24mm
This textbook contains:
• Accessible analysis, theory and diagrams, combining intuitive understanding and sophisticated analysis
• A choice of learning routes with different levels of difficulty and mathematics
• Real-world economic reasoning, not dry theory
• Online animations that illustrate macroeconomic fluctuations and shocks
• Continuous focus on South Africa as an open economy in an African and global context shaped by China, Trump’s trade
wars and Brexit
• Theoretical and policy analysis of unemployment, inflation, low growth and inclusive growth, and the NDP
• Analytical case studies of the global financial crisis, quantitative easing, the Euro crisis and the Eskom crisis
• First-hand, updated insights into how South African policy institutions, processes and instruments work
• Relevant South African data sources, with useful data tips
• An integration of the structural social and economic realities (notably inequality and poverty) of South Africa
• Incorporation of broader considerations, such as sustainable development.
Macroeconomics
The answers are given in How to think and reason in Macroeconomics – A South African text, a university textbook
with excellent feedback from students, lecturers and practitioners. This fifth edition with updated context and case studies
combines practical information with solid economic theory plus a discussion of South African economic issues, processes,
institutions and data. It enables the reader to analyse macroeconomic events and policies in a globalised and development
context, and understand the different perspectives in policy and political-economic debates.
How to think
and reason in
How does the South African economy work? Why do macroeconomic variables change? So what
if they do? What happens next? How do economic processes and policy institutions really work?
How can we reduce unemployment and maintain low inflation? What about poverty and inequality?
The book covers the main topics for a second-year or MBA course in Macroeconomics or a third-year course on
Macroeconomic Policy. Any manager or practising economist will also find this a lifelong handy reference source on how
the economy works.
FIFTH
EDITION
Philippe Burger is Professor of Economics, Vice Dean of the Faculty of Economics and Management Sciences and Pro
Vice-Chancellor: Poverty, Inequality and Economic Development at the University of the Free State. He is a past President
of the Economic Society of South Africa (ESSA) and was a member of the South African Statistics Council. He is a National
Research Foundation rated researcher and has been a research consultant to the OECD and visiting scholar at the IMF. He
is the 2002 recipient of the Founder’s Medal of ESSA for the best PhD thesis at a SA university and was associate editor of
the South African Journal of Economics. He is the author of Getting it right: A new economy for South Africa (2018).
www.juta.co.za
Macroeconomics
A SOUTH AFRICAN TEXT
Frederick C v N Fourie
Frederick C v N Fourie
Philippe Burger
ABOUT THE AUTHORS
Frederick Fourie has a PhD in Economics from Harvard University, has been Professor of Economics at the University
of the Free State since 1982, was appointed Distinguished Professor in 1996, and served as Vice-Chancellor there from
2003–2008. In the 1990s he was founding head of the Unit for Fiscal Analysis at the National Treasury and a member of
the first Competition Tribunal. From 2012-2018 he was Research Co-ordinator of the Research Project on Employment,
Income Distribution and Inclusive Growth (REDI3x3), based at the University of Cape Town. He is founding editor of the
online policy forum Econ3x3 and editor and co-author of The South African informal sector: Creating jobs, reducing poverty
(2018).
How to think and reason in
Philippe Burger
FIFTH EDITION
How to think and reason in
Macroeconomics
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How_to_think_BOOK_2019.indb 2
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How to think and reason in
Macroeconomics
Frederick C v N Fourie
Philippe Burger
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How to think and reason in Macroeconomics
First published 1997
Second edition 2001
Third edition 2009
Fourth edition 2015
Fifth edition 2019
Juta and Company (Pty) Ltd
First floor, Sunclare Building, 21 Dreyer Street, Claremont 7708
PO Box 14373, Lansdowne 7779, Cape Town, South Africa
www.juta.co.za
© 2019 Frederick C v N Fourie, Phillippe Burger and Juta and Company (Pty) Ltd
ISBN 978 1 48513 047 5 (Print)
ISBN 978 1 48513 048 2 (WebPDF)
All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means,
electronic or mechanical, including photocopying, recording, or any information storage or retrieval system, without
prior permission in writing from the publisher. Subject to any applicable licensing terms and conditions in the case of
electronically supplied publications, a person may engage in fair dealing with a copy of this publication for his or her
personal or private use, or his or her research or private study. See section 12(1)(a) of the Copyright Act 98 of 1978.
Project manager: Seshni Kazadi
Editor: Lilané Putter Joubert
Proofreader: Lilané Putter Joubert
Cover designer: Drag and Drop
Typesetter: Wouter Reinders
Indexer: Frederick Fourie
Typeset in 11 on 13 pt Photina MT Std
The author and the publisher believe on the strength of due diligence exercised that this work does not contain any
material that is the subject of copyright held by another person. In the alternative, they believe that any protected preexisting material that may be comprised in it has been used with appropriate authority or has been used in circumstances
that make such use permissible under the law.
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Table of contents
Preface��������������������������������������������������������������������������������������������������������������������������������������� ix
0.
Introduction and orientation: macroeconomics in the South African
context�������������������������������������������������������������������������������������������������������������������������� 1
Part I How does the economy work?
1.
Why macroeconomics? An introduction to the issues
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
2.
The basic model I: consumers, producers and government
2.1
2.2
2.3
3.
What is macroeconomics?������������������������������������������������������������������������������������������9
How can learning to think and reason in macroeconomics help me?����������������������10
Main macroeconomic problems and policy objectives��������������������������������������������11
The development objective���������������������������������������������������������������������������������������25
Intermediate objectives���������������������������������������������������������������������������������������������30
Conflict between the standard objectives – priorities and trade-offs�����������������������30
Priority choices of the South African government����������������������������������������������������������31
Main perspectives in the economic debate in South Africa�������������������������������������33
Analytical questions and exercises���������������������������������������������������������������������������41
The basic framework�������������������������������������������������������������������������������������������������46
The real (or goods) sector ����������������������������������������������������������������������������������������50
Analytical questions and exercises���������������������������������������������������������������������������74
The basic model II: financial institutions, money and interest rates
3.1 The monetary sector and interest rates��������������������������������������������������������������������76
3.2 Linkages between the monetary and the real sectors����������������������������������������������98
3.3 The IS-LM model as a powerful diagrammatical aid���������������������������������������������� 109
3.4Real-world application: The 2007–08 financial crisis – varying investor
behaviour and impotent monetary policy�������������������������������������������������������������� 134
3.5 Analytical questions and exercises������������������������������������������������������������������������ 138
4.
The basic model III: the foreign sector
4.1
4.2
4.3
4.4
4.5
Background – why trade internationally?��������������������������������������������������������������� 141
Imports, exports and capital flows������������������������������������������������������������������������� 142
The balance of payments and exchange rates������������������������������������������������������ 156
The BoP adjustment process��������������������������������������������������������������������������������� 171
The complete model – the BoP, the exchange rate and the domestic economy��� 172
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4.6
4.7
4.8
4.9
5.
Conflict between internal and external considerations������������������������������������������ 186
The IS-LM-BP model for an open economy����������������������������������������������������������� 188
Real-world application – the Euro crisis and the impact of confidence
on international capital flows��������������������������������������������������������������������������������� 204
Analytical questions and exercises������������������������������������������������������������������������ 210
Understanding sectoral coherence and constraints: how to use
macroeconomic identities
5.1 From equilibrium conditions to identities��������������������������������������������������������������� 214
5.2 The interpretation of identities – uses and abuses������������������������������������������������ 216
5.3 Expenditure, production and current account deficits������������������������������������������ 219
5.4 The sectoral balance identities������������������������������������������������������������������������������ 219
5.5 The financing of gross capital formation���������������������������������������������������������������� 225
5.6 The SNA at a glance – relationships between subaccounts���������������������������������� 228
5.7 Using the sectoral balance identities for decision making������������������������������������ 232
5.8 Analytical questions and exercises������������������������������������������������������������������������ 234
Addendum 5.1: National accounting definitions and conventions –
a student’s guide�������������������������������������������������������������������������������������������������������������� 235
6.
A model for an inflationary economy: aggregate demand
and supply
6.1 Essentials of the AD-AS model������������������������������������������������������������������������������ 241
6.2 Aggregate demand (AD)����������������������������������������������������������������������������������������� 243
6.3 Aggregate supply (AS)�������������������������������������������������������������������������������������������� 249
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together������������������� 272
6.5 Real-world application – the Eskom crisis, GDP and prices���������������������������������� 294
6.6 Analytical questions and exercises������������������������������������������������������������������������ 299
Addendum 6.1: Labour market changes following demand stimulation������������������������� 300
Addendum 6.2: Labour market details following a domestic supply shock�������������������� 301
Addendum 6.3: A complete example of IS-LM-BP and AD-AS for an increase
in the repo rate������������������������������������������������������������������������������������������������������� 302
Addendum 6.4: A complete example of IS-LM-BP and AD-AS for an increase
in the price of imported inputs (e.g. oil)����������������������������������������������������������������� 303
7.
Extending the model: inflation and policy reactions
7.1
7.2
7.3
8.
vi
Adjusting the model – inflation-augmented AD and AS curves����������������������������� 306
Managing inflation – policy options and the monetary reaction (MR) function����� 320
Analytical questions and exercises������������������������������������������������������������������������ 327
Macroeconomics in the very long run: growth theory
8.1
8.2
8.3
8.4
The importance of growth�������������������������������������������������������������������������������������� 329
Why growth theory?����������������������������������������������������������������������������������������������� 330
From intuition to formal analysis – from AD-AS to the Solow growth model��������� 332
Rearranging the model – towards income per capita�������������������������������������������� 336
8.5
Sources of sustained growth in ​ ​​– first conclusions�������������������������������������������� 338
8.6
8.7
Is any capital–labour ratio possible? The idea of balanced growth����������������������� 340
Expanding the model – the expanded balanced growth condition����������������������� 344
Y
N
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8.8
Using the model – changes in the balanced growth path due to
changing parameters��������������������������������������������������������������������������������������������� 348
8.9 Convergence between low-and-middle-income and high-income countries?������ 354
8.10 Human capital – the previously missing element��������������������������������������������������� 355
8.11 Summary and conclusions������������������������������������������������������������������������������������� 358
8.12 A last word on growth (for now …) ������������������������������������������������������������������������ 361
8.13 Analytical questions and exercises������������������������������������������������������������������������ 362
Addendum 8.1: The Cobb-Douglas production function������������������������������������������������� 363
Addendum 8.2: An illustration of balanced growth – the course of ratios between
key variables����������������������������������������������������������������������������������������������������������� 365
Part II Macroeconomic policy, unemployment, inflation and growth
in an open economy
9.
Monetary policy: the role of the Reserve Bank
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
9.9
10.
Definition and main instruments���������������������������������������������������������������������������� 371
Monetary policy design – four important choices�������������������������������������������������� 376
Inflation targeting in South Africa��������������������������������������������������������������������������� 380
The practice of monetary policy����������������������������������������������������������������������������� 383
Public debt management – the interface between financial markets and
fiscal and monetary policy������������������������������������������������������������������������������������� 386
Exchange rate policy and the problems of monetary policy in an
open economy�������������������������������������������������������������������������������������������������������� 389
Real-world application – quantitative easing and ‘creative monetary policy’
in the USA��������������������������������������������������������������������������������������������������������������� 392
Monetary policy and the ownership of the Reserve Bank������������������������������������� 394
Analytical questions and exercises������������������������������������������������������������������������ 394
Fiscal policy: the role of government
10.1 State, government and public sector��������������������������������������������������������������������� 397
10.2 Definition and instruments of fiscal policy������������������������������������������������������������� 397
10.3 The choice of overarching policy objectives���������������������������������������������������������� 402
10.4 Constraints on fiscal policy choices���������������������������������������������������������������������� 405
10.5 The decision on the main fiscal aggregates����������������������������������������������������������� 411
10.6 Public debt and public debt management������������������������������������������������������������� 431
10.7 Fiscal discipline and fiscal norms�������������������������������������������������������������������������� 436
10.8 Fiscal policy and development – broader criteria�������������������������������������������������� 451
10.9 Analytical questions and exercises������������������������������������������������������������������������ 452
Addendum 10.1: Measuring aggregate government expenditure����������������������������������� 454
Addendum 10.2: Measuring government revenue and the deficit����������������������������������� 459
11.
Policy problems: coordination, lags and schools of thought
11.1 Monetary vs. fiscal policy?������������������������������������������������������������������������������������� 461
11.2 Policy problems������������������������������������������������������������������������������������������������������ 464
11.3 The larger problem – different schools of thought������������������������������������������������� 467
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12.
Inflation, unemployment and low growth: causes and remedies
12.1
12.2
12.3
12.4
12.5
12.6
12.7
Inflation������������������������������������������������������������������������������������������������������������������� 481
Unemployment������������������������������������������������������������������������������������������������������� 501
Low economic growth�������������������������������������������������������������������������������������������� 528
Inclusive growth and development������������������������������������������������������������������������ 553
Policy design in practice – the National Development Plan����������������������������������� 558
A final thought – the structural dimension of macroeconomic problems�������������� 564
Analytical questions and exercises������������������������������������������������������������������������ 565
Index��������������������������������������������������������������������������������������������������������������������������������������������� 568
viii
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Preface
How to think and reason in macroeconomics – a South African text. Why the
complicated title?
First, this textbook purposefully and methodically teaches the reader how to think and
reason about economic behaviour, real-life processes and change in macroeconomics –
not merely how to manipulate a set of theoretical equations or shift a few curves around.
(After all, the economy does not have curves.)
Secondly, the text continually situates the analysis and comprehension of economic
processes in the South African context. Thus the reader will learn extensively about:
❐ relevant data and data sources to underpin understanding;
❐ economic institutions that shape economic processes, including policy institutions and
the political-economic landscape;
❐ policies that could be used (but also misused) in the pursuit of macroeconomic objectives
such as high employment, low inflation and steady growth; as well as
❐ broader considerations such as human development and inclusive growth – with South
Africa being an (upper-) middle-income country relative to peer countries in Africa and
elsewhere, as well as high-income countries.
But what does this really entail?
Combining intuitive understanding and sophisticated analysis
Modern macroeconomics, especially in advanced and postgraduate courses, typically
aims to equip students with the ability to manipulate complex mathematical models of the
economy. Yet one finds graduates with a first or advanced degree in economics who still do
not have the ability to analyse and converse about the basic operation and dynamics of the
economy, for example in response to cyclical or policy effects, or international economic
shocks. Economics graduates often have very limited knowledge of the institutions,
processes and data – and often feel they have to ‘unlearn’ or disregard prior ‘academic’
studies when they start work as practising economists in the private or public sectors.
Our point of departure is that theoretical insights and refinements should always be
rooted in a thorough intuitive understanding of economic behaviour, processes, data and
institutions. Without a solid intuitive understanding, technical wizardry and theoretical
sophistication have limited value in practice.
❐ Therefore, in this text, topics typically evolve from a thorough intuitive understanding
through increasing levels of theoretical sophistication up to the theoretical rigour
found in standard intermediate macroeconomics texts.
Preface
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In addition, without the ability to situate theoretical insights in the real-life institutional
context, theory becomes almost sterile. The practices of institutions such as the central
bank or national treasury, or ratings agencies and labour unions, often have as large a
bearing on economic processes and outcomes as the behaviour of individuals or businesses.
Also, it is important to have a sense of economic magnitudes: to know when a statistic or
number, mentioned by some commentator or churned out by an analyst, sounds plausible
… or just could not be right.
❐ In this book, pertinent institutional and historical information as well as data tables,
graphs and tips continually reinforce the link between theory (abstraction) and reality.
This also provides a confidence-building experience to students who could easily have a
sense of alienation if confronted with economic theory only.
So what? Let’s reason
To contribute to active learning and a higher knowledge retention rate, the text has been
written in an interactive style. Expositions are interspersed with questions and stimulating
data, or a fascinating institutional backdrop. Students are encouraged to ask questions
about the operation of the economy: Why do things happen? How does the process actually
occur? How do the institutions operate? So what? What happens next? Why does it matter?
Such a habit of thinking and asking questions makes the acquired insights ‘active’ and
ready for application.
In the same way, the policy chapters do not provide recipes to ‘solve’ macroeconomics.
They demonstrate how intelligent economic analysis can help one to think more effectively
and make fewer policy mistakes.
All of this will help to impart to users of the book (both students and practitioners) an
enduring and satisfying understanding of – and the ability to think and reason about –
macroeconomics in South Africa. Exhaustive experience with this approach to lecturing
macroeconomics has shown that students retain significantly more knowledge and
insights, even years afterwards, than with conventional mostly theoretical analysis. They
also feel confident in discussing both theory and its practical aspects – and to think on
their feet.
Learning routes – a choice of difficulty level
A distinguishing characteristic of the book is that the reader can choose to read and engage
with the subject matter, and especially the theory, at different levels of difficulty. Thus it
affords access at different levels of complexity, progressively providing deeper insights and
higher analytical capabilities.
These levels are:
❐ a mainly intuitive route, or level, using chain-reaction arguments in which a sequence of
changes in variables unfold, accompanied by relatively simple theory, basic equations
and basic diagrams; then moving on to
❐ a more theoretical level, where the sequence of changes is depicted and analysed with
more complex equations and diagrammatical aids such as the IS-LM-BP model and the
AD-AS or AD'-PC curves (see below); then, if desired,
❐ a more advanced level, using mathematical derivations and analysis presented in a
parallel series of ‘maths boxes’; these show the relevant mathematical derivations and
manipulations alongside the intuitive, chain-reaction and diagrammatical analyses –
to fully deepen understanding.
x
Preface
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Learning how macroeconomic changes unfold: from chain reactions to time-paths
and animations
A key objective is for the reader or student to develop a ‘feel’ for the economy: how
macroeconomic changes in fact are dynamic processes that unfold and evolve, rather than
being jumps from one static equilibrium to the next – which is not how people experience
the economy.
The first tool is the extensive use of chain reactions in analysing economic behaviour. Based
on the basic theories of consumption, investment, etc., the reader learns to construct
sequences of likely effects as disturbances spread from one variable to another and one
sector to another. This creates a real sense of how things unfold over the business cycle or
in response to an external shock or a policy intervention.
Building on this, novel time-path diagrams demonstrate the possible course of several
variables unfolding over time, affording a strong real-world feel to examples of the
consequences of macroeconomic disturbances or policy steps. A related feature is
the explicit clarification of the short, medium and long run. This develops the reader’s
understanding of the time dimension of disturbances and various adjustment processes
in the money market, balance of payments and aggregate supply.
The culmination of this is a new online learning aid, animations of key diagrams, ideal for
the video generation. These are vastly effective in giving readers a sense of dynamics and
changes in the economy. The analysis is not limited to comparing equilibrium points, but
can be seen as ‘live’ dynamic shifts of curves that move a point of intersection on the way
to a new equilibrium. These analytical visuals are paired with the time-path diagrams,
showing the corresponding course of the variables over time live – movies of the economy
changing and adapting to cycles, shocks and policies.
Enthusiastic feedback from lecturers and students indicates that the animations add
significantly to one’s understanding of macroeconomic forces and dynamics. These
animations are available online free of charge to students for use on laptops, tablets and
cell phones and can be accessed on the following websites:
❐ www.ufs.ac.za/macroecon
❐ https://jutapassmasters.co.za/learning/search.php?search=how+to+think
PowerPoint slides of all the diagrams in the book, with hyperlinks to the animations,
are available to lecturers. The slides provide a seamless transition from static diagrams
to animations in the lecture room (providing wi-fi is available). These slides can be
downloaded at:
❐ https://jutapassmasters.co.za/learning/search.php?search=how+to+think
Major features in terms of content
As an integral part of a distinctive approach to teaching macroeconomics and situating
it in the South African context, the book differentiates itself also with regard to content.
Chapter 0 contains some detail on this. Here we only note a few.
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An open-economy approach throughout
An important characteristic of this book is the explicit incorporation of the fact that
South Africa has a very open economy, strongly subject to international economic forces.
Whereas many textbooks consider the macroeconomic implications of international trade
and capital flows only in the final chapters, if at all, here they are incorporated throughout
the text, starting in the first chapters. Chapter 4 sets out these intricacies in depth and
provides a level of analysis not often accessible to readers of macroeconomics textbooks.
This should make the reader very comfortable with discussions of, for example, the balance
of payments, exchange rates, the gold price and the impact of events in South Africa’s
main trade partners on the local economy.
The emerging-market, middle-income and African context
The book illuminates the development context of the South Africa economy. From the
first chapter it situates the standard macroeconomic issues and policy objectives in
the circumstance of South Africa as a middle-income country and emerging-market
economy in Africa. A brief overview of the definition, measurement and analysis of
human development is presented, also with reference to the Sustainable Development
Goals (SDGs). Attention is given to development aspects by means of informative boxes
and explicit discussions of, for instance, the link between economic growth and human
and institutional development, as well as HIV and Aids (see chapters 8 and 12). The
first chapter also includes perspectives on the political-economic elements of race, class,
capitalism and apartheid that continue to shape the economic policy and development
debate in South Africa.
Unemployment – and structural unemployment
There is thorough coverage of the labour market and unemployment, particularly
recognising the role of labour-market features such as segmentation and entry barriers,
as well as the informal sector. This neatly complements a key feature of the book, i.e. the
analysis of structural unemployment – something economists and policymakers need to
engage with seriously. Structural unemployment is included in the theory, data and policy
discussion in several chapters. In the theoretical model the treatment of unemployment
and a long-run equilibrium output level is couched in a way that explicitly accommodates
the existence of structural unemployment and a structural rate of unemployment (SRU)
– while retaining easy comparability with texts and theory from abroad. (Such texts
usually have very little to say about structural unemployment in low- and middle-income
countries.)
The final chapter provides a thorough analysis of the causes of voluntary and involuntary
unemployment – and structural unemployment in particular. This includes possible links
to the development trajectory, demography, health and education status, technology
and capital intensity, sectoral factors, labour unions and labour mobility, social welfare,
migrant labour, etc. This informs a critical discussion of possible policy interventions,
including the limitations of conventional macroeconomic policy instruments to address
this problem.
Supply-side analysis quite exhaustive
In standard textbook presentations of the AD-AS model, the aggregate supply side often
gets only cursory treatment. This book presents a more exhaustive treatment of the
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aggregate supply side (in chapter 6) to match the depth of the derivation of the aggregate
demand side. The short- and long-run aggregate supply (AS) curves are derived from
behaviour in the labour market, using price-setting and wage-setting relationships in a
context that recognises imperfect competition and institutional rigidities in product and
labour markets. Differences between expected and actual prices explain the difference
between the short-run and long-run AS curves as well as related supply adjustment
processes towards a long-run, or structural, equilibrium. This well-grounded derivation
of the AS curve enables a much better analysis of supply shocks, revealing new nuances
and complexities, also in the policy context.
Inflation integrated from the start
Another distinctive feature is having an intensive and integrated treatment of inflation
and the inflationary context. While a variable price level is only formally introduced in the
AD-AS model in chapter 6 and inflation in chapter 7, the distinction between nominal and
real variables is present in the first theory chapters. This enables the investment function
to be stated as a function of the real rate of interest, and the money demand function as
a function of the nominal interest rate. Secondly, in chapter 7, a theoretical framework
is provided that prepares the reader to analyse macroeconomic shocks and adjustments
in a setting where inflation is a permanent phenomenon. It combines an inflationaugmented AD curve with inflation-augmented AS curves – the short- and long-run
Phillips (or PC) curves. Also included is a discussion of monetary reaction (MR) functions,
typically associated with inflation-targeting policy regimes. The final chapter then deals
exhaustively with the measurement, causes and remedies of inflation in South Africa.
Economic growth theory – in a way everyone can understand
In many macroeconomics courses, growth theory is often disregarded, or otherwise
experienced by students as murky and somewhat disconnected from macroeconomic
models that focus on the business cycle, unemployment and inflation. The treatment
in this book is a natural extension of the theory of aggregate supply in a time frame
stretching from the short and medium run to the long run and very long run. This
presentation of growth theory (chapter 8) provides a novel, intuitive and insightful grasp
of the idea of balanced growth paths. The exposition starts from a simple Solow model,
but soon broadens to include aspects such as social and economic institutions, thus also
linking growth theory to human capital and human development. Here the animations
are particularly useful in grasping the technicalities of one of the more challenging topics
in macroeconomics.
The section in the final chapter on the measurement, causes and remedies of low growth
in South Africa also considers aspects particularly relevant to many African countries,
e.g. human capital, income inequality, institutions, political barriers, culture, trust,
ethnicity, social division and geography. The relationship between economic growth and
the environment is also discussed.
A window on the real worlds of monetary and fiscal policy making
The text conveys a solid feel for the real world of policy making: the difficult choices
policymakers face and the constraints they have to deal with. In addition, the institutional
dimension is incorporated throughout, revealing the actual policy-making processes in
the National Treasury and the Reserve Bank. For example, in addition to analyses of the
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role and impact of monetary policy steps, chapter 9 explains the key choices in the design
of monetary policy (objectives, instruments, targets, including inflation targeting), as
well as the practice of monetary policy, i.e. monetary monitoring combined with basic
monetary policy making such as the determination of the repo rate by the Monetary
Policy Committee (MPC).
The chapter on fiscal policy is especially rich in this regard, distinguishing this book from
most others. The role and financing of government are central to the intense debates
on service delivery, public sector wages, government expenditure on health or higher
education (or Eskom bail-outs), VAT and income tax, the budget deficit and growing public
debt (and the hazard of ratings downgrades). Chapter 10 provides essential insights and
methods of analysis. It draws extensively on the practical experience of the authors in
either working in or advising the National Treasury, putting across an authentic sense of
how decisions are made in the budget process amidst complex constraints. Also shown is
how to make sense of public finance numbers and use fiscal yardsticks.
Using the national accounting identities as a tool to understand sectoral coherence and
constraints
The national accounts can be a dry subject area, dominated by definitions and accounting
conventions. But one can engage with the topic without doing accounting. Indeed, chapter
5 provides a unique treatment of the national accounting identities: as powerful tools to
bolster logical-intuitive reasoning and analyses of macroeconomic change. It becomes a
tool to understand the accounting-type coherence between sectors of the economy – the
numbers must add up, must balance – as well as underlying constraints on macroeconomic
change and adjustments. Along the way the reader will acquire a working understanding
of the System of National Accounts and important South African data sources.
Extensive case studies and real-world applications
In addition to real-world examples throughout the book, there are several major case
studies with full diagrammatical analysis and animations. These include the 2007–08
international financial crisis, quantitative easing and ‘creative monetary policy’ in the
USA, the Euro-zone public-debt crisis, as well as the ongoing Eskom crisis in South Africa
and its impact on gross domestic product (GDP) growth and inflation.
Changes in the fifth edition
The focus on the South African context, including its status as an upper-middle-income
country in the Southern Africa Development Community (SADC) and Africa, already
was present in the earlier editions. In this edition the quest to integrate the appropriate
context into the analysis has been sharpened and made more explicit, also in data boxes,
applications, examples and exercises.
All policy sections have been freshly updated to incorporate the newest policy approaches
as well as institutional changes in South Africa. Major policy initiatives, such as the
National Development Plan (which appears to be back on the table under president
Ramaphosa), are thoroughly discussed. Also noted are controversies relating to the
mandate and ownership of the Reserve Bank, frequent changes in Ministers of Finance,
the public debt issue, as well as the impact of recent political dynamics. The book retains its
unique, institution-rich treatment of the complex role of government in macroeconomic
relationships, events, policies and official South African data.
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Other updates include the implications of major changes in South Africa’s international
trade patterns, as well as recent international shocks such as Brexit and US president
Donald Trump’s trade war with China. On the development front it includes sections on
the SDGs and the Inclusive Development Index, developed by the World Economic Forum,
to complement the section on the United Nations Development Programme’s (UNDP)
Inclusiveness Index, which measures inclusive growth.
All data tables and graphs have been updated and new internet sources provided.
Numerous new analytical exercises and questions at the end of chapters engage with
recent developments in South Africa and internationally. These include Brexit, China’s
prominence and the possibility of South Africa having to request assistance – a bail-out –
from the International Monetary Fund (IMF).
August 2019
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Introduction and orientation: macroeconomics in the South African context
0
The objective of this book is to teach you to think and reason about macroeconomic events
as well as policy issues such as the balance of payments, inflation, unemployment and
economic growth in the South African context.
The book strives to teach an active way of thinking in the particular setting of South Africa
as an upper-middle-income (or ‘developing’1) country and emerging-market economy –
not dry, static theory with no real-world, historical or institutional context, or situated in
a European, British or American context.
Consequently, the subject matter is presented in a particular style that makes it something
between a textbook and a workbook, encouraging you to participate actively in developing
macroeconomic thinking skills – it is a think-and-work textbook. ‘Activity boxes’ challenge
the reader to find information or formulate a viewpoint on an issue, while other boxes
highlight interesting facts and events in the South African economy (including its
institutions and its international economic relations with the Americas, Europe, Asia and
Africa).
To give you a real sense of cycles and other changes in the economy, we provide – on the
internet – animations of key diagrams. Thus the analysis of shocks and policy impacts
is not limited to comparative statics (comparing static equilibrium points) but can be
seen as dynamic shifts of curves that move a point of intersection on a path to a new
equilibrium. These movies also show how the expected paths of variables unfold over
time. Theory becomes live action that embeds a much more intimate understanding of
macroeconomic change and processes. The animations are available free of charge on the
following websites:
❐ www.ufs.ac.za/macroecon
❐ https://jutapassmasters.co.za/learning/search.php?search=how+to+think
1 A categorisation of countries using the terms ‘developing’ and ‘developed’ – to distinguish poorer and richer countries – has been the
standard internationally. However, we approve of a recent policy change by the World Bank to stop using them. The two terms group
countries that are very dissimilar, do not recognise that development challenges and poverty exist also in the richest countries and that
all countries always are developing; the terms also suggest a patronising attitude. The World Bank distinguishes four groups, based on
Gross National Income (GNI) per capita: low-income countries, lower-middle-income and upper-middle-income countries, and then
high-income countries. South Africa is an upper-middle-income country. [At the moment (2019) the United Nations still uses these
terms (said to be ‘for convenience’), while the International Monetary Fund (IMF) distinguishes between ‘advanced economies’ and
all others as ‘emerging market and developing economies’.]
Chapter 0: Introduction and orientation: macroeconomics in the South African context
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Part I presents the basic theoretical framework. Chapter 1 sets the scene. After a brief
introduction to macroeconomics as a field and its usefulness to you as a citizen and other
role-players in society, the main macroeconomic problems and issues are described. These
also constitute the main macroeconomic policy objectives, as practised by policymakers in
the fields of, notably, fiscal and monetary policy – within the broader development context
of a middle-income country such as South Africa (within SADC and sub-Saharan Africa).
Unemployment, one of the most severe economic problems in South Africa, receives
prominent attention. A brief overview of the definition, measurement and analysis of
human development is presented, showing South Africa’s human development status
relative to relevant other countries. The chapter also provides a backdrop to understanding
the macroeconomic policy debate in South Africa. This includes a rudimentary outline of
the main schools of thought in economics – from Marxism to the two major mainstream
approaches – as well as an introduction to political-economic views (from the left to the
right) on race, class, capitalism and apartheid that continue to impact the macroeconomic
policy debate in South Africa. This political-economic background traverses the period
from colonial times, the Glen Grey Act of 1894 and the Natives Land Act of 1913 to the
1948 election victory of the National Party, the Freedom Charter of 1955, the ANC’s
armed struggle and the 1994 democratic election and beyond.
The text covers the main topics and components at the level of a second-year course
in macroeconomics or a third-year course in macroeconomic policy. While it generally
assumes prior knowledge of the basic Keynesian model at an introductory economics level,
this is not absolutely essential. In the first theory chapter (chapter 2), on the real sector,
the fundamental topics are reviewed, notably the role of expenditure – consumption,
investment, government expenditure, exports and imports – in determining the level of
output and real income in an economy. (The role of the supply side of the economy is
introduced in chapter 6.) Crucial intuitive insights and analytical abilities are developed,
notably the construction of logical sequences of events, i.e. the use of chain reasoning. This
ability will aid you considerably in thinking and reasoning about real-world economic
events and policy in South Africa and elsewhere, especially disturbances and resulting
short-run fluctuations (i.e. the business cycle), as well as the role of the National Treasury
and the national budget.
Chapter 3 explains the operation of the monetary sector of the economy in a way that
marries theoretical analysis and the everyday operation of money and capital markets in
South Africa. After studying this chapter, you should feel comfortable with discussions
of financial institutions, financial markets, interest rates and the Reserve Bank in the
financial news media, and understand the linkages between the financial world and real
economic activities (consumption, investment, production, employment, exports, imports
and so forth). You will be able to construct more complex chain reactions that link the
monetary and real sectors.
Together, the first two theory chapters provide you with most of the analytical insights
usually found in the so-called IS-LM model, which is a powerful diagrammatic aid and is
standard fare in intermediate macroeconomics textbooks. After an intuitive introduction
to the model and its uses, the more formal aspects of the theory are explained in an
accessible way.
The presentation of the IS-LM model and its mathematics illustrates an important
characteristic of the book. It enables you to read and understand the theory at different
levels, as follows.
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(a) A strongly intuitive understanding with the help of chain-reaction arguments and
relatively simple diagrams, enabling you to develop an intuitive and real-world
approach to economic reasoning. This promotes a thorough understanding of
economic processes rather than mechanics – a major benefit.
(b) A more theoretical level with the help of more complex diagrammatical aids such as
the IS-LM model; or
(c) The complete package of intermediate-level models coupled with and aided by
mathematical derivations and analysis in ‘maths boxes’.
The chapter ends with an extensive case study relating to the 2007–08 financial crisis,
which impacted the entire world economy. It is demonstrated how the two-sector ISLM model can be used to explain the course of events in the USA – the housing bubble,
quantitative easing and so forth – and how it pushed South Africa into a major recession.
The South African economy is an open economy, strongly subject to international
economic forces. A special characteristic of this book is the strong and explicit focus on
the open economy. Whereas many textbooks consider the macroeconomic implications of
international trade and capital flows only in the final chapters, here they are incorporated
throughout the text, starting in chapters 2 and 3. Chapter 4 sets out these intricacies in
depth and provides a level of analysis not often accessible to students in macroeconomics
textbooks. This should make you very comfortable with discussions of, for example, the
South African balance of payments, exchange rates and the gold price. Chain reactions
here also include external elements and disturbances originating in other countries,
including the balance of payments adjustment process (which could be different for South
Africa than for high-income economies). Also included is the growing role, in South
African imports and exports, of China and other Asian as well as African and SADC
countries – though economic conditions in the USA and Europe continue to influence the
South African economy intensely.
❐ You will encounter all the results of the IS-LM-BP model. After an intuitive introduction
to the model and its uses, the more formal aspects of the theory are explained in an
accessible way.
❐ Again, you can choose the extent to which you want to engage with the formal model.
(As noted before, there are many benefits to mastering the full model.)
This chapter also ends with an extensive real-world application: it explains the Euro crisis
that started in 2010 following a debt crisis in Greece and other countries, the subsequent
attempts of Germany to address this Eurozone problem, international repercussions and
so forth. It provides a fascinating demonstrating of the usefulness of the IS-LM-BP model
in analysing such a complex chain of events, including the impact on South Africa..
Macroeconomics in the real world is intimately involved with numbers. Understanding
and interpreting macroeconomics statistics are essential skills for any economist, business
person or modern citizen. Throughout the text you will encounter relevant quantitative
information on the South African economy. Much of this is to be found in ‘data tip’ boxes,
and in some cases you are prompted to find or calculate certain numbers yourself. You will
also be alerted to the many dangers inherent in analysing economic data. The approach
taken is in line with the view of the great British economist Joan Robinson on the purpose
of studying economics:
The purpose of studying economics is not to acquire a set of ready-made answers to
economic questions, but to learn how to avoid being deceived by economists.
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The insights into data provided here, as well as the thinking skills you will acquire
throughout the book, should enable you to evaluate economic arguments and data
interpretation in the news media with a critical eye. Tables and graphs depicting the course
of important macroeconomic variables in South Africa during the last three decades can
be found in most of the chapters, and information regarding the measurement of data in
a specific area of analysis in chapters 5 and 10.
A further dimension of economic numbers is that, in terms of the measured values of the
variables, they must and will remain within an encompassing set of constraints. These
are rooted in an accounting-type coherence between different sectors – the numbers must
add up, must balance. This coherence is captured in special equations, called identities,
involving key variables. These identities are derived from the national accounts, which
have an important role in ‘keeping the books’ of a country. The national accounts can
be a dry subject area, dominated by definitions and accounting conventions. But here we
do not do accounting at all. Indeed, chapter 5 provides a unique treatment. You will see
how these national accounting identities constitute a powerful additional tool of analysis
for the economist – a tool to understand the coherence between sectors of the economy
as well as underlying constraints on macroeconomic change and adjustments. Along the
way you will acquire a working understanding of the System of National Accounts and
important South African data sources. At the same time you will be alerted to the misuse,
by some ‘experts’, of the national accounting relationships.
Though inflation appears to be less of a problem in South Africa and internationally
now, compared to earlier decades, it remains a key factor, and always-present risk,
in macroeconomics. In chapter 6 you will acquire the ability to understand, from
a macroeconomic point of view, the forces acting on the average price level (in an open
economy). This knowledge is the foundation for the in-depth discussion of inflation in
chapters 7 and 12. Chapter 6 shows how the analysis of expenditure, or the aggregate
demand (AD) side of the economy – found in chapters 2 to 4 – must be supplemented with
an analysis of aggregate supply (AS) if the simultaneous determination of real income and
the average price level is to be understood. The theory of aggregate supply is rooted in
economic behaviour in the labour market, where the demand of firms for labour is related
to their price-setting behaviour in product markets, and where unions play an important
role in setting wages, as is the case in South Africa. At the same time, the presence of
structural unemployment, especially in the South African context, is highlighted. An
important element of aggregate supply theory is the existence of both a long-run and a
short-run aggregate supply (AS) curve. This leads to important conclusions on mediumrun adjustments on the supply side following short-run disturbances (whether on the
demand or the supply side). The Eskom capacity crisis and its impact on the South African
economy is the subject of the case study in this chapter. The power of the AD-AS model
in analysing the short- and long-run effects of such a bottleneck on GDP growth and the
price level (and inflation) is demonstrated clearly.
Chapter 7 adapts the AD-AS model, which is designed to explain changes in the average
price level, to a model that explains inflation as such, i.e. sustained increases in the price
level over the years. The adapted AD-PC model has the AS curve renamed as the Phillips
curve (PC-curve). The model strengthens your ability to analyse short-run cycles and
disturbances in the context of an economy where inflation is a permanent phenomenon.
The attention thus shifts to explaining increases or decreases in the rate of inflation rather
than in just the price level. Important lessons for policymakers are derived. The chapter
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also provides an analysis of typical anti-inflation policy by central banks, and the kind of
policy reactions one can expect if the Reserve Bank adopts an approach of steering the
economy towards a targeted inflation rate or interval (which indeed is the case).
Chapter 8 takes the analysis of the supply side (or production side) further by focusing on
the very long run, where economic growth (or the lack of it) is the prime concern. While
short-run fluctuations are very important for the well-being of people in a country, their
long-run welfare and standard of living depend much more on the long-run economic
growth trend – specifically, whether it is sufficient to increase income per person (or,
per capita income). Economic growth theory tries to explain the factors that determine
either low or high rates of growth in output (and thus income per capita). The concept
of a ‘balanced growth path’ is important in this context. The role of capital goods and
technology is highlighted, as is the crucial role of human skills, human development and
‘human capital’. You will also see how important the development of social and economic
institutions is to economic growth and development. Chapter 8 also completes part I of
the book, which comprises the basic macroeconomic model for an open, inflationary and
growing economy, as applied to South Africa.
Part II deals with macroeconomic policy and institutions, such as the South African
Reserve Bank and the National Treasury while focusing on the problems of inflation,
unemployment and low economic growth. If you wish to skip the policy and
institutional discussion, you can go directly to chapter 12 – the analysis of inflation,
unemployment and low growth. You should be able to follow most of it, although you
will be less equipped to understand fully the policy debates on these three problems.
Chapters 9 and 10 focus on macroeconomic policy, i.e. monetary policy (including exchange
rate policy) and fiscal policy. The standard analytical insights with regard to policy are
developed, using the logical-intuitive method encountered earlier. In addition, you will get
a feel for the real world of policy making: the difficult choices policymakers face and the
constraints they have to deal with. The institutional dimension – which may often be more
decisive than formal economic knowledge – is incorporated throughout the discussion,
revealing the actual policy-making processes in the National Treasury and the Reserve
Bank.
The chapter on fiscal policy is especially rich in this regard, and is something that
distinguishes this book from most other textbooks that are available. In the current South
African debate, the role of government as revealed in the annual budget is a key and often
divisive issue. It dominates many an economic argument – consider the intense debates
on service delivery, government expenditure on health or higher education or housing,
taxation, the budget deficit or public debt. It is therefore one area that you should be able
to analyse with some comfort. Chapter 10 is designed to give you the necessary insights
and methods of analysis. It pays particular attention to helping you evaluate the fiscal
state of the economy, using various fiscal yardsticks. It draws extensively on the practical
experience of the authors in the fiscal policy field in South Africa.
❐ This is one area where Joan Robinson’s adage (on page 3) is most pertinent. It is also one of
the most exciting areas of macroeconomics, as the frenzy surrounding budget day reveals.
Throughout the text you will be aware of the fact that economics is a science within which
major differences of opinion exist. These are often related to deep-seated philosophical
differences on the functioning of a market economy – consider the debate on capitalism
versus socialism, which is still very much alive behind the scenes in South Africa, despite
appearances to the contrary.
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In capitalism, man exploits man. In socialism, it’s exactly the other way around.
Anonymous
The debate on the budget (chapter 10) clearly illustrates these philosophical differences.
As background, chapter 1 has set out three main protagonists: Marxist thought, and
then the two major mainstream macroeconomic protagonists, i.e. the Keynesians/New
Keynesians and the Monetarists/New Classicals. You will not be able really to understand
the high emotions surrounding macroeconomic issues if you do not understand the basic
differences between the latter two mainstream schools of thought, with the Marxist school
of thought always present. This is especially true of the policy debate, where the different
views also present the policymaker with serious problems. Whom should the policymaker
believe? Chapter 11 explains the main differences and policy problems in this regard. (You
will also encounter some other practical problems in executing policy, e.g. policy lags.)
After all the analysis and discussions of chapters 1 to 11, the scene is set for the final
chapter: an in-depth analysis of the three major macroeconomic problems of inflation,
unemployment and low economic growth. The Monetarist/New Classical and New Keynesian
views are analysed and compared. It becomes apparent that conventional macroeconomic
analysis is not sufficient fully to understand the causes or to design appropriate policy
remedies. The severity of these problems appears to derive from more fundamental,
structural dimensions of a market economy, especially in a middle-income country such
as South Africa. This is especially true with regard to unemployment and the prevalence
of structural unemployment, which requires remedies other than macroeconomic policy
measures. Examples include: skills and education policy, competition policy, employmentintensive industrial policy, the strengthening of the informal sector, and land reform.
Consequently, this last chapter also broadens your understanding to include elements
outside conventional macroeconomics, such as human capital, income inequality,
institutions, culture, trust and social division, geography and the environment. After all,
economic life does not exist in a vacuum – it is part of the larger social fabric, and it has
to be analysed as such. The chapter ends with a discussion of inclusive development and
inclusive growth, concepts in the South African debate that integrate several concerns:
about growth, about unemployment, about poverty and inequality as well as human
development. This is followed by a real-world policy application: an explanation and
critical analysis of the National Development Plan, which may shape macroeconomic and
other important policies for the next 10 years and beyond, depending on whether and how
it is implemented.
So, there it is. Now read – and enjoy thinking and reasoning about macroeconomic events
and policy in complex South Africa!
Legend for icons
!
✍
Take note box
Activity box
π
Maths box
Animation available
The data tip box is self-explanatory.
6
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Part I
How does the
economy work?
A basic model for an open,
inflationary economy
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Why macroeconomics?
An introduction to the issues
1
After reading this chapter, you should be able to:
explain what macroeconomics entails and why it is useful to you and others;
interpret the main concerns that typically are the focus of macroeconomics;
identify and explain the standard objectives of macroeconomic policy;
analyse and assess the complexities involved in defining and pursuing these objectives
in a country such as South Africa, including the potential for conflict between objectives;
and
■ integrate macroeconomic objectives in a broader development context, and evaluate the
relative importance of macroeconomic goals in the broader social context in South Africa.
■
■
■
■
It goes without saying that the state, health and course of a country’s economy matter a
great deal. The material welfare of every household and individual in South Africa, as in
other countries, depends decisively on the state of affairs in the economy, now and in the
future. It is important to understand whether times are good or bad, so that people can
comprehend what is happening to them and can deal with it to their benefit, or so that
policymakers can take corrective action to try to moderate the turn of events, if required.
To do this, one must gain an understanding of how things work.
1.1
What is macroeconomics?
The economy comprises millions of individuals, workers and families, and thousands of
businesses, as well as labour unions and other organisations, all engaged in millions of
activities and transactions. For many purposes this is too much to make sense of in its
disaggregated multiplicity. What macroeconomics does is to simplify that multiplicity into
a broad, aggregate grasp on the cumulative and summary impact of all those millions of
actions. (Other branches of economics, e.g. microeconomics or labour economics, consider
the detail of small chunks of the economy or specific dimensions of economic behaviour.)
So macroeconomics is about understanding the course and ‘behaviour’ of the economy as
a whole – not just for the fun of it, but because the behaviour of that ‘whole’ influences the
lives and welfare of the millions of individuals and families that make up the economy. These
influences flow from macroeconomic phenomena such as the business cycle (upswings,
downswings, recessions and depressions), unemployment, inflation and economic
growth. In addition, they form the basis for macroeconomic policy steps by a government
that is trying to improve the lives of citizens by ameliorating negative experiences (such
as economic instability, high inflation, high unemployment and poverty) and enhancing
positive processes such as economic growth, employment and development.
1.1 What is macroeconomics?
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1.2
How can learning to think and reason in macroeconomics
help me?
An individual, a household or a firm cannot control the macroeconomic ebbs and flows of a
country, or the actions of policymakers. But one can understand these things better, learn
better to anticipate events or policy steps using best available information, and prepare
better to weather the storms or to exploit opportunities due to economic disturbances and
changes. At the very least one can feel less bewildered about the waves and storms, the
ups and downs of living in a country that is inevitably part of a global economy beset by a
multitude of forces and dynamics.
More specifically, politicians, civil servants, business people, labour unions, farmers,
mineworkers, families and individuals need to understand the waves and storms that
surround and threaten their efforts to make a dignified and decent livelihood. For instance,
an understanding of macroeconomics will be relevant to the following:
❐ An individual afraid of losing her job due to a recession – a recession that can originate
locally, or in economic events far away in the USA or Japan (such as the ‘subprime’
financial crisis of 2007–08 or the subsequent Eurozone crisis).
❐ Individuals hoping to get a job due to new factories being erected by private companies,
or roads being constructed through public works programmes.
❐ Retired people afraid of having their savings and pensions eroded by inflation. What
will the interest rate on bonds do? What will the stock market do?
❐ Young people concerned about their future income and wealth prospects or being
unable to find jobs despite economic growth, or families concerned about the impact of
their mortgage interest rate on their monthly budget.
❐ Businesses involved in strategic and annual planning of output and entrepreneurial
initiatives and not wanting to be caught unawares – or clueless – by interest rate
changes, exchange rate fluctuations, a slump or upsurge in sales for which they did not
prepare. This is the essence of understanding the business cycle: having some ability
to comprehend the state of the cycle and roughly anticipate prospects for the coming
year or two.
❐ Businesses and farmers facing the danger, in good times, of investing and expanding as
if the good times will never end, likewise the danger, in bad times, of cutting back and
not investing as if the bad times will never end.
❐ Farmers planning major export initiatives for their product, but who are concerned
about possible changes in the exchange rate or in sales prospects abroad.
❐ Farmers or factories concerned about the effect of the international oil price on their
input costs (diesel, etc.).
❐ Voters contemplating which political party’s economic policy is the best – whether it is
budgetary policy, interest rate policy, exchange rate policy, anti-inflation policy, growth
and development policy (such as the National Development Plan), environmental
policy or other policies.
❐ Labour unions needing to understand the state of the business cycle to gauge their
bargaining power in wage negotiations, whether (and how) to incorporate some
expectation of future inflation into their negotiations (including the expected impact
of likely policy steps on inflation expectations), and also how excessive wage claims can
impact on the pursuit of other important national goals such as the containment of
inflation.
❐ NGO or government officials and politicians caring about equity and social justice, or at
least the social consequences of economic shocks and policies.
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❐ Anybody who wants to understand why poverty and unemployment remain high
despite economic stimulation and growth, and why so much economic inequality exists
amidst more than a decade of successful global and domestic economic growth (since
the mid-1990s up to 2008).
Whoever you are, at the very least you need to have a minimum level of macroeconomic
literacy: understanding the news, understanding economists, understanding public
debate on economic policy (the Treasury and the budget, the Reserve Bank and the repo
rate); understanding news reports on national and international economic events –
unemployment rates, interest rates, the inflation rate, the exchange rate, the gold price,
the oil price, US interest rates, China’s economic growth, Europe’s debt crisis and struggles
with Brexit, the implications of economic growth or natural disasters in SADC and subSaharan Africa, the effects of climate change on the economy, and so forth.
The macroeconomic dimensions noted above can be summarised as comprising the
following:
❐ The short- to medium-run pattern and trend, notably the business cycle and fluctuations
in aggregate expenditure (or demand), output and employment, and ways possibly to
stabilise them through fiscal or monetary policy (i.e. government budgets, spending and
taxation and the deficit, as well as Reserve Bank steps such as a change in the repo rate);
❐ Ongoing medium-term phenomena such as inflation and adjustments of the productive
capacity (or supply side) of the economy, some of them occurring in reaction to shortterm shocks or policy steps; and
❐ Long-run growth and employment trends and ways to influence them.
All of these occur within the broader context of structural and institutional dimensions
related to the development challenges of a post-colonial, post-apartheid, middle-income
country with deep-seated problems of structural unemployment, poverty and inequality;
development backlogs, skills deficiencies and skills mismatches in the modern economy;
low rates of labour absorption by industry, segmented labour markets and barriers to
entry faced by job seekers; the economic marginalisation of poor people, as well as healthrelated issues such as HIV and Aids – and of course the wider issue of sustainability with
regard to the environment and climate change.
In these different contexts, we will also encounter – and come to understand – some of the
puzzles and dilemmas facing the policymaker, and effectively also the voter-citizen. These
include apparent trade-offs and difficult choices between desirable goals such as reducing
unemployment and reducing inflation. Or indications that certain policy steps that may
be good for the economy in the short run may be bad for the economy in the long run, or
vice versa. What appears to be good for economic growth may be bad for the environment
and climate change – or may make no real difference to the situation of the unemployed.
1.3
Main macroeconomic problems and policy objectives
The main problems and issues of concern in macroeconomics are best identified
by considering the main objectives of macroeconomic policy. People often think of
macroeconomic policy as synonymous with stabilisation policy. While the latter is an
important aspect, macroeconomic policy is concerned with much more than the business
cycle. The standard objectives of macroeconomic policy usually include the following:
1. Economic growth and increasing employment (i.e. reducing unemployment)
2. Stability of output and employment levels
3. Stable and low inflation
1.3 Main macroeconomic problems and policy objectives
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4. Balance of payments
5. Distributional and equity objectives and the reduction of inequality
6. Economic development and poverty reduction.
These constitute the main dimensions by which the overall health of an economy is
measured. A thorough diagnosis of the state of the economy as a whole will have to deal
with these aspects in one way or another.
Traditional macroeconomic textbooks, notably those of American or British origins,
normally will only list the first four or five of these objectives in their assessment of the
macroeconomic performance of a country. However, for South Africa as an upper-middleincome country and emerging-market economy, macroeconomic events and discussions
of policy objectives can never be severed from the encompassing concerns of economic
and human development as well as deep-rooted poverty and inequality.
For any student in a low- or middle-income country, it is essential to understand the linkages
and broader context of these issues. Section 1.5 gives some background on economic and
human development issues and objectives. We will also encounter development issues in
the chapters on long-term economic growth (chapters 8 and 12).
1.3.1
Economic growth and increasing employment
The pursuit of high economic growth is the objective that usually is accepted as the most
obvious one – often to such an extent that little critical thought is given to the issue.
The basic belief behind such general acceptance is that economic growth will lead to an
improvement in the living standards of the entire population. (As we will see below, the
matter is not so simple.)
Economic growth is defined as a sustained increase, over time, in the level of aggregate
production, i.e. gross domestic product or GDP. (A complementary definition considers the
trend in per capita GDP, i.e. in average GDP per person.)
The focus on the trend in the level of GDP is used in this definition to indicate that cyclical
deviations from the underlying trend in aggregate output are not of concern here.
Economic growth is a long-run policy consideration.
❐ This clearly distinguishes it from short-run or stabilisation objectives that are concerned
with cyclical fluctuations around the long-run trend of real GDP (i.e. the business cycle).
❐ This also means that the focus is on the behaviour of the full-capacity level of output
(GDP) over time (amidst upswings and downswings).
❐ In other words, the long-run growth path is the ‘base line’ or trend line around which
cyclical fluctuations occur. It indicates, and determines, the long-term rate of increase
(or decrease) in the average material standard of living of a population. In the long run
it is much more important for the wealth and welfare of people than fluctuations in GDP.
The simplest measure of aggregate economic growth is the annual growth rate of real
GDP, i.e. the percentage increase in real GDP from one year to the next. The per capita GDP
growth rate is the percentage increase in real per capita GDP from one year to the next.
This way of measuring growth unfortunately does not exclude the cyclical component of
the behaviour of GDP – it mixes cyclical increases and decreases in GDP with the long-run
trend. To see the long-run pattern, one has to smooth the annual growth rates by taking
averages over longer periods, as shown in table 1.1. (See chapter 12 for more details on the
definition and calculation of the GDP growth rate.)
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The data in table 1.1 and figure 1.1
clearly show how dramatically the South
African growth performance declined
since the mid-1970s (among cyclical
increases and decreases in growth) –
with the 1980s and early 1990s being
the worst. It is apparent how economic
growth has recovered after the change in
government in 1994.
Table 1.1 Average economic growth rates in South Africa
Real GDP
growth
However, the period after 2008 again
marks a period of sustained decline in
the GDP growth rate, with especially
the period 2014–18 becoming quite
disastrous.
Per capita real
GDP growth
1971–1975
3.68
1.22
1976–1980
3.10
0.72
1981–1985
1.42
–0.90
1986–1990
1.68
–0.48
1991–1995
0.88
–1.22
1996–2000
2.80
0.66
2001–2005
3.84
1.98
2006–2010
3.14
1.80
2011–2015
2.20
0.96
2016–2018
0.87
–0.53
Source: South African Reserve Bank (www.resbank.co.za).
Figure 1.1 Real GDP growth rate and moving average trendline 1960–2018
10
8
Percentage
6
4
2
0
2018
2016
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1976
1974
1970
1972
1968
1964
1966
1960
1962
–4
1978
–2
Source: South African Reserve Bank (www.resbank.co.za).
Does economic growth improve living standards? Per capita growth
An important perspective on the real GDP growth rate is provided by the population
growth rate. Only if the real economic growth rate exceeds the population growth rate
will there be an increase in real GDP per capita, i.e. GDP per person.
❐ Up to 1990 the South African population growth rate averaged approximately 2.5%
per annum. Since 1991 the rate of natural increase has fallen steeply to approximately
1.2% in 2017.
❐ Real economic growth was insufficient to compensate for the population growth for
more than a decade after 1980, but in the period after 1993, GDP per person increased
almost continuously, except for brief declines in 1998 and 2008–9 (see figure 1.2).
However, since 2014 per capita GDP has declined (negative growth).
1.3 Main macroeconomic problems and policy objectives
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The extent to which sustained growth in GDP contributes to people’s living standards also
depends on the composition of the output. For example, if increased military expenditure
and production are primarily responsible for the GDP growth, it does not have the same
effect on living standards as when the source of growth is expenditure on, and the
production of, basic household goods, housing and medical services.
Figure 1.2 Real GDP per capita (2010 base year) 1960–2018
62 000
57 000
52 000
47 000
R million
42 000
37 000
32 000
27 000
22 000
17 000
2018
2016
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
1962
1960
12 000
Source: South African Reserve Bank (www.resbank.co.za).
!
Even if per capita GDP increases numerically – if there is a positive per capita growth rate, as
was the case in much of the 1960s and 70s and the first two decades after 1993 – it need not be
the case that all (or even the majority) of the population are better off. This depends on the way
in which the benefits of economic growth are distributed among the population, i.e. the extent to
which people share in the growth. This is the issue encapsulated in the inequality objective (listed
previously as number 5 and discussed in section 1.3.5). Unfortunately, it regularly happens that
the benefits of growth largely flow to a relatively small group of already well-off people and do
not ‘trickle down’ to benefit the poor – the poor are not sufficiently part of expanding economic
activities. This phenomenon is likely to have been a contributing factor in the political tension and
mobilisation in South Africa in the 1960s and 70s as well as the dramatic rise in township protests
since 2009. Of course, it is much worse if per capita GDP starts to decline, as has occurred from
2014 onwards.
GDP growth and employment growth
Assuming a direct link between GDP growth and employment, and thus unemployment,
is not necessarily correct in reality. For example, increases in production capacity and
output due to the substitution of capital (i.e. machines) for labour – through the use of
more capital- and technology-intensive methods of production – can cause high growth
accompanied by stagnating or even declining employment. In South Africa this is visible
in the declining employment-intensity of output. Economic growth with low labour
intensity appears to be typical.
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Figure 1.3 Indices showing trend in real GDP and formal-sector employment since 1985 (1985=100)
250
200
Real GDP
Index
150
Formal-sector employment
100
2017
2015
2013
2011
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
0
1985
50
Source: South African Reserve Bank employment series, derived from Statistics SA’s Quarterly Employment Series
(QES) and its predecessors; GDP: South African Reserve Bank.
In general employment tends to grow much more slowly than GDP. Figure 1.3 shows the
absolute levels of real GDP and total formal-sector employment since 1985, while figure
1.4 shows the growth rates of real GDP and total formal-sector employment.1
❐ From 1985 to 2018, real GDP has more than doubled, while total formal-sector
employment has increased by only 30% (figure 1.3).
❐ Or, as figure 1.4 shows, from 1985 to 2018 the formal-sector employment growth rate
has persistently been significantly below the GDP growth rate. The average growth rate
for GDP over the entire period was 2.2% per year and that for formal-sector employment
0.8%.
Figure 1.4 Real GDP growth and formal-sector employment growth rates since 1985
6
Real GDP growth
5
4
Percentage
3
2
1
0
–1
–2
Formal-sector employment growth
2017
2015
2013
2011
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
–4
1985
–3
Source: South African Reserve Bank employment series, derived from Statistics SA’s Quarterly Employment Series
(QES) and its predecessors; GDP: South African Reserve Bank.
1
One should be careful with employment data and related calculations of coefficients. The Quarterly Employment
Series (QES) – which is based on formal-sector enterprises and government – and the more comprehensive Quarterly
Labour Force Survey (QLFS) produce somewhat different results, while the latter has been available for a shorter
historical period. See the Data Tip box in section 12.2.1, chapter 12. (Figures 1.3 and 1.4 with approximations of
longer-term trends, dating back to 1960, can be found in the fourth edition of this book.)
1.3 Main macroeconomic problems and policy objectives
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Another way to look at this, is to consider the macroeconomic ‘employment coefficient’. It
expresses the employment growth rate relative to (i.e. as a ratio of) the real GDP growth rate.
❐ For the formal sector alone, the average employment coefficient for 1960–2018 has
been estimated to be 0.52. This confirms a broad pattern from as far back as 1946. For
total employment, data for the period since 2001 suggest an employment coefficient
that is somewhat higher.
❐ Note that these values do not indicate ‘jobless growth’, which occurs when the
employment coefficient is negative. In South Africa this only occurred in an exceptional
few years after the political transition of the mid-1990s and in the major recession of
2008-09.
These numbers mean that formal-sector employment growth in South Africa tends
to occur only at roughly half the rate of GDP growth. If this is coupled with a growing
population and a growing labour force (a characteristic since 1994), this is likely to lead
to increasing unemployment – unless very high GDP growth rates are attained. Growth in
GDP therefore does not necessarily lead to a corresponding long-run increase in formalDoes the informal sector create employment?
According to the Quarterly Labour Force Survey, formal-sector employment plus employment
in agriculture and private households reached approximately 13.3 million in 2018 (employment
in agriculture was 0.85 million and in private households 1.3 million.) However, about 3 million
people work in the informal sector, of which an estimated 1.4 million are employers plus their
paid employees in enterprises, while 1.4 million work as owner-operators in their own oneperson enterprises. These workers are also affected by macroeconomic cycles and policies, but
macroeconomists and media reports often ignore this part of the economy. That is a weakness in
macroeconomic theory and policy thinking. The informal sector is an important current and potential
source of employment. (See section 12.2 for more on the informal sector and employment.)
sector employment. Formal-sector growth alone is unlikely to absorb enough workers to
significantly reduce unemployment.
Unemployment
Unemployment is one of the most important measures of macroeconomic performance.
It also is the most sensitive variable politically. It is discussed in depth in chapter 12.
Unemployment occurs when a person who is in the labour force, i.e. who is economically
active, does not have a job. Children, students and the elderly, for example, are not
regarded as part of the labour force, and thus are not counted as being unemployed. The
unemployment rate is calculated by expressing the total number of unemployed persons
as a percentage of the total labour force. In practice there are two definitions (see section
12.2 for a more detailed discussion):
❐ In terms of the strict definition, a person must be actively searching for a job to be
counted as unemployed. This is how the official un­em­ploy­ment rate in South Africa is
defined. It is also called the narrow unemployment rate. Table 1.2 and figure 1.5 show
the official unemployment rate in South Africa since 2000. It has been fluctuating
around 25% since 2000, but climbing steadily since 2016.
❐ In terms of the expanded definition, persons who are not actively searching for
work but who want to work and are willing to work – most of whom are so-called
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discouraged workers – are also included. It is also
called the broad unemployment rate. This rate is
much higher than the narrow unemployment
rate. In South Africa it has been approximately
8–10% higher than the narrow rate and has been
fluctuating around 34% since 2000, increasing
to 38% in 2019. Figure 1.5 shows the persistent
gap between the two unemployment rates.
Table 1.2 Unemployment rates in South Africa
Narrow
While the strict rate is the official rate of
unemployment in South Africa (in line with
international statistical agencies), researchers
often prefer to use the broad rate in the analysis
of unemployment. They argue that, given the
country’s development and structural challenges,
the more than three million discouraged and other
non-searching unemployed must be recognised as
part of the employment/unemployment problem –
that these marginalised workers cannot simply be
ruled out of consideration in policy analysis as being
‘not economically active’.
Broad
2000
23.30
30.00
2001
26.20
34.50
2002
26.60
34.70
2003
24.80
34.70
2004
23.00
33.70
2005
23.50
32.80
2006
22.10
30.90
2007
21.00
31.40
2008
22.80
29.50
2009
24.50
33.80
2010
25.40
36.10
2011
25.00
35.50
2012
25.20
35.60
2013
24.50
34.90
2014
25.40
35.80
2015
25.50
34.40
2016
27.10
36.60
The long-run level of the rate of unemployment
2017
27.70
36.80
depends partially on the long-run growth
2018
27.50
37.70
performance of GDP, but mostly on structural Source: Statistics SA.
characteristics of the labour market and the
economy. These do not change easily; indeed, a high level of ‘structural’ unemployment
is an ingrained characteristic of the South African economy (see section 12.2.3 for a
thorough discussion).
Figure 1.5 Unemployment rates since 2000
40
35
Broad rate of unemployment
30
Percentage
25
Narrow rate of unemployment
20
15
10
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
0
2000
5
Source: Statistics SA, QLFS data.
1.3 Main macroeconomic problems and policy objectives
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The sustainability of economic growth
The unqualified pursuit of high economic growth is increasingly questioned in the light of
the considerable costs of economic growth. These include the increasing pollution of the
environment (air, water, etc.), the accumulation of waste material (including dangerous
substances such as nuclear waste) and noise pollution. In recent years, the apparent impact
on climate change has become very prominent.
In addition, there are the disadvantages of a modern, industrialised urban life (traffic
congestion, noise, job stress in the rat race, and so forth). The fundamental question is
whether this kind of growth necessarily brings about a real improvement in people’s quality
of life.
Another crucial qualification is the impact of unqualified economic growth on the depletion of
natural resources. Concern exists worldwide that the world may be facing serious shortages
of essential natural resources within decades. One of the most important resources – also
in South Africa – is fresh water. Another is natural energy resources, some of which may be
exhausted or under stress relatively early in this century.
All of these factors impose important constraints on the sustainable rate of growth as well as
on the kind of growth that can and should be pursued. The fact that, in addition, economic
growth does not necessarily reach all sectors of the population, stresses the importance
of not pursuing more and more growth in an unqualified fashion. While an increase in the
general level of economic activity surely is important, especially in a country with development
problems and a growing population, it would be short-sighted to ignore the inherent dangers
in a single-minded growth-at-all-costs approach. (See the discussion of development in
section 1.4 and also chapter 12, section 12.3.6.)
1.3.2
Stability of output and employment
In contrast to a concern with the long-run level and growth of GDP and employment,
this objective relates to cyclical fluctuations in general economic activity, as measured by
changes in GDP (or the GDP growth rate) as well as total employment. Fluctuations in the
rate of unemployment generally are linked to the business cycle, i.e. fluctuations in GDP.
In most Western countries the pursuit or attainment of high (or even ‘full’) employment
is regarded as a responsibility of the government. This can be traced back to the Great
Depression of the early 1930s, the first major and sustained cyclical downturn that
struck the USA and the world (including South Africa) after the First World War. This
led to the acceptance by US President Franklin D Roosevelt of full employment as an
official government objective and responsibility. While there has been some rethinking of
this position in the West in the last couple of decades, few governments can dissociate
themselves from the problems of unemployment, since it is an important political factor
in most democratic elections.
In low- or middle-income countries with significant poverty, such as South Africa,
unemployment has a particular relevance from the point of view of both government and
labour unions. During cyclical downturns in the economy the plight of those losing their
jobs while already being members of poor households becomes acute.
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Usually, and especially in simple theoretical models of the economy, it is assumed that
there is a close correlation between the level of employment and the level of real GDP.
Following this, the basic policy assumption also is that cyclical fluctuations in GDP will
cause corresponding changes in total employment.
❐ The standard objective of stabilisation policy, therefore, is to moderate cyclical
fluctuations in GDP and thus simultaneously moderate fluctuations in employment.2
While the link between GDP and employment is weak in the context of long-run growth (figure
1.3), in the short-run or cyclical context a clearer correspondence between GDP fluctuations
and employment fluctuations is apparent – see figure 1.4. Nevertheless, the data in figure 1.4
show that sometimes the direction and often the magnitude of changes in the two variables
differ noticeably. One must realise that cyclical movements in production do not necessarily
cause corresponding changes in employment. In an upswing in production a corresponding
proportional increase in employment will not occur if the extra output is produced using
machines and capital goods which have surplus capacity, or with current employees initially
working below capacity. Likewise, in a downswing, employment can fall less than production
if labour unions use their power to prevent retrenchments; on the other hand, it could also
fall more if employers shift the burden of falling sales and profits disproportionately onto
labour. (In practice both of these effects may be operational at the same time.)
❐ Therefore, policy steps – such as monetary and fiscal policies – aimed at short-run levels
of GDP are not automatically appropriate or sufficient for achieving the employment
stability objective.
The important point is that one can distinguish two components of unemployment: a
cyclical component and a long-run or structural component. Macroeconomic policy can
influence GDP in the short run, bearing in mind that steps to moderate fluctuations in
GDP (or to promote GDP growth) will not automatically be effective to deal with cyclical
unemployment. However, this is even less the case with regard to long-run, or structural,
unemployment, which is largely outside the reach of standard macroeconomic policy
remedies. It is rooted in complex aspects of labour markets, spatial patterns, economic
marginalisation, underdevelopment and so forth.
This means that, given that employment is a legitimate objective of public policy, the
different kinds and components of unemployment require a combination of different
kinds of policy steps, many of them not macroeconomic in nature. Therefore, the design
of macroeconomic policies geared towards (un)employment must fully take account of
the labour-economic and other intricacies of unemployment. The macroeconomic debate
on unemployment of 25% cannot proceed as if it is primarily a low-growth problem or a
downswing-in-GDP problem.
The problem of unemployment is further complicated by the fact that it is also an integral
part of the broader problems of poverty and underdevelopment. This forces one to
consider a much wider set of perspectives, causes and policy options (see section 1.4 and
also chapter 12, section 12.2).
1.3.3
Stable and low inflation
The control of inflation is accepted as a very important macroeconomic policy objective
in most countries. It is discussed in depth in chapters 7 and 12. Table 1.3 displays the five2
As we will see later, ‘full’ employment does not actually mean 0% unemployment. It allows for frictional
unemployment and seasonal unemployment (see the box in chapter 6, section 6.3.2).
1.3 Main macroeconomic problems and policy objectives
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year averages for inflation in South Africa since the
1960s. Notice the steep increase in the inflation rate
in the 1970s, an increase that was reversed only
in the late 1990s – with relatively low rates then
sustained into the 2010s.
Table 1.3 The rate of inflation in South Africa
1961–1965
2.1%
1966–1970
3.4%
1971–1975
9.4%
Inflation is defined as a sustained increase in
the general or average price level. One-off or
intermittent increases in the average price level do
not constitute inflation. Likewise, increases in the
prices of individual products or services are not
inflation, but rather a change in relative prices. The
average price level is measured by different price
indices, the consumer price index (CPI) being the
most important.
1976–1980
12.1%
1981–1985
14.0%
1986–1990
15.4%
1991–1995
11.3%
1996–2000
6.7%
2001–2005
5.1%
2006–2010
6.9%
Inflation is measured as the rate of increase of
the average price level during a specified period,
normally one year. More specifically, the inflation
rate is the percentage change in the CPI during the
chosen period.
2011–2015
5.4%
2016–2018
5.5%
Source: South African Reserve Bank
(www.resbank.co.za).
The formulation and pursuit of this policy objective is no simple matter. For example, one
must distinguish between the prevention of higher (or increasing) inflation and the actual
reduction of the inflation rate. That the latter is automatically preferred to the former is
not accepted by all.
❐ Also bear in mind that, specifically when inflation is a policy objective, the existence of
various trade-offs will be of utmost importance. The most prominent (and controversial)
of these is the trade-off between inflation and unemployment (see chapters 7 and 12).
Another important link between inflation and other policy objectives derives from the
impact of high domestic inflation on the international competitiveness of a country, and
the subsequent impact on the current account of the balance of payments (objective 4).
If the South African inflation rate is persistently higher than that of its main trading
partners, this will impair exports and encourage import expenditure. This may continually
place the current account of the balance of payments under pressure (see the analysis in
chapter 4).
Inflation also can have important redistributional impacts (objective 5):
❐ People with debt (borrowers) benefit from inflation, since the real value of the debt
decreases gradually due to inflation. Homeowners with mortgage bonds are a good
example of such a group. By the same token, inflation harms lenders, since it reduces
the real purchasing power of debt repayments.
❐ Inflation harms any person with a constant or slow-growing income source. Pensioners
and people dependent on interest income are important examples.
❐ In a progressive income tax system, bracket creep harms income taxpayers: adjustments
to wages and salaries to keep abreast of inflation push people into higher tax brackets,
where they have to pay higher marginal and average tax rates – even though their
income has not increased in real terms. The state is the beneficiary of this redistribution
(unless it takes active steps to prevent bracket creep by regularly adjusting tax brackets
so that they remain constant in real terms).
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❐ People who (have to) spend the largest portion of their monthly income – especially
on consumer goods such as food and clothing – may experience a higher inflation rate
than people who spend only a relatively small portion of their income (and save or
invest much of it). This means that low-income households may experience a higher
inflation rate than high-income households.
1.3.4
Balance of payments (BoP)
While the balance of payments does not directly affect the welfare or living standards of
people, it is an important policy consideration, notably in an economy as open as South
Africa’s.
This objective should not be understood to mean that the BoP should always be in
equilibrium. As discussed in chapter 4, a BoP deficit or surplus need not be a problem
– as long as it does not persist indefinitely – and may even be desirable at times. What
one can say is that in the very long run the BoP must be in equilibrium. That means
that the average BoP position over a very long period should be that of equilibrium
(BoP = 0).
One reason why the BoP position is important is that it determines the foreign reserves
of the country, i.e. the stock of foreign currency. The foreign reserves are important,
inter alia, to finance imports (notably of essential inputs), to repay foreign debt, and
to support the currency in foreign exchange markets should it come under pressure
(see chapter 4).
Another reason for keeping an eye on the BoP is that the BoP position can have important
effects on the real economy (via money supply and exchange rate adjustments). It has
an important influence on other objectives of policy (e.g. GDP, growth, employment and
inflation). The BoP also influences the pursuit of these other objectives: policy steps to
attain growth and employment objectives often cause an undesirable impact on the BoP –
and especially on the current account.3
❐ Therefore, the BoP position is often an objective of policy in the sense that it is a
constraint on the extent to which other objectives can be pursued. As a consequence,
situations often arise where the BoP situation has to be corrected before other
objectives can be pursued.
In similar fashion, the individual components of the BoP, e.g. the current account
or the financial account, can also become important policy considerations at times,
requiring corresponding policy steps. In particular, a current account deficit cannot
be endured indefinitely. The financial account surplus necessary to finance it can be
achieved and sustained only with high interest rates (and sufficient foreign confidence
in the domestic economy) to attract foreign investment or loans. High interest rates are
likely to discourage the investment that is necessary for growth and for repaying the
foreign debt. A persistent current account deficit also makes a country vulnerable to
capital outflow problems. This has been the case with South Africa since 1994, when
the current account turned negative.
3
Chapter 4 demonstrates that the different channels of the BoP adjustment process can drastically affect the
effectiveness of, for example, monetary policy.
1.3 Main macroeconomic problems and policy objectives
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1.3.5
Distributional and equity objectives and the reduction of inequality
The equity of the distribution of income
and wealth between individual members
of the population is an important
consideration when evaluating just how
optimal the overall results of the economic
institutions, processes and interactions in
a country are. The issue is whether each
individual or household in society earns
or possesses a sufficient, fair or equitable
share of the national income and wealth.
Equity or equality?
Equity does not mean that everyone should
have an equal share (or quantity) of income
or wealth. This is not what it is all about.
Equity is about fairness and justice, which
are complex concepts. Equity cannot and
should not be reduced to a one-dimensional
measure such as equality in the quantity of
income or wealth of persons or households.
It is a characteristic of market economies
(and other types of economies, let it be said) that normal economic processes often lead to a
very unequal distribution of income and wealth. As a result, government has to include the
equitable distribution of wealth in its range of objectives. However, the way and extent to
which this objective must be pursued is very controversial. No consensus exists on what
constitutes a fair and equitable distribution of income and wealth. In particular, there is
little agreement between those who have much and those who have little. Yet, often it is
not too difficult to recognise something as unfair – even though it may be difficult to specify
accurately what would constitute fairness, let alone how to attain such a condition.
How does one measure the inequality of the distribution of income?
One important measure of inequality is the Gini coefficient, which is derived from the Lorenz
curve. When there is absolute equality, the Gini value is zero; a value closer to 1 indicates greater
inequality. Most countries lie between 0.3 (highly equal) and 0.7 (highly unequal). High-income
countries usually have Gini values around 0.40, while middle- and low-income countries have
values between 0.50 and 0.60. For South Africa the Gini value for income was estimated at 0.68
in 1991 – one of the highest in the world. Estimates from Statistics SA show the Gini coefficient
for income at 0.70 in 2000, rising to 0.72 in 2006 and thereafter declining gradually to 0.70 in
2009 and 0.68 in 2015. This slight downward movement is supported by similar estimates based
on the National Income Dynamics Study (NIDS). Income inequality in South Africa is stubbornly
high and persistent, despite significant progress in reducing poverty and deprivation levels.
Although inequality in South Africa has a significant racial pattern, there is also significant
inequality within each population group. The 2015 Gini coefficient for blacks was 0.65 – more
unequal than that for whites, which was at 0.51.
For more information on income inequality in South Africa, visit the website of Statistics SA at
www.statssa.gov.za.
In South Africa the distribution of personal income is exceptionally unequal compared
to other countries – even some Third World countries. South Africa has the ominous
reputation of having the highest degrees of income and expenditure inequality in the
world.
❐ According to the 2005/6 Income and Expenditure Survey of Statistics SA, the richest
10% of the population as a group received 51% of total income, while the poorest 50%
of the population received less than 10% of total income in the country. The Living
Conditions Survey of Statistics SA shows that by 2014/15 the income share of the
richest 10% had declined to 41%, while especially those in the middle gained.
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❐ Another way of putting this is to say that 10% of the population receives roughly 40%
of all income, while the remaining 90% receives 60% of all income. The political and
policy relevance of this inequality cannot be underestimated.
❐ Recent studies of the middle class confirm the presence of high inequality. Because
there are so many poor people, those with the occupations, lifestyle and stable income
to put them in ‘the middle class’, are not in the middle of the income distribution at all!
Who falls in the middle class? Households with a per capita income of only R3 800 up
to R12 750 per month in 2019 money terms. But the data show they are in the top
20% to 25% of households (which include the elite – the top 4%), thus up to 80% of
households have a lower standard of living. The share of the middle class has grown
slowly since 1993, but there has been a major demographic transformation, with
Africans constituting two-thirds of the middle class by 2017.
The large disparities between the incomes of individuals/households in South Africa and the
existence of extensive poverty alongside great wealth have exerted tremendous pressure on
the government to address this issue. This state of affairs has serious political implications
and threatens the legitimacy and acceptability of the entire public order – even after the
political transformation has run its course. This threat stems, in particular, from the fact
that the skew distribution of income seems to correspond largely with racial divisions.
❐ Unfortunately, the traditional macroeconomic policy debate, especially in the private
sector, often disregards (or studiously avoids) the distributional objective.
It is true that the South African government has been giving increasing attention to the
inequity of economic conditions. However, narrower macroeconomic issues do tend to
dominate the policy discussion in Pretoria – especially when a factor such as the BoP
becomes problematic and begins to dominate all policy thinking.
Even ‘normal’ macroeconomic policy steps necessarily have distributional effects:
❐ How much government spends and on what it spends, the kinds of taxes levied, and
the level of interest rates – to mention a few examples – do not affect all individuals to
the same extent: some benefit, others are harmed.
❐ Macroeconomic policy steps also affect the welfare levels in different regions of the
country, and the relationships between agriculture and other sectors, between small and
large business enterprises, between homeowners, investors and pensioners, and so forth.
This means that the equity dimension or objective should be kept in mind at all times, even
when contemplating ‘pure’ macroeconomic policy steps.
Likewise, inequality can have important effects on growth and employment (objective
1). Recent international research from the International Monetary Fund (IMF)4 indicates
that a high degree of inequality can be detrimental to economic growth. Inequality
undermines progress in health and education, inhibits full economic participation,
narrows the consumer market and the tax base, and creates deep tensions that undermine
social consensus and investor confidence. Their results show that longer growth spells are
robustly associated with lower inequality in the distribution of income, especially in lowand middle-income countries. Carefully designed redistributive policies can thus promote
the duration of high growth spells. The contrary, more traditional view is that policies
to reduce inequality (e.g. via taxes and government expenditure) can inhibit economic
growth by discouraging business investment.
4
Berg A, Ostry JD, Tsangarides CG and Yakhshilikov Y (2018). Redistribution, inequality and growth: new evidence,
Journal of Economic Growth.
1.3 Main macroeconomic problems and policy objectives
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Redistribution versus growth?
The relationship between economic growth and redistribution has deadlocked the public debate in an
unfruitful squabble since 1990. This often constituted the form in which the economic dimension of the
transition to a new political dispensation was discussed. Different political-economic constituencies
favoured different relationships between these two objectives. In its crudest form, the debate displayed a
split between two opposing viewpoints: Growth through redistribution or Redistribution through growth.
The latter viewpoint was favoured by the business sector and the pre-1994 policy establishment. Their
argument is that economic growth should be pursued first, in order to enlarge the economic ‘cake’. The
increased availability of income and wealth – the benefits of growth – will spread or filter down to all the
people in the country, including the poor, thereby establishing a more equitable distribution of income.
In addition, the growing economic cake will increasingly make it possible to channel more resources
to the satisfaction of basic needs (education, housing and health). Direct steps to attain speedier
redistribution – higher taxes to finance higher government spending on public services, for example – will
be counterproductive since they will simply retard economic growth. As a consequence, there would be
a shrinking pool of income and wealth to redistribute, and the goose that laid the golden eggs would be
strangled. (What would happen is that ‘poverty would be redistributed’.) This viewpoint can be discerned
in the proposals of the business sector.
The first viewpoint was held by representatives of those who were excluded from power in the previous
political dispensation. They argue that the business argument has only one objective: the protection of the
privileges of the rich and of the status quo of income and economic power distribution – and, moreover,
that the trickling down of benefits to the poor is a myth. The goose that lays the golden eggs is not under
threat at all. They argue further that direct government intervention should be used to restructure the
pattern of income and economic power. Increased government expenditure to build the capacity of the
poor and empower them will unleash their potential and lead the country to a new phase of economic
prosperity for all. Social expenditure on housing, schools and hospitals will also provide an economic
injection and new domestic economic opportunities – for all.
❐ This viewpoint was present in the initial policy documents of the ANC, as well as, for example, in the
proposals of Cosatu (the Congress of South African Trade Unions) and labour unions such as Numsa.
Different and subtler variants of these two viewpoints have developed in the past two decades. In the
Reconstruction and Development Programme (RDP) of the ANC, elements of both viewpoints are present.
The redistribution sentiment remains strong, though – perhaps not in its original crude form, but rather
with a strong focus on economic empowerment and capacity building. In pursuing this the government is
accorded a significant responsibility, with certain sections of the ANC pushing for a strong planning role
for the state.
In 1996 the government introduced the Growth, Employment and Redistribution (GEAR) programme.
For the most part, GEAR is a macroeconomic stabilisation policy aimed at setting the scene for a higher
economic growth rate and higher employment. A key component is tight fiscal policy and the reduction of
the budget deficit.
GEAR to a large extent considers a prudent fiscal policy as a prerequisite for growth, with growth then
generating the revenue that will help to finance more development. Therefore, GEAR leans over to the
redistribution through growth viewpoint.
In 2006 the government introduced the Accelerated and Shared Growth Initiative for South Africa
(ASGISA). With its emphasis more on microeconomic policy aspects, ASGISA, more than GEAR,
recognises that, within the constraints of the budget, some human development can and must take place
without waiting for growth.
⇒
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⇒
After 2009 two key policy frameworks were adopted. These are the New Growth Path (NGP) of 2010
and the National Development Plan (NDP) of 2012. The NGP focuses on growth via labour-intensive
manufacturing. The NDP is a comprehensive development plan that covers almost all areas of society,
e.g. demography, education, health, social protection, human settlements, spatial legacies, infrastructure,
agriculture and the rural economy, the economy and employment – and a ‘capable and developmental
state’.
Whereas GEAR, ASGISA and the NGP focused largely on economic growth, the NDP has a broader
concern with human capabilities, the inclusivity of growth and the reduction of unemployment and
poverty – also by tackling structural problems. Job creation and the reduction of inequality (and poverty)
are explicit objectives of the NDP. Nevertheless, the NDP has been heavily criticised by Cosatu as being
too free-market oriented, protecting the rich and not being concerned with the plight of poor workers –
especially in its chapter on the economy.
❐ The concept of inclusive growth has the potential to defuse the apparent tension between growth and
redistribution. If properly understood, it combines the increased participation of poor and marginalised
people in growing economic processes – i.e. via employment – with increased sharing in the benefits
of growth via equitable earnings, social expenditure and human capacity-building (see section 12.4 in
chapter 12). This implies that the nature of production and employment processes, and thus the nature
of growth itself, needs to be adapted to attain both objectives simultaneously.
❐ Unfortunately, this concept is prone to distortion. For example, many people in the private sector
appear to restrict the concept of inclusivity to benefit-sharing – and then in the restricted sense of
receiving social grants and social services – after growth has occurred. This would require no change
to current economic practices and simply recasts the old tension between growth and redistribution in
new terminology.
1.4
The development objective
One possible way out of the sterile, polarised debate on redistribution versus growth may
be found in the concept of development.
1.4.1
What is development?
Development is not a particular outcome or event. Development can be understood as a
decisive, comprehensive and integrated process that expands the range of choices that
people have and improves their standards of living. It therefore entails much, much more
than an increase in income or GDP or employment, as explained in the UN’s Human
Development Report 1990:
Human development is a process of enlarging people’s choices. The most critical ones are to lead
a long and healthy life, to be educated and to enjoy a decent standard of living … It is sometimes
suggested that income is a good proxy for all other human choices since access to income permits
exercise of every other option. This is only partly true for a variety of reasons:
❐ Income is a means, not an end. Well-being of a society depends on the uses to which income is
put, not on the level of income itself.
❐ Country experience demonstrates several cases of high levels of human development at modest
income levels and poor levels of human development at fairly high income levels.
❐ Present income of a country may offer little guidance as to its future growth prospects…
❐ Multiplying human problems in many industrial, rich countries show that high income levels, by
themselves, are no guarantee of human progress.
The simple truth is that there is no automatic link between income growth and human progress.
United Nations Human Development Report 1990 (1990: 10)
1.4 The development objective
How_to_think_BOOK_2019.indb 25
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It is not the redistribution or the growth of income as such that is important. What is
critical is the development of people, their potential, their abilities to experience a selfreliant and humane existence, and to use their increasing power of disposal over economic
means or resources to satisfy their needs. Real development can therefore deliver both
economic growth and the economic empowerment of the poor.
❐ This results in economic growth and redistribution through development. Development
therefore has the potential to dissolve the tension between growth and social
considerations.
What is the difference between economic growth and development?
This question can provoke a never-ending debate. The most important insight is that
development entails (and requires) much more than an increase in the total value of production
(GDP) or income, or even in per capita income. GDP growth is necessary but not sufficient
for human development. While increased household income or purchasing power is a crucial
element in eliminating poverty, alone it is insufficient to achieve development.
The single-minded pursuit of economic growth, narrowly defined, without taking the other
dimensions of human and social development into consideration, cannot but produce
distorted or unbalanced ‘development’ in a country. Human development can be absent in a
society despite fast growth in GDP or per capita incomes unless certain other steps are taken
and other endogenous social and economic processes are activated and empowered.
❐ This has been demonstrated by the failed efforts of the high-income countries, in previous
decades, to solve the poverty and development problems of the low- and middle-income
countries through large capital projects to achieve economic growth. (Also see chapter 12,
sections 12.3 and 12.4.)
1.4.2
How does one measure development?
Development is a complex process, as is the measurement of development. Through the
years different approaches to development have produced different measures. These have
evolved from crude measures that considered only per capita income to sophisticated
indicators that measure several dimensions of basic need satisfaction and of capacity
building and empowerment.
Besides measures of income or purchasing power, they include several ‘social’ indicators
of aspects such as education (level of schooling, literacy), life expectancy, nutrition levels,
health (e.g. infant mortality rates) and housing (persons per room, running water per
household, sanitation, etc.).
Such information can also be summarised in composite development indicators. The best
known of these indicators is the Human Development Index (HDI), which was developed by
the United Nations Development Programme. It provides, in a single number, a composite
measure of the level of development in a country, and of progress with development efforts.
The HDI is constructed from three indicators of the basic dimensions of human development:
❐ ability to lead a long and healthy life (i.e. life expectancy, which implicitly includes
factors such as nutrition, health and shelter);
❐ ability to acquire knowledge (measured by years of schooling, which implicitly includes
adult literacy and school enrolment); and
❐ ability to acquire a decent standard of living (measured by income in terms of
purchasing-power-adjusted real gross national income (GNI) per capita).
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1.4.3
The development picture – South Africa and other countries
For South Africa, the development picture as compared with four groups of countries is
shown in table 1.4.
The data show that South Africa compares quite well with other middle- and lower-income
countries in terms of per capita income levels, but relatively poorly in terms of life
expectancy – and also with regard to the overall development index, the HDI. A country
such as Vietnam, for example, has an income level only half of that of South Africa, but
its HDI is similar since its life expectancy is much higher (76.5 years in 2017 in contrast
to 63.4 years for South Africa).
Table 1.4 Development indicators
Rank
Country
Very high human
development
HDI
1990
2000
2010
2015
2017
Change
in HDI
rank
Life expectancy
(years)
Mean
years of
schooling
GNI per
capita
(2011
PPP US$)
2012–2017
2017
2017
2017
1
Norway
0.85
0.92
0.94
0.95
0.95
–
82.3
12.6
68 012
4
Ireland
0.76
0.86
0.91
0.93
0.94
+13
81.6
12.5
53 754
5
Germany
0.80
0.87
0.92
0.93
0.94
–1
81.2
14.1
46 136
12
Canada
0.85
0.87
0.90
0.92
0.93
–
82.5
13.3
43 433
13
USA
0.86
0.89
0.91
0.92
0.92
–5
79.5
13.4
54 941
19
Japan
0.82
0.86
0.89
0.91
0.91
+1
83.9
12.8
30 660
31
Greece
0.75
0.80
0.86
0.87
0.87
–1
81.4
10.8
24 648
37
Qatar
0.75
0.81
0.83
0.85
0.86
–1
78.3
9.8
116 818
49
Russia
0.73
0.72
0.78
0.81
0.82
+3
71.2
12.0
24 233
High human development
79
Brazil
0.61
0.07
0.73
0.76
0.76
+7
75.7
7.8
13 755
86
China
0.50
0.59
0.71
0.74
0.75
+7
76.4
7.8
15 270
101
Botswana
0.59
0.57
0.66
0.71
0.72
+8
67.6
9.3
15 534
Medium human development
113
South Africa
0.62
0.63
0.65
0.69
0.70
+6
63.4
10.1
11 923
115
Egypt
0.55
0.61
0.66
0.69
0.69
–
71.7
7.2
10 355
129
Namibia
0.58
0.56
0.59
0.64
0.65
–
64.9
6.8
9 387
130
India
0.43
0.49
0.58
0.63
0.64
+2
68.8
6.4
6 353
142
Kenya
0.47
0.45
0.54
0.58
0.59
+3
67.3
6.5
2 961
144
Zambia
0.40
0.43
0.54
0.58
0.59
–3
62.3
7.0
3 557
Low human development
154
Tanzania
0.37
0.40
0.49
0.53
0.54
+3
66.3
5.8
2 655
156
Zimbabwe
0.49
0.44
0.47
0.53
0.54
+2
61.7
8.1
1 683
157
Nigeria
–
–
0.49
0.53
0.53
–2
53.9
6.2
5 231
159
Lesotho
0.50
0.47
0.49
0.51
0.52
–1
54.6
6.3
3 255
180
Mozambique
0.21
0.30
0.40
0.43
0.44
+1
58.9
3.5
1 093
Source: United Nations Development Programme: Human Development Indicators – Statistical Update 2018.
PPP US$ is a special income measure designed to solve the exchange-rate problem in international comparisons of income.
1.4 The development objective
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❐ The spectre of Aids had a marked downward effect on life expectancy in South Africa
and other African countries after 1995: this affected their HDI values negatively.
❐ Life expectancy in South Africa fell from 62.2 years in 1992 to 53.3 in 2012. That
was a quite disturbing decline. However, it was turned around after that, following the
government’s eventual policy decision to provide antiretroviral medicine, as well as a
marked improvement in the efficacy of such medicine.
✍
Income and development
Study table 1.4. Why do you think the relationship between GDP per capita and the HDI values
as well as the relationship between GDP per capita and the components of the HDI values
are not perfect? What does this signify regarding the link between economic growth and
development? (Also see box in chapter 12, section 12.3.4.)
______________________________________________________________________________________
______________________________________________________________________________________
In 2017, Norway had the highest HDI in the world and the Niger the lowest. Qatar had
the highest per capita income in 2017, but it was ranked only number 37 given that some
other high-income countries performed better in terms of life expectancy and education
enrolment. (However, the first 20 countries all have very similar HDI values ranging from
0.91 to 0.95.) For 2017, South Africa ranked number 113 in a list of 189 countries. With
the exception of Papua New Guinea, the Solomon Islands, Yemen and Haiti, all countries
below number 150 are African countries. This demonstrates the enormous developmental
backlog still faced by Africa.
1.4.4
What does macroeconomic policy have to do with development?
The tension between growth and redistribution is often transmitted to the analysis
of the relationship between growth and development. A major reason for this is that
people reason as if development and redistribution are synonymous. Proponents of the
redistribution-through-growth approach then proceed to evaluate development-oriented
steps of government in the same way as they would evaluate redistribution efforts, i.e. as
a threat to growth and other macroeconomic objectives.
❐ This is a mistake. Development is something quite different from redistribution –
although good development, which addresses poverty successfully, should produce
improved income distribution patterns as well as economic growth.
Obviously it is true that the development efforts of a government often have significant
budgetary and fiscal implications. They usually entail government expenditure that has to
be financed. Government expenditure also has macroeconomic implications, as analysed
in the following chapters. Overambitious development-oriented government expenditure
can cause undesirable macroeconomic consequences – through an increasing tax burden,
an excessive budget deficit, crowding-out, inflation or excessive stimulation of the economy.
Therefore unwise development policy can threaten macroeconomic objectives.
On the other hand, a country can achieve good macroeconomic performance in the sense
of a high growth rate of real GDP, but in a way that does not address the problems of
severe poverty and underdevelopment. In particular, excessively conservative fiscal policy
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can seriously impair government development activities if funds for these purposes are cut
back. (See the discussion of fiscal policy in chapter 10.) Unwise macroeconomic policy,
therefore, can threaten development objectives.
The Sustainable Development Goals (SDGs) for 2030
The SDGs constitute an internationally adopted blueprint to achieve a better and more
sustainable future for all by 2030. It is a collection of 17 goals for global development, set
by the United Nations General Assembly in 2015. These include: no poverty; zero hunger;
good health and well-being; quality education; gender equality; clean water and sanitation;
affordable and clean energy; decent work and economic growth; infrastructure, new industries
and technologies; reduced inequality; sustainable cities and communities; responsible
consumption and production; climate action; life on land and below water; and peace, justice
and strong institutions. A total of 195 governments, including South Africa, have committed
to translating the goals and associated targets into national legislation and plans of action, to
establish budgets and monitor progress using appropriate indicators. Though non-enforceable,
implementation to tackle all the challenges started worldwide in 2016.
For more information on the SDG project, see: https://www.un.org/sustainabledevelopment
Development problems will not disappear conveniently unless steps are taken to initiate
development processes. Macroeconomic performance as conventionally measured in
itself is not sufficient. Therefore, the important thing is to pursue an appropriate balance
between macroeconomic objectives and development objectives.
❐ Achieving such a balance requires that macroeconomic objectives should not be
regarded as of absolute and sole importance. Their relative importance is to be found
in the fact that, if macroeconomic considerations do not receive sufficient attention in
the pursuit of development objectives, the economy can experience serious problems,
e.g. BoP crises, a drastic depreciation of the currency, runaway inflation, a disastrous
public debt burden and so forth. Correcting such severe macroeconomic errors will
require incisive structural adjustments which can impair development work seriously,
and for many years.
❐ By taking macroeconomic considerations seriously, a government can create room for
good development efforts. Healthy macroeconomic policy makes the pursuit of other
objectives possible. Therefore, macroeconomic objectives should be recognised, in this
wider context, as important constraints on development policy.
Yet this last point still does not mean that macroeconomic objectives should be seen as
being of absolute importance. What is necessary is a balance between the macroeconomic
and other objectives. This means that the discussion on macroeconomic policy must be
broadened expressly to include the development dimensions. Development objectives
should not be regarded as something separate from or opposite to macroeconomics, or as
something that can be addressed afterwards.
Ideally, a development orientation should guide and characterise all policy. For example,
proper development-oriented fiscal (and monetary) policy would also use development
indicators and objectives in the design and monitoring of policy.
In the final instance, development policy – which empowers people and unleashes their
economic and social capacity – can be an important instrument in boosting productivity,
1.4 The development objective
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output and employment – the basic macroeconomic indicators. Good development policy
will also serve macroeconomic objectives. Real development can deliver both economic
growth and the economic empowerment of the poor. In such a case, any choice between
growth and development is a false choice.
At the same time, the debate on development policy should, at all times, expressly take the
importance of macroeconomic constraints into account. Development objectives cannot be
pursued uncompromisingly either, especially not if via government expenditure programmes.
It is clear that macroeconomic policy is (or should be) much concerned with development.
However, in practice, the pursuit of development objectives also concerns microeconomic
and public management aspects, as well as budget practices, which takes the discussion
far beyond the normal macroeconomic frame of reference. This is one reason why
macroeconomists so readily disregard development aspects.
1.5
Intermediate objectives
While the list in section 1.3 contains the main objectives of macroeconomic policy, there
is also a set of secondary or intermediate macroeconomic objectives. These are important
because they have crucial implications for the other, main objectives – and are sometimes
important in their own right.
Most notable among these is the rate of interest. Whichever way it moves, it affects certain
groups of people positively and others negatively – homeowners, investors, borrowers,
lenders, farmers, pensioners, etc. These differential effects, and their consequences, can
make the interest rate an important policy objective at times.
Likewise, the exchange rate can harm or benefit people, which can also make it an important
objective at times. In this sense, interest rate and exchange rate levels are also important in
