Unit 2 Notes Economics

UNIT 2 NOTES:
MACROECONOMIC
PERFORMANCE
AND POLICY
MACROECONOMIC PERFORMANCE AND POLICY
MEASUREMENT OF THE ECONOMIC PERFORMANCE OF A

COUNTRY
Economists make use of a number of indicators in order to assess the performance of the country.
These indicators are designed to measure how well the various macroeconomic objectives of the
country have been achieved. Some of the indicators include;
GDP which measures the level of Economic Growth
RPI which measures the level of Inflation
Gini Coefficient which measures the level of Income Distribution
ILO count which measures the level of Unemployment
MEASURING NATIONAL INCOME

National income measures the total money value of the output of goods and services produced within
an economy over a period of time. Measuring the level and rate of growth of national income (Y) is
important to economists when they are considering:
i) The rate of economic growth
ii) Changes over time to the average standard of living of the population
iii) Changes over time to the distribution of income between different groups within the
Population
To measure how much output or income has been generated within a given time period we use
national income accounts. These accounts measure three aggregate components:
1. Output: this represents the total monetary value of the output of goods and services
produced in the country
2. Expenditure: this represents the total amount of expenditure on goods and services
taking place in the economy.
3. Incomes: this represents the total income generated through production of goods and
services.
NATIONAL INCOME AND GROSS DOMESTIC PRODUCT

MEANING AND USES OF GDP STATISTICS
Gross Domestic Product (GDP) measures the value of output produced within the geographical
boundaries of a country over a given time period usually one year. It is concerned only with the factor
incomes generated within the geographical boundaries of the country. For example, the value of the
output produced by Toyota in the UK counts towards UK’s GDP.
CONCEPTS OF NATIONAL INCOME

GNP (Gross National Product)
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Gross National Product (GNP) measures the final value of output or expenditure by a country’s
nationals/ citizens whether they are located at home or abroad.
GNP = GDP + Net property income from abroad (NPIA)
NPIA is the net balance of interest, profits and dividends coming into a country from assets owned
overseas matched against the flow of profits and other income from foreign owned assets located
within the country.
NB: The figure for net property income for the More Economically Developed Countries is usually
positive meaning that GNP is substantially higher than GDP while for the Less Economically
Developed Countries who are net recipients of overseas investment GDP is higher than GNP.
NNP (Net National Product)
Net national product (NNP) is the total market value of all final goods and services produced by
citizens of a country during a given period (gross national product or GNP) less depreciation of
capital stock. It measures the amount of goods produced by the citizens of a given country in a given
year which can be consumed without reducing future consumption.
NNP= GNP- Capital Consumption Allowance (Depreciation)
NOMINAL VS REAL GDP
When we want to measure growth in the economy we have to adjust for the effects of inflation.
Nominal GDP is the value of GDP measured at the current market prices i.e. it is the money value of
GDP since it has not been adjusted for inflation. It is not a good measure of economic growth because
it could lead to misleading conclusions about growth since the value of nominal GDP might increase
simply due to a rise in price levels rather than due to an increase in the output of goods and services.
Real GDP measures the volume of output produced within the economy. It is the value of GDP which
has been adjusted for inflation i.e. it is the value of GDP measured at constant prices. Real GDP is the
most accurate measure of economic growth since the effects of inflation have been removed. It can be
obtained from nominal GDP through a deflation process.
year price output nominal real
2008 50 1000 50000 50000
2009 55 1000 55000 50000
2010 55 1500 82500 82500
2011 60 1400 84000 77000
REAL GDP PER CAPITA

Real GDP per capita is a basic way of measuring the average standard of living for the inhabitants of a
country. It is the amount of Real GDP divided by the total population of a country.
Real GDP per capita= Real GDP
Population Size
LIMITATIONS OF GDP AS A MEASURE OF STANDARD OF LIVING
National income statistics are not an adequate measure of living standards or the social welfare of
people in a country due to the following reasons;
▪ Inequalities of income and wealth
GDP figures on their own do not show the distribution of income and the uneven spread of financial
wealth. Incomes and earnings may be very unequally distributed among the population and rising
national prosperity can still be accompanied by rising relative poverty levels.
▪ Economic growth and negative externalities
Rising national output might have been accompanied by an increase in pollution and other negative
externalities which have a negative effect on economic welfare. Output figures also tell us little about
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the quality of goods and services produced. Faster economic growth might improve living standards
today but lead to an over-exploitation of scarce finite economic resources thereby limiting future
growth prospects.
▪ Long working hours
Rising national output might have been achieved at the expense of leisure time if workers are working
longer hours. Long working hours or poor working conditions may negatively affect the health and
morale of the workers.
▪ The black market / illegal economy
GDP figures might understate the true living standards because of the existence and growth of the
black economy. The black economy includes economic activity that goes unrecorded e.g. income
from drug trafficking. The non-monetized sectors of the economy include output that is not sold at
market prices but involves barter trade, and self-consumed products.
▪ Quality of Goods and Services
The value of GDP does not indicate the quality of goods and services consumed in an economy, yet
the quality of goods and services consumed by people in an economy will influence their living
standards.
▪ Human Rights Issues
A country may have a high GDP per Capita but there may be serious violations of human rights e.g. a
country may have a high GDP as a result of using child labour.
INCOME VS WEALTH
Income is the money one receives from rendering a service or from owning a business property one
can rent or from other income producing investments. Wealth, on the other hand, is the ownership of
income producing assets. Most wealth originates from saved income – a person either saves and
invests a part of their income or they inherit assets from someone who saved and invested their
income. Most truly wealthy people will use the income produced by their assets but generally will not
sell their assets and spend the proceeds on consumption as this will reduce their wealth and the
income it can produce. It is therefore necessary to postpone present consumption in order to save and
invest in the acquisition of wealth that generates a stream of future income. Saving is therefore an
integral part of wealth creation.
A huge percentage of self-made millionaires did not have high incomes. Instead they accumulated
their wealth over time by regular savings (and prudent investment of that savings) or by starting a
business and plowing much of the profit back into the business each year to grow the business. While
some people with high incomes do save and invest regularly and build that savings into true wealth,
many people with very high incomes – sports figures, movie stars, some entrepreneurs whose
businesses take off and makes them a millionaire over night as well as most people who hit it big by
winning a lottery frequently end up spending their money as fast as they acquire it and end up broke
when they lose the job that is producing the income for them.
It is usually the person who steadily saves and invests money over time who retires wealthy while the
person who begins with a high paying job and a high propensity to consume ends up with little or
nothing to show for their efforts in the future. The position of large amounts of wealth, not merely
income, is what distinguishes rich people from the rest of the population. Income based on a large
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amount of wealth (investments) is generally more stable than income based on work, since a person
may lose his or her job and be suddenly without any income.
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THE TRADE CYCLE

This refers to the fluctuations of economic activities and real national income over a give period of
time. The following diagram illustrates a trade cycle;
The trend rate of growth represents the sustainable rate of growth at full capacity. The four stages of
the trade cycle include;
BOOM
In this stage of the trade cycle, real national income will be at its highest level. The economy will
experience full employment of its resources and an increase in imports in the long run. Inflationary
pressure will be very high at this stage.
RECESSION
This stage is characterized by a fall in real national income/ GDP as well as a fall in consumption and
investment expenditure. There is a decrease in imports as well as a loss of investor confidence in the
economy. The Unemployment rate begins to rise while the rate of inflation falls leading to a fall in the
rate of growth of earnings or income.
DEPRESSION
This is the severest point of a recession where there is a total collapse of the economy characterized
by the highest level of unemployment, the lowest level of investment and consumption and the lowest
level of inflationary pressure.
RECOVERY
This stage is characterized by an increase in real national income/ GDP as well as an increase in
consumption and investment expenditure. There is a fall in the Unemployment rate as well as an
increase in investor confidence levels. Inflationary pressure begins to increase.
NB: A business cycle may be caused by; Political changes, Climatic changes, outside shocks or
changes in the financial market e.g. the speculative bubble. A speculative bubble arises when as a
result of rapid economic growth, prices of assets e.g. house prices, share prices etc. begin to rise
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rapidly due to speculative demand. When people later realize that the asset prices have risen far above
their real value, they may start to sell their assets causing the speculative bubble to burst. This may
erode consumer and business confidence which may lead to an economic recession.
GDP/ INCOME/ OUTPUT GAP

The output gap (or GDP gap) refers to the difference between the actual level of national output and
its potential. An economy can operate either above or below its productive potential over a period of
time. For instance during a recession, an economy will not produce to its potential level of output
while during a boom, it may operate beyond its productive potential since workers may work for
extensively longer hours. The output gap can either be negative or positive.
Negative output gap
If actual GDP is less than potential GDP there is a negative output gap. Some factor resources
including labour are under-utilized and the main economic problem is likely to be high levels of
unemployment. High unemployment indicates an excess supply of labour in the factor market which
means there is downward pressure on real wage rates.
Positive output gap
If actual GDP is greater than potential there is a positive output gap. Some resources including labour
are working beyond normal capacity e.g. shift work and overtime. The main economic problem is
likely to be demand pull and cost-push inflation.
THE TRADE CYCLE AND OUTPUT GAP
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GOVERNMENT MACROECONOMIC
OBJECTIVES
Macroeconomic Objectives are the aims or goals that governments in all parts of the world seek to
achieve. They include;
● Economic growth
● A low rate of inflation / Price stability
● Full Employment / Low unemployment rate
● Balance of Payments equilibrium
● Equitable income distribution
● A clean environment
The Main Objectives of Government Economic Policy are therefore to ensure;
● Sustained economic growth

● Stable prices (low inflation)
● A high level of employment
● A rise in average living standards
● Sustainable position on the balance of payments
● Sound government finances/ Government balanced budget
ECONOMIC GROWTH AND ECONOMIC

DEVELOPMENT
MEANING AND MEASUREMENT OF ECONOMIC GROWTH- GDP
Definition of economic growth

Economic growth is best defined as the increase in the real GDP of a country over a given period of
time usually one year. It represents a long-term expansion of the productive potential of the
economy.
Economic Growth = RGDP1 – RGDP0 x 100
RGDP 0
WHERE;
RGDP1 is the current year real GDP
RGDP0 is the previous year real GDP
Practice Question
If the real GDP in 2010 was sh360b and rose to sh390b in 2011, calculate the economic growth rate
for the year 2011.
Economic Growth and the PPF
An increase in economic growth can be illustrated by an outward shift of the PPF. This is because
economic growth brings about an increase in the productive potential of an economy. An increase in
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productivity implies that more output can be obtained from the same quantity of inputs through
increased efficiency. Productivity refers to the rate at which factor inputs generate output. An increase
in productivity leads to;
● Economic growth and an improvement in the standards of living.
● A fall in the costs of production hence an increase in profits due to efficiency.
● A fall in inflationary pressure.
● An increase in employment levels.
● An improvement in the current account of Balance of Payments.
NB: A productivity gap exists when the actual output per unit of input differs from the potential
output per unit of input.
Factors affecting Economic Growth
❖ An increase in investment- this will lead to an increase in the production of goods and services
resulting in an increase in real GDP.
❖ Education and training- this will lead to an increase in labour productivity resulting in an
increase in the output per worker.
❖ Improvement in technology-this will lead to an increase in the productivity and efficiency of
factors of production. Technological improvements are important because they reduce the real
costs of supplying goods and services which leads to an outward shift in the Aggregate Supply
Curve.
❖ Investment in infrastructure- improved infrastructure will attract Foreign Direct Investment
(FDI).
❖ An increase in the quality and quantity of resources- an increase in the labour force due to
migration or the discovery of new resources will increase the productive potential of an
economy.
❖ Government policy- the government can use expansionary demand management policies or
supply side policies to influence the level of real output in the economy.
❖ Productivity growth- For most countries it is the growth of productivity that drives the long-
term growth. The root causes of improved efficiency come from making markets more
competitive and achieving better productivity within individual plants and factories.
❖ Political stability
❖ Changes in birth rates
Advantages of Economic Growth
● Higher Standard of Living– this is measured by an increase in real national income per
capita. If the growth in Real GDP is greater than the population growth rate, there will be an
increase in income per capita. This will lead to an increase in consumption thereby resulting to
an improvement in the standard of living.
● Employment creation- Economic Growth creates additional employment opportunities
because more workers are needed to generate the additional output.
● Higher Government Revenue- Economic Growth has a positive effect on government
finances as it increases tax revenues thus providing the government with extra money to
finance spending projects.
● Investor and Business Confidence- Economic growth normally has a positive impact on
company profits & business confidence creating an enabling environment for the growth of the
stock market and also for the growth of small and large businesses alike.
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● National Prestige- A high rate of Economic growth will earn a country respect both locally
and internationally.
● Income redistribution- increased economic growth will enable the government obtain the
revenue required to provide essential merit and public goods especially to the poor.
Disadvantages of economic growth
● Inflation- If the economy grows there is the danger of inflation as Aggregate demand
outpaces aggregate supply. Producer may take advantage of this by raising prices for
consumers.
● Environmental degradation- the increase in production and consumption resulting from
Economic growth can create negative externalities. For instance, there may be increased noise
and lower air quality arising from air pollution and road congestion, increased consumption of
de-merit goods, the rapid growth of household and industrial waste and the pollution that
comes from increased output in the energy sector. These externalities reduce social welfare
and can lead to market failure. Growth that leads to environmental damage can have a
negative effect on people’s quality of life and may also impede a country’s sustainable rate of
growth. Examples include the destruction of rain forests, the over-exploitation of fish stocks
and loss of natural habitat created through the construction of new roads, hotels, retail malls
and industrial estates.
● Balance of Payments deficit- as income increases, people tend to buy imported goods which
can lead to a BOP deficit in the long run.
● Depletion of non renewable resources.
MEANING AND MEASUREMENT OF ECONOMIC DEVELOPMENT

DEFINITION OF ECONOMIC DEVELOPMENT
Economic development refers to the sustainable increase in the living standards or quality of life of
individuals in a country. The quality of life is influenced by the quality and quantity of goods and
services consumed in an economy as well as other variables such as human rights, democracy,
infrastructure etc. Economic development in its simplest form is the creation of economic wealth for
all citizens within the diverse layers of society so that all people have access to potential increased
quality of life.
FEATURES OF ECONOMIC DEVELOPMENT
o An improvement in the standard of living.
o Growth of real GDP/GNP per capita.
o Reduction in absolute poverty i.e. people can attain minimum requirements of life e.g. food,
shelter, healthcare etc.
o Reduction in income inequality.
o Reduction in unemployment.
o Expansion in the manufacturing sector and the use of appropriate technology.
o Freedom of choice be it political, social or economic freedom.
o Improvement in infrastructure.
o Reduction in population growth.
o Improvement in savings and investment.
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MEASURES/ INDICATORS OF ECONOMIC DEVELOPMENT

