FACULTY OF BUSINESS &

MANAGEMENT SCIENCES
2022

ECONOMICS 512

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 FACULTY OF COMMERCE
ECONOMICS 512

STUDY GUIDE

MODULE: ECONOMICS 512 (2 nd SEMESTER)

1ST Year

Copyright © 2022
Richfield Graduate Institute of Technology (Pty) Ltd
Registration Number: 2000/000757/07
All rights reserved; no part of this publication may be reproduced in any form or by any
means, including photocopying machines, without the written permission of the Institution.

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 TABLE OF CONTENTS
TOPICS
Section A: Preface

1. Welcome 7

8
2. Title of Modules
8
3. Purpose of Module
8
4. Learning Outcomes
9
5. Method of Study
9
6. Lectures and Tutorials
9
7. Notices
10
8. Prescribed & Recommended Material
10
9. Assessment & Key Concepts in Assignments and Examinations
10
10. Specimen Assignment Cover Sheet
13
11. Work Readiness Programme
13
12. Work Integrated Learning
SECTION C: ECONOMICS 512 (2ND SEMESTER)

TOPIC 1. THE MONETARY SECTOR

1.1 Introduction 15

1.2 Definition of money 15

1.3 Functions of money 15

1.4 Money in South Africa 16

1.5 Financial intermediaries 17

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 1.6 South African reserve bank (SARB) 18

1.7. Supply of money 19

1.8 Demands for money 21

1.9 Equilibrium in the money market 23

1.10 The instruments of money policy 24

Review Questions

TOPIC 2. PUBLIC SECTOR

2.1 Introduction 28

2.2 Public sector in South Africa 28

2.3 Interaction with private sector (households & firms) 28

2.4 Macroeconomic growth and instability 30

2.5 Government failure 32

2.6 Nationalisation and privatisation 32

2.7 Financing of government spending 33

2.8 Taxation 33

2.9 Fiscal policy and the budget 35

Review Questions

TOPIC 3. THE FOREIGN SECTOR

3.1 Introduction
40

3.2 Why countries trade 40

3.3 Trade policy 42

3.4 Balance of payments 44

46
3.5 Exchange rate
49
3.6 The balance of payments, economic activity and

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Review Questions
TOPIC 4 INCOME DETERMINATION IN A CLOSED ECONOMY WITH
GOVERNMENT SECTOR

4.1 Introduction 53

4.2 Production, income and spending 53

54
4.3 Basic assumption of Keynesian macroeconomics
4.4 Consumption spending 54

56
4.5 Savings
56
4.6 Investment decision
4.7 Simple Keynesian model of a closed economy without a government 57

58
4.8 Algebraic version of Keynesian model
4.9 A change in investment spending: the multiplier 59

59
4.9.1 Process of initial increase in investment

Review Questions

TOPIC 5 KEYNESIAN MODEL OF AN OPEN ECONOMY WITH GOVERNMENT

SECTOR
62
5.1 Introductions
62
5.2 Introducing the government into the model
5.3 Government spending and taxation 63

5.4 Equilibrium level of income in an economy with a government sector 64

66
5.5 Fiscal policy
67
5.6 Introducing the foreign sector into the model: the open economy
5.7 Fiscal policy in an open economy: 69

Review Questions

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TOPIC 6. MACROECONOMIC THEORY AND POLICY

6.1 Introduction 72
6.2 Aggregate demand and aggregate supply Approach 72

6.3 Shifts in aggregate demand 75

6.4 Changes in as curve 76

6.5 Monetary transmission mechanism: 76

6.6 Monetarism 79

6.7 Combining monetary and fiscal policy: 79

6.8 Supply-side economics 79

6.9 Policy dilemma in an economy 80

Review Questions

TOPIC 7. INFLATION

7.1Inflation 84

7.2 Measuring inflation: CPI 84

7.3 Effects of inflation 85

7.4 Causes of inflation – demand pull & cost push Inflation 86

7.5 Drawbacks of inflation 88

Review Questions

TOPIC 8. UNEMPLOYMENT

8.1 Introduction 92

8.2 Unemployment 92

8.3 Cost of unemployment 92

8.4 Types of unemployment 93

8.5 Policies to reduce unemployment 93

8.6 Unemployment & inflation: The Phillip curve 94

8.7 Incomes policy 94

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REVIEW QUESTIONS

TOPIC 9. ECONOMIC GROWTH AND DEVELOPMENT

9.1 Introduction 97

9.2 Definitions and measurement of economic growth 97

9.3 Problems associated with GDP as a measure of Growth 98

9.4 Calculating economics growth 98

9.5 Business cycle 98

9.6 Sources of economic growth 99

9.7 Demand factors 99

REVIEW QUESTIONS

TOPIC 10. SOUTH AFRICAN ECONOMIC GRWOTH SINCE WORLD WAR II

10.1 Introduction 102

10.2 Factors, which contributed to a decline in economic growth: 103

10.3 Import substitution: 103

10.4 Foreign capital 103

10.5. Wages 104

10.6 Economic development 104

10.7 Stimulated interest in economic development 104

10.8 Problems in developing countries 104

10.9Theories of economic development 104

REVIEW QUESTIONS

TOPIC 11: ADDENDUM 512: CASE STUDY FOR TUTORIAL DISCUSSION 106

TOPIC 12: ADDENDUM 512: TYPICAL EXAMINATION QUESTIONS

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 SECTION A: PREFACE

1. WELCOME

Welcome to the Faculty of Business and Management Sciences at Richfield Graduate Institute of
Technology. We trust you will find the contents and learning outcomes of this module both interesting
and insightful as you begin your academic journey and eventually your career in the business world.

This section of the study guide is intended to orientate you to the module before the commencement
of formal lectures.

Please note that this study guide covers the content of various academic programmes at different
levels of the NQF and HEQF. Your lecturers will provide further guidance and additional study materials
covering parts of the syllabi that may have been omitted from this study guide. This will however not
be directly examinable.

The following lectures will focus on the common study units described:

SECTION A: WELCOME & ORIENTATION

Study unit 1: Orientation Programme Lecture 1

Introducing academic staff to the learners by academic head.

Introduction of institution policies.

Study unit 2: Orientation of Learners to Library and Students Facilities Lecture 2

Introducing learners to physical structures

Study unit 3: Discussion on the Objectives and Outcomes of Economic 512 Lecture 3

Study unit 4: Orientation and guidelines to completing Lecture 4

Assignments

Review and Recap of Study units 1-3

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2. TITLE OF MODULES, COURSE, CODE, NQF LEVEL, CREDITS & MODE OF DELIVERY

2nd Semester

Title Of Module: Economics 512

Code: ECO-512

NQF Level: 5

Credits: 10

Mode of Delivery: Contact and Distance

3. PURPOSE OF MODULE

3.1 Economics 512

The purpose of this module is twofold, firstly, to introduce learners to the main issues, concepts and
tools of economics and secondly to introduce learners to microeconomic concepts and analysis. The
introductory part deals with the definition of economics, what economics is about, why it is a science
and thereafter, basic concepts such as the economic problem, economic systems, and major features
of the South African economy and tools of economic analysis are explained. The rest of the module
introduces concepts of microeconomic units in the economy and microeconomic analysis including
demand for and supply of goods and services, output and pricing decisions by a representative firm,
elasticity of demand and supply, consumer behaviour, production and costs, Market Structures with
emphasis on Perfect Competition and introduction to imperfect competition, i.e., Monopoly,
Monopolistic Competition and Oligopoly.

3.2 Economics 512 (2nd Semester)

Economics 512 introduces macroeconomic concepts to the learner. These include the monetary
sector, public sector, aggregate determination. The learner is taught the disequilibrium of inflation
and unemployment. Finally, the concept of economic growth and the aspects of the South Africa
economic after World War 2 are introduced to give a perspective on the economic growth

4. LEARNING OUTCOMES

On completion of these modules the student will be able to:

• Define and explain the economic problem and the different economic systems Understand why
economics is a science
• Recognise the major flows in the economy and measuring the performance in the economy
• Understand the main features of the South African Economy
• Understand the use of tools of economic analysis including use of graphs
• Understand the concepts of supply and demand and analyse their interaction to show how prices
and quantities are determined
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• Understand and explain elasticity of demand and supply
• Analyse consumer choice and decision making
• Understand and explain concepts of production and cost
• Understand and analyse Perfect Competition as a market structure

5. METHOD OF STUDY

The sections that have to be studied are indicated under each topic. These form the basis for tests,
assignments and examination. To be able to do the activities and assignments for this module, and to
achieve the learning outcomes and ultimately to be successful in the tests and examination, you will
need an in-depth understanding of the content of these sections in the learning guide and prescribed
book.

In order to master the learning material, you must accept responsibility for your own studies. Learning
is not the same as memorising. You are expected to show that you understand and are able to apply
the information. Use will also be made of lectures, tutorials, case studies and group discussions to
present this module.

6. LECTURES AND TUTORIALS

Learners must refer to the notice boards on their respective campuses for details of the lecture and
tutorial time tables. The lecturer assigned to the module will also inform you of the number of lecture
periods and tutorials allocated to a particular module. Prior preparation is required for each lecture
and tutorial. Learners are encouraged to actively participate in lectures and tutorials in order to ensure
success in tests, assignments and examinations.

Notices

All information pertaining to this module such as tests dates, lecture and tutorial time tables,
assignments, examinations etc will be displayed on the notice board located on your campus. Learners
must check the notice board on a daily basis. Should you require any clarity, please consult you r
lecturer, or programme manager, or administrator on your respective campus.

7. PRESCRIBED & RECOMMENDED MATERIAL

7.1 Prescribed Material: Bachelor of Business Administration

Mohr P. Fourie L and Associates (2014): Economics for South African Students. 5th ed.
Pietermaritzburg. Van Schaik.

The purchasing of prescribed books is for the students own account and are compulsory for all
Students. This learner guide will have limited value if studied in conjunction with the prescribed text
book.

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8. RECOMMENDED MATERIAL, RESEARCH & LIBRARY

RESOURCES

8.1 Recommended Material

• Glahe F R & Lee, D R: (2011 Microeconomics: Theory and Applications. Harcourt Brace Jovanovich,
College Publishers, New York.

• Mostert, J W, Oosthuizen, A G, Smit, P C, van der Vyver T C: (2012) Micro-economics. Juta & Co.
Capetown

• Pindyck, R S, Rubinfield, D C: (2012 Microeconomics Study Guide (5th Ed) Prentice Hall, Englewood
Cliffs.

• Viljoen, R P, le Roux, J F, Marais, M M & van Eeghen, P H: (2012) Microeconomics. UNISA, Pretoria.

Web Sites:

S.A.R.B web site www.sarb.co.za

Economics weekly from Standard bank (www.standardbank.co.za)

NB: Students please note that there will be a limited number of copies of the recommended texts
and reference material that will be made available at your campus library. Students are advised to
make copies or take notes of the relevant information, as the content matter is examinable.

8.2 Independent Research:

The student is encouraged to undertake independent research

8.3 Library Infrastructure

The following services are available to you:

8.3.1 Each campus keeps a limited quantity of the recommended reading titles and a larger variety of
similar titles which you may borrow. Please note that Students are required to purchase the
prescribed materials.
8.3.2 Arrangements have been made with municipal, state and other libraries to stock our
recommended reading and similar titles. You may use these on their premises or borrow them
if available. It is your responsibility to safe keep all library books.
8.3.3 PCT&BC has also allocated one library period per week as to assist you with your formal research
under professional supervision.
8.3.4 The computers laboratories, when not in use for academic purposes, may also be used for
research purposes. Booking is essential for all electronic library usage.

9. ASSESSMENT
Final Assessment for this module will comprise two Continuous Assessment tests, an assignment and
an examination. Your lecturer will inform you of the dates, times and the venues for each of these.
You may also refer to the notice board on your campus or the Academic Calendar which is displayed
in all lecture rooms.

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9.1 Continuous Assessment Tests

There are two compulsory tests for each module (in each semester).

9.2 Assignment

There is one compulsory assignment for each module in each semester. Your lecturer will inform you
of the Assessment questions at the commencement of this module.

9.3 Examination
There is one two-hour examination for each module. Make sure that you diarize the correct date, time
and venue. The examinations department will notify you of your results once all administrative matters
are cleared and fees are paid up.

The examination may consist of multiple-choice questions, short questions and essay type questions.
This requires you to be thoroughly prepared as all the content matter of lectures, tutorials, all
references to the prescribed text and any other additional documentation/reference materials is
examinable in both your tests and the examinations.

The examination department will make available to you the details of the examination (date, time and
venue) in due course. You must be seated in the examination room 15 minutes before the
commencement of the examination. If you arrive late, you will not be allowed any extra time. Your
learner registration card must be in your possession at all times.

9.4 Final Assessment

The final assessment for this module will be weighted as follows:

Continuous Assessment Test 1 15%

Continuous Assessment Test 2 15%

Assignment 1 10%

40%

Examination 60%

Total 100%

9.5 Key Concepts in Assignments and Examinations

In assignment and examination questions you will notice certain key concepts (i.e. words/verbs) which
tell you what is expected of you. For example, you may be asked in a question to list, describe,
illustrate, demonstrate, compare, construct, relate, criticize, recommend or design particular
information / aspects / factors /situations. To help you to know exactly what these key concepts or
verbs mean so that you will know exactly what is expected of you, we present the following taxonomy
by Bloom, explaining the concepts and stating the level of cognitive thinking that theses refer to.

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Competence Skills Demonstrated
Knowledge observation and recall of information
knowledge of dates, events, places
knowledge of major ideas mastery of
subject matter

Question Cues
list, define, tell, describe, identify, show, label, collect, examine, tabulate,
quote, name, who, when, where, etc.

Comprehension understanding information grasp meaning

translate knowledge into new context
interpret facts, compare, contrast order,
group, infer causes predict consequences

Question Cues
summarize, describe, interpret, contrast, predict, associate, distinguish,
estimate, differentiate, discuss, extend

Application use information use methods, concepts, theories in

new situations solve problems using required skills or
knowledge

Questions Cues
apply, demonstrate, calculate, complete, illustrate, show, solve, examine,
modify, relate, change, classify, experiment, discover

Analysis seeing patterns organisation of parts

recognition of hidden meanings

identification of components

Question Cues
analyse, separate, order, explain, connect, classify, arrange, divide,
compare, select, explain, infer

Synthesis use old ideas to create new ones

generalize from given facts relate
knowledge from several areas predict,
draw conclusions

Question Cues
combine, integrate, modify, rearrange, substitute, plan, create, design,
invent, what if?, compose, formulate, prepare, generalize, rewrite

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 Evaluation compare and discriminate between ideas assess
value of theories, presentations make choices
based on reasoned argument verify value of
evidence recognize subjectivity

Question Cues
assess, decide, rank, grade, test, measure, recommend, convince, select,
judge, explain, discriminate, support, conclude, compare, summarize

10.WORK READINESS PROGRAMME (WRP)

In order to prepare Students for the world of work, a series of interventions over and above the formal
curriculum, are concurrently implemented to prepare Students.

These include:
• Soft skills
• Employment skills
• Life skills
• End –User Computing (if not included in your curriculum)

The illustration below outlines some of the key concepts for Work Readiness that will be included in
your timetable.

SOFT SKILLS LIFE SKILLS

Ti me Ma nagement Ma na ge Personal Finance
Worki ngi n Teams Dri vi ng Ski lls
Probl em Solving Skills Ba s ic Life Support & Fi rst Ai d
Attitude& Goa l Setting Entrepreneurial skills
Eti quettes & Ethi cs Couns elling s kills

WORK
READINESS
PROGRAMME

EMPLOYMENT SKILLS
CV Wri ti ng
Intervi ew Skills
Pres entation Skills
Empl oyer / Employee Relationship
End Us er Computing
➢ Ema i l & E-Commerce
➢ Sprea d Sheets
➢ Da ta base
➢ Pres entation
➢ Offi ce Word

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 It is in your interest to attend these workshops, complete the Work Readiness Log Book and prepare
for the Working World.

11. WORK INTEGRATED LEARNING (WIL)

Work Integrated Learning forms a core component of the curriculum for the completion of this
programme. All modules which form part of this qualification will be assessed in an integrated
manner towards the end of the programme or after completion of all other modules.

Prerequisites for placement with employers will include:

• Completion of all tests & assignment
• Success in examination
• Payment of all arrear fees
• Return of library books, etc.
• Completion of the Work Readiness Programme.

