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DEMAND-MANAGEMENT
POLICIES
Economics, IB 2
Learning outcomes: At the end of this
lesson, you should be able to:
Identify the goals
of government
macroeconomic
policies
Explain the
meaning and
nature of
government
budget.
1
2
3
Define demand-
management policy
and explain its types.
Lesson Starter
Match each of the concepts on the left with its description in the boxes.
TERM LETTE
R
1 Seasonal unemployment
2 Unemployment rate
3 Labour force
4 Unemployment
5 Frictional unemployment
6 Working population
7 Cyclical unemployment
A. A type of unemployment
that is short-lived and
occurs as people change
jobs and may be out of
work for a few weeks while
they do so.
B. Widespread, demand-
deficient unemployment
associated with
economic recessions.
C. The total number of
people in a country
allowed by law to work,
usually between 15 and
65 years old.
D. The total number of
people who are
employed plus the
unemployed who are
looking for work.
F. A type of unemployment that occurs
for several months of each year in
industries such as farming,
constructions and tourism, because of
changes in weather patterns and
consumer demand.
G. The percentage of
unemployed workers
in the total labour
force.
E. Worklessness: an
economic condition
whereby people who are
willing and able to work are
nevertheless unable to
secure jobs.
Solution to Lesson Starter
Match each of the concepts on the left with its description in the boxes.
TERM LETTE
R
1 Seasonal unemployment F
2 Unemployment rate G
3 Labour force D
4 Unemployment E
5 Frictional unemployment A
6 Working population C
7 Cyclical unemployment B
A. A type of unemployment
that is short-lived and
occurs as people change
jobs and may be out of
work for a few weeks while
they do so.
B. Widespread, demand-
deficient unemployment
associated with
economic recessions.
C. The total number of
people in a country,
usually between 15 and
65 years old.
D. The total number of
people who are
employed plus the
unemployed who are
looking for work.
E. Worklessness: an
economic condition whereby
people who are willing and
able to work are
nevertheless unable to
secure jobs.
F. A type of unemployment that occurs
for several months of each year in
industries such as farming,
constructions and tourism, because of
changes in weather patterns and
consumer demand.
G. The percentage of
unemployed workers
in the total labour
force.
Goals/objectives of Government
macroeconomy policies
Government macroeconomic policies, all over the world, often seek
to achieve the following 6 objectives or aims:
1. Economic Growth
2. Price Stability (i.e. low inflation)
3. Balance of payments equilibrium
4. Full employment (low unemployment)
5. Income redistribution (reducing the income gap between the rich and the
poor)
6. Environmental protection
Government macroeconomic
policies
Demand-management or Demand-side policies
Measures to influence the level of aggregate demand in an
economy in order to achieve desired macroeconomic
objective like growth, full employment, price stability etc.
Supply side policies
Measures to influence the level of aggregate
supply in the economy in order to achieve
desired macroeconomic objectives like growth,
full employment etc.
- Privatisation
- Commercialisation
- Deregulation
- Subsidies
- Education and training
An overview of Government Macroeconomic Policies
Fiscal policy
Use of taxes
+government spending
to control the economy
Monetary policy
Use of interest rates + money
supply + exchange rate to control
the economy
DEMAND-MANAGEMENT POLICY:
FISCAL POLICY
Governments have two broad
categories of policies available to
affect the level of aggregate demand
for goods and services in an economy.
These are called:
 Fiscal policy and
 Monetary policy
Together, these are broadly called
demand-management policies.
DEMAND-MANAGEMENT POLICY:
FISCAL POLICY
Fiscal policy is defined as the use of
government expenditure policies and
taxation policies to influence economic
activity and bring about desired
macroeconomic aims.
Fiscal policy can be expansionary which
increases aggregate demand and includes
an increase in government
expenditure or a reduction in taxation.
Fiscal policy can also be
contractionary which decreases
aggregate demand and includes a
decrease in government expenditure
or an increase in taxation.
Public/Government expenditure
Public expenditure refers to spending on goods and services by government at all levels:
federal/central, state and local: Government expenditure is divided into three categories.
Categories of
Public/Government
Expenditure
Capital Expenditure
Spending by government that
adds to capital stock of the
economy, such as spending to
upgrade national highways or on
building of schools or hospitals.
Such spending does not occur
every year.
Recurrent
Expenditure
Yearly or on-going
spending by
government such as
purchases of books
in schools, salaries
of public sector
workers.
Transfer Payments
Government payments to people
in the economy for which no goods
and services are produced in
return, such as unemployment
benefits, child support payments,
disability payments and pensions.
Government Revenue
Public revenue refers to government income from different sources: tax and non-tax
sources. Government can finance its expenditures from these sources.
• Rents from publicly owned buildings and land
• Admission charges, for example from public museums and monuments
• Revenue/Profits from the sale of some public services such as postal
services and public transport
• Proceeds from the sale (or privatization) of government-owned industries
and other publicly owned assets
• Interest charges on government loans to the private sector and overseas
governments
• Taxes on incomes, wealth and expenditures
Sources
of
Government
Revenue
Note that government can also borrow to finance its expenditures, but borrowing is not a
form of government revenue.
A government budget is a forecast or estimate of government
revenues and government expenditures for the coming year. That is, in
a budget, a government sets out what its expenditures will be for a period
and how it will raise revenue to meet the expenditure items. This is
known as government “fiscal stance”. There are three types of budget:
- Budget Surplus
- Budget Deficit
- Balanced Budget
Government Budget
Budget Surplus
Government Budget
Budget Surplus
Government
revenue
This is when government
revenue is greater than its
expenditure; that is government
plans to earn more than it
spends.
Government
expenditure
Budget Deficit
Government Budget
Budget Deficit
Government
revenue
This is when government revenue is less than
its expenditure; that is, government plans to
spend more than it earns.
