Faculty of Business & Economic Sciences Managing tomorrow Study Guide INTRODUCTION TO MACROECONOMICS ECO1002 / BED1202 / BED1222 / BED1022 / BED12X2 CHAPTER 12: THE FACTOR MARKETS: THE LABOUR MARKET Learning Outcomes The purpose of this chapter is to introduce the most important features of the labour market particularly the supply, demand and remuneration of labour. Once you have studied this chapter you should be able to: • Illustrate and explain the backward bending supply curve for labour; • Explain the main determinants of the supply of labour; • Explain why the demand for labour is a “derived demand”; • Explain what marginal revenue product (MRP) stands for; • Explain why the firm maximises profits (is in equilibrium) when it employs workers up to the point where MRP equals the wage rate; • Analyse various labour market imperfections; • Explain, with the aid of a diagram, the impact of the imposition of a minimum wage in a perfectly competitive labour market; • Explain why wages differ; and • Mention reasons for engaging in informal sector activity. Written assignment questions / Tutorial questions / Self-study questions: For your information: Statistics South Africa uses the following definition of unemployment as its official definition. The unemployed are those people within the economically active population who: (a) were not employed in the reference week, (b) actively looked for work or tried to start a business in the four weeks preceding the survey interview, (c) were available for work, i.e. would have been able to start work or a business in the reference week; or (d) had not actively looked for work in the past four weeks but had a job or business to start at a definite date in the future and were available. Note: The difference between nominal wages and real wages is detailed below: Nominal wages refer to the face value of the wages. John earns a wage of R10 000 per month is an example of a nominal wage. Real wages refer to the purchasing power of wages. To determine real wages, prices have to be taken into account. To find out what happened to real wages over time, price changes (inflation) have to be taken into account. E.g., if the inflation rate is 7% and money wages increase by 5%: Change in real wages = change in nominal wages minus inflation rate. Therefore in this case real wages decreased by approximately 2% (= 5% minus 7%). Nominal wages did not keep pace with inflation and therefore the purchasing power of the wages (i.e., the real wages) decreased. 1 List six of the most important differences between the labour market and the goods market (pp. 209 – 2010). (6) 2 List six requirements for perfect competition in the labour market (p. 210). 3 Illustrate (Fig. 12-3, p. 211) and explain the backward bending supply curve for labour. In your answer, you need to clearly differentiate between the so-called substitution effect and income effect. (5) Economics I – Study Guide Page 1 (6) The qty of labour supplied up to a certain point (B in the figure) & then as the wage rate further. This is called the backward-bending individual supply curve of labour. Why does this happen? • Substitution effect. As the wage rate , workers will tend to work more hours, i.e., they will be willing to sacrifice leisure to obtain a higher income. An in the wage rate the opportunity cost of leisure & will probably entice most workers to sacrifice leisure & to work longer, thus enabling them to purchase more g & s. • Income effect. As a worker’s spending on g & s , his / her marginal utility of consumption . Moreover, leisure is a normal good, the demand for a normal good as income . As the worker’s income (along with the wage rate), his / her demand for leisure will . The direction of the substitution effect always depends on the change in relative prices. 4 Name THREE factors that may shift the supply curve for labour (pp. 212). (3) 5 Why is the demand for labour a “derived demand” (p. 212)? (2) 6 Give an equation for calculating the marginal revenue product, clearly defining the various concepts involved in the equation (p. 213). (2) For a perfectly competitive firm, marginal revenue (MR) is = the price (P) of the product. For such a firm, marginal revenue product (MRP) is equal to marginal physical product (MPP) multiplied by the price of the product (P). Thus MRP = MPP * P. MRP is expressed in monetary terms. MPP indicates the physical value to the firm of employing an additional unit of labour. Note: To determine whether or not it will be profitable to employ an additional unit of labour, the MRP has to be compared to the marginal cost of labour. “As long as MRP is greater than the wage rate (w), i.e., as long as each additional worker’s contribution to the firm’s revenue is greater than the cost of hiring him or her, it will be profitable to expand employment. Equilibrium (i.e. maximum profit) is achieved when MRP is equal to the wage rate (w)” (Mohr et al. 2015:214). Example: The table below (Table 12A) has the marginal product schedule for a firm. If the firm is a perfect competitor and the price of the product is constant at R2 a unit, complete the table. If the wage rate is R8 an hour, how many workers does the firm hire? Economics I – Study Guide Page 2 Table 12A Quantity of labour (workers) 1 2 3 4 Marginal product (units per hour) 10 8 6 4 Marginal revenue product (Rands) Consider the information in Table 12A. The first column gives the number of workers and the second column shows the marginal physical product of labour, i.e., the additional units of an item that can be produced by hiring each additional worker. The next column requires you to calculate the MRP of labour. This is obtained by multiplying the MPP by the price of the product (given as R2 in the question). Using this information we can now calculate the MRP in Table 12B and determine how many workers the firm must hire. Table 12B Quantity of labour Marginal product (units Marginal revenue product (workers) per hour) (Rands) 1 10 10 x 2 = 20 2 8 8 x 2 = 16 3 6 6 x 2 = 12 4 4 4x2=8 If the wage rate is R8 an hour, the firm will then maximise profits by employing a maximum of four workers because that is the quantity that sets the MRP equal to the wage rate. 7 The table below gives you information about a firm operating in a competitive product market. Consider all factors of production fixed, with the exception of labour. The other factors of production cost the firm R50 a day, which may be thought of as a fixed cost. Assume the firm is a profit maximiser. Labour input Total physical product Marginal physical Marginal revenue (workers per day) (units per day) product (units per day) product (R per worker) 0 0 — — 1 22 2 40 3 56 4 70 5 82 6 92 7 100 8 106 a) Assume the firm sells its output at R3 per unit. Complete the last two columns in the table. (16 X ½ = 8) b) If the equilibrium market wage is R36 per day, the firm will hire workers per day and produce ___ units of output. (2) c) Given your answer to the preceding question, the firm will have total revenue of per day and total cost of per day. (2) d) The above will result in a (profit / loss) of per day. (2) For your information: If you were wondering why firms continue hiring workers until the marginal revenue product of labour is equal to the wage rate, here is an explanation: As long as the marginal revenue product (MRP) is greater than the wage rate, it will pay a firm to employ more workers, since the value of each additional worker (i.e., MRP) is greater than what it costs to hire the worker (the wage rate). Firms will therefore continue to employ workers until MRP = wage rate. 8 Name THREE factors that cause the demand curve for labour to shift (pp. 215 – 216). Note: Economics I – Study Guide Page 3 (3) Wages cause a movement along the demand or supply curve of labour. The demand for labour curve slopes downwards because of diminishing returns to labour. Note: Collective bargaining may be defined as a process during which negotiations between representatives of employers and unions are held to determine workers’ wages and other conditions of service (Mohr et al. 2008:288). 9 Give six reasons why labour markets can be imperfect (p. 216). (6) Remember: Whenever you draw a diagram in Economics, all axes and curves must be fully labelled. [Note: the labels on the axes must be written out in words.] Also ensure that you have included all necessary arrows. In the case of demand and supply diagrams that means that you should, in most cases, have four arrows. One arrow should indicate the direction in which the demand or supply curve has shifted. One arrow should indicate what has happened to “price”, while another arrow should indicate what has happened to “quantity”. The final arrow should indicate the transition from the original equilibrium point to the new equilibrium point. 10 “A trade union is an organisation of workers that promotes and protects the interests of its members in issues such as wages and working conditions, especially through negotiations with employers” (http://www.services.gov.za/en-za/RegisterTradeUnion.htm). a) Name the THREE methods that trade unions can use to attempt to increase the wage rate (p. 217). (3) b) Explain, with the aid of a diagram (Fig. 12-8 (c), pp. 217 – 218), how trade unions can try to increase wages and employment by trying to raise the demand for the product of a specific industry. (5) 11 Illustrate (Fig. 12-11, pp. 223 - 224) and explain the impact of the imposition of a minimum wage in a perfectly competitive labour market. (4) <See Figure 12-11> DD is the demand curve. SS is the supply curve. The equilibrium is at E with equilibrium wage rate We & equilibrium qty Ne. If the minimum wage is set below the equilibrium it will have no effect on the equilibrium wage rate & qty. If, however, the wage rate is set above the equilibrium at Wm, the qty demanded will be Nm & the qty supplied will be N1. The excess supply of labour will be equal to the difference between N1 & Nm. Unemployment will be equal to the difference between N e & Nm. 12 A headline in an online newspaper read, “Casuals ‘exploited’ by hospitality industry 1”. According to the article some employers in the hospitality industry were exploiting and underpaying their employees because no clear minimum wage for workers in this industry had been established. As a result, some of the workers called on government to intervene. Assume that in response to this article the government introduced a minimum wage for the hospitality industry. Use a diagram (Fig. 12-11, pp. 223 - 224) to explain the impact of the imposition of a minimum wage in this perfectly competitive labour market. Furthermore, besides stopping the exploitation of workers, mention two other reasons, that supporters of minimum wages may have used to convince the government to introduce a minimum wage in this industry (p. 223). (6) Same as Question 11’s answer, but add in that supporters of minimum wages argue that minimum wages will increase productivity (the higher wages may improve the nutrition, health, vigour & motivation of workers, thus making them more productive) & that wages are the most significant form of income and therefore constitute the largest source of the demand for goods and services. 13 Name and explain FIVE reasons why wages differ in the market (pp. 225 – 228). (3 X 2 = 6) Mackay, M. 14 December 2006. Casuals ‘exploited’ by hospitality industry, Independent online. [Online]. Available http://www.iol.co.za/news/south-africa/casuals-exploited-by-hospitality-industry1.307553#.T_HUmJHnFMQ [Accessed 28 June 2012]. 1 Economics I – Study Guide Page 4 14 • • • • A recent report indicated that SAB Miller’s chief executive officer (CEO), Alan Clark, earned a basic annual remuneration package of R122 million. Based on the knowledge that you have gained, explain how such exceptionally high pay could be economically justified. Further information: SABMiller plc is a South African multinational brewing and beverage company headquartered in London, England. It is the world's second-largest brewer measured by revenues (US $23.213 billion in 2013) (after the Belgian-Brazilian Anheuser-Busch InBev) and is also a major bottler of Coca-Cola. It has operations in 75 countries and employs approximately 70 000 people worldwide. About 5 600 workers are employed in its South African beer division, of which about 1 900 are union members http://en.wikipedia.org/wiki/SABMiller). Alan Clark was appointed as SABMiller’s CEO in April 2013. His profile on the company’s website indicates that he joined The South African Breweries Ltd in 1990 and held a number of management roles in South Africa, both in beer and soft drinks. It should also be noted that Dr Clark received his Doctorate of Psychology degree from the University of South Africa before joining The South African Breweries Ltd. (http://www.sabmiller.com/about-us/ourleadership/board-of-directors/alan-clark-chief-executive). ___ 2014. Highest paid CEOs in South Africa. [Online]. Available: http://businesstech.co.za/news/international/69599/highest-paid-ceos-in-south-africa/ [Accessed 28 September 2014]. (2 X 2 = 4) Discussion could revolve around: Job-related differences – explanation would revolve around the last paragraph of this subsection, namely that job-related differences include the educational, training or skill requirements of different occupations, the importance of experience & the degree of accountability or responsibility associated with the job. Worker-related differences – similar reasons to those in last paragraph of job-related differences Differences related to market structure – the less elastic the demand for the product, the higher the remuneration of labour will tend to be, ceteris paribus. Or possibly, workers employed by firms that have a significant degree of market power (i.e., those that operate in monopolistic or oligopolistic markets) will tend to earn more than those workers who are employed by firms operating in highly competitive goods markets. Differences in productivity - the important decisions made by CEOs have an effect on overall firm productivity. High pay provides an incentive not only for current CEOs, but also for aspiring CEOs, further enhancing productivity. Note: There are 3 main reasons why people engage in informal sector activity: • They can’t find employment in the formal sector. • They are engaged in illegal activities. • They don’t want to pay tax. Economics I – Study Guide Page 5 Revision: Indicate whether each of the following statements is True (T) or False (F). True (T) 1 2 A change in the wages of the workers will shift the market supply of labour. One of the requirements for perfect competition in the labour market is that labour should be heterogeneous (ie each worker must have unique skills). 3 Trade unions are interested in increasing the productivity of their members because as their productivity rises, the supply of their labour rises and their wages rise. 4 The labour supply curve is backward bending because at higher wages the income effect eventually dominates the substitution effect. 5 With respect to labour supply, the income effect leads a person to want to work more in order to raise his or her income. 6 The demand for labour is a derived demand, which implies that there will only be a demand for labour to produce a certain product if there is a demand for the product itself. 7 A firm will employ workers as long as the MRP is greater than the wage rate (w). 8 In a perfectly competitive market, the firm will maximise its profit where the price of labour (wage rate) equals the MRP. 9 Ms Ntuli owns a company that sells life insurance. When she employs 10 salespersons her firm sells R200 000 worth of contracts per week, and when she employs 11 salespersons, total revenue is R210 000. The marginal revenue product of the 11th salesperson is R10 000. Table 1 Labour Marginal product (Output) 0 0 1 20 2 45 3 80 4 100 5 110 10 In Table 1, the marginal product of the 3rd unit of labour is equal to 80. 11 In Table 1, if the product’s price is fixed at R5 a unit, the MRP of the third worker is equal to R175. 12 An increase in the productivity of workers will, ceteris paribus, shift the labour demand curve upwards to the right. 13 Introducing a minimum wage below the equilibrium wage in a perfectly competitive labour market will result in an excess demand for labour. 14 15 Figure 1 In Figure 1 above, R8 an hour is an effective minimum wage. At this minimum wage rate 4 000 hours of labour would be employed. Wage discrimination means workers with equal productivity are paid unequal wages, or workers with unequal productivity are paid equal wages. Economics I – Study Guide Page 6 False (F) CHAPTER 13: MEASURING THE PERFORMANCE OF THE ECONOMY Learning Outcomes The purpose of this chapter is to explain the standard macroeconomic objectives and to explain the criteria; concepts and techniques used to assess the performance of the economy. Once you have studied this chapter you should be able to: • Explain how the performance of the economy is measured; • Explain the five main macroeconomic goals; • Explain what the national accounts represent; • Explain how the performance of each objective is measured; • Define the most important national accounting concepts; • Calculate Gross Domestic Product (GDP); • Show how the basic national accounting concepts are linked; • Define the unemployment rate; • Define and interpret the Consumer Price Index (CPI); • Calculate the price level using the CPI; • Explain the balance of payments; and • Illustrate and explain a Lorenz curve and the Gini coefficient. Written assignment questions / Tutorial questions / Self-study questions: Note: Like any company, a country also needs a set of accounts which may be used to assess the performance of the economy. The national accounts are a set of accounts that may be used to determine how the economy is performing in respect of a range of objectives such as economic growth and employment creation. The national accounts reflect the level and composition of total economic activity in a particular period. The South African national accounts are compiled by the national accountants at Statistics South Africa and the South African Reserve Bank. 1 Name AND explain the FIVE macroeconomic objectives which are used to evaluate the economic performance in a country (pp. 234 – 235). (5 X 2 = 10) 2 Define the following concepts: a) GDP (p. 235); b) double counting (p. 235); and c) purchasing power (p. 239). (2) (1) (1) 3 What is the difference between a “final good” and an “intermediate good”? Give an example of each of these types of goods (p. 8 and p. 236). (2 X 2 = 4) • Final goods = goods (e.g. a loaf of bread) that are used or consumed by individuals, households & firms (i.e. these goods & services are purchased for final use by the purchaser, & not for resale or further processing & manufacturing). • Intermediate goods = goods (e.g. flour used by a baker) that are purchased to be used as inputs in producing other goods. Intermediate goods and services are thus processed further before they are sold to end users. 4 Define gross domestic product (GDP) and briefly explain the significance of each element of the definition (pp.235 – 236). (6) Gross domestic product (GDP) is the key concept in the national accounts. GDP is the total value of all final goods and services produced within the boundaries of the country in a particular period (usually one year). The word “gross” indicates that no provision for depreciation of capital goods (also called consumption of fixed capital) is taken into account. It is a total, that is, an aggregate for the economy as a whole. It is also a value. The only way in which the production of different goods and services may be added together, is by using values (i.e., prices of the goods multiplied by quantities). GDP is measured in a currency, e.g., the rand, rather than some physical measure, e.g., tons. Economics I – Study Guide Page 7 The next important element of the definition is the word “final”. One of the main problems that the national accountants are faced with is to avoid double counting. One way to avoid this, is to take into account final goods and services only and to ignore intermediate goods and services. The next important element is goods and services. Services (even though they are intangible) are included in GDP, together with tangible goods. (Note: services currently comprise about 2/3 of SA’s GDP.) The next important aspect is that only production inside the country (on SA soil) is taken into account. This is why it is called the “domestic product” – the production occurred inside the country. It also points to the fact that GDP is a geographic concept. It doesn’t matter who produces the goods & services (i.e., they could be foreigners) – as long as production occurs within the borders of the country, it is part of South African GDP. GDP also pertains to a specific period. It is confined to production within that period (usually a year). Production that occurred prior to or after the year in question is not taken into account. GDP is thus a flow concept. 5 Mention two ways in which the national accountants try to avoid double counting (p. 236). (2) Note: In the accounting sense (that is, after the fact, or after the events have occurred) total production, total income and total expenditure on the product are all equal. Production and income are two sides of the same coin. When production occurs, the factors of production are remunerated and the total value of the product is equal to the total income (including profit) earned by the various factors of production. But total income need not necessarily be spent. However, the national accountants incorporate any change in inventories into total spending. Any increase in inventories is included in investment spending and any decrease in inventories is subtracted from investment spending. In this way they ensure that total production = total income = total expenditure on the product in the national accounts. These equalities mean that the value of total economic activity may be approached from three different angles: the production approach (value added), the income approach (incomes of the factors of production) and the expenditure approach (spending on final goods and services). 