Students will be fully inducted on the Work Integrated Learning Module, the Workbooks & assessment
requirements before placement with employers.

The partners in Work Readiness Programme (WRP) include:

Good luck with your studies…

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 TOPIC 1

1. THE MONETARY SECTOR

LEARNING OUTCOMES

After studying this topic, you should be able to:

• Define the concept Money and demonstrate an understanding of

the functions and use of money
• Describe the main functions of the South African Reserve Bank
• Explain the supply of money and demand of money
• Describe the major instruments of monetary policy and demonstrate
how they work

1.1 INTRODUCTION

Money is the most important component in the economy. It is said to talk, make a woman or man and
make the world go round. Through time money has taken different forms, e xample cattle, seashells,
commodity, pieces of metal and gold. Modern societies have a sophisticated system of paper money
(bank notes) and coins issued by the central bank of the country. Now cheque (demand) deposits are
also part of readily acceptable means of payments or money.

Money is the driving force for all economic activities.

1.2 DEFINITION OF MONEY

The definition of money was derived from its functions. Money is anything that is generally accepted
as payment for goods and services or that is accepted as a settlement for debt.

1.3 FUNCTIONS OF MONEY

Money as a medium of exchange

Long before money was invented there was BARTER economies whereby people used to exchange
goods for goods. This means for barter trade to take place there was need for double coincidence of
wants between two parties, this means for example if a farmer who produce wheat needs mealie-
meal he will have to look for a miller who in turn will also like wheat to exchange his mealie- meal with
the wheat. Batter trade was characterised by numerous unnecessary transactions which were
cumbersome and inefficient.

The inefficiency of barter trade led to the use of money which does not depend on double coincidence
of wants. Monetary economies do not rely on the coincidence of wants therefore serves as a lubricant
or intermediary to smooth the exchange of goods and servi ces hence its efficiency as a medium of
exchange. This is the basic function of money (medium of exchange) and the definition of money was
derived from this function.

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Money as a unit of account

A unit of account is an agreed measure for allocating prizes of goods and services. All goods and
services are expressed in monetary terms. Money thus functions as unit of account. Since money is a
common measure for costs all goods and services it best helps us to decide on how best to spend our
incomes since both prize and income are expressed in monetary terms. For example, if we know that
chicken costs 30 rand a kilo and beef 70 rand a kilo, then we can easily calculate the opportunity cost
of beef in terms of the kilos of chicken we can get if we sacrifice be ef.

Also, the use of money as a unit of account helps us to calculate the total value of all goods and services
produced in the country (GDP). The function of money as a unit of account is closely related to its
function as a medium of exchange because what serves as a medium of exchange fulfils the function
of accounting unit.

However, money can lose its usefulness as a unit of account in times of inflation since monetary values
are adjusted for prize increases.

Money as a store of value

In any society we need to store wealthy (surplus production) in some form and money is the common
form to hold wealth since it can be used for exchange of goods at a later stage.

Wealth can also be stored or held in other forms like property, shares, stocks, assets etc but storing
wealth in the form of money has an advantage of being convenient and can be easily exchanged with
other assets hence it is more liquid than other stores of value.

But money also has disadvantages as a store of wealth because during inflation the purchasing power
of money is lost. During inflation money can’t retain wealth but other forms can retain it such as
shares, fixed property etc.

Money is a standard of deferred payment.

Prior to the invention of money all exchanges took place with the exchange of goods on the spot. The
use of money as a store of value makes it possible to defer payment. Goods can be obtained and their
value fixed in monetary terms with arrangements to pay later using money. Thus money became to
be a standard of deferred payment. This arises out of the store of value function and unit of account
functions of money. This function of money leads to creation of debts and granting of credit. It has led
to the development of dealing in debt and the capital market.

1.4 MONEY IN SOUTH AFRICA

Money should not to be confused with income and wealth. Income is the reward earned as a factor of
production in the production process whereas wealth consists of assets which have been accumulated
over time for example property and shares though it can take the form of money. Money is used to
measure both. In South Africa the South African Reserve Bank (SARB) is the monetary authority with
the sole right to issue and control the quantity of money in circulation. There are 3 concepts of money
supply depending on the degree of liquidity. Liquidity is the easy with which the asset is accepted as a
medium of exchange or means of payment. The three concepts are:

M1: Conventional Measure of money as liquidity (instant purchasing power) Consists of:

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• Notes and coins in circulation outside the monetary sector constitute money supply that is only
cash in hand to the public can be used as a means of payment. Cash at bank cannot be directly used
as a form of payment (it must be withdrawn and then used as payment) The monetary sector in
south Africa includes-SARB, COOPERATION FOR PUBLIC DEPOSITS, POST BANK, PRIVATE BANKING
INSTITUTIONS AND BUILDING SOCIETIES.
• Secondly demand deposits refer to deposits that can be withdrawn immediately by means of
cheque. It is a term used to describe money against which cheques can be written out. The value
of these deposits form part of the quantity of money since they can be immediately withdrawn and
used as payment M = C+ D

M = quantity of money

C = Cash (notes and coins) in the circulation outside the monetary sector

D = Demand deposits

NOTE – Demand deposits constitute the largest component of M1 (IT)

M2: Broader Definition of Money

M2 consists of M1 (coins, banknotes and demand deposits) plus:

All short-term and medium-term deposits which are not immediately available as a medium of
exchange but can be converted into a means of payment without loss of value. These deposits (e.g.
savings accounts) can be converted into M1 at very short notice and is known as near money (or quasi
money)

Thus, M2 can be defined as high powered money (M1) plus quasi (near) money or short-term deposits.

M3: Comprehensive measure of money supply

M3 consists of all of M2 plus long-term deposits of the domestic private sector with monetary
institutions. Maturity on long-term deposit is longer than 6 months. They can be converted into high-
powered money with substantial loss of value. It is less liquid than M2.

Note: Time Deposits, i.e., the short-, medium- and long-term deposits, can be converted into high-
powered money (cash) or liquidity (M1) with some loss of value (or commission that the bank will
charge for the service) for the conversion.

1.5 FINANCIAL INTERMEDIARIES

The invention of money gave birth to a group of financial intermediaries specialised in financial
transactions. Transactions can be divided into real and financial sector activities. These transactions
are different from real transactions because no goods or real financial services are involved. In the
financial sector there is a lot of transactions taking place involving different institutions specialising in
particular services for example banks, insurance companies, stock brok ers, etc. though these
institutions specialize in particular transactions they have one main function (they are intermediaries
between the surplus units and deficit units in the monetary economy). At any point in time they are
units for example households who want to save their incomes (surplus units) and other units for
example entrepreneurs wishing to start their businesses who are in search of funds (deficit units).

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These institutions specialise in acceptance of deposits and granting of credit. Credit is granted when a
person or institution lends money to another in exchange of securities or credit instrument. The
security or credit instrument stipulates the interest rate (cost of borrowing) and the payment plan.
Examples of securities are bills of exchange, promissory notes, Treasury bills and bankers acceptances.
When government is borrowing money it uses treasury bills and government stock or bonds as
securities.

1.6 SOUTH AFRICAN RESERVE BANK (SARB)

The South African Reserve Bank is the most important financial institution in in South Africa. It has the
legal sole right to issue money (money supply) and to protect the value of the currency in interest of
balanced and sustainable economic growth. In pursuit of its primary objective it performs its functions
independently but with regular consultations with the cabinet minister responsible for national
finance matters.

1.6.1 Functions of the South African Reserve Bank

• Issuing of bank notes and coins.
• Acting as a banker for other banks.
• Acting as a banker for the government.
• Acting as a custodian of the country’s gold and other foreign reserves.
• Formulating and implementation of the monetary policy

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The bank’s other functions are fulfilled and determined mainly by the goals of the monetary policy.

• Issuing of bank notes and coins

According to the Banks Act the SARB has the sole right to issue bank notes and coins. These coins and
bank notes make up about 25% of the country’s money supply. The rest is made up of demand (cheque
account) deposits. The cash comes into circulation when the SARB makes a purchase. The control of
the money supply allows the SARB to control inflation and support other economic initiatives.

• Acting as a banker for other banks.

The SARB’ keeps minimal amount as its reserves to meet any emergencies that arise. This reserve
serves as a monetary base to create demand deposits

The Bank’s accommodation policy also referred to as the refinancing system commonly known as repo
rate tender system is the main instrument through which monetary policy is conducted.

Through the refinancing system the Bank provides the daily liquidity needs of private banks. To ensure
that that the refinancing system has influence on the interest rates the Ce ntral bank has to compel
the private banks to borrow a sustainable amount (liquidity requirements) from SARB.

Instruments like cash reserve requirements and open market transactions are used to drain the excess
liquidity from the money market to ensure a liquidity shortage at all times. In this way the SARB acts
as the banker for other banks. This function allows the SARB to control the supply of money through
the money market.

• Acting as a banker for the government and advisor

Until the early 1990s the SARB handled all receipts and payments made by the government. The
central bank is the main banker of the government though the government have tax and loan accounts
with the private banks

SARB grants credit, deals with the weekly issues of the treasury bills on behalf of treasury department
in the government. It also advice the government on monetary and financial matters and responsible
for responsible for administration of exchange control regulations.

• Acting as custodians of the country’s gold and other foreign reserves The SARB keeps all the gold
and foreign exchange reserves for the country with the exception of essential balances held by
banks and the Treasury. Gold coins and gold bullion held are added to reserves at a market related
value. The level of the gold and foreign reserves held by the SARB indicates the status of the
country’s economy and prospects for future economic growth. It is also responsible for the
formulation of foreign exchange rate policy.

• Formulating & implementing monetary policy

THE SARB is responsible for formulating and implementing the country’s monetary policies. The goals
of monetary policy at any one time determine how the other functions are fulfilled.

1.7 SUPPLY OF MONEY

The quantity of money in circulation at any point in time is not the same as supply of money. The
quantity of money is the stock of money at a point in time. It can be only measured at a particular
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point in time. The supply of money is a flow concept, which is measured over a period of time.
However, at any point in time the supply of money is fixed although it varies over time. The supply is
determined by the SARB taking the state of the economy into account.

1.7.1 Creation of Demand Deposits

This creation of these demand deposits is by granting loans by way of over drafts to clients. Demand
deposits may be created if:

• The person has a good reputation and has reasonable amount of money deposited in other
accounts in the bank.
• The bank can be convinced of a person’s credit worthiness even if he/she does not have any other
deposit in the bank.

Withdrawals from demand deposits can be made by issuing cheques made out in the name of the
account. Today electronic (or internet) banking allows payment from demand deposits (current or
cheque accounts) using the Internet.

1.7.2 Reserve Cash Position

The business of banking involves the taking of deposits on behalf of holders of current (or cheque)
account, savings accounts and time deposits. Each bank must ensure that it has sufficient cash reserves
available for daily transactions including cash withdrawals. The bank, which forms part of a larger
banking system, must provide for any claims by the other banks, arising from clients issuing cheques,
which may exceed its own claims.

The Reserve Bank, as the regulatory authority, requires a percentage of the total deposits received by
a bank to be set-aside in the form of cash reserves. This is required to conduct daily business and
maintain the confidence of creditors. The rest of the deposit can be given out to clients in the form of
loans. For example, if the reserve ratio is 25%, then the bank keeps R25 from every R100 deposited as
reserve and can lend the remaining R75 of every R100 deposited to clients as loans.

1.7.3 The Credit Multiplier:

An increase in the demand deposits of a bank will increase the cash reserves of the bank. The cash
reserve (R) depends on the ratio (b) of the additional deposit (AD). The textbook indicates a reserve
ratio of 2.5% of total liabilities. If the bank’s demand deposits increased then 2.5% of that new deposit
should be kept as reserve. Thus additional reserves (AR) would be

AR = b (AD)

Thus AR = b (AD)

= 0.025% of R2000

= R50, 00

Of the newly deposit the bank will have R1950 left to give out as a loan.

So new loan granted through overdraft (Demand Deposit) will be R1950

20
The borrower will put this into his bank account. He deposits the R1950 into his account. The process
will repeat: New deposits are created.

Each time: AR = b (AD)

OR AD = ( 1 /b) (AR)

Where (1/b) is called the credit multiplier. It tells that every time the reserves increase by AR a new
deposit (AD) to the value of ( 1/b) times the AR is created by giving out new loans.

1.8 DEMANDS FOR MONEY

The demand for money arises from the amount that various participants in the economy plan to hold
in the form of money (cash) balances. The opportunity cost of holding any money (cash) balances is
that the income that could have been earned had the money been used to purchase bonds or given
out as a loan. This opportunity cost is measured in the form of interest foregone. Money will only be
held if it provides a service that is valued as highly as the opportunity cost of holding it.

1.8.1 Two Basic Components of the Demand for Money

Transaction demand: which arises from the medium of exchange function, i.e.
to exchange money for goods and services?

Demand for money as an asset: which arises from the store of value function?

1.8.2 The Liquidity Preference Demand for Money

Transactions Motive: Money required for daily transactions, e.g., purchasing goods.

Precautionary Motive: Money required taking care of unpredictable expenditures or emergencies.

Such expenditures may arise out of a medical emergency.

Speculative Motive: This is related to the function of money as a store of value. Speculative demand
is basically compares holding wealth in the form of money or bonds. It depends on the interest rate.
Speculative demand for money is high at low rates of interest and vice versa.

Both the transactions and precautionary demand for money once determined becomes fixed for a
given level of income. Speculative demand, however, fluctuates with changes in the rate of interest.

The diagrams below illustrate the demand for money.

21
Figure 1.1 Demand Curve Using Active and Passive Balances:

Discussion of the Graph

L1 is active balance (transaction and precautionary demand). It is fixed. Hence a vertical line.

L2 is passive balance (speculative demand). It varies with the rate of interest. Hence negatively sloped
line.

The demand for money is LL (the sum of active and passive balances). Shifts in the total demand for
money (LL) may occur as a result of an increase or decrease in income level.

1.8.3 Demand for Money (Liquidity Preference)

The liquidity preference demand for money is:

L = f (Y, I) where

L = quantity of money demanded

Y = national income

I = interest rate

22
1.8.4 Interest Rate
Interest rate should be regarded as a representative rate for different individual rates encountered in
practice. Interest rate refers to the price of acceptance of credit. This average rate may be obtained:
from the following:

• Bank rate
• Primary lending rate
• Bankers’ acceptance
• Rate of government stock

1.9 EQUILIBRIUM IN THE MONEY MARKET:

Equilibrium is the interaction between the demand for money and the supply of money.

Figure 1.2 Money Market Equilibrium

Interest Rate

I M1 M2
i1 E1

i2

L
0 M1 M2 L, M

Quantity of Money

23
1.9.1 Discussion of Diagram

In the figure, the equilibrium in the money market is established at the point of intersection (E1) of
demand LL and supply M1 M1. Higher interest will result in excess supply of money. Lower interest rates
will result in excess demand for money. An increase in supply of money M 2M2 leads to as drop in the
equilibrium interest rate for i 1 to i 2

1.10 THE INSTRUMENTS OF MONEY POLICY

Generally economic policy consists of monetary policy and fiscal policy. Fiscal policy is determined by
the government and monetary policy by the SARB. Monetary policy can be defined as the measures
taken by the monetary authorities to influence the supply of money with a view to achieving stable
prices, full employment and economic growth. Direct or Non–Market Oriented policies: e.g. direct
intervention e.g. credit ceilings and deposit rate control and seeks to guide or encourage financial
institutions to take certain actions on a voluntary basis. Market orie nted policies: operates through the
market and influences interest rates, demand for and supply of money.

ASSESSMENT QUESTIONS

Answers the following Questions:

1. Define money
2. How is it different from income and wealth?
3. Discuss the three basic functions of money
4. What is the difference between a money economy and a barter economy?
5. What is the basic function of a financial institution?
6. Explain any four of the functions of the South African Reserve Bank.
7. Explain how money can be created by granting of credit (in the form of overdraft)
8. What is the opportunity cost of holding money (cash balances)?
9. Discuss the demand for money. Include the three motives for holding money in your answer.
10. Define monetary policy and mention any three instruments of monetary policy.
11. Explain any three market-oriented instruments of monetary policy in South Africa.
12. What are the direct or non-market-oriented instruments of monetary policy?

