises, the gap
between output and input prices widens and the amount of profit increases. Therefore,
producers are willing to supply more output to earn more profit.
2. The cost effect: Although the wage rates and raw material costs remain unchanged in the
short run, average costs may rise as output increases. This is because, for example,
overtime payments may have to be paid and costs will be involved in recruiting more
members. To cover any extra costs that may be involved in producing a higher output,
producers will require higher prices.
3. The misinterpretation effect: Producers may confuse changes in the price level with
changes in relative prices. They may think that a rise in the price they receive for their
products indicates that their own product is becoming more popular. As a result they may
be encouraged to produce more.

Figure 3:
Shifts in the short-run aggregate supply curve
While a change in the price level will cause a movement along the short-run aggregate supply
curve, there are four main causes of a shift in the SRAS curve. These are:

1. A change in the price of factors of production: A rise in wage rates, not matched by an
increase in labor productivity, or a rise raw material costs, or a rise in energy prices will
make it more expensive for the producers to produce each unit of output. Therefore,
producers may decide to reduce their output, causing a decrease in SRAS, shifting AS the
curve to the left from AS1 to AS0 as illustrated in Figure 4.
2. A change in taxes on firms: A reduction in indirect taxes will reduce cost of production
and will increase the profitability from sales. This will encourage the producers to increase
output, causing an increase in SRAS. Similarly, a reduction in corporation tax leads to a
rise in retained earnings and a rise in investment expenditure. Firms will have increased
business capacity, enabling higher production levels. This will shift the AS curve to the
right from AS1 to AS2.
3. A change in factor productivity/quality of resources: A rise in labor productivity and/or
capital productivity will cause an increase in aggregate supply both in the short and long
run. Labor productivity may rise due to education and training, which improves the skills
of workers. The same workers will be able to produce more goods and services if they are
trained. Hence AS rises. Similarly, rising capital productivity can be a result of research
and development of technically advanced machinery. Technological improvements enable
the firms to produce more goods/better quality goods in a given time, hence AS rises.
4. A change in the quantity of resources: In the short run the supply of inputs may be
influenced by supply side shocks including natural disasters. Therefore, following a natural
disaster, the quantity of resources available for production will decline, allowing firms to
produce less. This will cause a reduction in SRAS. On the other hand, net immigration will
increase the amount of labor available to the economy, hence production levels will rise,
and SRAS curve will shift to the right.
5. A change in marginal rate of tax: Marginal rate of tax refers to the extra tax paid as a
proportion of additional income. If marginal rates of tax rise, there will a disincentive for
workers to supply labor as more of their hard-earned money goes to the government.
 Workers may reduce their supply of labor, leading to a fall in production of goods and
services, and a leftward shift in the SRAS curve.

Figure 4:
The long run aggregate supply curve
The long-run aggregate supply curve shows the relationship between real GDP and changes in the
price level when there has been time for input prices to adjust to changes in aggregate demand.

Keynesian View of LRAS

Keynesians often represent the LRAS curve as perfectly elastic at low rates of output, then upward sloping
over a range of output and finally perfectly inelastic. This is to emphasize their view that, in the long run,
an economy can operate at any level of output and not necessarily at full capacity. Figure 5 shows that from
0 to Y, output can be raised without increasing the price level. When output and hence employment are
low, firms can attract more resources without raising their prices. There is time for input prices to change
but, due to the low level of aggregate demand, they do not. For example, when unemployment is high, the
offer of a job may be sufficient to attract new workers.

As output rises from Y to Y1, firms begin to experience shortages of inputs and bid up wages, raw material
prices and the price of capital equipment. When output reaches YF, the economy is producing the maximum
output it can make with existing resources.

Figure 5:
Classical View of LRAS
Another group of economists, called new classical economists, illustrate the LRAS curve as a vertical line.
This is because they think that in the long run the economy will operate at full capacity. This version of the
LRAS curve is shown in Figure 6.

Figure 6

Shifts in LRAS
Both Keynesian and new classical economists agree that the causes of a shift in the LRAS curve
are a change in the quantity and/or quality of resources (factor productivity). Both of these will
increase the productive potential of an economy. The causes of an increase in the quantity of
resources in the long run are:

1. Net immigration: If the immigrants are of working age, this will increase the size of the
labor force.
2. An increase in the retirement age: This will increase the size of the labor force. A number
of countries have raised the age at which people can receive a state pension and some of
these countries plan to raise it even further in the future as life expectancy increases.
 3. More women entering the labor force: The proportion of women who work varies from
country to country. For example, in 2013 only 15% of women of working age were in the
labor force in Saudi Arabia, while 75% of women in Norway were in the labor force.
4. Net investment: If gross investment (total investment) exceeds depreciation (capital goods
that have to be replaced because they have become worn out or become out of date) there
will be additions to the capital stock.
5. Discovery of new resources: The discovery of, for instance, new oil fields or gold mines
can increase a country’s productive potential.

All of the above situations will cause the LRAS curve to shift to the right. The rightward shifts of
Keynesian and Classical LRAS curves are shown in figure 7 and 8.

Figure 7: Keynesian LRAS

Figure 8: Classical LRAS
Long Run Equilibrium
According to the classical economists, economy operates at full capacity in the long run. In such a case, the
long run equilibrium will occur at the point where AD curve, SRAS curve and LRAS curve will intersect
at point ec. Equilibrium income will be YF and price level will be Po. This is illustrated in figure 9 (a).

On the other hand, Keynesian economists argue that the economy can operate well below full employment
level of output in the long run as well. Therefore, the long run equilibrium may lie on point e K, where
AD=LRAS. The equilibrium output Y1 is well below the full employment level of output (YF), and price
level is P1. This is illustrated in figure 9 (b).

Figure 9:
Shifts in Aggregate Demand

Keynesian View
Figure 10 panel (b) shows that from 0 to Y0, an increase in AD will allow the output can be raised without
increasing the price level.

When output and hence employment are low, firms can attract more resources without raising their prices.
There is time for input prices to change but, due to the low level of aggregate demand, they do not. For
example, when unemployment is high, the offer of a job may be sufficient to attract new workers. They
wouldn’t demand higher wages in such a case. Further increases in AD cause the output to rise from Y0 to
Y1, firms begin to experience shortages of inputs and bid up wages, raw material prices and the price of
capital equipment. At this point, more output will only be produced by increasing the prices from P0 to P1.

When output reaches YF, the economy is producing the maximum output it can make with existing
resources. Therefore, if AD rises further and output cannot increase, pressure on resources will bid up the
price level from P2 to P3.

Figure 10:

Classical View
In suggesting the vertical LRAS, they also explain how an increase in aggregate demand will not allow the
output to increase, but will only cause inflation. This is illustrated in figure 11 panel (a). If the aggregate
demand rises for example due to consumer optimism, AD curve will shift to the right from AD0 to AD1 and
price level will rise from P0 to P1 in the short run. Firms respond to increased demand by making their
resources work overtime, and by increasing output along the SRAS curve from YF to Y1. As pressure on
resources bids up, wages increase leading to an increase in costs of production and prices. Therefore, SRAS
curve shifts to the left from SRAS0 to SRAS1. As price level rises, consumers and firms reduce their
expenditures, causing a movement leftward along the aggregate demand (AD1) curve. This will continue
until SRAS1=AD1=LRAS at price level P2 and equilibrium is restored at the full employment level of output
of YF. Therefore, classical economists suggest that an increase in spending in the long run will only result
in rising price level.
CHAPTER 3: ECONOMIC GROWTH

Definition of economic growth

Economic growth is an increase in the real output of an economy. For real growth to occur it needs
to be greater than the increase in inflation. Economic growth can be measured either in terms of
GDP or GNP, but is usually referred to as a change in real GDP.

Measurement of economic growth

The most widely used measurement of economic growth is GDP, although GNP is also used. It is
measured as the percentage rate of increase in real GDP, allowing, therefore, for the effects of
inflation. To allow comparison of economic growth either over time or between countries, it is
often measured in terms of GDP per capita thus allowing for differing sizes of population.

Distinction between nominal and real GDP

Nominal GDP is the value of goods and services using current prices. Real GDP is nominal GDP
adjusted for changes in inflation. It is sometimes referred to as GDP at constant prices. If inflation
is positive, real GDP will be lower than nominal. If inflation is negative – deflation, then real GDP
will be higher than nominal. To move from nominal to real GDP we use the GDP deflator which
measures price changes from a base year. The table below shows the Nominal GDP and Real GDP
values for various countries.
Money (or nominal) GDP is GDP measured in terms of the prices operating in the year in which
output is produced. It is sometimes referred to as GDP at current prices and is a measure that has
not been adjusted for inflation. Money GDP may give a misleading impression of how well a
country is performing. This is because the value of money GDP may rise not because more goods
and services are being produced but merely because prices have risen. For example, if 100 billion
products are produced at an average price of $5, GDP will be $500 billion. If in the next year the
same output of 100 billion products is produced but the average price rise to $6, money GDP will
rise to $600 billion. So to get a truer picture of what is happening to output, economists convert
money into real GDP. They do this by measuring GDP at constant prices, meaning the prices
operating in a selected year. By doing this they remove the distorting effect of inflation. For
example, in 2016 a country’s GDP is $800 billion and the price index is 100. Then in 2017, money
GDP is $900 billion and the price index is 120.

Years CPI Nominal GDP in $bn Real GDP in $bn

2016 100 800 800
2017 120 900

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 × 𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑖𝑛 𝑡ℎ𝑒 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟

𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 =
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟
Therefore:
$900 𝑏𝑖𝑙𝑙𝑖𝑜𝑛 × 100
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 = = $750 𝑏𝑖𝑙𝑙𝑖𝑜𝑛
120

𝐶𝑃𝐼 𝑖𝑛 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟

𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 =
𝐶𝑃𝐼 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟

The price index used to convert money into real GDP is called the GDP deflator, which measures
the prices of products produced rather than consumed in a country. So it includes the prices of
capital goods as well as consumer products and includes the price of exports but excludes the price
of imports.
Taking account of population: The use of per capita measures
The figures we have studied up till now are total GDP figures. Although they are useful for
showing how big the total output or income of one country is compared with another, we are often
more interested in output or income per head. Luxembourg has a much lower total GDP than the
UK, but it has a higher GDP per head. Other per capita measures are sometimes useful. For
example, measuring GDP per head of the employed population allows us to compare how much
an average worker produces.

𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
Real GDP per capita =
𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛

Country Real GDP Population Real GDP per capita

A $100 billion 1 billion $100
B $80 billion 0.5 billion $160

In the example above, country A is a larger country therefore has a higher total output of $100
billion, but output per head or income per head is $100 as population is larger as well. Country B
has a relatively lower total output. However, population is even lower, thereby income per head
is higher at $160. Therefore, in order to compare the standard of living between countries, we
need to use GDP per capita instead of total GDP.
Causes of economic growth
Economic growth can be caused by either shifting the AD or AS curves outwards. This can be
seen in Table 4.3.

Many of the causes mentioned in Table 4.3 are closely related. Some of them are developed below,
while others, such as depreciation, are explained elsewhere.

1. Government expenditure is mainly in the form of investment in new or improved

infrastructure such as roads and rail and power supplies. Improved transport allows goods
and people to flow more freely and thus facilitates production. As government spending
rises, AD rises in short run. The AD curve shifts to the right and the equilibrium real GDP
will also rise. In the long run, the productive capacity will rise, causing the long run
aggregate supply curve to shift to the right. This will also increase the equilibrium real
GDP leading to economic growth.
2. Lower income tax rates allow individuals to spend more. Lower corporation tax allowing
the firms to have higher retained earnings allowing the firms to invest more. As
consumption and investment rises, AD rises, AD curve will shift to the right and
equilibrium real GDP will also rise.
3. Lower interest rates have a similar effect. Interest rates is the return on saving and cost
of borrowing. As interest rates decline, cost of borrowing falls, allowing the consumers
and firms to take more loans. This will increase consumption and investment, hence
aggregate demand will rise. The AD curve will shift to the right and equilibrium real GDP
will rise.
4. Higher real wages mean that individuals are better off and feel able to spend more on
goods and services. As consumption rises, aggregate demand will rise. The AD curve will
shift to the right and equilibrium real GDP will rise.
5. Increased investment is the spending on capital goods including equipment and
machinery. This is likely to increase output and also improve the quality thus leading to
greater sales. It will also lead to greater labor productivity. Hence increased investment
will increase the long run productive potential of the economy, leading to a rightward shift
in LRAS curve and a rise in equilibrium real GDP.
6. Improved technology means that more can be produced with the same quantity of capital.
This is likely to lead to greater labor productivity which will increase the long run
productive potential of the economy. There will be a rightward shift in LRAS curve and a
rise in equilibrium real GDP.
7. Improved education and training affects both the quality and quantity of goods and
services. Increasing education and training leads to a more literate and skilled workforce
and thus greater labor productivity, which will increase the long run productive potential
of the economy. There will be a rightward shift in LRAS curve and a rise in equilibrium
real GDP.
8. Discovery/development of natural resources has stimulated growth in many countries
e.g. oil for Saudi Arabia and Norway or copper in Zambia. Higher amounts of raw
materials will be available for production, which means that firms will be able to produce
more goods and services. This will increase the long run productive potential of the
economy. There will be a rightward shift in LRAS curve and a rise in equilibrium real
GDP.
Consequences of economic growth

Traditionally economic growth has been looked on as an “economic good”, but it is clear that this
overlooks the considerable costs involved both in terms of human lives, culture and the
environment.

