Written by Giya.G, Abel.S and Substantially Revised and Edited by Ndlovu.E

MACROECONOMICS

MODULE EC104

Written by Giya.G, Abel.S and substantially revised and edited by Ndlovu.E

DEPARTMENT OF ECONOMICS

MIDLANDS STATE UNIVERSITY

©2005

CHAPTER ONE

INTRODUCTION

Macroeconomics

Macroeconomics is concerned with the study of the whole economy. Macroeconomics is concerned with the study of economy wide aggregates, such as the analysis of total output and employment, total consumption, total investment and national product. (Vaish,1995). It is concerned with the behaviour of the economy as a whole- with booms and recessions, the economy’s total output of goods and services and growth of out[put, the rates of inflation and unemployment, balance of payments, exchange rates etc. Because it is closely related to real world issues, macroeconomics also involves many non-economic factors such as political, historic, cultural and sociological factors. (Dornbusch et al, 1998).

Macroeconomic Problems

These arise when the economy suffers from high unemployment, inflation, or a balance of payments deficit. Therefore the government sets itself certain macroeconomic objectives:

• Low unemployment
• Low inflation
• A balance of payments surplus
• Economic growth

Macroeconomics and Microeconomics

The line between macroeconomics and microeconomics is less sharp than it used to be, but it is still there.

What makes this module different is that we focus on the economy as a whole.

• Instead of talking about the demand and supply of (say) pizza, we talk about the demand and supply of output.
• Instead of talking about what determines the demand for workers in the pizza industry, we talk about what determines the total demand for workers.

BUSINESS CYCLE

Business Cycles (or trade cycle)

A business cycle is the more or less regular pattern of expansion (recovery) and contraction (recession) in economic activity around a growth trend (Dornbusch et al, 1998). Business cycles can also be described as the periodic booms and slumps in economic activities. The ups and downs in the economy are reflected by the fluctuations in aggregate economic magnitudes, such as, production, investment, employment, prices, wages, bank credits etc. The upward and downward movements in these magnitudes show different phases of a business cycle (Dwivedi, 1996). Basically there are only two phases in a cycle, namely prosperity and depression. Considering the intermediate stages between prosperity and depression, the various phases of trade cycle may be enumerated as follows:

1)Expansion

2)Peak

3)Recession;

4)Trough

5)Recovery and expansion

Phase of Business Cycles

line of cycle

Peak steady growth line

Growth

Rates prosperity depression

expansion trough

peak recovery

trough

Time

Expansion or prosperity (or boom)

This boom is characterised by increase in output, employment, investment, aggregate demand, sales, profits, bank credits, wholesale and retail prices per capita output and a rise in standard of living. The growth rate eventually slows down and reaches the peak. However:

• A boom increases spending on imports, causing balance of payments problems.
• Once high levels of employment have been reached, output cannot be increased any further and the boom causes inflation.

Peak

• This is characterized by slacking in the expansion rate, the highest level of prosperity, and downward slide in the economic activities from the peak.

Recession

The phase begins when the downward slide in the growth rate becomes rapid and steady. Output, employment, prices, etc. register a rapid decline, though the realised growth rate may still remain above the steady growth line. So long as growth rate exceeds or equals the expected steady growth rate, the economy enjoys the period of prosperity, high and low. When the growth rate goes below the steady growth rate, it marks the beginning of depression in the economy. Depression begins when growth rate is less than zero i.e. the total output, employment, prices, bank advances etc. decline during the subsequent periods. In other words there is a slump in the economy. [A slump reduces spending on imports, thus improving the balance of payments. Reduced total spending lowers inflationary pressure.] The span of depression spreads over the period growth rate stays below the secular growth rate or zero growth rate in a stagnated economy.

Trough

This is the phase during which the downtrend in the economy slows down and eventually stops and the economic activities once again register an upward movement. Trough is the period of most severe strain on the economy.

Recovery

When the economy registers a continuous and rapid upward trend in output, employment, etc, it enters the phase of recovery though the growth rate. When it exceeds this rate, the economy once again enters the phase of expansion and prosperity. If economic fluctuations are not controlled by the government, the business cycles continue to recur as stated above.

Why worry about business cycles?

Business cycles, cause not only harm to business but also misery to human beings by creating unemployment and poverty. Governments in many countries assume the role of a key player in employment and stabilization. Stabilization broadly means preventing the extremes of ups and downs or booms and depression in the economy without preventing factors of economic growth to operate.

Trade Cycles or business cycles- simplified diagram

Government Macroeconomic Policies

Macroeconomic Policy Objectives

All governments like to achieve the following 4 major macroeconomic policy objectives:

(a)Full employment of labour force.

(b)A stable price level.

(c)B.O.P equilibrium ( surplus is desirable)

(d)A satisfactory rate of economic growth.

