Macro Economic

SAU LECTURE NOTE ON ECO 213 INTRODUCTION TO MACROECONOMICS I

COURSE OUTLINE

1. Nature and scope of macroeconomics

• Macroeconomics defined

• Why study macroeconomic

• Macroeconomic theories

• Relationship and interdependency of microeconomics and macroeconomics

• Drawbacks of macroeconomics

2. National income accounting

• Definitions

• Concepts associated with national income

• Methods of measuring national income

• Rationales of national income analysis

• Obstacles to national income measurement

• Circular flow of income (two sector economy)

3. Macroeconomic theories

• Classical economics: ideologies

• Keynesian economics: ideologies

• Monetarism: ideologies

• New Classical economics: ideologies

4. Unemployment

• Types of unemployment

• Unemployment in Nigeria

• Policy measures towards reducing unemployment

5. Inflation and deflation

• Meaning

• Types

• Causes

• Inflation unemployment relationship

• Inflation in Nigeria

• Measures to control inflation

6. Exchange rate

• Meaning

• Types

• Factors that affects exchange rate of a country

7. Interest rate

• Types of interest rate

• Interest rate and inflation

Recommended textbooks

➢ Macroeconomic theory by M.L Jhingan, 12th Edition

➢ Economic by David Beggs, latest Edition

➢ Macroeconomic by N George Mankiw, 4th Edition

NATURE AND SCOPE OF MACROECONOMICS

Macroeconomic Concepts: Macroeconomics is the study of the economy as a whole. Macroeconomics is the study of economic aggregates or averages, examines and attempting to understand the behaviour of the whole economy by analyzing the determination and interaction of such broad economic aggregates, the interrelations of the aggregates among various aggregates, their determination and causes of their fluctuations. In particular, it looks at output, income, and the interrelationships among sectors of the economy. It is the study of the factors that influence, and result from, the large scale functions of economies. It is the way economists measure the behavior and functioning of economies. To do this, economists quantify aspects of the economic process using economic aggregates, or averages — measurements such as the Gross National Product, unemployment, and inflation consumers' expenditures and savings, producers' output of products and producers' investment in capital, government revenues (taxes) and expenditures, exports and imports, the level and composition (by age, sex, and region) of employment, and the quantity of money in circulation. Issues involving the overall economic performance of the nation: • Do people find it easy or difficult to find jobs? • On average, are prices rising quickly, slowly, or not at all? • How much total income is the nation producing per year, and how rapidly is total income growing? • Is the interest rate charged to borrow money high or low? Rising or falling? • Is the government spending more than it collects in tax revenue? • Is the nation as a whole accumulating assets in other countries or is it becoming more indebted to them? • What level is the country’s currency? Will it rise or fall? • Why do long-term national growth rates differ? • What are the costs of long-term growth? These questions are the central macroeconomic concept and providing the answers to these questions is the core task of macroeconomics. Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions. They collect data on income, prices, and other economic variables from different periods and different countries and then attempt to formulate theories to explain the behaviour of the data. Macroeconomists develop models that explain the relationship between/among economic aggregates. Macroeconomic models: Models are theories that summarize, in most cases in mathematical terms, the relationship among economic variables. Economist use models to understand the working of the economy. Models have two variables: exogenous and endogenous. The model shows how changes in the exogenous variables affect the endogenous variables. Economic models and their forecasts are used by both governments and large corporations to assist in the development and evaluation of economic policy and business strategy Macroeconomic Theories: A set of principles that describes how the key macroeconomic variables are determined is called a macroeconomic theory. They are also defined as scientific theories that seek to explain phenomena associated with the macro-economy. Typically, every macroeconomic theory comes up with a set of policy recommendations that the proponents of the theory hope the government will follow. Thus macroeconomic theories inevitably provide policy recommendations intended to improve the performance of the economy and to correct macroeconomic problems. Among the macroeconomic theories are: Classical economics, Keynesian economics, aggregate market (AS-AD) analysis, IS-LM analysis, Monetarism, and New Classical economics.

Why study macroeconomic

• The task of macroeconomics is to interpret observations on economic aggregates in terms of the motivations and constraints of economic agents and to predict the consequences of alternative hypothetical ways of administering government economic policy. • The study also evaluates alternative policies and improves economic policies. • The study of macroeconomic is important in evaluating the overall performance of the economy using the national income. This also helps us understand the distribution of national income among the different groups and sectors of the economy • It helps us analyze the causes of economic fluctuation in the form of business cycle and to provide remedies e.g. the 1927 depression, the 2008/2009 depression • For understanding the behavoiur of individual units. The demand for individual products is as a result of the aggregate demand of the economy.

Drawbacks of macroeconomics • The regarding of aggregate as homogenous usually leads to wrong policy formulation. The aggregates are made without caring about the individual composition. If there are much larger or smaller quantities in the group of figures, the average/aggregate can be skewed up or down. E.g, income per capita as a measure of the welfare of the people will lead to wrong policy formulation in a country where there is high inequality in the distribution of income. Aggregate wage is also an example. A change in the wage of a group or sector will affect the aggregate wage either upward or downward and policy will be made from there. (macroeconomic paradoxes self-contradictory statement: a statement or proposition that contradicts itself but in fact is or may be true) • Indiscriminate use of macroeconomics is misleading. For instance, the measure for controlling general prices cannot be applied with advantage to the control of the prices of individual products. • Computation Problems: Measuring macroeconomic variables involves series of statistics and calculations in the aggregation of individual units. If individual units behave the same aggregation becomes easy but if not it becomes difficult.(use the demand of a product and the behaviour of individuals ). • Lack/accuracy of data: this is particular to developing countries. It will also affect the world macroeconomic analysis say in the comparison of the performance of different countries
Assignment: Analyze the relationship and interdependency of microeconomics and macroeconomics

NATIONAL INCOME ACCOUNTING

In simple terms, National income/output is the total value/total amount of goods and services produced in a year by a country. Everything that is produced and sold generates income. Therefore, output and income are usually considered equivalent and the two terms are often used interchangeably. A recent economist of development, Simon Kuznets defined it as the net output of commodities and services flowing in a year from a country’s productive system in the hands of the ultimate consumer. Definition of National Income Accounting: Is a term used in economics to refer to the bookkeeping system that a national government uses to measure the level of the country's economic activity in a given time period. National income accounting records the level of activity in accounts such as total revenues earned by domestic corporations, wages paid to foreign and domestic workers, and the amount spent on sales and income taxes by corporations and individuals either residing in the country or nationals of the country. Tables on national income, both real and nominal, are published by the NBS (national Bureau of statistics) in tables known as the National Accounts. Different measures of national income and output are used in economics to estimate total economic activity in a country or region, including gross domestic product (GDP), (GDP), gross national product (GNP), ,net national income (NNI), and adjusted national income (NNI* adjusted for natural resource depletion).. An understanding of these concepts is crucial in analyzing the performance of an economy.

Gross Domestic Product
Gross domestic product measures the market value of all officially recognized final goods and services (output) produced domestically in a country over some given interval of time usually one year. It is the sum of the production of goods and the supply of services in a given country, including business done by foreign countries' producers within its boundaries. GDP can be measured at factor cost or at market price/producers price. GDP at market price is the value of the goods and services produced in the country valued at the prevailing market prices. It includes indirect taxes (VAT, custom duties) and excludes subsidies. But GDP at factor cost measures value added in various economic activities. It includes the sum salaries and wages (compensation of employees), business profits (incorporated and unincorporated also called operating surplus), self-employed income and depreciation. (Factor cost and market price ought to be the same but market value is different from earnings of factors of production b/cos of the addition of indirect taxes in market price GDP). Thus GDP at factor cost = market price GDP- indirect taxes+ subsidies.
Definition: The NDP is defined as the GDP (factor cost) less capital consumption/depreciation. A case could be made that the NDP better reflects an economy’s level of production since it takes into account the value of capital that is consumed in the production process. Suppose, for example, that you own a car that generates N120,000 of transport income a year and you service it with N20,000 in damage (capital consumption). While your gross income is N120,000 (a part of the GDP), your net income net will be N100, 000 (a part of the NDP). Hence economists are most concerned with net domestic product than gross domestic product/income.
NDP= GDP(factor cost) –depreciation/capital consumption

Nominal GDP and adjustments to GDP
Nominal GDP is the value of GDP in current (actual) prices. Real GDP is the value of GDP in constant prices. The raw GDP figures that are published in most cases are called the nominal, historical, or current, GDP. When one compares GDP figures from one year to another, it is desirable to compensate for changes in the value of money – i.e., for the effects of inflation or deflation. To make it more meaningful for year-to-year comparisons, we need a measure that adjusts for the rise of fall in the prices of goods and services. Some indexes that can be used are; consumer price index, producer price index, and GDP deflator. The most common and appropriate factor used to convert GDP from current to constant values in this way is called the GDP deflator. Unlike consumer price index, that measures inflation or deflation in the price of household consumer goods, the GDP deflator measures changes in the prices of all domestically produced goods and services in an economy including investment goods and government services, as well as household consumption goods. This is done using a base year when the general price level is not too high or low. The base year is set at 1 or 100. To calculate real GDP for a particular year
Real/constant GDP = GDP for the current year* base year (100)/current year price index.
e.g assume the 1985 is the base year, and GDP for 1987 is N500, 000 while the price index for 1987 is 250, real GDP= 500000*100/250= N200000
GDP deflator= Nominal GDP /Real GDP Student: Given the following hypothetical output table, Year Unit of output (in million) Price per output (N) 1990 50 100 2000 70 150 2010 100 180 Using 1990 as the base year, calculate; the Nominal GNP for the year and the real GDP for each year
Gross National Product
This is the most comprehensive measure of a nation's total output of goods and services. Basically, GNP is the total value of all final goods and services produced within a nation in a particular year, plus income earned by its citizens (including income of those located abroad), minus income of non-residents located in that country. It can also be defined as GDP plus net income from abroad (income accruing to the nationals residents from investments abroad, less the income earned in the country owing to overseas residents). GNP measures the value of goods and services that the country's citizens produced regardless of their location. GNP is one measure of the economic condition of a country, under the assumption that a higher GNP leads to a higher quality of living, all other things being equal.
GNP at market price: this is the gross value of goods and services produced in a country in one year measured at the current market prices plus net income from abroad. It given as
GNP (market price) =GDP (market price) + net income from abroad.
GNP (factor cost): this is the sum of the money income accruing to the various factors of production of the nationals of a country in a year. It is given as
GNP (factor cost) = GNP (market price) - indirect taxes +subsidies. GNP (factor cost) = GDP (market price) - indirect taxes +subsidies+ net income from abroad.
NNP is the monetary value of finished goods and services produced by a country's citizens, whether overseas or resident, in the time period being measured (i.e., the gross national product, or GNP) minus the amount of GNP required to purchase new goods to maintain existing stock (i.e., depreciation). Depreciation (also known as consumption of fixed capital) measures the amount of GNP that must be spent on new capital goods to maintain the existing physical capital stock. NNP is also defined as the amount of goods in a given year which can be consumed without reducing future consumption. Setting part of NNP aside for investment permits capital stock growth
NNP (market price) = GDP (market price)- depreciation + net income from abroad
NNP (market price) = GNP (market price)- depreciation