To finance a deficit, government borrows. The
total stock of money borrowed by government
which is yet to be repaid is called public debt
and it is made up of domestic debt (borrowing
from domestic households or firms) or external
debt (borrowing from abroad). Government
borrows by issuing (selling) what is called
bonds to the public. Government later pays
back this debt with interest. In essence, the
public lends government money and this is a
form of saving by the public.
Government
expenditure
Budget Surplus
Government Budget
Balanced Budget
Government
revenue
This is when government revenue is
equal to government expenditure.
Government
expenditure
Expansionary Fiscal Policy
This is a form of Keynesian demand management
aimed at expanding economic activity. Keynesian
economists believe that that government intervention is
necessary to control the economy. Expansionary fiscal
policy can take any of the following forms:
a) Decrease in income tax to increase disposable
income and encourage greater consumption which
can lead to an increase in AD.
b) Decrease in corporate taxes to increase business
profits which will be used for greater investments by
firms, leading to an increase in AD.
c) Higher government spending on capital projects
may increase public services, leading to an increase
in AD.
Expansionary fiscal Policy
The impact if successful expansionary policy can
be seen in the diagram below. The AD curve
increases from AD1 to AD2, leading to an
increase in real GDP from Y1 to Y2, representing
economic growth. The general price level
increases from P1 to P2. Unemployment may
also likely reduce as more workers might be
needed to produce the extra output.
However, there is a trade-off between
unemployment and inflation. Higher real GDP
leads to higher employment or lower
unemployment, but the general price level rises
from P1 to P2, which means inflation increases.
There is also a trade off between economic
growth and inflation.
General
Price
level
Real GDP (Y)
DEMAND-MANAGEMENT
POLICIES
DEMAND-MANAGEMENT POLICIES
Learning outcomes: At the end of this lesson, you should be
able to-
-discuss the advantages and disadvantages of fiscal policy.
Starter
1. Give two examples of contractionary fiscal policy.
2. Use a fully labelled diagram to illustrate the effects
of a contractionary fiscal policy.
Advantages and Disadvantages of Fiscal Policy
Advantages
1. Fiscal policy is effective in the long run in
addressing deep recession. For example,
in the Great depression of the 1930s and
the world recession that started in 2008,
many countries recovered much faster by
adopting the Keynesian demand
management policies, specifically
increased government spending.
2. It can be used to target specific sectors of
the economy that will benefit the most.
For example, families may be given tax
cuts to boost higher consumer spending
in the economy and small businesses may
be granted fiscal stimulus to save them
from collapse during a deep recession.
Disadvantages
1. Time lags: Changes in fiscal policy
take time. In most countries,
changing the tax structure may
need to go through a parliamentary
decision-making process which can
be time-consuming. In addition, the
effects of fiscal policy changes take
time before they are felt.
2. Political pressure: Some necessary
fiscal changes may be unpopular
from a political stand point. For
example, government may be
unwilling to raise taxes to control
budget deficit for fear of losing
votes.
Advantages and Disadvantages of Fiscal Policy
Disadvantages
3. Unsustainable debt: Some fiscal decisions may throw a country into an
unsustainable level of debt. For example, expansionary fiscal policy through
increases in government spending may require that government increase
borrowing to achieve higher spending. This may be bad for a country that
already has high budget deficits.
4. Crowding-out Effect: Increased government spending may lead to increased
government borrowing. This may make government monopolize borrowing in
the financial market. Interest rate is likely to rise as borrowing by government
increases, making private sector borrowing more expensive. Therefore,
government borrowing reduces (crowds out) private sector borrowing and
investment.
5. It may cause a decline in net exports
DEMAND-MANAGEMENT POLICIES
Learning outcomes: At the end of this lesson, you should be
able to-
-Explain the Keynesian multiplier effect and perform
calculations on it.
The Keynesian Multiplier
The Keynesian multiplier or the multiplier is when an initial amount of change in
any component of aggregate demand leads to a greater final amount of change
in aggregate demand or national income.
It is the idea that an initial injection into the circular flow of income causes a
bigger final increase in real GDP.
For example, if the multiplier is 5, this means that a change in any component
of aggregate demand would cause a change in aggregate demand that is 5
times the initial change in the component of aggregate demand. Hence, if
investment increases by $10 million, aggregate demand will increase by 5 × $10
million = $50 million.
The Keynesian Multiplier
Government spending (G) and business investment (I) are injections into the circular
flow of income and any injections are multiplied through the economy as people
receive a share of the income and then spend a part of it. For example, if government
spends money on a building project, this money goes to a vast majority of people for
the factors of production they provide. The money goes to architects, engineers,
builders, electricians, plumbers etc. Those who provide the capital and raw materials
such as concrete, steels, water etc., also receive a share of the spending.
The people that earn this income save some of it (savings, S), pay taxes out of it (taxes,
T), buy imports (M) from it and spend the rest on domestic goods (consumption, C).
This cycle continues all over again when the money is spent on domestic goods or
services. Recall that S, T and M are leakages and C is an injection. The percentage of
additional income consumed is called marginal propensity to consume (MPC) while the
percentage additional income saved is called marginal propensity to save (MPS). The
percentage of additional income paid as tax is called marginal propensity to tax (MPT)
while the percentage of additional income spent on imports is called marginal
propensity to import (MPM).
How the Multiplier is calculated
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 (𝐾) =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐴𝐷
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
𝐾 =
1
1 − 𝑀𝑃𝐶
𝑜𝑟
1
𝑀𝑃𝑆 + 𝑀𝑃𝑇 + 𝑀𝑃𝑀
=
1
𝑀𝑃𝑊
Where: MPW is marginal propensity to withdraw (fraction of additional income
that is withdrawn from the circular flow of income).