On full employment, of labour force it is not possible to achieve this in the strictest sense. The use of official unemployment statistics as basis for setting policy objectives is also suspect. The list by government includes those defined as being unemployed by government rather than those who would be willing to take up paid employment should it become available. Some people on the register may be unemployable-aged, disabled, criminals and those not intending to work.

Table below shows some of the policies the government can use to try to get full employment, stable prices etc.

Policy / Description
Fiscal / Changes in government expenditure and taxation
Monetary / Changes in the money supply and interest rates
Prices and incomes / Legal or voluntary limits on price and wage increases
Regional / Measures to help depressed areas
Industrial / Government planning of industry
Commercial / Quotas, tariffs, exchange controls or free trade
Exchange rate / Encouraging a depreciation or appreciation of sterling

Problems of Policy Timing

The timing of policy events may be crucial to the efficiency and effectiveness of policies. There are basically three forms of time lag to consider in relation to the behaviour of policy makers and operation of the economy.

(a)Recognition lag- authorities perceive problems after some time.

(b)Administration lag- it takes time to set up the necessary administrative machinery in motion. For example Parliament approves income tax measures after debate but monetary policy options take days or hours to implement.

(c)Implementation lag- by the time the policy is implemented, new issues have arisen hence new policies have to be implemented/formulated or adapt the policy instruments introduced.

Chief Instruments of Economic Policy

The two important subdivisions of economic policy are the monetary policy and the fiscal policy. These two policies are applied as mutually complementary policies to serve as instruments of government’s economic policy which is applied to achieve certain social goals. Often the two overlap, because it is almost impossible to envisage any major fiscal or monetary measure which does not affect the other.

1. Fiscal Policy. This is the policy of government with regard to level of government spending and tax structure. Government expenditure includes transfer payments, government current expenditures and budgetary balance (extent of borrowing). Taxation (i) provides the funds to finance expenditure. (ii) Can also be used for income redistribution. Taxes are subdivided into direct and indirect. (i) Direct taxes – these are levied directly on persons / corporates and include income tax, corporate tax, poll tax and inheritance taxes, import duties. Typical uses for this instrument are a reduction in income inequalities, regulate aggregate demand, protection of domestic producers, reduce poverty, and provision of infrastructure and to adjust balance between aggregate demand and supply. Import duties are important sources of revenue in many African countries. Countries impose import tariffs for some or all of the following reasons: (a) Revenue, protection to local producers, (b) discriminate between essential and non-essential goods and (c) B.O.P purposes. (ii)Indirect tax is levied on a thing and is paid by an individual by virtue of association with that thing, e.g. local rates on property, sales taxes and excise duties. Tax structure can be regressive proportional or progressive. Tax incentives may be given - investment allowances, tax holidays, accelerated depreciation allowances, duty-free imports; no-tax concessions may be given by government for e.g. provision of roads, water and power. In some African countries rural taxation- was used e.g. Cameroon, Mali and Sudan.

Problems of Fiscal Administration

(a)Tax evasion

(b)Shortage of trained and experienced staff.

(c)Corruption.

(d)attitudes towards payment of taxes.

(e)poor co-ordination of budgets with development plans.

1. Monetary Policy- the manipulation of the volume of credit, interest rates and other monetary variables. Monetary policy is a policy which employs central bank’s control over the supply, cost and use of money as an instrument for achieving certain given objectives of economic policy. The policy is used to improve credit and saving facilities and to regulate macroeconomic balance of the economy. All governments run deficits in that their total spending exceeds the value of their tax and other current receipts. The deficit is financed by long-term borrowing from abroad and from local residents. Sometimes the long-term borrowings will not cover the gap which means it has to be financed by other means. Government usually fills the gap by short-term borrowing from the central and commercial banks. This borrowing from the banking system (deficit financing) usually has highly expansionary effects on money supply. In other words it increases the money supply by the amount of the deficit but is likely also to result in secondary increases in money supply by increasing the cash base of the banking system and hence its ability to lend more to private borrowers. (N.B. Expansionary does not mean inflationary). Monetary policy can be used for anti-inflationary purposes. Much industrial and commercial expansion is financed by bank credit (especially for working capital) so to restrict bank lending is liable to place a brake on new investment and economic expansion. It is possible for credit restrictions to be pushed to the extent of forcing a deflation on the economy, with serious avoidable loses of output and employment. Some economists have argued in favour of the use of high interest rates to curb aggregate demand. The effect of a move along these lines is to encourage the holding of larger money balances, reducing the pressure of demand for commodities.

Critique of the interest rate Reservations to the interest rate issue have been raised:

(a)Higher interest rates may discourage investment and thus impede the development of the economy. It can be counter argued that higher interest rates will raise the productivity of new investments because now only projects which promise large returns will be undertaken. Hence it may be possible to sustain the overall rate of economy growth even from a reduced volume of investment.

