ECONOMICS
Introduction
THE NATIONAL INCOME
One of the basic questions facing economics centers on whether the total output of goods and services is growing from year to year or it remains static. This question is very important because countries are keenly interested in the performance of their economy. National income estimates enable countries to calculate the total production of goods and services in a year. The lecture also focuses on the measurement of national income and their problems, uses and limitations of national income statistics and elementary theory of income determination. Meaning of National Income
National income can be defined as the monetary value of all the final goods and services that are produced in an economy within a given period of time, usually a year. Final goods are goods that are ultimately consumed rather than used in the production of another good. For example a car sold to a consumer is a final good; the components such as tires sold to the car manufacturer are not; they are intermediate goods used to make the final good. If the same intermediate goods were included too, this would lead to double counting. For example, the value of the tires would be counted once when they are sold to the car manufacturer, and again when the car is sold to the consumer.
The national income of a country can be measured in three different ways, viz the
Income Approach, the Output Approach and the Expenditure Approach. The use of any of these approaches produces the same result if carefully implemented. The measurement and analysis of the total output produced in an economy is known as social accounting.
National income Concepts
In national income accounting, economists and planners are usually interested in various national income concepts such as, Gross Domestic Product (GDP), Gross
National Product (GNP), Net National Product (NNP), and Disposable Income
(Yd). These concepts are considered in turn.
i.
Gross Domestic Product:
The gross domestic product of a country is the monetary value of all the final goods and services produced within the domestic territory of a country in a specific period, usually a year, irrespective of whether those who produced them are citizens or foreigners. ii. Gross National Product:
This is the main measure of the total output. It is at times; simply referred to as
National Income (NI). The Gross National Product of a country is the money value
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of all the final goods and services produced by nationals or citizens of a country
(in a specific period, usually a year) irrespectively of where they reside. Taking
Nigeria as a specific example, the GNP of Nigeria in a particular year, say 1990 is the money value of all finished goods and services produced by Nigerians living in Nigeria and those in other countries in 1990. The gross national product can simply be regarded as the gross domestic product plus the net property income from aboard, i.e. GNP = GDP + NPA. Where GNP is as preciously defined and NPA stands for Net Property Income from abroad. The net income earned from abroad is the difference between the income which citizens, firms or the government of a country earn abroad and income payable to foreigners on account of their investment in the domestic country. If NPA is positive then GNP
> GDP but if NPA is negative, then GDP < GNP. iii. Net National product (NNP):
The net national product of country is equal to the gross national product minus capital consumption allowance or depreciation. In order to provide for the wear and tear in the value of capital goods used in production of the national output, the amount used up, of the wear and tear of productive assets is usually set aside by deducting it from the value of the national output produced. The amount used up or the wear and tear of assets is what an accountants referred to as depreciation while an economist, on the other hand, refers to it as capital consumption allowance. iv. Disposable Income (Yd):
This can be defined as the national income plus transfer earning minus taxes i.e
Yd = Y+ TE – t, where Y is the national income, TE stands for transfer earnings and t denotes taxes.
VALUATION OF NATIONAL INCOME
The national income or output of a country can be valued in different ways. First in current prices i.e. the prices ruling at the time of measurement. When national income is valued at current prices it is known as nominal national income. If we want to compare the volume of output produced in a particular year with those of other years, we need to make adjustment for changes in price of goods and services produced. To achieve this objective, we need to re value the national output in terms of fixed prices. When the national output is valued in terms of fixed prices, this is technically referred as national income at constant prices or real national income,
National Income at Market Prices and Factor Costs
(i) GDP(MP) = GDP(FC) + indirect taxes - subsidies;
(ii) GNP(MP) = GNP(FC) +indirect taxes - subsidies; or GDP(MP) +NPA
(iii) NNP(MP) = NNP(FC) +Indirect taxes - subsidies; or GNP(MP) -Depreciation
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Measurement of National Income
The national income of a country can be measured in three ways, these are, the income approaches the output approach; and the expenditure approach. These approaches are discussed as follows:
The income approach
Under the income approach, the national income of a country is obtained by summing all income earned by all factors of production employed in the economy during a particular period of time usually a year. These incomes are in the form of wages, salaries, rents, interests, profits, dividends etc. When the national income is measured in this way, we arrive at national income at factor cost which can he defined in symbols as:
Y= Yw + Yr+Yrp+Yi
Where Yw= income received by individuals in form of wages salaries, commissions, bonuses, and other forms of employee earnings before deduction of taxes, Yr = net income from rentals and royalties, Yrp = retained profits of business enterprises, Ydp = disbursed profits of business enterprises, Yi = interest income. In using this approach, however, care taken to avoid double .
Consequently, all forms of transfer payments must be excluded because they are not rewards economic activities. Transfer payment are money paid to an individual by the government, firms or other non-governmental organizations for which there is no quid pro quo (i.e. no corresponding service or good exchange) example of transfer payments include: pensions, unemployment benefits, students grants etc
Problems Associated with the Income Approach
The main problems associated with the income approach include:
1. Problem of how to estimate the rent of owners – occupied house: If a person rents a house, such individual pays rent to the owner of the house. The rent paid, in this case, serves as an income to the owner, the rental value of the house must be included in the national income. However, since data on rents of owner’s occupied houses is not available in the Nigeria setting, it poses a lot of problem to statisticians when estimating rent.
2. Problem of retained earnings: the accounting Principle of companies usually make provision for retained earnings. This implies that not all profits after tax are shared as dividends to shareholders. In measuring the national income using the income approach the amount retained by companies needs to be added back
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to the personal income of individual shareholders so as arrive at the gross national income at factor costs. This exercise, however, creates some difficulties
3. Problem of how to estimate the income of self- employed: In developing countries, Nigeria inclusive, statistical information on the income of those that are self-employed or in the subsistence sector of the economy are not available.
This problem causes a lot of problem when estimating the gross national income.
4. Problem in estimating the net property income from abroad. To arrive at the gross national income, the net property income from abroad has to be added to the gross domestic income. the net property income from abroad is the difference between the income paid to foreigners and the income received from abroad as a result of ownership of productive assets in other countries. In developing countries the net property income may be positive or negative. If negative, it implies that foreigners on account of their investment in the domestic economy is greater than the income receipt from abroad with respect to domestic investments abroad. The reverse holds if the net property income from abroad is positive.
5. Problem of making provision for capital allowance or depreciation: To arrive at the net income; capital consumption allowance or depreciation has to be subtracted from the gross national income. This exercise however creates some difficulties since statisticians and economists may be faced with the problem of which method of depreciation to adopt.
6. Problem of the black or underground economy: The underground or black economy refers to all unrecorded economic transactions conducted In order to evade taxes in the economy. In Nigerian, for instance, a lot of activities are done in underground or black economy. This implies that some income earned are seldom recorded, this has the effect of underestimating the national income of an economy, 7. Problem of double counting: In measuring the national income via the income approach different are usually encountered when accounting for transfer payment. To avoid double counting, transfer payments or earnings have to be excluded under this approach.
The Output Approach
To calculate the national income through the output approach, we sum the values of all the final goods and services produced by firms in the economy at a given period of time usually a year, assuming that only four final goods are produced in an economy in a particular year, the values of these final products can be derived using the formula
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=
+
+
Where PAQA + PBQB+PCQC+PDQD is the sum of the products of the price and quantities of commodity A, B, C and D respectively. It should be noted that this approach emphasized the inclusion of only final goods and services whether they are sold to consumers or to the government or sold abroad as export or to other firms, In this regard, all intermediate goods must be excluded when using this approach, so as to avoid double counting. The main problem usually encountered when measuring the national income through this approach is that what is a final good to one industry may be an intermediate good to other industries, In a way to eliminate the problem of double counting, economists and statisticians always resort to the value-added basis when using the output approach.
Under the value added basis, the national income is computed by adding the valued added of various firms at each stages of production. The value added (VA) at every stage of production is defined as the value of output (VQ) minus the value of input (VI) i.e VA = VQ-VI.
Problems associated with the approach
1. Difficulty in measuring the value of goods consumed by producers: In Nigeria and other West Africa countries, several small-scale farmers consume part of what they produced without accounting for them. Since all the output of the subsistence sector of the economy have to be included in calculating the national output, sample survey which are not usually reliable are often used when calculating the national income through the income approach,
2. Difficulty in assessing the value of services rendered by housewives: Services rendered by house wives such as cooking, taking care of the children, shopping for the family etc; are productive activities which ought to be included in national income figure. However, as a result of lack of statistical data on these services and the difficulty that might arise in an attempt to estimate them, they are usualy excluded from national Income figures.
3. Problem in assessing the value of self-done activities: In measuring the national income of a country through the output approach, the value of self-done activities ought to be included; however, as a result of lack of information on these activities, they are usually excluded from national income figures. These activities under normal situation, would have been paid for if someone was employed to render them
4. Problem of making provision for capital allowance or depreciation: Like in the income approach, to arrive at the net national product, capital consumption
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allowance or depreciation has to be deducted from the gross national output.
This exercise however creates some difficulties.
5. Problem of defining of what a final good is or intermediate good: In developing economic like Nigeria, there are at times, problem of definition of what is a final good or intermediate good, when compiling national income figures. For example could a bicycle be regarded as a final good or intermediate good? This question becomes necessary since in the subsistence sector of the economy bicycles are usually the most convenient way of transporting heavy farm products to the market. When viewed from this perspective, bicycle could be regarded as an intermediate good that aid the production of other goods.
6. Problem of double counting: When measuring the national income via the output approach the value added on productive activities has to be included in the national output. However in Nigeria and other West Africa countries, most businessmen hardly distinguish between the value-added in and total revenue realized on account of production. This has the effect of overestimating the national output since total revenue includes some element of cost of production.
The Expenditure Approach
The expenditure approach to the measurement of the national income of a country entails summing up the total expenditure on final goods and services by private individuals, firms and the government since no country operates in autarchy or without any relation with other countries, we also add the value of expenditure by foreigners on domestic production (exports) and deduct the value of domestic expenditure on foreign production (imports). Using expenditure approach, the gross national expenditure or aggregate demand which is a measure of the national income can be expressed as
Y = C + 1 + G + (X-M)
Where C = Household expenditure on consumer goods
I = investment expenditure by firms
G = government expenditure
X = exports
M = imports
X-M= net exports
In computing national income using the expenditure approach, only expenditure on final goods and services should be included, all expenditure on intermediate goods have to be excluded.
Problem of the expenditure approach
1. Problem of definition of what is final good: To be able to measure the national income of a country accurately using the expenditure approach, knowing what is a final good or service is important. It is only when a final good or service is
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known and Identified that a statistician or economists would know what to include or exclude. Therefore, when there is a problem of product definition, double counting occurs.
2. Problem of unsold stock: All inventories are usually included in the GNP. The procedure is to take positive or negative changes in physical units of inventories and multiply them by current prices. Then the figure is added to total current production of the firm. But the problem is that firms recorded inventories at their original costs rather than at replacement costs. When prices rise there are gains in the in the book value of inventories. Contrariwise, there are losses when prices fall. So the book value of inventories overstates or understates the actual inventories. Thus for correct imputation of GNP, inventory evaluation is required. A negative valuation adjustment is made for gains and a positive valuation adjustment is made for losses. But inventory valuation is a very difficult and cumbersome procedure.
3. Conversion of market prices to factor costs: When national income is estimated using the expenditure approach, some adjustments have to be made so as to ensure the equality of national expenditure with national income and national output. This adjustment becomes important because under the expenditure approach the national expenditure is computed at market prices which are distorted by taxes and subsidies. Therefore to convert national expenditure to national income at factor cost, indirect taxes have to be deducted while subsidies have to be added.
4. Adjustment for net property income from abroad: To derive the gross national expenditure, adjustment has to be made for net property income from abroad.
This exercise involves adding all Incomes from overseas and deducting all incomes accruing to foreigners. This is a complex process.
5. Adjustment for exports and imports: When goods and services are produced in the domestic country, some of these goods are consumed locally while others are sold abroad. In the same vein, some goods consumed within the country are bought from abroad, therefore, exports have to be added to domestic expenditure while Imports deducted.
Note: It could be observed that if the three approaches are carefully adopted they result to the same thing this implies that:
National Income = National Expenditure = National Output.
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Numerical Example:
The following are the items of the income statement of the economy for a particular year (in billions of Naira). Determine the Gross National Product using
a) Expenditure approach and b) income approach.
Items
(N)’b
Rents
24
Personal consumption expenditure
1,080
Corporate income taxes
65
Undistributed corporate profits
18
Net exports
7
Dividends
35
Capital consumption allowance
180
Interest
82
Indirect business taxes
163
Gross private domestic investment
240
Compensation of employees
1,028
Government purchases of goods and services 365
Proprietors’ income
97
Solution:
Using the Expenditure approach:
Y = C + I + G + (X-M)
C = 1080; I = 240; G = 365; X = 7.
Hence; Y = 1080 + 240 + 365 + 7 = 1692.
Using the income approach
Capital consumption allowance 180
Indirect business taxes
163
Compensation of employees
1028
Rents
24
Interest
82
Proprietors’ income
97
Corporate income taxes
65
Dividends
35
Undistributed corporate profits 18
GNP
=N=1,692
The Uses of National Income Estimates
National income estimates are very important and serve many purposes.
1. It permits us to measure the level of production in the economy over a given period of time, and to explain the immediate causes of that level of performance.
2. It is used in economic planning: National income figure serves as indicator of economic growth, level of output and employment in the economy. Therefore,
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national income estimates enable planners to develop appropriate policies that will promote economic growth, ensure stable prices and reduce unemployment.
3. It is used for inter-sectoral comparison: With national income statistics, the performances of various statistic of the economy could be measured and appropriate policies directed towards revitalizing laggard sectors
4. It is used for inter-country comparison: Apart from measuring the performance or various sectors of the economy; national income figures, when expressed in terms of international currency such as dollar, are also useful for measuring the economic performance of different countries.
5. It is indicator of economic welfare or standard of living: the national income statistics serve as a useful indicator of economic welfare or standard of living when expressed in terms of real per capital index. The real national income, can therefore be expressed as:
(
)=
To convert the real national income to per capita income, it has to be divided by the population of the country at the point in time. This can also be written as:
=
6. Contributions to international organizations: National income figures serve as a very good yardstick for determining the contributions of countries to organizations such as international Monetary Fund, ECOWAS, and African Union etc. Limitations of national income estimates
National income estimate, though very useful have several limitations. These include: 1. It tells us nothing about the distribution of income: This means national income estimates never said anything about whether the national income of a country is concentrated in the hands of few individuals in the society.
2. It is not a good yardstick for measuring the welfare of citizens: National income figures are not a good measure of welfare of citizens in a country since negative externalities in the form of pollution, congestion and unpleasant working conditions are likely to arise in the process of increasing the national output.
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3. Exclusion of non-marketable activities: There are some activities, though highly productive, which are always excluded from national income because they are difficult to assign monetary value. These include self-done activities and services of housewives. It therefore implies and national income estimates lacks accuracy due to inability to assign monetary value to these activities.
4. National income estimate tells us nothing about the quantity of goods produced; since national income is the money value of goods and services produced in an economy at a particular period of time, it does not tell us anything about the quantity of each good produced. For instance, the welfare of citizens will not be guaranteed if the quantity of military goods in the national output is more than the quantity of consumer goods.
5. It does not reflect the amount of leisure available to citizens: one of the yardsticks for measuring the welfare in a country is the amount of leisure available to citizens. This information, however, is not reflected in national income estimate.
6. It is not a good measure for inter – country comparison of performance overtime.
The national income of countries is usually converted into common currency using the exchange rate. However, since the exchange rates are subject to fluctuation. It can be inferred that national income estimates are not a good measure of inter-country comparison
7. The underground economy: National income estimates does not capture the underground economy. The underground economy reflects those economic activities that are not reported to the government because those engaged in it are attempting to avoid taxes. This occurs when a plumber offers to work for less if paid in cash rather than by cheque or a farmer who sells vegetables of a roadside and undertakes his revenue to the Inland Revenue serves Factors affecting the level of a country’s national income
The main factors affecting the level of a country’s national income are:
1. The availability of natural resources: If a country has vast natural resources and can utilize it to her advantage, the level of national income will rise.
2. The number and quality of the labour force: The greater and more quality a country’s labour force, the higher the national income. A quality labour force is characterized with healthy and intelligent workers.
3. The state of technical knowledge in a country: The higher the state of technical knowledge, the greater the use of natural resources. As natural resources are efficiently utilized, the level of national income of a country will rise.
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4. The amount of capital available: The greater the quantity of capital available to the working population, the more productive they will be. Therefore, increase in productivity, will have the effect of increasing the level of national output and income in a country.
5. Government policy: Government fiscal and monetary policies also affect the level of a country’s national income. For instance, if the government aims at increasing the national output, policies will be directed towards giving of subsidies to producers so as to reduce their cost of production. In a situation whereby government wants to discourage production, heavy taxes may be imposed on producers. Similarly, monetary policies that reduces or increases interest rates may be directed at increasing or reducing production respectively.
5. Political situation in a country: if the political situation in the country is favourable, businessmen will be motivated to invest in machineries, factories etc.
As the level of investment increases the level of national output, income and employment will rise.
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THEORY OF INCOME DETERMINATION
The circular flow of income is a diagrammatic representation of the flow of income and expenditure of the various sectors of the economy. The circular flow of income shows how the national income is earned and how it is eventually spent in the economy. To examine a simplified version of the circular flow, it is essential to make following assumptions:
There are only two main sectors which contribute to the flow of goods and services in the household
There is no government sector in the economy. This assumption implies that there are no taxes or subsidies in the economy
The economy is closed i.e. there is no international trade.
Households spend all their income on goods and services produced by firms.
Firms do not invest.
Given these assumptions, the circular flow of income in a two-sector economy consisting of household and firms is represented in Figure below.
In the flow (1) of the circular flow above, households render factor services to firms for the purpose of earning wages and salaries. In return, firms as indicated in flow (2) make payments for hiring the services of households. In addition flow
(3) shows the flow of goods and services from firms to households while the last flow (4) indicates the payment for goods and services from household to firms.
Since it is assumed that households spend all their money income and that firms do not invest, it therefore implies that the flow of income in the economy will
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automatically equals the flow of expenditure i.e. national income equals national expenditure or national output.
In reality the household may not spend all their current income and could save some of it. Saving (S) represents leakage from the circular flow. In addition to the consumer spending, firms also carry out investment (I) spending. This is an injection to the circular flow of income, as it does not originate from consumers’ current income. Under this scenario, the circular flow of income in a simple closed economy is represented by figure (b) below
The two upper flows in Figure (Ib) indicate the product market. Households sell their labour services in this market in order to obtain income (salaries and wages). Moreover, the two lower flows indicate the product market. Here, firms supply their final goods and services to the household; the latter buy and eventually consume these goods and services. Household, in this framework save part of their income by buying financial assets in the money or capital market. On the last note, the financial mark provides funds which serve as a source of investment to firms. In the circular flows above, there is the assumption that there is no government sector. Since, in reality government has vital role to play in the economy, this assumption is relaxed at this point. In Nigeria, the government sector includes all three layers of government; local, state and federal; government sector levies a wide variety of taxes and charges on groups operating in the economy. These charges and taxes represent withdrawals or leakages from the circular flow and it is given by the flow (c). The government sector spends on the economy by paying the salaries and wages of public servant,
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current expenditure and on capital items such as road construction, hospitals and other social overhead. Government spending is an injection into the circular flow and is symbolized by G. The circular flow of income with governments sector is presented in Figure 1(c).
By further relaxing the assumption that the economy is closed, we add the foreign sector to the circular flow model as presented in Figure 1d. The foreign sector is a vital part of our economy. The components of the foreign sector are import and export. Exports (X) of goods are injections into the economy while imports (M) are leakages. When exports (X) are greater than imports (M), a balance of payments surplus occurs. When the reverse holds, the economy experienced balance of payments deficit.
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Concepts of savings, investments and consumption Concepts of Savings
Saving can be defined as that proportion of disposable income that is not spent in the current period. The disposable income of an individual, assuming there are no any transfer earnings during the period, is the total income earned during the current period minus taxes i.e Yd = Y-T where Yd is the disposable income, while
Y and T are gross income and taxes respectively. Saving(s), therefore, is the difference between the disposable income (Yd) and consumption (C) i.e S= Yd – C it should be observed that whatever is not consumed is saved. The relationship between savings and the level of income is a direct one. This means that as the level of income of an individual increases, the higher the level of savings, all things been equal. Given that Yd = Y; S=(Y-T)-C OR S= (Yd-C)
Factors Affecting Saving
There are several factors affecting the level of savings in the society. These factors are as follows.
The level of income: the higher the level of income in the society, all things being equal the higher the level of savings and vice versa.
the level of consumption: Consumption is one of the most important factors affecting saving; the higher the level of consumption of individuals in the society the lower the level of savings.
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The rate of interest: The rate of interest can be defined as the reward for parting with money by lenders. It can also be regarded as the cost of holding money. The higher the rate of interest, the higher the cost of holding money and the greater the level of savings and vice versa.
Government fiscal policy on taxation: Government fiscal policy on taxation is another factor affecting saving, for instance, if the government increases the tax, the disposable income of individual will fall thereby reducing households savings in the society.
Monetary policy affecting interest rates; deflationary monetary policies would have the impact of raising interest rates and would increase the level of saving in the society.
The value of money: the value of money affects individuals’ savings habit in the society. For instance during inflation the value of money falls persistently. As the value of money falls it serves as a poor store of value and people will prefer buying physical assets like lands, vehicles, and house rather than saving their money. Habits and customs: it has been observed that people’s habits also affect savings in the society. There are some people that will save weather the rate of interest is attractive or unattractive while there are others that will not save, while spendthrifts have the natural tendency to consume and dissave. Apart from habit, custom is another determinant of savings. Where the custom places much importance on savings, it is expected that the level of savings in such society will be very high.
Family ties: Family ties affect the level of savings. The more the family ties, the lesser the level of saving. This implies that in West African countries where extended family system is practiced, there will be much pressure on the level of income of the family, thereby leading to little or no saving on the part of the family. Concept of investment
Investment can be defined as the expenditure by firms on goods and services in the future period. It is the consumption meant for the production of other goods and services in the future period. It is a process of increasing real goods in the society. Investment is made up of three components, these include; fixed investment, inventory investment and residential investment. Example of investment goods are factories, machines, etc. total investment in the society is the total spending by firms on all forms of capital goods. Although investment is a smaller component of aggregate demand than consumption and government
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expenditure, it is more volatile than these other components. Factors affecting the level of investment have been identified. These factors include:
1. The rate of interest: In line with the classical theory, the rate of interest is one of the factors affecting investment. Accordingly, the relationship between the rate of interest and investment is an inverse one. This implies that the lower the rate of interest the higher the level of investment. It can also be inferred from this theory that the rate of interest is the cost of capital, as such, the higher the rate of interest the higher the cost of capital and the lower the willingness to invest and vice versa.
2. Businessmen expectation about future economic activities: investment is strongly influenced by businessmen’s expectation of future economic activity. If businessmen are optimistic about future economic activity, the level of investment will increase. The reverse holds if businessmen are pessimistic about future economic activity.
3. Political stability. If the political climate in the country is conducive, the level of investment will rise. However, in an environment characterized by political instability, businessmen will not be motivated to invest.
4. Rate of changes in aggregate demand: increase in aggregate demand affects the level of investment. An increase in aggregate demand will have the impact of increasing investment, while a fall in aggregate demand will have the opposite effect on investment.
5. Government fiscal policy: Government fiscal policy also affects the level of investment. For instance, an expansionary fiscal policy which reduces the tax has the effect of reducing the operating cost of firms, thereby increasing the profitafter –tax. As the profit-after–tax increase, dividend to shareholders as well as retained profit will rise, the increase in retained profit implies that firms will have more funds for investment purposes.
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4.0 NATIONAL INCOME DETERMINATION AND THE CONCEPT OF
MULTIPLIER
Equilibrium level of national income: This is the level of national income at which aggregate demand equals the monetary value of all the final goods and services produced in the economy. The equilibrium national income concept is important in macroeconomic analysis because of its relevance in the formulation of economic policies such as anti inflationary policies, employment policies, and economic growth policies and so on. For the determination we consider two approaches—income-expenditure approach or the withdrawalinjection approach. These two approaches are considered in turn.
Income-Expenditure Approach:
Under this approach, the equilibrium national income in an economy is attained at the point where aggregate expenditure (E) equal the national output (Y). the aggregate demand or aggregate expenditure in the economy is represented by
(E), while the national income or the monetary value of all the final goods and services produced in the economy is denoted by (Y). it therefore implies that the equilibrium national income is determined or established at the point where E=Y,
i.e.
( )=
( )
In a 2-sector economy composed of households and firms, the aggregate demand is made up of two basic components—consumption expenditure by the households (C) and investment expenditure by business firms (I). in this regard, the aggregate demand/expenditure in this economy can be written in symbols as: = +
Moreover, in a three sector economy, consisting of households, firms and the government; the aggregate demand can be written as:
=
+ +
While in the four sector economy made up of the households, firms, the government and the foreign sector the aggregate expenditure is:
= + + + −
Where X and M stands for exports and imports respectively. The equilibrium national income therefore is the point at which aggregate demand equals
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national output in the economy. The equilibrium national income therefore can be written symbolically as:
=
=
=
=
=
+
= + +
+ + +
−
(Two-sector Economy)
(Three-sector Economy)
(Four-sector Economy)
The equilibrium national income is presented graphically in the figure below. It could be observed that in a two-sector economy, equilibrium is established in point , where the 45 line (which is the locus of points equidistant from both axis) intersects the aggregate demand function. The level of national income which corresponds with this point of intersection is
. This level of national income is called the equilibrium national income in a two-sector economy.
The figure also indicates that as the aggregate demand increases, the equilibrium national also increases. For instance, when government expenditure (G) and net export (X-M) is added to the consumption function, the equilibrium national increased to and respectively. The main implication of this exposition is that any increase in policy raises the aggregate demand has the effect of increasing national income in the economy.
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2.
Injection-Withdrawal Approach
This approach indicates that the equilibrium national income is determined at the point where injections are equal to withdrawals in the economy. Injections are those autonomous components of the aggregate demand that infuse money into the circular flow of income system and they consist of investment, government expenditure and export. Withdrawals, on the other hand, are those flows that take away money from the circular flow of income system. They consist of savings, taxes and imports.
Using the withdrawals-injection approach, the equilibrium national income is attained in either two, three and four-sector economies when:
+
+
+
=
= +
= + +
(Two-sector Economy)
(Three-sector Economy)
(Four-sector Economy)
This can be shown graphically in the figure below. It can be observed that in a two-sector economy, the equilibrium level of national income is determined at the point where investment automatically equals savings (I = S). in a three and four sector economy, on the other hand, equilibrium national income is attained at point and where + = +
+ + = + + respectively. Gap Analysis
It should be observed that equilibrium in the level of national income is only attained at the point where the sum of withdrawals is equal to the sum of injections in the economy. Going by the Keynesian theory, the equilibrium level of national output may not correspond with the full employment level of income.
For instance if the equilibrium level of income (Ye) towards which the economy tends (as indicated in the figure below) is less than the full employment level of income at , withdrawals will be greater than injection (S>I). This implies that the economy will be demand-deficient and there will be deflationary gap. The deflationary gap is the amount by which the aggregate demand must be increased to push the economy to the full employment level.
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On the other hand, if the equilibrium level of national income is greater than the full employment level of income at , injections will be greater than withdrawals in the economy, aggregate demand will be greater than national output and inflationary gap will occur. The inflationary gap, on the other hand, is the amount by which demand must be reduced to push the equilibrium national income to the full employment level.
Algebraic Approach to Income Determination of Income
Using the 2-sector model
According to Keynes, the national income of a country is determined by the aggregate effective demand (AD) and the aggregate supply (AS). The aggregate effective demand refers to the aggregate expenditure of the society. In a simple economy, aggregate demand consists of two components: Aggregate effective demand for consumer goods (C), Aggregate demand for investment goods, (I).
Thus, the aggregate demand (AD) is given as:
=
=
+
=
(
ℎ
ℎ
−
)
The aggregate supply (AS) refers to the total supply of goods and services in the economy. The aggregate supply of goods and services multiplied by their respective constant prices equals the total value of goods and services (at constant prices). It denotes the real income of the society. Given that in this economic model of without government, taxes are not levied and hence, the total income (Y) becomes the disposable income. The disposable income is divided into two parts which is given as: Consumption (C) and Savings (S). Thus, the aggregate supply function is expressed as:
=
+
National income is determined at a level where aggregate demand (C + I) equals aggregate supply (C + S), i.e., national income reaches equilibrium where:
+ =
Or,
=
+
21
Concepts of Consumption and Savings
In macroeconomic analysis, consumption expenditure refers to expenditures by the household sector on currently produced final goods and services. This definition effectively excludes expenditure on goods and services that were produced in a previous accounting period. Consumption expenditures constitute a key component of aggregate expenditure used in national income determination which in its broadest form can be written in for an open economy as: Y = C + I + G + X – M.
Savings on the other hand is defined as the amount of income per time period that is not consumed by economic units. For the households, it represent that part of disposable income not spent on domestically produced or imported consumption of goods and services. For the firm, it represents undistributed business profits.
A good understanding of the determination of national income requires an understanding of the various concepts of consumption and savings which are:
Marginal Propensity to consume (MPC), Average propensity to Consume (APC),
Marginal Propensity to Save (MPS) and Average Propensity to Save (APS).
Marginal Propensity to Consume (MPC)
The MPC refers to the relationship between change in consumption (∆ ) and the change in income(∆ ). It is expressed as:
=
∆
∆
According to Keynes, the MPC decreases with income. However, we shall assume a constant marginal propensity to consume. For example, suppose that income increases from N200 to N300, and as a result, consumption increases from N250 to N325, thus the change in income∆ = 300 − 200 = 100, while change in consumption is, ∆ = 325 − 250 = 75. Hence the MPC can be expressed as:
∆
75
=
= 0.75
∆
100
Similarly, if income increases from N300 to N400, and consumption expenditure rises from N325 to N400, the MPC is thus expressed as:
=
=
∆
(400 − 325) = 75
=
= 0.75
∆
(400 − 300) = 100
22
Average Propensity to Consume
The APC is defined as the proportion of total income spent on consumer goods and services, i.e.,
=
C = Total consumption expenditure
Y = Total disposable income
Given the consumption function, =
=
=
+
If consumption function is given as;
=
Then,
=
+
, APC can be obtained as:
=
Note: If consumption function is C = bY, (i.e. without the constant term, ‘a’), then;
= =
Marginal Propensity to Save (MPS)
Since what is not consumed is by definition saved, the marginal propensity to save can be defined in a manner analogous to the definition of MPC as the ratio of the change in savings to the change in income. Thus, it is the slope of the savings function and symbolically, it can be written as:
∆
=
∆
Like the MPC, the value of MPS is greater than zero but less than one. Thus:
MPC + MPS = 1
Average Propensity to Save (APS)
APS refers to that proportion of income that is devoted to saving. Since it is the fraction of income that is saved, it is expressed as the ratio of total saving to total income. Calculation of marginal and average propensity to consume
Yr
1980
1985
1990
1995
2000
Y
(Income)
(‘000)
10
20
30
40
50
C
(Consptn.)