6 Name and explain the THREE methods used to calculate GDP (pp. 236 – 237). (3 X 2 = 6) Example: Apply the principle of added value and calculate the national income according to the production, income and expenditure methods using the information that follows: Assume that fish are produced by the inhabitants of NMMUland, which has a closed economy. Also assume that the inhabitants are able to make a living from this product. The fish are processed into canned fish and the wood into furniture. The producer sells fish to a cannery for R1 000. The wages the fisherman had to pay out amounted to R400, and his profit therefore amounted to R600. The cannery processes all the fish and sells it to a retailer for R3 000. Wages amounted to R1 200. The cannery therefore made a profit of R800. The retailer sells the canned fish to a variety of consumers for R12 000. Wages amounted to R3 500, and profit amounted to R5 500. Our knowledge of the three methods used to calculate GDP can be summarised as follows: Method What it measures Important equation GDP = value added by the How much value each firm adds primary sector + value added by Production method to the material that it uses to the secondary sector + value make its product added by the tertiary sector Income earned by the factors of GDI = wages + profit + interest Income method production (wages, rent, + rent interest and profit) Actual expenditure on final Expenditure flow = C + I + G + Expenditure method goods and services (X – Z) Economics I – Study Guide Page 8 So, our calculations will be as follows: Method Production method Sale of fish to cannery Cannery sells to the retailer (added value only R3 000 – R1 000) Retailer sells to consumers (added value only R12 000 – R3 000) Value added Income method Fisherman: Wages Profit Cannery: Wages Profit Retailer: Wages Profit National income Expenditure method Expenditure by consumers on final goods purchased 7 Rands 1 000 2 000 9 000 12 000 400 600 1 200 800 3 500 5 500 12 000 12 000 A gold mine extracts gold-bearing ore from the ground, which it sells to a refinery. The refinery sells the refined gold to a jeweller, who then manufactures various items of gold jewellery to sell to consumers. The sale values (measured in R millions) relating to these transactions are as follows: GOLD BEARING ORE (Sold by the gold mine): 600 REFINED GOLD (Sold by the refinery): 750 JEWELLERY (Sold by the jeweller): 800 a) Calculate the Value Added at each stage of this production process. (3) b) Calculate the Total Value Added. (There are two ways: explain both.) (3) c) In the context of Value Added, what is meant by double counting? Use figures provided above to give an example of double counting. (2) 8 Table 13.1 describes the process by which a loaf of bread is sold to a consumer as a final good. In the first stage of the production process, the farmer raises the wheat and sells enough for one loaf of bread to the miller for R2.00. The miller grinds the wheat into flour and sells the flour to the baker for R3.50. The baker uses the wheat to bake a loaf of bread which is sold to a grocer for R6.00. Finally, the grocer sells the bread to a consumer for R7.50. Table 13.1 Steps 1. 2. 3. 4. Farmer sells wheat to miller Miller sells flour to baker Baker sells bread to grocer Grocer sells bread to consumer Price R2.00 R3.50 R6.00 R7.50 a) Compute the value added at each of the four stages of the production process. (2) b) What is the total value added for this loaf of bread? How does it compare with the expenditure on the loaf of bread as a final good? (3) Note: • Primary sector = the sector in which raw materials (e.g. fishing & mining products) are produced. • Secondary sector = the manufacturing sector of the economy in which raw materials are used to produce other goods (e.g. processing minerals into mineral products such as steel). • Tertiary (services) sector = the services & trade sections of the economy (e.g. financial services). Economics I – Study Guide Page 9 9 The table below provides information on the economic performance of the small, imaginary economy of Timberland. GDP 2 000 Value added by primary sector 1 000 Value added by secondary sector a) b) c) d) 10 300 Calculate the value added by the tertiary sector. (2) Which approach to calculating GDP is being used? (1) Calculate the relative contributions by the primary, secondary and tertiary sectors to GDP. (3) Would the economy of Timberland be described as relatively developed or underdeveloped? Explain. (2) Differentiate between the following concepts: a) Subsidies and indirect taxes effect on market prices (p. 238); b) GDP at current / nominal prices and GDP at constant / real prices (p. 239); and c) GDP and GNI (p. 235 and p. 241). (3 X 2 = 6) 11 Briefly explain the differences between measurement at market prices, basic prices and factor cost (or income) (p.238). (6) • Market prices are used when GDP is estimated from the expenditure side. These are the prices paid when the expenditure occurs. • Basic prices relate to value added, that is, to the production approach to the estimation of GDP. To move from market prices to basic prices taxes on products (such as VAT) have to be deducted while subsidies on products have to be added. • Factor cost (or income) relates to the incomes of the factors of production, that is, to the income approach to estimating GDP. To move from basic prices to factor cost, other taxes on production (not linked to specific goods or services) have to be subtracted and other subsidies on production have to be added. 12 Why are national accounting totals (like GDP) estimated at constant prices as well as at current prices (pp. 239 – 240)? (6) The short answer to the question is that GDP is expressed at constant prices to eliminate the impact of inflation and to make it possible to estimate economic growth. When GDP and other national accounting totals are estimated, the actual prices ruling at the time are used. These prices are called current prices. The initial measurement or estimation is always at current prices. However, when we want to compare different years’ data to determine whether or not the economy has grown (and by which percentage), current prices have to be adjusted for inflation (i.e., for price changes) before any meaningful conclusions can be drawn. Once the impact of inflation has been eliminated, we are left with a set of data measured or estimated at constant prices. What happens is that the national accountants choose a base year and express the value of GDP and other national accounting aggregates at the prices that were obtained during the base year (i.e., at constant prices), along with the unadjusted values (i.e., at current prices). Note: Below, note the difference between nominal values and real values and how this relates to purchasing power. Nominal values are the unadjusted values as we observe them. For example, Anne earns R20 000 per month. But we want to know what the actual or real value of her salary is, in terms of what she can actually buy with her salary. Real values are adjusted for price changes and reflect purchasing power. For example, if my (nominal) salary increases by 5% but prices also increase by 5%, my nominal salary has increased, but my real salary remains unchanged. In other words, I can still buy the same amount of goods and services than before, not more. Nominal values are expressed at current prices and real values are expressed at constant prices. Economics I – Study Guide Page 10 13 Why do national income accountants include only final goods in measuring GDP for a particular year? Why don't they include the value of stocks and bonds sold? Why don't they include the value of used furniture bought and sold? (3) The Rand value of final goods includes the Rand value of intermediate goods. If intermediate goods were counted, then double counting would occur. The value of stocks and bonds sold is not included in GDP because such sales and purchases simply transfer the ownership of existing assets; such sales and purchases are not themselves (economic) investment and thus should not be counted as production of final goods and services. (The value of corporate stocks and bonds traded in a given year is excluded from the calculation of GDP because they make no contribution to current production of goods and services.) Used furniture was produced in some previous year; it was counted as GDP then. Its resale does not measure new production. 14 Explain the difference between expenditure on gross domestic product (GDP) and gross domestic expenditure (GDE) (pp. 242 – 244). (6) 15 Explain the significance of the difference between GDP and GDE (pp. 242 – 244). 16 Give the definition of GDP. Furthermore, provide the formula that is used to calculate GDP using the expenditure approach. Briefly provide an explanation of each component of the equation (p. 235 & pp. 242 – 244). (6) GDP is the total value of all final goods and services produced within the boundaries of the country in a particular period (usually one year). The following equation summarises the expenditure approach to measuring GDP: GDP = C + I + G + (X – Z) The variables on the right hand side of the equation refer to: • C = Consumption: This is the spending by households on g & s. Consumption includes purchases of durable goods e.g. TV's, cars; semi-durable goods e.g. clothes & light bulbs; non-durable goods e.g., food, petrol & services e.g. doctors services. [New housing not included in consumption, it is included in I!] • I = Gross private investment. The act of purchasing capital goods, e.g. machinery & buildings, is called investment or capital formation. It includes changes in inventories. [Includes expenditure on new housing. Stock and bonds are NOT included.] • G = Government purchases: This includes expenditure on goods (e.g. hospital supplies) & services (e.g. hospitals, roads) (including factor services). Government purchases, however, excludes transfer payments. • (X - Z) = Net exports (Exports – Imports). South African exports are South African goods sold to people in other countries. South African imports are goods purchased by South Africans from other countries. (6) For your information: The nominal value of the GDP in a particular year is measured in terms of the prices that were applicable in that particular year. During a period of continuous price increases it may be possible that the GDP will vary from one year to the next as a result of an increase in the production of goods and services or merely as a result of an increase in the prices of goods and services. As such, we cannot use a comparison of yearly nominal GDP values as an indication of economic growth because we cannot be sure that an increase in the GDP indicates real growth and not just an increase in prices. It is for this reason that estimates of the GDP in terms of real prices are also made. The GDP of different years is measured in terms of the prices in a particular year. Table 13A, which sets out the South African GDP in terms of current and constant values, serves as an example. Economics I – Study Guide Page 11 Table 13A: GDP per capita at current prices and constant prices, 2000 – 2014 Year GDP at current prices (R millions) GDP at constant (2010) prices (R millions) 2000 21 657 44 735 2001 23 481 45 075 2002 26 778 45 798 2003 28 632 46 287 2004 31 370 47 605 2005 34 281 49 335 2006 37 899 51 331 2007 42 863 53 334 2008 47 512 54 322 2009 49 682 52 838 2010 53 823 53 823 2011 58 584 54 930 2012 62 463 55 508 2013 66 845 56 047 2014 70 910 56 198 2015 73 549 56 169 Source: South African Reserve Bank. 2016. South African Reserve Bank Quarterly Bulletin, March 2016: Statistical tables: National accounts. Available: https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/7195/10Statistical%20ta bles%20%E2%80%93%20National%20Accounts.pdf Because 2010 prices were used to calculate real GDP, you will notice that the value of real and nominal GDP are the same in 2010. This must be so because the same prices were used in both calculations. 2010 was thus the base year for the calculations. Furthermore, recall that economic growth is the rise in potential production when the quantity and / or the quality of the available resources increase. In other words, we can say that economic growth is an increase in the real value of production and income. It is usually measured as the annual rate of increase in GDP at constant prices (i.e. real GDP). Note that GDP at current prices (i.e. nominal GDP) cannot serve as the basis for calculating economic growth since it increases on account of inflation as well. Only inflationadjusted figures can be used to calculate economic growth. Note: Nominal GDP (GDP at current prices) is the value of the final goods and services produced in a given year valued at the prices that existed in that same year. I.e., Current year production * current year prices. Traditionally, real GDP is calculated using prices of the base year (the year in which real GDP = nominal GDP). I.e., Current year production * base year prices. See Box 13-2 on page 240 for an example. Note: “The base year is the year in which the survey of household expenditure is done” (Mohr et al. 2007:68). It is also a year in which there have been few economic fluctuations. A census year is often chosen as the base year as Statistics South Africa has a lot of information for that year. The price index for the base year is always equal to 100 (Greyling and Powell 2005:63). Economics I – Study Guide Page 12 Example: Suppose the economy of the Republic of Diba produces only chocolates, t-shirts and bottled water. The following table shows the market prices of these products for 2004 and 2010 (in Rand), as well as the quantities produced during 2010. Use 2004 as base year and determine: Price Price Quantity Product (2004) (2010) (2010) Chocolate 2.50 6.00 10 000 T-shirts 9.00 45.00 4 000 Bottled water 0.40 4.20 8 000 a) Calculate the nominal GDP of Diba 2010. (Show the equations (or formulas) you used and all your calculations) b) Calculate the real GDP for the year 2010. (Show the equations (or formulas) you used and all your calculations) a) Answer: Nominal GDP 2010 = Current period production x current period prices = GDP@ nominal (current) prices = Q 2010 x P 2010 = (10000 x R6) + (4000 x R45) + (8000 x R4.20) = 50000 + 180000 +33600 Nominal GDP 2010 = R273600 b) Answer: Real GDP 2010 = Current period production x base period prices = GDP@ Real (constant) prices = Q 2010 x P 2004 = (10000 x R2.50) + (4000 x R9) + (8000 x R0.4) = 25000 + 36000 + 3200 Real GDP 2010 = R64200 17 Ecoland produces only bananas and ice-cream. The base year is 2013, and the table below (i.e. Table 13.2) gives the quantities produced and prices. Table 13.2 Good Bananas Ice-cream 2013 Quantity Price 1 000 bunches R2 a bunch 500 R20 each 2014 Quantity Price 1 100 R3 a bunch 525 R25 each a) Calculate Ecoland’s nominal GDP in 2013 and 2014. (Show all your calculations.) b) Calculate Ecoland’s real GDP in 2014. (Show all your calculations.) (3) (2) 18 Study the table below and answer the questions that follow. Ensure that you have shown all your workings. Goods 2005 Quantities 2005 Prices 2012 Quantities 2012 Prices Pencils 10 R1.00 20 R0.50 Bubblegum 15 R0.60 20 R0.80 Oranges 8 R4.00 15 R4.00 a) Calculate Nominal GDP in 2005. (3) b) Calculate Nominal GDP in 2012. (3) c) Assuming that 2005 is the base year, Real GDP in 2012 is ___. (3) 19 BEDLand produces only two products: gold and platinum. In 2013 the country produced 100 tons of gold at R500 000 per ton and 60 tons of platinum at R1 000 000 per ton. In 2014 the country produced 90 tons of gold at R600 000 per ton and 80 tons of platinum at R1 100 000 per ton. a) Calculate the value of nominal GDP in 2013. (3) b) Calculate the value of GDP at current prices in 2014. (3) c) Calculate the value of GDP in 2014 at constant 2013 prices. (3) d) When comparing the performance of the economy over time, should one calculate the growth rate in real or nominal GDP? Why? (3) Economics I – Study Guide Page 13 20 Peruse the table below and answer the questions that follow: Gross domestic expenditure (GDE) Exports of goods and services Imports of goods and services Consumption expenditure of households Change in inventories Consumption expenditure of general government Depreciation (consumption of fixed capital) a) b) c) d) 1 000 200 250 600 -50 250 100 Calculate GDP. Calculate the gross fixed investment expenditure (or capital formation). Calculate the net fixed investment expenditure (or capital formation). Which approach to measure GDP is being used? (3) (2) (2) (1) 21 How is the unemployment rate estimated? Ensure that you have included the formula that is used to calculate the unemployment rate (p. 244). (2) 22 What is the difference between the strict definition and the expanded definition of unemployment (p. 244)? (2) Strict vs Expanded unemployment rates in South Africa: 1st Quarter 2016 Expanded; Expanded; Expanded; Expanded; Expanded; Expanded; Expanded; Free Eastern Northern Cape; Cape; North West; Mpumalanga; Limpopo; 39 38.9 42.5 41.1 State; KwaZulu-Natal; 40.1 39.1 Expanded; South 36.3 Strict; Northern Africa; 34.9 Strict; Free Expanded; Cape; 32.7 Strict; Strict; Eastern State; 31.4 Gauteng; 31.3 Mpumalanga; Strict; Gauteng; Expanded; Cape; 29.1 Strict; North Strict; South 27.2 26.8 Western Cape; West; 25.2 Africa; 25 Strict; Western 24.1 Strict; KwaZuluCape; 21.7 Strict; Strict Limpopo; Natal; 20.4 18.9 Expanded Source: Stats SA. 2016. Quarterly labour force survey Quarter http://www.statssa.gov.za/publications/P0211/P02111stQuarter2016.pdf 23 1 2016 – Available: Define the concept “consumer price index (CPI)” and explain how the CPI figure is constructed by Statistics South Africa (p. 246). (6) Economics I – Study Guide Page 14 Note: By using the prices and the contents of the CPI basket it is possible to calculate the CPI. The formula is: CPI = Cost of basket in current period *100 . Cost of basket in base period Furthermore, note that a major purpose of the CPI is to measure inflation. The inflation rate is the percentage change in the price level from one year to the next. The inflation formula is: (CPI of this year - CPI of the previous year) * 100 CPI of the previous year Consumer inflation per province (% change year on year – 2015 - 2016) 9 8 7 6 5 4 3 2 1 0 8.2 7 6.7 6.1 6.9 6.1 6.2 6.5 6.5 4.8 Source: Stats SA. 2016. Consumer Price Index (CPI) http://www.statssa.gov.za/publications/P0141/P0141April2016.pdf April 2016 – Available: Example: Suppose that the market basket underlying the CPI in NestleWorld is composed of 3 bicycles, 10 pizzas, and 5 litres of milk. You are given the following information about prices of these items over the three year period 2007-2010. Price of a Bicycle Price of a Pizza Price per litre of milk 2007 R100 R4 R2 2008 R120 R5 R2 2009 R150 R5 R5 Given this information calculate the CPI on a 100 point scale for 2007, 2008, and 2009 using 2007 as the base year. Answer: To answer this question you will first need to calculate the cost of the market basket in each of the three years: Cost of market basket in 2007 = (3)*(100) + (10)*(4) + (5)*(2) = R350 Cost of market basket in 2008 = (3)*(120) + (10)*(5) + (5)*(2) = R420 Cost of market basket in 2009 = (3)*(150) + (10)*(5) + (5)*(5) = R525 To find the CPI index numbers use the following formula: CPI for year n = [(Cost of market basket in year n) / (Cost of market basket in base year)]*(100) CPI for 2007 = [(350) / (350)]*100 = 100 CPI for 2008 = [(420) / (350)]*100 = 120 CPI for 2009 = [(525) / (350)]*100 = 150 Economics I – Study Guide Page 15 Calculate the annual rate of inflation between 2007 and 2008, and the annual rate of inflation between 2008 and 2009. Answer: To find the rate of inflation use the percentage change formula: Percentage change in a variable = {[(Value of variable in current year) – (Value of variable in previous year)]/(Value of variable in previous year)} * (100%) Percentage change in the CPI from 2007-2008 = [(120 – 100) / 100] * 100 = 20% Percentage change in the CPI from 2008-2009 = [(150 – 120) / 120] * 100 = 25% 24 In 2013, consumers in Mohrville consumed only pencils, calculators and books. The prices and quantities for 2013 and 2014 are listed in the table below (i.e. Table 13.3). The reference base period for Mohrville’s CPI is 2013. Table 13.3 Base-period basket Base period price Current period price 200 Pencils 2 Calculators 5 Books R0.50 each R50.00 each R40.00 each R0.70 each R75.00 each R30.00 each a) What is the CPI for Mohrville in 2013? b) What is the CPI for Mohrville in 2014? 25 (2) (3) In 2013, consumers in NMMUVille consumed only pens and books. The prices and quantities for 2013 and 2014 are listed in the table below. The reference base period for NMMUVille’s CPI is 2013. Based on this information calculate the inflation rate between 2013 and 2014. Item Books Pens 2013 Quantity Price 10 R30 20 R1 2014 Quantity Price 8 R50 15 R2 Note: A trade deficit occurs when the value of a country’s imports is greater than the value of its exports. A trade surplus occurs when the value of a country’s exports is greater than the value of its imports. Note: The balance of payments consists of two major accounts (components), namely the current account and the financial account (previously called the capital account). Transactions in these two accounts are either indicated as debits (-) or credits (+). The net effect of the two accounts adds up to either a surplus (+) or deficit (-), which influences the third component of the balance of payments, namely the change in the country’s gold and other foreign reserves. This is also referred to as the balancing item. Note: In order to keep abreast of international best practice in the compilation and dissemination of balance-ofpayments statistics, the South African Reserve Bank (the Bank) has aligned South Africa’s balance-ofpayments statistics with the guidelines provided in the Sixth Edition of the Balance of Payments and International Investment Position Manual (BPM6) of the International Monetary Fund (IMF). This alignment process was first shown in the December 2014 South African Reserve Bank’s Quarterly Bulletin. Economics I – Study Guide Page 16 COMPARISON OF THE BPM5 (OLD METHOD) AND BPM6 (NEW METHOD) FRAMEWORKS AS ADOPTED BY SOUTH AFRICA BPM5 Current account Merchandise exports Net gold Minus: Merchandise imports Trade balance Net service payments Transportation Passenger fares Other Travel Other service Net income payments Net current transfer payments Net service, income and current transfer balance Current account balance Capital transfer account balance Financial account Direct investment Liabilities Assets Net direct investment (1) Portfolio investment Liabilities Assets BPM6 Current account Merchandise exports Net gold Minus: Merchandise imports Trade balance Net service payments Transportation Passenger fares Other Travel Other services Manufacturing service on physical inputs owned by others Repairs and maintenance services on movable goods Financial and insurance services Charges for the use of intellectual property Telecommunications, computer and information services Personal, cultural and recreational services Other business and miscellaneous services Net income payments Net current transfer payments Net service, income and current transfer balance Current account balance Capital transfer account balance Financial account Net direct investment (Inflow (+) / outflow (-)) (1) Net incurrence of liabilities Net acquisition of financial assets Net portfolio investment (Inflow (+)/outflow (-)) (2) Net incurrence of liabilities Equity securities Debt securities Net acquisition of financial assets Equity securities Debt securities Net portfolio investment (2) Net financial derivatives (Inflow (+)/outflow (-)) (3) Net incurrence of liabilities Net acquisition of financial assets Net other investment (Inflow (+)/outflow (-)) (4) Net incurrence of liabilities Net acquisition of financial assets Other investment Liabilities Assets Net other investment (3) Balance of financial account (1) + (2) + (3) Unrecorded transactions Change in net gold and other foreign reserves owing to balance of payments transactions Change in liabilities related to reserves SDR allocations and valuation adjustments Net monetisation (+) / demonetisation (-) of gold Change in gross gold and other foreign reserves Memo item: Change in capital transfer and financial accounts including unrecorded transactions Reserve assets (Increase (-)/ decrease (+)) (5) Balance of financial account (1) + (2) + (3) + (4) + (5) Memo item: Balance on financial account excluding reserve assets (1) + (2) + (3) + (4) Unrecorded transactions (6) Memo item: Change in capital transfer and financial accounts including unrecorded transactions (1) + (2) + (3) + (4) + (6) Source: South African Reserve Bank. 2014. South African Reserve Bank Quarterly Bulletin, December 2014: Note on the conversion and revision of South Africa’s balance-of-payments statistics. Available: https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/6532/06Note%20on%20the%20conversion%20an d%20revision%20of%20South%20Africa's%20balance-of-payments%20statistics.pdf Economics I – Study Guide Page 17 Example: 2015 Current account Merchandise exports, free on board 973 776 Net gold exports 67 662 Service receipts 191 656 Income receipts 98 016 Less: Merchandise imports, free on board 1 075 892 Less: Payments for services 197 643 Less: Income payments 198 382 Current transfers (net receipts +) -33 533 Balance on current account -174 340 Memo item: Trade balance -34 454 Capital transfer account (net receipts +) 243 Net lending to (+)/ borrowing from (-) rest of world -174 097 Financial account Net direct investment (inflow (+) / outflow (-)) -45 632 Net incurrence of liabilities 22 614 Net acquisition of financial assets -68 246 Net portfolio investment (inflow (+) / outflow (-)) 55 347 Net incurrence of liabilities 105 455 Equity and investment fund shares 89 824 Debt securities 15 631 Net acquisition of financial assets -50 108 Equity and investment fund shares -30 384 Debt securities -19 724 Net financial derivatives (inflow (+) / outflow (-)) 4 882 Net incurrence of liabilities -320 856 Net acquisition of financial assets 325 738 Net other investment (inflow (+) / outflow (-)) 118 593 Net incurrence of liabilities 69 780 Net acquisition of financial assets 48 813 Reserve assets (increase (-) / decrease (+)) 9 071 Balance on financial account 142 261 Memo item: Balance on financial account excluding reserve assets 133 190 Unrecorded transactions 31 836 Memo item: Balance on financial account excluding reserve assets including 165 026 unrecorded transactions Source: South African Reserve Bank. 2016. South African Reserve Bank Quarterly Bulletin, March 2016: Statistical tables: International economic relations. Available: https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/7195/09Statistical%20ta bles%20%E2%80%93%20International%20economic%20relations.pdf 26 Define the concept “balance of payments” and explain the key differences between the TWO main accounts of the balance of payments (pp. 249 – 252). (4) 27 How is the trade balance calculated (p. 250)? 