Note: 1 − 𝑀𝑃𝐶 = 𝑀𝑃𝑆 + 𝑀𝑃𝑇 + 𝑀𝑃𝑀 = 𝑀𝑃𝑊
𝑀𝑃𝐶 + 𝑀𝑃𝑆 + 𝑀𝑃𝑇 + 𝑀𝑃𝑀 = 1
Note: marginal propensity to tax (MPT) is also known as marginal tax rate (MTR).
Illustration
1. (a) Calculate the multiplier for an economy where the marginal propensity to consume is 0.75.
(b) By how much will national income increase is there is an investment of $50,000?
2. An economy has a marginal propensity to consume of 0.8. Calculate:
(a) its marginal propensity to withdraw.
(b) its multiplier.
(c) the amount of injections that would be needed if national income is to rise by $10 million.
3. In a country, the marginal propensity to save is 0.1, the marginal rate of taxation is 0.3, and the marginal
propensity to import 0.1. How will the value of the multiplier change if government lowers taxes, such that the
marginal rate of taxation drops to 0.2?
Monetary Policy
Monetary policy is defined as a set of measures by government or monetary
authorities to control the level of money supply and interest rate in a country.
Government uses expansionary monetary policy (i.e. increase in money supply or cut
in interest rate) to increase aggregate demand and contractionary monetary (i.e. cut
in money supply or increase in interest rate) policy to reduce aggregate demand.
There are many interest rates in a country. In fact banks are free to set their own
interest rates even though they are regulated by the government. However, the main
interest rate used for monetary policy is called the base rate (discount rate, prime
rate or monetary policy rate) that is set by a country's central bank. The central bank
is a state or government bank set up to keep a country's financial system under close
supervision and control and it is the apex regulator of banks.
Aims of
Monetary Policy
Low unemployment rate
To maintain a low and
stable inflation rate Long-term economic
growth
To achieve balance
between export revenue
and import expenditure
To reduce fluctuations in the
business cycle
What is Nigeria’s key interest rate called and who controls it?
Types of
Monetary
Policy
This involves reducing interest rate or
increasing money supply thereby
increasing borrowing and investment in
the economy, which ultimately leads to
an increase in AD, employment etc.
Expansionary or
loose
Contractionary or
deflationary or tight
This involves increasing interest
rate or cutting money supply
thereby decreasing borrowing and
investment in the economy, which
ultimately leads to an increase in
AD, fall in inflation etc.
Are central banks truly independent
CLASS WORK
Demonstrate, with the use of appropriate diagrams,
a) Expansionary monetary policy
b) Contractionary monetary policy
ADVANTAGES OF MONETARY POLICY
 It is relatively quick to implement, as the central
bank can set/alter the interest rate quickly.
 There is no political intervention, as the central bank
can adjust the interest rate without subjecting that
decision to political processes, unlike fiscal policy.
 Absence of crowding out effect: Interest rate can
simply be changed by the central bank without
crowding out private investment, unlike fiscal policy.
 Very small changes can be made to achieve more
precise targets than fiscal policy. For example, if an
inflation of 2% is targeted very small fractions of
changes in the interest rate can be made to achieve
this.
DISADVANTAGES OF MONETARY POLICY
 Time Lags: Though they are quick to change, it
may take time before the impact of monetary policy
on aggregate demand is felt.
 It is ineffective when interest rates are low:
Expansionary monetary policy achieved through
interest rate cuts cannot be used forever, as interest
rates will eventually approach zero and there will be
no room left for further reductions.
 Low consumer and business confidence: If
consumer and business confidence are low
especially when a country is in deep recession,
interest rate cuts may be ineffective to achieve
desired economic aims.
HOW COMMERCIAL BANKS CREATE MONEY
Commercial banks create money through a
process known as credit creation. This way, they
help to significantly increase the money supply in
the economy. Money supply is defined as the
total stock of money in circulation at a given
time, consisting of total currency in banks and
outside banks.
Credit creation occurs when commercial banks lend money to individuals and businesses
based on customer deposits made with them. Commercial banks lend out a multiple of
the depotit value, which is called money multiplier or banking credit multiplier. When a
deposit is made in a bank by a customer, the bank holds a fraction of the money to meet
customer withdrawals, while they lend out the remaining fraction. The fraction lent out is
called minimum reserve requirement which is defined as the percentage of deposits that
a central bank allows commercial banks to legally hold in reserve to meet the cash
requirements of the depositor.
HOW COMMERCIAL BANKS CREATE
MONEY
Commercial banks create money through a
process known as credit creation. This way,
they help to significantly increase the money
supply in the economy. Money supply is
defined as the total stock of money in
circulation at a given time, consisting of total
currency in banks and outside banks.
Credit creation occurs when commercial banks lend money to individuals and
businesses based on the customer deposits made with them. Commercial banks lend
out a multiple of the deposit value, which is called money multiplier or banking credit
multiplier. When a deposit is made in a bank by a customer, the bank holds a fraction of
the money to meet customer withdrawals, while they lend out the remaining fraction.
The fraction lent out is called minimum reserve requirement which is defined as the
percentage of deposits that a central bank allows commercial banks to legally hold in
reserve to meet the cash requirements of the depositor.
HOW COMMERCIAL BANKS CREATE
MONEY
Suppose the central bank sets a 20% minimum reserve requirement (MRR). A deposit
of $100,000 in a commercial bank will mean it will keep $20,000 to meet the cash
requirements of depositors, while it lends out $80,000. The borrower of this $80,000 will
take this money to their bank and deposit it, given they do not spend a fraction of it. This
second bank is also subject to an MRR of 20%. They keep $16,000 in reserves and
lend out $64,000. The borrower takes this money and deposits in their bank which is
also subject to an MRR of 20%. This deposit-lending cycle will continue through the
banking system. At the end of the process, the whole banking system would have
created $500,000 from the initial deposit of $100,000 i.e.
