ECO 202

Principles of Macroeconomics I
Course Outline:
1. Nature and Scope of Macroeconomics
2. National Income Accounting
3. National Income Determination
4. The Consumption Function
5. Investment
6. Government Aggregate Demand and Fiscal Policy
7. Price Level and Money
8. Money and Banking
9. International Trade
10. The Balance of Payments
11. The Theory of Exchange Rates
12. Unemployment
13. Main Schools of Economic Thought
14. Economic Systems

Textbooks:
1.Aboyade, O. (1983). Integrated Economics: A Study of Developing Economies: Addison-
Wesley Publishers Ltd
2.Dwivedi, D.N. (2005). Macroeconomics Theory and Policy: Tata McGraw Hill.
3.Jhingan, M.L. (2000). Macroeconomic Theory: 10th Revised and enlarged edition. Vrinda
Publication (p) Ltd
4.Lipsey, R.G. (1971). Introduction to Positive Economics. London. Wiedenfeld and Nicolson,
5.Blanchard, O. (1997). Macroeconomics. Prentice-Hall, Inc.
6.Olofin, S. 2001. An Introduction to Macroeconomics: Malthouse Publishers.
7.Google and U-Tube Platforms on the topics.

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 LECTURE ONE
Nature and Scope of Macroeconomics
Introduction
Eco 202’s focus is on the study of the characteristics and determinants of aggregate economic
variables, such as aggregate employment, output, income, growth, international trade etc.
Macroeconomics is the twin of microeconomics. The word macro implies large, hence the
course’s emphases will be on the totality of the economy. Macroeconomics is concerned with the
overall picture of the economy. This makes macroeconomics to attract the attention of people in
news reporting and in most public discussions .Issues such as the rate of unemployment, rate of
inflation, recession in the economy, balance of payment problems, etc are prominent in regular
discourse.
The course will also be concerned with the computation of national income and the
reason for recession or boom in an economy; the components of aggregate demand and their
influence on the level and behaviour of national income; the role of money and banking in the
economy and how monetary policies are used to control the economic activities; the role of
international trade in the global economic systems; the main schools of thought in economics,
and the contributions of each school to the advancement of the subject. Finally, students should
know the types of economic systems present in the world, their features and basic differences.

Distinction between Microeconomics and Macroeconomics

In microeconomics, the focus of analysis is the individual. In other words, microeconomics is
concerned with the study of economic behaviours of the individual agents in the economy. In
macroeconomics, however, the focus shifts to the aggregate. The focal point then becomes the
economy as whole and not individual parts of it.
In reality, there is a thin dividing line between micro and macroeconomics. However, it is still
possible to show some differences between the two. These are:
1. Microeconomics offers a detailed treatment of one aspect of the economic system but
ignore its interaction with the rest of the economy. On the other hand, macroeconomics
looks at the interdependency among all sectors of the economy for policy analysis.
2. While in microeconomics, we are concerned with optimization decisions households, and
firms, in macroeconomics we are more concerned with general national issues, such as
total employment; money and banking; aggregate national output; the general price level;
etc.
3. In terms of output, microeconomics deals with total output in each market, while
macroeconomics is interested in the aggregate output in the economy.
4. Macroeconomics focuses on the growth of the total economy while microeconomics
takes a more disaggregated approach by looking at changes in output in the individual
market.
5. In microeconomics, the study of equilibrium conditions are analysed at a particular
period. But it does not explain the time element. Therefore, microeconomics is
considered as a static analysis. On the other hand, macroeconomics is based on time lags,
rates of change and past and expected value of the variables.

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This slight division between micro and macro economics is not rigid, for the parts affect the
whole and the whole affects the part. There is a very strong inter-dependency between micro and
macroeconomics. The branch of economics called General Equilibrium Theory seeks to bring
together the two aspects of economics. Macroeconomics focuses more on the economy as a
whole, hence is greater attention is paid on its study because the subject matter affects peoples’
lives directly or indirectly; for example, high inflationary rate, unemployment rate, recessions in
the economy, balance of payment problem, etc.
Macroeconomic Goals and Performances
There are certain goals which every economy desires to achieve. These are:
1. high levels of employment and production;
2. stable prices;
3. economic growth; and
4. equity in distribution of income.
1. High Levels of Employment and Production
Gross output in an economy is produced by a combination of labour and capital, which are
employed in the production process. The output of an economy would be maximised if all
its factors of production are all employed and are also efficiently used. Unfortunately, this is
not always obtainable. Modern economics is characterized by gross unemployment and
underemployment of factors of production, which therefore keep level of output
permanently below potential or maximum output level. Therefore, it is one of the goals of
macroeconomics to see how available level of output can be brought close to its potential
level by minimising unemployment and underemployment of the main factors of
production.
2. Stable Prices
Every country seeks to control rapid increases or fluctuations in its price level. This is
because rising or fluctuating prices of goods and services may keep products out of the
hands, of those who would otherwise be able to obtain them and, in so doing, change the
distribution of the goods and services produced by the firms in the economy. Periods of
rising prices are usually associated with the period of inflation. Inflation occurs when there
is a general increase in the price level. Inflation produces many negative effects and only
little positive effect on an economy. For instance, it reduces the purchasing power of those
on fixed incomes like the pensioners. Additionally, inflation may also reduce levels of
savings in the economy, since much money would now be required by households to make
their basic purchases.However, despite the debilitating effects of inflation, many countries
have found it difficult to control the rapid rate of inflation in their domestic economies.
3. Economic Growth
This is the third macroeconomic goal. Economic growth refers to increases in the real output
level. However, a major limitation of this growth is that it only recognises changes in output
level but neglects other welfare indicators, like, literacy level, life expectancy level, leisure,
poverty level, etc. In addition, it ignores the ever-increasing pollution and other social costs
that may be associated with increasing output levels. Despite its limitations, economy
growth is still commonly accepted to reflect welfare level and every country desires a
marked increase in her economy growth rate.

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4. Distribution of Income
This is another area which has increasingly crept into the realm of macroeconomics. It is
now a stated macroeconomic objective of every country to promote equity in distribution of
income, which is associated with increasing rate of economic growth.
Dependence of microeconomic theory on macroeconomics
When aggregate demand rises during a period of prosperity, the demand for individual products
also rises. If this increase in demand is due to a reduction in the rate of interest, the demand for
different types of capital goods will go up. This will lead to an increase in the demand for the
particular types of labour needed for the capital goods industry. If the supply of such labour is
less elastic, its wage rate will rise. The rise in wage rate is made possible by increase in profits as
a consequence of increased demand for capital goods. Thus, a macro economic change brings
about changes in the values of micro economic variables- in the demand for particular goods, in
the wage rate of particular industries, in the profits of particular firms and industries, and in the
employment position of different groups of workers.
Dependence of macroeconomic theory on microeconomics
On the other hand, macroeconomic theory is also dependent on microeconomic analysis. The
total is made up of the parts. National income is the sum of the incomes of individuals,
households, firms and industries. Total savings, total investment and total consumption are the
result of the savings, investment and consumption decisions of individual industries, firms,
households and persons. The general price level is the average of all prices of individual groups
and services. Similarly, the output of the economy is the sum of the output of all individual
producing units. Thus, the aggregates and averages that are studied in macroeconomics are
nothing but aggregates and averages of the individual quantities which are studied in
microeconomics.
Why Macroeconomists Sometimes Disagree
Macroeconomics is thus the result of a sustained process of construction, of an interaction
between ideas and events. What macroeconomists believe today is the result of an evolutionary
process in which they have eliminated those ideas that failed and kept those that appear to
explain reality well.
This does not mean that macroeconomics today is ‘right.” Surely, new event will lead
macroeconomists to question some of their thinking: some may even lead to radical rethinking.
Nor does it imply that the lessons of history and the interactive process between ideas and events
are so strong that all macroeconomists agree on everything. They disagree on many issues,
although often less so than is commonly perceived. When they disagree, they do so for two very
different reasons.
First, even when they share the same view of the way the economy works, they often
disagree on the weight they assign to different objectives. Some economists are willing to reduce
income inequality even if some of the means needed to achieve is more important. Some
economists put more weight on fighting high unemployment than on fighting inflation because
they see unemployment as a major social evil. Others put more weight on fighting inflation,
which they see as more dangerous to society. Often, lines of disagreement run along political
lines.

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 For instance, in the United States, Democrats, and economists with Democratic leanings, usually
care more about income inequality and unemployment; Republicans, and economists with
Republican leanings, usually care more about growth and fighting inflation, which they see as
more dangerous to society. The measures that both groups recommended differ accordingly. As
long as people (and these economists) have different values, these disagreements will remain.
Second, reality often does not speak strongly enough to make all economists agree. In
contrast to researchers in most other applied sciences, economists cannot do controlled
experiments. For instance, when an engineer wants to find out how the temperature affects the
conductivity, of a material, he builds an experiment in which he changes the temperature,
making sure that everything else remains the same, and looks at the change in conductivity. But
macroeconomists who want to find out for example, how changes in the money supply affect
aggregate activity cannot perform such controlled experiments; they cannot make the world stop
while they ask the Central Bank of a country to change the money supply. Or, can they?
Typically changes in the money supply coincide with myriad other events, ranging from
changes in tax legislation, to strike, to unusual weather, and so on. Thus, to isolate the effect of
the change in the money supply on output, economists must, when the look at their data, control
the other variables that moved at the same time.
This is difficult enough, and it is because of this difficulty, that different economists looking at
the same episode can reach different conclusions. Looking at the same episode, one economist
can see a strong effect of money on activity, while another sees a weaker effect.
The availability and the study of more and more episodes, and the use of better and better
techniques to examine the data, narrow such differences of opinion over time. For example, there
is large agreement about the effects of money on economic activity, if not about the specific
channels through which these effects take place. But disagreements do and will still remain.

Practice Questions:
1. Define the following concepts:
a. Microeconomics
b. Macroeconomics
2. What are the major differences between micro and macroeconomics?
3. Why do you think people are more concerned with macro more than microeconomics?
4. Explain what you understand by interdependence of microeconomics and
macroeconomics?
5. Explain why economists sometimes disagree on economic issues?

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 LECTURE TWO
National Income Accounting
Introduction
Gross domestic product (GDP) measures the value of output produced by factors of production
in the domestic economy over a period of time, regardless of those who own these factors.
Again, you would notice that the concept of GDP is a flow. It measures output over a period of
time. For the purposes of computation, we only recognize final goods and services. This is to
avoid the problem of double counting and unnecessary exaggeration of the value of goods and
services produced.
In addition, GDP only takes into cognizance payments earned as a result of only goods and
services produced while payments not made in respect of produced goods and services are not
counted. Such uncounted payments are known as transfer payments.
When GNP is measured at current money value, its value is going to be affected by the price
level. It is possible for the value of GNP to double between two years, but this does not imply
that welfare level has increased. If the price level also doubles over the two years then the value
of GNP has not changed in the two years. Thus, when GNP is valued at the current price level, it
is referred to as nominal or GNP at current prices. On the other hand, GNP which has been cor-
rected for changes in the price level is called GNP at real prices or alternatively as real GNP. It is
the actual measure of changes in welfare level over a given period.

Definitions of Relevant Concepts

1. Gross Domestic Product (GDP): This is the monetary value of all goods and services
produced in an economy, irrespective of the nationalities of those who produced them,
over a given period of time, usually a year.
2. Gross National Product (GNP): This is the monetary value of goods and services
produced by the nationals of a country whether resident within or outside the country. It
is simply GDP plus income from abroad (i.e. income earned by nationals of the country
resident abroad minus income of foreigners resident within the country).
3. Net National Product (NNP): This is GNP minus depreciation. It is the value of national
product after making allowances for the depreciation of the capital used to produce the
output.
Limitations of GNP and NNP
There are certain limitations in the use of GNP and NNP as measures of economic well-being or
for the purpose of international comparison of well-being. Some of these limitations are:
1. Population: GNP and NNP are not very meaningful unless one knows the size of the
population of the country in question. For instance, a country's GNP may be $50 billion
but have a population of 500 million while another country may have a $20bllion but
with a population of 10 million. Clearly, the second country, though with a smaller GNP
has a higher standard of living. To make inter-country comparison more meaningful, per
capita income (PCI) - GNP divided by the population - is often used.
2. Leisure: GNP and NNP do not take into account leisure. Usually, as people become more
affluent, they substitute leisure for increased production. Yet, this increase in leisure time
which contributes to increased well-being does not show up in GNP and NNP.
Neither do the personal satisfaction (or displeasure) people get from their jobs.

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 3. Quality Changes: GNP and NNP do not take into account changes in the quality of
goods, unless its price reflects the improvement. For example, for a brand new type of
drug, if the output and cost of the new drug is the same as the old drug, GNP will not
increase, even though the new drug is twice as effective as the old one.
4. Value and Distribution: Both GNP and NNP say nothing about the social desirability of
the composition and distribution of the nation's output. Each good and service produced
is valued at its price. If the price of a bible is N100 and that of a pornographic book is
N100, both are valued at N100.00 each and entered into GNP computation without
revealing their relative importance. The two measures do not reveal how the goods and
services produced are distributed in the society. Are they evenly distributed? Or
distributed in favour of the rich? GNP is silent on these questions.
5. Social Cost: GNP and NNP do not reflect some of the social cost, arising from the
production of goods and services. In particular, they do not reflect environmental cost of
production activities.

Measurement of GNP
There are three basic approaches to measuring GNP.
There are:
1. The Expenditure Approach
2. The Income Approach
3. The Output Approach.
1. The Expenditure Approach
This involves adding together all the expenditure on final goods and services. Economists
distinguish among four categories of expenditure:
a. Personal Consumption Expenditure: These include the spending by households on
durable goods, non-durable goods and services. Personal consumption expenditure
usually accounts for the greatest proportion of total expenditure.
b. Gross Private Domestic Investment: These consist of all investment spending by firms in
the economy. Three broad types of expenditures are included in this category.
i. all final purchases of tools, equipment and machinery;
ii. all construction expenditures including expenditure on residential houses; and
iii. the change in total inventories.

c. Government Purchases of Goods and Services: This includes the expenditures of the
Federal, State and Local Governments in the performance of their functions. However, it
excludes transfer payments, since they do not arise from production processes.
d. Net Exports: This is simply the difference between the country's exports and her imports.
Thus, GNP using the expenditure approach can be summarised as:
GNP = Personal Consumption Expenditure + Gross Private Domestic Investment +
Government Purchases of Goods and Services + Net exports.

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2. The Income Approach
To use this approach, we simply sum up all the incomes earned by factors of production -
labour, capital, land and entrepreneur, for their contribution to production of the year's
output. This income is of various types, they are:
a. Compensation of Employees: This is the largest of the income categories. It includes the
wages and salaries that are paid by firms and government agencies to supplier of labour.
In addition, it comprises a variety of supplementary payments by employers for the
benefit of their employees, such as payments into public and private pension schemes and
welfare funds.
b. Rents: In the present context, rent is defined as payment to households for the supply of
property resources. For example, it includes house rents received by landlords.
c. Interest: This includes payment of money by enterprises to suppliers of money
capital .Interest paid by the government on treasury bill, savings, bonds and other
securities are excluded on the grounds that they are not payments for current goods and
services. They are regarded as transfer payments.
d. Proprietors' Income: This consists of net income of unincorporated businesses. In other
words, it consists of the net income of proprietorships and partnerships.
e. Corporate Profits: This is the net income of corporations. This is made of three parts:
i. dividends received by stockholders;
ii. retained earnings; and
iii. the amount paid by corporation as income taxes.
All the items discussed above are forms of income. In addition, there are two non-income
items, depreciation and indirect business taxes, that must be added to the sum of the income
items to obtain GNP.
On the basis of the above discussion, GNP via the income approach can be summarized as:
GNP = Compensation of Employees + Rent + Interest + Proprietors' Income + Corporate
profits + Depreciation + indirect Business Taxes.

