INTRODUCTORY

MACRO ECONOMICS

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 CHAPTER ONE
INTRODUCTION

Definition of Macroeconomics
Macroeconomics is that branch of economics which deals with and studies the
determinants and trends of economic aggregates. It deals with aggregate demand, aggregate
supply, aggregate output, and aggregate income etc. To study and analyze the economic
phenomenon whether it is demand, supply, output, income or employment in totality is
extremely complicated because each one of these includes a vast number of different
variables, say in terms of prices, goods, firms, individuals etc. If an examination of each of
these phenomena is to be undertaking prior to drawing of any conclusion about the working
of the economy as a whole, the task would be a very difficult undertaking. Hence to make
it a manageable affair, the use of aggregates is adopted. In other words, different
individuals and firms are arranged in reasonably few numbers of categories, after ignoring
individual differences between one individual and another of between one firm and another
and assuming that the members of one category will behave in a reasonably uniform
manner to make generalizations sufficiently valid.
This form of approach to the study of economic phenomena is known as macroeconomics
analysis or simply macroeconomics. In Greek terminology the term “Macro” means large.
The term was first used by Ragnar Frisch in 1933 and since then it has gained wide
acceptability and usage. The approach is in no way new. The entire analysis of the circular
flow of wealth by the Physiocrats was based on this kind of approach. The fact, however,
remains that the most significant developments in the field took place only after the Great
Depression, based of course on John Maynard Keynes’s General Theory of Employment,
Interest and Money published in 1936.

Development of Macroeconomics
As an analytical framework, macroeconomics has developed only after the Great
depression of 1930 specifically with the publication of John Maynard Keynes’s The
General Theory of Employment, Interest and Money. The main objective of this analysis

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was to find out the main causes of fluctuations in output and to suggest measures for
prevention of these occurrences or for keeping the economy operating at near full
employment. During the early years of 20th century, industrialized economies suffered
massive production losses, in other words depression. Unfortunately the classical theories,
of the day, would neither describe the economic malaise nor would they provide
prescription to the problems. Consequently, the importance of classical economics suffered
a great blow. Alternative approach had to be developed to explain the equilibrium state of
the economy without necessary being full employment equilibrium.
With the concepts of aggregate demand and aggregate supply, Keynes constructed the
principle of Demand that situated the operation of the economy on aggregate consumption,
total private investment, government expenditure and net export spending. The approach
explains how the economy may suffer from less than full employment condition, inflation,
unfavorable balance of payments and low economic growth, progress and development.
Subsequently, several paradigms, following Keynes’s path breaking work, have
undertaken economic analysis based on aggregated variables which are classified as
Macroeconomics and as such considered different from Microeconomics.

Differences between macroeconomics and microeconomics

Nature
The word ‘micro’ means small in Greek terminology. Hence, conventionally,
microeconomic has been considered as ‘economics based on individual agents’. It deals
with small constituents or components of the economy, that is to say, single economic units.
It is selective in nature, while analyzing the behaviors of the individual buyers and sellers
of commodities in the market. It studies the determination of prices, the level of
employment of labor and wages paid to workers in a certain industry. It deals with the
problems connected to the determination of prices of the various commodities and factors
of production and the problems related to the allocation of scarce resources between
alternative uses. On the other hand, macroeconomics focuses on the level of utilization of
resources, particularly, the level of employment, and the general level of prices. From the
earliest periods of developing macroeconomics, research has been conducted and geared

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towards identifying the factors that determine the rate of growth of resources – potential
output – and the level of their utilization at a given time.

Scope of Macroeconomics
Macroeconomics is a well-developed branch of Economic theory. It addresses itself to two
central problems of the economy as a whole. First, how national income, output and
employment levels were determined at a particular point in time and why modern
economies pass through phases of boom and depression during a specific period of time.
Secondly, the study seeks to identify the laws of economic growth and development. In
pursuit of the above objectives macroeconomic theory is divided into the following
subsections.

The Income Theory

This occupies the central position in macroeconomics. The theory of income examines the
factors that determine the level of output, income and employment in the economy. Under
macroeconomics, aggregate demand, determined by effective demand, is critical in
analysis of the level of consumption, investment, government expenditure and net exports.
On the account of this reason, the income theory includes discussions of consumption
function, investment function, fiscal policy and the study of balance of trade and payments.

Theory of Inflation or General Price Level

Whereas microeconomic theory is concerned with the study of the relative prices of goods
and services, macroeconomics is concerned with the determination of the general price
level in the economy. In other words, the analysis of inflation and deflation comes under
macroeconomics. Even prior to the publication of Keynes’s General Theory of
Employment, Interest and Money, the problem of prices was extensively discussed under
the Quantity Theory of Money.

Theory of Trade/Business Cycle

Casual observation shows that in modern free and capitalist economies, growth and
development do not proceed in a smooth and consistent order or pattern. Such economies

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progress with phases of booms, bursts, recessions, depressions and recoveries. These
phases form trade cycles with inflationary and deflationary gaps between potential and
actual output. Such intricacies have interested macroeconomists to identify the causes and
effects of such occurrences through the theory of trade cycles and the study of these
patterns is referred as theory of trade cycle.

Theory of Growth
Interest in problems of growth for underdeveloped countries is a relatively new field in
economic theory. In the post-world war period R. F. Harrod and E. D. Domar extended the
Keynesian analysis to a discussion of the problems of long – run economic development.
Growth theories attempt to explain the factors that determine the level of change in output
(growth) and its pace (rate of growth) in the economy. The earliest growth theories
emphasized that the difference in economic progress between nations was based on saving
and investments. It therefore meant that the economic growth was significantly determined
by such factors. However, with increase in the number of growth theories more factors
have been identified to be important in the growth function. These include level of
technology, invention and innovation, market size etc.

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 Chapter Two
National Income

1.0 Introduction
In common terms, national income refers to the total value of goods and services produced annually
in a year. National income has been defined as the total income accruing to a country from economic
activities in a year’s time. It includes payment made to all resources in the form of wages, interests,
rent and profits.

1.1 Definition of National Income

There are two classes of definitions of national income; the traditional definitions advanced by
Marshall, Pigou and Fisher, and the Modern definition.

The Marshallian definition. National income includes commodities produced, material and
immaterial and services of all kinds excluding depreciation and wearing out of machines plus income
from abroad.

The Pigovian definition. In addition to the Marshallian definition, A. A. Pigou included in his
definition of national income that income which can be measured in terms of money (objective
income of the community) plus income derived from abroad, which can be measured in terms of
money.

Fishers definition. Fisher adopted consumption as a criterion of national income instead of

production adopted by Marshall and Pigou. Fisher’s definition is considered to be better than that
of Marshall and Pigou because it provides an adequate concept of economic welfare, which is
dependent on consumption, and consumption represent out standard of living.

The Modern definition. Simon Kuznet has defined national income as “the net output of
commodities and services flowing during the year from the country’s productive system in the hands
ultimate consumers”.

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 The net value of all goods and services produced within a nation over a specified period of
time.

1.2 Concepts of National Income

1) Gross National Product (GNP)
This is the total value of all final goods and services produced in a country during a year, including
net income from abroad. It is the total monetary value of goods and services produced by nationals
of a certain country in a year irrespective of where they are produced from.
GNP = GDP + Net income from abroad
The figures used to assemble data include; 1) the manufacture of tangible goods such as cars,
furniture, and bread, and the provision of services used in daily living such as education, health care,
and auto repair; 2) gross private domestic investment in capital goods consisting of fixed capital
formation, residential construction and inventories of finished and unfinished goods; 3) goods and
services produced by the government; and 4) net export of goods and services (net income from
abroad).

The Difference between GDP and GNP

Gross National product measures the final value of output or expenditure by a country owned factors
of production whether they are located in that country or overseas. Gross domestic product (GDP)
is only concerned with incomes generated within the geographical boundaries of the country. So
output produced by Toyota in Uganda counts towards our GDP but some of the profits made by
Toyota here are sent back to Japan – adding to their GNP.
GNP = GDP + Net property income from abroad (NPIA)

2) GNP at Market Price

GNP at market price refers to GNP valued at the prevailing market price and is got by multiplying
the total output in a particular year by their market prices prevalent during that same year in a
country. It means the gross value of final goods and services produced in a year plus net income
from abroad.

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3) GNP at Factor Cost
GNP at factor cost is the sum of the money value of the income produced by and accruing to the
various factors of production in one year in a country.
GNP at factor cost = GNP at market price – Indirect taxes + subsidies

4) Net National Product (NNP)

Net National Product (NNP) is the total market value of all final goods and services produced by
citizens of an economy during a given period of time (GNP) minus depreciation.
NNP = GNP – Depreciation

5) NNP at Market Price

Net National Product at market price is the net value of final goods and services evaluated at market
prices in the course of one year in a country.
NNP at market price = GNP at market price – Depreciation

6) NNP at Factor Cost

Net National Product at factor cost is the net output evaluated at factor prices. It includes income
earned by factors of production. It is also called national income.
NNP at factor cost = NNP at market price – Indirect taxes + subsidies = National
Income

7) Domestic Income or Product

This is the income generated by the factors of production within the country from its own resources.
Domestic income = Nation Income – net income from abroad
Thus the difference between domestic income and national income is the net income earned from
abroad. Or if we add net income from abroad to domestic income, we get National income.

8) Private Income
Private income is any type of income (from any source, productive of otherwise) received by a
private individual or household, often derived from occupational activities. It can be arrived at by
making certain additions and deductions from NNP at factor cost.

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 Private income = National income + transfer payments + interest on public debt
– social security – profits and surpluses of public undertaking.

9) Personal Income
Personal income is the total income received by the individuals of a country from all sources in one
year. It excludes indirect taxes.
Personal Income = Private Income – Undistributed corporate profits – Profit taxes

10) Disposable Income

Disposable income is gross income minus income tax on that income. It is the actual income which
can be spent on consumption by individuals and families.
Disposable income = Personal income – Direct taxes

11) Real Income

Real income is the income of individuals or nationals after adjusting for inflation. It is calculated
by subtracting inflation from the nominal income. Therefore, real income is a more useful indicator
of well-being, since it is based on the amount of goods and services that can be purchased with the
income.

In order to find out the real income of a country, a particular year is taken as a base year when the
general price level is neither too high nor too low and the price level for that year is assumed to be
100.
Real NNP = NNP for the current year x Base year index (=100)
Current year index
12) Per Capita Income
This is the average income of the people of a country in a particular year. It is calculated by dividing
National income of a country by the population of the country in that year. Per capita income means
how much each individual receives, in monetary terms, of the yearly income that is generated in
their country through productive activities. That is what citizens would receive if the yearly income
generated by a country from its productive activities were divided equally among everyone. Per
capita income is usually reported in units of currency per year.

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This concept enables us to know the average income and the standard of living of the people. But
it is not reliable, because of unequal distribution of national income.

1.3 Measuring National Income

To measure how much output, spending and income has been generated we use national income
accounts. National income is a term used to measure the monetary value of the flow of goods and
services produced within the economy over a period of time. Measuring the level and rate of growth
of national income (Y) is important to economists when they are considering:
• The rate of economic growth and where the economy is in the business cycle
• Changes to overall living standards of the population
• Looking at the distribution of national income (i.e. measuring income and wealth
inequalities).

Estimates of National income (GNP) produced in a given year may theoretically be arrived at
through three different accounting approaches.

i) The income approach

Using the income approach, National income is estimated by estimates of the different kinds of
earnings people receive from producing the final goods and services. The earnings include:
• Total wages and salaries
• Profits of incorporated and unincorporated businesses
• Rental incomes
• Interest incomes
• Dividends – dividends earned by the shareholders form companies
• Direct taxes indirect business taxes depreciation
Thus, according to income method GNP = total wages and salaries + profits of incorporated and
unincorporated business + rental incomes + interest incomes + dividends + direct taxes + indirect
business taxes + depreciation + net income from abroad
(Plus certain adjustments to account for wear and tear on productive assets like plant and machinery
depreciation and what are called indirect business taxes)

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ii) Expenditure approach
Using the expenditure approach, National income is estimated by summing the amounts of money
that are spent on final goods and services by households (consumption), business firms (investment),
government (government purchases), and by the world outside the country (net export). Thus using
the expenditure approach;
GNP = C + I + G + (X – M)
Where C – Consumption expenditure
I – Investment expenditure by business firms
G – Government expenditure
X – Exports of goods and services
M – Imports of goods and services

iii) Product or Output approach (Value added)

Using the product or output approach, national income is estimated by summing up output of all the
various productive sectors in the country using the concept of value added; subtracting out costs of
their raw materials to avoid double counting and making suitable adjustments for depreciation and
for the value of imports and exports.
The productive sectors of the economy are the service industries, manufacturing and construction,
and extractive industries such as mining, oil together with agriculture.

In theory, all the three approaches should give the same grand totals – but of course in actual practice
there will be discrepancies, and sometime sizable discrepancies between the three estimates.

1.4 Difficulties in the measuring of national income

• The difficulty of defining boundaries of the nation, because national income includes also
income earned by nationals of a country abroad.
• The use of money as a unit of measurement of national income, because a number of goods
and services are difficult to be assessed in money terms. For example, bringing up of children
by a mother. By excluding such services, the national income will be less than want it is
actually is.