Total credit created = Initial deposit × money multiplier = $100,000 × 5 = $500,000.
Hence, the money multiplier is given by the formula:
Money Multiplier =
1
𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡
Methods for
controlling
money supply
Minimum reserve
requirement
Quantitative easing Open market operations
What other methods can you think of?
Central bank minimum
lending rate
HOW GOVERNMENT CONTROLS MONEY SUPPLY
1.Minimum reserve requirements (MRR): To increase money supply, the central bank
reduces the minimum reserve requirement while they increase it to reduce money
supply. The lower the MRR, the less commercial banks are required to keep in
reserves and the more commercial banks can lend out. Whereas, the higher the MRR,
the less commercial banks can lend out as they have to keep more of their deposits in
reserves.
2.Open market operations: This involves buying and selling government securities in
the open market by the central bank. A government security is a bond issued by the
central bank. They are redeemable (paid-back) after a number of years with interest.
Where government wishes to reduce money supply to control inflation, they sell
securities to individuals and institutions, thereby mopping up excess liquidity (money
supply) from circulation. This then reduces demand-pull inflation. On the other hand,
government can increase AD and employment by buying government securities from
the public. This releases more money into circulation which can boost investment,
production and employment. Unfortunately, this may lead to demand-pull inflation.
HOW GOVERNMENT CONTROLS MONEY SUPPLY
2. Open market operations: In addition, by the central bank selling government
securities to institutions, commercial banks have less funds to lend. This reduces the
supply of loanable funds and increases the interest rate which is the cost of borrowing.
Buying government securities has the opposite effect. This is shown in the diagram
below. An increase in interest rate will reduce AD as consumption and investment fall
and vice versa.
HOW GOVERNMENT CONTROLS MONEY SUPPLY
3. Central bank minimum lending rate: Also known as the base rate, discount rate or
refinancing rate, this is the interest rate which the central bank charges on loans and
advances to commercial banks. Note that commercial banks also borrow from the
central banks in times of financial difficulties. Where a commercial bank is unable to
raise short-term funds from the interbank market (a market consisting of commercial
banks which lend, on short-term basis, to fellow banks having liquidity problems), they
approach the central bank, as a last resort, to resolve their funding problems. If the CBN
adopts contractionary monetary policy such that the minimum lending rate is raised,
borrowing by commercial banks becomes more expensive and thus reduces. Hence,
money supply, investment and AD reduce. However, a decrease in the minimum lending
rate - an expansionary monetary policy - makes borrowing by commercial banks more
attractive. Hence, borrowing, investment and AD increase.
HOW GOVERNMENT CONTROLS MONEY SUPPLY
4. Quantitative Easing (QE): This is a form of monetary policy used by central banks as a
way to quickly increase the domestic money supply in hopes of spurring economic activity. It
involves the central bank issuing new money through newly created electronic cash and
using that to purchase assets, particularly government securities, from commercial banks and
other financial institutions. This puts more funds in the hands of these banks, increasing the
amount of credit available to borrowers. The funds the banks receive for the assets will then
be loaned to borrowers at attractive rates. The idea is that by making it easier to obtain
loans, interest rates will remain low and consumers and businesses will borrow, spend, and
invest. Increased spending leads to increased consumption, which increases the demand for
goods and services, fosters job creation, and, ultimately, increases AD.
However, there are downsides. Low interest rates can encourage companies to invest and
spend more, causing price rises and eventual inflation. In order to counter these effects,
central banks may reduce the money supply through quantitative tightening. The U.S.
Federal Reserve used QE following the 2008-09 financial crisis and again in 2020 in
response to the economic shutdown.
EQUILIBRIUM NOMINAL INTEREST RATE
Interest rate is the cost of borrowing funds or the reward
for savings. It can also be regarded as the opportunity cost
of holding or spending money. The nominal interest rate
is the rate of interest available in the money market before
adjusting for inflation. On the other hand the real interest
rate is the interest rate that has been adjusted for inflation.
If an economic agent spends money, they sacrifice other
things the money could have been used for such as saving
or investment. If nominal interest rate is high, then they
give up a large return on their savings and investment and
so they will hold or demand less money. If interest rate is
low, then the opportunity cost of spending or holding
money will be less and so they will hold or demand more
money. This is why the demand curve for money is
downward sloping as shown below. An increase in nominal
interest rate from i1 to i2 decreases money supply from Q1
to Q2 and vice versa.
Demand for money curve
EQUILIBRIUM NOMINAL INTEREST RATE
The supply of money curve is a vertical, perfectly inelastic
curve. This is so because the central bank controls money
supply and supplies a fixed quantity per period regardless
of the level of interest rate. The supply of money curve is
shown below. An decrease in the nominal interest rate
from i1 to i2 or and increase in it from i2 to i1 leaves the
money supply unchanged at Qm.
The supply and demand for money can be
combined to obtain the equilibrium nominal
interest rate as shown below. An increase
in the supply of money from SM to SM2
decreases the nominal interest rate from ie
to i2, while and decrease from SM to SM1
increases the interest rate from 1e to i1.
NOMINAL INTEREST RATE AND REAL INTEREST RATE
Recall that the nominal interest rate is the interest rate that has not been adjusted for inflation and
the real interest rate is interest rate adjusted for inflation. Both are connected by the formula
below:
𝑹𝒆𝒂𝒍 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆 = 𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆 − 𝒊𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝒓𝒂𝒕𝒆
Example 1: if the rate of interest in the market is 5% and the inflation rate is 3%, then the real
interest rate is 2%. This information is important for both savers and borrowers. A person saving at
a nominal interest rate of 5% will find that their real gain is only 2%, whereas someone borrowing at
the same rate will find that they are really only paying back 2%.