24
Think Points

1. How would explain to a family member what money is.

2. Is it true that producers could produce more if they had more money?
Explain.

3. What does it mean when we say that the SARB is independent?

4. How would you explain to your friend what M3 as a component of money supply is?

5. Explain to your brother how can expansionary monetary policy be applied.

25
 IMPORTANT CONCEPTS

Medium of exchange Passive balances

Barter economy Interest rate

Unit of account Demand-determined money

Store of value Supply

Commodity money Monetary policy

Credit money Monetary policy framework

Notes and coins in circulation Monetary growth targeting

Demand deposits Inflation targeting

Monetary aggregates Cash reserve requirement

Financial intermediaries Accommodation policy

Securities Open-market policy

Monetary authority Interest rates and bond prices

South African Reserve Bank Bank supervision

Supply of money Liquid asset requirement

Repurchase tender system

Repo rate

Money-creation process

Credit multiplier

26
Classical cash reserve

Bonds

Demand for money

Liquidity preference

Liquidity requirements (shortage)

Transactions demand

Precautionary demand

Precautionary demand

Active balances

27
 TOPIC 2

2. PUBLIC SECTOR

LEARNING OUTCOMES

After studying this topic, you should be able to:

• Explain the reasons for government participation in the economic

affairs.
• Explain why government spending has increased in recent years.
• Explain how government spending is financed
• Describe the major source of tax revenue
• Discuss the criteria for good tax
• Analyze how the burden of an excise tax is
distributed
• Explain what fiscal policy means

2.1 INTRODUCTION

In this section, the discussion is based on the role of the public sector in a mixed economy. Government
spending and the ways in which it can be financed, aspects of taxation and fiscal policy are introduced.
Finally it touches on privatization.

2.2 PUBLIC SECTOR IN SOUTH AFRICA

The structure of the public sector in South Africa is:

• Central Government: concerned with national issues such as defence, our relationship with the
rest of the world and economic and social problems on a national basis.

• Regional (Provincial) Government: covering regional and provincial issues

e.g. Housing, services, and education.
• Local Government: local issues e.g. provisions of sewerage, local roads, and street lighting and
traffic control.
• Public Corporations, Government or State Owned Enterprises (SOEs) e. g. Eskom, Telkom and
Transnet, etc.
•
2.3 INTERACTION WITH PRIVATE SECTOR (HOUSEHOLDS & FIRMS)

In a mixed economy both the government and the private sector participate in the economy. The idea
is to complement each other and not to compete. The government provides goods and services e.g.

28
law and order, health services. Apart from these goods and se rvices, government also makes transfer
payments to households e.g. old age pension fund and to the firms e.g. forms of export incentive
payments/ subsidies.

Households and firms pay taxes to the Government. The government uses its tax revenue to purchase
the inputs required to provide public goods and services. The inputs include labour, which is purchased
from households and goods such stationery, uniforms, building material which is purchased from
firms. The payments by government constitute income for households and firms. We can conclude by
stating there is a continuous flow of goods and money between the public sector (govt.) and the
private sector (households & firms).

2.3.1 What Is Mixed Economy?

A mixed economy is one in which the public sector, private sector and the market play important roles.
Usually the public sector steps in to provide those goods and services that the private sector cannot
produce due to the lack of private incentive (profits). In other words, the government steps in where
the market fails

2.3.2 Market Failures

The market fails when it cannot allocate resources efficiently. There are several reasons for market
failure:

• Monopoly and imperfect competition

• Public goods
• Externalities
• Asymmetric information
• Common property resources

Monopoly and imperfect competition

The analysis of price and output decisions by monopolies and other forms of imperfect competition
indicates that these market forms are allocatively inefficient. The government can attempt to make
this inefficient allocation of resources socially acceptabl e through regulation of monopolies and
through competition policy

Public goods

By nature the public goods have certain characteristics that make it impossible for the private sector.
These are:

• Non-excludability from consumption

Price can exclude individuals from consumption in the private sector. But public goods are made
available to all at the same time and no one can be excluded from consumption, e.g., street lights.

• Non-rivalrous consumption
Individual consumers in the private sector will have to compete for scarce goods with the highest
bidder winning. In the case of a public good the good is made available to all at the same time and
people do not have to compete with one another to see who gets the good, e.g., street lighting.

29
• Non-reject ability in consumption
No consumer has the power to reject a public good. Once the good is provided he/she becomes a
forced rider.

Purely private goods display excludability, rivalrous and reject ability in consumption through the
market mechanism. Public goods do not and hence cannot be produced by private firms. The
government has to ensure their production and distribution. Examples are: education, police services
and army. The charge at museums, parks, and other public facilities are called user charges. They do
not cover the full cost of the public good.

Externalities

These are cost or benefits arising indirectly from a transaction or activity. An example of negative
externalities or external cost is pollution. Where there are negative externalities the government must
regulate the activities of the producers. Positive externalities arise when activities yield benefits for
those indirectly involved, e.g., mosquito spray over a dam benefits those living in the area.

Asymmetric information

For the market to function efficiently there must perfect information. In the modern economy this is
not so someone group knows more than the others and has an unfair advantage. Such asymmetric
information can lead to the market failing to produce and supply the goods e fficiently. The
government can try to remove this asymmetry by providing information, or requiring disclosure of
information to all stakeholders.

Common property resources

Common property resources are those that are non-excludable but rivalrous in consumption.
Examples are resources such as fish in the sea, other wildlife, rivers, and common land. There can be
over exploitation of such resources by some to the disadvantage of others. The government can
introduce regulations to safeguard such properties.

2.3.3 Income Distribution

The market mechanism can generate sufficiently efficient distribution of income. However, this
distribution is not equal. If the distribution through the market is much skewed then the government
needs to step in and redistribute through its fiscal policy and budget mechanism. This can move
towards a socially desirable income distribution. To overcome income inequality the government
makes transfer payments, e.g., old age pension, grants and subsidies to benefit the di sadvantaged.

2.4 MACROECONOMIC GROWTH AND INSTABILITY

It is common for the market systems to experience a phase of rapid economic growth called booms
followed by a period of economic decline called recession. These periods of booms and recessions
make up the business cycle. Excessive fluctuations in the economy are not preferable the government
tries to stabilize the economy by reducing the peaks and troughs.

Macroeconomic monetary policy and fiscal policy form part of the instruments to deal with economic
instability. A major instrument of fiscal policy is the state budget presented annually (in March in South
Africa).

30
2.4.1 Government Intervention:

The next question I: How does the government intervene to resolve the above issues? There are five
options/instruments available:

• Public provision or Public ownership/financing

• Market Participation
• Government Spending
• Taxation
• Regulation

Public provision or Public ownership/financing

The government provides goods and services such as national defence, justice system, and
infrastructure. This can also be done through public ownership or public financing of enterprises.
Issues of nationalization and privatization fall under this topic. What types of enterprises and what
kind of goods should the government provide.

Market Participation

This concerns the government’s role as a participant in the economy.

Government Spending

This is measured by comparing the share of government spending with total spending in the economy.
Government spending is made up of consumption spending and investment spending. Government
spending is largely financed from taxation. Government spending is influenced by changes in consumer
preference, income growth that is accompanied by a proportionally greater growth in the demand for
public goods and service, political and other shocks, redistribution of income: In the developing
countries (the low-income groups.

Are numerous and politically powerful and they use the political process to redistribute income from
the high-income group to lower income groups. Severe political shocks like wars increases in
government spending. Rapid population growth in SA has resulted in large increases in the demand
for public goods and services like education and health services. In South Africa we developed the
RDP, which had a primary focus on social spending to influence government spending. People are
sometimes misled by misconception and entitlement: Some people are of the impression that public
services are free, and some feel entitled to a certain volume or standard of services, irrespective of
whether the services are affordable or not. The question is how the government should react to the
entitlement of people. If the government succumbs to population demands, government spending
may rapidly grow out of control.

Taxation

Taxation is a fourth instrument. It can be used to redistribute income through a progressive structure
that imposes higher rates on higher income earners. Businesses can be stimulated by tax incentives.

31
Regulation

This refers to laws, rules and regulations affecting private sector behaviour. Examples are Labour Laws,
Competitions Policy anti-tobacco law and other such regulatory legislations. They are enforced
through a system of fines and criminal penalties.

2.5 GOVERNMENT FAILURE:

Government failure occurs when politician’s bureaucrats and interest groups put their needs/interests
before those of society. The government fails to provide certain goods and services. Sometimes the
government attempts to resolve this by increasing spending.

2.5.1 Causes of Government Failure:

• Vote maximization by politicians by use of strategies to retain political control. Politicians propose
and support programmes that buy them votes.
• Bureaucratic failures occur because of lack of competition and lack of market incentives.
• Rent seeking by private Interest groups attempt to benefit at the expense of society. Economic
Rent can result from subsidies, tax allowances, profitable contracts, import tariffs and quotas.

2.6 NATIONALIZATION AND PRIVATIZATION:

Nationalization occurs when the government takes over ownership or management of private
enterprises. Privatization occurs when the government decides to transfer ownership of State-Owned
Enterprises (SOEs) to the private sector.

2.6.1 Reasons for privatization:

• SOEs are regarded as bureaucratic and unresponsive to innovative management. Privatization is

expected to solve these problems.
• Privatization will attract foreign investments.
• SOEs do not pay taxes. Privatization will extend the tax base.
• Privatized enterprises have greater access to capital.
• Proceeds from privatization of SOEs make funds available for social upliftment, e.g., housing,
education, and health.
• Privatization will increase private share ownership and promote black economic empowerment.

Arguments against Privatization (i.e. for Nationalization)

• Privatized firms will not necessarily be exposed to competition. Public monopolies will be replaced
by private monopolies.
• SOEs are expected to take into account externalities. Private firms do not.
• Private firms will not a broader view of public interest. Cross subsidies that exist among SOEs will
be eliminated.

32
2.7 FINANCING OF GOVERNMENT SPENDING

This occurs in three ways

• Income from property

• Taxes
• Borrowing
• Income from property: includes interest and dividend income that is derived from government
ownership of enterprises e.g. Telkom.
• Taxation: Taxation is the major source of financing government expenditure. However, it is not
sufficient to finance total government spending.
• Borrowing: The difference between government spending and its current revenue is called a
budget deficit. The government can borrow money in the domestic and international capital
markets or it can borrow from the central bank.

Borrowing from central bank will result in an overdraft facility. This type of financing increases money
supply and is potentially inflationary. Borrowing from the central bank increases the money supply.

2.8 TAXATION

Taxes are compulsory transfer from private businesses and the people to government. It is the largest
source of government revenue. Direct taxes are levied on the income or wealth of individuals (Personal
Income Tax) and organizations such as companies (company tax). Indirect taxes are levied on goods
and services and paid by consumers e.g. VAT and custom duties but collected by the seller on behalf
of the government. VAT is a general tax since it is levied on most goods and services. Specific taxes are
levies on selected goods, e.g. tobacco and alcohol.

2.8.1 Personal Income Tax

Personal income tax is the most important form of direct tax. Personal tax is levied on taxable income
of individuals. Taxable income is the legal tax base and is obtained by deducting personal and other
allowances from an individual’s personal income. Personal income taxes may be structured as:

2.8.2 Progressive Income Taxes: People with high incomes pay a larger percentage of their income as
tax than people with lower incomes.

2.8.3 Proportional: Income tax: Taxpayers pay a fixed proportion of income as tax. The rate for all
taxpayers is the same.

2.8.4 Regressive Income Tax: It is the opposite of a progressive tax. It takes a large percentage of the
income from low-income individuals and groups and lesser amounts from higher income groups. This
is least socially desirable

2.8.5 In South Africa:

• Personal tax is progressive

• Company tax is proportional
• Indirect tax is regressive
33
2.8.6 Modern Criteria for Good Tax
• Neutrality
• Equity
• Administrative efficiency

Neutrality: The market mechanism is functioning effectively and introducing the tax does not alter the
income distribution.

Equity: uses horizontal and vertical equity. Horizontal means people in the same position pay same
taxes. Vertical means people in different positions pay different amounts.

Rich people should therefore pay more tax than poor people

Benefit principal, the recipients of the benefits generated by particular government expenditure
should pay for the goods or services concerned.

• Administrative efficiency: The administration of the tax must be simple.

2.8.7 Tax Incidence: Who Really Pays the Tax?

Tax Incidence: In technical terms we say that the effective influence can be quite different from the
statutory influence. The effective influence or burden of a tax cannot be established by determining
who actually hands over the money to the government.

Burden of Excise Tax

Who pays the tax: for example, an exercise (indirect tax) on cigarettes

Consumers of cigarettes

Profit -makers - owners or shareholders of the cigarette companies.

Employees of the cigarette’s companies

Incidence of an Excise Tax

34
Discussion of Diagram

SS is your supply curve

DD is the demand curve

Normal equilibrium quantity is 150000pkts

After imposition of the tax, the supply curve shifts up to ST

New equilibrium is E1

The difference between E1 and E2 is tax. (R7, 20 –R 5, 20 = R2, 00) Who pays what?

Consumer: R7, 20 – R6, 00 = R1, 20

Producer: R6, 00 – R5, 20 = R0, 80

2.9 FISCAL POLICY AND THE BUDGET

Fiscal policy is the measures adopted by the government to influence the economy. A major
instrument of fiscal policy is the state budget. In implementing the fiscal policy, the government faces
certain lags. They are basic difficulties associated to attempt to stabilize the economy in time.

There are different kinds of lags:

• Recognition Lag: changes in economic activity and the recognition or realization that the changes
have occurred. Economic Data does not become available immedi ately.
• Decision Lag: Minister, Officials from different departments eventually the cabinet has to meet
and discuss matters and to consider various policy options.
• Implementation Lag: Plans need to be drawn up and implemented. This takes time.
• Impact Lag: When the policy measures are introduced a further period elapses before they actually
affect economic behaviour.

35
 ASSESSMENT QUESTIONS

Answer the following questions

• What is the public sector?
• What is a monopoly?
• What is the role of the Government in the economy?
• Define tax rate and average tax Rate?

Define the following.

• Fiscal Policy
• Budget
• Demand Management
• Monetary Policy
• Expansionary fiscal Policy
• Restrictive Monetary Policy

Review Questions

• Mention the three broad ways in which government spending can be financed.
• Give four reasons for the growth in government spending in south Africa in the post-war period
• Explain the difference between direct taxes and indirect taxes and give an example of each.
• Define the budget deficit.
• Explain the difference between progressive and regressive taxes and give an example of each
• Explain the difference between a marginal tax rate and an average tax rate (in respect of personal
income tax).
• Mention the three basic criteria for a good tax.
• Explain the difference between the statutory (or legal)
• Incidence of a tax and the effective incidence
• Use a diagram to explain the incidence of a specific excise tax on a good. Mention the three
parties who have to share the burden of the tax and clearly indicate the impact on each party.
• Define fiscal policy and mention the major instruments of fiscal policy.
• Distinguish clearly between fiscal policy and monetary policy.
• Suppose the government wishes to stimulate economic activity by applying expansionary
monetary and fiscal policy. Mention: Two monetary policy steps and

36
 • Two fiscal policy steps, which can be taken.

Think Points

• Explain to a relative why does market failure occurs.

• Explain the free rider problem in the provision of public goods.
• What are externalities? Indicate beneficial and harmful externalities and their implications.
• Explain how privatization would benefit a public enterprise like Telkom.
• Explain how a progressive tax works in practice.

37
 IMPORTANT CONCEPTS

General government Public debt

Public sector Interest on public debt

Market failure Tax neutrality

Public goods Horizontal equity

Rivalry Vertical equity

Excludability Benefit principle

Mixed goods Tax avoidance

User charge Tax evasion

Externalities Direct taxes

External costs Indirect taxes

38
 Macroeconomic policy Bracket creep

Fiscal policy Capital gains tax

Merit goods Value-added tax

Government spending Tax incidence

Transfer payment statutory incidence

Taxation Effective incidence

Regulation Specific tax

Government failure Ad valorem tax

Rent-seeking Deadweight loss.

Nationalisation Privatisation

Commercialisation Budget

Demand management Expansionary policy

Contractionary policy Lags

External benefits General tax

Asymmetric information Selective tax

Principal-agent problem Progressive tax

Moral hazard Proportional tax

Adverse selection Regressive tax

Common property resources Taxable income

Tragedy of the commons Marginal tax rate

Business cycle Average tax rate

39
 TOPIC 3

3. THE FOREIGN SECTOR

After studying this topic, you should be able to:

• Define and explain why international trade occurs?

• Identify and describe the major elements of the balance of
payments.
• Define and explain how exchange rates are determined in the
foreign exchange market.
• Define the terms of trade
• Analyse and explain the

3.1 INTRODUCTION

The notion of self-sufficiency is popular among politicians. Citizens want to be independent from other
countries. But countries like individuals are economically inter-dependent. Countries gain if every
country specializes in the production of certain goods, exporting the surplus, which is not consumed
domestically, and importing those goods, which are not produced domestically. Trade increases
economic welfare.