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• Double counting which arises from the failure to distinguish properly between the finished
goods and the intermediate products. Sometimes certain goods and services are included
more than once and if this happens, national income would be higher than what it is actually
is.
• Incomes earned through illegal activities such as ‘magendo’, should not be included. But by
excluding them, the national income would be less than the actual.
• There is a problem of whether to include the transfer payments in the national income or not.
Such payments like pension, unemployment allowance and interest on loans. These
payments fall under individual incomes as well as government expenditures.
• Inventories changes are included in the GNP. The problem is that firms record these
inventories at their original costs rather than at replacement costs. When prices rise, the
value of the inventories rise and when prices fall, the value of inventories falls. Adjustments
need to be done but the procedure is very cumbersome.
• The problem of estimating current deprecation value of a piece of capital. The usual method
is to base on the original cost of the asset, but prices change.
• Another problem is that of price changes. Prices are never stable which affects the measuring
of national income. When prices rise, national income also rises even though the production
might have fallen and vice versa.
• There is a problem of use of money as a unit of measurement; it does not include leisure
foregone in the process of production of a commodity.
• Some public services, which are included in national income, cannot be estimate correctly.
It is difficult to estimate the contribution made to national income by profits earned on
irrigation during the wet and dry season.

1.5 Problems of Measurement in a Developing Country

• Non-availability of data. Data relating to crops, forestry, employment, fisheries, animal
husbandry and activities of petty shopkeepers, construction workers etc. is not adequate
in developing countries. Also, data on consumption and investment expenditure is not
available.
• Non-monetarized sector. There is a large non-monetarized section in a developing
country i.e. the subsistence sector in which a large portion of production is carried out.

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• Illiteracy. Majority of people in such countries are illiterate and therefore do not keep
any accounts about the production and sales of their products.
• Lack of occupational specialization. Crop farmers are also engaged in supplementary
occupations like dairy farming, poultry, cloth making, etc. but income from such
activities is not included in the national income estimates.

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The Circular flow of Income and Expenditure

The circular flow of income and expenditure refers to all transactions, that is, payments
and receipts, which take place between the different sectors of an economy through time.
These transactions are classified in various forms; consumption spending, factor income or
payments, saving, investment, government purchase, transfer payments, imports and
exports. The discussion of the circular flow of income and expenditure is based on the
number of sectors assumed to constitute an economy at any particular time. The most basic
economic framework is a two-sector model, with the Household and Firms sectors only.
Addition of the government sector transforms a two-sector model into a three-sector model.
A three-sector model is a complete system but it remains closed to international
transactions. Introduction of export, imports and capital flows opens up the economy and
it forms a four-sector model.

Two Sector Model

This model comprises of the household and business sectors. The business sector comprises
of producers who supply commodities to the households. So, in the first place, income
flows in form of payment of rent, wage and interest income from the business sector to the
household sector for the supply of factor of the production used to produce goods services
by the firms. The household sector in turn spends its income on purchase of commodities
produced by the business sector.
This implies that the entire income of the household is spent on purchase of goods and
services, all goods produced by the business sector are sold out to the household sector and
no inventories are held. And also, that the business sector spends its entire income by way
of payments to the factors of production. This situation supports the conclusion that
economy is always at full employment.

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 A

B
A = Consumption
Spending
B = Goods and Services
Firms Household C = Factors of Production
D = Household Income
C
D

It important to notice that the above model ignores the saving and investment transactions
in the economy. Households do not spend all their income on consumption, there is saving
out of income. Also, firms use other source of resources rather than consumption and these
include investment and borrowing. Withdraw of income, in form of saving from the flow,
reduces income and it is known as a leakage. An introduction of income into the flow, in
form of investment in this case, is considered as an injection. If the amount of leakages is
greater than the amount of injection, the economy will considered as being at a less than
full employment point. However, adjustments are assumed to occur and thus reestablishing
the equilibrium point with injections being equalized to leakages. Thus, full employment
of the economy is considered to be achieved when savings are equal to investment.

A A = Consumption
B Spending
B = Goods and Services
C = Factors of Production
Firms F
Money Market E D = Household Income
Household
E = Saving
F = Investment
C
D

Three Sector Model

In modern societies the government or public sector performs a wide range of economic
functions. Most critical of such functions is the provision of “public goods” that cannot be
supplied by private business organizations. At the same time government is supported by
revenues collected from both the household and business sectors. Government levies direct

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and corporate taxes on households and firms in respectively to finance its spending on
subsidies, transfer payments and supply of public goods.

Governmen A = Consumption
t Spending
H G F E
B = Goods and Services
G H
C = Factors of Production
D = Household Income
F E
Firms Money Market Household E = Saving
A F = Investment
B G = Government Spending
D
C
H = Taxes

Presence of government causes an additional leakage in form of taxes, while at the same
time government spending, in terms of transfer payments, subsidies and provision of public
goods. The equilibrium condition of an economy can be stated as the equality of saving
and taxes with investment and government expenditure.

Four Sector Model

Nowadays almost all countries maintain trade relations with one another. This fact cannot
be ignored while discussing the circular flow of income. It is obvious that if a country
undertakes imports (M) from other countries, the amount spent on imported goods by the
households, is received by factors of production of the exporting nation and therefore a
leakage. Output produced by the domestic firms and sold aboard is earning the increase the
circular flow and therefore treated as an injection. This changes results into an open
economy and can be represented as follows;

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 Governme A = Consumption
nt
Spending
H G F E G H
B = Goods and Services
C = Factors of Production
D = Household Income
F E
Firms Money Market Household E = Saving
A F = Investment
B
G = Government Spending
C
H = Taxes
D
I = Imports
J = Exports
J Foreign Sector I

In a four-sector model, with household, business, government, and the foreign sector,
leakages are stated in terms of saving, taxes and imports. For equilibrium to be attained,
leakages must be equal to injections. In a four-sector model, injections are investment,
government spending and exports.

Importance of the circular flow of income

Broadly, the circular flow provides a clear view of an economy and from its study we can
have knowledge about the performance of an economy and its functions. However, the
Specific importance of the circular flow of income includes;

Calculation of national income: The circular of income helps in calculating the economy’s
national income through the flow of funds accounts. The flow of funds accounts provides
a complete picture of all monetary transactions in the economy and depict the link between
saving and investment, and lending and borrowing by the different sectors of the economy.

Formulation of Monetary Policy: A study of the circular flow explains the importance of
the monetary policy in establishing equilibrium between saving and investment.
Government controls the capital market through the monetary policy. Excess saving over
investments causes deflation, while excess investment over saving causes inflation. The

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government can control these situations by regulating investment with use of the monetary
policy tools.

Role of Fiscal Policy: The study of the circular flow of income highlights the importance
of the fiscal policy. In a three-sector model a government sector is included with
specification of how tax revenues are mobilized from households and firms. The model
also shows how government makes its spending on subsidies, transfer payments, provision
of public goods.

Formulation of Trade Policies: Due to participation in international trade of goods and

services and flow of capital, countries develop policies that are meant to influence these
flows. Effective interventions achieve the greater returns from dealing with countries are
done with help of circular flow of income based on a four-sector model.

Level of Economic Activities: The circular of income helps us to understand the effect of
certain variables on the level of economic activities. An increase in saving is seen to cause
a depression and therefore a reduction in employment. However economic activities are
augmented with injections in form of investments. Therefore, depending on the prevailing
conditions in an economy, leakages or injections could be varied to achieve a desired state
of the economy with help of a circular flow of income models.

1.6 Importance of National Income figures

- National income figures help us to know about the distribution of income in the
country.
- National income data are significant in reflecting the economic welfare of the country.
The higher the per capita income, the higher the economic welfare and vice versa.
- National income data from the basis of national policies such as employment policy.
- National income data is essential in economic planning.
- National income data is important for research scholars in economics

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 - For comparison purpose. National income figures can be used for international
comparisons to see the status of the economy at a particular time.

Review Question 1
1. Distinguish between
i) GNP and GDP
ii) National income at market price and National income at factor cost
iii) Real income and Per capita income
2. Explain the various methods of measuring nation income
3. Examine the usefulness of national income statistics in your country
4. Discuss the main problems involved in the estimation nation income figures.
5. What is meant by the circular flow of income?
6. Explain the circular flow of income in the four-sector model.
7. What the importance of the circular flow of income?

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 CHAPTER THREE
The Classical Theory of Income, Output and Employment

Classical economics is widely regarded as the first modern school of economic thought. Its
major developers include; Adam Smith, David Ricardo, Thomas Malthus and John Stuart
Mills. Classical economists’ reoriented economics away from an analysis of the ruler’s
personal interest to a class-based interest for example; identified the wealth of a nation with
the yearly national income instead of the king’s treasury. Smith saw this income as
produced by labour applied to land and capital equipment. Once land and capital equipment
are appropriated by individuals, the national income is divided up between labour,
landlords and capitalists in the form of wages, rent and interest rate.

Classical Theory of Employment

According to the classical economists, there is full employment in the economy, every job
seeker gets the job in accordance with his capabilities and there is never involuntary
unemployment. However, the resources of the economy are fully employed. The classical
theory of output and employment is based on the following assumptions;
• There is the existence of full employment without inflation.
• It assumes a closed laissez faire capitalist economy without foreign trade.
• Perfect competition in the labour and product markets.
• Labour is homogeneous.
• Total output of the economy is divided between consumption and investment
expenditure.
• The quantity of money is given.
• Wages and prices are flexible.
• Money wages and real wages are directly related and proportional.
• Capital stock and technological knowledge are given in the short run.

In other words, the Classicals believed in the free enterprise economy. It is told that the
classical economists never presented their model in the refined form. However, the credit

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goes to the modern economists who integrated the classical ideas. The classical model has
two pillars; the say’s law of market, and quantity theory of money.

Say’s Law
“Supply creates its own demand.” This is known as Say’s Law of markets named after Jean
Baptist Say (1767 – 1832). Say’s law argued that an economy is self-regulated provided
that all prices including wages are flexible enough to maintain it in equilibrium.

In a more simplistic and somewhat inaccurate form, Say’s law states that “supply creates
its own demand” and over production is impossible. This theory has major implications for
how government responds to periods of high employment or widespread unemployment.

Complete Classical Model

In its simplest form, the determination of output and employment in classical theory occurs
in labour, goods and money markets of the economy. In the labour market, the demand for
labour and the supply of labour determines the level of employment in the economy. Both
are functions of the real wage rate (W/P).

!
The Pigouian equation 𝑁 = 𝑞 " explains the entire proposition.

N – is the number of workers employed.

Y – is the national income.
W – is money wage rate.
q – is the fraction of income earned as salaries and wages.

This means that N can be increased by a reduction in W. Thus, the key to full employment
is a reduction in money wage. This is explained in the figure below;

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Employment Determination under the classical theory

𝑆
𝑑 𝑠
𝑤/𝑝#
𝑒
𝑤/𝑝

𝑁$ 𝑁# 𝑁

𝑤/𝑝#

𝑤/𝑝

MPL

𝑁$ 𝑁# 𝑁

S is the supply curve of labour and D is the demand curve for labour. The intersection of
the two curves at E shows the point of full employment NF and the real wage W/P at which
full employment is secured. If real wage is maintained at a higher level, W/P1, supply
exceeds the demand for labour by sd. N0 NF labour is unemployed.
Therefore, full employed is achieved at point E where there is no unemployed. MPL is the
marginal product of labour and it slopes downwards. Since every worker is paid wages
equal to his marginal product, the full employment level NF is reached when the wage rate
falls from W/P1 to W/P.
Total output in turn= depends upon the level of employment given the capital stock and
technological knowledge. It is shown by the production function Q = f (K, T, N) which
relates total output to NF level of full employment as shown below;

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Output Determination under the Classical theory

Q
Q=f(K,T,N)
Q

O Nf N
Given the stock of capital technological knowledge and resources, a precise relation exists
between total output and the amount of employment. Total output is an increasing function
of the number of workers Q = f (K, T, N).
In the figure, OQ corresponds to the full employment level of NF.

Further, it is the mechanism of the rate of interest which brings about the equality of savings
and investments so that the amount of commodities demanded should remain equal to the
amount supplied at the full employment level as shown in the figure below;
Savings Investment Equality

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SS is the saving curve and II is the investment curve. The two curves intersect at E where
the rate of interest is Or and both Savings & Investment are equal to OA. If there is an
increase in I, the I curve shifts to the right as I1 I1. Consequently, both S & I are equal.
Equilibrium in the money market is represented by the equation MV≡PT. It explains the
price level corresponding to the full employment level of output.

Keynes Criticism of Classical Theory

Keynes wrote in his General Theory attacking the Classical Theory on the following
grounds;
• Full employment equilibrium in the economy is unrealistic. He said that the general
situation in a capitalist economy is that of underemployment.
• The Say’s Law states that supply always created its own demand is unrealistic. All
income earned by the factor owners would not be spent in buying products which
they helped to produce. A part of the income is saved and not automatically
invested.
• Keynes did not agree with the classical view that laissez faire policy was essential
for adjusting the process of full employment equilibrium.
• The assumption that I and S were equal at full employment level and in case of any
divergence in equilibrium is brought about by r is unrealistic. Keynes held that the
level of savings depends on the level of income and not on r.
• The classical economists believed that money was demanded for transactions and
precautionary purposes and did not recognize the speculative demand for money.
• Keynes did not agree with Pigou that friction maladjustments alone account for
failure to utilize fully our productive power.
• Keynes refuted the Pigouvian theory that a cut in money wage could achieve full
employment in the economy and that the adoption of such a policy leads to a
reduction in unemployment.
• The Classists believed in the long-run full employment equilibrium through self-
adjusting process. Yet Keynes’s philosophy of life was a short-term philosophy.

24
Review Questions
1. Explain the classical theory of employment.
2. On what grounds did Keynes criticize the classical theory of employment?

25
 CHAPTER FOUR
The Principle of Effective Demand

In a capitalist economy, the level of employment depends on effective demand. This is the
starting point of Keynes theory of employment (the principle of effective demand).

Definition
1. Demand means desire.
2. Effective demand is when income is spent on buying consumption goods and
investment goods. Keynes used the term “effective demand” to mean the total demand
for goods and services at various levels of employment. Different levels of employment
represent different levels of aggregate demand.
Effective demand is when aggregate demand equals aggregate supply. This according to
Keynes, the level of employment is determined by effective demand, which in turn is
determined by aggregate demand price and aggregate supply price.