(b)A successful induction of people to substantially increase their money holdings may due to the withdrawal of purchasing power from commodity markets may be deflationary.

(c)Several studies have found the elasticity of demand for money with respect to the cost of holding it to be rather small. If this is the case, it would take a very large rise in interest rates to affect a significant increase in the demand for money.

Limitations of the state in achieving Macroeconomic Policy Objectives

(i)too many ministries, often with competing interests, too many public corporations and too many boards of one kind or another.

(ii)Too much corruption of civil service, civil servants badly motivated.

(iii)Too much red tape.

(iv)Too much political instability with governments often changed by military coups and other unconstitutional means. Governments are therefore preoccupied with tasks of maintaining their own popularity, authority and power.

CHAPTER TWO

NATIONAL INCOME ACCOUNTING

National Income is the outcome or the end result of all economic activities. Economic activities generate two kinds of flows (i) money flows- these are in exchange for services of factors of production in the form of flows- these are in exchange for services of factors of production in the form of wages, rent, interest and profits (i.e factor earnings) (ii) Product flows, are flows of consumer goods and services and productive assets. All human activities which create goods and services that can be valued at market price are broadly the economic activities.

Macroeconomics deals with a number of large totals or aggregates, which are used to conceptualize and measure key components of the economy. The most fundamental of these is the total output of goods and services, conventionally referred to as the national income. (Official data in most countries is now actually reported on a "domestic" rather than a "national" basis. The distinction, which is unimportant for most purposes, relates to the treatment of investment income received from non-residents and paid to non-residents. "Domestic income" is that produced within a country by all producers operating there, whether foreign or not. "National income" is that produced only by "nationals" of that country, whether they are producing it there or elsewhere.)

There is nothing inconsistent in referring to total output as income. Although what is earned as income can be measured separately from what is produced, the two aggregates are necessarily the same in amount. Before going on to see why, note that in either case such large totals can be expressed only in terms of money, not physical products as such. It is impractical to try to measure output or income in real, physical terms, simply because it is impossible to sum apples and oranges or any of the millions of goods and services which are produced and received as income in a modern economy. Instead, physical quantities must be converted to a common measure and the measure used for this purpose is the national unit of account, the dollar, pound, or other currency.

The value of total output or income in an economy during some accounting period, usually a year or quarter of a year, is a significant statistic. It is generally used as an indicator of the economy’s performance. Because a larger output or income is equated with a rise in the economic well being of a country’s population, a higher output or income is considered desirable and a lower one undesirable. The economy’s overall performance is tracked by the changing value of the total output or income statistic. Similarly, comparisons of relative well-being among different countries are based on these statistics and a host of political and social as well as economic implications flow from their behaviour over time.

The Circular Flow

A modern economy can be simply modeled in the aggregate by thinking of it as comprising two key sectors, households which consume produced goods and services and which supply labour and other productive services to firms, which use the labour and other productive services supplied by households to produce the goods and services the households consume. Households supply the services of productive factors (land, labour, capital, etc.) and the firms convert these inputs into produced goods and services which return to the households. Owners of firms are, of course, also part of the household sector where they function in their other capacity as consumers of goods and services.

The real flows of productive services and produced outputs have corresponding flows of money payments associated with them. Firms pay out wages and salaries in return for labour services, rents to owners of land and other natural resource inputs, and interest and profits to suppliers of capital and entrepreneurial inputs. Householders consequently have money income with which to pay for the produced goods and services that flow to them from firms. Thus, there are money flows corresponding to the real flows, but they move, of course, in the opposite direction.

Circular Flow of Income

Services of factors of Production

Goods and services

Spending

Incomes

Because the flows of payments for produced goods and services and payments for factor inputs are continuous, aggregate income/output in this simple model could be measured at any point, metering the flow anywhere in the circuit. If measured in terms of spending on produced goods and services, it would be natural to call this a measure of total spending or total expenditure. If measured in terms of outlays made for the services of productive factor inputs, it would be total income (from the point of view of the owners of those factor inputs). Obviously the two totals would have to be the same.

This is a greatly simplified model. One thing missing is the possibility of saving. If households do not spend all their income on produced goods and services, but hold some of it back as savings, every time income flows into the household sector the flow of payments made to producers will diminish. This is a "leakage" of income/spending from the system and the volume of the flow would diminish—the level of national income would fall. But if there are savings, there could also be new investment. If businesses borrowed income saved by households and used it to finance the building of new plant or for other business purposes, it would be injected back into the income stream (in the form of payments to workers and other factor owners who supplied the necessary real inputs needed to produce the new capital). Banks and other financial intermediaries serve as the nexus through which savings are converted into investment spending and returned to the income stream.