Following are the problems that occur due to increases in output:

Costs of economic growth

1- A decline in current consumption: If an economy is operating at full capacity, there will
be an opportunity cost involved in achieving economic growth. To produce more capital
goods, in order to increase the country’s productive capacity some resources will have to
be moved from producing consumer goods to producing capital goods. So the current
consumption of goods and services will have to be reduced. However, this will only be a
short-run cost since, in the long run, increased investment will increase the output of both
capital goods and consumer goods and services.
2- Stress and Anxiety: A growing economy is a dynamic economy that undergoes structural
changes. Workers may have to learn new skills and may have to change their occupation
and/or where they live. Some workers may find such changes difficult to cope with.
Economic growth may also be accompanied by increased working hours and pressure to
come up with new ideas and improvements
3- Depletion of natural resources: In addition, economic growth may be accompanied by
the depletion of natural resources and damage to the environment. Higher output may, for
example, involve firms using more oil, depleting fish stocks, building on green field sites
and creating more pollution.
4- Inflationary risks: If the economy is near full capacity, an increase in output brought
about by increase in aggregate demand may bid up the pressure on price of resources. This
is because supply of resources is limited. As prices of resources go up, producers raise the
price of goods and services leading to an increase in the general price level in an economy.
Benefits of economic growth
1- Higher living standards: The main benefit of economic growth is the increase in goods
and services that become available for the country’s citizens to enjoy. Higher the
consumption of goods and services, higher will be the amount of wants satisfied. This
raises the material living standards of people in a growing economy.
2- Fiscal Dividend: Economic growth makes it easier to help the poor. Higher incomes and
more spending increase tax revenue and some of this extra revenue may be given to the
poor in the form of higher benefits, better housing, better education and better health care.
Without any increase in output and income, a government may have to raise the tax rates
on higher income groups, and so reduce their living standards, in order to help the poor.
3- A rise in employment: Economic growth may also be accompanied by a rise in
employment. A rise in real GDP caused by higher aggregate demand is likely to create
extra jobs. An increase in aggregate supply may make a country’s products more
internationally competitive and so may generate more jobs.
4- Investment accelerator effect: A stable rate of economic growth tends to increase business and
consumer confidence. Higher the national income, higher the demand for consumer goods and
services. Since capital is a key factor of production, firms need to acquire capital goods to fulfill
this increased demand for consumer goods. This encourages investment and further increases in
economic growth rates.
5- Improved international prestige: In addition, economic growth may increase a country’s
international prestige and power. For example, China’s rapid economic growth since the early
1990s has increased its status as an economic and political power. Moreover, faster the national
income is growing, the easier a country will find to bear the expense of an arms race, or a program
of foreign aid.

Some economists in rich countries debate whether the benefits of economic growth outweigh the costs. For
those in poor countries, however, economic growth is seen as essential to bring people out of poverty.
Table 4.4 shows some of the main consequences in terms of benefits and costs.
107

Sustainability
Very rapid economic growth may be achieved but this may be at the expense of the living standards and
quality of life of future generations if it results from the reckless use of resources. Both developed and
developing countries are now becoming more concerned to achieve sustainable development. This occurs
when output increases in a way that does not compromise the needs of future generations. Materials such
as aluminum, paper and glass can be recycled. More use could be made of renewable resources in
preference to non-renewable resources, and improvements in technology may both increase output and
reduce pollution. Cutting back on CO2 emissions, reducing landfill and dumping less waste into rivers and
the sea are all central to realizing improved sustainability.
CHAPTER 4: EMPLOYMENT/UNEMPLOYMENT

Meaning of unemployment
Unemployment means those people of working age who are actively seeking work at the current
wage rate, but have been unable to do so. It does not include people who are pensioners, full-time
students, or those who choose to stay at home, perhaps to look after children. These are regarded
as inactive.

If the figure is to be expressed as a percentage, then it is a percentage of the total labor force. The
labor force is defined as those in employment plus those unemployed. Thus if 25 million people
were employed and 1.5 million people were unemployed, the unemployment rate would be:

𝑁𝑢𝑚𝑏𝑒𝑟 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 = × 100%
𝐿𝑎𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒
1.5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 = × 100% = 5.7%
26.5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

Measures of Unemployment
Claimant unemployment
Two common measures of unemployment are used in official statistics. The first is claimant
unemployment. This is simply a measure of all those in receipt of unemployment related benefits.
In the UK claimants receive the ‘jobseeker’s allowance’.

Claimant statistics have the advantage of being very easy to collect. However, they exclude all
those of working age who are available for work at current wage rates, but who are not eligible for
benefits. If the government changes the eligibility conditions so that fewer people are eligible, this
will reduce the number of claimants and hence the official number unemployed, even if there has
been no change in the numbers with or without work.
The following categories of people are ineligible for benefits and are thus not included in claimant
unemployment:

• People returning to the workforce (e.g. after raising children).

• Those who are on government training schemes (e.g. school leavers without jobs).
• People over 55. If such people are out of work, the benefit they receive is not regarded as
‘unemployment related’.
• Those in receipt of ‘employment and support allowance’ (previously called incapacity
benefit) but who nevertheless would be available for work of certain types.
• People seeking part-time work, rather than full-time work, for example students.

The claimant statistics therefore understate the true level of unemployment.

Standardized unemployment rates (ILO Method)

The more widely used measure involves a labor force survey using the International Labor
Organization definition of unemployment. In this measure, the unemployed are defined as
people of working age who are without work, available to start work within two weeks and
actively seeking employment or waiting to take up an appointment.

This measure picks up some of the groups not included in the claimant count. It also has the
advantage that it is based on internationally agreed concepts and definitions, so makes international
comparisons easier. More information is found on, for example, the qualifications job seekers
have. However, the data are more expensive and time-consuming to collect than the claimant count
measure. Also, as the data are based on a sample survey, they are subject to sampling error and to
a multitude of practical problems of data collection.

In addition to the possibility of different measures, there are a number of other problems:
1. Inactive workers. Although some of these are genuinely not interested in work, e.g. those
who have retired early, many would work if either their situation changed, e.g. mothers or
fathers with young children, or if the wage rate was more attractive.
2. Discouraged workers are those who are willing and able to work, but because they have
had no success finding a job have given up actively seeking employment.
 3. Part-time workers. Many of these may be working part time because they wish to, e.g.
mothers or fathers with children at school may want hours which fit with the school day.
Others, however, may want to work full time. These are counted as employed, but could
be seen as semi-unemployed.
4. Unreported legal employment. Some workers may register as unemployed to collect state
benefits, but in fact work, thus defrauding the state.
5. Unreported illegal employment. The so-called “underground economy” consists of
illegal activities, such as gambling, the sale of drugs and prostitution. People engaged in
these illegal activities, however, are in employment but are registered as unemployed.

Causes of unemployment

Demand-deficient or cyclical unemployment

Demand-deficient or cyclical unemployment is associated with economic recessions. As the
economy moves into recession, consumer demand falls. Firms find that they are unable to sell their
current level of output. For a time, they may be prepared to build up stocks of unsold goods, but
sooner or later they will start to cut back on production and cut back on the amount of labor they
employ. The deeper the recession becomes and the longer it lasts, the higher will demand-deficient
unemployment become.

As the economy recovers and begins to grow again, so demand-deficient unemployment will start
to fall again. Because demand-deficient unemployment fluctuates with the business cycle, it is
sometimes referred to as ‘cyclical unemployment’. Demand-deficient unemployment is also
referred to as Keynesian unemployment.

Demand-deficient unemployment is illustrated in figure 5.1. Assume initially that the economy is
at the peak of the business cycle. The aggregate demand for and supply of labor are equal at the
current wage rate of W1. There is no disequilibrium unemployment. Now assume that the economy
moves into recession. Consumer demand falls and as a result firms demand less labor. The demand
for labor shifts to ADL2.

If there is a resistance to wage cuts, such that the real wage rate remains fixed at W 1, there will
now be disequilibrium unemployment of Q1 – Q2. Some Keynesians specifically focus on the
reluctance of real wage rates to fall from W1 to W2. This downward ‘stickiness’ in real wage rates
may be the result of unions seeking to protect the living standards of their members (even though
there are non-members out of work), or of firms worried about the demotivating effects of cutting
the real wages of their workers.

Figure 5.1:

Frictional (search) unemployment

Frictional (search) unemployment occurs when people leave their jobs, either voluntarily or
because they are sacked or made redundant, and are unemployed for a period of time while they
are looking for a new job. They may not get the first job they apply for, despite a vacancy existing
and despite their being suitably qualified.

The problem is that information is imperfect. Employers are not fully informed about what labor
is available; workers are not fully informed about what jobs are available and what they entail.
Both employers and workers, therefore, have to search: employers searching for the right labor
and workers searching for the right jobs. The longer people search for a job, the better the wage
offers they are likely to be made.
Structural unemployment
Structural unemployment occurs where the structure of the economy changes. Employment in
some industries may expand while in others it contracts. There are two main reasons for this:

1- A change in the pattern of demand. Some industries experience declining demand. This
may be due to a change in consumer tastes as certain goods go out of fashion; or it may be
due to competition from other industries. For example, consumer demand may shift away
from coal and to other fuels. This will lead to structural unemployment in mining areas.
2- A change in the methods of production (technological unemployment): New techniques
of production often allow the same level of output to be produced with fewer workers. This
is known as ‘labor-saving technical progresses. Unless output expands sufficiently to
absorb the surplus labor, people will be made redundant. This creates technological
unemployment. An example is the loss of jobs in the banking industry caused by the
increase in the number of cash machines and by the development of telephone and Internet
banking.

Structural unemployment often occurs in particular regions of the country. When it does, it is
referred to as regional unemployment. Regional unemployment is due to the concentration of
particular industries in particular areas. For example, the collapse in the South Wales coal mining
industry led to high unemployment in the Welsh valleys. The level of structural unemployment
will depend on three factors:

• The degree of regional concentration of industry: The more that industries are concentrated
in particular regions, the greater will be the level of structural unemployment if particular
industries decline.
• The speed of change of demand and supply in the economy. The more rapid the rate of
technological change or the shift in consumer tastes, the more rapid will be the rate of
redundancies.
• The immobility of labor. The less able or willing workers are to move to a new job, the
higher will be the level of structural unemployment. Geographical immobility is a
particular problem with regional unemployment. Occupational immobility is a particular
problem with technological unemployment where old skills are no longer required.
Seasonal unemployment
Seasonal unemployment occurs when the demand for certain types of labor fluctuates with the
seasons of the year. This problem is particularly severe in holiday areas, such as Cornwall, where
unemployment can reach very high levels in the winter months.

The consequences of unemployment

Unemployment has consequences for the unemployed themselves, firms and the economy as a
whole.

Personal costs of unemployment

1- Loss of income: Workers who lose their jobs are likely to experience a fall in income. The
direct financial cost will be the difference between their previous earnings and
unemployment benefit. A fall in income will lead to a decline in their consumption of goods
and services which will result in a fall in their living standards.
2- Loss of on-the-job training: Workers are likely to find it more difficult to get another job
the longer they have been out of work. This is because they will miss out on training, will
get out of touch with advances in technology resulting in reduced productivity.
3- Low self-esteem and illness: Workers may also experience a decline in their physical and
mental well-being. Staying at home and not being able to cover household expenses may
result in frustration and stress. This may cause the unemployed workers to develop stress
related illnesses.

Costs to the economy

1- Loss of output: Since resources are left idle, output will be below its potential level.
Unemployment will lead to lower output being produced, which means fewer goods and
services will be available for people to consume. Living standards in the entire economy
will decline. Prolonged periods of unemployment may result in loss of labor productivity,
and a fall in potential output.
2- Loss of tax revenue: Since incomes have fallen, revenues from tax on incomes will also
fall. Also, lower incomes lead to reduced spending; therefore, revenues from indirect taxes
 also tend to decline. If state benefits are paid by the government, there will be an increase
in government spending on the benefits which could have been put to other purposes.
3- Deflationary gap: Lower aggregate demand not only from those made unemployed, but
also from those in employment deciding to save more, and consume less, in case they are
made unemployed. This fall in consumption then leads to further unemployment and the
development of a deflationary gap. The rise in savings can lead to a reverse multiplier
effect.
4- Hysteresis effect: There is a rise in the natural rate of unemployment {frictional, structural
and seasonal unemployment} as those made unemployed find that their skills become
outdated so that it is harder to find work, leading to a lack of confidence and motivation
and higher long run unemployment. This is sometimes called the hysteresis effect.
5- Regional problems: as unemployment is often concentrated in certain areas of a country.
This can lead the younger and the more enterprising people in the area to move away,
making it even more depressed and unlikely to attract new jobs.
6- Income inequality can be widened as more people go into relative poverty.

Social costs of unemployment

1- Effect on families and friends: Unemployed persons may become frustrated and stressed
out due to lack of financial resources. Personal relations may become strained as a result
of this frustration. There may be an increase in incidences of domestic violence and families
splitting up.
2- Crime and vandalism: Lack of financial resources may force the unemployed persons to
resort to unlawful ways of getting money. Incidences of street crime and robberies may
increase as a result.
3- Education: where education has to be paid for, families may be tempted to save money by
withdrawing children from schools while at the same time sending them out to work to
bring in more income.
CHAPTER 6: PRICE STABILITY/INFLATION
Introduction
Inflation refers to a general and sustained rise in the price level of goods and services. Inflation is
expressed as the rate of change of prices per period of time. For example if in 2010, inflation rate
in UK was 4.7%, it means that on average prices of all goods and services rose by 4.7% during
2010. Inflation rate is positive whenever prices rise, resulting in a rise in cost of living, and a fall
in purchasing power of money.