Aggregate Demand Price

Aggregate demand price is the amount of money, which the entrepreneur expects to get by
selling the output produced by the number of men employed. It refers to the expected
revenue from the sale of output produced at a particular level of employment. Different
aggregate demand price relates to different levels of employment in the economy.
The different demand prices at different levels of employment can be presented in a
statement called the aggregate demand price schedule or aggregate demand function.

26
Aggregate Demand Schedule
Level of employment (N) Aggregate demand price (D)
0 0
30 420
35 450
40 460
50 470
50 480

The table shows that with the increase in the level of employment, aggregate demand price
(D) increases. The aggregate demand curve can be drawn on the basis of the above schedule
as it slopes upwards.
Aggregate Demand Price

Aggregate Supply Price

When an entrepreneur employee a certain amount of labour, it requires certain quantities
of cooperant factors like land, capital & raw materials among others which will be paid
remuneration along with labour. Thus, each level of employment requires certain money
cost of production. At any given level of employment of labour, aggregate supply price is
the total amount of money, which all the entrepreneurs in the economy, taken together must
expect to receive from the sale of the output produced by that given number of men, if it is
to be just employing them. In brief, the aggregate supply price refers to the proceeds
necessary for the sale of output at a particular level of employment. Therefore, each level
of employment in different aggregate supply prices leads to different levels of employment.

27
Prof. Dillard “The aggregate supply function is a schedule of the minimum amounts of
proceeds required to induce varying quantities of employment.

Level of Employment (N) Aggregate Demand Price (D)

0 0
30 240
35 250
40 270
45 280
50 290
50 300

From the schedule, as the level of employment increases, aggregate supply also increases.
The aggregate supply curve can be drawn on the basis of the above schedule.

28
It slopes upwards from left to right because as the necessary proceeds increases, the level
of employment increases. Nevertheless, when the economy reaches the level of full
employment, the aggregate supply curve becomes vertical. At this point with increase in
the proceeds, it is not possible to exceed the level of full employment.

Determination of Effective Demand

The level of employment is determined at the point where the aggregate demand equals the
aggregate supply price. It is the point where what the entrepreneurs expect to receive equals
what they must receive and their profit is maximized. This point is called effective demand
and here, the entrepreneurs earn normal profits.

At ON1 level of employment the proceeds expected (revenue) exceeds the proceeds
necessary (C) i.e., RN1 > CN1. This indicates that it is possible for entrepreneurs to provide
employment to workers till ON level is reached where the proceeds expected and necessary
are equal at point E. It will not be profitable however for entrepreneurs to increase
employment beyond Nf because now the proceeds necessary (costs) exceed the proceeds
expected (revenue). Thus, E determines the level of employment in the economy which is
of under employment.

Shifting of the Aggregate Demand

Keynes regards the aggregate supply function to be given (fixed) because it depends on the
technical conditions of production, which do not change. It is the aggregate demand

29
function, which plays a vital, rile in determining the level of employment in the economy.
The aggregate demand function depends on the consumption function and the investment
function. The causes of unemployment may be a fall in either consumption expenditure or
investment expenditure or both. The level of employment can be raised by increasing either
the consumption expenditure or investment expenditure or both.

Shifting of Effective Demand

To raise the economy to the level of full employment requires raising the point of effective
demand by increasing the aggregate demand to point E. If the aggregate demand function
is raised beyond this point, the economy will experience inflation.

Importance of Effective Demand

The principle of effective demand is the most important contribution of Keynes.
• Determinant of employment. Effective demand determines the level of employment
in an economy. When effective demand increases. Employment also increases and
vice versa.
• It removes the Say\s law and full employment thesis. This principle points out that
underemployment equilibrium is a normal situation and full employment
equilibrium is accidental.

30
 • Replication of wage cost. The Pigouvian view that full employment can be
achieved by a reduction in money wage cost is also repudiated by this principle.
• Role of investment. The principle highlights the significant role of investment in
determining the level of employment in the economy. The two determinants of
effective demand are the consumption expenditure and the investment expenditure.
• It explains the paradox of poverty in the midst of potential plenty in the modern
capitalism.

Sample Questions
1. a) What is effective demand?
b) Explain the principle of effective demand.
c) Explain the role of effective demand in Keynes theory of employment.
2. a) Distinguish between aggregate demand price and aggregate supply price.
b) How is effective demand determined?
c) Explain the importance of effective demand.
3. Distinguish between output and employment determination under the Classical theory
and the Keynesian theory.

31
 CHAPTER FIVE
THE CONSUMPTION FUNCTION
The Consumption Function refers to the relationship between total consumption and gross
national income i.e. 𝐶 – 𝑓 (𝑌), Ceteris Paribas.
Propensity to consume or consumption function is a schedule of the various amounts of
consumption expenditure corresponding to different levels of income.
Consumption Schedule
Income (Y) Consumption (C)
0 30
80 90
110 110
170 160
230 210
290 260
350 310

Consumption expenditure increases with the increase in income. When income is zero
during the depression, people spend on their past savings on consumption because they
must eat in order to live. When income is 80, it is not sufficient to meet the consumption
expenditure of the community so that consumption expenditure is 90. When both
consumption and income is 110, it is basic consumption. After this, income increases by
60 and consumption by 50. This shows a stable consumption function during the short run
as assumed by Keynes. Consumption function can be illustrated below;

32
 The Consumption Function

The consumption curve slopes upwards to the right indicating that consumption is an
increasing function of income. B is the breakdown point where consumption is equals to
income. Above this point, income exceeds consumption. The proportion of income not
consumed is saved and is shown by the vertical distance between the consumption curve
and the 450 line. Therefore, the consumption function measures not only the consumption
but also the saving.

Properties of the Consumption Function

1. The Average Propensity to Consume: This is the ratio of consumption to any particular
level of income. APC = C/Y. APS = 1 – APC.
Graphically, the APC is anyone point on the consumption curve.

2. The Marginal Propensity to Consume: This refers to the ratio of the change in
ΔC
consumption to the change in income i.e. MPC = /ΔY. The MPC is constant at all
levels of income as shown in column 5.
MPS = 1 – MPC.
Y C APC = C/Y APS = S/Y MPC = ΔC/ΔY MPS = ΔS/ΔY
160
170 160 /170 = 0.94 = 94% 0.06 - -
210 50
230 210 /230 = 0.91 = 91% 0.09 /60 = 0.83 = 83% 0.17
260
290 260 /290 = 0.89 = 89% 0.11 ,, ,,
310
350 310 /350 = 0.885 = 88.5% 0.115 ,, ,,

33
Importance of MPC
In Keynes analysis, the MPC is given more prominence. Its values are assumed to be
positive and less than one which means that when income increases, the whole of it is not
spent on consumption (O<MPC<1). This tells us that;
• The consumption is an increasing function of income and it increases by less than
the increment in income.
• The theory explains the theoretical possibility of general over production or
underemployment equilibrium.
• The theory explains the relative stability of highly developed industrial economy.
This is because the gap between income and consumption at high levels of income
is for wide to be easily filled by investment. This may lead to underemployment.
Thus, the importance of MPC lies in filling the gap between income and consumption
through planned investment to maintain the desired level of income.

Its importance further lies in the multiplier theory. The higher the MPC, the higher the
multiplier and vice versa. The MPC is low in rich people and higher in poor people. This
accounts for higher MPC in Least Developed Countries and low in advanced countries.

Keynes Psychological Law of Consumption

Keynes propounded the fundamental psychological law of consumption, which forms the
basis of the consumption function. “Men are disposed as a rule and on average to increase
their consumption as their income increases but not as much as the increase in their
income.” The law means that there is a tendency of people to spend on consumption less
than the full increment of income.

Preposition of the Law

• When income increases, consumption expenditure also increases but by a smaller
amount.
• The increased income will be divided between consumption expenditure and
savings.

34
 • Increase in income leads to increase in both consumption and savings.

Assumptions of the Law

• Constant psychological and institutional complex. Such complexes are income
distribution, tastes, habits and social customs etc.
• Existence of normal condition. Absence of circumstances like war, revolution and
hyper-inflation among others.
• Existence of Laissez-faire capitation economy. The law operates in the rich
capitalist economy without government intervention.

Implications of Keynes Law (Importance of Consumption Function)

1. Invalidates Say’s Law: Because as income increases, consumption also increases
but by a smaller amount. That is all what is produced is not taken off the market as
income increases.
2. Need for state intervention: The psychological law highlights the need for
government intervention, unlike the Say’s Law, which is based on laissez-faire
policy.
3. Crucial Importance of Investment: Keynes psychological law stresses the gap
between income and consumption, which can only be filled by increased
investment.
4. Existence of underemployment equilibrium: The point of effective demand, which
determines the equilibrium level of employment, is not of full employment but of
underemployment because consumers do not spend the full increment of their
income on consumption and there remains a deficiency in aggregate demand.
5. Declining tendency of the Marginal Efficiency of Capital in laissez-faire economy:
When income increases and consumption does not increase to the same extent, there
is a fall in demand for consumer goods. The producer will reduce production which
will in turn bring a decline in the demand for capital goods and hence in the
expected rate of profit.
6. Danger of permanent over-saving or underinvestment gap: When people are rich,
their propensity to consume is low and they save more. This implies low demand,

35
 which leads to decline in investment, thus the tendency of secular stagnation of the
economy.
7. Unique nature of income propagation: The fact that increase in income is not spent
only on consumption explains the multiplier theory (the theory of propagation of
income). When initial injection of investment is made in the economy, it leads to
smaller successive increments in income because people do not spend their full
investment on consumption. Multiplier = 1 – 1/MPC. The higher the MPC, the higher
the multiplier and vice versa
8. Explanation of the turning point of the business cycles: This law explains the
turning point of business cycle.

Point B is the breakeven point. When income increases above the breakeven point by YIYII,
Consumption increases by a smaller amount CICII. Before the economy reaches the full
employment income YF, the down turn will start because the gap between 450 line and
curve continue to widen.

Conversely, the upturn in the economy starts before it reaches the stage of complete
depression because when income falls, consumption also falls but by less than the fall in
income. So, when the excess stock of goods is exhausted in the community during
depression, the existence of consumer expenditure on goods leads to revival. This is
explained by the section of the consumption curve above the 450-income line.

36
Determinants of the Consumption Functions
There are two principled factors that influence the consumption functions; the subjective
factors and the objective factors. The subjective factors are endogenous whereas the
objective factors are exogenous.

1. Subjective Factors
The subjective factors are the psychological characteristics of human, nature, social
practices and institutions.
i. Individual motive: These are motives, which lead individuals to refrain from spending
out of their incomes. They are; the desire to build reserves from unseen contingencies,
the desire to provide for anticipated future needs, the desire to enjoy an enlarged future
income, the desire to enjoy a gradually increasing expenditure in order to improve the
standards of living, the desire to enjoy a sense of independence and the desire to serve
business projects among others.
ii. Business motives: The subjective factors are also influenced by the behavior of
business corporations and governments. Keynes lists for motives of accumulation of
income and they are; the desire to do big things and to expand, the desire to meet
emergencies, the desire to serve large income and to show successful management, the
desire to provide adequate financial resources.
The factors remain constant in the short run and keep the consumption function stable.

2. Objective Factors
These cause shifts in the consumption function;
i. Change in the wage level: If the wage rises, the consumption function shifts
upwards. The workers having a high propensity to consume spend more out of their
increased income and this tends to shift the consumption curve upwards. A cut in
the wage rate will reduce the consumption function of the community due to a fall
in income, employment and output. This will shift the curve downward.
ii. Windfall gains or losses: unexpected changes in the stock market leading to gains
or losses tend to shift the consumption function upward or downward.

37
iii. Changes in the fiscal policy: For example, heavy commodity taxation adversely
affects the consumption function by reducing the disposable income of the people.
On the other hand, progressive taxation along with that of public expenditure on
welfare program tends to shift the consumption function by altering the distribution
of income.
iv. Expectations: For example, if a war is expected in the near future, people buy much
in excess of their current needs and the consumption function shifts upwards. On
the other hand, if people expect prices to fall, they would buy only those things that
are essential leading to a downward shift of the consumption function.
v. Change in the rate of interest: Changes in the interest rate may indirectly affect the
consumption function in many ways, for example; a rise in the rate of interest will
lead to a fall in the prices of bonds, thereby tending to discourage the propensity to
consume of the bondholders.
vi. Financial policies of corporations: If corporations keep more money in the form of
reserves, dividend payments to shareholders will be less; this will have the effect
of reducing the income of the shareholders, as the consumption function will shift
downwards.
vii. Holding of liquid assets: If people hold larger liquid assets, they will have a
tendency to spend more out of their current income and the propensity to consume
will have more upward and vice versa.
viii. Income distribution: If there are large disparities in income distribution
between the rich and the poor, the consumption function is low because the rich
have a low propensity to consume and the poor with a key low income are unable
to spend more on consumption. Consumption function will shift upwards if
measures are taken to reduce the income inequality.
ix. Attitude towards savings: If people value future consumption more than present
consumption, they will tend to save more and the consumption function will shift
downwards. This tendency may be reinforced by the state through compulsory
saving e.g. NSSF and compulsory life insurance among others.
x. Duessenberry Hypothesis: James Duesenberry propounded relative income
hypothesis affecting the consumption function. The hypothesis first of all relates to

38
 the demonstration effect and the tendency to emulate the consumption patterns of
one’s rich neighbors and even to surpass them.

The second part is the past peak of income. Once the community reaches a particular level
and standard of living, it is reluctant to come down to lower level of consumption. During
a recessive, consumption is now sustained by the reduction in currency and vice versa.