▪ GDP per capita at Purchasing Power Parity.
▪ Human Development Index ( HDI)
▪ Income distribution
▪ Human Rights
▪ Gender equality.
▪ Mortality rate.
▪ Population growth rate.
▪ Dependency ratio.
▪ Human Poverty Index ( HPI)
▪ Doctor to patient ratio.
▪ Access to clean water
▪ Access to mobile phones per thousand of the population
GDP per capita at Purchasing Power Parity
Purchasing power parity (PPP) allows for the comparison in the standard of living between countries
by taking into account the impact of their exchange rates. This purchasing power exchange rate
equalizes the purchasing power of different currencies in their home countries for a given basket of
goods.
GDP per capita is obtained by dividing the GDP by the population size of a country. It gives an
approximation of the value of goods produced per person in the country or an average figure of
national income per head of population. A high GDP per capita is an indicator of a standard of living.
However, GDP figures do not show the distribution of income in an economy. In a case where income
is unequally distributed among the population, a country can continue to have rising poverty incidents
despite having a high GDP per capita figure. PPP values also change very quickly and are likely to be
inaccurate or misleading.
Human Development Index
The Human Development Index (HDI) is a composite index of measuring economic development
combining measures of life expectancy, literacy, and GDP per capita at PPP. It is the most common
measure of development and has been adopted by the United Nations Development Programme
(UNDP) as a yardstick against which countries are ranked with respect to the quality of life. It is a
broader measure of development when compared to real GDP as it reflects a country’s achievements
in the most basic human capabilities i.e. living a long life, being knowledgeable and enjoying a decent
standard of living. The HDI combines three basic dimensions:
● Life expectancy
● Literacy rate (with two-thirds weighting) and the combined primary, secondary, and tertiary
gross enrollment ratio (with one-third weighting).
● Gross domestic product (GDP) per capita at purchasing power parity (PPP) in United States
dollars.
The HDI index ranges between 0 and 1 where the best countries are ranked 1 and the worst are ranked
0.
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Advantages of the HDI
● Data on Measures chosen is easy and cheap to collect.

● Measures chosen are fairly reliable.
● The use of education and health are signs of successful government policies.
● It is internationally recognized
● It can be used to compare development between countries
Disadvantages of the HDI
● PPP values change very quickly and are likely to be inaccurate and misleading.
● An indication of deprivation and poverty would increase the usefulness of HDI.
● It does not consider income distribution which is an indicator of welfare.
● Quality of life is not tackled effectively e.g. it does not capture the incidence of war, political
oppression, discrimination etc.
● Other measures such as access to the internet, access to clean water, access to electricity,
access to mobile phones etc. might be more useful
ECONOMIC GROWTH VS ECONOMIC DEVELOPMENT

Economic growth is just a component of economic development. It is a necessary condition for
economic development but not a sufficient condition to promote development. It is therefore possible
for a country to achieve economic growth without development e.g. in an instance where economic
growth is benefiting only a small subsection of the economy without a trickle down effect on
economically marginalized sections. Growth in GDP may also lead to an increase in negative
externalities thereby resulting to a fall in the quality of life.
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AGGREGATE DEMAND (AD)

This is the total demand for all goods and services in an economy over a given period of time. It is the
total planned expenditure from all sectors of the economy i.e. it is the planned expenditure from the
household sector, the business sector, the government sector and the foreign trade sector.
COMPONENTS OF AGGREGATE DEMAND

● Consumption expenditure
● Investment expenditure
● Government expenditure
● Net exports
This can be summarized in the following equation;
AD= C + I + G + (X-M)
Where;
C= Consumption expenditure
I= Investment expenditure
G= Government expenditure
X=Exports
M= Imports
CONSUMPTION EXPENDITURE
This is the total expenditure on goods and services by individuals and households ton satisfy their
needs and wants. Personal consumption expenditure on goods and services comprises the largest share
of total expenditure or Aggregate Demand. This includes demand for consumer durables e.g. washing
machines, audio-visual equipment and motor vehicles as well as non-durable goods such as food and
drinks. Household spending accounts for over sixty five per cent of aggregate demand in the UK.
Types of Consumption Expenditure
Consumption Expenditure can be divided into two categories;
● Autonomous consumption
This is the level of consumption that is independent of income i.e. the level of consumption even
if the income was zero.
● Income induced consumption

This is the level of consumption that is dependent of income i.e. the higher the income the higher
the consumption level.
These categories can be represented in an equation as follows;
C = a + bYd
Where
a= autonomous consumption
b= Marginal Propensity to Consume
Yd= disposable income i.e. income after tax
bYd= Income induced consumption
Determinants of Consumption Expenditure
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Consumer spending is often the main driver of growth or recession in an economy. The amount that
consumers spend is largely influenced by the income and attitude of the consumer e.g. a consumer can
decrease the level of consumption if he or she is worried about losing a job or is anxious about a low
pension.
Determinants of Consumption Expenditure include;
i) Disposable Income
This is the main determinant of Consumption Expenditure. With an increase in disposable income,
consumers are likely to increase Consumption Expenditure.
ii) Population size

An increase in the size of the Population, will lead to an increase Consumption Expenditure.
iii) Inflation
An increase in inflation will lead to a decrease in the purchasing power of money thereby leading to a
decrease in Consumption Expenditure.
iv) Savings
An increase in current savings will lead to a decrease in the level of Consumption Expenditure.
v) Consumer confidence
An improvement in the level of Consumer confidence in an economy will result in an increase in
Consumption Expenditure especially of durable goods.
vi) Wealth effect

An increase in the value of people’s wealth will result in an increase in Consumption Expenditure.
This is referred to as the Wealth effect. For instance, the most commonly held assert is a house. If the
prices of houses are increasing, people will feel inclined to spend on other goods and services since
they can borrow more on the strength of the value of their houses thereby leading to an increase in
Consumption Expenditure.
vii) Government policy

Government policies such as tax cuts, grants, subsidies etc. will lead to an increase in Consumption
Expenditure.
viii) Interest rates
When households can access credit cheaply due to low interest rates, there will be an increase in
Consumption Expenditure on interest sensitive goods.
Concepts of Average and Marginal Propensity to Consume
a) Average Propensity to Consume

This is the average amount of income that is spent on Consumption.
APC= Total Consumption Expenditure = C = a +b Yd = a + b

Total Disposable Income Yd Yd Yd
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b) Marginal Propensity to Consume

This is the rate of change of consumption following a change in income. It is the marginal
change in consumption arising from a unit change in income.
MPC= ∆Consumption Expenditure = ∆C = ∆ (a +b Yd) = ∂ C = b

∆Disposable Income ∆Yd ∆ Yd ∂Yd
ILLUSTRATION
Given the consumption function C= a + bYd where b= 0.8, interpret the value of b.
INTERPRET ATION
A Marginal Propensity to Consume of 0.8 means that if the value of disposable income was to go up
by 1 unit, there would be an increase in Consumption Expenditure by 0.8 units.
INVESTMENT EXPENDITURE
Investment refers to the accumulation of capital stock in an economy within a given time period. It is
the expenditure on capital stock such as new machines, equipment and buildings. Investment also
includes spending on working capital such as stocks of finished goods and work in progress. An
increase in investment will usually involves postponing current consumption in order to acquire
capital goods which will increase the productive capacity of an economy in future. Capital investment
spending in the UK accounts for between 15-20% of GDP in any given year.
Determinants of Investment Expenditure
i) Interest rates
A decrease in interest rates will lead to a decrease in the cost of borrowing resulting to an increase in
Investment Expenditure since most investors will be able to borrow cheaply so as to either establish
new investments or to expand existing ones.
ii) Investor confidence

If the investors are optimistic about the future performance of a country’s economy, they are likely to
invest more thereby leading to an increase in Investment Expenditure.
iii) Government policy

The government can encourage investment using policies such as tax holidays, privatization, subsidies
etc. it can also influence investment by establishing an effective legal system in order to reduce
corruption.
iv) Political Stability
A favourable political climate in a country will provide an enabling environment for investment
which will attract local and foreign investors thereby leading to an increase in Investment
Expenditure.
v) Education and training

Effective education and training will improve labour productivity thereby attracting investment.
vi) Income
An increase in income will result in an increase in Investment due to an increase in aggregate demand.
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Types of Investment
There are two broad categories of investment;
● Autonomous investment- This is the level of investment that is independent of income i.e.
one would rather borrow to finance the investment than do without it e.g. investment in human
capital such as college education.
● Income induced investment- This is the component of investment that is dependent of

income i.e. the higher the income or output the higher the consumption level.
GOVERNMENT EXPENDITURE
This is government spending on state-provided goods and services including public and merit goods.
Decisions on how much the government will spend each year are affected by developments in the
economy and also by the changing political priorities of the government. Examples of government
expenditure include the hiring of civil servants and military personnel and the construction of roads
and public buildings.
Determinants of Government Expenditure
i) Population size and structure

An increase in the population size will lead to an increase in government spending on essential
services such as education, health, security etc. Changes in the population structure will also influence
government expenditure e.g. an increase in the ageing population will lead to an increase in
government expenditure on social security.
ii) Tax revenue

An increase in tax revenue will lead to an increase in government expenditure.
iii) Level of economic performance

Government expenditure on social security such as unemployment benefits will increase when the
economy is in a recession.
iv) Political climate and stability

Government expenditure is influenced by the political climate in a country. A government is likely to
increase its expenditure on certain public goods in order to gain political popularity.
v) Government policy
Government policies such as subsidies, buffer stock schemes etc. will lead to an increase in
government expenditure. On the other hand, policies such as privatization will lead to a decrease in
government expenditure on nationalized industries.
NET EXPORTS
This is the difference between the expenditure on exports by foreigners and imports by domestic
consumers. Exports are goods and services produced domestically but sold to foreigners, while
imports are goods and services produced by foreigners but sold domestically. Exports sold overseas
are an inflow of demand (an injection) into the circular flow of income and therefore add to the
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demand for a country’s output. Imports are a withdrawal of demand (a leakage) from the circular flow
of income and spending i.e. Goods and services come into the economy but there is a flow of money
out of the economy to pay for them.
Net exports (X-M) reflect the net effect of international trade on the level of aggregate demand.
When net exports are positive, there is a trade surplus leading to an increase in AD and when net
exports are negative, there is a trade deficit leading to a fall in AD. Any change in the level of imports
or exports will therefore influence the level of aggregate demand.
Determinants of net exports
i) Domestic prices
If the prices of domestic goods are relatively higher than the prices of imports, there will be a fall in
demand for exports and an increase in demand for imports. This will lead to a fall in net exports.
ii) Quality of domestic goods
If the quality of domestic goods is lower than the quality of imports, there will be a fall in demand for
exports and a decrease in demand for imports. This will only be realized if the demand for both
imports and exports is price elastic.
iii) Exchange rates
If the value of a currency depreciates, exports will be cheaper than imports leading to an increase in
demand for exports and an increase in demand for imports.
iv) Trade barriers
Trade restrictions imposed on exports such as tariffs and quotas will lead to a fall in exports thereby
leading to a fall in net exports.
v) Income levels in foreign countries
An increase in the level of income in foreign countries will lead to an increase in exports and vice
versa.
Aggregate Demand (AD) Curve
The aggregate demand curve represents the total quantity of all goods and services demanded by the
economy at different price levels. It shows the relationship between the general price levels in an
economy and the total expenditure on goods and services from all sectors of the economy. The AD
curve slopes downwards from left to right like any other normal demand curve.
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Reasons why the aggregate demand curve slopes downwards

Wealth effect
As the price levels rise, the wealth of the economy declines in value because the purchasing power of
money falls. As buyers become poorer, they reduce their purchases of all goods and services. This
will lead to a decrease in aggregate demand thereby resulting to an upward movement along the AD
curve. On the other hand, as the price levels fall, the purchasing power of money rises. Buyers
become wealthier and are able to purchase more goods and services than before.
Interest rate effect
As the price level rises, households and firms require more money to handle their transactions.
However, the supply of money is fixed. The increased demand for a fixed supply of money causes the
price of money, the interest rate, to rise. Most banks will always adjust their interest rate upwards in
order to put up with inflation. As the interest rate rises, spending that is sensitive to rate of interest
will decline. This will lead to a decrease in aggregate demand thereby resulting to an upward
movement along the AD curve.
Net exports effect
As the domestic price level rises, foreign-made goods become relatively cheaper so that the demand
for imports increases. The rise in the domestic price level also means that locally made goods are
relatively more expensive to foreign buyers so that the demand for exports decreases. When exports
decrease and imports increase, net exports decrease. Because net exports are a component of real
GDP, the demand for real output declines as net exports decline resulting to an upward movement
along the AD curve.
Exchange rate effect
Real balance effect
NB: Any change in price levels will lead to a movement along the AD curve.
SHIFTS OF THE AGGREGATE DEMAND CURVE
AD will shift to the right from AD 1 to AD2 indicating an increase in aggregate demand while a shift to
the left from AD1 to AD3 indicates a decrease in aggregate demand. A rightward shift means that at the
same price level the quantity demanded of real GDP has increased while a leftward shift means that at
18
the same price level the quantity demanded of real GDP has decreased. A shift of the AD curve may
be brought about by a change in any non-price factor affecting the components of aggregate demand.
Such factors include;
a) Changes in money supply
b) Changes in consumer confidence
c) Changes in government expenditure
d) Changes in taxes
e) Changes in interest rates
f) Changes in population
g) Changes in the level of income abroad
h) Changes in the domestic level of income
i) Changes in investor confidence
j) Changes in exchange rates
k) Changes in trade barriers
l) Changes in quality of goods and services
m) Changes in income distribution
n) Changes in Expectations
Aggregate demand shocks
A number of unexpected events can happen which cause changes in the level of demand, output and
employment in the economy. These unplanned events are called “shocks.” One of the main causes of
fluctuations in the level of economic activity is the presence of demand-side shocks.
Some of the main causes of demand-side shocks are as follows:
● A capital investment boom e.g. a construction boom to increase the supply of new houses
or to build new commercial and industrial buildings.
● A rise or fall in the exchange rate – this will affect net exports and will have effects on
output, employment, incomes and profits of businesses linked to export industries.
● A consumer boom abroad in the country of one of a country’s major trading partners
which affects the demand for exports of goods and services.
● A large boom in the housing market or a slump in share prices.
● An unexpected cut or an unexpected rise in interest rates.
19
AGGREGATE SUPPLY (AS)