28 List and briefly explain the main elements of the current account of the balance of payments (pp. 250 – 251). (3 X 2 = 6) 29 List and briefly explain the key elements of the financial account of the balance of payments (pp. 251 – 252). (3 X 2 = 6) (2) Note: The analytical presentation of the financial account of the balance of payments and the international investment position has been amended to incorporate additional functional categories. The previous three functional categories in the financial account of the balance of payments, namely direct Economics I – Study Guide Page 18 investment, portfolio investment and other investment, were expanded to include two additional functional categories, namely financial derivatives and reserve assets. Example: The following data is available for a country’s balance of payments: Transactions Merchandise exports Net direct investment Income receipts Merchandise imports Net financial derivatives Net gold exports Payments for services Reserve assets Income payments Net portfolio investment Service receipts Net other investment Current transfers Capital transfer account Rands (millions) 680 268 101 967 48 254 743 325 0 48 534 138 984 -26 067 122 129 -134 865 115 116 130 714 -18 906 208 Calculate the following from the above data: a) The trade balance b) The balance on the current account c) The balance on the financial account d) The unrecorded transactions To calculate the trade balance (X - Z): Merchandise exports Add: Net gold exports Less: Merchandise imports TRADE BALANCE 680 268 48 534 743 325 -14 523 To calculate the balance on the current account: TRADE BALANCE Add: Service receipts Less: Payments for services Plus: Income receipts Less: Income payments Plus: Current transfers BALANCE ON THE CURRENT ACCOUNT -14 523 115 116 138 984 48 254 122 129 -18 906 -131 172 To calculate the balance on the financial account: Net direct investment Net portfolio investment Net financial derivatives Net other investment Reserve assets BALANCE ON THE FINANCIAL ACCOUNT 101 967 -134 865 0 130 714 -26 067 71 749 To calculate the unrecorded transactions: BALANCE ON THE CURRENT ACCOUNT Plus: Capital transfer account Plus: BALANCE ON THE FINANCIAL ACCOUNT Plus: UNRECORDED TRANSACTIONS -131 172 208 71 749 59 215 Economics I – Study Guide Page 19 Note: All unrecorded transactions are included under “unrecorded transactions”. This item serves to balance the whole account. 30 Study the table below and answer the questions that follow: Transactions Net direct investment Reserve assets Merchandise exports Income payments Merchandise imports Net other investment Payments for services Net financial derivatives Net gold exports Net portfolio investment Service receipts Current transfers Capital transfer account Income receipts a) b) c) d) 31 Rands (millions) 32 673 -32 703 719 445 115 449 743 756 20 162 150 929 13 139 75 298 32 625 126 185 -14 199 241 38 118 Calculate the trade balance. Calculate the balance on the current account. Calculate the balance on the financial account. Calculate the value of the unrecorded transactions. (4 * ½ = 2) (6 * ½ = 3) (6 * ½ = 3) (4 * ½ = 2) Study the table below and answer the questions that follow: Transactions Rands Current transfers -13 350 Direct investment 20 520 Payments for services 85 000 Net gold exports 30 340 Service receipts 85 050 Other investment 3 350 Merchandise imports 320 600 Income receipts 29 300 Income payments 65 300 Merchandise exports 550 950 a) Calculate the trade balance. b) Calculate the balance on the current account. c) Does the balance on the current account indicate a surplus or a deficit? (4) (2) (1) 32 List and briefly explain three possible measures of the equality or inequality of the distribution of income (pp. 252 – 253). (6) 33 Illustrate (Fig. 13-1, pp. 252 – 253) and explain the measurement of unequal distribution of income by means of the Lorenz curve. In your answer, you also need to define the concept “Gini coefficient”. Furthermore, by referring to your diagram, discuss the two extreme values between which the Gini coefficient can vary. (8) SEE FIGURE 13 – 1 ON PAGE 252 OF PRESCRIBED TEXTBOOK The cumulative percentage of the population (from poor to rich) is shown on the x-axis (horizontal axis) and the cumulative percentage of TOTAL income they receive is measured on the y-axis (vertical axis). The line that goes through a, b, c and d is the Lorenz curve. The diagonal 0B is the line of perfect equality. The shaded area is the area of inequality. If only one individual or household received all the income, the curve would trace the lower and right-hand borders of the diagram and we would experience perfect inequality. Economics I – Study Guide Page 20 The Gini coefficient is calculated by dividing the area of inequality of the Lorenz curve, by the rectangular triangle formed by the diagonal (the line of equality) and the two axes. B Cumulative % of income Line of perfect equality (Gini coefficient = 0) Area of inequality Lorenz curve 0 Cumulative % of population (from poor to rich) We can thus rewrite the above sentence as A follows: Gini coefficient = area between Lorenz curve & Line of Perfect Equality total area below Line of Perfect Equality (In other words, the Gini coefficient is the area shaded in green divided by the total of the areas shaded in green and light blue.) The Gini coefficient can vary between 0 and 1. If incomes are distributed perfectly equally, the Gini coefficient is 0 and the curve coincides with the line of perfect equality. If the total income goes to 1 individual or household the Gini coefficient is 1 (and coincides with 0AB). (A ½ mark is subtracted for each label that is missing from either the x-axis or the y-axis; maximum of -1 per diagram. A ½ mark is awarded to students who have correctly labelled the “line of perfect equality”. A ½ mark is awarded to students who correctly indicate that the Gini coefficient = 0 along the line of perfect equality. 1 mark is awarded to students who correctly indicate where the “area of inequality” is found. 1 mark is awarded to students who correctly label the “Lorenz curve”. A ½ mark is awarded to students who correctly label the x-axis. A ½ mark is awarded to students who correctly label the y-axis. (The word / symbol % must appear in the labels for the ½ mark to be awarded.) 1 mark is awarded for the correct definition / or method of calculating the Gini coefficient. A ½ mark may be awarded to students who correctly indicate that the line OAB is the “line of perfect inequality”. A ½ mark may be awarded to students who indicate that the Gini coefficient = 1 along the line of perfect inequality. (Please note this question is only out of 5 marks.)) Example: Refer to the table below that describes the income distribution in a country. Population Poorest 20% Next 20% Next 20% Next 20% Richest 20% Economics I – Study Guide Cumulative Percentage Population Income 20 5 40 10 60 25 80 60 100 100 Page 21 Revision: Indicate whether each of the following statements is True (T) or False (F). True (T) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 If we were to add up the value of output of all firms in the economy, we would overestimate the value of production taking place in the economy. If 2010 is the base year for real GDP calculations, we know for certain that nominal GDP equals real GDP in 2010. GDP at constant prices will usually be greater than GDP at current prices because of inflation. To derive GDP at market prices from Gross Domestic Expenditure, we must subtract spending on exports and add spending on imports. At a garage sale, you buy two old books and an old rocking chair; your spending on these items is not included in current GDP. When a South African doctor opens a practice in Windhoek, Namibia, his production there is part of South Africa’s GDP. The consumer price index is used to monitor changes in an economy’s production of goods and services over time. The content of the basket of goods and services used to compute the CPI changes every month. The CPI for 2013 is computed by dividing the price of the basket of goods and services in 2013 by the price of the basket of goods and services in the base year, then multiplying by 100. If the value of the consumer price index is 110 in 2005 and 121 in 2006, then the inflation rate is 11 percent for 2006 The current account of the balance of payments records all sales and purchases of goods and services as well as income flows to and from the rest of the world. If the financial account is in surplus, then there has been a net inflow of foreign capital into the country. In order to construct a Lorenz curve you must order the population from richest to poorest. The area between the Lorenz curve of a country and the diagonal of perfect equality represents the area of equality. The balance of payments is a statement of the value of all transactions between residents of one country and residents of one of their trading partners. The flow of goods between South Africa and the rest of the world is recorded in the current account of the South African balance of payments, while the flow of services is recorded in the financial account. A South African resident purchases shares to the value of R1 million in Microsoft, the American computer software company. This is recorded as a portfolio investment in the financial account. A country can afford to run current account deficits as long as they are matched by financial account surpluses. Economics I – Study Guide Page 22 False (F) CHAPTER 14: THE MONETARY SECTOR Learning Outcomes This chapter introduces money, the financial sector and monetary policy. The learning outcomes are the ability to: • Define money; • Describe the functions of money; • Define M1, M2 and M3; • Describe the main functions of the South African Reserve Bank; • Explain the demand for money; • Explain how money is created; and • Explain the basic instruments of monetary policy. Written assignment questions / Tutorial questions / Self-study questions: Note: The use of money eliminates the need for a double coincidence of wants associated with a barter economy (i.e. an economy in which goods are traded for other goods.) 1 What is money (p. 256)? (1) 2 Name and explain THREE functions of money (pp. 256 – 257). 3 Define / Explain the different measures of money, namely: a) the conventional measure (M 1) (p. 259); b) a broader definition of money (M 2) (p. 259); and c) the most comprehensive measure of money (M 3) (p. 259). (3 X 2 = 6) (1) (1) (1) Table 14A: Monetary aggregates (R millions) March April 2016 2016 M1 1 447 146 1 419 057 1 492 421 1 451 865 M2 2 424 559 2 417 003 2 458 423 2 438 949 M3 2 982 664 2 991 454 3 066 517 3 070 351 Source: South African Reserve Bank 2016 – Available: https://www.resbank.co.za/Research/Statistics/Pages/MonthlyReleaseOfSelectedData.aspx Description Jan 2016 Feb 2016 Note: The equation for money can be explained as follows: M=C+D Where: M = quantity of money C = cash (coins and notes in circulation outside the monetary sector) D = demand deposits Table 14B: Monetary aggregates (R millions) Coins and Demand deposits M1 (millions) Demand Banknotes (C) (D) (millions) deposits as a (millions) % 2010 65 079 797 796 862 875 92.46% 2011 75 396 871 874 947 270 92.04% 2012 81 042 954 100 1 035 142 92.17% 2013 87 014 1 045 025 1 132 039 92.31% 2014 94 193 1 147 079 1 241 272 92.41% 2015 101 053 1 327 455 1 428 508 92.93% Source: South African Reserve Bank. 2016. South African Reserve Bank Quarterly Bulletin, March 2016: Statistical tables: Money and banking. Available: Economics I – Study Guide Page 23 https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/7195/05Statistical%20ta bles%20%E2%80%93%20Money%20and%20Banking.pdf 4 Define the following concepts: a) demand deposits (p. 259); b) financial intermediary, with an example (p. 260); and c) the opportunity cost of holding money (p. 262). 5 (3 X 2 = 6) Fill in the missing words: When ______ is granted to a person or institution, the piece of paper that is normally issued in exchange for the funds and which stipulates the _______ at which the funds are loaned as well as _____ and ____ the loan is to be repaid is known as the credit instrument. Examples include bills of exchange, promissory notes and bankers’ acceptances. (2) 6 Name the South African Reserve Bank’s (SARB) FOUR major areas of responsibility (p. 261). (4) 7 Name and briefly discuss the THREE services provided by the SARB to the central government (pp. 261 – 262). (3 X 2 = 6) Below are two of the SARBs other area’s of responsibility: PROVISION OF ECONOMIC AND STATISTICAL SERVICES The banks collects, processes, interprets & publishes economic statistics & other info. The data these publications contain are a major source of info for policymakers, analysts & researchers. MAINTAINING FINANCIAL STABILITY The SARB presently regards financial stability (particularly price stability) as its most NB objective. In pursuit of this objective the Bank plays a pivotal role in the areas of bank supervision, overseeing the safety & soundness of the National Payment System, acting as a banker to other banks & making, issuing & destroying banknotes & coins. 8 Name and briefly discuss TWO of the areas in which the SARB plays a pivotal role in order to attain its objective of financial stability (p. 262). (2 X 2 = 4) Note: Money is created largely by banks and not by the mint or printing press. As such the question that is often asked is, how do banks create money? This question can be answered as follows: The basis of the money creation process is that banks issue loans to people and charge them interest against these loans. The interest the banks earn is extra money, or the profit they make from people paying to borrow money from them. So the profit that banks make from charging interest is money that they have “created”. We can thus summarise this discussion by saying that because of the fractional reserve system and the money multiplier, banks can turn the lent money into more then its original amount. In order to see this, let’s work through the process step-by-step. Step One: Suppose that Brad Rich receives R1 000 as a gift and decides to deposit it in Bank A. Bank A’s cash reserves increase by R1 000 and in exchange it creates a demand deposit to the amount of R1 000 in favour of Brad Rich. Bank A Assets Cash reserves Liabilities Demand (Brad) R1 000 deposits R1 000 Note: Money supply is unaffected at this stage. Cash reserves are demand deposits that banks have received, but have not loaned out. Economics I – Study Guide Page 24 Step Two: Bank A sets aside the portion of that R1 000 that is required reserves. For this example, assume that the required reserve ratio (cash reserve requirement) is 10%. So, R100 is set aside, and the remaining R900 becomes excess reserves. Bank A Assets Cash reserves R100 Excess reserves R900 Liabilities Demand (Brad) deposits R1 000 Note: Fractional-reserve banking: a banking system in which banks hold only a fraction of deposits as reserves. Reserve ratio: the fraction of deposits that banks hold as reserves. Step Three: Bank A decides to lend that R900 to Angelina Poor, who then deposits that R900 in her account. At this point, the money supply has increased. The R1 000 that Brad Rich deposited remains in the system, and we can now add Angelina Poor’s R900 to this. (Recall: M1 is equal to coins and notes in circulation outside the monetary sector as well as all demand deposits of the domestic private sector with monetary institutions. So, when Angelina borrowed R900 and the bank put that money in her demand deposit account, no one else in the economy had any less money, but Angelina had more than before. Consequently, the money supply has increased.) Bank A Assets Cash reserves R100 Excess reserves R900 Loans R900 Step Four: Liabilities Demand (Brad) Demand (Angelina) deposits R1 000 R900 Now suppose that Angelina spends the R900 on a new cellphone. She writes a R900 cheque to the cellphone retailer, who deposits the full amount of the cheque in Bank B. First, what happens to Bank A? It uses its excess reserves to honour Angelina’s cheque when Bank B presents it and simultaneously reduces her demand deposit balance from R900 to zero. Bank A’s situation is: Bank A Assets Cash reserves R100 Excess reserves R0 Loans R900 Step Five: deposits Liabilities Demand (Brad) Demand (Angelina) deposits deposits R1 000 R0 The situation for Bank B is different. Because of the cellphone retailer’s deposit, Bank B now has R900 that it didn’t have previously. Bank B Assets Cash reserves Economics I – Study Guide Liabilities Demand deposits (cellphone retailer) R900 Page 25 R900 Step Six: Bank B sets aside 10% of the R900—that is, R90—as required reserves. The remaining R810 becomes excess reserves. Bank B Assets Cash reserves Loans Liabilities Demand deposits R90 R810 R900 Step Seven: Bank B, now has R810 that may be lent—an action that will increase the money supply again. The figure below traces out the multiplier process to its end. Bank New deposits Demand New Cash Reserves A R1 000 R100 Loans (equal to new excess reserves) R900 B R900 R90 R810 C R810 R81 R729 D R729 R72.90 R656.10 E R656.10 R65.61 R590.49 . . . TOTALS (rounded) . . . R10 000 . . . . R9 000 . R1 000 It is crucially important to know exactly by how much the money supply will increase in response to a given change in deposits. This information is given by the money multiplier: 1 where b is the required cash reserve ratio Money multiplier = b In the above example, the required cash reserve ratio was 10%. As a result, the money multiplier is 10. Recall that the required cash reserve ratio could also be referred to as the required reserve ratio. The maximum amount of new money that may be created from any new money can be derived using the formula: Maximum change in demand deposits = D = 1 * R where R is the change in cash reserves b 1 * 1 000 = 10 * 1000 = 10 000 0.1 We can also use a formula [ R = b( D) ] to calculate the change in cash reserves. In terms of our example the change in cash reserves is equal to: R = 0.1(10 000) = 1 000. D = Economics I – Study Guide Page 26 Note: The money multiplier formula above can only tell us the change in money supply if we accept a couple of underlying assumptions: first, all funds are deposited into bank demand deposit accounts—that is, there is no cash leakage (no cash held out before depositing) and there are no non-demand deposits— and second, banks do not voluntarily hold excess reserves. The formula for finding out how much money the banking system can create out of any given amount of funds is: Actual money supply change = 1 * ER where ER is the change in excess reserves of the first bank to receive the initial injection of funds b In terms of our example: 10 X 900 = 9 000. Note: Demand deposits can be created in the following ways: • Provided a person has a reasonably good reputation & has a reasonable amount of money at his or her disposal, any bank will be prepared to create a demand deposit in favour of that person in exchange for cash deposited at that bank. For example, if Peter deposits R10 000 in an FNB account, FNB will issue Peter with a cheque book which will give him the right to write out cheques to the value of R10 000. • 2nd, banks noticed that the demand deposits held by them were not all withdrawn immediately or simultaneously. They got into the habit of lending some of these funds to deficit units in the form of overdraft facilities. Provided that the bank can be convinced of a person’s creditworthiness, a demand deposit can be created in that person’s favour without any cash deposit. 