3. The Output (or Value-Added)

This is simply the monetary value of all the value-added to every sector in the economy. In
other words, it is the monetary value of the contributions of all the output of goods and
services by various sectors, in the economy. It should be noted that the emphasis is on value-
added. Value-added is the amount of value added by a firm or industry to the total worth of
the product.
National Income, Personal Income and Disposable Income
Besides, GNP and NNP, other important national accounting concepts include national income,
personal income and disposable income.
National Income
This is the total amount paid to factors of production - land, labour, capital and entrepreneur. It is
derived from GNP by subtracting from the latter indirect business taxes and depreciation.

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Personal Income
This is the total amount an average individual receives as income. It differs from national income
in two ways. First, some people who have a claim on income do not actually receive it. For
example, although all the profit of a form belongs to the owners, not all of this is eventually paid
out to them. Second, some people receive income that is not obtained in exchange for services
rendered.
To reconcile personal income and national income, you subtract corporate profits from
national income, and add dividends to the result. Then you must deduct contributions for social
insurance and add government and business transfer payments.
Disposable Income
This is simply the take home pay of workers. It means the actual income which can be spent on
consumption of individuals and families. The whole of the personal cannot be spent on
consumption, because it is the incomes that accrue before direct taxes have actually being paid.
Therefore, in order to obtain the disposable income, direct taxes are deducted from personal
income. Thus Disposable income = personal income – direct taxes
Nominal and Real GDP
Nominal GDP: This is simply the sum of the quantities of final goods produced times their
current price. A warning is in order here. People often use the word nominal to denote small
amounts. Economists use nominal for variables expressed in units of the currency of the relevant
country.
Nominal GDP increases over time for two reasons. The first is that the production of most
goods increases over time. The second is that the naira price of most goods also increases over
time. We produce more and more goods each year, and their naira price increases each year as
well. If our intention is to measure production and its change over time, we need to eliminate the
effect of increasing prices. For this purpose, economists focus on real rather than nominal GDP.
To construct real GDP, we first choose a base year; we then construct real GDP in any year as
the sum of quantities produced times their price in the base year.
Suppose that an economy produces two goods, potatoes and cars. In year 0, which is taken as the
base year , it produces 100,000gm of potatoes and sells them at N100 a gram, and 10 cars that
sell for N400, 000 a car. If in year 1, it produces and sells 100,000gms of potatoes at a price of
N120 per gram and 11 cars at N400,000 a car. Nominal GDP in year 0 (base year) is thus equal
to N5,000,000 and nominal GDP in year 1 equal to N230, 000. This information is summarized
in table below:
Nominal GDP in Year 0 and in Year 1.

Year 0
Quantity N Price N Value
Potatoes 100,000 X 100 = 10,000,000
Cars 10 X 400, 000 = 4,000,000
Nominal GDP 14,000,000

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 Year 1
Quantity N Price N Value
Potatoes 100,000 X 120 12,000,000
Cars 11 X 400,000 4,400,000
Nominal GDP 16,400,000
The increase in nominal GDP from year 0 to year 1 is equal to N2, 400,000/N14, 000,000 =
17 per cent. But what is the increase in real GDP? Let us take year 0 as the base year – that is,
let’s add quantities in both year 0 and 1 using year 0 prices for potatoes and cars. Because we
take year 0 as the base year, real GDP is equal to nominal GDP in year; real and nominal GDP
are always equal in the base year. In year 1, real GDP is constructed to using year 1 quantities
and year 0 prices, so that it is equal to (100,000 x N100) + (11 x N400, 000) = 14,400,000. The
increase in real GDP is the equal to N400, 000/N14, 000,000 or 2.86 per cent.
Instead of using year 0 as the base year, we could have used year 1, or indeed any other
year. The choice of the base year will typically affect the measure of real GDP growth. For
example, if we had used year 1 as the base year, real GDP in year 0 would be equal to (100,000 x
N120) + (10 x N400, 000) = N16, 000,000. By construction, real and nominal GDP would be the
same in year 1, both equal to N16, 400,000. The increase in real GDP would be equal to N400,
000/ N16, 000,000, thus 2.5 percent. It would thus be smaller than the increase in real GDP we
obtained using year 0 as the base year.
Practice Questions:
1. Define national income.
2. Distinguish between real and nominal income.
3. What are the major limitations of using GNP for the purpose of international comparison
or well-being?
4. Distinguish between GNP at current prices and GNP at constant prices.
5. Discuss the three approaches of measuring the national income of a state.
6. What is the relationship between national income, personal income and disposable
income?
7. Explain the following concepts:
a. GNP
b. NNP
c. Personal Income (PI)
d. Per capita income (PCI)
e. Real GDP and Nominal GDP

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 LECTURE THREE
National Income Determination.
Introduction
An examination of the GNP for various years will show the fluctuations which take place in an
economy. A period of rising GNP followed by another period of declining GNP and so on;
however, these fluctuations, cause serious strains on the economy. How then do we explain why
national income fluctuates and how is it determined in various types of economics?
The Circular Flow of Income .The circular flow of income shows the transaction between the
agents in the economy. For instance, in a closed economy if we assume there are two economic
agents, i.e. the household and the firms, the circular flow of income in that economy can be
depicted as follows:

Circular Row of Income in a Two Sector Closed Economy.

The Circular Flow of Income
In the above economy, firms purchase factors of production from the households and for these
they pay incomes to the households. This first part of the relationship is depicted by the inner
flows in the figure above. On its own part, the households buy goods and services from the firms
and for these they make payments to the firms. Since we assume that there is no leakage in the
economy, then all sides of the transactions must be equal. This means that the income earned by
households must be equal to the value of output produced by the firms.

Circular flow of income with injections and leakages

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 However, if we introduce leakages and injections into our circular flow of income via
savings and investment, then the circular flow in income would be altered as illustrated in figure
above.
In the economy illustrated by the figure, we assume that households do not spend all their
income on current consumption of goods and services but save part of it. The amount saved then
constitutes a leakage from the system. On the other side, firms do not sell all their output to
households, some are investment goods. This represents an injection into the circular flow. An
injection is an addition to the income of domestic firms which does not arise from expen diture of
the households or an addition to the income of households that does not arise from the sale of
factor services to the firms.
Components of Aggregate Demand
In a closed economy and in the absence of government, there are two sources of demand. There
are: a. Consumption demand, and
b. Investment demand.
This can be represented as AD = C + I
Where AD is aggregate demand; C is consumption demand; and I is investment
1. Consumption demand: This is the total amount of money spent by households on goods
and services consumed in the economy. Such goods and services ranges from cars and
foods to theatre performances and electricity. This consumption purchases account for the
highest proportion of aggregate demand.
2. Investment demand: This consists of firms, desired or planned additions to boost their
physical capital (factories and machines) and to their inventories. Inventories are goods
being held for future production or sale.

Aggregate demand can be illustrated by the following diagram.

Aggregate demand curve in the absence of government and external sectors.

CASE A: Equilibrium National Income in a Closed Economy (without the Government)
Earlier on in this lecture, we introduced injections in form of investment and withdrawal via
saving into circular flow of income in a closed economy. The two are however carried out by
different agents in the economy.
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However, in such an economy, equilibrium national income occurs where savings equal invest-
ment, that is, withdrawal equals injection. When savings exceed investment, income falls, this
will lead to a reduction in households saving and this will continue until the two are equal. The
opposite holds when investment exceeds savings.
The equality between savings and investment could be demonstrated either statistically or
graphically.
Statistically, national income Y is equal to consumption expenditure C, plus investment
expenditure I.
i.e. Y = C + I ………………. (1)
From (1) I = Y – C ………………. (2)
But, we know that income minus consumption is equal to savings; therefore, equation (2)
can be written as I = S ………………......... (3)
Geometrically, this equality can also be shown as follows:

Equilibrium output level at which planned investment equals planned savings

In the figure above, savings and investments are equal when investment is N20m. The
equilibrium national income at this point is N100m. The investment curve is a horizontal line
because we assume it is exogenously determined, that is, fixed irrespective of the level of
national income. On the other hand, the savings function is an upward straight line because
we assume savings to be a fixed proportion of a given level of national income.
The income – Expenditure Approach: This is another graphical method for showing the
equilibrium level of national income. This is illustrated below:

Determination of national Income via the Income-expenditure approach

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 The 45° line shows the equality between actual expenditure and actual income. Points above
or below the line shows a combination for which expenditure exceeds income or expenditure is
less than income respectively. In this figure, the equilibrium level of income is determined at the
point of interaction of the aggregate expenditure function and the 45° line. At this point, the
aggregate demand will just be sufficient to buy up the total of all goods produced. Any other
point leads to disequilibrium.
Case B: Equilibrium National Income in a closed economy but with the presence of the
Government
At this juncture, we recognize the presence of the third economic agent, the government in our
analysis. The introduction of the government into the economy brings into our analysis another
type of withdrawal variable (i.e. taxes) and injection variable (i.e. government expenditure).
The introduction of these variables, however, did not alter the basic conditions for
equilibrium in the economy. The equilibrium conditions still require the equality of total
withdrawals and total injections.
Thus, the equilibrium condition in this economy can be statistically stated as:
Injection (I) = Withdrawal (W)
Or I + G = S + T
Where I = Investment expenditure G = Government expenditure
S = Savings T = Taxes
The Income-expenditure Approach: In this economy, we now alter the component of our
aggregate demand by now including government expenditure; thus, AD = C + I + G.
National income will be in equilibrium if aggregate desired expenditure is equal to national
income because in that case, desired purchase will be exactly equal to total production.
CASE C: Equilibrium National Income in the Open Economy.
Relaxing the assumption of a closed economy by allowing for the influence of foreign trade, that
is imports and exports, brings the introduction of imports and exports additional variables into
our analysis. This leads to having new form of withdrawal, i.e. Imports and another new
injection which is exports. Import constitutes a withdrawal because money spent on import goes
out of the economy and hence constitutes a leakage to the system. On the other hand, export
constitutes an injection into the economy from the sale of exports.
1. Equilibrium in terms of Withdrawal and Injections
Again, we assume that like other previous injections, export (x) is fixed, while import like
other withdrawals, is allowed to change proportionally with income. The resulting
equilibrium is shown below

Equilibrium in terms of withdrawal and injections

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 If withdrawals are less than injections, there will be a net expansionary force in the
economy; income will rise. This will also make tax, savings and imports rise. The expansion will
come to a halt when total withdrawals have risen to the level of total injections and vice versa.
National income will be in equilibrium when total desired withdrawals equal total desired
injections. Thus, the equilibrium condition is, once again, W = I. That is, S + T + M = I + G + X.
2. The Income-Expenditure Approach in an Open Economy
In the open economy, aggregate expenditure includes expenditure by foreign firms,
households and governments on domestically produced goods and services. This implies
that aggregate expenditure includes export values. At the same time, some consumption
expenditure made by domestic households, firms, and some government expenditure may go
to purchase goods and services produced in foreign countries. Hence, import values must be
excluded from aggregate expenditure. Thus, we have AD = C + I + G + (X - M)
Once again, national income will be in the equilibrium when aggregate desired ex-
penditure is equal to national income. When this is true, total desired purchases will just be
equal to total production.

Equilibrium nation income through the Income- expenditure approach

Practice Questions:
1. Draw the circular flow of Income.
2. Describe the equilibrium conditions of a closed economy.
3. Suppose the consumption function is C = 0.8Y and planned investment is N45m.
a. Draw a diagram showing the aggregate demand schedule.
b. If actual output is 120, what will be the level of unplanned investment?
4. Define what is meant by equilibrium output.
5. Construct the circular flow of Income for an open economy, showing the various
withdrawals and injections into the economy.
6. Discuss the equilibrium condition for an open economy.
7. Suppose the consumption function of an open economy is C = 8 + 0.2Y
a. What is the corresponding savings function?
b. What should be the planned level of investment that will guarantee equilibrium in the
economy?
8. Define the following concepts: a.injections; b.withdrawals; c.equilibrium output.

15
 LECTURE FOUR
The Consumption Function
Introduction
One of the most important components of aggregate expenditure is the consumption function.
The shape of this function is very important for analyzing the impact of government policies on
the economy.
Consumption (c)
The main determinant of consumption is surely income, or more precisely disposable income,
the income that remains once consumers have received transfers from the government and paid
their taxes. When their disposable income goes up, people buy more goods; when it goes down,
they buy fewer goods. These are other variations that affect consumption; for the moment, we
shall ignore them.
Let C denote consumption and YD denote disposable income. Then
C = c(YD)
(+)

This is just a formal way of stating that consumption is a function of disposable income. The
function C(YD) is called the consumption function. The positive sign below YD means a positive
relation between disposable income and consumptions; It captures the fact that when disposable
income increase, so does consumption. Economists call such an equation a behavioural equation,
to indicate that the equation captures some aspect of behaviour-in this case, the behaviour of
consumers.
It is often useful to be more specific about the form of the function-for example, to assume
that the function is linear. Here is such a case. It is reasonable to assume that the relation between
consumption and disposable income is given by:
C = co + c1YD
We are assuming now that the function is a linear relation: it is characterized by two
parameters, Co and C1. Let’s look at each in turn. The parameter C 1 is called the marginal
propensity to consume. It gives the effect on consumption of an additional naira of disposable
income. If C1 is equal to 0.7, then an additional naira of disposable income increases
consumption by N1 x 0.7 = 70 percent. A natural restriction on C 1 is that it be positive: An
increase in disposable income is likely to lead to an increase in consumption. Another natural
restriction is that C1 be less than 1: people are likely to consume only part of any increase in
income, and to save the rest.
The parameter Co has a simple interpretation. It is what people would consume if their
disposable income in the current year were equal to zero. A natural restriction is that if current
income is equal to zero, consumption is still positive. This implies that C o is positive. How can
people have positive consumption if their income is equal to zero? This is made possible either
by dissaving, borrowing or both. This means that a consumer can either lean back on what he
had saved before or actually go on borrowing.

16
Theories of Consumption Function
1. The Keynesian Theory
The basic hypothesis of the Keynesian theory of the consumption function is that current
consumption is related to current income. Algebraically, this implies that:
C = f(Y)
Where: C is current consumption and Y is current income.
However, more appropriately, the Y in the function is supposed to be Yd, that is, disposable
income.
To fully expose his hypothesis, Keynes introduced two other concepts: the average and the
marginal propensity to consume. Average propensity to consume (APC) is the proportion of
income spent on consumption. In other words, it is the ratio of consumption expenditure to total
income i.e. APC = C/Y. Marginal propensity to consume (MPC), on the other hand, measures the
relation between changes in consumption, ΔC and changes in income, ΔY. It is the ratio of ΔC to
ΔY (i.e. MPC = ΔC/ΔY).
Two basic hypotheses provide the core of the Keynesian theory of the consumption
function:
1. There is a break-even level of income at which APC = 1. Below this level, APC is greater
than unity and above it APC is less than unity.
2. The MPC is greater than zero but less than unity for all levels of income (see the figures
below).

Factors Influencing Consumption

Empirical studies suggest that many factors influence consumption. The first and arguably the
most important factor is the disposable income of the people. The figures below show the
positive relationship between the two variables:

Two possible stages for a consumption function:

1. The MPC is constant but the APC declines:
2. Both the APC and MPC decline as disposable income increases.
The above relationship between consumption and disposable income assumes other factors
affecting consumption are constant.