Example 2: If the nominal interest rate is 2% and the inflation rate is 4%, then the real interest rate
is −2%. This means a saver’s savings will decrease by 2% per annum, while a borrower will pay
back 2% less than the amount borrowed. This will be a disincentive to save and an incentive to
borrow.
PRACTICE QUESTIONS
Demand-Management Policies.pptx

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Demand-Management Policies.pptx

  • 2. Learning outcomes: At the end of this lesson, you should be able to: Identify the goals of government macroeconomic policies Explain the meaning and nature of government budget. 1 2 3 Define demand- management policy and explain its types.
  • 3. Lesson Starter Match each of the concepts on the left with its description in the boxes. TERM LETTE R 1 Seasonal unemployment 2 Unemployment rate 3 Labour force 4 Unemployment 5 Frictional unemployment 6 Working population 7 Cyclical unemployment A. A type of unemployment that is short-lived and occurs as people change jobs and may be out of work for a few weeks while they do so. B. Widespread, demand- deficient unemployment associated with economic recessions. C. The total number of people in a country allowed by law to work, usually between 15 and 65 years old. D. The total number of people who are employed plus the unemployed who are looking for work. F. A type of unemployment that occurs for several months of each year in industries such as farming, constructions and tourism, because of changes in weather patterns and consumer demand. G. The percentage of unemployed workers in the total labour force. E. Worklessness: an economic condition whereby people who are willing and able to work are nevertheless unable to secure jobs.
  • 4. Solution to Lesson Starter Match each of the concepts on the left with its description in the boxes. TERM LETTE R 1 Seasonal unemployment F 2 Unemployment rate G 3 Labour force D 4 Unemployment E 5 Frictional unemployment A 6 Working population C 7 Cyclical unemployment B A. A type of unemployment that is short-lived and occurs as people change jobs and may be out of work for a few weeks while they do so. B. Widespread, demand- deficient unemployment associated with economic recessions. C. The total number of people in a country, usually between 15 and 65 years old. D. The total number of people who are employed plus the unemployed who are looking for work. E. Worklessness: an economic condition whereby people who are willing and able to work are nevertheless unable to secure jobs. F. A type of unemployment that occurs for several months of each year in industries such as farming, constructions and tourism, because of changes in weather patterns and consumer demand. G. The percentage of unemployed workers in the total labour force.
  • 5. Goals/objectives of Government macroeconomy policies Government macroeconomic policies, all over the world, often seek to achieve the following 6 objectives or aims: 1. Economic Growth 2. Price Stability (i.e. low inflation) 3. Balance of payments equilibrium 4. Full employment (low unemployment) 5. Income redistribution (reducing the income gap between the rich and the poor) 6. Environmental protection
  • 6. Government macroeconomic policies Demand-management or Demand-side policies Measures to influence the level of aggregate demand in an economy in order to achieve desired macroeconomic objective like growth, full employment, price stability etc. Supply side policies Measures to influence the level of aggregate supply in the economy in order to achieve desired macroeconomic objectives like growth, full employment etc. - Privatisation - Commercialisation - Deregulation - Subsidies - Education and training An overview of Government Macroeconomic Policies Fiscal policy Use of taxes +government spending to control the economy Monetary policy Use of interest rates + money supply + exchange rate to control the economy
  • 7. DEMAND-MANAGEMENT POLICY: FISCAL POLICY Governments have two broad categories of policies available to affect the level of aggregate demand for goods and services in an economy. These are called:  Fiscal policy and  Monetary policy Together, these are broadly called demand-management policies.
  • 8. DEMAND-MANAGEMENT POLICY: FISCAL POLICY Fiscal policy is defined as the use of government expenditure policies and taxation policies to influence economic activity and bring about desired macroeconomic aims. Fiscal policy can be expansionary which increases aggregate demand and includes an increase in government expenditure or a reduction in taxation. Fiscal policy can also be contractionary which decreases aggregate demand and includes a decrease in government expenditure or an increase in taxation.
  • 9. Public/Government expenditure Public expenditure refers to spending on goods and services by government at all levels: federal/central, state and local: Government expenditure is divided into three categories. Categories of Public/Government Expenditure Capital Expenditure Spending by government that adds to capital stock of the economy, such as spending to upgrade national highways or on building of schools or hospitals. Such spending does not occur every year. Recurrent Expenditure Yearly or on-going spending by government such as purchases of books in schools, salaries of public sector workers. Transfer Payments Government payments to people in the economy for which no goods and services are produced in return, such as unemployment benefits, child support payments, disability payments and pensions.
  • 10. Government Revenue Public revenue refers to government income from different sources: tax and non-tax sources. Government can finance its expenditures from these sources. • Rents from publicly owned buildings and land • Admission charges, for example from public museums and monuments • Revenue/Profits from the sale of some public services such as postal services and public transport • Proceeds from the sale (or privatization) of government-owned industries and other publicly owned assets • Interest charges on government loans to the private sector and overseas governments • Taxes on incomes, wealth and expenditures Sources of Government Revenue Note that government can also borrow to finance its expenditures, but borrowing is not a form of government revenue.