any diagnosis of the economic situation, so they will usually be included in such an exercise.
A last factor sometimes proposed as a policy objective is a balanced budget. However, this is
not generally accepted, mainly because an intentional budget deficit can be an important
Keynesian policy instrument. In more sophisticated fiscal analyses, the preference is
for other fiscal norms (criteria) that are derived from specially defined budget balance
concepts, e.g. the primary deficit (see chapter 10).
1.6
Conflict between the standard objectives – priorities and trade-offs
While it may be simple to understand each objective in relative isolation, the problem in
practice is to pursue or realise all these objectives simultaneously. The fundamental problem
is that, given the way the economy works, several of the objectives are usually in conflict
with each other. The pursuit of one of them frequently has a negative impact on another.
This conflict often occurs in the form of a trade-off, where progress with one objective
is possible only at the expense of another. In such a situation the government is forced
to choose, i.e. it has to give priority to certain objectives over others. This choice is often
the source of serious political differences. The choices, and the disputes, are also strongly
determined by the relative influence and popularity of alternative economic schools of
thought (such as Keynesianism and Monetarism/New Classicism, as well as Marxism) in
policy-making circles.
The most well-known trade-offs are those between (a) employment and the BoP, and (b)
employment and price stability. These are fully discussed in chapters 6, 7 and 12.
30
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Chapter 4 will demonstrate how conflict can arise between BoP and unemployment
considerations. Stimulating the economy to relieve unemployment stimulates imports
and thus causes a deterioration in the current account (and the BoP). Cooling down the
economy to alleviate a current account deficit, on the other hand, is likely to aggravate
unemployment. Increasing interest rates to improve the financial account discourages
investments – which harms the growth and employment objectives.
Moreover, if unemployment and a BoP deficit occur simultaneously, the dilemma is
particularly acute: the economy suffers from two serious problems, but policymakers can
alleviate one only to the detriment of the other. The conventional solution for this policy
dilemma is to fight unemployment with expansionary fiscal policy, while simultaneously
using restrictive monetary policy to increase interest rates sufficiently to rectify the BoP
position (by attracting strong capital inflows). Theoretically, the correct combination of
these two steps can lead to the simultaneous achievement of both objectives. In South Africa
prior to 1994, the low sensitivity of foreign capital to domestic interest rates inhibited the
effectiveness of this policy package – especially since political conditions also discouraged
capital inflow. After 1994 it has become much less of a problem. However, this problem
might return if South Africa loses all three sovereign investor-grade credit ratings (i.e. the
sovereign credit ratings issued by Moody’s, S&P and Fitch rating agencies).
On a deeper level, trade-offs have to be faced when contemplating economic growth and
unemployment together with economic development and poverty reduction. Whereas
it is often assumed that higher economic growth will lead to lower unemployment and
progress with economic development, things are not so straightforward. As we will see
when we discuss the concept of structural unemployment (see box in chapter 6, section
6.3.2), certain kinds of growth can leave structural unemployment unreduced (compare
the concept of jobless growth). Depending on the way it occurs, economic growth can also
be accompanied by increasing inequality among citizens of a country, can make a limited
impact on the level of human development, or can harm the environment.
On the other hand, making economic growth truly inclusive could generate an important
convergence between economic growth, on the one hand, and development, employment
creation and poverty reduction on the other (see ‘Redistribution versus growth’ above).
1.7
Priority choices of the South African government
The South African government is also forced to choose between various policy objectives.
Throughout the years the South African government also did not award the same priority
to all its objectives:
❐ In the first half of the 1970s, economic growth had the highest priority. However, these
also were the last years of the so-called macroeconomic ‘golden age’ that started in
the 1960s in South Africa. The 1973 OPEC oil crisis introduced the period of high
inflation all over the world; price stability became a major policy concern. After the
1976 Soweto student uprising, when international economic pressure on South Africa
(e.g. trade sanctions) began, the BoP demanded increasing attention.
❐ A rather low priority was given to growth and employment in the period 1981–85.
South Africa registered rather good economic growth in 1981 following the boom in
the gold price. However, the large inflow of foreign reserves in 1981 caused a significant
spike in the inflation rate. Therefore, the government and the Reserve Bank came to
associate growth with unwanted inflation. This led to an under-emphasis of growth.
❐ Much changed in 1986. That year’s budget speech was unique in that it expressly gave
the highest priority to the economic conditions for social reform – i.e. the distribution,
1.7 Priority choices of the South African government
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❐
❐
❐
❐
❐
❐
❐
32
equity and development objectives, in conjunction with the employment objective. This
was a first for a Minister of Finance (then Barend du Plessis). The political protests
of those years (perhaps partly due to the previous neglect of the employment and
development objectives?) are likely to have been a major factor in this policy shift.
The financial sanctions imposed on South Africa put tremendous pressure on the BoP
though, pushing economic growth to the back burner.
The early 1990s represent a period of major political transition. Economic growth
received a higher priority, but, due to political uncertainty (resulting in low investment)
as well as the international recession, actual growth was at its lowest level since 1960.
During the 1990s the Reserve Bank under governor Chris Stals was very successful in
reducing inflation to below 10%.
After the first democratic election in 1994, the new government came to power with the
Reconstruction and Development Programme (RDP) as its mandate. The RDP emphasised
human development, but acknowledged the need for economic growth. It also acknowledged
the budgetary constraints that government faced. This year marked a significant shift in
government policy towards emphasising development and social spending.
In 1996 the government announced the Growth, Employment and Redistribution
(GEAR) strategy. GEAR was mainly a macroeconomic stabilisation policy that reflected
the basic principles of the so-called Washington consensus. (It is called thus because it
reflects the central ideas propounded by the IMF and the World Bank – both located in
the US capital Washington DC.) These principles include an emphasis on growth, fiscal
prudence and avoiding government dissaving (typically requiring cutting government
expenditure and deficits), monetary prudence (to get low inflation) and privatisation.
With the GEAR emphasis on a 6% growth target, many people – but most notably the
trade unions – accused government of neglecting employment, redistribution and social
spending. Although government succeeded in reducing the budget deficit and public
debt, it was less successful in stimulating investment and economic growth.
After 1999, when Tito Mboweni became governor, the Reserve Bank was able to use
conservative monetary policy to focus on maintaining an inflation rate of 6% on average
– though at times inflation exceeded 10% due to exchange rate or oil price shocks.
With a prudent macroeconomic (i.e. fiscal and monetary) policy in place at the turn of
the century, and the subsequent room created in the budget, the government turned to
the more microeconomic and redistributive aspects of policy. Since 2000 a permanent
expansion of the social welfare system was introduced. Whereas only 5.8 million people
received a type of social grant in 2003, by 2018 about 17.5 million people received
a social grant. The largest increase occurred in child support grants. In 2003 there
were 2.6 million child grants and in 2018 about 12.2 million. Approximately 45% of
households received some type of government grant in 2018.
In 2006, government introduced the Accelerated and Shared Growth Initiative South
Africa (ASGISA). ASGISA was a rather loose collection of initiatives to address the
binding constraints on growth. It included elements of industrial policy, small business
development and infrastructure investment. However, it never really got off the ground.
Government’s New Growth Path (NGP) of 2010 prioritised employment creation and
‘decent’ jobs through investment in massive infrastructure projects (also in rural areas),
reindustrialisation, minerals beneficiation, small business development and public
works programmes – while it also intended to produce equitable and inclusive growth
and decent jobs (via labour rights). With the focus on ‘jobs drivers’, little was said of
social objectives or changing the situation of marginalised people. The NGP was soon
superseded by the more encompassing National Development Plan (NDP) of 2012.
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❐ The NDP, which was formally adopted by government, presented plans with 2030 as
the end goal. While it thoroughly addressed many dimensions of society, at its core
the NDP prioritised ‘faster and more inclusive growth: an economy that will create
more jobs’. For GDP growth it mainly proposed increasing exports, linked to a growing
service sector and small business development for employment growth. Extensive
infrastructure expenditure was intended to stimulate growth while public works
programmes would create millions of temporary public-sector jobs in the interim years.
Social expenditure and social protection would be increased to eliminate poverty and
reduce inequality, while also transforming human settlements and the rural economy.
(In the period up to 2018 the implementation of the NDP was slow or absent, though.)
❐ The Minister of Finance up to May 2014, Pravin Gordhan, adopted economic growth
as the key to tackling unemployment and poverty, declaring that a growth rate of 7%
will be required for a generation to reduce unemployment. Since the rate of inflation
had been below 6% for several years, it was not a high priority and the Reserve Bank
(with new governor Gill Marcus and subsequently Lesetja Kganyago) had a low profile.
❐ This policy approach largely continued up to early 2019 (amidst a high rotation of
Ministers of Finance, including Nene, Van Rooyen (literally for a weekend), Gordhan,
Gigaba and Mboweni). At the same time, decisions with huge fiscal implications, such
as the abrupt announcement of free higher education, as well as repeated financial
bail-outs of state-owned enterprises (SOEs) such as Eskom, South African Airways
(SAA) and the SA Broadcasting Corporation (SABC), forced to the fore government
debt and the government’s ability to borrow money internationally (i.e. South Africa’s
sovereign credit rating).
❐ At this stage the NDP objectives had largely faded away, or was not being implemented
at all. However, in June 2019 President Cyril Ramaphosa recommitted the government
to the implementation of the goals of the NDP.
1.8
Main perspectives in the economic debate in South Africa
Any person reading the overview of policy choices and priorities of the South African
government since the 1970s will be struck by the strong undertone of opposing economic and
political philosophies. Moreover, when one considers the economic policy history, embedded
as it is in South Africa’s peculiar political history, one realises that it cannot be separated
from at least two debates: one on economic philosophy, the other political-economic.
1.8.1
Economic schools of thought – Classicism, Marxism and Keynesianism
Since early in the last century, South African policymakers have always been influenced
by the broader international debate between economic schools of thought (or ideologies).
This is discussed in depth in chapter 11 (section 11.3). At this stage it is necessary, though,
to note the broad outlines of the course of mainstream economics since its inception. It
has shaped, and still shapes, our everyday lives.
A very simple, rudimentary outline
This will be a very simple, even crude outline. Its very simplicity implies a high risk of hiding
important nuances. Nevertheless, such a simple outline has an important role: to set out
the very broad parameters of the main streams, or traditions, of thought in economics and
about economic policy. Once these are understood, the refinements of various economists
and schools of thought can be better understood and positioned within the large scope of
things. The biggest divide exists between the following two broad streams:
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A. Mainstream economic thought, which
accepts and works within the basic capitalist or
mixed-economy model.
B. Marxist thought, which is fundamentally critical of the
capitalist model and seeks radically alternative ways of organising economic activity. Some of the political alternatives proposed include socialism and communism (but few proponents
would approve any of the forms observed in former communist
states). Marxist thought is based on a deep criticism of the way
the interaction of private property, private enterprise and the
free market has lead to a high inequality of economic power,
political power and economic welfare among people and nations – while acknowledging that no system has produced economic growth and wealth (in the aggregate) like the capitalist
system. The state and politicians are seen as often being in cahoots with the capitalists: the ‘capitalist state’ is no antidote for
the market.
❐ While little formal economic theory (parallel to standard microeconomic or macroeconomic theory, say) has
been forthcoming from Marxist circles, Marx is one of
those historical and philosophical figures that one cannot ignore or avoid. Think of a fundamental economic
issue, and Marx has been there (i.e. he probably has said
something profound – whether right or wrong – about
it and it probably has influenced thinking about the issue). Marxist thought tackles issues at a different angle
and level, and rarely fails to provoke an intellectual reaction from the reader.
❐ Several loosely affiliated strands, ‘radical’ or ‘alternative’
in varying degrees, can be identified. These include
neo-Marxism, post-Keynesianism, Institutionalism and
Evolutionary Economics.
* * *
Mainstream economic thought and related theories are based on the principles of private property, private
enterprise and a significant role for the market, as well as at least a minimum role for government in the economy.
Within the mainstream, the latter element – the role of the state vis-à-vis the market – has been responsible for
an important, major divide between two broad sub-streams.
Mainstream Group 1 – the free market and
minimalist state group: This group believes, in
the core, in markets as the optimal organisational
mechanism for social and economic activity, and
in the smooth and efficient functioning of mar­kets
in determining equilibrium prices, quantities and
incomes. As a corollary, the role of the state should be
kept to a minimum – which comprises the provi­sion
of a public legal order and the en­forcement of private
property rights and contracts. Anything more than a
mini­malist state will be counterproductive and cause
more problems than benefits. Government failure is
a real risk.
34
Mainstream Group 2 – the mixed economy
group: This group believes, in the core, that markets
are very important but that they face and harbour
intrinsic de­ficiencies that constrain their ability to
work smoothly and efficiently, thus leading to distorted outcomes – market failures – in terms of prices,
quantities and incomes. The only agent that can step
in to rectify these distorted outcomes, is the state (i.e.
government), which can and must support, oversee,
regulate and complement the activities of the market
and private enterprise. (Within this group, a variety
of sub-views exist regarding the proper mix of ‘state
and market’, as well as the best design of government
in­terventions and activities in the economy.)
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From broad approaches to two seminal models
(1) The Classical model and its articles of faith
Mainstream Group 1 first entered the ring in the middle 1700s, with the works of Adam
Smith, founder of so-called Classical economic thought, and John Locke, the English
philosopher. Both were exponents of Classical liberalism, the philosophy built on the
fundamental belief that individual freedom and liberty are the highest good. The state is
fundamentally distrusted. No artificial restrictions are to be placed on individuals, least
of all by a state. If only individuals could be left alone to pursue their own interests in
complete freedom, a situation of harmony and equilibrium would prevail in society – a
‘natural order’ would emerge ‘as if arranged by an Invisible Hand’.
❐ Adam Smith’s most famous work on economics was An inquiry into the Nature and Causes
of the Wealth of Nations (1776). Its central thesis is that resources for the production of
wealth are best employed under conditions of governmental non-interference or laissez
faire.
The intellectual heirs of Adam Smith, in particular the neo-classical economists, refined
this view into the well-known atomistic model of ‘perfect’ competition. In this model the
unrestricted interaction of demand and supply theoretically leads to an efficient, optimal
equilibrium – as long as the state keeps its hands off. This theoretical model clearly
corresponds closely to the general Classical view.
The main thrust of the Classical approach to macroeconomics is the proposition that,
given unfettered markets, the economy will always tend towards a stable equilibrium at full
employment. The economy is inherently stable. Recessions and periods of unemployment
are only temporary and due to external disturbances; the economy will automatically
Marxist thought – a reaction to Classical views?
Living in London during the Industrial Revolution, Karl Marx (1818–1883) was highly critical
of the way industrialists exploited workers, including women and children, for the benefit of a
few, wealthy capitalists. In an era when Classical views were accepted wisdom, there was little
oversight or regulation of markets by government.
Marx developed a radical critique of the capitalist process of production. His classic book
Das Kapital (1867) highlighted fundamental characteristics, forces and contradictions in
the way a capitalist economy functions. These characteristics laid the foundation for large
inequalities and inequities between workers and the owners of business enterprises, i.e. the
capitalists.
The resultant class conflict, he predicted, would continually place the market system under
stress, leading to a series of crises. He foresaw a cycle of growth, followed by collapse,
followed by growth, etc. In the process, the capitalist class would become richer and the
working class poorer.
In the end, he predicted, the capitalist system would be destroyed by its intrinsic tensions
and crises. (It was to be replaced by socialism, an interim phase on the way to a classless,
stateless society.)
Footnote: The reader might find it interesting that Karl Marx’s sister Louise was married to a Dutch gentleman called
Johann Carel Juta. They moved to South Africa in 1853 and settled in Cape Town, where he built a publishing company
now known as Juta & Company – the publisher of this book. Mr Juta knew Marx well and encouraged him to write articles
for a Cape Town newspaper, De Zuid-Afrikaan.
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return to the full employment equilibrium promptly. As a result, unemployment is not a
real problem. No remedial steps are necessary, least of all from government. Protracted
periods of unemployment and recession cannot occur.
The Classical model of the economy was in vogue up to 1930.
(2) The Keynesian model and its articles of faith
Mainstream Group 2 emerged in the 1930s. While the Classical and the neo-classical
models constituted the dominant economic paradigm up to the end of the third decade of
the 20th century, the Great Depression of 1929–33 all but killed the Classical proposition
that unemployment at most is a temporary aberration (disequilibrium) that will disappear
spontaneously.
The Depression was triggered by the US stock market crash of 1929. It quickly spread
to the rest of the Western world. In the USA, hundreds of banks collapsed, bankruptcies
abounded, and employment rose to more than 10 million, which at the time represented a
25% unemployment rate (with similar rates in countries such as the UK). This lasted until
at least 1933. South Africa also experienced the Depression, with severe unemployment
and poverty being aggravated by the great drought of 1933.
From 1933 to 1938, US President Franklin D Roosevelt introduced the New Deal, a set
of economic policies intended to counter the effects of the Great Depression via large
government infrastructural projects and fiscal stimulation.
This was not dissimilar to the policies suggested by the British (Cambridge) economist
John Maynard Keynes (1883–1946). Keynes, one of the most influential people of the
20th century, published his General Theory of Employment, Interest and Money in 1936.
From the late 1920s he already proposed similar policies for the UK. The demise of the
Classical model coincided with the rise of Keynesian theory.
The crux of the Keynesian approach is the acceptance of the inherent instability of the
economy and the intrinsic imperfections and flaws of markets. Keynesian macroeconomic
theory demonstrated that the economy can stabilise (stagnate) at an equilibrium with
unemployment (see chapter 2). This was a radical deviation from Classical thought.
Moreover, Keynesianism prescribed deliberate government action in the form of a fiscal
stimulus as a remedy. In general, it favoured active anti-cyclical fiscal policy, and deficit
spending if necessary, to remedy the flawed dynamics of the unfettered market. The
positive economic impact of wartime government expenditure on the US economy, and of
the Marshall Plan in Europe, boosted this view. Keynesian macroeconomics – later refined
to include the attempted fine-tuning of the business cycle to minimise cyclical instability –
became the dominant policy approach of most Western governments until the mid-1970s.
The end of the business cycle was proclaimed (prematurely, as it turned out).
Ideologies, legacies and disciples
With both these large ideologies having been founded, and each having had a period of
dominance in economic teaching and research as well as policymaking, the stage was set
for a prolonged battle of ideas.
The unfolding of this process involved various comebacks, revisions and refinements.
It was interspersed with – and triggered by – definitive occurrences in the real world.
One example was the sudden high inflation of the late 1970s, which could not be explained
by existing Keynesian theory, and of which the timing and diagnosis fitted the analytical
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paradigm of the Classical proponents like a glove. University of Chicago economists such
as Milton Friedman had been working hard, from the 1950s, at rehabilitating Classical
liberal economic thought.
A first ‘reborn Classical’ approach, which came to be known as Monetarism, became very
popular in the high-inflation 1970s – following a decade of intense policy debates with
Keynesians (see chapter 11, sections 11.3.2 and 11.3.5). A central tenet was that policy
to fight unemployment is impotent in the long run and will only lead to permanently
higher inflation.
This was followed by the birth of the so-called New Classical School. This was a younger
and more extreme mutation in the Classical-Monetarist lineage (sometimes also called
Monetarism mark II; see section 11.3.3). It claimed that not only is policy impotent in the
long run (Friedman’s view), but also that it is impotent in the short run. The concept of
rational expectations, introduced by Robert Lucas (also from the University of Chicago), is
central to this approach.
Just as the advent of Keynesian economics in the 1930s did not mean the end of the
Classical tradition, so the resurgence of the Classical tradition in the form of Monetarism
and New Classical economics did not mean the end of the Keynesian approach. (That is
the nature of ideologies: they do not wither and die easily.)
From the late 1980s, Keynesian economists such as Mankiw and Blanchard addressed
the weaknesses of the older Keynesian approach – inter alia that it failed to explain the
high inflation of the 1970s. Their approach became known as New Keynesian economics.
While incorporating rational expectations into their models, they showed that various
wage and price rigidities can explain why an economy experiences unemployment and
instability in the short and medium run – a central tenet of original Keynesianism (see
chapter 6).
Nevertheless, at the turn of the century, New Classical economists appeared to think that
they had won the intellectual battle. The world was in an unprecedented era of economic
growth and prosperity, coinciding with an era of shrinking government involvement –
often in the form of financial and economic deregulation – in major Western economies.
Keynesian theory started to disappear from macroeconomic courses, first at postgraduate
level, and then from undergraduate textbooks.
Then the real world intervened – again. In late 2007, the subprime crisis struck in the USA
and quickly spread to other countries, leading to the greatest financial and economic crisis
in the world economy since the infamous Great Depression of the 1930s. Analysts quickly
pointed fingers to the legacy of Thatcher, Reagan and others: by making deregulation and
unfettered markets the centrepiece of policy in major high-income economies, they opened
the door for excessive risk-taking in financial markets – on a huge scale. Governments had
to respond quickly to prevent a worldwide economic meltdown. After bailing out several
banks and financial institutions, the government of US President Barack Obama launched
a government spending programme, notably on infrastructure, of unprecedented scale.
Several newspapers proclaimed – with a certain sense of irony – that this marked a return,
in the USA at least, to Keynesianism on a huge scale. (It was complemented by a huge
programme of monetary stimulation, until October 2014, called ‘quantitative easing’, run
by the US Federal Reserve – see the case study in section 3.4.) Similar policy shifts occurred
in Europe: although anti-Keynesian ideas did seem to have some purchase there previously,
the experience of the harm caused by fiscal austerity changed many policy minds.
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In the USA president Donald Trump enacted large tax cuts and market deregulation
in 2017–18. While these were seen as ‘freeing-up business’ steps that resembled the
‘supply-side’ policy approach of former president Reagan, Trump’s introduction of
protectionist international trade tariffs constitutes the opposite of free-market ideology.
Increased government spending on the military and on infrastructure ‘to get the
economy working again’ also suggests a Keynesian approach. On the whole, though, his
mix of policies appeared to be driven by political opportunism or populism, rather than
any coherent Keynesian (or non-Keynesian) policy framework or economic ideology.
South Africa – always a microcosm?
While most of this ideological battle occurred in the USA and the UK, and also in Europe,
countries such as South Africa have always been affected by the broader currents.
Through the use of foreign textbooks, studying abroad in the USA, UK and Europe,
and through international academic journals, conferences and communication, these
debates spilled over to South Africa quite rapidly. Elements of how this unfolded in South
African policy circles are discussed above (section 1.7) and in chapter 10 (on fiscal policy).
Views representing both main schools of thought are to be found among South African
universities and economists.
1.8.2
Political-economic perspectives – race, class, capitalism and apartheid
A broader South African context is provided by the debate on the constitutional, political
and social framework of the country – going from a colonial and later apartheid past
to a fully democratic, post-1994 present. That political history had a parallel economic
philosophy and policy history.
The interaction between politics and economics in South African history is a complex
and contested topic. Several theories exist on whether race-based legislation and policies
have inhibited economic development, or may have served the interests of business and
especially mining. There are too many to summarise here. Nevertheless, there are many
indications of an intricate symbiosis (or mutual dependence) between, first, the way the
capitalist economy and business sector was organised and managed since before 1900,
and, second, the development of various manifestations of racial supremacy, racial
exploitation, migrant labour, separate development and apartheid. In short: persons and
institutions who wielded political power and economic power were often in agreement
– since at least 1894, when the Glen Grey Act was promulgated – about the need to use
race-based measures and subjugation of especially black workers to further the economic
and political interests of a selected group of people.
The interesting thing to note is the contrasting role played by socialist/communist
thinking during the 20th century. During the mineworker strike of 1922, communist
sympathies and class consciousness among white workers were strong, as they were
united against (English) capitalists. During the 1930s and 1940s, there was a strong
block of support amongst the (at the time very poor) white Afrikaner community
for socialist views of the state and the economy, favouring state interventions and
redress to benefit the poor (white) class. Market-based philosophies were seen as
the other side of the coin of British imperialism and dominance by British capital.
Hence, during the Second World War, some support developed for the philosophy of
National Socialism, then strongly propounded in Nazi Germany. (This philosophy
combined socialist ideals with nationalist ideals regarding the self-determination of
the German people.)
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After the war, despite increasing involvement in the international economy, the National
Party government remained sceptical of classical-liberal economic thinking. This might
have been partly due to the association of the latter philosophy with growing criticism,
from overseas, against the system of apartheid and ‘separate development’. Also, the state
was seen to be, and was used as, an important instrument to strengthen the economy,
often for the disproportionate benefit of whites. After 1948 and the election victory of
the National Party, apartheid rapidly changed from a tacit understanding amongst the
powerful to an explicit, formalised and legalised social regulation system. Government
policymakers distrusted the ‘market’ and (English-dominated) business sector, and the
state was a major actor in steering the economy within the context of the capitalistapartheid economy.
In the Freedom Charter, adopted at Kliptown in 1955 following the ANC defiance campaign,
principles for a future South Africa were set out. Many of the economic clauses refer to
basic economic freedoms: to work, to be paid equitably, to own land, to be educated. What
raised the ire of the economic and political establishment at the time were clauses that
sounded just too socialist for comfort or raised fears of expropriation, such as:
The People Shall Share in the Country’s Wealth!
The national wealth of our country … shall be restored to the people
The mineral wealth beneath the soil, the Banks and monopoly industry shall be transferred to
the ownership of the people as a whole
All other industry and trade shall be controlled to assist the wellbeing of the people
The Land Shall be Shared Among Those Who Work It!
There Shall be Work and Security!
The Doors of Learning and Culture Shall be Opened!
Education shall be free, compulsory, universal and equal for all children
There Shall be Houses, Security and Comfort!
These yearnings of oppressed people did not find much sympathy in (white) establishment
circles, whether political or economic. The 1960s were an era of high economic growth based
largely on high gold export earnings. To whites there appeared to be little reason to change
political or economic policies. In the ANC the struggle was transformed into an armed struggle
(in 1961).
Only in the mid-1970s did voices in influential Afrikaner circles start to argue for the ‘free
market philosophy’ (notably economists such as Jan Lombard and Nic Wiehahn). By this
time, the National Party government increasingly associated socialism with the communist
threat. In addition, the latter had a very immediate presence in the form of support from
the USSR and China for liberation movements, the armed struggle and the border war.
Moreover, movements such as the ANC, Azapo and the PAC propounded various socialist
solutions for the South African economy and state. Thus, government sympathies started
to shift towards the free market ideology, a move encouraged by good relations with the
conservative UK government of Margaret Thatcher. In the early 1980s, the National Party
government and the business sector openly moved closer together around the free market
theme. Labour market liberalisations led to a new era for labour unions.
By the late 1980s, the first meetings (in Europe) between domestic economists/
businessmen and ANC economists-in-exile revealed a large gap between, respectively, free
market capitalist proponents and pro-state, socialist proponents – with a few outsiders
arguing for a Third Way, but without much success. In the years that followed, intense
lobbying and debate took place behind the scenes. After the 1994 election, the new ANCdominated government took a surprisingly conciliatory line with regard to key elements
1.8 Main perspectives in the economic debate in South Africa
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of the economy, notably property rights and private ownership of the economy (after
propounding nationalisation for many years), central bank independence, monetary and
fiscal discipline, a firm anti-inflationary stance, international trade liberalisation and so
forth. It had already adopted many elements of the Washington consensus, as noted above.
The adoption of the RDP (1994) and the GEAR (1996) policies followed, harbouring
elements of both (a) a state-directed approach to development and redress, and (b) a
market-based, business-oriented approach to economic policy. This was an evolving form
of social democracy, one could say. But it was a highly contested one, squeezed between
players such as, on the one hand, the more socialist Cosatu and the SACP, and, on the
other, the ANC government, often supported by the business sector (by now with a growing
black and black empowerment component).
At the time of the 2009 election, the role of the SACP and Cosatu in the so-called tripartite
alliance appeared to be gaining influence in ANC economic thinking. However, in the
following years the SACP fully submitted to the ANC approach without protest. Then,
in the run-up to the 2014 election, significant internal divisions developed in Cosatu,
particularly with respect to the economic policy component of the National Development
Plan (NDP). Numsa, Cosatu’s largest affiliate, together with a number of smaller Cosatu
affiliates, distanced themselves from the NDP and withdrew their support of the ANC in
the 2014 national election. These unions also broke away from Cosatu and formed the SA
Federation of Trade Unions (SAFTU). In 2018 Numsa established a Socialist Revolutionary
Workers Party (SRWP) as a ‘Marxist-Leninist political party fighting to overthrow the
brutal capitalist system’ – but it did not receive many votes.
Other political breakaways from the ANC were the Economic Freedom Fighters (EFF) as
well as new, non-Cosatu labour formations such as the Association of Mineworkers and
Construction Union (AMCU) (opposing ‘democratic capitalism’ and ANC policies) and
SAFTU (with its proclaimed ‘revolutionary and socialist orientation’). These signalled
a growing split in groupings on the left of the political spectrum – between those with
stronger class-based and socialist (or democratic socialist) views and those with stronger
social democratic views.
Alongside this big debate, parties such as the Democratic Alliance continued to represent
the more business- and market-oriented part of the political-economic spectrum (liberaldemocratic albeit with a social conscience) – but with signs of a growing social-democratic
component since 2015.
These broad political divisions would continue to shape the South African debate, also on
economic policy, in the years to follow.
❐ By developing a political party spectrum that is differentiated mainly on the basis of
economic policy – notably the role of government in the economy – South Africa would
join large parts of the world where economic ideology and policy are the main dividing
factors among political parties in elections.
Left, right or centre – or what?
Sorting out the left and the right in South Africa is not easy. Unlike other countries, we have
always had a left-to-right on politics and another one on economics. And the two have not
necessarily corresponded.
❐ The political left-to-right has always been along race-and-culture views, politics and policies.
❐ The economic left-to-right, as in other countries, is along views on market vis-à-vis state.
40
⇒
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⇒
Politically left and right – a race-based spectrum
Political conservatives, in terms of race-based paradigms, are the political right or far-right.
In the old South Africa, the National Party considered themselves moderate/centre, with the
Conservative Party (later the Freedom Front) on the right wing, the Democratic Party (later
the Democratic Alliance) viewed as ‘left’, and the ANC and PAC far out off the cliff on the
radical left. From the viewpoint of the ANC and PAC, the DP was centrist at best; the rest were
varying degrees of right and far-right. The ANC and its affiliates have always been proudly left.
While racial attitudes and politics still feature resiliently at grassroots level, South African
political parties today are increasingly differentiated according to their view on the economy
rather than on race and identity, as follows:
Economically left and right – a market-state spectrum
The basic positions can be defined as follows:
❐ Economic conservatives = free marketeers = economically on the right wing (several
variants of ‘classical liberals’ and libertarians: US Republican Party; UK Conservative
Party; South Africa: elements of the DA).
❐ Economic liberals = mixed economy moderates = economically centrist (several variants:
US: ‘bleeding heart’ liberals = Democratic Party; UK New Labour Party; European Social
Democratic Parties; South Africa: post-1994 Mandela-Mbeki ANC; centrist wing of the
current ANC; elements of the DA).
❐ Economic radicals = critical of market economies, neo-Marxist = economically leftist (Old
UK Labour Party; European Democratic Socialist Parties; European Communist Parties;
South Africa: pre-1994 ANC; left wing of post-1994 and current ANC, SACP and elements
of Cosatu; Saftu; Numsa and SRWP; EFF; AMCU).
1.9
Analytical questions and exercises
1. Discuss economic growth and price stability as objectives of macroeconomic policy.
Refer to all possible complementarities and/or trade-offs that might exist between
these two objectives, and also discuss the most current trends in the indicators that
are associated with these objectives.
2. The clearest indicator of South Africa’s worsening position globally has been the
sustained fall in the rand since 2011, frequently due to foreign investors selling SA
bonds and equity. In the first six months of 2019 alone, foreign investors withdrew
about R70 billion from South African bond and equity markets. What could this
imply for the pursuit of economic growth and development? Also explain how the
macroeconomic goals of balance of payments stability and price stability are affected.
(In Chapter 4 you will encounter a detailed analysis of the international context.)
3. Discuss price stability as an objective of macroeconomic policy in South Africa. In your
discussion, clearly define what is meant by the objective, and indicate how inflation
affects low-income households and pensioners, as well as borrowers and investors
respectively. Provide most recent values of suitable indicators of the situation.
4. ‘To solve South Africa’s unemployment problem, there is only one solution: the
economic growth rate needs to be increased.’ Critically discuss this statement with
reference to employment trends and various types of unemployment. (In Chapter 12
you will learn much more about employment and unemployment.)
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5. Discuss economic growth and the redistribution of income as objectives of
macroeconomic policy. In your discussion, clearly define what is meant by each
objective, and indicate any complementarities and/or trade-offs between these
two objectives. Provide most recent values of suitable indicators to measure these
objectives in South Africa.
6. Explain the possible effect of a higher inflation rate on interest rates and related
impacts on low-income groups and pensioners earning fixed interest income.
7. During the first two quarters of 2018 South Africa experienced consecutive negative
quarterly economic growth rates for the first time in many years – following steady
declines in the GDP growth rate since 2011. Can such a decline have any significant
effects on the country’s economic development? Discuss with reference to the
relationship between economic growth and economic development.
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The basic model I:
consumers, producers and government
2
After reading this chapter, you should be able to:
■ construct a basic model of production and income determination;
■ use the model to explain why and how total income in the economy tends to
fluctuate over the course of the ‘business cycle’;
■ compare and explain the behaviour of the main components of expenditure in an open
economy, i.e. consumption, investment, government expenditure, imports and exports;
■ compose chain reactions (or ‘chain reasoning’) to analyse the way changes in
economic variables (taxation, interest rates and so forth) or external disturbances work
dynamically through the economy; and
■ use graphical aids to support and critically evaluate your economic reasoning.
Unemployment, inflation, interest rates, exchange rates, the balance of payments, the
gold price, the budget, public debt, taxation, Reserve Bank policy – these issues are
what macroeconomics is all about. They deeply affect all our lives, whether as student,
household consumer, investor, business manager, employee, labour union member or
government official. News coverage and political-economic debates show the importance
of macroeconomic events and issues in these times, with the added complication of
concurrent development challenges.
As noted in chapters 0 and 1, the objective of this book is to enable you to think and reason
about actual macroeconomic events and policy. It does so by systematically building a
comprehensive framework of analysis (i.e. a theory or model of the macroeconomy) that
you can use to analyse events – in conjunction with a thorough intuitive grasp of the issues
and a concrete feel for South African economic processes, institutions and data.
As a first step towards understanding the operation of the economy, we consider, in this
chapter, the simple Keynesian theory of income determination. This theory was designed
originally to explain recessions and periods of unemployment. It emphasises the nature and
causes of short-run fluctuations in real domestic income and employment.
❐ The short run is a period usually thought to be up to three years. In later chapters
(chapters 6 and 7) we will also encounter adjustments, notably on the supply side of
the economy, that occur in the so-called medium term. This can be thought of as lasting
another three to seven years. The typical average for both processes, allowing for some
overlap, is approximately four to seven years. Short- and medium-term changes and
adjustments are frequently discussed in the context of business cycles with references
to ‘booms’ and ‘busts’, ‘upswings’ and ‘downswings’. Both the short- and medium-term
periods can be distinguished from the very long term, with a time horizon measured in
decades, which is the topic of economic growth (chapter 8).
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The simple model focuses on the so-called real sector (or goods sector) of the economy, where
real economic activities such as production, consumption, saving, investment, imports
and exports occur. The theory can, therefore, help us understand the short-run course of
the South African economy, especially the course of gross domestic product (GDP).
❐ You would have encountered this theory in an introductory economics course. This
chapter will, therefore, review this material in a summary fashion. Still, important
intuitive insights and new analytical abilities will be developed.
While the interest rate plays a major role in this chapter, its full explanation is left to
chapter 3, where the monetary sector – the world of financial institutions, money and
interest rates – is added to the framework. Chapter 4 considers matters such as the balance
of payments and exchange rates (the foreign sector).
The price level, which is essential for an analysis of inflation, is a prominent variable
in more modern versions of Keynesian theory. However, for explanatory reasons, this
is brought into the analysis only in chapter 6. (Inflation gets a thorough treatment in
chapters 7 and 12.)
❐ In the simple Keynesian model we assume, for the time being, that the average price
level P remains constant. While obviously unrealistic, it does not affect the initial
results of the analysis materially. And it is helpful to make things clear at the start. We
will relax this assumption in chapter 6. At the end of this book the model will be fully
developed and quite sophisticated.
❐ Nevertheless, throughout the book we will define all concepts and relationships in such
a way that the place of the average price level P (and the inflation rate π where appropriate) is evident.
Allowing for changes in the average price level P, and for inflation, brings us to the use of
the term ‘real’ in another context.
❐ This is the difference between so-called nominal values of economic variables (e.g.
nominal GDP) and real values of variables (e.g. real GDP). For example, nominal GDP
is the value of total output measured in terms of the current prices of goods and services.
The presence of inflation can inflate the measured value of a nominal variable artificially.
In real values this artificial inflation has been removed to reveal the true, underlying
change in a variable. Thus real GDP is the value of total output expressed in the prices
of a base year, e.g. 2010. It is also called GDP at constant prices. The significance of this
distinction will become clear as we proceed.
Inflation and the distinction between real and nominal
Working with variables and data in an inflationary context requires an acute awareness of the
difference between nominal and real values. It must be taken into account in the way values
are measured. The following are useful formulae:
Real values (e.g. GDP) = Nominal value (of GDP, say) deflated with a price index, i.e.
divided by a suitable price index
Real GDP growth rate = Nominal growth rate – inflation rate
[approximately]
Real interest rate
[approximately]
= Nominal interest rate – inflation rate
One must also ask whether certain economic behaviours reflect a reaction to a nominal value
or to a real value of a variable. For example, real investment reacts to real interest rates, but
money demand reacts to nominal interest rates (see sections 2.2.2 and 3.1.2).
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❐ Except where explicitly indicated otherwise, we will be concerned with real values of
GDP, income, consumption, investment, interest rates and so forth – without always
adding the adjective ‘real’.
In this chapter we focus on the determination of total production and real income in the
short run. This is measured in terms of real GDP. Changes in real GDP are reflected in the
business cycle (short-run fluctuations – i.e. upswings and downswings – in the economy).
Table 2.1 provides pertinent information on the business cycle in South Africa.
Table 2.1 Business cycle upswings and downswings in South Africa since 1968
✍
Upswings
Downswings
Jan 1968 – Dec 1970
Jan 1971 – Aug 1972
Sept 1972 – Aug 1974
Sept 1974 – Dec 1977
Jan 1978 – Aug 1974
Sept 1981 – March 1983
April 1983 – June 1984
July 1984 – March 1986
April 1986 – Feb 1989
March 1989 – May 1993
June 1993 – Nov 1996
Dec 1996 – Aug 1999
Sept 1999 – Nov 2007
Dec 2007 – Aug 2009
Sept 2009 – Nov 2013
Dec 2013 –
Note the variability in the duration of both upswings and downswings, the average duration of each being approximately
30 months, so that a full cycle takes approximately 5 years on
average. The recession of 51 months from March 1989 to May
1993 and the almost decade-long upswing after September 1999
have been the longest since the second World War. (See graphs in
section 1.3.1.)
* The official turning points are determined by the Reserve
Bank after a statistical analysis of approximately 230 time
series as well as consideration of economic events in the
vicinity of a possible turning point. The data requirements
cause a long time lag in the official announcement of a
turning point date.
Source: Key Information. Reserve Bank Quarterly Bulletin.
Approximately how many trillion rand was the GDP of South Africa last year?
_____________________________________________________________________________________
What is the definition of GDP?
_____________________________________________________________________________________
What is the difference between nominal and real GDP? Why is this difference important?
_____________________________________________________________________________________
What was the approximate growth rate in South Africa since 2010? How does it
compare with previous decades? How does one measure the growth rate?
_____________________________________________________________________________________
(Consult the formulae, tables and graphs in chapter 5 and chapter 1, section 1.3.)
DATA TIP
Macroeconomic data: which source?
The main source of macroeconomic data in South Africa is the Quarterly Bulletin of
the South African Reserve Bank. It is available from the Bank or from libraries, or at
www.resbank.co.za
For employment and unemployment data, the main source is the Quarterly Labour Force
Survey (QLFS), published by Statistics South Africa. It is available at www.statssa.gov.za
Tables and graphs depicting the course of the main macroeconomic variables in South
Africa can be found throughout this book.
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2.1
The basic framework
The crux of the original Keynesian approach is that the explanation of changes in production
and income, particularly in the short run, is to be found in fluctuations in total expenditure in the
economy. Thus, in the short run, total expenditure in the economy is at the centre of the action.
If that can be explained, the decisions that lead to (or are reflected in) the macroeconomic state
of the economy can be understood. Therefore, the basic Keynesian model is an expenditureor demand-determined model. (Later versions of the model also take the supply side into
consideration – see chapters 6 and 7.)
The significance of expenditure is that it induces and determines production decisions.
In the simple model, we more or less assume that the production (or supply) side of the
economy – the decisions of producers to produce – will respond without difficulty or delay
to changes in total expenditure. (This assumption will be relaxed in chapter 6 to make
the model more realistic.) Each level of production implies a corresponding level of real
domestic income. Depending on the methods of production chosen by producers, this is
likely to have some effect on employment.
The idea of an income-expenditure circular flow is very useful to illustrate the Keynesian
approach (see figure 2.3). It shows the circular flow of expenditure and income between
two key groups of role-players in a simple economy: households (consumers) and firms
(producers).
❐ In a more complete diagram, one will also indicate a public sector (state), a monetary
sector and a foreign sector. A complete circular flow diagram can be found at the beginning of chapter 6; also compare the one at the end of this chapter.
What we study on the macroeconomic level is the aggregate of activities taking place on a microeconomic level. The circular flow is a simplified representation of all transactions in the economy.
To see this, consider the three transactions (or exchanges) portrayed in figure 2.1.
There are three types of transaction:
1. A goods market transaction where Vusi buys vegetables from Vuyelwa’s grocery store.
In exchange for the vegetables, Vuyelwa’s store receives payment in the form of money.
Figure 2.1 Three types of transaction
A goods market transaction
Vuyelwa’s grocery store
(Firm)
Expenditure on goods
Vegetables
Vusi and his family
(Household)
A factor (labour) market transaction
Vuyelwa’s grocery store
(Firm)
Labour services
Wages
Sylvia
(Household)
A factor (capital) market transaction
Vuyelwa’s grocery store
(Firm)
46
Capital (funds)
Interest
John
(Household)
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2. A labour market transaction where Vuyelwa’s store employs Sylvia. In exchange for
her labour services, Sylvia receives a wage/salary from Vuyelwa’s grocery store.
3. A financial (or capital) market transaction where John buys shares in Vuyelwa’s
grocery store, or where John extends a loan to Vuyelwa’s grocery store. In exchange
for the capital funds invested in Vuyelwa’s grocery store, John receives dividends and/
or interest.
The labour and financial markets both are factor markets – labour and capital are factors
of production. Grouping them together, distinct from goods market transactions, and
aggregating all such transactions in the economy, one can represent the two types of
transaction between all firms and all households as follows:
Figure 2.2 All transactions together
Total expenditure
Goods
Firms
Households
Factors of production
Factor payments (income)
If we focus only on the flows of income and expenditure between firms and households
(and thus disregard the flows of factors and goods), the circular flow in the entire economy
can be represented as shown in figure 2.3:
Figure 2.3 A basic circular flow
Expenditure flow
(Payments for
goods)
FIRMS
(Producers)
HOUSEHOLDS
(Consumers)
Income flow
(Factor payments)
Our main concern now is the aggregate amount of real income that ends up in the pockets
of households and individuals in the bottom half of the circle. The volume of real income
flowing in the bottom half of the circular ‘tube’ depends on the volume of expenditure in
the top half. If the flow of total expenditure increases, for example, it is likely to induce
decisions to increase production to meet the increased expenditure. This implies a
corresponding adjusted level of sales and real income Y. The same is true for decreases in
2.1 The basic framework
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expenditure, which initially lead to unsold products and stock increases, to be followed by
a drop in production, income and employment (i.e. a recession).
This reasoning provides us with the first and basic chain reaction: changes in expenditure
cause adjustments in production and real income. When production has adjusted fully to
a change in total expenditure, a situation of macroeconomic equilibrium occurs. In such
a situation, neither expenditure nor production has any further reason to change, and
therefore income stabilises on a certain level. All demand/expenditure is satisfied, and all
production is sold. At such an equilibrium, the following condition is satisfied:
Total expenditure = Total production
In Keynesian theory, both short-run fluctuations and trends in real domestic income Y
are interpreted as changes in this equilibrium, or at least as movements towards a new
equilibrium point. Therefore, it is an equilibrium approach. Changes in the equilibrium level
of income are caused and explained by changes in total expenditure.
❐ Accordingly, a low level of income and employment – a recession – is caused by a too
low level of aggregate expenditure, i.e. a demand deficiency.
Figure 2.4 The business cycle: fluctuations in real GDP relative to its long-term trend
3 600
3 100
Acute recession
Strong upswing
R billion
2 600
2 100
Severe recession
1 600
Mild recession
2018/04
2017/03
2016/02
2015/01
2013/04
2012/03
2011/02
2010/01
2008/04
2007/03
2006/02
2005/01
2003/04
2002/03
2001/02
2000/01
1998/04
1997/03
1996/02
1995/01
1993/04
1992/03
1991/02
1990/01
1988/04
1987/03
1986/02
1985/01
1983/04
1982/03
1980/01
600
1981/02
1 100
Source: South African Reserve Bank (www.resbank.co.za).
Figure 2.4 shows cyclical fluctuations in real GDP around the long-term real GDP trend (or
potential GDP) of South Africa since 1980. Note the significant fluctuations from 1980 to 1993
and in 2008–09 and the smaller fluctuations around a strong upward trend in between.
A slowdown (or mild recession) occurs when the GDP data line becomes less steep, even
though it may still be increasing. A proper recession occurs when the data line drops below
previous levels of GDP. The ‘technical definition’ of a recession is two (or more) successive
quarters of negative growth in GDP. A generic definition of a recession is: a significant decline in
economic activity spread across the economy, lasting more than a few months, normally visible
in real GDP, real income, employment, industrial production, and wholesale and retail sales.
48
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Is a macroeconomic equilibrium a good thing?
Not necessarily, even though the concept of ‘equilibrium’, especially in the natural sciences but
also in everyday language, has a positive connotation (balance, harmony, etc). One of the main
contributions of Keynes was to show that an equilibrium does not necessarily occur at full
employment and, especially, that an economy can attain equilibrium and stabilise (stagnate) at
levels of high unemployment for considerable periods of time. In this way, he sought to explain
the Great Depression of 1929–33.
❐ This view contrasts strongly with the Classical or pre-Keynesian view that, given unfettered
markets, the economy will always tend towards a stable equilibrium with full employment.
Times of unemployment are temporary aberrations at most, in the Classical view.
❐ Today this view, or variations of it, can be found in the New Classical or Monetarist
approaches, for example (see chapter 11, section 11.3.4 as well as chapter 12, section 12.2.2).
A more complete chain reaction would run as follows:
Suppose total expenditure increases. At existing production levels, production is less than
the new level of expenditure. This will be apparent in a decrease in the stocks of producers,
which is a sign and inducement for producers to adjust their production levels to the new
expenditure levels. When (and if) they decide to do so, total production will increase
(as measured in terms of real GDP) and so will employment. The real income from the
increased sales flows to the different factors of production – managers, workers, land
owners, shareholders, other input suppliers, etc. – and real domestic income Y increases
correspondingly. This increase is bound to continue until production is equal to the new,
higher level of total expenditure – i.e. until a new and higher equilibrium level of real
income Y is reached. An economic upswing occurs.
In brief:
Total expenditure increases ⇒ stocks are depleted ⇒ increased production is induced ⇒
real GDP and real income Y increase
The role of stock adjustments is central in this chain reaction.
The entire Keynesian approach centres on this fundamental chain reaction. It enables
one to identify the likely causes of short-run fluctuations in real income Y, or the likely
consequences of fluctuations in expenditure.
❐ We will see in this chapter and others that there are different types of real expenditure
(e.g. consumption and investment) and that changes in these will cause changes in total
expenditure. Once total expenditure changes, the rest of the chain reaction remains
the same. In this way, one can gain insight into the causes of upswings or downswings
in the economy, or increases or decreases in the real economic growth rate.
The rest of the theory consists of a refined focus on real expenditure. It focuses on two
aspects:
(a) To understand and explain trends and fluctuations in expenditure as such, and
(b) To relate and translate all other disturbances and shocks in the economy – changes
in interest rates, the money supply, taxation, VAT, the gold price, the exchange rate,
the balance of payments (BoP), etc. – into one or another impact on (a component of)
expenditure. If this has been derived, the likely impact on production and real income
Y follows more or less automatically.
2.1 The basic framework
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The income–expenditure diagram or ‘45°
diagram’ shown in figure 2.5, is the basic
graphical aid of the simple Keynesian
approach. This shows the real sector (or goods
sector) of the economy, and illustrates the
interaction between total expenditure E and
total production to determine the equilibrium
level of real income Y. The graphical indication
of this level is where the total expenditure
line intersects the 45° line. Only at that level
of Y (i.e. Y0) will total production (measured
horizontally) be equal to total expenditure
(measured vertically). Any other Y level is
a disequilibrium level, since production can
be seen to be either higher or lower than
expenditure.
Figure 2.5 Equilibrium income determination
E
45° line
Aggregate
expenditure
Y0
Income Y
In other words, only at Y0 is the condition for macroeconomic equilibrium satisfied: Total
expenditure = Total production.
Any disturbance of, or fluctuation in, total expenditure is graphically reflected in vertical
shifts in the total expenditure line, with a corresponding change in the equilibrium level
of real income Y.
!
Does an economy have curves?
:
The usefulness of a graphical aid for sensible economic thinking and reasoning – our main
purposes – must be understood carefully. Its use is that it can serve:
❐ as a guide or ‘road map’ to indicate where an economic chain of logic (‘chain reasoning’) must
end up, or
❐ as an ‘afterwards test’ to check whether one’s thinking on the expected chain of consequences
of a disturbance has been correct.
Therefore, graphical manipulations and economic reasoning must occur in parallel. One should
always be able to use both of these methods.
The graphical illustration as such has no economic meaning. It is not an explanation of an
economic event to say that this or that line or curve or equilibrium point has shifted. An economy does not
have curves, and curves cannot explain economic events. Graphical depictions have meaning only
if used to support and supplement economic thinking and reasoning. The latter – the economic
explanation of the dynamic path between two equilibrium points – is ultimately what matters.
2.2
The real (or goods) sector
The basic thrust of the Keynesian approach is to understand, explain and anticipate
the behaviour of total expenditure. This is done by dividing total expenditure into different
components of expenditure. Each of these components can then be analysed using the
chain reaction set out above.
The main components or types of expenditure are consumption expenditure C, capital
formation (or investment) I, government expenditure G, and net exports, i.e. exports X
less imports M.
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Therefore:
Total expenditure = C + I + G + (X – M)
In the explanation of macroeconomic events, these types of expenditure are distinguished
because they are determined and explained by different factors, and flow from the decisions
of different agents with different motives and ways of decision making. For example, real consumption expenditure patterns are determined by other factors compared to real investment
behaviour, while decisions on government expenditure are something quite different. Different
decision-makers with different concerns are at work in each case. Therefore one has to distinguish between them and analyse their actions separately to understand events (i.e. if one
wants to develop a theory of expenditure and income).
Expenditure components: which data?
DATA TIP
The main source of data on the components of aggregate expenditure is the Quarterly
Bulletin of the Reserve Bank, in particular the national account section.
❐ The table ‘Expenditure on gross domestic product’ summarises the main expenditure
items of the real sector. Subsequent tables give detailed information on individual
components, e.g. consumption and capital formation (investment). The data are
presented in various formats and also disaggregated in various ways.
❐ The national accounts are explained in chapter 5, section 5.6 which shows the relation
between the different accounts and tables. Chapter 5 also contains many figures with
pertinent data on expenditure components.
The graph in figure 2.6 shows the behaviour of the main domestic expenditure components
for South Africa since 1960: consumption expenditure by households, gross fixed business
capital formation, and total expenditure by general government (all in real terms, constant
2010 prices). Observe the relative magnitudes of these categories of expenditure and
Figure 2.6 The components of aggregate expenditure (in real terms – 2010 prices)
2 000
1 800
Household consumption
1 600
1 400
R billion
1 200
1 000
800
600
Government expenditure
400
2017/04
2016/01
2014/02
2012/03
2010/04
2009/01
2007/02
2005/03
2002/01
2000/02
1998/03
1996/04
1995/01
1993/02
1991/03
1989/04
1988/01
1986/02
1984/03
1982/04
1981/01
1979/02
1977/03
1975/04
1974/01
1972/02
1970/03
1968/04
1967/01
1965/02
1963/03
1961/04
1960/01
0
2003/04
Business capital formation
200
Source: South African Reserve Bank (www.resbank.co.za).
2.2 The real (or goods) sector
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how they behave in relation to the upswings and downswings in real GDP. Note that both
household consumption and the fixed capital formation cycle broadly correspond with the
GDP cycle, although clearly more complex causalities are at work.
Traditionally, consumption and investment constitute the core of the theory, with other
components added on.
2.2.1
Real consumption
Real consumption C pertains to expenditure by households on consumable items and
services such as clothing, food, sport, movies, transport, medical services, books, pencils,
computers, fridges, lawnmowers and vehicles. Expenditure on imported items is included
in total real consumption expenditure.
❐ Total consumption expenditure is usually a very stable component of aggregate
expenditure.
❐ The national accounts for South Africa, discussed in more detail in chapter 5, section
5.6 (and for which data tables can be obtained from www.resbank.co.za), distinguish
between ‘consumption expenditure by households’ and ‘consumption expenditure by
general government’. This section deals with ‘consumption expenditure by households’,
usually denoted by C, while a later section deals with ‘consumption expenditure by general
government’, usually denoted by, or as part of, G. When discussing ‘consumption’ in this
book, ‘consumption expenditure by households’ is meant.
On what does consumption depend?
If one wishes to explain consumption expenditure, one usually thinks of the purchases
by individuals or consumers. Business enterprises also buy consumable items. In most
economic reasoning we will usually think mainly in terms of individuals or households.
Real consumption C depends on (or, is a function of) real disposable income YD, wealth,
the average price level, expectations, habits, etc.
C = f(real disposable income YD; wealth; expectations; habits;
demographic factors, etc.)
This means that the decisions to spend income on consumption goods largely are
determined (or caused) by these factors. Some of these factors have a positive impact on
consumption expenditure, others a negative impact.
❐ Of all these factors, the most important is the level of real disposable income YD.
Disposable income is the part of income Y that remains after taxation T has been paid
or subtracted (YD = Y – T).
❐ If real disposable income increases, individuals and households are likely to increase
their consumption spending. Decreasing real disposable income will depress total
consumption. Therefore, there is a positive relationship between real disposable income
and consumption.
❐ The part of disposable income that is not spent on consumption is saved. Therefore
saving also depends on disposable income.
❐ The essence of the relationship between real consumption and real disposable income
can be found in the marginal propensity to consume (MPC).
❐ A tax increase will decrease disposable or after-tax income, which should discourage
consumption spending. Here one finds a negative or inverse relationship between taxes
and consumption.
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✍
One can distinguish between durable, semi-durable and non-durable consumption, as well as
services. Can you mention examples of each?
_______________________________________________________________________________________
_______________________________________________________________________________________
_______________________________________________________________________________________
Visit www.resbank.co.za and download the annual data series, both at constant and current
prices, for total, durable, semi-durable and non-durable consumption, as well as services for the
period 1990 until the latest year available. Place these on a couple of graphs and describe what
you see. What is the difference between the constant and current prices?
_______________________________________________________________________________________
_______________________________________________________________________________________
Which percentage of gross domestic expenditure (GDE) does consumption C represent in South
Africa (approximately)?
_______________________________________________________________________________________
✍
Define the marginal propensity to consume (MPC). How is it related to the marginal propensity to
save (MPS)?
_____________________________________________________________________________________
_____________________________________________________________________________________
❐ If levels of wealth increase, people are better off, which encourages consumption spending. It is reasonable to expect a positive relationship between wealth and consumption.
A prominent example is the positive effect of rising stock market prices on wealth and
thus on consumption.
❐ If the average price level increases, the real value of assets will decrease. This decreases
the wealth of people and discourages consumption. In this way, the average price level
can have a negative impact on consumption.
The consumption function
The relationship between real consumption and real income, i.e. the consumption function,
can be expressed in mathematical terms as:
C = a + bY + . . . ...... (2.1)
This function can be depicted graphically on the income-expenditure diagram, as in
figure 2.7. The consumption line shows, for each level of Y (real income), the corre­spond­ing level of C (real consumption expenditure in the country), e.g. Y0 and C0 in the
figure. It depicts the overall behaviour of consumers and largely explains the level of
consumption in terms of real income.
The positive slope indicates the positive relationship between real consumption and real
income: as income Y increases, an increase in consumption C is induced. When income
decreases, consumption should decrease. The induced change in consumption expenditure is less than the change in income, therefore 0<b<1.
2.2 The real (or goods) sector
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❐ The slope of the consumption function is
directly related to the marginal propensity
to consume. (How?)
❐ Graphically, any change in consumption
due to a change in Y is indicated by a
movement on or along the C line.
❐ A change in one of the other factors that
determines consumption implies, graphically, a shift of the C line. If wealth levels
increase, for example, the C line is shifted
upwards. If taxation is increased, the C
line is shifted down. For simplicity, these
factors are captured by changes in the
intercept a in the consumption equation.
Figure 2.7 Keynesian consumption function
C
C = a + bY
C0
a
Y
Income Y
0
The intercept term, a, thus represents autonomous consumption, i.e. the portion of
consumption that is not sensitive to income levels and would occur irrespective of the level
of income. It can be interpreted, for instance, as a minimum existence level of consumption.
More complex relationships between consumption and income
The above consumption function is known as the ‘Keynesian consumption function’, as John
Maynard Keynes was one of the first major economists to define the relationship set out above
between income and consumption. After Keynes, a number of economists have suggested
more complex relationships between income and consumption. For instance, in his Relative
Income Theory, James Duesenberry has argued that consumption is not so much determined
by the absolute level of income but also by the income of the individual or households relative
to that of friends or neighbours, or relative to higher levels of their own income in an earlier
period. The latter implies that households are reluctant to scale down consumption if income
decreases after a period with higher levels of consumption.
Duesenberry’s Relative Income Theory was an early attempt to refine Keynes’s consumption theory. However, the best-known consumption theories following Keynes are the Permanent Income Hypothesis of Milton Friedman and the Life-cycle Hypothesis of Franco
Modigliani.
Permanent income: Friedman argues that a household’s consumption depends not so much
on the cur­rent income of a household at a cer­tain time but rather on the level of income
that this household expects to earn normally.
❐ What a household considers as normal depends on what it expects to earn in future.
This level of normal income is called its ‘per­manent income’ and is distin­guished from
unexpected, ‘tran­sitory income’ – usually measured as the difference between its
ac­tual and permanent income.
❐ When actual income decreases to below its normal or permanent level, households will
borrow or use savings to sustain consump­tion levels. When actual income increases
above the normal or permanent level, households will rather save than consume more.
This implies an element of stabil­ity in consumption patterns, since the consumption
expenditure of households will not react much to temporary or transitory increases or
decreases in income.
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Consumption smoothing and life-cycle income
The Keynesian consumption function is altered to become:
Y
(1 + r)
Ct = 
​  1 ​ (Yt + ​∑t​ + i
​​ ​ t + i i ​+ At )
N
T
where Ct is current consumption (in period t), Yt is current wage income (in period t), Yt + i is
expected future income in period t + i, r is the discount rate used to arrive at the present value
Yt + i
of the future income, ∑​ 
​, At is the present value of wealth (e.g. bonds, shares or property),
(1 + r) i
N is the amount of years that the individual expects to work and T is the amount of years that
the individual expects to live.
❐ Essentially this equation states that individuals sum all their current and expected future
income, add their existing wealth, and then divide it over the amount of years that they
expect to live, so as to establish what amount they can consume per period.
❐ From this equation it can be seen that a R1 change in Yt will cause consumption to only
Y
change by the rand amount __
​ Tt ​
❐ If consumption in a particular period does not match income, individuals can borrow
money at the prevailing interest rate. This introduces a role for the interest rate into the
consumption function. In addition, a higher interest rate will decrease the value of wealth
(i.e. bond and share prices, even house prices), which in turn will cause a decrease in
consumption.
Life-cycle income: According to this theory, households and individuals plan their
expenditure given an expected pattern of income over their entire life­time. Young people,
who have rela­tively low earnings, will borrow to support higher levels of consumption
– in expectation of higher earnings later in their careers, when the debt can be repaid.
This later period in their ca­reers, with its higher earnings, is also used to save for old age,
when income is likely to fall below consumption. This also means that con­sumption does
not only depend on in­come but also on assets (wealth). All this means that consumption
is likely to be relatively stable over the life cycle, and will in any case vary less than
in­come – a phenomenon called con­sumption smoothing. Therefore, this argument
implies an element of stability in this component of expenditure.
The permanent income and life-cycle hypotheses both require an al­teration of the Keynesian
consumption function. They imply that consumption becomes a function of income over a
longer time horizon. More specifically, a house­hold’s consumption depends not so much on
current income but on the expected future income stream of the household, plus its wealth.
Thus con­sumption will be averaged, or smoothed, across periods and will be less volatile than
income when income varies across periods.
❐ Note that consumption in these al­
ternative theories does not include durable
consump­tion. The latter is considered as investment from which households derive
a benefit (called an im­puted income). The total amount spent on buying a car or a
washing machine, for example, is not included in the consumption of the period in
which it was purchased. Rather, the benefit (consumption) is spread over the life span
of the asset. (This means that the annual depre­ciation of the asset must be counted as
part of consumption.)
2.2 The real (or goods) sector
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The distribution of income: It is likely that poor, middle-income and rich households have
different marginal pro­pensities to consume. Poor house­holds usually have a higher MPC – they
have little choice but to consume most of their income. A redistribution of income from highincome to low-income households can, therefore, cause an increase in total consumption.
Poor households are also often con­strained in their ability to borrow. Thus, poor households
might not be able to smooth their consumption over time and they are, therefore, much more
ex­posed to the effects of income fluctua­tions.
These alternative theories are important if one wants to understand empirical patterns
in income and consumption in depth. For understanding most macro­economic chain
reactions, they are of lesser importance, though, and it is suf­ficient to work with the
simple Keynesian consumption function most of the time (although there are a couple of
notable exceptions).
2.2.2
Real investment (capital formation)
Real investment I is the purchase of production or capital goods, for example factories
or machinery – real assets on which a return is expected from the sales of production.
(Expenditure on imported capital goods, e.g. machinery, is included in total investment.)
❐ Typically, real investment is a very unstable element in the economy. It is one of the
main sources of instability in a market economy.
❐ In the national accounts, investment is called ‘capital formation’. These two terms are
synonymous and are used interchangeably in this book.
❐ Study the behaviour of investment (business capital formation) in figure 2.6 to get a
feel for its relative size and its movement over time and over the business cycle.
✍
What is the difference between financial investment and real investment?
Financial investment is the purchase of financial assets, whereas real investment (capital
formation) is the purchase of real assets. The term ‘capital formation’ clearly indicates this.
Financial investment, however, is a form of saving. What is the role of the interest rate in the
case of financial investment, e.g. in deciding to invest in a savings account or certificate, or
another financial asset?
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
Is a purchase of shares real investment (capital formation) or financial
investment?
Does it depend on whether the shares are in a new project or existing shares? Are share
issues usually for specific investment projects or for a general addition to operational capital?
Does an investor usually know this? Does it matter?
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
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More specifically, what is of concern here is fixed investment: gross fixed capital formation
comprises the following components: residential buildings, non-residential buildings,
construction, transport equipment, machinery and other equipment.
The other (non-fixed) part of gross investment is change in inventories (or inventory
investment). This is merely a change in the unplanned and unsold inventory of produced
goods due to an imbalance between total production and total expenditure. It is not
investment in the true sense of the word. The value of change in inventories can also be
negative, i.e. when stocks are depleted in times when production is lower than sales.
Both these categories of real investment can also be divided according to the type of
institution involved – investment by private business enterprises IP, by public corporations
IPC and by general government IG.
Net capital formation differs from gross capital formation due to ‘consumption of fixed capital’,
which, in an accounting sense, can be understood as ‘allowance for depreciation’. Consumption
of fixed capital is supposed to measure that part of gross investment funds that is used for the
replacement of, for example, machinery. Net capital formation indicates the net addition to the
total capital stock.
In practice, it is not actual replacement that is measured, but an estimate of the wear and tear
or depreciation of assets over their normal life span.
The question is which types of investment to include. In macroeconomic reasoning,
one is usually concerned with explaining the investment activities of private business
enterprises. This is because general government investment IG, which is done by
government departments, is driven and explained by a very different set of factors,
mostly social and political. However, the behaviour of government business enterprises
or ‘public corporations’ is not that dissimilar from that of private firms in so far as they
have to avoid losses and must be active in capital markets. Also, investment by public
corporations IPC is not included in the concept of total government expenditure G, which
we will encounter in section 2.2.5, and thus not in the national budget either (the topic
of chapter 10). To ensure alignment with the latter, we will include investment by public
corporations in our definition of aggregate investment as comprising private and public
business fixed investment:
I = IP + IPC
DATA TIP
(Of course, some investment, e.g. in houses – i.e. residential investment – is done by
households. However, residential investment is relatively stable. In any case, it is not seen
as a driving force in economic growth or the business cycle in the way business investment
is. Hence the focus here is on understanding and explaining (private and public) business
fixed investment (capital formation).
In the national accounts and in published investment figures in for example the Quarterly
Bulletin of the Reserve Bank, gross capital formation comprises investment by all three
groups: private firms IP, public corporations IPC and government IG. One must therefore be
very careful when using investment figures for macroeconomic analysis: one must select
the non-government components of gross investment (capital formation).
2.2 The real (or goods) sector
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✍
Approximately what percentage of gross domestic expenditure (GDE) does business investment
constitute in South Africa?
______________________________________________________________________________________
Which factors determine business real investment?
The decisions of private and public business enterprises to invest largely depend on, and
are strongly influenced by, the following factors and variables:
Investment = f (real interest rates; expectations; business confidence;
regulations, etc.)
Real investment and the real
interest rate have an inverse or
Sensitivity vs. elasticity
negative relationship: an increase
This book refers to parameters in equations such
in the real interest rate is likely
as b and h as indicators of sensitivity. As slope
to discourage capital formation,
parameters, they denote the absolute change in one
while a decreased real interest
variable due to an absolute change in the other, such
∆x ​
rate is likely to stimulate capital
as ​ 
∆y
formation. This is so because the
Some macroeconomics textbooks incorrectly call
real interest rate is the opportuthese parameters elasticities. An elasticity measures
nity cost of capital formation.
the percentage change in one variable due to a
❐ The meaning of the term the
​ %∆x ​
percentage change in the other: 
%∆y
real interest rate was noted
One would only be able to call these parameters
in the introduction, and is
elasticities if, instead of the actual values of
explained in detail in the box
say, consumption and income, one uses natural
on the following page. Basically
logarithms of both the left- and right-hand variables.
it is the after-inflation rate of
interest. It is very important to
distinguish it from the nominal interest rate. Real investment behaviour is sensitive to the
real interest rate.
What is the meaning of the last statement? The real interest rate represents the return
that one could have earned by buying and holding bonds, and which one now forfeits
by investing in a real asset. Therefore it amounts to a cost item. Given expected rates of
return on planned investment projects, an increase in the interest rate (opportunity cost)
will make some projects, that were projected to be marginally profitable before, unviable
propositions. As a consequence, some projects will not be undertaken, i.e. real investment
is likely to decline.
❐ Note that it is not the real interest rate as such that is of importance, but the comparison
of the real interest rate with the expected real rate of return on the planned investment
project.
More formally, we can represent a very simple relationship between business investment I
and the real interest rate r as follows:
I = Ia  hr …… (2.2)
In this equation Ia is autonomous investment, i.e. the level that investment will be if the
interest rate is 0%. It can be understood to capture all the other elements listed in the
general formulation of the investment relationship above.
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Nominal and real interest rates – making sense in an inflationary context
Everyday experience in an inflationary environment can lead to confusion with measurements. This is
particularly true of interest rates.
If there is inflation a distinction should be made between nominal and real interest rates.
❐ Nominal interest rates are the rates usually mentioned when the bank charges a customer, say, the
‘prime rate’, or ‘prime-plus-one’, or when the Reserve Bank announces a change in the repo rate.
❐ Real interest rates are the effective interest rates after the eroding effect of inflation has been
removed.
A lender lending, for example, R1 000 to a borrower for a year would want a large enough amount of
money back after that year, first to provide a real return on the loan, and second to compensate for the
reduced buying power of every rand due to inflation. The real interest rate does the former. The nominal
rate is higher because it must also include compensation for inflation.
What then is the relationship between the nominal interest rate, the real interest rate and inflation, and
how does one calculate the real rate? There is a simple formula for this:
1 + i = (1 + r)(1 + π)
where i is the nominal interest rate, r is
the real interest rate and π is the inflation
rate. The nominal rate thus comprises the
following elements:
i = r + π + rπ
Since the last term of this equation, rπ,
usually is negligibly small, one can
approximate the nominal interest rate as:
Numerical examples
Suppose the real rate is 4% and inflation is 10%. Then the
nominal interest rate is:
Correct formula:
i = 0.04  0.1  (0.04)(0.1) = 0.144 (or 14.4%)
Approximate formula:
i≈r+π
i ≈ 0.04  0.1 = 0.14 (or 14%)
The approximate formula for the real interest rate is:
r≈i–π
while the precise formula is:
r = _____
​ 11 ++ πi ​– 1
The approximation can only be used when inflation and the real interest rate are fairly low.
The minus in the equation indicates that the relationship between I and r is inverse, i.e.
when the real interest rate increases, investment will decrease. The parameter h indicates
the sensitivity of investment to changes in the real interest rate r. A larger h indicates that
in­vestment is relatively more sensitive to a change in the real interest rate.
Graphically, the investment–interest-rate relationship can be depicted as in figure 2.8. Note that,
uncommonly, the dependent variable I is on the horizontal axis, and the independent variable r
on the vertical axis. Thus the intercept term of the investment function is on the horizontal axis.
The inverse economic relationship between real invest­ment I and the real interest rate
r is reflected graphically in a negative slope. Changes in the interest rate will influence
and determine the level of in­vestment. Graphically, this amounts to a movement along the
investment curve or function.
2.2 The real (or goods) sector
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✍
This negative relationship is true whether one borrows funds for capital formation or whether one
uses one’s own funds. Why?
______________________________________________________________________________________
______________________________________________________________________________________
Is there a positive or a negative relationship between financial investment and interest rates?
Why?
______________________________________________________________________________________
______________________________________________________________________________________
❐ The intercept will change – and the line will shift right or left – if one of the factors
contained in Ia (e.g. business confidence) changes.
Note that business investment (capital formation) in South Africa often does not react
strongly to changes in real interest rates.
Figure 2.8 The investment function
Factors such as tax incentives and depreciation
allowances, or decentrali­sation incentives, are r
often more important, if not decisive, in the
determination of in­vestment in South Africa.
r0
❐ Graphically, changes in these factors will
shift the invest­ment curve, since they will
be reflected in a change in Ia. (Why?)
r
In addition, the degree of business confidence
in the long-term prospects of the economy is
of critical importance, since investment is a
long-term decision and commitment. This is of
particular relevance in the post-1994 period,
when the expectations of both domestic and
foreign investors regarding the future of the
South African economy – and the economic
policies of the government – have been and
are likely to continue being more decisive
than interest rates in determining investment
patterns.
❐ Changes in confidence and expectations will
shift the curve in the diagram.
❐ The potent influence of expectations and
psychological factors is one reason why
investment can fluctuate wildly at times.
❐ A factor that often influences expectations is
the exchange rate. (How? Why?)
In the income–expenditure diagram (the 45°
diagram, which does not have the interest
rate on one of its axes), investment is depicted
as a horizontal line at the level of investment
determined in the diagram (see figure 2.9). In
60
1
l0
l1
la
l
Figure 2.9 Investment in the 45° diagram
l
45° Line
I1
l0
Income Y
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this way we are provided with a channel for interest rates to influence total expenditure in
the 45° diagram.
Any change in the level of real investment, due to either an interest rate change or some
other relevant factor, implies a parallel shift of the I line in the 45° diagram.
2.2.3
Macroeconomic equilibrium: the basic idea
The basic concept of equilibrium between total expenditure and total production, and the
corresponding graphical analysis of equilibrium in the 45° diagram, was explained above.
If one assumes, for a moment, that consumption and investment are the only kinds of
expenditure in the economy, together they constitute total expenditure.
Graphically, the C line and the I line can be added vertically to form the total expenditure
line. Together with the 45° line, the equilibrium level of real income Y is determined.
Investment as such is graphically depicted in the second diagram we encountered. The
two diagrams can be placed alongside each other as in figure 2.10:
Figure 2.10 Basic macroeconomic equilibrium
r
E
r0
C + I0
C
l0
l0
Investment l
l
Y0
lncome Y
At the equilibrium
Total expenditure = Total production
or, for this simple case with only consumption and investment expenditure,
C + I = Total production
Since production must be identical to income – all revenue from production sold must flow
to some production factor in the form of income – one can also describe the equilibrium as
the point where:
C+I = Y
Inserting the illustrative equations used above, this statement can be refined to:
...... (2.3)
Y = a + bY + Ia – hr This statement describes the equilibrium for this simple, illustrative case. (See section 2.2.6
for the general case.)
❐ But it is more than that. It is an equilibrium condition – it constitutes the requirement or
prerequisite for equilibrium in the real sector.
2.2 The real (or goods) sector
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2.2.4
Changes in the equilibrium: multipliers
The basic tools to analyse changes in the economy are available to us now. Although
the model still is very simple, one can already construct much more comprehensive
macroeconomic chain reactions. For example:
Suppose real interest rates fall. (The next chapter will explain why that can happen.) This
decreases the opportunity cost of investment. More planned investment projects become
potentially profitable and viable. Therefore, investment is encouraged. If investment does
increase, total expenditure and sales increase. This will cause a decline in inventories, which
is a sign and an incentive for producers to decide to increase production. When (and if) they
do increase production to match the higher level of expenditure, GDP and real income will
increase. The economy experiences an upswing. In brief:
r  ⇒ I  ⇒ total expenditure  ⇒ production  ⇒ Y 
Having gone through the logic of the economic chain reaction, one can now use the diagram
to test whether the above reasoning was correct. One does that by indicating the chain of
events on the two diagrams as in figure 2.11:
Figure 2.11 Changes in the macroeconomic equilibrium
r
E
r0
C + I1
r1
C + I0
l1
l1
l0
l0
l1
Investment l
l0
Y0
Y1
lncome Y
Was the chain of reasoning above correct or incorrect?
!
62
It is critically important not to go about these chain reactions or sequences of events in a
mechanical fashion. The various parts and actors in the economy do not fit together like
gears in a machine. People make choices and decisions – wise or unwise, responsible
or irresponsible. Each transition between steps is uncertain and subject to delays. An
expected change will not necessarily occur, or will not occur immediately or when expected.
One reaction may be weak, another strong. At most one should speak of incentives,
encouragements or discouragements. It is best to think of each reaction being likely (at most).
(Perhaps one should indicate this by placing a small question mark above each horizontal
arrow in the chain reactions.)
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✍
✍
Repeat the example above for an increase in interest rates. Also show this in a diagram.
If someone were to state that a reduction in interest rates will stimulate the economy and that
this therefore amounts to good news, (a) would you agree with that persons, and (b) would you
know exactly why he or she is right or wrong? Are lower interest rates beneficial for all people in
the economy? Why or why not?
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
(Some more considerations are encountered in chapter 3.)
The expenditure multiplier
The core of the idea of the multiplier is that any change in real expenditure ∆Exp – i.e. any
injection of expenditure into, or withdrawal of expenditure from, the circular flow – will
eventually lead to a change in equilibrium real income ∆Y significantly larger than the
original injection (or withdrawal).
The size of the multiplier K is the ratio between the eventual, cumulative change in Y
(i.e. ∆Y) and the original change in expenditure that caused it, i.e.
∆Y
​ ∆Exp ​
KE = _____
It can be seen on the 45° diagram in figure 2.12.
The value of the multiplier shows the extent
to which an expenditure injection (or
withdrawal) is amplified or multiplied.
The multiplier effect can be explained by refer­
ence to the existence of a multiplier process. The
crux of the multiplier process is that a number
of rounds of respending follow an initial injection
of expenditure. Each amount that is spent is
received by somebody else, and becomes that
person’s income. Of this, a certain percentage
will be respent (depending on the marginal
propensity to consume).
This yet again becomes another person’s
income, who spends part of it, and so forth –
until the process peters out. The cumulative
Figure 2.12 The multiplier effect
E
Aggregate
expenditure
E
Y
lncome Y
2.2 The real (or goods) sector
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change in income, i.e. the sum of each of these individual increases in income – will
therefore be much higher than the initial increase (injection) of expenditure and income.
That is, the initial injection is multiplied or amplified.
How large this cumulative sum of all the respending is will depend on the portion of
spending that is returned to the circular flow in each round, i.e. the percentage respent –
or, the percentage that does not leak from the income–expenditure stream. The larger the
leakage from the domestic expenditure flow in each round – e.g. in the form of savings,
taxation, or spending on imports – the smaller will be the cumulative total, and therefore
the smaller will be the value of the multiplier. In this way, one can see that the value of the
expenditure multiplier will be inversely related to the percentage leakage in each round.
It can be mathematically shown that
1
​  marginal
​
KE = __________________
leakage rate
Thus the value of the multiplier depends on factors such as the marginal propensity to
save (MPS), the marginal propensity to import and the marginal income tax rate – all
related to forms of leakages from the expenditure–income flow.
We can illustrate this in our simple model with only consumption and investment.
A multiplier can be derived from the equilibrium condition stated above:
Y = C+I
After substitution of the consumption and investment functions, it becomes:
Y = a + bY + Ia – hr
(
1
)
​  1 – b ​  ​(a + Ia – hr)
= ​ ____
...... (2.4)
1
where ​ 
1 – b ​is the multiplier KE and (1 – b) is the marginal leakage rate given for the above
equations of C and I.
This formula for KE is not generally correct. It recognises only one form of leakage: (1 – b)
is the marginal propensity to save or MPS. It is especially wrong for an open economy with
a significant degree of imports and with taxes.
❐ Remember that at this stage our model is still a simplified one that excludes government
and the foreign sector. These restrictions will be relaxed later.
❐ Calculations of the value of the multiplier with this formula produce unrealistically large
values.
Nevertheless, the formula in terms of the marginal leakage rate can be applied generally,
if one incorporates such leakage rates as the marginal propensity to save, the marginal
propensity to import, and the marginal income tax rate. The exact mathematical formula
for KE will in each case depend on exactly how each function in the macroeconomic model is
formulated mathematically (see maths box in section 2.2.6).
❐ Find out for yourself why the value of the multiplier depends on the size of MPC by
investigating how the multiplier process and the value of KE change if MPC increases
or decreases. Also experiment with some of the other leakages.
❐ In practice, the value of the multiplier is between 1 and 2.
The multiplier effect is valid for any injection (or withdrawal) of expenditure, i.e. any
vertical shift in the total expenditure line due to changes in government spending, taxation,
exports and so forth.
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2.2.5
Real government expenditure and taxation
Government expenditure concerns the purchase of goods and services by the general
government. This may vary from pencils to roads to policing services to army tanks. A
large portion of real government spending goes towards the payment of wages and salaries
of public servants.
DATA TIP
While the terms ‘government’ and ‘the state’ are used indiscriminately in everyday speech,
here one should be more specific. General government comprises the central government,
provincial governments, as well as local governments (municipalities). It does not include
public corporations.
Warning: Where data and measurement are concerned, the government sector is one of
the most complex (and confusing) areas of economics. Published data, even in tables in
the same publication, are often difficult to reconcile or they may even be contradictory.
This is due to reasons such as the following:
❐ Different definitions of ‘government’ or ‘public sector’ and the inclusion or exclusion of
different public institutions (universities, public corporations, etc.);
❐ Different data systems, e.g. the System of National Accounts (SNA) as against the
Government Finance Statistics (GFS), each with its own interpretations, objectives,
bases, rules and conventions;
❐ Different institutions that process data for different purposes, e.g. the Reserve Bank
as opposed to the National Treasury, which publishes its own budget figures in a
particular way.
For macroeconomic analysis, national accounts measures are best. You should, however,
always be very careful. (Even in the public debate, government data and concepts are often
used incorrectly.)
❐ Whenever you want to analyse the budget in some detail, national accounts data are not
suitable. See the analysis that is supplied annually in the Budget Review, published by
the National Treasury.
❐ Always be very careful to ascertain where you work with nominal data or real data.
See chapter 10, section 10.1 and addendum 10.1. See also Mohr (2019) Economic
Indicators, Van Schaik, chapter 10.
We define total government expenditure G as the sum of general government consumption
expenditure and general government investment.
❐ Note that many textbooks define G as government consumption expenditure only. One
reason for this is that it corresponds to the practice in the national accounts, the main
source of macroeconomic data, as well as in the national accounting identities (see
chapter 5).
❐ For the sake of consistency throughout this book, we will indicate government
consumption expenditure with the symbol GC.
The graph in figure 2.13 shows the two main components of total government expenditure,
i.e. government consumption expenditure GC as well as investment (capital formation) by
general government IG in South Africa since 1960.
2.2 The real (or goods) sector
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G and government investment
DATA TIP
In national accounts data only consumption expenditure by the general government is
indicated separately. Government investment is included in the gross capital formation
(investment) figure.
❐ Capital formation tables show a breakdown of investment between general
government, government enterprises and public corporations.
Total government expenditure G must thus be calculated as the sum of general
government consumption expenditure and fixed capital formation by general government.
See chapter 10, section 10.5.1 and addendum 10.1. Also see Mohr (2019) Economic Indicators.
✍
What percentage, approximately, of gross domestic expenditure (GDE) does total government
expenditure constitute?
______________________________________________________________________________________
What percentage, approximately, of gross domestic expenditure (GDE) does general government
consumption expenditure constitute?
______________________________________________________________________________________
What portion, approximately, of that is spent on wages and salaries?
______________________________________________________________________________________
Figure 2.13 Components of government expenditure as % of GDP
30
25
Total government expenditure
Percentage
20
Government consumption
15
10
5
Government capital formation
2018
2016
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
1962
1960
0
Source: South African Reserve Bank (www.resbank.co.za).
Note the peak in government consumption expenditure in the late 1980s and early 1990s,
as well as the decline under the new policy regime after 1994. For government capital
formation, the noticeable thing is the significant decline since the mid 1970s – a decline
that has not been reversed, despite a small and transient uptick in 2006–08.
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In macroeconomic reasoning we often ignore most of the institutional and definition
problems and broadly treat the general government in terms of total government
expenditure G and total taxation T. While this does not correspond one hundred percent
with budget figures and practices, for the purpose of macroeconomic analysis it is
close enough.
Government expenditure and taxation are the main elements of so-called fiscal policy.
Government borrowing to finance budget deficits is a third important element of fiscal
policy (see chapter 10 for a detailed discussion of fiscal policy).
These are primarily the administrative responsibility of the National Treasury, i.e. the
government department that handles the ‘purse’ of central government. However, in the
final instance, it is the decisions of the national government, more specifically the national
Cabinet, that determine fiscal policy and the national budget.
In macroeconomic reasoning, one usually regards government expenditure and taxation
decisions as exogenous or autonomous, i.e. as political decisions under full control of the
government. These decisions are taken ‘outside’ the economy (therefore exogenous).
Real government expenditure G is a direct component of total real expenditure and
influences it directly and fully.
❐ In the 45° diagram, as shown in figure 2.14, G (just like I) is shown as a horizontal line,
at the level of real government expenditure. It is then simply added, vertically, to the C
and I lines to get the total expenditure line.
❐ Also note that, whereas the equilibrium condition is Y = C + I in the absence of
government, with government it becomes Y = C + I + G.
Figure 2.14 Macroeconomic equilibrium with government expenditure
r
E
r0
C + I0 + G0
C + I0
C
G0
G0
l0
l0
l0
Investment l
Y0
lncome Y
Any increase in G has the same direct impact as any other direct increase in expenditure.
Graphically the expenditure line is shifted upwards by the exact amount of such
an increase.
❐ The expenditure multiplier KE also applies to changes in G: the eventual change in Y
exceeds the initial change in G by a factor equal to the multiplier.
2.2 The real (or goods) sector
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Taxation has an indirect effect on equilibrium income, i.e. via its impact on disposable
income and, in that way, on consumption. The consumption function must be adapted to
show the introduction of tax:
C = a + b(1  t)Y ...... (2.5)
where t is the tax rate on income. Thus (1 – t)Y is after-tax or disposable income. Note that
we simplify by assuming that all individuals pay the same tax rate, which is usually not
the case. We also ignore other types of taxes. Although this simplification can be relaxed
(e.g. to consider also a progressive tax rate system where individuals with higher income
pay a higher average tax rate), we maintain it to demonstrate the underlying impact of an
income tax on consumption.
❐ Graphically, the consumption function is shifted up or down as a result of tax changes.
❐ Since there is now an additional leakage from the expenditure due to the payment of
tax, the expenditure multiplier will differ from the no-tax case. Whereas the expenditure
1
multiplier was equal to ​ 
1 – b ​, with tax (and government expenditure G) we now have:
Y = C+I+G
which becomes:
Y = a + b(1 – t)Y + Ia – hr + G
(
1
)
​  ​(a + Ia – hr + G).
= ​ ​ 
1 – b(1 – t)
...... (2.6)
The marginal leakage rate is larger when there is an income tax in the model. Thus the
expenditure multiplier is smaller.
❐ If the tax rate t is higher, (1 – t) will be smaller; this increases the denominator of the
multiplier, and decreases the value of the multiplier. (Can you see that? The larger is t,
1
the smaller is b(1 – t), the larger is 1 – b(1 – t), and thus the smaller is 
​ 1 – b(1 – t) ​, which is
the expenditure multiplier.)
The tax multiplier
Since a tax increase is partly financed by the individual or households who consume less and
save less – the impact of the higher tax falls only partly on consumption – consumption will
decrease by less (and the C line will shift by less) than any increase in total taxation. However,
that (reduced) decrease in expenditure will experience the normal multiplier process.
❐ Therefore, the tax multiplier KT is smaller than the expenditure multiplier by a factor
equal to the marginal propensity to consume MPC:
KT = MPC × KE
❐ This means that a Rl million increase in government expenditure, for example, will
not have the same impact on equilibrium income Y as a Rl million reduction in total
taxation. The former has a larger impact.
❐ A balanced increase in the budget – equal increases in government expenditure and
taxation – will therefore have a positive net impact on Y. (This is the ‘balanced budget
multiplier’ result. See whether you can establish this by considering an increase in G of
R1 000 that is financed by an increase in T of R1 000.)
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✍
Tax reduction ⇒ _______________________________________________________________________
______________________________________________________________________________________
Graphically:
Does your economic reasoning tally with your graphical results?
How would the graphical analysis change if the tax reduction was specified as a cut in the
average tax rate? (See remark 4 below.)
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
Remarks
1. An increase in G and a reduction in T are both examples of expansionary fiscal policy
(and vice versa for restrictive policy).
2. In any discussion of the consequences of a change in government expenditure G,
one should analytically handle them in isolation, i.e. one should not automatically
assume that taxation T will be increased to finance the higher level of spending. Likewise,
a tax change should not be taken automatically to imply a corresponding change in
expenditure. If G and T both do happen to change, analyse first the one and then the
other to finally derive the net impact.
3. In practice, a large portion of taxation is in the form of income taxation. This implies
that the tax revenue of government is a function of total income: if income Y increases
during an upswing, income tax revenue of the Treasury will also increase, even in the
absence of an increase in the tax rate.
4. The graphical analysis of a change in taxation is complicated by the difference
between types of taxation. Only for a very simple kind of tax (a ‘lump sum’ tax where
everybody pays the same amount of tax irrespective of income levels) will a tax
change be depicted, in the 45° diagram, as a parallel shift of the consumption line.
In real life, the most important type of tax is income tax, where the total amount
of tax paid varies with the level of income. If it is a proportional tax (the example
we use here for simplicity), the percentage of tax deducted from income remains
constant, e.g. 25% means T = 0.25Y. Thus, the average tax rate remains unchanged
2.2 The real (or goods) sector
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as income increases. If it is a
Automatic stabilisers
progressive tax, the percent­
age of tax deducted increases
Since income tax payments increase when the
as income increases; the
economy is in an upswing phase, total taxation T
average tax rate will increase
increases in the process. This has a constraining
effect on total expenditure, which will hold back
as income increases. In both
the upswing. This effect automatically tempers the
cases the total amount of
upswing. Similarly, in a downswing phase, income
tax T paid will be more at
tax payments will automatically decrease, which
higher levels of GDP than
stimulates expenditure and restrains the severity of
at lower levels of GDP. In
the downswing. In this way, income tax serves as an
both cases, a decrease in
‘automatic stabiliser’ of the business cycle.
the average income tax
❐ This also implies that income tax is yet another
rate does not produce a
factor that effectively decreases the value of the
parallel upward shift in the
expenditure multiplier.
consumption function, but
rather rotates the C line up­
wards (anticlockwise) from its intercept with the vertical axis: the slope of the C
line increases, without any change in the intercept. Doing the same activity as on
the previous page for the case of a reduction in income tax will thus have a different
graphic result from the simple tax reduction case. (In the latter case, there would
be a parallel upward shift of the C line.) Note, however, that the resultant change in
equilibrium income Y will be in the same direction for both cases.
2.2.6
Real exports and imports (introductory)
The South African economy is ‘open’: a large part of total production is exported, and a large
part of total expenditure is spent on the purchase of imported items. Therefore international
trade affects the pattern of expenditure and production decisively. It is therefore essential to
understand fully the macroeconomic effect of foreign trade transactions.
✍
How ‘open’ is the South African economy? What percentage of South African GDP is exported
annually? _____________________________________________________________________
______________________________________________________________________________
What percentage of South Africa’s gross domestic expenditure (GDE) is spent on imported
items, i.e. effectively ends up in the pockets of foreign producers?
______________________________________________________________________________
The graph in figure 2.15 shows South African imports and exports in real terms since
1985 (at constant 2010 prices). Real exports and imports are elements of ‘expenditure on
gross domestic product’. The gap between the two shows net exports, which is an indication of,
but not equal to, the state (deficit or surplus) of the current account of the balance of payments
(see chapter 4). A close correlation between import fluctuations and GDP fluctuations can be
observed, e.g. during the long upswing since 2000. Also note the significant increase in
both exports and imports, in real terms, since the early 1990s, indicating a significant
increase in external trade.
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Figure 2.15 Exports and imports (in real terms – 2010 prices)
1 200
1 000
800
Real imports of goods and services
R billion
600
Real exports of goods and services
400
200
Real exports minus real imports
0
2018/01
2016/03
2015/01
2013/03
2012/01
2010/03
2009/01
2007/03
2006/01
2004/03
2003/01
2001/03
2000/01
1998/03
1997/01
1995/03
1994/01
1992/03
1991/01
1989/03
1988/01
1986/03
1985/01
–200
Source: South African Reserve Bank (www.resbank.co.za).
Chapter 4 discusses these issues in detail. Here it suffices merely to add net exports
(X – M) as a component of total expenditure. To arrive at the total demand that South
African producers experience, one must:
❐ add spending in foreign countries on South African goods to domestic expenditure, and
❐ deduct local spending on imported goods, since this spending merely flows to producers
in other countries.
Gross domestic expenditure is the sum of consumption, business investment and
government expenditure, i.e.
GDE = C + I + G
However, this is not equivalent to the total spending that is effectively felt by domestic producers.
The latter magnitude – the total demand for domestic production – is indicated by the term
expenditure on gross domestic product = C + I + G + (X – M).
❐ In published expenditure data, one also finds a ‘residual’ term. This is an unexplained error
term that is necessary to balance the different totals.
Therefore:
Total expenditure E = C + I + G + (X  M)
2.2 The real (or goods) sector
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For this, the complete open economy case, macroeconomic equilibrium will be at that level
of real income Y where
Total expenditure  Total production
or
C  I  G  (X  M)  Total production
Since production is identical to income, one can equivalently write the equilibrium
condition as:
C  I  G + (X  M)  Y
...... (2.7)
Graphically, one merely adds net exports to the total expenditure line. Any increase in net
exports is treated like any other expenditure injection (and is subject to the same multiplier
process):
(X  M)  ⇒ Total expenditure  ⇒ induces production ⇒ GDP  ⇒ Y 
π
The expenditure multiplier with exports and imports
While exports and imports are considered in detail only in chapter 4, it is useful to show
now how equation 2.6 can be expanded to include exports and imports. This then gives the
complete real sector expenditure multiplier.
If X is taken as exogenous, and the import function as M = ma + mY where m is the
marginal propensity to import (see chapter 4, section 4.2.1), then
Y = C + I + G + (X – M)
…… (2.7)
becomes equation (2.8):
Y = a  b(1 – t) Y + Ia – hr + G + X – ma – mY
(
1
)
​  1 – b(1 – t)
​  ​(a + Ia – hr + G + X – ma )
= ​ 
+m
...... (2.8)
The import propensity thus adds a marginal leakage rate, which decreases the size of KE.
✍
Complete the following diagram to depict the sequence above:
E
lncome Y
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If one considers the two graphs derived in this chapter, it appears that there is still one
unexplained variable, i.e. the real interest rate (r). What determines the level of real
interest rates? The explanation of interest rate changes can be found in the operation of
the so-called money and capital markets – or the monetary sector of the economy. This is the
subject of the next chapter.
The monetary sector is not a separate part of the economy at all. However, for purposes of
analysis, it is useful to distinguish (but not separate) this component or subsector of the
economy from the real sector.
A more complete circular flow
In section 2.1 the income–expenditure circular flow was developed as an intuitive way to
grasp the basic Keynesian reasoning. The concept of chain reasoning was developed from
this basic idea. At this stage, a more complete depiction of a circular flow can serve to
summarise the main components encountered so far:
Exports
Imports
EXPENDITURE
Consumption
+
+G )
I
+
C X–M
(
Investment
Government
expenditure
Saving
FIRMS
(Producers)
Disposable
income
HOUSEHOLDS
(Consumers)
Corporate
taxes
GOVERNMENT
Personal
income tax
REAL INCOME
This is an enhanced version of the simple circular flow of figure 2.3. Given the basic
counter-clockwise flow of expenditure and income between households and firms,
it highlights the different components of expenditure (consumption, investment,
government expenditure and net exports). Government has been added as a major
actor. Various leakages such as saving, import spending and taxes are shown, as are
injections such as investment, export earnings and government expenditure. An
increase or decrease in any of these will either diminish or boost the stream of aggregate
expenditure. The resultant impact on the flow of real income to households can then be
deduced quite readily.
2.2 The real (or goods) sector
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In the following chapters we will progressively fill in the blank spaces in this circular flow,
depicting additional elements of a modern, open economy. At the same time, the circular
flow diagram will serve to remind you of exactly where the topics in a particular chapter
fit into the broader economic picture. The circular flow will be completed at the beginning
of chapter 6.
2.3
Analytical questions and exercises
1. Suppose autonomous consumption increases. Explain, using the appropriate diagram,
what the impact will be on equilibrium income and expenditure.
2. From 2006 to 2008, as part of responses to the international financial crisis, interest
rates were increased from 11% to 15%. What will be the expected impact of an
increase in interest rates on investment and/or consumption, and finally on income?
Explain using the appropriate chain reactions and diagrams.
3. If South Africa develops an increased taste/need for imported products and/or
production inputs, will it lead to higher or lower national income? Explain using (a)
the relevant formula, and (b) the appropriate diagram.
4. How can the government increase output using: (a) government expenditure, and
(b) taxation? Explain, using a relevant diagram. (The budget implications of such
steps will be encountered in chapter 12.)
5. Suppose a simple economy with only consumption, investment and government.
Further suppose Income (Y) 5 R1000, the marginal propensity to consume (b) 5
0.8, autonomous consumption (a) 5 R100, Investment (I) 5 R80, Government
consumption (G) 5 R100 and the tax rate (t) 5 0.1.
a. Calculate the size of the expenditure multiplier.
b. Calculate the size of the tax multiplier.
c. Suppose investment (I) increases by R100, calculate the new income level
following the increase in investment. Also use the appropriate diagram to explain
the effect of the increase in investment on income.
d. Suppose the tax rate on income (t) increases from 0.1 to 0.15, what will be the
value of equilibrium income following the increase in the tax rate? Also use the
appropriate diagram to explain the effect of the increase in the tax rate on income.
6. It appears that, in the period after 2010, private corporations had large amounts of
savings (cash), but were not inclined to use that to invest in new ventures, factories, etc.
(compare figure 2.6 and the period from 1999 to 2008). Looking at the determinants
of private investment, which factor(s) do you think could explain that behaviour?
7. At President Ramaphosa’s Jobs Summit in August 2018, large private-sector
companies announced investment plans amounting to billions of rands. If these
plans were to be implemented, what would be the expected impact on the economy?
Construct a simple chain reaction and diagram.
8. Nine months after the 2018 Jobs Summit, in the second quarter of 2019,
unemployment had risen from 27% to 29%. How does that square with your analysis?
Can you explain what happened?
9. Download the Excel file containing Quarterly Labour Force Trends from the latest
QLFS page of Statistics SA. Use the data to describe what has happened since 2008
to the number of people who are (a) employed, (b) unemployed according to the
official definition of unemployment, and (c) unemployed when including discouraged
job-seekers. Is it possible for the number of employed people to increase while the
unemployment rate also increases? Explain. (You may want to consult chapter 12,
section 12.2.1 in this regard.)
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The basic model II: financial
institutions, money and interest rates
3
After reading this chapter, you should be able to:
■ explain the everyday, practical operation of financial markets;
■ explain the way interest rates are determined by money supply and demand;
■ explain movements in nominal and real interest rates and compare the different roles of
nominal and real interest rates in economic behaviour;
■ compose chain reactions that show how monetary disturbances impact on interest rates
and the real economy, and vice versa, and evaluate these with appropriate graphical aids;
and
■ assess the role of monetary policy and the Reserve Bank in the determination of real
income. (Monetary policy is discussed in detail in chapter 9.)
In the discussion of changes and fluctuations in expenditure in the real (or goods) sector
of the economy in chapter 2, the real interest rate featured as an important variable.
However, the theory and logic in that chapter left the interest rate dangling and its
behaviour unexplained. To fill this gap, we turn to an analysis of the monetary sector of the
economy: the world of money and interest rates. The monetary sector comprises various
financial institutions such as commercial banks, merchant banks and the Reserve Bank
(SARB), as well as the financial markets, which is where nominal and real interest rates are
determined.
Financial institutions and markets are integral parts of the economy. Real activities such as
consumption invariably imply financial transactions which involve bank accounts and, often,
bank credit to consumers. Commercial credit is essential for business activities. Investment
and saving imply flows of funds that are channelled via financial institutions. The same is true
for international financial flows deriving from foreign trade or foreign investment.
❐ The monetary sector can be seen to handle the ‘oil’ (money, credit and financial
transactions) necessary for the smooth functioning of the ‘wheels’ of real activities
(production, employment, consumption, investment, etc.) in the real sector. Its
importance largely derives from this facilitating role.
Real sector changes have monetary impacts, and monetary disturbances can have real impacts.
One must be able to analyse these interactions to understand the short-run and medium-run
cyclical behaviour of the economy (as well as the long-term issue of economic growth). This
chapter integrates the analysis of the monetary sector – and especially interest rates – into
your understanding of the real sector and short-run fluctuations in expenditure.
  Chapter 3: The basic model II: financial institutions, money and interest rates