NNP (factor cost) is net income measured at factor cost/prices. It is given as
NNP (factor cost) = NNP (market price)-indirect taxes +subsidies, this is also given as
NNP (factor cost) = National Income (NI) =GNP (market price)-indirect taxes + subsidies- depreciation.
NNP at factor cost = GDP at market price - depreciation + NFIA (net factor income from abroad) - net indirect taxes+ subsidies
NNP at factor cost = GDP @ factor cost + NFIA (net factor income from abroad)- depreciation
NNP at factor cost = GNP @ factor cost - depreciation
National income = domestic income + net income from abroad. (This may be positive or negative. It is positive if export is more than import and national income will be greater than domestic income)
Domestic income/product: this is income earned by the factors of production in a country using its own resources. It includes wages and salaries, rents, interest, dividends, undistributed cooperate profit, profits of unincorporated firms, self-employed, and direct taxes. It does not included income from abroad. Thus it is given as
Domestic income= NI-net income from abroad
Personal income: this is the total income received by individuals of a country from all sources before payment of direct taxes in that year. Personal income is not equal to national income because personal income includes transfer payments which are not included in notional income. We derive personal income from national income by deducting cooperate profit, profit taxes and employees contributions on social securities but business and government transfers payments and transfer payments from abroad in the form of gift, remittance from abroad, windfall gains, and interest on public debt which are source of income for the individuals are also added to national income.
Personal income = national income – undistributed corporate profits- profit taxes-social security’s+ transfer payments+ interest on public debt.
Disposable income: this is also called personal disposable income. This is the actual income that can be spent by the individuals. Personal income is not totally spent. Direct taxes are deducted from it. Thus disposable income (DI) = personal income – direct taxes.
Disposable income is dived into two consumption and savings. DI = consumption + savings.
Real NI (Real NNP): It follows the same method of the real GDP. Thus it is given as
Real NNP (NI) = current NNP * base year index (100)/current year index.
A related statistic to GDP/GNP is called the per capita income. GDP/GNP per capita: Gross domestic product per capita is the mean value of the output produced per person, which is also the mean income. It measures the value of production per person. It is given as GDP for the year/population of that year. To measure the standard of living, GDP per capita is often used although it is not a good measure because it is assumed that all citizens would benefit from their country's increased economic production. Similarly, GDP per capita is not a measure of personal income. GDP may increase while real incomes for the majority decline. The major advantage of GDP per capita as an indicator of standard of living is that it is measured frequently, widely, and consistently. It is measured frequently in that most countries provide information on GDP on a quarterly basis, allowing trends to be seen quickly. It is measured widely in that some measure of GDP is available for almost every country in the world, allowing inter-country comparisons. It is measured consistently in that the technical definition of GDP is relatively consistent among countries. The per capita GDP is especially useful when comparing one country to another because it shows the relative performance of the countries. A rise in per capita GDP signals growth in the economy and tends to translate as an increase in productivity. For a better comparison between countries we use GDP corrected using the current currency exchange rate. This brings all countries GDP to same level and proper comparison can be made.
Income per capita = national income/ population
GDP per capita is not a good measure of personal income
Real per capita income for any year = real national income for that year/ population A country’s rate of growth is generally the annual percentage increase in real GDP. Constant/real-GDP figures allow us to calculate a GDP growth rate, which indicates how much a country's production has increased (or decreased, if the growth rate is negative) compared to the previous year. Real GDP growth rate for year n = [(Real GDP in year n) − (Real GDP in year n − 1)] / (Real GDP in year n − 1)

GDP vs. GNP
GDP can be contrasted with (GNP) or (GNI). The difference is that GDP defines its scope according to location, while GNP defines its scope according to ownership. GDP is product produced within a country's borders; GNP is product produced by enterprises owned by a country's citizens. While GNP measures the output generated by a country's enterprises (whether physically located domestically or abroad) GDP measures the total output produced within a country's borders - whether produced by that country's own local firms or by foreign firms. The two would be the same if all of the productive enterprises in a country were owned by its own citizens, and those citizens did not own productive enterprises in any other countries. In practice, however, foreign ownership makes GDP and GNP non-identical. Production within a country's borders, but by an enterprise owned by somebody outside the country, counts as part of its GDP but not it’s GNP; on the other hand, production by an enterprise located outside the country, but owned by one of its citizens, counts as part of its GNP but not its GDP. Similarly, if a country becomes increasingly in debt, and spends large amounts of income servicing this debt this will be reflected in a decreased GNI but not a decreased GDP. Similarly, if a country sells off its resources to entities outside their country this will also be reflected over time in decreased GNI, but not decreased GDP. This would make the use of GDP more attractive for politicians in countries with increasing national debt and decreasing assets. Gross national income (GNI) equals GDP plus income receipts from the rest of the world minus income payments to the rest of the world. Some countries have switched from using GNP to GDP. For instance, in 1991, the United States switched from using GNP to using GDP as its primary measure of production.
GDP = consumption + investment + (government spending) + (exports − imports)
GNP = GDP + NR (Net income inflow from assets abroad or Net Income Receipts) - NP (Net payment outflow to foreign assets)
Calculations on national income.

1. Given a hypothetical data of Nigeria economy, Cal (a) GNP at factor cost (b) GDP at factor cost (c) national income (d) personal disposal income (000, naira) • GNP at market price = 29,498,163 • Net factor income from abroad = -5500 • Fixed capital consumption = 5789 • Indirect taxes= 11678 • Subsidies= 2300 • Transfer payments 2589 • Corporation tax 2376 • Undistributed corporate profit 2689 • Direct taxes paid by house holds 3289 • Interest on public debt 1178
Answer. (a) GNP @ factor cost = GNP (@ market price) – indirect taxes + subsidies = 29498163+2300-11678 = N 29488785 b) GDP (@ factor cost) = GNP (@ factor cost)- net income from abroad = 29488785—5500= N 29494285 (c) NI = NNP (@ factor cost) = GNP (Factor cost) – depreciation = 29488785 – 5789 = N 29482996 d) personal disposable income = PI – direct tax. PI = NI (NNP @ factor cost) + transfer payment + interest on public debt- undistributed corporate profit-corporation taxes (profit tax) = 29482996 + 2589 + 1178- 2689- 2376 = PI = N 29481698
Thus personal disposable income = PI – Direct tax = 29481698- 3289 = N 29478409

Student. 2. Given a hypothetical data of Nigeria economy, cal (a) GNP at factor cost (b) GDP at market price (c) national income (d) personal disposal income (e) personal savings if personal consumption is 80% of personal disposable income (f) per capita national income if the population for that year is 144 (000) (000, naira) • GNP at market price = 25225140

• Net factor income from abroad = -4500 • Consumption of fixed capital = 5789 • Indirect taxes= 15678 • Subsidies= 2380 • Government Transfer payments 1589 • Corporation tax 2376 • Transfer payment from abroad 1271 • Undistributed corporate profit 2689 • Direct taxes paid by house holds 2289 • Interest on public debt 878 • Social security 2478
APPROACHES TO THE MEASURE OF NI
In the measure of national income, three approaches are used: the income approach, the expenditure approach and the output/value added approach.
The output approach: This is the most direct of the three approaches most realistic . It sums the outputs of every class of enterprise to arrive at the total. The output approach focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces. Because of the complication of the multiple stages in the production of a good or service, only the final value of a goods or services at the market prices is included in total output. Using the value added approach, the contribution of the different sectors to the national income can be known and growth or fall of the sector can also be determined easily because we can compare the contribution with previous years. But its challenge is in the calculation of value added in monetary terms of public services like the force, health and educational sectors

The expenditure approach

The expenditure approach is basically an output accounting method. It focuses on finding the total output of a nation by finding the total amount of money spent. The expenditure approach works on the principle that all of the product must be bought by somebody, therefore the value of the total product must be equal to people's total expenditures in buying things. This is acceptable, because like output, the total value of all goods is equal to the total amount of money spent on goods. The basic formula for domestic output takes all the different areas in which money is spent within the region, and then combines them to find the total output/income.
It is given as GNP/GDP = C +I +G +X-M
Where:
C = Private/household consumption expenditures / personal consumption expenditures
I = gross private domestic investment
G = government consumption and gross investment expenditures. It also includes government expenditure on enterprises but expenditures on transfer payments such as social security or unemployment benefits are not added cos these payments are not made in exchange of goods and services. X = gross exports of goods and services. It captures the amount a country produces, including goods and services produced for other nations' consumption, therefore exports are added. M = gross imports of goods and services. Imports are subtracted since imported goods will be included in the terms G, I, or C, and must be deducted to avoid counting foreign supply as domestic.
Note: (X - M) is often written as XN, which stands for "net exports". In the expenditure-method equation given above, the exports-minus-imports term is necessary in order to null out expenditures on things not produced in the country (imports) and add in things produced but not sold in the country (exports).
Income approach
The income approach works on the principle that the incomes of the productive factors (producers,) must be equal to the value of their product, and determines GDP/GNP by finding the sum of all producers' incomes. Thus the approach sum total of incomes of individuals that is that firms pay households for factors of production they hire- wages for labour, interest for capital, rent for land and profits for entrepreneurship in a country during 1 year.
The main types of factor income are: • Wages and salaries. All sum received through productive activities • Rental income, rents of land, shop, houses and the estimates of all rentable assets used by the owners • Employee compensation (cost of fringe benefits, including unemployment, health, and retirement benefits); • Interest received • Dividend • Undistributed profits • Direct and indirect taxes • Depreciation : every cooperation makes allowance for expenditure for wears and tears • Net income from abroad. This is added when the national income is calculated from GNP • Royalties paid for the use of intellectual property and extractable natural resources. Formulae:

Difficulties in Measurement of National Income

There are many difficulties when it comes to measuring national income, however these can be grouped into conceptual difficulties and practical difficulties.