9 If the cash reserve requirement of the banking system is 20% and banks hold no excess reserves, then the value of the money multiplier will be ____. Ensure that you include the equation for the money multiplier in your answer. (2) 10 If a commercial bank increases its cash reserves (held at the Reserve Bank) by R5 million, what change in demand deposits will this bring about? Assume the Reserve Bank insists on a minimum cash reserve requirement of 4% and that the banks hold no excess reserves. (3) 11 If the cash reserve requirement is 5% and the increase in demand deposits amounts to R5000, what change in cash reserves will this bring about? (3) 12 A commercial bank receives new deposits equal to R200 000 and the required cash reserve ratio is 10%. a) Calculate the change in required cash reserves. b) What is the amount of new loans the bank can make? (2) (2) 13 Discuss changes in the required cash reserve ratio and open market transactions as TWO tools that the SARB has at its disposal to increase the quantity of money (pp. 270 - 271). (2) 14 Name and explain the Keynesian motives for holding money and state the respective determinants of each motive (pp. 263 – 264). (6) The 3 motives for holding money are: Transactions motive (½ mark) = the desire to hold money in its liquid form in order to transact between paydays (1 mark). ). [The desire to hold money to pay for everyday predictable expenses.] Determinant = national income / income (½ mark). Precautionary motive (½ mark) = the need to hold money to offset unforeseen expenditures (contingency) (1 mark). [The desire to hold money to pay for unpredictable expenses.] Determinant = national income / income (½ mark). Speculative motive (½ mark) = the choice between holding wealth in the form of money or bonds will depend on the interest rate (1 mark). [The stock of money people hold to take advantage of expected future changes in the price of bonds, stocks or other non-money financial Economics I – Study Guide Page 27 assets.] There is an inverse relationship between the qty of money demanded for speculative purposes & the level of interest rate (i.e. the qty of money demanded for speculative purposes will be higher when the interest rate is low) (or 1 mark). Determinant = interest rate (½ mark). Liquidity preference = f(transactions motive + precautionary motive + speculative motive) (or 1½ mark – if the motives have not been mentioned in the answer) But transactions motive + precautionary motive = L1 (or ½ mark) = f(Y) (or 1 mark) & speculative motive L2 (or ½ mark) = f(i) (or ½ mark) [where: L = quantity of money demand Y = national income i = interest rate] Liquidity preference = f(L1 + L2) (or 1 mark) = f(Y, i) (or 1½ mark) 15 What are the main determinants of the demand for money? Explain the link between each determinant and the quantity of money demanded (pp. 263 – 264). (4) The main determinants are income and interest rates. The demand for active balances, that is, the demand for money for transactions purposes (related to the function of money as a medium of exchange) is positively related to income. The higher the level of income, the greater the value of transactions entered into and therefore the greater the quantity of money demanded (for transactions purposes). In other words, the larger the economy becomes, the greater the value of the transactions and the greater the quantity of money required for transactions purposes. The demand for passive balances, that is, the demand for money for speculative purposes (related to the function of money as a store of value) is related to the current and expected level of interest rates. For example, if interest rates are high, the opportunity cost of holding money (which earns little or no interest) is high and the quantity of money demanded for speculative purposes will be low (ceteris paribus). There is thus an inverse relationship between interest rates and the quantity of money demanded for speculative purposes. This relationship tends to be strengthened if the expected level of interest rates is also taken into account. 16 Explain the inverse relationship between the quantity of money demanded and the level of interest rates (p. 264). (2) Note: “Market-oriented policy measures encourage financial institutions to take certain actions on a voluntary basis. In other words, the authorities create incentives to encourage private enterprise, and hence financial variables, to move in a desired direction. The monetary authorities create such incentives through their own buying and selling activities in the financial markets or by varying the terms on which they are prepared to offer credit. (South African Reserve Bank 2012 – Available: http://www2.resbank.co.za/internet/Glossary.nsf/0/357a1facec41261442256b430031b241?OpenDocu ment)” Note: Accommodation policy is the most important policy instrument used by the SARB. Below are some key points regarding accommodation policy. • The SARB is the only institution that can provide cash in indefinite quantities and therefore, fulfils the role of the lender of last resort. Accommodation policy thus represents the SARB’s function as a lender of last resort. • Accommodation offered by the SARB is the credit offered to commercial banks at the accommodation facility of the central bank. • The operational framework used by the SARB involves reliance upon the accommodation instrument known as the repo rate. o This framework is known as a cash reserve system of monetary control. o Under this system, banks are compelled to utilise the Reserve Bank’s accommodation facility through the repo system, which enables them to meet their daily liquidity requirements. o Liquidity refers to the commercial banks’ balances at the SARB that are available to settle their transactions with one and another, over and above the minimum statutory level of reserves required by law (South African Reserve Bank 2007:2). • The SARB’s role as lender of last resort is important for the maintenance of stability within the financial system. Economics I – Study Guide Page 28 • The commercial banks’ indebtedness to the SARB, and the SARB’s choice of discount rate, allows the Reserve Bank to indirectly control the money supply. 17 Explain accommodation policy and open-market policy (pp. 270 – 271). (2 X 2 = 4) Note: Direct or non-market orientated policy instruments mean that the monetary authorities instruct the banks and other financial institutions to do or to refrain from doing certain things with regard to their lending and borrowing activities. Examples of non-market orientated policy instruments are quantitative restrictions on bank credit (the so-called credit ceilings and deposit rate control). Credit ceilings (introduced in 1967; discontinued in SA in September 1980) • Credit ceilings are attempts to limit commercial banks’ ability to create money by restricting their capacity to issue loans, irrespective of their level of reserve requirements. • Credit ceilings will therefore restrict the growth in the money supply. Deposit rate control (introduced in South Africa in 1965; discontinued in SA in March 1980) • The SARB can directly control the money supply by stipulating the maximum interest rate that commercial banks may pay or may require clients to pay on deposits. • The main reason for the imposition of this type of control was to prevent the intense competition between banks and building societies from pushing deposit and mortgage rates upwards. • The SARB thus argued that it was attempting to protect borrowers from the burden of high interest rates that would (supposedly) have occurred had interest rates not been controlled directly.2 18 Name and explain TWO non-market-orientated policy instruments used by the SARB to restrict bank credit (see Note and p. 271). (2 X 2 = 4) 2 For further information you can consult the following text: Smit, P.C., Dams, D.J., Mostert, J.W., Oosthuizen, A.G., van der Vyver, T.C. and van Gass, W. 1997. Economics: A Southern African Perspective. Cape Town: Juta. Economics I – Study Guide Page 29 Revision: Indicate whether each of the following statements is True (T) or False (F). True (T) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 The most direct way in which money eliminates the need for a double coincidence of wants is through its use as a medium of exchange. When Phakamisa uses money to buy his lunch, he is showing the use of money as a “store of value” A R650 price tag on a pair of running shoes is an example of money functioning as a unit of account. Demand deposits can be withdrawn immediately by writing out a cheque (which is generally accepted as payment) and therefore demand (or cheque) deposits form part of the quantity of money. A financial intermediary receives deposits from lenders and makes loans to borrowers. The SARB’s current functions can be grouped into the following four major areas of responsibility: formulation and implementation of fiscal policy, service to the government, provision of economic and statistical services and maintaining financial stability. One of the services that the SARB provides to the central government is that of custodian of gold and foreign exchange reserves. The cash reserve requirement of any South African bank is held in a noninterest-bearing account with the SARB. Government transactions can exert an influence on money supply. John Maynard Keynes listed three types of motives for people holding money – transactions, precautionary and speculative. The transactions demand for money arises out of the need to hold money as a medium of exchange. This demand for money is a function of interest rates. The quantity of money demanded for transactions and speculative purposes is also called the demand for active balances and is related to the level of income in the economy. The opportunity cost of holding money is the interest that could have been earned by holding interest-bearing assets (e.g. bonds) instead. An open-market purchase by the SARB withdraws excess reserves from the banking system and causes the money supply to contract. Credit ceilings and deposit rate control are examples of market-orientated policy instruments used by the SARB to restrict bank credit. Economics I – Study Guide Page 30 False (F) CHAPTER 15: THE GOVERNMENT SECTOR Learning Outcomes Government affects the daily lives of a country’s citizens by instituting laws, rules and regulations, as well as by providing certain essential services. In this chapter the government sector, which is also called the public sector, is examined in detail. Once you have studied this chapter you should be able to: • Explain why government participates in economic affairs; • Describe how government intervenes in the economy; • Explain why governments, like markets, can fail; • Discuss the arguments for and against privatisation; • Explain what fiscal policy means; • Explain what monetary policy means; • Discuss government spending and financing; • Discuss the criteria for a good tax; • Discuss the various types of taxes; • Explain the impact of an excise tax (with and without the use of a diagram) (Revision from Chapter 5); and • Analyse who bears the burden of a specific excise tax (Revision from Chapter 5). Written assignment questions / Tutorial questions / Self-study questions: Note: The four main components of the government or public sector in South Africa include national government, provincial government, local government and public corporations. People question whether there are valid reasons for the government to intervene in the economy. Three valid reasons are mentioned below: • to correct market failure (that is, where markets do not produce efficient outcomes). • to try to achieve equitable outcomes (something markets are not very good at). • to achieve macroeconomic stability (given the tendency of markets to create instability). Note: Market failure occurs when the market system fails to achieve an efficient allocation of resources. Five of the main causes of market failure are: • Monopoly and imperfect competition (see Question 1); • Public goods - this type of mkt failure arises from the failure of the mkt to provide sufficient quantities of certain g & s;; • Externalities are costs or benefits of a transaction or activity that are borne or enjoyed by parties not directly involved in the transaction or activity. When there are external costs or benefits to production, the full costs to society differ from the private costs faced by firms. Since mkts register private costs only, the mkt mechanism fails to bring about a socially efficient allocation of resources in such cases (Also see Question 1); • Asymmetric information- in the real world, as opposed to a situation where perfect competition could arise, there is often a great deal of ignorance & uncertainty which makes it virtually impossible for consumers & firms to equate MB with MC. (If asymmetric information results in an outcome that is significantly different from that which would have occurred with symmetric information mkt failure occurs.) With asymmetric information there is an inefficient allocation of resources; and • Common property resources (see Question 1) (Mohr et al. 2015:278). 1 Discuss the following reasons for market failure and recommend how government can correct these. a) Monopoly and imperfect competition (p. 278); b) Negative externalities (pp. 280 – 281); and c) Common property resources (pp. 282 – 284). Remember: Economics I – Study Guide Page 31 (5) (4) (3) Whenever you draw a diagram in Economics, all axes and curves must be fully labelled. [Note: the labels on the axes must be written out in words.] Also ensure that you have included all necessary arrows. In the case of demand and supply diagrams that means that you should, in most cases, have four arrows. One arrow should indicate the direction in which the demand or supply curve has shifted. One arrow should indicate what has happened to “price”, while another arrow should indicate what has happened to “quantity”. The final arrow should indicate the transition from the original equilibrium point to the new equilibrium point. 2 Draw a fully labelled graph (Fig. 15-3, pp. 280- 281) to demonstrate the elements of a negative externality of consumption. (5) 3 Refer to the Article, “China: GEF Grants to reduce dioxins from pulp production and facilitate eco-transport development in city clusters 3”. The article indicates that firms that make and sell paper also create, as a by-product of the manufacturing process, a chemical called dioxin. Scientists believe that once dioxin enters the environment, it raises the population’s risk of cancer, birth defects and other health problems. a) Use a supply and demand graph to illustrate the negative externality mentioned in the article. Identify the current price and output and the socially optimal price and output. (5) b) Use MSB and MSC to explain if pulp is being overproduced or underproduced by the free market. Explain why the free market failed. (2) c) Explain what the government must do to fix this negative externality. (2) 4 Explain why public goods are not provided by the free market system. Ensure that you have defined any relevant terms and have also provided an example of a public good. (5) Public goods are goods that would not be provided in a free market system, because firms would not be able to adequately charge for them. This situation arises because public goods have two particular characteristics. They are: 1. Non-excludable - once the goods are provided, it is not possible to exclude people from using them even if they haven't paid. This allows 'free-riders' to consume the good without paying. 2. Non-rival - this means that consumption of the goods by one person does not diminish the amount available for the next person. We can see this if we look at the case of street lights. If a street light is provided by a firm, then it cannot exclude people from benefiting from it. It is not possible to charge people who walk under it. When people walk under it, it is also true that they don't make it go dimmer - they don't diminish the amount available for the next person. Street lights are therefore non-excludable and non-rival - they are public goods. 5 Asymmetric information could result in a different outcome in a goods market than if information were more readily available. Illustrate and explain the changes that occur in the goods market when all information becomes available to consumers (Fig. 15-4, pp. 281 – 282). (5) 6 Differentiate between the three broad functions of government (p. 286). (3 X 2 = 6) Note: A public private partnership (PPP) is defined as a contractual arrangement whereby a private party performs part of a government function and assumes the associated risks. In return, the private party receives a fee according to predefined performance criteria. Examples include hospitals, prisons, nature reserves, toll roads and the provision of accommodation to government departments. Note: • Selling government assets to the private sector is known as privatisation. • Nationalisation is the purchase of privately owned assets by the government. 7 Discuss THREE arguments for and THREE arguments against the privatisation of state-owned assets (pp. 288 - 289). (3 X 2 = 6) 3 World Bank. 2012. China GEF Grants to reduce dioxins from pulp production and facilitate ecotransport development in city clusters. [Online]. Available: http://www.worldbank.org/en/news/2012/03/29/china-gef-grants-to-reduce-dioxins-from-pulpproduction-facilitate-eco-transport-development-in-city-clusters [Accessed 12 June 2015]. Economics I – Study Guide Page 32 8 Numerous calls have been made to privatise public corporations such as South African Airways (see e.g., http://www.moneyweb.co.za/uncategorized/treasury-gives-saa-another-lifeline/). Discuss the main economic arguments in favour of and against the privatisation of public corporations such as South African Airways. A first advantage of privatisation will be the large amount that the government will potentially receive for selling SAA. These funds could be used to reduce the public debt, to finance specific projects or to lower tax rates. A second possible argument is that a privatised SAA will be much more efficient than the current government-owned SAA, since private firms are generally more efficient than public corporations. A possible third argument in favour of privatisation is that the government would no longer have to compensate for losses made by SAA. (Think here, for example, of the massive amounts that government has had to inject into SAA.) Other possible arguments include the following: A privatised SAA may succeed in attracting foreign capital; and profits made by the privatised firm will be taxable (although government currently potentially earns profits from its ownership of SAA). Those who are opposed to the privatisation of SAA will argue that such a step would create a private monopoly in activities in which SAA is involved and that this could give rise to exploitative behaviour. They will also argue that a privatised SAA would not take the public interest or external social benefits into account. For example, the privatised firm would tend to focus on the profitable activities and cease non-profitable operations, such as the provision of services to unprofitable destinations. From the above it is obvious that the privatisation of public corporations is not a simple issue. 9 Differentiate between the concepts “fiscal policy” and “monetary policy” and state the two main elements which each consists of (pp. 289 – 290). (2 X 2 = 4) 10 Explain how you will implement a monetary and / or a fiscal policy in order to: a) stimulate / expand the economy; and b) cool down / contract the economy. a) • • b) • • (2 X 2 = 4) To expand the economy: Fiscal policy – taxes & government expenditure. Monetary policy – the money supply & the interest rate. To contract the economy: Fiscal policy – taxes & government expenditure. Monetary policy – the money supply & the interest rate. 11 Name and explain THREE possible explanations for the trend of higher government spending in South Africa (pp. 290 – 291). (3 X 2 = 6) 12 Name and explain the THREE main ways in which government spending is financed (pp. 292 – 293). (3 X 2 = 6) 13 Fill in the missing words Public debt is the accumulated (debt / credit) __________ or (underspending / overspending) ________ of a country. (1) 14 Name and explain THREE criteria for a good tax system (pp. 293 – 294). (3 X 2 = 6) Note: According to the ability to pay principle, taxpayers should contribute according to their ability to pay, irrespective of the services they receive from government. The benefit principle states that taxpayers should pay for the services they receive, irrespective of their ability to pay. The problem, however, is that it is often difficult to determine the value of the benefit each taxpayer receives from different types of government spending. Economics I – Study Guide Page 33 15 Differentiate between “direct” and “indirect” taxation and give examples of each (p. 294). (2 X 2 = 4) 16 Differentiate between the concepts “progressive taxes”, “proportional taxes” and “regressive taxes” and provide an example of each (pp. 294 - 295). (3 X 2 = 6) Example: Income (R) 50 000 100 000 200 000 Progressive Tax Amount to Tax be paid as percentage taxes 10 000 20 25 000 25 60 000 30 Progressive Tax (e.g. personal income tax) Proportional Tax Amount to Tax be paid as percentage taxes 12 500 25 25 000 25 50 000 25 Proportional Tax (e.g. basic company tax) Regressive Tax Amount to Tax be paid as percentage taxes 15 000 30 25 000 25 40 000 20 Regressive Tax (e.g. VAT) Note: Figure 15A: Composition of main sources of tax revenue, 2009/10 – 2013/14 Economics I – Study Guide Page 34 Source: National Treasury 2015. 2015 Tax statistics. Available: http://www.treasury.gov.za/publications/tax%20statistics/2015/TStats%202015%20Inside%20WEB.pd f “The relative contribution of CIT to total tax revenue declined from 20.0% in 2010/11 to 18.9% in 2014/15. Reduced CIT collections resulted in a higher relative contribution by PIT. The contribution of PIT to total tax revenue was 35.9% in 2014/15. The extent of the shift is shown by the fact that while PIT contributed R93.5 billion more to tax revenue than CIT in 2010/11, it provided R167.3 billion more than CIT in 2014/15. The contribution of VAT increased from 25.7% in 2011/12 to 26.5% in 2014/15” (National Treasury 2015:8). Economics I – Study Guide Page 35 17 Use the requirements of a good tax to evaluate the following South African taxes: a) personal income tax, b) value-added tax (VAT), c) fuel tax and d) capital gains tax. a) Personal income tax. This is a progressive tax and therefore not a neutral tax. People try to avoid tax and because the tax is progressive, it may have a detrimental impact on the propensity to work and to save. It meets the requirement of equity, since it is both horizontally and vertically equitable. As far as administrative simplicity is concerned, some simplifications were introduced recently, but for persons with different types of income it remains a fairly complicated tax. b) Value-added tax (VAT) is regressive and therefore not equitable. It is fairly neutral, since most goods and services are taxed at the same rate. Administratively it is a fairly simple tax. The basic problem is the equity aspect. c) The fuel tax is not a neutral tax, since it provides an incentive to avoid paying the tax by using less fuel. It seems to be equitable, since only those who use fuel pay the tax. However, the tax is built into the prices of various products and in the end even the poor who do not own cars or buy fuel also pay the tax. Administratively it is quite simple. d) Capital gains tax (CGT) was introduced on neutrality and equity considerations. In the absence of CGT, people try to hide (taxable) income as (non-taxable) capital gains. In such a case, the question of the type of income earned is very important. With a CGT matters are much less uncertain. However, the calculation of capital gains can also be quite complicated. CGT is thus not administratively simple. 