Hyperinflation is when the prices are rising at phenomenally high rates and money becomes
almost worthless. For example, in mid-1990’s, Brazil experienced inflation rates averaging around
2300%.

Disinflation: when the general price level rises at a slower rate. For example, in 2013, prices in
UK rose by 7%, while in 2014, prices rose by 4%. So the inflation rate has declined between 2013
and 2014, while the prices continue to rise.

Deflation: is a persistent decline in the general price level of an economy, over a period of time.
In this case the rate of inflation is negative. The purchasing power of the currency has risen while
the cost of living has fallen.

Measurement of inflation: Consumer Price Index

Price inflation is measured by calculating the average percentage change in prices of all goods and
services from one point in time to another. Since we cannot measure the prices of all goods and
services in an economy, a basket of goods and services is chosen for the purpose of measuring
inflation. This basket consists of the goods and services that a typical family or household will
purchase. The prices of this typical basket of goods and services will then be monitored at a small
number of retail outlets across the economy. This price information will be used to compile the
consumer price index. A consumer price index provides a measure of price inflation in an
economy.

Consumer price index (CPI) provides a cost of living measure to the households. The index
indicates how much we need to spend in order to buy the same goods and services that we bought
in the earlier period. CPI will include indirect taxes such as sales tax and excise duties on goods
and services but does not account for changes in income tax or changes in price of assets such as
bonds or stocks. CPI may also exclude prices of oil and electricity since prices of these products
can be highly volatile.

Calculation of Consumer Price Index

In order to calculate CPI, the following steps have to be followed:

1- Selection of base year (index in the base year = 100). This is the reference point from which
inflation is measured.
2- Selection of a basket of goods.
3- Carry out a survey of the retail outlets to measure prices of the goods in the selected basket
in base year.
4- Decide on the weight given to each product in calculation of index. Weights refer to the
proportion of income spent on each product category. For example, if the weight of food
in 0.4, it means 40 percent of the income is spent in food consumption.
5- Survey the retail outlets again in current year and measure price changes since base year.
6- Multiply the weight of each good with percentage changes in price of each good and sum
the weighted price changes to get the rate of inflation. In table 1, the four goods chosen for
the purpose of CPI calculation are given. The proportion of income spent on and price of
each good is given. The weighted price change of each good is calculated by multiplying
the proportion of income spent on each good with the percentage change in its price. The
inflation rate is the sum of the weighted price changes calculated for all product categories.
Table 1: Calculation of CPI
Expenditure Price Price Percentage Weighted
on various index in index in change in price
Product
product Weights base current prices change
category
categories (in year year
$)
Clothing and 2500 0.25 100 150 50 % 12.5%
footwear
Household 1500 0.15 100 120 20% 3%
goods
Food 4000 0.40 100 90 -10% -4%
Travel 2000 0.20 100 160 60% 12%
Total 10,000 100 100 Inflation
rate =23.5%

7- The calculated of CPI: CPI in year 1 is calculated by adding the price inflation to the base
year CPI.

CPI in year 1 = CPI in base year + price inflation = 100 + 23.5 = 123.5

The CPI in year 1 is valued at 123.5. This represents a 23.5 percent increase in the price of the
basket since the base year. If the CPI in year 2 is 130, the inflation rate for the year 2 only can be
calculated as the percentage change in CPI since the last year.

CPI in year 2 – CPI in year 1

Inflation rate in year 2 = × 100%
CPI in year 1

130 − 123.5
= × 100%
123.5
= 5.26%
Problems in CPI calculation

1. Selection of Base year: When consumer price index is to be calculated, a base year is
selected which is the reference point from which inflation is measured. The selection of
base year is critical since this year should not have experienced high fluctuations in
economic activity. It should neither be a recessionary period nor a boom. Thereby,
selection of base year is the first challenge faced in calculation of CPI.
2. Select the basket of goods: It is nearly impossible to measure the changes in price of all
goods and services in an economy in order to construct a consumer price index. Therefore,
economists chose a basket of goods, which represents the goods consumed by an average
consumer in the economy. The price of the basket chosen should reflect the cost of living
of an average consumer. To decide which goods are to be included in and which are to
exclude from the basket of goods is a challenge faced in CPI calculation.
3. Select criteria to calculate weights: The CPI calculation requires that a weight should be
attached to the percentage change in price of each good. It is generally acceptable to
calculate weights on the basis of proportion of income spent on each good. However,
weights may change as consumer expenditure patterns change; therefore, weights will have
to be revised every period.
4. Select outlets to survey in order find price changes: It is nearly impossible for
economists to survey each and every outlet in the economy in order to find changes in price
of the basket of goods chosen. Therefore, a sample of outlets has to be chosen for the
survey. In choosing the sample, the sampling technique is to be decided. For example, the
sample may be chosen on the basis of stratified sampling. Also, sampling will lead to some
degree of sampling bias in the final CPI figure calculated.

The distinction between money (nominal) values and real values

Money values or nominal values are the values at the prices operating at the time. In contrast, real
values have been adjusted for inflation. To convert money values into real values, the figures are
multiplied by the price index in the current year and divided by the price index in the base year.
For example, a worker’s wages may rise from $5,000 in 2015 to $6,000 in 2016. The worker may
think he has received a 20% pay rise. He has in money terms but not in real terms if inflation has
occurred. If the consumer price index was 100 in 2015 and 125 in 2016, his wages in real terms
would have changed to: $6,000 × 100/125 = $4,800. So, in real terms, his income has fallen by
4%. With an inflation rate of 25%, a 20% pay rise will mean that the worker will be able to buy
fewer goods and services. Whenever, inflation rate is greater than the increase in workers’ income,
the real income/purchasing power will decline.

Another example can be taken to distinguish between real and nominal/money GDP. If 100 billion
products are produced at an average price of $5, Nominal/money GDP will be $500 billion. If in
the next year the same output of 100 billion products is produced but the average price rise to $6,
nominal/money GDP will rise to $600 billion. So, to get a truer picture of what is happening to
output, economists convert money/nominal GDP into real GDP. By doing this they remove the
distorting effect of inflation.

For example, in 2016 a country’s GDP is $800 billion and the price index is 100. Then in 2017,
money GDP is $900 billion and the price index is 120.

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 × 𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑖𝑛 𝑡ℎ𝑒 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟

𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 =
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟
Therefore:
$900 𝑏𝑖𝑙𝑙𝑖𝑜𝑛 × 100
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 = = $750 𝑏𝑖𝑙𝑙𝑖𝑜𝑛
120
Causes of inflation

Many economists argue that inflation is the result of either an increase in total demand which pulls
up prices (demand-pull inflation) or an increase in the costs of production which pushes prices up
(cost-push inflation).

Demand Pull inflation

Demand pull inflation is the inflation caused by increases in aggregate demand not matched
by equivalent increases in aggregate supply. Aggregate demand comprises of consumer
expenditure, investment expenditure, government expenditure and net exports.

Demand pull inflation may be cause by:

1) A reduction in income tax: will lead to an increase in disposable incomes. The purchasing
power of consumers will rise, boosting consumer spending. As consumption expenditure
rises, AD will rise leading to an increase in the price level.
2) A reduction in interest rates: Interest rate is defined as cost of borrowing and the return
on saving. As interest rates fall, the cost of borrowing falls. Consumers and firms increase
their demand for loans, boosting consumption and investment expenditure. This will result
in a rise in AD. On the other hand, interest rate is the return on saving. When interest rates
fall, return on saving declines. Hence consumers save less and spend more. As
consumption expenditure will rise, AD will rise leading to an increase in the price level.
3) A rise in government expenditure: on education, health an infrastructure will lead to
higher employment levels. As employment rises, people will earn higher incomes and will
increase their consumption expenditure. Firms will expect their profitability to rise
following a rise in consumer demand, hence they will increase investment spending. As a
result, the AD will rise leading to an increase in the price level.
4) An increase in net exports due to depreciation of the currency: Exchange rate is the
price of one currency in terms of another. As exchange rate depreciates, the domestic
currency becomes cheaper as compared to the foreign currency. Export prices fall, leading
to a rise in quantity demanded of exports. On the other hand, import prices rise leading to
a fall in quantity demanded of imports. If the demand for exports and imports is price
 elastic, export revenue will rise and import expenditure will fall, causing the net exports to
rise. As a result, AD rises leading to an increase in the price level.
5) Monetary inflation is a form of demand-pull inflation arising due to a rise in money supply
in an economy. Money supply is the total quantity of money in circulation in the economy.
If central banks allow the commercial banks to lend more by relaxing credit regulations
(for example, by reducing the paperwork required for borrowing), the money supply in the
economy will rise. Consumers and firms will increase their consumption and investment
spending as a result of a higher quantity of money being available. This will lead to a rise
in AD and a subsequent increase in the general price level of an economy.
A rise in money supply will reduce the interest rate in the economy. Interest rate is defined
as cost of borrowing and the return on saving. As interest rates fall, the cost of borrowing
falls. Consumers and firms increase their demand for loans, boosting consumption and
investment expenditure. This will result in a rise in AD. On the other hand, interest rate is
the return on saving. When interest rates fall, return on saving declines. Hence consumers
save less and spend more. As consumption expenditure will rise, AD will rise leading to
an increase in the price level.

In the figure below, the initial macroeconomic equilibrium is where the AD equals AS at the price
level P. A rise in aggregate demand will cause the aggregate demand curve to shift to the right to
AD1. The equilibrium price level rises to P1. The rise in price level is depicted as demand pull
inflation.

Figure 1:
Cost Push inflation
Inflation caused by rising production costs passed on by firms to consumers is called cost-
push inflation. A rise in cost of production leads to a decline in aggregate supply, resulting in an
increase in the general price level of an economy.

Cost push inflation can be caused by the following factors:

1. An increase in wages not matched by an increase in productivity: If the workers

demand wage increases which are not matched by increase in productivity, production
costs will rise. Firms may raise the prices to cover higher costs to keep their profits
unchanged. However, as workers demand higher wages, firms will reduce their demand
for labor causing the workers to become unemployed. Continuous increases in prices may
occur if the workers keep on demanding higher wages to compensate them for rising prices.
Higher wages again fuel the costs of production and lead to further increase in prices. This
is called the wage-price spiral.
2. Exchange rate depreciation: Cost push inflation may also result if prices of imported raw
materials increase. For example, if there is a fall in value of dollar against other currencies,
then the price of imports in terms of dollars will rise. Imported raw material will become
more expensive and there will be an increase in costs of production. This increase in costs
will be passed on to consumers as higher prices. Inflation caused by rising import prices is
called imported inflation.
3. Rising world energy prices: As world energy prices rise, for example prices of coal, oil,
gas rise, it becomes more expensive for the producers to produce goods and services. Cost
of production will rise, leading to a fall in aggregate supply and a subsequent rise in price
levels.
In the figure below, the initial macroeconomic equilibrium is where the AD equals AS at the price
level P. A fall in aggregate supply will cause the aggregate supply curve to shift to the left to AS1.
The equilibrium price level rises to P1. The rise in price level is depicted as cost push inflation.

Figure 2:
Consequences of inflation

Internal consequences

Negative Internal Consequences

1. Impact on real GDP and unemployment: Demand pull inflation caused by an increase
in AD leads to an increase in the real GDP. This is called economic growth. Higher output
leads to increased demand for labor, therefore, unemployment falls. On the other hand,
Cost-push inflation caused by a decrease in AS leads to a decline in the real gdp. This is
called negative growth. Lower output leads to reduced demand for labor, therefore,
unemployment rises.
2. Unplanned redistribution of income: Inflation causes the real value of fixed payments to
decline. Therefore, borrowers gain and lenders lose as a result of inflation. For example, if
Person A has borrowed $100,000 at the beginning of the year from Person B at an interest
rate of 10 percent per year. During the year, the prices rose by 15 percent. At the end of
year, the borrower will pay $10,000 in interest payments; however, the real value
(purchasing power) of this fixed payment will decline. Therefore, borrowers pay less and
lenders receive less in real terms causing unplanned redistribution of income.
3. Menu costs: As prices of goods and services rise due to inflation, the firms have to change
price lists, price labels, bar codes and catalogues. These changes involve time and costs.
The costs involved in making the above changes are called menu costs.
4. Shoe leather costs: Savers always want to earn higher interest income from their savings
in banks. If the rate of interest doesn’t rise in line with rising prices, inflation causes the
real value interest income to decline. Therefore, savers will pull their savings out of the
current financial institution and will search for financial institutions giving higher interest
rates. The time and money involved in this search is called shoe leather cost.
5. Fiscal drag: Inflation drags consumers into higher tax brackets despite of a decline in
purchasing power. For example, if the income of a person rises by 20 percent, he will have
to pay higher income tax on increased nominal income. However, if the prices increase by
25 percent, then actually the purchasing power of consumer will fall and his real income
will fall. However, since income taxes are charged on money income and not on real
income, the consumer will be dragged into higher tax brackets despite of a decline in his
purchasing power.
 6. Inflationary noise: Inflation causes producers and consumers to make wrong decisions.
For example, given economic theory, the price of any good may rise due to two reasons.
Firstly, inflation may cause the price of a good to increase. On the other hand, if consumers
increase their demand for a particular product, the demand curve for the product will shift
to the right and price will rise. Inflation leads to confusion of signals provided by the price
changes. If the price is only rising because of inflation, the producer may receive a wrong
signal that price of his product might be increasing due to its increasing demand. Therefore,
producer may extend its supply, whereas, actually there has been no increase in demand
and only inflation had caused prices to rise. This will lead to misallocation of resources.
7. Discourages investment: Inflation increases uncertainty in the market and makes it
difficult for entrepreneurs to plan ahead. When businesses cannot plan ahead, they are
discouraged to invest in new projects. Therefore, investment may decline as a result of
inflation.
8. Inflation causing inflation: If economy is experiencing demand pull or cost push inflation,
the general price level would be rising in an economy. Higher prices will reduce the real
income of workers. Therefore, workers may demand higher wages. If employers provide
workers with higher wages, then their cost of production may rise and aggregate supply
will fall. This will again result in cost push inflation. Therefore, inflation causes economic
agents to react in a manner that further leads to even more inflation.