17
Some other factors would however, cause a shift in the consumption function.
These factors are the following:
1. Changes in income Distribution: If households have different MPC, aggregate
consumption depends not on aggregate income but also on the distribution of this income
among households. Changes in the distribution of income will cause a change in the
aggregate level of consumption expenditure associated with any given level of national
income.
2. Changes in the Terms of Credit: Many durable consumer goods are purchased on
credit. If credit becomes more difficult or more costly to obtain, many households may
postpone their planned credit-financed purchases. There would then be a temporary
reduction in current consumption expenditure until the necessary extra savings are
accumulated.
Monetary authority can by controlling the cost and availability of credit shifts the
consumption function and thus affects aggregate demand.
3. Changes in Existing Stock of Durable Goods: It is now recognized that any period in
which durables are difficult or impossible to purchase and monetary savings are
accumulated, it is likely to be followed by a sudden outburst of expenditure on durables.
Therefore, this will shift upwards the consumption function.
4. Changes in Price Expectation: If households expect inflation to occur, they would be
willing to purchase durable goods, which they would otherwise not have bought for
another one or two years. In such circumstances, purchases made now yield savings over
purchases in the future.
5. Government Policy: Changes in government policies can also affect the relation between
national income and disposable income; for example, by altering tax rates. An increase in
income tax rate will, for example, reduce the amount of disposable income that reaches
the hands of the households out of any level of national income. This will therefore make
the consumption function curve to shift downwards.

Theories of the Consumption Function

The Keynesian theory as enunciated above relates current consumption to current income.
However, empirical studies carried out by researchers have not supported this theory. This has
led to several modifications of the hypothesis as discussed below.

1. The Permanent Income Hypothesis (PIH) This theory was developed by Professor Milton
Friedman. The hypothesis makes two important assumptions. First, people's income
fluctuates; second, people dislike fluctuating consumption. Thus, people will always try to
minimize the effect of fluctuation in income on their consumption.
Friedman believes that people's consumption is influenced by their permanent income,
rather than current income as argued by Keynes. Thus, during period of temporary increase
in their income, households do not increase their consumption by the same proportion. This
is because they perceive such increment as temporary. Therefore, they will save most of this
temporary extra income and put money aside to see them through the year when income is
usually low. People will only increase their level of consumption if their permanent income
has significantly increased

18
2. The Life-Cycle Hypothesis (LCH) This was jointly developed by Professors Franco
Modigliani and Albert Ando. The theory is very similar to the PIH. The theory assumes that
people have a clear conception about what their income will be over their lifetime and on
that basis form a lifetime consumption plan.
Just like the permanent income hypothesis, the life cycle hypothesis suggests that it is
average long run income rather than current income that is likely to determine the total
demand for consumer spending.
The LCH is illustrated by the diagram below

Consumption and the Life Cycle

The figure above shows a household actual income over its lifetime. OF is the household's
permanent income. OF is also the maximum amount that the household could spend on
consumption each year without accumulating debts that are passed on to future generation. If the
interest rates were zero, permanent income would just be the sum of all expected income divided
by the number of expected years of life or simply put average income over one's life span.

3. The Absolute Income Hypothesis (AIH) Keynes’ consumption income relationship is

known as the absolute income hypothesis, which states that when income increases
consumption also increases, but by less than the increase in income, and vice versa. This
means that the consumption income relationship is non proportional. James Tobin and
Arthur Smithies tested this hypothesis in separate studies and came to the conclusion that the
short run relationship between consumption and income is not proportional, but the time
series data show the long run relationship to be proportional. The latter consumption income
behaviour results through an upward shift or “drift” in the short run non proportional
consumption function due to factors other than income.

4. The Relative Income Hypothesis (RIH) -This theory was developed by James
Duesenberry. It is based on the rejection of the two fundamental assumptions of the
consumption theories of Keynes. Duesenberry states that (1) every individual’s consumption
behaviour is not independent but interdependent of the behaviour of every other individual,
and (2) that consumption relations are irreversible and not reversible in time.

19
 In formulating his theory of the consumption function, Duesenberry writes “A real
understanding of the problem of consumer behaviour must begin with a full recognition of
the social character of consumption patterns.
By the social character of consumption patterns, he means the tendency in human beings not
only to keep up with Joneses but also to surpass the Joneses. In other words, the tendency is
to strive constantly towards a higher consumption level and to emulate the consumption
patterns of one’s rich neighbours and associates.
Implications of the theories
1. The effect of changes in income on consumption. The major implication of these theories
is that, changes in a household current income will affect actual consumption only, so far
as they affect its permanent income.
2. Implications on the behaviours of the economy: The theories also hold that actual
consumption is not much affected by temporary changes in income.
3. The theories lay stress on factors other than income, which affect the consumer
behaviour

Practice Questions:
1. Why is the consumption function very important for policy planning?
2. Discuss the factors that affect the consumption function.
3. What are the major features of Keynesian theory of the consumption function?
4. Distinguish between two consumption theories you know.
5. Distinguish between Keynesian theory and the Life-cycle hypothesis on consumption
function.
6. What are the implications of the theories of consumption functions?

20
 LECTURE FIVE
Investment
Introduction
Having treated one of the major components of aggregate expenditure, the consumption function,
the next is to examine another component of aggregate expenditure, that is, investment. It is
divided into three distinct parts, business fixed investments; residential construction; and net
changes in business inventories. Furthermore, we shall look at the determinants of investment
and also the accelerator principle.
The Determinants of Investments
Several factors Influence the level of Investment in any country. Chief among these factors are
examined below:
1. The Rate of Interests: This is perhaps the most important determinant of investment.
Most investments are made with borrowed money for which the borrower must pay a
market rate of interest. Thus, the decision to invest or not depends on whether the
expected rate of return on new investment is greater or less than the interest rate that must
be paid on the amount to be borrowed to acquire these assets. Logically, the lower the
rate of interest the higher the amount of new investment that will be made. In a functional
form, we expect a negative relationship between investment (I) and rate of interest (r)
i.e. I = 1/r …………..… (1)
I = f(r) …………..… (2)
Marginal Efficiency of Capital (MEC) and the Rate of Interest
The marginal efficiency of capital is the rate of returns on new investment. Sometimes, it is also
referred to as "expected rate of return over cost” on new investment. At equilibrium, MEC and
the rate of interest will be equal. This is because firm would continue to make new investments
as long as the rate of return on the new investment is greater than the interest rates. Since capital
is also subject to diminishing returns, we expect the rate of return on new investments or
alternatively the MEC to fall as the stock of capital increases as shown in the curve below.

Capital

New Investment Expenditure.

21
 The figure above confirms our proposition that the MEC is negatively related to the stock
of capital. For instance, a fall in the rate of interest from r 2 to r1 causes an increase in new
investment expenditure from k1 to K2.
2. The Level of Income
Research studies have shown that the level of income might be a better inducement to investment
than the interest rate. This is because increase in income will lead to increase in demand for
goods and services. Assured of the presence of a willing demand for their output, businessmen
will undoubtedly be encouraged to increase their investment in order to cash on the potential
increase in their profit level.
3. Changes in Income
This is the accelerator theory. According to this theory, investment is related to the change in
national income. When income is increasing, it is necessary to invest in order to increase the
capacity to produce consumption goods. However, when income is falling, it may not even be
necessary to replace old capital, as it wears out let alone to invest in new capital
In symbols, I = f (ΔY) ,This implies that investment depends on change in output.
How the Accelerator Principle Works
Let's assume that there is a particular constant stock needed to produce a given level of an
industry's output. (The ratio of the value of capital to the annual value of output is called the
capital - output ratio). With this assumption, suppose that the industry is producing at full
capacity and the demand for its product increases. If the industry is to produce the higher level of
output, its capital stock must increase. This necessitates new investment.
The table below provides a simple numerical example of the accelerator. Assuming that it
takes N5 of capital to produce N1.00 of output per year. In year one and two, there is no need for
new investment. In year three, an increase of N10 of sales requires a new investment of N50. The
same thing applies in year four; an increase of N20.00 of sales requires an additional investment
of N100.00. As columns (3) and (5) show, the amount of new investment is proportional to the
change in sales. When the increase in sales tapers off in years seven and nine, investment
declines and eventually becomes zero in year ten.
An illustration of the accelerator theory of Investment
(1) (2) (3) (4) (5)
Year Annual Changes in Required stock of capital Net investment increases
sales (N) sales assuming a capital in required capital stock
output ratio of 5:1 (N) (N)
1 100 0 500 0
2 100 0 500 0
3 110 10 550 50
4 130 20 650 100
5 160 30 800 150
6 190 30 950 150
7 220 30 1100 150
8 240 20 1200 100
9 250 10 1250 50
10 250 0 1250 0

22
 This idea of accelerator principle that investment depends on the changes in demand
represents an important source of instability in national income. It combines with the multiplier
to generate economic cycles via the multiplier - accelerator model.
Three general predictions of the accelerator are the following:
1. Rising, rather than high levels of sales are needed to call forth net investment.
2. For net investment to remain constant, sales must rise by a constant amount per year.
3. The amount of net investment will be a multiple of an increase in sales because the
capital-output ratio is greater than one.
Limitations of the Accelerator
The accelerator model posits a mechanical and rigid response of investment to changes in sales.
It does this by assuming a proportional relationship between changes in income and size of the
desired capital stock, and by assuming a fixed capital- output ratio. Each of these assumptions is
invalid to some degree.
In the short run, there are many reasons why investment may not conform to the rigid
proportionality implied by the accelerator principle. The most obvious reason is that the
adjustment of actual desired capacity is asymmetric with respect to positive and negative output
changes. When the economy expands and actual capacity lags behind desired capacity, business
firms expand their capital stock. On the other hand, no firm would deliberately destroy enough of
its machine to bring actual capacity in line with desired levels when the economy enters a slump
and demand declines.
4. Expectations
Since present investments are usually made in expectation of future demand, the decision to
invest depends on the hope about the future. When a firm has a high optimism about the
future, it can embark on increased investments presently and vice versa. However, because
of the uncertainty about the future, firms are usually very cautious about increasing the level
of investment they made.
Relationship between savings, investments and the rate of interest
There is a close interdependence between savings, investments and the rate of interest. We have
mentioned in the earlier part of this lecture that most of the funds used for investment purposes
are borrowed from banks and other sources of credit schemes. Whenever the amount of funds
presently available from all these sources is not enough to sustain the magnitude of investments
the investors in the economy want to make, there will be competition for available funds. Since
the market rate of interest is however determined by the forces of demand and supply, the excess
demand in the market for funds will therefore push up the market rate of interest.
Financial Theories of Investment
Some economists have laid emphasis on the effects of financial factors on investment. But we
shall study only the profits theory of investment.
The Profits Theory of Investment
The profits theory regards profits, in particular undistributed profits, as a source of internal funds
for financing investment. Investment depends on profits and profits, in turn, depend on income.
In this theory, profits relate to the level of current profits and of the recent past. If total income
and total profits are high, the retained earnings of firms are also high, and vice versa.

23
Retained earnings are of great importance for small and large firms when the capital market is
imperfect because it is cheaper to use them. Thus, if profits are high, the retained earnings are
also high. The cost of capital is low and the optimal capital stock is large. That is why firms
prefer to reinvest their extra profits for making investments instead of keeping them in banks in
order to buy securities or to give dividends to shareholders. Contrariwise, when their profits fall,
they cut their investment projects. This is the liquidity version of the profits theory.
Another version is that the optimal capital stock is a function of expected profits. If the
aggregate profits in the economy and business profits are rising, they may lead to the expectation
of their continued increase in the future. Thus, expected profits are some function of actual
profits in the past.
Kt* = f(t-1)
Where Kt* is the optimal capital stock and f(t-1) is some function of past actual profits.
Edward Shapiro has developed the profits theory of investment in which total profits vary
directly with the income level. For each level of profits, there is an optimal capital stock. The
optimal capital stock varies directly with the level of profits. The interest rate and the level of
profits, in turn, determine the optimal capital stock. For any particular level of profits, the higher
the interest rate, the smaller will be the optimal capital stock, and vice versa.
Practice Questions:
1. What are the major determinants of investment?
2. Define the accelerator principle. How does it operate and what are its major limitations?
3. What are the limitations of the accelerator principle?
4. What are the effects of expenditure on the level of investment?
5 Mention and discuss the various factors which influence the level of investment in an
economy?
6. Discuss the relationship between
a. savings and investment
b. marginal efficiency of capital (MEC) and level of new investment.

24
 LECTURE SIX
Government, Aggregate Demand and Fiscal Policy
Introduction
Government exerts a lot of influence on the circular flow of income. Through its control over
taxes and spending decisions, the government also influences the behaviours of other economic
agents, such as the households and the firms. Fiscal policy is the use of taxes and government
spending decisions to influence the level of aggregate demand. Therefore, in this lecture, we
shall be looking at the role of government in the economy, and how it uses its fiscal power to
influence the level of economic activity.
1. The Government and Aggregate Demand
The Aggregate demand (AD) can be defined as:
AD = C + I + G
Where C = Consumption demand
I = Investment demand
G = Government demand for goods and services
Since government demand is one of the components of aggregate demand, the government
can use its tax policy and expenditure programs to influence the level of aggregate demand in the
economy. The effects of either of these tools of government on the level of aggregate demand.
a. The Effect of Taxes on National Income
The government can increase aggregate demand in order to close a deflationary gap by
reducing the tax rates. This will have an indirect effect on the economy by increasing the
level of aggregate disposable income. And, since consumption demand is a function of
disposable income, this will boost domestic demand and thus lead to increase in aggregate
demand.

Using taxes to close deflationary gap

A change in tax rate will not shift the aggregate demand function but will only alter the slope of
the function, since tax revenue will vary with national income. In figure above, reduction in tax
rate has increased aggregate demand from AD 1 to AD2 by changing the scope of the function.
Thus, the deflationary gap can be closed.

25
b. The Effect of Government Expenditure on National Income
An alternative way by which government can increase the aggregate level of economy is
through its expenditure policy. If increased government expenditure is met by tax revenue,
then the effect on aggregate demand will be minimal. This is because the increase in
government expenditure would have been matched by an equivalent decrease in private
expenditure. The reduction in private expenditure is called ‘crowding-out effect’.
However, the effect of increase in government expenditure on aggregate demand function
is different from the effect of taxes which we have just enunciated above. An increase in
government expenditure will shift the aggregate demand function upwards, parallel to the
former one

Using government expenditure to Using government expenditure to

eliminate a deflationary gap eliminate an inflationary gap

Thus, a deflationary gap may be removed by an appropriate increase in government

expenditure or decrease in tax rates. An inflationary gap may be removed by an appropriate
decrease in government expenditure.
2. Comparative Effects of Expenditure and Tax Changes
There is a difference in the comparative effect of government expenditure and tax revenue
of the same amount on aggregate demand. This is because increase in government
expenditure will have immediate and direct effect on aggregate demand; the same is not true
of taxes. A reduction in taxes of equal amount will not have same amount of effect on
aggregate demand because only part of extra income realized from reduction in taxes will be
spent. For instance, if government expenditure is raised by N100, 000 to close a deflationary
gap, and given that the multiplier is two, the final rise in national income is N200, 000. On
the other hand, if government cuts income tax rates sufficiently to reduce its revenue by
N100, 000 households will have an extra N 100,000 of disposable income.
Consumption expenditure will, however rise, by less than N100, 000 because only part of
the extra income will be spent. If marginal propensity to consume is 0.75, then the final rise
in national income will be N150, 000.