5,000
12,500
20,500
29,000
38,000
S
(Saving)
5,000
7,500
9,500
11,000
12,000
APC
0.50
0.63
0.68
0.73
0.76
23
APS
0.50
0.38
0.32
0.28
0.24
∆Y
10
10
10
10
∆C
7,500
8,000
8,500
9,000
DS
2,500
2,000
1,500
1,000
MPC
0.75
0.80
0.85
0.90
MPS
0.25
0.20
0.15
0.10
From the table above, it can be inferred that:
+
=1
+
=1
Given the second equation, i.e. MPC + MPS = 1, then,
=1−
,
,
=1−
Relationship between Income and Consumption
The relationship between income and consumption is generally expressed through consumption function.
Consumption Function
The private demand for goods and services account for the largest proportion of the aggregate demand in an economy and play a crucial role in the determination of national income. The functional relationship between aggregate consumption demand and the aggregate disposable income is expressed through a consumption function expressed as:
=
=
=
=
=
+
− . . ℎ
The slope of the consumption function gives the MPC and this can be derived mathematically as follows:
Given that:
= +
+∆ = + ( +∆ )
= ++ + ∆ and ∆ = − + +
+ ∆ substitute ∆ =( +
∆ = ∆
Hence,
∆
=
∆
+
)+
+
, we get;
+ ∆
According to Keynesian theory of consumption, = is always less than unity,
∆
but greater than zero, i.e. 0 < < 1. This fundamental relationship between
∆
24
income and consumption plays a crucial role in the Keynesian theory of income determination. From our consumption function, if the autonomous consumption
‘a’ is N3000.00 and assuming the marginal propensity to consume ‘b’ is 0.75, then the total consumption at various level of income can be shown in the table as follows: Income N
(Y)
5,000
10,000
15,000
20,000
25,000
Autonomous consumption N (a)
3,000
3,000
3,000
3,000
3,000
Workings:
C = a + bY
C = 3,000 + 0.75(5,000)
C = 3,000 + 0.75(10,000)
C = 3,000 + 0.75(15,000)
C = 3,000 + 0.75(20,000)
C = 3,000 + 0.75(25,000)
Total
Consumption
6,750
10,500
14,250
18,000
21,750
SAVING FUNCTION
Like consumption function, saving (S) is the function of income (Y), i.e., = ( )
Since Y = C + S, consumption and saving functions are counterparts of one another. Therefore, if one of these functions is known, the other can be easily obtained. For example, if consumption function is given as C = a + bY, then saving function can be derived as follows. we know that:
=
−
Substitute for a + bY for C in the above equation.
= −( + )
= − + (1 − )
This gives the saving function in which ‘1-b’ is the marginal propensity to save
(MPS). The slope of the saving function is negative because, there is no income, that is the level of savings when Y = 0. The MPS can be proved as follows:
Since
= +
∴∆ =∆ +∆
Dividing both sides by ∆ , we get;
∆
∆
1=
+
∆
∆
Or
∆
∆
=1−
∆
∆
Hence,
25
=
∆
=1−
∆
Numerical Example: Let consumption function be given as:
= 100 + 0.75
Saving function can be derived as follows:
= −
∴ = − (100 + 0.75 )
= − 100 − 0.75
= −100 + (1 − 0.75)
= −100 + 0.25
Savings at various level of income
Since the MPC is 0.75 derived from our earlier consumption function, then the
MPS will be 0.25, i.e. 1 – 0.75 = 0.25. With this information and using the same levels of income in our earlier table, the various levels of income can be calculated as follows:
Income N
Autonomous
(Y) consumption N (a)
5,000
3,000
10,000
3,000
15,000
3,000
20,000
3,000
25,000
3,000
Workings:
S =- a + bYd
S = -3,000 + 0.25(5,000)
S = -3,000 + 0.25(10,000)
S = -3,000 + 0.25(15,000)
S = -3,000 + 0.25(20,000)
S = -3,000 + 0.25(25,000)
Total Savings
-1,750
-500
750
2000
3250
In the analysis of national income determination, it also shows that total expected sale proceeds, i.e., the value of the total planned output. The schedule C
= 100 + 0.75Y gives the income-consumption relationship—consumption being a linear function of income. The schedule S = -100 + 0.25Y is the saving schedule derived from the consumption schedule. The saving schedule shows the incomesaving relations.
Investment Function
Unlike consumption and saving, the investment function is assumed to be autonomous. This means that the investment function is independent of changes in the disposable income. Although investment is affected by several factors such as interest rates, businessmen expectation, political stability, etc, these factors are not determined within the circular flow of income system. The investment function can therefore be written as:
I = I0
26
Graphical analysis of consumption savings and investment functions
The consumption, savings and investment functions considered above can be represented graphically. The slope of the consumption and savings function depend on the marginal propensity to consume and save out of the level of disposable income respectively. As the disposable income changes at a given marginal propensity to consume and save, consumption and savings function also change. Using the information in consumption and savings table derived above, the functions are graphically represented as follows:
Consumption Function
25,000
Consumption
20,000
15,000
10,000
5,000
0
5,000
10,000
15,000
Disposable Income
27
20,000
25,000
Savings Function
4,000
3,000
Savings
2,000
1,000
0
5,000
10,000
15,000
20,000
25,000
-1,000
-2,000
Disposable Income
Equilibrium level of national income:
This is the level of national income at which aggregate demand equals the monetary value of all the final goods and services produced in the economy. The equilibrium national income concept is important in macroeconomic analysis because of its relevance in the formulation of economic policies such as anti inflationary policies, employment policies, and economic growth policies and so on. For the determination we consider two approaches—income-expenditure approach or the withdrawal-injection approach. These two approaches are considered in turn.
1. Income-Expenditure Approach:
Under this approach, the equilibrium national income in an economy is attained at the point where aggregate expenditure (E) equal the national output (Y). the aggregate demand or aggregate expenditure in the economy is represented by
(E), while the national income or the monetary value of all the final goods and
28
services produced in the economy is denoted by (Y). it therefore implies that the equilibrium national income is determined or established at the point where E=Y,
i.e.
( )=
( )
In a 2-sector economy composed of households and firms, the aggregate demand is made up of two basic components—consumption expenditure by the households (C) and investment expenditure by business firms (I). in this regard, the aggregate demand/expenditure in this economy can be written in symbols as: = +
Moreover, in a three sector economy, consisting of households, firms and the government; the aggregate demand can be written as:
=
+ +
While in the four sector economy made up of the households, firms, the government and the foreign sector the aggregate expenditure is:
= + + + −
Where X and M stands for exports and imports respectively. The equilibrium national income therefore is the point at which aggregate demand equals national output in the economy. The equilibrium national income therefore can be written symbolically as:
=
=
=
=
=
+
= + +
+ + +
−
(Two-sector Economy)
(Three-sector Economy)
(Four-sector Economy)
The equilibrium national income is presented graphically in the figure below. It could be observed that in a two-sector economy, equilibrium is established in point , where the 45 line (which is the locus of points equidistant from both axes) intersects the aggregate demand function. The level of national income which corresponds with this point of intersection is . This level of national income is called the equilibrium national income in a two-sector economy.
29
The figure also indicates that as the aggregate demand increases, the equilibrium national also increases. For instance, when government expenditure (G) and net export (X-M) is added to the consumption function, the equilibrium national increased to and respectively. The main implication of this exposition is that any increase in policy raises the aggregate demand has the effect of increasing national income in the economy.
2.
Injection-Withdrawal Approach
This approach indicates that the equilibrium national income is determined at the point where injections are equal to withdrawals in the economy. Injections are those autonomous components of the aggregate demand that infuse money into the circular flow of income system and they consist of investment, government expenditure and export. Withdrawals, on the other hand, are those flows that take away money from the circular flow of income system. They consist of savings, taxes and imports.
Using the withdrawals-injection approach, the equilibrium national income is attained in either two, three and four-sector economies when:
+
+
+
=
= +
= + +
(Two-sector Economy)
(Three-sector Economy)
(Four-sector Economy)
30
This can be shown graphically in the figure below. It can be observed that in a two-sector economy, the equilibrium level of national income is determined at the point where investment automatically equals savings (I = S). in a three and four sector economy, on the other hand, equilibrium national income is attained at point and where + = +
+ + = + + respectively. Gap Analysis
It should be observed that equilibrium in the level of national income is only attained at the point where the sum of withdrawals is equal to the sum of injections in the economy. Going by the Keynesian theory, the equilibrium level of national output may not correspond with the full employment level of income.
For instance if the equilibrium level of income (Ye) towards which the economy tends (as indicated in the figure below) is less than the full employment level of income at , withdrawals will be greater than injection (S>I). This implies that the economy will be demand-deficient and there will be deflationary gap. The deflationary gap is the amount by which the aggregate demand must be increased to push the economy to the full employment level.
On the other hand, if the equilibrium level of national income is greater than the full employment level of income at
, injections will be greater than withdrawals in the economy, aggregate demand will be greater than national output and inflationary gap will occur. The inflationary gap, on the other hand, is the amount by which demand must be reduced to push the equilibrium national income to the full employment level.
Change in Aggregate Demand and the Multiplier
A change in aggregate demand is caused by a change in either consumption expenditure or in investment, or in both. In the Keynesian theory of income determination, however, consumption expenditure is a function of income: it
31
does not change unless income changes, whereas investment is exogenously determined. Therefore, a change in aggregate demand function is assumed to be caused by a change in investment. A change in investment may be in the form of a decrease or an increase in it. However, we are assuming an increase in investment and an upward shift in the investment schedule. The figure below illustrates an upward shift in the investment schedule from I to I + I, causing an upward shift in the aggregate demand function from C + I to C + I + I.
As shown in the figure, prior to the increase in investment, the aggregate demand schedule (C+I) intersected the aggregate supply schedule (C+S) at point E 1. That is, the economy was in equilibrium at point E1 where Y = OY1 = C+S = C + I = E1Y1.
When investment increases from I to I + I, as shown by upward shift in the Ischedule, it causes an upward shift in the aggregate demand schedule from C = I to C + I + I. Due to upward shift in the aggregate demand schedule, the equilibrium point shifts from E1 to E2 and, as a result, national income increases from OY1 to OY2. At this point, the increase in national income implies that E 1 represented a less than full employment situation. It is only under this condition that equilibrium point E1 can shift to point E2. The increase in the national income (Y) can be obtained as: Y = Y2-Y1.
This increase in income (Y) is the result of I. it may be seen in the above figure that Y>I. It means that when I takes place, the resulting Y is some multiple of I. the multiple (m) can be obtained as:
32
∆
∆
m is the investment multiplier.
=
The Simple Model of Multiplier
The multiplier model presented below answers the questions: Is there a definite relationship between Y and I? if yes, what determines this relationship?
These questions can be answered by working out mathematical relationship between Y and I. This is presented as follows:
Given that equilibrium level of income is:
=
+ -------------------------------------------------------(1)
Now let there be a I. when I takes place it results in Y and Y induces C.
Thus, the post-I equilibrium level of income equals:
+∆ =
+ ∆ + + ∆ -------------------------------------------(2)
Subtracting equation 1 from 2 gives:
∆ = ∆ + ∆ ---------------------------------------------------------(3)
Given the consumption function as C = a + bY
∆ = ∆ ----------------------------------------------------------------(4)
Substituting (4) into (3) gives:
∆ = ∆ + ∆ -----------------------------------------------------------(5)
∆ (1 − ) = ∆
∆ =
1
∆
1−
∆
1
=
∆
1−
=
Given that = expressed as:
=
∆
∆
=
=
and 1 −
=
=
therefore, multiplier (m) can also be
-------------------------------------------------(6)
The last term in equation 6 above indicates that m = reciprocal of MPS.
33
Alternate way of deriving the multiplier
This can be derived by subtracting a pre-I position from a post-I position (Y2Y1). Thus, given:
=
+
While C = a + bY1, the pre-I equilibrium level of income (Y1) may be rewritten as: =
+
+ -------------------------------------------------------------------(7)
1
=
( + )
1−
Similarly, at post-∆ equilibrium, Y2.
= + + ∆ ------------------------------------------------------------------------(8)
= +
+ +∆
=
( + + ∆ ) -----------------------------------------------------------(9)
By subtracting equation 8 from 9, we have;
1
1
( + +∆ )−
∆ =
( + )
1−
1−
∆ =
∆ --------------------------------------------------------------------(10)
Equation 10 yields the relationship between Y and I, that is Y equals 1/(1-b) times I. therefore, 1/(1-b) is the multiplier (m). Thus,
1
( )=
1−
Numerical Example:
Given that Y = C + I, where C = a + bY; = 100 + 0.75Y; and I = 200. Find the equilibrium level of national income and compare it to a new level of income if the investment spending increases to 300 thereby obtaining the investment multiplier. = 100 + 0.75 + 200
− 0.75 = 300
300
=
= 1200
0.25
34
When Investment increased to a new level of 300, then new equilibrium Y2 is derived as:
= 100 + 0.75 + 300
− 0.75 = 400
=
400
= 1600
0.25
From here:
∆ =
∆ =
−
−
= 1600 − 1200 = 400
= 300 − 200
( )=
= 100
∆
400
=
=4
∆
100
It may be concluded that if MPC = 0.75, the multiplier (m) equals 4. It implies that if m = 4, then any additional investment will generate an additional income equal to four times of ∆ . The value of the multiplier is determined by the size of the
MPC, i.e.
1
=
1−
Mathematical Derivation of the Equilibrium level of National Income
Example: Given that in a two sector economy,
=
=
=
+
+
Equilibrium is derived by substituting C and I into Y as follows:
=
−
+
+
= +
+
1
=
=
( +
1−
1−
)
The example above illustrates the derivation of equilibrium level of national income in a two sector economy. In an attempt to extend the model to three sector economy, we assume that apart from households and the business firms,
35
the economy is also composed of the government. Since households and business firms can save and invest, the government also imposes taxes on the households and the business firms. government imposes taxes so as to provide some basic functions such as infrastructural facilities, education etc., in the economy. In view of the above, assuming the government adopts proportion tax system and the tax rate is denoted by t, the equilibrium national income in a three sector economy can therefore be derived as follows:
Given that:
= + +
= +
=
=
= −
=
Hence, substituting, T, G, I, Yd and C into Y, we have:
=
=
+ ( −
+
)+
+
+
+
+
Re-arranging by putting all the Ys on one side:
[1 − (1 − )] =
+
+ 0+ 0
=
1 − (1 − ) or 1
=
( +
1 − (1 − )
The term
(1
)
+
0
+
+
0
+
)
is the multiplier in this economy. It could be observed that as
government imposed taxes in this economy, the multiplier is smaller relative to that in a two sector economy.
1
1
Following similar procedures as in the two and three sector economy, the equilibrium in a four sector economy can also be derived mathematically.
Given that:
= + + + − ,
= 0, = defined in the three sector economy.
0
36
while C, I, and G are as previously
Show that equilibrium level of income is:
1
=
( + 0 + 0 + 0 − 0)
(1 − )
1−
Practice questions
Suppose consumption is 40 + 0.75 , and investment is N60. (a) find equilibrium output, and consumption and saving at equilibrium. (b) show that at equilibrium spending equals output and saving leakages equal investment injections. Suppose consumption is 50 + 0.85 ; = 80;
= . Since there is no government sector, (a) derive an equation for the saving function, (b) find the equilibrium output by equating saving leakages and investment injections.
Given that = 20 + 0.80 , = 90, = 20,
= − ,
=
−
,
=0
0 = 10. (a) Find the equilibrium output, (b) find consumption and saving at equilibrium output. (c) Show the equality of leakages and injections from the spending flow at equilibrium (d) How is the N20 government expenditure financed? TN = Net tax revenues, TX = Gross Tax revenue, TR =
Transfers.
37
CONSUMPTION AND INVESTMENT THEORIES
Consumption and investment are very important aggregates in macroeconomics.
Indeed, they both play crucial roles in the determination of equilibrium level of income and employment. A change in any one of them will cause the level of national income to change through the multiplier effect. Therefore, there is the need to examine and analyze the determinants of these aggregate variables in order to design adequate macroeconomic policies that will bring about full employment and accelerated economic growth.
Theories of Consumption
Both consumption theory and knowledge of consumption function have come a long way since Keynes introduced the notion of consumption function in his
General Theory. Consumption can simply be defined as the spending by household on goods and services that yield utility in the current period. When all individual consumption is summed together we then have aggregate consumption. In other word, consumption is defined as that part of disposable income that is not saved, since income is either saved or spent (C= Yd –S). The question then is what determines the amount expended on goods and services in the whole economy? This question leads us to our discussion of consumption theory. Consumption Theory or function simply indicates these factors that determine aggregate consumption or demand and the relationship that exist between them. There are four types of consumption theory and each indicates those factors that are assumed to impact on aggregate consumption spending.
These theories of consumption are:
1. Absolute Income Hypothesis (AIH) by J.M Keyens
2. Permanent Income Hypothesis (PIH) by Milton Friedman
3. Relatives income (RIH) by J.S Deusenberry
4. Life cycle (LCH) by A.Ando, F. Modigliani.
1. The Absolute Income Hypothesis
The absolute-income theory of consumption is linked to the basic principle of
Keynes’ theory of consumption. This theory is based on a fundamental psychological law which states that “men are disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much as the increase in their income”. That is, ∆ ⁄∆ is positive and less than unity. Based on this law, the absolute-income theory of consumption hypothesizes that current consumption expenditure depends on the current and absolute level of income. Formally, the absolute income theory of consumption can be stated as current consumption is the function of the current income i.e.
=
(
)
38
Where: C = current consumption, and Y = current income.
The main properties of the Keynesian consumption function can be summarized as follows:
i.
ii.
iii. iv. The real consumption expenditure is a positive function of the real current disposable income. This property makes the absolute income hypothesis a short-run theory.
The marginal propensity to consume (MPC) ranges between zero and 1,
i.e. 0 <
< 1 (0 and 1 included).
The MPC is less than the average propensity to consume (APC), that is,
∆ ⁄∆ < /
The MPC declines as income increases, that is, less and less of an equivalent marginal income is consumed.
An additional factor that Keynes adduced to increase in consumption is the increase in wealth of the households. However, the first two properties are essential for the Keynesian theory of consumption, but not the latter two. In fact, property (iii) has been abandoned by the Keynesians on the ground that it does
∆
not stand the empirical test. The Keynesians hold that APC = MPC, i.e. = .
∆
The absolute-income theory of consumption is illustrated in the figure below.
The 450 line (C=Y) shows a hypothetical relationship between income and consumption, i.e., current consumption expenditure always equals the current income. It implies that if Y = 0, then C = 0. This is not a realistic proposition. For, people do consume even when their income equals zero.
39
Another feature of consumer behavior is that when income increases, people do not spend their entire incremental income on consumption. They save a part of it for their financial security during the period of unemployment, illness, death of the bread winner, or for investment to enhance their future income. The overall consumer behavior is shown by the curve C1. The curve C1 delineates Keyne’s absolute-income theory of consumption. As the curve C1 shows, consumption expenditure exceeds the current income up to a certain level of income (say Y =
N10,000). At point B, income and consumption break-even. Beyond point B, consumption expenditure increases with the increase in income but at a slower pace. Note that the slope of the curve C1 goes on diminishing with increase in income. The empirical analysis in subsequent years of Keynes theory revealed that MPC was of stable nature. In other words, the studies carried out later by the
Keynesians found a straight-line relationship between consumption and income.
The straight consumption function of the following form gives the absoluteincome hypothesis
=
+
Where a = intercept showing consumption at the zero level of income, and b stands for MPC. This consumption function is represented by C2 in our diagram above. The slope of C2 is a constant one given as b.
2. The Relative Income Hypothesis
Given the apparent contradictions observed between theory and empirical evidence, many economists embarked on several studies to reconcile the contradiction. The first attempt in this direction was Duesenberry in the late
1940s and, in the process, he propounded the relative income theory of consumption, also known as the Relative Income Hypothesis. This theory is based on the assumptions that (1) the consumption behavior of individuals is interdependent and not independent; and (ii) consumption relations are irreversible over time.
Duesenberry believes that a good understanding of the consumer behavior must incorporate the social character of consumption patterns. By social character, he means the tendency in human beings not only to keep up with the Joneses, but also to surpass the Joneses. In other words, the tendency is to strive constantly toward a higher consumption level and to emulate the consumption patterns of one’s rich neighbors and associates.
Thus consumers’ preferences are interdependent. It is, however, differences in relative incomes that determine the consumption expenditures in a community. A rich person will have a lower
APC because he will need a smaller portion of his income to maintain his consumption pattern. On the other hand, a relatively poor man will have a higher
40
APC because he tries to keep up with the consumption standards of his neighbor or associates. This provides the explanation of the constancy of the long-run APC because lower and higher APCs would balance in the aggregate. Thus even if the absolute size of incomes in a country increases, the APC for the economy as a whole at the higher absolute level of income would be constant.
The second part of the theory is the past peak income hypothesis which explains the short-run fluctuations in the consumption function and refutes the Keynesian assumption that consumption relations are reversible. The hypothesis states that during a period of prosperity, consumption will increase and gradually adjust itself to a higher level. Once people reach a particular peak income level and become accustomed to this standard of living, they are not prepared to reduce their consumption pattern during a recession (what Duesenberry calls, the Ratchet Effect.).
Thus, as income falls, consumption declines but proportionately less than the decrease in income because the consumer di-saves to sustain consumption. On the other hand, when income increases during the recovery period, consumption rises gradually with a rapid increase in saving.
Duesenberry combines his two related hypothesis in the following form:
=
+
Where C and Y are consumption and income respectively, t refers to the current period and the subscript (0) refers to the previous peak, a is a constant relating to the positive autonomous consumption and b is the consumption function. In this equation, the consumption-income ratio in the current period (Ct/Yt) is regarded as function of Yt/Y0, that is, the ratio of current income to the previous peak income. If this ratio is constant, as in periods of steadily rising income, the current consumption income ratio is constant. During recession when current income (Yt) falls below the previous peak income (Y0), the current consumption income ratio (Ct/Yt) will increase.
3. The Permanent Income Hypothesis (Milton Friedman)
This hypothesis was developed by Milton Friedman. It rests on the fact that consumption does not depend on the current disposable income (as in AIH) rather, it depends on some measure of expected or permanent income i.e.
= ( ) Where Yp is a measure of permanent income
According to this theory, consumption will not fall drastically even if for some reasons, peoples’ income fall below what they think their permanent income should be. Conversely, consumption will not rise very significantly if peoples’ income suddenly exceeds the level considered permanent. Thus, the permanent
41
income hypothesis states that the level of consumption will remain fairly stable every time. It is only when permanent income increases that consumption will increase and vice versa. Consumption level therefore depends on permanent income and that people do not change their consumption patterns in response to: every change up or down in their income receipts.
Permanent income is defined as the present value of the expected flow of income from the existing stock of both human and non-human wealth over long period of time. Friedman pointed out that current measure of Income for a household or for the whole economy could be greater or lesser than the permanent income.
The difference between these two is referred to transitory income which is regarded as temporary unexpected rise or fall in income. Consequently,
=
=
=
=
+
=
=
=
=
=>
=
−
+
Friedman also divided consumption into permanent and transitory consumption.
Permanent consumption is defined as the planned level of spending out of permanent income while transitory consumption is any unplanned or temporary increase or decrease in consumption spending. Combining the two concepts together, we then have;
Friedman also makes an important assumption about transitory consumption:
Transitory consumption is neither correlated with permanent income nor transitory income. Thus, transitory income is completely random. With this assumption, the basic consumption function in a permanent income hypothesis is expressed as:
=
That is, Permanent Consumption is a multiple (K) of permanent income. The relationship between consumption and permanent income can also be illustrated graphically as shown below.
42
From the diagram, CL is the long-run consumption function which represents the long-run proportional relationship between consumption and income of an individual. Over the long-run, transitory components of both variables cancel out and there is proportional relation between the permanent components. Cs is the non-proportional short-run consumption function where measured (current) income includes both permanent and transitory components. At OY0 income level where Cs and CL lines coincide at E0, changes in permanent income and measured income are identical, and so are permanent and measured consumption as shown by OC0. Here transitory factors are non-existent.
If we move to the left of point E0 on the CS curve at E3, the measured income declines to OY3 due in part to the negative transitory income component. Since permanent income at OY4 is higher measured income at OY3, permanent consumption will remain at OC3 and equal measured consumption.
On the other hand, a movement to the right of point E0 on the Cs curve at E1 shows measured income to be OY1 and measured consumption as OC2. But OC2 level of consumption can be maintained permanently at the permanent income level of OY2. Thus Y1Y2 is the positive transitory income component in measured income OY1 which is higher than the permanent income OY2.
43
4. The Life Cycle Hypothesis
Ando and Modgliani have formulated a consumption function which is known as the Life Cycle Hypothesis. According to this theory, consumption is a function of lifetime expected income of the consumer. The consumption of the individual consumer depends on the resources available to him, the rate of return on capital, the spending plan, and the age at which the plan is made. The present value of his income (or resources) includes income from assets or property and from current and expected labour income.
The aim of the consumer is to maximize his utility over his lifetime which will, in turn, depend on the total resources available to him during his lifetime. Given the life-span of an individual, his consumption is proportional to the resources.
But the proportion of resources that the consumer plans to spend will depend on whether the spending plan is formulated during the early or later years of his life.
As a rule, an individual’s average income is relatively low at the beginning of his life and also at the end of his life. This is because in the years of his life he has little assets, and during the late years his labour income is low. It is, however, in the middle of his life that his income, both from assets and labour, is high. As a result, the consumption level of the individual throughout his life is somewhat constant or slightly increasing, shown as the CC1 curve in the figure below.
Y0YY1 curve shows the individual consumer’s income stream during his lifetime
T. during the early period of his life represented by T1 in the figure, he borrows
CY0B amount of money to keep his consumption level CB which is almost constant. In the middle years of his life represented by T1T2, he saves BSY
44
amount to repay his debt and for the future. represented by T2T, he di-saves SC1Y1 amount.
In the last years of his life
The main difference between the lifecycle hypothesis (LCH) and permanent income hypothesis (PIH) is that the former explicitly considered the role of asset accumulation and the effect of age on household consumption.
THEORIES OF INVESTMENT/INVESTMENT DEMAND FUNCTIONS
1. Introduction
Investment is an important component of aggregate demand. It can also be argued that fluctuations in economic activities or business cycles can partly be fluctuations in investment. Under national income determination in previous chapter, investment was treated as autonomous (i.e. its value is not determined within the model and therefore it is independent of any macroeconomic variable or factor including current income level. In this section, investment is no longer taken as given from outside the model but we need to adequately analyze investment model by identifying those factors that determine or influence its level in an economy as well as the role attributable to each one of them
2. Investment Demand
Investment decisions are made by firms or private investors with the motive of making profits. Firms add to their existing plants and equipment because they foresee profitable opportunities to expand their output or because they can reduce costs by moving to more capital-intensive production methods. For instance, when an organization needed new-equipment, it developed new products for the company through investments spending. In this case, the firm has to weigh the benefits (returns) from new plant or equipment (i.e. increase in profits) against the cost of investment.
Aggregate /total investment includes spending or the flow of expenditure devoted to projects to produce goods which are not intended for immediate consumption. It includes investment in factory building, machinery, houses, etc.
Expenditure of firms on these items and many like them are regarded as investment. Investment project may also take the form of addition to both physical and human capital as well as inventory. Inventory refers to the stock of goods or resources held by firms to enable them meet temporary and unexpected fluctuations in their production or sales.
Total investment in an economy during a specific period is referred to as gross investment. However, in national income accounting, it is net investment (i.e gross investment less depreciation) that actually account for the level of
45
investment in an economy. Net investment measures the actual increase in the productive capacity in an economy.
Net investment (NI) = GI - depreciation
Investment decisions pertain to whether or not to undertake an investment project; how to make choice between competing investment projects; and how to find optimum level of investment. There are several methods of investment decision making. We shall however explain the role of (i) the Net Present Value
(NPV) and (ii) the Marginal Efficiency of Capital (MEC) in this course.
i.
The Net Present Value (NPV) Method
The NPV method is one of the popular methods of taking decision on investment projects. The net present value (NPV) is defined as the difference between the present value (PV) of a future income stream and the costs of investment (C).
That is:
=
−
The PV of a future income is the discounted value of the income expected at a future date. The future income is discounted at the market rate of interest. The need for discounting future income arises because money has a time value. The time value of money means preference for an amount of money today to the same amount at some future date. For example, N1000 today is always preferable today to N1000 after one year or some future time period. The PV of an income receivable after one year is obtained by a discounting formula given below. =
1+
=
1
1+
The amount of income receivable in the nth year can thus be given as:
=
(1 + )
=
(1 + )
1
R = amount expected after one year, i = rate of interest.
The market rate of interest is regarded as the opportunity cost or the time value of money. To compute the Total Present Value of a stream of income, the formula below is used.
=
(1 + )
+
(1 + )
+
(1 + )
+ ⋯+
46
(1 + )
=
(1 + )
Given the formula for the TPV, the Net Present Value is thus given as follows:
=
(1 + )
−
Where C is the total investment cost. Hence, if:
≥0 ,
ℎ
1000
Hence, the project is accepted since the discounted value is higher than the cost. ii. The Marginal Efficiency of Capital (MEC)
Keynes suggested an alternative method of investment based on what he called
Marginal Efficiency of Capital (MEC). This is also known as Internal Rate of
Return (IRR). MEC is defined as the rate of discount which makes the discounted present value of expected income stream equal to the cost of the capital. If for
47
example the cost of an investment project is C and it is expected to yield a return
R for one year, then MEC can be found as follows:
=
=
1+
Where, r is the rate of discount that makes the discounted value of R equal to C.
Therefore the value of r is the marginal efficiency of capital or the internal rate of return. If a capital project costing C is expected to generate an income stream over a number of years as R1, R2, R3, …Rn, then MEC of the project can be computed by using the formula:
=
(1 + )
+
(1 + )
+
(1 + )
+ ⋯+
(1 + )
Using our earlier example, we’ll try 20.27 per cent rate of discount.