3.2 WHY COUNTRIES TRADE

The basic reason for international trade is the distribution of

factors of productions (natural resource, capital labour and entrepreneurship) globally. A country uses
its most abundant factor of production to determine production. The other factors of production are
also important but can be imported. Japan has limited natural resources but it has large supplies of
capital entrepreneurship and skilled labour. Japan therefore produces and exports commodities such as
electronic equipment that require capital skilled labour.

3.2.1 Absolute Advantage:

Suppose Australia and Japan produced wool and digital cameras.

In Australia:

One worker produces 100 kg of wool or 5 digital cameras per week In Japan:

One worker produces 50kg of wool or 10 digital cameras per week from the above we see

that:

• Australia has an absolute advantage in wool production and Japan in digital cameras
40
• So, Australia can specialize in producing wool and Japan in producing digital cameras.
• Complete specialization would lead to:
One Australian worker producing 100 kg wool and One Japanese
worker producing 10 digital cameras.
• Suppose the trade ratio is 10 kg wool for a digital camera then:
• Australia will export 50 kg wool in exchange for 5 cameras.

The above illustrates benefits of trade arising from absolute advantage.

3.2.2 Law of Relative Advantage

This was discovered by David Ricardo (1772-1823). Both countries will benefit from trade if the
opportunity costs of production differ between two countries. The example in the textbook covers
South Africa and Germany.

A worker working for a day in each country is considered.

Germany: 2 cars or 8 barrels of wine

South Africa: 1 car or 6 barrels of wine

Germany produces both goods with fewer resources than South Africa. It has absolute advantage in
both and thus no incentive for trade.

Let us consider the opportunity cost of production

Opportunity cost of producing 1 car

Germany: by producing 2 cars foregoes 8 barrels of wine per day. Assuming constant opportunity
costs, the cost of producing 1 car is 4 barrels of wine.

South Africa: 6 barrels of wine have to be sacrificed for a car.

Thus, the opportunity cost of a car is less in Germany than in South Africa.

Opportunity cost of producing 1 barrel of wine:

Germany: the cost of 4 barrels of wine is one car or

One barrel of wine for ¼ cars

South Africa: the cost of 6 barrels of wine is one car or

One barrel of wine for 1 /6 car

Although Germany has absolute advantages in production of wine and cars Germany has a relative or
comparative advantage in production of cars and South Africa has a relative or comparative advantage
in production of wine. So based on the theory of relative or comparative advantage Germany will
produce cars and South Africa will produce wine provided Germany could get more than 4 barrels of
wine per car and South Africa can get a car for less than 6 barrels of wine.

Let’s say they settle for 5 barrels of wine in exchange for a car.

41
Gains from trade:
before trade after trade

Germany 4 barrels of wine/car 5 barrels of wine/car

South Africa 1 car/6barrels of wine 1car/5barrels of wine

3.2.3 Sources of Comparative Advantage:

• Technology
• Resource Endowments
• Differences in Trade or Demand

3.3 TRADE POLICY:

Trade leads to greater world production and consumption and by

implication increases in economic welfare. However, countries take steps to protect their economies.
In some cases, this trade policy takes the form of protecting the domestic industries like tariffs and
quotas.

3.3.1 Import Tariffs and Quotas

The instruments used to regulate international trade are import tariffs and quotas

3.3.2 Import Tariffs

Tariffs (import duties or taxes) are levied on imported goods. They may be used to raise revenue for
the government or to protect local firms from foreign competition.

A Revenue Tariff is imposed on items that are not produced in the domestic economy. In SA this
includes certain specialized computers and other electronic equipment.

Protective Tariffs, on the other hand, are imposed to protect a local industry or sector of the economy
from foreign competition.

42
These protective tariffs (duties or taxes) imposed on products imported into a country. Usually they
are used to protect local firms against competition from cheaper imports.

Two types of such tariffs:

• specific tariffs and

• ad valorem duties

A specific tariff is a fixed amount in money terms levied on each unit of the imported commodity e.g.
R3.00 levied on each bottle of wine.

An ad Valorem: tariff levied as a percentage on the value of the imported item, e.g. 50 % on the import
price of an imported car.

3.3.3 Quotas

An import quota is a quantitative restriction on imports. It is used to restrict quantities of a commodity

imported into a country. Import quotas are, therefore, a more direct form intervention than tariffs.

Figure 3.1 the Impact of a Specific Import Tariff

• DD-SS represent the domestic demand curve and supply curve with equilibrium price pd,
equilibrium point Ed and equilibrium quantity Q3 before international trade could take place.
• Because of cooperative advantage foreign based forms can produce the same product with the
same quantity at a lower cost.

43
• They therefore take advantage of our domestic market and produce /supply at the price Pw with
the supply curve Sw.. Consumers demand quantity Qs.
• Domestic producers supply quantity Q1.
• The difference (Q5-Q1) represents imports.
• Because domestic firms produce Q1 instead of Q3 unemployed takes place.
• As a result, the government imposes an import tariff to protect dome stic firms.
• An import tariff is the tax that is imposed on each unit that is imported.
• The tariff takes the price Pw to Pt.
• At a higher price Pt, domestic production increases to Q2 and foreign production decreases to Q4.
• Consumers demand quantity Q4, domestic firms produce quantity Q2.
• The difference (Q4-Q2) represents imports after international trade and after tax.

• Government revenue will be represented by the tariff (t) multiply by the imports (Q2) which is (Q4-
Q2).

3.3.4 Discussion of Diagram:

DD and SS represent original demand and supply of textiles before international trade.

With the introduction of international competition, the price falls to the world price Pw.

New equilibrium is Ew indicating and equilibrium quantity or Q 5.

World supply of textiles is represented by P w Sw

With the introduction of a specific tariff the domestic price increase to PE.

The new equilibrium is Et.

The new equilibrium is Q5 of which Q2 is produce domestically.

Domestic production increases and the volume of imports falls.

3.4 BALANCE OF PAYMENTS

International trade and other international transactions result in

a flow of funds between countries. All transactions relating to such flow of funds are recorded in
the balance of payments accounts of the countries concerned.

The Balance of Payments accounts consist of 2 major sections:

• Current account

44
 • Capital account

3.4.1 The Current Account

The current account simply reflects the Rand value of the goods and
services (merchandise) exported and imported during the period. Together with net
gold exports they constitute what is often referred to as the trade balance. In South Africa the net gold
exports are shown separately, instead of being shown as part of the merchandise’s exports. It is shown
separately in South Africa because gold used to play an important role in the international monetary
system.

The current account also has the following 2 items:

service receipts Payments

for services.

These items are called invisible exports. Payments for services include interest payments for interest-
bearing assets held by foreign shareholder and funds spent abroad South African tourists. Service
receipts include interest, dividends, wages and salaries earned by South Africans abroad.

Transfers also form current account items that concern private transfers of funds. Transfers are one-
way payments, e.g., gifts to relatives living abroad or similar transfers from people living abroad to
South Africans.

3.4.2 The Capital Account

The capital account records international transactions in financial assets. It is divided into 2 parts:

• Long-term capital movements

• Short-term capital movements

Long-term capital movements refer to assets with unexpired maturity of more than a year. This
includes fixed investments by foreign firms and individuals.

Short-term capital movements refer to assets that mature within 12 months.

The weakening of the current account of the balance of payments may be more than offset by the
improvements in the capital account.

3.4.3 Gold and Other Foreign Reserves

A country earns foreign currency by exporting goods and services and receiving capital inflows.
Similarly payments are made for imports and for capital outflows. If the receipts of foreign currency
exceed the payments of foreign currency, the country’s foreign exchange reserves increase (s urplus).
45
If the receipts are smaller the payments, the foreign reserves decrease (deficit). This is reflected by
the sum of the current account balances and the capital account balances.

Since payments and receipts do not necessarily coincide there may be large differences from week to
week and month to month. To ensure a smooth flow of international trade and finances foreign
currency reserves are required. In the event of a deficit in the balance of payments the reserves are
used to meet the deficit. Similarly in times of balance of payments surpluses the reserves are
strengthened by adding the surplus to the reserves. This means that in a sense the balance of
payments always balances.

This prevents large fluctuations in the exchange rate between the domestic currencies and foreign
currencies. The level of foreign reserves acts an indicator to the authorities of the magnitude by which
the economy can be stimulated without running into payments difficulties.

3.5 EXCHANGE RATE

International trade involves foreign currencies. South African importers have to

pay in the currencies of the countries from where they import for the goods they buy. Therefore
they obliged to exchange South African Rands for these foreign currencies. On the other hand,
importers in the other countries buying South African goods, such as Germany and the UK have
to pay for their imports or for South African exports in Rands. They will exchange their currencies
for Rands for this purpose. This leads to an exchange of foreign currencies. The exchange takes
place in the Foreign Exchange Market where different currencies are bought and sold at the
prevailing exchange rates (prices). The rate at which currencies are exchanged is known as the
rate of exchange or the exchange rate. The rate of exchange therefore represents a ratio the price
of one currency in items of another currency.

The increase in the value or price of one currency in terms of another currency is known as
Appreciation and the decrease in the value is called Depreciation. The foreign exchange market is an
international market in which one currency can be exchanged for other currencies. In South Africa the
market for US dollars is the most important element of the foreign exchange market as the US dollar
is accepted as payment by most countries.

3.5.1 Demand Foreign Currency

The demand For Foreign Currency e.g., the US Dollars comes from two sources:
• The first source is South African importers who have to pay in US dollar for the imported goods
and services.
• The second source is South African residents who wish to purchase dollar denominated assets,
such as shares of American Companies.

46
The exchange rate represents the price of US dollars in Rands. The more expensive the dollars are, the
smaller the quantity of the dollar demanded and vice versa. Therefore, the demand curve foe US
dollars is negatively sloped like any other demand curve

3.5.2 Supply of Foreign Currency

The supply of foreign currencies comes from two sources:

First source is the US importers of South African goods. These foreign buyers of South African exports
will exchange their dollars for Rands to pay us.

The second source is foreign investors who use US dollars for Rands to pay for the South African assets
purchased.

The supply curve for US dollars (Foreign Currency) will be positively sloped like any other supply curve.

3.5.3 Equilibrium Exchange Rate

Figure 3.2 (see Figure 17-4 in Text)

• DD-SS represents the demand curve and the supply curve for US dollars ($) at the South African
exchange rate market with the rand-dollar (R/$) exchange at equilibrium.

47
• Thus R8=$1 and $10 billion US dollars are demanded (at point E) If the South African exports to the
USA decreases.
• The supply of dollars in the South African exchange market decreases.
• The supply curve shift from SS to S1S1 (illustrated by point E1).
• As a result, R9=$1 and only $8 billion US dollars are demanded. The rand has lost value/depreciated
against the US dollar by R1.

3.5.4 Discussion: of Diagram:

The figure shows the South African market for US dollars. Quantity of dollars is measured on the
horizontal axis and the price of the dollars (SA Rands/dollar) is measured on the vertical axis. The figure
shows the demand curve (DD) and supply curve (SS) for US dollars. The rate at which the quantity of
dollars demanded equals the rate at which they are supplied. Is the equilibrium exchange rate.

This occurs at the intersection of the demand and supply curves. The equilibrium rate is R8, 00 per US
dollar and the equilibrium quantity of US Dollars is $10 billion.

At a higher price of the dollar there will be an excess supply of dollar and at a lowe r price of there will
be an excess demand of dollar when dollar becomes more expensive we say the dollar appreciates
leaving the rand to depreciate against the dollar. Any change in supply or demand will be reflected by
a shift of the relevant curve. We now use a decrease in the supply of dollar. A leftward shift of the
supply curve to S1 S1The equilibrium price (or exchange rate) changes by R1/US$ to R9, 00 per US$ and
the equilibrium quantity falls to $8 million.

When the dollar appreciates, imports from the US become more expensive in S.A and S A’s exports to
US become cheaper in the US. This will tend to stimulate S A’s exports similarly, when the dollar
depreciates imports from the
US becomes cheaper in SA but SA exports to US becomes more expensive i n US$ terms. This will tend
to dampen S A’s exports to the US.

3.5.5 Managed Float:

The authorities use the exchange rate to pursue particular policy objectives. The exchange rate can be
manipulated or managed by SARB. To meet these objectives this is called the managed float.

How Does Managing Float Work?

The SARB monitors developments in the foreign exchange market and decides whether or not to
intervene. Reserve Banks only intervene to stabilize the exchange rate with the necessary reserves it
has to do so.

48
 3.5.6 Terms of Trade
The total value of a country’s export earnings depends on the volume or quantity of exports and on
the prices of the exports. The total value of a country’s payments for imports depends on the quantity
of imports and the prices of the imports. If the export prices decline, a greater volume of exports has
to be produced and sold to earn the same revenue. More important than export prices are the ratio
between exports prices and imports Prices. This ratio is called the terms of trade. Changes in any of
the two price levels will alter the terms of trade.

3.6 THE BALANCE OF PAYMENTS, ECONOMIC ACTIVITY AND POLICY IN SOUTH AFRICA

International economic developments have important effects on economic activity and economic
policy in the domestic economy. Exports are a major source of demand for domestically produced
goods and, therefore, also of production, income and employment in the domestic economy.
Increasing exports can stimulate the economy.

Export promotion:
Steps to check domestic cost of production to make exports competitive. Assist potential
exporters to find international markets Allow or engineer depreciation against the rand.

A large portion of domestic spending in S.A is on imported goods and services. When a demand for
import increases the demand for foreign exchange increases. This adversely affects the Balance of
Payments

ASSESSMENT QUESTIONS

Answer the following questions:

1. Why is SA an open economy?

2. Define Balance of payments.
3. What is the difference between current account and capital account?
4. List the items under current account.
5. Give examples of foreign currencies
6. What is the difference between direct and indirect methods of the exchange rate determination?
7. Complete the following table:

Change Shift of Curve Rand Dollar

Demand for dollar increase (A) Depreciates Appreciates

Supply of dollar increase Supply curve to the right (B) Depreciates

49
Supply of dollar increase Supply curve to the left Depreciates (C)

D) Demand curve to the left Appreciates Depreciates

8. Define the balance of payments.

9. What are the two main sub-accounts of the balance of payments and what type of transaction is
recorded in each sub-account?
10. What is the difference between the current account and the financial account of the balance of
payments?
11. Use a diagram to explain what will happen to the exchange rate between the rand and the US
dollar if South African exports to the United States

increase, ceteris paribus.

12. Explain with the aid of a diagram, what happens to the exchange rate between the rand and the
dollar when the demand for dollars increases.
13. Mention two possible sources of:
a) The demand for dollars in South Africa and
b) The supply of dollars in South Africa.

14. Use a numerical example to distinguish between an appreciation and a depreciation of the rand
against the dollar.
15. Distinguish between a specific tariff and an ad valorem tariff.
16. Use a diagram to explain the impact of the imposition of a specific import tariff on domestic
production and imports. Clearly indicate the positions: a) Before international trade,
b) After international trade but without a tariff and
c) After the imposition of the tariff.

Think Points

1. Explain what you understand by the terms closed and Open economies.
2. What is the difference between a quota and a tariff?
3. How would a tariff protect the domestic industry?
4. What do you understand by the statement: “The balance of payments always
balances”?
5. What do you understand by depreciation and appreciation of a currency?

50
 IMPORTANT CONCEPTS

Open economy Terms of trade

Globalisation

Absolute advantage

Comparative (or relative)

Advantage

Equal advantage

Inter-industry trade

Intra-industry trade

Trade policy

Import tariffs

Specific tariffs

Ad valorem tariffs

Revenue tariffs

Protective tariffs Deadweight loss

Import quotas

Dumping

Export subsidies

Infant industries

Balance of payment

Current account

51
Trade balance

Financial account

Direct investment

Portfolio investment

Gold and other foreign reserves

Gross reserves

Net reserves

Exchange rate

Appreciation

Foreign exchange market

Floating exchange rates

Managed floating

Exchange rate policy

52
 TOPIC 4

4. INCOME DETERMINATION IN A CLOSED ECONOMY WITHOUT A GOVERNMENT

After studying this topic you should be able to:

• Explain the three central macroeconomic flows
• Identify the basic assumptions of the Keynesian macroeconomic model
• Explain with or without the aid of a diagram, the three important characteristics
of the consumption function
• Explain the relationship between consumption and saving
• Explain with the aid of a diagram the equilibrium level of income
• Define and discuss the level of autonomous spending the marginal
propensity to consume and the equilibrium level of income from a given diagram
• Calculate
➢ Private consumption expenditure
➢ The level of autonomous spending
➢ The multiplier
➢ The equilibrium level of income

4.1 INTRODUCTION

In this section we develop a simple macroeconomic model consisting of households and firms. WE
ignore the government and foreign sectors. The three central macroeconomic flows are total output
(production) total income and total spending. Total spending has two components: consumption by
households and investment by firms.