  • 11. A government budget is a forecast or estimate of government revenues and government expenditures for the coming year. That is, in a budget, a government sets out what its expenditures will be for a period and how it will raise revenue to meet the expenditure items. This is known as government “fiscal stance”. There are three types of budget: - Budget Surplus - Budget Deficit - Balanced Budget Government Budget
  • 12. Budget Surplus Government Budget Budget Surplus Government revenue This is when government revenue is greater than its expenditure; that is government plans to earn more than it spends. Government expenditure
  • 13. Budget Deficit Government Budget Budget Deficit Government revenue This is when government revenue is less than its expenditure; that is, government plans to spend more than it earns. To finance a deficit, government borrows. The total stock of money borrowed by government which is yet to be repaid is called public debt and it is made up of domestic debt (borrowing from domestic households or firms) or external debt (borrowing from abroad). Government borrows by issuing (selling) what is called bonds to the public. Government later pays back this debt with interest. In essence, the public lends government money and this is a form of saving by the public. Government expenditure
  • 14. Budget Surplus Government Budget Balanced Budget Government revenue This is when government revenue is equal to government expenditure. Government expenditure
  • 15. Expansionary Fiscal Policy This is a form of Keynesian demand management aimed at expanding economic activity. Keynesian economists believe that that government intervention is necessary to control the economy. Expansionary fiscal policy can take any of the following forms: a) Decrease in income tax to increase disposable income and encourage greater consumption which can lead to an increase in AD. b) Decrease in corporate taxes to increase business profits which will be used for greater investments by firms, leading to an increase in AD. c) Higher government spending on capital projects may increase public services, leading to an increase in AD.
  • 16. Expansionary fiscal Policy The impact if successful expansionary policy can be seen in the diagram below. The AD curve increases from AD1 to AD2, leading to an increase in real GDP from Y1 to Y2, representing economic growth. The general price level increases from P1 to P2. Unemployment may also likely reduce as more workers might be needed to produce the extra output. However, there is a trade-off between unemployment and inflation. Higher real GDP leads to higher employment or lower unemployment, but the general price level rises from P1 to P2, which means inflation increases. There is also a trade off between economic growth and inflation. General Price level Real GDP (Y)
  • 18. DEMAND-MANAGEMENT POLICIES Learning outcomes: At the end of this lesson, you should be able to- -discuss the advantages and disadvantages of fiscal policy.
  • 19. Starter 1. Give two examples of contractionary fiscal policy. 2. Use a fully labelled diagram to illustrate the effects of a contractionary fiscal policy.
  • 20. Advantages and Disadvantages of Fiscal Policy Advantages 1. Fiscal policy is effective in the long run in addressing deep recession. For example, in the Great depression of the 1930s and the world recession that started in 2008, many countries recovered much faster by adopting the Keynesian demand management policies, specifically increased government spending. 2. It can be used to target specific sectors of the economy that will benefit the most. For example, families may be given tax cuts to boost higher consumer spending in the economy and small businesses may be granted fiscal stimulus to save them from collapse during a deep recession. Disadvantages 1. Time lags: Changes in fiscal policy take time. In most countries, changing the tax structure may need to go through a parliamentary decision-making process which can be time-consuming. In addition, the effects of fiscal policy changes take time before they are felt. 2. Political pressure: Some necessary fiscal changes may be unpopular from a political stand point. For example, government may be unwilling to raise taxes to control budget deficit for fear of losing votes.
  • 21. Advantages and Disadvantages of Fiscal Policy Disadvantages 3. Unsustainable debt: Some fiscal decisions may throw a country into an unsustainable level of debt. For example, expansionary fiscal policy through increases in government spending may require that government increase borrowing to achieve higher spending. This may be bad for a country that already has high budget deficits. 4. Crowding-out Effect: Increased government spending may lead to increased government borrowing. This may make government monopolize borrowing in the financial market. Interest rate is likely to rise as borrowing by government increases, making private sector borrowing more expensive. Therefore, government borrowing reduces (crowds out) private sector borrowing and investment. 5. It may cause a decline in net exports
  • 22. DEMAND-MANAGEMENT POLICIES Learning outcomes: At the end of this lesson, you should be able to- -Explain the Keynesian multiplier effect and perform calculations on it.
  • 23. The Keynesian Multiplier The Keynesian multiplier or the multiplier is when an initial amount of change in any component of aggregate demand leads to a greater final amount of change in aggregate demand or national income. It is the idea that an initial injection into the circular flow of income causes a bigger final increase in real GDP. For example, if the multiplier is 5, this means that a change in any component of aggregate demand would cause a change in aggregate demand that is 5 times the initial change in the component of aggregate demand. Hence, if investment increases by $10 million, aggregate demand will increase by 5 × $10 million = $50 million.
  • 24. The Keynesian Multiplier Government spending (G) and business investment (I) are injections into the circular flow of income and any injections are multiplied through the economy as people receive a share of the income and then spend a part of it. For example, if government spends money on a building project, this money goes to a vast majority of people for the factors of production they provide. The money goes to architects, engineers, builders, electricians, plumbers etc. Those who provide the capital and raw materials such as concrete, steels, water etc., also receive a share of the spending. The people that earn this income save some of it (savings, S), pay taxes out of it (taxes, T), buy imports (M) from it and spend the rest on domestic goods (consumption, C). This cycle continues all over again when the money is spent on domestic goods or services. Recall that S, T and M are leakages and C is an injection. The percentage of additional income consumed is called marginal propensity to consume (MPC) while the percentage additional income saved is called marginal propensity to save (MPS). The percentage of additional income paid as tax is called marginal propensity to tax (MPT) while the percentage of additional income spent on imports is called marginal propensity to import (MPM).
  • 25. How the Multiplier is calculated 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 (𝐾) = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐴𝐷 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝐾 = 1 1 − 𝑀𝑃𝐶 𝑜𝑟 1 𝑀𝑃𝑆 + 𝑀𝑃𝑇 + 𝑀𝑃𝑀 = 1 𝑀𝑃𝑊 Where: MPW is marginal propensity to withdraw (fraction of additional income that is withdrawn from the circular flow of income). Note: 1 − 𝑀𝑃𝐶 = 𝑀𝑃𝑆 + 𝑀𝑃𝑇 + 𝑀𝑃𝑀 = 𝑀𝑃𝑊 𝑀𝑃𝐶 + 𝑀𝑃𝑆 + 𝑀𝑃𝑇 + 𝑀𝑃𝑀 = 1 Note: marginal propensity to tax (MPT) is also known as marginal tax rate (MTR).