1000 =
500
400
300
200
100
+
+
+
+
(1 + 20.27) (1 + 20.27)2 (1 + 20.27)3 (1 + 20.27)4 (1 + 20.27)5
1000 =
500
400
300
200
100
+
+
+
+
(1.2027) (1.2027)2 (1.2027)3 (1.2027)4 (1.2027)5
= 415.73 + 276.53 + 172.44 + 95.59 + 39.74 = 1000.03
Hence, 20.27% is the discount rate for this project.
Decision Rule:
> ,
= ,
−
< ,
ℎ
ℎ
ℎ
Derivation of the MEC Schedule
We have just described investment decision rule when a single project is involved. We now describe how total investment decision is taken when a firm has a number of possible investment projects to select from. Suppose a profitmaximizing firm having a large amount of investable funds is considering four investment projects—Project 1: setting up of a new production unit; project 2: expansion of the existing production plant; Project 3: modernization of the production plant; and Project 4: construction of a new building. In this case, the firm will have to work out the MEC of the different projects and list them in order
48
of their MEC. Suppose the cost of each of these projects is given in the table below: Projects
Project 1
Project 2
Project 3
Project 4
Cost of MEC (%)
Projects (N million) 100
25
100
18
100
15
100
10
This information can be presented in the form of a diagram as shown in the figure below. In this figure, the vertical axis measures the MEC and the horizontal axis shows investment cost cumulatively. The MEC of each project is shown in the form of a bar-diagram in its decreasing order.
When the top of the bars are joined by a solid line, it gives a stair-like MEC schedule. The stairs-like MEC schedule is the result of a small number of projects presented in the above figure. If a firm is considering a large number of investment projects of varying MEC and cost of capital and if they are all plotted together, the stairs like formation of the MEC schedule will get evened out and it will produce a smooth MEC schedule as shown in the figure below. The MEC schedule gives the investment demand schedule of an individual firm.
49
This figure shows the relationship between the market rate of interest and the investment demand under the investment rule that i = MEC. Given the MEC schedule, when the market rate of interest is Oi3, the profit maximizing investment demand is limited to OK1. And, when market rate of interest decreases from Oi3 to Oi2, the demand for capital increases to OK2 and when the interest rate falls to Oi1, investment demand increases to OK3. Thus, given the
MEC schedule and the market rate of interest, firm’s demand for capital can be easily known. It may thus be concluded that the MEC schedule represents the investment demand schedule for an individual firm.
The Accelerator Theory Investment
The accelerator theory of investment describes the technological relationship between the change in capital stock and the change in the level of output. The technological relationship between capital and output is defined as capitaloutput ratio, that is, ∆ ⁄∆ . Suppose that the demand for firm’s output in period t is given as Yt and firms use capital stock Kt to produce Yt. Denoting capital-output ratio (K/Y) by k, the relationship between capital stock (Kt) and the output (Yt) can be expressed as:
=
-------------------------------------------------------------------(1)
If the demand for output increase in period t+1 to Yt demand for output may be expressed as:
∆
=
−
+ 1.
The increase in the
----------------------------------------------------------(2)
The firm will hence be required to increase their desired capital stock of capital in period t+1 to produce an additional output of ∆
Given the capital-output
), the desired capital stock ratio (k) and the additional demand for output (∆ in period t+1 is given as:
=
-------------------------------------------------------------------------(3)
The change in capital stock (∆ be obtained as given below:
) in response to the change in output (∆
50
) can
∆
(4)
−
1
= (
=
(∆
−
)
1 )----------------------------------------------------------------------
We know that ∆
=
(
∆
=
1 . Hence, equation (4) can be re-written as;
1
=
(∆
1)
).
Therefore,
Equation (4) states the accelerator theory of investment. It reveals that the investment is a function of the change in the level of income (or output). The conclusions that follow from equation 4 can be stated as follows:
> 0, ℎ
1−
1 > 0
= 0, ℎ
1−
1 = 0
< 0, ℎ
1−
1 < 0
The implication of the accelerator theory expressed in equations (4) can be summarized as follows:
(1)When income is constant, investment is not necessary and firms will only concern themselves with the maintenance of the existing capital stock rather than expanding their stock of capital.
(2)If income is rising, it is necessary to invest in new plant and machinery in order to expand the existing capacity produce.
(3)In order to maintain the level of net investment, demand for firms’ products must be rising at a steady rate.
(4)Net investment is desirable if and only if aggregate demand is increasing at an increasing rate.
(5)New investment is a multiple of a change in output i.e.
= ∆ , i.e.
(. . accelerator coefficient multiplies by change in
=
−
)
(6)If aggregate demand remains unchanged, net investment will be zero.
Criticisms against Accelerator Principle
The accelerator theory has been criticized on certain grounds. The working of the accelerator principle rests on some assumptions and these assumptions provide the basis upon which the theory is criticized or attached.
(i)
The first assumption is that the existing stock of capital is fully utilized.
This assumption may not be true for all firms in an economy. If excess capacity exists in an economy the principle breaks down because
51
(ii)
(iii)
(iv)
additional output can be supplied from the existing capacity without necessarily incurring new investment spending.
The next assumption is that firms always alter their capacity to meet every change in demand. While firms may want to increase the capital stock when demand rises, they may be unwilling to divest as quickly when demand declines especially when the fall in aggregate demand is expected to be temporary.
The theory assumes that there is no time lag between the time investment decision is made and the time when acquisition of capital goods is done. Since capital investment is of long-term in nature, firms will examine their experience over a long period of time and in some cases will act on the basis of future expectation of demand profits.
The accelerator principle gives no consideration to the cost of capital
(real interest rate) as a factor influencing investment spending. The theory simply assumes that firms have unlimited fund to carryout its investment or expansion projects but this is not so.
Investment Model:
In economic theory, several factors affecting the level of investment have been identified. Empirical investigations have also shown that most of these factors, indeed, can be used to explain the aggregate investment spending in an economy.
These factors include:
(i)
(ii)
(iii)
(iv)
(v)
The rate of interest (r): The relationship between investment and rate of interest is a negative one. The rate of interest is the cost of capital and so the higher the cost of capital the lower the willingness to invest and vice versa.
The income level changes in Aggregate demand (∆Y): The relationship between investment and the change income in an economy is a positive one. The higher the income, the higher the level of aggregate investment and vice versa
Investors expectation about future economic activities (e): Investment is strongly influenced by businessmen’s expectation of future economic activities in the following ways: if investors are optimistic about future economic activities, the level of investment will increase but if they are pessimistic or skeptical about future economic activities, the level of investment would fall.
Political situation (P): If the political climate of a country is conducive or stable, the investment will rise while in a country characterized by political instability, investors will not be encouraged to invest. They may even withdraw their capital (divest).
Government fiscal action/policy: An expansionary fiscal policy which reduces the tax rate has the effect of reducing the operating cost of
52
firms, thereby increasing the profit-after-tax. As the profit-after-tax increases, dividends to shareholders as well as retained profit will rise.
The increase in retained profit implies that firm will have more funds for investment purpose. Apart from its effect on the operating costs of firms, expansionary fiscal policy which increases the level of government expenditure will increase the future demand for output. As businessmen expect future increase in output, they will increase their spending in investment goods. For contractionary FP, the opposite is the case.
(vi) Government Monetary Policy: An expansionary monetary policy by the central bank or monetary authority will affect the level of investment via the interest rate. Increase in money supply relative to money demand brings about a fall in interest rate. As interest rate falls, the cost of capital reduces thereby stimulating investment. For a contractionary (MP) the opposite is the ease.
(vii) Rate of Inflation: As the general price level is increasing, investors’ profit increase. As profit increases, businessmen would invest more.
The opposite is the case if the general price level is falling.
Taking all these factors together the aggregate investment function becomes:
= (∆ , , ,
=
∆ = ℎ
=
∗
,
, , )
=
=
=
∗
=
53
Definition of money
MONEY AND BANKING SYSTEM
Conceptually, money can be defined as any commodity that is generally acceptable as a medium of exchange and a measure of value. This is the conventional definition of money and it emphasizes the basic functions of money which are; the medium of exchange and measure of value. Going by these functions, money is defined by what it does. If one looks back into the history of money, one finds many kinds of commodities—cattle (cow, ox, horse, pig, goat), grains, stones, cowries shells, cigarette, metals (copper, brass, silver and gold), dried fish, coffee, leather, etc. have served as a medium of exchange and a measure of value at different stages of human civilization and in different parts of the world.
The commodity money had, however, some problems by today’s standard. It lacked (i) uniformity, (ii) homogeneity, (iii) standard size and weight (iv) durability and storability, (v) portability, (vi) stable value, and (vii) divisibility.
Owing to these problems, money has evolved over a long time into three major forms: (a) metallic coins, (b) paper currency and (c) demand deposits (operated through cheque system). These form of money perform the basic function of money constitute the total supply of money in the context of conventional approach to the definition of money.
Kinds of Money
The major kinds of money in the circulation are; Metallic coins, Paper Money and
Bank deposits.
i.
Metallic Coins
The second most important stage in the evolution of modern monetary system was the introduction of metallic coins made of iron, copper, silver and gold—and now alloy and aluminum. The invention and introduction of metallic coins must have been necessitated by the defects of commodity money—heterogeneity or non-homogeneity of money units, non-durability, perishability, non-portability, unstable value, and indivisibility. In Nigeria, metallic coins usually include, 1, 5, and 10 kobo coins which are now out of circulation. ii. Bank notes or Paper Money
The paper money consists of the currency notes printed, authenticated and issued by the state and the central bank of the country. They have their origin in the receipts issued by goldsmith to those who deposited precious metals with
54
them. Any note not backed with gold is referred to as fiduciary issue. In Nigeria paper money includes 5, 10, 20, 50, 100, 200, 500 and 1000 notes.
iii.
Bank notes/Paper money
The third form of common money is bank deposits. Bank deposits include three kinds of deposits: current account deposits, savings deposits and time deposits.
The current account deposits are available on demand. That is why current deposits are widely referred as demand deposits which can be transferred and used as medium of exchange by the instrument of cheque. Cheques have the merit of eliminating inconveniences of carrying heavy cash about as well as risks of money being stolen.
The Functions of Money
Money performs four major functions which includes (i) a medium of exchange
(ii) a measure of value (iii) a store of value, and (iv) a standard of deferred payments. i.
Money as a medium of exchange
Money functions as a medium of exchange between any two goods. This is the most important and unique function of money. The importance of this function lies in the fact that it solved one of the biggest problems of the barter system. In the barter system, for exchange to take place, there must be double coincidence of wants. The double coincidence of wants exists when, between any two persons, one is willing to accept what the other person is willing to give in exchange. Until this condition is fulfilled, exchange cannot take place. For example, a weaver cannot exchange his cloth for shoes unless the shoemaker wants cloth. In a modern, market economy, the problem of double coincidence of wants is solved by money. Since money is acceptable to all, the weaver can sell his cloth to any willing person (say to a farmer) for money and buy the shoes in exchange for money. This system works efficiently because money can buy anything. It has purchasing power and is acceptable to all. ii. Money as a measure of value
The second basic function of money is to work as a measure of value. All values are measured in terms of money. As a measure of value, money works as a common denominator, as a unit of account. Today, unlike barter system, the value of all the goods and services is expressed in terms of money. Money being a common denominator, the values of different goods can be added to find one value of all possessions of a person, of a firm and of a nation. In fact, money makes computation of national income possible. In the absence of money, measuring value would be an extremely difficult proposition in a modern economy. 55
In modern times, a society produces, buys and sells, and consumes goods and services in such a large number, variety and quantity that measuring and expressing values in terms of commodities, as in barter system would be a rather impossible task. If possible, it would mess up the entire exchange economy.
Money has made the task easier. Not only each good and service has a price, but also one can find and compare the relative prices in terms of money.
iii.
Money as store value
The third basic function of money is to work as a store of value. The need to store value must have arisen for such reasons as (i) need for storing surplus produce because production and consumption or exchange of goods and services are not instantaneous in most cases, (ii) need for storing value for future use due to uncertainties of life, and (iii) accumulative nature of the people. The advent of money has provided a means to store value for future use. Even the most perishable goods can be converted into money, provided there is a market for them, and value stored in terms of money. If prices do not increase over a long period, value can be stored for long without the loss of value. However, in case of rising prices, money stored loses its value in proportion to the general price rise. iv. Money as a standard of deferred payments
The money function in which money is used as a standard benchmark for specifying future payments for current purchases, that is, buying now and paying later. It means that a contract or agreement may specify (or imply) that the repayment of a debt be made using a particular monetary unit. It differs from other functions of money in that it is not functioning as an immediate medium of exchange or store of value but, rather, as a medium by which future payments will be made.
Characteristics or Qualities of Money
a. Homogeneity: Each unit of money must be homogenous, that is, each unit held by different individuals must be identical
b. General Acceptability: Each unit of money must be generally acceptable in exchange for goods and services purchased.
c. Portability: Each money unit must be easily carried about. In other words, it must be easily transmissible
d. Divisibility: Money must be capable of being divided into small units. In Nigeria, for instance, we have ½ k, 1k, 5k, 10k, 25k, 50k and N1 coins, N5 N10, N 20 , N50 N100
N200 N500 and N1000 notes.
e. Recognizability: Money must be easily recognizable by all and sundry in order to detect any counterfeit.
56
f. Relative Scarcity: Money must be relatively scarce in order to maintain its value.
g. Stability of value: there should be absence of inflation and deflation to make money stable in value as well as enable it serve some useful functions such as the store of value and means of deferred payment.
h. Durability: Money must be capable of staying long without spoiling or going bad
COMMERCIAL BANKING
The commercial banks serve as the king pin of the financial system of the country. They render many valuable services. The important functions of the
Commercial banks in the economy are as explained below.
Acceptance of Deposits
The earliest and most widely known function of a commercial bank is acceptance of deposits. These include current account deposit, payable on demand through the use of cheques. They also include savings deposit and time deposits which are payable subject to notice.
Making of Advances:
A commercial bank makes various types of advances such as loans, overdrafts and the discounting of bills. The loans may be short, medium or long term. In making overdrafts, the bank allows a customer to draw an account in excess of his deposit and pay interest on this excess. Banks discount bills for finance houses and brokers operating in the money market. They also discount (accept) bills of exchange which enable an importer to pay for goods brought from other countries. Investments:
Commercial Banks undertake investments in buildings, Real estates, agriculture and industrial projects.
Services to Customers:
These include payment of insurance premium, hire purchase, clubs subscriptions etc. they also include issuing of travelers ‘cheque’.
Operating in the Foreign Exchange Market:
Commercial banks buy and sell foreign exchange. With the ever-present possibility of changes in the values of key world currencies such as sterling, dollar, Euro, yen etc. speculating in the foreign exchange market has been very popular venture for commercial banks.
57
The Three Aims of Commercial banking:
Any commercial bank aims, basically at three objectives, these are Profitability,
Security and Liquidity. The success of commercial banking is determined largely by the degree to which the bank managers balance or trade-off these aims which at times may be conflicting. The bank seeks to achieve profitability by lending a very high proportion of the deposits at its disposal and getting interests in the process. It also invests a high proportion of its assets. These investments bring in considerable profits. By convention, banks in many parts of the world invest and loan out not less than 50% of their assets. The security consideration is reflected in the manner-in which commercial banks scrutinize any prospective borrower with respect to credit-worthiness, marketability of collateral security any prospective borrower with respect to credit-worthiness, marketability of collateral security and the profitability of investments that determines repayment ability. The banks also prefer investment in gilt-edged securities with lower earnings to riskier investments in shares or bonds with greater yields. Also banks try as much as possible to acquire securities that will mature rapidly at full value. Hence, they avoid irredeemable securities such as those which can fall quite drastically.
Commercial banks have been taught by bitter experiences of bank failures to pursue the objective of liquidity in several ways. They keep certain percentage of their assets in ready-cash to meet customers demand. The percentage kept as cash is consistent with the percentage of public cash requirements known to the managers from long experience. It varies from 8-20% depending on the situation.
Since cash kept by the bank yields no return, the retention of a minimum cash reserve is an example of the sacrifice of profit for liquidity.
Banks also keep proportion of their assets in liquid form i.e. in a form which can be quickly converted into ready-cash. These liquid include treasury bills, bills of exchange and bills from discount houses which have very small yields and again demonstrate the trade-off between profitability and liquidity considerations.
Credit Creation by Commercial Banks
Suppose there are a number of commercial banks in the banking system—Bank
1, Bank 2, Bank 3, and so on. And also, if we assumed that (i) the bank accepts only demand deposits, (ii) the bank’s cash reserve requirement (CRR) is 20%
(iii) the bank holds its assets only in the form of cash reserves and loans and advances. If an individual A makes a demand deposit of N100,000 in Bank 1 in which the bank holds 20% of the money (N20,000) as cash reserve requirement
58
and lends the excess cash of N80,000 to customer B who deposits the amount in
Bank 2 in which bank 2 also keeps 20% of the money (N16,000) and lends the remaining excess cash of N64,000 to another borrower C. If this process continues, the excess reserve with banks will be reduced to zero. The final picture that emerges at the end of the process of deposit and credit creation by the banking system is presented in a in the table below.
Bank
Bank 1
Bank 2
Bank 3
…….
…….
…….
…….
Bank n
Total
Deposit
(‘000)
100
80
64
…….
…….
…….
…….
00.
500
Reserves (20%)
(‘000)
20
16
12.8
…….
…….
…….
…….
00
100
Bank Loans
(‘000)
80
64
51.8
…….
…….
…….
…….
00
400
It can be seen from the table that a primary deposit of N100,000 in Bank 1 leads to the creation of a total deposit of N500,000. The table shows that the banks have created a total credit of N500,000 and maintain a total cash reserve of
N100,000 which equals the primary deposit. The total deposit created by the commercial banks constitutes the money supply by the banks.
The Deposit Multiplier
In the above example, the total deposit creation is 5-times the initial or primary deposit. It means, deposit multiplier is 5. The deposit multiplier (dM) can be obtained as follows:
=
∆
500,000
=
=5
∆
100,000
∆ =
∆ = ℎ
ℎ
ℎ
ℎ
If ∆ and ∆ are known in the above formula, then can be known easily. ∆ however can easily be known because it is the equal to the primary deposit, but
∆ would have to be computed. One way of computing ∆ is to get the sum of deposits created in each round. That is,
∆
= 100,000 + 80,000 + 64,000 + 51,800 + ⋯ + 00 = 500,000
It can be observed that this expression makes a geometric series and each successive deposit is 80% of the preceding one. It means that loan deposit ratio
59
is 0.8. By designating primary deposit as ∆ , reserves as ∆ ratio as , the entire series of deposit can be re-written as:
∆
= ∆ + ∆ ( ) + ∆ ( ) + ∆ ( ) + ⋯+ ∆ ( )
= ∆ (1 + + + + ⋯ +
)
∆
=
∆
=
and loan-deposit
Using the formula for adding up a geometric series 1, we can hence write the above as:
1
1−
∆
Given that 1-k is the cash reserve ratio, and if we designate this as r, then:
1
∆
In our example, ∆ = 100, and = 0.2
1
∆ =
100,000 = 500,000
0.2
Given that deposit multiplier is given as:
∆
=
∆
Therefore we can manipulate our ∆ function above to obtain dm which is given as: ∆
1
=
=
∆
Given that r = 0.2,
=
∆
1
=
=5
∆
0.2
Limitations of the “money creating” Powers of Commercial Banks
1. Keeping of excess reserves by banks
When banks keep excess reserves above legally required reserves, the above described process of multiple-deposit creation is disturbed, hence the said amount cannot be created. If for instance, instead of keeping 20%, banks kept
25%, it means that only N4000 will be created rather than N5000.
The sum to infinity of any geometric sequence in which the common ratio r is numerically less than 1 is given by ( ⋈ ) =
, where a = first term and r = common ratio.
1
60
2. The possibility of leakage into hand-to-hand circulation:
The process of multiple-deposit creation described above was based on the assumption that all the new money remained somewhere in the banking system.
But in practice, somewhere along the chain of deposit expansion, some customers who borrow will not leave the entire amount in a bank but will instead withdraw some into non-bank circulation or into hoarding outside the banking system, especially for precautionary reasons and when interest rates are very low. When this leakage occurs, the process described above in altered.
3. High Legal Reserve Ratio:
An increase in the legal reserve ratio by the central bank will also limit the amount created by the banking system.
4. Unavailability of collateral security:
The amount of credit created is limited by the unavailability of collateral securities required by commercial banks before granting loans.
CENTRAL BANKING
A central bank, as distinct from a commercial bank, is a financial institution owned by the government of a nation, run by board of directors, chaired by a
Governor appointed by the government and charged with the responsibility of managing the expansion and contraction of the volume, cost and availability of money in the interest of public welfare. While it may undertake commercial and quasi-commercial ventures, it is not profit-oriented institution.
Functions of Central Banks:
Banker of Commercial Banks:
Commercial banks by law or convention have deposit at the Central Bank. Thus if bank A wishes to settle account with bank B to which it owes N2,00, the Central bank simply effects the payment by increasing B’s deposit by N2,000 and reducing A’s deposit by the same amount. Also commercial banks borrow from he Central bank to which they sell government bonds and commercial bills.
Banker to the Central Government:
The Central government has an account at the central bank and may make payments by writing cheques on his account. Government can also borrow from the central bank by issuing bonds or treasury bill which the central bank purchases. When this happens, government account at the central bank rises by the amount for which the bonds and the treasury bills are bought.
Controller and Regulator of Money Supply”
There are a number of ways in which the central bank controls and regulates the supply of money.
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a. It has, in most countries, a monopoly of issuing notes and coins. It can therefore, expand money supply by issuing more notes and coins.
b. Variation in the reserve requirements of commercial bank is another device for regulating the money supply: If the Central Bank wishes to reduce money supply, it raises the ratio of cash to deposit which the commercial banks must maintain. As we have seen earlier, a rise in the cash to deposit expansion.
Conversely, an expansionary monetary objective is achieved, in part by lowering the cash to deposit ratio which increases lending and associated credit expansion by the commercial banks.
c. the third way in which the central bank regulates money supply is through
Open Market Operation. This involves the Central Bank in the market for bills and bonds. If the objective is a reduction in money supply, the central bank simply sell bills and bonds to the commercial banks. Since the latter pay by drawing cheques on their deposits at the Central Bank, their cash reserve accordingly falls. This reduces their capacity to make loans and expand credit.
Conversely, an expansionary monetary policy entails the purchase of bills and bonds from the commercial banks and the payment for these by increasing the commercial banks deposits at the central bank. This raises the cash reserves of the commercial banks and enlarges their base for lending and credit expansion.
d. The Manipulation of the Resident rate (Bank Rate) is another tool for regulating money supply. The rediscount rate is the interest rate charged by the
Central Bank whenever it discounts bills for commercial banks. If the central bank aims at reducing money supply, it raises the rediscount rate. This increases the cost of borrowing by the commercial banks. Since the latter are profit maximisers and loss minimisers, they will not only curtail the number of bills rediscounted at the Central Bank but will also raise their own rate of interest.
Such a rise in commercial bank interest rate tends to discourage borrowing to finance projects involving a large amount of capital expenditures. The effect is to reduce lending and credit expansion. On the other hand, if the central bank aims at increasing the money supply, it lowers the rediscount rate. This increases borrowing by the commercial banks. It also results in a reduction in commercial bank rate which encourages lending and credit expansion.
e. The Central Bank also regulates and controls money supply, through such direct measures as imposition of ceiling on commercial bank lending, and the imposition of selective credit control and credit rationing. Finally, there is moral suasion-a process of persuasion and reasoning with the understood implication of ultimate use of sanctions should reasoning and persuasion fail.
Lender of last Resort
When the commercial banks find themselves out of cash and threatened with a run out on their institution, the Central Bank stands prepare to bale them out by
62
lending to them and having their liquidity position strengthened. The significance of this function is that it makes the commercial banks look with some respect on the central Bank and willing to comply with Central Bank directives. Moreover, this willingness of the central bank to act as a lender of the last resort implies an obligation on the part of the Central Bank to support the money market and allied financial institutions which would have suffered in the wake of commercial banks collapse.
Management of Foreign Exchange
In an era of rigid exchange rate and persistent disequilibrium in the balance of payment, the management of a country’s foreign exchange reserves becomes an increasingly important aspect of central bank’s function. In most countries, the reserves of foreign currencies as well as gold are held at the central bank. The bank is therefore in a position to keep a tap on movements in the level of foreign reserves and gold and to advise on appropriate policy measure.
Financing Economic Development
In underdeveloped countries, the over-riding policy objective is a rapid transformation of the economy. This implies increasing role of the government in economic development. Government’s direct participation in economic activities and the shortage of domestic savings make central finance of economic development necessary. In Nigeria, the Central Bank supports the financial market. It makes grant for the establishment of an Industry Development Bank and it has helped to establish Agricultural Credit Bank. Moreover, the Nigerian
Central Bank helps in financing produce marketing by making loans to some marketing boards.
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INFLATION
Inflation has been defined in several ways by different authors, however, in the current literature; economists seem to agree that inflation is a situation in which there is a sustained and appreciable increase in the general level of prices.
Inflation is generally classified on the basis of its rate and causes. In terms of rate, inflation is classified as: (i) moderate inflation (ii) galloping Inflation, and
(iii) Hyper inflation.
(i)
Moderate Inflation
When the general level of price rises at a moderate rate over a long period of time, it is called moderate inflation or creeping inflation. The moderate rate may vary from country to country. However, a single digit rate of annual inflation is called moderate inflation or creeping inflation. An important feature of moderate inflation is that it is predictable. During the period of moderate inflation, the people continue to have faith in the monetary system and confidence in money as a store of value. Money continues to work as a medium of exchange.
(ii) Galloping Inflation
According to Baumol and Blinder, Galloping inflation is defined as an inflation that proceeds at an exceptionally high rate. They however did not specify what rate of inflation is exceptionally high. Samuelson and Nordhaus referred to inflation rate in the double-or triple-digit range of 20, 100 or 200 per cent a year as galloping inflation. The post war I in Germany is often cited as an example of galloping inflation. The wholesale prices in Germany increased 140 per cent in
1921 and a colossal 4100 per cent in 1922. Argentina, Brazil, Mexico, Peru and
Yugoslavia had galloping inflation during the 1970s and 1980s. The annual average rate of inflation in these countries during 1980-1991 was exceptionally high: Argentina—416.9%; Brazil—327.6%; Mexico—66.5%; Peru—287.3% and former Yugoslavia—123.0%. Incidentally, these cases are also cited as examples of hyper inflation.
(iii) Hyper Inflation
When prices begin to rise at more than three-digit rate per annum, it is called hyper inflation. During the period of hyper inflation, paper currency becomes worthless and demand for money decreases drastically. Germany suffered from hyper inflation in 1922 and 1923 when wholesale price index shot up by 100 million per cent between December 1922 and November 1923.
Hungarian
inflation of 1945-46 is the worst case of hyper inflation ever recorded: the rate of inflation averaged about 20,000 per cent per month for a year and in the last month prices skyrocketed by quadrillion per cent. In the period of inflation in
Germany, people carried basket-load of money to the market and brought goods in pocket. Price of a house in pre-inflation period was just sufficient to pay a day’s rent in post-inflation period.
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Open and Suppressed Inflation
In the contemporary writings on the subject, one often comes across the terms
‘open and suppressed inflation’. Open inflation according to Milton Friedman is an inflationary process in which prices are permitted to rise without being suppressed by government’s price control or similar techniques. In other words, prices are free to find their own level. Suppressed inflation exists in the economy in those conditions in which consequent upon adopting the policies of effective price control and rationing of essential goods by the government, the price increases are suppressed. In suppressed inflation, the symptoms of open inflation—rising prices—are replaced by the long queues of buyers waiting for their turn to buy at the government price control and rationing shops and by other forms of non-price rationing while the economy continues to be afflicted with the inflationary problem. The word ‘suppressed’ connotes postponement of the present demand to future and diversion of the demand from one good to another—from those whose prices are controlled and whose demand is rationed to those goods whose prices are not controlled and whose demand is not restricted through rationing.
Measures of Inflation
There are two common measures of inflation: (i) Percentage change in Price
Index Numbers and (ii) Change in GNP Deflator.
i.
Percentage change in Price Index numbers
The percentage change in price index number (PIN) is given as:
=
−
× 100
Where are the price index numbers in the year selected for measuring inflation and in the preceding year, respectively. The two widely used
PINs are wholesale Price Index (WPI) also called Producer price Index (PPI) and
Consumer Price Index (CPI). WPI is used to measure the general rate of inflation and CPI is used to measure the rise in the cost of living. If price index in year ‘t’ for instance is 207.8 and 182.7 in ‘t-1’, then the rate of inflation can be calculated as: =
207.8 − 182.7
× 100
182.7
= 13.74%
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ii.
GNP Deflator Measure
The GNP deflator is the ratio of nominal GNP to the real GNP of the same year. It is also defined as follows:
=
Where nominal GNP is GNP at current prices and Real GNP is GNP at constant prices. If for instance, the nominal GNP of a country (Nigeria) in a particular year say 1990 is given as N 47,0269, while the constant GNP is given as N20,8481.
The GNP deflator can hence be derived as:
=
470269
= 2.2557
208481
In terms of percentage;
= 2.2557 × 100 = 225.57%
This shows that the country’s nominal GNP was 225.57% of her real GNP or the nominal GNP was 225.57% higher than real GNP in that particular year. The percentage change in GNP deflator between any two years gives a measure of inflation. For example, if the GNP deflator was 258.892 in the previous year of our analysis, then the rate of inflation can be computed as:
=
258.892 − 225.569
= 14.77%
225.569
Theories of Inflation
Theories of inflation reveal the causes and sources of inflation. The perception and the sources of inflation have been a matter of controversy between the classicalists and Keynesians, between the Keynesians and the monetarists, and between these groups of economists and the structuralists. This has led to divergent views on the causes of inflation and the theories of inflation.
The Classical Theory of Inflation
The first and the comprehensive version of the classical theory of inflation was propounded by Irving Fisher in 1911. According to the classical theory, inflation occurs in direct proportion to increases in money supply, given the level of output. The classical theory of inflation is derived directly from the classical quantity theory of money. By Fisher’s equation;
66
=
And,
=
This equation can also be written in terms of percentage changes.
+
= +
= +
−
Where, p = % rate of inflation; m = % rise in money supply; v = % increase in velocity of money, and y = % increase in real output. For example, if there is full employment and money supply (M) increases by 5%, v and y remaining constant, the rate of increase in the general price level will be 5%.