Positive Internal Consequences

1. Inflation reduces the burden of debt: Inflation causes the real value of fixed payments
to decline. Therefore borrowers gain as a result of inflation. For example, if Person A has
borrowed $100,000 at the beginning of the year from Person B at an interest rate of 10
percent per year. During the year, the prices rose by 15 percent. At the end of year, the
borrower will pay $10,000 in interest payments and $100,000 principal amount back.
However, the real value (purchasing power) of this fixed payment will decline. Therefore,
borrowers pay less in real terms causing burden of debt to fall.
2. Stimulates output: Increasing prices of goods means that increasing output will be more
profitable for the firms. Since profit is the motive of firms in the private sector, a low and
stable rate of inflation is necessary to provide incentive for producers to increase their
output.
 3. Prevents unemployment: If inflation rate is zero, firms will not experience any increase
in profits without cutting its costs. Therefore, if prices are not rising, firms may try to cut
labor costs by making workers redundant. By cutting these costs firms will be able to
increase profits. However, a low and stable rate of inflation will steadily increase
profitability of firms in an economy; therefore, they will not need to cut costs by making
workers unemployed.

External Consequences of Inflation

1. A current account deficit: A rise in price level will make exports expensive and imports
cheaper. Demand for exports will fall, and the demand for imports will rise. If the demand
for exports and imports is price elastic, the export revenue will fall and import expenditure
will rise, leading to a current account deficit
2. A financial account deficit: A rise in price level will increase uncertainty in the economy;
therefore, inward investment will decline. Outward investment will rise due to rising
uncertainty in the domestic market. A fall in inflows and rise in outflows in financial
account will also lead to financial account deficit.
3. Exchange rate depreciation: As inflation in domestic economy reduces the export
revenues and inward FDI, the demand for domestic currency falls in the foreign exchange
market. On the other hand, a rise in import expenditure and outward FDI causes the supply
of the domestic currency to rise in the foreign exchange market. This will result in exchange
rate depreciation, which means the price of domestic currency will decline against the
foreign currencies.
CHAPTER 7: GOVERNMENT
MACROECONOMIC INTERVENTION
The aims of macroeconomic policy
The main government macroeconomic policy aims are:

• Full employment
• Low and stable inflation
• Balance of payments equilibrium
• Steady and sustained economic growth • Avoidance of exchange rate fluctuations
• Sustainable economic development.

Price Stability
This actually means low and stable inflation. An increasing number of governments are setting an
inflation target for their central banks to achieve. An inflation target makes the central bank more
accountable and may reduce inflationary expectations if firms, householders and workers have
confidence in the central bank’s ability to meet the target.

Balance of payments equilibrium

Most governments do seek to achieve a balance on the current account of the balance of payments
over time. In the short run, however, a government may welcome a current account deficit if it
arises from the import of raw materials and capital goods. Alternatively, it may encourage a current
account surplus in order to boost aggregate demand or to provide funds to repay external debt.

A government may also encourage a surplus on the financial account of the balance of payments
by attracting foreign direct investment. The investment could increase output and employment in
the country.

Stable Exchange Rate

There are a range of aims a government may have for its exchange rate. A government will usually
seek to prevent wide fluctuations in the value of a floating exchange rate because such fluctuations
are destabilizing. It may decide to operate a fixed exchange rate or a managed float. In these two
cases, it may have to maintain the rate or may seek to alter its value. It may reduce the external
value of its currency to make exports cheaper so as to gain a competitive advantage. A lower
exchange rate may increase output and create jobs.

Full employment
Governments seek to achieve as low unemployment as possible. The nearer an economy is to full
employment, the higher output will be and the higher the living standards people are likely to
enjoy. Governments will be particularly anxious to reduce long-term unemployment as such
unemployment can result in workers being discouraged and dropping out of the labour force. A
reduced labour force would lower potential output.

Sustainable Growth
Governments seek to increase both actual and potential output. They try to achieve sustained
growth by matching the trend growth in potential output with increases in actual output. They also
try to ensure that economic growth is sustainable so that future generations will be able to enjoy
higher living standards. As well as trying to achieve economic growth, governments aim for
economic development. They seek, for instance, to increase life expectancy and educational
opportunities.
Macroeconomic Policies
There are three macroeconomic policies:

1. Fiscal policy
2. Monetary policy
3. Supply side policies

Fiscal and monetary policies are demand side policies. They affect the aggregate demand. Supply
side policies affect the aggregate supply.

Fiscal Policy
Demand side
policies
Macreonomic Monetary
Policies Policy
Supply side
policies
Fiscal Policy

What is a budget?
The Budget is a record of government’s plans for public spending and raising tax revenues for the
coming year. In a budget, the government may simply change tax rates, announce new taxes as
well as public expenditure projects.

A government that plans for a budget deficit expects to spend more than it will earn from tax
revenues. Budget deficits are associated with expansionary fiscal policy where taxes are reduced
and government spending is increased in order to boost aggregate demand, employment and
output. Budget deficits are generally experienced during economic downturns, when tax revenues
are lower and need for public expenditure is higher.

On the other hand, the government may expect a budget surplus if the revenue it earns from taxes
is expected to exceed the public expenditure. The government may expect a surplus when using
contractionary fiscal policy to control inflation.

National Debt
The total amount of money borrowed by the public sector of the country is called the public sector
debt or national debt. Since government of any country represents its people, the national debt is
actually the debt of the tax payers of the country.

If the public sector spends more than it raises in tax revenues and all other revenues, government
will finance this shortfall with loans. The amount of money public sector needs in order to fulfill
its spending is normally called the public sector borrowing requirement.

Governments usually borrow from the private sector by selling short, medium and long term
government bonds. At maturity government will repay the bondholder along with interest payment.
Government bonds are bought and sold on the stock exchange.

Government debt can be:

1) Internal Debt: Owed to individuals, firms and banks within the economy.
2) External Debt: Owed to overseas individuals, firms, banks, governments and international
organizations such as World Bank.
National Debt as a percentage of national income of the economy tells about the ability of the
country to manage its debt repayments. If the interest payments rise faster than national income,
then taxes will have to be increased to make interest payments and other repayments. This will
reduce the economic activity in the country. If interest payments rise at a relatively slower rate
than national income, then it is not a situation to worry about as increase in income will enable the
country to meet its interest obligations. Any country unable to meet its interest or repayment
obligations faces bankruptcy.

Another claim is that national debt is still a burden on the economy. If the debt is internal, then
taxes are raised to repay the debt to domestic individuals and firms. Therefore, it’s just a transfer
of funds from one group of tax payers to others. On the other hand, if debt is external, then
increased tax revenue will go out of the economy to the lenders overseas.

Important Terms
National taxes: are those taxes levied by the central government.

Local taxes: are those taxes levied by the provincial or federal government.

Marginal tax rates: are the tax rates on a higher portion of income.

∆ 𝑇𝑎𝑥 𝑝𝑎𝑖𝑑
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒𝑠 = × 100%
∆ 𝐼𝑛𝑐𝑜𝑚𝑒

Average tax rates: is equal to the total tax paid as a proportion of an individual’s/ firm’s income.

𝑇𝑎𝑥 𝑝𝑎𝑖𝑑
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒𝑠 = × 100%
𝐼𝑛𝑐𝑜𝑚𝑒

Taxation
Types of tax
Designing a tax system
A tax system consists of all types of taxes in an economy. The tax system can be progressive,
regressive or proportional.
In a progressive tax system, the proportion of income taken in taxes rises as income rises. This
means that firms and people with higher incomes pay a higher proportion of their incomes in taxes
than those with lower incomes. Progressive tax system reduces income inequality as rich pay a
larger proportion of their income in taxes than poor. Progressive tax system is considered to be fair
as tax rate is based on a person’s ability to pay. The average tax rate will rise as income rises.
Secondly, the marginal tax rate is higher than the average tax rate. An example is shown below:

Annual Income Tax Paid Average rate of Tax Marginal rate of tax
rate
$20,000 $4000 20%
$50,000 $20,000 40% 53%
$80,000 $48000 60% 93%

In a regressive tax system, the proportion of income taken in taxes falls as income rises. This
means that firms and people with higher incomes pay a lower proportion of their incomes in taxes
than those with lower incomes. Regressive tax system increases income inequality as poor pay a
larger proportion of their income in taxes than rich. Regressive tax system is considered to be
unfair as tax rate is not based on a person’s ability to pay. The average tax rate will fall as income
rises. Secondly, the marginal tax rate is lower than the average tax rate An example is shown
below:

Annual Income Tax Paid Average rate of Tax Marginal tax rate
rate
$20,000 $10,000 50%
$50,000 $20,000 40% 33%
$80,000 $24000 30% 13%

A proportional tax takes the same proportion of income whatever may be the level of income.
The average tax rate is unchanged even if the income rises. Secondly, the marginal tax rate is
equal to the average tax rate. An example is shown below:

Annual Income Tax Paid Average rate of Tax Marginal tax rate
rate
$20,000 $2000 10%
$50,000 $5000 10% 10%
$80,000 $8000 10% 10%
Direct and Indirect Taxation

Direct Taxes
Direct taxes are taken directly from individuals or firms and are imposed on their incomes or
wealth. The tax burden falls on the person responsible for its tax payment.

Direct taxes include the following:

1) Personal Income tax: is a tax payable from an individual’s earnings usually on a pay as
you earn basis. Personal income tax depends on the level of income of an individual as well
as his personal circumstances. For example, a man with children might be charged with
lower rate of personal income tax than a person who does not have kids. Income tax in
many countries is a progressive tax, such that higher marginal tax rates are applied to
higher slices of a person’s income. Income tax is a payroll tax that the employers are
required to withhold from wages and salaries of each employee, and pay the total tax
collected to the government at the year end.
2) Corporation tax: is a tax levied on the profits of limited companies or corporations. It is
also called a profits tax if applied to unincorporated businesses. Government may impose
a one of windfall tax on the profits of a company which is either enjoying very high profits
or is becoming a monopoly power. Corporation taxes are mostly progressive and are kept
very low in some countries to encourage entrepreneurship.
3) Capital gains tax: is a tax levied on profit made on sale of shares, famous paintings,
jewelry, property and other valuable assets.
4) Wealth taxes: can include taxes on the value of residential and commercial land and
property. Wealth taxes may also include inheritance taxes on transfer of wealth from one
person to another.

Indirect Taxes
Indirect taxes are added to the price of goods and services and therefore collected from transactions
made by people and organizations. The collection of indirect taxes is mainly the job of the
producers who pass on the indirect taxes to consumers in form of raised prices. The incidence of
tax or the tax burden falls on the producer as well as the consumer. Where demand is highly price
sensitive, producers may not be able to pass on more burden of indirect taxes to consumers, as any
price increase will lead to a large reduction in demand for the product. Indirect Taxes increase the
cost of production of a firm, reducing its supply, leading to a rise in price and a fall in quantity
traded of the product.

Types of Indirect Taxes

Following are the types of indirect taxes:

1) Ad valorem taxes: such as Value Added Tax (VAT) and other sales tax are levied as a
percentage of the prices of goods and services. Some necessities such as food and
medicines may be exempted from these taxes. VAT is also levied on semi-finished goods,
components and materials, which the producer of final good can recover from the VAT it
collects on the sale of his output.
2) Excise Duties: are normally fixed charges on the amount sold and are levied on specific
goods such as cigarettes and alcohol. The aim is to discourage consumption of these goods.
3) Tariffs: are taxes imposed on the value of imported goods entering the country. Tariffs
may be used to raise the price of certain imported goods to protect domestic firms from
overseas competition. Domestic firms benefit from increased demand for their products as
opposed to imports, while those firms importing material face a hike in costs due to tariffs.

Reasons for Imposition of Taxes

Following are the reasons of imposition of taxes in an economy:

1) Taxes raise revenue to fund public expenditure: Tax revenue is major source of
financing for public sector expenditures, such as expenditures to build roads, bridges.
2) Taxes are used to manage the Macroeconomy: If an economy is experiencing high rates
of inflation, tax rates are increased so as to reduce disposable income and after-tax profits.
This will cause a reduction in consumption and investment expenditure, further causing the
aggregate demand and price level to fall. Cutting taxes in recessions help to boost economic
activity and employment.
3) Taxes can reduce income inequality: High income earners can be taxed more heavily
than low income earners so that the after-tax income gap between rich and poor reduces.
 4) Taxes can discourage spending on imported goods: A tariff on prices of goods purchased
from producers overseas will increase the price of imported goods. This will reduce the
demand for imports and encourage the consumers to purchase domestically produced
goods. The balance of payments will improve and domestic output and employment will
get a boost.
5) Taxes discourage consumption and production of harmful products: High rates of
indirect taxes are imposed on the prices of alcohol and cigarettes to discourage the
consumption of these goods.
6) Taxes can be used to protect the environment: Governments increase taxes on
productive activities which increase pollution. This reduces the return from such activities
which increase pollution, causing producers to use cleaner methods of production.