Conceptual Difficulties

• Inclusion of Services: There has been some debate about whether to include services in the counting of national income, and if it counts as output. Marxian economists are of the belief that services should be excluded from national income, most other economists though are in agreement that services should be included. • Identifying Intermediate Goods: The basic concept of national income is to only include final goods, intermediate goods are never included, but in reality it is very hard to draw a clear cut line as to what intermediate goods are. Many goods can be justified as intermediate as well as final goods depending on their use. • Identifying Factor Incomes: Separating factor incomes and non-factor incomes is also a huge problem. Factor incomes are those paid in exchange for factor services like wages, rent, interest etc. Non-factor are sale of shares selling old cars property etc., but these are made to look like factor incomes and hence are mistakenly included in national income. • Services of Housewives and other similar services: National income includes those goods and services for which payment has been made, but there are scores of jobs, for which money as such is not paid, also there are jobs which people do themselves like maintain the gardens etc., so if they hired someone else to do this for them, then national income would increase, the argument then is why are these acts not accounted for now, but the bigger issue would be how to keep a track of these activities and include them in national income.

Practical Difficulties

• Unreported Illegal Income: Sometimes, people don't provide all the right information about their incomes to evade taxes so this obviously causes disparities in the counting of national income. • Non Monetized Sector: In many developing nations, there is this issue that goods and services are traded through barter, i.e. without any money. Such goods and services should be included in accounting of national income, but the absence of data makes this inclusion difficult.
Some factors that affect the GNP or GDP include Population expansion or contraction; entrepreneurism, the creation of new goods and services; trade with other countries; war, through destruction or through expansion of trade; natural resources - their discovery or depletion.

Circular flow of income

The circular flow of income gives us a basic way of understanding how different parts of the economic system fit together. It shows in a diagram the connections between different sectors of our economic system. The circular flow of income is a neoclassical economic model depicting how money flows through the economy. The major sectors of the economy are the household sector, the firm, the government and the foreign sector. These different sectors interacts together giving us different forms of flows. Thus we have a two sector, three sector and a four sector economy circular flow of income.
Circular flow in a two sector economy.

This is the simplest version of the circular flow where the economy is modeled as consisting only the households and firms. In the National income, output, and expenditure are generated by the activities of the two most vital parts of an economy, its households and firms, as they engage in mutually beneficial exchange. Thus the two sector economy circular flow revolves around flows of goods and services and factors of production between firms and households. The primary economic function of households is to supply domestic firms with needed factors of production - land, human capital, real capital and enterprise in return for a reward while the function of firms is to supply private goods and services to households. The household sector supplies its factors of production to producers who produce goods and services by co-coordinating them. Producers or business sector in return makes payments in the form of rent, wages, interest and profits to the household sector. Again household sector spends this income to fulfill its wants in the form of consumption expenditure. Business sector supplies those goods and services produced and get income in return of it. Thus expenditure of one sector becomes the income of the other and supply of goods and services by one sector of the economy becomes demand for the other. Money flows to workers in the form of wages, and money flows back to firms in exchange for products. This process is unending and forms the circular flow of income, expenditure and production. This simplistic model suggests the old economic adage; “Supply creates its own demand”. This model of circular flow of income involves some basic assumptions:- 1. The economy consists of two sectors: households and firms. 2. Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S). 3. All output (O) produced by firms is purchased by households through their expenditure (E). 4. There is no financial sector. 5. There is no government sector. 6. There is no overseas sector. It is a closed economy with no exports or imports. 7. Goods and services flows in one direction and money payment to get these flows in return direction.

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Thus we have two flows: Real Flow and Money Flow. Real Flow- In a simple economy, the flow of factor services from households to firms and corresponding flow of goods and services from firms to households s known to be as real flow. Since there will be an exchange of goods and services between the two sectors in physical form without involving money, therefore, it is known as real flow.
Money Flow- In a modern two sector economy, money acts as a medium of exchange between goods and factor services. Money flow of income refers to a monetary payment from firms to households for their factor services and in return monetary payments from households to firms against their goods and services.
In this model GNP =GNI
Injections and Leakages, circular flow with savings and investment.
In the real economic system, the households do not spend all their income in the purchase of goods and services and the firms do not spend all their income in the purchase of current factors of production. Assumptions two and four are relaxed. Thus there are leakages and injections in the economy.
Leakages are withdrawals from the circular flow and these are in the form of

Leakages (Withdrawals) into Circular Flow of Income

Leakages (Withdrawals) are items that take money out of the circular flow. This includes: • Savings (money not used to finance consumption) (S) in banks accounts and other types of deposit • Imports (money sent abroad to buy foreign goods and services) (M) which flow into the economy • Taxes (money collected by government) (T) e.g. income tax and national insurance

Injections into Circular Flow of Income: Injections into the circular flow are additions to investment, government spending or exports so boosting the circular flow of income leading to a multiplied expansion of output. These are in the form of: • Investment. Money invested by firms into purchasing capital stock (I) e.g. on new technology • Exports. Money coming from abroad to buy domestically produced goods (X). • Government spending (G) e.g. on the NHS or defense. The circular flow will adjust following new injections into it or new withdrawals from it. An injection of new spending will increase the flow. A net injection relates to the overall effect of injections in relation to withdrawals following a change in an economic variable.
Savings and investment
The simple two sector economy circular flow is, therefore, adjusted to take into account withdrawals and injections. Households may choose to save (S) some of their income (Y) rather than spend it (C), and this reduces the circular flow of income. Marginal decisions to save reduce the flow of income in the economy because saving is a withdrawal out of the circular flow. However, firms also purchase capital goods, such as machinery, from other firms, and this spending is an injection into the circular flow. This process, called investment (I), occurs because existing machinery wears out and because firms may wish to increase their capacity to produce. There is a capital/credit market between savings and investment that coordinates the activities of the firms and the households. The house save to the capital market and the firms comes to the capital market to take the money in form of loan for investment

Diagram
An economy is in equilibrium when the rate of injections = the rate of withdrawals from the circular flow.
Significance of Study of Circular Flow of Income
1.Measurement of National Income- National income is an estimation of aggregation of any of economic activity of the circular flow. It is either the income of all the factors of production or the expenditure of various sectors of economy. However, aggregate amount of each of the activity is identical to each other.
2.Knowledge of Interdependence- Circular flow of income signifies the interdependence of each of activity upon one another. If there is no consumption, there will be no demand and expenditure which in fact restricts the amount of production and income.
3.Unending Nature of Economic Activities- It signifies that production, income and expenditure are of unending nature, therefore, economic activities in an economy can never come to a halt. National income is also bound to rise in future.

Macroeconomic theories

Macroeconomic theories are defined sets of principles that describe how the key macroeconomic variables are determined. They are also defined as scientific theories that seek to explain phenomena associated with the macro-economy. Thus macroeconomic theories inevitably provide policy recommendations intended to improve the performance of the economy and to correct macroeconomic problems. Among the macroeconomic theories are:
Classical economics: ideologies
Keynesian economics: ideologies
Monetarism: ideologies New Classical economics: ideologies