Wicksell, a classical economist provided an explanation of how increase in money supply results in increase in the level of prices. According to him, increase in the level of prices occurs when additional money flows into the economy in the form of loans and advances made by the banks to the businessmen to finance the new investment. The increase in investment demand increases the aggregate demand. The economy being in the state of full employment, additional resources are not available at the prevailing prices. The additional resources
(labour) are therefore acquired by bidding higher prices to acquire them. This marks the beginning of the rise in the price level. The rise in the input prices
(especially wages) leads to increase in money incomes. This leads to rise in the demand for consumer goods. Under the condition of full employment, the supply of consumer goods does not increase. Therefore, higher prices are bided to acquire goods. As a result, prices increase till the entire increase in aggregate demand is absorbed by the rise in prices. This is how increase in money supply causes inflation.
Another version of the classical theory of inflation, known as neo-classical theory of inflation was developed by the Cambridge economists. While the classical school considered increase in the supply of money as the cause of inflation, the
Cambridge school postulated increase in demand for money as the cause of inflation. According to the Cambridge school, the equation of the demand for money can be given as :
=
=
=
=
=
67
ℎ
The Cambridge equation yields the price level equation as;
=
This equation implies the general level of price increases proportionally with increase in demand for money, given k and R.
The Keynesian Theory of Inflation
Keyne’s theory of inflation is only a little more than an extension and generalization of Wikesell’s view. Keynes, however, made an important departure from the classical view. While the classical economists considered an increase in money supply as the only cause of an increase in the aggregate demand and the only cause of inflation, Keynes postulated that aggregate demand can as well increase due to increase in real factors, for instance, increase in consumer demand, increase in investment and increase in government expenditure. Such changes may take place even when supply of money is constant. Keynes explained is view using the concept of inflationary gap which is defined as planned expenditure in excess of output available at full employment.
The inflationary gap is so called because it causes only inflation, without increasing the level of output. This theory implies that the expenditure in excess of output at less-than-full-employment level is not inflationary even if prices increase. The Monetarist View on Inflation
The modern monetarist view is a modified version of the classical quantity theory of money. The modern monetarism is therefore sometimes called modern
Fisherianism. The modern monetarism holds that the general level of prices rises only due to an increase in money supply. To this extent, monetarists subscribe to the classical quantity theory of money. However, the modern monetarists make the following deviations from the modifications to the classical quantity theory of money.
i.
ii.
They do not subscribe to the classical view that there is a proportional relationship between the stock of money and the price level.
The modern monetarist do not agree with classical proposition that the supply curve is vertical in the short run. Monetarists such as Friedman argue that a reduction in the money stock does in practice first reduce the level of output, and only later have an effect on prices.
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iii.
Unlike the classical economists, modern monetarists distinguish between the short-run and long-run effects of change in the stock of money. They argue that, in the short run, changes in the stock of money can and do have important effect on the real output. but in the long run, in their opinion, change in money stock remains neutral to the real output. They argue that in the long run money is more or less neutral. Modern Theories of Inflation
The modern theory of inflation is, in fact, a synthesis of classical and Keynesian theories of inflation. The modern analysis of inflation shows that inflation is caused by both demand-side and supply-side factors. The demand-side factors are called demand-pull factors, and supply-side factors are called supply-side or cost-push factors. Accordingly, there are two kinds of inflation, viz:
i.
ii.
Demand-pull inflation, and
Cost-push inflation.
Demand-Pull Inflation
When majority of industries are operating close to full capacity while they experience increases in demand, we say there’s demand-pull inflation. It is a type of inflation that occurs when the economy is at or above full employment level of equilibrium. The increase in demand comes from several sources, however, but many economists focuses on government’s demands and increases in the money supply. Demand-pull inflation are generally characterized by shortages of goods and shortages of workers. Because there’s excess demand, firms know that if they raise their prices, they’ll still be able to sell their goods, and workers know if they raise their wages, they will still get hired. The diagram below illustrates demand-pull inflation.
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While demand increased from D1D1 to D2D2, supply remained unchanged thus causing price to rise from P1 to P2.
Cost-Push Inflation
This is a kind of inflation that is induced by a rise in the factors of production, particularly wages. If, for instance, the cost of living of workers suddenly rises and they hence demanded for and are granted higher wages, this increases cost of production. This will be reflected in the form of higher prices on commodities which consumers/workers have to purchase. This leads workers to demand for more wages since the initial increment has been eroded by the rising prices. In fact, the cycle continues and prices continue to rise. This is illustrated in the figure below.
We observe from the above graph that due to rising costs of production, the supply has fallen from S1S1 to S2S2 thus leading to higher prices. Here, price increases from P1 to P2.
Causes and Control of Inflation
Generally, the following could be said to be the cause of inflation.
i.
Excessive Money Supply
Excessive money supply through poor monetary policy or other methods invariably lead to inflation. In Nigeria, the 1974 Udoji Salary Awards and the
1981 minimum Wage Act injected a lot of money in the economy thus causing inflation. Expansionary monetary policy is also a contributory factor.
70
ii.
Fall in the supply of goods and services (especially agric products)
Agriculture is virtually abandoned in Nigeria—it is only left to the aged in the remote villages who practice subsistence farming using out-dated or archaic methods. This shortage of commodities has been one of the most influential causes of inflation in Nigeria today. Rising wages also increase production costs.
This thus leads to decreased supply of commodities thereby causing rise in prices. iii.
Budget deficits or government expenditure programmes
Almost all the governments of West African countries have been experiencing budget deficits since the 1970s. There is also enormous increase in government expenditure on development programmes and other capital projects or expenditures. These have contributed greatly to inflationary trends. iv. Imported inflation
Almost all our manufactured goods in Nigeria are imported from the advanced nations of the world who are currently experiencing inflation. This means a direct importation of these higher prices to West African nations.
v.
Increase in population/Population explosion
There is enormous increase in the population of West African nations in particular and the whole world in general. For Nigeria, the estimated population increased from about 55m in 1963 to more than 88.5m in 1991 and to 150m in
2002. The situation is worsened by the fact that majority of the population are children who fall under the unproductive sector of the society. They are, therefore, dependent on the working population hence they put pressure on the little goods and services available.
vi.
Activities of middle-men and monopolistic tendencies
There are too many middlemen in the chain of distribution of goods and services in Nigeria, for instance, these people are very exploitative hence they hoard available goods in order to sell at higher prices in black markets. Many others who have the influence from government quarters monopolize the supply of certain essential commodities, thereby charging higher prices than hitherto or what ought to be. vii. Excessive demand by consumers
Increase in the purchasing power of consumers leads to higher demands and thus inflation. This is the case in Nigeria due to higher wages resulting from frequent upward salary adjustment/revision.
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viii. Higher production costs
Higher wages and higher energy costs, as is the case in Nigeria have driven up the costs of production. These may hinder increased productivity, thereby resulting in inflation. Or the higher production costs are passed unto consumers in the form of higher prices on commodities.
ix.
War caused inflation.
During wars like the Nigerian/Biafran war, efforts are diverted from production of goods to the production of war equipment or armaments. Labour which could have been used in the production of foodstuffs were deployed to the war fronts.
Hence, demand cannot equate supply. Inflation therefore results.
General ways of controlling inflation
i.
Price control measures
This involves the setting up of a price control board by the government which fixes maximum prices charged for certain commodities experiencing inflation.
Experience, however has shown that this system, bedeviled with a myriad of problems, does not proffer the solution. The Nigerian case is a typical example.
What usually result are hoarding, profiteering, and black-marketing, thus negating the initial aims. ii. Wage control or wage freeze
Most governments place freezes on wage increases as a measure to combat inflation. But this policy does not work or is ineffective since workers have devised methods of making the government or employers of labour dance to their tunes. These ways include go-slow, work-to-rule, industrial actions, etc. these are most often used in democratic nations/societies. iii. Monetary policy
This involves the use of traditional monetary instruments to reduce the quantity of money in circulation. These include: Increase in the Bank or Discount Rate, increase in the Liquidity ratio, use of open market operation (contractionary monetary policy in this case), sectoral allocations or Special Directives, etc.
However, the experience in the developing world has shown that these traditional instruments of monetary policies have a lot of deficiencies hence their ineffectiveness. iv.
Fiscal policy
A combination of increase in personal income tax and reduction in government expenditure may prove effective especially when inflation is demand-pull in nature. These reduce the purchasing power of consumers thus reducing prices of commodities. 72
v.
Total ban on the importation of certain items
Especially when inflation is imported, the government is strongly tempted to place total ban on the importation of certain non-essential items. However, retaliation by other nations and political pressure lead to the lift of the ban no sooner than it was placed hence the ineffectiveness of such a policy. vi. Increase in the production of goods and services
Increase in production of goods and services is the most effective measure to inflation. Increase in the supply of products will naturally force prices down. In
Nigeria, concrete efforts should be made to increase production of essential but scare commodities. Large acres of land should be acquired for farm settlements where real farming is practiced. Loans should be given to real farmers to increase agricultural productivity, for there is no way you can check inflation other than flooding the market with enough goods and services.
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UNEMPLOYMENT
Unemployment is a situation in which able-bodied persons willing to work at the prevailing wage rate do not find job. Unemployment may also be defined as a situation of less than full employment. According to the United Nations, full employment is a situation in which employment cannot be increased by an increase in effective demand and unemployment does not exceed the minimum allowance that must be made for effects of frictional and seasonal factors.
Causes of Unemployment
The major types of unemployment are frictional, structural and cyclical.
Frictional unemployment
Frictional unemployment is temporary and occurs when a person (1) quits a current job before securing a new one, (2) is not immediately hired when entering the labor force, or (3) is let go by a dissatisfied employer.
Structural unemployment
The structural unemployment arises due to structural change in a dynamic economy so that some workers go out of job. Structural changes include change in structure or sectoral composition of the economy and change in technology.
Change in sectoral composition means gradual decline of some kinds of industries and emergence of new industries. The downfall or decay of some kind of industries throws people of specific skill out of job. They remain unemployed till they find new jobs. Technological changes alter the demand pattern of different kinds of skills. Some skills become obsolete and some less efficient. In a dynamic society, structural change is a continuous process. In this process, some persons find it difficult to get a new job requiring a new kind of job skill. The important thing in structural unemployment is that there are vacancies and there are job-seekers and yet there is unemployment because of mismatch between the demand and supply pattern of the labour market.
Cyclical unemployment
Cyclical unemployment is the result of insufficient aggregate demand. Workers have the necessary skills and are available to work, but there are insufficient jobs because of inadequate aggregate spending. Cyclical unemployment occurs when real GDP falls below potential GDP.
INFLATION AND RATE OF UNEMPLOYMENT
The relationship between inflation and employment was brought out by A.W.
Philips in 1958. He found an inverse relationship between the rate of changes in the money wage and the rate of unemployment. Two explanations were given for the inverse relationship.
74
(i)
(ii)
It is observed that when unemployment is very high, in which case the demand for labour is very low, the rate of fall in wage rate is assumed to be slow because labour would not be prepared to offer their services at less than the prevailing wage rate. On the other hand, when the rate of unemployment is very low, in which case the demand for labour is very high, the wage rate is expected to increase rapidly to attract any available unemployed labour.
In the period of rising business activity when unemployment falls with increasing demand for labour, the employers will bid up wages.
Conversely in period of falling business activity when demand for labour is decreasing and unemployment is rising, employers will be reluctant to grant wage increases. Rather, they will reduce wages. But workers and unions will be reluctant to accept wage cuts during such periods. Consequently, employers are forced to dismiss workers, thereby leading to high rates of unemployment. Thus when the labour market is depressed, a small reduction in wages would lead to large increase in unemployment.
Philips concluded on the basis of these arguments that the relation between rates of unemployment and of change of money wages would be highly non-linear when shown on a diagram. Such a curve is called the Philips curve. This is shown in the figure below.
The PC curve is the Philips curve and it relates the percentage change in money wage rate (w) on the vertical axis with the rate of unemployment (U) on the horizontal axis. Although Philips traced the relation between the rate of change in money wages and the rate of unemployment, it was later extended to examine the relationship between the rate of inflation and the rate of unemployment. It was assumed that a positive relationship exists between increase in wage rate
75
and level of prices which was confirmed in a US study. The Philips curve implies a positive relation between the rate of inflation and the rate of employment.
From policy point of view, the Philips curve implies that there exists a trade-off between the rate of unemployment and the rate of inflation, that is, a lower rate of unemployment can be achieved only by allowing inflation rate to increase. The trade-off between unemployment rate and inflation can be found using the diagram below. As shown in the figure, a 2.5 per cent (=6.5%- 4%) unemployment can be traded for a 2 per cent (=5% - 3%) inflation.
It means, from policy point of view, that if unemployment rate is intended to be reduced from 6.5% to 4%, a rise in inflation rate from 3% to 5% will have to be tolerated. If an inflation rate of 3% is the target, an unemployment rate of 6.5% will have to be accepted. A similar conclusion can be drawn by linking unemployment rate to wage-inflation rate given on the vertical axis on the right hand side.
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Introduction
INTERNATIONAL TRADE
A country does not produce all the goods and services that it consumes. Instead, it produces the goods and services in which it is good at producing and imports the goods and services in which it is not good at producing. International trade is the exchange of goods and services across international borders. An economy that engages in international trade is called an open economy. One that does not is called a closed economy and this is referred to as autarky. The advantages realized as a result of trade are called the gains from trade.
Basis of Foreign Trade
Nations of the world differ in their resource endowments. While some countries are better endowed with natural resources like vast fertile and cultivable land, larger mineral deposits, water and forest resources, better climatic conditions, some have large human power, some others are better equipped with technology. The important feature of distribution of world resources is irregularity or imbalance. Possibly no country can claim self sufficiency in its resource requirements or a perfectly balanced supply of resource. This uneven distribution of resources is the basis of foreign trade. For owing to differences in resource endowment, the production potentials of countries vary from industry to industry. Various countries therefore tend to specialize in the production of commodities which they can produce more efficiently than the others. This leads to international division of labour and thereby international trade. Furthermore, it is beneficial for countries to engage in international trade. The earliest evidence of gains from trade was provided by Adam Smith’s theory of
Absolute Advantage, and later refined by David Ricardo and Torrens in their theory known as the Comparative Advantage.
The Theory of Absolute Cost Advantage
According to the law of absolute advantage, countries can gain from specialization and international trade if each specializes in producing the goods in which it has an absolute advantage. A country has an absolute advantage over other countries in producing a good when it can produce the same amount of the good with a smaller amount of resources. In other words, a country has an absolute advantage over other countries in producing a good when it can produce a larger amount of the good with the same amount of resources. Suppose that there are two countries, country X and country Y, producing two goods, good A and good B. Further suppose that there are perfect mobility of
77
resources within each country, constant opportunity costs of production, no economies of scale, no transport costs, no trade barriers and no product differentiation. The quantity of goods that can be produced by the 2 countries is illustrated in the table below.
Good A Good B
Country X 2
4
Country Y 1
9
The table shows the quantity of each good that can be produced in each country with one unit of resources. In country X, one unit of resources can be used to produce either 2 units of good A or 4 units of good B. In country Y, one unit of resources can be used to produce either 1 unit of good A or 9 units of good B.
Therefore country X has an absolute advantage in producing good A and country
Y has an absolute advantage in producing good B. If for instance 400 and 200 units of resources are owned by country X and Y respectively and that these resources are allocated equally between the two goods, the table below illustrates the quantity of goods A and B that each country can produce.
Good A
Country X 400
Country Y 100
World
500
Good B
800
900
1700
Good A
Country X 800
Country Y 0
World
800
Good B
0
1800
1800
In country X, 400 units of good A and 800 units of good B are produced. In country Y, 100 units of good A and 900 units of good B are produced. Suppose each country completely specializes in producing the good in which it has an absolute advantage, the table below shows the total output of the two countries.
In country X, 800 units of good of good A are produced, while in country Y, 1800 units of good B are produced. Since the world output of good A has increased by
300 units and the world output of good B has increased by 100 units, we can conclude that countries can gain from specialization and international trade on the basis of the law of absolute advantage.
The theory of Comparative Cost Advantage
According to the law of comparative advantage, countries can gain from international trade if each specializes in producing the goods in which it has a comparative advantage. A country has a comparative advantage over other countries in producing a good when it can produce the same amount of the
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good at a lower opportunity cost. In other words, a country has a comparative advantage over other countries in producing a good when it can produce the same amount of the good by forgoing a smaller amount of other goods.
Suppose that there are two countries, country X and country Y, producing two goods, good A and good B. Further suppose that there are perfect mobility of resources within each country, constant opportunity costs of production, no economies of scale, no transport costs, no trade barriers and no product differentiation. The amount of each good that can be produced in each country with one unit of resources is presented in the table below.
Good A Good B
Country X 2
4
Country Y 3
9
In country X, one unit of resources can be used to produce either 2 units of good
A or 4 units of good B. In country Y, one unit of resources can be used to produce either 3 units of good A or 9 units of good B. Although county Y has an absolute advantage in producing both goods, each country has a comparative advantage in producing only one good.
In country X, if one unit of resources is used to produce 2 units of good A, the same unit of resources cannot be used to produce 4 units of good B. Therefore, the opportunity cost of producing 1 unit of good A in country X is 2 units of good
B. By the same token, the opportunity cost of producing 1 unit of good B in country X is 0.5 unit of good A.
In country Y, if one unit of resources is used to produce 3 units of good A, the same unit of resources cannot be used to produce 9 units of good B. Therefore, the opportunity cost of producing 1 unit of good A in country Y is 3 units of good
B. By the same token, the opportunity cost of producing 1 unit of good B in country Y is 0.33 unit of good A. This can be represented in the table below.
Good A Good B
2
Country X 4
=2
= 0.5
2
4
3
Country Y 9
=3
= 0.33
3
9
Since the opportunity cost of producing good A in country X is lower than that in country Y and the opportunity cost of producing good B in country Y is lower than that in country X, country X has a comparative advantage in producing good
A and country Y has a comparative advantage in producing good B.
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Suppose that country X has 400 units of resources and country Y has 200 units of resources. Further suppose that each country allocates its resources equally between the two goods. The table below shows the amount of each good produced in each country when the resources are allocated equally between the two goods.
Good A
Country X 400
Country Y 300
World
700
Good B
800
900
1700
Good A
Country X 800
Country Y 0
World
800
Good B
0
1800
1800
In country X, 400 units of good A and 800 units of good B are produced. In country Y, 300 units of good A and 900 units of good B are produced. But if the two countries specialize in producing the good in which it has a comparative advantage, the following table shows the amount of each good that would be produced in each country.
In country X, 800 units of good A are produced, while in country Y, 1800 units of good B are produced. The world’s output of goods A and B have each increased by 100 units.
The Gains from Trade
If the two countries pursue the policy of autarky, in other words, they do not engage in foreign trade, the domestic rate of exchange between the two goods will be determined by the per unit cost of producing the goods (A & B). The domestic exchange from our initial data is hence given as follows;
Domestic Exchange Rate in Country X
1 unit of A = 2 units of B or
1 unit of B = 0.5 unit of A
Domestic Exchange rate in Country Y
1 unit of A = 3 units of B
1 unit of B = 0.33 unit of A
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If we now assume that the two countries engage in foreign trade in which case, country X specializes in the production of good A and imports good B, while country Y specializes in the production of good B and imports good A, their gains from trade hence will be determined by their external exchange rate which is called terms of trade. This is given as:
=
× 100
A higher level of terms of trade is referred to as a favourable terms of trade which means more can be imported per unit of goods exported than at a lower rate. The two countries will benefit from trade if their terms of trade are higher than their domestic exchange rate. If country X specializes in the production of good A and import good B, the country can import 3 units of good B from country
Y instead of 2 units domestically. On the other hand, country Y can import 0.5 units of B from country X instead of 0.33 domestically.
The distribution of gains from trade
The gains from trade therefore will lie between the lower and upper ratios of the rates of exchange. If for instance, 1 unit of good A is exchange for 3 units of B, then the total gain from trade accrues to country X, and if 1 unit of B is exchange for 0.5 unit of good A, then the total trade accrues to country B. Any rate in between these ranges will be advantageous to the 2 countries.
Limitations of the law of comparative advantage
Trade barriers
The law of comparative advantage assumes that there are no trade barriers. In reality, there are trade barriers. Some governments protect domestic industries by discouraging imports through the use of protectionist measures such as tariffs, import quotas and subsidies. As a result, some countries produce goods in which they do not have a comparative advantage. Further, some countries are unable to export the goods in which they have a comparative advantage as much as they would like due to trade barriers imposed by foreign governments.
Transport costs
The law of comparative advantage assumes that there are no transport costs. In reality, there are transport costs which may outweigh any comparative advantage or disadvantage.
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Constant opportunity costs of production
The law of comparative advantage assumes that there are constant opportunity costs of production. In reality, as a country increasingly specialises in producing a good, it will experience increasing opportunity cost of producing the good. This is because factor inputs are not equally suitable for producing different goods. As a country increasingly specialises in producing a good, it has to use resources that are less suitable for producing the good to actually produce the good. This means that increasingly more units of resources are needed to produce each additional unit of the good. Therefore, increasingly more units of other goods have to be given up to produce each additional unit of the good. This will eventually lead to the disappearance of the country's comparative advantage in producing the good which is a reason why countries do not engage in complete specialisation in reality. Perfect mobility of resources within each country
The law of comparative advantage assumes that there is perfect mobility of resources within each country. In reality, due to factors such as differences in skill requirements, resources are not perfectly mobile in a country.
Sources of Comparative advantage
Differences in factor endowments
Factor endowments vary among countries. For example, Argentina has much fertile land, Saudi Arabia has large crude oil reserves and China has a large pool of unskilled labour. Since goods differ according to the resources that are used to produce them, a country has a comparative advantage in producing goods that intensively use resources it has in abundance. For example, Argentina has a comparative advantage in growing wheat because of its abundance of fertile land, Saudi Arabia has a comparative advantage in producing oil because of its abundance of crude oil reserves and China has a comparative advantage in producing textile because of its abundance of unskilled labour.
Economies of scale
A country may acquire a comparative advantage in producing a good through large-scale production. This occurs in industries where production is subject to economies of scale.
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BALANCE OF PAYMENTS
Definition and structure
Balance of payments is defined as a systematic record of all economic transactions between the residents of the reporting country and residents of foreign countries’ during a certain period of time. Each international transaction enters the accounts twice: once as a credit (+) and once as a debit (-). Debit transactions are any transaction that results in payment to foreigners, while credit transactions are any transaction that results into a receipt from foreigners.
Balance of payments accounts
The credit and debit items are shown vertically in the balance payments accounts of a country according to the principle of double-entry book-keeping.
Horizontally, they are divided into three categories: the current account, the capital account and the official settlements account or the official settlements account or the official reserve assets account.
i.
The Current Account
The current account of a country consists of all transactions relating to trade in goods and services and unilateral (or unrequited) transfers. These items may be further grouped as: (i) visible items; and (ii) invisible items. The visible items consists of all the merchandise exports and imports while the invisible items consists of services such as travels, shipping, banking, insurance. A third item which is called the transfer payments is usually distinguished and this consists of items like gifts, donations, military aid, technical assistance etc. they are different from other invisible items because it involves only unilateral transfers.
ii.
The capital account
The capital account of a country consists of its transactions in financial assets in the form of short-term and long-term lendings and borrowings, and private and official investments. In other words, the capital account shows international flow of loans and investments, and represents a change in the countries’ foreign assets and liabilities. Long term capital transactions relate to international capital movements with maturity of one year or more and include direct investments like building of a foreign plant, portfolio investment like the purchase of foreign bonds and stocks, and international loans. On the other hand, short-term international capital transactions are for a period ranging between three months and less than one year.
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iii.
The official settlements accounts
This item is in fact part of the capital account, but in the UK and USA balance of payments accounts show it as a separate account. The official settlements account measures the change in nation’s liquid and non-liquid liabilities to foreign official holders and the change in a nation’s official reserve assets during the year. The official reserve asset of a country includes its gold stock, holdings of its convertible foreign currencies and SDRs, and its net position in the IMF. The official reserves of a country are maintained to stabilize the exchange rate of the home currency and to make payments to the creditors in case there exists payment deficits on all other accounts.
Balance of Trade and balance of payments
Balance of Payments Categories
Credits (+)
Debits (-)
a. Exports of goods
b. Imports of goods
Balance of Trade = a b
c. Exports of services
d. Imports of services
e. Net transfers
Current Account Balance = (a b) + (c d) e
f. Foreign investment long-term short-term
h. Borrowing from overseas
g. Investment overseas long-term short-term
i. Lending to overseas
Capital Account Balance = (f g) + (h i)
Increase in Official Reserve
= Current account surplus + Capital account surplus
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If the total receipts from foreigners on the credit side exceed the total payments to foreigners on the debit side, the balance of payments is said to be favourable.
On the other hand, if the total payments to foreigners exceed the total receipts from foreigners, the balance of payments is unfavourable.
The balance of trade is the difference between the values of goods and services exported and imported. It contains the first two items of the balance of payments account on the credit and the debt side. This is known as balance payments on current account. It is also defined as the difference between the value of merchandise exports and imports.
Causes of Disequilibrium in BOP
There are many factors that may bring a deficit or surplus in its balance of payments. First, there may be temporary disequilibria caused by random variations in trade, seasonal fluctuations, the effects of weather on agricultural production etc.
Deficits or surpluses arising from such temporary causes are expected to correct themselves within a short time.
Second, there are chronic fundamental disequilibria. They may arise due to fundamental changes in the economic condition of a country. They may be due to changes in consumer tastes within the country or abroad thereby affecting the country’s imports or exports.
Third, technological changes in methods of production or products in the domestic industries or in the industries of other countries may affect the country’s ability to compete in the home foreign markets. This may be due to changes in costs and prices and the quality of products following technological improvements. Fourth, another cause is the change in the country’s national income. If the national income of a country increases it will lead to an increase in imports thereby creating a deficit in its balance of payments, other things remaining the same. If the country is already at the full employment level, an increase in income will lead to inflationary rise in prices which may increase its imports and thus bring disequilibrium in the balance of payments.
Fifth, inflation is another cause of disequilibrium in the balance of payments. If there is inflation in the country, prices of exports increase. As a result, exports fall. At the same time, the demand for imports increases. Thus increase in export prices leading to decline in exports and rise in imports results in adverse balance of payments.
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Sixth, a country’s balance of payments also depends on its stage of economic development. If a country is developing, it will have a deficit in its balance of payments because it imports raw materials, machinery, capital equipment, and services associated with the development process and exports primary products.
The country has to pay more for costly imports and gets less for its cheap exports. This leads to disequilibrium.
Lastly, borrowings and lendings by countries also result in disequilibrium in the balance of payments. A country which gives loans and grants on a large scale to other countries has a deficit in its balance of payments on capital account. If it is also importing more, as is the case with the USA, it will have chronic deficit. On the other hand, a developing country borrowing large funds from other countries and international institutions may have a favourable balance of payments. But such a possibility is remote because these countries usually import huge quantities of good, raw materials, capital goods, etc. and export primary products. Such borrowings simply help in reducing balance of payments deficits.
Measures to Correct Disequilibrium
1. Adjustment through Exchange Rate Depreciation
Under flexible exchange rates, the disequilibrium in the balance of payments is automatically solved by the forces of demand and supply for foreign exchange.
The exchange rate varies with varying supply and demand conditions, but its always possible to find an equilibrium exchange rate which clears the foreign exchange market and creates external equilibrium. This is automatically achieved by a depreciation of a country’s currency in case of deficit in its balance of payments and by an appreciation of the currency in the event of a surplus.
Depreciation has the effect of encouraging exports and discouraging imports, while the converse happens in the case of appreciation. When exchange rate depreciation takes place, foreign prices are translated into domestic prices.
If for instance the Naira suffers from depreciation against the US dollar, this means that Nigerian exports will be cheaper in the US while the American exports to Nigeria will be more expensive. This situation will stimulate increase in demand for Nigerian exports and limits demand for American exports in
Nigeria which eventually will bring about an equilibrium in the balance of payments. 2. Devaluation or Expenditure-switching policies
Devaluation raises the domestic price of imports and reduces the foreign price of exports of a country devaluing its currency in relation to the currency of another country. Devaluation is referred to as expenditure switching policy because it switches expenditure from imported to domestic goods and services. When a country depreciates its currency, the price of foreign currency increases which
86
makes imports dearer and exports cheaper. This causes expenditures to be switched from foreign to domestic goods as the country’s exports rise and the country produces more to meet the domestic and foreign demand for goods with reduction in imports. Consequently, the balance of payments deficit is eliminated.
3. Direct controls
To correct disequilibrium in the balance of payments, governments also adopt direct controls which aim at limiting the volume of imports. The government restricts the import of undesirable or unimportant items by levying heavy imports duties, fixation of quotas etc. At the same time, it may allow imports of essential goods duty free or at lower import duties, or fix liberal import quotas for them. For instance, government may allow free entry of capital goods, but impose heavy import duties on luxuries. Import quotas are also fixed and the importers are required to take licenses from the authorities in order to import certain essential commodities in fixed quantities. In these ways, imports are reduced in order to correct an adverse balance of payments. The government also imposes exchange controls exchange control has a dual purpose. They restrict imports and also control and regulate the foreign exchange. With reduction in imports and control of foreign exchange, visible and invisible imports are reduced consequently; adverse balance of payments is corrected.
4. Adjustment through capital movements
Capital movements also bring equilibrium in the balance of payment. They can be used to finance deficits or surpluses in the balance of payments. A deficit can be financed by capital inflows and a surplus by capital outflows. This can be explained under the flexible exchange rates and perfect capital mobility. When capital is perfectly mobile, a small change in the domestic interest rate brings large flows of capital. The balance of payments is said to be in equilibrium when the domestic interest equals the world rate. If the domestic interest rate is lower than the world rate, there will be large capital outflow which will produce a large depreciation of the currency. On the contrary, if the domestic interest rate is higher than the world rate, large capital inflows will lead to appreciation of the currency. 5. Stimulation of exports
A deficit in the balance of payments can also be corrected by encouraging exports. Exports can be encouraged by producing quality products, by reducing exports through increased production and productivity, and by better marketing.
An increase in exports causes the national income to rise by many times though the operation of the foreign trade multiplier. The foreign trade multiplier expresses the change in income caused by a change in exports. Ultimately, the deficit in the balance of payments is removed when exports rise faster than imports. 6. Expenditure reducing policies
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A deficit in the balance of payments implies an excess of expenditure over income. To correct it, expenditure and income should be brought into equality.