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The location of this topic in
the circular flow diagram
(compare p. 73)
FINANCIAL
INSTITUTIONS
Supply of credit
Interest
rates
Savings
Monetary
policy
Demand for credit
FIRMS
dit
cre
rcial
e
m
m
Co
RESERVE
BANK
Government C
ons
borrowing
um
er c
(deficit)
redi
HOUSEHOLDS
t
GOVERNMENT
✍
How high are interest rates in South Africa currently? Can you indicate the current level of a
particular interest rate?
______________________________________________________________________________________
DATA TIP
Monetary sector data: which source?
The main source of monetary data is the Quarterly Bulletin of the Reserve Bank, which
provides an extensive set of banking, financial and monetary data. For macroeconomic
analysis, the following tables in the sections ‘Money and banking’ and ‘Capital market’
are most relevant:
❐ ‘Monetary aggregates’: money stock figures.
❐ ‘Money market and related interest rates’: short-term interest rates, such as the BA
rate and the prime rate.
❐ ‘Capital market and related interest rates’: long-term interest rates.
On the internet, consult the Quarterly Bulletin at: www.resbank.co.za. Also see Mohr
(2019) Economic Indicators, chapter 9.
3.1
The monetary sector and interest rates
Interest rates are analysed at two levels: first, in terms of the practical, everyday operation
of money markets and, second, more formally in terms of the behavioural relationships that
lie behind and explain this everyday operation – the supply of money MS and the demand
for money MD. In doing this, the distinction between nominal and real interest rates must
be kept in mind. (See the box in chapter 2, section 2.2.2 on the calculation of nominal and
real interest rates.)
❐ Nominal interest rates are the rates usually mentioned when the bank charges a
customer, say, the ‘prime rate’, or the rate earned on a savings account, or when the
Reserve Bank announces a change in the repo rate.
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❐ Real interest rates are the interest rates earned in effect after the eroding effect of
inflation has been removed from the nominal value. An approximate formula for the
real interest rate is: r  i – π.
❐ So, if the inflation rate is 7%, and the nominal interest rate is 12%, the real interest rate
is (approximately) 5%.
3.1.1
The practical determination of nominal interest rates in the
money market
Although one is used to thinking of nominal interest rates in the context of, for example,
savings accounts or, especially, interest rates on loans or on an overdraft, the main interest
rates are those determined in the money market. Other interest rates usually depend largely
on what happens in the money market.
Where are the money and capital markets?
The financial market is arbitrarily divided into the money market and the capital market:
❐ The money market handles instruments/assets with a term or ‘maturity’ of up to one year
(‘short term’). Associated with these are short-term interest rates.
❐ Transactions in financial instruments with a term of more than one year (‘long term’) occur
in the capital market, which is organised in exactly the same fashion as the money markets.
In this market one finds long-term interest rates.
The money and capital markets do not exist in a physical location or building. They are
constituted by a large number of financial institutions, such as commercial and investment
banks, pension funds and long-term insurers that are continually in contact with each other
via telephone, video and computer links. These institutions have ‘dealer rooms’ where dealers
handle large amounts of money, buying and selling in the money market.
Buying and selling transactions occur on behalf of clients who either have surplus funds to invest
in money and capital market assets (‘instruments’), or who require funds on credit/loan for a certain
period. Each transaction establishes a price and a nominal interest rate. These materialise, as you
watch, on computer screens, as the transactions occur (followed by electronic book entries).
When a lot is happening in the market and many opportunities to make profit from buying
and selling present themselves, the adrenalin flows fast, the dealers’ voices are hoarse from
shouting, and their eyes red from staring at video and computer screens. (One must remember
that, even with very small price or interest differentials, significant profit can be made, given
the large amounts that are involved.) Very often dealers do not last long; the stress is too
great. On the other hand, dealers experience tremendous excitement, and some almost
become addicted to it, like one can become addicted to gambling.
❐ Visit the dealer room of a bank to see for yourself how nominal interest rates materialise on
computer screens before your eyes.
Money market dealers trade, on behalf of clients, in short-term financial instruments
or ‘financial paper’. The purpose of the trade is to connect lenders (financial investors)
and borrowers; in other words, the money market channels funds. The financial paper is
merely the proof of a claim (like an IOU). Most of these claims exist for a relatively short
period, normally three months (90 days) at most.
Various kinds of money market paper exist, each with its own nominal interest rate. Each
transaction determines a price for the paper at that moment, which implies a certain
nominal interest rate for that transaction (and type of paper or asset).
3.1 The monetary sector and interest rates
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For the main types of money market paper this occurs as follows:
(1) Treasury bills (TBs)
Treasury bills are one type of debt instrument issued by the Treasury/government when it
borrows from the private sector during the course of the year to finance the budget deficit.
This occurs regularly, usually every Friday. A TB is issued as proof of the loan, and it entitles
the holder/lender to receive a specified amount (the nominal or face value, e.g. R100 000)
typically after 91 or 182 days. (The Treasury has also issued 273-day TBs.) Alternatively, one
can say that the lender is a financial investor who buys the TB at a certain price.
The interest that the lender/investor receives for the loan to the government (i.e. for the
financial investment in TBs) derives from the fact that she pays less than the R100 000 for
the TB, e.g. R97 000. This discount depends on the interest that the government is willing
to pay, or that it has to pay in order to sell the TBs.
❐ The discount implies that, when the investor claims the full R100 000 after three months,
she has earned a certain percentage nominal rate of return or nominal rate of interest – in
this case, the ‘91-day TB rate’. For this example, the TB rate would amount to:
(
)(
)
3 000 365
​  97 000 ​  ​​ ​ 
​ 
91 ​  ​× 100 = 12.45%.
❐ Note: The higher the price the lender
has to pay, the lower the nominal
interest rate, and vice versa. If the
price of TB went down to R96 000,
the rate of return would be:
(
)(
)
4 000 365