Measures to raise the Propensity to Consume

Unless there is a change in the propensity to consume as pointed out by Keynes,
employment and investment will not increase. Therefore, there is a need to study the
measures to raise the propensity to consume;
i. Income redistribution: Propensity to consume can be raised by redistributing
income from the rich to the poor. This is because the Marginal Propensity to
Consume is higher in low-income people than the rich. This can be done through
taxation and public spending.
ii. Increased wages: Increase in wages will lead to shifting of the consumption
function upwards. But the wage policy affects the level of employment in the
economy. Therefore, the long run wage policy should be such that wage increases
are accompanied with increase in labour productivity.
iii. Social security measures: these tend to raise the consumption function in the long
run. Examples of social security measures are; unemployment relief, medical
facilities and old age pension etc.
iv. Credit facilities: When loans are easily and cheaply available to the people, they
buy more.
v. Advertisement: Advertisement through the various media to make the consumers
familiar with the use of products. The consumers are attracted towards them and
they tend to buy them which raises their propensity to consume.
vi. Development of the means of transport: Prices may fall due to the reduced transport
costs. Also commodities are available to the people in their respective locations.
All these raise the propensity to consume.

39
vii. Urbanization: Deliberate urbanization by the state shifts the consumption function
upwards. When urbanization takes place, people move from the rural to urban areas.
In urban areas, they are influenced by the demonstration effect.

40
 CHAPTER SIX
THE INVESTMENT FUNCTION

Definition
i) Investment: Investment means an addition to the existing equipment.
Investment means an addition to the stock of goods in existence. (real
investment)
ii) Capital: Capital refers to real assets like factories, plants, equipment, and
inventories of finished and unfinished goods.
It is any previously produced input that can be used in the production process
to produce other goods.
Therefore, investments are the acquisition of real capital assets during any period of time.

Types of investment
1) Induced investment. This is the type of investment influenced by factors like prices,
wages, demand and interest rate which affect profits. For example, the increase in demand
due to increase in income, brings about an increase in investment.
Induced investment is a function of income. I = f(y) As income increases, investment also
increases and vice-versa

Figure: Induced investment

Investment
I
I3 I is the investment curve which shows
induced investment at various levels of
I2 income
a

O Y1 Y2 Y3 Income Y

41
From the above figure we can derive the following:
i) The Average propensity to invest (API), which is the ratio of investment to income.
%
𝐴𝑃𝑆 = !, at any point on the investment curve.

ii) The Marginal Propensity to Invest (MPI), which is the ratio of change in investment to
the change in income.
∆%
𝑀𝑃𝐼 = ∆!

2) Autonomous investment. This is the type of investment that is not influenced by the
level of income. Autonomous investment is influenced by exogenous factors like;
innovations, inventions, growth of population and labour force, research, social and legal
institutions whether changes, war, revolution etc. It is independent of the level of income
and is not influenced by changes in demand.
Investment in economic and social overheads by either the government of private
enterprises is autonomous. For example, building of dams, roads, hospitals, etc. since
investment on these projects is generally associated with public policy, autonomous
investment is regarded as public investment.

Diagrammatically, autonomous investment is represented as follows.

Autonomous investment
Investment

At all levels of income, the

amount of investment I1
I2 III remains constant. I11
I1 Indicates an increased
I1 II steady flow of investment
at a constant rate I2.

O Income Y

42
Determinants of the level of Investment
There are three factors that are taken into consideration when making any investment
decision, they are; the cost of the capital asset; the expected rate return; and the market rate
of interest.
Keynes sums up these factors in the concept of Marginal efficiency of Capital (MEC).

The Marginal efficiency of Capital is the highest rate of return expected from an additional
unit of capital asset over its cost.
According to Keynes, MEC is equal to the rate of discount which would make the present
value of the series of the returns expected from capital equal to its supply price.

𝑅# 𝑅( 𝑅)
𝑆' = + + ⋯+
(1 + 𝑖)# (1 + 𝑖) ( (1 + 𝑖))

Sp - Is the supply price of the cost of capital

Ri - is the prospective yield (expected annual returns from the capital assets)
i - is the rate of discount (= MEC)

*
The term (#,-)
is the present value (PV) of the asset in future. It depends on the rate of

interest.
i.e.
*!
(#,-)!
after one year
*!
(#,-)!
after two years

Therefore, the present value is inversely related to the rate of interest.

The MEC is compared with the market rate of interest. If the MEC is lower than the rate
of interest, no firm will borrow to invest in capital assets. Thus, the equilibrium condition
for a firm to hold, the optimum capital stock is where MEC is equal to the interest rate.

43
 The analysis applies to the whole economy. The figure below shows the MEC curve of an
economy.

MEC

Interest rate

r1

r2
MEC

O K1 K2 Capital Stock K

As capital increases, the MEC falls. This is because of the operation of the law of marginal
returns in production.
When capital increases from K1 to K2, MEC falls from r1 to r2. The increase in the
company stock by K1K2 is the net investment of the economy.
At optimum, MEC is equal to the rate of interest. Thus, the negative slope of the MEC
curve indicates that as the rate of interest falls, the optimum stock of capital increases.

The Marginal Efficiency of Investment

This is the rate of return expected from a given investment on a capital asset after covering
all costs, except the rate of interest; it is the rate of interest that equates the supply price of
capital asset to its prospective yields.
The MEI relates the investment to the rate of interest. The higher the rate of interest the
lower the investment. The MEI schedule also known as the Investment demand schedule
shows the amount of investment demanded at various rates of interest and has a negative
slope. Interest rate (r)

44
Marginal Efficiency of Investment

r1

r2
MEI

O I1 I2 Investment (I)

To what extent the fall in the interest rate will increase investment depends on the elasticity
of investment demand curve or the MEI curve.

r r

r1 A r1 B

r2 r2

MEI
MEI
O I1 I2 O I1 I2 Investment

The less elastic the MEI curve, the lower the increase in investment as a result of fall in the
rate of interest and vice versa
In panel A, the MEI is less elastic and therefore the increase in investment is lower than in
panel B where the MEI is mores elastic.
Also at a fixed interest rate, the higher the MEI the larger the volume of investment

45
MEI,

MEI1 MEI2

I1 I2 Investment

What is the difference between MEC and MEI?

i) The MEC is based on a fixed supply price whereas MEI depends on induced
changes in the supply price
ii) The MEC shows the rate of return on all successive units of capital without
regards to the existing stock of capital while MEI shows the rate of return on
only units of capital over and above the existing stock of capital.

Factors affecting the inducement to invest other than the interest rate

1) Uncertainty. The business expectations are very uncertain. They may change quickly
and drastically in response to the general mood of the business community, rumours, news
of technical developments, political events, etc. these factors tend to bring instability in the
investment function and make it difficult to calculate the expected annual returns on life of
capital assets.
2) Existing stock of capital goods. If the existing stock of capital goods is large, it would
discourage potential investors from entering into the making of goods.
3) Level of income. Increase in the income in the economy due to rise in money wage rates
and other factors prices, will lead to increase in the demand for goods which will in turn
raise the inducement to invest. On the other hand, the inducement to invest falls with the
fall in income.
4) Consumer Demand: If the current demand for consumer goods is increasing rapidly,
more investment will be made. Also, the future demand for the products influences the
level of investment.

46
5) Liquid assets. If the investors possess large assets, the inducement to invest is high.
This is more so with firms which keep large reserve funds. On the other hand, the
inducement to invest is low for investors having little liquid asset.
6) Inventions and Innovations. If inventions and technological improvements lead to more
efficient methods of production which reduces costs, the MEC of new capital assets will
rise. Higher MEC will induce firms to make larger investments in the new capital assets.
7) Growth of Population. A rapidly growing population means a growing market for all
types of goods in the economy. To meet the demand of an increasing population,
investment has to increase.
8) Government Policy. If the government levies taxes on goods, their prices will be high
and their demand will be too low, which lowers the inducement to invest. On the other
hand, if the sate encourages private enterprises by providing credit, and other facilities,
inducement to invest will by high.
9) Political Climate. If there is political instability in the country, the inducement to invest
is affected. On the other hand, a stable government creates confidence in the business
community whereby the inducement to invest is raised
10) New Products. The nature of new products affects the inducement to invest. If the
sale prospects of a new product is higher and the expected revenues are more than the costs,
the inducement to invest will be high.
Question
1. a) Distinguish between
i) Capital and Investment
ii) Induced and Autonomous Investment
iii) MEC and MEI
b) Explain how the rate of interest in an economy affects the level of investment.
c) Discuss the determinants of investment in an economy apart from the rate of interest

47
 CHAPTER 5B

SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS

As a starting point for analyzing financial markets, we discuss the key macroeconomic
variables that measure activity in these markets. Our emphasis here is not on behavior but
on accounting. Accounting refers to the way in which various numbers are defined and
added up. A personal accountant might help an individual add up his income and expenses.
A national income accountant does the same thing for the economy as a whole. The national
income accounts include, in particular, GDP and the many related statistics

The rules of national income accounting include several important identities. Recall that
an identity is an equation that must be true because of the way the variables in the equation
are defined. Identities are useful to keep in mind because they clarify how different
variables are related to one another. Here we consider some accounting identities that shed
light on the macroeconomic role of financial markets.

Some Important Identities

Recall that gross domestic product (GDP) is both total income in an economy and the total
expenditure on the economy’s output of goods and services. GDP (denoted as Y) is divided
into four components of expenditure: consumption (C), investment (I), government
purchases (G), and net exports (NX):

This equation is an identity because every dollar of expenditure that shows up on the left
side also shows up in one of the four components on the right side. Because of the way
each of the variables is defined and measured, this equation must always hold.

In this chapter, we simplify our analysis by assuming that the economy we are examining
is closed. A closed economy is one that does not interact with other economies. In
particular, a closed economy does not engage in international trade in goods and services,
and it does not engage in international borrowing and lending. Actual economies are open
economies—that is, they interact with other economies around the world. Nonetheless,
assuming a closed economy is a useful simplification with which we can learn some lessons
that apply to all economies. Moreover, this assumption applies perfectly to the world
economy (interplanetary trade is not yet common!).

Because a closed economy does not engage in international trade, there are no imports and
exports, making net exports (NX) exactly zero. We can simplify the identity as

48
This equation states that GDP is the sum of consumption, investment, and government
purchases. Each unit of output sold in a closed economy is consumed, invested, or bought
by the government.

To see what this identity can tell us about financial markets, we subtract C and G from both
sides of this equation to obtain

The left side of this equation (Y -C - G) is the total income in the economy that remains
after paying for consumption and government purchases: This amount is called national
saving, or just saving, and is denoted S. Substituting S for Y - C - G, we can write the last
equation as

This equation states that saving equals investment.

To understand the meaning of national saving, it is helpful to manipulate the definition a

bit more. Let T denote the amount that the government collects from households in taxes
minus the amount it pays back to households in the form of transfer payments (such as
Social Security and welfare). We can then write national saving in either of two ways:

Or

These equations are the same because the two T’s in the second equation cancel each
other, but each reveals a different way of thinking about national saving. In particular, the
second equation separates national saving into two pieces: private saving (Y - T - C) and
public saving (T - G).
private saving: the income that
Consider each of these two pieces. Private saving is the amount of households have left after paying
income that households have left after paying their taxes and paying for taxes and consumption
for their consumption. In particular, because households receive
public saving: the tax revenue
income of Y, pay taxes of T, and spend C on consumption, private that the government has left
saving is Y - T - C. Public saving is the amount of tax revenue that the after paying for its spending
government has left after paying for its spending. The government
receives T in tax revenue and spends G on goods and services. If T budget surplus: an excess of tax
exceeds G, the government receives more money than it spends. In this revenue over government
spending
case, public saving (T - G) is positive, and the government is said to
run a budget surplus. If G exceeds T, the government spends more budget deficit: a shortfall of tax
revenue from government
spending

49
than it receives in tax revenue. In this case, public saving (T - G) is
negative, and the government is said to run a budget deficit.

Now consider how these accounting identities are related to financial markets. The
equation S 5 I reveals an important fact: For the economy as a whole, saving must equal
investment. Yet this fact raises some important questions: What mechanisms lie behind this
identity? What coordinates those people who are deciding how much to save and those
people who are deciding how much to invest? The answer is the financial system. The bond
market, the stock market, banks, mutual funds, and other financial markets and
intermediaries stand between the two sides of the S = I equation. They take in the nation’s
saving and direct it to the nation’s investment

The Meaning of Saving and Investment

The terms saving and investment can sometimes be confusing. Most people use these terms
casually and sometimes interchangeably. By contrast, the macroeconomists who put
together the national income accounts use these terms carefully and distinctly.

Consider an example. Suppose that Larry earns more than he spends and deposits his
unspent income in a bank or uses it to buy some stock or a bond from a corporation.
Because Larry’s income exceeds his consumption, he adds to the nation’s saving. Larry
might think of himself as “investing” his money, but a macroeconomist would call Larry’s
act saving rather than investment.

In the language of macroeconomics, investment refers to the purchase of new capital, such
as equipment or buildings. When Moe borrows from the bank to build himself a new house,
he adds to the nation’s investment. (Remember, the purchase of a new house is the one
form of household spending that is investment rather than consumption.) Similarly, when
the Curly Corporation sells some stock and uses the proceeds to build a new factory, it also
adds to the nation’s investment.

Although the accounting identity S 5 I shows that saving and investment are equal for the
economy as a whole, it does not mean that saving and investment are equal for every
individual household or firm. Larry’s saving can be greater than his investment, and he can
deposit the excess in a bank. Moe’s saving can be less than his investment, and he can
borrow the shortfall from a bank. Banks and other financial institutions make these
individual differences between saving and investment possible by allowing one person’s
saving to finance another person’s investment.