Expenditure-reducing policies aim at reducing aggregate demand through higher taxes and interest rates thereby reducing expenditure and output. The reduction in expenditure and output, in turn, reduces the domestic price level. This gives rise to switching of expenditure from foreign to domestic, goods. Consequently, the country’s imports are reduced and balance of payments disequilibrium is corrected. 88
THE NATIONAL INCOME
One of the basic questions facing economics centers on whether the total output of goods and services is growing from year to year or it remains static. This question is very important because countries are keenly interested in the performance of their economy. National income estimates enable countries to calculate the total production of goods and services in a year. The lecture also focuses on the measurement of national income and their problems, uses and limitations of national income statistics and elementary theory of income determination. Meaning of National Income
National income can be defined as the monetary value of all the final goods and services that are produced in an economy within a given period of time, usually a year. Final goods are goods that are ultimately consumed rather than used in the production of another good. For example a car sold to a consumer is a final good; the components such as tires sold to the car manufacturer are not; they are intermediate goods used to make the final good. If the same intermediate goods were included too, this would lead to double counting. For example, the value of the tires would be counted once when they are sold to the car manufacturer, and again when the car is sold to the consumer.
The national income of a country can be measured in three different ways, viz the
Income Approach, the Output Approach and the Expenditure Approach. The use of any of these approaches produces the same result if carefully implemented. The measurement and analysis of the total output produced in an economy is known as social accounting.
National income Concepts
In national income accounting, economists and planners are usually interested in various national income concepts such as, Gross Domestic Product (GDP), Gross
National Product (GNP), Net National Product (NNP), and Disposable Income
(Yd). These concepts are considered in turn.
i.
Gross Domestic Product:
The gross domestic product of a country is the monetary value of all the final goods and services produced within the domestic territory of a country in a specific period, usually a year, irrespective of whether those who produced them are citizens or foreigners. ii. Gross National Product:
This is the main measure of the total output. It is at times; simply referred to as
National Income (NI). The Gross National Product of a country is the money value
1
of all the final goods and services produced by nationals or citizens of a country
(in a specific period, usually a year) irrespectively of where they reside. Taking
Nigeria as a specific example, the GNP of Nigeria in a particular year, say 1990 is the money value of all finished goods and services produced by Nigerians living in Nigeria and those in other countries in 1990. The gross national product can simply be regarded as the gross domestic product plus the net property income from aboard, i.e. GNP = GDP + NPA. Where GNP is as preciously defined and NPA stands for Net Property Income from abroad. The net income earned from abroad is the difference between the income which citizens, firms or the government of a country earn abroad and income payable to foreigners on account of their investment in the domestic country. If NPA is positive then GNP
> GDP but if NPA is negative, then GDP < GNP. iii. Net National product (NNP):
The net national product of country is equal to the gross national product minus capital consumption allowance or depreciation. In order to provide for the wear and tear in the value of capital goods used in production of the national output, the amount used up, of the wear and tear of productive assets is usually set aside by deducting it from the value of the national output produced. The amount used up or the wear and tear of assets is what an accountants referred to as depreciation while an economist, on the other hand, refers to it as capital consumption allowance. iv. Disposable Income (Yd):
This can be defined as the national income plus transfer earning minus taxes i.e
Yd = Y+ TE – t, where Y is the national income, TE stands for transfer earnings and t denotes taxes.
VALUATION OF NATIONAL INCOME
The national income or output of a country can be valued in different ways. First in current prices i.e. the prices ruling at the time of measurement. When national income is valued at current prices it is known as nominal national income. If we want to compare the volume of output produced in a particular year with those of other years, we need to make adjustment for changes in price of goods and services produced. To achieve this objective, we need to re value the national output in terms of fixed prices. When the national output is valued in terms of fixed prices, this is technically referred as national income at constant prices or real national income,
National Income at Market Prices and Factor Costs
(i) GDP(MP) = GDP(FC) + indirect taxes - subsidies;
(ii) GNP(MP) = GNP(FC) +indirect taxes - subsidies; or GDP(MP) +NPA
(iii) NNP(MP) = NNP(FC) +Indirect taxes - subsidies; or GNP(MP) -Depreciation
2
Measurement of National Income
The national income of a country can be measured in three ways, these are, the income approaches the output approach; and the expenditure approach. These approaches are discussed as follows:
The income approach
Under the income approach, the national income of a country is obtained by summing all income earned by all factors of production employed in the economy during a particular period of time usually a year. These incomes are in the form of wages, salaries, rents, interests, profits, dividends etc. When the national income is measured in this way, we arrive at national income at factor cost which can he defined in symbols as:
Y= Yw + Yr+Yrp+Yi
Where Yw= income received by individuals in form of wages salaries, commissions, bonuses, and other forms of employee earnings before deduction of taxes, Yr = net income from rentals and royalties, Yrp = retained profits of business enterprises, Ydp = disbursed profits of business enterprises, Yi = interest income. In using this approach, however, care taken to avoid double .
Consequently, all forms of transfer payments must be excluded because they are not rewards economic activities. Transfer payment are money paid to an individual by the government, firms or other non-governmental organizations for which there is no quid pro quo (i.e. no corresponding service or good exchange) example of transfer payments include: pensions, unemployment benefits, students grants etc
Problems Associated with the Income Approach
The main problems associated with the income approach include:
1. Problem of how to estimate the rent of owners – occupied house: If a person rents a house, such individual pays rent to the owner of the house. The rent paid, in this case, serves as an income to the owner, the rental value of the house must be included in the national income. However, since data on rents of owner’s occupied houses is not available in the Nigeria setting, it poses a lot of problem to statisticians when estimating rent.
2. Problem of retained earnings: the accounting Principle of companies usually make provision for retained earnings. This implies that not all profits after tax are shared as dividends to shareholders. In measuring the national income using the income approach the amount retained by companies needs to be added back
3
to the personal income of individual shareholders so as arrive at the gross national income at factor costs. This exercise, however, creates some difficulties
3. Problem of how to estimate the income of self- employed: In developing countries, Nigeria inclusive, statistical information on the income of those that are self-employed or in the subsistence sector of the economy are not available.
This problem causes a lot of problem when estimating the gross national income.
4. Problem in estimating the net property income from abroad. To arrive at the gross national income, the net property income from abroad has to be added to the gross domestic income. the net property income from abroad is the difference between the income paid to foreigners and the income received from abroad as a result of ownership of productive assets in other countries. In developing countries the net property income may be positive or negative. If negative, it implies that foreigners on account of their investment in the domestic economy is greater than the income receipt from abroad with respect to domestic investments abroad. The reverse holds if the net property income from abroad is positive.
5. Problem of making provision for capital allowance or depreciation: To arrive at the net income; capital consumption allowance or depreciation has to be subtracted from the gross national income. This exercise however creates some difficulties since statisticians and economists may be faced with the problem of which method of depreciation to adopt.
6. Problem of the black or underground economy: The underground or black economy refers to all unrecorded economic transactions conducted In order to evade taxes in the economy. In Nigerian, for instance, a lot of activities are done in underground or black economy. This implies that some income earned are seldom recorded, this has the effect of underestimating the national income of an economy, 7. Problem of double counting: In measuring the national income via the income approach different are usually encountered when accounting for transfer payment. To avoid double counting, transfer payments or earnings have to be excluded under this approach.
The Output Approach
To calculate the national income through the output approach, we sum the values of all the final goods and services produced by firms in the economy at a given period of time usually a year, assuming that only four final goods are produced in an economy in a particular year, the values of these final products can be derived using the formula
4
=
+
+
Where PAQA + PBQB+PCQC+PDQD is the sum of the products of the price and quantities of commodity A, B, C and D respectively. It should be noted that this approach emphasized the inclusion of only final goods and services whether they are sold to consumers or to the government or sold abroad as export or to other firms, In this regard, all intermediate goods must be excluded when using this approach, so as to avoid double counting. The main problem usually encountered when measuring the national income through this approach is that what is a final good to one industry may be an intermediate good to other industries, In a way to eliminate the problem of double counting, economists and statisticians always resort to the value-added basis when using the output approach.
Under the value added basis, the national income is computed by adding the valued added of various firms at each stages of production. The value added (VA) at every stage of production is defined as the value of output (VQ) minus the value of input (VI) i.e VA = VQ-VI.
Problems associated with the approach
1. Difficulty in measuring the value of goods consumed by producers: In Nigeria and other West Africa countries, several small-scale farmers consume part of what they produced without accounting for them. Since all the output of the subsistence sector of the economy have to be included in calculating the national output, sample survey which are not usually reliable are often used when calculating the national income through the income approach,
2. Difficulty in assessing the value of services rendered by housewives: Services rendered by house wives such as cooking, taking care of the children, shopping for the family etc; are productive activities which ought to be included in national income figure. However, as a result of lack of statistical data on these services and the difficulty that might arise in an attempt to estimate them, they are usualy excluded from national Income figures.
3. Problem in assessing the value of self-done activities: In measuring the national income of a country through the output approach, the value of self-done activities ought to be included; however, as a result of lack of information on these activities, they are usually excluded from national income figures. These activities under normal situation, would have been paid for if someone was employed to render them
4. Problem of making provision for capital allowance or depreciation: Like in the income approach, to arrive at the net national product, capital consumption
5
allowance or depreciation has to be deducted from the gross national output.
This exercise however creates some difficulties.
5. Problem of defining of what a final good is or intermediate good: In developing economic like Nigeria, there are at times, problem of definition of what is a final good or intermediate good, when compiling national income figures. For example could a bicycle be regarded as a final good or intermediate good? This question becomes necessary since in the subsistence sector of the economy bicycles are usually the most convenient way of transporting heavy farm products to the market. When viewed from this perspective, bicycle could be regarded as an intermediate good that aid the production of other goods.
6. Problem of double counting: When measuring the national income via the output approach the value added on productive activities has to be included in the national output. However in Nigeria and other West Africa countries, most businessmen hardly distinguish between the value-added in and total revenue realized on account of production. This has the effect of overestimating the national output since total revenue includes some element of cost of production.
The Expenditure Approach
The expenditure approach to the measurement of the national income of a country entails summing up the total expenditure on final goods and services by private individuals, firms and the government since no country operates in autarchy or without any relation with other countries, we also add the value of expenditure by foreigners on domestic production (exports) and deduct the value of domestic expenditure on foreign production (imports). Using expenditure approach, the gross national expenditure or aggregate demand which is a measure of the national income can be expressed as
Y = C + 1 + G + (X-M)
Where C = Household expenditure on consumer goods
I = investment expenditure by firms
G = government expenditure
X = exports
M = imports
X-M= net exports
In computing national income using the expenditure approach, only expenditure on final goods and services should be included, all expenditure on intermediate goods have to be excluded.
Problem of the expenditure approach
1. Problem of definition of what is final good: To be able to measure the national income of a country accurately using the expenditure approach, knowing what is a final good or service is important. It is only when a final good or service is
6
known and Identified that a statistician or economists would know what to include or exclude. Therefore, when there is a problem of product definition, double counting occurs.
2. Problem of unsold stock: All inventories are usually included in the GNP. The procedure is to take positive or negative changes in physical units of inventories and multiply them by current prices. Then the figure is added to total current production of the firm. But the problem is that firms recorded inventories at their original costs rather than at replacement costs. When prices rise there are gains in the in the book value of inventories. Contrariwise, there are losses when prices fall. So the book value of inventories overstates or understates the actual inventories. Thus for correct imputation of GNP, inventory evaluation is required. A negative valuation adjustment is made for gains and a positive valuation adjustment is made for losses. But inventory valuation is a very difficult and cumbersome procedure.
3. Conversion of market prices to factor costs: When national income is estimated using the expenditure approach, some adjustments have to be made so as to ensure the equality of national expenditure with national income and national output. This adjustment becomes important because under the expenditure approach the national expenditure is computed at market prices which are distorted by taxes and subsidies. Therefore to convert national expenditure to national income at factor cost, indirect taxes have to be deducted while subsidies have to be added.
4. Adjustment for net property income from abroad: To derive the gross national expenditure, adjustment has to be made for net property income from abroad.
This exercise involves adding all Incomes from overseas and deducting all incomes accruing to foreigners. This is a complex process.
5. Adjustment for exports and imports: When goods and services are produced in the domestic country, some of these goods are consumed locally while others are sold abroad. In the same vein, some goods consumed within the country are bought from abroad, therefore, exports have to be added to domestic expenditure while Imports deducted.
Note: It could be observed that if the three approaches are carefully adopted they result to the same thing this implies that:
National Income = National Expenditure = National Output.
7
Numerical Example:
The following are the items of the income statement of the economy for a particular year (in billions of Naira). Determine the Gross National Product using
a) Expenditure approach and b) income approach.
Items
(N)’b
Rents
24
Personal consumption expenditure
1,080
Corporate income taxes
65
Undistributed corporate profits
18
Net exports
7
Dividends
35
Capital consumption allowance
180
Interest
82
Indirect business taxes
163
Gross private domestic investment
240
Compensation of employees
1,028
Government purchases of goods and services 365
Proprietors’ income
97
Solution:
Using the Expenditure approach:
Y = C + I + G + (X-M)
C = 1080; I = 240; G = 365; X = 7.
Hence; Y = 1080 + 240 + 365 + 7 = 1692.
Using the income approach
Capital consumption allowance 180
Indirect business taxes
163
Compensation of employees
1028
Rents
24
Interest
82
Proprietors’ income
97
Corporate income taxes
65
Dividends
35
Undistributed corporate profits 18
GNP
=N=1,692
The Uses of National Income Estimates
National income estimates are very important and serve many purposes.
1. It permits us to measure the level of production in the economy over a given period of time, and to explain the immediate causes of that level of performance.
2. It is used in economic planning: National income figure serves as indicator of economic growth, level of output and employment in the economy. Therefore,
8
national income estimates enable planners to develop appropriate policies that will promote economic growth, ensure stable prices and reduce unemployment.
3. It is used for inter-sectoral comparison: With national income statistics, the performances of various statistic of the economy could be measured and appropriate policies directed towards revitalizing laggard sectors
4. It is used for inter-country comparison: Apart from measuring the performance or various sectors of the economy; national income figures, when expressed in terms of international currency such as dollar, are also useful for measuring the economic performance of different countries.
5. It is indicator of economic welfare or standard of living: the national income statistics serve as a useful indicator of economic welfare or standard of living when expressed in terms of real per capital index. The real national income, can therefore be expressed as:
(
)=
To convert the real national income to per capita income, it has to be divided by the population of the country at the point in time. This can also be written as:
=
6. Contributions to international organizations: National income figures serve as a very good yardstick for determining the contributions of countries to organizations such as international Monetary Fund, ECOWAS, and African Union etc. Limitations of national income estimates
National income estimate, though very useful have several limitations. These include: 1. It tells us nothing about the distribution of income: This means national income estimates never said anything about whether the national income of a country is concentrated in the hands of few individuals in the society.
2. It is not a good yardstick for measuring the welfare of citizens: National income figures are not a good measure of welfare of citizens in a country since negative externalities in the form of pollution, congestion and unpleasant working conditions are likely to arise in the process of increasing the national output.
9
3. Exclusion of non-marketable activities: There are some activities, though highly productive, which are always excluded from national income because they are difficult to assign monetary value. These include self-done activities and services of housewives. It therefore implies and national income estimates lacks accuracy due to inability to assign monetary value to these activities.
4. National income estimate tells us nothing about the quantity of goods produced; since national income is the money value of goods and services produced in an economy at a particular period of time, it does not tell us anything about the quantity of each good produced. For instance, the welfare of citizens will not be guaranteed if the quantity of military goods in the national output is more than the quantity of consumer goods.
5. It does not reflect the amount of leisure available to citizens: one of the yardsticks for measuring the welfare in a country is the amount of leisure available to citizens. This information, however, is not reflected in national income estimate.
6. It is not a good measure for inter – country comparison of performance overtime.
The national income of countries is usually converted into common currency using the exchange rate. However, since the exchange rates are subject to fluctuation. It can be inferred that national income estimates are not a good measure of inter-country comparison
7. The underground economy: National income estimates does not capture the underground economy. The underground economy reflects those economic activities that are not reported to the government because those engaged in it are attempting to avoid taxes. This occurs when a plumber offers to work for less if paid in cash rather than by cheque or a farmer who sells vegetables of a roadside and undertakes his revenue to the Inland Revenue serves Factors affecting the level of a country’s national income
The main factors affecting the level of a country’s national income are:
1. The availability of natural resources: If a country has vast natural resources and can utilize it to her advantage, the level of national income will rise.
2. The number and quality of the labour force: The greater and more quality a country’s labour force, the higher the national income. A quality labour force is characterized with healthy and intelligent workers.
3. The state of technical knowledge in a country: The higher the state of technical knowledge, the greater the use of natural resources. As natural resources are efficiently utilized, the level of national income of a country will rise.
10
4. The amount of capital available: The greater the quantity of capital available to the working population, the more productive they will be. Therefore, increase in productivity, will have the effect of increasing the level of national output and income in a country.
5. Government policy: Government fiscal and monetary policies also affect the level of a country’s national income. For instance, if the government aims at increasing the national output, policies will be directed towards giving of subsidies to producers so as to reduce their cost of production. In a situation whereby government wants to discourage production, heavy taxes may be imposed on producers. Similarly, monetary policies that reduces or increases interest rates may be directed at increasing or reducing production respectively.
5. Political situation in a country: if the political situation in the country is favourable, businessmen will be motivated to invest in machineries, factories etc.
As the level of investment increases the level of national output, income and employment will rise.
11
THEORY OF INCOME DETERMINATION
The circular flow of income is a diagrammatic representation of the flow of income and expenditure of the various sectors of the economy. The circular flow of income shows how the national income is earned and how it is eventually spent in the economy. To examine a simplified version of the circular flow, it is essential to make following assumptions:
There are only two main sectors which contribute to the flow of goods and services in the household
There is no government sector in the economy. This assumption implies that there are no taxes or subsidies in the economy
The economy is closed i.e. there is no international trade.
Households spend all their income on goods and services produced by firms.
Firms do not invest.
Given these assumptions, the circular flow of income in a two-sector economy consisting of household and firms is represented in Figure below.
In the flow (1) of the circular flow above, households render factor services to firms for the purpose of earning wages and salaries. In return, firms as indicated in flow (2) make payments for hiring the services of households. In addition flow
(3) shows the flow of goods and services from firms to households while the last flow (4) indicates the payment for goods and services from household to firms.
Since it is assumed that households spend all their money income and that firms do not invest, it therefore implies that the flow of income in the economy will
12
automatically equals the flow of expenditure i.e. national income equals national expenditure or national output.
In reality the household may not spend all their current income and could save some of it. Saving (S) represents leakage from the circular flow. In addition to the consumer spending, firms also carry out investment (I) spending. This is an injection to the circular flow of income, as it does not originate from consumers’ current income. Under this scenario, the circular flow of income in a simple closed economy is represented by figure (b) below
The two upper flows in Figure (Ib) indicate the product market. Households sell their labour services in this market in order to obtain income (salaries and wages). Moreover, the two lower flows indicate the product market. Here, firms supply their final goods and services to the household; the latter buy and eventually consume these goods and services. Household, in this framework save part of their income by buying financial assets in the money or capital market. On the last note, the financial mark provides funds which serve as a source of investment to firms. In the circular flows above, there is the assumption that there is no government sector. Since, in reality government has vital role to play in the economy, this assumption is relaxed at this point. In Nigeria, the government sector includes all three layers of government; local, state and federal; government sector levies a wide variety of taxes and charges on groups operating in the economy. These charges and taxes represent withdrawals or leakages from the circular flow and it is given by the flow (c). The government sector spends on the economy by paying the salaries and wages of public servant,
13
current expenditure and on capital items such as road construction, hospitals and other social overhead. Government spending is an injection into the circular flow and is symbolized by G. The circular flow of income with governments sector is presented in Figure 1(c).
By further relaxing the assumption that the economy is closed, we add the foreign sector to the circular flow model as presented in Figure 1d. The foreign sector is a vital part of our economy. The components of the foreign sector are import and export. Exports (X) of goods are injections into the economy while imports (M) are leakages. When exports (X) are greater than imports (M), a balance of payments surplus occurs. When the reverse holds, the economy experienced balance of payments deficit.
14
Concepts of savings, investments and consumption Concepts of Savings
Saving can be defined as that proportion of disposable income that is not spent in the current period. The disposable income of an individual, assuming there are no any transfer earnings during the period, is the total income earned during the current period minus taxes i.e Yd = Y-T where Yd is the disposable income, while
Y and T are gross income and taxes respectively. Saving(s), therefore, is the difference between the disposable income (Yd) and consumption (C) i.e S= Yd – C it should be observed that whatever is not consumed is saved. The relationship between savings and the level of income is a direct one. This means that as the level of income of an individual increases, the higher the level of savings, all things been equal. Given that Yd = Y; S=(Y-T)-C OR S= (Yd-C)
Factors Affecting Saving
There are several factors affecting the level of savings in the society. These factors are as follows.
The level of income: the higher the level of income in the society, all things being equal the higher the level of savings and vice versa.
the level of consumption: Consumption is one of the most important factors affecting saving; the higher the level of consumption of individuals in the society the lower the level of savings.
15
The rate of interest: The rate of interest can be defined as the reward for parting with money by lenders. It can also be regarded as the cost of holding money. The higher the rate of interest, the higher the cost of holding money and the greater the level of savings and vice versa.
Government fiscal policy on taxation: Government fiscal policy on taxation is another factor affecting saving, for instance, if the government increases the tax, the disposable income of individual will fall thereby reducing households savings in the society.
Monetary policy affecting interest rates; deflationary monetary policies would have the impact of raising interest rates and would increase the level of saving in the society.
The value of money: the value of money affects individuals’ savings habit in the society. For instance during inflation the value of money falls persistently. As the value of money falls it serves as a poor store of value and people will prefer buying physical assets like lands, vehicles, and house rather than saving their money. Habits and customs: it has been observed that people’s habits also affect savings in the society. There are some people that will save weather the rate of interest is attractive or unattractive while there are others that will not save, while spendthrifts have the natural tendency to consume and dissave. Apart from habit, custom is another determinant of savings. Where the custom places much importance on savings, it is expected that the level of savings in such society will be very high.
Family ties: Family ties affect the level of savings. The more the family ties, the lesser the level of saving. This implies that in West African countries where extended family system is practiced, there will be much pressure on the level of income of the family, thereby leading to little or no saving on the part of the family. Concept of investment
Investment can be defined as the expenditure by firms on goods and services in the future period. It is the consumption meant for the production of other goods and services in the future period. It is a process of increasing real goods in the society. Investment is made up of three components, these include; fixed investment, inventory investment and residential investment. Example of investment goods are factories, machines, etc. total investment in the society is the total spending by firms on all forms of capital goods. Although investment is a smaller component of aggregate demand than consumption and government
16
expenditure, it is more volatile than these other components. Factors affecting the level of investment have been identified. These factors include:
1. The rate of interest: In line with the classical theory, the rate of interest is one of the factors affecting investment. Accordingly, the relationship between the rate of interest and investment is an inverse one. This implies that the lower the rate of interest the higher the level of investment. It can also be inferred from this theory that the rate of interest is the cost of capital, as such, the higher the rate of interest the higher the cost of capital and the lower the willingness to invest and vice versa.
2. Businessmen expectation about future economic activities: investment is strongly influenced by businessmen’s expectation of future economic activity. If businessmen are optimistic about future economic activity, the level of investment will increase. The reverse holds if businessmen are pessimistic about future economic activity.
3. Political stability. If the political climate in the country is conducive, the level of investment will rise. However, in an environment characterized by political instability, businessmen will not be motivated to invest.
4. Rate of changes in aggregate demand: increase in aggregate demand affects the level of investment. An increase in aggregate demand will have the impact of increasing investment, while a fall in aggregate demand will have the opposite effect on investment.
5. Government fiscal policy: Government fiscal policy also affects the level of investment. For instance, an expansionary fiscal policy which reduces the tax has the effect of reducing the operating cost of firms, thereby increasing the profitafter –tax. As the profit-after–tax increase, dividend to shareholders as well as retained profit will rise, the increase in retained profit implies that firms will have more funds for investment purposes.
17
4.0 NATIONAL INCOME DETERMINATION AND THE CONCEPT OF
MULTIPLIER
Equilibrium level of national income: This is the level of national income at which aggregate demand equals the monetary value of all the final goods and services produced in the economy. The equilibrium national income concept is important in macroeconomic analysis because of its relevance in the formulation of economic policies such as anti inflationary policies, employment policies, and economic growth policies and so on. For the determination we consider two approaches—income-expenditure approach or the withdrawalinjection approach. These two approaches are considered in turn.
Income-Expenditure Approach:
Under this approach, the equilibrium national income in an economy is attained at the point where aggregate expenditure (E) equal the national output (Y). the aggregate demand or aggregate expenditure in the economy is represented by
(E), while the national income or the monetary value of all the final goods and services produced in the economy is denoted by (Y). it therefore implies that the equilibrium national income is determined or established at the point where E=Y,
i.e.
( )=
( )
In a 2-sector economy composed of households and firms, the aggregate demand is made up of two basic components—consumption expenditure by the households (C) and investment expenditure by business firms (I). in this regard, the aggregate demand/expenditure in this economy can be written in symbols as: = +
Moreover, in a three sector economy, consisting of households, firms and the government; the aggregate demand can be written as:
=
+ +
While in the four sector economy made up of the households, firms, the government and the foreign sector the aggregate expenditure is:
= + + + −
Where X and M stands for exports and imports respectively. The equilibrium national income therefore is the point at which aggregate demand equals
18
national output in the economy. The equilibrium national income therefore can be written symbolically as:
=
=
=
=
=
+
= + +
+ + +
−
(Two-sector Economy)
(Three-sector Economy)
(Four-sector Economy)
The equilibrium national income is presented graphically in the figure below. It could be observed that in a two-sector economy, equilibrium is established in point , where the 45 line (which is the locus of points equidistant from both axis) intersects the aggregate demand function. The level of national income which corresponds with this point of intersection is
. This level of national income is called the equilibrium national income in a two-sector economy.
The figure also indicates that as the aggregate demand increases, the equilibrium national also increases. For instance, when government expenditure (G) and net export (X-M) is added to the consumption function, the equilibrium national increased to and respectively. The main implication of this exposition is that any increase in policy raises the aggregate demand has the effect of increasing national income in the economy.
19
2.
Injection-Withdrawal Approach
This approach indicates that the equilibrium national income is determined at the point where injections are equal to withdrawals in the economy. Injections are those autonomous components of the aggregate demand that infuse money into the circular flow of income system and they consist of investment, government expenditure and export. Withdrawals, on the other hand, are those flows that take away money from the circular flow of income system. They consist of savings, taxes and imports.
Using the withdrawals-injection approach, the equilibrium national income is attained in either two, three and four-sector economies when:
+
+
+
=
= +
= + +
(Two-sector Economy)
(Three-sector Economy)
(Four-sector Economy)
This can be shown graphically in the figure below. It can be observed that in a two-sector economy, the equilibrium level of national income is determined at the point where investment automatically equals savings (I = S). in a three and four sector economy, on the other hand, equilibrium national income is attained at point and where + = +
+ + = + + respectively. Gap Analysis
It should be observed that equilibrium in the level of national income is only attained at the point where the sum of withdrawals is equal to the sum of injections in the economy. Going by the Keynesian theory, the equilibrium level of national output may not correspond with the full employment level of income.
For instance if the equilibrium level of income (Ye) towards which the economy tends (as indicated in the figure below) is less than the full employment level of income at , withdrawals will be greater than injection (S>I). This implies that the economy will be demand-deficient and there will be deflationary gap. The deflationary gap is the amount by which the aggregate demand must be increased to push the economy to the full employment level.
20
On the other hand, if the equilibrium level of national income is greater than the full employment level of income at , injections will be greater than withdrawals in the economy, aggregate demand will be greater than national output and inflationary gap will occur. The inflationary gap, on the other hand, is the amount by which demand must be reduced to push the equilibrium national income to the full employment level.
Algebraic Approach to Income Determination of Income
Using the 2-sector model
According to Keynes, the national income of a country is determined by the aggregate effective demand (AD) and the aggregate supply (AS). The aggregate effective demand refers to the aggregate expenditure of the society. In a simple economy, aggregate demand consists of two components: Aggregate effective demand for consumer goods (C), Aggregate demand for investment goods, (I).
Thus, the aggregate demand (AD) is given as:
=
=
+
=
(
ℎ
ℎ
−
)
The aggregate supply (AS) refers to the total supply of goods and services in the economy. The aggregate supply of goods and services multiplied by their respective constant prices equals the total value of goods and services (at constant prices). It denotes the real income of the society. Given that in this economic model of without government, taxes are not levied and hence, the total income (Y) becomes the disposable income. The disposable income is divided into two parts which is given as: Consumption (C) and Savings (S). Thus, the aggregate supply function is expressed as:
=
+
National income is determined at a level where aggregate demand (C + I) equals aggregate supply (C + S), i.e., national income reaches equilibrium where:
+ =
Or,
=
+
21
Concepts of Consumption and Savings
In macroeconomic analysis, consumption expenditure refers to expenditures by the household sector on currently produced final goods and services. This definition effectively excludes expenditure on goods and services that were produced in a previous accounting period. Consumption expenditures constitute a key component of aggregate expenditure used in national income determination which in its broadest form can be written in for an open economy as: Y = C + I + G + X – M.
Savings on the other hand is defined as the amount of income per time period that is not consumed by economic units. For the households, it represent that part of disposable income not spent on domestically produced or imported consumption of goods and services. For the firm, it represents undistributed business profits.
A good understanding of the determination of national income requires an understanding of the various concepts of consumption and savings which are:
Marginal Propensity to consume (MPC), Average propensity to Consume (APC),
Marginal Propensity to Save (MPS) and Average Propensity to Save (APS).
Marginal Propensity to Consume (MPC)
The MPC refers to the relationship between change in consumption (∆ ) and the change in income(∆ ). It is expressed as:
=
∆
∆
According to Keynes, the MPC decreases with income. However, we shall assume a constant marginal propensity to consume. For example, suppose that income increases from N200 to N300, and as a result, consumption increases from N250 to N325, thus the change in income∆ = 300 − 200 = 100, while change in consumption is, ∆ = 325 − 250 = 75. Hence the MPC can be expressed as:
∆
75
=
= 0.75
∆
100
Similarly, if income increases from N300 to N400, and consumption expenditure rises from N325 to N400, the MPC is thus expressed as:
=
=
∆
(400 − 325) = 75
=
= 0.75
∆
(400 − 300) = 100
22
Average Propensity to Consume
The APC is defined as the proportion of total income spent on consumer goods and services, i.e.,
=
C = Total consumption expenditure
Y = Total disposable income
Given the consumption function, =
=
=
+
If consumption function is given as;
=
Then,
=
+
, APC can be obtained as:
=
Note: If consumption function is C = bY, (i.e. without the constant term, ‘a’), then;
= =
Marginal Propensity to Save (MPS)
Since what is not consumed is by definition saved, the marginal propensity to save can be defined in a manner analogous to the definition of MPC as the ratio of the change in savings to the change in income. Thus, it is the slope of the savings function and symbolically, it can be written as:
∆
=
∆
Like the MPC, the value of MPS is greater than zero but less than one. Thus:
MPC + MPS = 1
Average Propensity to Save (APS)
APS refers to that proportion of income that is devoted to saving. Since it is the fraction of income that is saved, it is expressed as the ratio of total saving to total income. Calculation of marginal and average propensity to consume
Yr
1980
1985
1990
1995
2000
Y
(Income)
(‘000)
10
20
30
40
50
C
(Consptn.)