26
The Theory of Fiscal Policy
Balanced and Unbalanced Budgets
People formerly believed that a prudent government must always balance its budget. But
nowadays, it is generally accepted that a government can run an unbalanced budget in order to
stabilize the economy. For example, a government can run a deficit budget to stimulate the
economy during period of recession.
Definitions
1. A budget is regarded as balanced when its current revenue is equal to current
expenditure.
2. A budget is said to be unbalanced when there is budget deficit or surplus.
3. Budget surplus occurs when government revenue exceeds its expenditure.
4. A budget deficit occurs when government revenue falls short of its expenditure.
A budget can be financed either by raising taxes or through borrowing. When government
spends more without raising its taxes, its extra expenditure is said to be deficit financed. This
deficit can be met by increase in borrowing either from the central bank of the state or from the
private sector of the economy.
The Balanced Budget Multiplier
What would be the effect of balanced budget spending on aggregate demand? A natural
assumption would be that an equivalent increase in government spending and taxes would leave
aggregate demand and equilibrium output unchanged. But this is not true. Let's assume that
government finances a new expenditure of N300, 000 by tax revenue of equal amount. Although,
this implies that the budget is balanced, but we shall soon see that this action has positive effect
on aggregate demand. The increase of N300, 000 in government spending raises aggregate
demand by N300, 000. But since the marginal propensity to consume (MPC) out of disposable
income is less than 1 (say 0.7) this reduction in income by N300, 000 reduces consumption
demand by only N210, 000 (0.7 x 300,000).
Thus, the initial effect of tax and spending package is to increase aggregate demand by
N300, 000 because of government spending but reduce it by only N210, 000 because higher
taxes reduce consumption demand. Thus, a balanced aggregate demand has increased aggregate
demand by N90, 000 (i.e. N300, 000 - N210, 000). This example illustrates the principle of
balanced budget multiplier, which states that an increase in government spending, accompanied
by an equal increase in tax, results in an increase in output.
Tools of Fiscal Policy
These tools can be classified into automatic and discretionary measures.
1. Automatic Tools of Fiscal Policy: Built-in Stabilizer
Automatic stabilizers are mechanisms in the economy that reduces the response of national
income to shock. They are automatic since they are already built-in into the functioning of
the economy and, thus, they do not require deliberate intervention to make them work. Thus,
they tend to cause injections as income falls or withdrawals as national income rises and
vice-versa, without the government making policy decisions to bring about these changes.
Examples of automatic stabilizers include taxes, national insurance or progressive taxes.
These yield increases when national income rises and decreases when it falls, thereby
respectively bringing about expansionary and inflationary forces on the economy.

27
 2. Active or Discretionary Fiscal Policy
Although the automatic stabilizer are always at work, government can embark on active or
discretionary fiscal policies which alter spending levels or tax rates in order to stabilize the
level of aggregate demand. While built-in stabilizers are often designed for short term minor
fluctuations, discretionary fixed policies are used to cater for persistent fluctuation or gap in
the economy.
Countercyclical Fiscal Policy: Automatic and Discretionary Changes
It may be inferred from the relationship between (a) Public expenditure and GNP; (b)
taxation and GNP; that a countercyclical fiscal policy would require increase in public
expenditure and reduction in taxation to fight depression, and reduction in public
expenditure and increase in taxation to controlling inflation. In other words, fighting
depression would require deficit budgeting and control inflation requires surplus budgeting
Some of the budgetary changes are automatic and some are discretionary. The automatic
budgetary adjustment takes place only when fiscal policy has built-in flexibility. The
automatic budgetary changes should follow the change in GNP. Built-in flexibility in the
fiscal policy implies that as GNP falls, both income and consumption decline.
Consequently, the revenue from both direct and indirect taxes declines. Government
establishment and committed expenditure remaining the same, public expenditure exceeds
its revenue, and the budget automatically runs into deficit. This effect is more quick and
powerful in the countries, which provide unemployment allowances and other relief
benefits. When GNP increases, tax base expands and tax revenue increases. Expenditure
level remaining the same, the budget automatically shows surplus.
The deficit surplus resulting from fluctuation in GNP works as automatically stabilizer of
the economy. However, it is generally believed that automatic stabilizers prove to be
adequate and serve useful purpose only for short-term fluctuations in the economy.
Automatic stabilizers prove generally to be inadequate to control the economic fluctuations
of larger amplitude; under such conditions, discretionary changes in budget become
necessary.
The discretionary changes in the budget refer to the changes in the tax structure, and in
the level and pattern of public expenditure by the government on its own discretion.
Discretionary changes include change in tax rate structure, abolition of existing taxes,
imposition of new taxes, increasing and decreasing the public expenditure, changing the
pattern of public expenditure, etc. Discretionary changes are so designed as to arrest the
inflation and deflationary trends in the economy and to mitigate the destabilizing forces,
such as, increase or decrease in aggregate demand.
Problems in Formulating Counter- Cyclical Fiscal Policy
Formulating a counter-cyclical fiscal policy is not a straight forward affair. It involves certain
complications, which should be born in mind while devising the tax and expenditure policy to
stabilize the economy. Eckstein has pointed out some complications as follows.
1. All expenditures do not have the same multiplier effect. For example, transfer payments
by the government do not create a direct demand for goods and services. Some public
expenditure (e.g. free education and hospital facilities) replaces the private expenditure.

28
 2. Not all tax – changes have the same multiplier effect. For example, taxes paid by the upper
incomes groups have lower multiplier effect than those paid by lower income groups. This is
because of the differences in their marginal propensity to consume (MPC).The multiplier
effects of indirect taxes are not clearly known.
3. Deficit financing through public borrowing may reduce private investment. This kind of
deficit financing reduces the multiplier effect.
4. There are practical difficulties in relation to the assessment of time lags and accuracy of
forecasts. Therefore, there is uncertainty in relation to effectiveness of fiscal policy.
Practice Questions:
1. Explain what you understand by ‘balanced budget’.
2. Define the following terms.
a. balanced budget;
b. balanced budget multiplier;
c. budget surplus; and
d. budget deficit
3. Distinguish between automatic stabilizers and discretionary policy.
4. Describe, with appropriate diagrams, how a government can close deflationary gap in an
economy.
5. A prudent government must at all times ensure that it operates a balanced budget: True or
False? Explain.
6.. If the government desires to remove unemployment in the economy by increasing its
spending by N1, 000,000, and she raises money to finance this increased expenditure by
raising tax rates equal to the amount spent, what is the effect of this spending on the
economy?
7. Explain what you understand by ‘tools of fiscal policy’.

29
 LECTURE SEVEN
Price Level and Money

Introduction
The history and the role of money in the economy cannot be overemphasized. Money performs
useful functions in the economy which make it indispensable for the functioning of the economy.
Just as it has its advantages, money has also brought about the problem of inflation into the
modern society. Inflation is seen by many people today as the number one public enemy.
The Price Level
Right from the time of the classical economists, economy has been divided into two parts: the
real part and the monetary part. Allocation of goods and services take place in the real sector.
Only relative prices matter in this part of the economy.
On the other hand, money prices or the price level is determined in the monetary sector of
the economy. Here price level is determined by the quantity of money supply in the economy.
The classical economists have considered these two parts of the economy as independent of each
other. Money has no impact on the real sector of the economy and thus has been considered as a
veil behind which actual production takes place. This doctrine is referred to as the neutrality of
money.
Inflation and Deflation
Inflation is a period of persistent increase in the general price level. Deflation rep resents the
opposite. All economists agree that rapid inflation or deflation is harmful to an economy, and
often many people get hurt as a result. Economists also agreed that inflation is a monetary affair.
In other words, inflation arises because there is increase in demand of real goods, thereby leading
to increase in prices. The effect of inflation on the economy depends on whether it is anticipated
or not. When inflation is anticipated, the necessary cushions are already built into contract
agreements etc. so that people are protected. Another example is the case of indexed wages.
Effects of Inflation
Inflation influences the allocation of resources in the economy by changing the structure of
relative prices often in an absurd way. Since, prices are not rising in the same proportion;
commodities which are enjoying higher relative prices will witness inflow of production
resources, which might not necessarily be to the benefit of the society.
Inflation also redistributes wealth from lenders to borrowers. Lenders suffer a loss on the
real value of their money if they are paid back during the period of inflation. For instance, Mr. X
lends Mr. Y N100, 000 at 5 percent interest for one year. If the price level rises by 10 per cent
over the year, Mr. X has actually earned a negative rate on the actual amount loan (in terms of
purchasing power) than the N100, 000 he lent to him at the beginning.
Another major effect is on the fixed income of the people. This is because the purchas ing
power of their income falls during the periods of inflation.
However, inflation is not entirely a loss; some people actually gain out of it. Inflation might also
lead to increase in total production considering the fact that producers gain from inflation and
may therefore be encouraged to increase their production activities.

30
Causes of Inflation
As we noted ear1ier in this lecture, inflation cannot be permanently sustained without an increase
in money supply. Thus, all the permanent causes of inflation are money-related.
The first cause of inflation is an appreciable increase in the quantity of money supply. When
the government prints more money in order to finance a deficit budget or to prosecute a war, this
will have the effect of increasing aggregate money supply, and therefore, the general price level.
Another cause of inflation is often excessive demand over supply. That is increase in
demand without a corresponding increase in supply. The increase in aggregate demand might be
caused by increase in wages of workers as we had in Nigeria during the Udoji Award. The
consequent increases in cash balance with the workers will cause a rightward shift in aggregate
demand and with a fixed supply curve, the price level will increase.
The third cause of inflation is cost-push Inflation. This is a result of increase in production
costs to producers who then review upwards the prices of their products in order to still make
profit. A common example of this is the increase in exchange rate of Naira to dollars. Many
firms in Nigeria depend on imported inputs to produce. Hence, when the exchange rate increases
from about N1.00 = $1.00 to N7.00 = $1.00, there will be a corresponding sevenfold increase in
their production costs. Thus, they were forced to increase the prices of their output because of the
change in the exchange rate.
Control of Inflation
The control of inflation is always hinged on the cause of the inflation. For instance, for a money-
induced inflation, efforts should be made to reduce aggregate money supply. The Central Bank
of Nigeria has been trying to reduce the supply of money in the economy through credit squeeze
on the commercial banks.
Fiscal policy could also be used to control inflation. The government could reduce its budget
deficit or rather promote budgetary surplus.
Also relevant here is the famous Phillips curve. This curve was developed in 1958 by Prof.
A. W. Phillips. This curve suggests that it is possible to trade-off more inflation for less
unemployment or vice-versa.

Philips Curve
Then through a combination of fiscal and monetary policies, it was thought that the
government could reduce the rate of inflation for some level of unemployment.

31
Money
Money is anything generally acceptable as a means of payment for goods and services and for
the settlement of debts. Money performs various functions, and different kinds of money vary in
the degree of efficiency with which they can fulfill these functions. These functions include the
following:
1. The Medium of Exchange: This is the most important function performed by money.
Money allows the complexity of modern economy based on specialisation to be possible.
This removes barter, which is the system of exchanging goods for goods directly. This is a
cumbersome system in which every transaction requires a double coincidence of wants.
2. Unit of Account: Money provides a common denominator by which all other commodities
are expressed. Therefore, this makes it very easy to record economic transactions, involving
different commodities. As a unit of account, money allows for the formation of prices which
can then be used for recording transaction entries in books of accounts.
3. A Store of Value: Possession of money confers purchasing power on the holder who can
then decide either to spend it now or save for future transactions. More importantly, money
as a store of value introduces flexibility into the money economy. It is now possible to sell
goods today, store the money until one needs it later on. However, for money to be able to
function effectively as a store of value, then it must have a stable value. Rapid fluctuation in
the general price level reduces the usefulness of money as a store of value.
4. A Standard of Deferred Payment: Money also allows for the practice of credit system in
an economy. In other words, it is possible to buy now and pay later or alternatively
speaking, to sell now and collect money later on. However, this is impossible in a barter
economy. This decoupling of purchase/sales and payments provide much of the
development, which characterises our economy today. It is a fact that many companies
borrow from banks or make use of credit facilities to be able to function effectively.
The Determinants of Demand for Money
Money could either be held as liquid cash or be used to purchase income earning assets which
would generate some rates of return. The holding of money therefore have an opportunity cost
which is the rate of Interest that could have been earned if the money were used to purchase
income earning assets such as treasury bills.
The total amount of money balances that everyone wishes to hold for all purposes is called
the Demand for Money. There are generally three purposes for holding money. These are
transactive motive, precautionary motive and speculative motive. The three motives are
discussed fully below.
1. Transactive Demand for Money: This is the total amount of money that people want to
hold in order to carry out their day-to-day activities such as settling their bills. The
transactive demand for money arises because of the time difference between the receipts
and expenditures of households and firms.
For instance, while workers are paid wages and salaries at the end of the month they often need
money to meet some financial commitments between one period of salary payment and another
period. Money held for this purpose depends on two factors.
1. the size of national income measured at current prices; and
2. the time span between one payment period and another

32
2. The Precautionary Demand for Money: This refers to the money held for the purposes of
meeting unexpected contingencies. Life is often full of uncertainty. Unexpected business
opportunities may arise, for which a firm may need money to take advantage. If the firm has
not made adequate provisions for such an occurrence, then it may not be able to benefit from
such unexpected opportunities.
The demand for money for this purpose however depends on the rate of interest. The
higher the rate of interest, the higher the opportunity cost of holding money and invariably
the less the amount of money held for precautionary motive. However, the total amount of
money held for this purpose varies directly with the size of the national income.

3. The Speculative Demand for Money: This is the money set aside for the purposes of
speculative trading. For instance, if one thinks prices are now very low and may rise in the
future, the tendency is to buy now and to postpone selling until prices rise and vice-versa.
Hence, when prices are low, people will rush to purchase and this will therefore reduce
money held for speculation.On the other hand, in a situation when prices have come down.
In such a situation, large quantities of money may be held in anticipation of a more
favorable change in price before they make their purchases in the future. The speculative
demand for money also varies inversely with the rate of interest.
It is very important to note the differences between the transactive, precautions and the
speculative demands for money. Whereas, the transactive and precautionary motives
emphasize the role of money as a medium of exchange, the speculative motive emphasizes
its role as a store of wealth.
The Demand for Money
Let’s formalize our discussion of the demand for money as follows.
Let “NWealth” represent the financial wealth of households in naira-thus, the naira sign. At
a point in time, financial wealth is given. Households must choose how much to hold in money
and how much to hold in bonds. Let their demand for money be denoted by M d and their demand
for bonds by Bd (the superscript d stands for demand). Whatever they choose, their decisions
must be such that money and bond holding add up to their wealth:
Md + Bd = NWealth (8.1)
We just saw that an individual’s money demand depends primarily on two variables, his
level of transaction and the interest rate. This suggests that money demand for the economy as a
whole depends on the overall level of transactions in the economy and on the interest rate. The
overall level of transaction is hard to measure. But it is reasonable to assume that it is roughly
proportional to nominal income-equivalently nominal output.