Classical economics: ideologies
Classical economics is widely regarded as the first modern school of economic thought. The term "classical economics" was coined by Karl Max to refer to Ricardian economics– the economics of David Ricardo and James Mill and their predecessors – but usage was subsequently extended to include the followers of Ricardo. This includes Adams Smith, David Ricardo, Jean-Baptiste Say, and Thomas Robert Malthus. The Classical School of economic theory began with the publication in 1776 of Adam Smith's monumental work, The Wealth of Nations where he believed that land, labor, and capital are the three factors of production and the major contributors to a nation's wealth. Their ideal of economy is a self-regulating market system that automatically satisfies the economic needs of the populace. The market mechanism is described as an "invisible hand" that leads all individuals, in pursuit of their own self-interests, to produce the greatest benefit for society as a whole. The classical economists did not differentiate between macroeconomic and microeconomic theory. They used their understanding of (micro) economic theory to analyze both micro and macroeconomic phenomena. Classical economists conceived of the macro economy as no more than aggregated microeconomics. Thus, what we now conceive of as aggregate supply was simply the sum of each firm’s production decision. Similarly, aggregate demand was the sum of all individual demand curves. The classical theory of economics dominated the 18th and early 19th centuries and laid the foundation of modern economics. Sometimes referred to as laissez faire economics, classical theory concentrated on growth, free trade, competition and economies free from government regulation. Under this viewpoint, the concern for profit ensures that society's resources are used in the most beneficial manner, without direction by government. The role of government is to provide public goods such as national defense, infrastructure, education and a system of justice that includes enforcement of contracts. From a classical economics perspective, government is the problem, not the solution. Inefficiency and unemployment arise because government prevents markets from achieving equilibrium through regulations, taxes, or other forms of meddling. Classical economists maintain that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP that is obtained when the economy's resources are fully employed. While circumstances arise from time to time that cause the economy to fall below or to exceed the natural level of real GDP, self-adjustment mechanisms exist within the market system that work to bring the economy back to the natural level of real GDP. Classical economics relies on three key assumptions--flexible prices, Say's law (Supply side of the economy Supply creates its own demand), and saving-investment equality--in the analysis of macroeconomics. The theoretical structure of classical economics is based on a view that the macro-economy operates in aggregate according to the same basic economic principles that guide markets and other microeconomics phenomena. Flexible Prices, wage and interest rate: They assumed that prices and wages would drop until the market cleared, and all goods and labor were sold. With flexible prices, unrestricted by government regulations or market control, markets are able to quickly and efficiently achieve equilibrium. In particular, a market is able to quickly eliminate any shortage and surplus that exists, reaching a balance between the quantity demanded and quantity supplied. This is especially important for resource markets in which equilibrium means that full employment is maintained and unemployment is not a problem. The primary implications of this theory are that aggregated markets especially resource markets automatically achieve equilibrium and in so doing maintain full employment of resources without the need for government intervention and that government intervention is more likely to create macroeconomic problems. If there was any unemployment, then the following would happen:
Unemployment (surplus of labour) ---( fall in wages----( increased in demand for labour---( restore full employment (equilibrium). Any unemployment left in the economy would be purely voluntary unemployment. Unemployment results from the rigidity of wage structure and interference in working of free market system in the form of trade union legislation, minimum wage legislation e.t.c. Say's Law: The second assumption of classical economics is that the aggregate production of good and services in the economy generates enough income to exactly purchase all output. This means that the economy is always capable of demanding all of the output that its workers and firms choose to produce. Thus, the economy is always capable of achieving the natural level of real GDP. Say's law is commonly summarized by the phrase "supply creates its own demand" and is consistent with the modern circular flow model. With Say's law of markets a mismatch between aggregate demand and aggregate supply is a rare and temporary occurrence. The economy is most unlikely to experience an aggregate surplus or shortage of production. Saving-Investment Equality: The last assumption of classical economics is that saving by the household sector exactly matches investment expenditures on capital goods by the business sector. This assumption ensures that Say's law holds because any decrease in consumption demand for output due to saving is replaced by an equal amount of investment demand. The saving-investment equality is assured by applying the notion of flexible prices to interest rates in the financial markets assuming that flexible interest rates will always maintain equilibrium. For example, if there was an autonomous increase in saving (an increase in “thrift”), the real interest rate would decrease as the supply of loanable funds increased. The lower interest rates would induce entrepreneurs to borrow the “extra” saving. Thus, if GDP is the sum of consumption (C) and Investment (I), and C decreases (as saving increases), I increases by the same amount, and GDP stays exactly the same. As another example, suppose there is some technological improvement that causes an increase in the rate of return on investment (an increase in “enterprise”). The desired increase in investment translates to an increase in demand for loanable funds, leading to a higher real interest rate. The higher interest rate induces an increase in saving to finance the investment. As a result, consumption decreases and investment increases, while overall output stays the same. They however failed to consider what will happen when the funds from aggregate saving exceed the needs of all borrowers in the economy. This will lead to a fall in real GDP below its natural level because investment expenditures will be less than the level of aggregate saving.
Increase in investment---( increased demand for money--( interest rate is increased---(increased savings---(fund is provided for investment the economy is restored to equilibrium.
Savings increases(Interest rate falls--(demand for money increases--(investment increases---interest rises-(savings increases-(economy in equilibrium.

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This implies a vertical aggregate supply curve based on the available resources, with factor prices adjusting so that all resources are fully employed, and output prices adjusting for all goods and services to be purchased. As a consequence, aggregate demand has no effect on the levels of output or employment. The only way to change output or employment is either an increase in the supply of labor or an increase in labor productivity, which would shift the aggregate supply curve to the right. They introduced the value theory and distribution theory. The value of a product was thought to depend on the costs involved in producing that product. Economists also applied this classical framework to macroeconomic issues, especially unemployment, economic growth, quantity of money theory and business-cycle stability
Tthe most important implications of classical economics are that efficiency and full employment are attained without government intervention. Government is not needed to direct resources to the most desired activities--markets do this automatically. Government is not needed to keep resources working--markets do this automatically and any problems of inefficiency and unemployment that might emerge are attributable to government intervention.

Keynesian Economics: ideologies
From the beginning of the Great Depression in 1929, Classical economics started having problem in explaining the economy and they finally fell out of favor in the 1930s largely because it did not adequately explain the occurrence of high rates of unemployment during the Great Depression and this resulted to the Keynesian Economics led by John Maynard Keynes in his book ‘the General Theory of Employment, Interest and Money’ published in 1939. The Classicalists were highly criticized for not being able to see the importance of the short-run changes that were taking place. They held many variables fixed and focused on the supply side of the economy and this could not give a viable answer for what was happening. This brought about a great deal of criticism from many analysts and cast the entire economics discipline in a bad light, much like what happened after the Great Recession of 2007-09. The Keynesian economics showed that the depression was as a result of the failure of the government to control the economy through appropriate policies. Thus to the Keynesians, the economy is inherently unstable and need to be guided by discretionary policies. He insisted that direct government intervention was necessary to increase total spending. Nonetheless, Classical economics is the jumping off point for understanding all modern macroeconomic theories, since in one way or another they change or relax the assumptions first discussed in the Classical school of thought to derive a more realistic model. In Keynes's theory, the quantity theory broke down because people and businesses tend to hold on to their cash in tough economic times, a phenomenon he described in terms of liquidity preferences. Keynes also explained how the multiplier effect would magnify a small decrease in consumption or investment and cause declines throughout the economy. Keynes also noted the role uncertainty and animal spirits can play in the economy. Keynes' arguments proved the modern rationale for the use of government spending and taxing to stabilize the economy. Government would spend and decrease taxes when private spending was insufficient and threatened a recession; it would reduce spending and increase taxes when private spending was too great and threatened inflation. His analytic framework, focusing on the factors that determine total spending, remains the core of modern macroeconomic analysis.
Keynesian perspective argues that an economy left to its own devices will not use its full capacity. Because of this, Keynes argued that government intervention is necessary to ensure an economy operates at its fullest. Keynes had a view that demand creates its own supply and unemployment is as a result of ineffective demand because people do not spend their whole income on consumption. They believe that savings is a private virtue and a public vice. In such a situation, aggregate demand will fall below the level required to purchase exciting output and this will lead to resource unemployment. The Keynesians mainly believe in the short-run analysis and according to Keynes, ‘in the long-run we are all dead’, immediate results in economic theories. Policies focus on the short-term needs and how economic policies can make instant corrections to a nation. Keynesian macroeconomics is mainly concerned with the determinant of demand. They believe that supply adjust to demand. An inadequate demand leads to a fall in production and this causes unemployment. This thus calls for the government involvement in the economy to boost aggregate demand. Thus they advocates for maximum government intervention in the economy to them, the economy is incapable to correct itself when ever there is shortage (unemployment) because prices and wages do not adjust easily, it takes lags, making them rigid and can only adjust after a long period. He is known for the analysis of liquidity preference, liquidity trap and the marginal efficiency of capital in macroeconomic analysis. In the theory of money, he distinguished three motives of holding money; transactional motive, precautional motive and speculative motive

MONETARIST ECONOMICS
Problems arose in the 1970s and early 1980s when stagflation occurred. Stagflation occurs when unemployment and inflation are both high at the same time. The decade of the 1970s saw rising oil prices caused by an OPEC oil embargo on the United States. This oil embargo caused both high inflation and steep economic downturn that in turned caused high unemployment. Keynesians were puzzled by the outbreak of stagflation because the original Phillips curve ruled out concurrent high inflation and high unemployment. This led to the Monetarist economics led by Milton Friedman. According to the monetarist, both inflation and unemployment are largely monetary phenomenon. Inflation is as a result of too much money in circulation while unemployment is often strengthened as a result of inadequate money supply. The monetarist and classicalist are not too far apart (they are most times classified/ called the new classical school) . Like the classicalist, the monetarist believed that the problem of unemployment is as a result of regulation (minimum wage legislations) and union- enforced wages and these causes dis-equilibrium in the labour market. They also believed that there is some natural rate unemployment that cannot be wiped away from the economy since people are always moving from one job to the other. They believed more on the reduction/control of inflation than unemployment. In their view, an unguided expansion of money supply coupled with sticky wages and increases in unemployment benefits is the cause of stagflation. They are not in total agreement to the government control of the economy because it is usually at some costs. Fluctuations in the economy (business cycle) are mainly as a result of irregular growth in money supply. Thus to keep the economy stable, there should be a gradual increase in the money supply.

THE NEW CLASSICALIST ECONOMICS
The New Classical School emerged from the classical school in the 1970s in response to the failure of Keynesian economics to explain stagflation and to modify the views of the monetarist. They became the dominant school in Macroeconomics based on the fact that the new concepts and ideas which emerged from New Classical economics such as rational expectations were accepted by the opposing new Keynesian school except for the fact that the New Keynesian still maintained the effectiveness of fiscal policy. It is led by Robert Lucas, Jr. followed by some other economist among who are Thomas Sargent, Robert Barro, Neil Wallace, Patrick Minford and Edward C. Prescott. Their analysis is based on three assumptions. 1. Market clear easily 2. Rational expectation 3. Aggregate supply
Market clearing easily: This assumption is based on the flexibility of prices and wages and that the economy is always in a state of continuous equilibrium. Since prices and wages adjust easily, any unemployment is regarded as natural unemployment/voluntary unemployment and this is as a result of the reluctance of the people to take job at the prevailing price/wage rate and lack of incentive/motivation. In the fig below, SSL is the supply of labour which is inelastic in the long-run and DDL is the demand for labour. The market is in equilibrium at ON and wage rate OW while ONt is the total labour force in the economy. The labour forces outside this equilibrium level are not prepared to work at the wage rate OW.