5,000
12,500
20,500
29,000
38,000
S
(Saving)
5,000
7,500
9,500
11,000
12,000
APC
0.50
0.63
0.68
0.73
0.76
23
APS
0.50
0.38
0.32
0.28
0.24
∆Y
10
10
10
10
∆C
7,500
8,000
8,500
9,000
DS
2,500
2,000
1,500
1,000
MPC
0.75
0.80
0.85
0.90
MPS
0.25
0.20
0.15
0.10
From the table above, it can be inferred that:
+
=1
+
=1
Given the second equation, i.e. MPC + MPS = 1, then,
=1−
,
,
=1−
Relationship between Income and Consumption
The relationship between income and consumption is generally expressed through consumption function.
Consumption Function
The private demand for goods and services account for the largest proportion of the aggregate demand in an economy and play a crucial role in the determination of national income. The functional relationship between aggregate consumption demand and the aggregate disposable income is expressed through a consumption function expressed as:
=
=
=
=
=
+
− . . ℎ
The slope of the consumption function gives the MPC and this can be derived mathematically as follows:
Given that:
= +
+∆ = + ( +∆ )
= ++ + ∆ and ∆ = − + +
+ ∆ substitute ∆ =( +
∆ = ∆
Hence,
∆
=
∆
+
)+
+
, we get;
+ ∆
According to Keynesian theory of consumption, = is always less than unity,
∆
but greater than zero, i.e. 0 < < 1. This fundamental relationship between
∆
24
income and consumption plays a crucial role in the Keynesian theory of income determination. From our consumption function, if the autonomous consumption
‘a’ is N3000.00 and assuming the marginal propensity to consume ‘b’ is 0.75, then the total consumption at various level of income can be shown in the table as follows: Income N
(Y)
5,000
10,000
15,000
20,000
25,000
Autonomous consumption N (a)
3,000
3,000
3,000
3,000
3,000
Workings:
C = a + bY
C = 3,000 + 0.75(5,000)
C = 3,000 + 0.75(10,000)
C = 3,000 + 0.75(15,000)
C = 3,000 + 0.75(20,000)
C = 3,000 + 0.75(25,000)
Total
Consumption
6,750
10,500
14,250
18,000
21,750
SAVING FUNCTION
Like consumption function, saving (S) is the function of income (Y), i.e., = ( )
Since Y = C + S, consumption and saving functions are counterparts of one another. Therefore, if one of these functions is known, the other can be easily obtained. For example, if consumption function is given as C = a + bY, then saving function can be derived as follows. we know that:
=
−
Substitute for a + bY for C in the above equation.
= −( + )
= − + (1 − )
This gives the saving function in which ‘1-b’ is the marginal propensity to save
(MPS). The slope of the saving function is negative because, there is no income, that is the level of savings when Y = 0. The MPS can be proved as follows:
Since
= +
∴∆ =∆ +∆
Dividing both sides by ∆ , we get;
∆
∆
1=
+
∆
∆
Or
∆
∆
=1−
∆
∆
Hence,
25
=
∆
=1−
∆
Numerical Example: Let consumption function be given as:
= 100 + 0.75
Saving function can be derived as follows:
= −
∴ = − (100 + 0.75 )
= − 100 − 0.75
= −100 + (1 − 0.75)
= −100 + 0.25
Savings at various level of income
Since the MPC is 0.75 derived from our earlier consumption function, then the
MPS will be 0.25, i.e. 1 – 0.75 = 0.25. With this information and using the same levels of income in our earlier table, the various levels of income can be calculated as follows:
Income N
Autonomous
(Y) consumption N (a)
5,000
3,000
10,000
3,000
15,000
3,000
20,000
3,000
25,000
3,000
Workings:
S =- a + bYd
S = -3,000 + 0.25(5,000)
S = -3,000 + 0.25(10,000)
S = -3,000 + 0.25(15,000)
S = -3,000 + 0.25(20,000)
S = -3,000 + 0.25(25,000)
Total Savings
-1,750
-500
750
2000
3250
In the analysis of national income determination, it also shows that total expected sale proceeds, i.e., the value of the total planned output. The schedule C
= 100 + 0.75Y gives the income-consumption relationship—consumption being a linear function of income. The schedule S = -100 + 0.25Y is the saving schedule derived from the consumption schedule. The saving schedule shows the incomesaving relations.
Investment Function
Unlike consumption and saving, the investment function is assumed to be autonomous. This means that the investment function is independent of changes in the disposable income. Although investment is affected by several factors such as interest rates, businessmen expectation, political stability, etc, these factors are not determined within the circular flow of income system. The investment function can therefore be written as:
I = I0
26
Graphical analysis of consumption savings and investment functions
The consumption, savings and investment functions considered above can be represented graphically. The slope of the consumption and savings function depend on the marginal propensity to consume and save out of the level of disposable income respectively. As the disposable income changes at a given marginal propensity to consume and save, consumption and savings function also change. Using the information in consumption and savings table derived above, the functions are graphically represented as follows:
Consumption Function
25,000
Consumption
20,000
15,000
10,000
5,000
0
5,000
10,000
15,000
Disposable Income
27
20,000
25,000
Savings Function
4,000
3,000
Savings
2,000
1,000
0
5,000
10,000
15,000
20,000
25,000
-1,000
-2,000
Disposable Income
Equilibrium level of national income:
This is the level of national income at which aggregate demand equals the monetary value of all the final goods and services produced in the economy. The equilibrium national income concept is important in macroeconomic analysis because of its relevance in the formulation of economic policies such as anti inflationary policies, employment policies, and economic growth policies and so on. For the determination we consider two approaches—income-expenditure approach or the withdrawal-injection approach. These two approaches are considered in turn.
1. Income-Expenditure Approach:
Under this approach, the equilibrium national income in an economy is attained at the point where aggregate expenditure (E) equal the national output (Y). the aggregate demand or aggregate expenditure in the economy is represented by
(E), while the national income or the monetary value of all the final goods and
28
services produced in the economy is denoted by (Y). it therefore implies that the equilibrium national income is determined or established at the point where E=Y,
i.e.
( )=
( )
In a 2-sector economy composed of households and firms, the aggregate demand is made up of two basic components—consumption expenditure by the households (C) and investment expenditure by business firms (I). in this regard, the aggregate demand/expenditure in this economy can be written in symbols as: = +
Moreover, in a three sector economy, consisting of households, firms and the government; the aggregate demand can be written as:
=
+ +
While in the four sector economy made up of the households, firms, the government and the foreign sector the aggregate expenditure is:
= + + + −
Where X and M stands for exports and imports respectively. The equilibrium national income therefore is the point at which aggregate demand equals national output in the economy. The equilibrium national income therefore can be written symbolically as:
=
=
=
=
=
+
= + +
+ + +
−
(Two-sector Economy)
(Three-sector Economy)
(Four-sector Economy)
The equilibrium national income is presented graphically in the figure below. It could be observed that in a two-sector economy, equilibrium is established in point , where the 45 line (which is the locus of points equidistant from both axes) intersects the aggregate demand function. The level of national income which corresponds with this point of intersection is . This level of national income is called the equilibrium national income in a two-sector economy.
29
The figure also indicates that as the aggregate demand increases, the equilibrium national also increases. For instance, when government expenditure (G) and net export (X-M) is added to the consumption function, the equilibrium national increased to and respectively. The main implication of this exposition is that any increase in policy raises the aggregate demand has the effect of increasing national income in the economy.
2.
Injection-Withdrawal Approach
This approach indicates that the equilibrium national income is determined at the point where injections are equal to withdrawals in the economy. Injections are those autonomous components of the aggregate demand that infuse money into the circular flow of income system and they consist of investment, government expenditure and export. Withdrawals, on the other hand, are those flows that take away money from the circular flow of income system. They consist of savings, taxes and imports.
Using the withdrawals-injection approach, the equilibrium national income is attained in either two, three and four-sector economies when:
+
+
+
=
= +
= + +
(Two-sector Economy)
(Three-sector Economy)
(Four-sector Economy)
30
This can be shown graphically in the figure below. It can be observed that in a two-sector economy, the equilibrium level of national income is determined at the point where investment automatically equals savings (I = S). in a three and four sector economy, on the other hand, equilibrium national income is attained at point and where + = +
+ + = + + respectively. Gap Analysis
It should be observed that equilibrium in the level of national income is only attained at the point where the sum of withdrawals is equal to the sum of injections in the economy. Going by the Keynesian theory, the equilibrium level of national output may not correspond with the full employment level of income.
For instance if the equilibrium level of income (Ye) towards which the economy tends (as indicated in the figure below) is less than the full employment level of income at , withdrawals will be greater than injection (S>I). This implies that the economy will be demand-deficient and there will be deflationary gap. The deflationary gap is the amount by which the aggregate demand must be increased to push the economy to the full employment level.
On the other hand, if the equilibrium level of national income is greater than the full employment level of income at
, injections will be greater than withdrawals in the economy, aggregate demand will be greater than national output and inflationary gap will occur. The inflationary gap, on the other hand, is the amount by which demand must be reduced to push the equilibrium national income to the full employment level.
Change in Aggregate Demand and the Multiplier
A change in aggregate demand is caused by a change in either consumption expenditure or in investment, or in both. In the Keynesian theory of income determination, however, consumption expenditure is a function of income: it
31
does not change unless income changes, whereas investment is exogenously determined. Therefore, a change in aggregate demand function is assumed to be caused by a change in investment. A change in investment may be in the form of a decrease or an increase in it. However, we are assuming an increase in investment and an upward shift in the investment schedule. The figure below illustrates an upward shift in the investment schedule from I to I + I, causing an upward shift in the aggregate demand function from C + I to C + I + I.
As shown in the figure, prior to the increase in investment, the aggregate demand schedule (C+I) intersected the aggregate supply schedule (C+S) at point E 1. That is, the economy was in equilibrium at point E1 where Y = OY1 = C+S = C + I = E1Y1.
When investment increases from I to I + I, as shown by upward shift in the Ischedule, it causes an upward shift in the aggregate demand schedule from C = I to C + I + I. Due to upward shift in the aggregate demand schedule, the equilibrium point shifts from E1 to E2 and, as a result, national income increases from OY1 to OY2. At this point, the increase in national income implies that E 1 represented a less than full employment situation. It is only under this condition that equilibrium point E1 can shift to point E2. The increase in the national income (Y) can be obtained as: Y = Y2-Y1.
This increase in income (Y) is the result of I. it may be seen in the above figure that Y>I. It means that when I takes place, the resulting Y is some multiple of I. the multiple (m) can be obtained as:
32
∆
∆
m is the investment multiplier.
=
The Simple Model of Multiplier
The multiplier model presented below answers the questions: Is there a definite relationship between Y and I? if yes, what determines this relationship?
These questions can be answered by working out mathematical relationship between Y and I. This is presented as follows:
Given that equilibrium level of income is:
=
+ -------------------------------------------------------(1)
Now let there be a I. when I takes place it results in Y and Y induces C.
Thus, the post-I equilibrium level of income equals:
+∆ =
+ ∆ + + ∆ -------------------------------------------(2)
Subtracting equation 1 from 2 gives:
∆ = ∆ + ∆ ---------------------------------------------------------(3)
Given the consumption function as C = a + bY
∆ = ∆ ----------------------------------------------------------------(4)
Substituting (4) into (3) gives:
∆ = ∆ + ∆ -----------------------------------------------------------(5)
∆ (1 − ) = ∆
∆ =
1
∆
1−
∆
1
=
∆
1−
=
Given that = expressed as:
=
∆
∆
=
=
and 1 −
=
=
therefore, multiplier (m) can also be
-------------------------------------------------(6)
The last term in equation 6 above indicates that m = reciprocal of MPS.
33
Alternate way of deriving the multiplier
This can be derived by subtracting a pre-I position from a post-I position (Y2Y1). Thus, given:
=
+
While C = a + bY1, the pre-I equilibrium level of income (Y1) may be rewritten as: =
+
+ -------------------------------------------------------------------(7)
1
=
( + )
1−
Similarly, at post-∆ equilibrium, Y2.
= + + ∆ ------------------------------------------------------------------------(8)
= +
+ +∆
=
( + + ∆ ) -----------------------------------------------------------(9)
By subtracting equation 8 from 9, we have;
1
1
( + +∆ )−
∆ =
( + )
1−
1−
∆ =
∆ --------------------------------------------------------------------(10)
Equation 10 yields the relationship between Y and I, that is Y equals 1/(1-b) times I. therefore, 1/(1-b) is the multiplier (m). Thus,
1
( )=
1−
Numerical Example:
Given that Y = C + I, where C = a + bY; = 100 + 0.75Y; and I = 200. Find the equilibrium level of national income and compare it to a new level of income if the investment spending increases to 300 thereby obtaining the investment multiplier. = 100 + 0.75 + 200
− 0.75 = 300
300
=
= 1200
0.25
34
When Investment increased to a new level of 300, then new equilibrium Y2 is derived as:
= 100 + 0.75 + 300
− 0.75 = 400
=
400
= 1600
0.25
From here:
∆ =
∆ =
−
−
= 1600 − 1200 = 400
= 300 − 200
( )=
= 100
∆
400
=
=4
∆
100
It may be concluded that if MPC = 0.75, the multiplier (m) equals 4. It implies that if m = 4, then any additional investment will generate an additional income equal to four times of ∆ . The value of the multiplier is determined by the size of the
MPC, i.e.
1
=
1−
Mathematical Derivation of the Equilibrium level of National Income
Example: Given that in a two sector economy,
=
=
=
+
+
Equilibrium is derived by substituting C and I into Y as follows:
=
−
+
+
= +
+
1
=
=
( +
1−
1−
)
The example above illustrates the derivation of equilibrium level of national income in a two sector economy. In an attempt to extend the model to three sector economy, we assume that apart from households and the business firms,
35
the economy is also composed of the government. Since households and business firms can save and invest, the government also imposes taxes on the households and the business firms. government imposes taxes so as to provide some basic functions such as infrastructural facilities, education etc., in the economy. In view of the above, assuming the government adopts proportion tax system and the tax rate is denoted by t, the equilibrium national income in a three sector economy can therefore be derived as follows:
Given that:
= + +
= +
=
=
= −
=
Hence, substituting, T, G, I, Yd and C into Y, we have:
=
=
+ ( −
+
)+
+
+
+
+
Re-arranging by putting all the Ys on one side:
[1 − (1 − )] =
+
+ 0+ 0
=
1 − (1 − ) or 1
=
( +
1 − (1 − )
The term
(1
)
+
0
+
+
0
+
)
is the multiplier in this economy. It could be observed that as
government imposed taxes in this economy, the multiplier is smaller relative to that in a two sector economy.
1
1
Following similar procedures as in the two and three sector economy, the equilibrium in a four sector economy can also be derived mathematically.
Given that:
= + + + − ,
= 0, = defined in the three sector economy.
0
36
while C, I, and G are as previously
Show that equilibrium level of income is:
1
=
( + 0 + 0 + 0 − 0)
(1 − )
1−
Practice questions
Suppose consumption is 40 + 0.75 , and investment is N60. (a) find equilibrium output, and consumption and saving at equilibrium. (b) show that at equilibrium spending equals output and saving leakages equal investment injections. Suppose consumption is 50 + 0.85 ; = 80;
= . Since there is no government sector, (a) derive an equation for the saving function, (b) find the equilibrium output by equating saving leakages and investment injections.
Given that = 20 + 0.80 , = 90, = 20,
= − ,
=
−
,
=0
0 = 10. (a) Find the equilibrium output, (b) find consumption and saving at equilibrium output. (c) Show the equality of leakages and injections from the spending flow at equilibrium (d) How is the N20 government expenditure financed? TN = Net tax revenues, TX = Gross Tax revenue, TR =
Transfers.
37
CONSUMPTION AND INVESTMENT THEORIES
Consumption and investment are very important aggregates in macroeconomics.
Indeed, they both play crucial roles in the determination of equilibrium level of income and employment. A change in any one of them will cause the level of national income to change through the multiplier effect. Therefore, there is the need to examine and analyze the determinants of these aggregate variables in order to design adequate macroeconomic policies that will bring about full employment and accelerated economic growth.
Theories of Consumption
Both consumption theory and knowledge of consumption function have come a long way since Keynes introduced the notion of consumption function in his
General Theory. Consumption can simply be defined as the spending by household on goods and services that yield utility in the current period. When all individual consumption is summed together we then have aggregate consumption. In other word, consumption is defined as that part of disposable income that is not saved, since income is either saved or spent (C= Yd –S). The question then is what determines the amount expended on goods and services in the whole economy? This question leads us to our discussion of consumption theory. Consumption Theory or function simply indicates these factors that determine aggregate consumption or demand and the relationship that exist between them. There are four types of consumption theory and each indicates those factors that are assumed to impact on aggregate consumption spending.
These theories of consumption are:
1. Absolute Income Hypothesis (AIH) by J.M Keyens
2. Permanent Income Hypothesis (PIH) by Milton Friedman
3. Relatives income (RIH) by J.S Deusenberry
4. Life cycle (LCH) by A.Ando, F. Modigliani.
1. The Absolute Income Hypothesis
The absolute-income theory of consumption is linked to the basic principle of
Keynes’ theory of consumption. This theory is based on a fundamental psychological law which states that “men are disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much as the increase in their income”. That is, ∆ ⁄∆ is positive and less than unity. Based on this law, the absolute-income theory of consumption hypothesizes that current consumption expenditure depends on the current and absolute level of income. Formally, the absolute income theory of consumption can be stated as current consumption is the function of the current income i.e.
=
(
)
38
Where: C = current consumption, and Y = current income.
The main properties of the Keynesian consumption function can be summarized as follows:
i.
ii.
iii. iv. The real consumption expenditure is a positive function of the real current disposable income. This property makes the absolute income hypothesis a short-run theory.
The marginal propensity to consume (MPC) ranges between zero and 1,
i.e. 0 <
< 1 (0 and 1 included).
The MPC is less than the average propensity to consume (APC), that is,
∆ ⁄∆ < /
The MPC declines as income increases, that is, less and less of an equivalent marginal income is consumed.
An additional factor that Keynes adduced to increase in consumption is the increase in wealth of the households. However, the first two properties are essential for the Keynesian theory of consumption, but not the latter two. In fact, property (iii) has been abandoned by the Keynesians on the ground that it does
∆
not stand the empirical test. The Keynesians hold that APC = MPC, i.e. = .
∆
The absolute-income theory of consumption is illustrated in the figure below.
The 450 line (C=Y) shows a hypothetical relationship between income and consumption, i.e., current consumption expenditure always equals the current income. It implies that if Y = 0, then C = 0. This is not a realistic proposition. For, people do consume even when their income equals zero.
39
Another feature of consumer behavior is that when income increases, people do not spend their entire incremental income on consumption. They save a part of it for their financial security during the period of unemployment, illness, death of the bread winner, or for investment to enhance their future income. The overall consumer behavior is shown by the curve C1. The curve C1 delineates Keyne’s absolute-income theory of consumption. As the curve C1 shows, consumption expenditure exceeds the current income up to a certain level of income (say Y =
N10,000). At point B, income and consumption break-even. Beyond point B, consumption expenditure increases with the increase in income but at a slower pace. Note that the slope of the curve C1 goes on diminishing with increase in income. The empirical analysis in subsequent years of Keynes theory revealed that MPC was of stable nature. In other words, the studies carried out later by the
Keynesians found a straight-line relationship between consumption and income.
The straight consumption function of the following form gives the absoluteincome hypothesis
=
+
Where a = intercept showing consumption at the zero level of income, and b stands for MPC. This consumption function is represented by C2 in our diagram above. The slope of C2 is a constant one given as b.
2. The Relative Income Hypothesis
Given the apparent contradictions observed between theory and empirical evidence, many economists embarked on several studies to reconcile the contradiction. The first attempt in this direction was Duesenberry in the late
1940s and, in the process, he propounded the relative income theory of consumption, also known as the Relative Income Hypothesis. This theory is based on the assumptions that (1) the consumption behavior of individuals is interdependent and not independent; and (ii) consumption relations are irreversible over time.
Duesenberry believes that a good understanding of the consumer behavior must incorporate the social character of consumption patterns. By social character, he means the tendency in human beings not only to keep up with the Joneses, but also to surpass the Joneses. In other words, the tendency is to strive constantly toward a higher consumption level and to emulate the consumption patterns of one’s rich neighbors and associates.
Thus consumers’ preferences are interdependent. It is, however, differences in relative incomes that determine the consumption expenditures in a community. A rich person will have a lower
APC because he will need a smaller portion of his income to maintain his consumption pattern. On the other hand, a relatively poor man will have a higher
40
APC because he tries to keep up with the consumption standards of his neighbor or associates. This provides the explanation of the constancy of the long-run APC because lower and higher APCs would balance in the aggregate. Thus even if the absolute size of incomes in a country increases, the APC for the economy as a whole at the higher absolute level of income would be constant.
The second part of the theory is the past peak income hypothesis which explains the short-run fluctuations in the consumption function and refutes the Keynesian assumption that consumption relations are reversible. The hypothesis states that during a period of prosperity, consumption will increase and gradually adjust itself to a higher level. Once people reach a particular peak income level and become accustomed to this standard of living, they are not prepared to reduce their consumption pattern during a recession (what Duesenberry calls, the Ratchet Effect.).
Thus, as income falls, consumption declines but proportionately less than the decrease in income because the consumer di-saves to sustain consumption. On the other hand, when income increases during the recovery period, consumption rises gradually with a rapid increase in saving.
Duesenberry combines his two related hypothesis in the following form:
=
+
Where C and Y are consumption and income respectively, t refers to the current period and the subscript (0) refers to the previous peak, a is a constant relating to the positive autonomous consumption and b is the consumption function. In this equation, the consumption-income ratio in the current period (Ct/Yt) is regarded as function of Yt/Y0, that is, the ratio of current income to the previous peak income. If this ratio is constant, as in periods of steadily rising income, the current consumption income ratio is constant. During recession when current income (Yt) falls below the previous peak income (Y0), the current consumption income ratio (Ct/Yt) will increase.
3. The Permanent Income Hypothesis (Milton Friedman)
This hypothesis was developed by Milton Friedman. It rests on the fact that consumption does not depend on the current disposable income (as in AIH) rather, it depends on some measure of expected or permanent income i.e.
= ( ) Where Yp is a measure of permanent income
According to this theory, consumption will not fall drastically even if for some reasons, peoples’ income fall below what they think their permanent income should be. Conversely, consumption will not rise very significantly if peoples’ income suddenly exceeds the level considered permanent. Thus, the permanent
41
income hypothesis states that the level of consumption will remain fairly stable every time. It is only when permanent income increases that consumption will increase and vice versa. Consumption level therefore depends on permanent income and that people do not change their consumption patterns in response to: every change up or down in their income receipts.
Permanent income is defined as the present value of the expected flow of income from the existing stock of both human and non-human wealth over long period of time. Friedman pointed out that current measure of Income for a household or for the whole economy could be greater or lesser than the permanent income.
The difference between these two is referred to transitory income which is regarded as temporary unexpected rise or fall in income. Consequently,
=
=
=
=
+
=
=
=
=
=>
=
−
+
Friedman also divided consumption into permanent and transitory consumption.
Permanent consumption is defined as the planned level of spending out of permanent income while transitory consumption is any unplanned or temporary increase or decrease in consumption spending. Combining the two concepts together, we then have;
Friedman also makes an important assumption about transitory consumption:
Transitory consumption is neither correlated with permanent income nor transitory income. Thus, transitory income is completely random. With this assumption, the basic consumption function in a permanent income hypothesis is expressed as:
=
That is, Permanent Consumption is a multiple (K) of permanent income. The relationship between consumption and permanent income can also be illustrated graphically as shown below.
42
From the diagram, CL is the long-run consumption function which represents the long-run proportional relationship between consumption and income of an individual. Over the long-run, transitory components of both variables cancel out and there is proportional relation between the permanent components. Cs is the non-proportional short-run consumption function where measured (current) income includes both permanent and transitory components. At OY0 income level where Cs and CL lines coincide at E0, changes in permanent income and measured income are identical, and so are permanent and measured consumption as shown by OC0. Here transitory factors are non-existent.
If we move to the left of point E0 on the CS curve at E3, the measured income declines to OY3 due in part to the negative transitory income component. Since permanent income at OY4 is higher measured income at OY3, permanent consumption will remain at OC3 and equal measured consumption.
On the other hand, a movement to the right of point E0 on the Cs curve at E1 shows measured income to be OY1 and measured consumption as OC2. But OC2 level of consumption can be maintained permanently at the permanent income level of OY2. Thus Y1Y2 is the positive transitory income component in measured income OY1 which is higher than the permanent income OY2.
43
4. The Life Cycle Hypothesis
Ando and Modgliani have formulated a consumption function which is known as the Life Cycle Hypothesis. According to this theory, consumption is a function of lifetime expected income of the consumer. The consumption of the individual consumer depends on the resources available to him, the rate of return on capital, the spending plan, and the age at which the plan is made. The present value of his income (or resources) includes income from assets or property and from current and expected labour income.
The aim of the consumer is to maximize his utility over his lifetime which will, in turn, depend on the total resources available to him during his lifetime. Given the life-span of an individual, his consumption is proportional to the resources.
But the proportion of resources that the consumer plans to spend will depend on whether the spending plan is formulated during the early or later years of his life.
As a rule, an individual’s average income is relatively low at the beginning of his life and also at the end of his life. This is because in the years of his life he has little assets, and during the late years his labour income is low. It is, however, in the middle of his life that his income, both from assets and labour, is high. As a result, the consumption level of the individual throughout his life is somewhat constant or slightly increasing, shown as the CC1 curve in the figure below.
Y0YY1 curve shows the individual consumer’s income stream during his lifetime
T. during the early period of his life represented by T1 in the figure, he borrows
CY0B amount of money to keep his consumption level CB which is almost constant. In the middle years of his life represented by T1T2, he saves BSY
44
amount to repay his debt and for the future. represented by T2T, he di-saves SC1Y1 amount.
In the last years of his life
The main difference between the lifecycle hypothesis (LCH) and permanent income hypothesis (PIH) is that the former explicitly considered the role of asset accumulation and the effect of age on household consumption.
THEORIES OF INVESTMENT/INVESTMENT DEMAND FUNCTIONS
1. Introduction
Investment is an important component of aggregate demand. It can also be argued that fluctuations in economic activities or business cycles can partly be fluctuations in investment. Under national income determination in previous chapter, investment was treated as autonomous (i.e. its value is not determined within the model and therefore it is independent of any macroeconomic variable or factor including current income level. In this section, investment is no longer taken as given from outside the model but we need to adequately analyze investment model by identifying those factors that determine or influence its level in an economy as well as the role attributable to each one of them
2. Investment Demand
Investment decisions are made by firms or private investors with the motive of making profits. Firms add to their existing plants and equipment because they foresee profitable opportunities to expand their output or because they can reduce costs by moving to more capital-intensive production methods. For instance, when an organization needed new-equipment, it developed new products for the company through investments spending. In this case, the firm has to weigh the benefits (returns) from new plant or equipment (i.e. increase in profits) against the cost of investment.
Aggregate /total investment includes spending or the flow of expenditure devoted to projects to produce goods which are not intended for immediate consumption. It includes investment in factory building, machinery, houses, etc.
Expenditure of firms on these items and many like them are regarded as investment. Investment project may also take the form of addition to both physical and human capital as well as inventory. Inventory refers to the stock of goods or resources held by firms to enable them meet temporary and unexpected fluctuations in their production or sales.
Total investment in an economy during a specific period is referred to as gross investment. However, in national income accounting, it is net investment (i.e gross investment less depreciation) that actually account for the level of
45
investment in an economy. Net investment measures the actual increase in the productive capacity in an economy.
Net investment (NI) = GI - depreciation
Investment decisions pertain to whether or not to undertake an investment project; how to make choice between competing investment projects; and how to find optimum level of investment. There are several methods of investment decision making. We shall however explain the role of (i) the Net Present Value
(NPV) and (ii) the Marginal Efficiency of Capital (MEC) in this course.
i.
The Net Present Value (NPV) Method
The NPV method is one of the popular methods of taking decision on investment projects. The net present value (NPV) is defined as the difference between the present value (PV) of a future income stream and the costs of investment (C).
That is:
=
−
The PV of a future income is the discounted value of the income expected at a future date. The future income is discounted at the market rate of interest. The need for discounting future income arises because money has a time value. The time value of money means preference for an amount of money today to the same amount at some future date. For example, N1000 today is always preferable today to N1000 after one year or some future time period. The PV of an income receivable after one year is obtained by a discounting formula given below. =
1+
=
1
1+
The amount of income receivable in the nth year can thus be given as:
=
(1 + )
=
(1 + )
1
R = amount expected after one year, i = rate of interest.
The market rate of interest is regarded as the opportunity cost or the time value of money. To compute the Total Present Value of a stream of income, the formula below is used.
=
(1 + )
+
(1 + )
+
(1 + )
+ ⋯+
46
(1 + )
=
(1 + )
Given the formula for the TPV, the Net Present Value is thus given as follows:
=
(1 + )
−
Where C is the total investment cost. Hence, if:
≥0 ,
ℎ
1000
Hence, the project is accepted since the discounted value is higher than the cost. ii. The Marginal Efficiency of Capital (MEC)
Keynes suggested an alternative method of investment based on what he called
Marginal Efficiency of Capital (MEC). This is also known as Internal Rate of
Return (IRR). MEC is defined as the rate of discount which makes the discounted present value of expected income stream equal to the cost of the capital. If for
47
example the cost of an investment project is C and it is expected to yield a return
R for one year, then MEC can be found as follows:
=
=
1+
Where, r is the rate of discount that makes the discounted value of R equal to C.
Therefore the value of r is the marginal efficiency of capital or the internal rate of return. If a capital project costing C is expected to generate an income stream over a number of years as R1, R2, R3, …Rn, then MEC of the project can be computed by using the formula:
=
(1 + )
+
(1 + )
+
(1 + )
+ ⋯+
(1 + )
Using our earlier example, we’ll try 20.27 per cent rate of discount.