18 Refer to the table below in order to answer the questions that follow: Income R50 000 R100 000 R200 000 Amount of Tax Due Tax Schedule A Tax Schedule B R10 000 R20 000 R30 000 R30 000 R80 000 R40 000 Tax Schedule C R17 500 R25 000 R30 000 Tax Schedule D R15 000 R30 000 R60 000 a) Tax Schedule A is an example of a ___ tax system, because the ratio of tax paid to taxable income __ as taxable income increases. (2) b) Tax Schedule B and Tax Schedule C are examples of a ___ tax system, because the ratio of tax paid to taxable income __ as taxable income increases. (2) 19 If a doctor, a lawyer, and a teacher enter a coffee shop and make the following statements: Doctor: I had taxable income of R250 000 and paid R50 000 in income tax. Lawyer: I had taxable income of R300 000 and paid R60 000 in income tax. Teacher: I had taxable income of R50 000 and paid R10 000 in income tax. Given that all three live under the same tax laws. What can be said of the income tax that they are paying? (Provide proof for your answer.) (4) Note: Taxes reduce the disposable (or after-tax) income of households, with the result that households can afford to purchase fewer goods and services than before. By reducing disposable income, taxes indirectly reduce consumption spending C by households. Revision of 1st Semester work: 20 Illustrate (Fig. 5-13, pp. 96 – 97) and explain the incidence of an excise tax on cigarettes. Ensure that you have mentioned all the groups that share the burden of this excise tax. (7) Economics I – Study Guide Page 36 21 Using the graph below, answer the questions that follow. Note: ST is the new supply curve after the imposition of an excise tax. 50 ST 45 S 40 35 Price 30 25 20 15 10 5 D 0 0 50 100 150 200 250 300 350 400 450 Quantity a) b) c) d) e) f) g) h) What was the equilibrium price in the market before the tax? What is the amount of the tax? How much of the tax will the buyers pay? How much of the tax will the sellers pay? How much will the buyer pay for the product after the tax is imposed? How much will the seller receive after the tax is imposed? As a result of the tax, what has happened to the level of market activity? How much revenue will the government earn from the imposition of this tax? a) b) c) R25 R15 R10 (difference between what the buyers have to pay now (R35) and what they had to pay before the tax was imposed (R25)) R5 (difference between what the sellers get now (R20) and what they received before the tax was imposed (R25). Alternatively, if the buyer bears R10 of the tax and the total tax is R15, then the seller has to bear the other R5 of the tax.) R35 R20 As a result of the tax, the level of market activity has fallen, from 200 units being bought and sold to only 150 units being bought and sold. (Amount of tax, i.e., R15 * new equilibrium quantity of 150) = R2250. d) e) f) g) h) (1) (1) (1) (1) (1) (1) (1) (2) For your information: The relative price elasticities of the demand and supply curves will determine the distribution of the burden of the excise tax. For example, if the demand is totally price inelastic, i.e., if the demand curve is vertical, the consumers will bear the full burden of the tax. However, if the demand is totally price elastic, i.e., if the demand curve is horizontal, the suppliers (including their employees) will bear the full burden to the tax. Economics I – Study Guide Page 37 Revision: Indicate whether each of the following statements is True (T) or False (F). True (T) 1 2 3 4 5 6 7 8 9 10 11 12 13 Market failure is a situation in which the market provides the ideal or optimal amount of a particular good. When a negative externality exists, the market is said to overproduce the good connected with the negative externality. Another term for a positive externality is an external benefit. An example of an activity that creates a positive consumption externality is getting a flu vaccination. The main source of state (government) revenue is income from property. An increase in government expenditure would be classed as an expansionary fiscal policy. Political shocks and other major disturbances could exert strong upward pressure on government spending. If the government finances part of its spending by borrowing from the SARB, this is called inflationary financing. One criterion for a good tax is neutrality, which means that taxation should have the minimum possible effect on relative prices. Tax avoidance refers to the practice of using illegal ways of avoiding taxes. A tax such as VAT would generally be viewed as regressive, because the VAT burden increases as household income rises. Tax is progressive when the higher income groups are taxed at a higher rate than the lower income groups. A proportional income tax is a tax that taxes income at a constant rate. The degree to which the burden of a tax can be shifted depends on the price elasticities of the demand and supply of the goods and services in question. Economics I – Study Guide Page 38 False (F) CHAPTER 16: THE FOREIGN SECTOR Learning Outcomes The purpose of this chapter is to explain the interaction between the foreign sector and the domestic economy. Once you have studied this chapter you should be able to: • Explain what globalisation entails; • Explain why international trade occurs; • Explain the concepts of absolute advantage and comparative / relative advantages; • Analyse the impact of an import tariff; • Describe the major elements of the balance of payments; • Distinguish between the current account and the financial accounts of the balance of payments; • Explain the foreign exchange market for American dollars / Euros (etc.) in South Africa; • Explain the effects of a decrease / increase in the supply of dollars (foreign currency) on the value of the rand; • Explain the effects of a decrease / increase in the demand for dollars (foreign currency) on the value of the rand; and • Define the terms of trade and explain their significance. Written assignment questions / Tutorial questions / Self-study questions: 1 Define the following concepts: a) b) c) d) e) 2 openness of an economy (p. 300); exchange rate (p. 305); depreciation (p. 305 and p. 307); appreciation (p. 305 and p. 307); and terms of trade, together with its equation (p. 311). (1) (1) (1) (1) (2) Fill in the missing words: a) Self-sufficiency (also known as ________) is the ability of a country to (produce everything / only a few of the goods and services) ________ that its citizens require (p. 301). (1) b) Devaluation is the forced (decrease / increase) ________ in the value of the domestic currency in terms of another currency activated by the government. (1) c) Revaluation is the forced (decrease / increase) ________ in the value of the domestic currency in terms of another currency activated by the government. (1) 3 Name and explain TWO reasons why countries trade with one another (pp. 301 – 304). (2) Note: Apart from the World Trade Organisation (WTO), two other global organisations are central to international economic relations: the International Monetary Fund (IMF) and the World Bank. During World War II, the United States, Great Britain and a few other allies held regular discussions about the shape of the post-war international economic order. The culmination of these talks was the meetings held at Bretton Woods in the United States in July 1944, where the outlines of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (World Bank) were agreed upon. Note: A country has an absolute advantage in the production of a good or service if its output per unit of inputs for that good or service is higher than that of another country. For example, Country A can produce maize more efficiently than country B, and country B can produce diamonds more efficiently than country A. A country has a comparative (relative) advantage in producing a good or service if it can produce it at a lower opportunity cost than any other country. For example, Country A can produce maize and diamonds more efficiently than country B, but it is much more efficient than country B in the production of maize relative to its efficiency in the production of diamonds. Economics I – Study Guide Page 39 Note: There are 2 approaches to comparative advantage In using these models to determine the lower opportunity costs from both an input and output viewpoint, you must pay attention to the format of the chart. It makes a difference! Input Method The “input method” provides data on the amount of resources needed to produce one unit of output. The table below gives productivity information for Ted and Nancy. Productivity data using the input method Time required to produce one Time required to produce one bushel of radio wheat Ted 20 minutes 5 minutes Nancy 30 minutes 15 minutes The table below shows the opportunity costs for each producer. To find the opportunity cost of producing one radio, the amount of resources it takes to produce a radio goes above the amount of resources that it takes to produce a bushel of wheat. Ted Nancy Opportunity cost of producing one radio 1 radio = (20 minutes / 5 minutes) = 4 bushels 1 radio = (30 minutes / 15 minutes) = 2 bushels Opportunity cost of producing one bushel of wheat 1 wheat = (5 minutes / 20 minutes) = 0.25 radio 1 wheat = (15 minutes / 30 minutes) = 0.5 radio In the 20 minutes it takes Ted to produce one radio, he instead could have produced four bushels of wheat. Instead of producing one radio in 30 minutes, Nancy could have produced two bushels of wheat. The fact that Nancy has the lower opportunity cost of producing radios means she has the comparative advantage in radios. In the five minutes he needs to produce one bushel of wheat, Ted could have made ¼ of a radio. Nancy’s opportunity cost of producing one bushel of wheat is ½ of a radio. Because his sacrifice in producing a radio is less than Nancy’s, Ted has the comparative advantage in wheat production. If Ted specialises in wheat production while Nancy specialises in radio production, their combined output of radios and wheat will be larger than it would be if each person produced both products. Output Method The “output method” gives data on the amount of output that can be produced with a given amount of an input. Now let’s take this same set of productivity data and turn it into an output format. To do this, we ask how many units of an item the producers can create with a given amount of resources. Let’s suppose that both producers have one hour to produce each product. The table below shows how many radios and how many bushels of wheat each producer can make in one hour. From this output viewpoint, you once again see that Ted has the absolute advantage in the production of both products. With the same amount of resources (one hour of labour), he can produce more radios and more wheat than Nancy. Productivity data using the output method Ted Nancy Time required to produce one radio 60 minutes / 20 minutes = 3 radios 60 minutes / 30 minutes = 2 radios Time required to produce one bushel of wheat 60 minutes / 5 minutes = 12 bushels 60 minutes / 15 minutes = 4 bushels But what about the opportunity cost to produce each item? Check out the table below, which shows how to calculate each producer’s opportunity cost of the two items. To find Ted’s opportunity cost of producing one radio, the number of radios he can produce in one hour goes under the number of bushels of wheat he can produce in that same time frame. Economics I – Study Guide Page 40 Ted Nancy Opportunity cost of producing one radio 1 radio = 12/3 = 4 bushels 1 radio = 4/2 = 2 bushels Opportunity cost of producing bushel of wheat 1 bushel = 3/12 = 0.25 radios 1 bushel = 2/4 = 0.5 radios one Because Ted’s cost per radio is four bushels of wheat, whereas Nancy’s cost is only two bushels, we know Nancy has the comparative advantage in producing radios. Ted has the comparative advantage in wheat production since he has the lower opportunity cost of producing a bushel of wheat (¼ radio compared to Nancy’s ½ radio). Does this sound familiar? This is the same result we reached using the input method. The differences in opportunity costs define the limits of a trade in which both parties will benefit. If Nancy specialises in radio production, she will accept no less than two bushels of wheat for one radio. Ted will pay no more than four bushels of wheat per radio. Thus, the “terms of trade” acceptable to both producers must lie in the range between two bushels for one radio and four bushels for one radio. For example, suppose they agree to trade one radio for three bushels of wheat. By producing and trading one radio to Ted, Nancy will have a net gain of one bushel. Her opportunity cost of producing the radio is two bushels and she receives three bushels in return for the radio. Because his opportunity cost of producing one bushel is ¼ radio, Ted’s opportunity cost of producing the three bushels, which he trades to Nancy, is ¾ radio. Thus, the trade gives Ted a net gain of ¼ radio. Both producers gain by specialising according to their comparative advantage. When it comes to producing wheat, Ted would have to receive at least ¼ of a radio in trade for a bushel of wheat. Nancy would require at least ½ of a radio before she would trade a bushel of wheat. The acceptable terms of trade would be found between ¼ radio and ½ radio per bushel of wheat. Another example of the input method: Suppose there are two countries, two goods and a single factor of production: Russia and South Africa, beer and vodka and labour. Their labour costs for a barrel of each are as follows: Table 16A: Absolute advantage (labour requirements) Labour required to produce an item (hours per unit South Africa produced) Beer 4 hours Vodka 8 hours Russia 10 hours 2 hours Obviously, South Africa is better in the production of beer than Russia and Russia is better in the production of vodka than South Africa. We can thus say that • South Africa has an absolute advantage in the production of beer over Russia • Russia has an absolute advantage in the production of vodka over South Africa. In this case, the logical thing for the two countries would be to specialise in the commodity they have an absolute advantage in and buy the other commodity from the other country. It is clear that this would result in the maximum output possible and hence give both countries higher consumption in an “equitable trade”. Now, consider the same situation where we replace vodka with cars: Table 16B South Africa Russia Beer 4 hours 10 hours Cars 120 hours 400 hours Clearly, South Africa has an absolute advantage over Russia in the production of both commodities. Does this mean that South Africa should produce both and workers in Russia just sit on their hands? The answer is, of course, no. The principal reason is that it would be irrational and inefficient to waste the labour of the Russians, however ineffective they might be relative to South Africa. To decide who does what, we need an extension to the principle of absolute advantage: Economics I – Study Guide Page 41 Now, consider the opportunity cost of the two commodities above for the two countries: Table 16C South Africa Russia 1 cars 30 1 cars 40 Opportunity cost of beer (in terms of cars) Opportunity cost of cars (in 30 barrels 40 barrels terms of beer) If international trade is to take place, a country specialises in that product where the opportunity costs of the product are the lowest (of the two countries at stake). This means that if trade takes place, Russia must specialise in beer (because 1 1 is smaller than ) and South Africa must specialise in cars 40 30 (because 30 is smaller than 40). The message of comparative advantage is the same as absolute advantage: Both countries should specialise in the commodity where they have comparative advantage and trade. Note that it is impossible for one country to have a comparative advantage in the production of both commodities. Comparative advantage therefore implies that there is always room for mutually beneficial trade, regardless of who the producers are and what they produce. 4 The following table shows the maximum amount of coffee and tea that can be produced by South Africa and Brazil using the same quantity and quality of inputs, if all inputs are used to produce 1 product only (e.g. SA could produce 162kg of tea and 0kg of coffee, or it could produce 54kg of coffee and 0kg of tea). South Africa Brazil a) b) c) d) e) f) g) h) i) 5 Tea (T) (kilograms) 162 216 Coffee (C) (kilograms) 54 108 Which country has an absolute advantage in producing tea? Provide a reason for your answer. Which country has an absolute advantage in producing coffee? Provide a reason for your answer. Calculate the opportunity cost of tea in South Africa. Calculate the opportunity cost of coffee in South Africa. Calculate the opportunity cost of tea in Brazil. Calculate the opportunity cost of coffee in Brazil. Which country has a comparative advantage in producing tea? Provide a reason for your answer. Which country has a comparative advantage in producing coffee? Provide a reason for your answer. Suppose SA and Brazil wish to maximise their combined total output and they agree to trade with each other in tea and coffee at a favourable price. Which country should specialise in tea and which country should specialise in coffee, or should each country produce a combination of both goods? Provide reasons for your answer. Assume there are two countries, Japan and Germany. Also assume that these countries produce two goods, viz. computers and cars. Under conditions of full employment, one labourer in Japan can produce either 100 cars or 50 computers. One labourer in Germany can produce either 40 cars or 10 computers. This scenario can be depicted as follows: Product Japan Germany Cars 100 40 Computers 50 10 Based on the scenario depicted above, answer the following questions: a) Which country has an absolute advantage in the production of cars? b) Which country has an absolute advantage in the production of computers? Economics I – Study Guide Page 42 (1) (1) c) d) e) f) g) h) i) What is the opportunity cost of producing 1 computer in Japan? (1) What is the opportunity cost of producing 1 computer in Germany? (1) Which country has a comparative advantage in the production of computers? (1) What is the opportunity cost of producing 1 car in Japan? (1) What is the opportunity cost of producing 1 car in Germany? (1) Which country has a comparative advantage in the production of cars? (1) For mutual beneficial trade to exist, which country should produce and export cars and which country should produce and export computers? (2) 6 Differentiate between import tariffs and quotas as policy instruments used by authorities to influence international trade and capital movements (p. 304). (2 X 2 = 4) 7 Who would benefit and who would lose if the South African government further increased the tariff on imported frozen chicken leg quarters from Brazil4? Explain. (4) At the time of writing, cheap imported frozen chicken leg quarters from Brazil had a strong impact on the poultry industry in South Africa. On the one hand, they were a relatively cheap source of food for South Africans, since they were being sold at lower prices than domestically produced chickens. On the other hand, however, the cheap imports were creating problems for the South African poultry industry, reducing its profitability and putting jobs at risk. If the South African government decided to further increase the tariff on these imports, the consumers would tend to lose because the chicken legs would become more expensive, but the South African poultry industry would tend to benefit, as far as both profitability and employment are concerned. 8 List SIX policy instruments used by authorities to influence international trade and capital movements (p. 304). (6) Note: Questions 9 and 10 are revising 1st Semester work: 9 Illustrate (Fig. 5-16, pp. 97 – 98) and explain the economic impact of implementing an import tariff on domestic production and imports. Clearly indicate the position (i) before international trade, (ii) after international trade but without a tariff and (iii) after the imposition of the tariff. (6) 10 The following diagram shows the demand and supply curves for a country’s domestic cloth market. 4 Magwaza, N. 6 October 2014. No local benefit in poultry tariffs yet, IOL. [Online]. Available: http://www.iol.co.za/business/news/no-local-benefit-in-poultry-tariffs-yet-1.1760252#.VcNoUvm2Vds [Accessed 30 July 2015]. Economics I – Study Guide Page 43 a) b) i. ii. iii. c) i. ii. iii. iv. v. If the cloth market is closed to international trade, what would be the equilibrium price and quantity in the domestic cloth market? (2) If the cloth market is opened to international trade, and the world price of cloth is R60/m 2, what would be the level of domestic demand; (1) domestic supply; and (1) imports? (2) The government now imposes a tariff of R24/m2 on cloth imports. Determine the direct effects of the tariff on the domestic price (the price consumers would pay); (2) domestic demand; (1) domestic supply; (1) the quantity of imports; and (2) government revenue. (2) Note: Three arguments used to promote trade barriers are the dumping argument, the infant industry argument and the national security argument. These arguments and their flaws are discussed below. • The dumping argument asserts that protection is needed to protect domestic industries from foreign dumping practices designed to eliminate competition. (Dumping is when a firm sells its products in a foreign country at a lower price than in the country of origin.) • The problem with this argument is that it is extremely difficult to determine if a firm is dumping ∵ what might look like dumping may simply be comparative advantage [The foreign firm may be more efficient & allegations of dumping may simply be the political response of domestic firms that can’t compete with efficient foreign firms]. • The infant industry argument is that it is necessary to protect a new industry to enable it to grow into a mature industry that can compete in world mkts [The infant industry argument is that to allow a new manufacturing industry to establish a foothold, governments should temporarily support the new industry (with tariffs, import quotas, & subsidies) until it has grown strong enough to meet international competition]. • The problem with this argument is that protection from foreign competition serves no purpose unless the protection helps make the industry efficient. However, in case after case, protection seems to foster the development of inefficient industries. Another problem is that protection tends to create monopolistic conditions in the domestic mkt & the protected firms tend to become complacent & reluctant to adapt to changing circumstances. Another problem is that governments, influenced by political motives, are often poor judges of which industries ought to be protected. • The national security argument is that countries must protect industries that produce defence equipment & armaments as well as those industries upon which the defence industries rely [it is often argued that industries that produce products that will be essential in times of war or international crisis should be protected]. • The problem with this argument is that virtually all industries can claim a direct or indirect contribution to national security, & firms or industries tend to exaggerate their strategic importance in an attempt to obtain protection from foreign competition. [For instance, the pillow industry can claim that it contributes to national defence ∵ without good pillows, plant workers will be unable to sleep well & hence their efficiency will be . The pillow industry can make a claim for protection—which, incidentally, it did in the USA in the 1950s using the argument just described!] 