Aggregate supply hypothesis: This is based on two assumptions: rational decisions are always taken by the firms and the people; the supply of labour and output depends on their relative prices. If we take the goods market, as shown in the fig below, the economy is in initial equilibrium at point a where the aggregate demand (AD), long run aggregate supply (LRAS) and short run aggregate (SRAS) met, price is OP while output level is OY. If the people anticipate increase in money supply, this will increase aggregate demand and AD shifts to the right to AD1. Price moves upward to OP2, there is increase in supply in the short-run to SRAS1 and the economy is still at equilibrium at point b with no increase in output OY. But if the aggregate demand is not anticipated due to money supply (i.e people anticipate aggregate demand not because money supply is increasing but by some other factors such as population growth) , the economy moves from its initial level to point c where AD1 meets SRAS, price will rise to OP1 while output will increase to OY1. But in the long run, with adjustments in the economy, output will come back to OY with price at OP2.

Rationale expectations: They believe that the people form/ have expectation of the future. This is the most important hypothesis of the New Classical Economies and their difference from the classical economics. This hypothesis is used to explain the Philips curve. The arrival of the new classicalist, economist had generally adaptive expectations where agents were assumed to look at the recent past to make expectations about the future. Under rational expectations, agents are assumed to be more sophisticated. A consumer will not simply assume a 2% inflation rate because that has been the average for the past few years; he will look at current monetary policy and economic conditions to make an informed forecast. When new classical economists introduced rational expectations into their models, they showed that monetary policy could only have a limited impact. However, these expectations are based in most cases on wrong forecast hence the New Classical Economist believe that natural rate of unemployment cannot be different from actual rate of unemployment. If people are rational, they will always remember that past increase in prices and changes in prices have always led to an increase in the quantity of money which increases aggregate demand, hence there will not be a tradeoff between unemployment and inflation both in the short-run and long run. The Philips curve of the new classicalist is thus vertical given equilibrium/ natural rate of unemployment. Form the fig below, natural rate of unemployment is Un, at PC Philips curve. When the people under predict the rate of inflation (expected inflation is less than inflation), they will believe that the aggregate demand has increased and this will lead to increase in output and employment shifting the Philips curve to the PC Un1 lower than the natural rate and if they over predict the rate the opposite will take place and unemployment and inflation rises to Un2 higher than the natural rate of unemployment.
The new Classical are also known for their real business cycle analysis (RBC).

NEW KEYNESIAN ECONOMICS The New Classicalist were highly criticized that market does not clear easily by the New Keynesian School that was given birth to by the Keynesian Economist in 1980s’. Among its members is N. Gregory Mankiw. New Keynesian models investigated sources of sticky prices and wages, which would not adjust, allowing monetary policy to have impact on the economy. New Keynesian Economists believe that market-clearing models cannot explain short-run economic fluctuations, and so they advocate models with “sticky” wages and prices. Their theories rely on this stickiness of wages and prices to explain why involuntary unemployment exists and why economic policies (monetary and fiscal policy) has a strong influence on economic activity. Their analysis is based on the Menu Costs, Aggregate-Demand Externalities and Staggering Prices. Menu Costs: A major reason why prices do not adjust immediately to clear markets is that adjusting prices is costly. To change prices, firms may need to send out a new catalog to customers, distribute new price lists to its sales staff, or, in the case of a restaurant, print new menus. These costs of price adjustment called “menu costs,” discourage firms from adjusting continuously/easily. Although most economists disagrees (classical and new classical) about the effect of menu costs in explaining short-run economic fluctuations arguing that such cost are usually are very small and are unlikely to help explain recessions, which are very costly for society. New Keynesians replied that “small” does not mean “inconsequential.” Even though menu costs are small for the individual firm, they could have large effects on the economy as a whole leading to aggregate demand externalities. Aggregate demand externalities: externality is the situation where the action of an individual/ firm affects the other person positively or negatively. Aggregate demand externality is thus the macroeconomic impact of one firm’s price adjustment on the demand for all other firms’ products. It is also a situation where the prices change action of firm/firms affects the aggregate demand. Prices adjust slowly because changes in prices have externalities. For instance, a price reduction by one firm benefits other firms in the economy. When a firm lowers the price it charges, it lowers the average price level slightly and thereby raises real income (Nominal income is determined by the money supply). This stimulates higher real income, in turn, raises the demand for the products of all firms. In the presence of this aggregate-demand externality, small menu costs can make prices sticky, and this stickiness can have a large cost to society. Assume there is increase in money supply and Dell Lap-Top distributors in Nigeria increases price, and then, after a fall in the money supply, decides whether to cut prices. If it did so, its buyers would have a higher real income and would therefore buy more products from other firms/companies as well. But the benefits to other companies are not what Dell Lap-Top distributors cares about, may be to maintain their customers. Thus, they would sometimes fail to pay the menu cost and cut its price, even though the price cut is socially desirable. This is an example in which sticky prices are undesirable for the economy as a whole, even though they may be optimal/good for those setting prices. The Staggering of Prices: New Keynesian explanations of sticky prices often emphasize that not everyone in the economy sets prices at the same time. Instead, the adjustment of prices throughout the economy is staggered. This staggering complicates the setting of prices because firms care about their prices relative to those charged by other firms. This can make the overall level of prices adjust slowly, even when individual prices change frequently. Assume first, that price setting is made at the same time or at the same rate and firms adjust prices on the first of every month when there is a change in the economy. There is increase in money supply and aggregate demand rises on the 15th of November, output will be higher the economy will be in boom and this will be on from 15th November to December 1st.
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But because it is not easily for firms/different sectors to have such uniform price setting, price changes are staggered. Thus If the money supply rises on November 15th, and some firms decides change prices on the 18th while the other firms change theirs on the 25th, but because some of the firms will not change their prices on the 18th, a price increase by any firm (those that responded first) will raise that firm’s relative price (as compared to other firms), which will cause it to lose customers. Therefore, these firms will probably not raise their prices at all or not very much. Hence, staggering makes the price level sluggish, because no firm wishes to be the first to post a substantial price increase. In new Keynesian theories recessions are caused by some economy-wide market failure. Thus, new Keynesian economics provides a rationale for government intervention in the economy, such as countercyclical monetary or fiscal policy

UNEMPLOYMENT

Simply defined, unemployment is defined as a situation in which persons who are willing and able to work at the prevailing wage structure/level are not employed. According to International Labour Organization (ILO) unemployment is said to be more encompassing, “the unemployed is a member of the economically active population, who are without work but available for and seeking for work, including people who have lost their jobs and those who have voluntarily left work. But this definition is not widely accepted because of the preponderance of housewives who possess the ability and willingness to work and the definition of the age bracket which is not the same in all countries stand as limitations to the definition by ILO. The Keynesian economists see unemployment as a situation in which the number of people able and are willing to work at prevailing wage exceeds the number of jobs available, and at the same time, firms are unable to sell all the goods they would like (Bannock et al, 1998). The classical case of unemployment is premised/ based on the inflexibility of wages. Unemployment results because labor, due to organized activities does not allow wages to decline for the accommodation of excess labor when there is incidence of unemployment. Given wage – price flexibility, there are automatic forces in the economic system that tends to maximize full employment and produce output at that level. Thus, full employment is regarded as a normal situation and any deviation from this is something abnormal that automatically tends towards full employment The amount of unemployment in an economy is measured by the unemployment rate, which is the percentage of workers without jobs in the labor force. The labor force only includes workers actively looking for jobs. It is the sum of the employed and unemployed. People who are retired, pursuing education, or discouraged from seeking work by a lack of job prospects are excluded from the labor force. This is derived from the working population which consists of persons in the country who are in the age bracket of 16-65 and are well and fit to work. It excludes institutionalized in mental hospitals, nursing homes and prisons. (working population – special duties, military, nursing mothers, full time house wife, full time schooling and those who just chose not to work = labour force) Labour force = No of employed + No of unemployed Unemployment rate = no of unemployed/labour force * 100
The labour market consists of persons in the labour force who are not self-employed and the employers of labour. At a given working population of a country, the labour force can change as persons move in and out. At high wage rate, those who decided not to work may change their minds and come in increasing the labour market and the opposite with a lower real wage rate. Thus the labour face participation rate shows the percentage of non-institutionalized civilian working-age population that are employed or actively looking for job. It is also given as the percentage of the non-institutionalized civilian working population that is in the labour force.
Labour force participation rate = labour force/working population (non-institutionalized civilian)*100 Types of Unemployment.
Unemployment can be generally broken down into several types that are related to different causes. Based on the sources we have
Seasonal Unemployment: This that occurs as a result of seasonal fluctuations. It is observed, the demand for agricultural workers usually declines after the planting season and remains low until the harvesting season. Similarly, the demand for construction workers usually falls during the rainy season and picks up during the dry season.
Frictional Unemployment: This occurs when workers spend time searching for new jobs as well as new entrance into the labour force. For example, a worker in Delta State may leave his present job to Abuja with the expectation of getting a higher paid job. Unfortunately, when he got to Lagos, he could not find a job. During this period without a job, he is being classified by labour economists as a frictionally unemployed worker. Several factors are responsible for frictional unemployment. First, there is imperfect flow of information in the labour market. This is because the labour market is not dynamic as the neoclassical economists contended. Second, it usually takes a long time for unemployed workers to get in touch with potential employers who may have available job openings. Even though the size of the labour market is constant, at every point in time, there are new entrants in the labour force.
Structural Unemployment: Structural unemployment occurs when there are some structural changes in the economy, mismatch between workers' skills and the skills required for open jobs. Such structural changes may take the form of a decrease in demand for certain skills or a change in technology of a certain industry. Structural unemployment may result because there are individuals who look for jobs in a location that has no industry that can use their skills or because these individuals possess the wrong skills to offer available employers. Large amounts of structural unemployment can occur when an economy is transitioning industries and workers find their previous sets of skills are no longer in demand. It can also occur when people are being replaced with machines. The argument is that as soon as a country becomes technologically advanced, there is always the tendency to use more machines in the production of goods and services. Thus, a worker who operates one machine day after day eventually becomes specialized in a particular job. There is however, a greater risk of unemployment in such a situation. This is because the affected worker may find it difficult to change to something else especially when he is old. Nigeria is not yet technologically advanced. Therefore, technological unemployment does not pose a serious threat to our economy. Structural unemployment is similar to frictional unemployment since both reflect the problem of matching workers with job vacancies, but structural unemployment covers the time needed to acquire new skills not just the short term search process. While frictional unemployment is a short-run issue, structural unemployment is a long-run adjustment process.
Classical unemployment: This occurs when wages are too high for employers to be willing to hire more workers. Wages may be too high because of minimum wage laws or union activity.
Cyclical unemployment: This is also called Demand –Deficit or Keynesian unemployment. This occurs when the aggregate demand falls and wages and prices have not yet adjusted to restore full employment. It is directly related to the business cycle. It is that part of unemployment associated with changes in business condition (recessions and depression). While some types of unemployment may occur regardless of the condition of the economy, cyclical unemployment occurs when growth stagnates.
Modern classification of unemployment: this differentiates between voluntary and involuntary unemployment. Under this approach, frictional, seasonal, structural and classical are classified as voluntary while cyclical is classified as involuntary unemployment. Voluntary unemployment does not pose much problem to the economy. Frictional unemployment cannot be wiped out and it improves the productivity of labour and total economic productivity. Same is applicable to structural unemployment.