​  96 000 ​  ​​ 
​  91 ​  ​× 100 = 16.71%.
​
❐ Since TBs are issued/sold on tender,
the initial or issue rate is also called
the ‘tender TB rate’.
❐ Issues of TBs occur in the so-called
primary market.
What are government bonds
(or stock)?
Government bonds are similar to treasury
bills. Both are debt instruments issued by
the National Treasury to finance the budget
deficit. However bonds have a longer term
(or ‘maturity’) attached to them. Treasury
bills typically have terms of 3, 5, 10, 15 or 20
years. Bonds with terms up to 3 years are
called ‘short-term’ bonds. (Government stock
is a synonym for government bonds.)
However, the holder of a bill does not necessarily have to wait the full three months to
get the money back. If the money is needed earlier, the bill can be sold to somebody else
(in the so-called secondary market). Depending on market conditions at that stage – the
supply and demand of TBs – the seller will get a particular price for his TB (still below
the face value).
❐ For instance, suppose that after holding a TB for 30 days, a financial investor decides to
sell his TB. Note that the buyer, should
she decide to hold it till maturity,
A free market?
will hold it for 61 days. If the seller
sells it for R98 200, say, then the
Although these transactions occur in the
corresponding nominal interest rate
money market, where supply and demand are
of decisive importance, this trade does not
on the TB will be:
(
)
1 800 365
​  98 200 ​  )​​ ​ 
​
( 
61 ​  ​× 100 = 10.97%.
❐ Thus, trade and prices in the secondary
market determine corresponding nominal TB interest rates. In this way the
78
occur in a completely free market. The Reserve
Bank continually monitors the market and
steers it in the direction it desires by intervening
in the market in various ways (see the
discussion of the money supply that follows).
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TB rate is determined daily, depending on the buying and selling (demand and supply)
of TBs.
For example, if investors have surplus funds and are eager to invest in TBs, the demand
for financial paper is high and the price increases accordingly, leading to a decrease in the
nominal interest rate.
A shortage of funds in the money market, on the other hand, means a relatively high supply
of financial paper by holders who would rather have cash, which is likely to translate into
a decrease in price and upward pressure on the nominal interest rate.
A similar story can be told for other types of money market paper.
(2) Negotiable certificates of deposit (NCDs)
Negotiable certificates of deposit arise when short-term financial investments are made at
banks. NCDs usually are issued/sold by banks as a way of getting hold of cash when they
experience a liquidity/cash shortage. An NCD is the certificate that is issued as proof of (or
in exchange for) the investment. This type of instrument is in high demand by investors,
and usually carries a relatively high nominal interest rate. An active secondary market
in NCDs also exists. As is the case with TBs, the NCD can be sold to a third person (or
‘third party’) if the investor needs his money before the expiry date. The price the investor
obtains in this instance will always be lower than the nominal value or redemption value;
the difference determines the nominal interest rate.1
(3) Banker’s acceptances (BAs)
Banker’s acceptances are surely the most important short-term money market instrument,
and the BA rate – mentioned daily in the news – is one of the best indicators of short-term
nominal interest rate trends. A BA is a bill of exchange (a credit instrument) that is guaranteed
by a bank. It usually comes into existence in the context of production credit, for example when
a producer requires credit to buy inputs. Instead of buying on account, she pays the seller
with a bill of exchange that is payable, for
instance, three months later. To get the
In layman’s terms, one can describe a BA
seller to accept the bill, the producer asks
as a ‘post-dated, bank-guaranteed cash
her bank to guarantee the bill (by signing
cheque’. While this is not 100% correct
on the back, thereby ‘accepting’ it). Such a
technically – a BA is an instrument of credit;
banker’s acceptance constitutes a claim on
a cheque is not – this does give one a rough
the bank, entitling the holder to receive a
idea. As is the case with a post-dated cheque,
certain amount from the bank at a certain
the BA gives the holder the right to receive
date in the future. The initial recipient of
a certain amount in future. As with a cash
cheque, it is payable to whoever holds it – in
the BA can now sell it in the secondary
fact, a BA is transferable and can be sold –
market; the price – once again, lower than
and it is guaranteed by a bank.
the face value – results in a corresponding
nominal BA rate.
Although these financial instruments come into existence for different reasons and are
issued by different institutions, they (and other financial assets, such as government
bonds) all share the following characteristics:
1
This is as if my savings book shows a certain amount or balance that can be drawn only at a future date. If I want to sell
this savings book to somebody else before that date, he or she will surely only be willing to pay me an amount less than
the balance shown.
3.1 The monetary sector and interest rates
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❐ There is an inverse relationship between the price and the nominal interest rate.
❐ The price, and thus the nominal rate of interest, is determined by the buying and selling
of the paper, i.e. by the demand for and supply of such instruments.
Even if one understands the money market and how nominal interest rates are determined
every day, one may still not understand why interest rates change. Why does the demand
for financial instruments sometimes increase and sometimes decrease? What determines
the supply of instruments in the market? To understand this, we have to look beyond (or
behind) the visible trade in financial instruments.
❐ The supply of and demand for financial instruments can be understood in terms of the
underlying supply of and demand for cash or money.
❐ Therefore, one must understand the role of money in the economy.
3.1.2
More formally – the supply of and demand for money
Briefly, the process that occurs is the following:
❐ If people or institutions hold more money (e.g. cash) than they really want in their
portfolio – i.e. there is a surplus of money holdings (which also means the supply of
money exceeds the demand for money) – they are likely to buy financial paper (as a
short-term financial investment). An increased demand for such paper is likely to cause
an increase in the price, and a decrease in the nominal interest rate.
❐ If there is a shortage of money (which also means that the demand for money exceeds
the supply) – i.e. people want to improve their cash position – they tend to sell financial
paper. The increased supply of paper on the market causes a decrease in price, and the
nominal interest rate increases.
In other words, nominal interest rates depend on the trade in money market instruments,
and this trade is determined by the supply of and the demand for money. If one understands
fluctuations in these demand and supply relationships, one will be able to understand
nominal (and real) interest rates.
!
Money or income?
When one speaks of ‘money’ in macroeconomics it is important to distinguish it from the everyday
usage of the term. The latter usage – as in ‘Do you have enough money to buy a car?’ – actually
concerns income or wealth rather than money. The decision to buy something or not depends on
whether you have earned or saved enough income with which to buy it.
In macroeconomics, the term ‘money’ very specifically refers to that which is used as a medium
of exchange or as a means of payment to facilitate buying and selling transactions. Everyday
examples of money are cash (coins and banknotes) and money in a cheque account. In the
decision to buy a vehicle, the amount of money in this specific sense plays no decisive role. If,
however, you decide that you do have enough income to buy the car, you must decide whether
you will use money for the transaction. If you wish to use money, you must convert the income
into money form for that purpose. If you do not wish to use money, you may be able to exchange
something else of value, e.g. sheep, for the car. It still is a valid transaction.
Obviously, most transactions in a modern economy are concluded (and, indeed, expedited
immensely) with the aid of money as the medium of exchange or payment. However, that
does not invalidate the formal and very important analytical distinction between money and
income.
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The demand for money (MD)
The aggregate demand for money in the economy depends mainly on the amount of
money people require for transactions. Therefore, the total money value, or nominal
value, of transactions (in a year, say) in the country is decisive. This in turn depends on
the total volume of goods that is to be exchanged, i.e. the total volume of goods produced,
as measured by real GDP (or Y).
❐ This means that, if Y increases (the economy is in an upswing and economic activity
increases), the demand for money typically increases. As more goods are produced and
exchanged, more money is required to conclude these transactions.2 There is a direct
or positive relationship between Y and MD.
❐ This suggests that there is an endogenous or built-in effect of the business cycle on the
demand for money, and hence on interest rates. Data show that interest rates typically
start to increase about halfway into an upswing phase, and again start to drop in the
latter part of the downswing phase.
In addition to the volume of (real) production, the nominal value of transactions also
depends on the average price level P [Nominal GDP = P × Y]. Accordingly, an increase in
the average price level (as experienced when inflation occurs) also increases the demand
for money. There is a positive relationship between P and MD.3
A final important factor determining the demand for money is the nominal interest rate i.
The demand for money depends on the amount of money people want to hold at one time
(instead of going to the bank to get money for each transaction). Holding money is not
free of cost, however, since one forfeits interest: the interest rate is the opportunity cost of
holding money/cash.
The higher the nominal rate of interest, the less willing people will be to hold significant
amounts of money/cash. That is, a higher nominal rate of interest will decrease the
demand for money; a lower rate is likely to increase the demand for money. There is an
inverse or negative relationship between i and MD.
Therefore the (nominal) money demand relationship is as follows:
MD = f(i; Y; P)