This is the total amount of output that all firms in an economy are willing and able to supply at
different price levels in a given period of time. It is the total amount of output of all goods and
services produced in an economy and represents the ability of an economy to produce goods and
services either in the short run or in the long run.
Aggregate Supply (AS) Curve

The aggregate supply curve depicts the quantity of real GDP that is supplied by the economy at
different price levels. The shape of the AS curve will depend on the following conditions;
I. Excess capacity
This condition occurs when the economy has unutilized or unemployed resources i.e. when the
economy has many factors operating at less than their productive capacity e.g. when there is
high level of unutilized land, unemployed labour etc. Under this condition, it is possible to
increase output at the same cost hence the price levels will remain constant. The AS curve will
therefore be perfectly elastic
II. Full employment

This is when all economic resources in a country are fully and efficiently employed. Under this
condition, it is not possible to increase the amount of output hence the level of real output will
remain constant. The AS curve will therefore be perfectly inelastic
NB: This condition can only exist in the long run.
III. The Intermediate range

This occurs when there is some excess capacity in some sections of the economy and not in
others. For producers to increase their production, they will have to attract more resources/
factors by paying higher prices or costs resulting in a general increase in price levels. The AS
curve will be upward sloping under his condition
The above three conditions can be used to obtain an overall AS curve usually referred to as the
Keynesian long run AS curve or the inverted L-Shaped AS curve as shown below;
The long-run aggregate supply curve

In the long run, the aggregate supply curve is assumed to be vertical. The long run AS curve measures
a country’s potential output using the concept of the production Possibility Frontier. It is vertical
because it shows the potential level of real output that the economy is capable of producing. Potential
output is not affected by the price level as shown below;
20
CHANGES IN AGGREGATE SUPPLY

Changes in AS can be caused by price or non-price factors. A change in price levels will lead to an
upward or downward movement along the intermediate or full employment range of the AS curve.
Non price factors that may lead to shifts in the AS curve include;
a) Changes in the cost of production
b) Changes in the level of technology
c) Changes in wages
d) Changes in the quantity and quality of resources
e) Investment in human capital
f) Changes in weather conditions
g) Free trade
h) Privatization and deregulation
i) Research and development
Aggregate supply shocks
Aggregate supply shocks might occur when there is

● A sudden rise in oil prices or other essential inputs
● The invention of a new production technology
EQUILIBRIUM REAL OUTPUT

MACROECONOMIC EQUILIBRIUM

21
The Macro-economic equilibrium is established at the point where AD = AS i.e. Ye. Changes in the
equilibrium real output will occur due to changes in either AD or AS. An increase in either AD or AS
will lead to an increase in the level of equilibrium real output and vice versa.
EFFECTS OF A SHIFT IN THE AS CURVE ON EQUILIBRIUM REAL OUTPUT

A) An outward shift
Effects
● An increase in equilibrium real output
● A decrease in price levels
Causes of an outward shift

i) A decrease in the cost of production
ii) An improvement in technology
iii) An improvement in research and development
iv) Decrease in wages
v) Increased investment in human capital
vi) Favourable weather conditions
vii) Decrease in natural disasters
viii) Improvement in free trade
ix) Increased privatization
B) An inward shift
Effects
● A decrease in equilibrium real output
● An increase in price levels
Causes of an outward shift

i) An increase in the cost of production
ii) Use of inappropriate technology
iii) An increase in wages
iv) Poor weather conditions
v) Occurrence of natural disasters
vi) A decrease in subsidies to producers
vii) A decrease in the quantity and quality of resources
EFFECTS OF A SHIFT IN THE AD CURVE ON EQUILIBRIUM REAL OUTPUT
22
A) An increase in AD
As AD increases from AD1 to AD5, there is an increase in real output from Y1 to Y4. During excess
capacity, an increase in AD will result to an increase in real output with no effect on price levels.
Producers can increase their production at the same cost resulting in a constant price P 1. As the
economy enters the intermediate range, an increase in AD will lead to demand pull inflation. There is
an increase in price levels as well as an increase in real output. As the economy approaches the full
employment level, a further increase in AD will result in severe demand pull inflation with little or no
effect on real output. This shows that the effect of an increase in AD on real output will depend on the
elasticity of the AS curve. An increase in AD is more effective in the short-run when the AS curve is
either perfectly elastic or relatively elastic. However, in the long-run when the AS curve is perfectly
inelastic, an increase in AD will have no effect on real output but will cause severe demand pull
inflation.
B) A fall in AD
The effect of a decrease in AD on price levels and real output will depend on the elasticity of the AS
curve. When the AS curve is perfectly inelastic (full employment level) a decrease in AD will lead to
a fall in price levels with no effect on real output. In the intermediate range, a decrease in AD will
lead to a fall in both price levels and real output. When the economy is at excess capacity, a decrease
in AD will lead to a fall in real output with no effect on price levels.
23
MULTIPLIER AND ACCELERATOR EFFECTS

The multiplier process
This is an index expressing the number of times a change in national income exceeds the change in
injections that caused it. An initial change in aggregate demand can have a much greater final impact
on the level of equilibrium national income. This is commonly known as the multiplier effect and it
comes about because injections of demand into the circular flow of income stimulate further rounds of
spending which can lead to a much bigger effect on equilibrium output and employment i.e. one
person’s spending is another’s income. The multiplier principle states that a change in any of the
components of AD will lead to multiple and successive changes in the level of real output such that
the overall change in real national income is greater than the initial change in the component of AD
that brought it about. The multiplier indicates how much real output changes after a change in AD. It
exceeds one because a change in AD sets off other changes in consumption which brings about the
increase in real national income.
For instance, consider a £300 million increase in business capital investment created when an
overseas company decides to build a new production plant in Kenya. This will set off a chain reaction
of increases in expenditures. Firms who produce the capital goods that are purchased will experience
an increase in their incomes and profits. If they in turn, collectively spend about 3/5 of that additional
income, then £180m will be added to the incomes of others.
At this point, total income has grown by (£300m + (0.6 x £300m). The sum will continue to increase
as the producers of the additional goods and services realize an increase in their incomes, of which
they in turn spend 60% on even more goods and services. The increase in total income will then be
(£300m + (0.6 x £300m) + (0.6 x £180m). The process can continue indefinitely such that each time,
the additional rise in spending and income is a fraction of the previous addition to the circular flow.
Multiplier effects can be seen when new investment and jobs are attracted into a particular town, city
or region. The final increase in output and employment can be far greater than the initial injection of
demand because of the inter-relationships within the circular flow.
Multiplier (k) = ∆Y
∆ Injections
General Knowledge
Types ofkmultiplier
= ∆Y
a) Positive
∆ AEmultiplier
A Positive multiplier exists when an increase in any of the injections leads to a multiple
increase
AE = C+Iin national income. For instance, an increase in Government expenditure will lead to
an increase in aggregate demand and national income. The increase in national income will
lead
C = to
a +anbYincrease in Consumption and Investment expenditure which leads to a further
increase in aggregate demand and national income. The positive multiplier process will
therefore
I = I* lead to a greater increase in national income than the initial increase in Government
expenditure that brought it about.
AE = a + bY + I*
Let ↑G
B = a + ↑AD
I* i.e. sum↑Y ↑C
of autonomous ↑AD ↑Yand investment.
consumption
AE = B + bY
Impact of a Positive Multiplier
At●equilibrium,
An increase
AEin=economic
Y growth
● An increase in inflation
Y = B + bY
24
Y –bY = B
Y =__B__ If we allow B to change, Y will be expected to change by a certain amount;

● A decrease in unemployment
● An improvement in the standard of living
NB: The impact of the positive multiplier will depend on the size of the multiplier, the size of the
leakages in the economy and the accuracy in measuring the multiplier.
b) Negative multiplier
A Negative multiplier exists when a decrease in any of the injections leads to a multiple
decrease in national income. For instance, a decrease in Investment expenditure will lead to a
decrease in aggregate demand and national income. The decrease in national income will lead
to a decrease in Consumption expenditure which leads to a further decrease in aggregate
demand and national income. The Negative multiplier process will therefore lead to a greater
decrease in national income than the initial decrease in Investment expenditure that brought it
about.
↓I ↓AD ↓Y ↓C ↓AD ↓Y
Impact of a Negative Multiplier

● A decrease in economic growth
● A decrease in inflation
● An increase in unemployment
● A fall in the standard of living
Factors influencing the size of the multiplier

a) The marginal propensity to consume
b) Government policy e.g. changes in direct tax
c) The marginal propensity to import- if people spend more on imports out of the additional
income, this demand will not be passed on in the form of extra spending on domestically
produced output.
d) Level of spare capacity in the economy
Evaluation
● It is difficult to measure the multiplier
● It takes a long time for the full impact of the multiplier to take effect
● There may be leakages in the economy which offset the impact of the multiplier
ILLUSTRATION
Calculate the value of the multiplier given that an increase in investment by $25m resulted to an
increase in the level of national income by $300.
INTERPRETATION
This means that an increase in investment will result in an increase in national income equivalent to
12 times the increase in investment.
The accelerator principle
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Planned capital investment by private sector businesses is linked to the growth of demand for goods
and services. When consumer or export demand is rising strongly, businesses may increase
investment to expand their production capacity and meet the extra demand. This process is known as
the accelerator effect. Conversely, a slowdown in consumer demand can create excess capacity and
may lead to a fall in planned investment demand. The accelerator principle states that the level of
investment in an economy varies directly with the level of national income. The accelerator is
therefore the amount by which a change in national income will lead to a change in investment.
Accelerator = ∆I where I= Investment
∆Y Y = National Income
The accelerator and multiplier can be used to explain the general business cycle. This is because the
initial multiplier effect triggered by an increase in any of the injections will lead to an increase in
National Income which will in turn lead to an increase in investment through the accelerator principle.
This will lead to a further multiplier effect thereby resulting to an increase in economic growth and
vice versa.
∆I ∆Y ∆I ∆Y ∆I
k a k a
FACTORS INFLUENCING AGGREGATE EXPENDITURE/ NATIONAL
INCOME
Monetary policy e.g. interest rates. A cut in interest rates makes it cheaper to borrow. This results in
an increase in consumption and investment which will lead to an increase in aggregate expenditure as
more people will borrow so as to finance increased consumption and investment. Aggregate supply is
also likely to increase as firms will increase their output to meet increased aggregate demand.
Fiscal policy- this entails the use of taxes and government expenditure to regulate the level of
national expenditure. An increase in government expenditure is likely to increase aggregate
expenditure while an increase in taxes is likely to cause a fall in aggregate expenditure due to its
impact upon disposable income i.e. disposable income falls leading to a fall in consumption
expenditure.
Technological progress- technological progress is likely to increase the productive potential of an
economy leading to increased real national output. This will result in an increase in real national
income which will trigger an increase in consumption expenditure.
Change in productivity- productivity refers to the output per unit of input. Increased productivity
implies the production of more output from the same level of input resulting in increased real national
output.
Commodity prices- an increase in the price of commodities will result in a fall in aggregate
expenditure as less can be purchased at a given level of disposable income.
Wealth effect e.g. changes in house and stock prices.
Exchange rate movements- an appreciation in the value of a county’s currency makes exports
expensive hence reducing the level of aggregate expenditure.
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THE CIRCULAR FLOW OF INCOME AND EXPEDITURE

The circular flow of income and expenditure is a simple model of the economy which shows the
movement of goods and services between households and firms and their corresponding payments in
money terms. This can be illustrated diagrammatically as follows;-
Where;
I= Investment
G= Government expenditure
X= Exports
S= Savings
T= Tax
M= imports
Households provide factors of production such as labour to firms which produce goods and services.
In return, households receive factors incomes e.g. salaries from the firms which in turn are spent on
goods and services produced by firms. Not at all the current income is spent. Some is saved which
represents a leakage from the circular flow. Leakages represent a flow of money away from the
circular flow i.e. when money is used for purposes other than the production of and expenditure on
goods and services. Other leakages include taxes and expenditure on imports. In addition to consumer
27
spending, businesses also carry out capital investment spending e.g. the purchase of new plant and
machinery. Investment represents an injection of money to the circular flow of income. Injections
represent a flow of money into the circular flow. Other injections besides investment include
government expenditure and expenditure on exports by foreigners.
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MACROECONOMIC POLICY INSTRUMENTS

DEMAND MANAGEMENT POLICIES
Demand management occurs when the government attempts to influence the level and growth of AD
hence the levels of national income, employment, rate of inflation, growth and the balance of
payments position. The government can either use expansionary or contractionary demand
management policies to bring about the achievement of macroeconomic objectives.
● Expansionary /Reflationary policies seek to increase AD and raise the level of planned
expenditure at or near the level of potential GDP
● Contractionary / Deflationary policies decrease AD in the event of aggregate demand
running ahead of AS and posing inflationary risks or leading to an unsustainable deficit on the
balance of payments
There are two main types of demand management policies;

● Fiscal policy
● Monetary policy
FISCAL POLICY
Fiscal policy involves the use of government spending and taxation to influence both the pattern of
economic activity and also the level and growth of aggregate demand, output and employment. Fiscal
policy is carried out by the legislative and/or the executive branches of government. The two main
instruments of fiscal policy are government expenditure and taxes. The government collects taxes in
order to finance expenditures on a number of public goods and services e.g. roads and national
defense.
Tax
A tax is a compulsory transfer of income and wealth from individuals and firms to the government.
There are two main types of taxes;
Direct Tax- this is a tax imposed on the income of individuals or on the profits of a firm.
Indirect Tax- this is a tax imposed on the expenditure on goods or services.
Tax Systems
i) Progressive tax- this is where the tax rate increases with an increase in income i.e. the
higher the income bracket, the higher the tax. The UK income tax system is progressive.
Everyone is entitled to a tax-free income. Thereafter, as income grows, people pay the
starting rate of tax (10%) before moving onto the basic tax rate (22%). Higher income
earners pay the top rate of tax (40%) on each additional pound of income over the top rate
tax limit. This is the highest rate of income tax applied.
ii) Regressive tax- this is where the tax rate decreases with an increase in income.
iii) Proportional tax- this is where the tax rate remains the same for all income brackets. For
example, we might have an income tax system that applied a standard rate of tax of 25%
across all income levels.
Reasons for Taxation
29
● To raise government revenue.