  • 26. Illustration 1. (a) Calculate the multiplier for an economy where the marginal propensity to consume is 0.75. (b) By how much will national income increase is there is an investment of $50,000? 2. An economy has a marginal propensity to consume of 0.8. Calculate: (a) its marginal propensity to withdraw. (b) its multiplier. (c) the amount of injections that would be needed if national income is to rise by $10 million. 3. In a country, the marginal propensity to save is 0.1, the marginal rate of taxation is 0.3, and the marginal propensity to import 0.1. How will the value of the multiplier change if government lowers taxes, such that the marginal rate of taxation drops to 0.2?
  • 27. Monetary Policy Monetary policy is defined as a set of measures by government or monetary authorities to control the level of money supply and interest rate in a country. Government uses expansionary monetary policy (i.e. increase in money supply or cut in interest rate) to increase aggregate demand and contractionary monetary (i.e. cut in money supply or increase in interest rate) policy to reduce aggregate demand. There are many interest rates in a country. In fact banks are free to set their own interest rates even though they are regulated by the government. However, the main interest rate used for monetary policy is called the base rate (discount rate, prime rate or monetary policy rate) that is set by a country's central bank. The central bank is a state or government bank set up to keep a country's financial system under close supervision and control and it is the apex regulator of banks.
  • 28. Aims of Monetary Policy Low unemployment rate To maintain a low and stable inflation rate Long-term economic growth To achieve balance between export revenue and import expenditure To reduce fluctuations in the business cycle What is Nigeria’s key interest rate called and who controls it?
  • 29. Types of Monetary Policy This involves reducing interest rate or increasing money supply thereby increasing borrowing and investment in the economy, which ultimately leads to an increase in AD, employment etc. Expansionary or loose Contractionary or deflationary or tight This involves increasing interest rate or cutting money supply thereby decreasing borrowing and investment in the economy, which ultimately leads to an increase in AD, fall in inflation etc. Are central banks truly independent
  • 30. CLASS WORK Demonstrate, with the use of appropriate diagrams, a) Expansionary monetary policy b) Contractionary monetary policy
  • 31. ADVANTAGES OF MONETARY POLICY  It is relatively quick to implement, as the central bank can set/alter the interest rate quickly.  There is no political intervention, as the central bank can adjust the interest rate without subjecting that decision to political processes, unlike fiscal policy.  Absence of crowding out effect: Interest rate can simply be changed by the central bank without crowding out private investment, unlike fiscal policy.  Very small changes can be made to achieve more precise targets than fiscal policy. For example, if an inflation of 2% is targeted very small fractions of changes in the interest rate can be made to achieve this.
  • 32. DISADVANTAGES OF MONETARY POLICY  Time Lags: Though they are quick to change, it may take time before the impact of monetary policy on aggregate demand is felt.  It is ineffective when interest rates are low: Expansionary monetary policy achieved through interest rate cuts cannot be used forever, as interest rates will eventually approach zero and there will be no room left for further reductions.  Low consumer and business confidence: If consumer and business confidence are low especially when a country is in deep recession, interest rate cuts may be ineffective to achieve desired economic aims.
  • 33. HOW COMMERCIAL BANKS CREATE MONEY Commercial banks create money through a process known as credit creation. This way, they help to significantly increase the money supply in the economy. Money supply is defined as the total stock of money in circulation at a given time, consisting of total currency in banks and outside banks. Credit creation occurs when commercial banks lend money to individuals and businesses based on customer deposits made with them. Commercial banks lend out a multiple of the depotit value, which is called money multiplier or banking credit multiplier. When a deposit is made in a bank by a customer, the bank holds a fraction of the money to meet customer withdrawals, while they lend out the remaining fraction. The fraction lent out is called minimum reserve requirement which is defined as the percentage of deposits that a central bank allows commercial banks to legally hold in reserve to meet the cash requirements of the depositor.
  • 34. HOW COMMERCIAL BANKS CREATE MONEY Commercial banks create money through a process known as credit creation. This way, they help to significantly increase the money supply in the economy. Money supply is defined as the total stock of money in circulation at a given time, consisting of total currency in banks and outside banks. Credit creation occurs when commercial banks lend money to individuals and businesses based on the customer deposits made with them. Commercial banks lend out a multiple of the deposit value, which is called money multiplier or banking credit multiplier. When a deposit is made in a bank by a customer, the bank holds a fraction of the money to meet customer withdrawals, while they lend out the remaining fraction. The fraction lent out is called minimum reserve requirement which is defined as the percentage of deposits that a central bank allows commercial banks to legally hold in reserve to meet the cash requirements of the depositor.