The signs below the equation indicate the kind of relationship between the left-hand
variable (MD) and the corresponding right-hand variable:  indicates a direct or positive
relationship;  indicates an inverse or negative relationship.
Since we prefer to work in real terms when studying economic relationships and behaviour,
it is preferable to state the money demand relationship in real terms. We will also do so
with money supply MS later on. It will also prepare the ground for later chapters when we
explicitly introduce the price level and inflation into the model.
2
3
Producers typically also require additional production credit if they want to increase production; since credit creation
also leads to money creation, an increase in production also leads to an increased money supply.
Although a higher price level increases the transactions demand for money, it may cause the demand for money
held for precautionary reasons (i.e. holding money in ready form to deal with unexpected (good and bad) events and
opportunities) to decrease. This reduction becomes more likely when a higher level of inflation is not a transitory event,
but a more enduring feature of the economy. When money is held it loses real value due to inflation. As a result, people
and institutions may wish to reduce their money holdings so as to minimise this inflationary loss.
3.1 The monetary sector and interest rates
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Money demand, investment and their opportunity costs
In chapter 2, when analysing investment behaviour, we argued that the opportunity cost of
investment is the real interest rate. Here, when analysing the demand for money, we argue that
the opportunity cost of holding money is the nominal interest rate. Why the difference?
When deciding to make a real investment in capital goods, the relevant best alternative is buying
a bond with a certain nominal and real yield (interest rate): i = r + π, so there is a real interest rate
r plus compensation for inflation. Funds invested in a capital good will grow for two reasons: the
value of the capital good should rise with inflation and there should be a real return from using the
capital to produce and sell goods.
If inflation is 10%, a machine bought now for R100 should have a value of R110 a year from
now. On top of that it can yield a real return (after allowing for depreciation) for the investor. A
bond bought for R100 now will yield inflation (e.g. 10%) plus a real interest rate (e.g. 5%). The
nominal yield will be R15 (a nominal interest rate of 15%).
In both cases there is compensation for inflation plus a real return. The increase in the price
or value of the capital good and the nominal interest rate on the bond both indemnify the real/
financial investor against inflation. All that is relevant in deciding whether to buy the capital
good is to compare its expected real return with the real interest rate on bonds.
❐ So the opportunity cost of buying a capital good (i.e. investment) is the real interest rate.
When holding money in the form of cash, there is no compensation for inflation and no real
return. A R100 note now is still a R100 note a year from now – and its buying power will have
been eroded by inflation. By not putting that money in a bond, one loses the entire nominal
interest (= R15) that one could have earned.
❐ Therefore, the opportunity cost of holding money is the nominal interest rate.
Formally, the demand for money can be divided into three types:
❐ Transactions demand: the need for money to use in ‘active’ form in transactions. This
depends largely on the value of transactions, i.e. nominal Y.
❐ Precautionary demand: holding money in ‘ready’ form, since one cannot at all times foresee
all transactions. This depends on income Y and the interest rate (opportunity cost), as well
as expectations (pessimistic or optimistic). In times of pessimism, people may want to hold
more cash as a precautionary step.
❐ Speculative demand: money comprises part of a person’s asset portfolio, together with
other financial assets such as bonds. If a person expects the prices of other assets to
increase, he will hold less cash and rather buy other assets, hoping to profit from the
expected price increase. On the other hand, if a decrease in asset prices is expected, a
person is likely to exchange part of her assets (wealth) for cash/money. What does this
decision have to do with interest rates? Recall that the higher the price of financial assets
such as bonds or BAs, the lower the rate of return (interest rate). If interest rates are low, it
is not unreasonable to expect that they may increase at some time in the future (implying
that the prices of bonds may decrease). It may then be wise to rather sell one’s bonds and
hold more cash/money in ‘passive’ form. This means that a low rate of interest creates the
incentive for a greater demand for money (from a speculative point of view). Speculative
demand, therefore, is largely determined by interest rates.
For most macroeconomic reasoning, it is sufficient to use only the transactions and
precautionary motives, with Y and the interest rate as main determinants. For the sake of
convenience, these can be combined into one line of reasoning, as was done above.
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❐ Under the standard macroeconomic convention, real sector symbols such as C, I and Y
always indicate real values. Strangely enough, in the monetary sector the convention
is that MS and MD are nominal variables.
❐ To convert them to real values, the convention is to write them as a fraction, i.e. divide
M
​ MP ​ and ​ 
them by the price level P, i.e. 
P .​
❐ We will also work increasingly with the real interest rate r.
S
D
The above relationship can be rewritten for the real demand for money:
MD
​ 
P ​ = f(i; Y)
We can then express the real money demand mathematically as:
MD
​ 
P ​= kY – li
...... (3.1)
In this equation 
​ MP ​ indicates the real amount of money required in the economy for
transactions; the parameter k indicates how responsive real money demand is to changes
in real income, and l indicates how responsive real money demand is to changes in the
nominal interest rate i. P does not appear as a variable on the right-hand side because its
effect is captured on the left-hand side.
D
M
Note that the ​ 
P ​in the above equation is the
demand for real money. The concept of real
money can be understood as follows. We demand
money mainly to conduct transactions (i.e. to
buy goods and services). If the average price level
increases by a certain percentage (e.g. when
there is inflation), we will require proportionally
more nominal money so that in real terms we will
have the same amount of money to conduct our
transactions of goods and services.
D
Graphically, the real money demand relationship can be depicted as in figure 3.1.
Changes in the rate of interest result in a move
along the curve. Changes in Y and P shift the
real money demand curve. (How?)
Figure 3.1 Real money demand
i
MD
​  P ​

Real quantity of money
The money supply (MS)
The nominal stock of money is the amount that the monetary system (i.e. the central
banks plus all other financial institutions) is supplying at a particular moment, under the
watchful eye (if not control) of the central bank. Thus, when economists talk about the
money supply, they usually talk about the stock of money. (In standard economic theory,
it is assumed that the central bank is able to control the level of money supplied by the
monetary system.)
The nominal stock of money can be defined as the total amount of money that is present
in the economy at a particular moment. However, there are different definitions of what
constitutes money. In published official data in South Africa, there are four different
definitions of the stock of money or the money supply:
3.1 The monetary sector and interest rates
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M1A =Sum of coins and banknotes in circulation, plus cheque and transmission
deposits of the domestic private sector at monetary institutions.
M1 =M1A plus other demand deposits held by the domestic private sector at
monetary institutions.
M2 =M1 plus other short-term deposits and all medium-term deposits at monetary
institutions (including savings deposits).
M3 = M2 plus all long-term deposits held by the domestic private sector.
You will note that the definition gets broader and broader, progressively including assets
that are more difficult to convert to, or use as a means of payment. M1 comprises the
immediately ‘liquid’ instruments.
The graph in figure 3.2 shows the value of coins and notes, M1, M2 and M3. Note how small
a proportion coins and notes are of M3 – usually less than 5%. Notice the continual and
strong growth in all these aggregates over time amidst up- and downswings in the economy.
Figure 3.2 The money supply (coins and notes, M1, M2 and M3)
4 000
M3
3 500
3 000
M2
R billion
2 500
2 000
M1
1 500
1 000
500
Coins and notes
Jan-17
Oct-14
Jul-12
Apr-10
Jan-08
Oct-05
Jul-03
Apr-01
Jan-99
Oct-96
Jul-94
Apr-92
Jan-90
0
Source: South African Reserve Bank (www.resbank.co.za).
✍
How large is the money stock in SA currently?
Coins and notes = R ...................... billion
M1A = R ....................... billion
M1 = R ....................... billion
M2 = R ....................... billion
M3 = R ....................... billion
Since the 1980s the Reserve Bank has preferred to use M3 as the most important money
supply indicator. However, there is no general agreement on which definition is best. One
should choose an appropriate measure depending upon what one wants to analyse.
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✍
Who creates money in the economy? The government? The Reserve Bank? How is it created?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
What determines the money supply relationship in the economy? This relationship reflects
the money creation process that occurs mainly via (a) lending by the commercial banking
system (in reaction to a demand for credit from within the economy), but is also influenced
by (b) the deliberate actions of the Reserve Bank as part of monetary policy.
❐ One can use the balance sheets of banks and the Reserve Bank to better understand the
money supply and credit creation process (see next subsection).
The nominal quantity of money available at any moment is the result of the credit creation
process and interaction between individuals, firms and banks, and between banks and the
Reserve Bank.
❐ Money creation does not occur via the printing of notes but, rather, via the extension
of credit (loans) by banks.
❐ Banks lend money that has been deposited by clients, e.g. in cheque accounts, to other
persons. This can be a direct loan, such as a mortgage to buy a house, or the provision
of an overdraft. When this facility is used by the borrower to pay for something, the
money typically flows to the bank account of the supplier of the goods or service; that
person or institution’s bank can then, in turn, put out a portion of this deposit on loan,
and so on. Each time this occurs there is an addition to both the total amount of credit
extended and the total amount of bank deposits in the country; and each creation of a
deposit is equivalent to money creation.
❐ There are a number of rounds of lending and relending, with deposits being created
and recreated all the time. Gradually this process peters out. The cumulative result of
this process of relending is the total money stock or supply of money. In this way, an
initial ‘injection’ of a deposit is multiplied, with an eventual effect on the money stock
much greater than the initial injection – it is a credit multiplier process that takes
place.
❐ The extent of the money creation process, i.e. the value of the credit multiplier, depends
on how much is relent in each round. A ceiling is placed on this by the legally prescribed
minimum cash reserve that banks have to hold, implying a forced ‘leakage’ from the
process in each round. Each commercial bank is legally compelled (by the Reserve
Bank) to hold a specified minimum percentage of all deposits at the bank in the form
of cash. Only the remainder may be put out on loan. In 2009 this reserve requirement
was at 2.5% of deposits.
❐ The higher this percentage leakage, the smaller the portion that can be lent in each
round. Therefore the maximum scope of the money creation process is inversely
proportional to the minimum reserve requirement (the leakage rate).
1
❐ This means that the value of the credit multiplier is ​ R ​, where R = reserve requirement
(e.g. 0.025, meaning 2.5% of deposits). The logic of this is the same as with the
expenditure multiplier outlined in chapter 2: the more that is held back (or that leaks
from the process) in each round, the smaller the cumulative effect of the money creation
process. The credit multiplier can be quite large – it is 40 in the South African case.
3.1 The monetary sector and interest rates
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It is important to note that the reasoning here concerns the maximum scope of the money
creation process. Banks can choose voluntarily to hold higher-than-required reserves or
so-called excess reserves (see the balance sheet subsection that follows). The holding of
excess reserves restrains the money and credit creation process. Because banks hold an
additional percentage of deposits, the effective value of the credit multiplier will decrease.
❐ For example, should banks choose to hold excess reserves equal to 1% of deposits, while
1
the required reserve requirement is 2.5%, the effective multiplier will be ​ 
0.025 + 0.01 ​ =
1
28.6. Compare this to the value of 
​ 0.025 ​= 40 if no excess reserves are held. The formula
of the credit multiplier thus indicates a maximum value.
❐ Excess reserves result in an element of uncertainty regarding the extent of any change
in the money stock; they also imply that changes in the money supply do not occur
mechanically.
❐ The proportion of excess reserves that banks hold is very sensitive to the nominal
interest rate they can charge on loans. When the prime rate increases, for instance, the
opportunity cost of holding excess reserves increases – the bank has an incentive to
reduce excess reserves and lend a larger proportion of the deposits that it holds.
✍
What is the value of the credit multiplier if the cash reserve requirement is 2.5% and banks hold
2% excess reserves on average?
__________________________________________________________________________________
The role of the Reserve Bank in the money supply process
Three factors that determine the supply of money have been identified so far: injections of
money into and withdrawals from the banking system, banks voluntarily holding excess
reserves, and changes in the minimum reserve requirement.
The last factor is under the control of the Reserve Bank. Though it has not been used much
in recent years, it is an instrument to control the money supply – it is an instrument of
monetary policy. The Reserve Bank can and does use two other instruments of monetary
policy to influence the money supply:
(1) The repo rate (or ‘repurchase’ rate): This rate – which is not to be confused with the
prime overdraft rate – is the nominal interest rate (i.e. the price) that commercial banks
have to pay when they borrow from the Reserve Bank (have a look at the balance
sheet of the SARB further on). Banks do this when they run low on cash reserves or
borrow with the intent to support their credit creation activities. The former is where
the Reserve Bank functions as ‘lender of last resort’, providing ‘accommodation’ to
commercial banks.
❐ Increases in the repo rate discourage commercial banks from borrowing from the
Reserve Bank and, accordingly, restrain their ability to create credit/money.
❐ The opposite occurs when the Reserve Bank decreases the repo rate. When the
repo rate decreases banks are encouraged to borrow more from the Reserve Bank.
As banks then start lending out the money that they borrowed from the Bank, the
credit multiplier starts to operate. The loans reflect in the bank balances (deposits)
of firms and households in various banks. With a multiplier value of, for example,
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40, the cumulative effect can be huge. In this way changes in the repo rate have a
significant impact on the money supply via loans and deposits.4
The repo rate is formally announced by the governor of the SARB after the regularly
scheduled meetings of the Monetary Policy Committee (MPC).
❐ Practically it is made effective via a weekly tender process in which banks express
their need for accommodation (funds). Depending on the total liquidity needs of
banks, the rate is set (in line with the MPC decision) by adjusting the amount of
funds the SARB is willing to provide to banks.5
Bank profit originates from the difference between the nominal interest rate that
banks pay on their liabilities (loans from the SARB and private deposits) and the
nominal interest rate that they earn on their loans and advances to households and
firms. Thus the repo rate at which the banks borrow (the ‘wholesale price of credit’)
will determine the rate that banks will charge (the ‘retail’ price) on the loans that
they extend. This explains why, when the repo rate increases, the prime overdraft rate
charged by banks immediately follows suit.
❐ The margin between the repo rate and the prime overdraft rate typically is 3.5%.
The graph in figure 3.3 shows the consistently parallel way these two rates have
moved over time, and how their cyclical movement relates to the business cycle. (The
repo rate’s predecessor prior to 1997 was known as the bank rate.)
Figure 3.3 The repo (bank) rate and the prime overdraft rate
25
Prime rate
Nominal interest rates (%)
20
15
10
Bank rate/Repo rate
5
2017
2015
2013
2011
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
0
Source: South African Reserve Bank (www.resbank.co.za) and Quantec.
4
5
This process will commence with an increase in the ‘loans extended to bank’ on the asset side of the SARB.
Simultaneously, the excess reserves that banks hold with the SARB (appearing on the liability side of the SARB
balance sheet) will also increase. As banks then start lending out the money that they borrowed from the SARB, the
‘loans and advances’ on the asset side and the ‘deposits’ on the liability side of the bank balance sheet start to increase.
Because of the higher levels of deposits and thus the increase in the amount of cash reserves required, the excess
reserves of banks will decrease and be converted into required reserves.
Should the repo rate remain constant, it does not mean that the amount of credit extended and deposits created in the economy
will necessarily remain unchanged (indeed, it usually does not remain unchanged). When the level of economic activity
increases, one could also expect that there will be increases in the demand for bank loans and in the demand for deposits held
for transactional purposes. Thus, banks may borrow more reserves from the SARB to finance an increase in their loan book
even when the repo rate remains unchanged (which, in effect, means that the SARB accommodates the additional demand by
allowing the money supply to increase at the prevailing repo and interest rate level). Given a cash reserve requirement of 2.5% and
thus a credit multiplier of 40, relative to their total deposits, banks will not need to borrow that much from the SARB.
3.1 The monetary sector and interest rates
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Unlike cash reserve requirements (discussed earlier) and open market operations (discussed later), the repo rate conveys a direct price signal to the financial markets as to
the Reserve Bank view regarding the direction into which the interest rate should be
moving. Cash reserve requirements and open market operations can also influence
the nominal interest rate level in the economy, but the effect is more indirect.
Because of the clarity of its signal, the repo rate is the most important monetary policy
instrument that the SARB uses to conduct monetary policy and to convey its policy
stance to the financial markets. This is the case not only in South Africa but in most
countries with a monetary policy system pursuing a clear goal (usually low inflation).
(2) Open market operations (OMOs): This refers to the Reserve Bank’s buying and selling
of treasury bills or short-term government bonds in order to influence the supply
of money in the economy. Selling of bonds withdraws money from circulation
and decreases the money supply; buying bonds brings money into circulation and
increases the money supply. (Remember that government bonds are originally issued
by the Treasury in the primary market to finance the budget deficit.6 Open market
transactions thus occur in the secondary market, with the role of the Reserve Bank
being that of dominant market participant able to influence the market significantly.)
❐ See sections 3.4 and 9.7 for an explanation of ‘quantitative easing’, a practice introduced in the USA in 2008. It is similar to open market operations but involves
the sale, by a central bank, of long-term government bonds as well as other, privatesector financial assests such as MBSs (Mortgage-Backed Securities).
Summary: determinants of the money supply
Household, firm and bank actions:
1. Injections of money (deposits, inflows) into and withdrawals (outflows) from the domestic
banking system. This includes international in- or outflows of funds due to a surplus or
deficit on the balance of payments (see chapter 4).
2. Banks voluntarily holding excess reserves or reducing their excess reserves.
3. Banks borrowing more reserves from the SARB to finance an expansion of their loan book
(see footnote 4).
Reserve Bank actions:
4. Changes in the official minimum reserve requirement by the Reserve Bank, which affects
the size of the credit multiplier.
5. Open market operations by the Reserve Bank, which either injects or withdraws money
from circulation.
6. Changes in the repo rate instituted by the Reserve Bank.
✍
What is the prime rate? How high is it at the moment?
____________________________________________________________________________________
____________________________________________________________________________________
6
88
The matter is complicated by the fact that even primary issues of bonds used to be handled by the Reserve Bank in its
capacity as agent of the Treasury. However, see chapter 9, section 9.5 for current arrangements.
Chapter 3: The basic model II: financial institutions, money and interest rates
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A bank balance sheet approach
To gain a better understanding of how a change in credit leads to a change in the money
supply and what role the central bank (i.e. the Reserve Bank) plays in the process, we can
examine the balance sheets of the central bank and the commercial banks.
❐ We will see linkages between key, corresponding items in the Reserve Bank and commercial bank balance sheets.
❐ In the commercial bank balance sheet we will see the link between deposits (liability
side) and the loans (asset side) so enabled.
Figure 3.4 Balance sheets – SA Reserve Bank and commercial banks
SOUTH AFRICAN RESERVE BANK BALANCE SHEET
COMMERCIAL BANK BALANCE SHEET
Assets
Liabilities
Assets
Liabilities
Gold and foreign reserves
Liquidity provided
Utilisation of cash reserves
Loans granted to banks
(repurchase agreements)
Advances and investments
Advances
Banks
Other
Investments
Government stock (bonds)
Other
Notes and coins
Deposits
Central government
Banks and mutual banks
Required reserve balances and
excess reserves
Other
Capital and liabilities other than
notes, coins and deposits
Central bank money and gold
Banknotes and coins
Gold coin and bullion
Deposits with the SARB
Deposits*
Other assets
Loans and advances
Mortgage advances
Overdrafts and loans
Instalment debtors, leases
Foreign currency loans
Other
Investments (bonds, shares)
Fixed assets
Other liabilities to the public
Loans received from SARB
(repurchase agreements)
Other
Foreign loans
Other loans and advances
Other liabilities to the public
Capital and other liabilities
Other assets
*Including cash, cheque and transmission accounts, short-, medium- and long-term savings.
The asset side of the balance sheet of the South African Reserve Bank comprises, among
others, gold and foreign reserves as well as loans granted to banks.
❐ The gold and foreign reserves include the dollars, euros, yen and pounds etc. held by
the SARB.
❐ The loans to banks comprise the repurchase agreements into which the SARB enters
with banks, i.e. when banks borrow from the SARB at the ‘repo rate’.
❐ Government bonds that the SARB buys in OMOs appear on the asset side of the balance
sheet of the SARB under ‘government stock’ (under ‘investments’; see below).
The liability side of the SARB balance sheet includes:
❐ Notes and coins circulating in the economy. Just as a treasury bill is an IOU
whereby government promises to pay you the face value of the bill, so a R100
note is an IOU issued by the SARB whereby they promise to pay you R100 if you
offer them your IOU (bank note). (Until the 1990s banknotes had such a promise
written on them).
❐ Deposits made by government (the SARB acts as banker to government) and commercial
banks. The latter includes the required reserves that they need to hold, as well as
additional (excess) reserve deposits at the SARB.
3.1 The monetary sector and interest rates
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The asset side of the balance sheet of commercial banks includes:
❐ The deposits that they hold at the SARB (the required reserves as well as the excess
reserves), and
❐ Loans and advances that the banks extend to firms and households. These include mortgage
advances, overdrafts and loans, instalment credit and leases. (The asset side of banks may
also include investments in bonds and shares as well as some fixed assets.)
The liability side of the balance sheet of commercial banks includes:
❐ Private deposits (i.e. if you deposit money at the bank, the bank owes you the money).
❐ Loans that the banks receive from the SARB in the form of repurchase agree­ments, and
on which they pay the repo rate. (Banks may also borrow from other banks, and from
foreign banks and institutions.)
These two liability-side items are the main elements that enable banks to extend loans to
households and firms, i.e. to create credit (which then is reflected on the asset side of their
balance sheets). This is the heart of the money creation process.
❐ If ‘deposits’ increase on the liability side of commercial bank balance sheets, their
conversion into loans to households and firms will be visible in the amount of ‘loans
and advances’ on the asset side.
❐ Observe the mechanism through which changes in the repo rate will affect the liability side
of the balance sheets of commercial banks, and thus the basis of their credit extension
to the private sector, i.e. their money creation. If a repo rate change encourages banks to
borrow from the Reserve Bank, it will reflect first as an increase in ‘loans received from
SARB’ on their liability side, but when it is used to extend loans to households and firms, it
will reflect similarly as an increase in ‘loans and advances’ on the asset side of their balance
sheets.
❐ Likewise, changes in the required reserves (held at the SARB) will impact on the latitude
of commercial banks to extend loans, from deposits, to households and firms.
❐ The asset side reveals how voluntary excess deposits (excess reserves) at the SARB will
reduce the scope for loans that can be extended by commercial banks.
Note how:
❐ Loans from the Reserve Bank to banks are symmetrically reflected as assets for the
Reserve Bank and liabilities for commercial banks.
❐ Required and excess reserves are symmetrically reflected as assets for commercial
banks and liabilities for the Reserve Bank.
It is also possible to compile a consolidated balance sheet for the whole monetary sector
(defined to include, inter alia, the Reserve Bank, commercial banks, the Land Bank, the Post
Bank and the Corporation for Public Deposits). The components of the nominal M3 money
supply and the loans that the monetary sector extends then appear as assets and liabilities
on the sector balance sheet.
Thus an increase in M3 can be traced back, for instance, to an increase in the extension of
credit to the private sector, which in turn can be broken down into increases in mortgage
loans or overdraft facilities, and so forth. Indeed, most of the increase in M3 can be traced
back to changes in the different types of credit extended to the private sector.
One can thus gain insight into money supply conditions and dynamics by studying the
consolidated balance sheets of the monetary sector together with those of the commercial
banks and the Reserve Bank. These balance sheets are published regularly in the Quarterly
Bulletin of the Reserve Bank.
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The bank sector balance sheet in numbers
The numbers referring to the above discussed balance sheet can be found in the Quarterly
Bulletin of the South African Reserve Bank. The graphs in figures 3.5 and 3.6 present some
of the salient features of the data. Whereas deposits constitute M3 and thus the liability
Figure 3.5 M3 and its counterparts
4 000
Total credit extended to
the private sector
3 000
M3
R billion
2 000
1 000
Foreign assets
Net credit extended to
government
0
–1 000
Jul-18
Jan-17
Jul-15
Jan-14
Jul-12
Jan-11
Jul-09
Jan-08
Jul-06
Jan-05
Jul-03
Jan-02
Jul-00
Jan-99
Jul-97
Jan-96
Jul-94
Jan-93
Jan-90
–2 000
Jul-91
Net other assets and
liabilities
Source: South African Reserve Bank (www.resbank.co.za).
Figure 3.6 Private credit extension and its main components
4 000
Total credit
extended to
private sector
3 500
3 000
R billion
2 500
2 000
Other loans and advances
Mortgage advances
1 500
1 000
500
Jul-18
Jan-17
Jul-15
Jan-14
Jul-12
Jan-11
Jul-09
Jan-08
Jul-06
Jan-05
Jul-03
Jan-02
Jul-00
Jan-99
Jul-97
Jan-96
Jul-94
Jan-93
Jul-91
Jan-90
0
Instalment sale credit
Leasing finance
Source: South African Reserve Bank (www.resbank.co.za).
3.1 The monetary sector and interest rates
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side of the banking sector, ‘loans and advances’ constitute the asset-side counterparts to
M3. In figure 3.5, the graph shows M3 and these counterparts. The lines represent the
counterparts to M3 and add up to the value of M3, itself represented by the shaded area.
One of the main components of loans and advances is credit extension to the private sector.
The graph in figure 3.6 shows its main components, of which the category of mortgages
is the largest.
The money supply function
The instruments of monetary policy are the main determinants of the supply of money.
The nominal money supply MS is mainly a function of exogenous policy factors under the control
of the monetary authorities. In simple theory this is as far as one would go. It implies a
vertical money supply curve that is shifted left or right by curtailments or expansions of
the nominal money supply as a consequence of monetary policy steps.
A first refinement that we need to make is to convert the money supply function, and
the diagram, from dealing with the nominal money supply MS to the real money supply,
indicated as 
​ MP ​. This parallels the formulation of the money demand function in real terms
above. We will also increasingly use the real interest rate r in our analysis.
M
❐ Henceforth, when we use the term ‘money supply’, we mean the real money supply ​ 
P .​
S
S
A further possible refinement would be to include the practice that banks frequently hold
excess reserves. This means that the effective money supply is lower than it would have
been without excess reserves, i.e. when only the exogenous policy factors play a role. Why
would a bank hold excess reserves, and how does that affect the money supply function?
❐ In a period of uncertainty excess reserves provide security.
❐ Excess reserves also provide a ‘buffer’ to protect a bank against unexpected, large
withdrawals of cash by its clients. Especially when the repo rate is high, a bank will want
to ensure that it is not forced to go to the Reserve Bank for assistance (accommodation).
Holding excess reserves is not without cost, however. If a bank holds excess reserves, it
forfeits the interest it could have earned by putting the funds out as loans: the interest rate is
the opportunity cost of holding excess reserves. High interest rates are likely to discourage
the holding of excess reserves and encourage maximum lending. Lower interest rates can
induce banks not to lend to the fullest extent.
This suggests the possibility of a positive relationship between the interest rate and credit/
money creation. Graphically, this is represented as a money supply curve with a positive
slope. The steepness of the curve (the value of the slope) will depend on the interest
responsiveness of the money supply. (How?)
This positive relationship can be valid only up to the point where banks are fully loaned up.
Then money creation in the banking system reaches a ceiling. Exactly where this ceiling
is will depend on the exogenous policy factors analysed above – most importantly, the size
of the cash reserve requirement. Graphically, this means that the money supply curve
becomes vertical at this point.
The money supply can therefore be depicted in two ways, as shown in figure 3.7.
M
For most macroeconomic chain reactions, it is sufficient to use the simple, vertical ​ 
P​
curve. One should, however, always keep the role of excess reserves in mind, as it can be
decisive in some lines of reasoning.
S
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Figure 3.7 Two depictions of the real money supply
i
Simple form:
MS
​  P ​

Refined form:
i
M
​ 
​
P
S
Real quantity of money
Real quantity of money
Is the money supply exogenous or endogenous?
❐ If a portion of the money supply curve is interest responsive (i.e. non-vertical graphically), then
the money supply is partially endogenous (i.e. dependent on factors within the economy)
and reacts spontaneously to changes in the economy.
❐ If policymakers respond to problems such as unemployment by allowing the money supply
to grow, then this money supply growth is (partially) an endogenous result or symptom of
events in the economy.
In both cases the control of the Reserve Bank over the money supply is not complete, nor
independent. If only the exogenous policy instruments determine the money supply, then it is
exogenous and Reserve Bank control is complete. That is the case with a vertical money supply
curve (graphically).
Supply and demand interaction: equilibrium in the monetary sector?
Graphically (see figure 3.8), it is simple to
indicate that the equilibrium between the Figure 3.8 Money market equilibrium
supply of and demand for money is
deter-S
i
MD
M
​
and
​ 
mined by the intersection of the ​ 
​  MP ​

P
P​
curves which determines an equilibrium
interest rate as well as an equilibrium quantity
of money.
S
Mathematically the equilibrium in the money
market can be expressed as:
MS
i0
MD

​ 
P ​ = ​  P ​
M
and because ​ 
P ​ = kY – li, the money market
equilibrium condition can be rewritten as:
D
MS
​ 
P ​= kY  li
…… (3.2)
MD
​  P ​

Real quantity of money
3.1 The monetary sector and interest rates
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Any shift in either or both of the curves will
lead to a new interest rate level. An increase
in the money demand (e.g. due to an increase
in Y) will lead to a rate increase. Likewise, an
expansion of the money supply should result
in downward pressure on the rate of interest.
Figure 3.9 Money market changes
i
MS
​  P ​

However, such a mere diagrammatical or i1
mathematical statement is not sufficient – one
must analyse and understand the economics i0
behind these diagrammatical stories. The
demand for money must be linked to the
demand for financial assets and to money
​  MP ​

M
​  P​
market instruments in particular. Changes in 
or 
​  MP ​, and changes in the equilibrium interest
Real quantity of money
rate and quantity (see figure 3.9), can then be
understood and interpreted in terms of the trade in financial instruments.
D
D
S
For example, suppose (due to some change in the economy) the real demand for money were
M
to increase (​ 
P ​shifts right graphically). The following chain of events would occur in the
money market:
D
At the initial interest rate level i0 there will be an excess demand for money. This implies
that the public requires more money (not income) for transactions than they currently
have in their portfolios. One way to get hold of money is to sell some of their financial
instruments/assets. The sale of financial paper implies an increased supply of, for example,
BAs on the money market. This causes downward pressure on the prices of BAs, which is
equivalent to upward pressure on the BA rate. The interest rate moves to i1.
✍
A similar story can be told for an increase in the money supply (MS ). Complete this chain
reaction in the space below:
______________________________________
Graphical test:
______________________________________
______________________________________
______________________________________
______________________________________
______________________________________
______________________________________
______________________________________
______________________________________
______________________________________
______________________________________
______________________________________
______________________________________
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M
These events explain, practically, why the increase in ​ 
P ​leads to an increase in the
nominal rate of interest, as shown in the diagram. It thus explains the path between the
two equilibrium points.
M
❐ At both equilibrium points: ​ 
P ​ = kY – li.
D
S
Remarks
1. In practice, quite a number of different short-term rates of interest exist (compare the
interest rate information in the Quarterly Bulletin of the Reserve Bank). In addition,
there are long-term rates of interest, for example on 20-year Eskom stock or long-term
government stock. Therefore, the single rate of interest shown in the diagram must thus
be understood as being representative of the interest rate spectrum.
✍
How many interest rates?
See how many different rates you can find in the Quarterly Bulletin or in financial weeklies or the
financial pages of newspapers. Can you classify them into groups?
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
2. The relationship between short-term and long-term interest rates is called the
‘term structure of interest rates’ or the ‘yield curve’. It is standard practice to use
the interest rates on government bonds when constructing the yield curve. 7 The
relative height of short-term as against long-term interest rates – the slope of the
yield curve – and their expected relation in future is of great interest to financial
investors and portfolio managers who must decide between investment in shortor long-term assets.
❐ Usually, when the short-term interest rates are lower than the long-term interest
rates (i.e. there is a positive yield curve), it indicates that there is an expectation in
financial markets that interest rates are likely to increase in future.
❐ If short-term interest rates are higher than long-term interest rates (a negative
yield curve), the expectation is for interest rates to decrease in future.
❐ Close to the peak of a business cycle, when money market conditions become tight
because of the high demand for short-term credit), the yield curve tends to become
negative – short-term rates become higher than long-term rates. A negative yield
curve also means interest rates are relatively high. Hence, there is an expectation
that they will decrease in future. When the economy is close to the trough of the
business cycle (i.e. in recession), money market conditions are not tight, so there
is not much upward pressure on short-term interest rates. The yield curve will be
positive. This implies that interest rates are relatively low. Hence, interest rates are
expected to increase in future.
7
When one compares short-term and long-term interest rates, one should ensure that they are issued by the same
institution. This will ensure that the risk premium included in both the short-term and the long-term interest rate are
the same and that the only difference between the short-term and long-term interest rate is the time to their maturity.
Government is one of few institutions to issue both short-term and long-term bonds.
3.1 The monetary sector and interest rates
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For portfolio managers, it is very important to know what the interest rate is
expected to do in the future, because, as you may recall from above, there is an
inverse relationship between the interest rate and the price of a financial asset (or
‘security’).
✍
Which are higher – short-term rates or long-term rates?
Find examples of short-term rates and long-term rates for a few years and compare the levels,
also on a graph. Is there any pattern?
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
(Hint: Is there any link to the business cycle? Compare graphs comparing the yield curve to the
economic growth rate.)
3. Note that neither the government nor the Reserve Bank sets interest rates in the sense of
a legal prescription or decree. The Reserve Bank influences, manages or controls interest rates via the money market by influencing the money supply and changing the repo
rate. The Bank indeed has many potent ways to influence the course of interest rates
decisively (these are discussed in depth in chapter 9), but they still do not amount to
‘interest rate fixing’.
4. In the analysis above, we saw
how open market operations
Monetary policy and the demand side of the
monetary sector
(OMOs) can change the supply of money in the market,
In practice, the repo rate, which constitutes a cost
thereafter leading to a change
factor for banks, has an immediate effect on the
in the rate of interest. In praclending rates of banks.
tice, the sale of, for example,
❐ This can influence the demand for credit
(graphically, a move along the MD curve), which
government stock in OMOs
can result in a new equilibrium money stock and
usually has an immediate efinterest rate.
fect on interest rates, since
❐
This is discussed in the analysis of the practice of
each transaction carries a
monetary policy in chapter 9.
certain price and thus a corresponding rate of interest. If
the Reserve Bank experiences
difficulties in selling stock, it has to reduce the price sufficiently to attract buyers, i.e.
the rate of interest must be increased sufficiently. To keep one’s economic reasoning
on track, it might be safer, though, to understand the effect of open market transactions as first affecting the money supply, which in turn causes a change in the rate of
interest.
5. The Quarterly Bulletin of the SARB contains information about the weekly money
market accommodation that the SARB provides to banks in the form of, mainly, repo
transactions. The accommodation means that banks are continuously experiencing a
shortage of funds that they are unable to fill by borrowing in the market (by borrowing
from other banks in the so-called ‘interbank market’). Thus they need to borrow from
the SARB. News media sometimes refer to this when they report on the ‘money market
shortage’.
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Why always a shortage?
In practice the Reserve Bank prefers the money market always to show a modest shortage. Why?
A shortage means that banks are forced to go to the Reserve Bank for accommodation. This in
turn means that the repo rate is continually activated as a cost factor for banks, which makes
it an effective policy instrument for the Bank (see chapter 9).
❐ The Reserve Bank maintains the necessary shortage by using either open market
operations or changes in the minimum reserve requirement to manipulate the supply side
of the market.
❐ Only when the shortage becomes unusually large can one really expect upward pressure
on interest rates.
❐ In early 2014 the average shortage (amount of accommodation) ranged between
R20 billion and R40 billion. (Is this relatively large or small? What percentage of the money
stock does this constitute? Compare the money supply figures above.)
✍
1. Commentators may state that an increase in interest rates is a symptom of prosperity and
good times. Why?
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
This effect on interest rates typically occurs in the later stages of an upswing – as the
economic upswing gains momentum, credit bottlenecks start to develop, creating upward
pressure on interest rates. (It is as if the economy heats up and runs a temperature.)
2. If you have to explain why interest rates have declined, what are all the possible causes
(including policy steps)? Make a list. (Hint: Distinguish between demand-side and supplyside causes, and between endogenous and policy-related causes.)
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
Built-in cycles?
The restraining feedback effect may imply some kind of cyclical tendency in the economy. The
automatic increase in interest rates at the end of an upswing, which dampens expenditure,
may perhaps initiate the start of a downswing phase. Likewise, decreasing interest rates at the
end of a recession may be the beginning of forces that may initiate the next upswing.
In practice, this factor alone cannot explain the cyclical movement in the economy (also
see section 3.2.2). In chapter 4 other factors are identified that may constitute inherent or
endogenous cyclical forces.
3.1 The monetary sector and interest rates
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3.2
Linkages between the monetary and the real sectors
At this point we can combine the elements of the model encountered so far: the monetary
sector and the real sector. Together the two sectors constitute a coherent model of the
economy (temporarily excluding the external sector variables and the price level). Different
chain reactions can now be linked together to explain most macroeconomic changes in
these two sectors. The three diagrams involved can be juxtaposed to illustrate the linkages
between the two sectors.
The first important linkage is from the monetary sector (or money market) to the real
sector (or goods market).
Working with both nominal and real interest rates in one set of diagrams
Before we demonstrate that, we need to find a way to link the money market diagram
– which has the nominal interest rate i on its vertical axis – with the real investment
diagram, which has the real interest rate r on its vertical axis.
The two diagrams in figure 3.10 show how the money market diagram can be converted
into one with the real interest rate on its vertical axis. Given an inflation rate π, for every
nominal interest rate level i there is an equivalent real interest rate r. So, if a nominal rate
i0 is determined in the money market, in effect a real rate r0 is also determined (given the
inflation rate).
Note how the vertical displacement of the two diagrams is equal to the inflation rate π, as
required by the expression r = i – π, or i = r + π. (See the box in chapter 2, section 2.2.2, for
a discussion of this expression.)
Figure 3.10 The money market with nominal and real interest rates
The money market with a
nominal interest rate
i
The money market with a
real interest rate
r
MS
​  P ​