● To reduce negative externalities.
● To reduce income inequality.
Budget
This is a statement showing the current and future government revenue and expenditure. A budget
deficit is a situation where government expenditure exceeds government revenue. The budget deficit
is usually financed by government borrowing e.g. the government issues long-term, interest-bearing
bonds and uses the proceeds to finance the deficit. The total stock of government bonds and interest
payments outstanding, from both the present and the past, is known as the national debt. Thus, when
the government finances a deficit by borrowing, it is adding to the national debt. The revenues from
the budget surplus are typically used to reduce any existing national debt. A budget surplus is a
situation where government revenue exceeds government expenditure. In the case where government
expenditure is exactly equal to tax revenue in a given year, the government is running a balanced
budget for that year. This is one of the macroeconomic objectives of the government.
Types of Fiscal policy

● Expansionary fiscal policy
This involves an increase in government expenditures or a decrease in taxes in order to stimulate
aggregate demand (fiscal stimulus). An increase in government expenditure on goods and services
will lead to an increase in aggregate demand since government expenditure is a component of
aggregate demand the AD curve will shift outwards to the right. On the other hand, a decrease in
income tax will lead to an increase in disposable income thereby resulting in an increase in the
purchasing power of consumers. This will lead to an increase in consumption expenditure hence an
increase in aggregate demand since consumption expenditure is a component of aggregate demand.
The AD curve will therefore shift outwards to the right;
Effects
● An increase in real output (economic growth).
● An increase in negative externalities due to an increase in production
● A decrease in unemployment due to an increase in demand for labour.
● BOP surplus may be reduced since the demand for both local goods and imports may increase
due to an increase in disposable incomes leading to an increase in imports and a fall in exports.
● An increase in demand pull inflation.
● The government may be forced to borrow in order to finance the increased expenditure as it
may run into a budget deficit.
Contractionary fiscal policy
This involves a decrease in government expenditure or an increase in taxes in order to reduce the level
of aggregate demand. The decrease in government expenditure on goods and services will lead to a
fall in aggregate demand since government expenditure is a component of aggregate demand the AD
curve will shift inwards to the left. On the other hand, an increase in income tax will lead to a fall in
disposable income thereby resulting in a decrease in the purchasing power of consumers. This will
lead to a fall in consumption expenditure hence a decrease in aggregate demand since consumption
expenditure is a component of aggregate demand. The AD curve will therefore shift inwards to the
left.
30
Effects
● A decrease in real output.

● A decrease in negative externalities due to a decrease in production
● An increase in unemployment
● Increased tax burden which could be a dis-incentive to work.
● A decrease in demand pull inflation.
● A fall in government borrowing and a possible budget surplus.
NB: Discretionary fiscal policy occurs when the government deliberately alters government
expenditure and taxes while automatic fiscal policy occurs when government expenditure and taxes
vary automatically over the fluctuations in the business cycle e.g. taxes will fall due to a low
unemployment rate during a recession.
EFFECTIVENESS OF FISCAL POLICY
Fiscal policy is more effective in the short run than in the long run but the degree of effectiveness will
depend on the following factors;
State of the economy

An expansionary fiscal policy is more effective in turning around the economy during a recession.
Many countries opted to use fiscal stimulus in the form of bail out plans to deal with the economic
crisis of 2008. This policy may however not be effective in increasing real output when the economy
is the full employment level.
Flexibility
Fiscal policy is less flexible since some changes in government expenditure or taxes may require
parliamentary approval before they are implemented.
Time lag
Most changes in government expenditure and taxes once implemented affect the economy
immediately e.g. changes in government expenditure on goods and services. However, some changes
31
in government expenditure e.g. expenditure on education, healthcare, infrastructure etc. may take long
to be fully effective.
Political interference
Fiscal policy is vulnerable to political interference. For instance, the government may be reluctant to
increase taxes in order to maintain its political popularity.
Magnitude of the change

The effectiveness of fiscal policy will depend on the magnitude of the change in government
expenditure or taxes.
Crowding out effect

This occurs when an increase in domestic borrowing by the government to finance its expenditure or
budget deficit reduces the chances of private sector firms accessing the same funds from the public.
The public would prefer government bonds to company shares thereby leading to a fall in private
investment. An expansionary fiscal policy may lead to the crowding out effect.
.
Conflict between policy objectives
Fiscal policy used to solve a problem such as unemployment may be in conflict with other objectives
such as price stability. The effectiveness of fiscal policy will depend on the degree of conflict between
the policy objectives.
Nature of government expenditure

Government expenditure on goods and services will lead government expenditure to changes in
Aggregate Demand while government expenditure on education, healthcare, subsidies etc. will lead to
an increase in productivity thereby resulting to an increase in Aggregate Supply in the long run. The
effectiveness of fiscal policy will therefore depend on the nature of government expenditure.
MONETARY POLICY
Monetary policy involves the use of interest rates and money supply to control the level and rate of
growth of aggregate demand in the economy so as to achieve an economic objective. There are two
types of monetary policy;
● Expansionary monetary policy

This involves a decrease in interest rates and an increase in money supply in order to stimulate
aggregate demand. The decrease in interest rates will lead to a fall in the cost of borrowing thereby
resulting to an increase in both consumption and investment expenditure. The aggregate demand will
therefore shift outwards as shown below;
32
Effects
● An increase in real output (economic growth).
● An increase in negative externalities due to an increase in production
● A decrease in unemployment due to an increase in demand for labour.
● An increase in demand pull inflation.
● BOP deficit may increase because the increase in inflation will make exports less competitive
in the world market leading to a fall in exports. Domestic consumers will also demand more
imports due to an increase in income as a result of economic growth.
● The decrease in interest rates may lead to improvements in income distribution due to the low
cost of borrowing especially for the poor.
● The decrease in interest rates may lead to an outflow of hot money since some local investors
may take their money to foreign banks in order to capitalize on higher interest rates.
● Contractionary monetary policy

This involves an increase in interest rates and a decrease in money supply in order to reduce aggregate
demand. The increase in interest rates will lead to an increase in the cost of borrowing thereby
resulting to a fall in both consumption and investment expenditure. The aggregate demand will
therefore shift inwards as shown below;
33
Effects
● A decrease in real output.

● A decrease in negative externalities due to a decrease in production
● An increase in unemployment due to a decrease in demand for labour.
● Hot money inflows due to high interest rates.
● A decrease in inflation.
● Possible correction of BOP deficit due to a fall in the price of exports and a fall in demand for
imports.
Monetary Policy Committee (MPC)
Since 1997, the Bank of England has had operational independence in the setting of interest rates. The
Bank aims to meet the Government's inflation target of 2 per cent for the consumer price index by
setting short-term interest rates. Interest rate decisions are taken by the Monetary Policy Committee
(MPC) at their monthly meetings. If the inflation rate is either above or below the target, the MPC
will adjust interest rates accordingly in order to keep inflation within the target. The independent
nature of the MPC has enabled the UK to control inflation without political interference.
Factors considered by the MPC when making interest rate decisions.
i) Economic growth
ii) Trends in the Exchange Rate
iii) The unemployment rate.
iv) The Savings level
v) Prices of commodities and raw materials
vi) House prices
vii) Share prices/ financial markets
viii) Consumer confidence levels
ix) Investor confidence levels
x) External shocks e.g. the oil crisis
xi) Global economic performance
xii) Export and import levels
NB: Changes in these factors will influence MPC decisions on interest rates.
Effectiveness of the MPC in Interest rate control
● The effectiveness of the MPC will depend on the responsiveness of consumers and investors
to changes in interest rates.
● The effectiveness of the MPC in making interest rate decisions will depend on the magnitude
of the changes in the factors as well as the relative importance of the factors.
● Some changes in interest rates might not take effect immediately.
34
● Decisions on what actions are to be taken to achieve the inflation target are made on the basis
of majority votes where pessimistic members of the committee may influence the decisions
thereby making the MPC to overreact in controlling the level of inflation.
● The MPC may overreact on some temporary changes in the level of inflation leading to
negative economic consequences. It may also use inaccurate information relating to the factors
under consideration thereby arriving at wrong decisions on interest rates.
Effects of Changes in Interest Rates
There are several ways in which changes in interest rates influence aggregate demand. These are
collectively known as the transmission mechanism of monetary policy. One of the main channels
that the MPC uses to influence aggregate demand, hence inflation, is through the lending and
borrowing rates charged by the market. When the Bank’s base interest rate rises, banks usually
increase both the rates that they charge on loans, and the interest that they offer on savings. This tends
to discourage businesses from taking out loans to finance investment and encourages the consumer to
save rather than spend thereby depressing aggregate demand. Conversely, when the base rate falls,
banks tend to cut the market rates offered on loans and savings. This will tend to stimulate aggregate
demand. Changes to the level of interest rates take time to have an impact on overall economic
activity - i.e. there is a time lag involved. A change in interest rates can have wide-ranging effects on
the economy. The transmission mechanism resulting from a change in official base interest rates is
shown in the flow chart below
The Transmission mechanism of Monetary Policy
Short-term changes in interest rates feed through fairly quickly to the rest of the UK financial system.
Official interest rate decisions affect market interest rates such as mortgage interest rates, rates of
35
interest on savings accounts and also credit card rates. Policy actions and announcements about the
interest rate affect expectations about the future course of the economy and the confidence with which
these expectations are held. In addition, they affect asset prices and the exchange rate.
These changes in turn influence the spending and savings decisions of millions of households and
businesses. The affect aggregate demand comprising of domestically generated demand and net
external demand which is determined by export and import demand. Domestic demand results from
the spending, saving and investment behaviour of individuals and firms within the economy. For
instance, lower market interest rates increase domestic demand by encouraging consumption rather
than saving by households as well as investment spending by firms. Asset prices rise and people feel
wealthier and generally more confident about the future. As a result, consumption increases. A lower
official interest rate causes financial capital to flow out of the pound and into other currencies which
in turn causes the exchange rate to fall. A falling exchange rate reduces export prices while increasing
the price of imports hence the demand for domestically produced goods increases. Changes in
aggregate demand relative to the economy’s ability to supply output affect domestic inflationary
pressure in the economy. On the other hand, changes in import prices resulting from changes in the
exchange rate will affect inflation either directly through changes in the prices of imported food and
consumer goods or through changes in the prices of raw materials which results in cost push inflation.
Effects of a cut in interest rates

A cut in interest rates makes it cheaper to borrow money. Aggregate demand will increase due to an
increase in consumption and investment expenditure. Aggregate supply is also likely to increase as
firms will increase their output to meet the increase in aggregate demand.
Evaluation
● It depends on the size of the cut in interest rate.
● There are other determinants of aggregate demand e.g. the exchange rate might change.
● An increase in debt might have long term contradictory effects.
● The impact will depend on the elasticity of the AS curve i.e. the availability of spare capacity.
● The impact will depend on the size of the multiplier.
THE EFFECTIVENESS OF MONETARY POLICY

Monetary policy is more effective in the short run than in the long run but the degree of effectiveness
will depend on the following circumstances;

When the economy is in a recession business and consumer confidence is very low hence the policy
may be ineffective in increasing real output and economic growth. An expansionary Monetary policy
may also be ineffective in increasing real output when the economy is at the full employment level.
Time lag
Changes in interest rate may not affect the economy immediately since consumers and investors will
take time to adjust their expenditures. This is because consumers and investors cannot borrow
unnecessarily just because interest rates have changed. It may therefore take up to two years for the
effects of interest rate changes to fully affect the economy
36
Flexibility
Monetary policy is relatively flexible since interest rates can be adjusted by the MPC during their
monthly meetings.
Implementation lag
Interest rate changes may not have an immediate effect on debtors due to the fact that they have
negotiated a fixed interest rate.
Interest rate elasticity of investment

The effectiveness of the monetary policy will depend on the degree of responsiveness of investment to
changes in interest rates. If investment is interest rate elastic, monetary policy will be more effective.
SUPPLY-SIDE POLICIES
Supply-side economic policies are mainly designed to improve the productivity of an economy, make
markets and industries operate more efficiently, reduce the costs of production and thereby contribute
to a faster rate of growth of real national output through an increase in aggregate supply. Most
governments now accept that an improved supply-side performance is the key to achieving sustained
economic growth without a rise in inflation. However, supply-side reform on its own is not enough to
achieve this growth. There must also be a high enough level of aggregate demand. Supply side
policies are more effective in the long run than in the short run. They include;
Education and training
Privatization
Research and development
Technological improvement
Subsidies
Trade liberalization
Tax cuts and tax holidays
Development of infrastructure
Supply-side policies in product markets are designed to increase competition and efficiency. If the
productivity of an industry improves, then it will be able to produce more with a given amount of
resources thus shifting the AS curve to the right.
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These policies include;

1. Privatization
Over the last ten years, many former state-owned businesses have been privatized. Examples in
Britain include British Gas, British Telecom, British Airways, British Steel, British Aerospace, the
regional water companies, the main electricity generators and distributors, and the Railways.
Examples in Kenya include Kenya Airways, Kenya Reinsurance, and Kenya Railways. Privatization
is designed to break up state monopolies and create more competition.
Effects of Privatization
● Increased real output/ economic growth in the long run.
● A fall in inflation in the long run.
● A fall in government expenditure on loss making state corporations.
● An increase in the level of competitiveness leading to an increase in exports.
● An increase in government revenue since privatization is a source of government revenue in the
short run.
● An increase in investment.
Evaluation
● The policy will lead to an increase in unemployment in the short run since privatized firms will
reduce their number of workers in order to cut down costs and maximize profit.
● Prices of goods and services may increase fuelled by the profit motive of private firms leading to
consumer exploitation especially when a public monopoly is transferred to the private sector.
● There will be a loss of economic control by the government especially if the state corporation is
sold to foreign investors.
● There may be a time lag in the privatization process i.e. the positive effect of privatization will be
felt after some time.
2. Education and Training

Investment in education and training will lead to an increase in the productivity of labour due to an
improvement in the skills within the work force which will improve the employment prospects of
thousands of unemployed workers. The economic returns from extra education spending can vary
according to the stage of development that a country has achieved.
Improved training, especially for those who lose their job in an old industry may improve the
occupational mobility of workers in the economy which would help reduce the problem of structural
unemployment. A well-educated workforce serves to attract foreign investment in the economy.
Effects of Education and Training
● Increased real output/ economic growth in the long run.
● A fall in inflation in the long run.
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● Possible increase in the government budget deficit due to high government expenditure in
education in the short run.
● An increase in negative externalities due to increased production in the long run.
● A high opportunity cost to the government due to the diversion of funds to education.
● Decrease in unemployment
● A possible increase in the government debt burden.
● A BOP surplus due to increased exports since exports are more competitive following the high
productivity of labour and the high volume of production.
Evaluation
● Effects of Education and Training will be felt in the long run.