Together these two determine the levels of output and income.

The model developed is a simple Keynesian model.

4.2 PRODUCTION, INCOME AND SPENDING

In the national accounts total spending during any particular period

is also always equal to total production. In macroeconomics theory, there is no guarantee that total
spending will equal total production or income. Production creates income, which is often then used
to purchase the products that were produced in the first place. By definition, income equals products
but there is no guarantee that all income will be spent. When income is spent, total production will be
sold and we would expect this process to continue at the current level of production.

53
There are 2 reasons why spending in any particular period can be greater than the income earned.

• Households and firms can use savings from a previous period to finance their spending or they can
purchase goods and services on credit.
• Total spending can also be less than total income.

4.2.1 The Three Possible Relationships between Production and Income (Y) and Spending (A)

• A = Y: equilibrium Aggregate spending equals equilibrium level of income and production

• A>Y: disequilibrium total spending is greater than production and income – production and income
will tend to increase.
• A<Y disequilibrium total spending is less than production and income – production and income will
fall.

There are some economists who believe that total spending (A) will always is equal to total production
or income (Y) and this will occur at the fullemployment level of production. This is based on the notion
that supply creates its own demand (Say’s Law).

4.3 BASIC ASSUMPTION OF KEYNESIAN MACROECONOMICS

The model consists on household & firms; we assume that prices, wages, interest rates are given. The
money market cannot be analysed within this model. The fact that the government is excluded means
we cannot use the model to analyse or explain macroeconomic policy. Using the model enables us to
focus on some of the important relationships in the economy without being distracted by unnecessary
details. Once these important relationships have been established the assumptions can then be
relaxed.

Note the following:

• Demand and supply is concerned with the plans or decisions of households and firms.
• Consumption spending uses the symbol C Invest spending uses the symbol I
• Symbols are used to explain how the various sectors of the economy operate and predict how they
will react under certain circumstances.
• Macroeconomic theory is aimed at understanding what happens. It deals with plans and intentions.

4.4 CONSUMPTION SPENDING

Consumption increases as income increases (there is a positive relationship between consumption

spending and income). Consumption is positive even if income is zero. When income increases,
consumption increases but the increase in consumption is less than the increase in income.

54
Figure 4.1 The Consumption Function:

4.4.1 Discussion of Diagram

The line C is called consumption function. 3 important features

• Households spends more as their income increases

• Consumption does not fall to zero
• Increase in consumption when income increase is smaller than the increase in income

Distance from 0 to C1 is autonomous consumption that is independent of the level of income Total
consumption is made up of:

Autonomous consumption is shown by the vertical intercept of the consumption function. It is

independent of income.

Induced Consumption fraction of income consumed as income increases. It increases proportionately

with income.

The slope indicates induced consumption and is called marginal propensity to consume (MPC) and the
symbol c is used for this fraction.

As the income increases (Y1 to Y2) consumption increases C 2 to C3

The ratio between change in consumption and change in income is called marginal Propensity to
consume and uses symbol C

The position of the consumption function is determined by all non-income factors.

55
4.4.2 The Consumption Function
Total consumption is the sum of autonomous consumption C and induced consumption (cY) – a
fraction (c) of income (Y) and is written as:

Total Consumption = C + cY

Factors That Affect Consumption

• Interest rate: higher the interest rate, more expensive credit becomes and smaller the
consumption spending will be.
• Expectation: difficult to predict, has an impact on consumption behaviour. Wealth: consumption
spending is also affected by consumer’s wealth and changes in their wealth.
• Income Distribution: Low-income household spend a larger portion of their income than high-
income families.

4.5 SAVINGS

Savings (S) is Income (Y) that is not spent Use the following

formula:

Income (Y) = Consumption (C) + Saving (S) or (Y = C + S)

The Marginal Propensity to Save (MPS) is the proportion of an increase in income that is not consumed.

If c is the MPC (see above) then the MPS is (1 – c)

4.6 INVESTMENT DECISION

Producers take investment decisions depending on the cost of obtaining the capital goods and the
returns from the expenditure on the capital goods. The expenditure on the capital goods is called
investment (I). Since these investment decisions are independent of the level of income it is referred
to as autonomously determine and is fixed for a given period. It is indicated by the symbol (I)

Borrowing funds finance a large portion of investment spending by firms. When they borrow, the firms
have to pay interest on the borrowed funds. Interest rate is, therefore, an important element in
determining the amount of investment.

The Investment decision thus involves 3 important variables:

• Cost of capital goods

• Interest rate
• Expected revenue (returns)

Lower interest rate, the higher the expected return on the investment. There is an inverse relationship
between the interest rate and the expected return on investment spending.

56
4.7 SIMPLE KEYNESIAN MODEL OF A CLOSED ECONOMY WITHOUT A GOVERNMENT

4.7.1 Total Spending

Consumption (C) is a function of income(Y)

Investment (I) is not a function income

To obtain aggregate spending we add C and I at each level of Y.

The aggregate spending (A) is equal to total income (Y) in equilibrium.

To discuss the simple Keynesian model, we use the diagram with a 45o line through the origin.

4.7.2 The 45- Degree Line

The 45o line represents points on both axes that are equidistant from the two axes. It helps determine
total spending (A) and total income (Y) that are equal. On this line A = Y.

Figure: Aggregate Spending

4.7.3 Discussion of Diagram:

Consumption spending C is positively related to the level of income.

57
This is obtained by adding consumption and investment I at each level of income. The vertical
difference between the two is the autonomous level investment

Figure: Equilibrium Income

Aggregate spending
A A=Y

E (A= C + I)

Y0 Y

Total production, income

4.7.4 Discussion of Diagram

The equilibrium level of income Y0 is the level of income (Y0) at which the aggregate spending function
A intersects the 45-degree line.

At any level of income lower than Y0 there is excess demand and at any level of income higher than Y0
there is excess supply along the aggregate spending function.

4.8 ALGEBRAIC VERSION OF KEYNESIAN MODEL

• Income (Y) is divided into

i. Consumption C = C + cY ii Savings

S=Y-C

• Total Income Y= C+ S
• Total Expenditure (A) is made up of:
i. Consumption function: C = C+ cY ii. Investment Spending I = I

• Total Expenditure A =C + I

58
• Equilibrium condition Y = A.
i.e. C+ I=C +S

4.9 A CHANGE IN INVESTMENT SPENDING: THE MULTIPLIER

The multiplier tells us by how much income changes if there is an initial change in investment. The size
of the multiplier depends on the fraction of the additional income generated in each round that is
spent in the next round of induced consumption. This fraction is the marginal propensity to consume.
(MPC or the c in cY)

4.9.1 Process of Initial Increase in Investment

An increase investment of R100million is made in a new factory. The money is paid to the workers of
the construction company to pay wages for workers, cost of supplies (materials), for equipment’s
required in the factory and profits of the construction company. In other words, the R100 million
becomes income in some peoples’ hands. This is the first round. Let us see what happens
subsequently. If the MPC is 4/5 or 80% of income Then 80% of the R100m (or R80million) is consumed
or spent on demand for additional goods. This R80 m goes to the producers of those goods and
services. These producers use this sum to pay for labour, materials, equipment and retain some as
profits.

Thus, the R80m also becomes income in the second round of expenditures.

This process continues and the amount becomes smaller at each stage until it becomes zero. Adding
up the additional income from the first stage to the last gives us the total income generated by the
initial R100 million investments. The multiplier can be calculated as follows:
From the algebraic version of the Keynesian model we have:

Total Income is divided into Consumption and Savings.

I.e. Y = C + S

Also, Total Expenditure consists of Consumption and Investment

I.e. A = C + I

Therefore, in equilibrium Y = A or
C+ S=C +I

Therefore, S=I

And S = 1/5(Y) if 4 /5 is consumed

1
Therefore /5(Y) = R100million
i.e. Y = R100Million x 5

= R500m

From the above Income increases by 5 times the initial investment. Thus 5 is the investment multiplier
in this simple Keynesian model. It is obtained as follows:

Multiplier = 1 /MPS

59
 ASSESSMENT QUESTIONS

Answer the following questions:

1. Define equilibrium?
2. List 4 major consumer good?
3. What is the value of induced consumption called?
4. Define the multiplier?
5. Calculate multiplier if: c = 3/6 c = ¼
c = 7/10

State whether the following are True/False

Indicate whether each of the following statements is true (T) or false (F).

1. In the Keynesian macroeconomic model prices, wages and interest rates are regarded as exogenous
variables, in other words they are assumed to be given.
2. Macroeconomic theory deals with economic aggregates.
3. In macroeconomic theory aggregate spending is always equal to aggregate income.
4. According to Say’s law, goods and services will only be produced if there is a demand for them.
5. Consumption spending can exceed income because households can use savings from a previous
period to finance such spending in the next period.
6. The full-employment level of production (or income) is the level of production (or income) at which
all the factors of production are fully employed.
7. In the Keynesian model there will always be an automatic tendency towards full employment if the
economy is operating at a level of production or income below the full-employment level.
8. Explain, with the aid of a diagram, the significance of the 45 line in the Keynesian macroeconomic
model. What do points above and below the 45 line represent?
9. Explain, with the aid of a diagram, the equilibrium level of income in a Keynesian model without a
government or a foreign sector. Clearly indicate the equilibrium level of income as well as the areas
of excess demand and excess supply.

Think Points

1. Explain what marginal propensity to consume is.

2. In an economy without government and foreign sector what

60
 are the two components of expenditure?
3. Why is investment regarded as independent of income?
4. How does the income multiplier work?
5. What determines the size of the multiplier?

IMPORTANT CONCEPTS
Macroeconomics

Consumption spending

Investment spending

Aggregate spending (demand)

Total production or income

Keynesian model

Equilibrium

Inventories (stocks)

Say’s law
Consumption function

Autonomous consumption

Induced consumption

Marginal propensity to consume

Saving

Investment function

Excess demand

Excess supply

45-degree line

61
 TOPIC 5

5. KEYNESIAN MODEL OF AN OPEN ECONOMY WITH GOVERNMENT SECTOR

Learning Outcomes

After studying this topic, you should be able to:

• Discuss how government spending affects the level of

production and income.

• Describe how the introduction of a proportional income tax

affects the multiplier.

• Use the simple Keynesian model to analyse the effects of

fiscal policy.

• Explain how exports and imports affect the level of income

in the domestic economy

Analyse the effects of the changes in the government

spending in the open economy

5.1 INTRODUCTION:

Economic theories serve three purposes:

• To explain what is happening in the economy

• To predict what will happen if something changes
• To help us to analyse the economic policy

5.2 INTRODUCING THE GOVERNMENT INTO THE MODEL

We introduce government spending (G) into the model. The impact G and taxes (T) need to be
considered on:

• Level of aggregate spending (A)

• The multiplier
• Equilibrium income (Y)

62
 5.3 GOVERNMENT SPENDING AND TAXATION

The government spending and taxes are the essential

ingredients of the state budget and they are the main instruments of fiscal policy. By introducing the
government, we therefore incorporate the budget and fiscal policy into our analysis. We start by
examining the determinants of government spending (G) and taxes (T) by explaining G & T.

5.3.1 Government Spending

Government Spending is political issue Government spending is related more too political objectives
rather than levels of income (Y). There is a trade-off between political and economic objectives.

The symbol G is used for Government Spending. Bar ( -) above G is used to represent that it is
autonomous. The level of Income does not influence G. Since it is expenditure, we add government
spending to aggregate spending (A).

Thus we have A = C+I+G with C = C + cY; and I & G being autonomous.

Figure 19-2

5.3.2 Discussion of Diagram

To obtain level of aggregate spending A, we add G, which is independent of Y to C + I where C = (C =cY)

The intercept A1 increase by G to A2 and the whole curve shifts upwards by the same distance.

The new aggregate spending curve is C+I+G

The 45-degree line is also shown because the introduction of government moves the intersection
between aggregate spending and the 45-degree line from E1to E2

The level of income increases to Y1 to Y2

63
Changes in income will be equal to the change in autonomous spending Algebraically the model can

be expressed as:

Y=A

A=C+I+G C=C + cY

Increase in government spending can be used to raise the level of produce and income.

The proportion is called the tax rate.

As taxpayers increase their tax rate also increases Disposable income is

expressed as:

Yd= Y-T1, Since T=tY

Yd=Y-tY

Yd= (1-t) Y

It is algebraically expressed as: C=C+c(1-t) Y

Proportional tax is a leakage or withdrawal from the circular flow.

5.3.3 Effects of Proportional Taxes Leaves aggregate

spending A unchanged
• Reduces the multiplier
• Reduces the equilibrium level of income YO

5.4 EQUILIBRIUM LEVEL OF INCOME IN AN ECONOMY WITH A GOVERNMENT SECTOR

Government spending (G) is an injection in the circular flow of spending ad income.

It raises the level of aggregate spending A at each level of income.

Taxes represent leakage from the circular flow

Let’s look at diagram on Page 495 of the text book as it explains our concept well

64
5.4.1 Discussion of diagram

Original aggregate spending curve prior to the introduction of government is indicates by A 1

The equilibrium level is income is Y1

With the introduction of government spending the aggregate spending curves shifts parallel to A2.

With the introduction of a proportional income tax, the aggregate spending curve becomes flatter as
indicated by A 3

The eventual equilibrium level of income is indicated by Y 3

The eventual equilibrium level of income can always be obtained by multiplying autonomous spending
A by the multiplier. All that changes when the government is introduced with the following:

Autonomous spending A has an additional component

The multiplier becomes smaller, thus reducing induced consumption

65
5.4.2 Expression of Aggregate Spending Is:

A=C+I+G

5.4.3 Multiplier

Without Taxes: we had Multiplier = 1/s or 1/(1-MPC) or 1 /(1- c)

With proportional taxes the Multiplier becomes: 1/1-c(1-t)

5.5 FISCAL POLICY

Fiscal policy refers to the use of government spending (G) and taxes (T) to affect important
macroeconomic variables such as aggregate production or income (Y).

5.5.1 Impact of Changes in Our Two Fiscal Variables, Government Spending (G) and Taxes (T)

Government wishes to increase the equilibrium level of income it can increase G or decrease t. the
decrease in G will initially have a direct impact on aggregate spending A. A decrease in t will raise the
equilibrium level of income in a direct way by increasing disposable income and consumption at leach
level of income.

Government wishes to reduce the equilibrium level of income, it can decrease G or increase t. The
effects will be exactly the opposite direction to those described above. Suppose the eq uilibrium level
of incomes YO is below the full employment level income (Y f) and that the government wishes to close
this gap by rising its spending

Fig 19 –6(Page 499 of textbook)

66
5.5.2 Discussion of Diagram

The original level of income is YO which is lower than the full employment level of income Y f

Government can close gap between YO and Yf by raising government spending by g (GO to G1)

The increase in income is greater than the increase in government spending because the effect of mult iplier.

The ratio between Y and G is the multiplier

5.6 INTRODUCING THE FOREIGN SECTOR INTO THE MODEL: THE OPEN ECONOMY

Domestic expenditure (C+I+G) does not represent all expenditure

on the domestic product. Parts of the domestic products are exported and the spending on these exports
comes from the rest of the world.

Spending on exports by foreigners constitutes an injection into the circular flow of income and
spending in the domestic economy. On the other hand, domestic income is spent on imported goods
and services.

Spending on imports constitutes a leakage or withdrawal from the circular flow of income and spending
in the country.

67
How do Exports and Imports affect the following?

• Level of aggregate spending (A)

• The multiplier
• Equilibrium level of income (Y)

5.6.1 Exports (X)

The demand for South African exports depends largely on economic conditions in the rest of the world,
our international competitiveness, and exchange rates. Therefore, Exports are autonomous and
independent of South African aggregate income (Y)

Export is: X=X

Like any other injection into the domestic flow of income and spending if it is a subject to a multiplier, they
leave the slope of a curve unchanged.

Any increase in export X will increase aggregate spending A.

