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ECO 1002 Study Guide (1)

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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
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