MS
​  P ​

r0
i0
i0
r0
MD
M
​
​ 
P
D
​  P ​


Real quantity of money
Real quantity of money
From now on we will use the right-hand version of the money market diagram, with the
real interest rate r on the vertical axis (while keeping in mind that actual money market
behaviour – the buying and selling of financial instruments, and real money demand and
supply – is based on the nominal interest rate).
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❐ If the inflation rate is zero, the two diagrams become identical. Since in this chapter we
are still assuming, for the sake of exposition, that the price level P is constant, the new
diagram does not affect our analysis at all. But it does mean that our diagrammatical
apparatus is equipped to deal with the inflationary context when that becomes
necessary (e.g. in chapter 6).
3.2.1
The Keynesian transmission mechanism in the short run
The first important linkage is from the monetary sector (or money market) to the real
sector (or goods market). Changes in the monetary sector cause changes in the rate of interest
that, via the impact on investment (capital formation), influence aggregate expenditure and
consequently real GDP.
This sequence is particularly important in the analysis of the consequences of monetary
policy steps. A more complete example follows.
Suppose the repo rate is increased by the Reserve Bank. This discourages the lending
and money creation capacity of banks. The money supply contracts. This is likely to
cause excess demand in the money market. Sales of money market instruments (to
increase money holdings) cause downward pressure on their prices, and thus upward
pressure on nominal interest rates (towards a new money market equilibrium). In effect
this increases real interest rates with the same amount. The higher real interest rates
discourage investment. (Why?) The likely decrease in investment expenditure I decreases
aggregate expenditure (C + I + G + X – M). Accumulating stocks discourage production.
If and when production decreases, real GDP and thus real income Y decrease. The level
of economic activity declines and the economy experiences a downswing or cooling down
period. In brief:
Repo rate  ⇒ MS  ⇒ upward pressure on r ⇒ I discouraged; if I  ⇒ total
expenditure decreases ⇒ production discouraged ⇒ real GDP and Y decline.
Figure 3.11 Effect of an increase in the repo rate
E
r
r
MS
​  P ​

C + I0 +
C + I1 +
M
​ 
​
P
D
Real quantity of money
G+X–
M
G+X–
M
I0
I1
I
I
Y
The left-hand diagram in figure 3.11 shows what happens in the money market, and with
the interest rate, when the money supply changes due to the repo rate change. The middle
diagram shows what happens to investment due to the change in interest rate. The righthand diagram shows what happens to total expenditure E and consequently to the level of
production (GDP) or income Y.
3.2 Linkages between the monetary and the real sectors
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In this theory or view of the macroeconomy, therefore, the connection between monetary
disturbances and the real sector occurs via the interest rate-investment link. (Note that
the middle diagram has a monetary variable on the vertical axis and a real variable on the
horizontal axis.) This is the so-called Keynesian transmission mechanism: the transmission from
monetary to real variables occurs primarily via interest rates. (The Classical or Monetarist
view differs from this. It is discussed in chapter 11.)
✍
1. Suppose the reserve requirement is increased ⇒
_____________________________________________________________________________________
_____________________________________________________________________________________
Diagram:
2. Suppose the Reserve Bank sells government stock in open market transactions ⇒
_____________________________________________________________________________________
_____________________________________________________________________________________
Diagram:
To summarise:
1. The implications of money market conditions or events are not limited to the
monetary sector of the economy. They are also transmitted to the real sector. In this
transmission, the link between the real rate of interest and investment is decisive.
2. The main significance of monetary disturbances and events is the consequences they
have for real GDP and employment.
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3. The direct causes of, for example, a downswing in the economy can be found in
reductions in one or more of the components of aggregate expenditure (e.g. G or X),
but may actually lie further back in money market conditions. The reverse is true for
an upswing.
Remember that these rather long chain reactions do not come about in a mechanical
fashion. Each step depends on human decision making; uncertainties abound, and delays
or weak reactions often occur. This can significantly influence the speed and extent of the
real impact of a monetary disturbance or policy step. And even though we are working
with short-run changes, these chain reactions can take a year or two to complete.
How strong is the real impact of a change in the money supply?
One specific important factor in these events is the interest rate responsiveness of the
​ MP ​ = kY – li. We have seen that interest rate
demand for money MD – the parameter l in 
changes are of critical importance in understanding the real impact of a monetary policy
step in the form of a money supply change: the larger the interest rate change, the larger
the real impact (via investment). However, what determines the extent to which the interest
rate will increase or decrease?
D
Reconsider the chain reaction in the case of a restrictive monetary policy step such as an
increase in the cash reserve requirement.
❐ What happens in the money market is that the initial decline in the money supply
results in an excess demand situation. This is what causes the upward pressure on the
nominal (and thus real) interest rate.
❐ How far will the interest rate increase? It depends on the extent that the rate needs
to increase in order to dampen or ‘choke’ the excessive money demand sufficiently to
attain balance with the new, reduced supply of money.
❐ Put differently, the interest rate increase must encourage people and institutions to
hold less money/cash and to rather buy financial assets. How far it needs to increase
before demand has been curtailed sufficiently depends on the sensitivity of people and
institutions to the interest rate. If a small interest rate increase is sufficient to curtail all
the excess demand, money market equilibrium will be reached promptly. The interest
rate will increase only minimally and the impact on the real economy will be relatively
mild.
❐ In other words, if money demand reacts strongly and sensitively to nominal interest
rate changes (if the demand for money is highly interest rate responsive, i.e. a large value
M
of l in ​ 
P ​ = kY – li) the real impact of a monetary policy step such as an increase in the
money supply on the interest rate will be relatively weak. (In extreme cases monetary
policy can be entirely impotent; in practice this is a rare event, limited to periods
when confidence in the economy is extremely low. The Great Depression in the USA
and many other countries was one such event and the 2008–09 financial crisis was
another.)
❐ Conversely, if money demand is relatively insensitive to nominal interest rate changes
M
(i.e. a small value of l in ​ 
P ​ = kY – li) interest rates will change quite a lot during the
chain reaction and a relatively larger real impact can be expected. In such a situation
monetary policy is relatively powerful.
❐ The diagrams in figure 3.12 illustrate the impact of a money supply contraction on the
real interest rate for the contrasting cases of money demand with high and low interest
rate responsiveness (left-hand and right-hand side diagrams respectively).
D
D
3.2 Linkages between the monetary and the real sectors
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❐ The left-hand diagram below shows the impact of a money supply contraction on the
equilibrium real interest rate for a money demand relationship with a relatively high
interest rate responsiveness. The right-hand diagram shows a much larger change in
the equilibrium real interest rate for a similar contraction in money supply if the money
demand has a relatively low interest rate responsiveness.
Figure 3.12 The impact of the interest rate responsiveness of money demand
r
r
MS
​  P ​

MS
​  P ​

r1
r1
r0
D
​  MP ​

r0
MD
​  P ​

Real quantity of money
Real quantity of money
In addition to factors that determine the extent of the real interest rate change, the rest of
the impact of the monetary policy step will depend on:
❐ How strongly investment reacts to a real interest rate change. A high interest
responsiveness of investment (a high sensitivity to the rate of interest, indicated by a
large h in I = Ia – hr) will strengthen the impact; and
❐ How strongly any change in investment expenditure impacts on production and income.
This depends on the extent of the multiplier process. Therefore, all the determinants
of the value of the expenditure multiplier KE – various leakage rates – are potentially
relevant.
The table summarises the
potency and impact of a
money supply change.
Potency of
monetary policy
Interest responsiveness of money demand:
Interest responsiveness of investment:
Expenditure multiplier:
High
Lower
Low
Higher
High
Higher
Low
Lower
Large
Higher
Small
Lower
The interest rate as a cost factor
Although an interest rate increase due to restrictive monetary policy, for example, has been
analysed primarily as a factor influencing expenditure or demand, interest rates can also be
an important cost consideration for a business enterprise. Thus interest rate changes can also
affect the production or supply side of the economy.
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Note that these conclusions about potency apply specifically to monetary policy steps
in the form of money supply changes. If a monetary policy step is defined in terms of
interest rate changes, a very different result emerges. We will return to this issue in
section 3.3.8.
3.2.2
Secondary effects and ‘crowding out’
There is a second linkage between the two sectors. This one operates in the opposite direction,
i.e. from the real to the monetary sector: any change in real income Y has an effect on the
monetary sector (via real money demand). This effect attains prominence with regard to the
expected consequences of increases in government expenditure (although it is present for
any change in total expenditure, even those originating in monetary disturbances). It can be
illustrated by means of an example:
Suppose government tries to stimulate the economy by increasing government
expenditure G. The subsequent chain reaction exhibits two distinct effects:
Primary effect: G  ⇒ total expenditure increases ⇒ production encouraged ⇒ real
GDP and Y increase.
Secondary effect: As and while GDP increases, so does the volume of goods to be
traded ⇒ total value of transactions increases ⇒ transactions demand for money
increases, i.e. money demand increases (graphically, 
​ MP ​ shifts right); this puts upward
pressure on (nominal and real) interest rates (why?); increasing real interest rates,
in turn, start to discourage private investment (why?) ⇒ as investment declines, the
rise in total expenditure is held back ⇒ production growth is held back ⇒ real GDP
and Y growth are held back.
D
Graphically, this secondary effect and the net effect of an increase in government expenditure can be represented as shown in figure 3.13.
Figure 3.13 Net effect of an increase in government expenditure
E
r
Shift in money demand
due to initial increase in
real income
r
C + I + G1
Secondary effect
∆I
Primary effect
C+I+
G0 + X –
M
•
Net
effect
on
income
I
MD
​  P ​

Real quantity of money
+X–M
∆I
I
Y
Note that the secondary, feedback effect via the money market runs counter to the initial
increase in Y. Income is pushed up but then starts experiencing a force in the opposite
direction. However, the secondary impact on Y, being a side-effect, is weaker than the
primary impact.
3.2 Linkages between the monetary and the real sectors
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❐ The net impact on Y will still be in the direction of the primary effect (in the example
above there would still be a positive impact on real income Y).
❐ In practice the two effects are not separated in time. It is not an increase in Y followed by
a distinct, smaller decline. It is not a two-step process. As the primary effect gathers
speed, the secondary effect simultaneously becomes operational. This effectively starts
to put a brake on the growth in real income and progressively restrains the net change
in Y. (We will see this even better when we use the IS-LM diagram in section 3.3.6.)
❐ Thus, in reality, there will probably be no zigzag or cyclical movement in the level of
real income Y. What happens is that, in the later stages of the expansion, the increase
in income starts to lose momentum due to the braking effect of the secondary interest
rate increase.
❐ However, the rate of increase or growth rate of Y, i.e. the percentage change in Y per
quarter or per annum, will go through a cycle: it will increase initially, but decline when
the secondary, restraining effect takes effect.
The point is that monetary feedback effects may noticeably reduce the income-boosting effect of an
increase in government expenditure. The growth in real income is gradually restrained or choked
by the rising interest rate.
This secondary counter-effect
is valid for any stimulation of
GDP and applies to changes in
exports X and the autonomous
components of consumption
(the a-term) and investment
(the Ia term). It also applies to
changes in investment due to
monetary policy pressure on the
real interest rate and changes in
consumption due to income tax
changes (affecting disposable
real income (1 – t)Y).
A term less often heard is the ‘crowding-in’ effect of
government expenditure. What does this indicate?
It indicates the stimulation of private investment
that may result from government investment in,
for example, infrastructure. This is due to the
opportunities that the stimulation of the economy
creates for private economic activity in general, or
specifically for the private sector to supply inputs to
government projects. These backward and forward
linkages with government investment can serve to
create more room for private investment, hence the
idea of crowding in.
In the macroeconomic debate, the secondary effect really came to prominence with regard
to the use of government expenditure to stimulate the economy (fiscal expansion). The
expected advantages of increases in government expenditure may be partially offset by the
real sector impact of the upward movement in interest rates.
❐ Since private investment is depressed by the higher interest rates that result from the
increase in government expenditure, the process has been called the ‘crowding out’ of
private investment by government expenditure.
How strong is crowding out? On what does it depend?
The strength of the crowding-out effect is one of the major disputes in the debate on the
potency of fiscal policy. Four factors are relevant. Three of these were encountered in the
discussion of the potency of monetary policy above and are restated only briefly:
❐ The extent of the crowding-out effect depends first on the income responsiveness of the
M
demand for money – i.e. the k in ​ 
P ​ = kY – li. Recall that the secondary effect is initiated
by an increase in the transactions demand for money due to an increase in production and
income. In the diagram 
​ MP ​shifts to the right. If this reaction is strong – k is relatively large
so that money demand is very income responsive (and shifts a lot) – the secondary effect
D
D
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will be larger and crowding out will be stronger. If money demand has a low income
responsiveness, i.e. k is relatively small, crowding out will be weaker.
❐ A second factor is the interest
responsiveness of the demand
In practice, the initial state of the money market
is also relevant in this process. A market with
for money – i.e. the parameter
M
surplus liquidity will easily absorb the extra demand
​
=
kY
–
li.
The
increase
in
l in ​ 
P
without significant upward pressure on interest
money demand causes excess
rates emerging. However, if the process starts with a
demand in the money market.
significant money market shortage – a tight market –
If money demand has a high
the upward reaction of interest rates definitely comes
interest rate responsiveness
into play.
– i.e. l is relatively large – the
real interest rate will increase
M
relatively little before reaching a new equilibrium. The ​ 
P ​curve will be relatively flat.
A relatively small negative impact on investment and income follows. Crowding out is
relatively weak in this case. If money demand is interest unresponsive, i.e. l is relatively
small, crowding out will be relatively stronger. (Why?)
❐ A third factor is the interest responsiveness of private investment – the h in I = Ia – hr.
A high responsiveness will increase the secondary effect on expenditure and income.
❐ The fourth factor is the size of the expenditure multiplier KE, which determines the ultimate
impact on Y of any change in investment. As before, all the leakage rates are relevant.
D
D
The table summarises the potency and impact of fiscal expansion via increased government expenditure.
In reality, the strength of the
crowding-out effect is an empi­
rical question. It depends on
the factual conditions and behavioural patterns in a par­ticu­
lar country at a particular time.
(For example, in chapter 2 it
was mentioned that investment
in South Africa appears to be
relatively insensitive with regard
to changes in the interest rate.)
✍
Potency of
fiscal policy
Income responsiveness of money demand:
Interest responsiveness of money demand:
Interest responsiveness of investment:
Expenditure multiplier:
High
Lower
Low
Higher
High
Higher
Low
Lower
High
Lower
Low
Higher
Large
Higher
Small
Lower
How does the existence of monetary feedback effects affect the size of the expenditure
multiplier?
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
The value of the expenditure multiplier KE mentioned above is still overoptimistic, since the
secondary effect – which reduces the change in Y – is not taken into account.
3.2 Linkages between the monetary and the real sectors
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Which factors determine the income responsiveness of the demand for money?
It depends on the behaviour patterns of economic participants (buyers, sellers, producers,
consumers, workers), as well as institutional factors. For example:
❐ The increasing use of credit cards implies that the direct need for cash reacts less quickly
to increases in transaction volumes.
❐ The accessibility of the money market for firms wishing to expand their activities is also
important. The more easily they can obtain credit via the issue of banker’s acceptances, for
example, the smaller their need for trade credit from commercial banks. This implies that
their demand for money (bank credit in particular) increases relatively slightly.
❐ Workers who receive weekly wages need to hold smaller precautionary balances, whereas
monthly wages create a need to hold more money, either in cash or on deposit at a bank.
Whatever the factors that determine the income responsiveness of money demand, they are
not likely to change rapidly. In general, these elasticities are relatively stable, at least in the
short and medium term.
Different countries can also have very different elasticities, depending on factors such as the
level of development and the nature of their economic and financial institutions.
3.2.3
Financing the budget deficit
Although the budget deficit as an element of fiscal policy is analysed in depth in chapter
10, it is desirable to analyse some interactions of the deficit with the rest of the economy
at this stage. The financing of the budget deficit by the Treasury constitutes a critically
important form of interaction between the real and the monetary sectors. It also provides
further insight into the concept of crowding out.
In the case of a budget deficit – when total tax revenue falls short of total government
expenditure – the shortfall must be financed in some way or another. Since borrowing is
the main form of deficit financing, the deficit is often called the ‘deficit before borrowing’.
There are three main methods of financing a budget deficit: domestic borrowing from
the private non-bank sector, borrowing from the Reserve Bank, and foreign loans. Our
concern here is the different macroeconomic consequences of the three options.
(1) Domestic borrowing from the private non-bank sector
This is the most general and traditional method of deficit financing: the government gets
financing by selling government bonds and TBs in the financial markets to large corporations
(such as pension funds and life
insurers). Treasury bills are usually
Crowding out mark II?
sold weekly as part of a running
Since a deficit-induced increase in interest rates
borrowing process.
can also discourage private investment, a form of
❐ We can interpret government
crowding out may also exist in this case. However,
borrowing as a component
this is not a secondary or indirect monetary effect,
of the demand for credit. De(which we can denote as ‘crowding out mark I’).
pending on financial market
Rather, it concerns the direct financial market effect of
conditions and behaviour, an
government borrowing. One should thus distinguish
increase in borrowing is likely
this ‘direct’ form of crowding out – crowding out
mark II – from the indirect one analysed above –
to cause upward pressure on
‘crowding out mark I’.
interest rates, which is likely to
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discourage private investment and is likely eventually to have a contractionary effect
on aggregate expenditure and production.
❐ The standard method of financing is restrictive. If the amount of borrowing is extensive
and places substantial demands on the money market, the contractionary effect on
domestic real income can be significant.
✍
What determines the extent of the impact of government borrowing on interest rates? Can you
explain?
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
(Hint: Consider monetary responsiveness.)
The impact on the actual money market
There is no rule of thumb regarding the size of the deficit that can be financed without putting
inordinate pressure on financial markets (i.e. on interest rates). It depends on economic and
market conditions at a particular time.
In times of monetary tightness (limited liquidity in the market), a relatively stronger interest
reaction can be expected. In an economic downturn, which usually brings about a low
demand for money and credit, a large deficit can be financed domestically without noticeable
upward pressure on interest rates.
Actually, the important question is whether the deficit that is announced in the budget speech
in Parliament comes as a surprise for money and capital market participants. Usually the
markets discount the expected deficit before the national budget is presented – the expected
impact is already largely reflected in the interest rate situation before the budget.
If the budgeted deficit is as expected, there should be no further impact on interest rates. If the
budget deficit is, say, unexpectedly large, interest rates may increase noticeably soon after the
budget speech.
❐ The impact of the budget deficit on interest rates is particularly important in understanding
interest rate patterns in the USA, as well as changes in the dollar exchange rate. As we will see
in chapter 4, US interest rates can be of great importance for the South African economy.
(2) Borrowing from the Reserve Bank
An alternative is for the government to borrow from the Reserve Bank. This can be effected
by selling TBs or government bonds to the Reserve Bank. The payment that the government
receives for the bills constitutes the loan.
❐ Since such transactions constitute an inflow of money from ‘outside’ the economy, they
lead to an injection of money into the system. The resultant money supply expansion
is likely to cause downward pressure on interest rates. Therefore this method of deficit
3.2 Linkages between the monetary and the real sectors
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financing is expansionary.
Because of the credit multiplier,
the ultimate increase in the
money supply will in all
likelihood be much larger than
the initial injection into the
money supply resulting from
the government financing its
deficit with ‘new money’.
This method is also called financing of the deficit
via money creation. In the media one often notices
the expression ‘financing the deficit with the printing
press’, as if the government finances the deficit by
printing money. This is merely a manner of speaking,
and does not indicate what usually really happens.
Remember that the government in South Africa does
not control the printing or issue of money – only the
Reserve Bank is mandated to do so. Also, actual paper
notes and coins are not the issue where the money
supply is concerned – recall that notes and coins
constitute only a fraction of the total M3 money supply.
Since such monetary expansion is
commonly regarded as inflationary
(see chapters 7 and 12) and has
indeed in reality led to inflationary
and even hyperinflationary episodes – Zimbabwe being a case in point – this is not a popular or
approved form of deficit financing. In practice, governments will only use it in extraordinary
circumstances (see chapter 10).
❐ In contrast, domestic borrowing from the private sector is described as a ‘noninflationary method of deficit financing’.
(3) Foreign loans
In this case, the Treasury goes offshore to foreign money and capital markets and sells
(or ‘floats’) bond issues there. The inflow of the borrowed funds from outside implies a
monetary injection, which increases the money supply. The macroeconomic effect is
expansionary.
❐ The so-called ‘Yankee’ and ‘Samurai’ bonds that the South African Treasury issued are
two examples. The ‘Yankee’ bond is a dollar-denominated bond, while the ‘Samurai’
bond is a yen-denominated bond.
Which option?
The choice that government makes between these options will clearly depend on general
economic as well as money market conditions (among other things).
❐ In some situations, government (the Treasury) may expressly want to use an
expansionary method of financing; at other times definitely not. The likely extent of
any crowding out that may occur surely is relevant, as are the private investment level
and prospects.
❐ A further consideration with regard to both domestic and foreign loans is the extent of
annual interest payments, which indeed can become an important expenditure item,
eventually claiming a significant part of the expenditure budget.
❐ As foreign loans are usually denominated in what is called a ‘hard currency’ (i.e. either
dollars, pounds, euros or yen), foreign loans have the additional disadvantage that foreign
exchange is required when they are to be repaid or when interest is paid on them.
❐ This also means that the government faces exchange rate risk. If the exchange rate changes
before the due date, the size of the loan in rand terms can balloon (or shrink, depending on
the case). For example, should the rand depreciate from $1 = R12 to $1 = R18, it means
that for every $1 that the South African government borrowed, it now effectively owes the
lender (maybe a US bank) R6 more in rand terms. This is a 50% increase in the foreign
indebtedness of the government purely due to a depreciation of the rand, i.e. without it
actually having borrowed more.
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These considerations are closely linked to the problems of fiscal policy and public debt
management. They are part of a more comprehensive set of considerations and arguments
that are relevant in the policy context, and which are analysed further in chapter 10.
❐ Remember that domestic borrowing from the non-bank private sector is the primary
and predominant method of financing.
The deficit and the balance of payments (BoP)
Although the international aspects of macroeconomics are analysed in chapter 4, it is
desirable to note certain linkages at this stage:
❐ Foreign loans imply an inflow of foreign capital. Therefore they constitute a link between
the budget deficit and the balance of payments deficit or surplus. (How?)
❐ Such a link also results when the budget deficit is financed with domestic loans. The
upward pressure that this places on interest rates can attract foreign capital, which
strengthens the capital account, and thus the balance of payments. (This is of particular
importance in the USA, but also has important implications for South Africa; see below.)
Crowding out mark III?
We have encountered two possible forms of crowding out. Chapter 4 will show that the
financing of a budget deficit via borrowing also can lead to the crowding out of exports – a
possible third form of crowding out linked to the budget deficit or to government expenditure.
(Once again, this has been a major issue in the USA.)
3.3
The IS-LM model as a powerful diagrammatical aid
The diagrammatical exposition encountered so far is straightforward. All the main
components in the chain reactions are individually visible. Each diagram represents
a recognisable component or sector in the overall picture and shows specific economic
behavioural relationships such as consumption or investment. The three diagrams
alongside one another show how disturbances are transmitted from the monetary to the
real sectors via the interest–investment diagram. It also allows for secondary or feedback
effects from the real to the monetary sectors.
Thus, a complete diagrammatical framework has been developed. A sequence of economic
events can be followed clearly through the diagrams. However, working with three
diagrams is cumbersome and imprecise.
3.3.1
Essentials of the IS-LM model
The IS-LM model is an alternative way of depicting these relationships diagrammatically
(see figure 3.14). It is a diagram that summarises these three diagrams into one, somewhat
complex, diagram.
It is a more abstract diagram in that it derives ‘equilibrium curves’ from the various behavioural
relationships. These curves do not permit the direct type of behavioural interpretation
possible in the diagrams encountered so far, e.g. a consumption function that directly shows
consumption behaviour. The IS-LM curves are indirect, derived curves.
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On the other hand, the IS-LM diagram provides a concise and powerful graphical (and
mathematical) tool for analysing macroeconomic changes. Still, it does not add much
economic reasoning or content to the analysis. Mostly, it is a diagrammatic tool.
The IS-LM model integrates the real and the monetary sectors and shows their interrelatedness
and interaction in one diagram. It offers a one-diagram summary of the traditional three
diagrams in the simple two-sector Keynesian 45° diagram model. The model depicts the key
macroeconomic relationships in a diagram with real income Y and the real interest rate r on
the two axes. As the name indicates, the IS-LM model comprises two curves: the IS curve and
the LM curve.
The IS curve is a summary curve that depicts the real sector – i.e. the two diagrams shown
in chapter 2, containing the interest rate, investment, consumption, government expenditure,
net exports and aggregate expenditure – in a single diagram.
❐ The IS curve shows combinations of the real interest rate r and real income Y that are consistent
with equilibrium in the real sector.
❐ It is a series of potential equilibrium points, from the point of view of relationships and
behaviour in the real sector. It has a negative slope.
The LM curve is a summary curve
that depicts the monetary sector
– i.e. the demand for money and
the supply of money – on the same
axes as the IS curve.
❐ The LM curve shows combinations
of the real interest rate r and real
income Y that are consistent with
equilibrium in the money market.
❐ It is a series of potential
equilibrium points, from the
point of view of relationships
and behaviour in the monetary
sector. It has a positive slope.
Figure 3.14 The IS-LM model
r
r1
r0
LM curve
•
•
Overall macroeconomic
equilibrium Y1 and r1:
simultaneous equilibrium in
real and monetary sectors
IS curve
Y
Y0 Y1
The intersection of the two curves
indicates an overall macroeconomic equilibrium – simultaneous equilib­rium in the real
sector and monetary sector (money market). The intersection is the only point among
the two sets of potential equilibrium points denoted by the two curves that produces
equilibrium in both sectors.
The IS-LM diagram can be used to show the impact of macroeconomic disturbances on
the equilibrium levels of real income and real interest. Macroeconomic shocks translate
into a shift in either the IS or the LM curves, or both, resulting in a new intersection point.
This indicates a change in the equilibrium values of r and Y.
For instance, an increase in aggregate expenditure will shift the IS curve right, leading to
both a higher real interest rate and a higher level of real income. The equilibrium point
changes from (r0; Y0) to (r1; Y1).
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Which is which?
How does one remember which curve is the IS and which the LM? Try the following association:
❐ IS: Investment, Savings and other real sector variables.
❐ LM: Liquidity, Money and other monetary sector variables.8
3.3.2
Deriving the IS curve
As noted above, the IS curve shows combinations of the interest rate i and real income Y that
are consistent with equilibrium in the real sector. The IS curve is derived directly from the 45°
diagram and the accompanying interest–investment diagram. The derivation is shown in
the set of diagrams in figure 3.15.
The starting point for this derivation is an equilibrium position in the 45° diagram. This shows
a level of Y, which depends on a level of aggregate expenditure – notably a level of investment
I0 – which is consistent with a particular interest rate r0. From this it follows that those levels
– e.g. Y0 and r0 – represent a particular pairing of Y and r that is consistent with the condition
for equilibrium in the real sector, i.e. that aggregate expenditure equals aggregate production.
This pair can be plotted as a point on the income–interest (Y-r) pair of axes.
If the interest rate were at another level, say r1, it would imply a different level of investment I and of aggregate expenditure, and hence of equilibrium real income – therefore,
another equilibrium pairing, say of r1 and Y1 on the Y-r axes.9 A line connecting these
(and other such) points is the IS curve. It has a negative slope.
In general, each equilibrium level of Y has a specific, corresponding interest rate r as its
counterpart. Stated differently, each point of equilibrium in the real sector has two sides:
a specific level of Y and a corresponding level of r.
❐ In this way one can derive, from the interest-investment diagram and the 45° diagram,
many such pairings of Y and r that satisfy the conditions for equilibrium in the real
sector.
❐ If these (r; Y) pairs are plotted on a dia­gram with these two variables on the axes, the
result is the IS curve.
Note that the IS curve is a set of points where equilibrium in the real sector may occur
– where the conditions for equilibrium in the real sector are satisfied. Along the IS
curve, the real sector would be in equilibrium. Thus an important interpretation of the
IS curve is as a series of potential equilibrium values of Y and r, given the way economic
actors in the real (or goods) sector – investors, consumers, the government – behave.
When economic shocks and fluctuations have run their course and a new equilibrium
has been attained in the real sector, it will always be one of the points on the IS curve.
8
9
Formally, the IS label comes from the real sector equilibrium condition I = S, which is an alternative way of stating
Y = C + I + G + (X – M). The LM label derives from the money market equilibrium condition restated as L = M, where
L denotes money demand MD and M the money supply MS.
Put differently: any equilibrium level of income other than Y0 would entail a level of the interest rate that differs from
i0 (otherwise there would not be an equilibrium in the real sector).
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Figure 3.15 Deriving the IS curve
r
Equilibrium
pair (r0;Y0 )
Equilibrium
pair (r1;Y1 )
E
r0
C
r1
+G
+ I1
+X
–M
C
+G
+ I0
+X
–M
I1
I0
I0
I1
Y0
Investment I
Y1
r
Different interest rates
reappear on vertical
axis of new diagram
Values of Y in 45°
diagram reappear on
horizontal axis of IS
diagram
Income Y
Corresponding
pairs of Y and r
denote points that
form the IS curve
r0
(r0;Y0 )
r1
(r1;Y1)
IS curve
Y0
Y1
Income Y
❐ Note that, at a point lower down (to the right) on the IS curve, investment I will always
be at a higher level than at any point higher up on the IS curve. (If this is not clear to
you, scrutinise the derivation diagrams of the IS curve again, focusing on the level of
investment I associated with each of the two points on the IS curve: I1 is associated with
point Y1 and r1 on the IS curve.)
❐ The IS curve alone cannot be used to analyse sequences of events in the economy. It
summarises only one part of the economy, i.e. relationships and changes in the real
sector. The addition of the LM curve is necessary to incorporate monetary effects and
to complete the model.
❐ Diagrammatically: to determine the actual equilibrium point and value of Y, a specific
point among the series of potential equilibrium points on the IS curve must be selected.
❐ This will depend on the LM curve (see section 3.3.4).
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The IS curve as a summary curve
Economic changes involving r and Y can be summarised in terms of the IS curve. Consider
a simple change in the interest rate. It would lead to a different equilibrium level of income
Y. While this can be depicted using the two diagrams shown in the first part of this chapter,
the IS curve is a handy, concise summary curve that depicts the string of equilibrium
points among which the real economy can settle following such a change in r. Given a
particular change in r, the resultant change in equilibrium Y is shown by the IS curve
(excluding monetary effects).
π
A formula for the IS curve
Since the IS curve represents (r; Y) points that satisfy the equilibrium conditions for the real
sector (or goods market), we already have derived its equation in chapter 2 (see equation 2.6):
(
)
1
​  1 – b (1 – t) ​  ​(a + Ia + G – hr)
Y = ​ 
…… (3.3 = 2.6)
= KE(a + Ia + G) – KEhr
If this equation is solved for r, one can see that the slope parameter of the IS curve is 
​ K1h ​and its
1
E
__
intercept ​  h ​(a + Ia + G):
1
1
​  K h ​Y…… (3.4)
r=
​  h ​(a + Ia + G) – 
E
If exports and imports are included, we have, from chapter 2 (equation 2.8):
(
1
)
​  1 – b(1 – t) + m ​ ​(a + Ia – hr + G + X – ma )
Y = ​ 
…... (3.5)
= KE(a  Ia  G  X  ma  hr)
as a formula for the open-economy IS curve.
3.3.3
Properties of the IS curve
The slope of the IS curve
The well-known sequence following a decline in the real interest rate also indicates the
slope of the IS curve. Since a lower interest rate will be associated with a higher equilibrium
income level (other factors being the same), the IS curve has a negative slope, as indicated
in the diagram.
Moving along the IS curve, shifting the IS curve
The sequence starting with an interest rate
change illustrates an important characteristic of the IS curve.
❐ If the interest rate changes, the change
in Y from one equilibrium to the next
is depicted as a move along the IS curve
from one point to another. (Compare the
first diagram in figure 3.15.)
A shift in the IS curve would occur if, for
some reason, a higher or lower equilibrium
level of Y occurs without the interest rate r
having changed.
Formal rule for shifting vs. moving
along a curve
The shifting of the two curves is the most
important aspect of the IS-LM model for
rudimentary analysis and reasoning about
economic events. It is essential to master
this part of the theory.
❐ A curve shifts if a relevant variable
not on one of the axes of the diagram
changes.
❐ If one of the variables on the axes
changes, there is a move along the
curve.
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The primary reason for such a shift is an exogenous change in expenditure. If exogenous
expenditure is higher, e.g. due to a higher level of government expenditure, it would
imply a higher equilibrium level of Y being paired with the initial level of r.
Since this change does not involve the interest rate, the initial interest rate would now
be paired with a different, higher level of real income Y (to the right in the horizontal
dimension). The whole set of potential equilibrium points – the points (r; Y) that satisfy the
conditions for equilibrium in the goods market – would lie on a different plane.
❐ Diagrammatically, this translates into a Figure 3.16 Shifting the IS curve
shift of the IS curve, horizontally, to the
r
right (see figure 3.16).
When we analyse disturbances in an
IS-LM diagram this means that changes
New real sector
equilibrium Y1 at
in any factor other than the interest rate,
unchanged r0
which impact on aggregate expenditure
and hence on real income Y, will shift the
IS curve. These include exogenous changes
in consumption, investment, government r0
expenditure, taxation (which affects consumption), exports or imports.
Entire IS curve
❐ Any exogenous change in expenditure
shifts to the right
that boosts Y would shift the IS curve to
Y0
Y1
Y
the right.
❐ Any exogenous change in expenditure
that decreases Y would shift the IS curve to the left. (See the examples in section 3.2.2.)
How far will the IS curve shift?
The extent of the shift in the IS curve following an exogenous change in expenditure depends
on the resultant change in equilibrium Y. Obviously this depends on the magnitude of the
change in expenditure. A small increase in G, for example, would shift the IS curve less than a
large change would.
In addition, it would depend on the relationship between the change in G and the eventual
change in Y that results. This depends, simply, on the size of the expenditure multiplier KE:
❐ If the multiplier is small, IS shifts relatively little (for a given change in G).
❐ If the multiplier is large, IS shifts relatively much (for a given change in G).
To be specific, the IS curve will shift horizontally a distance equal to ∆Expenditure × KE
How steep is the IS curve?
For more sophisticated analysis the factors determining the steepness of the IS curve are
important. The clue to the steepness of the IS curve lies in the reasoning behind the slope
of the curve. The slope of the IS curve will depend on the magnitude of the change in real
income Y, given a certain initial change in the interest rate r. A smaller change in Y would
result in a relatively steep IS curve; a relatively large change in Y gives rise to a relatively
flat IS curve. Diagrammatically, this can be represented as in figure 3.17.
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The more important question is: which economic factors or characteristics determine the
slope of the IS curve? Reconsider the example of a drop in interest rates in chapter 2,
section 2.2.4:
r  ⇒ I  ⇒ total expenditure  ⇒ production  ⇒ Y 
How much will Y change?
Two factors determine the
extent of the change in Y:
Figure 3.17 The slope of the IS curve
r
IS steeper
Slope of IS curve depends on how
1. The first is the reaction
much Y changes in response to a
change in the interest rate
of investment to the
interest rate change.
(r0;Y0 )
r0
The extent of the reaction depends on the
r1
sensitivity of investors
to the interest rate, i.e.
IS flatter
the interest responsiveness of investment – the
size of h in I = Ia – hr
(or in the formula for
Y
Y0
Y1
Y2
IS, see equation 3.5 in
the maths box above). If this sensitivity/responsiveness is high, a given interest rate
change will elicit a strong investment reaction and the eventual change in Y will be
​ K1h ​). A low
relatively large. This would make the IS curve relatively flat (its slope being 
interest responsiveness of investment would make the IS curve relatively steeper.
2. The second factor is the reaction of total production to the change in aggregate expenditure. This reaction involves the multiplier process (see section 3.2.1). If the multiplier KE is large, the change in I in the first step will be amplified considerably and the
eventual, cumulative change in Y would be large. A large multiplier KE would therefore make the IS curve flatter (its slope being 
​ K1h ​). A smaller multiplier would make
the IS curve steeper. (Remember that the size of the multiplier depends on various
marginal leakage rates. See
Note that the multiplier affects both the slope of the IS
the examples below.)
E
E
curve and the extent to which the IS curve would shift
following an exogenous change in expenditure.
In the diagram above, therefore,
the slope of the ‘flatter’ IS curve
reflects either a high interest responsiveness of investment or a large multiplier, or both.
The ‘steep’ IS curve reflects either a low interest responsiveness of investment or a small
multiplier, or both.
Examples
Effect on slope of IS curve
Investors not very sensitive to interest rates (h)
→
High interest responsiveness of investment (h)
→
Large multiplier KE→
Small multiplier KE→
High propensity to consume b →
High propensity to save (1 – b) →
High propensity to import m→
Cut in income tax rates t→
Steeper
Flatter
Flatter
Steeper
Flatter
Steeper
Steeper
Flatter
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Points off the IS curve
Since the IS curve is a collection of combinations of Y and r that are consistent with real
sector equilibrium, any point off the IS is a disequilibrium point in the real sector. At
such a point the interest rate is too high or too low to be compatible with the level of real
income. Alternatively, the income level Y is too low or too high to be compatible with that
interest rate (and the resultant investment level). For such a pairing of Y and r, aggregate
expenditure would not be equal to aggregate output, so there would not be real sector
equilibrium.
3.3.4
Deriving the LM curve
In this section we add the second element in the IS-LM model, i.e. the LM curve. Following
that, we can use both curves to analyse economic events and changes.
Whereas the IS curve summarises economic relationships and equilibria in the real sector
of the economy, the LM curve summarises relationships and equilibria in the monetary
sector. More specifically, the LM curve summarises the money market derived in the first
sections of this chapter. It differs from that depiction of the monetary sector in that it
makes explicit the link between monetary relationships and real income Y.
As noted above, the LM curve shows combinations of the real interest rate r and real income Y that
are consistent with equilibrium in the money market. The LM curve is derived directly from the
money market diagram, in conjunction with the 45° diagram (see section 3.2.1).
The essential linkage between the money market and real income lies in the real demand
for money relationship (now written in converted form with the real interest rate r). Recall
that:
MD
​ 
P ​= f(i; Y)
= kY – li
But with i = r  π:
MD
​ 
P ​= f(r; π; Y)
= kY  lπ  lr
The key element to notice is the presence of Y on the right-hand side. It indicates that the
specific position of the real money demand curve in the money market diagram depends
on the prevailing level of real income Y. If Y is relatively high, the money demand curve
would be in a position relatively far to the right. If Y is relatively low, the money demand
curve would be in a position less to the right.
❐ In general, for each level of Y the money demand curve would be in a different position
(other things being the same).
Notice the presence of inflation on the right-hand side. It was mentioned in section 3.1.2
that a higher price level causes the nominal demand for money to increase. This effect
M
, the real demand for money. However, the
of P was handled by working in terms of ​ 
P ​
above equation indicates that inflation (continually increasing P) has an impact on the real
demand for money. The relationship is negative. As shown in section 3.1.2, holding money
means that one is not compensated for the loss of value due to inflation. Therefore, one
would prefer to hold less money when inflation is present. An increase in the inflation rate
will decrease one’s real money demand.
D
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❐ In general, for each level of π the money demand curve would be in a different position
(other things being the same).
Money demand and money supply together determine the equilibrium interest rate in the
M
M
, each different money ​ 
moneymarket. For a given real money supply ​ 
P​
P ​curve would
imply a different equilibrium real interest rate.
❐ For a given money supply (and inflation rate), therefore, each level of Y would imply a
different position for money demand and a different equilibrium interest rate r. Thus
there is a relationship between Y and the equilibrium interest rate r in the money
market. The LM curve depicts this relationship.
S
D
Figure 3.18 Deriving the LM curve
r
For income at the higher level of Y monetary
demands is at a higher level. Hence a higher
r is necessary for money market equilibrium
r
Corresponding pairs of Y
and r denote points that
form the LM curve
LM curve
M
S
r1
r0
(r1;Y1)
r1
MD for income at Y1
r0
(r0;Y0 )
MD for income at Y0
Quantity of money
Y0
Y1
Y
To derive this in the diagram (see figure 3.18), do the following:
❐ The starting point for this derivation is an equilibrium in the money market (left-hand
diagram). For a given money supply (and inflation rate), this shows an equilibrium
interest rate that is compatible with the prevailing position of money demand, which
in turn depends on the prevailing level of Y. Hence that combination of r and Y – e.g.
r0 and Y0 – is consistent with money market equilibrium. This pair can be plotted as a
point on the income–interest (Y-r) pair of axes.
❐ Suppose Y is at a different, higher level. This would imply a higher level of money demand,
or a position more to the right. The equilibrium interest rate would be higher, resulting
in a second equilibrium pairing of, say r1 and Y1 on the income–interest (Y-r) axes. A line
connecting these (and other such) points is the LM curve. It has a positive slope.
In general, each equilibrium level of the interest rate r has a specific, corresponding income
level Y as its counterpart. Stated differently, each point of equilibrium in the monetary
sector has two sides: a specific level of r and a corresponding level of Y.
❐ In this way one can derive, from the money market diagram and the 45° diagram, many
such pairings of Y and r that satisfy the conditions for equilibrium in the money market
(monetary sector).
❐ If these (r; Y) pairs are plotted on a diagram with these two variables on the axes, the
result is the LM curve.
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Note that the LM curve is a set of points where equilibrium in the monetary sector may
occur – where the conditions for equilibrium in the money market are satisfied. Along the
LM curve the money market is in equilibrium. Thus an important interpre­tation of the LM
curve is the following: the LM curve shows a series of potential equilibrium values of Y and
r, given the way economic actors in the monetary sector behave. When economic shocks
and fluctuations have run their course and a new equilibrium has been attained in the
monetary sector, it will always be one of the points on the LM curve.
π
A formula for the LM curve
Since the LM curve represents (r; Y) points that satisfy the equilibrium conditions
for the money market, we already have derived its equation above (see equation 3.2).
In real interest format it is:
MS
MD