Definition of 'Natural Unemployment': This is defined as the lowest rate of unemployment that an economy can sustain over the long run. Keynesians believe that a government can lower the rate of unemployment (i.e. employ more people) if it were willing to accept a higher level of inflation (the idea behind the Phillips Curve). However, critics of this say that the effect is temporary and that unemployment would bounce back up but inflation would stay high. Thus, the natural, or equilibrium, rate is the lowest level of unemployment at which inflation remains stable. Also known as the "non-accelerating inflation rate of unemployment" (NAIRU). The output level associated with the natural rate of unemployment is called full employment or potential output. Full employment is a situation in which all available labor resources are being used in the most economically efficient way. Full employment embodies the highest amount of skilled and unskilled labor that could be employed within an economy at any given time. The remaining unemployment is frictional. Full employment is attainable within any economy, but may result in an inflationary period. The inflation would result from workers, as a whole, having more disposable income, which would drive prices upward.
When the economy is said to be at full employment, it is at its natural rate of unemployment. Economists debate how the natural rate might change. For example, some economists think that increasing labor-market flexibility will reduce the natural rate. Other economists’ dispute the existence of a natural rate altogether! The concept of full employment does not imply that all persons in the labour force are employed bit that the demand for labour is equal to the supply at exciting wage rate in other words, there is no involuntary unemployment.

The natural rate of unemployment is not automatic. That is there is no guarantee that an economy will operate at its natural rate employment rate in a country may be above or below the natural rate. Deficiency in aggregate demand may shift unemployment above it natural rate (unemployment problem) while unlimited demand may shift it below (no unemployment problem). Moonlighting and government policies may bring unemployment below it natural rate and push the economy beyond the potential output level. Natural rate of unemployment can also change upward or downward. Economic growth leads to policies that reduces the natural rate of unemployment and hence raise the full employment. Potential output.

Unemployment and growth
Unemployment is a crucial issue in any economy because of its impact on growth. There is a negative relationship/correlation between GDP and unemployment. This gives us our Okun's law named after the economist Arthur Okun who first documented it in the 1962 represents the empirical relationship between unemployment and economic growth. The first version of Okun's law states that a 3% increase in output would lead to a 1% decrease in unemployment. This means that the economy experiences 1 percentage point increase in unemployment for every 3 percentage point decrease in GDP from its long-run level. Similarly, 3 percentage point increase in GDP from its long-run level is associated with 1 percentage point decrease in unemployment. Thus the economy must grow at a rate of 3% for the unemployment rate to remain unchanged. In reality, though, Okun’s law is a statistical relationship rather than a structural feature of the economy. Okun coefficients can change over time because the relationship of unemployment to output growth depends on laws, technology, preferences, social customs, and demographics. Some economists have suggested that labor market reforms have made most industrialized countries more like the United States to have smaller Okun coefficients. Therefore, countries that heavily regulate labor markets tend to have higher unemployment. In order to understand why the relationship between changes in output and changes in unemployment is not one-to-one, it's important to keep in mind that changes in output are also associated with changes in the labor force participation rate, changes in the number of hours worked per person, and changes in labor productivity. Thus some of the reasons why GDP may increase or decrease more rapidly than unemployment decrease or increases include: As unemployment increases, • There is a reduction in the multiplier effect created by the circulation of money from employees • unemployed persons may drop out of the labour force (stop seeking work), after which they are no longer counted in unemployment statistics • employed workers may work shorter hours • labor productivity may decrease, perhaps because employers retain more workers than they need
Over time, the relationship between changes in output and changes in unemployment has been estimated to be about 2 to 1 rather than the 3 to 1 that Okun originally proposed. (This ratio is also sensitive to both geography and time period). Also, economists have noted that the relationship between changes in output and changes in unemployment is not perfect, and Okun's Law should generally be taken as a rule of thumb as opposed to as an absolute governing principle since it is mainly a result found in the data rather than a conclusion derived from a theoretical prediction.
Note the following: The natural rate of GDP growth is 3%; The natural unemployment rate is 5.8%; The natural rate of unemployment (or the NAIRU) is approximately 5.8%--where the economy is at full employment.
Other impacts/costs of unemployment are: increase in social crimes (rubbery, immorality), poverty, health (mental illness and other forms of ill health), suicide, violence among youth etc.
Curbing unemployment. In an economy where prices and wages are flexible, the economy can easily adjust to full employment level but this will take a long run. But in the absence of that and to cut the period short, fiscal and monetary policies (expansionary) such as reduction in tax, increase in government spending and increase in money supply can be put in place by the government to increase aggregate spending, increase growth (GDP) and reduce unemployment. Other policy measures are: a) creation of training facilities to help acquire relevant skills and reduce structural unemployment. B) Establishment of employment agencies to train people for self-employment to reduce frictional unemployment. c) Introduction of investment subsidies or tax breaks to encourage entrepreneurship and provision of employment. d) Reducing the power of organized labour union. This will help to eliminate classical unemployment by ensuring that wages are not too high for employers to employ.
Unemployment in Nigeria Unemployment has been a major macroeconomic problem facing Nigerian’s economic growth. From 1960 after independence, different policies have been put in place to combat this problem. Available data shows that employment situation have not improved adequately to impact positively on the labour market despite the high records of improvements in gross output represented by the GDP. The nature of the unemployment in Nigeria is more of disguised unemployment. The recorded figure for unemployment significantly understates the number of people who are actually willing to work at the existing set of wage rate. Unemployment has been on the rising trend especially between 1980 and 1989 and between 1999 and date. It rose from 4.2 % in 1980 to 7.1% in 1987. This fell to 1.8% in 1995 (Babangida’s regime) and started growing again. Between 1999 and 2010, the unemployment rate grew continuously from 11.7% to 21.2% and 23.9 in 2011. The rate of unemployment differs as regards the age group, educational group and sex. In 2007 in Nigeria, for persons between ages 15 and 24 years, 55.1% were unemployed while persons between 25 and 44 years, 36.5% were unemployed. Also, 12.3% of those without schooling, 15.3% of those with primary education, 63% of those with secondary education and 8.2% of those with post-secondary education were unemployed respectively and in 2009, post-secondary unemployment rate increased to 21.3% while those who never attended school was 21% respectively. As regards sex, males constituted 57.7% while female were 42.35 in 2007. The low rate of female unemployment rate is as a result of the low labour force participation rate of female.

Causes of unemployment in Nigeria
Bad Educational Planning: It is a widely believed that the high rate of unemployment among our graduates is traceable to our poor educational system. The educational system does not equip our graduates with adequate skills and tools necessary for them to meet societal needs. The educational system is also faulty because it does not prepare the graduates for self-employment
Bad Economic Planning/Plan Implementation: Another factor identified to be responsible for Nigeria’s current problem is bad economic planning. The nation is facing a serious economic and financial crisis. In order to remedy the situation, several economic and manpower policies have been adopted having major implications for labour-management relations. One of such policies was the introduction of the Structural Adjustment Programme (SAP) in July 1986, Nigeria Poverty Eradication Programme (NAPEP) in 2001. The major challenge is that the implementations of these plans were never carried out as planned. High population growth rate: The growing population accounts for the worsening scenario of unemployment over the years. In 1990, Nigeria’s population was estimated at 88.7 million and 102.5 million in 1997. In 2010, Nigeria’s population was about 158 million people (population growth rate of 58%). The major consequence of the galloping population growth and rapid urbanization is mounting unemployment, especially in the urban centers given rural migration. For a period of 10 years (1991 – 2000), population growth rate was 2.57 percent. An increase in population signals an increase in labor supply and in the face of low demand, unemployment cannot be denied. In 2004, the country had a population growth rate was 3.0 percent with a dependency ratio of 62.8 percent.
Wrong Impression About technical and Vocational Studies: Students have wrong impression about technical and vocational education and this also accounts for the deteriorating state of unemployment in Nigeria. A large number of job seekers lack practical skills that could enhance self - employment. That is why rather than providing jobs for others, the graduate unemployed persons keep depending on the government and the non – vibrant private sector for job offers.
The Neglect of the Agricultural Sector: The agricultural sector has been the leading provider of employment in Nigeria especially in the sixties and in the seventies when the sector provided employment for more than 60 percent of the Nigerian population. However, unfortunately, in the wake of oil discovery, our attention on agriculture has been drawn away to the oil sector where employment capacity is very low. The resulting effect is the large number of job seekers who have no place in the oil industry. Even with the expansion of the industry, unemployment has continued to grow at an alarming rate.
Poor Enabling Environment: The poor economic enabling environment that characterizes the economy over the years has continued to pose serious challenges to employment generation in Nigeria. The power sector is nothing to talk about. This, coupled with poor security environment has continued to hamper investment drives and thereby reducing the prospects of employment generation. Many job seekers who would have embarked on self - employment programs are unable to do so because of the hostile production environment. Others who make attempt are forced to wind up due to absence of infrastructures and the overall heat of the investment environment.