● It is expensive and bears a high opportunity cost
● It may lead to brain drain where educated citizens may find jobs overseas.
● There may be inequality in the distribution of education i.e. not everyone will benefit equally.
3. Labour Market Reforms
The government can promote flexibility in the labour market by reducing trade union powers. In the
UK, many of the traditional legal protections enjoyed by the trade unions have been taken away e.g.
restrictions on their ability to take industrial action and enter into restrictive practice agreements with
employers. The result has been a decrease in strike action in virtually every industry and a significant
improvement in industrial relations. Other reforms a government can implement include the reduction
or removal of national minimum wage, the reduction of unemployment benefits, the reduction of the
marginal tax rate on income and the promotion of labour mobility. These polices will lead to an
increase in the supply of labour and/ or a fall in the cost of labour resulting in an increase in
production and an outward shift of the AS curve.
Effects
● Increased real output/ economic growth
● A fall in inflation due to a fall in the cost of labour
● Decrease in unemployment
● A decrease in government expenditure on unemployment benefits.
● An increase in negative externalities due to increased production
● An increase in investment due to a low cost of production.
● A fall in BOP deficit since exports are more competitive due to a decrease in the cost of
production/ cost of labour
Evaluation
● Effects of Labour Market Reforms will be felt in the long run
● Workers may be exploited due to reduced trade union powers
● There may be Political interference from politicians out to win public approval
● An increase in the income gap due to a decrease in the National Minimum Wage.
4. Income Tax Reforms

Lower rates of income tax improve incentives for people to work longer hours or take a new job
because they get to keep a higher percentage of the money they earn. Cutting tax rates for lower paid
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workers may help to reduce the extent of the ‘unemployment trap’ a situation where people feel that
they may be better off not working than if they stayed within the labour force.
NB: Supply-side policies do not operate in isolation from changes in aggregate demand. If there is
insufficient AD, it is unlikely that better supply-side performance can be achieved over a number of
years. Equally, if aggregate demand grows too quickly, acceleration in wage and price inflation might
require deflationary policies that ultimately harm a country’s productive potential.
EFFECTIVENESS OF SUPPLY SIDE POLICIES
Supply-side policies are more effective in the long run than in the short run. This is because the
effects of most Supply-side policies take long before feeding into the economy. The degree of
effectiveness will depend on the following factors;
Cost
Most Supply-side policy instruments are very expensive.
Opportunity cost
The amount of money used by the government to implement Supply-side policies such as education
could have been used to finance other projects.

Supply-side policies are more effective when the economy is approaching the full employment level.
They are ineffective when the economy is in a recession due to lack of demand for goods or services.
Supply side bottlenecks

An increase in government expenditure on some projects e.g. infrastructure such as roads might lead
to the increase in some industrial materials such as cement. This will lead to a fall in production or
supply of goods in other sectors of the economy.
Political interference
The effectiveness of some Supply-side policies such as expenditure on infrastructure may be
influenced by the political environment of the country.
Conflict between fiscal and Supply-side policies

It is difficult to distinguish between Supply-side policies and fiscal policies such as government
expenditure on infrastructure, education etc. it is therefore difficult to operate a Supply-side policy
without an impact on Aggregate demand.
Difficulty in measuring productivity

It is difficult to measure the productivity of factors of production such as labour due to the incidence
of disguised unemployment, sick leave etc.
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INFLATION
DEFINITION AND MEASURES OF INFLATION
Inflation is best defined as the sustained/ persistent increase in the general price level of goods and
services in an economy over a given period of time. It leads to a fall in the purchasing power or value
of money hence price stability is a major government objective in all countries. The UK Government
has set an inflation target of 2% using the consumer price index (CPI). It is the job of the Bank of
England through the Monetary Policy Committee (MPC) to set interest rates so that AD is controlled
and the inflation target is reached.
There are various indexes used to measure inflation. They include;
● Retail Price Index/Consumer Price Index
● Producer price index
● GDP Deflator.
● Harmonized Index of Consumer prices
Retail Price Index (RPI).
The consumer price index (CPI) is the most common measure of inflation and is usually referred to as
the headline rate of inflation. It measures the change in the prices of a “basket” of goods and services
consumed by the average household.
Procedures for the computation of the RPI
1. Undertake a family expenditure survey on a sample of 7000 average households.
2. Select a bundle of 650 goods and services commonly bought by the average households
3. Attach different weights on the 650 items in relation to the proportion of income spent on
them.
4. Select a base year in which the prices of goods and services are assumed to be stable and all
price changes will be established with reference to the base year price which is set at 100.
5. Establish the percentage change of the prices of the selected bundle of items within a given
time period with reference to the base year price.
6. Establish the value of RPI by multiplying the percentage change in prices with the respective
weight of the item.
WORKED EXAMPLE
Assume that there are only two goods in an economy whereby households spend 75% of their income
on food and 25% on cars. There is an increase in the price of food and cars by 8% and 4%
respectively. Establish the value of RPI.
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ITEM PROPORTION WEIGHT % CHANGE IN WEIGHTED

OF INCOME PRICE WITH PRICE
SPENT ON REFERENCE INDEX
ITEM TO BASE
YEAR
FOOD 75% 0.75 108 81
CARS 25% 0.25 104 26
∑=1 ∑=107
RPI = ∑ W(∆P) = 107

∑W
Inflation rate = RPI1 – RPI0 x 100 = 7%
RPI0
Where RPI1 = current year RPI
RPI0 = previous year RPI
PRACTICE QUESTION
Determine the RPI based on the data below;
ITEM PRICES IN 2000 PRICES IN 2011 CONSUMPTION
(BASE YEAR) (CURRENT YEAR) AS A % OF
INCOME.
FOOD 250 320 30
CLOTHING 280 340 10
HOUSING 220 280 20
TRANSPORT 240 260 30
OTHERS 170 190 20
SOLUTION
ITEM CONSUMPTION WEIGHT % CHANGE IN WEIGHTED
AS A % OF PRICE WITH PRICE INDEX
INCOME. REFERENCE
TO BASE
YEAR
FOOD 30 0.3 128 38.40
CLOTHING 10 0.1 121 12.14
HOUSING 20 0.2 127 25.45
TRANSPORT 30 0.3 108 32.50
OTHERS 20 0.2 112 22.35
RPI = ∑ W (∆P) = 130.85 = 118.95
∑W 1.1
Limitations of the RPI
● The accuracy of the RPI will depend on the information received from the average household.
● Not all average households are considered in the survey.
● It is difficult to establish the average household in an economy.
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● Not all goods and services are considered in the computation hence the value of RPI might
give misleading information about the actual rate of inflation.
● Frequent adjustment to the weights and basket of goods and services is necessary in order to
cater for the changes in demand for various goods and services in the market. Such
adjustments are complicated.
● The selection of the most appropriate base year is a difficult and subjective concept.
● It is difficult to accommodate improvements in the quality of goods or services in the price
index hence the rate of inflation may be overstated.
Uses of the RPI
● It is used to calculate the rate of inflation.

● It is used as a basis for the calculation of the required increase in certain payments such as
unemployment benefits.
● It can be used to convert nominal GDP into real GDP.
● It is a measure of the cost of living in an economy.
● It is used by the government in economic policy formulation.
Other values of the RPI

The general value of RPI may not be very accurate due to distortions in the market price of goods and
services as a result of interest repayment on mortgage, indirect taxes, etc. Such price distortions will
either inflate or deflate the value of RPI. To solve this problem the following formulation of RPI can
be computed;
RPIX
It is also referred to as the underlying rate of inflation. It measures price changes by excluding the
effects of mortgage interest rates hence it is more accurate than the general RPI.
RPIX= RPI – Mortgage Interest Repayment.
RPIY
It is also referred to as the core rate of inflation. It measures price changes by excluding the effects
indirect taxes such as VAT and Local Authority Taxes. It is most accurate measure of inflation.
RPIY= RPIX – Indirect Taxes
NB: The steps followed in computing RPI, RPIX and RPIY will always remain the same.
HARMONIZED INDEX OF CONSUMER PRICES (HICP)

This is a standard measure of inflation used to compare changes in the cost of living between member
states within a particular region. It is the most recent type of price index and is used by the European
Union (EU).
PRODUCER PRICE INDEX (PPI)

The PPI is used to measure changes in the average prices of goods and services purchased by the
industrial sector of the economy. It is also referred to as the wholesale price index. Since it does not
consider the final price [paid by the consumer, it is a limited measure of inflation.
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THE GDP DEFLATOR

The GDP Deflator measures the average change in the prices of both consumer goods and capital
goods. It is a measure of the change in the prices of all domestically produced final goods and services
in an economy.
GDP Deflator= Nominal GDP x 100

Real GDP
CAUSES OF INFLATION
The main causes of inflation
Inflation can come from several sources. Some come direct from the domestic economy, e.g. the
decisions of the major utility companies providing electricity or water on to increase the prices of
their products, or the increase in prices by leading food retailers based on the strength of demand and
competitive pressure in their markets. Inflation can also come from external sources, for example an
unexpected rise in the price of crude oil or other imported commodities. Fluctuations in the exchange
rate can also affect inflation. For instance a fall in the value of a country’s currency will result in an
increase in import prices which feeds through directly into the consumer price index. The causes of
inflation can broadly be classified into three categories;
● Demand-pull inflation.
● Cost-push inflation
● Money supply inflation
Demand-pull inflation
Demand pull inflation results from an increase in the level of Aggregate Demand. It exists when the
growth in the level of AD is greater than the capacity Aggregate Supply can meet. The result is excess
demand for goods and services and pressure on businesses to raise prices in order to increase their
profit margins.
Possible causes of demand-pull inflation include:
1. A depreciation of the exchange rate which increases the price of imports and reduces the
foreign price of UK exports. If consumers buy fewer imports, while exports grow, AD in will
rise. There may be a multiplier effect on the level of demand and output
2. Higher demand from a fiscal stimulus e.g. through a reduction in direct or indirect taxation
or higher government spending. If direct taxes are reduced, consumers will have more
disposable income causing demand to rise. Higher government spending and increased
government borrowing feeds through directly into extra demand in the circular flow of
income.
3. Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand
e.g. in raising demand for loans or in causing a sharp rise in house price inflation.
4. Faster economic growth in other countries: this may provide a boost to a country’s exports
overseas. Export sales provide an extra flow of income and spending into the circular flow
thus boosting AD.
NB: Any factor that will lead to an increase in the components of AD is a possible cause of demand
pull inflation.
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An outward shift of the AD curve from AD1 to AD2 causes demand pull inflation where the price
levels increase from P1 to P2.
EVALUATION
● The magnitude of the demand pull inflation will depend on the elasticity of the AS curve.
Demand pull inflation is less severe when the AS curve is elastic.
● The extent to which Demand pull inflation will affect prices will depend on the magnitude of
the shift of the AD curve.
● The extent to which inflation will increase will depend on the actions of the Monetary Policy
Committee (MPC).
Cost-push inflation
This is a situation where inflation is caused by an increase in the costs of production. Cost-push
inflation occurs when firms respond to rising costs, by increasing prices to protect their profit
margins. There are many reasons why costs might rise:
1. Component costs: e.g. an increase in the prices of raw materials and other components used
in the production processes of different industries. This might be because of a rise in world
commodity prices such as oil, copper and agricultural products used in food processing
2. Rising labour costs – this may be caused by an increase in wages, which are greater than
improvements in productivity. Wage costs often rise when unemployment is low and also
when people expect higher inflation so they bargain for higher wages in order to protect their
real incomes.
3. Higher indirect taxes imposed by the government e.g. a rise in the specific duty on alcohol
and cigarettes, an increase in fuel duties or a rise in the standard rate of Value Added Tax.
Depending on the price elasticity of demand and supply for their products, suppliers may
choose to pass on the burden of the tax to consumers.
4. A depreciation of the exchange rate- this increases the price of imported raw materials.
Cost-push inflation can be illustrated by an inward shift of the aggregate supply curve. This causes
a fall in national output and a rise in price levels.
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An increase in the cost of production will result to a fall in Aggregate Supply thereby leading to a
leftward shift of the AS curve from AS 1 to AS2. General Price levels will increase from P 1 to P2. A fall
in AS is referred to as a supply shock and will lead to a fall in real output from Y1 to Y2.
EVALUATION
● The extent to which inflation will increase will depend on the magnitude of the shift in the AS
curve.
● The extent to which inflation will increase will depend on the elasticity of the AD curve. Cost-
push inflation will be more severe when the AD curve is inelastic.
● The extent to which the cost of production will increase will depend on the relative importance
of the factor of production whose price is increasing or on whether cheaper substitutes are
available for use by producers.
● The extent to which inflation will increase will depend on the actions of the Monetary Policy
Committee (MPC).
Money Supply inflation
Monetarists argue that the main cause of inflation is an increase in money supply. This may be caused
by;
● Printing more money.
● Increased lending.
● BOP surplus.
● Domestic and external borrowing by the government.
The increase in money supply will lead to an increase in purchasing power thereby resulting in a high
level of demand for goods and services which triggers off an increase in price. This is based on the
quantity theory of money which can be expressed in the following equation;
MV = PT
Where M = Money Supply
V = Money Velocity
P = prices.
T = Number of transactions.
Money velocity and the Number of transactions are assumed to be relatively constant. An increase in
money supply will therefore lead to an increase in general price levels (inflation). This implies that
any increase in money supply in the money market will lead to an increase in demand for goods and
services in the product market. The process by which a change in money supply affects the demand
for goods and services in the market is referred to as the monetary transmission mechanism. This
mechanism will be influenced by the velocity of money.
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EVALUATION
● The extent to which an increase in money supply will influence the level of inflation will
depend on the income elasticity of demand.
● The rate of transactions is assumed to be constant but in reality, there could be some changes
in the number of transactions within a given time period. This will influence price levels.
● The extent to which inflation is caused by money supply will depend on the quantity and
magnitude of money supply i.e. the amount of money supplied and the velocity of money.
● The extent to which money supply can influence inflation will depend on the actions of the
Monetary Policy Committee (MPC).
CATEGORIES OF INFLATION
1. CREEPING INFLATION
This is a low level of inflation that ranges between 1-9%. It is also referred to as a single digit
inflation rate. E.g. the UK is having a creeping inflation of about--------
2. MODERATE INFLATION
This is a rate of inflation that ranges between 10-99%. It is commonly referred to as a double digit
inflation rate and is common in the less economically developed countries. e.g. the current rate of
inflation in Kenya is about------
3. HYPER INFLATION
This is the highest level of inflation. It exists when prices are increasing very rapidly to the extent
that money becomes worthless as a medium of exchange such that people may start using
commodities such as gold and silver as a medium of exchange or the currency of other countries.
Due to hyperinflation in Yugoslavia 1993, a 500 billions bill was printed.
4. STAGFLATION
This is a condition where both inflation and unemployment are increasing. Inflation and
unemployment are generally inversely related.
CONSEQUENCES OF INFLATION
The effects or cost of inflation will depend on the following condition;