5.6.2 Imports (Z)

When income in the domestic economy increases, this automatically results in an increase in import.
Some proportion of income is spent on imports. There is a positive relationship between the domestic
economic activity and imports

5.6.3 Exports and Imports and Aggregate Spending

Net exports and Imports must be added to aggregate as follows:

A = C+I+G+(X-Z)

Where (X – Z) is the difference between exports and imports are called net exports

Exports X is autonomous with respect to income Y.

If we assume that import Z are also autonomous, we have Z=Z

Net exports (X-Z) then have the following effect on the aggregate spending:

A = C + I + G+ (X-Z)

If exports (X) are greater than imports (Z), net exports (X - Z) will be positive.

5.6.4 Induced Imports

In the case of induced imports, imports are a function of income. Imports reduce domestic aggregate
spending A and therefore, also total income Y. If income is the main determinant of import Z, then the
import function resembles the consumption function (mY) where m is the marginal propensity to
import. Imports also have an autonomous component Z.

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The import function is Z= (Z +mY)

5.7 FISCAL POLICY IN AN OPEN ECONOMY:

If we assume that imports and exports are autonomous then fiscal policy is a strong policy instrument. The
multiplier does not change. If we accept that imports are positively related to income, then the multiplier
becomes smaller. Hence fiscal policy will have a weaker effect. If we take the Balance of Payments into
account then the position becomes more complicated. Expansionary policy will increase income and imports
and reduce net exports adversely affecting the balance of payments.

5.7.1 The Government and the Foreign Sectors and the Economy

The conclusions given below are based on our earlier assumptions concerning this model.

• Introduction of autonomous G increases aggregate spending and income through the multiplier.
However, G does not affect the multiplier.
• Proportional tax reduces the size of the multiplier and therefore, the level of income.
• Tax affects income indirectly in that it reduces disposable income.
• Exports constitute autonomous injection into the economy. And increase equilibrium level of income like
any other autonomous spending.
• Imports are a leakage or withdrawal from the economy and if they are positively linked to income, they
reduce the equilibrium level of income. The leakage reduces the size of the multiplier

ASSESSMENT QUESTIONS

Answer the following questions:

1. How do I and G affect level of aggregate spending A?

2. What are the impacts of the government spending on the economy?
3. Define and explain proportional, progressive and regressive taxation
4. What is disposable income?
5. Derive the expenditure multipliers a Multiplier without tax b multiplier without tax
6. How is the equilibrium level of income with government spending and a proportional tax expressed?
7. Using the multiplier formula state whether the following are true or false
a) c=6/7 t=1/8 the multiplier is 8

69
 b) c=2/3 t=1/10 the multiplier is 4
c) c=2/3 t=1/10 the multiplier is 2.5

Answer the Following:

1. Why is government spending classified as part of autonomous spending in the Keynesian model?
2. How does government spending affect?
a) aggregate spending and
b) The multiplier in the Keynesian model?
3. Explain the difference between income Y and disposable income
4. Explain how a proportional income tax affect
a) Autonomous spending,
b) Aggregate spending and
5. The multiplier in the Keynesian model.
6. A diagram to illustrate the impact of an increase in government spending in a Keynesian model of an
economy without a foreign sector and comment on the size of the change in the equilibrium level of
income relative to the change in government spending.
7. Define fiscal policy and explain how the equilibrium level of income can be raised through fiscal policy in a
Keynesian model.
8. Calculate the equilibrium level of income in an economy without a foreign sector if:
a) C = R100m; I = R200m; G = R280m; c = 4/5; & t = 1/4
b) C = R50m; I = R250m; G = R300m; c 9/11; & t = 1/12
c) C = R30m; I = R200m; G = R400m; c 3/4; & t = 1/6
9. If C = R40m, I = R260m, G = R200m, c = 7/8, t = 1/7 and Yf = R2400m, by how much must government
spending increase to bring the economy to full employment? Show all your calculations.
10. Suppose the equilibrium level of income is below the full -employment level of income and that the
government wants to eliminate the gap. Explain, with the aid of a diagram, how this can be achieved by
changing the level of government spending (assuming an unchanged tax rate). Also comment on the size of
the change in government spending that is required relative to the desired change in the level of income.

Think Points

1. What are the sources of government revenue?

2. What are net exports? Explain the circumstances under which the net exports may be positive or negative.
3. Why imports are considered a leakage from the economy?
4. What is the marginal propensity to import?

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5. Although exports are not consumed in our country it is considered important for
economic growth?

IMPORTANT CONCEPT
Aggregate spending
Autonomous spending

Equilibrium level of income

Multiplier

Government spending

Taxes

Proportional income tax

Tax rate

Disposable income

Injections

Withdrawals

Fiscal policy

Exports

Imports

Net exports

Autonomous imports

Induced imports

Marginal propensity to import

71
 TOPIC 6

6. MACROECONOMIC THEORY AND POLICY

LEARNING OUTCOMES

After studying this topic, you should be able to:

• To demonstrate how aggregate demand and supply curves can be

used
• To analyse certain developments in the economy and to explain
the monitory transmission mechanisms.
• Describe how changes in interest rates can affect important
macroeconomic variables such as total production and price level
• Use aggregate demand (AD) and aggregate supply (AS) model to
illustrate policy dilemmas
• Describe major features of monetarism and supply side
economics.

6.1 INTRODUCTION:

In this section we relax all the assumptions of the macroeconomic model. Prices, wages, interest rates
and other factors affecting aggregate supply are variable. Next, we introduce the Aggregate Supply
(AS) – Aggregate Demand (AD) model and examine the monetary transmission mechanism. Within
this framework we discuss monetary and fiscal policy and finally look at supply side approach.

6.2 AGGREGATE DEMAND AND AGGREGATE SUPPLY APPROACH

The Aggregate Demand and Aggregate Supply (AD – AS) Models the most popular model used recently.
It incorporates views of different schools of thought. It deals with the general price level in the
economy, with total production of goods and service or income. THE AD and AS curves are much the
same as the demand and supply curves encountered earlier.

Aggregate Demand

The AD curve is determined by everything that determines total expenditure

72
(A). The determinants of AD include households (C), investment by firms (I), Government Spending (G)
Taxes (T) exports (X) and imports (Z) as well as all the factors that influence these, especially interest
rate (i).

G and T are the two basic elements of Fiscal Policy. Expansionary could include increasing G or
decreasing T or both together. This is illustrated by a rightward shift of the AD. Contractionary Fiscal
policy will be the opposite (decreasing G and/or increasing T), illustrated by a leftward shift of the AD,
Expansionary monetary policy (decreasing interest rate) will shift the AD curve rightwards and
contractionary monetary policy (increasing interest rate) will shift the AD to the left.

Aggregate Supply Curve

AS curve is concerned with the cost of producing the total output of goods and services (e.g., GDP)
whereas the microeconomic supply curve only deals with a specific goods or services. The cost of
production is governed by the prices, import prices and prices of intermediate goods and the
productivity of the factors of production. For given factor prices, and given level of productivity the
AS curve slopes up from left to right. Changes in any of these prices will shift the AS curve (e.g., a decrease
in anyone or more of the prices will shift the AS upwards or to the left and vice versa.

The slope of the AS curve

The AS curve can be very flat or very steep.

See Figure 20-2 in textbook>

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Discussion of Diagram

The flat part (between income levels 0 and Y 1 ) is sometimes called the Keynesian range where an
increase in AD will increase income without increasing prices. Between Y1 and Yf the AS slopes up from
left to right.(like a normal supply curve). At Y f full employment (Classical range) is reached. Any
increase in AD will not increase real income (output) but will be inflationary.

74
6.3 SHIFTS IN AGGREGATE DEMAND

Figure 20 –3 in Textbook

Discussion of Diagram

Original AD curve is AD0 and AS curve is AS0 with equilibrium at E0. The price level is P 0 and output level is Y0.

Expansionary monetary and fiscal policies will shift the AD to AD1 the new equilibrium will be at E1 and
the output level at Y1 . The price level rises to
P1 .

Figure 20-4 in Textbook

75
6.4 CHANGES IN AS CURVE

Discussion of Diagram

Original AS is AS0, AD is AD0, and Equilibrium is E0. Price level is P 0 and output level is Y0. Increase in,
say; import prices will shift the AS to AS 1. The new equilibrium will be at E1 and the price level rises to
P1 and output level to Y1 .

6.5 MONETARY TRANSMISSION MECHANISM:

The way in which changes in the monetary sector are transmitted is called Monetary Transmission
Mechanism. A key element is the relationship between interest rate (i) and investment spending (I
which affects total spending (A) and AD.

76
Discussion of Diagram

• Thus :
• If the South African Reserve Bank (SARB) reduces the repo rate.
• Commercial banks will reduce the interest rate.
• When interest rate decreases, investment will increase.
• When investments spending increases, total spending increase.
• When total spending increase, aggregate/total demand for goods in the economy will increase.

• When aggregate demand increases, production will increase, thus reducing unemployment but
prices/inflation increases.

77
• Thus to reduce unemployment inflation increases.
• This is what is called= expansionary monetary policy.
• And the opposite is called= contractionary monetary policy.

Graph (a) shows interest rate (i) and Investment spending (I). I represent the investment schedule.
Original interest rate is at i 0 with equilibrium at E0 and level of Investment at I 0. A change in i tp i1 of
(Ai) will lead to equilibrium at E1 with I at I1 . The change in Investment is AI

This change is represented in graph (b) by a shift of total spending from A 0 to A1 changing equilibrium
from E0 to E1. Output increases by AY from T0 to Y1. With the multiplier having full effect.

The change in (A) is reflected in graph (c). The Ad shifts from AD 0 to AD1. Equilibrium shifts from E0 to
E1 with the output increasing by AY from Y0 to Y1 and price level by AP from P 0 to P1.

This is how the monetary transmission mechanism works.

Changes in the monetary sector are transmitted to the real sector of the economy through the monetary
transmission mechanism.

The monetary sector includes the financial markets and variables such as the quantity of money
suppose the Reserve Bank increase the quantity of money (for example by buying securities on the
open market). The increase in money supply will be accompanied by a decrease in the interest rate.
At a lower interest rate more investment project will be profitable than before. Investment spending
(I) will therefore increase.

Keynesian scepticism about effectiveness of monetary policy is based on 3 considerations:

• The view that the quantity of money demanded is far more sensitive to changes in the interest rate than
indicated by the money demand curve (fig 20.3)
• The view that investment is far less sensitive to changes in the interest rate than indicated in (fi g 20.3)
• The view that changes in the interest rate may be overshadowed by shifts of the investment function.

78
 6.6 MONETARISM:

Equation of Exchange

Point of departure for the monetarist argument for working the transmission mechanism is the equation (or
equality) of exchange

Equation of exchange MV =PY

Where M = the quantity of money

V = the velocity of circulation of money

P = the average (or general) price level

Y = the real value or physical quantity of goods and

service produced

Quantity Theory of Money

Velocity of circulation of money is assumed to be stable

Quantity of money (M) is determined by the monetary authorities and that is not affected by changes in
output (Y) or price (P)

Predicting the effect of the changes in the quantity of money is known as theory of money. Since velocity of
circulation of money (V) is constant, it follows that; any changes in M will result in an equi -proportional
change in the monetary value of the total production or income. This is the monetarist’s direct transmission
mechanism:

Essence of Monetarism

• Money supply is an important determination of nominal production to income (PY)

• Movements in the quantity of money are the best indicator of the stance of monetary policy
• Velocity of circulation of money (V) is stable.
• Changes in the money supply can only effect real production or output in the short-run.
• Private sector is stable.
• Changes in the money supply can disturb the stability of the private sector.
• Timing of the monetary policy can be spread out over a number of years.
• Attempts to stimulate or dampen economic activity through discretionary monetary and fiscal policy are
major cause of poor economic performance.

79
6.7 COMBINING MONETARY AND FISCAL POLICY:

Below are some interesting points about implementing monetary and fiscal policies.

• Fiscal policy has generally been more successful in stimulating a depressed economy. Monetary can be
employed with greater assurance to dampen an overheated economy in which inflationary pressures is
severe.
• Fiscal policy is subject to parliamentary approval and the decision in this respect is normally taken by
politicians. Monetary Policy on the other hand is formulated by a central bank. (SA Reserve Bank) which
enjoys autonomy.
• Pressure on politicians to act in the interest to voters has resulted in fiscal policy being generally aimed
at stimulating aggregate demand, while Reserve Bank and other banks traditionally take more
conservative attitude towards the economic policy.

6.8 SUPPLY-SIDE ECONOMICS

Earlier it was assumed the supply will adjust to demand. It was also assumed that aggregate spending is the
driving force that determined aggregate economic activity. During post-war period most countries
experienced inflation problems. High inflation, low economic emphasized the aggregate supply side.

Supply-siders claimed a lot of the credit for the strong performance of the United States economy.
Supply-side economics is an emphasis on aggregate supply. Supply-siders agree that cuts in the
government spending and goods and spending will release some resources which can then be used by
the private sectors. Supply-side program such as deregulation means all rules, and regulations, which
restrict the exercise of entrepreneurship, should be reviewed and preferably scrapped.

6.9 POLICY DILEMMA IN AN ECONOMY

This introduces a further dimension by adding the balance of payments to the policy issues. Imports
and exports are taken into account. This can become even more complicated particularly in developing
countries where economic growth requires the importation of capital goods.

The additional complication refers to the balance of payments constraints. Exports are autonomous
with respect to income but there is a positive relationship between imports (Z) and income (Y). Balance
of payment problems affects production and income and results in a high unemployment.
Conventional fiscal and monetary policies have to be supplemented by other policies like controls and
regulations.

80
 ASSESSMENT QUESTIONS

Indicate whether the following are true or false

1 Stagflation is a term used to describe high unemployment accompanied by a high inflation rate.
2 The monetary transmission mechanism is the process through which changes in the interest rate
give rise to changes in variables such as spending and production.
3 The AS curve illustrates the levels of output in the economy, which will be supplied at different
price levels.
4 The AD curve illustrates the levels of total expenditure in the economy at various price levels.
5 The introduction of the AD-AS model means that the assumption of a fixed price level (as in the
simple Keynesian models) has been dropped.
6 The AD-AS model can be used to analyse changes in the price level.
7 An increase in aggregate demand is usually accompanied by a fall in the equilibrium level of
income.
8 When government spending increases, the aggregate demand curve shifts to the right.
9 If the interest rate increases, the aggregate demand curve will shift to the left.
10 A concretionary fiscal policy will shift the aggregate demand curve to the left.
11 An increase in the cost of production (e.g. the cost of labour) will result in an upward (or leftward)
shift of the aggregate supply curve.
12 An unfavourable supply shock (e.g. an increase in the price of oil) results in an increase in the
domestic cost of production of each level of output.
13 A simultaneous increase in aggregate supply and fall in aggregate demand will lead to a decrease
in the price level.
14 When the AS curve is very steep, an increase in aggregate demand leads to an increase in
production with little or no increase in the price level.
15 A decrease in aggregate supply, illustrated by a leftward or upward shift of the AS curve, has an
adverse effect on both the price level and the level of production in the economy.
16 An increase in aggregate supply is always desirable, since it would result in a lower price level and
an increased level of production, ceteris paribus.

Short questions

81
 1 Define a monetary transmission mechanism.
2 Use aggregate demand (AD) and aggregate supply (AS) curves to analyse the impact of an
expansionary fiscal policy on prices and production in the economy when income is below the full-
employment level.
3 Define stagflation.
4 Use aggregate demand (AD) and aggregate supply (AS) curves to analyse the impact of a supply shock
on prices and production in the economy.
5 With the aid of a diagram, why policy makers cannot solve the stagflation dilemma using only
demand management (i.e. monetary and fiscal policies).

Think Points

1 Describe the AS – AD model of macroeconomic analysis.

2 Define the various lags associated with monetary and fiscal policies.
3 What is contractionary economic policy?
4 What is the policy dilemma in an open economy?
5 What do you understand by demand management?

IMPORTANT CONCEPTS

Aggregate demand

Aggregate supply

Fiscal policy

Monetary policy

Contractionary policy

Expansionary policy

Trade-off

Demand management

82
Stagflation
Supply shock
Incomes policy
Monetary transmission
Mechanism
Recognition lag
Decision lag
Implementation lag
Impact lag

Policy dilemma
Balance of payments constraint

Monetarism
Supply-side economics

Classical dichotomy

83
 TOPIC 7

7. INFLATION

Learning Outcomes

After studying this topic, you should be able to:

• Define Inflation

• Explain why inflation is a problem

• Describe how inflation is measured

• Analyse the effects and costs of inflation

• Distinguish between demand-pull and cost –push inflation.