​ 
P ​= ​  P ​
= kY – lπ  lr
If solved to get the interest rate on the left-hand side, it becomes:
k
(
1 MS
)
r = ​ l ​Y – 
​  l ​​ 
​  P ​+ lπ ​
…… (3.6)
(
)
S
​ 1l ​​ 
​  MP ​ + lπ .​
Thus the slope of the LM curve is ​ kl ​and its intercept is 
The LM curve as a summary curve
Whereas the money market diagram can be used to analyse the relationship between
the money market and real income, the LM curve is a handy, concise summary curve that
depicts the string of points along which the money market can settle following a change in
real income Y. Given a particular change in Y, the resultant change in equilibrium r – via
a shift of the real money demand curve – is shown by the LM curve (for a given real money
M
supply ​ 
P ​and inflation π).
S
3.3.5
Properties of the LM curve
The slope of the LM curve
Since a higher level of Y is associated with a higher equilibrium interest rate (for a given
money supply), the LM curve has a positive slope, as indicated in figure 3.19.
Moving along the LM curve, shifting the LM curve
If Y changes, the change in r from one equilibrium to the next is depicted as a move along
the LM curve.
A shift in the LM curve would occur if the equilibrium interest rate were to change for a
reason other than a change in Y.
Three main factors can shift the LM curve: changes in the price level P, an exogenous
​ MP ​. In
increase in the real demand for money 
​ MP ​, and a change in the real money supply 
each case the set of points that satisfy the conditions for money market equilibrium, i.e.
the LM curve, moves.
D
1.
118
S
At a higher price level, there would be a higher transactions demand for money,
implying a higher interest rate is necessary to yield money market equilibrium
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(at the prevailing level of Y). The initial level of Y would then be paired with a different,
higher level of r.
❐ Diagrammatically, this is shown as a horizontal, leftward shift of the LM curve.
2. At a higher level of real demand for money (linked to an exogenous factor, e.g. pessimistic
expectations) there would be a higher precautionary demand for money, implying a
higher equilibrium interest rate (at the prevailing level of Y). The initial level of Y
would now be paired with a different, higher level of r.
❐ Diagrammatically, this is shown as a leftward shift of the LM curve.
3.
At a higher level of the real money supply, and at the prevailing level of Y, a new and
lower level of the interest rate would be necessary to attain equilibrium in the money
market. The initial level of Y would now be paired with a different, lower interest
rate r.
❐ Diagrammatically, this is shown as a rightward shift of the LM curve.
When we analyse disturbances in an IS-LM diagram, this means:
❐ If the money supply is increased, it will shift the LM curve right. If the money supply
contracts, it will shift the LM curve left.
❐ If the price level increases, the LM curve shifts left. If the price level decreases, the LM
curve shifts right.
❐ If money demand increases for an exogenous reason, the LM curve shifts left. If it
decreases for some reason, the LM curve shifts right.
The case of a change in the real money supply is very important, especially in analysing
the effects of monetary policy in the IS-LM diagram.
How far will the LM curve shift?
In the case of an expansion in the real money supply, the LM curve will shift right
M
1
(horizontally) by a distance equal to the change in 
​  P ​multiplied by ​ k .​
S
How steep is the LM curve?
The clue to the steepness of the LM curve lies in the reasoning behind the slope of the curve.
The slope of the LM curve will depend on the magnitude of the change in equilibrium
interest necessary to re-establish equilibrium in the money market, following a particular
change in real income Y. A smaller change in r would imply a relatively flat LM curve; a
relatively large change in r implies a relatively steep LM curve. Diagrammatically, this can
be represented as shown in figure 3.19.
The economic factors or characteristics that determine the slope of the LM curve are
important. Reconsider the example of an increase in real income Y, the resulting increase
in money demand, and the eventual increase in the equilibrium interest rate. How much
will r change? Two factors or sensitivities are relevant:
M
1. The income responsiveness of the demand for money (which is k in the ​ 
P ​equation; also
see the LM equation (3.6) in the maths box). This determines the extent to which
monetary demand increases following a given increase in real income Y.
❐ If k, the income responsiveness of money demand, is high, money demand 
​ MP ​ will
increase (shift in the money market diagram) relatively a lot following an increase
in Y, and the interest rate will have to be raised relatively a lot higher to restore
equilibrium in the money market. This would make the LM curve relatively steep
(its slope being ​ kl ​).
D
D
3.3 The IS-LM model as a powerful diagrammatical aid
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Figure 3.19 The slope of the LM curve
r
Slope of LM curve depends
on how much r has to increase to re-establish money
market equilibrium for a
higher level of Y
LM curve steeper
r2
LM curve flatter
r1
r0
(r0; Y0)
Y0
Y
Y1
❐ If monetary demand is relatively unresponsive to changes in Y, meaning k is small,
the LM curve will be relatively flat.
​ MP ​ equation;
2. The interest rate responsiveness of the demand for money (which is l in the 
also see the LM equation (3.6) in the maths box). Following a given increase in real
money demand (a shift to the right in the money market diagram due to a higher Y),
this responsiveness determines by how much the interest rate would have to increase
to choke off the excess demand for money in the money market (for the existing real
money supply).
❐ If the demand for money reacts strongly to interest rate changes – the interest
responsiveness of money demand l is high – a relatively small interest rate increase
would be sufficient to restore money market equilibrium. As a result, the LM curve
k
would be relatively flat (its slope ​ l ​will be smaller).
❐ If the interest responsiveness of money demand is low, a relatively large interest rate
increase would be necessary to restore money market equilibrium. Consequently,
the LM curve would be relatively steep.
D
LM a mirror-image of the money demand curve?
In terms of the effect of interest responsiveness the slope of the LM curve is the same as that
of the money demand curve.
MD ​curve and a
❐ A high interest responsiveness of money demand implies a relatively flat​ 
P
relatively flat LM curve.
MD ​curve and a
❐ A low interest responsiveness of money demand implies a relatively steep ​ 
P
relatively steep LM curve.
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To summarise:
Effect on slope of LM curve
→
Flatter
Low income responsiveness of money demand k
High income responsiveness of money demand k
→
Steeper
→
Steeper
Low interest responsiveness of money demand l
→
Flatter
High interest responsiveness of money demand l
Points off the LM curve
Since the LM curve is a collection of pairs of Y and r that are consistent with money market
equilibrium, any point off the LM is a disequilibrium point in the money market. At such a
point, the interest rate is too high or too low to be compatible with the level of real income
(and resultant level of money demand). For such a pairing of Y and r, aggregate monetary
demand would not equal the money supply and there would not be equilibrium in the
money market (or monetary sector).
3.3.6
IS and LM together – simultaneous equilibrium in the real and monetary
sectors
Section 3.3.1 intuitively described the use of the IS and LM curves to determine an overall
equilibrium. Shifts in either curve would lead to a new equilibrium level of GDP and the
interest rate. Graphically, this new equilibrium was to be found at the intersection point
of the two curves.
Why is equilibrium at the intersection?
It was noted that the intersection between the two curves is the only point among the two
sets of potential equilibrium points (denoted by the two curves) that produces equilibrium
in both sectors. This statement needs to be formalised. The question is why the economy
would be at, or would gravitate to, the point of intersection or simultaneous equilibrium.
The reason is that at any point other than the intersection, forces would exist that would push
the economy towards the intersection.
Consider a point such as 1 (see figure 3.20), which is on the IS curve but not on the LM curve.
Being a point on the IS curve, there would be equilibrium in the real sector (goods market),
i.e. between total expenditure and total production. However, that particular pairing of the
interest rate r1 and income Y1 would not Figure 3.20 Equilibrium in the IS-LM model
produce equilibrium in the monetary
r
sector: any point off the LM curve is
one of money market disequilibrium.
LM curve
In this case, for that particular interest
r2
2
rate and income level, the resultant
r1
1
money demand would be relatively
depressed and would be lower than the
r0
available money supply: there would
0
be an excess supply of money. Money
market participants would hold more
cash than desired at that interest rate.
They would then tend to buy money
IS curve
market instruments (e.g. BAs), which
Y1
Y0
Y2
Income Y
would tend to push up the price of these
3.3 The IS-LM model as a powerful diagrammatical aid
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Simultaneous equilibrium in the goods and money markets
π
We have the formula for the IS curve:
Y = KE(a + Ia + G – hr)……(3.3)
and the formula for the LM curve:
(
k
1 MS
)
r=
​  l ​Y – 
​  l ​​ 
​  P ​+ lπ ​……(3.6)
Substituting (3.6) into (3.3) produces:
(
[
(
)])
k
1 M
Y = KE ​ a + Ia + G – h​ ​ l ​Y – ​ l ​​ 
​  P ​+ lπ ​  ​  ​
S
Solving for Y and simplifying produces:
(
MS
Y = 1 (a + Ia + G) + 2 ​ 
​  P ​+ lπ
)​
……(3.7)
where
K
1 = 
​  KE hk
1 + 
​  El ​
​
……(3.7.1)
K Eh
2 = ​ 
​
l  KEhk
Equation 3.7 shows how the equilibrium level of real income Y depends on expenditure
elements as well as real money supply – as captured in the IS and LM curves respectively.
Note that 1, the expenditure multiplier that incorporates secondary effects, is very
different from, and smaller than, KE, which is the expenditure multiplier in the model
without a monetary sector (chapter 2). This demonstrates the constraining impact of the
secondary effect in the money market on changes in Y.
The equilibrium level of the real interest rate can be solved from (3.7) to produce:
(M
S
)
r = 1 (a  Ia  G)  2 ​ 
​  P ​+ lπ ​
……(3.8)
where
kKE
1 = 
​  l  K hk ​
E
2 = 
​  l + K1 hk ​
E
……(3.8.1)
The equilibrium level of r likewise depends on expenditure elements and the real money supply.
We will return to equation (3.7) in chapter 6 when we derive the aggregate demand (AD) curve.
instruments and push down interest rates. As this happens, investment will increase and
GDP will increase. In the diagram this would push the economy down along the IS curve
towards the intersection. This process will continue until the intersection at point 0 is
reached, because only then would there be no disequilibrium in the monetary sector, and
thus no forces for change.
A similar argument applies to a point such as 2, which is on the LM curve but not on the
IS curve. While the money market would be in equilibrium, the real sector would not be.
While there would be output (production) at the level of Y2, the interest rate r2 at point
2 would be too high for a goods market equilibrium to exist. The interest rate at point 2
is such that investment spending and durable consumption spending would be relatively
low – too low to buy up all the production. There would be an excess supply of goods
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and inventories would increase. This would induce producers to cut back on production,
moving the economy towards Y0. As this happens the interest rate would fall to r0. The
process of cutting back will continue until GDP and aggregate expenditure is on par, which
would only be when the economy has moved down the LM curve to meet the IS curve, i.e.
at the intersection point 0.
The point of intersection is the only point where both the real and the monetary sectors are in
equilibrium, implying the absence of excess supply or excess demand in the goods or money
markets that could induce a change in output, expenditure, interest rates or money market
behaviour.
If any disturbance changes conditions, the economy will not be at a simultaneous
equilibrium any more. Graphically the disturbance will be seen in a shift in one or both of
the IS and LM curves, implying a new intersection point. With the initial values of Y and
r the economy would not be at the new intersection point and would be in disequilibrium.
This will put into motion the kind of forces described above, moving the economy towards
a new simultaneous equilibrium and point of rest at the new intersection point. The
particular pairing of r and Y would persist until a new disturbance occurs.
Analysing disturbances: shifting curves
To use the model, one must be able to translate economic disturbances or policy steps into
shifts in the curves:
❐ Shifts in the IS curve: any exogenous change in expenditure – in C, I, G or (X – M) –
that boosts expenditure and thus Y would shift the IS curve towards the right. Any
exogenous decrease in expenditure shifts the IS curve towards the left.
– If G is increased, the IS curve shifts to the right.
– If G declines, the IS curve would shift to the left.
– If exports fall, the IS curve would shift to the left.
– If taxes are reduced, this would lead to an exogenous boost in consumption, and the
IS curve would shift to the right.
– If restrictions are placed on imports, an exogenous drop in imports would result,
(X – M) would increase, and the IS curve would shift to the right.
– If investment falls due to a drop in investor confidence (i.e. at the prevailing interest
rate level), it would shift the IS curve to the left.
❐ Shifts in the LM curve: the primary reason for a shift in the LM curve is an exogenous
or policy change in the money supply (see also discussion below).
– If the money supply expands, the LM curve shifts right.
– If the money supply contracts, the LM curve shifts left.
!
The IS-LM model, in particular, is a case where it is crucial to remember that a purely
diagrammatical analysis – ‘that this or that curve has shifted’ – is no explanation of economic
events. It only provides a way of checking your economic reasoning.
❐ Therefore, always use the diagram in conjunction with the appropriate economic chain
reasoning. Use the three-diagram set outlined in chapters 2 and 3 where necessary.
Examples
1. Suppose there is an increase in government expenditure. This would shift the IS
curve to the right. As the diagram indicates, the equilibrium will change. The new
3.3 The IS-LM model as a powerful diagrammatical aid
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equilibrium shows a higher level
of real income Y1, coupled with a
higher interest rate r1.
Figure 3.21 Fiscal expansion in the IS-LM model
r
LM curve
In the context of the 45° diagram
(see section 3.2.2), this would be
depicted as an upward shift of the G
r1
line and the aggregate expenditure
2
r0
line in the 45° diagram. The subse1
quent upswing in Y would increase
monetary demand, depicted as a
rightward shift of the 
​ MP ​curve in
the money market diagram. The resulting increase in the interest rate
would be transmitted to the real
Y0
Y1
Y2
sector via reduced investment, implying a secondary, constraining effect on the economic expansion.
New macroeconomic
equilibrium point:
Y1 and r1
D
IS curve
Income Y
The IS-LM diagram in figure 3.21 summarises the simultaneity of these processes. In
response to the increase in aggregate expenditure, income starts increasing. This is
the primary effect. On the diagram this implies a force trying to move Y horizontally
to the right (arrow 1). If nothing else were to change, Y would increase to Y2 (which
would be the full multiplier effect as if there was no monetary sector; see equation 2.6
in chapter 2).
However, as soon as Y starts increasing, the secondary, money-market effect kicks in.
Money demand starts to increase, which causes the interest rate to start rising. The
rising interest rate, in turn, causes investment to decrease. This partially offsets the
expenditure boost due to the initial increase in government expenditure. This implies
a force on Y in the direction of arrow 2.
The net effect of these two forces is the bold blue arrow. Income never gets to Y2.
Income only increases from Y0 to Y1 and the interest rate has increased from r0 to r1.
❐ We see that as the IS curve shifts, the equilibrium point moves along the LM curve.
In terms of the chain reaction, the increase in government expenditure has the
following effects:
G  ⇒ total expenditure  ⇒ production  ⇒ Y 
Primary effect
M
While Y  ⇒ ​ 
P ​ ⇒ r ⇒ I  ⇒ total expenditure  ⇒ production  ⇒ Y 
Interest rate change + Investment change and expenditure offset
= Concurrent secondary effect
D
The economics behind the move from the initial to the new equilibrium point in the
IS-LM diagram therefore is the entire sequence of events following an increase in G: the
primary effect on Y (expansionary impact on real sector) plus the concurrent secondary
effect on r and I (upward pressure on the interest rate in the monetary sector).
❐ This example compellingly illustrates ‘crowding out’, explained in section 3.2.2.
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Moving up the ramp
This example shows the impact of the secondary or feedback effect via the monetary sector
very graphically. It also provides a telling (if rather mechanical) analogy.
Imagine the equilibrium point being pushed to the right by the forces generated by an increase
in expenditure. However, the equilibrium point cannot move ahead in a horizontal direction. As
it moves to the right, it is forced up a ‘ramp’ formed by the LM curve: the equilibrium point not
only moves to the right, it also has to go up the slope of the LM curve.
The ‘ramp’ exists due to the upward pressure on interest rates generated by the economic
expansion. The eventual ‘horizontal’ change in Y is less than it would have been in the
absence of a ramp (a secondary effect). Going up the slope saps the energy of the expansion.
Which path to the new equilibrium?
The path from one equilibrium to a next need not be exactly along the LM curve, as drawn in
figure 3.21. The path of adjustment of the economy will depend on the speed of adjustment in
each sector or market.
r
❐ If the interest rate adjusts quickly
LM curve
relative to the goods market, the
economy will loop, for instance,
from points 1 to 2, and then again
New macroeconomic
3
from 2 to 3 (black dotted arrows).
equilibrium point
❐ If the money market adjusts
2
more slowly, a bigger loop from
point 1 to 3 can materialise
(blue dotted arrow).
1
❐ To simplify the graphics, we will
normally just indicate the net
IS curve
effect, i.e. a move along the LM
curve from point 1 to point 3.
Y
2. Suppose the money supply expands due to an expansionary monetary policy step
such as a cut in the repo rate, which encourages more credit creation by banks. This
would shift the LM curve to the right. As the diagram indicates, the equilibrium would
change to one with a higher level of real income Y1 coupled with a lower interest
rate r1.
In the context of the 45° diagram, this would be depicted as a rightward shift of the
M
vertical ​ 
P ​ curve. This would decrease the interest rate. As intended, this will stimulate
investment and, in turn, output and income Y (see section 3.2.1). However, this is not
the end of the story – there will be a secondary money market effect. The upswing
in Y will increase monetary demand – a rightward shift of the 
​ MP ​curve – resulting in
upward pressure on the interest rate which will, by discouraging investment, imply a
constraining effect on the economic expansion.
S
D
The IS-LM diagram in figure 3.22 again captures the complex simultaneity of these
processes. In response to the increase in real money supply, the real interest rate
3.3 The IS-LM model as a powerful diagrammatical aid
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starts to drop. This is the primary effect. In the diagram
this implies a force trying
to move r vertically downwards (arrow 1). If nothing
else were to change, r would
decrease to r2 to re-establish
money market equilibrium
on the new LM curve.
Figure 3.22 Monetary expansion
r
LM curve
r0
r1
New macroeconomic
equilibrium point:
Y1 and r1
1
r2
However, as soon as r starts
2
decreasing, investment is
IS curve
stimulated, as is production
and real income. This causes
the secondary, money-market
Y0
Y1
Y
effect to be activated. The
demand for money starts to
increase, causing upward pressure on the (still falling) interest rate. This implies a force on
r and Y in the direction of arrow 2.
The net effect of these two forces is the bold blue arrow. The interest rate never drops
as far as r2. Income increases from Y0 to Y1 and the interest rate has decreased from r0
to r1. Investment has increased.
❐ Therefore, we see that as the LM curve shifts, the equilibrium point moves along the
IS curve.
While the main effect may be on the money market (the interest rate change), the transmission mechanism ensures that it also impacts on the real sector (real income Y). This
diagram therefore illustrates the Keynesian transmission mechanism in the case of an
expansionary monetary policy step.
In both cases, the IS-LM mechanics serve as a concise rendition of the many economic
relationships in the real and monetary sectors of the economy, including the interaction
and feedback effects between them. In this sense, the IS-LM model integrates the real and
monetary sectors.
Which path to the new equilibrium?
As before, the actual path from the initial equilibrium
to the new one need not be exactly along the IS
curve. The path of adjustment will depend on the
speed of adjustment in each sector.
❐ If the interest rate drops quickly relative to
the growth in investment and income in the
goods market, a big loop from point 1 to 3 can
materialise (blue dotted arrow).
❐ If investment reacts rapidly when interest rates
start to drop, the economy will have smaller
loops, for instance, from points 1 to 2, and then
again from 2 to 3 (black dotted arrows).
❐ We will normally just indicate the net effect along
the IS curve from point 1 to point 3.
126
r
LM curve
1
2
3
IS curve
Y
Chapter 3: The basic model II: financial institutions, money and interest rates
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✍
Suppose taxes are increased ⇒
_______________________________________________________________________________________
_______________________________________________________________________________________
IS-LM diagram:
Suppose the cash reserve requirement is increased ⇒
_______________________________________________________________________________________
_______________________________________________________________________________________
IS-LM diagram:
Suppose exports increase ⇒
_______________________________________________________________________________________
_______________________________________________________________________________________
IS-LM diagram:
3.3 The IS-LM model as a powerful diagrammatical aid
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The IS-LM is therefore a quick tool for checking one’s economic reasoning, indicating the
basic direction of changes in Y and r. At the same time, however, one loses much of the
diagrammatic richness of the traditional three-diagram model. Hence it is wise to open the
IS-LM ‘black box’ and take out these three diagrams frequently as a way of making absolutely
sure that your economic reasoning is correct. In a way, the very conciseness of the IS-LM
model increases one’s chances of making a mistake.
Of course, while one should never use the three diagrams without giving serious attention
to the relevant economic chain reasoning, this is even truer in the case of the IS-LM model.
The use of the latter model can easily degenerate into pure mechanical manipulation. Do
not fall into this trap.
3.3.7
Different slopes and policy effectiveness
The preceding discussion and examples illustrate the basic application of the IS-LM
mechanics for disturbances originating in either the monetary or the real sector of the
economy.
An interesting dimension of the IS-LM mechanics is the effect of steeper or flatter curves
on the magnitude of the resultant changes in Y and r. These results have an important
implication for the effectiveness of policy. Thus we now reconsider the discussion in
section 3.2 regarding the potency of (a) monetary policy and (b) fiscal policy. Various
responsiveness parameters and multipliers were shown to be relevant. A few examples
suffice to illustrate the basic points.
How potent is monetary policy in affecting real income?
Section 3.2.1 concluded that the potency and impact of a monetary policy step in the form
of a money supply increase will depend on:
❐ the interest responsiveness of money demand l;
❐ the interest responsiveness of investment h, and
❐ the size of the expenditure multiplier KE.
However, these factors also determine the slopes of the IS and LM curves (sections 3.3.3
and 3.3.5). This information can now be combined with the diagrammatical analysis to
answer a question such as the following: what is the effect on real income Y of a one unit
change in the money supply, given different slopes for the LM curve?
❐ For a similar but somewhat surprising analysis regarding the potency of an interest
rate step, see section 3.3.8.
Therefore, consider the impact of a given monetary policy stimulus in the form of a one
unit real money supply increase. It will shift the LM curve to the right by a distance of
​  MP .​ 10 Equilibrium Y will increase, combined with a decline in the real interest rate r.
​ 1k ​
S
The diagram in figure 3.23 illustrates the influence of the slope of the LM curve on the
change in real income Y (for the same horizontal shift of the LM curve):
❐ If the LM curve is relatively steep, the change in Y is relatively large – monetary policy
is more potent.
❐ If the LM curve is flat, the change in real income Y is smaller – monetary policy is less
potent.
10 Can you see why this is the value? Consider the formula for the LM curve (equation 3.6), but solve this formula for Y
on the left-hand side.
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Figure 3.23 Monetary stimulus – influence of LM curve slope
r
For a similar horizontal shift a
flatter LM produces a smaller
change in both Y and r
r
LM shifts to
the right
LM shifts to
the right
r0
r1
r0
r1
IS curve
Y0 Y1
IS curve
Y
Y0
Y1
Y
The economic reason for the latter case lies in the interest responsiveness (parameter l) of the
demand for money. If this responsiveness is low – the 
​ MP ​curve is relatively steep, as is the LM
curve – the interest rate will drop much before money market equilibrium is restored (and
all the additional money has been absorbed in portfolios).
D
The ‘liquidity trap’
An extreme case is that of a completely horizontal LM curve. In such a case, a monetary
stimulus would have no effect whatsoever on income or the interest rate. All extra liquidity
would be absorbed (‘trapped’) in portfolios without any impact on interest rates – there is an
infinite demand for money (a horizontal MD curve). If this situation were to occur, monetary
policy would be entirely impotent.
In the 1940s and 1950s, some economists believed that this condition prevailed at low interest
rates. Although for many years thought to be a theoretical oddity, the liquidity trap drew new
attention first in the late 1990s in Japan when the Bank of Japan decreased its lending rate to
banks to zero per cent, while still failing to stimulate lending.
In 2008 the liquidity trap again drew attention when, in the face of the subprime crisis in the USA,
banks were unwilling to lend to each other as they did not know the extent to which the balance
sheets of borrowing banks were contaminated by bad assets. Effectively this meant that the
interbank market came to a virtual standstill with interbank rates increasing significantly. In an
effort to reignite lending, the major central banks reduced lending rates to banks significantly,
some even providing guarantees for the interbank lending activities. For a time these steps were
not altogether successful, meaning that central banks were unable to spur lending even at much
reduced central bank lending rates. This event appeared to reaffirm the relevance of the liquidity
trap theory. However, its relevance seems to be limited to periods characterised by crises of
confidence. Under normal conditions the liquidity trap theory is not applicable.
The 2007–08 financial crisis in the USA has shown that monetary policy impotence can also
spring from behaviour that is reflected in a very steep IS curve, rather than a very flat LM curve.
(See section 3.4.)
The opposite extreme of the liquidity trap theory is the case of a vertical LM curve. Any
monetary stimulus would have a maximum impact on real income. Therefore, monetary policy
would be very potent in stimulating the economy.
The vertical LM curve is called the Classical case, mainly because it seems to suggest a
preference for monetary policy rather than fiscal policy.
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The diagram in figure 3.24 illus­
trates the influence of the slope
of the IS curve on the outcome
(for the same horizontal shift of
the LM curve):
❐ If the IS curve is flat, the
change in real income is large –
monetary policy is very potent.
❐ If the IS curve is relatively
steep, the change in Y is smaller
– monetary policy is less potent.
Figure 3.24 Monetary stimulus – influence of IS curve slope
r
LM0
LM1
r0
If IS curve is
flatter, change in
Y is larger and
change in r smaller
IS curve
‘flat’
The economic reasons for the
IS curve
‘steep’
latter case are as follows:
❐ If the interest responsiveness
Y0
Y
of investment (h in the invest­
ment equation) is high, invest­
ment will react strongly to the policy-induced drop in interest rates.
❐ If the expenditure multiplier KE is large, the increase in investment has a strong
multiplier effect on real income Y.
To summarise, the impact on real income of a monetary policy stimulus in the form of an
increase in the money supply is larger if:
❐ the LM curve is relatively steep, and/or
❐ the IS curve is relatively flat.
Similarly, such monetary policy is less potent in affecting real income if the IS curve is
relatively steep and/or if the LM curve is relatively flat. (Similar types of conclusion can be
made regarding the impact of monetary stimulation on the real interest rate.)
These policy examples illustrate that the magnitude of changes in the interest rate or real
income can differ greatly depending on the relative slopes of the two curves. However, this
is a purely mechanical illustration. The question is: why or when would curves be steep or
flat? Which factors determine the slope, and what is the economic interpretation of slopes?
To answer these questions, we have to turn to more formal IS-LM theory.
How potent is fiscal policy in affecting real income? Or, how strong is crowding out?
Section 3.2.2 concluded that the potency and impact of fiscal expansion via increased
government expenditure will depend on:
❐ the income responsiveness of money demand k;
❐ the interest responsiveness of money demand l;
❐ the interest responsiveness of investment h, and
❐ the size of the multiplier KE.
Once again, these factors also determine the slopes of the IS and LM curves, as shown in
sections 3.3.3 and 3.3.5. Combining the information about these discussions with the
diagrammatical analysis, one can answer a question such as: what is the effect on real
income Y of a one unit change in government expenditure (or in taxation), given different
slopes for the IS curve?
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Therefore, consider an expansionary fiscal
policy step, e.g. an increase of one unit
(e.g. R1 m) in government expenditure. It
would shift the IS curve horizontally to
the right. Equilibrium Y will increase,
combined with an increase in the real
interest rate r.
Figure 3.25 Fiscal stimulus – influence of LM curve slope
r
If LM curve is steeper change in Y is
smaller and change in r larger: stronger
secondary effect (crowding out)
LM curve
‘steep’
LM curve
‘flat’
The diagram in figure 3.25 illustrates the
influence of a flat or a steep LM curve on
the change in Y:
r0
❐ If the LM curve is relatively steep, the
change in Y is relatively small – fiscal
policy is less potent. Crowding out
IS1
IS0
is relatively strong (i.e. the ‘ramp’ is
more steep).
Y0
Y
❐ If the LM curve is relatively flat, the
change in Y is relatively large – fiscal
policy is more potent. Crowding out is relatively weak (i.e. the ‘ramp’ is less steep).
The economic reasons for the latter case are as follows:
❐ If the income responsiveness of money demand (k in the money demand equation)
is low, there will be a relatively small increase in the transactions demand for money
when Y increases), and/or
❐ If the interest responsiveness l of money demand is high, a relatively small change in r
will be sufficient to re-establish money market equilibrium.
The Classical case again
If the LM curve were vertical, fiscal expansion (e.g. an increase in G) would have no effect on real
income. Fiscal policy would be totally impotent. Crowding out would be complete, and any increase
in G would be exactly offset by an equal reduction in private spending (investment).
If the LM curve were horizontal – the liquidity trap case – fiscal expansion would be
enormously potent in stimulating real income. There would be absolutely no upward pressure
on interest rates, and no crowding out whatsoever.
Again, while these issues were part of the policy debate decades ago, today they merely serve
to illustrate extreme theoretical cases (and to test your understanding of the theory). In reality,
the IS and LM slopes lie between these two extremes (although they may differ widely from
country to country).
The pair of diagrams in figure 3.26 illustrates the influence of the slope of the IS curve on
the outcome (for the same horizontal shift of the IS curve):
❐ If the IS curve is relatively flat, the change in real income Y is smaller – fiscal policy is
less potent.
❐ If the IS curve is relatively steep, the change in Y is relatively large – fiscal policy is more
potent.
The latter result occurs since:
❐ The interest responsiveness h of investment is low – this reduces the restraining effect
of the secondary interest rate increase on investment.
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❐ The expenditure multiplier KE is small – in the secondary phase this limits the restraining
impact of the investment reduction on Y.
However, the role of the multiplier is complex. It also affects the magnitude of the shift in
this IS curve: a larger multiplier implies a bigger shift, the impact of which may outweigh
the contrary effect that occurs via the slope of the IS curve.
Figure 3.26 Fiscal stimulus – influence of IS curve slope
r
For a similar horizontal shift, a steeper IS
produces a larger change in both Y and r
r
LM curve
r1
LM curve
r1
r0
r0
IS shifts
to the
right
Y0
Y1
IS shifts
to the
right
Y
Y0 Y1
Y
In summary, the impact of a given fiscal policy stimulus on real income is larger if:
❐ the LM curve is relatively flat (i.e. the ‘ramp’ is less steep, implying limited crowding out),
and/or
❐ the IS curve is relatively steep.
Conversely, fiscal policy is less potent if the IS curve is relatively flat and/or the LM curve
is relatively steep.
A similar analysis can be made regarding the impact on the interest rate following a fiscal
policy step.
3.3.8
The potency of monetary policy when the interest rate is targeted
The above discussion contrasts the result of a steep LM (with money demand not being
interest sensitive), with a flat LM (with money demand being interest sensitive). The
discussion compares the potency, under contrasting behavioural sensitivities, of monetary
policy for equivalent increases in the money supply.
❐ In the money market diagram (see figure 3.8), this comparison relates to equivalent
M
horizontal dimensions of shifts (e.g. rightward) of the ​ 
P ​line (measured by its position on
the horizontal axis).
❐ In the IS-LM diagram, it relates to equivalent horizontal shifts of the LM curve (see
figure 3.23).
S
The focus on such ‘money supply steps’ was very relevant up to the 1970s and 1980s and
even the 1990s when many countries, including South Africa (from 1986 to 1997) had
money supply targets.
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However, these days the focus of many central
banks is to engineer desired interest rate
changes. The question then is not the potency
of a given ‘money supply step’, but what the
potency of a given ‘interest rate step’ will be.
Figure 3.27 Monetary expansion
r
LM0
Thus one must compare the potency (for
contrasting behavioural sensitivities) of
monetary policy for equivalent changes in
the interest rate.
❐ In the IS-LM diagram, this is indicated
by equivalent downward displacements of
the LM curve (see figure 3.28). Thus it
relates to equivalent vertical dimensions
of right- or leftward shifts of the LM
curve. (This is measured by the change
in its intercept on the vertical axis.)
LM1
Horizontal dimension of rightward
shift of LM curve
Income Y
Vertical dimension of rightward
shift of LM curve
When the focus is on the comparative
effectiveness of a given interest ratebased change, the outcome regarding the
potency of monetary policy changes dramatically.
❐ The potency result becomes the opposite of that for equivalent money supply-based
changes.
In figure 3.28, the diagrams contrast the impact on Y, for different LM slopes, of equivalent
interest rate-based steps. (This will usually be effected by equivalent changes in the repo rate,
e.g. a decrease.) This interest rate step is shown as identical vertical drops in the LM curve.
To someone accustomed to equivalent horizontal shifts of the LM curve this may look
completely wrong. But it is not – and it is an important point for graphical analysis.
Figure 3.28 Interest rate-based monetary expansion – influence of LM curve slope on change in real income
r
Equal vertical displacements of the LM curve
r
LM1
r0
LM2
r1
LM1
r0
r1
IS
IS
Y0
Y1
LM2
Y
Y0 Y1
Y
For equivalent vertical shifts in LM, a flat LM curve – which reflects a more interestsensitive money demand – will result in a larger increase in income compared to the case
where the LM is steeper. Compare the changes from Y0 to Y1 in the two cases.
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❐ A flat LM curve makes such a monetary policy step more potent in changing Y.
❐ A steep LM curve would make an equivalent monetary policy step less potent in changing Y.
This is the opposite of the conventional result, which was derived based on equivalent changes in
the money supply.
Note that this potency result also applies when measuring potency in terms of changing
the market interest rate (the intersection of IS and LM). Compare the changes from r0 to r1
in the two cases.
❐ A flat LM curve makes such a monetary policy step more potent in changing Y.
❐ A steep LM curve would make an equivalent monetary policy step less potent in
changing Y.
Central bank behaviour that targets the interest rate can be described by a so-called
monetary policy reaction function (see chapter 7). Interest rate-based changes are
usually engineered by a change in the repo rate, but they can also be achieved through
a money supply change: central banks change the money supply and/or the repo rate
with whatever amount necessary to bring about the desired change.
3.4
Real-world application: The 2007–08 financial crisis – varying
investor behaviour and impotent monetary policy
In trying to analyse real-world economic events, an important point to bear in mind is
that the values of the parameters in the behavioural equations such as h, the sensitivity
of investment to changes in the real interest rate, or b, the propensity to consume, are
not cast in stone. The same goes for the autonomous components of consumption and
investment (the constant terms a and Ia in their respective equations). These parameters
describe, or capture, human behaviour, expectations and sensitivities – and human
behaviour can change.
Changes in the behaviour of people would, therefore, change these parameters. Graphically,
that would shift the IS and LM curves and/or change their slopes. This shows that such
changing behaviour can affect the impact and potency of policy. A policy that was potent
five years ago may become less potent now.
An excellent example is how the 2007–08 financial crisis and its multi-year aftermath
played out in the USA. It also illustrates the huge impact that problems in the financial
system can have on the real economy and real people. In the words of Timothy Geithner,
US Treasury Secretary during the Great Recession:
I learned something valuable ... which is how fragile financial systems are, how connected
they are to the economy, how hard it is to separate trauma in a financial system from trauma
in the economy, how hard it is to protect the average person from financial panics.
Time magazine, 26 May 2014, p. 48.
In simplified terms the following occurred.
The run-up: the dot-com bubble and expansionary monetary policy
The financial crisis had a long run-up. Its roots can be found in the reaction of US
monetary policy authorities to the bursting of the so-called dot-com bubble in 2000.
During 1997–2000 share prices on the New York Stock Exchange and the NASDAQ stock
market increased dramatically. Especially the share prices of internet-related companies
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rose far above their intrinsic value due to speculative trading and inflated expectations – a
stock price ‘bubble’ developed. When the bubble burst and share prices fell, the NASDAQ
index fell from 5047 in 2000 to 1114 in 2002, losing 78% of its value.
The resulting fall in wealth caused a drop in consumer expenditure and hence a recession
in the USA. To counter this shock, the US Federal Reserve or ‘Fed’ (the US central bank)
lowered the Fed Funds rate (the policy rate in the USA) to push market interest rates down.
The lower interest rates succeeded in restoring investment and economic growth. However,
the lower interest rates also led to the next asset bubble, this time in the housing market.
The housing bubble and the crisis in the financial system
The housing bubble occurred because US banks, in reaction to the lower interest rates,
simultaneously (and somewhat recklessly) lowered their requirements for approving
mortgage loans. This quickly grew a market for so-called subprime borrowers (i.e.
borrowers whose balance sheets are not strong enough to be ‘prime borrowers’). The risk
of a subprime borrower not being able to repay a mortgage loan is significantly higher
than that of a prime borrower.
Banks subsequently repackaged these risky subprime mortgages together with prime
mortgages and sold these mixed-risk packages to other financial institutions as low risk,
prime securities. (Such a package is called a Mortgage-Backed Security, or MBS, and the
repackaging is called securitisation.) Inexplicably, ratings agencies rated these packages
as top-drawer AAA investments; thus, financial institutions were keen to invest in them.
By 2007–08 many financial institutions experienced problems when large numbers of
subprime borrowers defaulted on their mortgages. Institutions saw their balance sheets
weaken to the point that Lehman Brothers went bankrupt in 2008 while most other large
US investment banks only survived because the US government and Federal Reserve, as an
emergency measure, extended very large loans to them at low interest rates.
Despite these measures, the financial stress experienced by these institutions marked
the start of the worldwide financial crisis. Because so many banks and other financial
institutions were affected by MBS holdings, widespread uncertainty and a lack of trust
in the banking and financial system developed. Financial institutions became unwilling
to extend loans. Households and businesses found it difficult to borrow, and consumer
and business expenditure dropped. Households and businesses also preferred to reduce
their debt before investing. Likewise, the uncertainty reduced the willingness of potential
investors to invest. As a result, the US economy entered a recession.
The monetary policy reaction: ‘quantitative easing’ (QE)11
The Fed responded by implementing three waves of quantitative easing from November
2008 to October 2014. In effect the Fed started buying up huge volumes of government
bonds as well as MBSs from financial institutions, thereby injecting trillions of dollars of
money into the financial system. (See section 9.7 for more detail on the nature of this
monetary policy step, which is almost similar to open market transactions.) This monetary
11 In 2008 the US government also implemented the Troubled Asset Relief Program (TARP), in terms of which the
Treasury spent $350 billion to buy MBSs and other financial assets (and later also equity) from troubled financial
institutions such as AIG and Citigroup. The aim of the program was to stabilise these institutions by strengthening
their balance sheets. It amounts to an injection of $350 billion into US financial markets, and thus TARP is
analytically more or less equivalent to QE, as shown in figure 3.29. Hence we do not show TARP separately.
3.4 Real-world application: The 2007–08 financial crisis
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expansion drove the nominal Fed Funds rate down to 0.25%. With inflation very low,
the real interest rate came close to 0%. To its surprise the Fed found that investment did
not respond and remained flat. The US recession (which infected the rest of the world)
continued for several years.
The question is why QE was so ineffective, if macroeconomic theory tells us that moneysupply expansion, by reducing interest rates, would stimulate investment and consumption
expenditure, and thereby boost GDP growth. For the first round of monetary stimulus
(after the dot-com collapse) the theory appeared to be correct. So what happened with QE?
Understanding the crisis in the IS-LM model: varying slopes and policy impotency
The IS/LM model can be used to understand why the US Federal Reserve failed in its efforts
to stimulate economic activity. The reason is the variable, even fickle, nature of investment
behaviour in particular, which manifested during the financial crisis.
The IS/LM model in figure 3.29 applies to the USA. Suppose that, prior to the financial
crisis, there is equilibrium in both the money market and the goods market at point 0,
where LM0 intersects with IS0. The real interest rate equals r0 and output equals Y0.
Figure 3.29 The financial crisis and quantitative easing in the USA
IS shifts left and rotates
clockwise; a reverse rotation
occurs later on
r
IS1
LM shifts left initially, then
right again in the QE phase,
and left if QE is phased out
IS0
IS2
LM1
LM0
0
r0
r1
r4
1
4
r3
3
r2
2
Y1
Y2
Y0 ;Y3
Y4
Y
LM2
0 = Initial equilibrium Y0 r0
1 = New equilibrium Y1 r1
after LM shifts left and
IS shifts and rotates
clockwise. Recession.
2 = Post-QE equilibrium
Y2 r2 after QE monetary
stimulus: interest rates
collapse, but expenditure is unresponsive.
Monetary policy
impotent. Still recession.
3 = Equilibrium Y3 r3 after
fiscal expansion (IS
shifts right to IS2).
Recession over.
0 = Final equilibrium Y0 r0
if confidence returns
and fiscal stimulus withdrawn (IS rotates and
moves back to IS0) and
QE is reversed
(LM shifts left to LM 0).
4 = Equilibrium Y4 r4 occurs
if QE is not phased out.
Risk of further bubbles.
The impact of the financial crisis
When the financial crisis broke out, two things happened. First, financial institutions
became unwilling to extend and roll over loans. As the quantity of loans extended shrank,
their balance sheets shrank and thus the money supply shrank. In figure 3.29 this is
shown by a leftward shift of the LM curve from LM0 to LM1.
Secondly, households cut back their autonomous consumption a and companies cut
back their autonomous investment Ia. With investors also uncertain about the future,
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companies cut back autonomous investment even further. These cutbacks would reflect in
a leftward shift of the IS curve.
But that is not all. The diagram also shows the slope of the IS curve becoming steeper.
Recall that its slope reflects the sensitivity of investment to changes in the interest rate, h,
as well as the marginal propensity to consume, b. When uncertainty increases, investors
become less sensitive to interest rate changes: h falls and the IS curve becomes steeper.
Likewise, when households’ marginal propensity to consume out of income is reduced
(when they decide to rather repay debt), b falls – which also causes IS to become steeper.
Therefore, with the drop in autonomous consumption and investment as well as h and b,
the IS curve shifts and rotates – it changes from IS0 to IS1.
Given these moves of the IS and LM curves, a new equilibrium would settle at point 1, with
the interest rate at r1 and real output much lower at Y1.
The failed policy response: QE and thereafter
To counter this contraction in output, the US Federal Reserve massively expanded the
money supply in three waves of quantitative easing. These steps are shown as a shift of the
LM curve from LM1 to LM2, intersecting IS1 at a new equilibrium point 2. At this point the
real interest rate r2 is close to 0%. However, despite the huge drop in the interest rate, the
steepness of IS1 implies that the output level only increases minimally from Y1 to Y2 – still
far below the pre-crisis level Y0.
Being stuck at Y2 while the interest rate level has collapsed to r2 shows how monetary
policy became impotent due to the changing behaviour of economic agents. Due to fear
and uncertainty they all but stopped responding to a drop in the rate of interest. And,
since nominal interest rates cannot go below 0%, monetary policy could not stimulate the
economy to grow beyond Y2.
The only alternative for the US government was to use expansionary fiscal policy, running
much larger budget deficits. The fiscal stimulus was supposed to shift the IS curve from IS1
to IS2, resulting in the interest rate increasing to r3 and output to Y3, i.e. back to the initial
output level Y0 – but with a much-reduced rate of interest (equilibrium point 3).
(At the time of writing this fiscal policy had not been entirely successful in stimulating the
US economy – implying that the IS curve was still lying somewhere between IS1 and IS2.)
The aftermath: back to normal?
Once confidence returns to the US economy fiscal stimulus can be withdrawn. While the
latter will shift the IS from IS2 towards IS1, the return of confidence will shift and rotate
the IS curve back from IS1 to IS0. Reversing the quantitative easing will shift the LM curve
leftward from LM2 back towards LM0 – possibly reaching equilibrium close to equilibrium
point 0 where it all started.
Were the quantitative easing not to be reversed, an equilibrium would occur at point 4.
While output Y4 would be much higher than the pre-crisis level, the real interest rate r4
would be much lower. This could create a renewed risk of a bubble and excessive borrowing.
To push the interest rate up to a less risky level (such as r0), the quantitative easing would
need to be reversed, at least partially, to get LM to a position such as LM0. (To suppress any
tendency towards excessive borrowing it might even be necessary to push the interest rate
noticeably higher than r0. Graphically this means shifting LM even further left.)
3.4 Real-world application: The 2007–08 financial crisis
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International repercussions: how did the financial crisis affect South Africa?
Due to limitations of space, the knock-on effects of the financial crisis on South Africa
cannot be analysed here. It suffices to say that the main effects stem from a decline in
GDP in the USA (initially, and later also in Europe) and hence in their imports from other
countries, including South Africa.
The analysis of the impact of these changes on GDP and interest rates in the IS-LM diagram
is left to the reader as an exercise.
But that is not the whole story. The financial crisis also led to foreign investor nervousness
in the USA, Europe and Asia. This can spill over into a wariness to invest in emerging
markets, which could have an impact on capital inflows into South Africa. To understand
these, one has to study the international dimensions of the macroeconomy – the topic of
the next chapter.
* * *
This completes the discussion of the IS-LM model. It will be encountered again in
chapter 4, where it will be analysed in the context of an open economy and expanded
on by the addition of a third curve, the BP (or balance of payments) curve. This curve
will give information regarding the external balance of the economy, and augments the
discussion on the internal balance (as shown by the IS-LM equilibrium).
3.5
Analytical questions and exercises
1. Suppose exports increase, what will be the effect on income and the interest rate if
the income responsiveness of money demand is low compared to when the income
responsiveness of money demand is high?
2. Suppose government expenditure increases, what will be the effect on income and
the interest rate if the income responsiveness of money demand is high compared to
when the income responsiveness of money demand is low?
3. Suppose tax rates increase, what will be the effect on income and the interest rate if
the interest rate responsiveness of investment is low compared to when the interest
rate responsiveness of investment is high?
4. Suppose autonomous investment increases, what will be the effect on income and
the interest rate if the interest rate responsiveness of investment is high compared to
when the interest rate responsiveness of investment is low?
5. Use chain reactions and the IS-LM model to explain and illustrate the impact of an
increase in the repo rate on national income and the interest rate.
6. Use chain reactions and the IS-LM model to explain and illustrate the impact of a
decrease in the cash reserve requirement on national income and the interest rate.
7. Use chain reactions and the IS-LM model to explain and illustrate the impact of a
decrease in taxes on national income and the interest rate.
8. In question 6 of chapter 2, the puzzling lack of private investment after 2010 was
noted. Consider your response again, now also noting the level of interest rates in the
period after 2008 compared to earlier periods. Would you change your explanation, or
perhaps add to it? Can interest rate levels explain the observed lacklustre investment
behaviour? Analyse and discuss.
9. Use chain reactions and the IS-LM model to explain and illustrate the impact of the
increase in the gold price on national income and the interest rate.
10. Use chain reactions and the IS-LM model to explain and illustrate the impact of a
stimulating fiscal policy on national income and the interest rate.
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The basic model III:
the foreign sector
4
After reading this chapter, you should be able to:
■ explain the behaviour of international trade in goods and services (i.e. imports and exports), and foreign investment and lending (international capital flows);
■ appraise the role and importance of the balance of payments, the current account, the
financial account and foreign reserves;
■ assess and explain movements in exchange rates, including the practical, everyday
determination of these rates in foreign exchange markets;
■ assess the external implications of domestic economic disturbances and fluctuations;
■ compose chain reactions that show how external disturbances impact on domestic
financial markets as well as the real economy, and evaluate these with graphical aids;
■ analyse the role of the balance of payments adjustment mechanism in creating cyclical
forces; and
■ unravel key linkages between foreign interest rates, the gold price, the rand and the dollar.
While the South African economy is relatively strong in the African context, in the world
context it is small. Owing to the openness of the South African economy, it is extremely
vulnerable to external shocks, and foreign factors often dominate the economic news.
Therefore a sound understanding of the linkages between the national economy and
foreign economic relations is essential if we are to grasp events in the South African
economy. The ‘closed’ model of the economy, as introduced in the previous chapters,
must therefore be amended. This chapter presents the main elements of a Keynesian
macroeconomic model (or theory) for an open economy.
✍
What percentage of GDP is exported? Which are the most important products that local
producers export from South Africa? Which countries are our main trading partners?
______________________________________________________________________________________
______________________________________________________________________________________
What percentage of GDE is spent on imported products? Which are the most important
products imported by South Africans? From which countries mainly?
______________________________________________________________________________________
See Mohr (2019) Economic Indicators, sections 7.2 and 7.3.
  Chapter 4: The basic model III: the foreign sector
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The location of this topic in the circular
flow diagram (compare pp. 73, 76)
International capital
flows
Ex
FOREIGN
COUNTRIES
po
rts
Ex
ch
a
rat nge
e
Im
po
FINANCIAL
INSTITUTIONS
rts
Disposable
income
FIRMS
HOUSEHOLDS
GOVERNMENT
Some preliminary definitions
The balance of payments (BoP) is an accounting record of a country’s involvement in international trade (exports and imports) and international capital flows. The former category
of transactions is indicated on the current account of the balance of payments and the
latter on the financial account.
The most important international ‘price’ is the exchange rate. This denotes the international
exchange value (or external value) of, for example, the South African rand against another
currency such as the US dollar, e.g. $1 = R10.00 or £1 = R17.00. (The latter represents
the indirect way of quoting the exchange rate. The direct way would be the other way
around, i.e. R1 = $0.10 or R1 = £0.06.)
Another relevant variable is the price ratio between average
price levels in the home
P
​ P ​
country, e.g. South Africa, and those in the rest of the world: 
SA
Foreign
The exchange rate and the price ratio can be combined into one concept, the real effective
exchange rate, denoted by ( the Greek letter theta). (The term ‘effective’ indicates an average
exchange rate; see section 4.3.2 on exchange rate definitions.) It is defined as:1
1
PSA
P
Foreign
Foreign
SA
 = 
​  Average exchange rate ​ 
​  P
​ = Average exchange rate in direct form  
​  P
​
1
140
Note that in many USA and UK textbooks the direct way of expressing the exchange rate is used, also in these
formulas. In general one should always be very careful when working with formulas containing an exchange rate.
Chapter 4: The basic model III: the foreign sector
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✍
What are the latest figures for the balance on the current account, the financial account and the
BoP?
______________________________________________________________________________________
What is the current exchange rate of the rand against the US dollar, the British pound, the Euro
and the Japanese yen?
DATA TIP
______________________________________________________________________________________
Warning: Data on foreign economic transactions are almost as complex as data on the
government sector (also see chapter 2).
❐ Different institutions, e.g. the SA Reserve Bank and the SA Revenue Service (Customs
and Excise division), gather and publish data for different purposes and in various ways.
❐ At least three sets of data are available: national accounts data, balance of payments
data and trade statistics. They may use different terms or may include different
elements or have different frequencies, or may be only in nominal or real terms.
❐ Before June 1999, data on imports and exports in balance of payments tables in the Quarterly
Bulletin of the Reserve Bank differed from data in the national accounts tables. However,
in the revised data system used since June 1999 these figures are exactly the same,
removing the ambiguities in Reserve Bank foreign sector data. The two sets of tables do
use different terms for elements such as labour income flows, though.
❐ The foreign trade statistics of the SA Revenue Service (Customs and Excise division)
pertain to trade in goods only (including gold). They are published monthly.
For macroeconomic and expenditure analysis, it is usually sufficient to use national accounts
data on imports and exports. If one wishes to analyse the current account of the balance of
payments or capital flows, though, the balance of payments table is more comprehensive.
(See other explanatory boxes that follow.)
Exchange rate data can be found in the section on ‘International economic relations’ in
the Quarterly Bulletin. This section also contains a table ‘Gold and other foreign reserves’.
Data on the balance of payments and exchange rates can be found on the Reserve Bank
website (www.resbank.co.za), while data on trade statistics can be found on the website
of the South African Revenue Service (www.sars.co.za) under ‘Customs and Excise’.
International comparisons of economic data are difficult and can easily lead to absurd
conclusions. Be careful, especially as far as exchange rate conversions of variables such as GDP,
wage levels or petrol prices are concerned. Comparisons of rates of change (GDP growth rate,
inflation rate) and ratios (tax ratio, import ratio) are less risky, although still subject to differences
in definition and calculation. (An interesting website is 'World in Figures' of the Economist
magazine at https://worldinfigures.com or www.economist.com. Also see Mohr (2019)
Economic Indicators, chapter 7.)
4.1
Background – why trade internationally?
One way to study international economic relations is to attempt to understand why
countries engage in international trade and to explain the pattern of imports and
exports. (For example, why does South Africa import clothes pegs – surely they can
be manufactured locally?) Such questions are explored in courses on international
4.1 Background – why trade internationally?
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economics. In macroeconomics these questions are not considered further. Consequently,
we shall analyse only total import and export levels, ignoring the microeconomic details
of trade patterns.
Who are South Africa’s main trading partners?
South Africa's trade with regions and top 10 partners: shares in 2018 and 1994
Import share
2018
1994
Export share
2018
1994
Asia
45.4%
27.8%
Asia
31.3%
26.8%
European Union
28.5%
46.0%
Africa
26.5%
13.5%
Africa
11.9%
3.4%
European Union
23.5%
31.4%
NAFTA*
7.0%
12.9%
SADC
22.8%
11.2%
SADC
6.5%
2.5%
NAFTA*
7.3%
11.1%
China
18.3%
1.8%
China
9.2%
0.8%
Germany
9.9%
16.6%
Germany
7.5%
6.4%
USA
5.9%
11.4%
USA
6.7%
10.1%
Saudi Arabia
5.8%
0.1%
United Kingdom
5.0%
9.5%
India
4.1%
0.6%
Japan
4.8%
8.5%
Nigeria
4.1%
0.0%
India
4.7%
0.8%
United Kingdom
3.5%
12.0%
Botswana
4.3%
0.0%
Thailand
3.1%
0.8%
Namibia
3.8%
0.0%
Japan
3.1%
10.0%
Mozambique
3.4%
2.6%
Italy
2.7%
4.0%
Netherlands
3.3%
Total imports (R)
1.24 trillion
81.8 billion
Total exports (R)
1.15 trillion
3.3%
65.1 billion
Source: Department of Trade and Industry (www.thedti.gov.za).
Note the persistence of some large countries such as the USA, UK, Germany and Japan – but
also the new dominance of China and growing role of India, Saudi Arabia and Nigeria. The
shares of the Asian bloc, Africa and SADC have grown since 1994, while that of the European
Union and North America have shrunk. (NAFTA = USA, Canada and Mexico)
4.2
Imports, exports and capital flows
As indicated in chapter 1, imports and exports are important for the macroeconomy since
they impact directly on total expenditure.
❐ Exports X imply an injection of expenditure (by foreigners) into the domestic expenditure
flow, and imports M imply a leakage from the expenditure flow to the rest of the world.
❐ Net exports (X – M) – i.e. the net injection – constitute a direct component of total
expenditure = C + I + G + (X – M).
Therefore it is essential to understand the behaviour of X and M as well as their consequences for the state of the economy.
International payments relating to imports and exports are recorded in the current account
of the balance of payments (BoP). The gap between real exports and imports is net exports. It
differs from the current account because the current account also includes factor payments
(e.g. dividends, wages) paid across borders. A close correlation between import fluctuations and
GDP fluctuations can be observed.
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Figure 4.1 Exports and imports (in real terms – 2010 prices)
1 200
1 000
800
Real imports of goods and services
R billion
600
Real exports of goods and services
400
200
Real exports minus real imports
0
2018/01
2016/03
2015/01
2013/03
2012/01
2010/03
2009/01
2007/03
2006/01
2004/03
2003/01
2001/03
2000/01
1998/03
1997/01
1995/03
1994/01
1992/03
1991/01
1989/03
1988/01
1986/03
1985/01
–200
Source: South African Reserve Bank (www.resbank.co.za).
The graph in figure 4.1 depicts the movements in real imports and exports as well as
net exports since 1980. What is notable from the graph is that for long stretches of time
real imports were less than real exports. This was the case in the period 1985 to 1994.
Since 2003, imports have exceeded exports by a substantial margin, leaving net exports
negative. Also note that, since the early 1990s, both real imports and real exports have
increased significantly.
Which products comprise the main elements of South African imports and
exports?
The main export categories (2018) are precious metals and gems (18%), iron and other ores
(13%), vehicles (11%), mineral fuels (11%), iron, steel and aluminium (9%) and machinery and
equipment (8%).
The main import categories are machinery and equipment (22%), mineral fuels including oil
(18%) and vehicles (8%), and also plastic products, pharmaceuticals, technical and medical
apparatus, and chemical products.
Capital and intermediate goods represent a large portion of imports. Therefore the causal link
between changes in total production and imports is likely to be strong (see below).
4.2.1
Imports (M)
Imports concern the purchase of foreign products (both consumer goods and capital
goods). The major share of South African imports comprises machinery and capital items;
oil is also an important item.
Expenditure on imports by all participants is included: households, business enterprises,
the government sector, government corporations, etc.
4.2 Imports, exports and capital flows
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Which factors determine imports?
PSA
M = f(YDSA; 
​  P
​ ; rand; ...)
Foreign
+
+
+
A part of import expenditure involves the purchase of imported consumer goods.
Therefore, like consumption C, it depends positively on disposable income YD and thus on
total income Y. Furthermore, a very large portion of import expenditure is on production
inputs (machinery and intermediate inputs, often high-tech items). Since increases in
output require more inputs, the demand for imported inputs is strongly influenced by total
production Y (see previous box). In both cases, total income is a crucial determinant.
This suggests the concept of marginal import propensity. (Can you define it?) One can then
write a simple import function as:
M = ma + mY + ... ...... (4.1)
where m is the marginal import propensity. If national income Y increases, imports will
increase. An upswing (or downswing) in the economy frequently causes an increase (or
decrease) in imports. This means that imports behave pro-cyclically: imports increase and
decrease concurrently with the business cycle.
✍
General tax increases will affect import expenditure positively/negatively (choose one
alternative). Why?
______________________________________________________________________________________
______________________________________________________________________________________
Rising imports can be a symptom of (too) good times. Why?
______________________________________________________________________________________
______________________________________________________________________________________
Restrictive policy often causes imports to decline. Why?
______________________________________________________________________________________
______________________________________________________________________________________
A second factor influencing the decision to import is the price of imported goods relative to
the price of locally produced goods. (In the case of essential items that are not produced
in South Africa, such as oil or high-tech machinery, one may have less freedom of choice;
thus, a lower price sensitivity is likely.)
❐ The relevant variable is the price ratio, defined above. The expected relationship is
positive, since a higher price ratio (e.g. due to increasing South African prices) is likely
to encourage imports (and discourage exports, see section 4.2.2).
The exchange rate is a third important factor determining imports. This follows from the
fact that the exchange rate determines the price of an imported product in South African
rands. For example: if the external value of the rand is $1 = R10.50 and an imported video
recorder costs $300, the price in rand is R3 150. Rands have to be exchanged for dollars
to buy the machine; therefore the rate of exchange determines the effective rand price of
the imported item.
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✍
How does South Africa’s inflation rate compare with those of our main trade partners? Is this likely to
encourage or discourage imports? What about exports? (Explain your answer.)
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
A higher price ratio will make local producers less/more (choose one alternative) competitive
relative to foreign producers (import competitors).
If the external value of the rand
increases – e.g. when the rand
strengthens from $1 = R10.50
to $1 = R10.00 – imports are
encouraged because the rand
price of imports effectively de­
clines. The international purchas­
ing power of the South African
rand has increased. Therefore the
likely relationship between M and
the rand is positive.
❐ Be very careful here. If you
think in terms of the actual
number 10.50 or 10.00,
the relationship is negative:
a stronger rand means the
exchange rate number decreases
– which leads to an increase in
imports M.
Terms of trade is a concept similar to the price ratio.
It is published in the Quarterly Bulletin of the Reserve
Bank and is calculated as the export price index
divided by an import price index, expressed as an
index. A weakening of the terms of trade means that
South African export prices have decreased relative
to the prices of imported products: the country earns
less from exports, compared to what it needs to pay
for imports.
See Mohr (2019) Economic Indicators, section 7.4.
Each international transaction actually comprises a
double transaction: the necessary foreign exchange
or currency is bought first, and then the item is
bought with that foreign currency. It also means
that the demand for foreign currency is a derived
demand, i.e. it is derived from the demand for the
products that importers want to buy.
The price ratio and the exchange
rate jointly determine the real
effective exchange rate , defined
above. The real effective exchange rate can be thought to impact on m, the marginal
propensity to import. If  increases – due to an increase in the external value of the rand, or
an increase in the price ratio – m will increase, and vice versa. The argument is that changes
in  will affect a country’s willingness to import goods from abroad – i.e. the portion of every
extra R1 of income that will be spent on imported goods and services. So we can write the
marginal propensity to import as being dependent on the value of , i.e. m().
❐ In thinking and reasoning about open economy chain reactions it will often be better
to work
in terms of the constituent elements of , i.e. the exchange rate and the price
P

ratio ​  P ​. One must be able to work in both formats.
SA
Foreign
Other factors that can influence imports are trade policy (import taxes, import tariffs or
quotas, etc.), trade sanctions or boycotts.
4.2 Imports, exports and capital flows
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✍
Depreciation or devaluation?
If the rand weakens, i.e. its external value decreases, it is said that the rand ‘depreciates’. (The
opposite is an ‘appreciation’.) What does devaluation mean? And revaluation? If you do not know,
read section 4.3.2.
A more complete import function thus would be:
M = ma + m()Y
...... (4.2)
In this form, the real effective exchange rate Figure 4.2 The import function
– and thus the price ratio and the exchange
E
rate – are built into the import propensity
parameter. (While we will not always write
m as m() in diagrams and mathematical
expressions, its presence must always be
remembered.)
M 5 ma 1 mY
❐ An increase in  – due to a strengthening m
a
rand and/or a higher price ratio – will encourage imports, i.e. the import propensity
m will be higher.
❐ The import function can be depicted in
the 45° income–expenditure diagram as a
positively sloped line/curve, as in figure 4.2.
Income Y
If Y increases, the ensuing increase in M will
be apparent as a move along the M curve.
❐ An increase in  implies a steeper import curve. If any of the elements of the real
effective exchange rate – the price ratio or the exchange rate – changes, the import
function will rotate.
❐ Trade policy steps such as an import tax, tariff or quota or trade sanctions will shift the
import curve up or down.
4.2.2
Exports (X)
Insufficient domestic production of exports can
Since South African exports are
occur if there are not enough South African goods
actually imports by other countries
to meet export demand. However, at this stage we
from South Africa, the explanation
assume that there are no supply-side restrictions.
of exports is relatively simple.
(This will change in chapter 6.) However, as a rule,
Accordingly, South African exports
aggregate supply bottlenecks very rarely constitute
are determined by factors similar
a real constraint on export levels – except in the
to those concerning imports. It is
case of agricultural products, where a drought can
important to realise, though, that
have a disastrous effect on exports. It is quite simple
the export decision is primarily taken
to analyse the expected effects of a drought (or a
in another country, i.e. a South
miners’ strike) on export performance, and hence on
African producer’s supply of export
aggregate economic performance.
goods occurs on demand from
foreigners. It specifically does not
depend on domestic income or production (GDP) to any significant extent.
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Which factors determine exports?
Exports depend not only on foreign income levels (YForeign or Yf ), but also on the price ratio
(terms of trade) and the exchange rate. Thus:
PSA
​ P
​; rand; ...)
X = f(YForeign; 
Foreign



The expected signs (+ or –) of the variables follow from arguments similar to those with
regard to imports. Exports will have a negative relationship with the price ratio – relatively
higher domestic prices will discourage exports. And they will have a negative relationship
with the value of the rand – a weaker rand will make exports cheaper for foreigners.
Similar to our handling of the import function above, the real effective exchange rate can
also be brought into the slope parameter of an export function:
X = va + v()Yf + …
...... (4.3)
The parameter v is not interpreted as a marginal propensity, but as an indication of the
home country’s share of world trade. A higher value of v will reflect a higher share of
world trade, if Yf represents world income. An increase in  – due to a stronger rand or
a higher price ratio – will discourage exports (imports by foreign countries from South
Africa), and thus reduce our share of world trade v.
Graphically, in the 45° diagram, the X curve is simply a horizontal line (see figure 4.3).
❐ A change in foreign income levels (e.g. upswings or downswings in the economies of
major trading partners) will shift the export curve up or down correspondingly.
❐ A change in the trade share v (due to a change in the real effective exchange rate ) will
also shift the export curve.
✍
What is the impact of relatively high domestic inflation on South African exports?
______________________________________________________________________________________
______________________________________________________________________________________
What does the expression ‘we are pricing ourselves out of world markets’ mean?
______________________________________________________________________________________
______________________________________________________________________________________
Net exports
Putting both the X and the M curves on the 45° diagram enables us also to observe net
exports. Net exports is the numerical difference between imports and exports, i.e. (X – M).
Plotting that difference against income gives us the net exports (X – M) curve. As shown
in figure 4.3, net exports (X – M) is a line with a negative slope.
Observing the difference between the X and M curves relative to income shows why trade
deficits (when the imports of goods exceeds the export of goods) are more prone to occur
at higher levels of income than lower levels of income.
4.2 Imports, exports and capital flows
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Figure 4.4 A change in net exports
Figure 4.3 Exports and net exports
E
E
C 1 I 1 G 1 (X 2 M)0
Imports M
Exports X
Net exports (X 2 M)
C 1 I 1 G 1 (X 2 M)1
(X 2 M)
Y
Y
Income Y
Any change in one or more of the factors that determine X and/or M will imply a change
in (X – M), which – as a direct component of total expenditure – will cause a change in the
real economy (with the usual multiplier effect, as in figure 4.4). For example:
Suppose the rand appreciates ⇒ effective price of imports declines (and the effective price of SA
exports for foreigners increases) ⇒ imports are encouraged and exports discouraged ⇒ (X – M)
declines ⇒ total expenditure declines ⇒ production discouraged ⇒ GDP and Y decline.
✍
Foreign inflation declines ⇒
______________________________________________________________________________________
______________________________________________________________________________________
Upswing in the USA ⇒
______________________________________________________________________________________
______________________________________________________________________________________
What is the difference between ‘Expenditure on Gross Domestic Product’ and ‘Gross Domestic
Expenditure’ in the national accounts? Why is this difference important?
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
If you do not know, read addendum 5.1 (chapter 5).
Remarks
1. Conceptually (X – M) also can be called the trade balance. If X exceeds M there is
a trade surplus; if import payments exceed export earnings, there is a trade deficit.
However, the trade balance includes only imports and exports of goods. Services are
excluded. Therefore the trade balance is also called the goods balance.
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2. If trade in services – payments and receipts for services such as international tourism,
transport, financial and insurance services – is included, one gets ‘net exports’.
❐ In our macroeconomic reasoning and chain reactions this is how we interpret
(X – M).
3. Net exports still exclude inflows and outflows of income payments, i.e. compensation
of employees as well as returns on investment (dividends and interest earned abroad).
Income payments thus reflect trade in factors of production – labour and capital. Also
excluded are international transfers.
❐ These excluded items are denoted as ‘invisible trade’.
What is the difference between the trade balance, net exports and the
current account in actual data?
The numerical difference between net exports and the current account can be quite large,
but also quite variable between quarters and years.
The table below shows net exports and the current account in 2018. The two balances
differ markedly. It shows how ‘invisible trade’ can affect the current account significantly,
often negatively. For example, in 2018, the net figure for income receipts and payments
was R97 billion – R251 billion = –R154 billion and for exports (R1 176 + R72 + R210)
billion – (R1 223 – R218) billion = –R17 billion. Income payments always exceed income
receipts by far. Thus the net income outflows aggravated the negative payments balance
before transfers.
DATA TIP
Note that in the Quarterly Bulletin BoP data are recorded only in nominal terms, whereas the
Bulletin’s national accounts (SNA) data are published in both nominal and real terms. The
table below is in nominal terms. Note that, if income receipts and payments are excluded
from the balance of payments column, the export and import totals are the same as in the
national accounts column.
A trade balance (or goods balance) can also be calculated. However, trade balance
figures are also published by the South African Revenue Service (Customs and Excise
Division) on a monthly basis. These say little about macroeconomic trends, since they
fluctuate a lot between months. Second, annual totals also differ from SNA and balance
of payments numbers. For macroeconomic analysis, it is best to use the SNA data.
National accounts 2018
R million
Balance of payments 2018
R million
Exports of goods and services
1 457 641
Merchandise exports
Exports of goods
1 247 226
Net gold exports
71 678
210 415
Service receipts
210 415
Less: Imports of goods and services
–1 440 883
Income receipts
96 507
Imports of goods
–1 222 944
Less: Merchandise imports
–1 222 944
–217 939
Less: Payment for services
–217 939
Less: Income payments
–250 552
Exports of services
Imports of services
Exports minus Imports
16 748
Current transfers (net receipts (+))
Balance on current account
1 175 547
–35 674
–172 962
Source: South African Reserve Bank (www.resbank.co.za).
4.2 Imports, exports and capital flows
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4. The current account is the broadest measure: it includes net exports and net income
payments, as well as net current transfers. A positive net inflow of payments for goods
and services implies that the current account is in surplus (and vice versa).
5. A current account deficit means that a country is importing more goods, services and
factors than it exports: total expenditure buys up all domestic production and more.
It is a sign, therefore, that a country is ‘living beyond its means’. Consequently, one
solution is to curb total expenditure.
✍
An economic upswing is likely to strengthen/weaken the current account. (Choose one option
and explain why.)
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
It is often stated that the government cannot stimulate the economy before the current account
is ‘ready’ for it. What does this mean?
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
(Hint: If there is a current account deficit, any stimulation is bound to lead to what?)
6. The extent to which the current account will deteriorate when Y increases will
depend on the marginal propensity to import. A high propensity will cause imports
to react strongly to any increase in GDP, causing the current account to deteriorate
significantly. This can be important if a country is inclined to experience current
account problems. In South Africa, the import propensity is relatively high, especially
since any meaningful expansion of production is dependent on imported inputs. South
African consumer expenditure patterns also contribute to a high marginal propensity
to import. This has important macroeconomic implications (see section 4.5.3).
7. A depreciating rand should stimulate exports and curb imports. The current account
balance is bound to improve after such a depreciation. The appreciation of the
currency is likely to weaken the current account balance.
8. Any positive or negative change in net exports (X – M) has a multiplier effect on
income (via the expenditure multiplier KE).
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The peculiar J curve
In practice it often happens that, following a currency depreciation, the current account first deteriorates
and then improves. On a graph with the current account on the vertical axis and time on the horizontal
axis, this produces a curve with a J shape. Why does this happen?
Import and export contracts usually are valid for a relatively long
Time of
period of time. In addition, many import contracts are denominated
depreciation
Current account
in foreign currency such as the dollar. Therefore, if the rand
depreciates suddenly, existing contract volumes will continue to
be imported and exported for some time. Given a weaker rand,
0
payments for the contracted volume of imports will require more
Time
rands (since the prices of imports are denominated in foreign
currency). This implies an increase in the outflow of payments for
imports. Export prices are mostly denominated in rands; hence
total receipts for exports will remain constant for some time.
The net effect is that the current account deteriorates initially. Only after some time will contracts
adjust to the new external value of the rand, causing export volumes to increase and import volumes to
decrease. This means that the volume effect on the current account starts to dominate the price effect. Only
then will the current account show an improvement. The diagrammatic result: a J curve.
The Marshall-Lerner condition
The typical existence of a J curve implies that the net effect of a depreciation of the currency is that
the current account (X – M) improves (albeit with some delay). As noted, this is because the effect on
the current account of the change in the volume of imports and exports is stronger than the contrary
effect of the change in the price of imports and exports (in rands). If this is indeed the case, the socalled Marshall-Lerner condition is satisfied. (The condition is satisfied if the sum of the exchangerate elasticities of imports and exports exceeds 1.) If imports and exports have very low elasticity to
exchange rate changes – implying such small changes in the volume of imports and exports that the
current account will deterioriate following a currency depreciation – this condition is not satisfied. In
reality, the Marshall-Lerner condition is satisfied in most cases. So we will continue to assume that a
currency depreciation leads to an improvement in (X – M).
Volumes vs. values
The J curve and Marshall-Lerner condition illustrate an important issue with regard to imports and
exports: one should be extremely careful in analysing volumes versus values. Changes in the exchange
rate influence the rand value of a particular import or export volume dramatically. They can even cause rand
values to increase while volumes decline, and vice versa. In open-economy macroeconomic analysis,
both volumes and rand values are important:
❐ For BoP analysis, the rand values are decisive.
❐ For expenditure and production analysis, it is actually the volumes that are important, since they
indicate the real quantities being imported or exported, or the real expenditure involved.
However, national accounts data do not really reflect real quantities. Real figures are derived simply by
deflating rand values with an estimated price index. The exchange rate effect is not removed from the
data. Therefore patterns in real import and export data (national accounts) will not correspond exactly to
patterns in import and export volumes.
4.2 Imports, exports and capital flows
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✍
The degree of openness of the economy will influence the size of the multiplier. How and why?
(Hint: Consider the import propensity.)
______________________________________________________________________________________
______________________________________________________________________________________
9. The normal secondary effects (monetary feedback effects) will also follow from any
stimulation of income due to changes in (net) exports. As production and income
are stimulated, interest rates are pushed up by an increased demand for money. This
increasingly acts as a brake on the upswing, thereby restraining the expected upswing
in the economy.
10. One factor that complicates the analysis of the likely consequences of an export surge
is that efforts at export promotion often lead to a subsequent increase in imports. This
is due to the necessary importation of production inputs. In this sense, South African
exports are often import-stimulating. (Normally one would exclude this effect from
the analysis.)
4.2.3
Capital flows
Capital inflows are all inflows of foreign funds for the purpose of fixed investment (in
fixed assets), as well as financial investment (for the purchase of financial assets). Capital
inflows include foreign loans by either the private sector or the public sector (e.g. for
infrastructural projects or for financing a budget deficit).
The flow of capital into and out of the country is recorded in the financial account of
the BoP. Direct and portfolio investment can be distinguished, also in published data. The
former pertains to setting up new companies or foreign subsidiaries, or acquiring shares
in companies with the objective of gaining a meaningful say in management, as well as
investment in real estate. The latter pertains, for example, to purchases or shares or bonds
with the objective of financial returns on the investment, rather than having a say in
management, i.e. there is no longer-term commitment. It also includes the acquisition of
long-term debt and money market instruments.
In figure 4.5, the graph shows quarterly capital movements for the period 1980 to 2018,
as recorded in the financial account of the balance of payments. Three distinct periods can
be observed. In the period between 1985 and 1994, capital movements were rather small.
Real investment, financial investment and the financial account
The important macroeconomic distinction between real investment (capital formation) and
financial investment was explained in chapter 2. In the financial account of the BoP, these
matters are handled differently, which can be confusing. The financial account combines flows of
funds for the sale and purchase of all kinds of assets: residential homes, commercial buildings,
factories, land, companies, shares, government and other stock, even deposits with financial
institutions; it also records loans and loan repayments. However, it does distinguish between
direct investment, portfolio investment and other investment. Compare the balance of payments
table in section 4.3.1.
See also Mohr (2019) Economic Indicators, 131–2.
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Figure 4.5 International capital flows – the financial account
100
80
Financial account
R billion
60
40
20
2018/01
2016/03
2015/01
2013/03
2012/01
2010/03
2009/01
2007/03
2006/01
2004/03
2003/01
2001/03
2000/01
1998/03
1997/01
1995/03
1994/01
1992/03
1991/01
1989/03
1988/01
1985/01
–20
1986/03
0
Source: South African Reserve Bank (www.resbank.co.za).
This was mainly due to the international isolation of, and financial sanctions against,
South Africa in the period prior to 1994. Since 1994, capital movements increased significantly. However, notice that capital flows were still rather modest and stable between
1994 and 2003. In the third period, after 2003, capital inflows into South Africa increased
dramatically (albeit with quite some volatility) – and from 2015 with even more volatility.
Also see figure 4.6.
Which factors determine capital inflows?
Capital flows across international borders because capital owners are seeking the highest
possible real rates of return on investments (whether real or financial investments).
Therefore the main factors that determine the inflow of capital into a country are relative
interest rates (on financial investments), relative rates of return (on real investment), the
exchange rate,2 and economic and political expectations. Accordingly:
rSA
K-inflow = f (​ 
rForeign ​; relative SA rates of return; rand; expectations)