  • 35. HOW COMMERCIAL BANKS CREATE MONEY Suppose the central bank sets a 20% minimum reserve requirement (MRR). A deposit of $100,000 in a commercial bank will mean it will keep $20,000 to meet the cash requirements of depositors, while it lends out $80,000. The borrower of this $80,000 will take this money to their bank and deposit it, given they do not spend a fraction of it. This second bank is also subject to an MRR of 20%. They keep $16,000 in reserves and lend out $64,000. The borrower takes this money and deposits in their bank which is also subject to an MRR of 20%. This deposit-lending cycle will continue through the banking system. At the end of the process, the whole banking system would have created $500,000 from the initial deposit of $100,000 i.e. Total credit created = Initial deposit × money multiplier = $100,000 × 5 = $500,000. Hence, the money multiplier is given by the formula: Money Multiplier = 1 𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡
  • 36. Methods for controlling money supply Minimum reserve requirement Quantitative easing Open market operations What other methods can you think of? Central bank minimum lending rate
  • 37. HOW GOVERNMENT CONTROLS MONEY SUPPLY 1.Minimum reserve requirements (MRR): To increase money supply, the central bank reduces the minimum reserve requirement while they increase it to reduce money supply. The lower the MRR, the less commercial banks are required to keep in reserves and the more commercial banks can lend out. Whereas, the higher the MRR, the less commercial banks can lend out as they have to keep more of their deposits in reserves. 2.Open market operations: This involves buying and selling government securities in the open market by the central bank. A government security is a bond issued by the central bank. They are redeemable (paid-back) after a number of years with interest. Where government wishes to reduce money supply to control inflation, they sell securities to individuals and institutions, thereby mopping up excess liquidity (money supply) from circulation. This then reduces demand-pull inflation. On the other hand, government can increase AD and employment by buying government securities from the public. This releases more money into circulation which can boost investment, production and employment. Unfortunately, this may lead to demand-pull inflation.
  • 38. HOW GOVERNMENT CONTROLS MONEY SUPPLY 2. Open market operations: In addition, by the central bank selling government securities to institutions, commercial banks have less funds to lend. This reduces the supply of loanable funds and increases the interest rate which is the cost of borrowing. Buying government securities has the opposite effect. This is shown in the diagram below. An increase in interest rate will reduce AD as consumption and investment fall and vice versa.
  • 39. HOW GOVERNMENT CONTROLS MONEY SUPPLY 3. Central bank minimum lending rate: Also known as the base rate, discount rate or refinancing rate, this is the interest rate which the central bank charges on loans and advances to commercial banks. Note that commercial banks also borrow from the central banks in times of financial difficulties. Where a commercial bank is unable to raise short-term funds from the interbank market (a market consisting of commercial banks which lend, on short-term basis, to fellow banks having liquidity problems), they approach the central bank, as a last resort, to resolve their funding problems. If the CBN adopts contractionary monetary policy such that the minimum lending rate is raised, borrowing by commercial banks becomes more expensive and thus reduces. Hence, money supply, investment and AD reduce. However, a decrease in the minimum lending rate - an expansionary monetary policy - makes borrowing by commercial banks more attractive. Hence, borrowing, investment and AD increase.
  • 40. HOW GOVERNMENT CONTROLS MONEY SUPPLY 4. Quantitative Easing (QE): This is a form of monetary policy used by central banks as a way to quickly increase the domestic money supply in hopes of spurring economic activity. It involves the central bank issuing new money through newly created electronic cash and using that to purchase assets, particularly government securities, from commercial banks and other financial institutions. This puts more funds in the hands of these banks, increasing the amount of credit available to borrowers. The funds the banks receive for the assets will then be loaned to borrowers at attractive rates. The idea is that by making it easier to obtain loans, interest rates will remain low and consumers and businesses will borrow, spend, and invest. Increased spending leads to increased consumption, which increases the demand for goods and services, fosters job creation, and, ultimately, increases AD. However, there are downsides. Low interest rates can encourage companies to invest and spend more, causing price rises and eventual inflation. In order to counter these effects, central banks may reduce the money supply through quantitative tightening. The U.S. Federal Reserve used QE following the 2008-09 financial crisis and again in 2020 in response to the economic shutdown.
  • 41. EQUILIBRIUM NOMINAL INTEREST RATE Interest rate is the cost of borrowing funds or the reward for savings. It can also be regarded as the opportunity cost of holding or spending money. The nominal interest rate is the rate of interest available in the money market before adjusting for inflation. On the other hand the real interest rate is the interest rate that has been adjusted for inflation. If an economic agent spends money, they sacrifice other things the money could have been used for such as saving or investment. If nominal interest rate is high, then they give up a large return on their savings and investment and so they will hold or demand less money. If interest rate is low, then the opportunity cost of spending or holding money will be less and so they will hold or demand more money. This is why the demand curve for money is downward sloping as shown below. An increase in nominal interest rate from i1 to i2 decreases money supply from Q1 to Q2 and vice versa. Demand for money curve
  • 42. EQUILIBRIUM NOMINAL INTEREST RATE The supply of money curve is a vertical, perfectly inelastic curve. This is so because the central bank controls money supply and supplies a fixed quantity per period regardless of the level of interest rate. The supply of money curve is shown below. An decrease in the nominal interest rate from i1 to i2 or and increase in it from i2 to i1 leaves the money supply unchanged at Qm. The supply and demand for money can be combined to obtain the equilibrium nominal interest rate as shown below. An increase in the supply of money from SM to SM2 decreases the nominal interest rate from ie to i2, while and decrease from SM to SM1 increases the interest rate from 1e to i1.
  • 43. NOMINAL INTEREST RATE AND REAL INTEREST RATE Recall that the nominal interest rate is the interest rate that has not been adjusted for inflation and the real interest rate is interest rate adjusted for inflation. Both are connected by the formula below: 𝑹𝒆𝒂𝒍 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆 = 𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆 − 𝒊𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝒓𝒂𝒕𝒆 Example 1: if the rate of interest in the market is 5% and the inflation rate is 3%, then the real interest rate is 2%. This information is important for both savers and borrowers. A person saving at a nominal interest rate of 5% will find that their real gain is only 2%, whereas someone borrowing at the same rate will find that they are really only paying back 2%. Example 2: If the nominal interest rate is 2% and the inflation rate is 4%, then the real interest rate is −2%. This means a saver’s savings will decrease by 2% per annum, while a borrower will pay back 2% less than the amount borrowed. This will be a disincentive to save and an incentive to borrow.