Government spending

Types of spending: capital (investment) and current

1) Capital expenditure, or gross fixed capital formation, are the terms used for government
investment. This is spending by the government on goods and services intended to create
future benefits, such as:
• infrastructure investment in transport, such as road building
• health and education, such as new hospitals or schools or sewage systems
• research spending, such as defence, space or vaccinations.
2) Current expenditure is government consumption expenditure on goods and services for
current use to directly satisfy the individual or collective needs of members of the
community. This can include the wages of public sector employees, road maintenance, etc.

Reasons for government spending

Governments spend money for many different reasons including to:

• supply goods and services that the private sector would fail to do, such as public goods,
including defence; merit goods such as hospitals and schools; and welfare payments and
benefits, including unemployment and disability benefit.
• achieve supply-side improvements in the macro economy, such as spending on education
and training to improve labor productivity
• reduce the effects of negative externalities, such as pollution
Distinction between expansionary and contractionary fiscal policy
Fiscal policy is the use of government revenue and expenditure to control the economy. This
includes government borrowing.

Contractionary fiscal policy

The opposite is contractionary (sometimes called deflationary) fiscal policy where government
revenue is increased, often leading to a budget surplus, leading to lower inflation, higher
unemployment and lower economic growth. Following are the tools of contractionary fiscal
policy:

1) A rise in direct taxes:

• Direct taxes include income tax and corporation tax. A rise in income tax will cause
the disposable income to fall. As a result, consumption expenditure will fall.
• A rise in corporation tax will cause the after-tax profits to fall. This will cause the
investment expenditure to fall. As consumption and investment will fall, aggregate
demand will fall.
2) A fall in government spending: As government spending falls, the government cuts
spending on education, infrastructure, and etc. This will reduce the jobs available, incomes
will fall and consumption expenditure will fall. Firms expect consumer demand to fall.
Therefore, they reduce investment expenditure. The effects for contractionary fiscal policy
can be observed in figure below. The initial equilibrium price level is P and equilibrium
real GDP is Y. Due to a fall in AD, the AD curve shifts to the left to AD1. The output and
employment fall from Y to Y1 and the price level falls from P to P1.
Figure 1:
Expansionary fiscal policy
Expansionary fiscal policy involves increasing aggregate demand resulting in economic growth,
more employment, but also higher inflation and possibly a deficit in the balance of payments. In
general, expansionary fiscal policy would result in a budget deficit. Following are the tools of
expansionary fiscal policy:

1) A fall in direct taxes:

• Direct taxes include income tax and corporation tax. A fall in income tax will cause
disposable income to rise. Consumption expenditure will rise as a result.
• A fall in the corporation tax will cause the after tax profits to rise. This will cause
the investment expenditure to rise. As consumption and investment will rise,
aggregate demand will rise.
2) A rise in government spending: As government spending rises, the government increases
spending on education, infrastructure, and etc. This will increase the number of jobs
available, incomes will rise and consumption expenditure will rise. Firms expect consumer
demand to rise. Therefore, they increase investment expenditure. The effects of an
expansionary fiscal policy can be observed in figure below. The initial equilibrium price
level is P and equilibrium real GDP is Y. Due to a rise in AD, the AD curve shifts to the
right to AD1. The output and employment rises from Y to Y1 and the price level rises from
P to P1.

Figure 2:
Effectiveness of the fiscal policy

1- Adverse supply-side effects: High tax rates may discourage effort and initiative. The
higher the marginal tax rate (MPT), the greater the stability provided by the tax system.
But the higher tax rates are, the more likely they are to create a disincentive to work and to
invest. For example, steeply progressive income taxes may discourage workers from doing
overtime or seeking promotion. A higher marginal rate of income tax is equivalent to a
higher marginal cost of working. People may prefer to work less and substitute leisure for
income.
High unemployment benefits may increase equilibrium unemployment. High
unemployment benefits, by reducing the hardship of being unemployed, may encourage
people to spend longer looking for the ‘right’ job rather than taking the first job offered.
This reduction in labor supply may lead to a decline in economy’s output (Aggregate
supply).

2- Contractionary fiscal policy is unpopular from a political standpoint: A contractionary

fiscal policy requires the central government to impose higher rates of income tax. When
disposable income falls as a result, the general public becomes unhappy with the current
government and may decide not to favor the current government again. Governments
knowing this may not employ contractionary fiscal policy even when its necessary.

3- Expansionary fiscal policy requires a large size of government budget: When

government employs an expansionary fiscal policy, it is required to cut taxes and raise
government spending. If the government already has a large and persistent budget deficit,
it may not be in a position to cut taxes and increase government spending, rendering the
fiscal policy to be less effective.

4- Problems of predicting the effect of changes in taxes: A cut in taxes, by raising people’s
real disposable income, increases not only the amount they spend but also the amount they
save. The problem is that it is not easy to predict the relative size of these two increases. In
part it depends on whether people feel that the cut in tax is only temporary, in which case
 they may simply save the extra disposable income, or permanent, in which case they may
adjust their consumption upwards.

5- Random shocks: Forecasts cannot take into account the unpredictable, such as the attack
on the World Trade Center in New York in September 2001. Even events that, with
hindsight, should have been predicted, such as the banking crisis of 2007–9, often are not.
Unfortunately, unpredictable or unpredicted events do occur and may seriously undermine
the government’s fiscal policy.

6- Time lag: Fiscal policy can involve considerable time lags. If these are long enough, fiscal
policy could even be destabilizing. Expansionary policies taken to cure a recession may
not come into effect until the economy has already recovered and is experiencing a boom.
Under these circumstances, expansionary policies are quite inappropriate: they simply
worsen the problems of overheating. Similarly, contractionary policies taken to prevent
excessive expansion may not take effect until the economy has already peaked and is
plunging into recession. The contractionary policies only deepen the recession.
Monetary Policy
Monetary policy is the use of money supply, interest rates, exchange rates and credit regulations
to manipulate the level of economic activity. Monetary policy is a demand-side economic policy.
It is usually controlled by the central bank. Monetary policy has consisted of:

• Targeting the money supply

• Controlling interest rates
• Credit regulations

Tools of monetary policy: interest rates, money supply and credit regulations
Interest rates are the cost of borrowing money and the return on saving money. In the last twenty
to thirty years, many governments have stopped directing the central bank as to the rate of interest
to set and has given it independence.

Money supply is the total amount of money in an economy. This can be taken as notes, coins and
easily accessible accounts, e.g. current accounts. Controlling the money supply has proved to be
very difficult and has been largely abandoned in favor of interest rates, although money supply is
still measured as one aspect to consider when deciding policy. In recent years many central banks
have used quantitative easing as a means of increasing the money supply.

Credit regulations: Central banks may impose rules and regulations on commercial banks in order
to manipulate money supply. In past central banks have placed upper limits (ceilings) on bank
loans, and informal requests by central banks have been made to restrict commercial bank lending
and control money supply. Central banks may increase the number of formalities and paper work
required to get loans from commercial banks. This will reduce borrowing and will restrict money
supply.
Distinction between expansionary and contractionary monetary policy
Expansionary monetary policy
If the economy is operating with some degree on unemployment, monetary policy may aim to
achieve the full employment level of national income in an economy. The central bank will need
to induce higher spending to close this gap. An expansionary monetary policy will work in the
following manner to achieve full employment in an economy:

Step 1: Use the instruments of monetary policy to manipulate intermediate targets

Central banks may reduce the number of formalities and paper work required to get loans from
commercial banks. This will increase borrowing and will expand money supply.

Step 2: An increase in money supply will lead to lower interest rates

In figure 1, the original supply of loanable funds is S, yielding an interest rate of r1, where S=D
(point e1). As the central bank raises the money supply by relaxing credit regulations, the supply
of loanable funds rises, shifting the supply curve will shift from S to S1. When the interest rate has
fallen to r2, a new equilibrium is established at point e2.

Figure1:
Step 3: A decline in interest rates will lead to higher spending

Effect of a fall in interest rate on investment

Interest rate is negatively related to investment expenditure. Since interest rate has fallen, cost of
borrowing and financing investment expenditure has declined; therefore, larger will be the number
of investment opportunities that will show a profit. Therefore, lower the interest rate higher the
investment expenditure.

Effect of a fall in interest rate on consumption

Since interest rate is the return on saving, as interest rate falls, return on saving falls. Therefore,
people have less incentive to save, resulting in lower level of savings and higher level of
consumption.

Step 4: A rise in aggregate demand, real GDP and price level

As consumption and investment rise, the aggregate demand rises. As a result, the aggregate
demand curve will shift to the right. The effects of an expansionary monetary policy can be
observed in figure 2. The initial equilibrium price level is P and equilibrium real GDP is Y. Due
to a rise in AD, the AD curve shifts to the right to AD1. The output and employment rises from Y
to Y1 and the price level rises from P to P1.

Figure 2:
Contractionary monetary policy
If the economy is operating with high rates of inflation, monetary policy may aim to reduce the
price level in an economy. The central bank will need to reduce spending to reduce the price level.
A contractionary monetary policy will work in the following manner to control inflation in an
economy:

Step 1: Use the instruments of monetary policy to manipulate intermediate targets

Central banks may increase the number of formalities and paper work required to get loans from
commercial banks. This will reduce borrowing and will contract the money supply.

Step 2: A reduction in money supply will lead to higher interest rates

In figure 3, the original money supply is S1, yielding an interest rate of r1, where the demand and
supply of loanable funds are equal. As the central bank reduces the money supply from, the supply
of loanable funds curve will shift to the left from S1 to S2. When the interest rate rises to r2, the
quantity demanded and quantity supplied of loanable funds become equal again. Monetary
equilibrium is established with a higher interest rate.

Figure 3:
Step 3: A rise in interest rates will lead lower spending

Effect of a rise in interest rate on investment

Interest rate is negatively related to investment expenditure. Since interest rate has risen, cost of
borrowing and financing investment expenditure has increased; therefore, smaller will be the
number of investment opportunities that will show a profit. Therefore, higher the interest rate,
lower the investment expenditure.

Effect of a rise in interest rate on consumption

Since interest rate is the return on saving, as interest rate rises, return on saving rises. Therefore,
people have a higher incentive to save, resulting in higher level of savings and lower level of
consumption.

Step 4: A fall in aggregate demand, real GDP and price level

As consumption and investment fall, the aggregate demand falls. As a result, the aggregate demand
curve will shift to the left. The effects of a contractionary monetary policy can be observed in
figure 4. The initial equilibrium price level is P and equilibrium real GDP is Y. Due to a fall in
AD, the AD curve shifts to the left to AD1. The output and employment falls from Y to Y1 and
the price level falls from P to P1.

Figure 4:
Effectiveness of monetary policy

1. Commercial banks are difficult to be controlled: In practice, it can be difficult to control

the money supply. This is partly because commercial banks have a strong incentive to try
to increase their lending and may seek to get round any limits a central bank seeks to
impose on the growth of their lending. Trying to control certain forms of money may lead
to new forms of money being used.

2. Time lags: Using interest rates is also not without problems. There is a time lag between
changing interest rates and the full effect being transmitted to the macroeconomy. Some
economists have estimated that it can take as long as 18 months for interest rate changes to
have their full impact. This is, however, less time than in the case of some fiscal policy
measures.

3. Mobility of financial expenditure: With increasing mobility of financial expenditure, it

can be difficult for a country to operate an interest rate that is significantly different from
rival countries. If, for example, the country reduces its rate of interest to a level noticeably
lower than that of its rival countries, hot money may flow out of the country. A rise in the
rate of interest may discourage foreign direct investment as it would raise foreign firms’
costs and the firms may expect demand to fall in the country.

4. Interest elasticity of investment demand: Whether or not lower interest rates induce
spending, depends on the interest elasticity of investment demand. Interest elasticity of
investment demand refers to the degree to which firms change their level of investment in
response to changes in interest rates.
In a situation where firms are pessimistic about the economic prospects of the country, they
will not increase investment even if interest rates decline. In such a case, investment
demand is inelastic with respect to interest rates. This means that a large reduction in
interest rates (from r0 to r1) will lead to a small proportionate increase in investment
expenditure (from I0 to I1). This is illustrated in figure 8.7. As lower interest rates fail to
 induce a significant increase in investment, aggregate expenditure will not increase
significantly, resulting in a limited impact on equilibrium national income. Figure 8.7:

5. Expectations: If central bank reduces the interest rates to increase consumption and
investment, consumers and firms will only increase spending if they expect the lower
interest rates to persist. If everyone expects lower interest rate to be a temporary policy,
consumers will continue to save more and spend less. Firms will not increase investment
in fear of rising interest costs in future. Therefore, aggregate expenditure and national
income will not rise in response to a decline in interest rates.
Supply side policies

Supply-side policies are aimed at increasing the productive capacity of an economy. The aim is
to shift the long run supply curve to the right, LRAS to LRAS1, leading to an increase in real
growth and thus employment, while, at the same time, resulting in a fall in the price level.