Imperfect Flow of Labour Market Information: The labour market is not perfectly competitive, as contended by the neoclassical economists. There are imperfections in the labour market, which eventually create the natural rate of unemployment. There is hardly labour market information in Nigeria. This has hindered the mobility of labour from one geographical region to another. For example, there may be job openings in Lagos and job seekers in the remote rural areas will not know about them. Thus there is high rural-urban migration.
Unstable Political Environment: Politics cannot be separated from economics. A stable political environment usually enhances macroeconomic stability. In Nigeria, there is high political instability, inter-tribal wars and youth crisis. These hinders the flow of foreign investment which would create employment
Other factors include:

i) Limited impact of government direct employment generation efforts

ii) Use of inappropriate technology. (iii) Weak sectorial linkages as well as a result of low value added production and export

Question:
(1)What is the difference among natural unemployment rate, full employment rate and potential output level?
(2) How do changes in the unemployment rate affect the rate of GDP growth?" [When unemployment changes by 1%, GDP falls by 2%. There are three reasons why this is so.] a) Some workers are needed no matter what. You can't lay off everyone! A firm will still need managers and accountants even if the firm is making less money than it usually does. b) Training and transaction costs are high. Firms will retain workers by cutting hours, working remaining workers harder, reducing their staff through retirement, or asking workers to use vacation time. c) When the economy is overheating, not all of the new jobs are filled by the unemployed. Some discouraged workers will be attracted to the labor market. Overall, the interaction of these factors will make interpreting the data complex. Many economists say that Okun's Relation is a better term than "Okun's Law" since the relation comes from an observation of data. Using the line the students have drawn, show that GDP changes by less than unemployment.
(3) "What would happen to prices if there were zero unemployment?" [Prices and wages would skyrocket.]
(4) Discuss why some unemployment is good. Explain that structural plus frictional unemployment equals the natural rate of unemployment. Why is some unemployment, 5.8%, natural? [Frictionally unemployed workers are between jobs, and presumably advancing their careers. Structurally unemployed workers are out of a job because their work has become obsolete. In other words, the economy is creating new jobs while destroying inefficient ones. Economists call this creative destruction. Paul Krugman explains that workers can be structurally unemployed when they receive higher than market clearing wages such as a minimum wage or efficiency wage.]
5) Why is structural unemployment regarded as voluntary unemployment? This reason is because it is expected that if one is thrown out or the demand of its labour falls because it is obsolete, it is expected that the person should take a lower paid job/real wage to remain employed or acquire the need skills that can attract a higher real wage job

One implication of Okun's law is that an increase in labor productivity or an increase in the size of the labor force can mean that real net output grows without net unemployment rates falling (the phenomenon of "jobless growth"). • Unemployment Rate: The number of unemployed people, expressed as a percentage of the labor force. • Labor Force: The people in a nation who are aged 18 or over and are employed or actively looking for work. • Okun's Law (Relation): A 1% change in the unemployment rate results in a 2% change in real GDP • Natural GDP Growth Rate: a 3% GDP growth rate is consistent with full employment • Natural Rate of Unemployment: Frictional plus Structural unemployment. The Congressional Board Office estimates this rate at 5.2% • NAIRU: The Non Accelerating Inflation Rate of Unemployment. The same as the Natural Rate - 5.2%

1. There is a link between GDP, unemployment, and inflation. (2.) When unemployment changes, GDP changes by less. (3.) Okun's law states that a 1% change in unemployment will change GDP by 2%.

EXCHANGE RATE Given other factors such as interest rates and inflation, the exchange rate is one of the most important determinants of a country's relative level of economic health. Exchange rates play a vital role in a country's level of trade, and important to every free market economy in the world. Exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency. Thus, the exchange rate can also be considered a price of one currency in terms of the other. We have nominal exchange rates and real exchange rates. Nominal exchange rates are established on currency financial markets. Rates are usually established in continuous quotation (they may be fixed). Real exchange rates are nominal rates corrected by inflation measures. The "real exchange rate" (RER) is the purchasing power of a currency relative to another. It is based on the GDP deflator measurement of the price level in the domestic and foreign countries. Exchange rates are determined in the foreign exchange market and the foreign exchange market (also known as FX or forex) is the largest market in the world. In the market we have the spot exchange rate which is the current exchange rate and the forward exchange rate which is an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.
Determination of Exchange rate in a free market This is determined by the forces of demand and supply just like any other goods. The equilibrium rate/the exchange rate are the rate at which the demand for foreign currency equals the supply. The demand for foreign exchange is a derived demand. It arises from the demand of the goods and services of that country to another country. Using two countries, Nigeria and US, the demand and supply of exchange can be analysed as follows: The demand for US dollar is the supply of Naira. When Nigerians buy goods and services from US, they cannot pay with naira hence they need dollar to make the payment, a demand for dollar and to get the dollar to make the payment, they have to give naira out in exchange for the dollar needed to make the payment. Hence a demand for dollar is a supply of naira in the market. Likewise, the supply of US dollar is the demand for naira. Like other goods, the demand for foreign exchange is downward sloping while the supply is upward sloping. The point/price where the demand and supply meets is the equilibrium point or the exchange rate. This is shown in the fig below.

The demand for US dollar by Nigerians is shown by the supply for naira S1S1 while the supply for US dollar is reflected by the demand for naira curve D1D1. The exchange rate is point p1 where D1D1 meets with S1S1. An expansion of the demand, a shift to the right (indicating an increase in the demand for Nigerian goods and services by US) will lead to an increase in the price given that the supply is constant while a fall will lead to a fall in the price. Also an expansion in the supply of naira curve (indication an increase in the demand for US goods) will lead to a fall in the price with respect to naira while a fall in the supply will lead to an increase in the price in favour to naira. These changes in the demand and supply lead to the appreciation and depreciation of a country’s currency. An appreciation means that the rate at which the naira exchanges with dollar has increase. That is if it was 1$ to N150, appreciation means 1$ to N140. Appreciation occurs when the demand curve expands (at constant supply curve) or a contraction in the supply curve (at a constant demand curve) while a depreciation will occur when the demand curve contracts (at a constant supply curve) or the supply curve expands at a constant demand curve). A currency will tend to become more valuable whenever demand for it is greater than the available supply and it will become less valuable whenever demand is less than available supply.

FACTORS THAT CAUSES A COUNTRY’S CURRENCY TO APPRECIATE OR DEPRECIATE
1. Changes in taste: A change in the taste (a change in demand) for the product of a country, other things held constant will cause the exchange rate to change in favour (appreciate) of the country. For example a sudden increase in the desire of Nigerian for U.S goods will make the supply of naira to increase and the demand for dollar increase leading to depreciation of naira viz aviz U.S dollar. The increase in demand of the world for china products has made their currency to appreciate.
2. Relative income changes: an increase in the income (real) of the people in a country, will lead to an increase in their general demand. If the income of a country say Nigerians increases while that of U.S remains constant, the citizens will have more money to spend and since the demand for import is positively related to importation, there will be increase in the demand for imported goods which will lead to an increase in the supply of naira while the U.S where they will get the goods will experience increase in the demand for dollar. Thus naira will depreciate with respect to dollar.
3. Changes in relative prices: The inflation rate is also considered to be a determinant of the exchange rate. A high inflation rate should be accompanied by depreciation of the exchange rate. The more so if other countries enjoy lower inflation rates, since it should be the difference between domestic and foreign inflation rates to determine the direction and the scale of exchange rate movements. The ratio of goods and services in Nigeria to U.s indicates the purchasing power parity between the two countries. If a pair of shoe is sold for $3 in U.S and the same pair of shoe is sold for N900 in Nigeria, the relative prices will be 3:900. Thus the purchasing power parity is N300 equal $1. Is if the prices of goods and services in Nigeria rises while that of U.S is constant, demand for dollar will increase while that of naira will fall. Thus naira will depreciate.
4. Terms of Trade and changes in export and import: an increase in the export of a country more than import will lead to an increase in the demand for its currency so that the exchange rate will be favoured. Also the terms of trade affects exchange rate. The term of trade is a ratio that is comparing export prices to import prices. It is related to current accounts and the balance of payment. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners.
5. Relative interest rate: Interest rates on treasury bonds will influence the decision of foreigners to purchase domestic currency in order to buy these treasury bonds. Higher interest rates will attract capital inflow from abroad, thereby increasing demand for the currency, and therefore the currency will appreciate relative to other foreign currencies. Note, what is important is difference between domestic and foreign interest rates, thus a reduction in foreign interest rates would have a similar effect. Accordingly, an increase of domestic interest rates by the Central Bank could be considered a way to defend the currency. But, it may be the case that foreigners rather buy shares instead of treasury bonds. If this were the strongest component of currency demand, then an increase of interest rate may even lead to the opposite results, since an increase of interest rate quite often depresses the stock market, leading to share sales by foreigners. A restrictive monetary policy (increasing interest rates) usually also depresses the growth perspective of the economy. If foreign direct investment are mainly attracted by future growth prospects and they constitute a large component of capital flows, then this FDI inflow might stop and the currency could weaken. Therefore, interest rates do have an important impact on exchange rate but one has to be careful to check additional conditions. Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates
6. Speculation: The increase in speculative activities also affects the exchange rate greatly. These are people who buy and sell currencies with intention to resell or repurchase for profit motive. Speculation leads to short-run fluctuations in the exchange rate. If speculators are expecting a fall in the value of a currency in the near future, they will sell that currency in that possession and start buying the one they are expecting to rise. This will increase the supply of the currency speculated to fall leading to a fall the exchange rate of that currency while he exchange rate of the other currency they are buying begins to rise.
7. Political Stability, Psychological Factors and Economic Performance: Political or psychological factors are also believed to have an influence on exchange rates. Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.
8. Structural Influences: Structural changes are changes that bring about the change in the consumers’ demand for commodities. These include technological changes and innovations. These changes lead to a change in foreign demand for goods and services. If a country is experiencing structural change, there will be increase in demand for domestic goods, increase in export, increase in demand for the currency and an appreciation of the value of the currency and its exchange rate rises.
9. Bank activities/changes in bank rates: if the bank rate rises relative to other countries, more funds will flow into the country in form of savings to enjoy these high rates. This will lead to an increase in the demand for the domestic country’s currency and the exchange rate rises while the opposite is the case if bank rate falls.