50
 CHAPTER SEVEN
THE MULTIPLIERS

To Lord Keynes, an increase in expenditure (an increase in demand) increases

income more than the original increase in expenditure

Keynes Investment Multiplier

The Keynes investment multiplier establishes a precise relationship between aggregate
employment and income and the rate of investment. It tells us that when investment
increases, income increases by K time.
𝛥𝑌 = 𝐾𝛥𝐼
Implying that;
∆𝑌
𝐾=
∆𝐼

Where K is the multiplier coefficient and it is the power, which multiply initial investment
expenditure to obtain the formal increase in income. The value of the multiplier is
determined by the MPC; the higher the MPC, the higher the value of the multiplier and
vice versa.
Y=C+I
ΔY = ΔC + ΔI

But; ΔC = CΔY
ΔY = CΔY + ΔI
ΔY – CΔY = ΔI
ΔY (1 – C) = ΔI
𝛥𝑌 𝐼
=
𝛥𝐼 𝐼 – 𝐶

/!
But; /%
= 𝐾

51
 𝐼
𝐾=
𝐼 – 𝐶

Where C is the MPC

O≤K≤∂
O ≤ MPC ≤ I

The formula shows that the size of the multiplier varies directly with the MPC. Also
𝐼
𝐾 =
𝑀𝑃𝑆

How the Multiplier Works

The multiplier works both forward and backward;

1. Forward Working of the Multiplier

In forward working, an increase in investment leads to increased production which creates
income and generates consumption expenditure. Suppose that the MPC of the economy is
½, an increase in investment will lead to a rise in production and income. ½ of this income
will be spent on consumption goods which will lead to increase in production and income
by the same amount and so on.

52
C + I is the investment curve. The original equilibrium is at EI where C + I intersect to the
450 line. An increase in I by ΔI leads to a new curve C + I + ΔI which intersect the 450 at
EII and income. The distance between C + I and C + I + ΔI since MPC is half.

2. The Backward Working

The backward operation of the multiplier occurs when a reduction in investment leads to
contraction of income and consumption, which in turn leads to cumulative decline in
income, and consumption till the contraction in aggregate income is the multiple of the
initial decreased in investment. The higher the MPC, the greater the value of the multiplier
and the greater the cumulative decline in income and vice versa.

Leakages of the Multiplier

Leakages are the potential diversions from the income stream, which tend to weaken the
multiplier. Therefore, the increase in income in each round declines due to leakages in the
income stream. They include;
1. Saving: Since the MPC is less than one, the whole increment in income is not spent on
consumption. A part of it is saved which goes out of the income stream and increase in
income in the next round declines. Therefore, the higher the MPS, the smaller the size
of the multiplier and the greater the amount of leakages and vice versa.
2. Strong liquidity preference: If peoples\ desire to hoard the income inform of money
is high, it will act as a leakage out of the income stream.
3. Purchase of Old Stock and Securities: If a part of the increase in income is used in
buying old stocks and securities instead of consumer goods, the consumption
expenditure will fall and its effect on income will be less than before. That is the size
of the multiplier falls with the fall in consumption expenditure.
4. Debt Cancelation: If a part of increased income is used to repay debts to banks instead
of spending it for further consumption; that part of income goes out of the income
stream and the multiplier is weakened.
5. Inflation: When increased income leads to price inflation, the multiplier effect of
increased income will be affected at higher prices. This is because the increased income
will be absorbed by higher prices and real consumption and income falls.

53
6. Imports: If increased income is spent on the purchase of imported goods, it acts as a
leakage out of the domestic income stream because such expenditure fails to affect the
consumption of domestic goods.
7. Undistributed profits: If profits accruing to joint stock companies are not distributed
to the shareholders but are kept in the reserve fund, it acts as a leakage from the income
stream. This is because the income will be reduced and hence consumption of goods
will be reduced which weakens the multiplier.
8. Taxation: Progressive taxes have the effect of lowering the disposable income and
reducing the consumption expenditure. In addition, consumption taxes tend to rise the
prices of goods, all of which reduce the income stream and lower the size of the
multiplier.
9. Excess stock of consumer goods: If the increased demand of consumption goods is
met from the existing excess stock of consumption goods, there will be no further
increase in output. The income stream will lower to the half till the old stocks are
exhausted.
10. Public Investment Programs: If the increase in income is because of increased
investment due to public expenditure, the increased income may not be used for further
investment.

Assumptions of Multiplier
Keynes theory of multiplier works under certain assumption, which limits its operation.

Criticisms of Multiplier
The theory of multiplier has been severely criticized by the post Keynesian economists.
Prof. Hart considers it “useless fifth wheel.” The criticism is in the following grounds;
#
1. That 𝐾 = # – 2 is a mere arithmetic multiplier and not a true behavior multiplier that

shows relationship between consumption and income.

2. It is a timeless analysis. The multiplier does not involve the true lag between the receipt
of income and its expenditure on consumption goods and also in producing
consumption goods.

54
3. A worthless theoretical Toy. According to Hazlitt, it can never be a mechanical
relationship between investment and income.
4. Acceleration effect ignored. The theory studies the effect of investment and income
through changes in consumption expenditure, but it ignores the effect of consumption
and investment, which is known as the acceleration principle.
5. MPC does not remain constant. According to Gordon, in a dynamic economy, it is not
likely for MPC to remain constant. Because of increase in private investment or public
spending leads to a rise in MPC.
6. Relationship between consumption and income. Keynes establishes a linear relation
between consumption and income and that MPC is less than one and greater than zero.
But empirical studies of the behavior of consumption in relation to income show that
the relation is non-linear and is complicated.

Importance of Multiplier
The importance of Keynes multiplier lies in the following;
1. Investment. The multiplier shows the importance of investment in income and
employment theory. A fall in investment leads to cumulative decline in income and
employment by the multiplier process and vice versa.
2. Trade cycle. The multiplier highlights the different phases of the trade cycle. When
there is a fall in investment, income and employment decline in a cumulative manner
leading to recession and ultimately to depression. On the other hand, an increase in
investment leads to revival and if this process continues to a boom.
3. Saving – Investment Equality. It also helps in bringing the equality between savings
and investment. When there is a divergence between savings and investment, an
increase in investment leads to a rise in income via the multiplier process by more than
the increase in initial investment. Because of the increase in income, savings also
increases and equals investment.
4. Formulation of economic policies. The multiplier is an important tool in formulating
economic policies. Thus, the principle presupposes state intervention in economic
policies.

55
5. It helps to achieve full employment. if investment is insufficient to bring employment,
the state can inject regular investment for this purpose until the level of full
employment is reached.
6. Deficit financing. In situation of depression, increased public expenditure through
public investment programmes by creating a budget deficit helps in increasing income
and employment by multiplier.
7. Public investment. The multiplier highlights the importance of public investment in
creating or controlling income & employment for example by increasing investment
during a depression or decrease investment in periods of over full employment.

Multiplier in an Underdeveloped Country

Keynes never formulated the economic problems of underdeveloped countries. However,
the value of multiplier will be much higher than in a developed country. We know that the
multiplier depends on the size of the Marginal Propensity to Consume. Since in an
underdeveloped country the MPC is high, small increment in investment are likely to
induce full employment much earlier than in a rich country where the MPC is low. This is
something paradoxical and contrary to fact. For the assumption on which the multiplier
theory is based do not hold in underdeveloped country because of the following;
1. Involuntary unemployment. Keynes assumed an involuntary unemployment
associated with the capitalist economy. In this case, involuntary unemployment in
underdeveloped countries is insignificant when considered in relation to the total
working population of the country. In fact, in an underdeveloped country, there
exists disguised unemployment. The existence of disguised unemployment instead
of involuntary unemployment hinders the working of the multiplier theory.
2. The supply curve of output in an underdeveloped country is inelastic which renders
the working of the multiplier difficult. The industries producing consumption goods
are unable to expand output and offer more employment.
3. Since the MPC is high in underdeveloped countries, the increased income is spent
on self-consumption of food products by the farmers, which lead to a reduction in
the marketable surplus of food. Therefore, prices of food products rise without a
rise in the aggregate real income.

56
4. Output is difficult to increase due to non-availability of sufficient raw materials,
capital equipment and skilled labour.

57
 CHAPTER EIGHT
MONEY AND BANKING

Money
This is anything generally acceptable as an instrument in the settlement of debts or any
other trade obligations. Money is a legal tender accepted not for its own sake but because
other people will accept it in the exchange of goods and services.

Qualities of good money

1. Acceptability. Money must be generally acceptable in society. All people must accept
it and should have confidence in its capacity to enable them settle their obligations.
2. Scarcity. Good money must be relatively scarce therefore it should not be in plentiful
supply.
3. Durability. Good money should be long lasting in terms of value and form. It should
not deteriorate over time.
4. Divisibility. Good money should be divisible into smaller units (denominations)
without loss of value. This can facilitate small transactions.
5. Homogeneity. All money units of the same denomination should be homogenous i.e.
similar and identical in all ways. One piece of money should be as good as another of
the same denomination in terms of color, size, etc.
6. Recognizable. Good money should easily be recognized in such a way that even an
illiterate person can differentiate between unit of different denomination or between
genuine and forged money.
7. Portability. Good money should be easy to carry or move around with. It must not be
heavy or bulky. An individual should be able to move with a large sum of money with
minimum difficulty.
8. Good money should be made in such a way that it cannot be easily forged.

1. Functions of money

58
1. Medium of exchange. Individuals exchange what they have for money which they can
later on use to buy what they do not have.
2. Serve as a store of wealth. Individuals can keep their wealth in form of money. This
form is not bulky, perishable and can easily be converted into other forms of wealth.
3. Acts as a standard of deferred payment. It makes it possible to carry out transactions
without immediate cash payment.
4. It is a unit of account. All prices of goods and services as well as business calculations
can be worked out in terms of money.
5. Acts as a measure of value. The value of goods and assets can easily be expressed in
terms of money.

Advantages of barter trade system

1. Helps to check inflation. This is with the exchange of goods for goods or service, no
prices will rise but only the correct portion for a desired commodity will be got.
2. It is good for modern economies which lack foreign currency to effect international
trade.
3. It improves upon the BOP position. This is because the country does not spend money
importing goods that are lacking in the country since exchange is by barter.
4. It widens the market particularly for LDC‟s because most of them cannot produce all
that they want. So, by means of barter trade, they exchange for what they do not have
hence creating market for each other.
5. Helps the country to dispose off their surplus output which would be wasted.

Disadvantages of barter trade

1. Lack of double coincidence of wants. It is difficult to get what you want with what one
wants hence making the system difficult.
2. Where goods are perishable, they cannot stay long until one gets another person who
wants them or has what he wants thus goods end up persisting.
3. It is difficult to determine the value of one commodity in relation to other commodities
e.g. how much should be given in order to get a goat.

59
4. It is not easy for some commodities to be divided into small units e.g. to get thigh of
cow. It necessitates killing the whole cow hence a problem of division.
5. The system is tiresome i.e. because it needs contracts between buyers and sellers. Some
people have to move long distance to get market.
6. Some commodities are too bulky thus difficult to export hence failing the system.
7. Does not enable determination of value of commodity.

Types and Evolutions of Money

1. The earliest form of exchange was the barter system of trade. This involved the
exchange of goods for goods.
2. Commodity money standard. This involved the use of certain commodities to
determine the value of other commodities. The advantage with these commodities was
that they had an intrinsic (real) value. However, some of them were bulky while others
were perishable.
3. Durable metals such as copper, iron and silver were adopted. These were long
lasting but plentiful in supply therefore they were less suitable for use as a medium of
exchange.
4. Rare metals such as gold were later on adopted. These metals were relatively scarce
and durable. However, each time the price of gold increased, people could melt their
coins into metals thereby causing a shortage in the supply of coins in the country and
vice versa.
5. Paper money. This form of money originated from the receipts issued by the gold
smith acknowledging that they have acquired gold deposits. After some time, people
developed confidence in these receipts and then started using them in carrying out
transactions. Since they were as good as gold.
6. Fiduciary issue. For example; cheques, banknotes, or drafts. Fiduciary money
depends for its value on confidence that it will be generally accepted as a medium of
exchange.
7. Bank deposits. This is the final state in the development of money. This is the money
kept in the commercial banks on the current account and the money crated by
commercial banks in the process of giving out loans.

60
8. Convertible money refers to the type of money that can easily and readily be converted
into other countries’ currencies. E.g., Dollar, pound. Inconvertible money is money that
can only be used in a country where it is issued. Such money is not readily acceptable
in exchange with other currencies or in exchange for goods and services in other
countries.

Supply and demand for money Supply of money

This refers to the total amount of money in an economy at a given time. It consists of money
in circulation and bank deposits. To a large extent, the supply of money is determined by
the central bank and to a small extent by the automatic mechanism in the economy. As
determined by the central Bank, supply of money is inelastic i.e., at whatever rate of
interest, quantity supplied of money remains the same. Aggregate Money demand refers to
total amount held in cash at a particular time by households and income earners as a result
of refraining from consumption.

Factors determining money supply

1. Central Bank (Central Monetary Authority). The amount of money in circulation at
any one time is largely determined by government through the central bank. It may
increase the supply of money by printing more of it and can also reduce the amount of
money in circulation by withdrawing some amount of money from circulation.
2. Capital outflow or inflows. When more foreign capital flows into the country, the
supply of money will increase. This inflow can be in form of foreign investment, loans,
profits from investments abroad etc. And where more capital flows out of the country,
supply of money will decrease.
3. Balance of payment surplus. When a country’s exports increase, more forex will be
realized and if this exceeds the foreign exchange expenditure, a surplus will be created
on the BOP. This surplus will result into an increase in money supply. The reverse is
true if there is a BOP deficit.
4. Open Market Operations (OMO) this is the buying and selling of securities to the
Central Bank. When government wants the supply of money in the economy to

61
 decrease, it will sale securities to the public. And when they the supply of money to
increase, they will buy the securities back from the public.
5. Credit Creation. This is the process through which money lent out by the commercial
banks expands into a greater volume of credit. The increased volume of credit will also
add onto the existing amount of money in circulation and so the supply of money will
increase.
6. Government Borrowing. Government can borrow money from outside the country.
This money will be converted into local currency and so there will be an increase in the
amount of money in circulation.