Supply-side policies are largely aimed at improving productivity and productive capacity. As can
be seen from this, they are essentially microeconomic measures used to influence the macro-
economy. Productivity is the quantity of goods and services produced per unit of input. By
increasing productivity, therefore, the real output of the economy can be increased so that LRAS
has shifted outwards without any increase in the price level. In the diagram below, the initial
equilibrium price level is p1 and real GDP is Y. As a result of the supply side policies, the LRAS
shifts to the right to LRAS1. The equilibrium price level falls to P and real GDP rises to Y1.
Tools of supply-side policy
These policies are often grouped under two headings: labor market measures and product market
measures.

Labor market measures

• Trade union reforms: Ensuring that trade unions do not restrict the working of the labor
market by making it more rigid. This has been controversial as it is difficult to decide
between protecting the rights of workers and freeing up the market so it responds to the
needs of the economy. So if the power of trade unions reduce, they will not be able to go
for strikes. There will be more days at work. The productive capacity will rise and long run
aggregate supply will rise. The LRAS curve will shift to the right.
• Education and training. Government spending on education and training improves
workers’ human capital. They become better quality workers. Their productivity improves
and so the LRAS curve shifts to the right.
• Tax and benefits. It is argued that high rates of direct tax act as a disincentive to people to
work and firms to make profits. Lower rates would encourage more people to work,
especially if these were linked to lower unemployment benefits thus providing a real
incentive to find jobs. Equally, lower taxes on firms would lead to them trying to be more
efficient as they now keep more of their profits and use these for investment. The
productive capacity will rise and long run aggregate supply will rise. The LRAS curve will
shift to the right. Lower income tax will act as an incentive
for unemployed workers to join the labor market, or for existing workers to work harder.
Lower corporation tax provides an incentive for entrepreneurs to start and so increase
national output.

• Local versus national pay agreements. National pay rates often fail to reflect differences
within a country of the supply and demand for labor thus preventing people in areas of high
supply from finding work. If governments abolish the national minimum wages, wage rates
will decline in areas where there is a surplus of workers. Unemployment will fall,
productive capacity will rise and LRAS will shift to the right.
Product market policies
• Privatization and deregulation are ways of introducing competition into the market thus
increasing efficiency and greater productivity. Privatization refers to sale of state owned
assets to private owners. Since private firms aim to maximize profits, they are more
efficient. Wastage is reduced and cost per unit declines. This results in a rise in productive
capacity and LRAS shifts to the right.
• Government may help to improve supply-side performance by giving assistance to firms
to encourage them to use new technology and innovate. This can be done through grants
or through the tax system. This will also encourage a more entrepreneurial culture.
Governments can also improve infrastructure so people and goods can move faster and
more easily. Technological innovation and increased entrepreneurship will lead to higher
productive capacity and LRAS will shift to the right.

Effect of supply side policies on macroeconomic aims

1. As LRAS rises, the LRAS curve shifts to the right. A new equilibrium is established at a lower
price level and a higher real GDP. Hence, a rise in LRAS leads to good deflation and
potential/actual economic growth.
2. As more output is produced, a higher number of employment opportunities will arise. Demand for
labor will rise, leading to a fall in unemployment.
3. Lower price of domestic goods will lead to a fall in price of exports, while imports will appear
relatively more expensive. This may result in a rise in quantity demanded of exports and a fall in
quantity demanded of imports. Export revenue may rise, import expenditure will fall, causing the
balance of trade to improve, and the current account balance to improve.
4. Higher demand for exports will lead to a rise in demand for domestic currency in the foreign
exchange market. While lower demand for imports will reduce the supply of domestic currency in
the foreign exchange market. As a result, exchange rate will appreciate (domestic currency will
rise in value as compared to foreign currencies).

Limitations of supply side policies

1. Large budget is required: Supply side policies like education and training, provision of
grants for research are expensive and time consuming for the government. If governments
 already have a budget deficit, it means that government spending is already higher than tax
revenue. In such a scenario, government will not be able to invest in education/training
programs, hence supply-side policies will be difficult to implement. However, if
governments have a budget surplus, it means that government spending is already lower
than tax revenue. In such a scenario, government will be able to invest in education/training
programs, hence supply-side policies will be easier to implement.
2. Supply side policies take a long time to show their full effect: Supply side policies like
education and training take around 5 to 10 years to show their full effect. Privatization
leads to unemployment and higher prices in short run, however, rationalization in long run
leads to higher efficiency and output levels. Hence supply-side policies may achieve
macroeconomic aims in long run. In short run, demand side policies are to be implemented.
CHAPTER 8: INTERNATIONAL ECONOMIC
ISSUES

The reasons for international trade

Absolute advantage
If a country is more efficient than the other country in producing a good or a service, then that
country is said to have an absolute advantage in the production of that particular good. Absolute
advantage is used in the context of international trade, where for a given set of resources, one
country can produce more of a particular product than the other country. Following are the
assumptions for this model to work:

1. In a two-country, two goods case, there is a linear PPC, which means there are constant
opportunity costs.
2. The assumption is that both the countries devote half of its resources to each product before
specialization.
3. There are no barriers to trade or transport costs.
4. There are constant returns to scale, which means that as inputs are increased, the output
rises by same proportion as inputs.

Specialization is when countries concentrate on producing the goods which they can produce the
best. If both countries do not specialize, then each country will allocate half of its resources to the
production of each good. Then Indonesia can produce 500 kilos of rice and 200 tons of coffee,
while Brazil can produce 200 kilos of rice and 500 tons of coffee. Total output of each country is
700 before specialization.

Before specialization After Specialization

Rice Coffee Rice Coffee
Indonesia 500 200 1000 0
Brazil 200 500 0 1000
Total 700 700 1000 1000
Clearly, Indonesia has an absolute advantage in production of rice while Brazil has an advantage
in production of coffee. If countries specialize, Indonesia will produce only rice and Brazil will
produce only coffee. Therefore, Indonesia will double its output of rice and Brazil will double its
output of coffee.

Advantages of specialization and trade:

1) Each country experiences a rise in output after specialization as shown in the table thereby
leading to economic growth. More workers will be needed to produce higher output
leading to an increase in employment in both countries.
2) Since each country produces the good in which it has an absolute advantage, higher supply
of goods, increased competition and absence of trade barriers leads to lower prices.
3) Absence of trade barriers means that consumers will have a higher variety of goods and
services not only from the domestic market, but also from other countries.
4) Resources will be utilized better as each country will concentrate on producing the goods
for which its resources are best suited. Other goods can be imported.
5) When firms can produce for and export to the world market without any trade barriers, they
will produce in bulk, leading to lower per unit costs and economies of scale.
Comparative Advantage
A country is said to have a comparative advantage in production of a good if it can produce that
good incurring a lower opportunity cost than the other countries. Assume there are two countries
Taiwan and Chile, both producing music players and wheat. Assumptions are the same as for the
theory of comparative advantage. Each country is allocating half of their resources to production
of music players and the other half to wheat production. Following is their output:

Before specialization After specialization

Music players Wheat (tons) Music players Wheat (tons)
Countries produced by 50 produced by 50 produced by produced by
workers workers 100 workers 100 workers
Chile 400 35 0 70
Taiwan 500 30 1000 0
Total Output per 1000 70
900 65
period

In above example, the opportunity cost of one ton of wheat is (400/35) 11.42 music players for
Chile, while for Taiwan its 16.66 (500/30) music players. Therefore, Chile is producing wheat
incurring a lower opportunity cost than Taiwan. Chile is said to have a comparative advantage in
production of wheat.

A country is said to have absolute advantage in production of a good, if it is able to produce that
good or service at a lower average cost per unit than other countries. This means that given each
country employs half of its resources in production of each good, a country will have an absolute
advantage in production of the good which it can produce in higher quantity than the other country.
In the above example, Taiwan has absolute advantage in production of music players while Chile
has an absolute advantage in production of wheat.

If each country would specialize, then Chile will produce only wheat and Taiwan will produce
music players only. Each country will allocate all its resources to the production of the good it is
specializing in. Therefore, 100 workers will produce double the output produced by 50 workers.
Specialization has led to an increase in total output of music players by 100 units, while total output
of wheat rises by 5 tons. If Taiwan now agrees to trade 400 music players for 30 tons of wheat
from Chile, then each country will be better off than it was before trade and specialization.

Evaluation
1) For trade to benefit both countries, the exchange rate should be in the middle of the
opportunity cost ratios of the two countries. The opportunity cost of one ton of wheat is
(400/35) 11.42 music players for Chile, while for Taiwan its 16.66 (500/30) music. If Chile
exports 1 ton of wheat and imports 14 music players from Taiwan, then both countries
benefit from trade as they incur lower costs and higher benefits.
2) Benefits of trade will depend on the mobility of factors of production between
different industries. If the factors of production are perfectly mobile, countries can
specialize in the production of the good in which they have a comparative advantage and
close the other industry. However, if factors of production are immobile, workers
producing one good will not be able to produce the other with the same level of
productivity, causing output to decline. A large number of workers may become
unemployed as well. In such a case, trade will be less beneficial.
3) Benefits of trade will depend on the size of trade barriers and transport costs. The
model doesn’t account for trade barriers and transport costs. If the trade barriers or transport
costs are very high, they will increase the cost of imports. In such a case, even if the other
country is selling a good at a lower price, the addition of transport costs and tariffs may
eliminate the differences in prices of goods between the two countries. Hence, trade will
not benefit both countries in this scenario. However, if the trade barriers/transport costs are
significantly lower, countries will find it cheaper to import some goods rather than
producing the goods themselves, allowing trade to benefit both countries.
Terms of trade
The terms of trade of a country are defined as the ratio of a country’s export prices to import prices.

The terms of trade are calculated as follows:

𝐼𝑛𝑑𝑒𝑥 𝑜𝑓 𝑒𝑥𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒𝑠

𝑇𝑒𝑟𝑚𝑠 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 = × 100
𝐼𝑛𝑑𝑒𝑥 𝑜𝑓 𝑖𝑚𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒𝑠

An increase in the index indicates that more imports can be purchased with a given quantity of exports
and so the terms of trade are said to have improved or to have become more favorable. For example, if
the base year terms of trade is 100. This means that one unit of exports can be used to purchase one unit
of imports. The export prices rise by 100% while import prices rise by 50%. The terms of trade will
now be 133. This means that for every 1 unit of exports, 1.33 units of imports can be purchased.

200
𝑇𝑒𝑟𝑚𝑠 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 = × 100 = 133
150

Conversely, a reduction in the index indicates that fewer imports than previously can be purchased with
a given quantity of exports and so the terms of trade are said to have deteriorated or worsened. For
example, if the base year terms of trade is 100. This means that one unit of exports can be used to
purchase one unit of imports. The export prices rise by 50% while import prices rise by 100%. The
terms of trade will now be 75. This means that for every 1 unit of exports, 0.75 units of imports can now
be purchased.

150
𝑇𝑒𝑟𝑚𝑠 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 = × 100 = 75
200
Causes of changes in terms of trade

1) Changes in exchange rate: If the exchange rate of a country depreciates, it means that domestic
currency is cheaper as compared to foreign currencies. Hence, price of exports will fall and
price of imports will rise, causing the terms of trade to worsen. This would mean that fewer
imports can be purchased with a given amount of exports.
2) Changes in domestic inflation rate: If the domestic inflation rate is greater than that in trading
partner countries, the price of exports will rise by a larger proportion, while that of imports will
rise by a smaller proportion, causing the terms of trade to become favorable. This means more
can be imported from a given amount of exports now.
3) Changes in productivity: If government provides education and training to workers in the
domestic economy, their productivity will rise. This will result in a fall in cost per unit of
production and an increase in aggregate supply of goods and services. As aggregate supply rises,
domestic price level will decline, causing exports to become cheaper and terms of trade to
worsen. This would mean that fewer imports can be purchased with a given amount of exports.
4) Changes in domestic income per capita: If the domestic economy experiences economic
growth, with rising income per capita, the demand for imports will also rise. This will result in
an increase in import prices and worsening terms of trade. This would mean that fewer imports
can be purchased with a given amount of exports.
Other factors affecting terms of trade are summarized in the chart below:

Consequences of changes in terms of trade

Impact on aggregate demand (AD)

An unfavorable movement in terms of trade means that exports price may have fallen, and/or import prices
may have risen. As a result, the quantity demanded of exports will rise and quantity demanded of imports
will fall. If the price elasticity of demand for exports and imports is greater than one (demand is price
elastic), the export revenue will rise and import expenditure will fall, causing the net exports to rise. A rise
in net exports leads to a rise in the current account balance, which may turn out to be beneficial for the
economy.

Furthermore, a rise in net exports will lead to a rise in aggregate demand and real GDP. This is referred to
as economic growth. As real GDP rises, there will be a rise in demand for labor, causing unemployment
to fall. On the other hand, there will be a rise in domestic price level, which is referred to as demand pull
inflation.
In the diagram below, the initial equilibrium price level is P and equilibrium real GDP is Y. Due
to a rise in AD, the AD curve shifts to the right to AD1. The output and employment rises from Y
to Y1 and the price level rises from P to P1.

Figure 1:

Impact on aggregate supply

An unfavorable movement in terms of trade means that exports price may have fallen, and/or import prices
may have risen. As a result, the imported raw materials may have become more expensive. More expensive
raw materials will fuel into higher cost of production and a decline in aggregate supply of goods and
services. As aggregate supply declines, the real GDP will decline leading to negative growth. Falling
output will cause the demand for labor to fall and unemployment to rise.

On the other hand, a rise in cost of production and a fall in AS will lead to a rise in domestic price level,
which is known as cost push inflation.