33
 If nominal income increases by say, 10%, it is reasonable to think that the amount of
transactions in the economy will also increase by roughly 10 percent. Thus, we write
Md = NYL (i) (8.2)
(-)

This equation reads as “Money demand is equal to nominal income times a function of the
interest rate, denoted L(i).” This equation summarizes what we have said so far:
1. First, the demand for money increases in proportion to nominal income. If income
doubles, increasing from NY to N2Y, then, the demand for money increases from NY
L(i) to N2YL(i); thus it also doubles.
2. Second, the demand for money demands negatively on the interest rate. This relation is
captured by the function L(i) and the negative sign under the interest rate, which indicates
a negative relationship. This demand for money decreases when the interest rate
increases.
The relation between the demand for money and the interest rate implied by the equation
above is represented in the figure below, the interest rate, i, is measured on the vertical axis.
Money, M, is measured on the horizontal axis. The Md curve represents the demand for money
for a given level of nominal income, NY. It is downward sloping, because a lower interest rate
leads to a higher demand for money. The Md curve gives rate, say i, an increase in nominal
income from NY to NY increases the demand for money from, say, M to M’. Put another way,
the demand for money shifts to the right, from Md to Md’. At any interest rate, the demand for
money is larger than before the increase in nominal income.
Interest rate, i

Md’
($Y’ > $Y)

Md

M M’
Money, M
The demand for money

34
The Demand for Bonds
Remember that the demand for money and the demand for bonds are not independent decision
but that the two have to add up to financial wealth. We can thus look at the demand for bonds
implied by the demand for money. From equations (8.1) and (8.2), the demand for bonds is given
by
Bd = NWealth - Md
= NWealth - NYL (i)
An increase in wealth leads to a one-for-one increase in the demand for bonds. This
conclusion comes from out assumption that the demand for money depends on income and the
interest rate, not on wealth. Thus, an increase in wealth goes into higher bond holdings rather
than into higher money holdings. An increase in income leads to an increase in the demand for
money, and thus to a decrease in the demand for bonds. And an increase in the interest rate,
which makes bonds more attractive, leads to an increase in the demand for bonds.

Practice Questions:
1. Define inflation?
2. Just as inflation has its bad side, it also has its positive impact on the economy. Discuss.
3. If you are made the Minister of Finance, what measures will you take to control inflation
in the economy?
4. Give three reasons why people demand for money.
6. Inflation is a monetary affair, True or False?
7. Inflation is not entirely bad. Do you agree? Explain.
8. What is money? Why is money essential for the functioning of modern economy?

35
 LECTURE EIGHT
Unemployment
Introduction
Macroeconomics deals with three main variables - employment, output and the general price
level. In this lecture we want to look at employment. Ordinarily, you know that the employed
refers to people who are doing some work for a living. This naturally includes those who are
self-employed. Conversely, the unemployed are those who are willing to work but are not
currently employed.
Unemployment
One of the major problems confronting every modern economy is that of unemployment. It is an
economic condition in which the number of people who are willing and able to work but are
without a job. Unemployment is a stock concept measured at a point in time; it is an indication of
the resources of the country that is presently unutilised.
The implications of unemployment in an economy are grievous. First, it implies that the
economy is operating at below full employment level in which case it means that the society is
foregoing some potential output. Second, it will increase the pressure on those who are presently
working since they have to cater for their unemployed relatives or in some cases part of their
taxes will be used to provide for the unemployed. Third, it could also lead to increment in social
menace such as armed robberies, prostitution, etc.
Voluntary versus Involuntary Unemployment
Keynes distinguishes between voluntary and involuntary unemployment. Voluntary
unemployment occurs when the unemployed is unwilling to take up the available job at the going
wage rate. Involuntary unemployment occurs when a person is willing to accept a job at the
going wage rate but could not find one.
Causes of Unemployment
In discussing the causes of unemployment, it is useful to distinguish different kinds of un-
employment.
1. Frictional unemployment: This is the amount of unemployment that is associated with
normal turnover of labour. It is unemployment that occurs in the course of leaving one
job and finding another.
2. Structural unemployment: Structural changes in an economy can be a cause of
unemployment. The process of economic development implies changes in input and
output mix. While the demand for some products will be increasing, others will be
decreasing. However, it might take sometimes for workers who are laid-off in the
declining industry to learn the required skills to cross over to the growing industry.
Essentially, structural unemployment thus occurs when there is a mismatching between
the unemployed and the available jobs in terms of regional location, required skills, or
any relevant dimension.
3. Deficient demand unemployment: Unemployment that occurs because there is
insufficient aggregate demand to purchase full employment output is called deficient
demand unemployment. It is measured by the excess of the supply of workers looking for
jobs over the number of jobs available. It will be positive when there is deficient
aggregate demand and negative when there is excess aggregate demand.

36
 4. Search unemployment: This occurs among people who could find work of the type for
which they are fitted but who remained unemployed in order to search for a better offer
than they have received so far.
5. Seasonal unemployment: This results from seasonal fluctuations in demand for labour.
For example, employment in ice factories is only for the summer; similarly, ice-cream
sellers remain unemployed during winter. The same is the case with agricultural workers
who remain employed during harvesting and sowing seasons and remain idle for the rest
of the year.
Control of Unemployment
The best remedy for unemployment is an understanding of the nature and causes of such
unemployment. In other words, one needs an understanding of the type of unemployment before
appropriate control measures can be taken. For instance, frictional unemployment is inevitable in
any economy. However, any policy measure that makes moving between jobs easier and quicker
can, however, reduce the volume of frictional unemployment somewhat.
Structural unemployment may be checked by policies of retraining and relocating labour as
part of a general effort to facilitate the adjustment of labour supplies to changing patterns of
demand
Unemployment that is due to deficient aggregate demand can be resolved by increasing
aggregate demand. This can be done by any expansionary fiscal (e.g. increasing government
expenditure) or monetary (e.g. reducing interest rates) policies.
Genuine search unemployment may be reduced, first, by making it easier for individuals to
locate job vacancies and second, by increasing the possibility that individuals will accept an offer
received earlier in their search period. The first can be done, for example, by the provision of
market information on job availability; the second requires increasing the cost of search to the
unemployed individual, for example, by reducing unemployment benefits.
The Unemployment Rate
The labor force is defined as the sum of those employed and those unemployed:
L = N +U
Labor force = Employment + Unemployment
The unemployment rate in turn is defined as the ratio of the number of unemployed to the
labor force.
u= U
L
Unemployment rate = Unemployment
Labor force

What determines whether a worker is defined as unemployed or not? Until the 1940s in the
United States and until more recently in most other countries, the number of people registered in
unemployment offices was the only available source of data on unemployment, and only those
workers who were registered in unemployment offices were counted as unemployed. This
system led to a poor measure of unemployment. How many of the truly unemployed actually
registered varied both across countries and across time.
37
Those who had no incentive to register, for example, those who had exhausted their
unemployment benefits – were unlikely to take the time to come to the unemployment office;
thus, they were not counted. Countries with less generous unemployment benefit systems were
likely to have fewer unemployed registering; thus, those countries had smaller measure of
unemployment rates.
Today, most countries rely on large surveys of households to compute the unemployment
rate. In the United States, this survey is called the current population survey (CPS), and it relies
on interviews of 60,000 households every month. The survey classified somebody as employed
if he or she has a job at the time of the interview; it classifies somebody as unemployed if he or
she does not have a job and has been looking for work in the last four weeks. Most other
countries use a similar concept of unemployment, although the definition of what “looking for
work” means exactly varies across countries. In the United States in 1994, estimates based on the
CPS survey showed that on the average over the year, 123 million people were employed and 8
million people were unemployed. The unemployment rate was thus 8/(123 + 8), or 6.1 percent.
Note an important characteristic of the definition of the unemployment rate. Only those
looking for work are counted as unemployed; those who are not looking are counted as not in the
labour force. But when unemployment is high, many of those without jobs simply give up
looking for work and thus are no longer counted as unemployed. These people are known as
discouraged workers. To take an extreme case, if all workers without a job gave up looking, the
unemployment rate would equal zero, and the unemployment rate would be a very poor indicator
of what is happening in the labor market. This extreme case does not hold, but a milder version is
present. Typically, high unemployment is associated with many workers dropping out of the
labor force. Equivalently, a high employment rate is typically associated with a low participation
rate, defined as the ratio of the labour force to the total population of working age. Since the start
of economic reform in Eastern Europe in the early 1990s, unemployment has increased, often
dramatically. But equally dramatic has been the drop in participation rates. In Poland, for
example, 70% of the decrease in employment in 1990 was accounted for by early retirements-in
other words, by people dropping out of the labour force.

Practice Questions:
1. What do you understand by unemployment? Why is unemployment a problem in modem
economics?
2. Define and explain the various types of unemployment known to you.
3. If you are the President of a country with high unemployment rate, what are the measures
you can adopt to control it?
4. Differentiate between voluntary and involuntary unemployment
5. What are the various measures which could be used to control high unemployment rate?

38
 LECTURE NINE
The Banking System
Introduction
Money and banks are some of the most familiar subjects to most people; we come across both of
them almost every day of our lives. They are both very important for the smooth running of
today's highly advanced economic system. While money is the medium through which economic
exchanges take place, banks serve as a useful medium through which those who need money are
brought into contact with those who have money, which they do not presently need.
The banking system could be variously categorized. There are commercial banks that deal
with the ordinary public. They accept deposits from customers and also transfer these deposits
among their customers. When ordered to do so by cheques, banks make loans available to their
customers and many also invest in interest- earning financial assets.
In addition, there are specialised banking institutions like the merchant banks, investment
banks, building societies etc, which perform specialised banking functions for their customers.
The third main element of the banking system is the Central Bank. It is the apex of the
banking institutions, and it also serves as the regulator of the financial institutions in the
economy of any given modern state.
Creation of Deposit Money: This is under the province of the commercial banks. They are able
to do this because bank deposits need to be only fractionally backed up by notes and coins. We
can illustrate how this process occurs by taking two hypothetical cases:
1. When there is only one commercial bank; and
2. Introduce complications caused by the existence of many independent banks.
1. A Single Monopoly Bank
Assuming there is only one bank in an economy (with many branches) and assume that a
deposit of N100, 000 is made by Mr. A. in cash.
With this deposit, it is possible for the bank to create multiple deposits. Let us say that a
deposit needs to be backed by a 10 per cent cash reserve.
It is then possible for the monopoly bank to create further deposit of N90,000. Assume, by way
of example that the bank loans N50,000 to a customer and buys N40,000 worth of bonds in the
open market. This transaction will appear in the bank's books, once the borrower has written
cheques on the loanable amount. This N90, 000 will now constitute additional money to the
economy.
Thus, with a few strokes of the pen, the bank has created a further N90, 000 in deposit
money with the original N100, 000 cash deposit.
The above example is however too simplistic considering that there are many banks in an
economy. We shall now consider a more realistic example of many banks.
2. Many Banks
The analysis however depends on a number of assumptions:
1. There are many banks in the system.
2. The legal reserve ratio is 10 per cent. This is the amount of cash reserve that is assumed
to be held against deposit liabilities.

39
 3. All banks in the system have made loans up to the limit set by the reserve requirement
before the receipt of additional cash.
4. All funds, loans and cheques drawn on one bank are deposited in the same or another
bank.
6. There is no cash drain on the system.
The process may be described as follows. The first bank, on receiving the N100, 000, places
N10, 000 in the reserves and proceeds to lend the remaining N90, 000. This is lent to a customer,
who later writes a cheque to a creditor for N90, 000. The receiver of the cheque then deposits it
in a bank. The receiving bank proceeds to keep N9, 000 and lend out N81, 000. The money
comes into the possession of another person, when it is spent by the borrower and the cheque
deposited in a bank. The receiving bank keeps 10 per cent in the reserve and the rest is lent out.
When the original cash receipt of N100, 000 has diffused itself throughout the system, deposits
will amount to N1, 000,000 (ten times the cash reserved) and loans up to N900, 000
The Process of Multiple Bank-Deposit Expansion through the Banking System

(1) (2) (3)

New Deposits(N) Reserves(N) Loans and/or
investments(N)
1st step 100,000 10,000 90,000
2nd step 90,000 9,000 81,000
3rd step 81,000 8,100 72,900
: : : :
: : : :
All Banks 1,000,000 100,000 900,000

This process of deposit creation is shown in schematic form in Table 9.3 Column 1 is the
sum of geometric series.
This can be expressed as
100,000 + 100,000 (9) + 100,000 (9)2 +……… + 100,000 (9)n
(10) (10) (10)

This could be reduced to

N100, 000 (1) = 1,000,000
(1 – 9/10)

Limitations to the Credits Expansion of an Individual Bank

1. Deposit: The amount that an individual bank can lend is dependent on the amount
customers have deposited with it.
2. Legal reserve requirement: This is inversely related to the amount of credit created.
3. The extent to which cheques are used for transactions in the economy.

40
 4. As a member of a banking system, a bank cannot expand credit more rapidly than other
members of the system. If it did, it would lose much of its reserves to other banks through
the clearing house.
The Role of the Central Bank
The Central Bank is the agent of monetary policy. This can be defined as the attempt to regulate
the supply of money, the terms and availability of credit. The Central Bank is the apex financial
system in an economy. However, the instrument by which the Central Bank performs its role
varies from one country to another.

Functions
1. Banker to the Government: Governments, like other economic agents, need to hold
their funds in an amount into which they can make deposits and against which they can
draw cheques. Such government deposits are usually held by the Central Bank.
2. Manager of the Public Debt: The Central Bank helps the government with its
debt .management. It helps the government in raising new funds and managing its debt
instruments. For Instance, the Central Bank usually purchases any part of new issues of
public debt that is not taken up by other lenders on the day of issue at what seems like a
reasonable interest rate.
3. Banker to Commercial Banks: The Central Bank accepts deposits from commercial
banks and will on order transfer these deposits among them. Central Banks also lend
money to commercial banks when they are short of cash or in liquidity crises.
4. Lender of Last Resort: Commercial banks often have sudden needs for cash and one
way of getting it is to borrow from the Central Bank. Central Bank is a lender of last
resort because when other sources have failed the Central Bank would lend money to
commercial banks with good investments but in temporary need of cash. Those
commercial banks pay interest on the loan at a rate that used to be called the bank rate but
is now called the minimum lending rate.
5. Regulator of the Money Supply: The Central Bank has great power to influence the
money supply. By this power the Central Bank tries to control inflation in the economy.
Instruments used by the Central Bank to control Commercial Banks
1. Currency Control: In most countries, the Central Bank has the sole power to issue paper
money. No attempt is made, however, to control the overall money supply by controlling
the quantity of bank notes in circulation. Suppose that the public wishes to increase the
fraction of total money supply it holds as notes and coins. Faced with a cash drain to the
public, the commercial banks will withdraw deposits from the Central Bank and the bank
will print the necessary bank notes.
2. The Reserve Base: Much more importantly than the currency control is the Central
Bank's control over the reserves available to the banking system. The Central Bank
requires commercial banks to hold reserves against their deposit liabilities. These
reserves are called the reserve base of the money supply. Through the manipulation of
this reserve base, the Central Bank can influence the money supply in an economy.
Monetary Policy
The Central Bank is responsible for the operation of monetary policy. One major objective of
monetary policy is to influence the aggregate demand and through that national income,

41
employment and prices. Another objective is to provide a cushion for the country's financial
system from the kinds of panics and crashes that have caused occasional financial havocs.
The major tools of monetary policy have changed over the years. In the past, the Central
Bank sought to influence the economy by influencing the term and availability of credit. It was
believed that aggregate expenditure could be raised by making it easy to get credit on easy terms
and vice-versa.
More recently, Central Banks have shifted emphasis to controlling the supply of money
directly and expecting this to have a definite effect on the interest rate and the amount of loan-
financed expenditure. There are several ways by which the Central Bank tries to achieve this.
These include open market operations, bank rate, reserve requirements, moral suasion and credit
guidelines.
Open Market Operations involve the sale or purchase of government securities in the open
market. Through this, the Central Bank would be able to influence commercial bank reserves and
indirectly, the money supply in an economy. An open market operation is very effective,
particularly, in countries with well developed money markets.
Bank Rate is the price paid by the owner of securities to the Central Bank for converting the
securities into cash. Interest rates charged by the banks follow the bank rate. Hence, by varying
the bank rate, the central bank influences the availability and cost of credit and hence the money
supply.
Reserve Requirement is the ratio of its deposits that a commercial bank must keep in the form
of cash and common interest earning balances with the Central Bank. This requirement reserve
ratio pre-determines the maximum amount of credit that can be created by banking system. By
the manipulation of the reserve requirement ratio, the Central Bank influences the money supply
in the economy.
Moral Suasion is a persuasive attempt by the Central Bank to the commercial banks to reduce
the amount of their credit to the public. Credit guideline is also used to control the amount of
credit given by the commercial banks and to which sectors of the economy it is given.