1000 =
500
400
300
200
100
+
+
+
+
(1 + 20.27) (1 + 20.27)2 (1 + 20.27)3 (1 + 20.27)4 (1 + 20.27)5
1000 =
500
400
300
200
100
+
+
+
+
(1.2027) (1.2027)2 (1.2027)3 (1.2027)4 (1.2027)5
= 415.73 + 276.53 + 172.44 + 95.59 + 39.74 = 1000.03
Hence, 20.27% is the discount rate for this project.
Decision Rule:
> ,
= ,
−
< ,
ℎ
ℎ
ℎ
Derivation of the MEC Schedule
We have just described investment decision rule when a single project is involved. We now describe how total investment decision is taken when a firm has a number of possible investment projects to select from. Suppose a profitmaximizing firm having a large amount of investable funds is considering four investment projects—Project 1: setting up of a new production unit; project 2: expansion of the existing production plant; Project 3: modernization of the production plant; and Project 4: construction of a new building. In this case, the firm will have to work out the MEC of the different projects and list them in order
48
of their MEC. Suppose the cost of each of these projects is given in the table below: Projects
Project 1
Project 2
Project 3
Project 4
Cost of MEC (%)
Projects (N million) 100
25
100
18
100
15
100
10
This information can be presented in the form of a diagram as shown in the figure below. In this figure, the vertical axis measures the MEC and the horizontal axis shows investment cost cumulatively. The MEC of each project is shown in the form of a bar-diagram in its decreasing order.
When the top of the bars are joined by a solid line, it gives a stair-like MEC schedule. The stairs-like MEC schedule is the result of a small number of projects presented in the above figure. If a firm is considering a large number of investment projects of varying MEC and cost of capital and if they are all plotted together, the stairs like formation of the MEC schedule will get evened out and it will produce a smooth MEC schedule as shown in the figure below. The MEC schedule gives the investment demand schedule of an individual firm.
49
This figure shows the relationship between the market rate of interest and the investment demand under the investment rule that i = MEC. Given the MEC schedule, when the market rate of interest is Oi3, the profit maximizing investment demand is limited to OK1. And, when market rate of interest decreases from Oi3 to Oi2, the demand for capital increases to OK2 and when the interest rate falls to Oi1, investment demand increases to OK3. Thus, given the
MEC schedule and the market rate of interest, firm’s demand for capital can be easily known. It may thus be concluded that the MEC schedule represents the investment demand schedule for an individual firm.
The Accelerator Theory Investment
The accelerator theory of investment describes the technological relationship between the change in capital stock and the change in the level of output. The technological relationship between capital and output is defined as capitaloutput ratio, that is, ∆ ⁄∆ . Suppose that the demand for firm’s output in period t is given as Yt and firms use capital stock Kt to produce Yt. Denoting capital-output ratio (K/Y) by k, the relationship between capital stock (Kt) and the output (Yt) can be expressed as:
=
-------------------------------------------------------------------(1)
If the demand for output increase in period t+1 to Yt demand for output may be expressed as:
∆
=
−
+ 1.
The increase in the
----------------------------------------------------------(2)
The firm will hence be required to increase their desired capital stock of capital in period t+1 to produce an additional output of ∆
Given the capital-output
), the desired capital stock ratio (k) and the additional demand for output (∆ in period t+1 is given as:
=
-------------------------------------------------------------------------(3)
The change in capital stock (∆ be obtained as given below:
) in response to the change in output (∆
50
) can
∆
(4)
−
1
= (
=
(∆
−
)
1 )----------------------------------------------------------------------
We know that ∆
=
(
∆
=
1 . Hence, equation (4) can be re-written as;
1
=
(∆
1)
).
Therefore,
Equation (4) states the accelerator theory of investment. It reveals that the investment is a function of the change in the level of income (or output). The conclusions that follow from equation 4 can be stated as follows:
> 0, ℎ
1−
1 > 0
= 0, ℎ
1−
1 = 0
< 0, ℎ
1−
1 < 0
The implication of the accelerator theory expressed in equations (4) can be summarized as follows:
(1)When income is constant, investment is not necessary and firms will only concern themselves with the maintenance of the existing capital stock rather than expanding their stock of capital.
(2)If income is rising, it is necessary to invest in new plant and machinery in order to expand the existing capacity produce.
(3)In order to maintain the level of net investment, demand for firms’ products must be rising at a steady rate.
(4)Net investment is desirable if and only if aggregate demand is increasing at an increasing rate.
(5)New investment is a multiple of a change in output i.e.
= ∆ , i.e.
(. . accelerator coefficient multiplies by change in
=
−
)
(6)If aggregate demand remains unchanged, net investment will be zero.
Criticisms against Accelerator Principle
The accelerator theory has been criticized on certain grounds. The working of the accelerator principle rests on some assumptions and these assumptions provide the basis upon which the theory is criticized or attached.
(i)
The first assumption is that the existing stock of capital is fully utilized.
This assumption may not be true for all firms in an economy. If excess capacity exists in an economy the principle breaks down because
51
(ii)
(iii)
(iv)
additional output can be supplied from the existing capacity without necessarily incurring new investment spending.
The next assumption is that firms always alter their capacity to meet every change in demand. While firms may want to increase the capital stock when demand rises, they may be unwilling to divest as quickly when demand declines especially when the fall in aggregate demand is expected to be temporary.
The theory assumes that there is no time lag between the time investment decision is made and the time when acquisition of capital goods is done. Since capital investment is of long-term in nature, firms will examine their experience over a long period of time and in some cases will act on the basis of future expectation of demand profits.
The accelerator principle gives no consideration to the cost of capital
(real interest rate) as a factor influencing investment spending. The theory simply assumes that firms have unlimited fund to carryout its investment or expansion projects but this is not so.
Investment Model:
In economic theory, several factors affecting the level of investment have been identified. Empirical investigations have also shown that most of these factors, indeed, can be used to explain the aggregate investment spending in an economy.
These factors include:
(i)
(ii)
(iii)
(iv)
(v)
The rate of interest (r): The relationship between investment and rate of interest is a negative one. The rate of interest is the cost of capital and so the higher the cost of capital the lower the willingness to invest and vice versa.
The income level changes in Aggregate demand (∆Y): The relationship between investment and the change income in an economy is a positive one. The higher the income, the higher the level of aggregate investment and vice versa
Investors expectation about future economic activities (e): Investment is strongly influenced by businessmen’s expectation of future economic activities in the following ways: if investors are optimistic about future economic activities, the level of investment will increase but if they are pessimistic or skeptical about future economic activities, the level of investment would fall.
Political situation (P): If the political climate of a country is conducive or stable, the investment will rise while in a country characterized by political instability, investors will not be encouraged to invest. They may even withdraw their capital (divest).
Government fiscal action/policy: An expansionary fiscal policy which reduces the tax rate has the effect of reducing the operating cost of
52
firms, thereby increasing the profit-after-tax. As the profit-after-tax increases, dividends to shareholders as well as retained profit will rise.
The increase in retained profit implies that firm will have more funds for investment purpose. Apart from its effect on the operating costs of firms, expansionary fiscal policy which increases the level of government expenditure will increase the future demand for output. As businessmen expect future increase in output, they will increase their spending in investment goods. For contractionary FP, the opposite is the case.
(vi) Government Monetary Policy: An expansionary monetary policy by the central bank or monetary authority will affect the level of investment via the interest rate. Increase in money supply relative to money demand brings about a fall in interest rate. As interest rate falls, the cost of capital reduces thereby stimulating investment. For a contractionary (MP) the opposite is the ease.
(vii) Rate of Inflation: As the general price level is increasing, investors’ profit increase. As profit increases, businessmen would invest more.
The opposite is the case if the general price level is falling.
Taking all these factors together the aggregate investment function becomes:
= (∆ , , ,
=
∆ = ℎ
=
∗
,
, , )
=
=
=
∗
=
53
Definition of money
MONEY AND BANKING SYSTEM
Conceptually, money can be defined as any commodity that is generally acceptable as a medium of exchange and a measure of value. This is the conventional definition of money and it emphasizes the basic functions of money which are; the medium of exchange and measure of value. Going by these functions, money is defined by what it does. If one looks back into the history of money, one finds many kinds of commodities—cattle (cow, ox, horse, pig, goat), grains, stones, cowries shells, cigarette, metals (copper, brass, silver and gold), dried fish, coffee, leather, etc. have served as a medium of exchange and a measure of value at different stages of human civilization and in different parts of the world.
The commodity money had, however, some problems by today’s standard. It lacked (i) uniformity, (ii) homogeneity, (iii) standard size and weight (iv) durability and storability, (v) portability, (vi) stable value, and (vii) divisibility.
Owing to these problems, money has evolved over a long time into three major forms: (a) metallic coins, (b) paper currency and (c) demand deposits (operated through cheque system). These form of money perform the basic function of money constitute the total supply of money in the context of conventional approach to the definition of money.
Kinds of Money
The major kinds of money in the circulation are; Metallic coins, Paper Money and
Bank deposits.
i.
Metallic Coins
The second most important stage in the evolution of modern monetary system was the introduction of metallic coins made of iron, copper, silver and gold—and now alloy and aluminum. The invention and introduction of metallic coins must have been necessitated by the defects of commodity money—heterogeneity or non-homogeneity of money units, non-durability, perishability, non-portability, unstable value, and indivisibility. In Nigeria, metallic coins usually include, 1, 5, and 10 kobo coins which are now out of circulation. ii. Bank notes or Paper Money
The paper money consists of the currency notes printed, authenticated and issued by the state and the central bank of the country. They have their origin in the receipts issued by goldsmith to those who deposited precious metals with
54
them. Any note not backed with gold is referred to as fiduciary issue. In Nigeria paper money includes 5, 10, 20, 50, 100, 200, 500 and 1000 notes.
iii.
Bank notes/Paper money
The third form of common money is bank deposits. Bank deposits include three kinds of deposits: current account deposits, savings deposits and time deposits.
The current account deposits are available on demand. That is why current deposits are widely referred as demand deposits which can be transferred and used as medium of exchange by the instrument of cheque. Cheques have the merit of eliminating inconveniences of carrying heavy cash about as well as risks of money being stolen.
The Functions of Money
Money performs four major functions which includes (i) a medium of exchange
(ii) a measure of value (iii) a store of value, and (iv) a standard of deferred payments. i.
Money as a medium of exchange
Money functions as a medium of exchange between any two goods. This is the most important and unique function of money. The importance of this function lies in the fact that it solved one of the biggest problems of the barter system. In the barter system, for exchange to take place, there must be double coincidence of wants. The double coincidence of wants exists when, between any two persons, one is willing to accept what the other person is willing to give in exchange. Until this condition is fulfilled, exchange cannot take place. For example, a weaver cannot exchange his cloth for shoes unless the shoemaker wants cloth. In a modern, market economy, the problem of double coincidence of wants is solved by money. Since money is acceptable to all, the weaver can sell his cloth to any willing person (say to a farmer) for money and buy the shoes in exchange for money. This system works efficiently because money can buy anything. It has purchasing power and is acceptable to all. ii. Money as a measure of value
The second basic function of money is to work as a measure of value. All values are measured in terms of money. As a measure of value, money works as a common denominator, as a unit of account. Today, unlike barter system, the value of all the goods and services is expressed in terms of money. Money being a common denominator, the values of different goods can be added to find one value of all possessions of a person, of a firm and of a nation. In fact, money makes computation of national income possible. In the absence of money, measuring value would be an extremely difficult proposition in a modern economy. 55
In modern times, a society produces, buys and sells, and consumes goods and services in such a large number, variety and quantity that measuring and expressing values in terms of commodities, as in barter system would be a rather impossible task. If possible, it would mess up the entire exchange economy.
Money has made the task easier. Not only each good and service has a price, but also one can find and compare the relative prices in terms of money.
iii.
Money as store value
The third basic function of money is to work as a store of value. The need to store value must have arisen for such reasons as (i) need for storing surplus produce because production and consumption or exchange of goods and services are not instantaneous in most cases, (ii) need for storing value for future use due to uncertainties of life, and (iii) accumulative nature of the people. The advent of money has provided a means to store value for future use. Even the most perishable goods can be converted into money, provided there is a market for them, and value stored in terms of money. If prices do not increase over a long period, value can be stored for long without the loss of value. However, in case of rising prices, money stored loses its value in proportion to the general price rise. iv. Money as a standard of deferred payments
The money function in which money is used as a standard benchmark for specifying future payments for current purchases, that is, buying now and paying later. It means that a contract or agreement may specify (or imply) that the repayment of a debt be made using a particular monetary unit. It differs from other functions of money in that it is not functioning as an immediate medium of exchange or store of value but, rather, as a medium by which future payments will be made.
Characteristics or Qualities of Money
a. Homogeneity: Each unit of money must be homogenous, that is, each unit held by different individuals must be identical
b. General Acceptability: Each unit of money must be generally acceptable in exchange for goods and services purchased.
c. Portability: Each money unit must be easily carried about. In other words, it must be easily transmissible
d. Divisibility: Money must be capable of being divided into small units. In Nigeria, for instance, we have ½ k, 1k, 5k, 10k, 25k, 50k and N1 coins, N5 N10, N 20 , N50 N100
N200 N500 and N1000 notes.
e. Recognizability: Money must be easily recognizable by all and sundry in order to detect any counterfeit.
56
f. Relative Scarcity: Money must be relatively scarce in order to maintain its value.
g. Stability of value: there should be absence of inflation and deflation to make money stable in value as well as enable it serve some useful functions such as the store of value and means of deferred payment.
h. Durability: Money must be capable of staying long without spoiling or going bad
COMMERCIAL BANKING
The commercial banks serve as the king pin of the financial system of the country. They render many valuable services. The important functions of the
Commercial banks in the economy are as explained below.
Acceptance of Deposits
The earliest and most widely known function of a commercial bank is acceptance of deposits. These include current account deposit, payable on demand through the use of cheques. They also include savings deposit and time deposits which are payable subject to notice.
Making of Advances:
A commercial bank makes various types of advances such as loans, overdrafts and the discounting of bills. The loans may be short, medium or long term. In making overdrafts, the bank allows a customer to draw an account in excess of his deposit and pay interest on this excess. Banks discount bills for finance houses and brokers operating in the money market. They also discount (accept) bills of exchange which enable an importer to pay for goods brought from other countries. Investments:
Commercial Banks undertake investments in buildings, Real estates, agriculture and industrial projects.
Services to Customers:
These include payment of insurance premium, hire purchase, clubs subscriptions etc. they also include issuing of travelers ‘cheque’.
Operating in the Foreign Exchange Market:
Commercial banks buy and sell foreign exchange. With the ever-present possibility of changes in the values of key world currencies such as sterling, dollar, Euro, yen etc. speculating in the foreign exchange market has been very popular venture for commercial banks.
57
The Three Aims of Commercial banking:
Any commercial bank aims, basically at three objectives, these are Profitability,
Security and Liquidity. The success of commercial banking is determined largely by the degree to which the bank managers balance or trade-off these aims which at times may be conflicting. The bank seeks to achieve profitability by lending a very high proportion of the deposits at its disposal and getting interests in the process. It also invests a high proportion of its assets. These investments bring in considerable profits. By convention, banks in many parts of the world invest and loan out not less than 50% of their assets. The security consideration is reflected in the manner-in which commercial banks scrutinize any prospective borrower with respect to credit-worthiness, marketability of collateral security any prospective borrower with respect to credit-worthiness, marketability of collateral security and the profitability of investments that determines repayment ability. The banks also prefer investment in gilt-edged securities with lower earnings to riskier investments in shares or bonds with greater yields. Also banks try as much as possible to acquire securities that will mature rapidly at full value. Hence, they avoid irredeemable securities such as those which can fall quite drastically.
Commercial banks have been taught by bitter experiences of bank failures to pursue the objective of liquidity in several ways. They keep certain percentage of their assets in ready-cash to meet customers demand. The percentage kept as cash is consistent with the percentage of public cash requirements known to the managers from long experience. It varies from 8-20% depending on the situation.
Since cash kept by the bank yields no return, the retention of a minimum cash reserve is an example of the sacrifice of profit for liquidity.
Banks also keep proportion of their assets in liquid form i.e. in a form which can be quickly converted into ready-cash. These liquid include treasury bills, bills of exchange and bills from discount houses which have very small yields and again demonstrate the trade-off between profitability and liquidity considerations.
Credit Creation by Commercial Banks
Suppose there are a number of commercial banks in the banking system—Bank
1, Bank 2, Bank 3, and so on. And also, if we assumed that (i) the bank accepts only demand deposits, (ii) the bank’s cash reserve requirement (CRR) is 20%
(iii) the bank holds its assets only in the form of cash reserves and loans and advances. If an individual A makes a demand deposit of N100,000 in Bank 1 in which the bank holds 20% of the money (N20,000) as cash reserve requirement
58
and lends the excess cash of N80,000 to customer B who deposits the amount in
Bank 2 in which bank 2 also keeps 20% of the money (N16,000) and lends the remaining excess cash of N64,000 to another borrower C. If this process continues, the excess reserve with banks will be reduced to zero. The final picture that emerges at the end of the process of deposit and credit creation by the banking system is presented in a in the table below.
Bank
Bank 1
Bank 2
Bank 3
…….
…….
…….
…….
Bank n
Total
Deposit
(‘000)
100
80
64
…….
…….
…….
…….
00.
500
Reserves (20%)
(‘000)
20
16
12.8
…….
…….
…….
…….
00
100
Bank Loans
(‘000)
80
64
51.8
…….
…….
…….
…….
00
400
It can be seen from the table that a primary deposit of N100,000 in Bank 1 leads to the creation of a total deposit of N500,000. The table shows that the banks have created a total credit of N500,000 and maintain a total cash reserve of
N100,000 which equals the primary deposit. The total deposit created by the commercial banks constitutes the money supply by the banks.
The Deposit Multiplier
In the above example, the total deposit creation is 5-times the initial or primary deposit. It means, deposit multiplier is 5. The deposit multiplier (dM) can be obtained as follows:
=
∆
500,000
=
=5
∆
100,000
∆ =
∆ = ℎ
ℎ
ℎ
ℎ
If ∆ and ∆ are known in the above formula, then can be known easily. ∆ however can easily be known because it is the equal to the primary deposit, but
∆ would have to be computed. One way of computing ∆ is to get the sum of deposits created in each round. That is,
∆
= 100,000 + 80,000 + 64,000 + 51,800 + ⋯ + 00 = 500,000
It can be observed that this expression makes a geometric series and each successive deposit is 80% of the preceding one. It means that loan deposit ratio
59
is 0.8. By designating primary deposit as ∆ , reserves as ∆ ratio as , the entire series of deposit can be re-written as:
∆
= ∆ + ∆ ( ) + ∆ ( ) + ∆ ( ) + ⋯+ ∆ ( )
= ∆ (1 + + + + ⋯ +
)
∆
=
∆
=
and loan-deposit
Using the formula for adding up a geometric series 1, we can hence write the above as:
1
1−
∆
Given that 1-k is the cash reserve ratio, and if we designate this as r, then:
1
∆
In our example, ∆ = 100, and = 0.2
1
∆ =
100,000 = 500,000
0.2
Given that deposit multiplier is given as:
∆
=
∆
Therefore we can manipulate our ∆ function above to obtain dm which is given as: ∆
1
=
=
∆
Given that r = 0.2,
=
∆
1
=
=5
∆
0.2
Limitations of the “money creating” Powers of Commercial Banks
1. Keeping of excess reserves by banks
When banks keep excess reserves above legally required reserves, the above described process of multiple-deposit creation is disturbed, hence the said amount cannot be created. If for instance, instead of keeping 20%, banks kept
25%, it means that only N4000 will be created rather than N5000.
The sum to infinity of any geometric sequence in which the common ratio r is numerically less than 1 is given by ( ⋈ ) =
, where a = first term and r = common ratio.
1
60
2. The possibility of leakage into hand-to-hand circulation:
The process of multiple-deposit creation described above was based on the assumption that all the new money remained somewhere in the banking system.
But in practice, somewhere along the chain of deposit expansion, some customers who borrow will not leave the entire amount in a bank but will instead withdraw some into non-bank circulation or into hoarding outside the banking system, especially for precautionary reasons and when interest rates are very low. When this leakage occurs, the process described above in altered.
3. High Legal Reserve Ratio:
An increase in the legal reserve ratio by the central bank will also limit the amount created by the banking system.
4. Unavailability of collateral security:
The amount of credit created is limited by the unavailability of collateral securities required by commercial banks before granting loans.
CENTRAL BANKING
A central bank, as distinct from a commercial bank, is a financial institution owned by the government of a nation, run by board of directors, chaired by a
Governor appointed by the government and charged with the responsibility of managing the expansion and contraction of the volume, cost and availability of money in the interest of public welfare. While it may undertake commercial and quasi-commercial ventures, it is not profit-oriented institution.
Functions of Central Banks:
Banker of Commercial Banks:
Commercial banks by law or convention have deposit at the Central Bank. Thus if bank A wishes to settle account with bank B to which it owes N2,00, the Central bank simply effects the payment by increasing B’s deposit by N2,000 and reducing A’s deposit by the same amount. Also commercial banks borrow from he Central bank to which they sell government bonds and commercial bills.
Banker to the Central Government:
The Central government has an account at the central bank and may make payments by writing cheques on his account. Government can also borrow from the central bank by issuing bonds or treasury bill which the central bank purchases. When this happens, government account at the central bank rises by the amount for which the bonds and the treasury bills are bought.
Controller and Regulator of Money Supply”
There are a number of ways in which the central bank controls and regulates the supply of money.
61
a. It has, in most countries, a monopoly of issuing notes and coins. It can therefore, expand money supply by issuing more notes and coins.
b. Variation in the reserve requirements of commercial bank is another device for regulating the money supply: If the Central Bank wishes to reduce money supply, it raises the ratio of cash to deposit which the commercial banks must maintain. As we have seen earlier, a rise in the cash to deposit expansion.
Conversely, an expansionary monetary objective is achieved, in part by lowering the cash to deposit ratio which increases lending and associated credit expansion by the commercial banks.
c. the third way in which the central bank regulates money supply is through
Open Market Operation. This involves the Central Bank in the market for bills and bonds. If the objective is a reduction in money supply, the central bank simply sell bills and bonds to the commercial banks. Since the latter pay by drawing cheques on their deposits at the Central Bank, their cash reserve accordingly falls. This reduces their capacity to make loans and expand credit.
Conversely, an expansionary monetary policy entails the purchase of bills and bonds from the commercial banks and the payment for these by increasing the commercial banks deposits at the central bank. This raises the cash reserves of the commercial banks and enlarges their base for lending and credit expansion.
d. The Manipulation of the Resident rate (Bank Rate) is another tool for regulating money supply. The rediscount rate is the interest rate charged by the
Central Bank whenever it discounts bills for commercial banks. If the central bank aims at reducing money supply, it raises the rediscount rate. This increases the cost of borrowing by the commercial banks. Since the latter are profit maximisers and loss minimisers, they will not only curtail the number of bills rediscounted at the Central Bank but will also raise their own rate of interest.
Such a rise in commercial bank interest rate tends to discourage borrowing to finance projects involving a large amount of capital expenditures. The effect is to reduce lending and credit expansion. On the other hand, if the central bank aims at increasing the money supply, it lowers the rediscount rate. This increases borrowing by the commercial banks. It also results in a reduction in commercial bank rate which encourages lending and credit expansion.
e. The Central Bank also regulates and controls money supply, through such direct measures as imposition of ceiling on commercial bank lending, and the imposition of selective credit control and credit rationing. Finally, there is moral suasion-a process of persuasion and reasoning with the understood implication of ultimate use of sanctions should reasoning and persuasion fail.
Lender of last Resort
When the commercial banks find themselves out of cash and threatened with a run out on their institution, the Central Bank stands prepare to bale them out by
62
lending to them and having their liquidity position strengthened. The significance of this function is that it makes the commercial banks look with some respect on the central Bank and willing to comply with Central Bank directives. Moreover, this willingness of the central bank to act as a lender of the last resort implies an obligation on the part of the Central Bank to support the money market and allied financial institutions which would have suffered in the wake of commercial banks collapse.
Management of Foreign Exchange
In an era of rigid exchange rate and persistent disequilibrium in the balance of payment, the management of a country’s foreign exchange reserves becomes an increasingly important aspect of central bank’s function. In most countries, the reserves of foreign currencies as well as gold are held at the central bank. The bank is therefore in a position to keep a tap on movements in the level of foreign reserves and gold and to advise on appropriate policy measure.
Financing Economic Development
In underdeveloped countries, the over-riding policy objective is a rapid transformation of the economy. This implies increasing role of the government in economic development. Government’s direct participation in economic activities and the shortage of domestic savings make central finance of economic development necessary. In Nigeria, the Central Bank supports the financial market. It makes grant for the establishment of an Industry Development Bank and it has helped to establish Agricultural Credit Bank. Moreover, the Nigerian
Central Bank helps in financing produce marketing by making loans to some marketing boards.
63
INFLATION
Inflation has been defined in several ways by different authors, however, in the current literature; economists seem to agree that inflation is a situation in which there is a sustained and appreciable increase in the general level of prices.
Inflation is generally classified on the basis of its rate and causes. In terms of rate, inflation is classified as: (i) moderate inflation (ii) galloping Inflation, and
(iii) Hyper inflation.
(i)
Moderate Inflation
When the general level of price rises at a moderate rate over a long period of time, it is called moderate inflation or creeping inflation. The moderate rate may vary from country to country. However, a single digit rate of annual inflation is called moderate inflation or creeping inflation. An important feature of moderate inflation is that it is predictable. During the period of moderate inflation, the people continue to have faith in the monetary system and confidence in money as a store of value. Money continues to work as a medium of exchange.
(ii) Galloping Inflation
According to Baumol and Blinder, Galloping inflation is defined as an inflation that proceeds at an exceptionally high rate. They however did not specify what rate of inflation is exceptionally high. Samuelson and Nordhaus referred to inflation rate in the double-or triple-digit range of 20, 100 or 200 per cent a year as galloping inflation. The post war I in Germany is often cited as an example of galloping inflation. The wholesale prices in Germany increased 140 per cent in
1921 and a colossal 4100 per cent in 1922. Argentina, Brazil, Mexico, Peru and
Yugoslavia had galloping inflation during the 1970s and 1980s. The annual average rate of inflation in these countries during 1980-1991 was exceptionally high: Argentina—416.9%; Brazil—327.6%; Mexico—66.5%; Peru—287.3% and former Yugoslavia—123.0%. Incidentally, these cases are also cited as examples of hyper inflation.
(iii) Hyper Inflation
When prices begin to rise at more than three-digit rate per annum, it is called hyper inflation. During the period of hyper inflation, paper currency becomes worthless and demand for money decreases drastically. Germany suffered from hyper inflation in 1922 and 1923 when wholesale price index shot up by 100 million per cent between December 1922 and November 1923.
Hungarian
inflation of 1945-46 is the worst case of hyper inflation ever recorded: the rate of inflation averaged about 20,000 per cent per month for a year and in the last month prices skyrocketed by quadrillion per cent. In the period of inflation in
Germany, people carried basket-load of money to the market and brought goods in pocket. Price of a house in pre-inflation period was just sufficient to pay a day’s rent in post-inflation period.
64
Open and Suppressed Inflation
In the contemporary writings on the subject, one often comes across the terms
‘open and suppressed inflation’. Open inflation according to Milton Friedman is an inflationary process in which prices are permitted to rise without being suppressed by government’s price control or similar techniques. In other words, prices are free to find their own level. Suppressed inflation exists in the economy in those conditions in which consequent upon adopting the policies of effective price control and rationing of essential goods by the government, the price increases are suppressed. In suppressed inflation, the symptoms of open inflation—rising prices—are replaced by the long queues of buyers waiting for their turn to buy at the government price control and rationing shops and by other forms of non-price rationing while the economy continues to be afflicted with the inflationary problem. The word ‘suppressed’ connotes postponement of the present demand to future and diversion of the demand from one good to another—from those whose prices are controlled and whose demand is rationed to those goods whose prices are not controlled and whose demand is not restricted through rationing.
Measures of Inflation
There are two common measures of inflation: (i) Percentage change in Price
Index Numbers and (ii) Change in GNP Deflator.
i.
Percentage change in Price Index numbers
The percentage change in price index number (PIN) is given as:
=
−
× 100
Where are the price index numbers in the year selected for measuring inflation and in the preceding year, respectively. The two widely used
PINs are wholesale Price Index (WPI) also called Producer price Index (PPI) and
Consumer Price Index (CPI). WPI is used to measure the general rate of inflation and CPI is used to measure the rise in the cost of living. If price index in year ‘t’ for instance is 207.8 and 182.7 in ‘t-1’, then the rate of inflation can be calculated as: =
207.8 − 182.7
× 100
182.7
= 13.74%
65
ii.
GNP Deflator Measure
The GNP deflator is the ratio of nominal GNP to the real GNP of the same year. It is also defined as follows:
=
Where nominal GNP is GNP at current prices and Real GNP is GNP at constant prices. If for instance, the nominal GNP of a country (Nigeria) in a particular year say 1990 is given as N 47,0269, while the constant GNP is given as N20,8481.
The GNP deflator can hence be derived as:
=
470269
= 2.2557
208481
In terms of percentage;
= 2.2557 × 100 = 225.57%
This shows that the country’s nominal GNP was 225.57% of her real GNP or the nominal GNP was 225.57% higher than real GNP in that particular year. The percentage change in GNP deflator between any two years gives a measure of inflation. For example, if the GNP deflator was 258.892 in the previous year of our analysis, then the rate of inflation can be computed as:
=
258.892 − 225.569
= 14.77%
225.569
Theories of Inflation
Theories of inflation reveal the causes and sources of inflation. The perception and the sources of inflation have been a matter of controversy between the classicalists and Keynesians, between the Keynesians and the monetarists, and between these groups of economists and the structuralists. This has led to divergent views on the causes of inflation and the theories of inflation.
The Classical Theory of Inflation
The first and the comprehensive version of the classical theory of inflation was propounded by Irving Fisher in 1911. According to the classical theory, inflation occurs in direct proportion to increases in money supply, given the level of output. The classical theory of inflation is derived directly from the classical quantity theory of money. By Fisher’s equation;
66
=
And,
=
This equation can also be written in terms of percentage changes.
+
= +
= +
−
Where, p = % rate of inflation; m = % rise in money supply; v = % increase in velocity of money, and y = % increase in real output. For example, if there is full employment and money supply (M) increases by 5%, v and y remaining constant, the rate of increase in the general price level will be 5%.