Figure 2:
In the figure above, the initial macroeconomic equilibrium is where the AD equals AS at the price
level P. A fall in aggregate supply will cause the aggregate supply curve to shift to the left to AS1.
The equilibrium price level rises to P1. The rise in price level is depicted as cost push inflation.

Free Trade or Protectionism

Free trade is defined as trade without any trade barriers. While protectionism refers to the policies
implemented by a government to protect its domestic firms against foreign competition.

Gains from Free Trade

1) International trade allows countries to benefit from specialization: In absence of
international trade, each country would have produced all goods and services it needs, allocating
resources to a wide variety of products, rather than to their best use. This would have resulted
in higher costs, lower output and living standards. International trade allows countries to
specialize in the production of those goods which they produce at lowest cost and trade the
surplus with other countries in exchange of imports. Therefore, incomes, consumption, output
and living standards are higher with free trade.
2) International trade can increase consumer choice: Consumers can enjoy greater variety of
goods from all over the world.
3) International trade increases competition and efficiency: Through international trade, each
country’s firms will face competition from imported goods, therefore will give them an
incentive to become more efficient and reduce costs. Consumers will also benefit from lowest
possible prices due to high competition in international market.
4) International trade creates additional business opportunities: A firm which is unable to
expand due to small market size in domestic economy will have access to a wider market with
free trade. A firm can expand its sales and scale of production as it will be selling its product to
a lot more consumers in the global market. This will allow the firm to lower its costs, earn higher
revenues and profits.
5) Free trade enables firms from best workforces, resources and technologies from anywhere
in the world: Having access to international markets allows firms to find best and lowest cost
sources for materials and components from different producers all over the world. Wages and
 salaries are very low in many developing countries, therefore unrestricted capital movement
allows firms to locate their factories in low wage countries, incur lower cost of production and
earn higher profits. Firms may also import new machinery or technology not available in the
domestic economy, borrow from banks overseas which offer low interest rates and hire
workforce from anywhere in the world, thereby lowering costs.
6) International Trade increases economic interdependency and therefore reduces potential
for conflicts: If economies are more dependent on each other for trade of goods and services,
then armed conflicts are less likely. Therefore, free trade promotes international cooperation
and peace.

Disadvantages of Free Trade

1) International trade with low cost economies is threatening jobs in many developed
countries and reducing opportunities for growth in less-developed countries: Increasing
trade and competition from rapidly growing economies is threatening the survival of many
established firms in developed economies. Established firms may lose market share and may
close down if they are unable to compete with businesses from low cost economies. Small
business in less developed countries may not grow if cheap imports are available in the
economy.
2) International trade is contributing to rapid resource depletion and climate change: Due to
access to wider markets, and increasing scale of production, earth’s natural resources are being
used up at a very fast rate. Increasing travel and transportation of goods across international
borders by road, rails, ships increase pollution and emissions of greenhouse gases, resulting in
climate change which may not be reversible.
3) International trade may increase exploitation of workers and environment: Free movement
of capital across international borders has led firms from developed countries to locate their
factories in less-developed countries which have low wages and low tax rates. This does not
only increase unemployment in developed countries, but also lead to the exploitation of workers,
resources and environment in less developed countries as their labor/environmental protection
laws may be weak.
4) International trade may be increasing the gap between rich and poor: Multinational
companies from developed and rapidly developing countries dominate the demand for natural
 resources such as timber, zinc, copper and etc., thereby forcing down the price of raw materials
exported by less developed countries. This reduces revenues for producers in less developed
countries and increases profit margin of multinationals, increasing the gap between rich and
poor.

Arguments in Favor of Protectionism

1. To protect infant industries: Infant industries are new industries that have a low
output and a high average cost. Firms in a new industry may find it difficult to survive
when faced with competition from more established, larger foreign firms. This may be
because the foreign firms are taking advantage of economies of scale and benefiting
from their names being well-known. Protecting a new infant industry by putting tariffs
or quotas on imports may give it time to grow and so benefit from economies of scale
and to gain a global reputation. If the infant (also called sunrise) industry has the
potential to develop into an efficient industry in line with comparative advantage, then
using trade restrictions may be justified. It is, however, difficult to identify which new
industries will develop and gain a comparative advantage. It is, for example, very
difficult to estimate the long-run average cost curves of firms in the industry.
There is also the risk that an infant industry may become dependent on protection.
Knowing that rival foreign products are being made artificially expensive, it may not
feel any pressure to lower its costs.

2. To protect declining industries: If declining (also called sunset) industries, which have
lost their comparative advantage, go out of business quickly there may be a sudden and
large rise in unemployment. If the industry is granted protection and that protection is
gradually removed, unemployment might be avoided. As the industry reduces its output,
some workers may retire and some leave for jobs in other industries.
There is again, however, a risk that the industry may resist reductions in the protection it
receives. This can lead to considerable inefficiency. For example, a country’s steel industry
may have lost its comparative advantage while its car industry does have a comparative
advantage. If the government imposes tariffs on steel, it will disadvantage its car industry,
 which will now have to buy more expensive steel from domestic producers. This will raise
the car industry’s costs of production and so may lose it sales at home and abroad.

3. To protect strategic industries: Some governments seek to protect industries that

produce products they regard as strategic, such as weapons, fuel and food. They may not
want to be dependent on foreign supplies of these products. For example, a government
may be worried that firms and households in its country would be seriously
disadvantaged if fuel was cut off due to a trade dispute or a military conflict. As a result
it may protect some home industries even if they are relatively inefficient.

4. To prevent dumping: There may be an economic justification for imposing trade

restrictions in the case of dumping as this practice may be regarded as unfair
competition. Dumping involves selling products in a foreign market at below the cost
price.

In the short run, consumers will benefit from dumping as they will enjoy lower prices.
In long run, cheap imports may destroy the market share of domestic firms .
The foreign firms tend to drive out the domestic firms from the market; they may gain a
monopoly and then raise their prices. Indeed, foreign firms may engage in dumping
with the specific intention of gaining control of a market in another country by
destroying existing competition and preventing new domestic firms from becoming
established.
Foreign firms may be able to engage in dumping by covering losses with previous
supernormal profits, by charging high prices in their home markets or because they receive
subsidies from their governments. In reality, it can be difficult to determine if dumping is
taking place or whether the foreign firms have gained a comparative advantage.

5. To improve the terms of trade: If a country purchases a large proportion of another

country or countries’ exports of a product, it may be able to force down its price. By
imposing trade restrictions, it can lower demand and as its demand is significant this may
lead to a lower price. This will improve the country’s terms of trade and allow it to purchase
 more imports for the same quantity of exports. Similarly, if a country accounts for a
significant proportion of the world’s supply of a product, quotas on its exports may
improve its terms of trade. Restricting the supply of exports will drive up their price and
so increase the purchasing power of exports. Of course, such action distorts trade and is
likely to reduce global output. It may also provoke retaliation.

6. To improve balance of payments: A government may impose trade restrictions in order to

improve its current account position. For instance, imposing tariffs may encourage consumers
to switch from buying imports to buying domestic products. This again, however, may provoke
retaliation. If foreign governments do retaliate by imposing their own trade restrictions then,
while the country’s imports may fall, so might its exports. International trade would decline and
again global output would fall. In addition, if the country’s products are not internationally
competitive because of strategic problems, trade restrictions would only provide a short-term
boost to the current account.

7. To provide protection against cheap labor: It is sometimes argued that trade restrictions
should be imposed on products from countries where wages are very low. The view is that, in
order to compete, wages and so living standards in the country would have to fall. This is not a
very strong argument. Low wages do not always mean that a country will be able to produce
products more cheaply as labor productivity may be low and so labor costs may actually be
relatively high. If low wages are actually linked to low costs, it may indicate that the
countries have a comparative advantage. There may be moral arguments for imposing
trade restrictions on products produced using slave or child labor. Even here, however,
other approaches may be more appropriate as trade restrictions may drive down wages
even further in relatively poor countries.

8. Other reasons: There are a number of other reasons why a government may impose trade
restrictions. Tariffs may be used to raise revenue. This will be successful if demand for
imports is inelastic. A government may also engage in trade restrictions to try to persuade
another government to reduce its trade protection. By retaliating against, for instance,
another government imposing a quota on its exports, it may persuade the other government
 to remove its quota. There is, however, a risk that a trade war will develop. In addition, a
government may seek to protect a range of industries to avoid the risks attached to
overspecialization.

Arguments against Protectionism

1) Protectionist measures such as tariffs make imports more expensive. When imports
become more expensive, domestic consumers are unable to afford imported products. They
are forced to buy domestically produced goods. Therefore, protectionism leads to reduced
choice for domestic consumers.

In the diagram above, world supply without tariff is at price Wp. The domestic demand is
500 units and domestic supply is 100 units, leading to a shortage of 400 units which is
imported. The consumer surplus is represented by areas A + B + C+D +E+F. When tariff
is imposed to protect domestic producers, world supply with tariff is now at price Wpt. The
domestic demand now is 400 units and domestic supply is 200 units, leading to a shortage
of 200 units which is imported. Consumer surplus after tariff is represented by areas A+B.
This shows that protectionist tools such as tariffs lead to a reduction in consumer surplus
and consumer choice.
2) Trade restrictions increase trade costs; therefore do not allow countries to take
advantage of specialization and trade: Countries specialize in production of the goods
which they can produce at a lower opportunity cost than other countries (in which they
have a comparative advantage). If countries specialize and trade according to their
comparative advantage, they will be able to produce and sell their goods at a much lower
price than other countries. However, trade barriers such as tariff increase the price of
imports and reduce the cost differences between countries. This leads to erosion of
comparative advantage and does not encourage countries to engage in specialization and
trade.
3) May provoke retaliation from other countries reducing exports and current account
balance: If country A imposes a tariff on imports from country B, then country B may also
impose trade barriers on imports from country A. This will cause the exports of country A
to decline along with its imports, and there might be a reduction in current account balance
if exports reduce by a larger magnitude.
Tools of protectionism
1. Tariff: A tariff is a tax on a particular product as it is imported. They can be either specific
or ad valorem. A tariff raises the price of imports, and reduces the quantity demanded of
imports. This increase in price clearly enables the domestic industry that was previously
unable to compete with the foreign imports to increase its sales. However, the tariff has a
significant impact on consumer welfare.
Initially, the price is Pw at which the domestic consumers are demanding Q1 units, whereas
domestic producers are supplying Q2 units. Hence, the shortage of Q1 to Q2 units is
imported. When the tariff is imposed, the price of imports rises to Pw+t. Due to the higher
import prices, the domestic consumers demand less of the good, and reduce their quantity
demanded to Q3 units. Domestic firms can now sell more as imports are expensive. Hence
domestic sales rise to Q4 units. The shortage now is Q3 to Q4 units which will be imported.
A rise in price of imports has caused the imports to decline and domestic sales to rise.

In the diagram, the consumer surplus is areas 1 till 5, and producer surplus is area 6 when
the price is Pw. When the tariff is imposed, the price rises to Pw+t, the consumer surplus
falls to area 1 as the consumers have to pay a higher price and can consume a lesser
quantity. The surplus for domestic producers will rise to area 2 and 6, as they can sell more.
The government revenue is calculated by multiplying the tariff per unit with the number of
units imported after tariff. The government revenue is represented by area 4. The areas 3
and 5 represent the dead weight loss from the tariff.
Evaluation: The effectiveness of a tariff in reducing the quantity demanded of imports
depends on the price elasticity of demand for imports. If the demand for imports is price
elastic, a small tariff leading to a small increase in price of imports, will lead to a large
proportionate fall in quantity demanded of imports. The tariff will be more effective in this
case. If the demand for imports is price inelastic, a tariff leading to an increase in price of
imports, will lead to a smaller proportionate fall in quantity demanded of imports. The tariff
will be less effective in this case.
2. Quota: A second common method of protection is an import quota which is a limit to the
quantity imported. The limit can be in terms of an actual number or percentage share of the
market. For example, the USA currently imposes a quota on the import of sugar. Quotas
normally involve the issuing of licenses to companies allowing them to import the product
up to a particular limit. Like tariffs, quotas, involve society, particularly consumers, in a
welfare loss but arguably quotas may involve a greater overall welfare loss to society than
tariffs because they generate no tax revenue for the government.
Initially, the price is Pw at which the domestic consumers are demanding Q1 units, whereas
domestic producers are supplying Q2 units. Hence, the shortage of Q1 to Q2 units is
imported. When the quota is imposed, the total supply curve of the good is drawn to the
right of domestic supply curve. The supply curve Stotal shows the total supply of the good
(which includes domestic supply plus the import quota). The price is now P1 (where Qd
equals Stotal). At this price, the domestic demand is Q3, while domestic supply of the good
is Q4, hence Q3 to Q4 units are imported, which represent the size of the quota.
In the diagram, the consumer surplus is areas 1 till 5, and producer surplus is area 6 when
the price is Pw. When the quota is imposed, the price rises to P1 (where Qd equals Stotal),
the consumer surplus falls to area 1 as the consumers have to pay a higher price and can
consume a lesser quantity. The surplus for domestic producers will rise to area 2 and 6, as
they can sell more. The foreign producer’s revenue is represented by area 4. The areas 3
and 5 represent the dead weight loss from the quota.
3. Export subsidy: is a grant given by the government to the exporters of a product. It allows
businesses whose price would be too high abroad to reduce their cost of production and
increase their supply. This will result in a fall in price of exports thus raising their
competitiveness. The quantity demanded of exports will rise, causing exporting firms to
benefit from higher sales and profits.