Demand for money / liquidity preference

Money is not demanded in the same way as goods and services are demanded. Instead, the
demand, for money is influenced by certain motives.
1. Transaction motive / financial motive. People should carry money in cash so as to be
able to carry out transactions i.e., buy what they want and when they want it.
2. Precautionary motive: People hold money in cash for emergency cases i.e., to enable
them solve their unforeseen financial problems.
3. Speculative motive: People hold money in cash so as to gain capital gains or to avoid
loses on securities. E.g., Treasury bills and bonds if the rate of interest on securities is
expected to fall in the near future, speculators convert their securities into cash.

Liquidity preference
This is the desire by people to hold their wealth/assets in cash or near cash form rather than
in any other forms of wealth.

Factors influencing liquidity preference

1. Level of transactions. If they are very high, then the desire to have wealth in cash will
also be high and vice versa.
2. Rate of interest on securities. If this rate is high and is expected to remain so for some
time, it will low/liquidity preference.

62
3. The price level. If the price of goods and services in the economy is low, liquidity
preference will also be low and vice versa.
4. Levels of income. If the level of one’s income is very high, liquidity preference will be
very low and vice versa.
5. Degree of uncertainty. If the degree of uncertainty is high, the liquidity preference will
also be high and vice versa.

Liquidity trap
This is a point at which the rate of interest is too low to encourage investors to invest in
bonds or transfer bills.

Quantity theory of money

This theory states that the general price level in the economy is determined by the quantity
of money in circulation, i.e., the velocity of circulation and the volume of production
(Transactions level). In other words, the quantity of money in circulation is directly
proportional to the general price level. Therefore, any increase in the amount of money in
circulation will lead to a corresponding increase in the price level and vice versa. For
example, if the amount of money in circulation, doubles, the price level will also double.

Fisher’s Equation of Exchange

Prof. Irving Fisher of America amended the crude quantity theory by means of an equation
called Transaction Equation or Fisher’s formula.
𝑀𝑉 = 𝑃𝑇
𝑀𝑉
𝑃 =
𝑇
Where M – Quantity of money in circulation V – Velocity of circulation T - Total number
of transactions (volume of production) P - General Price level
A change in any of these variables will influence price. M and V vary directly with price
while T varies in an inverse proportion with price. Fisher’s concept emphasizes that the
transaction and velocity i.e. the rate at which money changes hands.

63
According to the theory, in every transaction there is always a buyer and a seller hence for
an aggregate economy the value of sales must be equal to the value of receipts. The value
of sales represents the number of transactions conducted over any time period multiplied
by the average price at which these transactions take place. i.e. PT = Sales Where P =
average price level T = level of transactions.

On the other hand, the value of purchases must equal to the amount of money in circulation
in that economy multiplied by the average number of times it changes hands over the same
period of time.
MV = sales
M = Money supply
V = Velocity of circulation
Thus, Fisher’s equation that MV =PT.
In this tradition quantity theory of money, it is assumed that “V” and “T” are constant, the
volume of transactions and money supply are also assumed to be determined independently
with other variables with in the economy. On the commodity side, a number of transactions
“T” could be regarded as proportional to the level of Real income “Q” and thus the identity
MV =PQ.
Note: M can be money demand or money supply provided the economy is in equilibrium.

Assumptions
1. This theory assumes that money is demand for transaction purposes only and therefore,
it is held for only a very short period of time before it is spent on consumption.
2. It assumes that V and T are constant.
3. It assumes that all transactions take place using money as medium of exchange.

Limitations of the quantity theory of money

1. To say that MV = PT is no theory but simply a truism. This merely shows that the
variables M, V, T and P are related.

64
2. The theory only attempts to explain how the value of money is affected by the
increase in its supply. However, it does not show how the value of money is
determined.
3. The theory wrongly assumes that all transactions take place using money as the
medium of exchange. It does not take into account the use of barter system of
exchange.
4. The theory does not explain the rise of prices in the economy of commodities due
to other causes rather than increase money supply. Price can increase due to other
causes such as - Increase in cost of production - Increase in taxes. - Shortage in supply
of foods, etc.
5. The theory only considers the transaction motive as the reason why people hold
money in cash. However, there are other motives which explain why people hold
money in cash.
6. Where the MPS is high, an increase in money supply will not lead to a
corresponding increase in the price level but instead to an increase in savings. This
will lead to a reduction in the velocity of saturation and eventually prices will fail.
7. There is nothing like a general price level in the economy. Different commodities
have different prices therefore it is only proper to refer to a series of price levels.
8. The theory wrongly assumes that V and T are constant which is not the case. These
two variables tend to change with the levels of economic activity.
9. The theory does not consider the price control measures that may be existing in
the economy such as the maximum price legislation or resale price maintenance.
These measures can prevent prices from increasing even when the quantity of money
increases.
10. Haggling between buyers and sellers in the market always results into an agreed
price. 11. Where an increase in the quantity of money is accompanied with a
corresponding increase in the production of goods and services, there may not be
an increase in price.

Value of money

65
This refers to the amount of goods and services which a unit of money can purchase. The
bigger the volume of goods a unit of money can purchase, the higher will be the value of
money and vice versa. This value is therefore determined by the prices of goods and
services in the market. On the other hand, the external value of money refers to the amount
of forex which a unit of money can purchase. The bigger the volume of forex, that can be
purchased, the stronger will be the value of the currency and vice versa. The external
therefore is determined by the exchange rate.

Banking
Banks are financial institutions which deal in money. They collect money from those who
have it to spare or who are saving it out of their income and lend it out against securities or
goods to those who require it. There are various kinds of banks as discussed below:

Commercial banks:
These are financial institutions which accept deposits from the public and which extend
credit to those who are in financial need.

Functions of Commercial Banks

1. They accept and safeguard the surplus funds from the public inform of deposits and they
make such funds available to the owners on demand.
2. They offer credit to those in financial need. From these credit facilities, commercial
banks do earn interest. Credit can be given inform of loans either on short-, medium- or
long-term basis. It can also be informed of overdrafts (money that has been over drawn on
a current account).
3. They maintained different accounts i.e. current, savings, fixed accounts.
4. They facilitate the transfer of money on behalf of their customers. Money transfer can
be informed of bank drafts, standing orders and direct credit transfers, direct debit transfers.
5. They provide facilities for keeping valuable items for their customers e.g. land titles,
wills, and certificates.
6. They give final advice to their customers on matters concerning their businesses and
their money.

66
7. They assist traders engaged in International Trade by issuing travelers cheques and
exchanging their currencies.
8. Commercial banks act as a trustees, executors and administrators of wills of their
deceased customer.
9. They also act as referees to their customers i.e., they can give a confidential report about
the financial status and a credit worthiness of their customers.
10. They implement policies of the Central Bank e.g., reducing the amount of money in
circulation so as to control inflation.

Types of accounts operated by commercial banks

1. Current Accounts Money on this type of account is referred to as demand deposits.
And it has the following features. a) It is operated by means of cheques. b) No interest is
paid on the balances of this account. c) An account holder is required to pay some charges
to run his account. d) There are no restrictions on deposits and withdrawals on this account.
e) Those account are very suitable for business persons and large organizations

2. Savings Accounts i) Customers are required to maintain a mini balance on the savings
account. ii) Some interest is earned on the balances or deposits on the saving account.

3. Fixed deposit account (time deposit) i) Deposits on this account are made once and for
a specified period of time ii) Withdrawals are also made once at the expiry of the stated
period or after a notice of 30 days. iii) A high rate of interest is earned.

Problems facing banking institutions in Uganda

1. The political atmosphere discourages the growth of sounding banking system;
economic activities cannot go on, investments in the banking industries especially by
foreigners.
2. The large subsistence sector. This restricts the banking business. Many people further
still do not know how to open accounts.
3. Conservatism of many people in LDCs. Many are still stuck to tradition. They prefer
saving money at home which restrict the banking system.

67
4. The low-income level of most people in LDC‟s limits the level of savings, poverty is
high so people would prefer to survive rather than save.
5. The level of economic transactions is low. Low demand for loans explained by the low
incomes of the subsistence economy.
7. The absence of credit worthy customers makes conditions for making loans rigid. Many
people in LDCs are poor i.e. have no securities to able them obtain loans.
8. Many commercial banks have been subjected to mismanagement and corruption. The
inefficiency and arrogance of staff has kept potential customers away.
9. High marginal propensity to consume and low marginal propensity to save put
commercial banks in a weaker position of mobilizing customers.
10. Banks are concentrated in urban areas therefore the scope for commercial banks to
mobilize savings are limited.
11. Ignorance of the presence of different accounts.
12. Preference of asset to cash.
13. Non reliable banks (not trusted)
14. Negative attitude towards banks.

Credit creation
This is a process through which commercial banks expand the amount of credit (money
lent out) out of the initial amount of money deposited. Through experience, commercial
banks realized that not all customers need their money at a given time, therefore they keep
a small percentage of their total deposits in cash form which can satisfy all the day to day
requirements of their customers (cash ratio) and then lend out the rest.

The process of credit creation is based on the following Assumptions.

1. There are a number of banks, X, Y, Z etc, with different deposits.
2. Every bank has to keep a given cash ratio.
3. A new deposit is made to the bank to start with.

Example

68
Given that that the initial deposit is 100,000/= and the cash ration 20%. Customer A makes
an initial deposit of Sh.100,000 and the bank keeps 20% of his money in cash form i.e.,
20,000/= and lends out a balance of 80,000/= to customer B. Customer B will deposit this
money in the same bank. The bank will keep 20% of this money in cash form i.e., 16,000/=
and the balance of 64,000/= will be lent out to customer C. Customer C will deposit his
money on his account on the same bank. The bank again keeps 20% of this deposit in cash
12,800/= and will lend out a balance of 51,200/= to customer D. He will also do the same
and the process will continue until there is no money to lend.

Illustration
Rate Bank Stage Deposit Reserve
Requirement
𝑟 = 20% A 1 $100,000 $20,000
B 2 $80,000 $16,000
C 3 $64,000 $12,800
D 4 $51,200 $10,240
E 5 $40,960 $81,192
Summing the total funds issued (loans), the credit created can be established. Although
this process can continue, it does not create an infinite amount.

Factors which limit the process of credit creation

1. Cash ratio: The bigger the rate of cash ratio, the smaller will be the amount of money
available in commercial banks for lending. Therefore, less credit will be created and
vice versa.
2. The number of deposits available in the bank. If there are less deposits available, there
will be little money in commercial to lend. This will therefore limit the banks’ ability
to create more credit and vice versa.
3. General preference by the public to hold their money in cash. This implies that these
banks would have less money to lend out which will in return limit the process of credit
creation and the reverse is true.
4. Lack of collateral security by the borrowers. In LDCs, there are very few persons who
have collateral security which can enable them to secure loans, this limits the banks’
ability to lend money and hence their ability to create credit and vice versa.

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5. The level of demands for loans by the public. When people are reluctant to borrow
money from commercial banks, the banks will have excess liquidity which makes it
difficult for them to create more credit and if the demand for loans is very high more
will lent out and more credit will be created.
6. Influence of the Central Bank on the commercial bank activities. E.g., variations in the
bank rate, legal reserve requirements. All these affect the ability of the commercial
bank to create more credit.
7. Policies of the Central bank in respect to the amount of money in circulation.
Government may restrict the amount of money in circulation through the Central Bank
and instruct commercial banks to limit giving out loans.

Credit multiplier refers to the number of times the initial deposits multiply itself to give
a total deposit. This credit multiplier is equal to the reciprocal of the cash ration.

Central bank
This is a financial instruction responsible for managing the central monetary system of a
country. It is concerned with the supply and use of money in the economy.

Functions of the central bank

1. Issuing currency: A central bank is concerned with printing and issuing bank currency
notes and coins. It is also responsible for maintaining the internal and external values
of currencies.
2. Acts as a banker to government. Just in the same way as commercial banks are bankers
to their customers. In pursuing this function, the central bank accepts deposits from
government departments lends money to government departments and also buys and
sells securities on behalf of government.
3. Acts as a Banker to Commercial banks. It accepts deposits from commercial banks,
lends them money and makes payments on their behalf. In addition, it settles financial
indebtedness between these banks. Therefore, a central banks acts as a clearing house.

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4. Acts as a banker to other financial institutions like IMF and the World Bank. Each of
these institutions have an account in the central bank of the country in which they
operate.
5. Acts as a manager of foreign exchange. It acts as chief custodian or controller of forex
of all currencies in the country.
6. The lender of last resort. If a commercial bank fails to get funds to settle its debt from
anywhere else, the central bank is always willing and ready to lend them. Similarly, it
can also lend money to government.
7. Acts as a controller of credit in the economy. I.e., it regulates the amount of money in
circulation. In doing so, it employs a number of tools (tools of the monetary policies)
such as the bank rate, legal reserve requirement.

How the central bank controls credit

The central bank controls credit by using monetary policies as discussed below:
1. Open Market Operations.
This is the buying and selling of securities to the public. When the government wishes to
restrict the amount of money in circulation it sells securities to the public hence some
money will be withdrawn from circulation. On the other hand, when the government wishes
to expand credit to the economy it will buy back its securities from the public and by so
doing more money will be injected into the economy.
2. Bank rate.
This is the rate at which commercial banks borrow money from the central bank. When the
central bank wishes to restrict the amount of money in circulation, it will raise its bank rate.
Commercial bank will then increase its interest rates making it difficult for individual to
borrow and vice versa.
3. Selective Credit Control.
Central bank can direct commercial banks to be selective or to discriminate amongst their
borrowers i.e., to favor certain borrowers over others depending on the needs of the
economy e.g., favoring the agriculture sector and not the industrial sector.
4. Legal Reserve Requirement.