11 Name TWO factors each which will cause: a) a demand by South Africans for foreign currency (pp. 305 – 306 and p. 308). b) a demand by foreigners for South African rands (p. 306 and p. 308). c) a supply of rands internationally (p. 308). Example: So, four possible reasons for an appreciation of the rand against the US dollar could be • An increase in the price of gold or other important mineral exports. • A decline in the amount of imports from the United States. • An increase in investment by Americans in South Africa, for example on the JSE. Economics I – Study Guide Page 44 (2) (2) (2) • An increase in spending by American tourists in South Africa. Remember: Whenever you draw a diagram in Economics, all axes and curves must be fully labelled. [Note: the labels on the axes must be written out in words.] Also ensure that you have included all necessary arrows. In the case of demand and supply diagrams that means that you should, in most cases, have four arrows. One arrow should indicate the direction in which the demand or supply curve has shifted. One arrow should indicate what has happened to “price”, while another arrow should indicate what has happened to “quantity”. The final arrow should indicate the transition from the original equilibrium point to the new equilibrium point. 12 Illustrate (Fig. 16-2, pp. 306 – 307) and explain the foreign exchange market for American dollars in South Africa. In your answer, differentiate between the following concepts: a) excess demand and excess supply for dollars; and b) depreciation and appreciation on the y-axis. (2 X 2 = 4) (2) a) excess demand and excess supply for dollars; and (2 X 2 = 4) At lower prices there will be an excess demand for dollars e.g. at a price of R6 the qty demanded will be Q1 & qty supplied will be Q2. Excess demand will be Q2Q1. At higher prices there will be an excess supply of dollars, e.g. at a price of R10 the qty demanded will be Q3 & the qty supplied will be Q4. Excess supply will be Q3Q4. If the dollar becomes more expensive there will be an movement on the Y-axis, the Rand depreciates (it takes more Rands to buy $1). A movement on the Y-axis shows an appreciation of the Rand (less Rand buys more dollars). For your information: Economics I – Study Guide Page 45 As you may recall from Question 1(b) the exchange rate is the price of one country’s currency (e.g. the rand) in terms of another country’s currency (e.g. the US dollar). Exchange rates can be expressed directly or indirectly. The direct rate (R/$ rate) is the amount of rands needed to buy one US dollar, while the indirect rate ($/R rate) is the amount of US dollars needed to buy one rand. Most countries, however, use the direct method and we will thus focus on this method. For a South African, the direct method of expressing the exchange rate between the rand and the US dollar involves writing down the number of rand that are needed to buy one dollar at that time. For instance, the price of one US dollar on 14 July 2010 at 10:13 was equal to R7.52. The direct quotation is thus that $1 = R7.52, or simply that the R/$ rate is R7.52 per dollar. The slash (/) separating the symbols for the two currencies in any exchange rate is equivalent to a division sign, since exchange rates are simply ratios. (Just an aside: on 14 July 2015 the price of a US dollar was equal to R12.33. Almost one year later on 7 June 2016 the price of one US dollar was equal to R14.86.) 13 Consider the rand/dollar exchange rate. Assume that the exchange rate is currently quoted as R7.50 to the US dollar. a) If Thabile bought the complete fourth season of the television show, True Blood, as a 7-disc Blu-ray disc set for $30 through ebay.com, the online auction and shopping website, how much would she have to pay in rand terms? (Ignore bank and other charges.) (2) b) If the exchange rate were to change to R7.80 to the dollar, which currency has appreciated and which has depreciated? (2) c) How much would Thabile now have to pay in rand terms (assuming the television show still costs $30)? (2) 14 Use the following table to answer the questions: USD ($) GBP (£) USD ($) 1 1.60 GBP (£) 0.63 1 EUR (€) 0.69 1.10 ZAR (R) 9.87 15.11 EUR €) 1.46 0.91 1 13.11 ZAR (R) 0.10 0.066 0.077 1 a) Charlotte has saved £100. The phone she wants to buy costs R900. How much money will she have left in British Pounds after buying the phone? (2) b) Mpho received a gift of €20. How many South African Rands can she buy with this money? (2) c) Kobus has R1 000 spending money to take on his trip to the U.S.A. How many Dollars will he have to spend there? (2) d) Sizwe has $11 and wants to purchase music online for €10. Does he have enough money to make the purchase? (2) 15 Illustrate (Fig. 16-3, p. 307) and explain the effects of a decrease in the supply of dollars on the value of the rand. Ensure that you have mentioned one factor that could have caused this decrease in supply of dollars. (6) 16 Consider the following situation. Tourism from South Africa to the United States increases sharply because of a fare war among airlines. Illustrate and explain the effects of this situation on the exchange rate between the rand and the United States dollar ($). (Assume that you are a South African who wants to visit the USA when answering this question.) (5) Economics I – Study Guide Page 46 The in the demand for dollars due to more SA tourists visiting the USA shifts the demand curve to D1. The equilibrium price (or exchange rate) changes to $1 = P1 & the equilibrium qty to Q1. The new equilibrium is E1. The Rand has depreciated against the US dollar (the dollar has appreciated against the Rand). 17 Consider the South African market for Japanese Yen. a) Illustrate what will happen to the exchange rate between the rand and the Japanese Yen (¥) if South African exports to Japan increase, ceteris paribus. Remember to label your diagram. (4) b) Has the price of the Japanese Yen (¥) increased or decreased in rand terms as a result of the increase in exports? (1) c) Did the increase in exports lead to an appreciation or a depreciation of the rand against the Yen (¥)? (1) 18 Explain the effect of a depreciating rand for South Africa by discussing its effect on (i) export prices, (ii) import prices, (iii) the current account and (iv) domestic prices (p. 308). (2) Example: In the simplified case of two countries and two commodities, terms of trade is defined as the ratio of the price a country receives for its export commodity to the price it pays for its import commodity. In this simple case the imports of one country are the exports of the other country. For example, if a country exports R50 worth of product in exchange for R100 worth of imported product, that country's terms of trade are 50/100 = 0.5. The terms of trade for the other country must be the reciprocal (100/50 = 2). When this number is falling, the country is said to have "deteriorating terms of trade". If multiplied by 100, these calculations can be expressed as a percentage (50% and 200% respectively). If a country's terms of trade fall from say 100% to 70% (from 1.0 to 0.7), it has experienced 30% deterioration in its terms of trade. Economics I – Study Guide Page 47 19 Study the table below and answer the questions that follow. Terms of Trade Index of prices 100 105 Year 2006 2011 export Index of prices 100 101 import Terms of Trade 100 A a) Calculate the terms of trade for A (p. 311). (Remember to show all your calculations and to include the formula that you used.) (3) b) What does a decrease in the terms of trade mean (p. 3111)? (2) c) Describe the movement in the terms of trade from 2005 – 2010. (3) export price index x 100 import price index 105 = x 100 101 = 103,9 terms of trade = a) b) Indicates that a country is poorer since greater volumes of exports need to be produced in order to afford the same value of imports. There has thus been a welfare loss, ceteris paribus. c) The terms of trade increased from 2006 – 2011 (1 mark). An increase in the terms of trade indicates an improvement in the welfare of the country (1 mark) since fewer exports are needed to buy the same amount of imports (1 mark). Economics I – Study Guide Page 48 Revision: Indicate whether each of the following statements is True (T) or False (F). True (T) 1 2 3 4 5 6 7 8 9 10 11 12 The law of relative (or comparative) advantage states that two countries will benefit from trade if the opportunity costs of production (or relative prices) differ between the two countries. The price at which one currency exchanges for another currency is the exchange rate. A country has a comparative advantage in producing a good if it can produce that good at a lower opportunity cost than another country. As a result of an increase in tariffs, imports decrease and government revenue increases. Import quotas are a form of protection whereby goods having a set price may be imported. Dumping occurs when a foreign firm sells its exports at a lower price than it costs to produce them. If South Africans demand goods produced in the United States of America, it leads to a demand for US dollars and a supply of South African rands on the foreign exchange market. An increase in South African imports from the USA will give rise to an appreciation of the rand against the US dollar. If the rand appreciates against other currencies, South African exports will become more competitive. The exchange rate is $0,50 = R5,00. If a car sells for $16 000, then its cost in rands would be R160 000. The table shows the case of two countries, ABCLand and the XYZLand, both producing carpets and fighter aircraft. The table shows output rates per day in the two countries if all resources are fully and efficiently employed. Carpets Fighter aircraft ABCLand 100 4 XYZLand 500 25 Based on this information XYZLand should export fighter aircraft to ABCLand. The table shows the case of two countries, ABCLand and the XYZLand, both producing carpets and fighter aircraft. The table shows output rates per day in the two countries if all resources are fully and efficiently employed. Carpets Fighter aircraft ABCLand 100 4 XYZLand 500 25 An appropriate international exchange ratio that would allow mutually advantageous trade to take place would be 1 aircraft = 22 carpets. Economics I – Study Guide Page 49 False (F) CHAPTER 19: MORE ON MACROECONOMIC THEORY AND POLICY Learning Outcomes The purpose of this chapter is to use aggregate demand (AD) and aggregate supply (AS) curves to analyse monetary and fiscal policies and supply shocks. Once you have studied this chapter you should be able to: • Describe the effects of expansionary monetary and fiscal policy in the AD – AS framework; • Describe the effects of an increase in the cost of production in the AD – AS framework; • Describe how changes in interest rates can affect important macroeconomic variables such as total production and the price level; • Use the AD – AS model to illustrate the policy dilemma in the open economy; • Explain how three major schools of thought differ in their understanding of how the economy functions; and • Describe the major features of supply-side economics. Note: Sub-section 19.1 This sub-section is very important. It shows how AD and AS can be combined to analyse a variety of macroeconomic issues and should be studied in detail. Here are some important hints: • students must know the factors causing shifts in the AD and AS curves; and • students must be able to use the AD-AS model to explain the impact on the price level and total production (or income) of: i.expansionary and contractionary monetary and fiscal policies ii.a change in aggregate supply (e.g. a supply shock). Written assignment questions / Tutorial questions / Self-study questions: 1 Compare the assumptions of the simple Keynesian model to the assumptions of the AD-AS model. Discuss the implications that these assumptions have for the AD-AS model (Box 19-1, p. 360). (12) 2 List and explain the three reasons why the aggregate demand curve is downward sloping (pp. 361 – 362). (6) 3 What factors would cause the AD curve to shift (see Table 19-1, p. 363)? (5) 4 What factors would cause the AS curve to shift (see Table 19-2, p. 364)? (4) 5 Name the ONE factor which causes a movement along both the AD and AS curve (see Table 19-1, p. 363 and Table 19-2, p. 364). (1) 6 Discuss the shape of the short-run aggregate supply curve. Hint: To answer this question it is best to analyse the AS curve as having three distinct phases. (3 X 2 = 6) The AS curve can have a flat (horizontal) phase, a rising (upward sloping) phase & a vertical phase. Economics I – Study Guide Page 50 • • • Along the flat part, sometimes called the Keynesian range, an in AD will result in in real output without an in the price level. [This is the phase where the economy is in recession so there are plenty of unused FOP in the economy. Not all labour is employed, in fact, unemployment is high thus making it difficult for workers to negotiate higher wages. As a result cost of production will be small so there will be a large in real output implying a relatively flat AS curve.] Along the vertical part (sometimes called the classical range), an in AD will result only in an in the price level. The curve becomes vertical ∵ production can’t be expanded beyond the full-employment level in the short-run. Between these 2 parts (i.e. in the so-called intermediate range), both the price level & real output will if AD . [This part shows a higher level of production, & much more use of labour & other FOP. An in supply is still possible as demand goes up, but prices also become more expensive. This is ∵ we are beginning to run short of some FOP, causing upward pressure on prices.] Recall from Chapter 15: a) To expand the economy: • Fiscal policy – taxes and government expenditure. • Monetary policy – the money supply and the interest rate. b) To contract the economy: • Fiscal policy – taxes and government expenditure. • Monetary policy – the money supply and the interest rate. Remember: Whenever you draw a diagram in Economics, all axes and curves must be fully labelled. [Note: the labels on the axes must be written out in words.] Also ensure that you have included all necessary arrows. In the case of aggregate demand and aggregate supply diagrams that means that you should, in most cases, have four arrows. One arrow should indicate the direction in which the demand or supply curve has shifted. One arrow should indicate what has happened to “price level”, while another arrow should indicate what has happened to “total production, income”. The final arrow should indicate the transition from the original equilibrium point to the new equilibrium point. 7 Illustrate (Fig. 19-4, pp. 365 – 458) and explain the effect of expansionary monetary and fiscal policy in the AD – AS framework. Ensure that you have stated under what conditions this policy will be used. (5) Economics I – Study Guide Page 51 8 Illustrate (Fig. 19-5, p. 366) and explain the effect of an increase in the cost of production, e.g. increased imported oil price, in the AD – AS framework. Ensure that you mention what situation this scenario will give rise to. (5) 9 The price of oil increased to more than $147 per barrel on 11 July 2008, and this pushed the price of petrol up. Using the AD – AS model, explain with the aid of a diagram (Fig. 19-5, p. 366), what the inflationary effect will be. Furthermore, mention what situation this scenario will give rise to. (5) 10 Use the AD-AS model to illustrate and explain the stagflation phenomenon (Fig. 19-5). Can stagflation be combated by expansionary monetary or fiscal policies? Explain. (5) The diagram is the same as Figure 19-5 on page 366 of the textbook. Stagflation is a simultaneous stagnation (or decrease in production, income and employment) and inflation (increase in prices). The cause originates on the supply side, as illustrated in Figure 19-5. Monetary and fiscal policies work via the demand side of the economy, illustrated by shifts of the AD curve. Expansionary monetary and fiscal policies (illustrated by a rightward shift of the AD curve) may be used to increase production and employment, but this will be at the expense of even higher prices (inflation). Likewise, contractionary monetary and fiscal policies (illustrated by a leftward shift of the AD curve) may be used to combat inflation but this will be at the expense of even lower production and higher unemployment. Monetary and fiscal policies alone are therefore not the answer. 11 Assume that the government announces a 10% reduction in personal income tax rates. a) Indicate whether the government is applying an expansionary monetary or an expansionary fiscal policy. (1) b) Using the AD – AS model, explain with the aid of a diagram, what the expected effect on the equilibrium price level and level of real output will be. (4) c) When will the government apply the policy you indicated in Question 11 a)? (1) 12 Assume that construction spending on new homes rises dramatically, greatly increasing total investment spending in South Africa. Using the AD – AS model, explain with the aid of a diagram, what the expected effect on the equilibrium price level and level of real output will be. (3) The aggregate demand curve shifts to the right, and both the price level and real output increase. 13 Assume that an economic recession occurs in the European Union, significantly reducing foreign purchases of South African exports. Using the AD – AS model, explain with the aid of a diagram, what the expected effect on the equilibrium price level and level of real output will be. (3) The aggregate demand curve shifts to the left, both the price level and real output decline. Note: The “monetary transmission mechanism” indicates the ways in which changes in the monetary sector of the economy work their way through to the rest of the economy. For example, if interest rates change, the transmission mechanism indicates how such a change may affect total spending, production, income and employment in the economy, as well as how it may influence the general price level. 14 Name and explain the main lags that have to be taken into account when attempting to stabilise the economy. Furthermore, you should indicate their relative lengths (pp. 372 – 373).(4 X 2 = 8) 15 Explain how the Classical School, the Keynesians and the Monetarists differ in their understanding of how the economy functions by discussing their views regarding: a) the stability of the economy; b) the policy prescriptions they recommend; c) their views regarding the relationship between demand and supply; and d) their views regarding the monetary and real sides of the economy (see sub-section 19.4, pp. 375 – 378.) (3 X 4 = 12) Classical School Economics I – Study Guide Keynesian School Page 52 Monetarism Believe that a free-market economy is intrinsically stable & effective in achieving macroeconomic objectives. Believe that the free-market economy is inherently unstable. Do NOT believe in the use of macroeconomic tools to stabilise the economy. Believe in the use of macroeconomic tools to stabilise the economy. They thus favour government intervention & believe that appropriate fiscal policy should be implemented to stabilise the economy. Believe in Say’s Law – “Supply creates its own demand”. The basic idea underlying Say’s law is that production creates income, & also the necessary means to purchase the g & s that are produced. Saving will AUTOMATICALLY be invested. All output will always be sold. AS will adjust passively to AD. (OR simply say - Demand creates its own supply.) Not all income that is earned in 1 period is spent on the output produced in that 1 period. Believe that the monetary & real sides of the economy are entirely separate. Believe that the money market can affect the real economy, at least in the short run. Other interesting facts: Classical School No reason for unemployment. Unemployment was regarded as a short-run, temporary phenomenon which would be eliminated in due course by the working of the market mechanism. Short-run price & wage adjustments cause unemployment. Inflation is caused by excessive increases in the money supply. 16 Keynesian School Labour market can be out of equilibrium, causing involuntary unemployment. There is a possibility of underspending in 1 period; , not all the output is purchased, stocks produced begin to (∵ of the excess supply), & this sends a signal to firms to cut back on production. This causes unemployment to . Inadequate AD causes unemployment. Inflation is a complex phenomenon, but is caused by excessive AD. The monetary transmission mechanism works via changes in interest rates. Believe that a free-market economy is intrinsically stable & effective in achieving macroeconomic objectives. Do NOT believe in the use of macroeconomic tools to stabilise the economy. They thus believe that government intervention should be restricted to the minimum. The governments should NOT use discretionary fiscal & monetary policies to try to stabilise the economy. Believe in Say’s Law – “Supply creates its own demand”. The basic idea underlying Say’s law is that production creates income, & also the necessary means to purchase the g & s that are produced. Saving will AUTOMATICALLY be invested. All output will always be sold. Believe that the money market can affect the real economy, at least in the short run. Monetarism Short-run price & wage adjustments cause unemployment. Inflation is caused by excessive increases in the money supply. Growth in the money supply should be regulated in such a way that it merely keeps abreast of the growth in real production. Such action will avoid inflation & have the least disturbing effect on the free-market economy. Explain the concept “supply-side economics” (see sub-section 19.4, pp. 378 – 379). In your answer you also need to outline the THREE main elements of supply-side economics. (4) Economics I – Study Guide Page 53 Note: The Laffer Curve5 postulates a relationship between tax revenue & tax rates whereby tax rates above a certain level will result in less tax revenue ∵ of more tax evasion & reduced transfers. Note: Now that you know what the Laffer Curve is you may be asking yourself, how does the Laffer Curve relate to supply-side economics and why is determining the location where the economy is on the curve so important in assessing tax policy? Economist Arthur Laffer observed that tax revenues would obviously be zero when the tax rate was either at 0% or 100%. In between these two extremes would have to be an optimal rate where aggregate output and income produced the maximum tax revenues. This idea is presented as the Laffer Curve shown in the figures below. 5 You may wish to read this recent article about the effects of high tax rates in the United Kingdom: Mitchell, D.J. 2 July 2012. The Laffer Curve in the United Kingdom, Forbes. [Online]. Available: http://www.forbes.com/sites/danielmitchell/2012/07/02/the-laffer-curve-wreaks-havoc-in-the-united-kingdom/. [Accessed: 2 July 2012]. Economics I – Study Guide Page 54 The difficult decision involves the analysis to determine what is the optimum tax rate for producing maximum tax revenue and the related maximum economic output level. Laffer argued that low tax rates would actually increase revenues because low rates improved productivity, saving and investment incentives. The expansion in output and employment and thus, revenue, would more than compensate for the lower rates. 