• Explain some policy measures to combat stagflation

7.1 INFLATION

A continuous and considerable rise in price in general Neutral definition: increase of goods and services
from year to year

Inflation as a Process: increase of goods and services from year-to-year Inflation is concerned with a

considerable increase in prices.

Inflation refers to an increase in priced in general

7.2 MEASURING INFLATION: CPI

The commonly used indicator of general price level is the consumer price index ( CPI) To calculate inflation,
we use the percentage change in the CPI from the one period to the next. Inflation is expressed as an annual
rate although the period is not restricted to a year.

(a) Month on the Same Month during Previous Year

For example. DEC 1993 =163.3 DEC 1992 =148.6

Answer: (163.3 – 148.6)/148.6 x 100

84
(b) Annual Average on Annual Average: when the inflation rate has to be calculated for a calendar year.
Example: 1994: CPI = 157.0 and 1993 CPI = 144.1

Answer: (157.0 –144.1)/144.1 x 100 = 9.0

Measuring Inflation: PPI

This price index called production price index (PPI). The price of imported goods is measured at the
where they enter the country and not where they are sold.

The PPI includes capital and intermediate goods

PPI excludes services

PPI measures cost of production rather than cost of living

See examples in prescribed textbook

7.3 EFFECTS OF INFLATION

Distribution effects

Inflation benefits debtors at the expenses of creditors. Difference between the nominal interest rate
and inflation rate is called the interest rate. Redistribution applies to all assets of which nominal values
are fixed. Old people tend to have relatively fixed nominal incomes; inflation tends to redistribute
income and wealth from the elderly to the young. Apart from the redistribution between private
lenders & private borrowers there is also a significant redistribution from the private sector to the
government.

Economics Effects

Inflation has various economic effects, which may result in lower economic growth and higher
unemployment. Private Sectors tend to become more concerned with anticipating inflation than with
profitable new production opportunities. Inflation also stimulates speculative practices that do not
add to the country production capacity. By reducing values of existing savings, inflation may also
discourage saving.

One of the serious economic effects of inflation is that it can produce balanced of payments problems.
Inflation increases export costs and prices. Thus, it reduces exports.

Social and Political Effects

Inflation also has social and political consequences, which can further undermine the performance of
the economy. Price increases make people unhappy. When a general price level increase, it does not
mean that all prices are increasing.

85
7.4 CAUSES OF INFLATION – DEMAND PULL & COST PUSH INFLATION

• Demand – Pull Inflation

• Cost – Push Inflation

7.4.1 Demand – Pull Inflation Caused by the following:

86
• Increased consumption spending by household
• Increased investment spending by firms
• Increased Government spending
• Increase in Export earnings
• Demand-pull inflation is the result of increases in the money supply

Fig 21-1

Discussion of Diagram

An increase in aggregate demand leads to an increase in the price level (P) and increase in production
income (Y)

Demand-pull has a positive impact on production income and employment

When the economy is at full employment further increases in aggregate demand simply leads to price
increases.

Increase of goods and services results in a rightward shift

7.4.2 Cost Push Inflation

Main sources of cost-push inflation:

• Increase in wage and salaries

• Cost of imported capital and intermediate goods
• Increases in profit margins

87
Decrease and productivity
Natural disaster for example flood

Figure 21-2

Discussion of Diagram:

An increase in the cost of production results in an increase in the price level and a decrease in
production and income. Cost-push has a negative impact on production, income and employment
which is called stagflation

Total production (Y) increases and is illustrated by an upward (leftward) shift of the AS curve from AS1
to AS2. Price increases and level of income fall.

7.5 DRAWBACKS OF INFLATION

It ignores possible linkages between aggregate demand and aggregate supply in the economy

It does not deal with the dynamic process of inflation

88
 ASSESSMENT QUESTIONS

Indicate whether each of the following statements is true (T) or false (F)

1. Inflation is a continuous and considerable increase in the general level of prices.

2. If prices increase at a constant rate, there is no inflation.
3. The consumer price index (CPI) and the inflation rate are one and the same thing.
4. The PPI and the CPI are based on the same basket of items.
5. Inflation reduces the real value (or purchasing power) of money.
6. Inflation tends to benefit government at the expense of the private sector.
7. Inflation tends to redistribute income and wealth from elderly people with relatively fixed
nominal incomes to younger people whose nominal incomes keep pace with inflation.
8. The fact that taxpayers are taxed on their nominal incomes, irrespective of what happens to
their real incomes, can give rise to bracket creep (as in the case of South Africa).
9. Cost-push inflation can be illustrated by an upward or leftward shift of the AS curve.
10. Increased profit margins, decreased productivity and increases in the prices of imported capital
goods are all potential causes of cost-push inflation.

Answer the following questions

1. Define inflation.
2. *Explain why policy makers regard inflation as a problem.
3. Distinguish three main types of costs of inflation and give examples of each.
4. Use aggregate demand (AD) and aggregate supply (AS) curves to illustrate

89
 the difference between cost-push inflation and demand-pull inflation and mention possible
causes of each type of inflation.
5. With the aid of diagrams, what policy measures can be used to combat cost-push inflation and
demand-pull inflation respectively and comment on the possible side effects of these
measures?
6. Define the consumer price index (CPI) and the production price index (PPI) and mention at least
two differences between them.

Think Points

1. What are the CPI and PPI? Explain the difference.

2. What is cost push inflation?
3. What is the GDP deflator?
4. Explain the velocity of circulation of money?
5. Explain how the SARB controls inflation.

IMPORTANT CONCEPTS

Inflation

Consumer price index

Headline inflation

Core inflation

CPIX inflation

Production price index

GDP deflator

Distribution effects

90
Real interest rate

Bracket creep

Fiscal divided

Economic effects

Social and political

Effects

Hyperinflation

Deflation

Quantity theory

Equation of exchange

Velocity of circulation

Demand-pull inflation

Cost-push inflation

Stagflation

Incomes policy

Underlying factors

Initiating factors

Propagating factors Conflict

approach

Effective claims

Indexation

Inflation targeting

91
 TOPIC 8

8. UNEMPLOYMENT

Learning Outcomes

After studying this topic, you should be able to:

• Define Unemployment

• Identify and explain the cost of unemployment,

• Distinguish between the types of unemployment

• Indicate some policies to combat unemployment

• Unemployment & inflation: The Phillips Curve

• Explain Incomes Policy

8.1 INTRODUCTION

In this section we examine a few aspects of unemployment and look as possible trade-offs between
inflation and unemployment.

8.2 UNEMPLOYMENT

• Difficult to define and measure

• Bad for society as well, as the unemployed
• People searching for a job are called unemployed

8.3 COST OF UNEMPLOYMENT

• Unemployment entails significant costs

• The individual who becomes unemployed suffers a loss of income, shock and frustration
• In certain circumstances unemployment can results in hunger, cold, ill health, and even death
• In the industrial countries private or individual cost of unemployment have been reduced by the
availability of unemployment benefits and social welfare programs
• In SA unemployment benefits are moderate
• Unemployment means loss of experience and human development.
• Increased unemployment tends to result in an increase in psychological disorder, divorce and
suicide
• Unemployment is a loss to society
• When unemployment is high, large amounts of is required to support the unemployed.
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8.4 TYPES OF UNEMPLOYMENT

The basic distinction is between voluntary and involuntary unemployment. The unemployment rate
is expressed as the percentage of the labour force and therefore, unemployment should be
considered involuntary.

Unemployment falls into the following categories:

• Frictional Unemployment: Move from job to job, not a serious problem.

• Seasonal Unemployment: occupational requires workers for part of the year only.
• Cyclical (demand deficiency): Slump or recession in the economy. Gives rise to employment.

Structure Unemployment: a mismatch between qualifications and job requirement or when jobs
disappear because of structural changes in the economy. A serious probl em, workers need to be
trained. Certain workers lack the necessary education training or skills required to obtain a job.
Changes in production methods or techniques can cause a drop in demand for people with particular
qualifications of skills. Changes in the types of goods and services being produced.

Jobs can be lost as a result of a structural decline in certain industries. Discrimination can cause
unemployment

8.5 POLICIES TO REDUCE UNEMPLOYMENT

• The supply side, steps must be taken to limit population growth. Stricter immigration can be
regarded as policy strategy to reduce unemployment. In supply of labour, SA has a shortage of
skills and over supply of unskilled and semi-skilled labour
• The demand side, additional employment opportunities can be created by raising the aggregate
demand for service and increase the labour intensity of production
• Increase government spending has to be financed. It is financed by raising the taxes.
• Stimulated consumption and investment spending by lowering taxes or interest rates.
• Raise the demand for domestically produced goods and service by increasing the demand for
export.
• Increase the labour intensity of production
• Government can embark on special employment program. Promote small businesses and the
informal sector
• Tax incentives or subsidies to stimulate employment –influence the relative price of labour

8.6 UNEMPLOYMENT & INFLATION: THE PHILLIP CURVE

An inverse relationship between inflation and unemployment

Philips found that statically relation between inflation and unemployment could be illustrated by a
curve running downwards from left to right Lower unemployment levels are associated with higher
rates of increase in the general price levels and the vice versa.

93
The Phillip curve was originally regarded as a clear indication that unemployment and inflation could
be traded off against each other.

Fig 22-2

Discussion of Diagram:

• Inflation and unemployment increased at the same time: Stagflation in the diagram is illustrated
by a rightward shift of curve.
• The same factors which cause a leftward shift of the AS curve gives rise to a rightward shift of
Phillip curve.
• Phillip curve is indicated by P1

8.7 INCOMES POLICY

Incomes policy is used to contain both inflation and unemployment

Some form of government intervention in the determination of wage and prices.

One of the major problems of an income policy is that it inhibits the working to the market mechanism
at the microeconomics levels.

IMPORTANT CONCEPTS

Unemployment

Frictional unemployment

Seasonal unemployment

94
Cyclical unemployment

Structural unemployment Phillips curve stagflation

income policy

ASSESSMENT QUESTIONS

Indicate whether each of the following statements is true (T) or false (F)

1. Unemployment entails significant costs both to the individuals who are unemployed and to society
at large.
2. It is easy to define and measure unemployment.
3. The unemployed include those people who are not willing to work.
4. The unemployment rate is obtained by expressing the number of unemployed people as a
percentage of the labour force.
5. There will always be some frictional unemployment and this type of unemployment is not regarded
as a serious problem.
6. Cyclical unemployment occurs when there is a recession as a result of a temporary lack of sufficient
aggregate demand in the economy. In other words, cyclical unemployment is associated with
recessions.
7. Structural unemployment is a serious problem since it cannot be reme died by simply increasing the
aggregate demand for goods and services.
8. Workers who are replaced by labour-saving machines become structurally (or

95
 technologically) unemployed.
9. Structural unemployment is usually limited to specific industries, sectors or categories of workers.
10. The Phillips curve is an illustration of a possible trade-off between inflation and unemployment.

Answer the following questions

1. Distinguish between frictional, seasonal, cyclical and structural

unemployment and give
2. An example of each type.
3. Illustrate and explain the Phillips curve and discuss the policy implications of the
4. Existence of such a curve.
5. Discuss the different types of unemployment,
6. Give 4 reasons for increase of unemployment in South Africa.
7. Explain incomes policy.

Think Points

1. What is frictional unemployment?

2. What are the effects of unemployment?
3. Define and explain stagflation.
4. Explain supply side policy.
5. Is there a trade-off between inflation and unemployment?

96
 TOPIC 9

9. ECONOMIC GROWTH AND DEVELOPMENT

Learning Outcomes

After studying this topic you should be able to:

• Define economic growth and economic development

• Explain how economic growth and development are measured

• Explain what is meant by business cycle.

• Identify the major sources of economic growth

• Enumerate the major problems experienced by developing countries

• This section takes a brief look at economic development and

growth.

9.1 DEFINITIONS AND MEASUREMENT OF ECONOMIC GROWTH

Traditionally defined as the annual rate of increase in the total production or increase in the economy.
This definition has to be qualified in two important respects: Production or income should be
measured in real terms and the figures should also be adjusted for the population growth.

Total real production is commonly represented by real gross domestic product (read GDP) real gross
national (real GNP).

9.2 PROBLEMS ASSOCIATED WITH GDP AS A MEASURE OF GROWTH

• Non-market production is difficult to measure or estimate the value of activities that are not sold
in the market example farmer’s consumption
• Unrecorded activity: serious problem, if activities in the economy are not recorded. Can result in a
serious underestimation of the value of GDP.
• Data Revisions: occurs when original estimates are frequent adjusted as a new and better data
becomes available.
• Economic Welfare: many economists argue that GDP and other national accounting totals are not
good measure of the economic welfare

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9.3 CALCULATING ECONOMICS GROWTH

Most figures refer to annual rates of change. Four bases that are used are real GDP, real GNP, and
real GDP per capita and real GNP per capital. Economic growth is not a smooth process. It can vary
significantly from year to year. This feature of economic growth is related to a phenomenon called
business cycle.

9.4 BUSINESS CYCLE

Business cycle is the pattern of upswing (expansion) and downswing (contraction) in the economy.
This can be discerned, in economic activity over a number of years.

A business cycle has 4 phases: (a) trough (b) peak (c) upswing (d) downswing]

Causes of Business Cycle

Economists have been interested in fluctuations in the level and growth of economic activity and a lot
has been written about the subject. Economists spent considerable time and effort to explain why
economic activity does not grow smoothly. The Classical economists believed that market economies
are inherently stable and fluctuation was temporary. Economic growth was derived exogenously i.e.
by factors outside the market system.

Common elements in all theories are that the causes of business cycle are sought out all the
important economic problems to the day. Economists believe that market forces will, if given the
opportunity sort out all the important economic problems of the day. Keynesians economists that
exogenous do not cause the business cycle.

Keynesians believe business cycles are caused by endogenous. The government must intervene in the
economy by applying by applying monetary and fiscal policies. It is believed that an upswing carries
the seeds of its own destruction. As the economy grows, interest rates increase imports increase,
foreign exchange reserve falls. Keynesians regarded the business cycle as an inherent feature of
modern market economics.

9.5 SOURCES OF ECONOMIC GROWTH

Sources can be grouped into 2 broad categories supply factors and demand factor:

Supply Factors

Natural Resources: always possible to increase the exploitation of the available natural resources.
Minerals are non-renewable or exhaustible asset. Deposits may therefore become exhausted or too
expensive to exploit.

Labour: size of labour force depends on factors such as the size and the age and gender distribution
of population. The growth of the labour force depends on the natural increase in the populat ion and
migration between countries. Quality of labour force depends on the factors such as education,
training and health.

98
Capital: quality and quantity of country’s capital. Economics growths require more and better capital
equipment. An increase in the capital stock may take the form of either capital widening or capital
deepening. Capital widening occurs when the amount of capital per worker is increased.

Entrepreneurship: is the driving force behind economic growth. Entrepreneurship’s talent shou ld be
fostered. Government may also have to act as an entrepreneur, particularly in the earlier stages of
economic development

9. DEMAND FACTORS

Demand for goods and services consists of consumption demand (C), investment demand and
government demand and net exports (X-Z) Three sets of demand factors:

• Domestic demand (consumption, investment and government Spending)

• Export (x)
• Import substitution (attempts to reduce imports)

9.7.1 Domestic Demand

In principal it is always possible to increase domestic demand by increased government spending any
expansion in domestic demand should, however, be matched by an increased supply, otherwise, it
will result in inflation and balance of payment problems... This is the major weakness of the strategy
of inward industrialization, which had often been propagated in SA. During the apartheid era.

9.7.2 Exports

An increase in exports raises the growth rate and also relieved the balance of payments constraints.
The main problem is that the demand for exports is largely determine by economic conditions in other
countries.

9.7.3 Import Substitution

Another growth idea linked to the balance of payments is to reduce imports by manufacturing
previously imported goods domestically. It played a significant role in the initial growth of the South
African manufacturing sector. Import substitution has not reduced the country’s dependence on
imports and has a number of drawbacks. It focuses on domestic market, local manufacturers and not
on international market.