Wicksell, a classical economist provided an explanation of how increase in money supply results in increase in the level of prices. According to him, increase in the level of prices occurs when additional money flows into the economy in the form of loans and advances made by the banks to the businessmen to finance the new investment. The increase in investment demand increases the aggregate demand. The economy being in the state of full employment, additional resources are not available at the prevailing prices. The additional resources
(labour) are therefore acquired by bidding higher prices to acquire them. This marks the beginning of the rise in the price level. The rise in the input prices
(especially wages) leads to increase in money incomes. This leads to rise in the demand for consumer goods. Under the condition of full employment, the supply of consumer goods does not increase. Therefore, higher prices are bided to acquire goods. As a result, prices increase till the entire increase in aggregate demand is absorbed by the rise in prices. This is how increase in money supply causes inflation.
Another version of the classical theory of inflation, known as neo-classical theory of inflation was developed by the Cambridge economists. While the classical school considered increase in the supply of money as the cause of inflation, the
Cambridge school postulated increase in demand for money as the cause of inflation. According to the Cambridge school, the equation of the demand for money can be given as :
=
=
=
=
=
67
ℎ
The Cambridge equation yields the price level equation as;
=
This equation implies the general level of price increases proportionally with increase in demand for money, given k and R.
The Keynesian Theory of Inflation
Keyne’s theory of inflation is only a little more than an extension and generalization of Wikesell’s view. Keynes, however, made an important departure from the classical view. While the classical economists considered an increase in money supply as the only cause of an increase in the aggregate demand and the only cause of inflation, Keynes postulated that aggregate demand can as well increase due to increase in real factors, for instance, increase in consumer demand, increase in investment and increase in government expenditure. Such changes may take place even when supply of money is constant. Keynes explained is view using the concept of inflationary gap which is defined as planned expenditure in excess of output available at full employment.
The inflationary gap is so called because it causes only inflation, without increasing the level of output. This theory implies that the expenditure in excess of output at less-than-full-employment level is not inflationary even if prices increase. The Monetarist View on Inflation
The modern monetarist view is a modified version of the classical quantity theory of money. The modern monetarism is therefore sometimes called modern
Fisherianism. The modern monetarism holds that the general level of prices rises only due to an increase in money supply. To this extent, monetarists subscribe to the classical quantity theory of money. However, the modern monetarists make the following deviations from the modifications to the classical quantity theory of money.
i.
ii.
They do not subscribe to the classical view that there is a proportional relationship between the stock of money and the price level.
The modern monetarist do not agree with classical proposition that the supply curve is vertical in the short run. Monetarists such as Friedman argue that a reduction in the money stock does in practice first reduce the level of output, and only later have an effect on prices.
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iii.
Unlike the classical economists, modern monetarists distinguish between the short-run and long-run effects of change in the stock of money. They argue that, in the short run, changes in the stock of money can and do have important effect on the real output. but in the long run, in their opinion, change in money stock remains neutral to the real output. They argue that in the long run money is more or less neutral. Modern Theories of Inflation
The modern theory of inflation is, in fact, a synthesis of classical and Keynesian theories of inflation. The modern analysis of inflation shows that inflation is caused by both demand-side and supply-side factors. The demand-side factors are called demand-pull factors, and supply-side factors are called supply-side or cost-push factors. Accordingly, there are two kinds of inflation, viz:
i.
ii.
Demand-pull inflation, and
Cost-push inflation.
Demand-Pull Inflation
When majority of industries are operating close to full capacity while they experience increases in demand, we say there’s demand-pull inflation. It is a type of inflation that occurs when the economy is at or above full employment level of equilibrium. The increase in demand comes from several sources, however, but many economists focuses on government’s demands and increases in the money supply. Demand-pull inflation are generally characterized by shortages of goods and shortages of workers. Because there’s excess demand, firms know that if they raise their prices, they’ll still be able to sell their goods, and workers know if they raise their wages, they will still get hired. The diagram below illustrates demand-pull inflation.
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While demand increased from D1D1 to D2D2, supply remained unchanged thus causing price to rise from P1 to P2.
Cost-Push Inflation
This is a kind of inflation that is induced by a rise in the factors of production, particularly wages. If, for instance, the cost of living of workers suddenly rises and they hence demanded for and are granted higher wages, this increases cost of production. This will be reflected in the form of higher prices on commodities which consumers/workers have to purchase. This leads workers to demand for more wages since the initial increment has been eroded by the rising prices. In fact, the cycle continues and prices continue to rise. This is illustrated in the figure below.
We observe from the above graph that due to rising costs of production, the supply has fallen from S1S1 to S2S2 thus leading to higher prices. Here, price increases from P1 to P2.
Causes and Control of Inflation
Generally, the following could be said to be the cause of inflation.
i.
Excessive Money Supply
Excessive money supply through poor monetary policy or other methods invariably lead to inflation. In Nigeria, the 1974 Udoji Salary Awards and the
1981 minimum Wage Act injected a lot of money in the economy thus causing inflation. Expansionary monetary policy is also a contributory factor.
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ii.
Fall in the supply of goods and services (especially agric products)
Agriculture is virtually abandoned in Nigeria—it is only left to the aged in the remote villages who practice subsistence farming using out-dated or archaic methods. This shortage of commodities has been one of the most influential causes of inflation in Nigeria today. Rising wages also increase production costs.
This thus leads to decreased supply of commodities thereby causing rise in prices. iii.
Budget deficits or government expenditure programmes
Almost all the governments of West African countries have been experiencing budget deficits since the 1970s. There is also enormous increase in government expenditure on development programmes and other capital projects or expenditures. These have contributed greatly to inflationary trends. iv. Imported inflation
Almost all our manufactured goods in Nigeria are imported from the advanced nations of the world who are currently experiencing inflation. This means a direct importation of these higher prices to West African nations.
v.
Increase in population/Population explosion
There is enormous increase in the population of West African nations in particular and the whole world in general. For Nigeria, the estimated population increased from about 55m in 1963 to more than 88.5m in 1991 and to 150m in
2002. The situation is worsened by the fact that majority of the population are children who fall under the unproductive sector of the society. They are, therefore, dependent on the working population hence they put pressure on the little goods and services available.
vi.
Activities of middle-men and monopolistic tendencies
There are too many middlemen in the chain of distribution of goods and services in Nigeria, for instance, these people are very exploitative hence they hoard available goods in order to sell at higher prices in black markets. Many others who have the influence from government quarters monopolize the supply of certain essential commodities, thereby charging higher prices than hitherto or what ought to be. vii. Excessive demand by consumers
Increase in the purchasing power of consumers leads to higher demands and thus inflation. This is the case in Nigeria due to higher wages resulting from frequent upward salary adjustment/revision.
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viii. Higher production costs
Higher wages and higher energy costs, as is the case in Nigeria have driven up the costs of production. These may hinder increased productivity, thereby resulting in inflation. Or the higher production costs are passed unto consumers in the form of higher prices on commodities.
ix.
War caused inflation.
During wars like the Nigerian/Biafran war, efforts are diverted from production of goods to the production of war equipment or armaments. Labour which could have been used in the production of foodstuffs were deployed to the war fronts.
Hence, demand cannot equate supply. Inflation therefore results.
General ways of controlling inflation
i.
Price control measures
This involves the setting up of a price control board by the government which fixes maximum prices charged for certain commodities experiencing inflation.
Experience, however has shown that this system, bedeviled with a myriad of problems, does not proffer the solution. The Nigerian case is a typical example.
What usually result are hoarding, profiteering, and black-marketing, thus negating the initial aims. ii. Wage control or wage freeze
Most governments place freezes on wage increases as a measure to combat inflation. But this policy does not work or is ineffective since workers have devised methods of making the government or employers of labour dance to their tunes. These ways include go-slow, work-to-rule, industrial actions, etc. these are most often used in democratic nations/societies. iii. Monetary policy
This involves the use of traditional monetary instruments to reduce the quantity of money in circulation. These include: Increase in the Bank or Discount Rate, increase in the Liquidity ratio, use of open market operation (contractionary monetary policy in this case), sectoral allocations or Special Directives, etc.
However, the experience in the developing world has shown that these traditional instruments of monetary policies have a lot of deficiencies hence their ineffectiveness. iv.
Fiscal policy
A combination of increase in personal income tax and reduction in government expenditure may prove effective especially when inflation is demand-pull in nature. These reduce the purchasing power of consumers thus reducing prices of commodities. 72
v.
Total ban on the importation of certain items
Especially when inflation is imported, the government is strongly tempted to place total ban on the importation of certain non-essential items. However, retaliation by other nations and political pressure lead to the lift of the ban no sooner than it was placed hence the ineffectiveness of such a policy. vi. Increase in the production of goods and services
Increase in production of goods and services is the most effective measure to inflation. Increase in the supply of products will naturally force prices down. In
Nigeria, concrete efforts should be made to increase production of essential but scare commodities. Large acres of land should be acquired for farm settlements where real farming is practiced. Loans should be given to real farmers to increase agricultural productivity, for there is no way you can check inflation other than flooding the market with enough goods and services.
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UNEMPLOYMENT
Unemployment is a situation in which able-bodied persons willing to work at the prevailing wage rate do not find job. Unemployment may also be defined as a situation of less than full employment. According to the United Nations, full employment is a situation in which employment cannot be increased by an increase in effective demand and unemployment does not exceed the minimum allowance that must be made for effects of frictional and seasonal factors.
Causes of Unemployment
The major types of unemployment are frictional, structural and cyclical.
Frictional unemployment
Frictional unemployment is temporary and occurs when a person (1) quits a current job before securing a new one, (2) is not immediately hired when entering the labor force, or (3) is let go by a dissatisfied employer.
Structural unemployment
The structural unemployment arises due to structural change in a dynamic economy so that some workers go out of job. Structural changes include change in structure or sectoral composition of the economy and change in technology.
Change in sectoral composition means gradual decline of some kinds of industries and emergence of new industries. The downfall or decay of some kind of industries throws people of specific skill out of job. They remain unemployed till they find new jobs. Technological changes alter the demand pattern of different kinds of skills. Some skills become obsolete and some less efficient. In a dynamic society, structural change is a continuous process. In this process, some persons find it difficult to get a new job requiring a new kind of job skill. The important thing in structural unemployment is that there are vacancies and there are job-seekers and yet there is unemployment because of mismatch between the demand and supply pattern of the labour market.
Cyclical unemployment
Cyclical unemployment is the result of insufficient aggregate demand. Workers have the necessary skills and are available to work, but there are insufficient jobs because of inadequate aggregate spending. Cyclical unemployment occurs when real GDP falls below potential GDP.
INFLATION AND RATE OF UNEMPLOYMENT
The relationship between inflation and employment was brought out by A.W.
Philips in 1958. He found an inverse relationship between the rate of changes in the money wage and the rate of unemployment. Two explanations were given for the inverse relationship.
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(i)
(ii)
It is observed that when unemployment is very high, in which case the demand for labour is very low, the rate of fall in wage rate is assumed to be slow because labour would not be prepared to offer their services at less than the prevailing wage rate. On the other hand, when the rate of unemployment is very low, in which case the demand for labour is very high, the wage rate is expected to increase rapidly to attract any available unemployed labour.
In the period of rising business activity when unemployment falls with increasing demand for labour, the employers will bid up wages.
Conversely in period of falling business activity when demand for labour is decreasing and unemployment is rising, employers will be reluctant to grant wage increases. Rather, they will reduce wages. But workers and unions will be reluctant to accept wage cuts during such periods. Consequently, employers are forced to dismiss workers, thereby leading to high rates of unemployment. Thus when the labour market is depressed, a small reduction in wages would lead to large increase in unemployment.
Philips concluded on the basis of these arguments that the relation between rates of unemployment and of change of money wages would be highly non-linear when shown on a diagram. Such a curve is called the Philips curve. This is shown in the figure below.
The PC curve is the Philips curve and it relates the percentage change in money wage rate (w) on the vertical axis with the rate of unemployment (U) on the horizontal axis. Although Philips traced the relation between the rate of change in money wages and the rate of unemployment, it was later extended to examine the relationship between the rate of inflation and the rate of unemployment. It was assumed that a positive relationship exists between increase in wage rate
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and level of prices which was confirmed in a US study. The Philips curve implies a positive relation between the rate of inflation and the rate of employment.
From policy point of view, the Philips curve implies that there exists a trade-off between the rate of unemployment and the rate of inflation, that is, a lower rate of unemployment can be achieved only by allowing inflation rate to increase. The trade-off between unemployment rate and inflation can be found using the diagram below. As shown in the figure, a 2.5 per cent (=6.5%- 4%) unemployment can be traded for a 2 per cent (=5% - 3%) inflation.
It means, from policy point of view, that if unemployment rate is intended to be reduced from 6.5% to 4%, a rise in inflation rate from 3% to 5% will have to be tolerated. If an inflation rate of 3% is the target, an unemployment rate of 6.5% will have to be accepted. A similar conclusion can be drawn by linking unemployment rate to wage-inflation rate given on the vertical axis on the right hand side.
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Introduction
INTERNATIONAL TRADE
A country does not produce all the goods and services that it consumes. Instead, it produces the goods and services in which it is good at producing and imports the goods and services in which it is not good at producing. International trade is the exchange of goods and services across international borders. An economy that engages in international trade is called an open economy. One that does not is called a closed economy and this is referred to as autarky. The advantages realized as a result of trade are called the gains from trade.
Basis of Foreign Trade
Nations of the world differ in their resource endowments. While some countries are better endowed with natural resources like vast fertile and cultivable land, larger mineral deposits, water and forest resources, better climatic conditions, some have large human power, some others are better equipped with technology. The important feature of distribution of world resources is irregularity or imbalance. Possibly no country can claim self sufficiency in its resource requirements or a perfectly balanced supply of resource. This uneven distribution of resources is the basis of foreign trade. For owing to differences in resource endowment, the production potentials of countries vary from industry to industry. Various countries therefore tend to specialize in the production of commodities which they can produce more efficiently than the others. This leads to international division of labour and thereby international trade. Furthermore, it is beneficial for countries to engage in international trade. The earliest evidence of gains from trade was provided by Adam Smith’s theory of
Absolute Advantage, and later refined by David Ricardo and Torrens in their theory known as the Comparative Advantage.
The Theory of Absolute Cost Advantage
According to the law of absolute advantage, countries can gain from specialization and international trade if each specializes in producing the goods in which it has an absolute advantage. A country has an absolute advantage over other countries in producing a good when it can produce the same amount of the good with a smaller amount of resources. In other words, a country has an absolute advantage over other countries in producing a good when it can produce a larger amount of the good with the same amount of resources. Suppose that there are two countries, country X and country Y, producing two goods, good A and good B. Further suppose that there are perfect mobility of
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resources within each country, constant opportunity costs of production, no economies of scale, no transport costs, no trade barriers and no product differentiation. The quantity of goods that can be produced by the 2 countries is illustrated in the table below.
Good A Good B
Country X 2
4
Country Y 1
9
The table shows the quantity of each good that can be produced in each country with one unit of resources. In country X, one unit of resources can be used to produce either 2 units of good A or 4 units of good B. In country Y, one unit of resources can be used to produce either 1 unit of good A or 9 units of good B.
Therefore country X has an absolute advantage in producing good A and country
Y has an absolute advantage in producing good B. If for instance 400 and 200 units of resources are owned by country X and Y respectively and that these resources are allocated equally between the two goods, the table below illustrates the quantity of goods A and B that each country can produce.
Good A
Country X 400
Country Y 100
World
500
Good B
800
900
1700
Good A
Country X 800
Country Y 0
World
800
Good B
0
1800
1800
In country X, 400 units of good A and 800 units of good B are produced. In country Y, 100 units of good A and 900 units of good B are produced. Suppose each country completely specializes in producing the good in which it has an absolute advantage, the table below shows the total output of the two countries.
In country X, 800 units of good of good A are produced, while in country Y, 1800 units of good B are produced. Since the world output of good A has increased by
300 units and the world output of good B has increased by 100 units, we can conclude that countries can gain from specialization and international trade on the basis of the law of absolute advantage.
The theory of Comparative Cost Advantage
According to the law of comparative advantage, countries can gain from international trade if each specializes in producing the goods in which it has a comparative advantage. A country has a comparative advantage over other countries in producing a good when it can produce the same amount of the
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good at a lower opportunity cost. In other words, a country has a comparative advantage over other countries in producing a good when it can produce the same amount of the good by forgoing a smaller amount of other goods.
Suppose that there are two countries, country X and country Y, producing two goods, good A and good B. Further suppose that there are perfect mobility of resources within each country, constant opportunity costs of production, no economies of scale, no transport costs, no trade barriers and no product differentiation. The amount of each good that can be produced in each country with one unit of resources is presented in the table below.
Good A Good B
Country X 2
4
Country Y 3
9
In country X, one unit of resources can be used to produce either 2 units of good
A or 4 units of good B. In country Y, one unit of resources can be used to produce either 3 units of good A or 9 units of good B. Although county Y has an absolute advantage in producing both goods, each country has a comparative advantage in producing only one good.
In country X, if one unit of resources is used to produce 2 units of good A, the same unit of resources cannot be used to produce 4 units of good B. Therefore, the opportunity cost of producing 1 unit of good A in country X is 2 units of good
B. By the same token, the opportunity cost of producing 1 unit of good B in country X is 0.5 unit of good A.
In country Y, if one unit of resources is used to produce 3 units of good A, the same unit of resources cannot be used to produce 9 units of good B. Therefore, the opportunity cost of producing 1 unit of good A in country Y is 3 units of good
B. By the same token, the opportunity cost of producing 1 unit of good B in country Y is 0.33 unit of good A. This can be represented in the table below.
Good A Good B
2
Country X 4
=2
= 0.5
2
4
3
Country Y 9
=3
= 0.33
3
9
Since the opportunity cost of producing good A in country X is lower than that in country Y and the opportunity cost of producing good B in country Y is lower than that in country X, country X has a comparative advantage in producing good
A and country Y has a comparative advantage in producing good B.
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Suppose that country X has 400 units of resources and country Y has 200 units of resources. Further suppose that each country allocates its resources equally between the two goods. The table below shows the amount of each good produced in each country when the resources are allocated equally between the two goods.
Good A
Country X 400
Country Y 300
World
700
Good B
800
900
1700
Good A
Country X 800
Country Y 0
World
800
Good B
0
1800
1800
In country X, 400 units of good A and 800 units of good B are produced. In country Y, 300 units of good A and 900 units of good B are produced. But if the two countries specialize in producing the good in which it has a comparative advantage, the following table shows the amount of each good that would be produced in each country.
In country X, 800 units of good A are produced, while in country Y, 1800 units of good B are produced. The world’s output of goods A and B have each increased by 100 units.
The Gains from Trade
If the two countries pursue the policy of autarky, in other words, they do not engage in foreign trade, the domestic rate of exchange between the two goods will be determined by the per unit cost of producing the goods (A & B). The domestic exchange from our initial data is hence given as follows;
Domestic Exchange Rate in Country X
1 unit of A = 2 units of B or
1 unit of B = 0.5 unit of A
Domestic Exchange rate in Country Y
1 unit of A = 3 units of B
1 unit of B = 0.33 unit of A
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If we now assume that the two countries engage in foreign trade in which case, country X specializes in the production of good A and imports good B, while country Y specializes in the production of good B and imports good A, their gains from trade hence will be determined by their external exchange rate which is called terms of trade. This is given as:
=
× 100
A higher level of terms of trade is referred to as a favourable terms of trade which means more can be imported per unit of goods exported than at a lower rate. The two countries will benefit from trade if their terms of trade are higher than their domestic exchange rate. If country X specializes in the production of good A and import good B, the country can import 3 units of good B from country
Y instead of 2 units domestically. On the other hand, country Y can import 0.5 units of B from country X instead of 0.33 domestically.
The distribution of gains from trade
The gains from trade therefore will lie between the lower and upper ratios of the rates of exchange. If for instance, 1 unit of good A is exchange for 3 units of B, then the total gain from trade accrues to country X, and if 1 unit of B is exchange for 0.5 unit of good A, then the total trade accrues to country B. Any rate in between these ranges will be advantageous to the 2 countries.
Limitations of the law of comparative advantage
Trade barriers
The law of comparative advantage assumes that there are no trade barriers. In reality, there are trade barriers. Some governments protect domestic industries by discouraging imports through the use of protectionist measures such as tariffs, import quotas and subsidies. As a result, some countries produce goods in which they do not have a comparative advantage. Further, some countries are unable to export the goods in which they have a comparative advantage as much as they would like due to trade barriers imposed by foreign governments.
Transport costs
The law of comparative advantage assumes that there are no transport costs. In reality, there are transport costs which may outweigh any comparative advantage or disadvantage.
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Constant opportunity costs of production
The law of comparative advantage assumes that there are constant opportunity costs of production. In reality, as a country increasingly specialises in producing a good, it will experience increasing opportunity cost of producing the good. This is because factor inputs are not equally suitable for producing different goods. As a country increasingly specialises in producing a good, it has to use resources that are less suitable for producing the good to actually produce the good. This means that increasingly more units of resources are needed to produce each additional unit of the good. Therefore, increasingly more units of other goods have to be given up to produce each additional unit of the good. This will eventually lead to the disappearance of the country's comparative advantage in producing the good which is a reason why countries do not engage in complete specialisation in reality. Perfect mobility of resources within each country
The law of comparative advantage assumes that there is perfect mobility of resources within each country. In reality, due to factors such as differences in skill requirements, resources are not perfectly mobile in a country.
Sources of Comparative advantage
Differences in factor endowments
Factor endowments vary among countries. For example, Argentina has much fertile land, Saudi Arabia has large crude oil reserves and China has a large pool of unskilled labour. Since goods differ according to the resources that are used to produce them, a country has a comparative advantage in producing goods that intensively use resources it has in abundance. For example, Argentina has a comparative advantage in growing wheat because of its abundance of fertile land, Saudi Arabia has a comparative advantage in producing oil because of its abundance of crude oil reserves and China has a comparative advantage in producing textile because of its abundance of unskilled labour.
Economies of scale
A country may acquire a comparative advantage in producing a good through large-scale production. This occurs in industries where production is subject to economies of scale.
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BALANCE OF PAYMENTS
Definition and structure
Balance of payments is defined as a systematic record of all economic transactions between the residents of the reporting country and residents of foreign countries’ during a certain period of time. Each international transaction enters the accounts twice: once as a credit (+) and once as a debit (-). Debit transactions are any transaction that results in payment to foreigners, while credit transactions are any transaction that results into a receipt from foreigners.
Balance of payments accounts
The credit and debit items are shown vertically in the balance payments accounts of a country according to the principle of double-entry book-keeping.
Horizontally, they are divided into three categories: the current account, the capital account and the official settlements account or the official settlements account or the official reserve assets account.
i.
The Current Account
The current account of a country consists of all transactions relating to trade in goods and services and unilateral (or unrequited) transfers. These items may be further grouped as: (i) visible items; and (ii) invisible items. The visible items consists of all the merchandise exports and imports while the invisible items consists of services such as travels, shipping, banking, insurance. A third item which is called the transfer payments is usually distinguished and this consists of items like gifts, donations, military aid, technical assistance etc. they are different from other invisible items because it involves only unilateral transfers.
ii.
The capital account
The capital account of a country consists of its transactions in financial assets in the form of short-term and long-term lendings and borrowings, and private and official investments. In other words, the capital account shows international flow of loans and investments, and represents a change in the countries’ foreign assets and liabilities. Long term capital transactions relate to international capital movements with maturity of one year or more and include direct investments like building of a foreign plant, portfolio investment like the purchase of foreign bonds and stocks, and international loans. On the other hand, short-term international capital transactions are for a period ranging between three months and less than one year.
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iii.
The official settlements accounts
This item is in fact part of the capital account, but in the UK and USA balance of payments accounts show it as a separate account. The official settlements account measures the change in nation’s liquid and non-liquid liabilities to foreign official holders and the change in a nation’s official reserve assets during the year. The official reserve asset of a country includes its gold stock, holdings of its convertible foreign currencies and SDRs, and its net position in the IMF. The official reserves of a country are maintained to stabilize the exchange rate of the home currency and to make payments to the creditors in case there exists payment deficits on all other accounts.
Balance of Trade and balance of payments
Balance of Payments Categories
Credits (+)
Debits (-)
a. Exports of goods
b. Imports of goods
Balance of Trade = a b
c. Exports of services
d. Imports of services
e. Net transfers
Current Account Balance = (a b) + (c d) e
f. Foreign investment long-term short-term
h. Borrowing from overseas
g. Investment overseas long-term short-term
i. Lending to overseas
Capital Account Balance = (f g) + (h i)
Increase in Official Reserve
= Current account surplus + Capital account surplus
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If the total receipts from foreigners on the credit side exceed the total payments to foreigners on the debit side, the balance of payments is said to be favourable.
On the other hand, if the total payments to foreigners exceed the total receipts from foreigners, the balance of payments is unfavourable.
The balance of trade is the difference between the values of goods and services exported and imported. It contains the first two items of the balance of payments account on the credit and the debt side. This is known as balance payments on current account. It is also defined as the difference between the value of merchandise exports and imports.
Causes of Disequilibrium in BOP
There are many factors that may bring a deficit or surplus in its balance of payments. First, there may be temporary disequilibria caused by random variations in trade, seasonal fluctuations, the effects of weather on agricultural production etc.
Deficits or surpluses arising from such temporary causes are expected to correct themselves within a short time.
Second, there are chronic fundamental disequilibria. They may arise due to fundamental changes in the economic condition of a country. They may be due to changes in consumer tastes within the country or abroad thereby affecting the country’s imports or exports.
Third, technological changes in methods of production or products in the domestic industries or in the industries of other countries may affect the country’s ability to compete in the home foreign markets. This may be due to changes in costs and prices and the quality of products following technological improvements. Fourth, another cause is the change in the country’s national income. If the national income of a country increases it will lead to an increase in imports thereby creating a deficit in its balance of payments, other things remaining the same. If the country is already at the full employment level, an increase in income will lead to inflationary rise in prices which may increase its imports and thus bring disequilibrium in the balance of payments.
Fifth, inflation is another cause of disequilibrium in the balance of payments. If there is inflation in the country, prices of exports increase. As a result, exports fall. At the same time, the demand for imports increases. Thus increase in export prices leading to decline in exports and rise in imports results in adverse balance of payments.
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Sixth, a country’s balance of payments also depends on its stage of economic development. If a country is developing, it will have a deficit in its balance of payments because it imports raw materials, machinery, capital equipment, and services associated with the development process and exports primary products.
The country has to pay more for costly imports and gets less for its cheap exports. This leads to disequilibrium.
Lastly, borrowings and lendings by countries also result in disequilibrium in the balance of payments. A country which gives loans and grants on a large scale to other countries has a deficit in its balance of payments on capital account. If it is also importing more, as is the case with the USA, it will have chronic deficit. On the other hand, a developing country borrowing large funds from other countries and international institutions may have a favourable balance of payments. But such a possibility is remote because these countries usually import huge quantities of good, raw materials, capital goods, etc. and export primary products. Such borrowings simply help in reducing balance of payments deficits.
Measures to Correct Disequilibrium
1. Adjustment through Exchange Rate Depreciation
Under flexible exchange rates, the disequilibrium in the balance of payments is automatically solved by the forces of demand and supply for foreign exchange.
The exchange rate varies with varying supply and demand conditions, but its always possible to find an equilibrium exchange rate which clears the foreign exchange market and creates external equilibrium. This is automatically achieved by a depreciation of a country’s currency in case of deficit in its balance of payments and by an appreciation of the currency in the event of a surplus.
Depreciation has the effect of encouraging exports and discouraging imports, while the converse happens in the case of appreciation. When exchange rate depreciation takes place, foreign prices are translated into domestic prices.
If for instance the Naira suffers from depreciation against the US dollar, this means that Nigerian exports will be cheaper in the US while the American exports to Nigeria will be more expensive. This situation will stimulate increase in demand for Nigerian exports and limits demand for American exports in
Nigeria which eventually will bring about an equilibrium in the balance of payments. 2. Devaluation or Expenditure-switching policies
Devaluation raises the domestic price of imports and reduces the foreign price of exports of a country devaluing its currency in relation to the currency of another country. Devaluation is referred to as expenditure switching policy because it switches expenditure from imported to domestic goods and services. When a country depreciates its currency, the price of foreign currency increases which
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makes imports dearer and exports cheaper. This causes expenditures to be switched from foreign to domestic goods as the country’s exports rise and the country produces more to meet the domestic and foreign demand for goods with reduction in imports. Consequently, the balance of payments deficit is eliminated.
3. Direct controls
To correct disequilibrium in the balance of payments, governments also adopt direct controls which aim at limiting the volume of imports. The government restricts the import of undesirable or unimportant items by levying heavy imports duties, fixation of quotas etc. At the same time, it may allow imports of essential goods duty free or at lower import duties, or fix liberal import quotas for them. For instance, government may allow free entry of capital goods, but impose heavy import duties on luxuries. Import quotas are also fixed and the importers are required to take licenses from the authorities in order to import certain essential commodities in fixed quantities. In these ways, imports are reduced in order to correct an adverse balance of payments. The government also imposes exchange controls exchange control has a dual purpose. They restrict imports and also control and regulate the foreign exchange. With reduction in imports and control of foreign exchange, visible and invisible imports are reduced consequently; adverse balance of payments is corrected.
4. Adjustment through capital movements
Capital movements also bring equilibrium in the balance of payment. They can be used to finance deficits or surpluses in the balance of payments. A deficit can be financed by capital inflows and a surplus by capital outflows. This can be explained under the flexible exchange rates and perfect capital mobility. When capital is perfectly mobile, a small change in the domestic interest rate brings large flows of capital. The balance of payments is said to be in equilibrium when the domestic interest equals the world rate. If the domestic interest rate is lower than the world rate, there will be large capital outflow which will produce a large depreciation of the currency. On the contrary, if the domestic interest rate is higher than the world rate, large capital inflows will lead to appreciation of the currency. 5. Stimulation of exports
A deficit in the balance of payments can also be corrected by encouraging exports. Exports can be encouraged by producing quality products, by reducing exports through increased production and productivity, and by better marketing.
An increase in exports causes the national income to rise by many times though the operation of the foreign trade multiplier. The foreign trade multiplier expresses the change in income caused by a change in exports. Ultimately, the deficit in the balance of payments is removed when exports rise faster than imports. 6. Expenditure reducing policies
87
A deficit in the balance of payments implies an excess of expenditure over income. To correct it, expenditure and income should be brought into equality.
Expenditure-reducing policies aim at reducing aggregate demand through higher taxes and interest rates thereby reducing expenditure and output. The reduction in expenditure and output, in turn, reduces the domestic price level. This gives rise to switching of expenditure from foreign to domestic, goods. Consequently, the country’s imports are reduced and balance of payments disequilibrium is corrected. 88
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