EXCHANGE RATE REGIME Exchange rate regime is defined as the condition under which the exchange rate between two countries is determined. Each country, through varying mechanisms, manages the value of its currency. As part of this function, it determines the exchange rate regime that will be applied to its currency. Basically we have two major regimes: clear-floating/fluctuating/ flexible and fixed/pegged/hybrid exchange rate system.
Fixed Exchange: A fixed / pegged, rate is a rate where the government (central bank) sets, determines and maintains the official exchange rate at an agreed rate. A set price will be determined against a major world currency (usually the U.S. dollar, and also other major currencies such as the euro, the yen or a basket of currencies). To maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged to fill the gap (increase supply) in excess demand or buy off the excess supply by drawing on its foreign reserve. If, for example, it is determined that the value of naira is equal to N1: US$140, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. Foreign reserve is a reserved amount of foreign currency held by the central bank that it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/ deflation) and ultimately, the exchange rate. The central bank can also adjust the official exchange rate when necessary. In fig a below, given the demand and supply of naira as DD and SS, an increase in the demand for naira which would have led to excess demand and appreciation of the currency to P1 will be controlled by government supplying the deficit in the supply into the market so that the exchange rate remains at P. the opposite takes place in the fall in the demand.

Merits:
1. Stability in the economy: One of the macro-economic objectives is economic stability. Hence countries especially developing country may decide to peg its currency to create a stable atmosphere for foreign investment. With a peg, the investor will always know what his or her investment's value is, and therefore will not have to worry about daily fluctuations.
2. It is less inflationary: A pegged currency can also help to lower inflation rates and generate demand, which results from greater confidence in the stability of the currency.
3. No bad effect of speculator: In the face of fixed exchange rate, speculators cannot trade hence the currency is protected from the effect of their wrong expectations which can depreciate or appreciate a currency.
4. Certainty: Fixed exchange rate system creates certainty about foreign payment among exporters and importers of goods and services because they know what they have to receive or pay for foreign exchange.
5. It encourages international trade: As a result of the stability of prices in the international trade, trade can be predicted in the international market which will encourage more trading (export and import). This also creates certainty among exporters and importers.
6. It develops international money and capital market: The stability and certainty created encourages the easy flow of long term capital among nations which helps in the development of the market because plans can be made.
Demerits:
1. Monetary policy is made ineffective in correcting imbalance in an open economy: Given that the exchange rate is not under the control of the market, monetary policy using interest rate to increase output cannot be effective because any appreciation of the currency as a result of change in interest rate will be covered up thus bringing the economy back to its initial level.
2. Heavy burden on the government: Large reserve of foreign currencies needed to maintain the exchanges are required to avoid devaluation of currency in the face of balance of payment (BOP) deficit. These create a lot of work for the government to do monitoring the forex market.
3. Mal-allocation of resources: As a result of the complication in the control, there is high mis-allocation of resources. Resources that would have been used for development projects are used to always maintain the market
4. Complex system: it is very complex because it needs highly skilled administrators to control it. It is also time consuming and all these will lead to uncertainty of results and mistakes in policy formulation and implementation.
5. Persistent balance of payment disequilibrium: the problem of balance of payment problem cannot only be solved temporarily since the system does not allow the free working of monetary and fiscal policy. Also there is lag between the discovery of the shortage/excess in supply and the time the gap is fill which will always leave the BOP in a disequilibrium state. .
6. Not feasible for a long time: The exchange rate of a country cannot remain fixed vis-à-vis other currency for long especially when one county will benefit more with a floating exchange rate and pressure of speculators. For example, between 1994 and 2005, the China’s currency (RMB) was pegged to the United States dollar at RMB 8.2768 to $1. Also from the end of World War II until 1967, Western European countries maintained fixed exchange rates with the US dollar based on the Bretton Woods system. But that system had to be abandoned due to market pressures and speculations in the 1970s in favor of floating, market-based regimes.
Flexible Exchange system: This is a system where the currencies of countries are allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world. New equilibrium or exchange rates are established each time the demand or /and supply of currencies changes. It is referred to as a market based exchange rate which will change whenever the values of either of the two component currencies change. A floating rate is often termed "self-correcting," as any differences in supply and demand will automatically be corrected in the market. Take a simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market.
Merits:
1. Simple: It is simple to operate because government do not need to constantly study the activities in the forex market to know when to come in and does not allow deficit or surplus in the economy.
2. Smooth and automatic adjustment of disequilibrium in the BOP. With the constant adjustment of the demand and supply the economy rarely experience disequilibrium. There is no serious pressure on the BOP and no need for the accommodation of gold movements.
3. Effective monetary policy: Monetary policy tools are effective in controlling the economy. Interest rate can be lowered to increase output and in the face of inflation it can be increase also.
4. Autonomy of economic policy: The system allows the domestic country to carry out her policies which are mainly full employment and growth that are sometimes sacrificed under the fixed system.
5. There is no need for foreign reserve: This will reduce the work of the government. It will also reduce borrowing and lending short-term funds to buy off the excess supply or manually bringing the market to equilibrium.
6. Mistakes are avoided: Fixed system requires predicting and reading the market accurately. This may lead to mistakes but will be avoided in the face of flexible system.
7. Do not require complicated trade restrictions: Trade is allowed freely in the countries and this will make countries to work towards increasing their competiveness so that they can gain from the trade.
Demerits:
1. Exchange risk and uncertainty: There is high uncertainty of the exchange rate and this may make the currency of a country face serious depreciation.
2. Effect of speculators: speculators will have opportunity to operate which can have adverse effect on the currency.
3. Mis-allocation of resources: The floating exchange rate creates a market economy where the decision on what to produce, how to produce and for whom to produce is take by the private individuals who are profit oriented. Thus resources that would have been used for the welfare of all will be channeled into the production of what will give that profit thus mis-allocating resources.
4. Encourages inflation: The constant changing in the rate creates room for inflation in the economy either as a result of high demand in exchange rate as a result of the demand for the local goods and services which increase their income or through importation (imported inflation)
5. Breaking the world market: There will not be one currency which will serve as a medium of exchange, unit of account or store of value or standard of deferred payment when any currency can appreciate and speculators will always want to hold currency with high values. In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency reflects its true value against its pegged currency, a "black market” (which is more reflective of actual supply and demand) may develop. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market. In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation. However, it is less often that the central bank of a floating regime will interfere. Thus we have other systems of exchange rate such as: 1. Adjustable peg system: A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the devaluation of a currency. The exchange rate are pegged or fixed for a period but if faced with the problem of deficit and surplus BOP, the exchange rate is devalued or revalued and a new rate is fixed or pegged. Some governments keep their currency within a narrow range. As a result currencies become over-valued or under-valued, causing trade deficits or surpluses. A country tries to maintain a fixed rate until all its exchange reserves are exhausted, and then the exchange rate is re-pegged either at a lower rate or a higher rate as the case may be as shown in fig b below.

Given the demand and supply of the currency as DD and SS1, the exchange rate is pegged at point a. if the demand for the foreign exchange increases, the demand curve moves to D1D1 but the exchange rate is still at a because the monetary authority will sell foreign reserve to cover for the shortage in supply. This continues until point c. when the reserve of the country is serious affected so that the monetary authority cannot continue at the pegged point E, and the demand for foreign exchange rises further to point e, a new peg is established say E1 at a new demand curve D3. The process of using reserve continues again until it cannot be maintained and a new peg is also established at E2. This adjustment can be upward or downward. The merits of the system are that there is no un-certainty, inflation is checked and it avoids depression and protection policies however it has its demerit among which is that it is over optimistic and difficult to control capital movement.
2. Dirty floating system: in this type of exchange rate system, exchange is determined by the forces of demand and supply but monetary interventions comes in time to time to control excessive fluctuation in the exchange rates, government prevents violent fluctuation by selling and purchasing foreign exchange in the market to fill the gap and stabilize the economy.
3. Crawling peg: The government reassesses the value of the peg periodically and then changes the peg rate accordingly. The adjustments are done gradually as compared to the adjusted peg. This is called trotting peg or gliding parity system. Usually, this causes devaluation, but it is controlled to avoid market panic. This method is often used in the transition from a peg to a floating regime, and it allows the government to "save face" by not being forced to devalue in an uncontrollable crisis.
4. Exchange rate band: this is a system where currency is allowed to fluctuate within a given limit (upper and lower limit) but it is not allowed to move outside the boundary as shown in fig c below.

Assuming that the exchange rate between dollar and naira is $1: N125, an upper limit of $1: N135 and a lower limit of $1: 115 can be created. Provided that the fluctuation of the currency is within the boundary, the monetary authority cannot come in, they can only come in when the exchange rate gets to the margin and intervene to supply more currency or buy the excess demand off. In the fig above if the fluctuation get to point A, US economy will supply more dollar or Nigeria buys the excess naira supply