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This is the minimum amount of deposits that commercial banks are required by low to keep
with the central bank. If it is high, the commercial banks will have little money to lend and
therefore, there will be little money in circulation and vice versa.
5. Special Deposits.
This is an additional deposit of money which a commercial bank may be required to keep
with the central bank over and above the reserve requirement. This tool will be employed
when the Central Bank realizes that commercial banks still have a lot of money yet it would
like to restrict its lending.
6. Marginal requirement.
This is the difference between the amount of loan borrowed and value of asset mortgaged
as security. When the Central Bank wishes to restrict credit, it will raise the margin
requirement.
7. Moral Suasion.
The central bank can appeal or give advice to the commercial bank, to regulate their lending
so that it suites the needs of the economy.
8. Direct intervention by the Central Bank.
The central bank can come out physically to control operations of a commercial bank by
employing their staff or even taking over its management in an attempt to control its leading
habits.

Monetary Policy
These are guidelines taken by government to stabilize the economy by regulating the
amount of money in circulation.

Objectives of the Monetary Policy

1. To stabilize the prices of goods and services in the economy i.e., to control inflation or
price fluctuations.
2. To stabilize the country’s B.O.P position.
3. To stabilize the exchange rates i.e., rate at which a country’s currency is exchanged for
other currencies.
4. To ensure full employment in the economy for both labor and other factor services.

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5. To ensure a more even distribution of income amongst people in society.
6. To increase the rate of economic growth and development in the economy.
7. Increase the level of Aggregate demand.

Limitations of the monetary policy in LDC’s

1. Ignorance of the public about the tools used by the monetary policy e.g. the OMO
operations. Some people in society do not understand how this tool operates.
2. A lot of corruption in LDCs. This hinders the success of some tools such as the selective
credit control.
3. Defiance of the privately owned banks. Some of these banks do not follow instructions
and guidelines give to them by the central bank.
4. A lot of borrowing outside the banking system. Therefore, the effectiveness of the bank
rate as a tool of the monetary policy is very low.
5. A lot of external influence by the donor countries and international finance institutions
like IMF. These institutions may force a country to make policies which may contradict
those of the central bank e.g., devaluation of a country’s currency.
6. High liquidity preference. Many people in LDCs prefer to keep their money in cash
rather than in the banks. Therefore, the Central bank has less influence over such
money.
7. Most LDCs economies are not highly monetized as some transactions take place in
form of barter system of exchange.
8. Government influence. There is a lot of interference in the operations of the central
bank e.g., it may instruct the central bank to print more money to help it finance its
operations even when it is not economically viable.
9. The financial markets in LDC’s are not well developed. Therefore, government
securities and shares cannot be bought or sold very easily.
10. Banks are not evenly distributed in the markets of LDCs. Many of them are
concentrated in urban areas. Hence, they mainly influence activities in those areas than
in the rural areas.

The Non-Banking Financial Intermediaries

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These are institutions which provide facilities for mobilizing savings but do not carry out
normal banking services e.g., do not create credit in the same ways commercial banks do
but they offer financial assistance in form of long-term loans to the public for specific
projects. Examples include development banks, building societies, insurance companies,
post office savings banks, insurance companies.

Differences between banking and non-banking financial intermediaries

1. Banking financial intermediaries create money through the process of credit creation
while non-bank financial intermediaries do not create money but rather lend out the
surplus money.
2. Banking financial intermediaries offer short time loans while non-bank financial
intermediaries offer long term loans.
3. Banking financial intermediaries maintain short time deposits while non-bank financial
intermediaries maintain long time deposits.
4. Banking financial intermediaries undertake investment risks like lending for
construction of dams etc.
5. Banking financial intermediaries charge low interest on the borrowers while non-bank
financial intermediaries charge high interest rates to protect themselves from heavy
losses.

Role of non-banking financial intermediaries

1. Provide Capital. The capital provided helps to finance development in the different
sectors of the economy.
2. Provide both long term and medium loans. This is to the trust worthy customers who
are interested in expanding their businesses to mention but a few.
3. To provide loans for risky ventures.
4. Non-banking financial institutions give advice related to investments and other
economic issues to help investors and those planning to carry out other business
ventures.
5. Non-banking financial institutions provide employment to different people i.e.,
cashiers, accountants, secretaries, to mention but a few saving unemployed labor.

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6. Assist individuals to assist developers in drawing up physical possibility studies.

Specialized Roles
1. Insurance companies deal in business of insuring against risks e.g. fire, marine cargo,
burglary etc.
2. Encourage businessmen to take risks, promote investments plus production roles.
3. By compensating losers, output is established.
4. Continuity of business or development project is assured.
5. Contribute towards to a country’s invisible trade.
6. Promotes savings life assurance policies for the benefit of families.

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 CHAPTER NINE
INFLATION

Inflation refers to the persistent increase in the price of goods and services in the economy
or the persistent increase in the average or general price level. The State of inflation can
be classified according to speed or degree of intensity.
i) Creeping/mild inflation. This is a gradual increase in the general price level.
This type of inflation occurs when the price level persistently rises over a period
of time. Such inflation increases at a rate of 3% or less. It is usually unnoticeable
by the public and therefore, it is considered a good state of inflation.
ii) Single digit/walking/trotting inflation. This is a moderate rate of inflation and
capital less than 10%.
iii) iii) Hyper/Galloping/Runaway inflation. This is a state of inflation where prices
rise very rapidly. It increases at a rate of about 30% and therefore it is usually
very noticeable to the public.

Types of inflation (theories of inflation)

1. Demand Pull Inflation.
It arises when aggregate demand in the economy exceeds aggregate supply. This theory
assumes full employment of all resources in the economy which implies that supply cannot
be increased at whatever costs.

Causes of demand-pull inflation

i) Increase in population size.
ii) Increase in amount of money is circulation.
iii) Increase in disposal income.
iv) Increase in foreign demand.
v) Decrease on interest rates.
vi) Expected future price increase.
vii) Scarcity of raw materials

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2. Cost push theory.
This is explained by the cost push. This type of inflation is caused by an increase in the
cost of production. The increase in the cost of production may be as a result of an increase
in wages.
i) increase in rent,
ii) increase in price of raw materials
iii) increase in transport costs
iv) increase in taxes
v) increase in the interest rates
This increased cost of production may be passed on to the consumers in form of high prices.

3. Imported inflation.
This arises from the importation of goods from countries that are already suffering from
inflation. The high costs of purchasing these goods from the country of origin are coupled
with the higher taxes and transport costs make the importing countries experience imported
inflation.

4. Monetary inflation.
This can be explained by the monetary theory. According to the theory, an increase in the
amount of money in the economy will lead to a corresponding increase in the price level.
In other words, there will be too much money chasing few goods. This can be explained
further by fisher’s equation of exchange i.e.
MV = P or PT = MV
From the above equation the price level is approximately related to the amount of money
in circulation.

5. Structural inflation.
This is caused by the non-correspondence between goods available in the market and what
is demanded. It is also caused by bottlenecks existing in the economy.

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Causes of Structural Inflation
1) Collapse of imported supply or trade restrictions.
2) Bottlenecks of foreign trade (over taxation)
3) Breakdown of the industrial sector like lack of spare parts.
4) Off season, for agricultural goods.
5) Natural calamities e.g., draught, pests, floods Political instabilities like wars.

General causes of inflation

1. Acute shortage of essential commodities in the economy such as soap, sugar etc. This
may be as a result of industrial breakdown or some other bottlenecks in the economy.
2. Irrational expansionary monetary policy. This has led to the printing of too much
money and circulating it in the economy without a corresponding increase in the goods
and services.
3. Importation of goods from countries already suffering from inflation. When this is
combined with the high taxes and transport costs, the local businessmen will have no
option other than increasing the prices of the imported goods.
4. The rising costs of production for the goods and services in the economy. This may be
as a result of an increase in the wage rates, interest rate, transport cots, etc. This increase
in the cost of production is passed on to consumers in form of increased prices.
5. Supply rigidities / bottlenecks in the economy which may result from natural factors
like drought, pests and diseases etc. All these have a negative effect on the agricultural
sector thus resulting into reduced output and increased prices.
6. Speculation. Many local businessmen in Uganda have speculative behavior such
people always expect future price increases and therefore they create acute shortage of
goods in the market which leads to increases in the prices.
7. Escalating prices of petroleum products in the country. This causes an increase in the
transport costs and therefore the prices of goods and services have also to increase.

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Positive consequences of (Mild) Inflation
1. Redistribution of income or money to investments, because people do not want to
hold money, they buy as much as possible.
2. Full utilization of resources. This is because investors will always wish to employ
all means and resources to earn bigger and large profits and savings that will be idol
will be put to use.
3. It induces workers to put much effort in their work to maintain their standards of
living. This in the long run increases production.
4. It is easier to affect politically through taxation. It has always been argued that
budgetary deficit in the basic policy implementation for economic development
(increased government revenue).
5. Gain by businessmen and entrepreneurs. Because as price rises, production costs
lag behind since wages and salaries may be fixed by agreements which are not
revised immediately.
6. Job creation due to increased investments.
7. Promotes post savings.
8. Mobility of labor
9. Innovation and creativity.
10. Import sub industry set up
11. Increased GDP

Negative consequences
1. Loss of incentive to work hard. This is because the rate of change of wages lags behind
the rate of inflation.
2. Reduction in voluntary savings. This is because all that is earned is consumed and
worse still, if one saves, the money loses value.
3. Inflation makes it difficult to plan. This is because future prices will be different from
today’s prices which lead to production without plans.
4. Production shifts from productive to non-productive activities e.g. people will begin to
invest in things like precious metals instead of saving.

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5. Reduction in volume of exports and increase in that of imports. This is because of the
high domestic prices this leading to balance of payment problems.
6. Uneven distribution of income between peasants and business people. This aggravates
income equality.
7. Reduction in consumption. Consumers consume less due to increase in cost of living
and hence general lowering of standards of living.
8. Hoarding of essential goods. This is because producers go on expecting high prices or
their increase thus hoarding begins to occur.
9. Agitation for higher wages through trade unions. This makes producers to adopt capital
intensive techniques of production thus leading to unemployment and other related
disadvantages.
10. Loss of money value. Loss of money value makes people lose confidence in the
currency and people resort to barter trade exchange and prefer other countries currency.
11. Emergency of Immoral activities like smuggling, prostitution.
12. Causes misery among majority that cannot afford high prices.
13. Importation of cheaper goods from aboard thus stagnancy of home industries.
14. Discourages investments by foreign investors
15. Makes government unpopular.

Measures of controlling inflation

1. Reduced government expenditure on the less productive activities e.g., political gifts.
This will reduce the amount of money in circulation hence reducing the rate of inflation.
2. Increased production. There should be an increase in the volume of goods and services
produced in the country. This will help to cub the demand-pull inflation.
3. Price control measures. Price and wage control measures should be put in place. These
will help to suppress the inflation prevailing in the country e.g., maximum price
legislation, resale price maintenance.
4. Restriction of importation from countries already suffering from inflation. The
government can put restrictions on goods coming from already suffering from inflation.
This will help to cub imported inflation.

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5. Infrastructure development. Government should improve on the state of infrastructure
to facilitate the movement of resources and transportation of goods from one part of
the country to the other.
6. Restrictive Monetary Policies. The government can sale securities that is treasury bills
and bonds, to the public so as to limit the amount of money in circulation.
7. Improvement in the Investment Climate. The government can improve the investment
climate by ensuring political stability in the country. This will enable people to
concentrate and produce more. This can also be achieved by designing favorable tax
policies for instance tax holidays and concession.
8. The government can liberalize the economy and give subsidies to local producers. This
will enable them produce more goods and services.

Theoretical relationship between inflation and unemployment

1. At a high rate of inflation, savings and investments are discouraged causing
unemployment.
2. High levels of unemployment lead to low production resulting into inflation.
3. High levels of inflation lead to persistently high wage demand and this makes
employers to adopt capital intensive techniques of production hence causing
unemployment.
4. High inflation rates reduce aggregate demand leading to cyclic unemployment.
5. Fighting inflation through restrictive monetary policies like high tax rates, low
government spending and so on, tend to lower the funds meant for investment hence
causing unemployment.
6. Fighting unemployment through expansionary monetary policies like high government
expenditure and reducing tax rates leads to inflation.
7. Both inflation and unemployment lead to a) Income inequality. b) Low standards of
living c) Rural Urban Migrations d) Brain Drain e) Unpopularity of reigns due to high
rate of social evils, political instability etc.

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 CHAPTER TEN
UNEMPLOYMENT

Unemployment is a situation where labour is willing to work at the ruling wage rate but
is unable to find jobs. Also, it can be defined as a situation where part of the labour force
is idle i.e., not engaged in any economic activity.

Nature of unemployment
Unemployment can be classified as being: -
i) Involuntary unemployment.
This occurs when labour is willing to work under the prevailing conditions but is unable to
get jobs.
ii) Voluntary unemployment.
This occurs when labour is not willing to work at the ongoing wage rate or working rate.

Causes of voluntary unemployment

1. Low wage rate. If one feels that the wage rate is too low compared to the amount of
work involved in the job. He may prefer to remain unemployed.
2. Nature of the job. One may opt to remain unemployment if he feels that the job
available is inferior or can damage his esteem.
3. Some people may be unemployed can because they have negative attitudes towards
work or just because they are lazy.
4. Poor working conditions: Were the conditions of working a given employment
opportunity are very poor, an employee may opt to remain idle.
5. Good economic background: One may prefer to remain unemployed if he/she comes
from a wealthy family.
6. High unemployment benefits. Were the unemployment benefits are high, an individual
may prefer to remain unemployed than to work.
7. Desire for leisure.
8. Target workers. A target worker can decide to remain unemployed after achieving his
objective.