● The rate of the increase in inflation i.e. whether inflation in accelerating or stable. An
accelerating inflation rate is likely to have more serious consequences than a stable inflation rate.
● Whether inflation is anticipated or un-anticipated. Anticipated inflation will have minimal
consequences as compared to un-anticipated inflation.
● The type of inflation e.g. creeping inflation will have minimal effect as compared to hyper
inflation.
CONSEQUENCES OF UN-ANTICIPATED INFLATION
Un-anticipated inflation is more severe than anticipated inflation because it is difficult to predict the
rate of inflation in an economy. Unanticipated inflation will have the following effects;
1. Increase in Bop deficit
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An increase in inflation in an economy will make the domestic goods more expensive than
imported goods. This will lead to a fall in the volume of exports and an increase in imports
thereby resulting in a balance of payments deficit.
2. Decrease in savings
Due to an increase in expenditure on goods and services resulting from price increases,
savings are bound to decrease. There will also be a decrease in the value of savings.
3. Lenders lose while borrowers gain

With an increase in prices, lenders will lose since they will receive back the amount of loan at
a lower value while borrowers will gain with inflation since they will pay back their loan at a
lower value than the initial value.
4. Increase in unemployment
An increase in inflation will lead to a fall in demand for goods and services thereby resulting
to an increase in unemployment.
5. Effects on government
In increase in inflation will lead to fall in the value of tax revenue received by the government.
On the other hand the government can gain with inflation as a borrower since it will pay back
its loans of a lower value.
6. Reduced welfare for fixed income earners

Individuals who earn incomes will suffer welfare losses during inflation because of a decrease
in the purchasing power of this income.
7. A fall in the standards of living- due to a fall in the amount of goods and services that fixed
income earners but, living standards may fall.
CONSEQUENCES OF ANTICIPATED INFLATION
Anticipated inflation exists when prices are expected to rise and consumers, firms and the government
are able to plan their expenditure by adjusting economic variables such as wages, prices etc. in line
with inflation. Consequences of anticipated inflation include;
1. MENU COST
These are the costs incurred by firms when changing their price tags in line with inflation.
2. SHOE LEATHER COST
These costs are incurred by consumers when comparing prices between different retail outlets.
3. TRADE UNION ACTION
When trade unions are expecting an increase in inflation, they may advocate for salary
increments. This can result in industrial actions such as strikes.
4. PHSYCHOLOGICAL COSTS
An increase in inflation can make consumers and producers more disturbed and frustrated due
to a fall in purchasing power.
5. INDEXATION
This is a process whereby the value of economic variables such as pension, wages, prices etc
are adjusted in line with the inflation rate.
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POLICIES USED TO CONTROL INFLATION
Policies used to control inflation will depend on the type of inflation. It is however difficult to know
the actual cause of inflation since it is brought about by different factors. According to Keynesian
economists, monetary policy is ineffective in controlling inflation because by increasing interest rates,
there will be a decrease in investment. They believe that inflation can be controlled through
government intervention using fiscal policy. The main policies that can be used in controlling
inflation are;
1. DEMAND MANAGENT POLICIES

a) Monetary policy
b) Fiscal policy
2. SUPPLY SIDE POLICIES
3. EXCHANGE RATE CONTROL
4. DIRECT PRICE CONTROL
5. WAGE RATE CONTROL
DEMAND MANAGENT POLICIES

These are policies which are used to influence the level of aggregate demand in an economy over a
given period of time. They consist of either monetary or fiscal policies.
MONETARY POLICY
To control the level of inflation, the government should use a contractionary monetary policy which
involves a decrease in money supply and an increase in interest rates. A contractionary monetary
policy is used to reduce the level of aggregate demand thereby reducing demand pull inflation. This is
because a decrease in money supply will lead to a decrease in the purchasing power of consumers
thereby resulting to a decreasing in consumption expenditure.
On the other hand, an increase in interest rates will lead to a high cost of borrowing thereby resulting
to a decrease in consumption expenditure on interest sensitive goods such as cars. This will lead to a
decrease in aggregate demand in the economy thereby resulting to a fall in demand pull inflation.
EVALUATION
● An increase in interest rates can instead of offering a solution create more inflation especially if
the higher interest rate can attract an inflow of short term investment in the local banks by
foreigners (hot money). This would result in an increase in money supply in the economy leading
to an increase in aggregate demand which will result in demand pull inflation.
● The effectiveness of the monetary policy will depend on the magnitude of the increase in interest
rates.
● The effectiveness of the monetary policy will be influenced by the actions of the Monetary Policy
Committee (MPC) on interest rates and the accuracy of the information concerning inflation.
● The effectiveness of the monetary policy will depend on consumer and investor confidence. An
increase in interest rates will have minimal effect if consumer and investor confidence is high.
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● The effectiveness of a contractionary monetary policy will depend on the elasticity of the AS and
AD curves. It will not be effective when the AS curve is perfectly elastic since price levels will be
relatively constant.
● Monetary policy is more effective in the short run than in the long run.
FISCAL POLICY
Fiscal policy involves the use of government spending and taxation to influence economic
performance i.e. the level of aggregate demand, output and employment. To control the level of
inflation, the government should use a contractionary fiscal policy. This involves a decrease in
government expenditure or an increase in taxes in order to reduce the level of aggregate demand. The
decrease in government expenditure on goods and services will lead to a fall in aggregate demand
since government expenditure is a component of aggregate demand the AD curve will shift inwards to
the left. On the other hand, an increase in income tax will lead to a fall in disposable income thereby
resulting in a decrease in the purchasing power of consumers. This will lead to a fall in consumption
expenditure hence a decrease in aggregate demand since consumption expenditure is a component of
aggregate demand. The AD curve will therefore shift inwards to the left.
Evaluation
● The effectiveness of a contractionary fiscal policy in controlling inflation will depend on the
magnitude of the increase in taxes or decrease in government expenditure.
● An increase in indirect taxes such as VAT will cause more inflation (cost push inflation) instead
of controlling it.
● A contractionary fiscal policy will lead to a decrease in AD leading to a decrease in economic
growth and an increase in unemployment.
● Fiscal policy is less flexible since it takes time to change laws on taxes and government
expenditure.
● The bulk of government expenditure is on essential services such as education, health, security
etc. It is difficult to reduce government expenditure on such services.
These are measures designed to improve the productivity of an economy, make markets and industries
operate more efficiently, reduce the costs of production and increase real national output through an
increase in aggregate supply. They include;
● Education and training
● Privatization
● Research and development
● Technological improvement
● Subsidies
● Trade liberalization
● Tax cuts and tax holidays
● Development of infrastructure
Supply-side policies in product markets are designed to increase the productivity of an industry thus
shifting the AS curve to the right which will reduce the price levels.
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Exchange rate policies

Exchange rate refers to the price of one currency in terms of another country’s currency. The
government can use exchange rate policies to influence economic activity. To reduce the level of
inflation, the government can appreciate the value of the currency in order to make imports cheaper
than exports. This will reduce the demand for exports and increase the demand for imports thus
reducing aggregate demand.
Evaluation
● The effectiveness of this policy in controlling inflation will depend on the elasticity of demand for
exports and imports. If the demand for exports and imports is price elastic, the policy will be more
effective.
● The effectiveness of this policy in controlling inflation will depend on the magnitude of the
increase in the exchange rate.
● Exchange rate control is a barrier to free trade and can lead to trade wars between countries.
● It is difficult to control the value of currency in a free market system where the exchange rate is
determined by the forces of demand and supply.
● A fall in demand for exports will lead to a decrease in economic growth and an increase in
unemployment.
Direct price Control

This is a policy aimed at reducing price increases in an economy through a government imposed price
ceiling beyond which prices should not rise.
Evaluation
● There will be an increase in administrative costs to the government when this policy is used to
control inflation.
● The policy cannot be effective in a free market economy where the price of commodities are
determined through the price mechanism.
Wage rate control

As the rate of inflation increases, workers and trade unions usually bargain for higher wages. The
increase in wages results in cost push inflation leading to a spiral effect which will generate a
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continuous increase in inflation. The government can control this problem by fixing a maximum wage
for certain categories of workers in a given industry. Wage rate control will also reduce the
purchasing power thereby reducing demand pull inflation
Evaluation
● The effectiveness of this policy will depend on the power of the wage regulation system imposed
by the government within the labour market.
● The system is difficult to impose in a free market system where wages are determined by the
forces of demand and supply.
DEFLATION
Deflation refers to a fall in the general price level. It is a negative rate of inflation. It leads to an increase
in the value of money.
Costs of Deflation
1. Discourages consumer spending. When there are falling prices, this often encourages people to
delay purchases because they will be cheaper in the future. In particular, it can discourage consumers
from buying luxury goods / non-essential items, e.g. flatscreen TV) because you could save money by
waiting for it to be cheaper. Therefore, periods of deflation often lead to lower consumer spending
and lower economic growth; (this, in turn, creates more deflationary pressure in the economy.
2. Increase real value of debt. Deflation increases the real value of money and the real value of debt.
Deflation makes it more difficult for debtors to pay off their debts. Therefore, consumers and firms
have to spend a bigger percentage of disposable income on meeting debt repayments. (in a period of
deflation, firms will also be getting lower revenue, and consumers will likely to get lower wages).
Therefore, this leaves less money for spending and investment.
3. Real wage unemployment. Labour markets often exhibit ‘stable wages’. In particular, workers resist
nominal wage cuts (no one likes to see their wages actually cut, especially when you are used to
annual pay increases. Therefore, in periods of deflation, real wages rise. This could cause real-wage
unemployment.
Benefits of deflation
Despite the costs of deflation, it could be beneficial.
1. Deflation from increased efficiency and lower costs of production. The right kind of deflation
involves lower prices through increased productivity and better technology i.e. when the Aggregate
Supply curve shifts to the right – which both lowers the price level and increases real GDP.
2. Improved international competitiveness. If one country has deflation, and others have inflation,
then that country will become more internationally competitive, leading to a rise in exports.
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UNEMPLOYMENT

DEFINING AND MEASURING UNEMPLOYMENT

Unemployment is a situation where people who are willing, available and able to work at the
prevailing wage rate cannot find work.
It is a situation where people who are registered as unemployed, are willing, available and able to
work at the going wage rate cannot find work despite an active search for work.
There are two main measures of unemployment:

The Claimant Count
The Claimant Count measure of unemployment includes those unemployed people who are
eligible to claim the Job Seeker's Allowance (JSA. The Claimant Count is a “head-count” of
people claiming unemployment benefit and is calculated as follows;
Unemployment rate= JSA Claimants x 100

Total Workforce
The JSA claimants must be able to prove that they are looking for work and must be registered at
unemployment offices. The age range for eligibility is 18 - 60/65.
Advantages of the Claimant Count
i) It is relatively less expensive since it does not involve a survey.

ii) Information about unemployment is obtained quickly.
iii) Current Unemployment figures are readily available because records on claimant count are
updated frequently.
Disadvantages of the Claimant Count
i) The method may overstate the unemployment rate because some individuals may make
false claims while others may be receiving unemployment benefits with no intention of
working again.
ii) It is not internationally recognized because not all countries pay unemployment benefits.
iii) It only considers those claiming unemployment benefits, yet some unemployed individuals
may not be claiming the benefits hence the unemployment rate may be understated.
iv) Many categories of people are excluded from the count because they do not qualify to
receive unemployment benefits. They include;
a) Married women whose husbands are in employment.

b) Students searching for part time jobs.
c) Youth (under 18) looking for employment.
d) Individuals currently in retraining schemes.
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The Labour Force Survey/ ILO Count
The Labour Force Survey or ILO Count covers those who are without any kind of job including
part time work but who have looked for work in the past four weeks and are able to start work in
the next two weeks. The figure also includes those people who have found a job and are waiting to
start in the next two weeks. The unemployment statistics are obtained through a survey conducted
either through interviews or questionnaires. This method is internationally recognized but is prone
to sampling problems. The age range for eligibility is 16 - 65.
Unemployment rate= Those actively seeking and ready to start working x 100
Total Workforce
Advantages of the Labour Force Survey
i) It is internationally recognized.
ii) It helps in inter- country comparisons of the unemployment level.
iii) It provides a more complete measure of unemployment since it includes both the
unemployment benefits claimants as well as individuals who are unemployed but
are not claiming the benefits i.e. it is not affected by the classification of who
qualifies to be considered as unemployed as is the case with claimant count.
Disadvantages of the Labour Force Survey
i) It is very expensive since it requires both financial and non financial resources to
collect unemployment data.
ii) The accuracy of this method is subject to sampling and response errors because
some respondents who are included in the sample might give wrong information.
iii) Current Information on the unemployment situation is not readily available when
needed since the survey takes a longer time to conduct.
CONSEQUENCES OF UNEMPLOYMENT
Benefits of Unemployment
i) It gives people time to explore job opportunities and to consider new jobs or opportunities.
ii) It may leave people with more time to pursue their leisure activities.
iii) It results in a decrease in the costs of production due to the availability of cheap labour.
Costs of Unemployment
1. Loss of national output: Unemployment involves a loss of potential national output and
represents an inefficient use of scarce resources. If some people choose to leave the labour
market permanently because they have lost the motivation to search for work, this can have a
negative effect on long run aggregate supply (LRAS) and thereby damage the economy’s
growth potential.
2. Loss of Income: Unemployment usually results in a loss of income whereby majority of the
unemployed experience a decline in their standard of living.
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3. Fiscal costs: The government loses out because of a fall in tax revenues and higher spending
on welfare payments for families with people out of work. The result can be an increase in the
government budget deficit which then increases the risk that the government will have to raise
taxes or scale down plans for public spending on public and merit goods
4. Social costs: Rising unemployment is can fuel the incidence of crime, and social dislocation
e.g. increased divorce rates, poor health, apathy and lower life expectancy.
TYPES OF UNEMPLOYMENT
A) Demand Deficient/ Cyclical Unemployment
This is associated with economic recessions and occurs when the level of aggregate demand is not
enough to maintain national output at full employment level. Since labour has a derived demand,
fewer workers are demanded when the aggregate demand for goods and services falls hence
unemployment sets in.
Policies to reduce Demand Deficient/ Cyclical Unemployment