17 Study the diagram below and answer the questions that follow: a) At what point will government maximise revenue? (1) b) What will be the effect on government revenue if the tax rate increases from 40% to 80%? (1) c) What is the implication for the government if the tax payer is taxed at 100%? (1) d) What illegal behaviour by the worker will be encouraged if the tax rate is too high? (1) Revision: Indicate whether each of the following statements is True (T) or False (F). True (T) 1 2 3 4 5 6 7 8 9 10 11 The AD curve shifts to the right with an increase in taxes or a decrease in government purchases. The AS curve is horizontal in the intermediate range. In the AD-AS model, if AD falls, there will be a fall in the general level of prices and a fall in output. In the AD-AS model, if the cost of productive resources rise, aggregate demand is unaffected. Restrictive monetary and fiscal policies are normally applied during recessions. The recognition lag occurs because it takes time to implement decisions. A Monetarist believes that if the economy was left alone, it would rarely operate at full employment. Say’s law says demand creates its own supply. According to Keynes, the economy is inherently unstable. Supply-side fiscal policies focus on improving the incentives to work, save and invest. The Laffer curve represents the relationship between real GDP and various possible tax rates. Economics I – Study Guide Page 55 False (F) CHAPTER 20: INFLATION Learning Outcomes Chapter 13 states that price stability is one of the most important macroeconomic aims. (The other macroeconomic objectives are: economic growth, full employment, balance of payments stability and an equitable distribution of income.) As such, economists warn against the detrimental effect that inflation might have on the economy. Despite this few consumers know what inflation really means, and few can give a scientific explanation for it. The purpose of this chapter is to define inflation, the different types and effects. Once you have studied this chapter you should be able to: • Define inflation; • Distinguish between different measures of inflation; • Calculate CPI; • Calculate the GDP deflator; • Explain why inflation is regarded as a problem; • Explain, using diagrams, the difference between demand-pull and cost-push inflation; • Identify the factors that give rise to demand-pull and cost-push inflation; and • Explain “inflation targeting” as a policy measure that can be used to combat inflation. Written assignment questions / Tutorial questions / Self-study questions: 1 Define the concept “inflation” and discuss the significance of the different elements of the definition (p. 382). (5) Inflation is defined as a continuous & considerable rise in prices in general. Inflation thus refers to a process in which the prices of most g & s are by a large amt from year to year. This is a neutral definition, in that it does not point to any possible cause of inflation. The increase in prices must be significant. An increase of, say, 1% per year might not be inflation – it could, for example, be ascribed to increased quality of goods and services. The increases must also be continuous – a once-off increase in prices is not inflation. Finally, the increase must apply to prices in general. Increases in the prices of individual goods or services (eg oil, food) do not constitute inflation. 2 Explain each of the following methods whereby the rate of inflation is measured: a) the consumer price index (CPI) (p. 382 and Chapter 13); b) the producer price index (PPI) (p. 383). (2 X 1 = 2) For your information: • The CPI underwent reweighting with the introduction of new expenditure weights, based largely on the Income and Expenditure Survey of 2010/2011. Associated with this change was the update of the CPI basket. • The CPI was rebased so that December 2012=100. • The South African CPI has 2 equally important objectives: 1. To measure inflation in the economy so that macroeconomic policy is based on comprehensive and up-to-date price information and to provide a deflator of consumer expenditure in the expenditure national accounts. 2. To measure changes in the cost of living of South African households to ensure equity in the measures taken to adjust wages, grants, service agreements and contracts. Economics I – Study Guide Page 56 Restaurant and hotels, 3.33% Miscellaneous, 13.94% Education , 2.66% Food and nonalcoholic beverages, 18.19% Recreation and entertainment, 4.07% Alcoholic beverages and tobacco, 5.37% Communication, 2.54% Clothing and footwear, 4.37% Transport, 16.07% Housing and utilities, 23.14% Health, 1.39% Household contents, equipment and maintenance, 4.93% Figure 20A: Distributions of the April 2016 CPI basket Source: Stats SA. 2016. Consumer Price Index (CPI) April 2016: Additional Tables – Available: http://www.statssa.gov.za/publications/P0141/P0141April2016_Tables.pdf • In constructing the CPI, Stats SA: o Selected the goods and services to be included in the basket. For example, minibus taxi trips are now included in the basket, while VHS recorders and cassettes are excluded (Statistics South Africa, 2008). More recently it was decided to include antiviral and retroviral drugs in the basket, while corned meat and tombstones are excluded (Statistics South Africa, 2014). The SA basket currently contains 393 goods & services arranged in 12 large groups. o Assigned a weight to each good or service to indicate its relative importance in the basket. The 3 main groups are housing & utilities (23.14%), food and non-alcoholic beverages (18.19%) & transportation (16.07%) (see Figure 20A). o Decided on a base year for calculating the CPI – namely that it would be December 2012. (The price index for the base year is always equal to 100.) o Decided on a formula for calculating the CPI. Employees collect prices each month to calculate the value of the CPI for that month. For the current CPI: “A monthly survey of about 70 000 prices drives the change in the inflation rate from month to month. This is a large number of prices considering that, in the US (a substantially larger economy), about 80 000 prices are used each month. The prices are collected in 26 different urban areas and then aggregated to calculate the headline CPI.6” 6Kelly, P. 19 February 2013. Revised ‘basket’ makes CPI more accurate and relevant, Business Day. [Online]. Available: http://www.bdlive.co.za/opinion/2013/02/19/revised-basket-makes-cpi-moreaccurate-and-relevant [Accessed 12 July 2015]. Economics I – Study Guide Page 57 Index (December 2012 = 100) April 2015 March 2016 Percentage change April 2016 Month-onmonth Year-onyear Western Cape (Weight:15.55) 114.1 120.3 121.1 0.7 6.1 Eastern Cape (Weight:8.12) 113.7 120.4 121.7 1.1 7.0 Northern Cape (Weight:1.57) 113.6 118.2 119.1 0.8 4.8 Free State (Weight:5.12) 114.1 120.8 121.7 0.7 6.7 KwaZulu-Natal (Weight:15.33) 113.4 120.0 121.2 1.0 6.9 North West (Weight:5.59) 113.4 119.0 120.3 1.1 6.1 Gauteng (Weight:36.97) 114.4 120.5 121.5 0.8 6.2 Mpumalanga (Weight:5.69) 113.1 119.3 120.4 0.9 6.5 Limpopo (Weight:6.06) 114.1 121.6 123.5 1.6 8.2 CPI for total country (Weight:100) 114.0 120.3 121.4 0.9 6.5 Source: Stats SA. 2016. Consumer Price Index (CPI) http://www.statssa.gov.za/publications/P0141/P0141April2016.pdf April 2016 – Available: One might wonder whether it matters if the CPI is overstated – the answer is, YES! Many decisions depend on the CPI and any errors in the CPI will lead to errors in these decisions. For instance, some wage contracts are linked to the CPI. If the CPI overstates inflation, then the firms pay too much and some workers might lose their jobs if the firm decides to fire them. Additionally the government links large amounts of its expenditure, including Social Security payments, to the CPI. If the CPI overstates inflation, then government outlays rise more rapidly than justified whereas if the CPI understates inflation, then outlays do not rise enough to offset the true inflation rate. 3 Tabulate the main differences between the CPI and the PPI (p. 383). (4 X 2 = 8) Note: A major purpose of the CPI is to measure inflation. The inflation rate is the percentage change in the price level from one year to the next. The inflation formula is: (CPI of this year - CPI of the previous year) *100 CPI of the previous year Economics I – Study Guide Page 58 Example: Use the information in the following table and determine the country’s inflation rate for the year 2004 as experienced by consumers: Year 2001 2002 2003 2004 CPI 82.2 85.7 92.3 96.9 Answer: CPI Inflation rate 2004 = [(CPI 2004 - CPI 2003) / CPI 2003] x 100% CPI Inflation rate 2004 = [(96.9 - 92.3) / 92.3] x 100 CPI Inflation rate 2004 = 4.98% Example: For a simple economy that consumes only oranges and haircuts, we can calculate the CPI. The CPI basket is 10 oranges and 5 haircuts. (Remember: in Chapter 13 we learnt that the quantities are fixed when calculating the CPI basket as we want to pick up the change in price!) The table below shows the prices in the base period. Item Quantity Price Oranges 10 R1.00 Haircuts 5 R8.00 Cost of CPI basket at base period prices The cost of the CPI basket in the base period was R50. Cost of CPI R10 R40 R50 The table below shows the prices in the current period. Item Quantity Price Oranges 10 R2.00 Haircuts 5 R10.00 Cost of CPI basket at base period prices The cost of the CPI basket in the current period is R70. Cost of CPI R20 R50 R70 The following three steps must be followed to calculate the CPI: 1. Find the cost of the CPI basket at base period prices. See above (R50). 2. Find the cost of the CPI basket at current period prices. See above (R70). 3. Calculate the CPI for the base period and the current period. The CPI is calculated using the formula: CPI = (Cost of basket in current period/Cost of basket in base period) *100. Using the numbers for the simple example, the CPI is CPI = (R70/R50) * 100 = 140. The CPI is thus 40% higher in the current period than it was in the base period. (Recall from Chapter 13: the CPI is always equal to 100 in the base period.) 4 If the consumer price index at the end of 1998 was 100 and at the end of 1999 was 120, then the rate of inflation for 1999 was ___. (2) 5 If the consumer price index was 128 at the end of 1994 and 136 at the end of 1995, what was the rate of inflation for 1995? (2) 6 In 2004 the CPI was 105; in 2005 it was 112. The inflation rate between 2004 and 2005 was ______. (2) Economics I – Study Guide Page 59 7 Complete the table below by calculating the values of the missing index numbers and year-onyear rates. (4) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Year 2009 2010 8 Index Index Rate 103.1 109.5 6.2 104.3 110.2 5.7 105.7 111.1 5.1 106.2 111.3 4.8 106.6 111.5 4.6 107.0 111.5 A 108.2 B 3.7 108.5 112.3 3.5 108.9 C 3.2 108.9 112.6 3.4 108.9 112.8 D Complete the table below by calculating the values of the missing index numbers and year-onyear rates. (4) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Year 2014 2015 9 Index Index Rate 106.1 110.8 4.4 107.3 111.5 A 108.7 113.1 4.0 109.2 114.1 4.5 109.4 B 4.6 109.7 114.9 C 110.6 116.1 5.0 111.0 116.1 4.6 111.0 116.1 4.6 111.2 116.4 D 111.2 116.5 4.8 You are given some statistical accounts for the country of Fruitopia which produces two goods, apples and oranges. The accounts contain information on the price of apples and the price of oranges for the years 2005 to 2008. Fruitopia is using 2005 as the base year. Year 2005 2006 2007 2008 Price (apples) R1.00 R1.10 R1.21 R1.33 Quantity (apples) 100 105 110 115 Price (oranges) R2.00 R2.40 R2.88 R3.46 Quantity (oranges) 100 105 100 100 a) Calculate the cost of this market basket in 2005. b) Calculate the CPI in each year. c) Calculate the inflation rate between 2005 and 2006 (and between 2006 and 2007). (2) (8) (4) Note: From the above it should be clear that the CPI is not simply another term for the inflation rate. Should you still not be sure why not, find an explanation below: The consumer price index is an index of the cost of a basket of consumer goods and services, and therefore an index of the cost of living in the economy – it indicates the level of the cost of living. The inflation rate is a rate of change – it indicates the rate at which prices (the CPI) has changed. The CPI serves as a basis for estimating the inflation rate. 10 Name and explain the THREE main effects of inflation (pp. 384 – 386). 11 Why does the combination of inflation and a progressive income tax system tend to redistribute income in the economy? What is this phenomenon called? (5) With inflation, taxpayers’ nominal (money) incomes increase, while their real (inflation-adjusted) incomes may remain unchanged, or even fall. Income tax, however, is levied on nominal income, not real income. With a progressive income tax, marginal and average tax rates increase as nominal income increases. As taxpayers move into higher income brackets as a result of inflation, they have to pay more tax, not only in nominal (money) terms, but in real terms (by paying higher tax rates). The combination of inflation and a progressive income tax thus benefits government at the expense of taxpayers. Put differently, there is a redistribution of income from taxpayers to the government. This phenomenon is called bracket creep or the fiscal dividend. 12 Write a short note on each of the following: a) demand-pull inflation (p. 388); and b) cost-push inflation (p. 389). 13 (3 X 2 = 6) (2) (2) Identify THREE different factors that could give rise to demand-pull inflation. You are not required to explain why these factors give rise to demand-pull inflation, but it is important to state the direction of change (pp. 388 - 389). (3) Economics I – Study Guide Page 60 Dec 109.2 113.0 3.5 Dec 111.0 116.8 5.2 14 Identify THREE different factors that could give rise to cost-push inflation. You are not required to explain why these factors give rise to cost-push inflation, but it is important to state the direction of change (pp. 389 – 390). (3) 15 Illustrate and explain the following types / causes of inflation: a) demand-pull inflation (Fig. 20-1, p. 389). Ensure that you have mentioned what causes demand-pull inflation; and (5) b) cost-push inflation (Fig. 20-2, p. 390). Ensure that you mention the phenomenon that is likely to occur due to this type of inflation. (5) a) Demand-pull inflation occurs when total spending exceeds the economy’s capacity to produce. It is inflation that occurs when aggregate spending increases faster than output or production (1 mark). / Demand-pull inflation occurs when the AD for goods and services increases while AS remains unchanged (or 1 mark). Demand-pull inflation occurs when the aggregate demand for g & s (due to an in for e.g. consumption spending by households) (or 1 mark). This is illustrated by the rightwards shifts of the AD curve from AD to AD , AD & AD (1 mark). 1 2 3 4 AS is the aggregate supply curve & AD the aggregate demand curve. The original equilibrium 1 is at E with a general price level of P & a total production of Y . 1 1 1 The original equilibrium is at E with a general price level of P & a total production of Y . 1 1 1 Excess capacity in the economy stage: If there is an in the aggregate demand for g & s, the aggregate demand curve will shift to the right to AD & then to AD . The new equilibrium is at E (1 mark) with a general 2 3 3 price level of P (1 mark) & total production of Y (1 mark). 3 f Full employment stage: When the economy is at full employment, further in aggregate demand simply lead to price (1 mark). This is indicated by the shift of the AD curve from AD to AD . 3 4 Conclusion: As long as there is still excess capacity in the economy (or ½ mark), the in the price level (or 1 mark) will be accompanied by in production & income (or 1 mark). However, when full employment is reached (or ½ mark), further shifts in the AD curve (from AD to AD ) lead to price only (or 1 mark). 3 Economics I – Study Guide 4 Page 61 [A ½ mark is subtracted for each label which is missing from either the x-axis or the y-axis; maximum of -1 per diagram. Only a very broad explanation of what causes demand-pull inflation is required. However, the student may also be awarded a mark if he / she mentions that demand-pull inflation can be caused by any (or a combination) of the various components of aggregate demand, i.e. increased consumption spending, increased investment spending, increased government spending & increased export earnings.] b) Cost-push inflation that occurs from the supply side of the economy. Prices ∵ of a in per unit production costs. E.g. wages or the unexpected in the price of raw materials. 16 What policy measures can be used to combat demand-pull inflation? Ensure that you comment on the possible side-effects of these measures (p. 389). (3) 17 What policy measures can be used to combat cost-push inflation? Ensure that you comment on the possible side-effects of these measures (p. 390). (3) 18 You are the chief economic advisor for the government of NMMUland. NMMUland is experiencing demand-pull inflation despite the stated objective of the government to achieve price stability. Explain, with the aid of a diagram, what steps the government of NMMUland should take to achieve this objective. Note: you must clearly indicate any changes to aggregate demand or aggregate supply, prices and production that might result from the actions taken by the government on the diagram you have drawn. In your explanation you must discuss the instruments of fiscal policy, how these instruments are applied and what effect they have. (7) The government must implement restrictive (or contractionary) (1 mark) fiscal policy measures (i.e., the government must increase taxes, and / or decrease government spending). They must decrease government spending (½ mark) and increase taxes (½ mark). This will lead to a decrease in aggregate demand, illustrated by a leftward shift of the aggregate demand curve (1 mark). The price level decreases (1 mark) and the income (or production) will decrease (1 mark). Lower prices are traded-off against higher unemployment (1 mark). [Or: 1 mark for leftward shift of AD, 1 mark for decrease in price level, 1 mark for decrease in Y if no explanation is given, but diagram and arrows are correct.] 19 Define the concept “stagflation” (p. 390 and p. 366). Economics I – Study Guide Page 62 (1) 20 Explain THREE key features of inflation targeting as a policy measure that can be used to combat inflation in South Africa (p. 396). (3) 21 Discuss THREE advantages and THREE disadvantages of inflation targeting (p. 397). (Learn the first three advantages and disadvantages mentioned in your textbook.) (2 X 3 = 6) For your information: Inflation has the following effects on the current account of the South African BoP: High inflation leads to the prices of domestic goods being high compared to those of other countries that are not experiencing high inflation. The makes domestic goods uncompetitive on foreign markets and results in decreased exports. Imports will also seem relatively cheaper to local residents, so imports will increase. The combined effect of decreased exports and increased imports will lead to a current account deficit. Revision: Indicate whether each of the following statements is True (T) or False (F). True (T) 1 2 3 4 5 6 7 8 9 10 11 An increase in the price of fruit is a good example of inflation. Inflation refers to rising prices at a given time period. The PPI does not include capital and intermediate goods, but does include services. Inflation results in a redistribution of wealth in the economy and tends to benefit the home-owner who has a mortgage bond with a fixed interest rate on his or her house (i.e. a debtor). The fact that taxpayers are taxed on their nominal incomes, irrespective of what happens to their real incomes, can give rise to bracket creep. High inflation tends to stimulate speculative activity at the expense of productive activity. Excessive government spending can cause demand-pull inflation. Demand-pull inflation usually leads to increased prices and increased unemployment. Increases in government purchases can create cost-push inflation. Cost-push inflation is caused by supply shocks like higher oil prices and poor weather conditions. Stagflation means a simultaneous decrease in the unemployment and inflation rates. CHAPTER 21: UNEMPLOYMENT Learning Outcomes Economics I – Study Guide Page 63 False (F) The purpose of this chapter is to introduce students to the definition, cost and types of unemployment. In addition, students must be able to describe the trade-off principle of the Phillips curve. Once you have studied this chapter you should be able to: • Describe the costs of unemployment • Distinguish between the different types of unemployment; • List some possible causes of structural unemployment; • Discuss the policies that can be used to reduce unemployment; • Explain what the Phillips curve means; and • Explain the “incomes policy” as a policy measure that can be used to combat inflation. Written assignment questions / Tutorial questions / Self-study questions: For your information: Politicians and Economists agree that the high level of unemployment in South Africa is the most serious economic and social problem that this country faces (Mohr et al. 2015:400-401; http://www.news24.com/SouthAfrica/Politics/Zuma-Fight-unemployment-20081017). The cost of unemployment is not just the loss of income; it also involves the loss of self-esteem. High unemployment also leads to greater social unrest, violence and crimes. Recall from Chapter 12: • Statistics South Africa uses the following definition of unemployment as its official definition. The unemployed are those people within the economically active population who: (a) were not employed in the reference week, (b) actively looked for work or tried to start a business in the four weeks preceding the survey interview, (c) were available for work, i.e. would have been able to start work or a business in the reference week; or (d) had not actively looked for work in the past four weeks but had a job or business to start at a definite date in the future and were available. • Statistics South Africa also calculates the expanded unemployment rate. This measure of unemployment includes discouraged work seekers. A discouraged job-seeker is a person who was not employed during the reference period, wanted to work, was available to work/start a business but did not take active steps to find work during the last four weeks, provided that the main reason given for not seeking work was any of the following: no jobs available in the area; unable to find work requiring his/her skills; lost hope of finding any kind of work. 35 30 31.0 27.9 27.9 26.3 26.2 26.2 25 25.1 24.7 22.6 20 15 9.9 10 6.9 5 6.8 6.3 6.2 6.0 5.1 5.0 4.7 3.7 3.6 0 Figure 21A: Unemployment rates around the world – modelled on the ILO estimate – 2014 data Economics I – Study Guide Page 64 Source: http://data.worldbank.org/indicator/SL.UEM.TOTL.ZS Figure 21B: Educational attainment of the unemployed by population group, Q1: 2015 and Q1: 2016 Source: Stats SA. 2016. Quarterly labour force survey Quarter 1 2016 – Available: http://www.statssa.gov.za/publications/P0211/P02111stQuarter2016.pdf Table 21A: Labour force characteristics by set – All population groups Jan - March Oct – Dec 2015 2015 Both sexes (15 – 64) Unemployment rate 26.4 24.5 Employed / population ratio (absorption) 43.2 44.2 Labour force participation rate 58.6 58.5 Women Unemployment rate 28.7 26.9 Employed / population ratio (absorption) 37.2 38.1 Labour force participation rate 52.2 52.0 Men Unemployment rate 24.4 22.5 Employed / population ratio (absorption) 49.3 50.4 Labour force participation rate 65.2 65.1 Source: Stats SA. 2016. Quarterly labour force survey Quarter 1 http://www.statssa.gov.za/publications/P0211/P02111stQuarter2016.pdf Jan – March 2016 26.7 43.0 58.7 29.3 37.0 52.4 2016 24.6 49.1 65.2 – Available: Note the differences between the different schools of economic thought regarding their views of unemployment: Classical School Keynesian School Monetarists Views Labour market can be out of No reason for regarding equilibrium, causing involuntary unemployment. unemployment unemployment. There is a Unemployment was possibility of under-spending in regarded as a shortShort-run price & run, temporary 1 period; , not all the output is wage adjustments phenomenon which purchased, stocks produced cause would be eliminated unemployment. begin to (∵ of the excess in due course by the supply), & this sends a signal to working of the market firms to cut back on production. mechanism. ShortThis causes unemployment to Economics I – Study Guide Page 65 run price & wage adjustments cause unemployment. . Inadequate AD causes unemployment. 