Money and Capital Markets

Where expenditure exceeds the receipts of firms or of the government, the deficits have to be
bridged by borrowing. The institutions where funds are made available to firms and the
government at a price- the rate of interest are the financial markets. Because finance is required
by different types of firms, by the government and by nationalised industries, for different
purposes and for different periods of time, there is a great variety in the types of loan available
and in the institutions providing or arranging soft loans. Nevertheless, financial markets can be
classified into two broad groups: The money markets (dealing in short-term loans) and the
capital market (where medium and long term capital is raised). It must be stressed that neither
the money market nor the capital market is a formal organisation where buyers and sellers meet
regularly in a particular building to transact business. Instead, they are merely a collection of
institutions which are connected, in the case of money markets, by dealings in bills of exchange
and short term loans. In the case of capital markets, it is through channeling medium and long
term finance to those requiring it.

42
Generally, money market comprises of (i) the discount market (which in turn consists of
institutions linked by dealings in bills discount houses; merchant banks, commercial banks and
the central bank), bills of exchange are important source of short term finance – the commercial
bills are for firms and treasury bills are for the government (2) parallel money market which has
developed to meet specific requirements of particular borrowers and lenders to make for the
restrictions placed on bank lending.
The capital market consists of such institutions as the insurance companies, investments
trusts, unit trusts, finance companies, building societies, etc
Practice Questions:
1. Give a classification of banking system known to you?
2. Distinguish between the Central Bank and the Commercial Bank?
3. What are the main functions of the Central Bank?
4. How does the Central Bank control the money in circulation?
5. Analyse the process of credit creation in an economy. What are the limitations to this
process?
6. Give a classification of banking institutions in your country.
7. Suppose the Central Bank raises cash-deposit ratio from 5% to 10%. What will be the
effect on the level of money supply in the economy of a state?
8. Discuss the functions of the Central Bank in an economy. Can you contrast these
functions with those performed by the commercial banks.

43
 LECTURE TEN
International Trade
Introduction
In the realm of trading for economic purposes, no country is an island. There are trade relations
between one country and another. In this lecture, we shall discuss the basic theories of
international trade and the reasons why countries engage in trade.
Just as individuals trade among themselves, nations also engage in trade with one another. This
trade between one nation and the rest of the world is called international trade. Nations engage in
trade for various reasons. In the first place, trade permits specialisation, and specialisation
increases output. Because a country specialises in the goods it produces particularly well, it can
trade them for goods that other countries are especially good at producing. Thus, both the
country and her trading partner benefit.
In addition, some countries have more and better resources of certain types than others.
Nigeria has oil; Canada has timber; and Japan has skilled labour force and so on. International
differences in resource endowments, and in the relative quantity of various types of human and
non-human resources, are important for specialisation.

Theories of International Trade

1. Absolute Advantage
This theory was propounded by Adam Smith to explain the need for trade. This theory can
be illustrated as follows: Assuming that there are two countries A and B, and also two
commodities X and Y. With the same quantity of resources, if country A can produce more
of commodity X than country B, then country A is said to have absolute advantage over
country B in commodity X while country B has absolute disadvantage in commodity X. The
two countries would benefit from trade if country A has absolute advantage in commodity X
while country B has absolute advantage in commodity Y.
A numerical example will suffix. Suppose Nigeria can produce 1 electronic computer or
10,000 cases of wine with 1 unit of resources. Suppose that Japan can produce 2 electronic
computers or 5,000 cases of wine with 1 unit of resources. If Nigeria shifts 1 unit of its
resources from producing computers to producing wine, it will increase its production of
wine by 10,000 cases and reduce its production of computers by 1 computer. On the other
hand, if Japan shifts one unit of its resources from production of wine to computers, it will
increase the production of computer by 2 computers and reduce its production of wine by
5,000 cases of wine.
The net effect of this shift in the utilisation of resources on world output of computers
and wine is that world output of both wine and computers would increase with trade. It
therefore pays for Nigeria to specialise in producing wines, while Japan specialises in
producing computers.

2. Comparative Advantage
This theory owes its origin to David Ricardo. This theory is an extension of the absolute
advantage theory of trade. The theory maintained that even in a situation where a country
has absolute advantage in producing-the two commodities, over another country trade could

44
 still occur provided that there are differences in the relative efficiencies in producing the two
goods in the two countries.
A numerical example will make this point clearer. Let us make adjustment to our earlier
example. Suppose Nigeria can produce 1 electronic computer or 4,000 cases of wine with 1
unit of resources while Japan can produce 2 electronic computers and 5,000 cases of wine
with 1 unit of resources. In this case, Japan is a more efficient producer of both computers
and wine. Nonetheless, as we shall see, world output of both goods will increase if Japan
specialises in the production of computers and Nigeria specialises in the production of wine.
Table 10.2 demonstrates this conclusion. If 2 units of Japan resources are shifted from
wine to computer production, 4 additional computers and 10,000 fewer cases of wine are
produced. If 3 units of Nigeria resources are shifted from computer production to wine
production, 3 fewer computers and 12,000 additional cases of wine are produced. Thus, the
combined effect of this redeployment, of resources in both countries is to increase the world
output of computers by 1 and to increase the world output of wine by 2,000 cases.

Even though Japan is more efficient than Nigeria in the production of both computer and wine,
world output of both goods will be maximized, if Japan specialises in computers and Nigeria in
wine. Basically, this is so because the degree of efficiency of Japan in the production of both
goods differs. It is twice as efficient as Nigeria in producing computers but only 25 per cent more
efficient than Nigeria in wine.
The theory of comparative advantage forms the basis of trade among nations. A nation has a
comparative advantage in those products where its efficiency relative to other nation is highest.
However, unlike the predictions of these two theories, what we have in real life is incomplete
specialisation.
The Terms of Trade
The phrase terms of trade is defined as the quantity of imported goods that a country can obtain
in exchange for a unit of domestic goods. It is the ratio of the price of export to the price of
import. In the above table it is possible for Japan to produce 2,500 cases of wines by giving up 1
computer. Thus, the ratio of domestic exchange should be 2,500: 1. Similarly Nigeria can
exchange a case of wine for 1/4,000 of a computer by diverting its own resources from wine to
computer. Thus, while Japan will not be willing to exchange one computer for less than 2,500
cases of wine, Nigeria will not be willing to exchange a case of wine for less than 4,000 of a
computer.
But where will the price ratio lie between 2,500:1 and 4.000:1? The answer depends on
world supply and demand for the two products, the stronger the demand for computers (relative
to their supply), and the weaker the demand for wine (relative to its supply) the higher the price
ratio and vice-versa.
Openness in Financial Markets
Openness in financial markets allows financial investors to hold both domestic and foreign
assets, thus to diversify their portfolios, and to speculate on movements in foreign versus
domestic interest rates, exchange rates, and so on.

45
 Given that buying or selling foreign assets implies, as part of the operation, buying or selling
foreign currency (sometimes called foreign exchange), the size of transactions in foreign-
exchange markets gives a sense of the importance of international financial transactions.
In 1994 the daily volume of foreign-exchange transactions in the world was N1 trillion, of
which 80%-about N800 billion-involved dollars on one side of the transaction.
Most of the transactions are associated not with trade, but with purchases and sales of
financial assets. The volume of transactions in foreign exchange markets is not only high but also
rapidly increasing. For a country as a whole, openness in financial markets has an important
implication. It allows the country to run trade surpluses and trade deficits. Recall that a country
running a trade deficit is buying more from the rest of the world than it is selling to rest of the
world. Thus, it must borrow the difference. It does so by making it attractive for foreign financial
investors to increase their holding of domestic assets, in effect to lend to the country.

Barriers to International Trade

There are various restrictions to free flow of trade among nations. The restrictions are
collectively called barriers to trade and they include tariffs, quotas, export subsidies, licenses,
etc. The net effect of these barriers is that they make domestic prices to be different from
international market prices.
Despite the advantages to be derivable from free trade, experience has shown that not everyone
benefits equally from free trade. Thus, for various reasons ranging from reasonable to spurious
ones, countries impose restrictions on free trade. Such restrictions include tariffs, quotas,
subsidies and other non-tariff barriers.
Tariff can be defined as a tax, which the government imposes on imports. Usually, the
purpose of a tariff is to cut down on imports in order to protect domestic industries and workers
from foreign competition. A secondary purpose however is to generate revenue for the
government. On the other hand, quotas refer to the maximum amount of certain commodities that
can be imported annually into the country.
Finally, export subsidies represent another means by which governments try to give their
domestic industries an advantage in international competition. Such subsidies may take the form
of outright cash disbursements, tax exemptions, etc. Other non- tariff barriers to free trade
include licensing requirements and unreasonable product quality standards. By granting few
licenses to import from other countries and by imposing unrealistically stringent product quality
standards, government discourages imports.
A world of free trade would be one with no tariffs, quotas or any other restrictions on
importing or exporting. In such a world, a country would import all those commodities that it
could buy from abroad at a delivered price lower than the cost of producing them at home.
Now suppose that a country imposes a 20 per cent tariff on all imports. This does not
prohibit trade but by making all imported goods more expensive, it affects the profit margin of
imports. Any foreign goods that enjoy a cost advantage of less than 20 per cent are now
effectively prohibited; while imported goods that enjoy cost advantage in excess of 20 per cent
will still be in demand, but because their domestic price has increased, a smaller quantity will be
demanded than if there were no tariff.

46
Arguments for Tariffs and Quotas
1. The most frequent cited non-economic reason for tariff is national defence. Because of
the sensitivity of some industries to the economy, tariffs as barrier may protect them
against foreign competition.
2. Another reason for tariffs is the need to protect infant industries. It is argued that because
some industries are new they cannot withstand foreign competition. Foreign firms, the
argument goes, are experienced and enjoy economies of scale which enable them to
charge lower prices than domestic industries that are still very new. While it may look
reasonable, this argument is however widely abused. It has provided a cover for
inefficient firms to continue to operate. Many of these firms even after decades of their
establishment continue to claim that they are 'infants'.
3. Tariffs are sometimes imposed to protect domestic jobs and to reduce unemployment at
home. This argument is however criticised on the ground that it can lead to retaliation
from other countries. It is maintained that without tariffs, government can still achieve
this objective through monetary and fiscal tools.
Practice Questions:
1. What is international trade?
2. Give four reasons why countries engage in international trade.
3. State the principle of comparative advantage.
4. Why do you think your country participates in international trade?
5. Comparative advantage rather than absolute advantage should be the basis for
international transactions, True or False? Explain.
6. Explain what you understand by the terms of trade.
7. What do you understand by tariffs?
8. Why do countries impose tariffs on free trade?
9. Are the arguments for tariffs justified in view of the benefits which can be derived from
free trade? Give reasons.
10. Distinguish between tariffs and non-tariff barriers to free trade.
11. What is the meaning of tariff?
12. What are the arguments for imposing trade tariffs?
13. What are the arguments against tariffs?
14. Distinguish between tariffs and non-tariff trade barriers. Give examples of each

47
 LECTURE ELEVEN
The Balance of Payments
Introduction
Trade transaction that takes place between individuals give rise to two things, First the exchange
of physical goods or services and second, the exchange of money between the transactions. As it
happens in the case of individuals so it is with international trade. The exchange of commodities
between one nation and her trading partners necessitates the payment by the nation to her trading
partners. A record which summarizes such payments is called balance of payments.
This refers to the record of transactions between one country and her trading partners. In order to
know what is happening to the course of international payments, governments keep track of the
actual transactions among countries. Every transaction, whether of imports or exports is recorded
and classified according to the payments or receipts that would typically arise from it. Any item
that gives rise to the purchase of foreign currency (e.g. paying for imports) is recorded as a debit
on the balance of payment accounts and any item that gives rise to the sale of foreign currency
(through exports) is recorded as a credit.
One feature of balance of payments account is that it always balances. While it is possible
for holders of naira to want to purchase more dollars in exchange for naira, than holders of
dollars want to sell in exchange for naira, it is not possible for holders of naira actually to buy
more dollar than dollar holders wish to sell. Every dollar that is bought must be sold by someone,
and every dollar that is sold must be bought by someone. Since the dollars actually bought must
be equal to the dollars actually sold, the payments made between countries must balance; even
though, desired payments may not.
As an important tool of international trade, usually is divided into three.
The Current Account
This records all transactions in goods and services. Goods (visibles) are goods that can be seen
when they cross international borders, e.g. cars, oil, cocoa, and groundnut.
Services (invisibles) are things that we cannot see, such as insurance and freight haulage,
and tourist expenditures. Other items under invisibles are interest and dividends. When the
country receives dividends and interests on loans and investment in foreign countries, these are
credited in her balance of payments and vice-versa.
The Capital Account
This records transaction related to movement of long and short term capital. Capital movements
may be divided in several ways. One important division is between direct and portfolio invest
ment. Direct foreign investment occurs when firms transfer funds in order to create new capital
in foreign countries. Portfolio investment, however, occurs when equities or bonds are
purchased. If for example, a Nigerian saver buys a share issued by an American Company, this is
a portfolio investment, and it represents a debit item on the Nigerian balance of payments.
Capital movements may also be classified according to their term. Purchase of bonds in

48
another country may be termed long term capital outflow. However, a deposit may be classified
as short term since the foreign bank has the obligation to pay the deposit on demand.

Official Financing
This represents transactions involving the Central Bank of the country whose balance of
payments is being recorded. There are three ways in which credit items may occur on the official
financing account. First, the Central Bank may borrow from IMF. This represents a capital
inflow and is thus a credit item on the balance of payments. Second, the bank may borrow from
other Central Banks. Third, the bank may run down its official reserves of gold and foreign ex-
change. This is a credit item because it gives rise to the selling of foreign exchange and a
purchase of naira.
The fundamental relation among the three main divisions is that their sum must be equal to
zero. That is the balances on the current, capital and official settlement account must be zero.
Why this it is possible and what happens in most cases is that a country might have surplus
or deficit in the current account. A deficit occurs when the value of the country's imports exceeds
her exports. This deficit must however be matched by a net surplus on capital plus official
settlement accounts which means borrowing abroad or running down exchange reserves.
In normal terms, when we speak of balance of payment deficit or surplus, we refer to a
balance on some parts of the accounts. Usually, we refer to the balance on current plus capital
account.
Balance of payment deficits has been the bane of many developing countries including
Nigeria. It has led to increasing foreign indebtedness of these countries and a massive depletion
of their foreign reserves. Ways by which deficit on the balance of payments is resolved include
devaluation of local currency, borrowing from IMF and other international organisations,
depletion of foreign reserves, import restrictions, and export promotion.

The Choice between Domestic and Foreign Assets

Openness in final markets implies that financial investors face the choice of holding domestic
versus foreign assets. It might appear that we have to think about at least two new decisions, the
choice of holding domestic versus foreign money, and the choice of holding domestic versus
foreign interest-paying assets. But remember why people hold money: to engage in transactions.
For somebody who lives in Nigeria, whose transactions are thus mostly or fully in naira, there is
little point in holding foreign currency: It cannot be used for transactions, and if the goal is to
hold foreign assets, holding foreign currency is clearly less desirable than holding foreign bonds,
which pay interest. Thus, the only new choice we have to think about is that between domestic
and foreign interest-paying assets.This gives a relation between the domestic nominal interest
rate, the foreign nominal interest rate, and the expected rate of depreciation. Remember that an
increase in E is a depreciation, so that (E et+1 – Et)/Et is the expected rate of depreciation of
depreciation in domestic currency. If the domestic currency is expected to appreciate, then this
term is negative.