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9. Expectation of better jobs in the near future: If one feels that the jobs available are not
all that good to him/her such a person may remain unemployed. This is because he may
have hopes of getting a better paying job in the near future.
10. Cultural rigidities. Some people remain voluntarily unemployed just because they feel
their cultural or religion do not allow them to do certain jobs.
11. Being too qualified for the job available.

iii) Open Unemployment: This is a situation where labour is unemployed and is actively
looking for jobs.

iv) Hidden unemployment: This is a situation where labour appears to be working but when
it is actually not. In other words, it is disguised unemployment.

v) Casual unemployment: This occurs to workers who get work to do for a very short time
after which they get unemployed again for some time e.g., unemployment amongst workers
like shoe shiners, cart pushers, car washers, etc.

vi) Persistent unemployment: This is a state of unemployment which exists in an economy

despite all attempts to solve it.

vii) Under employment: It is a situation where labor is not fully utilized or underutilized.
Underutilization of labor can take the following forms.
1. Where labor works for fewer hours than it ought to.
2. Where people are employed in occupations below their qualifications i.e., occupations
for which they are over qualified e.g., a grained secondary school teacher to teach in a
primary school.
3. Where people are engaged in socially unnecessary activities e.g., prostitution, gambling
etc.
4. Where labour is engaged in unproductive activities for example, venders; very small-
scale roadside sellers in which case there is little or no production at all.

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v). Disguised unemployment: This is a situation where there are very many people doing a
piece of work which would actually have been done by just a few persons. In such a case,
the marginal productivity of labour is zero. This implies that even if such labour is
removed, total output will remain the same.

Types of unemployment
These are classified according to causes as shown below:
1. Seasonal unemployment: This is a situation where workers are unable to find jobs due
to climatic changes for instance, in certain seasons when coffee or cotton picking is in
progress, much labour will be required than in other periods. Therefore, when the climate
is unfavorable labour experiences seasonal unemployment.

2. Frictional Unemployment: This is also known as transitional/normal unemployment.

This is a situation where the labour force is unemployed while in the process of moving or
switching from one job to another e.g., from being a classroom teacher to a banker.

Causes of frictional unemployment

a) Ignorance of the existence of job opportunities elsewhere.
b) Specialized training in a given job and hence lack of the required skills in other jobs. In
other words, it is due to the occupational immobility of labour.
c) Changes in the conditions of goods and services in the economy which brings about
changes in the tests and preferences.
d) Technological development which has resulted into automation of some activities.
e) Structural breakdown in the economy. This could be as a result of political instabilities
in the economy.

3. Structural Unemployment This is a long-term unemployment which arises from

massive economic changes in a country’s structural setup more especially in the patterns
of goods and services. These goods usually lead to a corresponding change in development
or collapsing of certain industries. All labour in the collapsing industries may experience
structural unemployment.

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Causes of Structural unemployment
1. Changes in the patterns of goods and services. This brings about changes in fashions and
changes in tests and preferences.
2. Technological advancement which may involve the use of capital-intensive techniques
of production.
3. Long periods of training which may cause labour immobility.
4. Exhaustion minerals/raw materials in the economy.
5. Political instabilities in the country which may cause structural breakdowns in the
economy.
6. A depression in the economy. During a depression, all activities in the economy will be
generally low and therefore there will be low levels of economic activities.
7. Unfavorable government policies which adopt certain structural adjustment programs
like retrenchment, privatization, etc.

4. Cyclic Unemployment (Keynesian unemployment)

This is a type of unemployment which results from a deficiency in aggregate demand. It
exists due to fluctuations in the business or trade cycle. And it is common during the
expression period when the demand for goods and services is very low which forces
employers to lay off some workers.

Causes of cyclic unemployment

1. A fall in investment.
2. A fall in prices of goods and services
3. A decrease in incomes.
4. A fall in the exports.
5. Increase in importation
6. A fall in the savings
7. Reduced government expenditure.

5. Technological unemployment:

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This type of unemployment occurs when modern techniques of production have been
employed. The machines used tend to substitute and hence such labour is laid off.
6. Residue Unemployment:
This is caused by physical / mental disability such that one cannot qualify to take up a given
job for example the blind, lame, etc.

7. Casual Unemployment:
This occurs amongst private practitioners such as car washers, tailors, wheel barrow
pushers etc. These people work only when their work to do after which they become
unemployed.

8. Disguised (Hidden) Unemployment:

This occurs when work available to a given labour force is insufficient to help in full
employment. When some of this labour is withdrawn, there will be no decrease in total
output therefore the marginal productivity of such labour is 0. Such labour appears to be
fully employed but unproductive due to ill health, lack of motivation, lack of education,
poor tools and equipment.

9. Open Urban Unemployment: This mainly occurs in urban areas. It is a situation where
people in urban areas are actively looking for jobs.

Causes of open urban unemployment

1. Rural Urban Migration
2. High population growth rates i.e., the rate at which the population is growing exceeds
the rate at which jobs are being created.
3. Inappropriate technology.
4. Inappropriate education system i.e., the graduates from such a system are trained to be
job seekers than job makers.
5. Poor manpower planning by the government.
6. Low rate of industrialization hence limited job opportunities being created.
7. Privatization which has led to the laying off excess labour.

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8. Restructuring of the civil service i.e., retrenchment
9. Discrimination in the labour market.
10. Shift competition forcing closure of some businesses.

Measures to reduce open urban unemployment

1. Rural transformation i.e., establish small scale industries in rural areas.
2. Population control.
3. Changing the education system i.e., subjects that are practical should be encouraged like
carpentry, agriculture, wood work than those which are theoretical.
4. Labour intensive and intermediate techniques of production should be used especially in
the small-scale industry.
5. The economy such be diversified i.e., create a number of economic activities.
6. Jobs should be advertised.
7. Local and foreign investors should be encouraged to set up investments in the country.
8. The market for the goods and services should be widened.
9. Provision of credit.

10. Natural Unemployment:

This exists when the labour market in the economy is in equilibrium. Therefore, this is a
normal type of unemployment which exists in developed countries.

General Causes of Unemployment in LDCs

1. High population growth rate: The high population growth rate has led to many people
entering the labour market yet the rate at which jobs are being created is low. This is
because, most of the resources have been directed towards consumption rather than
investment in areas which could create jobs thereby increasing the levels of unemployment.
2. Inappropriate education system: The system of education in LDCs prepares school
leavers for non – existent jobs. It trains them to be job seekers than job makers.
3. Limited market for both agriculture and industrial products: This is partly due to the
discovery of artificial fibers which have replaced the natural fibers. It is also due to the
competition with the high-quality imports from the development countries.

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4. The continued use of capital-intensive technology: These techniques are inappropriate
in LDCs because they substitute labour rather than supplementing on it thereby causing
unemployment.
5. Poor manpower planning: This has been due to the poor employment policies in LDCs.
There was no serious attempt to forecast, foretell the manpower requirements in these
countries so as to ensure a balance between goods and services of labour. This has created
surplus labour in some fields and a shortage in other fields.
6. Rural urban migration: There has been a tendency for people to leave the countryside to
go to towns in search of better paying jobs. This has resulted into an influx of people in
towns actively looking for jobs which they may at times fail to get.
7. Seasonal changes: The agricultural sector in Uganda is mainly based on natural
conditions. During the dry season, the sector tends to be unproductive and the
agriculturalists will be unemployed.
8. Unfavorable structural adjustment programs: The current economic policies being
pursued by LDC economies such as privatization, retrenchment etc. have increased the
levels of unemployment in this country.
9. Existence of massive poverty: Poverty makes it difficult for people to gainful
employment. Many people therefore are unemployed because they are poor while others
are poor because of unemployment e.g., some families have found it difficult to educate
their children because they are poor. This has made them less competitive in the labour
market.
10. Discrimination in the labour market based on sex, age, tribe, religion, etc.: In LDCs,
jobs are not given out on merit but rather they are given out basing on religion, family
connection, political affiliations etc. Those people with the relevant qualifications end up
being unemployed on the above ground.
11. Poor land tenure system: The system of land ownership in LDCs is unfair. Most land
is owned by just a few land lords while the majority of the people are landless. This makes
it difficult for such persons to employ themselves.
12. Shortage of competent factors of production such as capital and entrepreneurship in
relation to the amount of labour available.

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13. Political instabilities: Wars in LDCs have destroyed a lot of productive activities and
these have reduced their productive capacities. In the end, many people have been rendered
jobless.
14. Ignorance of job opportunities: Some people in LDCs are not aware of the existence of
jobs elsewhere. This is because, they do not have access to the media and therefore they
have remained unemployed.
15. Poor attitudes towards work and laziness.
16. Physical and mental incapacitation. (Residue unemployment).
17. Unfair trade union activities which tend to limit the entry of new workers in a bid to
attain higher wages.
18. The slow growth rate of LDC economies: The rate of growth of these economies is for
lower than the increase in the labour force especially among the commercial and industrial
sectors. These sectors cannot adequately absorb the surplus labour force.

Measures to solve unemployment in LDCs

1. Educational reforms: There is need to change the education system in such way that it
equips learners with relevant skills which would make unemployment job makers.
2. Population control policies: Need to control the size of the population in a country by
reducing the birth rate and regulating migrations. This will then leave an optimum size of
the labour force in the country.
3. Diversification of the economy: The government should promote industrialization and
development of other sectors in the economy. This can be achieved by removing bottle
necks such as inadequate power supply, poor roads etc. All of which make industries to
operate at full capacity.
4. Manpower planning: There is need to forecast the manpower requirements in the country
so as to have a balance between the goods and services of manpower.
5. Use of appropriate technology: The most appropriate techniques of production in LDCs
are labour intensive and intermediate technology. These can absorb most of surplus labour
available in these countries.
6. Land reform policies: There is need to change the system of land ownership in such a
way that land is redistributed from the few landlords to the majority who are landless. This

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will increase employment opportunities in the agriculture sector e.g. in Uganda people have
got access to land through the land act.
7. Rural development: There is need to develop the rural areas so as to make them better
areas or places to live in. This will in turn reduce on the number of rural urban migrates.
This can be achieved by using measures like rural electrification, delocalization of
industries.
9. Increase in aggregate Demand: When there is demand difference in the economy such
as during a recession government can stimulate effective demand so as to increase
investments and employment opportunities. This can be done by adopting expansionary
monetary policies fiscal policies.
10. Advertising of existing jobs: This can be done through the mass media. 10. Maintaining
political stability.
11. Training of workers: Governments in LDCs should encourage or make it possible for
workers to train on the jobs or to go for retraining courses. This will minimize the structural
unemployment.
12. Improvement in the infrastructure: The infrastructure in LDCs should be improved
upon so that workers can easily move from one place to another where the jobs exist.
13. Attraction of foreign investors: The governments in LDCs should encourage foreign
investors to set up investments in these countries. These investments will provide jobs to
the unemployment. This can be done through policies like privatization, liberalization,
giving tax holidays.
14. Expansion of the market: The governments in LDCs should find measures of expanding
the market so as to increase on the employment levels. This can be done through economic
integration.
15. The go back to land policy: The governments should encourage people to go back to
the rural areas and also encourage rural – rural migrations people should migrate from one
rural are to another rural area.

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Disadvantages or consequences of unemployment
1. It has led to poverty in the country.
2. It has led to high dependence burden.
3. It has led to Rural Urban Migration and all its associated problems like congestion,
shortage of accommodation, prostitution, etc.
4. Has led to income inequality.
5. It has led to an increase in the crime rate i.e., the unemployed in LDCs seek illegal ways
and means of survival, through stealing.
6. It makes the government unpopular.
7. It has led to low tax revenue.
8. It has led to poor standards of living i.e., poor feeding, housing, clothing, medical care,
low education, etc.
9. It leads to wastage of a country’s productive resources such as land and labour as these
remain unexploited.
10. It is the origin of political instability.
11. It has led to labour force cannot exploit the potentialities of the country leading to low
levels of output and growth of the country’s G.D.P.

The Keynesian theory of Unemployment

This theory explains the major causes of cyclic or demand deficient or Keynesian
unemployment. According to Keynes, this type of unemployment is caused by deficiency
in aggregate demand for goods and services in the economy. Keynes explained that the
recessions and depressions experienced by an economy bring about a stagnation in the level
of economic activities which lead to a fall in investments. Consequently, a fall in the level
of employment. Therefore, since the demand for labour is derived, once aggregate demand
reduces, producers will find themselves with unsold goods. They will thus be forced to
reduce the level of investment and lay off some workers. Such workers are said to be
experiencing the Keynesian unemployment. Keynes suggested some solutions to this type
of unemployment. He argued that it can be solved by raising the level of aggregate demand.

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Review Question
a) Explain the Keynesian theory of unemployment.
b) To what extent is this theory of unemployment applicable to your country?
c) Explain how the level of aggregate demand can be increased in an economy.

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References:

M. L. Jhingan, (2010) Macro Economic Theory 12 Edition

Abel Andrew, B. and Bernanke Ben, S. (2006), Macroeconomics 4th Edition, Pearson
Education, New Delhi

Case, Karl E. (2014). Principles of Economics, 9th Edition, India, Pearson.

Durnbusch Rudiger, Fischer Stanely and Startz Richard (2002), Macroeconomics, Tata
MacGraw-Hill Publishing House New Delhi

Mankiw, N. Gregory. (2014). Principles of Economics, 6th Edition, Cengage Learning,

New Delhi.

Somashekar Ne. Thi (2005), Modern Macro Economic Theory, Anmol Publications PVT
Ltd, New Delhi

Vaish, M.C. (2006), Macroeconomic Theory, Vikas Publishing House PVT Ltd, New
Delhi

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