1 Differentiate between the individual cost of unemployment and the cost to society as a whole (p. 401). (7) 2 Name and explain the different types of unemployment (pp. 401 – 402). (4 X 2 = 8) Note: The LFPR is the fraction or % of the working-age population who are members of the labour force or economically active population. This can be expressed as follows: Labour force (or economically active population) Working - age Population The unemployment rate is the percentage of the labour force that is unemployed. The unemployment rate is Number of people unemployed 100 Labour force Example: The population of NMMU Town is 100 people and the labour force is made up of 75 people. If 5 of these people are unemployed, the unemployment rate is a) 5/100 x 100. b) 5/80 x 100. c) 5/75 x 100. d) There is not enough information provided to calculate the unemployment rate. Answer: C Example: UPPIEland uses the same method to calculate the LFPR as we do in South Africa. Working-age people employed in the formal sector 9 449 Working-age people employed in the informal sector 4 187 Working-age people without jobs who want jobs 4 184 Working-age people without jobs who don’t want jobs 13 166 Total female population aged 15 – 64 years 16 210 Total male population aged 15 – 64 years 14 777 Total working-age population of UPPIEland 30 987 Total population of UPPIEland 42 367 Calculate the LFPR for UPPIEland. Labour force (or economical ly active population) Working - age Population 17820 100 9449 + 4187 + 4184 100 = = 57.5% * * 30987 1 16210 + 14777 1 Calculate the strict unemployment rate for UPPIEland. Number of people unemployed 100 Labour force 4184 100 4184 100 = = 23.5% * * 9449 + 4187 + 4184 1 17820 1 Economics I – Study Guide Page 66 4 Peruse the information in the table below: Working-age people employed in the formal sector Working-age people employed in the informal sector Working-age people without jobs who want jobs Working-age people without jobs who don’t want jobs Total female population aged 15 – 64 years Total male population aged 15 – 64 years Total population of UPPIEland a) Calculate the LFPR for TASSIEland. b) Calculate the strict unemployment rate 7 271 4 124 4 369 13 394 15 408 13 998 46 686 (3) for TASSIEland. (3) 5 Using the table below, calculate the strict unemployment rate. Structural unemployment Frictional unemployment Cyclical unemployment Employed Discouraged workers 6 (3) 400 200 100 8 000 500 The table below shows the employment and unemployment statistics for the country of Utopia. Utopia uses the strict definition of unemployment. Use the table to answer the questions that follow: Structural unemployment 2 000 Frictional unemployment 63 000 Cyclical unemployment 900 Employed 550 000 Discouraged workers 59 000 a) How many people are unemployed in Utopia? b) How many people in Utopia’s labour force? c) Calculate the unemployment rate in Utopia (show calculation). (1) (1) (2) 7 Name THREE reasons for the existence of structural unemployment (p. 402). (3) 8 Name THREE supply-side policies to reduce unemployment (pp. 402 – 403). (3) 9 Name THREE demand-side policies to reduce unemployment (p. 403). (3) Note: The mechanism underlying the Phillips curve can be summarised as follows: an increase in aggregate demand raises the price level and output. More output requires more employment, and hence leads to lower unemployment. 10 Illustrate (Fig. 21-2, pp. 405 – 406) and explain the trade-off principle embodied in the Phillips curve. (5) Note: A conventional Phillips curve be used to provide an illustration of stagflation. Stagflation means that stagnation (high unemployment) is associated with high inflation, or increased unemployment with increased inflation. A fixed conventional Phillips curve does not allow for such a phenomenon, but an outward shift of such a curve would allow for stagflation. In the diagram below PC is a conventional Phillips curve. If there are changes in the economy that give rise to a new conventional Phillips curve PC1, the combination of inflation and unemployment could change from A to B, that is, both inflation and unemployment could increase at the same time. 11 Explain an incomes policy as a policy measure that can be used to combat inflation and mention THREE reasons why an incomes policy is usually ineffective (pp. 406 – 407). (4) Economics I – Study Guide Page 67 12 What kinds of monetary and fiscal policies could be introduced to reduce unemployment? Why would we expect these policies to have inflationary consequences? Illustrate your answer diagrammatically. (6) The appropriate policies would be expansionary monetary and fiscal policies. Expansionary monetary policy involves reducing interest rates and making credit more easily available. Expansionary fiscal policies include increased government spending and tax reductions. Expansionary monetary and fiscal policy would increase aggregate demand in the economy and will therefore tend to raise prices as well. In terms of the AD-AS model such policy would give rise to a rightward shift of the AD curve (from AD to AD1) and this will tend to increase production, income and employment (and reduce unemployment) but at the same time will also tend to raise prices, as illustrated below. Production increases from Y0 to Y1 but the price level also increases from P0 to P1. Note: Factors which affect the LFPR include the following: • The age distribution of the population • Retirement rules & the availability of social security • Social, cultural, religious or other conventions about the role of women in society • The availability of household appliances, child care centres & other institutions which enable women to take up paid employment outside the home • The level of development & structure of the economy Revision: Indicate whether each of the following statements is True (T) or False (F). True (T) 1 2 3 The unemployed include those people who are not willing to work. A recent accounting graduate from a major university is searching for a place to begin his career as an accountant. This individual is best considered as being frictionally unemployed. Suppose that over a period of years the country of Quasiland switched from being an agriculturally-based economy to a technologically-based economy. As a result, many people lost jobs because they lacked the correct skills. These people would be considered part of the cyclically unemployed. Economics I – Study Guide Page 68 False (F) 4 5 6 7 8 9 10 11 12 Workers at a clothing factory in Newcastle lose their jobs when the firm relocates to Lesotho. These workers would be structurally unemployed as the firm no longer operates in South Africa and there is no prospect of it returning. If a worker is temporarily laid off because the economy is in a recession, frictional unemployment increases. Workers who are replaced by labour-saving machines become structurally (or technologically) unemployed. One example of a supply-side measure that can be taken to reduce unemployment is limiting population growth. The Phillips curve describes the relationship between real GDP and inflation. Moving along the (short-run) Phillips curve indicates that higher unemployment leads to a higher inflation rate. An incomes policy is usually associated with calls to firms to limit their profit margins. In South Africa, the strict rate of unemployment is different from the broad rate of unemployment because the strict rate of unemployment excludes discouraged work-seekers who are not actively looking for work. An increase in investment spending is appropriate policy measure to solve the problem of cyclical unemployment CHAPTER 22: ECONOMIC GROWTH AND BUSINESS CYCLES Learning Outcomes The purpose of this chapter is to examine the definition, measurement and causes of economic growth, the definition of the business cycle and the difference between economic growth and economic development. After mastering the prescribed sections, you should be able to: • Define economic growth and economic development; • Explain difficulties in measuring economic growth; • Explain what is meant by the business cycle; and • Identify the major sources of economic growth. Written assignment questions / Tutorial questions / Self-study questions: Note: The gross domestic product is the total value of all final goods and services produced within the boundaries of a country in a particular period (usually 1 year). Economics I – Study Guide Page 69 Figure 22A: South Africa’s nominal GDP in relation to that of other African countries, 2015 Source: http://www.imf.org/external/pubs/ft/weo/2016/01/weodata/index.aspx Figure 22B: An international comparison of nominal GDP, 2015 Source: http://www.imf.org/external/pubs/ft/weo/2016/01/weodata/index.aspx Economics I – Study Guide Page 70 National accounts 2015 R million 2015: Current Prices 2015: Constant Prices % of Real GDP Final consumption expenditure by households 2417768 1848021 60 Final consumption expenditure by general government 829112 626546 20 Gross fixed capital formation 826285 638394 10188 12011 Gross domestic expenditure 4083353 3124972 Exports of goods and services 1233094 911034 Less: Imports of goods and services 1273493 965555 Expenditure on gross domestic product 4042954 3070451 Change in inventories 21 Source: Stats SA. 2016. GDP 2010 to 2015 – Historical Series (in Excel) – Available: http://www.statssa.gov.za/publications/P0441/GDP_2010_to_2015_Historical_Series_.xlsx 1 Define the concept “economic growth” and explain how it is measured (p. 410). (4) Economic growth is the annual rate of increase in total real production and income in the economy. To measure economic growth we need a measure of total production and income and for this purpose gross domestic product (GDP) is usually used. It has to be emphasised, however, that nominal GDP cannot be used for this purpose. Nominal GDP first has to be adjusted to eliminate the impact of inflation. In other words, real GDP should be used. In principle, an adjustment should also be made for the size of the population, that is, per capita data ought to be used, but this is not always done. Generally, the economic growth rate is calculated as the annual rate of increase in real GDP. Note: It should be noted that even if per capita GDP in Country A is twice as high as per capita GDP in Country B this doesn’t necessarily imply that every resident in Country A is twice as well off as every resident in Country B because even per capita GDP is still an average figure for the economy as a whole. It is obtained by dividing GDP by the population size and contains no information about the distribution of income and wealth. In principle, it is possible that all the income in Country A accrues to one person, while the rest of the population earn nothing. Against this, GDP in Country B could be lower, but distributed more evenly among the population. 2 Why do national income accountants include only final goods in measuring GDP for a particular year? Why don't they include the value of stocks and bonds sold? Why don't they include the value of used furniture bought and sold? (3) <SEE CHAPTER 13’S WORKSHEET FOR THIS ANSWER> Note: The GDP deflator reveals the avg. change in prices of all the g & s that are included in GDP from year to year. We calculate the GDP deflator by using nominal GDP & real GDP in the formula: GDP deflator = 3 GDP at current prices *100 GDP at constant prices or Nominal GDP * 100 Real GDP You are given some statistical accounts for the country of Fruitopia which produces two goods, apples and oranges. The accounts contain information on the price of apples and the price of oranges for the years 2005 to 2008. Fruitopia is using 2005 as the base year. Year 2005 2006 2007 2008 Price (apples) R1.00 R1.10 R1.21 R1.33 Quantity (apples) 100 105 110 115 Price (oranges) R2.00 R2.40 R2.88 R3.46 a) Calculate the nominal GDP in each period. b) Calculate real GDP in each period. Economics I – Study Guide Page 71 Quantity (oranges) 100 105 100 100 c) Calculate the GDP deflator in each year. d) Calculate the inflation rate between 2005 and 2006 (and between 2006 and 2007). 4 GDP has been labelled the “grossly deceptive product” and the “grossly distorted product”. Discuss, by referring to some of the problems associated with GDP (p. 410). (3 X 2 = 6) The problems associated with measuring economic growth include the following: • Non-market production. It is difficult to measure or estimate the value of activities that are not sold in a market. E.g. certain services, like those provided by housewives 7 or the gardening done by members of the family, are not taken into account. • Unrecorded activity. Many transactions or activities in the economy are never recorded. These unrecorded activities range from illegal activities such as smuggling to legal activities such as hawking. • Data revisions. The original estimates of GDP & other national accounting aggregates are frequently adjusted as new & better data become available. • Economic welfare. • The 1st problem is that unwanted by-products (or externalities) such as environmental pollution are not measured. • The 2nd problem is that no allowance is made for the depletion of natural resources. • A 3rd problem is that the data say nothing about the purpose of production or expenditure. • A 4th problem is that it is difficult to account for changes in the quality of g & s. • A 5th problem is that GDP doesn’t take account of the distribution of production & income. 5 Discuss THREE of the problems associated with GDP as a measure of economic welfare (p. 410). (3) 6 Explain how unrecorded activities affect the measurement of GDP. 7 Illustrate (Fig. 22-1, pp. 411 – 412) and explain the business cycle, clearly differentiating between the exogenous and endogenous factors which cause fluctuations in the level of economic activity. (5) <INSERT FIGURE 22-1> The figure shows a complete business cycle from 1 trough (pt A) (½ mark is awarded to students who have identified 1 of the troughs on their diagram) to the next trough (pt C). The cycle describes a pattern of fluctuation around the long-term trend (alternative 1 mark). After the trough, there is an upswing (often called a boom / expansion), indicated by A to B (½ mark) in the figure. The peak is reached at point B (½ mark), followed by a downswing (often called a recession / contraction) from B to C (½ mark). • • 8 (2) Classical economists (½ mark – correct school of thought) regarded fluctuations in the growth of economic activity as temporary phenomena that could be ascribed to exogenous factors (i.e. factors which originate outside the market system cause business cycles [½ mark – correct explanation]). 1 e.g. of an exogenous factor that may affect the business cycle is changes in weather conditions (e.g. droughts caused by the El Niño phenomenon). According to the Keynesian view (½ mark – correct school of thought), business cycles are endogenous (i.e. factors which originate from within the market system cause business cycles [½ mark – correct explanation]) to private market economies. What is the essential difference between the classical and Keynesian views on the causes of business cycles? (4) Classical view Keynesian view 7 Nel, J. 19 April 2015. Housewife worth more than R50 000 per month, News24.com. [Online]. Available: http://www.fin24.com/Economy/Housewife-worth-more-than-R50-000-per-month-20150419 [Accessed 14 July 2015]. Economics I – Study Guide Page 72 The economy is inherently stable Business cycles are caused by external (exogenous) factors (i.e., economic change in the result of factors that originate outside the economy) Government intervention and the incorrect use of policies can cause disequilibrium Weather conditions, technological change and market shocks cause upswings and downswings The economy is inherently unstable Business cycles are part and parcel of the way in which a modern economy functions. Keynesians believe that economic change is the result of endogenous factors Government intervention may be required for stability Changes in consumer spending patterns, the level of investment spending and production decisions give rise to upswings and downswings Note: Leading indicators change before the economy changes and give a glimpse of where the economy is heading. Lagging economic indicators (e.g., the unemployment rate) do not change directions until after the cycle has changed. 8 Name the THREE most important leading indicators used in South Africa which tend to signal what to expect as far as economic activity is concerned (p. 412). (3) 9 Name and explain THREE major supply-side sources of economic growth (pp. 414 – 415).(3 X 2 = 6) Note: The supply-side sources of economic growth all contribute to the country’s production capacity, or the potential output of the economy.] 10 South Africa is extremely well endowed with minerals and other natural resources. Are natural resources a necessary or sufficient condition for economic growth? Discuss. (8) Natural resources are a mixed blessing. They are an important factor of production and as such can play an important role in economic growth and development. South Africa is well endowed with a number of natural resources, particularly minerals, and the development of the South African economy was to a large extent based on South Africa’s mineral riches. Natural resources provide a basis for wealth and employment creation and their impact are felt throughout the economy. Mineral exports are also a major source of foreign exchange, which can be used to pay for the imported goods (particularly capital and intermediate goods) that are so essential for sustained economic growth. However, the mere possession of natural resources is no guarantee that a country will experience economic growth. There are many examples of resource rich developing countries which did not record rapid or sustained economic growth. The extraction of minerals has to be managed sensibly (e.g., to avoid polluting the environment and over-exploiting the resources). The income earned from selling such non-renewable or exhaustible assets also has to be managed sensibly. There have been many instances (also in South Africa) where an economic boom based on natural resources (e.g., as a result of a sharp increase in the gold price) has been mismanaged, for example, by granting large wage increases or reducing taxes. Because the prices of most minerals are determined in foreign currency (e.g., US dollars) or international commodity markets, the prices of such minerals can vary sharply, particularly in local currency (e.g., rand). Changes in mineral prices and/or exchange rates can thus cause great instability in the domestic economy. As a result, economists often refer to the natural resource as a curse, rather than a blessing. 11 Name the THREE demand factors that play an important role in contributing to economic growth (pp. 415 – 416). (3) 12 Name and explain THREE possible causes of low economic growth (p. 416). Revision: Indicate whether each of the following statements is True (T) or False (F). Economics I – Study Guide Page 73 (3 X 2 = 6) True (T) 1 2 3 4 5 6 7 8 GDP, as a measure of economic growth in a country, takes the impact of unrecorded activity and environmental destruction into account. Phases and turning points of the business cycle are: expansion, peak, recession and trough. An expansion ends when the economy hits a trough and then enters a recession. Classical economists believe that the causes of the business cycle are sought outside the market system, that is, in exogenous factors. Economic growth can be stimulated from the supply-side by a rise in domestic demand. Capital widening occurs when the capital stock is increased to accommodate the increasing labour force. The number of newly registered unemployed is considered a leading indicator. A recession occurs when real GDP decreases for at least 6 months. Economics I – Study Guide Page 74 False (F) SOME IMPORTANT REMINDERS Change in own price of a good causes a movement along the demand curve or supply curve, not a shift in these curves; other factors cause demand and supply curves to shift (see Table 4-3 and Table 4-5). In market equilibrium, QD = QS. Labour force participation rate = LFPR = The unemployment rate is Labour force (or economical ly active population ) Working - age Population Number of people unemployed 100 Labour force Marginal revenue product = MRP = MPP * P How much is a Billion? Be careful when working with large figures: In Britain: A thousand million = 1 000 000 000 000 A British billion = 1 000 000 000 000 (million million) The American billion = 1 000 000 000 (thousand million) Although it is best to write Oxford English in scientific work, like Economics In South Africa a billion is most often used today meaning a thousand million (1 000 000 000) but not always, In Afrikaans a thousand million (1 000 000 000) is called a “miljard”. Recent government publications sometimes also use the term “billion” meaning a thousand million (1000 000 000) (although not correct, one should take note thereof). Denoting GDP as Y, we can say that Y = C + I + G + NX National income accounting: Summary • • GDE mp GDP mp • • • • • GNP GNP Net GDP fc NI =C+I+G … (one spends at the market) = GDE + NX =C+I+G+X-Z = GNI = GDP + Net Payments rest of the world = Gross – Depreciation = GDP mp – Indirect Tax + Subsidies NNP fc … (earn income from Production) Economics I – Study Guide Page 75 Measures & Differences GDP at current prices Nominal GDP * 100 or *100 GDP at constant prices Real GDP GDP deflator = Money multiplier = 1 b Change in demand deposits = D = Change in cash reserves = 1 * R where R is the change in cash reserves b R = b( D) Opportunity cost of an increase in X in terms of Y = terms of trade = Y (−1) X export price index 100 import price index Change in the price level causes a movement along the aggregate demand or aggregate supply curve, not a shift of these curves; other factors cause demand and supply curves to shift (see Table 20-1 and Table 20-2). Inflation rate = (CPI of this year - CPI of the previous year) * 100 CPI of the previous year Economics I – Study Guide Page 76