The main objective of these policies would be to increase the level of aggregate demand in the
economy. This can be achieved through;
● A reduction of interest rates.
● A reduction of income tax.
● An increase in government expenditure.
● Currency devaluation- this will make exports cheaper and imports more expensive.
Limitations arising from the use of Policies to reduce Demand Deficient Unemployment
● The effect of the fiscal and monetary policies can only be seen after a time lag.
● The policies may lead to a conflict of economic objectives e.g. as the economy approaches full
employment, an increase in AD may lead to inflation and current account deficit in Balance of
payments.
B) Equilibrium Unemployment/ Natural rate of Unemployment
This is the difference between the demand for and supply of labour at the market wage rate. There are
three main types of Equilibrium Unemployment;
i) Frictional unemployment
ii) Structural unemployment
iii) Seasonal unemployment
i) Frictional unemployment.
Frictional unemployment is transitional unemployment due to people moving between jobs. It occurs
when individuals quit their present jobs or when they’re sacked and remain unemployed as they
search for new jobs. Many qualified workers seeking work are not able to find new jobs right away,
usually because of a lack of complete information about new job openings or due to high
unemployment benefits which reduce unemployment hardships thereby encouraging people to turn
down job offers. While it is likely that qualified workers will soon be matched with new jobs, these
workers are considered frictionally unemployed during the time that they spend searching for their
new jobs.
Policies to reduce Frictional Unemployment
● Improved information services- this can be done through improved facilities at the job centers,
private agencies, internet and print media which would help unemployed individuals to find
jobs faster.
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● Reduced unemployment benefits- this would force unemployed individuals to take up jobs
more quickly due to the increased unemployment hardship.
● Reduced income tax- the government can reduce the income tax for low income earners so as
to encourage individuals to find jobs more quickly. The UK government has introduced a 10%
starting rate of income tax for low income earners to encourage them to search and take up
employment. However, this cut in income tax may not be enough to reduce frictional
employment.
ii) Structural Unemployment
Structural unemployment occurs when there is a long run decline in demand in an industry leading to
a reduction in employment perhaps because of increasing international competition or a decline in
traditional industries. This unemployment persists due to the occupational immobility of labour. It can
be divided into two;
Regional unemployment- this is caused by a decline in traditional industries in a region thereby
leading to a retrenchment of workers. For instance, due to the decline in coal mining, textile, steel
manufacturing and car manufacturing industries in the north and west of the UK, many of the former
workers have been laid off.
Technological unemployment- this is caused by changes in production techniques. As firms adopt
labour saving capital intensive technology, the number of workers employed falls e.g. the use of
robots in car manufacturing and computers in the service industry has led to a sharp decline in the
number of workers employed.
Policies to reduce Structural Unemployment
Retraining schemes- this will equip workers with additional skills in order to make them
occupationally mobile. However, they are expensive to finance and their impact can only be felt after
a time lag.
Regional parity- this involves giving grants and subsidies and tax cuts to firms so as to encourage
them to relocate to areas of high structural unemployment.
Market solution- this entails the unemployment problem to the free market. High unemployment
rates will drive down wages which will attract new firms into the area which will solve the
unemployment problem.
iii) Seasonal unemployment
This is caused by seasonal fluctuations in demand for labour and is common in industries where the
demand for labour is high during peak periods and low during off- peak seasons e.g. tourism,
agriculture, construction etc.
C) Disequilibrium /Real wage unemployment:
This is considered to be the result of real wages being above their market clearing level leading to an
excess supply of labour. Economists believe that a national minimum wage risks creating
unemployment in industries where international competition from low-labour cost producers is
severe. However there is relatively little evidence that the minimum wage has created rising
unemployment.
SEASONAL ADJUSTMENTS TO UNEMPLOYMENT FIGURES
Unemployment statistics are seasonally adjusted to allow for fluctuations in the unemployment
figures. At Christmas time and during New Year festivities, unemployment figures are artificially
reduced because people take up temporary employment in the retail sector. The same also happens in
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summer. The seasonally adjusted unemployment figure excludes the temporary changes in
unemployment so that a clear picture of the underlying unemployment can be obtained.
UK’S UNEMPLOYMENT STATISTICS

YEAR UNEMPLOYMENT (Millions) UNEMPLOYMENT RATE %
1990 1.5 5.8
1991 2.2 6.6
1992 2.6 9.2
1993 2.8 10.4
1994 2.4 9.4
1995 2.3 8.4
1996 2.1 8.0
1997 1.6 6.2
1998 1.3 4.8
1999 1.2 4.6
2000 1.1 4.0
2001 1.0 3.6
2002 1.0 3.5
2003 0.9 3.9
2004 0.8 3.8
2005 1.2 4.0
2006 1.6 4.2
2007 1.7 5.1
2008 1.9 6.1
2009
2010
Since 1993, the unemployment rate has been declining gradually but in recent years, it has begun to
show an upward trend. The fall in unemployment can be attributed to several factors;
a) Labour market reforms which have increased the flexibility of labour markets.
b) Retraining schemes which have increased the mobility of workers.
c) Unemployment benefits reforms where people can only obtain JSAs for a given period of time
after which they have to re-apply.
d) The high National Minimum Wage has encouraged unemployed workers to look for jobs.
e) Economic growth- Labour has a derived demand therefore rising production generates a
higher demand for labour.
The recent increase in unemployment can be attributed to;

a) An increase in immigration
b) An increase in the number of women and older people who are searching for jobs
c) An economic recession which has forced numerous firms to either close down or to retrench
workers.
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GOVERNMENT POLICIES TO REDUCE UNEMPLOYMENT

The policies used to reduce unemployment are similar to those used to promote economic growth.
They include;
1. DEMAND MANAGENT POLICIES

a) Monetary policy
b) Fiscal policy
2. SUPPLY SIDE POLICIES
3. EXCHANGE RATE CONTROL
DEMAND MANAGENT POLICIES

These are policies which are used to influence the level of aggregate demand in an economy over a
given period of time. They consist of either monetary or fiscal policies.
MONETARY POLICY
To control the level of inflation, the government should use an expansionary monetary policy which
involves a decrease in interest rates and an increase in money supply. An expansionary monetary
policy is used to increase the level of aggregate demand bringing about an increase in real national
output. More workers will be required to generate the additional output hence the unemployment rate
will fall. A decrease in interest rates will lead to a low cost of borrowing thereby resulting to an
increase in consumption and investment expenditure. This will lead to an increase in aggregate
demand in the economy thereby resulting to a fall in the unemployment rate.
FISCAL POLICY
Fiscal policy involves the use of government spending and taxation to influence economic
performance. To reduce the level of unemployment, the government should use an expansionary fiscal
policy. This involves a decrease in taxes or an increase in government expenditure in order to increase
the level of aggregate demand. The increase in government expenditure on goods and services will
lead to an increase in aggregate demand since government expenditure is a component of aggregate
demand the AD curve will shift outwards to the left. On the other hand, a decrease in income tax will
lead to an increase in disposable income thereby resulting in an increase in the purchasing power of
consumers. This will lead to an increase in consumption expenditure hence an increase in aggregate
demand and real output since consumption expenditure is a component of aggregate demand. More
workers will be required to generate the additional output hence the unemployment rate will fall.
They include;
● Increased spending on education and training- this will stimulate an improvement in the
human capital of the workforce such that more of the unemployed have the skills to take up the
available jobs since there will be an improvement in the occupational mobility of labour. Since the
pattern of employment in most economies is constantly changing, people need to have sufficient
flexibility to adapt to structural changes in industries over the years
● Welfare reforms e.g. lower starting rates of income tax and the introduction of tax credits
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● Employment subsidies- the Government may give subsidies to those firms that take on the long-
term unemployed which will create an incentive for businesses to increase the size of their
workforce.
● Policies to promote entrepreneurship and the growth of small-medium size enterprises e.g. setting
up SME loans and advice centers.
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BALANCE OF PAYMENTS
WHAT IS THE BALANCE OF PAYMENTS?
This is a record of a country’s financial transactions with the rest of the world. It is a statement that
records payments made by a country to other countries or receipts due to a country from other
countries. The BOP account therefore serves as an important measure of the relative performance of a
country’s economy in the global economy.
THE STRUCTURE OF BOP

There are three main accounts in BOP;
● Current account
● Capital account
● Financial account
Current account
The current account balance comprises the balance of trade in goods and services, net investment
incomes from overseas assets as well as the net balance of private transfers between countries and
government transfers e.g. UK government payments to help fund the various spending programmes of
the European Union. Net investment income arises from interest payments, profits and dividends from
external assets located outside a country. For instance, the net investment income flow for the UK is
positive which is a reflection of the heavy investment overseas by British businesses and individuals.
The transfer balance is negative mainly because the British government is a net contributor to the EU
budget. The current account is the most important part of BOP because it reflects an economy’s
international competitiveness. It is further subdivided into four sub sections;
i) Visible trade/ Trade in goods

This section contains records of all payments for imports and receipts from exports involving physical
goods. Trade in goods includes exports and imports of oil and other energy products, manufactured
goods, foodstuffs, raw materials and components. The difference between the value of exports and the
value of imports is referred to as the Balance of Trade (BOT).
BOT=Xg - Mg
A BOT surplus exists when Xg > Mg while a deficit exists when Xg < Mg
ii) Invisible trade/ Trade in services

This section contains records of all payments for imports and receipts from exports involving services.
Trade in services includes exports and imports involving banking, insurance, consultancy, tourism,
transport, education and health services. The difference between the value of exports and the value of
imports is referred to as the Balance of Invisible Trade (BOIT).
BOIT=Xs – Ms
A BOIT surplus exists when Xs > Ms while a deficit exists when Xs < Ms
iii) Income Flows.
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This section contains a record of inflows and outflows of investment income such as dividends, profit
and interest. The difference between inflows and outflows of incomes is referred to as the net income
flows.
Net income flows = Inflows of investment incomes - Outflows of investment incomes
iv) Transfer payments/ Current transfers

This section is concerned with money transfer between governments and countries e.g. bilateral aid,
loans and reparations. The difference between inflows and outflows of transfers is referred to as the
net current transfers.
Net current transfers = Inflows of transfer payments - Outflows of transfer payments
NB: the current account balance is the sum of BOT, BOIT, Net income flows and Net
current transfers
ILLUSTRATION
Given that in 2020 the UK exported goods worth £163,704m to other countries and services worth
£61,777m while it imported goods worth £184,302m and services worth £49,099m, calculate;
a) BOT
b) BOIT
c) Balance of trade in Goods and Services.
BALANCE OF PAYMENTS
CURRENT ACCOUNT BALANCE
TRADE IN GOODS
Export of Goods 163,704m
Import of Goods 184,302m
BOT -20,598m
TRADE IN SERVICES
Export of Services 61,777m
Import of Services 49,099m
BOIT 12,678m
BALANCE OF TRADE IN GOODS AND SERVICES
BOT -20,598m
BOIT 12,678m
-7,920m
Given also that remittances from abroad totaled up to £114,145m while £98,368m was sent by UK
companies to shareholders abroad and that the UK gave grants to developing countries totaling up to
£21,649m and received £15,261m from the US navy as military assistance, calculate;
a) Net income flows
b) Net current transfers
c) Current account balance
BALANCE OF PAYMENTS
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INCOME FLOWS
Inflows of investment incomes 114,145m
Outflows of investment incomes 98,368m
Net income flows 15,777m
CURRENT TRANSFERS
Inflows of transfer payments 15,261m
Outflows of transfer payments 21,649m
Net current transfers -6,388m
Balance of Trade in Goods and Service -7,920m
Net income flows 15,777m
Net current transfers -6,388m
1469m
INTERPRETATION
Trade in Goods
The UK Balance of Trade has registered a deficit i.e. visible imports > visible exports. This is due to
the emergence of economies such as China and India which produce relatively cheaper commodities.
The relatively higher cost of production due to relatively higher wages paid to workers makes its
exports internationally uncompetitive. The decline in the manufacturing sector (de-Industrialization)
coupled with the expansion of the service sector as well as high exchange rates have all contributed to
a BOT deficit.
Trade in Services
The balance of trade in services has been positive for many years. Strong surpluses are especially
common in financial and business services and hi-tech knowledge services. This is because Britain
has a comparative advantage in selling financial services to the rest of the world. London is one of the
three main financial centers in the world and has the largest share of trading in many international
financial markets. Many overseas banks have established themselves in London’s money and capital
markets. UK based commercial banks, fund managers, securities dealers, insurance companies and
money market brokerage represent a huge asset for the UK balance of invisible trade account.
However, the strong performance in services is not enough to outweigh the significant deficit in the
Balance of Trade. The UK also runs a deficit in international travel and transportation mainly because
of the growth of demand for overseas holidays as living standards have improved.
Income Flows
There is a surplus in the net income flows account due to the fact that income brought into the country
by UK citizens living abroad (remittances) and income earned from investments abroad (interest,
dividends and profit) has been greater than the income leaving the country.
Transfer Payments
The UK government pays a considerable amount of money to the European Union. The outflow of
government fund is greater than inflows leading to a deficit in the current transfer account.
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THE IMPACT OF CURRENT ACCOUNT DIS-EQUILIBRIUM ON AD AND REAL