49
Practice Questions:
1. Define balance of payments.
2. Write short notes on the following;
a. Current account
b. Capital account
c. Official financing
4. What do you understand by balance of trade?
5. Distinguish between balance of payment surplus and deficits on the balance of payment
accounts.
6. Is it true that balance of trade must always balance? Explain.
7. Why do countries especially the developing countries worry about the persistent deficits
in their balance of payments?

50
 LECTURE TWELVE
The Theory of Exchange Rates
Introduction
The medium of exchange in international trade that is, foreign currency. Since the currency of
the country will not usually be accepted by people in other countries, there must be an accepted
means by which one country's currency can be converted into another for the purposes of
economic transactions. This is the realm of foreign exchange transaction. Exchange rate simply
refers to the price at which a country purchases foreign currency and sells her currency
respectively. Alternatively, it is the price of one currency in terms of another country's currency,
for example, N118 to $1.00.
The Determination of Exchange Rates
In today's world, exchange rates are determined in highly competitive free markets by the forces
of demand and supply, and these rates change often to reflect the underlying demand and supply
relations.
For the purpose of illustration, we assume-two countries model - Nigeria and America.
Therefore, in this market, there are only two groups of private traders: people who have naira and
want dollars, trade with people who have dollars and want naira. Also for the moment, we
assume that the Central Bank of Nigeria does not intervene in the market.
The Demand for Dollars
The demand for dollars arises because holders of naira wish to make payments in dollars; this
arises from imports of American goods and services into Nigeria and from capital movement
from Nigeria to America.
The Supply of Dollars
Dollars are offered in exchange for naira because holders of dollars wish to make payments in
naira. The supply of dollars on the foreign exchange market arises because of Nigerian exports of
goods and services to America and because of capital movements from America to Nigeria.

S
P
ri
c
e
of D
a
Quantity of Dollars

The determination of the equilibrium exchange rate under competitive conditions

The demand for dollars is downward sloping. This indicates that as the dollar becomes
cheaper, holders of naira will demand more dollars in order to buy American goods. The supply
curve for dollars is upward sloping. This indicates that as naira becomes cheaper, holders of
dollars will offer more dollars in order to buy naira with which to buy Nigerian commodities.

51
The equilibrium exchange rate is determined at the point of intersection between the demand for
dollar and supply of dollars. Assume that the current price of dollars is too low, say N30 to a
dollar. At this exchange rate, the demand for dollars exceeds the supply. Thus, some people who
require dollars to make payments to America will be unable to obtain them and the price of
dollars will be forced up. The value of the dollar vis-à-vis the naira will appreciate or,
alternatively put, the value of Naira vis-à-vis the dollar will depreciate.

What Causes the Exchange Rate to Change?

1. Differing Rate of Inflation: All things being equal, the exchange rates of countries with
high inflation will be depreciating, while those countries with low inflation, rate will be
appreciating.
2. Capital Movement: Major capital flows can exert major influences on exchange rates,
appreciating the currencies of capital importing countries and depreciating the currencies
of capital exporting countries.
3. Structural Changes: At the existing price levels, an economy can undergo structural
changes that affect the exchange rate. If the structural changes have a positive impact on
cost structure (i.e. reducing cost of production, for example, through innovation), the
value of the currency might appreciate or vice- versa.
Central Bank Management of the Exchange Rate
In the previous section, we considered exchange rates that are determined purely by market
forces of demand and supply. However, in reality, we know that only very few countries allow
its exchange rate to be left solely to market forces. More often, countries through their central
authorities influence the exchange rates of their countries.
Fixed Exchange Rates
Under the Bretton Woods system that lasted from 1944 until the early 1970's, governments did
not allow their currencies to fluctuate freely on exchange markets. Usually, the rates were fixed
within very narrow margins. Each government stated an official price for its currency (usually in
terms of dollars) which was called the currency's par-value. The Central Bank then entered the
market, buying and selling whatever quantities of foreign exchange necessary to maintain this
par-value. Such an exchange rate is called a fixed or pegged exchange rate. When it is changed,
the country's currency is said to be devalued or revalued in case of a fall or a rise in its par-value,
respectively.
An example will suffix here. Assume the fixed exchange rate is N70.00 to $1 However, for
some reasons, the demand for dollars increases such that it is greater than its supply to the
market. Normally, we expect the exchange rate to change: to prevent this, the Central Bank
might enter into the exchange market and sell sufficient dollars to make demand equal to supply
at the fixed exchange rate.

Managing Flexible Exchange Rates

Even with the collapse of Bretton Woods Agreement, when countries no longer fix the par-value
of their currencies, they still try to influence the exchange value of their currencies. They use
various tools to achieve this. First, the bank can attempt to influence the long term equilibrium
exchange by various forms of payment restrictions thereby curtailing the demand for foreign
exchange.

52
 Second, the bank can attempt to smoothen out short and medium term fluctuations in the
exchange rate by open market purchases and sales of foreign exchange.
Third, through the manipulation of interest rate, the monetary authorities try to influence the
flow of capital in and out of the country, thus influencing the exchange rates of their currencies.

Nominal Exchange Rates

Nominal exchange rates between currencies are quoted in two ways:
1. the number of units of foreign currency you can get for one unit of domestic currency, or
2. the number of units of domestic currency you can get for one unit of foreign currency.
Following the example given earlier, the nominal exchange rate between the dollar and
the naira, (N), is 118 N for 1 dollar, or, equivalency, 0.008 dollar for 1 naira.
In this study, we shall define the nominal exchange rate as the number of units of domestic
currency you can get for one unit of foreign currency or equivalently, as the price of foreign
currency in terms of domestic currency, and we shall denote it by E. For example, when looking
at the exchange rate between Nigeria and the United States from the viewpoint of the Nigeria (so
that the naira is the domestic currency), E will denote the number of naira one can get for 1 $-
thus, from our exchange, 118. We shall then write if for short as the N/$ (naira per $) example
rate. To convert N into $, simply divide by E. To convert $ into naira, multiply by E.
Exchange rates between foreign currencies and naira change everyday, indeed every minute
during the day. These changes are called nominal appreciations or nominal depreciations-
appreciations or depreciations for short. An appreciation of the domestic currency is an increase
in the price of the domestic currency in terms of a foreign currency. Given our definition of the
exchange rate as the price of the foreign currency in terms of domestic currency, an appreciation
corresponds to a decrease in the exchange rate, E.
This is more intuitive than it first seems: consider the naira and dollars (again from the
viewpoint of the Nigeria). An appreciation of the naira (also called a naira appreciation) means
that the naira’s value goes up in terms of the dollars. Equivalently, the dollar is worth fewer
naira, which is the same as saying that the exchange rate has decreased. Similarly, a depreciation
of the naira (or naira depreciation) means that the naira is going down in terms of the dollars, and
thus corresponds to an increase in E
That an appreciation corresponds to a decrease in the exchange rate, and depreciation to an
increase, will almost surely be confusing to you at first-it confuses many professional
economists-but it will eventually become second nature as your understanding of open-economy
macroeconomics deepens. Until then, you may find it useful to consult Table 13.1 below which
summarises the terminologies.

53
 Currency Appreciation and Depreciation

Nominal exchange rate (E) Price of dollars in naira equivalently

Number of naira per dollar (N /$)
Appreciation of the naira Price of dollars in naira decreases
Value of naira increases Equivalently: Number of naira per
dollar decreases, i.e. (E) decreases.
Depreciation of the naira Price of dollars in naira increases
Value of naira decreases Equivalently: Number of naira per
dollar increases, i.e. (E) increases.

Practice Questions:
1. What do you understand by exchange rate?
2. What are the factors that determine exchange rate in a competitive economy?
3. Write notes on the following:
a. Managed exchange rate
b. Flexible exchange rate
c. Fixed exchange rate
4. If N70 exchanges for 30 Deutschmarks (Dm) and N80 exchanges for $ 1, what is the
exchange rate between Dm and $1?
5. Distinguish between exchange rate depreciation and appreciation.

54
 LECTURE THIRTEEN
Main Schools of Economic Thought
Introduction
The development of economics as a discipline has passed through several stages, from the
Mercantilists through the Physiocrats to the Classical economists. From Marxist to Keynesians
and to Monetarists, All these groups have influenced developments in the discipline.
There has also been an individual contribution of reputable economists. Prominent among
these are Adam Smith, David Richardo, F. Quesnay, J.J. Mills, Karl Marx, J.M. Keynes, and M.
Friedman. Their ideas moulded the discipline as we have it today.
The classical school represents the first serious school of economic thought. Prior to them, there
had been some primitive schools of economic thought, such as the mercantilists, and the
physiocrats. The mercantilists, led by J. Child, were leading businessmen in their time. They
were interested in a strong nation with vast army that would be able to protect their foreign
business transactions.
The mercantilists longed for specie that is precious metal which they believed could only be
obtained through international trade. This school also favoured government intervention in the
economy.
The physiocrats were based in France, and they were a shade more advanced than the
mercantilists. They believed in the natural order, that is, everything has been ordained by God.
The physiocrats gave us the idea of surplus value which they believed could only be obtained
from the agricultural sector. The major contribution of the physiocrats to economic thought is the
idea of the circular flow of income. The circular flow income owes its origin to Dr. F. Quesnary
who was also the leader of the physiocrats. They advocated for laissez faire, that is, free
enterprise and minimum government intervention in the economy.

1. The Classical School

The classical school can be sub-divided into two:
a. The first is the traditional classicists consisting of Adam Smith, David Richardo, Rev.
Marthus, J.S. Mill etc. The second group consisted of the modern classicists or what is
sometimes called neo- classicists. Economists in this group include Alfred Marshall,
Irving fisher, A. C. Pigou, etc. This latter school refined and built upon the main ideas of
the traditional classicists.
b. The two cornerstones of the classical school are the Say’s Law of Market and the
Quantity Theory of Money. The classicists believed in the existence of full employment
in the economy and a situation of less than full employment was regarded as abnormal.
Piguo maintained that unemployment results from the rigidity of the wage structure and
interference in the working of free market system in the form of trade union legislation,
minimum wage legislation, etc.

55
The classical analysis was based on the Say's law of market that "supply creates its own demand"
The classicists thus ruled out the possibility of over production. This position was, however,
attacked by Keynes who proposed the opposite view that demand creates its own supply.
Unemployment results from the deficiency of effective demand because people do not spend the
whole of their income on consumption.
The classicists also believed that savings and investments are always equal. According to
them, savings and investments are functions of rate of interest. Any temporary difference
between the two can be corrected through the mechanism of interest rates. For instance, when the
rate of interest rises, savings rises and investment declines and this adjustment continues until the
two are equal. Keynes again attacked the classical position. He argued that intended savings
hardly equal intended investment, since both processes are undertaken by different groups of
people. While households make savings decisions, investment decisions are made by the firms.
The classicists emphasized the importance of saving or thrift in capital formation, for
economic growth. They believed that the more the savings of the people, the greater the capital
formation and hence the faster the pace of economic growth. To Keynes however, savings was a
private virtue and public vice. According to him, increases in savings reduce consumption,
leading to a fall in effective demand and, therefore, a slump in the employment level.
The classicists artificially divided the economy into two - the monetary sector and the real
sector. The monetary sector only helps in determining prices while production and consumption
decisions are made in the real sector.
The above classicalist’s position was demonstrated via the quantity theory of money. The
quantity theory, as formulated by Irving Fisher, shows a proportional relationship between
changes in money supply and changes in the price level. In the words of Fisher, "Other things
remaining unchanged, as the quantity of money in circulation increases, the price level also
increases in direct proportion and the value of money decreases and vice- versa". (Fisher, the
Purchasing Power of Money, Rev. Ed. 1926).
The classicists emphasized the transactions demand for money and hence the demand for
money in the economy depends upon the value of transactions undertaken in the economy.
Classical economics was based on the laissez faire policy of self-adjusting economic system
with no government intervention. The government involvement in the economy should be
limited to, maintenance of law and order, justice and provision of social infrastructures.
According to them, the invisible hand will allocate goods and services in the economy
unhindered.
The classical economics was a microeconomic analysis which the orthodox economists tried
to apply to the economy as a whole. On the other hand, Keynes however had adopted the macro
approach to economic problem.

2. The Marxian Economy

The Marxian economy is based on the teachings and doctrines of Karl Marx (1818 - 1883). Kar1
Marx wrote his celebrated book 'Das Kapital' in which he exposes his doctrines.
"Marx contributed to the theory of economic development in three respects; namely, in
broad respect of providing an economic interpretation of history, in the narrower respect of
specifying the motivating forces of capitalist development, and in the final respect of suggesting
an alternative path to planned economic development".

56
 In interpreting history, he made use of the principle of dialectical materialism. He viewed
historical events as the result of continuous struggle between different classes and the groups in
the society. The main cause of this struggle is the conflict between 'the mode of production and
the under1ying 'relations of production', The mode of production refers to a particular
arrangement of production in a society that determines the entire social, political and religious
ways of living, The relations of production relate to the class structure in the society.
Marx uses his theory of surplus value as the economic basis of his theory. According to him
capitalism is divided into two great classes: the workers who own nothing but their labour power
and the capitalists who own the means of production. The capitalist purchase labour power at its
own value which is the amount necessary for the maintenance of labour. According to Marx, the
value of the commodities necessary for the sustenance of labour is never equal to the value of the
produce of that labour. If a labourer works for a ten-hour day, but it takes him six hours to
produce goods to cover his subsistence, he will be paid wages equal to six hours' labour. The'
difference worth four hours' labour goes into the capitalist's pocket in the form of net profit, rent
and interest. Marx calls this unpaid work "surplus value".
The capitalist appropriates the surplus value produced by labour and then reconverts it into
capitals since profits are determined by the amount of capital. The goal of the capitalist therefore
is to accumulate and accumulate capital.
The increasing accumulation of capital however forces the capitalist to introduce cost-saving
techniques, like replacing labour with machines. This leads to the growth of industrial reserve
army of the unemployed; on the one hand, and a reduction of the surplus value, on the other
hand, since surplus value is generated by labour on what he called variable capital. This leads to
what Marx refers to as the tendency for the falling rate of profit. The reduction in labour
employed leads to over- production and under-consumption in the economy. This further
exacerbates the falling rate of profit problem. A capitalist crisis has begun.
In each period of the crisis, the stronger capitalists expropriate the weaker capitalists and
along with it grow the misery of the working class. It is this centralisation of capital on the one
hand, and the growing misery of the workers on the other hand that finally provided the death
knell of capitalist system and provided the impetus for the capitalism transformation to
socialism. Poverty will disappear and the "dictatorship of the proletariat" will be established.
Marx prediction about capitalism has failed to come into being. There is no increasing
misery of labour in the advanced capitalist societies as asserted by Marx. And technological
development has not increased the industrial reserve army. Despite the fact that much of his
prediction has not come to pass, Marx has made useful impact on the process of economic
development. And, many countries today adhere to the economic formulations of Karl Marx.

3. Keynesian School of Economic Thought

Keynesian macroeconomics is named after one man, J.M. Keynes (1883-1946). His ideas were
contained in the book, 'The General Theory of Employment, Interest and Money" which he
published in 1939.
Keynes was very critical of the classical economists. The Great Depression of 1929-1933
provided a basis for launching his attack on the classical position. Keynes rejected Say's Law of
Market and showed how total demand for goods and services could differ from a country's
productive capacity.