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 IMPORTANT CONCEPTS

Economic growth

Real GDP Import substitution

Real per capital GDP Economic development

Real GNI Human development

Unrecorded activity Stages of economic growth

Business cycle Dependency theory

Boom (upswing) Basic needs

Recession (downswing)

Leading indicators

Capital widening

Capital deepening

Technology

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 ASSESSMENT QUESTIONS

Answer the following questions:

1. Define and explain the concept economic growth.

2. Explain why it is important to use real per capita GDP when measuring economic growth.
3. Explain four problems associated with GDP as a measure of total production in the economy.
4. What is a business cycle?
5. Mention the four phases of a complete cycle.
6. What is the main source of economic growth viewed from?
a) The supply side and
b) The demand sides?

Think Points

1. Explain Rostow’s stages of growth

2. List the problems of LDCs with respect to development.
3. What are the main sources of economic growth?
4. What are peaks and troughs in the business cycles?

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 TOPIC 10

10. SOUTH AFRICAN ECONOMIC GROWTH SINCE WORLD WAR II

Learning Outcomes

After studying this topic, you should be able to:

• Understand and explain the growth of the South African

Economy in the 20th Century
• Describe and explain the first phase from 1946 to 1974 and a
phase of low
• Describe and explain the phase from 1975 to 1994.
• Outline and examine some thoughts for future growth

South Africa’s growth experience can be classified into three phases in the post-World War II period.

• Rapid growth – 1946 – 1974

• Lower growth, stagnation and decline – 1975 – 1993 Sustained but relatively slow
growth from 1994.
The anti-apartheid campaigns in the middle period did adversely affect the economy.

10.1 FACTORS, WHICH CONTRIBUTED TO A DECLINE IN ECONOMIC GROWTH:

Broad developments affected South Africa’s growth. They included:

➢ Variations in economic growth in industrialized countries.

➢ Variations in growth of world trade.
➢ Technological change
➢ Developments related to gold
➢ Process of import substitution
➢ Developments on the capital account of the balance of payments
➢ Wage increase

• World Economic Growth: changed drastically after the oil 1973. To some extent the post-war
growth of the South African economy was simple a reflection of international trends .
• World Trade: Prolonged upswing in the industrial countries during the 198`0s, which resulted in a
renewed boom in the international trade during the second half of the decade. These trends had
significant implications for developing countries such as South Africa.
• Technology: The replacement of natural resources intensive mechanical and technologies has
promoted implications for the structure of production, both
• Gold: Gold dominated SA exports throughout the pro-war period. Contribution of gold to South
African export earnings was an important growth factor during most of the post-war period. South

102
 African export earning was much more stable than those of most industrialization countries. Gold
became a major source of instability in the South African economy, mainly because of fluctuations
in the gold price.
• Import Substitution: During the apartheid era manufacturing growth was largely based on the
local production of previous imported consumer goods. Firms also supplied much of the capital
and know what is required to establish a domestic manufacturing industry. Import substitution
provides a major stimulus to the growth manufacturing in South Africa.
• Foreign Capital: A large portion of the finance required to establish and expand the manufacturing
industry was obtained from abroad. Between 1946 and 1974 SA could afford to run large deficits
on the current account of its balance of payments
• Wages: Another change that occurred in 1970`s was the surge in wages, especially those of
unskilled workers. These increases were awarded in a stagnating and declining economy and
exerted strong upward pressure on labour costs per or output procedure.

10.2 ECONOMIC DEVELOPMENT

Refers to the development of living conditions in less developed countries. It entails an improvement
in the quality of life of the majority of the population as a result of economic growth, the reduction
of inequality and eradications of absolute poverty.

10.3 STIMULATED INTEREST IN ECONOMIC DEVELOPMENT

After World War II a number of things happened that stimulated economic development. They
included:

• Rapid growth of less developed countries (LDC)

• Communications resolution
• Cold War
• Population explosions
• De-colonization & consequent political independence

10.4 PROBLEMS IN DEVELOPING COUNTRIES

Most countries of the world are classified as Less Developed Countries (LDCs).
The differences among the LDC’s are therefore large in fact much larger than the differences between
LDC’s which explains why the LDC’s as a group are poorer than the DC’s

• Population Growth: Rapid population growth can create a number of problems. Many new fobs
have to be created to accommodate he increase in the labour force.
• Natural Resources: e.g. in the tropics where the climate is not conducive to farming and crop,
livestock diseases are common. Natural resources are not a prerequisite for economic
development.

103
• Agricultural Practices: Can be attributed to traditional farming methods and land ownership
systems. It has therefore impeded development.

• Capital: LDC’s generally suffered from a critical shortage of capital goods and has access to finance
to remote economic development. Foreign companies are reluctant to train their workers of to
reinvest their profits
• Infrastructure: LDC’s infrastructure is poorly developed access to markets is usually a major
problem.

10.6 THEORIES OF ECONOMIC DEVELOPMENT

There is no single theory of economic development. Involves social economic process.

Rostow’s Stages of Economics Growth

Each country passes through certain stages during the course of development.

Based on the empirical observations that a rise in per capita income in different countries was
accompanied by a fall in the proportion of the labour force

Stages:

• Traditional society: low per capita income

• Precondition for take-off: there is some accumulation of capital in the form of infrastructure, as
well as a movement from traditional economic activity.
• Take-off Modern methods of production are used. Lasts a generation
• Drive to maturity: benefits of investments are realized
• High mass consumption: material standards of living are high and social welfare systems are well
developed.

Dependency theories

Dependency theorists believed under development of LDC’s is functionally related to the economic
development of the advance’s capitalist countries.

Regard the core as being dependent on the poverty and under development of LDC, which is called
periphery

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 ASSESSMENT QUESTIONS

1. Explain the three phases of South African economic growth since World War II.
2. What factors led to a decline in economic growth? Explain each briefly.
3. Discuss the problems associated with growth in developing countries.
4. What was Rostow’s Theory of Economic Growth?
5. What do you understand the dependency theories to be?

Think Points

1. What measures must be undertaken in a cyclical downswing?

2. What is the increase in capital stock called?
3. What were Rostow’s stages of economic growth?
4. What transformation is required in the South African Skills Development?
5. Explain developing policies for economic growth

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 TOPIC 11

11. ADDENDUM 512: EXAMINATION QUESTIONS

RICHFIELD INSTITUTE OF TECHNOLOGY

HIGHER EDUCATION AND TRAINING

FACULTY OF BUSINESS, ECONOMICS & MANAGEMENT SCIENCES

ECONOMICS 512

2ND SEMESTER NATIONAL FINAL EXAMINATION

Duration: 2 Hours Marks: 100 Date: xxxxx

Examiners: xxxxxxx Moderator: xxxxxxxx

This paper consists of 7 questions and 4 pages including this page.

PLEASE NOTE THE FOLLOWING:

1) Ensure that you are writing the correct examination paper, and that there are no missing pages.
2) You are obliged to enter your learner number and centre name on all answer sheets. The answer
sheets provided are the property of the Richfield Institute of Technology and all extra sheets
must be handed to your invigilator before you leave the examination room. Number your
answer sheet and ensure that they are stapled in the correct sequence
3) If you are found copying or if there are any documents / study material in your possession, or
writing on parts of your body, tissue, pencil case, desk etc, your answer book will be taken away
from you and endorsed accordingly. Appropriate disciplinary measures will be taken against you
for violating the code of conduct of the Business College Examinations Board. Therefore, if any of
these materials are requested to hand these over to your invigilator before the official
commencement of this paper.
4) You are required to answer all questions. Rule off after each question.
SUGGESTED TIME REQUIRED TO ANSWER THIS QUESTION PAPER

106
 NUMBERS QUESTIONS MARKS TIME IN MINUTES

1 Question One 20 25

2 Question Two 35 35

3 Question Three 30 35

4 Question Four
15 25

Question One (20 Marks)

Define and give an example of each of the following Economics concepts

1.1 Aggregate spending (2)

1.2 Autonomous spending (2)
1.3 Nationalization (2)
1.4 Stagflation (2)
1.5 Monetary Transmission Mechanism (2)

1.6 Inflation targeting (2)

1.7 Frictional unemployment (2)
1.8 Business cycle (2)
1.9 Absolute advantage (2)
1.10 Capital Account (2)

Question Two (35 Marks)

2.1 Identify and explain the five (5) sources of cost push inflation (10)

2.2 Outline five (5) essence of Monetarism (5)

2.3 Explain with examples the following types of taxation:

2.3.1 Progressive tax (3)
2.3.2 Proportional tax (3)
2.3.3 Regressive tax (3)
2.4 State and explain the criteria for a good tax system

107
 (11)

Question Three (30 Marks)

Answer the following questions

3.1 Discuss any three (3) basic functions of money (10)
3.2 Explain the functions of the South African Reserve Bank (SARB) (10)
3.3 Discuss the two (2) causes of inflation and elaborate with the aid of a diagram the relationship
between inflation and unemployment
(10)
Question Four (15 Marks)
Read the case below and answer the question that follows:
The Global Village: Connected World Drives Economic Shift

After the World War II many countries realized a mutual beneficial from working with each other
where buying and selling was just a wireless step away from each nation, aim being to reinstate the
global economy, recover the relevant losses and a sustainabl e growth.

“The division between rich and poor countries is blurring as technology becomes a global commodity
that developing and emerging countries import and adapt to catch up with advanced economies.
Dervis looks at 3 fundamental shifts in the global economy that are leading to major adjustments in
the balance between east and west: convergence of emerging and advancing economies and
guaranteed economic growth”

Source: www.IMF.org/external/pubs/ft/survey/so/2012/new083012A.htm (accessed 26/10/2012)

Question:

In view of the above information and the fact that South Africa is a both open and mixed economy,
identify and explain factors that delays Economic Development & Growth in the country (15)

END OF QUESTION PAPER

108
 RICHFIELD INSTITUTE OF TECHNOLOGY

HIGHER EDUCATION AND TRAINING

FACULTY OF BUSINESS, ECONOMICS & MANAGEMENT SCIENCES

ECONOMICS 512

2ND SEMESTER NATIONAL FINAL EXAMINATION MEMO

Duration: 2 Hours Marks: 100 Date: xxxxxxxxxx

Examiners: xxxxxxxx Moderator: xxxxxxxxx

This paper consists of 4 questions 5 pages including this page.

PLEASE NOTE THE FOLLOWING:

1) Ensure that you are writing the correct examination paper, and that there are no missing pages.
2) You are obliged to enter your learner number and centre name on all answer sheets. The answer
sheets provided are the property of the Richfield Institute of Technology and all extra sheets
must be handed to your invigilator before you leave the examination room. Number your
answer sheet and ensure that they are stapled in the correct sequence
3) If you are found copying or if there are any documents / study material in your possession, or
writing on parts of your body, tissue, pencil case, desk etc, your answer book will be taken away
from you and endorsed accordingly. Appropriate disciplinary measures will be taken against you
for violating the code of conduct of the Business College Examinations Board. Therefore, if any of
these materials are requested to hand these over to your invigilator before the official
commencement of this paper.
4) You are required to answer all questions. Rule off after each question.
SUGGESTED TIME REQUIRED TO ANSWER THIS QUESTION PAPER

NUMBERS QUESTIONS MARKS TIME IN MINUTES

1 Question One 20 25

2 Question Two 35 35

3 Question Three 30 35

4 Question Four
15 25

Question One (20 Marks)

109
Define and give an example of each of the following Economics concepts

1.11 Aggregate spending (2)

Partitioning of the total income(Y) over expenditures, either on C, G, I or both. √√
1.12 Autonomous spending (2)
Consumption without income i.e. (Y=0). √√
1.13 Nationalization (2)
Conversion of private property to be state owned. √√
1.14 Stagflation (2)
Simultaneous increase of both inflation and unemployment rates. √√
1.15 Monetary Transmission Mechanism (2)
The way in which changes in the monetary sector are transmitted is called Monetary
Transmission Mechanism. A key element is the relationship between interest rate (i) and
investment spending (In which affects total spending (A) and AD. √√√
1.16 Inflation targeting (2)
Monitoring and regulation of inflation rate by the central bank’s monetary policy towards a
specific value, (3% to 6% in S.A). √√
1.17 Frictional unemployment (2)
Moving from one job to another in pursuit of higher salary or due to geographical reasons. It is
not a serious problem because the person earns a living while shifting from those jobs. √√
1.18 Business cycle is the pattern of upswing (expansion) and downswing (contraction) in the
economy. This can be discerned in economic activity over a number of years. A business
cycle has 4 phases (a) trough (b) peak (c) upswing (d) downswing
1.19 Absolute advantage: It is notion that countries trade takes place when one country can
produce one product more efficiently than others and has to specialize in that.
1.20 Capital Account (2)
It is an account records international transaction in financial assets. it is divided into 2 parts long
term and short term.

110
Question Two (35
Marks)

2.1 Identify and explain the five (5) sources of cost push inflation. (10)

• Increase in wage and salaries

• Cost of imported capital and intermediate goods
• Increase in profit margins
• Decrease in productivity
• Natural disaster

2.2 Outline five (5) essence of Monetarism (5)

• Money supply is an important determination of a nominal production of income
• Velocity of circulation of money is stable
• Changes in the money supply can only effect real production or output in short run
• Private sector is stable
• Timing of the monetary policy can be spread out over a number of years
• Movements in the quantity of money are the best indicator of the stance
• Changes in the money supply can disturb the stability of the private sector

2.3 Explain with examples the following types of taxation:

2.3.1 Progressive tax (3)
A tax is progressive when the ratio of tax paid to taxable income increases as taxable income
increases. Eg PAYE

2.3.2 Proportional tax (3)

A tax is proportional if the ratio of tax paid to taxable income is the same for all levels of income. e. g.
company tax
2.3.3 Regressive tax (3)
A tax is regressive if the ratio between tax paid and taxable income decreases as taxable income
increases. Eg VAT

2.4 State and explain the criteria for a good tax system
(11)
• Neutrality + explanation
• Equity + explanation
• Administrative simplicity

111
 Question Three (30 Marks)

Answer the following questions

3.4 Discuss any three (3) basic functions of money (10)

• Medium of exchange + explanation

• Store of value + explanation
• Unit of account + explanation

3.5 Explain the functions of the South African Reserve Bank (SARB) (10)

• Formulation and implementation of the monetary policy

• Banker to the government
• Banker to the banks
• Custodian of gold and foreign exchange reserves
• Issue of notes and coins
• Supervision of banks

3.6 Discuss the two (2) causes of inflation and elaborate with the aid of a diagram the relationship
between inflation and unemployment (10)

Demand – Pull Inflation√√

▪ Increased consumption spending by household

▪ Increased investment spending by firms

▪ Increased Government spending

▪ Increase in Export earnings

▪ Demand-pull inflation is the result of increases in the money supply

Cost – Push Inflation√√
▪ Increase in wage and salaries
▪ Cost of imported capital and intermediate goods
▪ Increases in profit margins
▪ Decrease in productivity
▪ Natural disaster e.g. flood

112
 The relationship between inflation and Unemployment

Graph-√√√√√
Demand-Pull Discussion (any3 above) √√√
Cost-Push Discussion (any3 above) √√√
Question Four (15 Marks)
Read the case below and answer the question that follows:
The Global Village: Connected World Drives Economic Shift

After the World War II many countries realized a mutual beneficial from working with each other
where buying and selling was just a wireless step away from each nation, aim being to reinstate the
global economy, recover the relevant losses and a sustainabl e growth.

“The division between rich and poor countries is blurring as technology becomes a global commodity
that developing and emerging countries import and adapt to catch up with advanced economies.
Dervis looks at 3 fundamental shifts in the global economy that are leading to major adjustments in
the balance between east and west: convergence of emerging and advancing economies and
guaranteed economic growth”

Source: www.IMF.org/external/pubs/ft/survey/so/2012/new083012A.htm (accessed 26/10/2012)

Question:

In view of the above information and the fact that South Africa is a both open and mixed economy,
identify and explain factors that delays Economic Development & Growth in the country (15)

▪ Population Growth√: Rapid population growth can create a number of problems. Many new fobs
have to be created to accommodate he increase in the labour force. √√

113
▪ Natural Resources√: e.g. in the tropics where the climate is not conducive to farming and crop,
livestock diseases are common. Natural resources are not a prerequisite for economic
development. √√
▪ Agricultural Practices√: Can be attributed to traditional farming methods and land ownership
systems. It has therefore impeded development. √√
▪ Capital√: LDC’s generally suffered from a critical shortage of capital goods and has access to
finance to remote economic development. Foreign companies are reluctant to train their
workers of to reinvest their profits. √√
▪ Infrastructure√: LDC’s infrastructure is poorly developed access to markets is usually a major
problem. √√

END OF MARKING MEMO

114