In the diagram below, the world price of the good is Pw. At this price, the domestic supply
of the good is Q1 units while domestic demand is Q2 units, leading to a surplus of Q1 to
Q2 units which is exported. As the exporters are granted a subsidy, the domestic producers
receive Pw+s, which represents the price received from the consumer plus the subsidy. At
this price, domestic supply rises to Q3, and domestic demand falls to Q4. Hence Q3 to Q4
units are exported, showing a rise in exports. As the exports rise, less of the product is
available for domestic consumers, causing the price in the domestic market to rise, and
quantity demanded to fall to Q4.

Although this will increase sales and thus output and employment, it may also increase
inefficient allocation of resources if the exporting firms which are granted a subsidy lack
 potential. The government could have used the money to focus on goods in which the
country had potential comparative advantage. In this case long-term economic growth may
be reduced.

4. Embargoes: involve a complete ban on the import of a particular product. Such bans are
normally imposed for political reasons involving disputes between nations or during times
of war. Many countries placed embargoes on Syria as a result of the recent civil war. There
may also be embargoes on products that are deemed to be dangerous or harmful such as
drugs. The longest standing embargo is that of the USA on foreign trade with Cuba.

5. Excessive administrative burdens: Countries may seek to limit the quantity of imports of
particular products into a country by imposing excessive administrative burdens, so-called
“red tape”, for importers to go through. These may include having to meet country specific
health or production standards, detailed documentation or having to bring all imported
products through only one entry point, procedures and documentation processes. The
impact is to benefit domestic producers but to reduce consumer welfare as foreign products
are no longer available or only in small quantities thus reducing competition.
Current account of the balance of payments

Components of the current account of the balance of payments

The current account of the balance of payments comprises trade in goods, trade in services, primary
income and secondary income. Any inflow of currency from abroad is a credit item, while outflow
is a debit item.

1. Trade in goods: is sometimes referred to as visible trade and is the difference between
exports and imports of goods. This trade in goods consists of exports and imports of goods
such as oil, agricultural products, computers, white goods and clothing.
2. Trade in services is sometimes referred to as invisible trade and is the difference between
exports and imports of services. It is not possible to see these literally going into or out of
a country. They consist of items such as international tourism, travel, financial services and
insurance. The Rio de Janeiro Summer 2016 Olympic Games brought thousands of tourists
to Brazil. In order to pay for goods and services whilst in Brazil, these overseas tourists
had to change their own currency into Brazilian reals, bringing money into Brazil. This
expenditure by overseas tourists represents an invisible export for Brazil. If on the other
hand a UK producer uses a foreign shipping company to transport its goods, this would
represent an invisible import for the UK because it is taking money out of the UK.

The visible and invisible balance together are sometimes called the balance of trade.

3. Primary income is the net flow of profits, interest and dividends from investments in other
countries and net remittance flows (money sent home) from migrant workers. Qatar, for
instance, owns buildings such as Canary Wharf and The Shard in London from which it
receives income. Indian workers in Dubai send money home to their families in India.
4. Secondary income refers to transfers of money where an economy receives no direct
benefit, such as a good or service, in return. Some examples include overseas aid, military
grants and payments to international organizations.

The balance of the current account is the difference between all the inflows of money from trade
in goods and services and the primary and secondary income and the outflows. This is likely to
give rise to imbalances in the current account where either more money has gone out than has
come in, a deficit, or more money has flowed in than has flowed out, a surplus.

In the chart above, the economy’s expenditure on imported goods is more than its revenue from exports of
goods, hence balance of trade in goods only is in a deficit. On the other hand, the economy’s expenditure
on imported services is less than its revenue from exports of goods, hence balance of trade in services only
is in a surplus. The balance of trade in goods and services is in a deficit as overall export revenue is less
than import expenditure. The primary income and secondary income balances are negative indicating that
outflows were more than inflows. The total current account balance shows a deficit which means that the
sum of all inflows in current account was less than the outflows. The current account balance is calculated
by summing up the balance of trade in goods and services, balance on primary income and secondary
income.
Causes of imbalances in current account

Reasons for an imbalance, in these examples a deficit, include the following:

1. Structural problems: An imbalance is likely to occur when there is limited domestic
production so that a country relies on imports, or because of high standards of living
residents demand a wider range of goods. It may be the case that the developing countries
lack physical and human capital, therefore produce low quality goods which are not in
demand in the international market. This will result in lower export revenue and higher
import expenditure as domestic citizens would prefer imported goods. Hence the current
account will move into a deficit.
A surplus could arise because a country has a reputation for excellence in particular areas
of production, e.g. Germany for engineering products or because of cheap labor leading to
lower prices, e.g. China.
2. Overvalued exchange rate: Countries may lack competitiveness due to an overvalued
currency (e.g. Portugal and Greece as members of the euro could not devalue in the period
2008–2011). An overvalued exchange rate means that exports will be more expensive
leading to a fall in quantity demanded of exports. The imports will appear cheaper, hence
quantity demanded of imports will be higher. If the Marshal-Lerner condition is met, which
means that the sum of elasticities of exports and imports would be greater than 1, the
balance of trade will decline, moving the current account into a deficit.
3. High rate of inflation: If an economy has a high rate of inflation, may be greater than that
of their competitors, its exports will be more expensive leading to a fall in quantity
demanded of exports. The imports will appear cheaper, hence quantity demanded of
imports will be higher. This will cause the balance of trade to decline, moving the current
account into a deficit.
4. Growing domestic economy: Development of new industries sometimes requires the
import of capital goods. So, this may lead to a higher import expenditure and a current
account deficit in the short run. However, in the long run when the industries have
developed, the economy can export more of manufactured goods, and the current account
balance may improve. In this case, the deficit will not persist in the long run.
 5. Lack of confidence in the economy: A deficit is likely to occur when there is lack of
confidence in an economy. This may be because of economic factors such as persistent
current account deficits or large increases in the government deficit. Equally, investors may
fear political change or lack of a stable government.
6. Recession in a trading partners economy: If a country’s main trading partners experience
negative economic growth, the incomes in the partner economies would be declining. Then
they will buy less of its exports, worsening the current account. The opposite will be true
if the main trading partners are growing rapidly.

Consequences of imbalances in the current account of the balance of

payments
The consequences for the domestic economy include the following:

1. Effect on the aggregate demand, output and employment: A deficit on the current
account will cause the aggregate demand to fall. As aggregate demand declines, the real
GDP will also fall causing a reduction in demand for labor and higher unemployment. The
graph below shows the effect of a current account deficit. The initial equilibrium price level
is P and equilibrium real GDP is Y. Due to a fall in AD, the AD curve shifts to the left to
AD1. The output and employment fall from Y to Y1 and the price level falls from P to P1.
2. The government may need to tighten fiscal and monetary policies: to reduce domestic
demand and to introduce supply-side policies to improve productive capability. Consumers
will have less access to imported goods as the government imposes tariffs or quotas.
3. Depreciation of the currency: A current account deficit means exports might be lower
than imports. This will result in a fall in demand for the currency and a rise in supply of
currency in the foreign exchange market, leading to exchange rate depreciation. In the
diagram below, the initial equilibrium exchange rate is at 1£ equals €1.3. A fall in demand
and a rise in supply of the currency will cause the demand curve of the currency to shift to
the left and supply curve to the right. The exchange rate will fall to 1£ equals €1.10.

4. Depletion of foreign currency reserves: As the current account is in a deficit, the outflows
from current account are higher than inflows. To pay for the excess of outflows over
inflows, the foreign exchange reserves will be run down.
5. Borrowing: As the government needs finance the current account deficit, it may end up
taking loans from International monetary fund or from other countries’ governments. In
such a case, interest expense will pile up. As tax revenue will be used to pay back the
interest on the loans, government will have fewer funds left for development expenditure,
for example, spending on education and health.
Exchange rates
Definition of exchange rate: An exchange rate is the price of one currency expressed in terms of
another currency, or against a basket of other currencies.

Determination of a floating exchange rate: A floating exchange rate is where a government

allows the external value of its currency to be determined by the market forces of supply and
demand.

As the exchange rate appreciates, the currency is more expensive as compared to another currency.
Hence, its exports become more expensive and the quantity demanded of its exports will decline.
This will lead to fewer people buying the currency and quantity demanded of the currency will
fall. Owing to the inverse relationship between exchange rate and quantity demanded of the
currency, the demand curve for the currency is downwards sloping.

As the exchange rate appreciates, the currency is more expensive as compared to another currency,
and foreign currency becomes cheaper. Hence, its imports become cheaper and the quantity
demanded of its imports will rise. This will lead to more people selling the currency and quantity
supplied of the currency will rise. Owing to the direct relationship between exchange rate and
quantity supplied of the currency, the supply curve for the currency is upwards sloping.
The exchange rate will be determined by the interaction of demand and supply. In the figure below.
the equilibrium price of the US dollar in terms the Malaysian ringgit is given on the y axis and the
equilibrium is $1 to MYR3. If the demand for dollars increases, the demand curve shifts to the
right D to D1 and the price of the dollar rises from MYR3 to MYR4. It has appreciated in terms
of the ringgit while the latter has depreciated in terms of the dollar. An appreciation of a floating
exchange rate takes place when it increases in value compared to another currency. This can
be seen in the figure below.

The figure below shows the effects on the ringgit. To buy more dollars, more ringgits have to be
sold/supplied causing the price to fall from $1 to $0.75. A depreciation of a floating exchange
rate takes place when it decreases in value compared to another currency.
Causes of changes in a floating exchange
rate: demand and supply of the currency

Factors that cause the value of an exchange rate to change can include:

1. Balance of payments disequilibrium: A balance of payments disequilibrium may arise

as inflows of currency in the economy may rise due to higher exports, and outflows of
currency from the economy may fall due to lower imports. Higher inflows would increase
the demand for the currency and lower outflows may reduce the supply of the currency in
the foreign exchange market. As a result, exchange rate may appreciate. This impact is
shown in the figure below:
2. High domestic inflation: A country with an inflation rate higher than that of other
countries will find that its exports would become expensive. The quantity demanded of
exports will fall, and if the demand for exports is elastic, then the export revenue will also
fall. A fall in inflow of currency will result in a fall in demand for the currency. On the
contrary, imports will appear cheaper and the demand for imports will rise. If the demand
for imports is price elastic, the import expenditure will rise. A rise in outflow of currency
will lead to a rise in supply of the currency in foreign exchange market. This will result in
exchange rate depreciation as shown in the figure below:
3. Interest rates: International money seeks the highest return. If a country raises its rate of
interest, this will attract inflows of money. Non-residents will need to buy the currency,
raising the demand for the currency in the foreign exchange market. Local residents will
reduce saving abroad as domestic interest rates are higher. Outflows of currency will
decline, resulting in reduced supply of the currency in the foreign exchange market. As a
result, exchange rate will appreciate as shown in the figure below:
4. Foreign direct investment: Inflows of money to build factories etc will increase the
exchange rate as this requires the purchase of the domestic currency. This will raise the
demand for the currency in the foreign exchange market. As a result, exchange rate will
appreciate as shown in the figure below:
5. Speculation: If people expect the exchange rate of a country to rise, they will buy, the
currency to make a profit by buying it back at a lower price. When people buy the currency,
raising the demand for the currency in the foreign exchange market, leading to exchange
rate appreciation. The rise in demand and appreciation of the currency is shown in the
figure below:
Consequences of exchange rate depreciation

Impact on aggregate demand (AD)

An exchange rate depreciation will cause a fall in export prices and a rise in import prices. As a
result, the quantity demanded of exports will rise and quantity demanded of imports will fall. If
the price elasticity of demand for exports and imports is greater than one (demand is price elastic),
the export revenue will rise and import expenditure will fall, causing the net exports to rise. A rise
in net exports leads to a rise in the current account balance, which may turn out to be beneficial
for the economy.

Furthermore, a rise in net exports will lead to a rise in aggregate demand and real GDP. This is
referred to as economic growth. As real GDP rises, there will be a rise in demand for labor,
causing unemployment to fall. On the other hand, there will be a rise in domestic price level,
which is referred to as demand pull inflation.

In the diagram below, the initial equilibrium price level is P and equilibrium real GDP is Y. Due
to a rise in AD, the AD curve shifts to the right to AD1. The output and employment rises from Y
to Y1 and the price level rises from P to P1.

Figure 1:

Impact on aggregate supply

An exchange rate depreciation causes import prices to rise. As a result, the imported raw materials
may have become more expensive. More expensive raw materials will fuel into higher cost of
production and a decline in aggregate supply of goods and services. As aggregate supply declines,
the real GDP will decline leading to negative growth. Falling output will cause the demand for
labor to fall and unemployment to rise.

On the other hand, a rise in cost of production and a fall in AS will lead to a rise in domestic price
level, which is known as cost push inflation.

Figure 2:

In the figure above, the initial macroeconomic equilibrium is where the AD equals AS at the price
level P. A fall in aggregate supply will cause the aggregate supply curve to shift to the left to AS1.
The equilibrium price level rises to P1. The rise in price level is depicted as cost push inflation.

Impact on terms of trade

As a currency depreciates, it will make exports cheaper and imports more expensive. Terms of
trade is the ratio of index of export prices to import prices. As export prices fall, and import price
rises, the terms of trade will become unfavorable. This means fewer imports can be bought for a
given amount of exports.

Effect on domestic producers

As exchange rate falls, the import prices rise. More expensive imports lead to lower competitive
pressure on domestic firms, resulting in rising inefficiency, costs and prices in the domestic market.
Quality of goods in domestic market may also suffer.