OUTPUT
A) A CURRENT ACCOUNT DEFICIT
This occurs when the payments for imports and outflow of incomes and transfers are greater than the
receipts from exports and inflows of incomes and transfers i.e. the value of money leaving the country
is greater than the value of money entering.
A current account deficit will lead to a fall in AD and real output due to the negative multiplier effect
since leakages exceed injections. A fall in real output will also lead to an increase in unemployment.
CAUSES OF A CURRENT ACCOUNT DEFICIT
● A high domestic rate of Inflation

● A high exchange rate
● Low quality of domestically produced goods and services
● Rapid growth of emerging economies
● De-Industrialization
B) A CURRENT ACCOUNT SURPLUS
This occurs when the receipts from exports and inflows of incomes and transfers are greater than the
payments for imports and outflow of incomes and transfers i.e. the value of money entering the
country is greater than the value of money leaving it.
A current account surplus will lead to an increase in AD and real output due to the positive multiplier
effect since injections exceed leakages.
CAUSES OF A CURRENT ACCOUNT SURPLUS
● A low exchange rate

● Superior quality of exports
● A low domestic rate of Inflation
● Discovery of new resources e.g. oil
● Rapid industrial development
● Protectionism and subsidies
Capital account
This section of BOP records the transactions involving fixed assets. The greater part of Capital
account deals with the flow of capital associated with migration. As immigration into a country
increases, capital account inflows will increase leading to a Capital account surplus since the
immigrants’ assets become part of the host country’s assets. The UK’s Capital account is always in
surplus. The Capital account can be divided into;
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i) Capital outflow account

ii) Capital inflow account
Capital outflow account

This refers to the outflow of long term investments or multinational companies from an economy. The
Capital outflow enlarges the stock of capital in the other country which generates an inflow of
investment income in the long run. The Capital outflow contributes to a BOP deficit in the short run
but a BOP surplus in the long run.
Capital inflow account

This refers to the inward movement of long term investment or multinational companies into a
country. The inflow of capital may lead to;
a) An increase in the level of capital stock into a country thereby leading to an increase in the
productive capacity. This increases AS in the long run.
b) An increase in investment will trigger a positive multiplier effect thereby leading to a more
than proportionate increase in real output.
c) An increase in employment and national income.
d) An increase in the quantity and variety of goods and services resulting to increased
competition.
e) An outflow of investment income in the long run
f) Inflow of technology.
Net Capital flow

This is the difference between inward and outward capital movement. Positive Net Capital flows are
realized when a country acquires more long-term investment from other countries than its Capital
outflows to other countries. The economy will therefore experience an increase in investment
expenditure as well as an increase in its productive capacity leading to an outward shift of both the
AD and AS curves.
Financial account
This section of BOP records transactions involving foreign currency revenue and financial investment
by foreign companies as well as local companies abroad. It records short term financial flows (hot
money flows), borrowed funds, load repayments, movement of currency reserves etc. When the
outflow of short term financial assets is greater than inflows, the net financial flows are negative and
vice versa. Positive net financial flows will lead to an increase in money supply in the economy
thereby leading to an increase in the purchasing power.
BOP DISEQUILIBRIUM
This exists when a country is having a deficit or surplus in its BOP.
BOP Deficit
This exists when the total outflow of resources from an economy exceeds the inflow. It may be caused
by;
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a) A high exchange rate

b) A high domestic rate of inflation
c) Low domestic interest rates
d) Poor terms of trade- this is the rate at which a country’s exports are exchanging with its
imports.
Effects of a BOP Deficit

i) A decrease in economic growth and an increase in unemployment- an increase in
imports into the country may reduce domestic production thereby leading to a fall in exports.
A fall in domestic production will lead to a decrease in economic growth and an increase in
unemployment.
ii) An increase in the variety of goods and services available to consumers- this is because
the country is importing more goods and services than it is exporting leading to an
improvement in the standards of living of consumers.
iii) A fall in general price levels- this is because total expenditure in the economy will fall
shifting the AD curve inwards hence a fall in general price levels.
iv) Depletion of foreign exchange reserves- due to the need to finance imports, foreign
exchange reserves may decrease. The government may be forced to borrow so as to
replenish the reserves leading to an increase in external debt hence an increase in the debt
burden to the government.
POLICIES TO CORRECT A BOP DEFICIT
● Demand management policies

● Exchange rate policies
● Supply side policies
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Demand management policies

a) Expenditure reducing policies
These policies are concerned with the reduction of the overall expenditure in the economy.
This will lead to a fall in demand for both imports and domestically produced goods and
services. The most commonly used expenditure reducing policies are contractionary fiscal and
monetary policies. Their overall effect is a fall in BOP deficit, an increase in unemployment, a
fall in real output and a fall in inflation as shown below;
b) Expenditure switching policies

These policies are used to reduce the demand for imports by replacing it with demand for
domestically produced goods and services. This will involve the setting up of tariff and non
tariff barriers e.g. trade quotas. Their overall effect is an increase in AD and real output in an
economy as shown below;
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Limitations of Expenditure switching policies

1. It may lead to retaliation and trade wars between trading partners
2. Trade barriers interfere with free trade
3. The policy is inflationary.
Exchange rate policies

The two main factors that affect the price of exports relative to imports are the cost of production and
the exchange rate. A change in the exchange rate will therefore lead to a change in the prices of
imports and exports. A BOP deficit can be reduced by depreciating the value of a country’s currency
in order to make exports cheaper than imports. However, the deficit will worsen initially before
improving in the long run because businesses tend to be tied into contracts which would not allow
them to change the volume of imports immediately or to export more when the currency depreciates.
Some businesses will therefore continue to import the same quantity imports even after a currency
devaluation thereby leading to an increase in the value of imports resulting in an increase in BOP
deficit.
Limitations of Exchange rate policy

1. It interferes with free trade i.e. it is a barrier to trade
2. It is difficult to control the value of currency in a free market system i.e. it can only work in a
fixed exchange rate system.
3. It increases inflationary pressure
4. It worsens the BOP deficit in the short-run i.e. the J curve effect
5. Its effectiveness will depend on the price elasticity of demand for imports and exports. It is only
effective if the Marshall Lerner condition is met i.e. PEDx + PEDm>1
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Supply side policies

These policies are aimed at increasing the productive capacity of an economy e.g. privatization,
investment in research and development, improvement of transport and communication channels,
subsidies etc. There will be a fall in the cost of production and an improvement in the quality of
domestically produced goods thereby making them more internationally competitive. Aggregate
supply will increase leading to an outward shift of the AS curve as shown below.
Supply side policies will not only help in reducing the BOP deficit but will also help reduce
unemployment as well as inflation.
Evaluation
● It may take time to realize the increase in real output in the economy.
● Privatization may not reduce monopoly power as is the case with many industries
● A BOP deficit may not matter for many countries.
BOP Surplus
This exists when the total inflow of resources from an economy exceeds the outflow. It may be caused
by;
a) A low exchange rate
b) A low domestic rate of inflation
c) High domestic interest rates
d) Favourable terms of trade
e) Low costs of production
Effects of a BOP Surplus
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i) An increase in economic growth and employment creation- a persistent surplus implies that
the country is experiencing export led growth. Export led growth exists when the increase in
the country’s GDP is attributable to export promotion. As the GDP of a country increases, the
rate of unemployment falls.
ii) Higher standard of living – a country may use its surplus or export earnings to import more
goods or services in the long-run which will lead to an increase in the variety of goods
available to consumers. The standard of living will therefore improve.
iii) Inflation- a BOP surplus will lead to an increase in the purchasing power of economic agents
in an economy due to the additional inflow of money. This will lead to demand pull inflation.
iv) A rise in the exchange rate- a persistent surplus may lead to a rise in exchange rates due to an
increase in demand for the local currency. This will lead to a fall in exports in the long-run.
v) De-Industrialization- this exists when the surplus is used to buy more imports leading to a
decline in the domestic manufacturing sector of the economy.
vi) An increase in consumer and investor confidence in the economy.
POLICIES TO CORRECT A BOP SURPLUS
● Expenditure increasing policies

● Appreciation of the Exchange rate
● Removal of trade barriers
● Lending (giving foreign aid)
● Encouraging capital outflow
Expenditure increasing policies

These policies are concerned with increasing the purchasing power of consumers in order to
increase demand for both imports and domestically produced goods and services. The increase in
demand for imports will lead to a fall in the current account and BOP surplus. However, the
increase in demand for Imports will depend on the income elasticity of demand for imports. On
the other hand, an increase in demand for locally produced goods and services will lead to a fall in
exports since domestic producers will not have enough goods to export leading to a fall in BOP
surplus.
The most commonly used expenditure increasing policies are expansionary fiscal and monetary
policies.
CONFLICTS RESULTING FROM THE USE

OF POLICY INSTRUMENTS
It is rare for any government to be able to meet all its objectives at the same time. There are potential
trade-offs between objectives implying that choices between different goals may have to be made.
The government should therefore only implement a policy if its benefits outweigh the negative effects
on the economy. Some of the possible conflicts between the policy instruments are;
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Changes in interest rates
An increase in interest rates to control inflation may create more inflation since the high interest rate
will lead to an increase in the cost of borrowing thereby increasing the cost of investment and
production. This will lead to cost push inflation. The inflow of hot money due to high interest rates
may make the exchange rate stronger thereby reducing the competitiveness of a country’s exports
leading to a fall in economic growth due to the negative multiplier effect. An increase in interest rates
to control inflation may also lead to an increase in the income gap because the rich will gain since
they can afford to save more while the poor will lose due to the high cost of borrowing.
A decrease in interest rates to stimulate aggregate demand may lead to an outflow of hot money from
the economy. This represents a leakage which may lead to a fall in economic growth due to a negative
multiplier effect.
Unemployment and Inflation – the Phillips Curve
When unemployment falls to low levels, there is a risk that wage and price inflation will pick up. The
demand for labour is increasing and labour shortages in many industries and occupations may arise.
This puts upward pressure on salaries as employers offer higher pay both to recruit and retain their
key workers. Falling unemployment leads to an increase in AD which can lead to demand pull
inflation if SRAS is inelastic.
However, Unemployment has many causes and there is no automatic rule that falling unemployment
must lead to rising inflation. For instance the British economy has enjoyed a very long period of
falling unemployment without any significant acceleration in inflation which can be attributed to
supply side improvements such as higher capital investment, increase in productivity, lower labour
costs and the benefits of rapid innovation.
Inflation and economic growth
Sustained growth caused by rising aggregate demand can lead to acceleration in inflation as the
economy uses up scarce resources and short run aggregate supply becomes inelastic. When the AS
curve is elastic, an outward shift of aggregate demand can easily be met by a rise in real GDP i.e.
70
there is plenty of spare capacity and supply responds elastically to the higher level of AD. However,
when the AS curve becomes inelastic, the trade-off between growth and inflation worsens. An
increase in AD tends to lead to higher prices rather than increased output and employment.
However, the trade off between growth and inflation can be avoided if an economy is able to increase
potential output by improving their supply-side performance e.g. advances in technology and the
benefits that come from product and process innovations. Potential output is also increased by
expanding the stock of capital goods (higher investment) and through an increase in the available
labour supply.
Economic Growth and the Balance of Payments
When aggregate demand is high as a result of increasing higher incomes resulting from economic
growth, the demand for imported goods and services e.g. cars will increase leading to an increase in
the BOP deficit. The experience of the UK in recent years shows that the size of the trade deficit is
largely cyclical. The strong growth of GDP and consumer demand has led to a large increase in the
trade deficit in goods and services.
However, this may be attributed to the strength of the exchange rate. When sterling pound is strong,
the relative prices of imports coming into the UK falls, and British exports because more expensive in
international markets thereby causing a slowdown in export sales and a rise in the demand for
imports.
71

Unit 2 Notes Economics

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UNIT 2 NOTES:

MEASUREMENT OF THE ECONOMIC PERFORMANCE OF A

MEASURING NATIONAL INCOME

NATIONAL INCOME AND GROSS DOMESTIC PRODUCT

CONCEPTS OF NATIONAL INCOME

REAL GDP PER CAPITA

THE TRADE CYCLE

GDP/ INCOME/ OUTPUT GAP

THE TRADE CYCLE AND OUTPUT GAP

● Sustained economic growth

ECONOMIC GROWTH AND ECONOMIC

Definition of economic growth

Disadvantages of economic growth

MEANING AND MEASUREMENT OF ECONOMIC DEVELOPMENT

MEASURES/ INDICATORS OF ECONOMIC DEVELOPMENT

GDP per capita at Purchasing Power Parity

Human Development Index

Advantages of the HDI

● Data on Measures chosen is easy and cheap to collect.

Disadvantages of the HDI

ECONOMIC GROWTH VS ECONOMIC DEVELOPMENT

AGGREGATE DEMAND (AD)

COMPONENTS OF AGGREGATE DEMAND

● Income induced consumption

Determinants of Consumption Expenditure

ii) Population size

vi) Wealth effect

vii) Government policy

Concepts of Average and Marginal Propensity to Consume

a) Average Propensity to Consume

APC= Total Consumption Expenditure = C = a +b Yd = a + b

b) Marginal Propensity to Consume

MPC= ∆Consumption Expenditure = ∆C = ∆ (a +b Yd) = ∂ C = b

ii) Investor confidence

iii) Government policy

v) Education and training

● Income induced investment- This is the component of investment that is dependent of

Determinants of Government Expenditure

i) Population size and structure

ii) Tax revenue

iii) Level of economic performance

iv) Political climate and stability

Aggregate Demand (AD) Curve

Reasons why the aggregate demand curve slopes downwards

SHIFTS OF THE AGGREGATE DEMAND CURVE

● A large boom in the housing market or a slump in share prices.

● An unexpected cut or an unexpected rise in interest rates.

AGGREGATE SUPPLY (AS)

Aggregate Supply (AS) Curve

II. Full employment

III. The Intermediate range

The long-run aggregate supply curve

CHANGES IN AGGREGATE SUPPLY

Aggregate supply shocks

Aggregate supply shocks might occur when there is

EQUILIBRIUM REAL OUTPUT

EFFECTS OF A SHIFT IN THE AS CURVE ON EQUILIBRIUM REAL OUTPUT

Causes of an outward shift

Causes of an outward shift

EFFECTS OF A SHIFT IN THE AD CURVE ON EQUILIBRIUM REAL OUTPUT

Y =B If we allow B to change, Y will be expected to change by a certain amount;