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The business cycle and fluctuations in prices, production and employment could not be
reconciled with the classical idea that the total demand for goods always matches productive
capacity.
Keynes also revolted against the classical approach dichotomy in which the physical and
monetary aspects of the economy were treated in water-tight compartments. Keynes attempted
the integration of both the physical and the monetary aspects in his analysis. According to
Keynes, a meaningful discussion of aggregate level of output and employment is not complete
without a complete theory of monetary economics. In a dynamic economy, expectations play a
key role. Money serves as a subtle devise to link the present to the future.
Rather than the full employment equilibrium position in the economy as enunciated by the
classical school, Keynes stated that what is obtained in real life is unemployment equilibrium.
This means that the economy always settles at less than full employment. Thus, the quantity
theory of money of the classical school which postulated a direct relationship between the money
supply and the price level in an economy may not always hold. This is because given the present
employment in the economy, increase in the money supply rather than leads to increase in prices
would result in increase in output and employment.
Keynesian macroeconomics concerns itself above all with the factors that determine
demand. This is also a major difference with the classical theory. In the classical economics,
more attention was focused on production, that is, to the supply side. In the classical way of
thought, total demand adjusts to the supply, and in Keynes on theory, the opposite is the case. If
there is inadequate demand, production falls because the level of expenditure is too low. This
causes unemployment. This is where Keynes calls for government involvement in the economy
to boost aggregate demand. Rather than advocating for minimal government intervention,
Keynes called for maximum government involvement in the economy.
Keynes was also famous for his theory of multipliers. This is closely linked with the
marginal propensity to consume. The multiplier is the multiple by which national income will
change if an item of aggregate demand is changed. However, the value of the multiplier would
depend upon the value of marginal propensity to consume.
Keynes is also remembered for introducing other terms like liquidity preference, liquidity
trap and marginal efficiency of capital into economics literature. His ideas and postulations were
not entirely new. He owed some of them to the economists before him. The concept of marginal
which he used could be traced to the neo-classicalists. And as far as the concept of multiplier is
concerned, Keynes himself recognises he’s indebted" to Mr. R.F. Kahn.
Keynes contributed a lot to the development of economic thought. His reasoning proved
very useful in both trade cycle theory and welfare economics. He also shed new light on the
motive of holding money. He made a distinction between the three methods of holding money
i.e. transactive, precautionary and speculative motives.
In post-Keynesian era, there has been prolific addition and refinement of the basic
Keynesian idea. For instance, the concept of multiplier was extended by bringing in numerous
variants of it, for example, the balanced budget multiplier, which sheds new light on fiscal
policy. Most of these additions and refinements, however, owe their origin to the stimulations
provided by Keynes's General Theory.

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4. Monetarist School
The foremost exponent of this school is the Nobel laureate, Professor Milton Friedman of the
Chicago University. He reformulated the Quantity Theory of Money. In his reformulation,
Friedman asserted that money does matter. He regarded money as any durable commodity and
the demand for it depends on the services which it can render to the holder. He posited that
wealth can be held in five different forms:
a. money;
b. bonds;
c. equities;
d. Physical non-human good; and
e. human capital.
The monetarists emphasize the role of money in explaining short term changes in national
income. They argue that the role of money has been neglected by the Keynesians. Friedman was
able to demonstrate that changes in the money supply cause changes in national income. Thus,
monetarists believe that all recession and depression are caused by severe contraction of money
and credit while booms and inflation are the outcome of excessive increase in the money supply.
While Keynes has argued that demand for money is a function of both the level of income
and the rate of interest, the monetarists hold that the rate of interest plays no part in determining
the demand for money. The demand for money is the transactive demand for money which is
determined by the level of income.
The monetarists also hold that monetary policy is superior to fiscal policy. This is a direct
anti-thesis of the Keynesian school. Instruments of monetary policy include bank rate, open
market operation, changes in reserve ratios, selective credit control. They hold that against fiscal
policy, monetary policy possesses greater flexibility and it can be implemented rapidly.
A major limitation of the monetary policy, however, is the long operation lag. Friedman
himself admits that the time lag involved is so large that contra cyclical monetary policy might
actually have a destabilising effect on the economy.
Current Developments
Today, three groups dominate the research headlines; the new classical, the new Keynesians, and
the new growth theorists. (Note the generous use of the word “new” unlike producers of laundry
detergents, economics stop short of using “new and improved”. But the subliminal message is
the same.)
New Classical Economics and Real Business Cycle Theory
The rational expectations critique was more than just a critique of Keynesian economics. It also
offered its own interpretation of fluctuations. Instead of relying on imperfections in labour
markets, on the slow adjustment of wages and prices, and so on to explain fluctuations, Lucas
argued, macroeconomics should see how far they could go in explaining fluctuations as the
effects of shocks in competitive markets with fully flexible prices and wages.
This is the research agenda that has been pursued by the new classical. The intellectual
leader is Edward Prescott, and the models he and his followers have developed are known as real
business cycle (RBC) models. These models assume that output is always at its natural level.
Thus, all fluctuations in output are movements of the natural level of output, as opposed to
movements away from the natural level of output.

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 Where do these movements come from? The answer proposed by Prescott is technological
progress. As new discoveries are made, productivity increases, leading to an increase in output.
The increase in productivity leads to an increase in the wage, which makes it more attractive to
work and thus leads workers to work more. Productivity increases therefore lead to increases in
both output and employment as we indeed observe in the real world.
The RBC approach has been criticized on many fronts. Technological progress is the result
of very many innovations, each of which takes a long time to diffuse. It is hard to see how this
process could generate anything like the large short-run fluctuations in output that we observe in
practice. It is also hard to think of recessions at times of technological regress, times in which
productivity and output both go down. Finally, as we have seen, there is very strong evidence
that changes in money, which have no effect on output in RBC models, in fact, have strong
effects on output in the real world.
Thus, at this point, most economists do not believe that the RBC approach provides a
convincing explanation of major fluctuations in output. The approach has nevertheless proved
useful. It has drilled in the correct point that not all fluctuations in output are deviations of output
from its natural level. At a more technical level, it has provided a number of new techniques for
solving complex models, which are widely used in research today. It is likely to evolve rather
than disappear. Already, some recent RBC models have started introducing nominal rigidities,
thus allowing for the effects of money on output.
New Keynesian Economics
The term “new Keynesians” denotes a loosely connected group of researchers who share a
common belief that the synthesis that has emerged in response to the rational-expectations
critique is basically correct. But they also share the belief that much remains to be learned about
the nature of imperfections in different markets, and about the implications of those
imperfections for macroeconomic evolutions.
One line of research has focused on the determination of wages in the labour market. One
influential researcher in this area has been George Akerlof from Berkeley, which has explored
the role of “norms”, the rules that develop in any organisation in this case, the firm, to assess
what is fair or unfair. This research has led him and others to explore issues previously left to
research in sociology and psychology and to examine their macroeconomic implications.
Another line of new Keynesian research has explored the role of imperfections in credit
markets. Here, we have to assume that the effects of monetary policy work through interest rates,
and that firms and people can borrow freely at the quoted interest rate. In practice, most people
and many firms can borrow only from banks. And banks often turn down potential borrowers,
despite their willingness to pay the posted interest rate. Why this happens, and how it affects our
view of how monetary policy works, has been the subject of much research, in particular by Ben
Bernanke of Princeton.
Yet another direction of research is nominal rigidities. Fischer and Taylor have shown that
with staggering of wage or price decisions, output can deviate from its natural level for a long
time. This conclusion raises a number of issues. If staggering is indeed responsible, at least in
part, for fluctuations, why don’t wage setters/price setters synchronise decision? Why aren’t
prices and wages adjusted more often? Why aren’t all prices and wages changed, say, on the first
of each month? In tackling these issues, Akerlof and N. Gregory Mankiw (from Harvard
University) have derived a surprising and important result, often referred to as the menu cost
explanation of output fluctuations.

60
 Each wage or price setter is largely indifferent as to when and how often he changes his own
wage or price for a retailer; changing the prices on the shelf every day or every week does not
make much difference to profits). Thus, even small costs of changing prices such as those
involved in printing a new menu, for example, may lead to infrequent and staggered price
adjustment. In turn, this staggering leads to slow adjustment of the price level, and thus to large
aggregate output fluctuations in response to movements in aggregate demand. In short, decisions
that do not matter much at the individual level (how often to change prices or wages) lead to
large aggregate effects (slow adjustment of the price level, and thus large effects of shifts in
aggregate demand on output).
New Growth Theory
After being one of the most active topics of research in the 1960s, growth theory went into an
intellectual slump. Since the mid 1980s, however, growth theory has made a strong comeback.
The set of new contributions goes under the name of new growth theory.
Two economists, Robert Lucas (the same Lucas who spearheaded the rational expectation
critique) and Paul Romer (from Berkeley), have played an important role in defining the issues.
When growth theory faded in late 1960s, two issues were left largely unresolved. The first was
the determinants of technological progress. The second was the role of increasing returns to
scale-whether, say, doubling capital and labour may actually lead to more than a doubling of
output. These are the two major issues on which new growth theory has concentrated. Clearly,
these propositions leave a lot of room for disagreement.
The major area of disagreement is in the length of the “short run”, the period of time over
which aggregate demand affects output. At one extreme, real business cycle theories start from
the assumption that output is always at its natural level: The short run is very short indeed… At
the other, theories of hysteresis in unemployment imply that the effects of demand may be
extremely long-lasting, that the short run may in fact be very long.
The other area of disagreement is in the role for policy. While conceptually distinct, it is
largely related to the first. Those who believe that output returns quickly to its natural level are
typically willing to impose tight rules on both monetary and fiscal policies, from constant money
growth to the requirement of a balanced budget. Those who believe that the adjustment is slow
typically believe in the need for more flexible stabilization policies.
Despite these disagreements, this core provides a framework in which to conduct and
organize research. More important, it provides a framework to interpret events and discuss
policy.

Practice Questions:
1.Identify the main schools of economic thoughts
2. Write short notes on the following: a. Adam Smith b. David Richardo c.Karl Marx
a. J.M Keynes
3. What are the main ideas of the classical economists?
4. Highlight the major ideas of Karl Marx.
6. What are the similarities between the classical school and the Keynesians?
7. What are the proponents of quantity theory of money as propounded by Milton
Friedman?

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 LECTURE FOURTEEN
Economic Systems
Introduction
Economies of different countries of the world can be classified into three. The fundamental
criteria for such classification are based on the role of the state in such countries and the method
of allocation of resources within the country. In this lecture, we shall discuss the three basic
economic systems and their examples.
Distinctions can be made among three basic economic systems:
1. Command Economy,
2. Market Economy, and
3. Mixed Economy.

The three economic systems relate to the means and methods by which different economies
try to answer their socio-economic problems. It focuses on the means of ownership of resources,
the role of the state, allocation of resources etc. within each economy. For proper elucidation of
the major features of each of this system, we shall discuss them separately.
The Command Economy
This refers to the economy system in practice in USSR, China and in most of the Eastern
European countries. It is also variously referred to as socialism or communism.
In a command economy, the state plays the dominant role in answering the basic economic
problems faced by the economy. Usually, the state owns the means of production. In other
words, all enterprises and business ventures are owned by the state. Moreover, the state also
imposes production quota on these enterprises.
The allocation of resources in a command economy is also done by the state. The state
determines what to produce, the quantity, for whom and the price to charge for the commodities
produced. Development plans are very common in the command economies. It expresses how
the objectives and goals of the state and how those objectives could be achieved. Development
plans set targets to be achieved and all the state resources are mobilised to attain the set goals.
In most cases, goods are distributed to people via rationing by coupon. Weekly or monthly
coupons are given out to households to enable them purchase fixed quantity of commodities at
certain prices.
In command economy, the state also takes a visible role in the distribution of income. A
stated the objective of a command economy is to promote equity in the distribution of income.
The state determines the remuneration to households and many services such as housing are
undertaken by the' state to help the poor people.
Command economies also ensure a full utilisation of resources available in the economy.
Employment of labour is guaranteed to all able-bodied people in the economy. Although western
economists often alleged that what obtains is underdevelopment because labour is less than
efficiently utilsed. Development plans like we mentioned above is also used by the state to fully
mobilise its resources for the goals of the society.

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The Market Economy
This is a complete anti-thesis of the command economy. This is the type of economy which is
prevalent in Western European countries. It is also called a capitalist economy.
In a market economy, the slogans are laissez faire and minimum government intervention. In
such economies, the forces of demand and supply are expected to allocate the available
resources.
There is a strong faith in the price mechanism. The price mechanism which already
embodies the scarcity concept determines what to produce, the quantity and for whom to
produce. An increase in the price of a commodity is a signal for producers to increase the output.
Moreover, goods are produced for those who are willing to pay the highest price for it.
Unlike in a command economy where the available output is distributed through rationing
by coupons, in a market economy the price system distributes the output available. The forces of
demand and supply determine the price of the commodity. Thus, those who can afford it would
get it; others who cannot, would have to go without it.
The state in a market economy also concerns itself less with distribution of income. The
means of production is generally owned by private individuals. And the returns to each
household depend on the resources owned by that household. While those who own much of
these resources appropriate the bulk of the income in the economy, those with less resource go
with corresponding low income. This is why there are wide income gaps among individuals in a
market economy.
In a pure market economy, there is no room for economic plans. The presence of economic
plans implies an active role for the government within the economy. This is however against the
principle of a market economy. The role of the state is only limited to laying down general rules
governing the agents in the economy. It is believed that the economic agents in the economy, in
the pursuit of their individual goals, would inadvertently promote the goals of the society.
Mixed Economy
This is a hybrid of both a command economy and a market economy. In real life, only very few
economies fit rigidly into the description of either a command or market economy. What we
have is a mixture of the features of both systems. We can only talk in terms of approximation,
i.e. closeness to either the market or the command economy.
Mixed economy is the most common economic system in developing countries. It is an
economy in which the good features of both the command and market economies are
incorporated. In such an economy, both the state and the individual or put more technically, both
the private and public sectors join hands together and become partners-in-progress in solving the
major economic problems of the society.
As we noted above, in a mixed economy, there is the active participation of the state. The
role of the state goes beyond laying rules and regulations, to actually participating in the
economy. Ownership of resources is jointly borne by both the state and private individuals. Thus,
just as the state set up economic ventures either singularly or in partnership with the private
sector, so also do the private entrepreneurs in the economy set up their own business ventures.
In a mixed economy, the state is the dominant participant. It usually prepares development
plans; highlight the goals of the society and how resources of the society can be harnessed

63
towards achieving such goals. It then becomes the duties of the state and the private sector to see
how these goals are to be achieved.
The state in this type of the economy also concerns itself with the distribution of income.
Through fiscal policy, and provision of services that benefit the poor people in the society, the
state seeks to reduce inequality in income distribution and to raise the average standard of
welfare in the economy.
Although, there is a reliance on the price system to distribute the available out put of goods
and services in the economy, there are some cases when the state intervenes in the operation of
this market system, through imposition of minimum or maximum price legislation.

Practice Questions:
1. Mention different economic systems you know.
2. Compare and contrast the command and the market economies.
3. Give four practical examples of each of the economic systems you know.
4. What are the distinguishing characteristics of a capitalist economy?
5. Do you think any country can be strictly classified into any of the three basic economic
systems?
6. Write short notes on the following:
a. Command economy
b. Market economy
c. Mixed economy
7. Compare and contrast the capitalist economy and the socialist economy?
8. Give three examples of countries practicing the socialist system.
9. Which of the systems do you recommend for your country? Why?

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