?
Optimism about expected real returns on real investment (i.e. economic growth possibilities)
should attract foreign investors. Furthermore, local interest rates that increase relative to
foreign rates should induce inflows of foreign capital (and strengthen the financial account).
The main effect of the exchange rate is that it determines the effective cost, for a foreign investor,
of the purchase of an asset. A relatively weak rand reduces the prices of South African assets
for foreign investors and encourages foreign investment. This implies an inverse relationship
between the value of the rand and capital inflows. On the other hand, a weak rand reduces the
effective value of dividends to a foreigner – a discouraging factor. Normally this effect is small,
however, and the inverse relationship mentioned above is likely to predominate.
2
Until 1995, South Africa had a special exchange rate for capital flows – the so-called financial rand.
4.2 Imports, exports and capital flows
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Interest rates and risk premiums in emerging markets
Changes in the interest rate, rather than differences between the levels of interest rates in countries,
are what matters here. Interest rates in South Africa always tend to be higher than in countries such
as the USA or UK. Yet there is no perpetual flow of capital into South Africa. But South Africa will
experience capital outflows when the domestic interest rate level decreases even though domestic
rates still are higher than in other economies.
When searching for investment options across potential target countries, international investors
do not simply decide on the basis of nominal interest rates (or nominal rates of return) in
different countries. They take a broader view.
First, they will take note that high nominal interest rates usually reflect high inflation in a target
country. This implies some risks. An inflation rate that is relatively high is likely to lead to
currency depreciation over the duration of the investment. This will reduce the buying power,
in the investor’s home country, of the nominal return earned in the target country. Moreover,
such depreciation will decrease the value, in home currency, of the capital when it is repatriated
eventually. (The longer the term of the investment, the higher is this risk.) For this reason,
investors will often compare real rates of interest: r ≈ i – π.
Second, investors are sensitive to risks relating to economic and political instability. An investor
investing in, say, a low- or middle-income country or ‘emerging market’, will want some
premium built into the return or interest rate to compensate for the higher risk compared to a
‘safe’ investment in the USA or Germany, for instance. Everything else being equal (including
inflation rates), the typical investor will at least require a real interest rate that is higher by the
amount of the risk premium. Thus:
Required real interest rate in risky country = Real interest rate in safe countries + risk premium
The safe country rate will depend on international capital market conditions, but will not vary
much. The premium will depend on each individual target country.
❐ The risk premium for South Africa, compared to the USA or other OECD countries, may
be in the order of 3%. This can increase dramatically if events occur that signal political
uncertainty and risk.
❐ In a stable situation, the gap between South African nominal rates and average OECD
nominal rates is an approximate indication of the combined exchange rate and political risk
premiums in the eyes of international investors.
Political uncertainty, disturbances and unrest can be potent factors. Such factors have
quite frequently affected South Africa’s external economic relations negatively, with
the Sharpeville incident of 1961 and the Soweto uprising of 1976 as notable examples.
Political instability continues to bedevil many low- and middle-income countries in Africa
and elsewhere (see chapter 12, section 12.3.4).
The perceived high risk of investment in South Africa required a substantial risk premium
in order to induce foreign investors to consider investment here. This was the case, for
instance, in the 1980s and early 1990s when foreign investors watched the political course
of events much more than interest rate or rate of return differentials. Thus, international
capital flows to South Africa were not very sensitive to interest rate differentials (i.e. they
were interest rate inelastic). For these reasons, there was a relatively low flow of capital into
South Africa, especially for direct investment.
The situation improved after 1994. Although there is still a significant risk premium,
capital flows are more sensitive to interest rate changes and rate of return differentials.
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This does not mean that politics does not play a role. Rather, the more legitimate and
more stable post-1994 political environment has reduced political uncertainty and the
risk premium. However, since 2009 the risk premium has increased again, mostly because
of weak economic conditions, but also increased political risk. Elections and changes of
party and national leadership, or contentious policy views expressed by presidents or
party officials, regularly cause heightened political concern. Since South Africa is part of
the so-called emerging markets, foreign investors will continue to pay more attention to its
politics than those of democratically mature economies such as the USA, UK and Japan.
Therefore, in contrast to South Africa, there is high international mobility of capital into the
USA. In particular, there is a tremendous international sensitivity to American interest
rates. A small rate increase in the USA can cause a tremendous inflow of foreign capital
into the USA.
❐ This illustrates the fact that one should be careful in applying macroeconomic reasoning
to different countries.
❐ The US example is crucial in understanding movements in the gold price, the dollar and
the rand. (See section 4.5.3.)
Foreign loans by the private sector normally derive from investment plans. The same is true
for large infrastructural projects of the state or of quasi-state institutions (e.g. Eskom,
Telkom and Transnet). Foreign borrowing towards the financing of a budget deficit
depends on the borrowing requirement of the government, the cost and conditions of
such loans compared to domestic loans, and the debt-management policy of the state
(discussed in chapters 9 and 10).
How do foreign capital flows affect the economy?
The analysis of the short-term macroeconomic impact of foreign capital inflows is quite
complex. To understand this, one must clearly distinguish between possible real and
monetary effects.
Not being a direct component of aggregate expenditure, an inflow of foreign capital (e.g. a
foreign loan) as such has no direct impact on aggregate spending, and hence no direct or
immediate effect on real income. (The repayment of foreign loans is simply an outflow, or
a negative inflow, of capital, requiring an analogous analysis.)
To see this, one must distinguish analytically the inflow of funds from their actual use. If
the funds are used to purchase existing shares, there is no new real investment, and hence
no direct real impact. However, even if the funds are used to finance new real investment,
one should rather analyse the effects of the investment expenditure separately – with the
foreign capital simply the method of financing, having no real expenditure effect in itself.
Foreign capital inflows as such therefore have no direct real effect on the economy.
But surely the inflow of funds
must have a monetary impact?
This is true – with the crucial
qualification that the effect of
the financial account cannot
be determined and analysed
on its own. Further on we shall
see that the financial account,
together with the current account – i.e.
It is important to note that in the long run the inflow
of foreign capital is important in the sense that it
boosts the domestic pool of funds available to
finance investment. In this way it is important for
long-term real economic growth (see chapter 12,
section 12.3).
the whole balance of payments – has important
4.2 Imports, exports and capital flows
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implications for monetary conditions. But one cannot analyse the monetary impact of the
financial account separately – the net balance of the two accounts is what matters here.
To understand this, we first have to consider the exchange rate and the balance of
payments, and the complex two-way interaction between these two. At this stage it is
sufficient to note that a net inflow of funds will expand the domestic money supply. A net
outflow will contract the domestic money supply.
In the following section, the entire network of interrelationships will be traced and
explained. The final and comprehensive picture will materialise.
4.3
The balance of payments and exchange rates
4.3.1
The balance of payments (BoP)
In accounting terms, the balance of payments (BoP) is the sum of the balances on the
current and financial accounts:
BoP = Current account balance + Financial account balance
The graph in figure 4.6 shows historical patterns for annual data on these two elements
for South Africa. Note how, before 1994, the current account was managed (via the
management of GDP growth) to counter financial account imbalances. Specifically, note
the major turnarounds in 1984–85 and again in 1993–94. After 1994, a shortage of
international capital ceased to be a problem, and even more so after 2003. This inflow
enabled the economy to carry a large deficit on the current account – the by-product of
high economic growth – without any problem.
However, in 2007 and 2008, questions were increasingly being asked about the sustain­
ability of the current account deficit when it reached levels of 7% and 8% of GDP (compared
to the 3% international rule of thumb that is often cited in the press).
Figure 4.6 The current account and the financial account
300
270
240
Financial account
210
180
150
120
R billion
90
60
30
0
–30
–60
–90
–120
Current account
–150
–180
–210
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
–240
Source: South African Reserve Bank (www.resbank.co.za).
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The unease reached new heights since 2013, when the relatively large current account
deficit, combined with weak GDP growth prospects and a relatively large budget deficit,
caused the South African economy to be seen as rather fragile.
The balance of payments table
The composition and terms of the balance of payments table in the Quarterly Bulletin
of the Reserve Bank is somewhat confusing. The components of the current account
were discussed above. The table below adds the financial account figures to the current
account figures shown on p. 149.
Balance of payments 2018 (R billion)
Current Account:
Merchandise exports
1 175 547
Net gold exports
71 678
Service receipts
210 415
Income receipts
96 507
Less: Merchandise imports
–1 222 944
Less: Payment of services
–217 939
Less: Income payments
–250 552
Current transfers (net receipts (+))
–35 674
Balance on current account
–172 962
DATA TIP
Capital transfer account (net receipts (+))
236
Financial Account:
Net direct investment
10 360
Net portfolio investment
33 224
Net financal derivatives
7 209
Net other investment
102 595
Reserve assets (increase (–)/decrease (+))
–11 337
Balance on the financial account with change in reserves included
142 051
Balance on the financial account (change in reserves excluded)
153 388
Unrecorded transactions
30 675
Balance of Payments with change in reserves included
Balance of Payments (change in reserves exluded, unrecorded transactions included)
–
11 337
Source: South African Reserve Bank (www.resbank.co.za).
❐
❐
❐
❐
The capital transfer account item is relatively insignificant in economic analysis.
‘Other investment’ mainly includes trade credits, and is typically quite large.
Unrecorded transactions denote a capital flow error term, and can be significant.
In the published table in the Quarterly Bulletin the actual number for the ‘Balance
of payments’ is not shown. Due to accounting conventions, its value is shown in
the financial account just above the ‘balance on the financial account’ as ‘Reserve
assets (increase (–)/decrease (+))’. In the tables above and in chapter 5, section 5.6,
we have labelled it ‘Balance of payments (excl. change in reserves, incl. unrecorded
transactions)’. Being equal to the change in reserves, it also equals the sum of
the balances on: the current account, the capital transfer account (very small), the
financial account (change in reserves excluded), and unrecorded transactions.
4.3 The balance of payments and exchange rates
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What causes an imbalance in the balance of payments (BoP)?
The BoP position depends on all the factors that determine the international flow of goods
and capital: domestic and foreign income levels, interest rates and rates of return, price
levels and exchange rates, as well as expectations, perceptions of risk and so forth. A change
in one or more of these factors – as in the many chain reactions we have encountered –
normally also leads to a concurrent change in imports and exports (and thus the current
account) or capital inflows (the financial account). From these follow a net impact on the
BoP – which is always in the thick of things, as we will see.
We will consider three illustrative examples and elaborate on them throughout this chapter, as well as in chapter 6 (when introducing inflation):
1. A change in the money supply or repo rate (i.e. a disturbance in the money market/
monetary sector). The primary and secondary effects that usually follow a monetary
policy step, e.g. an increase in the repo rate, were explained in chapter 3 (section 3.3.6).
To summarise: The net effect of an increase in the repo rate is an increase in interest
rates and a decrease in real income (through several concurrent processes, the details
of which are not relevant now).
❐ The higher interest rates are likely to attract an inflow of foreign capital, which
affects the financial account of the balance of payments: a financial account
surplus will develop.
❐ The drop in income is likely to lead to a fall in imports, which affect the current
account of the BoP: a current account surplus will develop.
Together these two effects will determine the BoP position, in this case unambiguously
a surplus.
2. A change in aggregate expenditure (i.e. a disturbance in the domestic goods market).
The primary and secondary effects of an increase in government expenditure were
explained in chapter 3 (sections 3.3.2 and 3.3.6).
To summarise
The net effect of an increase in government expenditure is an increase in real income
accompanied by an increase in interest rates.
❐ The higher interest rates are likely to attract an inflow of foreign capital, which
strengthens the financial (or capital) account of the balance of payments.
❐ The upswing in income is likely to lead to a rise in imports, which negatively affect
the current account of the BoP.
The net impact of the two opposing effects will determine the ultimate BoP position.
3. A change in exports (i.e. a disturbance in the foreign sector), for example due to an
economic upswing in the USA. (See chapter 2, section 2.2.6; section 4.5.3 in chapter
4 contains a complete chain reaction.)
In brief: The net effect of an increase in exports is an increase in real income
accompanied by an increase in interest rates.
❐ Increasing exports are directly reflected in an improved current account.
❐ Increased export earnings imply an expenditure injection in the economy, which
causes income Y to increase (see chapter 2, section 2.2.6).
❐ The upswing in income is likely to lead to a rise in imports (why?), which is a
negative impact on the current account.
❐ The increase in Y is likely to lead, via increased money demand, to higher interest
rates. These are likely to attract foreign capital, which strengthens the financial (or
capital) account.
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The net impact of these effects will determine the ultimate BoP position. It is likely to
be in a surplus.
✍
What is the effect of the following on the BoP?
Suppose South Africa’s inflation is higher than foreign inflation ⇒
______________________________________________________________________________________
______________________________________________________________________________________
Suppose South Africa’s interest rates are higher than foreign interest rates ⇒
______________________________________________________________________________________
______________________________________________________________________________________
Suppose South Africa has to repay foreign debt ⇒
______________________________________________________________________________________
______________________________________________________________________________________
Suppose the repo rate is reduced ⇒
______________________________________________________________________________________
______________________________________________________________________________________
What are the consequences of a BoP disequilibrium?
A surplus on the balance of payments (BoP > 0) implies a net inflow of payments (for
whatever purpose). A deficit (BoP < 0) implies a net outflow of funds, i.e. outflows exceed
inflows (in a given period).
The BoP has a direct impact on three key variables:
1. the foreign reserves;
2. the money supply (monetary liquidity); and
3. the exchange rate.
(1) Impact on foreign reserves
Since foreign payments to South Africans initially occur in the form of foreign currency, a
surplus on the BoP causes the amount of foreign currency – or ‘foreign reserves’ – in the
country to increase. Likewise, a deficit will cause the foreign reserves to decline, while a BoP
equilibrium will leave reserves unaffected. In this way the state of the foreign reserves is a
good indicator of the BoP situation.
The graph in figure 4.7 shows the balance of payments together with the foreign reserves
since 1985. The balance of payments is a net figure, reflecting the current and financial
accounts. These are nominal values, hence the apparent increase in the magnitude of
the figures. Note how the stock of gold and foreign reserves increased since 1996, with
temporary dips in 2002–03, 2009–10 and 2016–17. The graph indicates that the BoP in
South Africa has improved significantly even though the current account of the balance
of payments has registered a significant and growing deficit. However, 2008, 2013 and
2018 were difficult years.
4.3 The balance of payments and exchange rates
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Figure 4.7 The balance of payments and foreign reserves
780
720
660
Gross gold and foreign reserves
600
540
480
R billion
420
360
300
240
180
120
Balance of payments
60
0
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1985
–120
1986
–60
Source: South African Reserve Bank (www.resbank.co.za).
DATA TIP
Net and gross foreign reserves
Technically, foreign reserves also are affected by a number of other international monetary
flows. In published BoP data, the following are distinguished:
❐ Change in net gold and other foreign reserves, and
❐ Change in gross gold and other foreign reserves.
The differences between these two depend on changes in three factors: (1) the net
monetisation/demonetisation of gold, (2) SDR allocations and calculations (SDR: Standard
Drawing Rights at the IMF) and (3) liabilities related to reserves.3
If one wants to evaluate changes in foreign reserves as such, the gross figure is the relevant one.
However, the net figure is closest to the macroeconomic concept of ‘the balance of payments’.
Foreign reserves are critically important since they are essential in paying for imports.
A country cannot sustain a BoP deficit for an indeterminate period of time: eventually
there will be insufficient foreign currency reserves to pay for imports – especially essential
imports such as oil.
❐ A rule of thumb in this regard is that a country should have sufficient reserves to cover
three months’ imports.
❐ The following table from the Reserve Bank shows the performance of the SA economy
in this regard. During the 1990s the average number of months of imports covered
by foreign reserves was quite low. However, in the 2000s the foreign reserve position
improved. As table 4.1 indicates, the foreign reserve position improved from less
than two months of imports in 2003 to averaging 4.6 months of imports from 2009
onwards. Still, that is not a huge buffer.
3
160
This concerns foreign loans by the Reserve Bank and the government from foreign banks and governments, but for
specialised purposes other than trade or capital flow. Therefore it falls outside the ambit of the BoP as conventionally
understood, and does not necessarily have any effect on the macroeconomy.
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Foreign reserves and the ‘man in the street’
The level of foreign reserves may be one of the most important considerations in Reserve
Bank interest rate policy (in conjunction with other policy goals such as inflation; see chapter
9). As soon as foreign reserves reach relatively low levels, the Reserve Bank may consider
pushing up interest rates (e.g. via a repo rate increase) in order to restrain expenditure and
therefore imports, and perhaps to attract foreign capital.
Therefore, if either the current or the financial account shows a deteriorating trend, and
depending on the state of the other account, one can expect that interest rates may be
increased. Obviously such a step affects the economy and, for example, homeowners,
negatively. Therefore the level of foreign reserves is of great importance for everyone.
❐ On the other hand, low reserves normally are symptomatic of a period of BoP deficits.
This might cause the rand to depreciate, which is negative for import prices and thus
for inflation. Shoring up reserves with a repo rate increase will also serve the inflation
objective.
Foreign reserves also are essential if the Reserve Bank Table 4.1 Foreign reserves
wants to support the rand in foreign exchange markets
Imports of goods and services covered
as part of its exchange rate policy (see section 4.3.2).
by reserves (average number of months)
If there is a continuous current account deficit, the
financial account should be in surplus to compensate.
As long as capital inflows occur continually, a country
can sustain a current account d eficit without running
into foreign reserve problems. However, if there is a
sustained capital outflow, current account deficits
cannot be tolerated for very long.
(2) Impact on the money supply
An important consequence of a BoP deficit or
surplus, referred to above, is that it influences the
nominal money supply MS. A net inflow of payments
(even if in foreign currency initially) leads to an
increase in the domestic money supply, as follows:
2003
1.8
2005
2.8
2007
3.0
2009
4.6
2011
4.3
2013
4.3
2015
4.9
2016
5.4
2017
4.9
2018
4.7
Source: South African Reserve Bank, balance
of payments tables (www.resbank.co.za).
Suppose a foreigner wishes to buy an item from a South African producer. She first buys
rands from the Reserve Bank (via her bank), then uses these to pay the export company.
When the funds are deposited in the company’s bank account, the total amount of deposits
in the country (i.e. M3) increases. Alternatively, if the export company is paid in dollars
or other foreign currency, this company has to exchange the foreign currency for rands
(that come from the Reserve Bank, via her bank), which it then deposits in its account.
The impact on the nominal (and real) money supply is identical: the deposit is a monetary
injection, which will be followed by the normal credit multiplier process. In the aggregate
there is an increase in domestic monetary liquidity (nominal and real).
Therefore:
BoP > 0 ⇒ increase in nominal (and real) MS
BoP < 0 ⇒ decrease in nominal (and real) MS
4.3 The balance of payments and exchange rates
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This impact on the money supply will occur as long as there is a BoP disequilibrium. As
soon as a deficit or surplus is eliminated, there will be no further impact on the money
supply from this source.
There are ways for the Reserve Bank to counter the impact of such an inflow of foreign
currency on the nominal money supply. Such a step is called the sterilisation of the foreign
currency inflow. A sterilisation entails that the Reserve Bank conducts an open market
operation where it sells bonds on the domestic capital market equal in value to the rand
value of the foreign reserve inflow.
The BoP constraint
Until 1976 it was usually the case that South Africa experienced significant capital inflows. As
a result, the country could afford to run large current account deficits. But 1976 was a turning
point. (What happened in that year?) The subsequent loss of foreign confidence in South Africa’s
political-economic future – and again in 1985 – drastically changed this situation. A huge and
increasing withdrawal of foreign capital occurred, causing a continuous and large deficit on
the financial account. Hence the current account had to be kept in surplus to earn enough
foreign exchange to finance the financial account deficit. This meant that imports had to be
curtailed at all costs. In turn this implied that the authorities could not allow the economy to
experience too strong an upswing. (Can you explain why not?) Therefore, restrictive policy had
to be used to protect the BoP. Especially in the period between 1985 and 1994, South Africa
was in the ironic position that only weak to moderate upswings could be allowed; anything
better would have caused BoP difficulties.
❐ This analysis shows just how effective financial sanctions – and not the trade sanctions
introduced earlier – were in applying pressure on the former South African government to
change the political system.
❐ Note that in this way the balance of payments position can create a significant constraint
on the economic growth rate that can be sustained. This is what is indicated by the term
‘the balance of payments constraint’.
(3) Impact on the exchange rate
The last important effect of the BoP on the economy concerns the exchange rate. We must
first understand exchange rates before this effect can be explained.
4.3.2
Exchange rates
What is the exchange rate?
As mentioned at the beginning of this chapter, the exchange rate is the price of one
currency in terms of another, e.g. $1 = R10.00 or £1 = R17.00. This is also called the
nominal exchange rate.
The exchange rate of the rand against the dollar, say, determines the ‘outside’ or external
value of the rand, i.e. for a foreign resident who wants to buy rands, or for a South African
wishing to buy foreign currencies with rands. The exchange rate therefore determines the
foreign or international purchasing power of the rand.
The external value of the rand is something completely different from the internal value
or domestic purchasing power of the rand, which is a reflection of the domestic impact of the
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!
The way rand–dollar exchange rates are usually written (i.e. $1 = R10.00) may be somewhat
confusing. If the rand depreciates (weakens) against the dollar, the numerical value of the rate of
change actually increases: the exchange rate increases.
Why does a change in the exchange rate from $1 = 10.50 to $1 = R10.20 represent a
strengthening of the rand? Think of the dollar as an item that you buy, just like a can of cola. If the
price of cola decreases, from R10.50 to R10.20, you can buy more cola per rand, i.e. in terms of
buying cola the purchasing power of the rand has increased. The same applies to buying a dollar.
If the price of a dollar decreases from R10.50 to R10.20, then the purchasing power of the rand in
terms of the dollar has increased. The rand has strengthened.
The exchange rate between the rand and some other currencies, such as the Japanese yen, is
expressed the other way around, for example, R1 = ¥10.00.
To prevent confusion and incorrect macroeconomic reasoning, it is safer not to think in terms of
increases or decreases of the exchange rate, but rather of increases or decreases in the value of
the rand (except when a formula requires the exchange rate as such).
inflation rate. (This is true even though there may be important links between these two
concepts of purchasing power.)
If the rand strengthens (the external value of the rand increases), one would say that the
rand has appreciated. Depreciation is the opposite – the rand weakens.
❐ One should therefore use the terms ‘appreciation’ and ‘depreciation’ with care. Only a
currency (the rand or the dollar) can depreciate or appreciate, not the exchange rate.
❐ The terms ‘devaluation’ and ‘revaluation’ have a similar but different meaning. This is
explained later.
In practice, there is no such thing as the exchange rate, but a whole spectrum of rates.
An exchange rate exists between each pair of currencies in the world, i.e. the rate at which
one can be exchanged for the other. The dollar–rand exchange rate is merely the most
prominent one, seen as representative of the value of the rand against other currencies.
The euro–rand exchange rate is also very important.
Special exchange rates
The real exchange rate is an adjusted exchange rate that takes differences between countries’
price levels (and thus inflation rates) into account. The real exchange rate is calculated as
follows using the normal (nominal) exchange rate in its indirect manner of quotation, i.e.
$1 = R10.00. (The real exchange rate is expressed in the direct form.)
1
PSA
​  P
​
Real exchange rate = 
​  Exchange rate ​× 
Foreign
The effective exchange rate expresses the value of the rand relative to a ‘basket’ of important
foreign currencies, namely those of the main trading partners of the country. It is a
kind of weighted average exchange rate. As such, its value is less sensitive to currency
disturbances in a single country, for example the USA. It is expressed as an index.
By combining these two operations, a real effective exchange rate, indicated with the symbol
, can be calculated (also as an index):
PSA
​
Real effective exchange rate () = Effective exchange rate × 
​  P
Foreign
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Note that by convention the Reserve Bank publishes both these exchange rates in the
direct way (see the introduction to this chapter). Thus a decrease in the external value of
the rand is represented by a decrease in the numerical value of the exchange rate.
Often it is safer to reason in terms of nominal rates rather than real rates, and to handle
the price ratio as a separate variable, as is done in this chapter. Doing so makes the analysis
more transparent and easier to follow.
Figure 4.8 Nominal effective and real effective exchange rates
350
300
250
Index
200
Nominal effective exchange rate of the rand
150
100
2018/07
2017/01
2015/07
2014/01
2012/07
2011/01
2009/07
2008/01
2006/07
2005/01
2003/07
2000/07
1999/01
1997/07
1996/01
1994/07
1993/01
1991/07
1990/01
0
2002/01
Real effective exchange rate of the rand
50
Source: South African Reserve Bank (www.resbank.co.za).
Figure 4.8 depicts both the real and the nominal effective exchange rates. The real effective
exchange rate in South Africa is much more stable than the nominal effective exchange
rate (though it has had a dip in 2001–02). The nominal effective exchange rate displays a
downward trend, especially prior to 2001, which is an indication of the impact of inflation.
After 2006 and especially from 2011 to 2016 there is a discernible downward trend.
Buying and selling rates for currencies
Most often the media report only one exchange rate for, say, the rand/dollar. Currency
dealers such as banks and ‘bureaux de change’ (smaller scale currency dealers in cities or at
international airports) quote two rates, often seen in two columns on electronic boards. The
‘We buy’ column is the exchange rate at which the dealer is willing to buy a foreign currency,
while the ‘We sell’ column is the rate at which a foreign currency is sold. As with any other
commodity or product, a currency dealer wants a profit.
❐ For instance, a currency dealer will buy dollars from you at R10.5112 (it is always quoted
to four places after the decimal point), while they will sell to you at R10.7353. The R0.2241
difference is the profit margin of the dealer.
❐ Exchange rates in the media may be the middle rate between the buy and sell rates, or
alternatively they may quote the sell rate. Therefore, always ensure that you know which
one is quoted.
❐ Rates quoted and published by the SARB are middle rates, calculated as weighted
average daily rates of banks at approximately 10:30.
❐ The difference between the buy and sell rates is called the spread.
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Where and by whom are exchange rates determined?
As with interest rates, exchange rates are not fixed or set by law or decree by some or other
authority or governmental body – and specifically not by the Reserve Bank. Exchange
rates are determined, on a daily basis, in the so-called foreign exchange (‘forex’) market.
(Foreign exchange = currencies of other countries.)
Where is the forex market?
The forex market, like the money market (see chapter 3), is not a building or a place. A large
number of forex dealers – primarily at banks and the Reserve Bank – are continually in contact
with each other by electronic means. Currencies – rand, dollar, euro, pound, etc. – are bought
and sold on behalf of clients of the banks wishing to conclude international transactions.
Using computers, video monitors and telephones, they make and receive offers, and as deals
are struck and ‘prices’ agreed upon, exchange rates are determined minute by minute. As in
the money market, dealers experience tremendous excitement, especially when things are
happening in forex markets, or if rumours appear about possible important events all over the
world. Speculators can make huge profits (or losses!) from small differentials or movements
in rates. Enormous amounts of funds flow (electronically) across borders due to these
transactions.
Obviously, foreign exchange markets are internationally oriented, and international capital
is extremely mobile. Instant electronic communication and transactions make distance and
international borders irrelevant.
Since the important forex markets are scattered around the globe – New York, London, Zurich,
Hong Kong, Tokyo – forex trade goes on 24 hours a day.
Mostly, foreign exchange markets work as simply as a vegetable market: fundamentally,
the (external) value of the rand is determined by the demand for, and supply of, rand in
forex markets at a particular time. The same is true for any other currency.
❐ If the demand for a currency (e.g. the rand) increases, there is upward pressure on its
external value, and it is likely to appreciate (e.g. the rand–dollar exchange rate will
change from $1 = R10.00 to
$1 = R9.80). If the supply of
What are ‘spot’ and ‘forward’ exchange rates?
rands increases, there will be
The ‘spot exchange rate’ is the conventional rate
downward pressure on the
that is determined daily for immediate (on the ‘spot’)
rand, and depreciation occurs.
trade in foreign currencies.
❐ The supply and demand for
However, importers and exporters often wish
rands can be depicted in a
to protect themselves against future changes in
diagram similar to that for
exchange rates. To reduce uncertainty with regard
any microeconomic market;
to planned future transactions, they then conclude
a straightforward analysis of
agreements for foreign exchange transactions to
shifts in either the demand
occur on some date in the future: the price and
or the supply curves can prequantity are agreed upon today for a transaction in
dict the expected results of
the future. The agreed-upon exchange rate is the
changing market conditions.
‘forward exchange rate’. Guesses, expectations and
(In fact, the foreign exchange
risks regarding the future course of exchange rates
market is one of the few realare decisive in these cases.
life markets whose operation
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and relatively smooth adjustment to equilibrium approximate the theoretical model of
a ‘perfectly competitive’ or atomistic market.)
The basic reason why currencies are bought and sold is to make international
transactions possible. Importers must first exchange their rands for yen, for example,
before they can pay for a Japanese import. Likewise, a foreign importer must exchange
his means of payment, e.g. dollars, for South African rands: the importer must first buy
the South African rands, and then use them to purchase the South African product (the
double transaction). In the first instance, therefore, exchange rates are determined by
the activities of importers, exporters, foreign investors, foreign borrowers, etc.
❐ Of course, policy intervention by the relevant authority (the Reserve Bank in the South
African case) can also play a significant role. This is explained below.
Which factors determine exchange rate movements?
The inflow and outflow of funds – either for import and export payments or for capital
flows – determines the intensity and extent of forex buying and selling transactions, i.e.
the demand and supply for foreign exchange.
❐ Each outflow of funds from the country implies a demand for foreign exchange – which
is mirrored by an exactly equivalent supply of rands.
❐ Each inflow of funds into South Africa implies a demand for rands (i.e. a supply of foreign
currency).
❐ If the inflow exceeds the outflow of funds, there is an excess demand for rands. That
should translate into upward pressure on the external value of the rand.
❐ Likewise, a net outflow of funds leads to an excess supply of rands on forex markets, and
downward pressure on the rand.
At this juncture, the decisive importance of the BoP is unmistakable. A BoP surplus (= net
inflow of funds indicated by rising foreign reserves) implies an excess demand for rands,
and hence upward pressure on the value of the rand, with appreciation the likely outcome.
In brief:
BoP > 0 ⇒ excess demand for rands ⇒ upward pressure on the rand ⇒ rand appreciates
A BoP deficit (= a net outflow of funds and falling reserves) causes downward pressure
on the rand. As long as there is a BoP deficit or surplus, pressure exists on the rand to
depreciate or appreciate. Only when (and if) a BoP deficit or surplus is eradicated would
pressure on the rand to adjust disappear.
❐ Exchange rates often undergo smaller day-to-day fluctuations due to minor influences
on markets: single large transactions, rumours of transactions or policy events (in South
Africa or elsewhere), speculative transactions and so forth. However, the BoP position
remains as the underlying determinant of the direction of change of the exchange rate.
Remember that the value of the rand against the dollar can change simply because
the dollar, as such, has strengthened or weakened on international markets, often due
to factors in the US economic scene unrelated to the rand or South African economic
conditions. In such a case it is preferable to analyse the value of the rand by comparing it
with other currencies, or with a group of other currencies.
❐ This is why (and when) the effective exchange rate is particularly useful, being more
stable and less subject to distortion by foreign country-specific shocks.
The previous analysis focused on short- and medium-term movements in the external
value of the rand. That excludes an important question: which factors determine the longterm tendency in the exchange rate?
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In principle, the analysis of the decisive role of the BoP is valid for the longer term,
ignoring smaller disturbances. Sustained BoP deficits would lead to sustained downward
pressure on the currency (depreciation), while sustained BoP surpluses would augur well
for sustained currency appreciation. (Sustained current account or financial account
tendencies, in turn, explain basic tendencies in the BoP.)
However, the question is: which underlying factors determine or cause sustained BoP
tendencies? Important determinants are discussed below.
Inflation differentials
In some of the examples above it was demonstrated that, if South African inflation is higher
than that in other countries (especially its main trading partners), it would discourage
exports and encourage imports. The current account would deteriorate, which would
weaken the BoP (assuming that the financial account is unaffected), eventually leading to
downward pressure on the external value of the rand.
❐ Therefore, a sustained gap between the inflation rates of South Africa and its trading
partners will cause a long-term, gradual depreciation of the rand.
❐ In practical terms, one can state the argument as follows: the only way in which South
African exporters can remain competitive in world markets while South Africa is
experiencing higher domestic inflation than the rest of the world is if the rand persistently
and gradually depreciates to compensate. Such depreciation will prevent the effective
price for the foreign buyer of the South African product from increasing all the time due
to South African inflation.
❐ One may therefore expect an annual rate of depreciation over the long term that is roughly
equivalent to the difference between the average trading partner inflation rate and the
South African inflation rate.
This is one of the most important underlying explanations of long-term tendencies in
exchange rates.
The theory of purchasing power parity (PPP)
This is a more formal and more theoretical version of this rule of thumb. It is a typical
equilibrium approach, and it posits that exchange rates will tend towards an equilibrium
P
situation where the exchange rate is precisely equal to the price ratio (​ 
​). The exchange rate
P
would change precisely proportionate to changes in the price ratio. While in the short run it never
works like this in practice, inter alia because factors other than prices also play a role, there is
an important element of truth in this theory when viewed over the longer run.
Domestic
Foreign
International competitiveness or non-competitiveness
This is another important factor determining trade patterns and therefore the current
account. Competitiveness depends on factors such as productivity, input cost tendencies,
labour force skills, innovative management and marketing, technological developments,
natural resource development, human development and so on.
Political-economic expectations and perceptions
These are important long-term factors, especially on the financial account side. If a
country is regarded as safe, stable and prosperous (e.g. Switzerland), it can experience
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significant capital inflows over an extended period of time. This can cause a sustained
appreciation of the currency (depending, of course, on the current account position). The
opposite holds for when a country is considered unsafe and unstable. In the South African
case, perceptions about safety and stability are potentially some of the most important
negative factors in the future (as they have been during the past couple of decades).
What are fixed and floating exchange rates? Exchange rate policy
Exchange rates that are determined by the interaction of demand and supply in a fully
free and smoothly functioning foreign exchange system are called floating exchange rates.
However, this would be an extreme, pure case. Even if the foreign exchange market
operates smoothly, the behaviour of the exchange rate can be influenced significantly by
dominant sellers or buyers of, for example, rands. One such dominant buyer is the Reserve
Bank, which has the responsibility of keeping a watchful eye over the exchange rate. This
is the objective of exchange rate policy, and part of the responsibilities of the Reserve Bank.
By taking part, on a relatively large scale, in purchases or sales of rands in the foreign
exchange market, the Reserve Bank can influence the ‘price’ of the rand. This is the
system that exists in South Africa and in the majority of countries in the world (albeit
in different forms and with different degrees of central bank action). It works in the
following way:
❐ If the Reserve Bank wishes to prevent the rand from depreciating (too much), it can enter
the market and purchase a substantial amount of rands – using foreign currencies as
payment – thereby supporting the value of the rand and preventing a further decline.
❐ The opposite occurs if the Reserve Bank sells large quantities of rands, e.g. by buying
dollars. In this way it can put downward pressure on the value of the rand, thereby
preventing it from appreciating. The need for such a step occurs less frequently, except
to smooth erratic jumps.
Supporting the rand requires dollars or other currencies to pay for the rands that the Bank
is purchasing. Therefore the rand can be supported only as long as the Reserve Bank has
sufficient foreign currency reserves to purchase rands. Because reserves are being used up
as long as support is given, at some point reserves must start reaching critically low levels.
This is one reason why a country’s foreign reserves are so important and are constantly
monitored by policymakers.
❐ In addition to its own foreign reserves, a central bank might also have foreign credit
lines (i.e. loan facilities) on which it can draw at times to obtain foreign reserves (these
loans have to be repaid, of course).
The Bank cannot, therefore, prevent currency depreciation indefinitely. It can at most
prevent unwanted short-term dips, or try to smooth the behaviour of the exchange rate
if transient erratic movements occur, for instance, due to market rumours or speculative
trading.
❐ Therefore the moderation of exchange rate volatility, rather than the sustained
prevention of depreciation (or appreciation), is the main aim of exchange rate policy.
When the Reserve Bank participates (or ‘intervenes’) in the forex market in this way, the
exchange rate is not freely floating in the true sense of the word. It is then appropriate to
speak of a system of ‘dirty floating’.
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The Reserve Bank: always there to support the rand?
The limited ability of the Reserve Bank to prevent a depreciation of the rand was clearly
demonstrated in 1998 when the Asian crisis caused significant downward pressure on the
rand. The Reserve Bank attempted to stabilise the value of the rand by selling its foreign
reserves. It even borrowed foreign reserves to then sell in support of the rand. However, these
attempts failed to prevent the depreciation of the rand. The Reserve Bank ended up with what
was known as a net open forward position (also known as the international liquidity position
of the Reserve Bank), that increased from negative $12.7 billion in April 1998 to negative
$23.2 billion in September 1998. After the events of 1998 the Bank decided against such
practices. When the rand again came under pressure in 2001, the Bank did not intervene
in the forex market. The rand depreciated significantly (as it might have done even had the
Reserve Bank intervened). However, after a couple of months foreign investors realised that
the rand was significantly undervalued, and its earlier depreciation was reversed. In January
2019 the international liquidity position of the Reserve Bank was positive $44 billion.
Note: While it is true that the Reserve Bank does not formally fix the exchange rate in
this system, it is as true that its participation or intervention in the market always constitutes a form of policy influence (‘control’) of the exchange rate. The exchange rate is not
determined by market forces alone. However, any intervention cannot continue indefinitely
– ultimately, market forces will be decisive.
A system of fixed exchange rates occurs when this intervention of the Reserve Bank is so
absolutely dominant that it effectively pegs the exchange rate at a particular level (even if
it is technically free to move). This system can be illustrated as follows:
❐ Suppose the Reserve Bank wants to prevent the rand from going above, for example,
$1 = R10.00. All it has to do is to be willing to flood the market with rands at that rate
(price) – i.e. supply any amount of rands at that price, no matter how large the demand
for rands. Then no foreigner would have to pay more than $0.10 for a rand. Whatever
the demand for rands, no upward pressure on the rand can occur. In effect, the rand is
fixed or ‘pegged’ at that rate.
❐ Likewise, if the Reserve Bank wants to prevent the rand from depreciating below $1 =
R10.00, all it has to do is purchase all rands offered to the market at that price. If it is
willing to buy whatever quantity is supplied, no downward pressure on the rand can
develop, and its value cannot fall below that level. In effect, the exchange rate is fixed.
❐ If there is downward pressure on the rand due to substantial selling of rands, and if the
foreign reserves are insufficient to finance further purchases of rands, the Bank will
not be able to counter the downward pressure on the rand. All it can do then is to allow
the rand to fall to a new ‘floor price’. This is what is meant by the term devaluation: an
explicit policy decision to go to a lower floor price for the rand. (Thus devaluation is the
fixed exchange rate equivalent of depreciation.) Conversely, a policy decision to peg the
rate at a higher level is called revaluation.
❐ Note that even fixed exchange rates are not fixed by law. Fixed exchange rates are
similar to any system of floor prices and price ceilings.
From 1946 to 1971 most Western countries had a system of fixed exchange rates – the
outcome of the so-called Bretton Woods Agreement. After 1971, various countries
experimented with freely floating exchange rates and systems of controlled, or dirty, floating.
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4.3.3
The BoP and exchange rates: a restatement and summary
The basic linkages between internal economic variables and different external sector
variables are complex but fascinating, and can be summarised as follows.
❐ The exchange rate is determined by the net inflow or outflow of funds. Thus the BoP
position is a decisive factor. In turn the BoP position is determined (caused) by changes
in exports and imports (current account) and in capital inflows (financial account).
❐ The current account (X – M) influences total expenditure (C  I  G  X  M) – and
thus also production GDP and Y – directly.
❐ The financial account on its own has no direct short-term effect on expenditure (see
section 4.2.2).
❐ In other words, the real sector is influenced, in the first instance, by the current account,
since it affects expenditure directly.
❐ The monetary sector is influenced by the current account and financial accounts
together, i.e. by the BoP, and not by the financial account alone. (Of course, this effect
on the monetary sector will subsequently impact on the real sector.)
The current and financial accounts together, i.e. the BoP position, have two important
consequences:
(a) the money supply is influenced, and
(b) the exchange rate is influenced.
Normally one can expect the efOne should therefore take care not to argue the
fect on the money supply to occur
seemingly obvious, i.e. that the monetary sector is
first. The effect on the exchange
influenced by the financial account (as the expected
rate is likely to become apparent
parallel argument for the influence of the current
somewhat later. Though the effect
account on the real sector). It is incorrect reasoning.
of the balance of payments on the
exchange rate is direct (through
the interaction of the supply and demand for currency), the effect very often is strengthened and even triggered when news about the size of the current account deficit (or surplus) is published and discussed in the media and financial circles. These changes in the
money supply and in the exchange rate will then have further effects on the economy (see
below for complete chain reactions).
The main consequences of exchange rate movements are changes in exports and imports,
i.e. in the current account; however, capital inflows can also be affected.
❐ All this means that the exchange rate has an effect on the BoP.
Therefore:
❐ There is an important interaction and two-way causation between the exchange rate
and the BoP (and its components).
❐ In addition, both the exchange rate and the BoP have important links with the rest of
the economy.
At the same time, the real and monetary sectors of the economy also are in continuous
two-way interaction, as analysed in chapter 3. How everything fits together will soon be
demonstrated. First we must consider the so-called BoP adjustment
The exchange rate also affects the rand price of
process, which is an important part
imported inputs, which can influence production
costs and inflation. This is analysed in chapter 6.
of the whole picture.
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4.4
!
The BoP adjustment process
Important note to instructors and students
Most textbooks explain the BoP adjustment process under either of two extreme exchange rate
regimes: either fixed rates or fully flexible rates. While it simplifies the analysis, it limits the analysis
to theoretically extreme cases. Most countries have a system of dirty floating exchange rates,
hence the BoP adjustment process will exhibit elements of both pure systems.
The analysis in this book integrates these elements into one chain of events, distinguishing between
an initial and a later, concluding effect. The same approach is followed in the analysis in terms of
the IS-LM and IS-LM-BP models in sections 4.7 and 4.8.
The crux of the idea of a BoP adjustment process is that a BoP disequilibrium activates
forces that tend to eliminate the disequilibrium. These forces operate via the abovementioned effects of the BoP on the money supply and the exchange rate. Suppose there is a
BoP surplus (BoP > 0). One can then expect the following two adjustment effects:
1. Initial BoP effect: via the money supply (while the exchange rate is still relatively passive
or rigid).
2. Concluding BoP effect: via the exchange rate (when it starts to adjust).
Both of these effects will operate as long as there is a BoP disequilibrium (BoP  0). On the
whole, what happens is the following complex chain reaction. This constitutes the BoP
adjustment process:
M
BoP > 0 ⇒ (i) inflow of foreign exchange ⇒ 
​  P ​  ⇒ i  ⇒ I  ⇒ total expenditure 
⇒ Y  ⇒ M  ⇒ current account 
S
⇒ (ii) inflow of foreign exchange ⇒ excess demand for rands ⇒ rand  ⇒ X 
and M  ⇒ current account 
Both effects will cause the current account to deteriorate. Hence they will reduce the BoP
surplus.
Both these adjustment effects will continue as long as BoP  0, and hence continues to
push the BoP towards equilibrium. When and if BoP equilibrium is reached, the process
stops.
In practice, the process will seldom reach equilibrium so smoothly. Moreover, it rarely
happens that the adjustment process proceeds uninterrupted to the end. New disturbances
may interfere. What is important is the basic direction of the adjustment effects via the money
supply and the exchange rate.
The BoP adjustment is not the end of the story either. The deterioration of the current
account will, in turn, have a cooling-down effect on expenditure and GDP, with the
accompanying secondary downward pressure on interest rates (see section 4.5).
4.4 The BoP adjustment process
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✍
Suppose BoP < 0 ⇒
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
!
4.5
Remember that, as with other chain reactions, there continues to be much uncertainty, especially
regarding the speed and smoothness of the adjustment process. At each step people have to
take decisions and make choices. Nothing adjusts automatically or mechanically. Ultimately,
everything that occurs is the result of the (responsible or irresponsible) decisions of human
beings.
The complete model – the BoP, the exchange rate and the
domestic economy
Our model has been developed sufficiently to analyse the expected consequences of any
internal or external disturbance (as reflected in changes in foreign trade or in capital flows).
It is illustrated with the same three examples introduced in section 4.3.1 – although with
the direction of change reversed – followed by an exposition of a general method.
At the same time we will consider the impact of the exchange rate and BoP adjustment
on the effectiveness of fiscal and monetary policy steps – a recurring theme in all chapters
thus far.
Each of these examples now includes three secondary effects, a concept first introduced in
chapter 3 and its IS-LM analysis (e.g. sections 3.2.2 and 3.3.6).
❐ As mentioned before, in practice the primary and secondary effects are not neatly
separated in time as distinct steps that follow one another ­– say, as if an increase in Y is
followed by a distinct increase in money demand. The secondary effects concurrently
become operational as the primary effect gathers speed. Different secondary effects
may, though, have different dynamics and time spans. Nevertheless, their typical effect
is to either curb or turn around initial changes in key macroeconomic variables such as
real income Y and the real interest rate r.
❐ In the open economy there are more secondary effects – three – than in the closed
economy, where there is one only. As we will see, the secondary effects flowing from the
balance of payments are likely to commence a while later, but will still unfold parallel
and concurrent to ongoing changes in main variables.
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4.5.1
Monetary policy steps – consequences and effectiveness
Example 1: the internal and external effects of a cut in the repo rate
Primary effect:
(1) Lower repo rate ⇒ banks pay less for Reserve Bank accommodation ⇒ banks
encourage credit creation ⇒ money supply expands ⇒ excess supply of money ⇒
increase in acquistion of money market paper ⇒ prices of money market paper rise
⇒ decrease in nominal (and real) interest rates ⇒ capital formation I encouraged ⇒
aggregate demand increases ⇒ production encouraged ⇒ Y increases (= upswing in
the economy).
As Y increases ⇒ imports M increase (why?) ⇒ current account (CA) deficit develops.
The decrease in r causes an outflow of foreign capital, leaving the financial account
(FA) in a deficit. Together these two effects imply that a balance of payments deficit
develops: BoP < 0.
Secondary effects:
(2) Money market effect: As Y increases, it causes the demand for money to increase
concurrently ⇒ upward pressure on interest rates ⇒ initial drop in interest rates
gradually comes to an end ⇒ initial increase in investment is curbed ⇒ initial increase
in aggregate demand arrested ⇒ increase in Y brought to an end ⇒ rise in M arrested
and initial weakening of (X – M) comes to an end.
❐ The main impact of this secondary effect is that the changes in r, I, Y and M will
be smaller than they would have been, had there been no such effect via money
demand. While this secondary effect operates in the opposite direction from the
primary effect, it is a weaker force. The secondary effect does not cancel the primary
effect, it only reduces it.
The net effect of the primary and secondary effects leaves Y higher, r lower and both the
current and financial accounts in deficit. There is a BoP deficit (BoP < 0).
Further secondary effects due to BoP < 0:
(3) Initial BoP effect (foreign reserves adjustment): The BoP deficit causes (i) an outflow
of foreign exchange ⇒ money supply decreases ⇒ upward pressure on interest
rates (which causes the outflow of foreign capital to decrease or reverse and the
financial account deficit to decrease); the increase in the interest rate discourages real
investment I ⇒ aggregate demand/expenditure decreases, causing Y to decrease; as
Y decreases it dampens imports ⇒ (X – M) increases ⇒ prevailing current account
deficit is reduced; the turnaround in the real interest rate will also start to encourage
or reverse capital outflows; thus the financial account is likely to start improving. On
both fronts, the BoP deficit is being reduced.
The contraction in Y implies that the initial upswing has turned around (for now …).
(4) Concluding BoP effect (exchange rate adjustment): The initial BoP deficit also leads to (ii)
an excess supply of rand (excess demand for foreign exchange) ⇒ downward pressure
on the rand ⇒ stimulation of exports and discouragement of imports ⇒ (X – M)
increases ⇒ current account deficit is reduced, and so is the remaining BoP deficit.
The BoP tends towards equilibrium. The process will continue as long as BoP ≠ 0 and
until BoP = 0.
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This cumulative increase in (X – M) due to these two BoP effects again boosts aggregate
expenditure, which reverses the short decline in Y – the economic upswing resumes
(Y expands again).
It is likely that the foreign reserves effect (phase 3 above) will come about sooner than the
exchange rate effect (phase 4).
Summary of changes
It is interesting to note the changes that occur in the main macroeconomic variables, i.e.
income Y, interest rate, rand, BoP and exchange rate.
In particular, consider the beha­
In this way the BoP adjustment process may cause
viour of income Y. Following an
a cyclical movement in Y, or will at least have a
initial upswing in income (held
restraining effect in the later phases of an upswing
back somewhat by the secondary,
(or downswing). Thus one finds signs of inherent
money market effect), the BoP
sources of cyclical movements in production and
adjustment activates monetary
income in the BoP adjustment process. In practice,
forces in the opposite direction
this factor in itself is not sufficient to explain the larger
– via foreign reserves – which
cyclical movements in the economy. However, it does
reverse the upswing and pushes
contribute to cyclical forces and fluctuations.
Y into the early phases of a
downswing. However, before long
the exchange rate adjustment again places
upward pressure on income – the downswing Figure 4.9 Illustrative time path of key variables due
to a decrease in the repo rate
may be short lived, and an upswing period
may recur. Thus the net effect of all these
processes on Y is likely to be positive.
Interest rates first decrease, only to experience
repeated upward pressure in later stages. The
net effect should be a rate decline.
The rand depreciates during the latter
stages of the BoP adjustment phase (phase
4). This depreciation is the main cause of
the final upswing towards the end – mainly
because the depreciation stimulates exports
and discourages imports, thereby boosting
aggregate expenditure.
The balance of payments goes into deficit,
which is then reversed. The current and
financial accounts change as side-effects of
the primary and secondary effects.
❐ This is in contrast to example 3 that follows
(the case of an export stimulus), where
the primary effect (i.e. initial disturbance)
will directly and immediately influence
the current account.
The diagram in figure 4.9 is a stylised illus­
tration of the course of these main variables
174
r
Time
Y
Time
Rand
Time
BoP
BoP adjustment
phase
Demand expansion
op to 3 years
Chapter 4: The basic model III: the foreign sector
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over time during the primary and three secondary effects. Study it carefully and see
whether it conforms to your understanding of the whole chain reaction.
❐ Of course, in reality time paths never are so smooth, and shocks and disturbances occur
simultaneously. Our purpose here is to isolate the basic directional effects encountered
by an open economy following an initial stimulus.
The effectiveness of monetary policy
Note that the basic impact of the monetary policy step on real income is countered by the
foreign reserve, or money supply, effect of the BoP. This effect can take place because, and
as long as, the exchange rate is rigid or slow to adjust. Subsequently, however, the flexible
exchange rate effect does the opposite and boosts the potency of monetary policy. For
practical monetary policy, it is important to ascertain which of these effects will dominate
in practice.
Monetary stimulation in a situation with fixed or very rigid exchange rates has been called
‘sending the money supply overseas’.
Example 1 illustrates how, for a decrease in the repo rate, a BoP deficit develops as a result of
the monetary stimulation. That implies an outflow of funds/money, which contracts the money
supply. That means that the initial monetary stimulus is counteracted or even nullified by the
BoP effect.
When the exchange rate starts to adjust, it speeds up the elimination of the BoP deficit, which
will counter the monetary contraction effect somewhat. In a fully free and quick-adjusting
floating exchange rate system, the exchange rate will adjust so rapidly that the BoP deficit
does not even get the opportunity to emerge. Then there would be no opportunity or reasons
for the money supply outflow to take place. The monetary policy impact will be 100%.
However, if the exchange rate adjusts very slowly or not at all, the money supply effect has
ample opportunity to manifest itself, implying a considerable outflow of money. Then one
can indeed say that the money supply is simply being ‘sent overseas’, with little domestic
monetary impact of the monetary policy step.
This produces the important policy conclusion that rigid exchange rates undermine
the potency of monetary policy, while a quick-adjusting exchange rate enhances the
effectiveness of monetary policy.
❐ In the extreme case of a fixed exchange rate regime, and if capital is perfectly mobile,
the outflow of capital following monetary stimulation would completely offset the
initial stimulation. The rigid exchange rate effect is dominant, and monetary policy
would be entirely ineffective.
❐ In the other extreme of an instantly adjusting floating exchange rate, monetary policy
would be maximally effective: any monetary stimulus is boosted since falling interest
rates weaken the domestic currency, which stimulates net exports (X – M). The flexible
exchange rate effect dominates.
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4.5.2
Fiscal policy steps – consequences and effectiveness
Example 2: the internal and external effects of a cutback in government expenditure
Primary effect:
(1) Reduction in government expenditure ⇒ aggregate expenditure decreases ⇒ negative
impact on domestic production ⇒ real income Y decreases.
As Y decreases ⇒ imports M decrease ⇒ a current account surplus develops.
Secondary effects:
(2) Money market effect: As Y decreases, it causes a concurrent decrease in the demand for
money ⇒ downward pressure on interest rates ⇒ encouragement of real investment
I ⇒ increase in aggregate demand, partially countering the impact of the initial
reduction in government expenditure ⇒ curbs the fall in Y ⇒ decline in M curtailed
and initial strengthening of (X – M) comes to an end.
The net effect of the primary effect and the secondary, money market effect leaves Y
lower, r lower and (X – M) > 0, i.e. a current account (CA) surplus.
The decrease in r causes an outflow of foreign capital, causing a deficit on the financial
account (FA). The net effect on the BoP is uncertain: depending on the relative size of the
CA and FA positions, the BoP = CA + FA could be in balance, in a surplus or in a deficit.
Since the state of the BoP is decisive for the further BoP adjustment effects, we must make
some assumptions here. If foreign investors consider the economy well-integrated into the
global economy, international capital flows will be relatively sensitive to domestic interest
rate changes. Therefore, should interest rates decrease as a result of the secondary effect,
there will be a relatively large outflow of foreign capital. Thus, one might expect the deficit
on the FA to exceed the surplus on the CA, in which case BoP < 0. We assume this case to
apply to South Africa at the moment.
❐ If capital flows were not that sensitive to domestic real interest changes, the deficit on
the FA would have been smaller than the surplus on the CA – implying a BoP surplus.
Thus we have further secondary effects due to BoP < 0:
(3) Initial BoP effect (foreign reserves adjustment): The BoP deficit causes (i) an outflow
of foreign exchange ⇒ contraction in money supply ⇒ upward pressure on interest
rates (which causes the outflow of foreign capital to decrease or reverse and the FA
deficit to decrease); the increase in the interest rate also discourages real investment I
⇒ aggregate demand/expenditure decreases, causing Y to decrease; as Y decreases it
dampens imports ⇒ (X – M) increases ⇒ prevailing CA surplus is reduced; however,
the turnaround in the real interest rate will also start to reverse capital outflows; thus
the FA deficit is likely to start being reversed. Assuming a stronger FA effect, the net
effect would be that the BoP deficit is being reduced.
The decrease in Y implies that the initial downswing has been followed by a continuation
of the downswing that exacerbates the decline in Y.
(4) Concluding BoP effect (exchange rate adjustment): The initial BoP deficit also leads to (ii)
an excess supply of rand (excess demand for foreign exchange) ⇒ downward pressure
on the rand ⇒ stimulation of exports and discouragement of imports ⇒ increase in
(X – M) ⇒ current account surplus increases again. This helps to eliminate the
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remaining BoP deficit – the BoP tends towards equilibrium. The process will continue
as long as BoP ≠ 0 and until BoP = 0.
Note how, towards the end, the depreciation of the rand is responsible, via an induced
increase in (X – M), for a stimulation of aggregate expenditure. This reverses the twophase contraction of Y – a small recovery begins when Y increases.
Summary of changes
Following an initial contraction of real income
Y (held back somewhat by the secondary,
money market effect), the BoP adjustment
activates monetary forces in the same direction
– via foreign reserves – which exacerbates the
decline in Y into a deeper recession. Only after
the exchange rate adjustment occurs do we see
the first signs of recovery. Real income would
have gone through a business cycle trough –
which is no surprise, given the contractionary
fiscal step that initiated everything. Only at the
end is there a small recovery.
Interest rates first decrease, but in the BoP
adjustment stages they experience upward
pressure twice. The net effect should still be a
rate decrease, though.
The rand depreciates during the latter
stages of the BoP adjustment phase (phase
4). This depreciation is the main cause of
the final recovery down towards the end
– the depreciation stimulates exports and
discourages imports, thereby boosting aggre­
gate expenditure.
Figure 4.10 Illustrative time path of key variables due
to a government expenditure cutback
r
Time
Y
Time
Rand
Time
BoP
BoP adjustment
phase
The balance of payments goes into deficit,
Demand contraction
which is then reversed. The current and
up to 3 years
financial accounts play complex roles in this
process, since they often move in contradictory directions.
The effectiveness of fiscal policy
The basic impact of a fiscal policy step – whether contractionary or expansionary – on real
income is strengthened by the money supply effect of the balance of payments. The flexible
exchange rate effect – depreciation or appreciation – works in the opposite direction.
This produces the important conclusion, as regards South Africa, that a rigid or fixed
exchange rate strengthens the potency of fiscal policy, while a quick-adjusting exchange
rate undermines its effectiveness.
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4.5.3
External disturbances
Example 3: the effect of an economic downswing in the USA on the SA economy
Primary effect:
(1) Lower YUSA ⇒ US imports MUSA
decrease ⇒ decreased imports
from abroad, including South
Africa ⇒ XSA decreases ⇒
(X – M) decreases, i.e. cur­
rent account goes into defi­
cit ⇒ aggregate expenditure
decreases ⇒ production dis­
couraged ⇒ Y declines.
(2) As Y decreases, a concurrent
decrease in imports M de­
velops ⇒ positive impact on
(X – M), i.e. current account
(CA) improves a bit.
The importance of diagrammatical aids
These examples demonstrate that it can become
quite bewildering to sort out the complexities of
open-economy chain reactions. This is why it
is so important to master, and use, appropriate
diagrammatical aids to guide and check our chainreaction thinking.
From the initial 45o model we developed the IS-LM
in chapter 3, which offers a concise and powerful
‘roadmap’ to analyse chain reactions.
Later in this chapter it is expanded by including the
BP curve, which enables us to bring the state of
the balance of payments, and the BoP adjustment
process, into the graphical analysis.
The net effect on the current
account will still be a substantial deterioration.
Secondary effects:
(3) Money market effect: As real income Y declines, the real demand for money decreases ⇒
downward pressure on real interest rates, which, in turn, causes investment to increase
⇒ upward pressure on aggregate demand ⇒ initial decrease in aggregate demand
countered ⇒ production encouraged ⇒ decrease in Y curbed, downswing comes to an
end; drop in M arrested and deterioration in CA comes to an end; CA in deficit.
The decrease in interest rates should lead to an outflow of foreign capital, which hurts
the financial account (FA) – the FA will be in a deficit.
The net effect of the primary effect and the secondary effect leaves Y lower, r lower and
the current and financial accounts in deficit. Thus the BoP will have a deficit.
Thus we have further secondary effects due to BoP < 0:
(4) Initial BoP effect (foreign reserves adjustment): The BoP deficit causes (i) an outflow of
foreign exchange ⇒ money supply decreases ⇒ upward pressure on interest rates
(which causes the outflow of foreign capital to decrease); higher rates discourage
real investment I ⇒ aggregate demand/expenditure decreases, causing Y to decrease
further; as Y decreases it dampens imports ⇒ (X – M) increases ⇒ prevailing CA deficit
is reduced. The rise in interest rates will encourage capital inflows, so the existing FA
deficit will shrink.
(5) Concluding BoP effect (exchange rate adjustment): The initial BoP deficit also leads to (ii)
an excess supply of rands (excess demand for foreign exchange) ⇒ downward pressure
on the rand ⇒ stimulation of exports and discouragement of imports ⇒ increases (X
– M) ⇒ CA deficit is reduced.
This depreciation-induced increase in (X – M) boosts aggregate expenditure, which
turns around the sustained downswing. Y will increase, also pulling up interest rates.
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The financial account will improve further, and so will the remaining BoP deficit. The
BoP tends towards equilibrium. The process will continue as long as BoP ≠ 0 and until
BoP = 0.
Summary of changes
Figure 4.11 Illustrative time path of key variables due
In contrast to example 1 (internal monetary to a decrease in exports
disturbance), where the current account
changed mainly as part of the BoP
r
adjustment phase, in this case the initial
disturbance directly and immediately affects
the current account. As a result, the current
account pattern is somewhat intricate:
Time
❐ The current account deteriorates
initially, due to the direct role of exports.
Y
As income decreases due to the export
decline, imports are likely to start
declining. This will restrain the current
account deterioration. On balance the
Time
current account will still deteriorate.
Later, when the balance of payment
Rand
adjustment process comes into play, the
current account improves due to changes
in income and the exchange rate.
Time
❐ The financial account is hurt by the
secondary, money market impact on
BoP
interest rates and goes into deficit, but
later improves during the BoP adjustment
processes.
BoP adjustment phase
❐ Income declines due to the export shock
and then again due to the initial BoP
Demand contraction
adjustment effect, but then recovers due
up to 3 years
to the depreciation of the rand.
❐ The real interest rate first drops, but increases in the BoP adjustment phases.
❐ The rand depreciates in the later stages of the BoP adjustment process, when it is the
main cause of the final recovery at the end.
Theoretically the BoP surplus should be eliminated at the end, since the BoP adjustment
process should continue until BoP = 0. In practice, the process rarely gets to equilibrium
so effortlessly. Nevertheless, the basic nature and direction of the adjustment process is
unchanged.
The export shock example appears similar to the fiscal contraction example. Note the
following differences, though:
❐ In the fiscal contraction example, a CA surplus develops, but it is overshadowed by a
FA deficit, hence a (small) BoP deficit develops. In the export example, a substantial
CA deficit develops immediately, on top of which a FA deficit develops, so that the BoP
deteriorates much quicker and goes into a much larger deficit.
❐ The BoP adjustment process is much longer in the export example.
❐ The rise of r during the BoP adjustment is larger in the export example, due to the
larger BoP deficit and its effects on the money supply.
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❐ The downswing in Y is likely
to last longer than in the fiscal
example.
In all these examples the change in the exchange
rate is, simultaneously, a symptom of one condition,
but also the cause or source of a new phase. More
specifically, one can say that a depreciating rand is
a symptom of a BoP deficit, but also the seed of the
BoP recovery process.
Note that a rigid exchange rate
heightens the domestic effects
– whether negative or positive –
of a change in exports, while a
quickly adjusting exchange rate
puts a damper on export-led economic fluctuations. (This parallels the conclusion about
the positive impact of a slowly adjusting exchange rate on the effectiveness of fiscal policy,
but in this case it makes export-led downswings worse.)
Remark
All these examples are still incomplete, since the effect on the price level is omitted. This
will be rectified in chapter 6.
4.5.4
Analysing internal and external disturbances – a general method
What follows is a general method to analyse the complete, expected consequences of
any internal or external disturbance, as reflected in a change in foreign trade or capital
inflows.
Internal disturbances
1. Derive the primary effect of (i.e. initial impact on) internal variables such as expenditure
components, aggregate expenditure and thus Y. Also derive the endogenous effect on
the current account.
2. Following the primary effect, derive the concurrent secondary internal effect and its
endogenous impact on the current account. Derive the net effect on Y.
3. Summarise the effects of steps 1 and 2 on both the current account and the financial
account (itself the result of the interest rate change occurring in steps 1 and 2).
4. Show the initial BoP adjustment process (rigid exchange rate or foreign reserves effect).
5. Show the concluding BoP adjustment process (flexible exchange rate effect).
Finally, note the impacts of steps 4 and 5 on expenditure and Y (as well as other relevant
variables). Summarise the movements and net effect on different variables.
External disturbances
1. Derive the initial exogenous impact on the current or financial account, and the
ensuing effect on internal variables such as aggregate expenditure and thus Y. Also
identify any concurrent endogenous effect on the current account (and/or financial
account) that is likely to accompany these changes. In this way determine the net,
combined effect on the BoP.
2. Following the primary effect, derive the concurrent secondary internal effect and its
endogenous impact on the current account. Derive the net effect on Y.
3. Summarise the effects of steps 1 and 2 on both the current account and the financial
account (itself the result of the interest rate change occurring in steps 1 and 2).
4. Show the initial BoP adjustment process (rigid exchange rate or money supply effect).
5. Show the concluding BoP adjustment process (flexible exchange rate effect).
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Finally, note the impacts of steps 4 and 5 on expenditure and Y (as well as other relevant
variables). Summarise the movements and net effect on different variables.
At each juncture, take the time to ask why something happens, and what the expected
consequences of that occurrence are likely to be as one moves along the chain reaction.
✍
Complete the following:
Suppose taxation is decreased ⇒
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Suppose the rand depreciates strongly ⇒
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4.5.5
Chain reactions in reverse – the likely causes of events
We can use our knowledge of the linkages and interactions between internal and external
variables to uncover the likely causes of observed changes in economic variables. That
is, we return to possible chain reactions, searching for the likely source of changes. For
example, what are the likely causes of the following occurrences?
(a) A depreciation of the rand
Answer: An excess supply of rands on the foreign exchange market, which is likely to be
a reflection of a net outflow of payments via the current and/or financial accounts (i.e. a
BoP deficit). Of course, the likely causes of the latter can also be, for example, a withdrawal
of capital (investment) by foreigners.
(b) Increasing interest rates
Answer: The immediate cause is either an increase in money demand or a decrease in
the money supply, or both. The cause of the former is likely to be an economic upswing
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(increase in Y), i.e. some stimulus on the economy, or a large budget deficit that is financed
via domestic borrowing. A money supply contraction can follow from either:
❐ internal causes, the main candidates being one or several restrictive monetary policy
steps; or
❐ an external factor that has resulted in a BoP deficit (which implies a leakage of money
from the domestic economy).
(c) A depreciating rand and increasing interest rates occurring together
Answer: (Complete by eliminating some of the possible causes identified in (a) and (b).
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(d) A current account deterioration
Answer: (Complete)
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The budget deficit and the BoP
It is important to note certain important linkages between the budget deficit and the BoP:
❐ Foreign loans to finance a budget deficit imply an inflow of foreign capital. This links the
budget deficit and the BoP (which may be in deficit or surplus).
❐ Such a linkage also emerges where a budget deficit is financed via domestic borrowing.
The upward pressure that it may put on interest rates can attract foreign capital, which will
strengthen the financial account, and thus the BoP.
The crowding out of exports by a budget deficit
With the exception of the late 1990s and early 2000s, the last linkage has been a major issue
in the USA since the 1980s. It is argued that a budget deficit financed by domestic borrowing
pushes up interest rates. Given the high sensitivity of international capital to US interest rates,
this causes a significant inflow of capital. The subsequent demand for dollars causes the
dollar to appreciate. In turn, this discourages foreign purchases of US goods (as reflected in
a current account deficit). Therefore, US exports are restricted – or ‘crowded out’ – by the
budget deficit. This association between the budget deficit and the current account deficit is
known as the ‘twin deficit phenomenon’.
❐ This effect can only occur in a country with high international capital mobility, and can only
occur in a system of floating (or controlled floating) exchange rates.
❐ This effect decreases the fiscal multiplier, because the restriction of exports counteracts
any fiscal stimulation.
✍
182
The world financial crisis of October 2007–08: open economy aspects
We introduced this case study in section 3.4 – reread that section. Now try to deduce what
the accompanying open-economy changes would be for the US economy due to the various
changes in the US rate of interest and GDP indicated by the analysis and diagram. Secondly,
what would be the expected effects on South African exports, imports or capital flows – and
hence on internal variables such as GDP?
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(e) A financial account improvement
Answer: Possible causes include high interest rates relative to the rest of the world,
new foreign confidence in the growth potential of the South African economy and/or
foreign optimism about the political stability in South Africa.
(f) A shrinking balance of payments deficit
Answer: (Complete.)
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4.5.6
Thirteen open economy puzzles
1. Is a weak rand relative to, for example, the dollar a good thing or a bad thing? And a
strong rand?
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2. Is a balance of payments surplus good and a deficit bad?
Sustained BoP surpluses are not necessarily desirable. Sustained surpluses imply that
the foreign reserves of a country are increasing all the time. If foreign reserves are
in excess of what is required to finance any foreseeable BoP deficit, it amounts to an
unnecessary hoarding of wealth that is not being used to improve living standards in
the country. It would be better to use it to import goods that can improve the standard
of living of the inhabitants of the country.
BoP deficits are a problem when the foreign reserves are near exhaustion and the
financing of the deficit becomes a problem (i.e. the country does not have sufficient
foreign currency reserves to pay for imports). Sustained deficits or continuously
deteriorating deficits especially are a source of anxiety. On the other hand, temporary
or short-term deficits need not be a cause for concern.
3. Why does government have to wait for a considerable current account surplus to be
present before it can institute measures to stimulate the economy?
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4. Is a sustained current account surplus (or current account deficit) a good (or bad)
thing?
A current account deficit need not be a problem if it is accompanied by sufficient capital
inflows (a financial account surplus). However, if a country experiences shortfalls in
capital inflows (as South Africa has at times), a sustained current account deficit can
cause very serious BoP and foreign reserve problems.
Whether a current account deficit is a problem also depends on the phase of the
business cycle at a particular moment. A current account deficit at the beginning of
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an upswing phase is particularly undesirable since any growth in economic activity
will stimulate imports, exacerbate the deficit and put the foreign reserves under
pressure. However, at the end of an upswing phase a current account deficit is less of
a problem, being a natural side-effect of the upswing (why?) that is likely to disappear
during the subsequent downswing (why?).
!
For a country with high international capital mobility – meaning that changes in interest rates
would elicit a strong capital flow reaction – current account deficits might be less of a problem.
Together with the deteriorating current account that accompanies an upswing, one would usually
also find upward movement in interest rates (as a secondary effect). If the increase in the interest
rate elicits a strong inflow of foreign capital, it can improve the financial account to such an extent
that any current account deficit is easily financed, without pressure on foreign reserves. In such a
situation, the current account side-effect of an upswing presents no problem at all.
❐ The correct economic reasoning will, therefore, depend on the country concerned and its
particular economic characteristics.
5. What is the likely effect of high South African inflation (relative to its main trading
partners) on the external value of the rand?
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6. How is it possible that gold and platinum mines can show low profits in a period when
the international gold and platinum prices are high (and vice versa)?
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Questions 7 to 11 should be tackled as a group. They are intended to challenge the reader to put
together a number of causal relationships in the international arena. Individually they are not
complex, but when combined they constitute a powerful set of linkages which are essential to
understanding some of the most important interrelationships and transfer of shocks between
South Africa and the global economy.
7. High American interest rates and a strong dollar often occur simultaneously. Why
would that be? (Is the same true for South African interest rates and the rand?)
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8. A strengthening of the US dollar on foreign exchange markets often occurs in concert
with a drop in the gold price. Can you think of a possible explanation or linkage? (Can
there be a similar link between the oil price and the US dollar?)
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9. Therefore, it often happens that, when the gold price increases, the rand simultaneously
appreciates (and vice versa). Why would this be? (Can there be a similar link between
the oil price and the rand?)
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10. Therefore: what is a possible four-way linkage between US interest rates, the dollar,
the rand and the gold price? How does the oil price link up with this foursome?
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11. Finally: can you derive an important linkage between the American budget deficit, the
dollar, the rand and the gold price?
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12. What is the link between the American budget deficit, the American current account
deficit, and the American financial account surplus? (Hint: See the preceding
discussion about the ‘twin deficit phenomenon’ and the crowding out of exports.)
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13. What is a link between the American budget deficit, the American current account
deficit, the Chinese current account surplus and the value of the US dollar relative to
the Chinese yuan?
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4.6
Conflict between internal and external considerations
The previous discussion demonstrates the existence of important linkages between
internal economic variables (e.g. interest rates, GDP, unemployment, the budget deficit)
and external variables (e.g. the exchange rate, the BoP). It is important to note that desirable
changes in internal variables do not necessarily augur well for external variables – and vice
versa. For example, whereas high interest rates may be ‘good’ for the financial account
and foreign reserves, they are detrimental to investment (and homeowners, due to high
bond rates).
An important tension exists between the BoP and unemployment considerations. This
conflict manifests itself in South Africa during the course of each business cycle. During
an upswing, unemployment decreases, but the current account deteriorates. During a
downswing, the external position improves, while unemployment deteriorates.
This tension is less severe if capital flows are relatively sensitive to interest rate changes.
Rising interest rates associated with the secondary effect of an economic upswing will
stimulate capital inflows and cause a financial account surplus that may match or even
exceed the current account deficit. Thus capital inflows provide more than enough cover
for the outflow of payments on the current account.
❐ However, the Reserve Bank might still be concerned about the sustainability of such
capital inflows – particularly when these flows mostly comprise easily reversible
portfolio flows (e.g. financial investments on the JSE and not foreign direct investment).
Therefore, the central bank might still wish to reduce the deficit on the current
account and thereby reduce the risk of a sudden reversal on the financial account for
the economy.
✍
If there is low capital mobility, the combination of a BoP deficit and an overheated economy
is not a policy problem. Why would this be? On the other hand, a BoP surplus combined with
unemployment is not a problem irrespective of capital mobility. Why?
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
The tension between a deteriorating current account and a decrease in unemployment
creates a policy dilemma: stimulation of the economy to alleviate unemployment hurts the
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current account, with concomitant pressure on foreign reserves. One way to address the
current account deficit is to use policy to constrict income Y. However, that will increase
unemployment. In the South African context this unavoidable tension creates a severe
predicament for policymakers and politicians.
Although inflation – one of the most important dimensions of internal equilibrium – is
discussed in later chapters, it is necessary to note two open-economy linkages concerning
inflation:
❐ To the extent that aggregate expenditure is affected by current account, BoP and
exchange rate changes, aggregate demand in the economy is influenced. This implies a
potential influence on the average price level and, therefore, inflation.
❐ Since the exchange rate directly influences the cost of imported inputs, it has critical
implications for cost-push and supply-side inflation.
All these linkages simultaneously bring a larger number of objectives or considerations
into play, and make the evaluation of any particular internal–external situation that much
more difficult. The ideal may be to attain all internal as well as external objectives. As we
shall see, however, the relationships and causal linkages between economic variables often
make the simultaneous achievement of important policy goals impossible. Situations that
require a complex ‘trade-off ’ – where one objective can be pursued only at the cost of
another – develop quite often.
The preceding remarks on inflation highlight an important aspect: this discussion of openeconomy macroeconomic aspects still is incomplete since the price level and inflation
have not been incorporated. Likewise, any discussion of inflation that excludes external
considerations is, equally, incomplete. Therefore, we shall return to the foreign sector in
chapter 6, when the price level is introduced into the model.
Trade policy
In such difficult situations, the standard fiscal and monetary policy package is not
sufficient, and other policy instruments have to be considered. The instruments of trade
policy, e.g. tariff or import quotas, are important examples in the open economy.
❐ A tariff is a tax on imported items that increases the effective price of those imported
goods. This discourages imports. Quotas are quantitative restrictions on the quantities
of goods that may be imported.
❐ Tariffs and quotas are important since they may be used to restrict imports directly – in
contrast to the indirect restraining of imports by contracting total expenditure.
❐ A government can also pay a subsidy to local producers, allowing them to reduce
their price to below the price of the imported goods. The European Union is very often
accused by low- and middle-income countries that are dependent on agricultural
exports of protecting European farmers with such subsidies. Governments of these
countries have been debating this issue (as well as other trade issues) for years in the
so-called Doha rounds, without reaching a final deal. (Doha is a city in Qatar where the
first round of negotiation took place.)
❐ The desirability of implementing tariffs and quotas has been hotly debated in policy
circles with little indication that consensus will be reached in the foreseeable future.
The way these instruments affect the situation differs from normal fiscal or monetary
policy steps. One side-effect of a direct measure such as tariffs is that it switches domestic
expenditure from imports to domestic production (while aggregate expenditure remains
unchanged). In the domestic economy this implies an expansion of total demand (which
4.6 Conflict between internal and external considerations
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may be desirable or undesirable at that stage). Since such a stimulation of demand may
be unwanted for other reasons (e.g. inflation), policymakers must keep this expenditureswitching effect in mind. It may be necessary to add other policy steps to absorb the extra
expenditure and limit the expansionary effect.
❐ Direct import-restricting steps are called a policy of ‘expenditure switching’.
❐ The indirect restraint of imports via a contraction of total expenditure is called a policy
of ‘expenditure reduction’.
✍
What is the WTO? Why is it important for South Africa in these times? How does it affect our
economic prospects?
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
What have been the main stumbling blocks in reaching a deal in the Doha rounds?
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________
4.7
The IS-LM-BP model for an open economy
In chapter 3 the IS-LM diagram was introduced and explained as a diagram that summarises
the basic economic relationships in the monetary and real sectors. In principle, the IS and
LM curves are not different in the open economy, although one should take note of certain
open-economy aspects.
In this section we add a new curve, the BP curve (or BoP curve). We show how this model
can be used to add important open-economy insights, in particular a refined analysis
regarding the BoP position and the ensuing BoP adjustment process.
!
188
Remember the warning, in chapter 2, that the IS-LM model – and therefore also the extended
IS-LM-BP model – is a mechanical tool that encourages purely mechanical manipulation of curves.
While it is very instructive and powerful, one should always use such diagrammatic manipulation
only as a support system for economic logic and reasoning.
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4.7.1
The IS curve in the open economy
For the open-economy IS curve, aggregate expenditure must be defined to include net exports
(X – M). Actually this is how the IS curve was defined and derived in chapter 3.4 Hence
we do not have to add anything to that analysis. However, it is useful to highlight certain
open-economy aspects of the IS curve.
Changes in exports or imports caused by factors other than Y or r – e.g. changes in
exchange rates or foreign economic conditions – would shift the IS curve.
Examples
1. An upswing in the USA that is
How far would IS shift?
likely to increase US imports is
The size of the expenditure multiplier affects the
likely to boost South African
distance that the IS curve would shift following an
exports (including those to
exogenous change in expenditure (chapter 3, section
the USA) and thus aggregate
3.3.3). The higher the import propensity, the smaller
expenditure. This would be
the multiplier, and thus the smaller such a shift.
reflected in a rightward shift
of the IS curve, and a new
equilibrium value of Y and r.
2. A BoP surplus in South Africa is likely to cause upward pressure on the external value
of the rand. Such appreciation is likely to encourage imports and discourage exports.
The net decline in (X – M) and, therefore, aggregate expenditure would be reflected in
a leftward shift of the IS curve, to produce new equilibrium values of Y and r.
The slope of the IS curve
You will recall from chapter 3 (section 3.3.3) that the slope of the IS curve depends, inter alia,
on the multiplier. In turn, the size of the multiplier depends on various ‘marginal leakage rates’.
One of these is the marginal propensity to import.
❐ If the import propensity is high, the total leakage rate would be higher, and the multiplier
smaller. This would make the IS curve steeper. A low import propensity would make the IS
curve flatter. The higher the import propensity, the steeper the IS curve.
❐ Hence, the IS curve for an open economy would be steeper than one for a closed economy
(an economy without any imports).
4.7.2
The LM curve in the open economy
The LM curve was defined and derived in chapter 3 in terms of real money demand and
real money supply in the economy. That derivation allowed for foreign sector influences in
the monetary sphere. It is worth highlighting some of these.
The slope of the LM curve, which depends mainly on the domestic demand for money, is
not markedly different in an open economy.
The position of the LM curve depends decisively on the money supply. International inflows
and outflows of payments strongly influence the supply side of the money market. Such
flows derive mainly from the BoP position.
4
Historically, the IS-LM model was developed primarily to analyse a closed economy. Most textbooks first derive the IS curve
for the closed economy, and then add open-economy elements.
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❐ For example, a BoP surplus implies an inflow of funds, which expands domestic
liquidity. In terms of our analysis, this is equivalent to the effects of an expansionary
monetary policy step in the form of an increase in the real money supply. The LM curve
would therefore be shifted rightward by the money supply effect of a BoP surplus. A BoP
deficit, which implies a net outflow of payments/funds, would shift the LM curve leftward.
These characteristics are particularly important when one analyses the BoP adjustment
process in the IS-LM diagram.
Simultaneous equilibrium in the goods and money markets – the open
economy case mathematically
π
We have the formula for the open economy IS curve:
Y = KE(a + Ia – hr + G + X – ma)…… (4.4 = 3.5)
where the multiplier in an open economy equals:
1
​  1 – b(1 – t) + m ​
KE = 
and the formula for the LM curve:
(M
)
1
r=
​  k ​Y – 
​  l ​ ​ ​ 
P ​ 1 l ​ …… (4.5 = 3.6)
l
S
where the nominal money supply in an open economy equals:
MS = D + eF
where D represents domestic deposits, e, the exchange rate defined as the amount of domestic
currency necessary to purchase one unit of foreign currency (e.g. 10 rands per dollar) and F
represents foreign reserves (e.g. dollars, yens, euros). Foreign reserves multiplied by the exchange rate
are added to the domestic money supply because the Reserve Bank and other domestic institutions
that bought the foreign reserves had to pay for them with domestic money, i.e. rands in the South
African case. These rands are now foreign-held deposits that can be used to buy South African goods
priced in rands. In essence, by adding the foreign reserves multiplied by the exchange rate to domestic
deposits, we add the value of foreign-held rand deposits to domestically held rand deposits – the sum
of all deposits then constituting the money supply.
Substituting equation (4.5) into (4.4) produces:
(
[
(
)])
k
1 M
​  l ​Y – 
​  l ​​ ​ 
Y = KE ​ (a + Ia + G + X – ma) – h ​ 
P ​1 lπ ​  ​  ​
S
Solving for Y and simplifying produces:
MS
Y = 1(a + Ia + G + X – ma) + 2 (​ 
P ​1 lπ)
...... (4.6)
where
KE
1 = ​ 
​
1 + K hk/l
E
K Eh
​
2 = ​ 
l + K hk
...... (4.6.1)
E
Equation 4.6 shows how the equilibrium level of real income Y depends on expenditure elements as
well as the real money supply – as captured in the IS and LM curves respectively.
We will return to equation 4.6 in chapter 6 when we derive the aggregate demand (AD) curve.
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4.7.3
The BP curve
The BP curve adds precision and clarity to the analysis of the BoP position and the adjustment
process in an IS-LM framework. Essentially the curve provides a way to read the BoP
condition, following a disturbance, directly off the diagram. In addition, it can be used
to make the analysis of the BoP adjustment process in the diagram more explicit. This is
shown in figure 4.12.
The BP curve is a summary curve that depicts the external sector – imports, exports, capital
flows and the BoP – on the r-Y axes. Like the IS and LM curves, it is a derived curve showing
equilibrium points, in this instance in the external sector.
❐ Points on the curve indicate a state of BoP equilibrium.
❐ Points above the curve indicate a BoP surplus, and points below it indicate a BoP
deficit.
Essentials of the model
This information on the BoP surplus and deficit
areas can be used to characterise the external
dimension of any internal economic equilibrium
indicated by the intersection of the IS and LM
curves.
Thus one would analyse normal shifts in IS or
LM, and get to an equilibrium point such as
(r0; Y0). The diagram in figure 4.12 illustrates
a point where r and Y (and X and M and capital
inflows) are such that there is a BoP deficit.
(The position of the BP curve as such may also
have been affected by the initial disturbance.)
Figure 4.12 The IS-LM-BP model
r
BoP surplus
area
LM curve
BP
curve
r0
BoP deficit
area
IS curve
Once the BoP situation at such a point has
Y0
Income Y
been derived, the expected BoP adjustment
processes will follow. The BP curve may also
shift due to this adjustment. Nevertheless, the process will take the equilibrium to a point
on the BP curve. BoP equilibrium will have been attained, together with goods market and
money market equilibria. All three sectors will be in simultaneous (short-run) equilibrium.
The formal derivation of the BP curve
The BP curve is defined as follows:
The BP curve shows all combinations of real income Y and the interest rate r that are
consistent with the conditions for BoP equilibrium (i.e. in the external sector).
The BP is a series of points at which the BoP would be in equilibrium, were the economy to
be on the curve. Where the economy is, depends on the location of the internal economic
equilibrium, and consequently on the positions of the IS and LM curves. The BP curve
indicates the BoP characteristics of that equilibrium.
The shape of the BP derives from linkages between the BoP and the two variables on the
axes, i.e. real income and the interest rate:
❐ Real income affects imports, which affect the current account of the BoP.
❐ Interest rates affect capital inflows, which affect the financial account of the BoP.
4.7 The IS-LM-BP model for an open economy
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The BP curve is derived as follows (see
figure 4.13):
❐ Consider a pairing Y0 and r0 in the
diagram which is consistent with balance
of payment equilibrium. For a higher level
of Y, a higher level of imports would be
present. To counter this negative impact
on the BoP and re-establish a point of BoP
equilibrium, the real interest rate would
have to be higher to attract the necessary
capital inflows.
❐ Thus a second pairing (Y1 and r1) with
BoP equilibrium would lie above and to
the right of the first point. Any number
of such points can be derived. Connecting
them produces the BP curve.
Figure 4.13 Deriving the BP curve
r
r1
r0
(r1;Y1)
BP curve
Y1
Income Y
(r0;Y0)
Y0
The slope of the BP curve
The BP curve has a positive slope because, starting from a point with BoP equilibrium, a
higher level of Y would imply higher imports, requiring a higher interest rate to attract
sufficient capital inflows to re-establish BoP equilibrium.
How steep is the BP curve?
The steepness of the BP curve depends on how much the interest rate has to increase,
given a certain increase in real income, to re-establish BoP equilibrium. Hence the relative
steepness or flatness of the BP curve will depend on the following factors:
(1) The income responsiveness of imports. If imports react strongly to a higher level of
real income – the income responsiveness of imports is high – the interest rate would
have to be significantly higher to attract sufficient capital to counter the outflow of
payments on the current account. This would make the BP curve relatively steeper. A
low income responsiveness of imports, on the other hand, would serve to make the BP
curve relatively flatter.
(2) The responsiveness of foreign capital flows to domestic real interest rates. If foreign capital
inflows react strongly to higher domestic real interest rates, only a moderate increase in
interest rates would be sufficient to counter the current account deterioration following
a given increase in income. Therefore the BP curve would be relatively flatter. If foreign
capital is less sensitive to domestic interest rates, the BP curve would be relatively steep.
❐ In everyday terms, this sensitivity can be understood in terms of capital mobility:
low capital mobility to and from a country implies a fairly steep BP curve, and high
capital mobility a fairly flat BP curve.
❐ Countries often differ much with regard to the degree of capital mobility. The
income responsiveness of imports appears to be less decisive (although not
irrelevant). For a country such as the USA, very high capital mobility would
dominate import responsiveness effects. That is why its BP curve is very flat. For
a country such as South Africa prior to 1994 or countries such as Zimbabwe and
Lesotho, a high import propensity as well as relatively low capital mobility work
together to produce a fairly steep BP curve. After 1994, and especially after 2000,
South African capital mobility has increased markedly.
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Important: the slope of the BP curve relative to the LM curve
The relative slope of the BP curve decisively affects even a simple diagrammatical analysis.
What is crucial is the slope of the BP curve relative to the slope of the LM curve:
❐ If capital mobility is low, the BP curve must be drawn steeper than the LM curve. This
was the case in South Africa prior to 1994.
❐ If capital mobility is relatively high, the BP curve would be flatter than the LM curve.
This would be the case in the USA, or South Africa in the 2000s.
Since the slope of BP (relative to LM) depends on international capital mobility – which is
so vulnerable to international perceptions, political expectations and risk assessment of the
group of so-called emerging markets – for South Africa it can easily become steeper than the
LM curve again. For many low- or middle-income countries it would be steeper in any case.
In some cases, the relative slopes do not make a large difference to the outcome (e.g. a
monetary stimulation). However, in other cases (e.g. a fiscal stimulation), they do make a
crucial difference.
❐ Where relevant we will present both scenarios: a relatively steep BP and a relatively flat
BP, so that the reader can handle any situation.
Points off the BP curve
Points off the BP curve indicate pairings of Y and r that do not imply BoP equilibrium. The
level of imports or the level of capital inflows would be incorrect, given the level of exports.
The current account and the financial account would therefore not add up to zero.
❐ At points in the area above the BP curve there is a BoP surplus. The interest rate is
too high for equilibrium, attracting more capital than required to match the current
account position.
❐ At points in the area below the BP curve there is a BoP deficit. The interest rate is too low
for equilibrium, causing insufficient capital inflows to match the current account position.
Shifting the BP curve
Shifts in the BP curve are caused by any change (other than Y and r) that affects either the
current account or the financial account:
❐ If the disturbance improves the BoP position, the BP curve shifts to the right.
❐ If the disturbance weakens the BoP position, the BP curve shifts to the left.
Three main factors shift the BP curve – an exogenous change in exports, an exogenous
change in capital flows and the exchange rate:
❐ An increase in exports or capital inflows would shift the BP curve to the right. A drop in
exports or capital flows would shift the curve to the left.
❐ An appreciation of the rand, which stimulates imports and inhibits exports and capital
inflows, would shift the BP curve to the left. Depreciation would shift it to the right.
4.7.4
Using the IS-LM-BP model – the basics
The usefulness of the BP curve can best be seen if one distinguishes three phases – in two
groups – when analysing economic events:
(1) The disturbance phase, when the basic internal effect takes hold, with an accompanying
BoP situation developing.
(2) & (3) The BoP adjustment phases, when the money supply and the exchange rate effects
of a BoP surplus or deficit take hold.
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(1) The disturbance phase: the BP curve as an indicator of the BoP position
The first purpose of the BP curve is to indicate the BoP position that accompanies a
particular IS-LM intersection following an economic disturbance.
❐ The IS-LM intersection shows a pairing of Y and r consistent with both real sector and
monetary sector equilibrium – i.e. internal economic equilibrium.5
❐ The BP curve gives additional information about such an internal equilibrium, i.e. the
accompanying BoP position. It therefore shows the external dimensions of the internal
equilibrium determined by the IS-LM curves.
Internal disturbances
For internal disturbances such as our two
policy examples the addition of the BP curve
shows the accompanying BoP position. (The
diagrams below correspond to the first phases
of the chain reactions of these examples.)
Figure 4.14 Monetary stimulus
r
Internal real or monetary disturbances
shift the IS and LM curves as usual. The BP r0
curve is not affected by these disturbances r1
as such. It remains static, serving mainly
as a reference point from which to evaluate
the BoP dimension of the new IS-LM
intersection point (internal equilibrium).
❐ If the IS-LM intersection point is below
the BP curve, it indicates that the BoP is in
deficit (see figure 4.14).
❐ A position above the BP curve indicates a
BoP surplus as a by-product of the internal disturbance.
LM0
LM1
BP
BoP in
deficit
IS
Y0 Y1
Y
In the case of a monetary stimulus, a BoP deficit develops – irrespective of the relative
slopes of the BP and LM curves. (Check for yourself whether this statement is correct.)
For a fiscal stimulus, the relative slopes make a marked difference. This is illustrated in
figure 4.15. When cross-border capital flows are very interest-sensitive (and thus the BP is
flatter), a BoP surplus develops. Lower capital mobility implies that a BoP deficit develops.
(Why? See the examples.)
External disturbances
For external disturbances, the analysis is a bit more complicated. The BP curve itself is
shifted by external sector shocks or disturbances. Hence one cannot manipulate only
the IS or LM curves – possible shifts in the BP must also be shown. This is the case,
in particular, for exogenous changes in exports or changes in imports induced by the
exchange rate.
Shifts in the BP curve are caused by any change (other than Y and r) that affects either the
current account or the financial account:
5
194
Once again, this may be a full employment or an unemployment equilibrium.
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Figure 4.15 Fiscal stimulus with differing relative slopes
Fiscal stimulus: BP flatter than LM
r
Fiscal stimulus: BP steeper than LM
r
LM
BP
BoP in
surplus
r1
BP
r0
IS0
Y0
Y1
r1
BoP in
deficit
r0
IS1
IS1
IS0
Y
❐ If the disturbance improves the BoP position, the BP curve shifts to the right. For
example, an increase in exports would
shift the BP curve to the right. A drop in
exports would shift the curve to the left.
❐ If the disturbance weakens the BoP position, the BP curve shifts to the left. An
appreciation of the rand, which stimulates imports and inhibits exports, would
shift the BP curve to the left. Depreciation
would shift it to the right.
LM
Y0
Y
Y1
Figure 4.16 An increase in exports – IS and BP shift
r
r1
LM
BoP in
surplus
r0
BP0
BP1
To analyse an external disturbance, the
graphical impact on the IS or LM curves as
IS0
IS1
well as on the BP curve must be shown (see
Y
Y0 Y1
figure 4.16).
❐ In the disturbance phase, the increase in exports shifts the BP curve to the right (in
addition to the rightward shift of the IS curve).
❐ In the case of a BP that is steeper than LM, the BP curve must be shifted far enough so
that the new IS-LM intersection is above the BP curve, to indicate the BoP surplus that
surely must come about (starting out from BoP equilibrium).
!
In the IS-LM-BP model, the equilibrium values of Y and r – the state of the domestic economy –
are always indicated by the intersection of IS and LM. In this sense, the IS and LM curves are
dominant. The BP curve shows only the external dimension of that equilibrium.
However, as shown below, a certain BoP condition can lead to further changes in either the IS or
LM positions, and hence to a new internal equilibrium with new external characteristics. However, even
then the IS and LM curves always denote the equilibrium levels of Y and r.
4.7 The IS-LM-BP model for an open economy
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(2) & (3) The two BoP adjustment phases: the role of the BP curve in the adjustments
A second, and more complicated, purpose of the BP curve is to indicate impacts on the domestic
economy that may flow from the external dimension of an internal equilibrium. The essence of
such impacts was encountered in the discussion of the BoP adjustment process.
The following are key elements of the BoP adjustment process in terms of all three curves
(starting from an internal equilibrium with a BoP deficit or surplus):
(a) The initial, money supply effect – or rigid exchange rate effect – which shifts the LM
curve.
(b) The concluding, flexible exchange rate effect, which shifts both the IS and the BP
curves (in the same direction).
(c) Whereas the sensitivity of capital flows Figure 4.17 BoP adjustment from a surplus
to interest rate changes may determine r
whether the BoP develops a surplus or
LM
a deficit (compare the two possible out1
BoP in
comes of a fiscal stimulus above), it does
surplus
not affect the direction in which the LM,
2
BP or IS curves will shift due to a surplus
BP
3
or a deficit on the BoP.
In the case of a BoP surplus (see figure 4.17):
(a) Rigid exchange rate effect: LM shifts right
(due to inflow of funds) in the initial
End: internal
phase of BoP adjustment. This moves the
and external
IS
equilibrium from point 1 to point 2.
equilibrium
(b) Flexible exchange rate effect: both IS
and BP shift to the left (due to currency
appreciation) in the concluding BoP
adjustment phase. This moves the Figure 4.18 BoP adjustment from a deficit
equilibrium from point 2 to point 3 in r
the diagram.
In the case of a BoP deficit (see figure 4.18):
(a) Rigid exchange rate effect: LM shifts left
(due to an outflow of payments/funds)
in the initial BoP adjustment phase. This
moves the equilibrium from point 1 to
point 2.
(b) Flexible exchange rate effect: both IS and
BP shift to the right (due to currency
depreciation) in the concluding BoP
adjustment phase. This moves the
equilibrium from point 2 to point 3.
✍
196
3
BP
2
Y
End: internal
and external
equilibrium
Start: BoP
in deficit
1
LM
IS
Y
The above BoP adjustment diagrams have been drawn for a BP that is flatter than the LM.
Repeat the exercise for a BP that is steeper than the LM and show that LM, IS and BP move in
the same direction as in the diagrams above.
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Fixed and perfectly flexible exchange rates
❐ If the exchange rate is fixed (not just rigid), only the rigid exchange rate effect and shifts
will occur.
❐ If the exchange rate is perfectly flexible and adjusts instantaneously, only the flexible
exchange rate effect and shifts will occur.
As noted earlier, most textbooks explain the BoP adjustment process in terms of either of
the extreme exchange rate regimes. While it simplifies the analysis considerably, these are
theoretically extreme cases unlikely to be of much practical use. In reality, most countries have
a system of dirty floating exchange rates. Thus both effects are typically present, although not
necessarily at the same time and with the same strength. Unfortunately, reality is quite messy in
this regard – and, of necessity, so must our analysis be.
These shifts in the IS, LM and BP curves can be spliced onto the tail end of any disturbance
of the IS-LM curves that produces a BoP deficit or surplus. Then they actually show the
effect of the BoP adjustment process very clearly.
❐ Theoretically, the BoP adjustment processes, and hence the shifts, would continue until
BoP = 0. That is, the shifts would be such that at the end the IS-LM intersection point
would also be on the BP curve. There would be simultaneous internal and external balance
(equilibrium). (Of course, this excludes the labour market: unemployment can still be
present at such a simultaneous, short-run equilibrium.)
4.7.5
Using the model for an open economy – disturbances and policy
effectiveness
In section 4.5 the consequences of three types of disturbance were analysed: a monetary
policy step, a fiscal policy step, and a change in exports. Chain reactions became quite
complex, indicating the need for diagrammatical support.
We now revisit those examples in terms of the IS-LM-BP model for an open economy, but
with the direction of change reversed.
Figure 4.19 shows the complete set of IS-LM-BP graphics for a particular disturbance
followed by the complete BoP adjustment process. Because so much is compressed into
one diagram, it is very crowded and complicated and should be studied carefully. Also
consult the simpler diagrams (the 45° diagram and supplementary diagrams) in chapters
2 and 3, and remember the economic chain reasoning behind the curves, repeated below.
Ultimately that is what matters.
Example 1: the internal and external effects of an increase in the repo rate
Primary effect:
(1) [The process starts at point 0 on the IS-LM-BP diagram.]
Higher repo rate ⇒ banks pay more for Reserve Bank accommodation ⇒ banks
discourage credit creation ⇒ money supply contracts ⇒ excess demand for money
⇒ increase in sales of money market paper ⇒ prices of money market paper fall ⇒
increase in nominal (and real) interest rates ⇒ capital formation I discouraged ⇒
aggregate demand decreases ⇒ production discouraged ⇒ Y decreases (= downswing
in the economy).
4.7 The IS-LM-BP model for an open economy
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As Y declines, imports M decrease (why?) ⇒ current account (CA) surplus develops.
The increase in r causes an inflow of foreign capital, leaving the financial account (FA)
in a surplus.
Secondary effects:
(2) Money market effect: As Y decreases, it causes the demand for money to decrease
concurrently ⇒ downward pressure on interest rates ⇒ initial rise in interest rates
gradually comes to an end ⇒ initial fall in investment is curbed ⇒ initial fall in
aggregate demand arrested ⇒ fall in Y brought to an end ⇒ drop in M arrested and
initial strengthening of (X – M) comes to an end.
❐ The main impact of this secondary effect is that the changes in r, I, Y and M will
be smaller than what they would have been had there been no such effect via
money demand. While this secondary effect operates in the opposite direction from
the primary effect, it is a weaker force. The secondary effect does not cancel the
primary effect, it only reduces it.
The net effect of the primary and secondary effects leaves Y lower, r higher and both the
current and financial accounts in surplus. There is a BoP surplus (BoP > 0).
[The economy is at point 1 on the diagram. The increase in the repo rate causes the LM curve to
move from LM0 to LM1 and the economy is now at point 1 on the diagram. This point lies above
the BP curve and thus indicates the presence of a surplus in the BoP. This corresponds with our
economic reasoning thus far.]
Further secondary effects due to BoP > 0:
(3) Initial BoP effect (foreign reserves adjustment): The BoP surplus causes (i) an inflow of
foreign exchange ⇒ MS increases ⇒ downward pressure on interest rates (which causes
the inflow of foreign capital to decrease or reverse and the FA surplus to decrease) ⇒
the decrease in the interest rate encourages real investment I ⇒ aggregate demand/
expenditure increases, causing Y to increase; as Y increases it stimulates imports ⇒
(X – M) decreases ⇒ prevailing CA surplus is reduced; the turnaround in the real
Figure 4.19 Increase in repo rate
r
LM1
r1
r3
1
3
LM2
LM0
BP1
2
BP0
0
r0
IS1
Y1 Y3
198
LM shifts left initially, and right
again in the initial BoP adjustment
phase
Y0
IS0
Y
0 5 Initial equilibrium
Y0r0 with BoP equilibrium
1 5 New equilibrium
Y1r1 with BoP surplus
(point is above BP0 curve)
2 5 Temporary equilibrium
Y2r2 after initial BoP adjustment
phase (foreign reserves effect).
Still BoP surplus
3 5 Final equilibrium
Y3r3 after concluding BoP adjustment phase (flexible exchange rate
effect). Both internal and external
equilibrium.
IS and BP shift left due to the
concluding BoP adjustment phase
Chapter 4: The basic model III: the foreign sector
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interest rate will also start to discourage or reverse capital inflows; thus the FA is likely
to start deteriorating. On both fronts the BoP surplus is being reduced.
The increase in Y implies that the initial downswing has turned around (at least for
now … ).
[The economy is at point 2 on the diagram.]
(4) Concluding BoP effect (exchange rate adjustment): The initial BoP surplus (now already
slightly reduced) also leads to (ii) an excess demand for rands (excess supply of
foreign exchange) ⇒ upward pressure on the rand ⇒ stimulation of imports and
discouragement of exports ⇒ decreases (X – M) ⇒ CA surplus is reduced, and so is the
remaining BoP surplus. The BoP tends towards equilibrium. The process will continue
as long as BoP ≠ 0 and until BoP = 0.
This cumulative decrease in (X – M) due to these two BoP effects again reduces
aggregate expenditure, which reverses the short recovery of Y – a further economic
downswing occurs (Y declines again).
[The economy ends up at point 3 on the IS-LM-BP diagram.]
It appears likely that the foreign reserves effect (phase 3 above) will come about sooner
than the exchange rate effect (phase 4).
Summary of changes
Note the changes that occur in the main macro­
economic variables, i.e. income Y, interest rate,
rand, BoP and exchange rate. As far as r and Y
are concerned their cyclical movements can be
checked against their up-and-down changes on
the axes of the IS-LM-BP diagram.
The time-path diagram (figure 4.20)
illustrates the stylised course of these main
variables over time during the primary and
three secondary effects of the example above.
❐ As noted before, in reality time paths are
never so smooth, and multiple shocks and
disturbances occur on top of one another.
Our purpose here is to isolate the basic
directional effects encountered by an open
economy following an initial stimulus.
Policy effectiveness again
This analysis confirms the conclusions regarding policy effectiveness: the effectiveness of
monetary policy is undermined by a rigid or
slowly adjusting exchange rate (which allows
the money supply effect time to take hold), and
enhanced by a quickly adjusting exchange rate.
❐ If the exchange rate is completely flexible
and adjusts rapidly, the downward shift of
Figure 4.20 Illustrative time path of key
variables – increase in the repo rate
r
Time
Y
Time
Rand
BoP
Time
BoP adjustment
phase
Demand contraction
up to 3 years
4.7 The IS-LM-BP model for an open economy
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the LM curve – the money supply or rigid exchange rate effect – would not occur at all.
All that remains is the flexible exchange rate effect, which boosts the effectiveness of
monetary policy.
❐ If the exchange rate is fixed, the IS curve would not adjust at all, and the downward
shift in the LM curve would be decisive and substantial. Indeed, this shift in the LM
curve would cancel the initial, policy-induced upward shift in the LM curve. Monetary
policy would have no net impact on real income.
Example 2: the internal and external effects of an increase in government expenditure
Primary effect:
(1) [The process starts at point 0 on the IS-LM-BP diagram (see figure 4.21).]
Increase in government expenditure ⇒ aggregate expenditure increases ⇒ positive
impact on domestic production ⇒ real income Y increases.
As Y increases ⇒ imports M increase ⇒ a current account (CA) deficit develops.
Secondary effects:
(2) Money market effect: As Y increases, it causes a concurrent increase in the demand for
money ⇒ upward pressure on interest rates ⇒ discouragement of real investment ⇒
decrease in aggregate demand, partially countering the impact of the initial increase
in government expenditure ⇒ curbs the upturn in Y ⇒ growth in M curtailed and
initial weakening of (X – M) comes to an end.
The net effect of the primary effect and the secondary, money market effect leaves Y
higher, r higher and (X – M) < 0, i.e. a CA deficit.
The increase in r causes an inflow of foreign capital, causing a surplus in the financial
account (FA). The net effect on the BoP is uncertain: depending on the relative size of the
CA and FA positions, the BoP = CA + FA could be in balance, in a surplus or in a deficit.
As we did in section 4.5.2, we assume international capital flows to be relatively
sensitive to domestic interest rate changes. Therefore, should interest rates increase as
a result of the secondary effect, there will be a relatively large inflow of foreign capital.
Thus, one might expect the surplus on the FA to exceed the deficit on the CA, in which
case BoP > 0.
❐ If capital flows were not that sensitive to domestic real interest changes, the surplus
on the FA would have been smaller than the deficit on the CA – implying a balance of
payments deficit. (We leave this case to the reader as an exercise.)
[The economy is at point 1 on the diagram.]
Thus we have further secondary effects due to BoP > 0:
(3) Initial BoP effect (foreign reserves adjustment): The BoP surplus causes (i) an inflow of
foreign exchange ⇒ expansion of money supply ⇒ downward pressure on interest
rates (which causes the inflow of foreign capital to decrease or reverse and the FA
surplus to decrease); the decrease in the interest rate also encourages real investment
I ⇒ aggregate demand/expenditure increases, causing Y to increase; as Y increases
it swells imports ⇒ (X – M) decreases ⇒ prevailing CA deficit is reduced; however,
the turnaround in the real interest rate will also start to reverse capital inflows; thus
the FA surplus is likely to start being reversed. Assuming a stronger FA effect, the net
effect would be that the BoP surplus is being reduced.
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Chapter 4: The basic model III: the foreign sector
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Figure 4.21 Increase in government expenditure
r
LM shifts right initially in the first
BoP adjustment phase
LM0
BP shifts left in the concluding BoP
adjustment phase
LM1
3
r3
r0
BP1
1
r1
2
BP0
0
IS2
IS0
Y0
IS1
IS shifts right initially, then left in the
concluding BoP adjustment phase
Y
Y3
0 5 Initial equilibrium
Y0r0 with BoP equilibrium
1 5 New equilibrium
Y1r1 with BoP surplus
(point is above BP0 curve)
2 5 Temporary equilibrium
Y2r2 after first BoP adjustment
phase. Still BoP surplus
3 5 Final equilibrium
Y3r3 after entire BoP adjustment
process. Simultaneous internal and
external equilibrium
The increase in Y implies that the initial upswing has been followed by another upswing.
[The economy is at point 2 on the diagram.]
(4) Concluding BoP effect (exchange rate adjust­
ment): The initial BoP surplus also leads
to (ii) an excess demand of rands (excess
supply of foreign exchange) ⇒ upward
pressure on the rand ⇒ stimulation of
imports and discouragement of exports
⇒ decrease in (X – M) ⇒ current account
deficit increases again. This helps to
eliminate the remaining BoP surplus –
the BoP tends towards equilibrium. The
process will continue as long as BoP ≠ 0
and until BoP = 0.
Note how, towards the end, the
appreciation of the rand is responsible,
via an induced decrease in (X – M), for
a contraction of aggregate expenditure.
This partially reverses the two-phase
expansion of Y.
[The economy ends up at point 3 on the IS-LM-BP
diagram.]
Summary of changes
The time-path diagram (see figure 4.22)
illustrates the stylised course of these main
variables over time during the primary and
three secondary effects of the example above.
Figure 4.22 Illustrative time path of key
variables – increase in government expenditure
r
Time
Y
Time
Rand
BoP
Time
BoP adjustment
phase
Demand expansion
up to 3 years
4.7 The IS-LM-BP model for an open economy
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Example 3: the probable effect of an economic upswing in the USA on the
South African economy
Primary effect:
(1) [The process starts at point 0 on the IS-LM-BP diagram (see figure 4.23).]
Higher YUSA ⇒ US imports MUSA increase ⇒ increased imports from abroad, including
South Africa ⇒ XSA increases ⇒ (X – M) increases, i.e. current account (CA) goes into
surplus ⇒ aggregate expenditure increases ⇒ production encouraged ⇒ Y increases.
(2) As Y increases, a concurrent increase in imports M develops ⇒ negative impact on
(X – M), i.e. current account deteriorates a bit.
The net effect on the current account will still be a substantial improvement.
Secondary effects:
(3) Money market effect: As real income Y increases, the real demand for money increases
⇒ upward pressure on real interest rates, which, in turn, causes investment to decrease
⇒ downward pressure on aggregate demand ⇒ initial increase in aggregate demand
countered ⇒ production discouraged ⇒ increase in Y curbed, upswing comes to an
end; increase in M arrested and improvement in CA comes to an end; CA in surplus.
The increase in interest rate should attract an inflow of foreign capital, which improves
the financial account (FA) – the FA will be in a surplus.
The net effect of the primary effect and the secondary effect leaves Y higher, r higher
and the current and financial accounts in surplus. Thus the BoP will have a surplus.
[The economy is at point 1 on the diagram.]
Thus we have further secondary effects due to BoP > 0:
(4) Initial BoP effect (foreign reserves adjustment): The BoP surplus causes (i) an inflow of
foreign exchange ⇒ money supply increases ⇒ downward pressure on interest rates
(which causes the inflow of foreign capital to decrease) ⇒ encourages real investment
I ⇒ aggregate demand/expenditure increases, causing Y to increase further; as
Figure 4.23 Increase in exports
r
LM shifts right in the initial BoP
adjustment phase
LM0
BP shifts right initially, then left in
the concluding BoP adjustment
phase
LM1
1
r1
r3
r0
0
3
2
IS0
Y0
202
Y1 Y3
BP0
IS2
BP2
BP1
IS1
Y
0 5 Initial equilibrium
Y0r0 with BoP equilibrium
1 5 New equilibrium
Y1r1 with BoP surplus
(point is above BP0 curve)
2 5 Temporary equilibrium
Y2r2 after first BoP adjustment
phase. Still BoP surplus
3 5 Final equilibrium
Y3r3 after entire BoP adjustment
process. Simultaneous internal and
external equilibrium
IS shifts right initially, then left in the
concluding BoP adjustment phase
Chapter 4: The basic model III: the foreign sector
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Y increases it stimulates imports ⇒ (X – M) decreases ⇒ prevailing CA surplus is
reduced. The drop in interest rates will discourage capital inflows, so the existing FA
surplus will shrink.
[The economy is at point 2 on the diagram.]
(5) Concluding BoP effect (exchange rate adjustment): The initial BoP surplus also leads to (ii)
an excess demand for rands (excess supply of foreign exchange) ⇒ upward pressure
on the rand ⇒ stimulation of imports and discouragement of exports ⇒ decreases
(X – M) ⇒ CA surplus is reduced.
This appreciation-induced decrease in (X – M) contracts aggregate expenditure,
which turns around the sustained upswing. Y will decrease, also dragging interest
rates down further. The FA will shrink further, and so will the remaining BoP surplus.
The BoP tends towards equilibrium. The process will continue as long as BoP ≠ 0 and
until BoP = 0.
[The economy ends up at point 3 on the IS-LM-BP diagram.]
Summary of changes
Figure 4.24 shows that, in contrast to example 1 above (internal monetary disturbance),
where the current account changed mainly as part of the BoP adjustment phase, in this
case the initial disturbance directly and immediately affects the current account.
The export stimulation example appears
similar to the fiscal stimulation example.
Note the following differences, though:
❐ In the fiscal expansion example, a CA deficit develops, but it is overshadowed by a
FA surplus, hence a (small) BoP surplus
develops. In the export example, a substantial CA surplus develops immediately,
on top of which a FA surplus develops, so
that the BoP improves much quicker and
goes into a much larger surplus.
❐ The BoP adjustment process is much
longer in the export example.
❐ The decline of r during the BoP adjustment
is larger in the export example, due to the
larger BoP surplus and its effects on the
money supply.
❐ The upswing in Y is likely to last longer
than in the fiscal example.
Note that a rigid exchange rate enhances the
beneficial domestic effects of exports, while a
quickly adjusting exchange rate puts a brake
on the export-led economic upswing. This
parallels the conclusion about the positive
impact of a slowly adjusting exchange rate
on the effectiveness of fiscal policy.
Figure 4.24 Illustrative time path of key
variables – increase in exports
r
Time
Y
Time
Rand
BoP
Time
BoP adjustment
phase
Demand contraction
up to 3 years
4.7 The IS-LM-BP model for an open economy
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Conclusion
Theoretically, the BoP surplus should be eliminated at the end, since the BoP adjustment
process should continue until BoP = 0. In practice, the process rarely gets to equilibrium
so effortlessly. Nevertheless, the basic nature and direction of the adjustment process is
unchanged.
However, this neat outcome is a
theoretical result. In practice it
rarely happens that the adjustment
process proceeds to the end – it is
likely to be interrupted by new
economic disturbances. What is
important is the basic direction of
the adjustment effects via the money
supply and the exchange rate.
Internal equilibrium and unemployment?
Remember that internal equilibrium need not be
accompanied by full employment. This is the
central theme of the Keynesian approach. Even if
the BoP adjustment process pushes the economy
towards a point of simultaneous internal and
external equilibrium, there could still be substantial
unemployment. These issues are discussed in
chapter 6.
Finally, as noted earlier, all these
examples are incomplete since the
effect on the price level still is absent. This will be rectified in chapter 6.
Important: While these diagrams are quite powerful, they have intrinsic limitations. In
diagrams such as these one can indicate only the direction and the approximate magnitude
of shifts in the curves – and hence the resultant changes in Y and r. Depending on how
far each curve shifts, and on the different slopes of the curves, the net impact on Y and r
can vary.
❐ The diagrams are not intended to produce accurate ‘forecasts’ of changes in Y and r,
and any attempt to do so goes beyond the limits of diagrammatical analysis.
❐ To get more specific forecasts, one has to use much more sophisticated mathematical
analysis and empirical econometric estimates of the various parameters and multipliers.
❐ Even then there will always be imprecision and substantial uncertainty. As noted earlier
in this book, the economy is not a machine, and changes do not happen mechanically.
Therefore the quantitative results of sequences of events cannot be forecast with
mechanical precision.
✍
The world financial crisis of 2007–08 – using the IS-LM-BP model
We introduced this case study in section 3.4 and earlier in this chapter.
Now is the time to redo that analysis using the IS-LM-BP model, and apply that to both the
USA and South Africa.
4.8
Real-world application – the Euro crisis and the impact of
confidence on international capital flows
The European Union is a monetary union comprising (in 2014) 28 European countries.
Since 1 January 2002, 18 of these countries have used a single currency called the Euro
(€), therefore no foreign exchange transactions are necessary (or possible) between these
countries. (The 18 countries are Austria, Belgium, Cyprus, Estonia, Finland, France,
Germany, Greece, Ireland, Italy, Latvia, Luxembourg, Malta, the Netherlands, Portugal,
Slovakia, Slovenia and Spain.)
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The Euro is managed by the European Central Bank (ECB). The single currency also
means that none of the 18 countries using the Euro can pursue an independent,
nationally-managed monetary policy: any policy-induced change in domestic interest
rates will be reversed by capital flows (see ‘sending the money supply overseas’ in
section 4.5.1). However, each country’s government retains control over its own
fiscal policy.
The Euro crisis: a brief overview
The Euro crisis started in 2010, peaked between 2010 and 2012 and was mostly resolved by
2014 (although Greece received assistance until 2018). It appears to have resulted from a
failure to harmonise fiscal policy (especially budget deficits), which – as we shall see below –
is necessary for a monetary union to be a success. A serious lack of fiscal discipline tends to
lead to a loss of confidence and, in turn, destabilising flows of funds among countries.
The protagonists in this crisis are Germany, on the one hand, and Portugal, Italy, Greece
and Spain (also called the PIGS countries, an acronym based on their initials) on the other.
Germany started the 2000s with a large budget deficit and relatively high labour cost. To
address these problems, it implemented what today is called an austerity policy – a policy
of fiscal and general economic contraction, intended to drive down the budget deficit (and
labour cost).
The PIGS countries did the opposite – presumably to obtain or sustain political support
for their governments. Fiscal expansions in the PIGS countries increased GDP growth and
led to current account deficits, which in turn required high levels of capital inflows from
financial investors outside their countries to finance these deficits.
The scale of fiscal expansions was such that the governments of Greece and Italy in
particular ran large budget deficits, driving up their public debt/GDP ratios to well above
100% (in the case of Greece to 130%). In Greece some creative public-sector accounting
also hid the actual size of the deficits and public debt for a number of years. Unaware of
the real nature of the deficits, German banks had gladly financed much of the Greek public
debt, contributing much to the capital inflows.
However, in 2010 the full extent of the debt problems facing the PIGS countries became
clear. Foreign investors lost confidence in the government bonds issued by these countries
and many withdrew their funds. As a result, governments such as those of Greece and
Italy had to offer much higher interest rates to attract foreign capital. In many cases
they were not fully successful in attracting investors. The IMF (in partnership with the
ECB) had to extend and facilitate very large loans to assist Greece in particular. The
country’s fiscal predicament worsened and the spectre of default on Greek government
bonds arose.
Although all the PIGS countries were supposed to arrest their fast-increasing public
debt/GDP ratios by implementing cutbacks in government expenditure and deficits,
they were at first reluctant to do so. In the case of Greece the situation became dire.
Default on government bonds was in the air. To avoid such a crisis, the IMF and ECB
facilitated negotiations with foreign banks that led to ‘write-downs’ of existing Greek
debt. These meant that foreign creditors would agree to extending a new loan of, say,
70c (€0.70) to fully replace every €1 of an old loan. In effect the creditor would lose
30c for each €1 of the loan – thus ‘taking a haircut’ rather than risking total default
on the loan.
4.8 Real-world application – the Euro crisis
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The impact on the Greek economy was huge. Banks took a hit and general economic
confidence evaporated; the crisis intensified. After several months of dithering, the Greek
government was forced – also as part of the ongoing international write-down deal – to
implement large cutbacks in government expenditure to get the deficit under control and
reduce public debt levels. These cutbacks meant, for example, that Greek civil servants
were forced to accept salary reductions, leading to street protests in Athens and other
Greek cities – and a deep political crisis.
In contrast, confidence in the German economy increased significantly as many investors
saw it as a paragon of good economic management and good financial investment
opportunities.
Using the IS-LM-BP framework to explain the Euro crisis
With some adjustments, example 2 in section 4.7.5 above can be used to explain the Euro
crisis. In example 2 an exchange rate adjustment occurs after a fiscal stimulus as the
second component of the BoP adjustment process; this helps to take the economy back to
equilibrium. In contrast, since a single currency is used by all eighteen Euro countries, an
exchange rate adjustment is not possible. The situation among these countries is similar
to having a fixed exchange rate. In a fixed exchange rate system, there can be no exchange
rate adjustment process – only a foreign reserves adjustment.
However, in a single currency system the foreign reserves adjustment of the BoP has
a peculiarity. Since no exchange of domestic currencies is necessary to buy or sell
goods or government bonds, foreign reserves are not involved in transactions between
Eurozone countries. Thus, any buying of Greek bonds by a Eurozone-based financial
investor would see Euros flow directly into the seller’s Greek bank account. Thus it has
a direct impact on the Greek money supply – not via a foreign exchange transaction, as
is normally the case. This implies that the normal BoP adjustment via foreign reserves
reduces to a direct money supply adjustment. The end result is the same, but it is much
more direct and rapid.
Figure 4.25a is an IS-LM-BP model for Greece (or any other PIGS country), while figure
4.25b is an IS-LM-BP model for Germany.
Analysing events in Greece
The analysis starts at equilibrium point 0 where IS0, LM0 and BP0 intersect, with output
for Greece at Y0 and the interest rate at r0. The Greek government then enters a period of
fiscal expansion that would eventually lead to the crisis.
Graphically the fiscal stimulus is portrayed by the IS curve shifting right from IS0 to IS1.
Output expands and an internal equilibrium is reached at point 1, with the interest rate
higher at r1.
This point 1 is above the BP0 curve, indicating that the balance of payments (BoP) has
gone into a surplus: although the primary effect of the fiscal stimulus causes a current
account (CA) deficit, international capital flows are relatively sensitive to an increase in
the interest rate; this leads to an inflow on the financial account (a FA surplus) which
exceeds the deficit on the CA. As a result there is a net surplus on the BoP – exactly as in
example 2.
❐ These inflows mostly comprised financial investments by German banks that were
buying Greek government bonds. (For simplicity we ignore inflows from outside the
Euro zone.)
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Figure 4.25a Fiscal stimulus and the confidence crisis in the Greek economy
IS shifts right in initial fiscal
stimulus and left in later
fiscal contraction
r
IS0
r1
r3
IS1
LM shifts right in the first
BoP adjustment, then left in
second BoP adjustment
BP1
LM0
LM1
1
3
BP0
r2
r0
LM2
2
0
BP shifts up and rotates
anticlockwise
Y3 Y0
Y1 Y2
Y
0 = Initial equilibrium Y0 r0
1 = New equilibrium Y1 r1
after IS shifts right (due
to fiscal stimulus). BoP
surplus.
2 = Equilibrium Y2 r2
after BoP adjustment
(equivalent to monetary
expansion).
Confidence crisis
occurs – BoP shifts up and
rotates anticlockwise. Capital
outflow and BoP deficit
develops.
3 = Equilibrium Y3 r3 after
BoP adjustment as well
as fiscal contraction.
Major recession.
0 = Possible final equilibrium Y0 r0 if confidence
returns and capital
inflows resume. BP
rotates and moves back
to BP0. BoP surplus
develops, followed
by BoP adjustment
(equivalent to monetary
expansion): LM shifts
back to LM0.
As explained above, the BoP surplus implies an inflow of Euros into Greece that causes a
direct increase in the Greek money supply (the ‘initial’ BoP adjustment effect). As a result,
the LM curve shifts right from LM0 to LM1. A new internal and external equilibrium is
established at point 2, with the interest rate dropping to r2 and output increasing to Y2 –
again, exactly as in example 2.
Note that, since the Euro regime implies that the exchange rate cannot adjust, there will
be no ‘concluding’ BoP effect via an exchange rate adjustment.
However, the Greek story does not end at point 2. There is a confidence problem that is not
apparent from the IS-LM-BP diagram. The Greek government ran large budget deficits and
sold the government bonds to foreign investors. As the stimulus continued for a number
of years, the Greek public debt/GDP ratio increased sharply, reaching 130%. The Greek
government was supposed to cut back on its expenditure, but they refused.
In 2010 this led to a crisis of confidence. Wary foreign investors started demanding much
higher interest rates on Greek government bonds. Graphically, this investor reluctance
(or: increased risk aversion) means that the BP curve shifts up. The Greek government
found it almost impossible to finance its budget deficit and had to offer very high interest
rates on their government bonds to attract investors. However, even these rates were
not enough. Investors started withdrawing their funds in large amounts, causing major
capital outflows.
Simultaneously, investors’ behaviour regarding risk-taking changed. Foreign capital inflows
became much less sensitive to Greek interest rates than prior to the crisis. This lower interestrate sensitivity of foreign financial investors makes the BP curve much steeper.
4.8 Real-world application – the Euro crisis
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These two effects mean that, in figure 4.25a, the BP shifts and rotates from BP0 to BP1.
This is critical: whereas BP0 is flatter than the LM curves, the new BP1 is steeper than the
LM curves. This changes the whole situation. Point 2 now lies well below BP1, reflecting
that a large BoP deficit has developed. This is largely due to the large outflow of Euros from
Greece (a deficit on the FA) that, together with the CA situation, implies a BoP deficit.
Now the BoP adjustment process kicks in, in the form of a contraction in the money supply,
moving the LM curve from LM1 towards LM2. The internal equilibrium starts moving up
the IS1 curve. At about this time, given the severity of the crisis and international pressure,
the Greek government was eventually forced to implement a severe austerity package,
cutting government expenditure sharply. In the diagram, the IS curve is forced from IS1
back to IS0.
The combined shifts of LM and IS culminate in a new internal and external equilibrium
being established at point 3 (roughly along the path indicated by the dashed blue arrow).
The new equilibrium interest rate is at r3 and output at Y3. Graphically one can see that
this new equilibrium at point 3 results from the new position and, especially, new slope of
the BP1 curve.
Note that Y3 is much lower than Y2 or even Y0. This indicates the huge price that Greece
eventually had to pay – in terms of a deep recession and a large drop in employment –
for previous years of excess and unwillingness to cut budget deficits and manage public
debt timeously.
Should Greece maintain a prudent fiscal policy for a number of years and the Greek public
debt/GDP ratio decline to sustainable and manageable levels, confidence in the Greek
economy may return and foreign capital inflows might resume. In the diagram the BP
curve will shift and rotate back to BP0; point 3 will then come to lie above BP0 due to
a BoP surplus having developed. The subsequent inflow of funds (which constitute the
BoP adjustment process) will increase the Greek money supply. The LM curve will shift
back from LM2 to LM0, with equilibrium returning to a point such as point 0 – implying a
recovery of GDP and employment. Greece will have recovered from the crisis.
Analysing changes in Germany
In Germany almost the opposite happened to what happened in Greece. In the early 2000s
the German government ran a large budget deficit. In figure 4.25b this is indicated as
equilibrium point 0. The German government subsequently decided to rein in the budget
deficit by cutting government expenditure. Graphically this shifts the IS curve left from
IS0 to IS1. At the new internal equilibrium (point 1), coupled with a decline in income to
Y1, there is a deficit on the balance of payments. (This is the primary effect: the decline in
income reduces imports, creating a surplus on the CA of the BoP. However, the drop in
the interest rate towards point 1 causes a capital outflow, causing a deficit on the FA that
exceeds the CA surplus. Hence, at point 1 the German BoP is in a deficit.)
Note: The outflow of Euros from Germany and the inflow of Euros into the PIGS countries
were largely two sides of the same coin. Euros flowing out of Germany often willingly
found their way to countries such as Greece and Italy.
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Figure 4.25b Fiscal austerity and the German economy
LM shifts right in the first
BoP adjustment, then left in
second BoP adjustment
r
IS0
IS1
LM1
LM0
LM2
BP0
0
r0
r2
r1
r3
2
BP1
1
3
Y2 Y1 Y3
Y0
Y
0 = Initial equilibrium
Y0 r0
1 = New equilibrium
Y1 r1 after IS shifts
left (due to fiscal
contraction). Major
recession. BoP
deficit.
2 = Equilibrium Y2 r2
after BoP adjustment (equivalent to
monetary contraction). Recession
worsens.
Greek crisis causes
investors to have
stronger confidence in
Germany. BoP shifts
down. Capital inflow
and BoP surplus
develops.
3 = Equilibrium Y3 r3
after BoP adjustment. Upswing, but
ends well below
starting point Yo.
The outflow of funds due to the BoP deficit reduced the money supply in Germany. This
shifts the LM left from LM0 towards LM1, with a new internal and external equilibrium
likely to be established at point 2. The BoP deficit shrinks, moving towards BoP = 0. (This
is the initial BoP effect, operating through direct changes in the money supply – with no
exchange rate effect occurring.)
However, now something changes. Simultaneous to the loss of confidence in Greece and
the other PIGS countries, confidence in Germany increased. Investors became willing to
accept lower interest rates on German bonds. As a result the BP curve moves downwards.
The BP curve moves from BP0 to BP1.
With the BP curve moving to BP1, point 2 now lies above BP1, reflecting that a surplus has
developed on the BoP due to the capital inflow (FA surplus).
❐ If an increase in investors’ sensitivity to German interest rates also occurs, the BP
curve would become flatter. (This is not shown in the diagram.) In the German case the
change in slope does not change the basic result – the BP is flatter than the LM curve
in any case.
As a result, a BoP adjustment occurs for a second time. The LM curve shifts from LM1 to
LM2. A final equilibrium is reached at point 3, with output (GDP) higher at Y3 and the
interest rate having declined to r3.
This indicates that, after having gone through an austerity phase, Germany eventually
benefited from the subsequent increase in international investor confidence in the German
government and economy. Of course, the German people also paid a heavy price – a
dramatic drop in GDP and employment – but in their case it was early in the process. Still,
their final equilibrium GDP is much below the starting point.
4.8 Real-world application – the Euro crisis
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Implications: the need for harmonised fiscal discipline in the Euro zone
The PIGS crisis demonstrates that the behaviour of foreign investors depends greatly on
the confidence that they have in an economy or government, notably its fiscal policies.
Furthermore, a loss of international confidence can have severe implications for a national
economy. In the context of the Euro zone, such a national crisis can affect other member states
badly and threaten the sustainability of the Euro single currency area as such. Therefore,
such a single currency model, which already implies coordinated/unified monetary policy,
needs measures to keep budget deficits and public debt in line with each other.
Following the PIGS crisis, Euro zone members have signed a compact (the Treaty on
Stability, Coordination, and Governance in the Economic and Monetary Union) to try to
ensure fiscal discipline amongst member states. The goal is to get national governments
to maintain structurally balanced budgets – i.e. the budget balance excluding cyclical
effects on expenditure and revenue should not be in a deficit – and to eventually reduce
all national debt levels to below 60%. The compact, pushed by Germany, requires member
countries to introduce laws strictly limiting their structural government budget deficits
to less than 0.5% of GDP (or a more lenient 1% if their debt/GDP ratio is significantly
below 60%).
The compact also foresees that the European Commission would have the power to
review the national budgets of member states to avoid repeating past excesses. Such
supra-national control over fiscal policy is essential for the Euro single-currency
area to function efficiently and without disruptive confidence crises. The question is
whether voters in the different countries – who are at very different stages of economic
development and levels of wealth – would be willing to accept their government budgets
being prescribed by an external body (in effect, the all but dominant Germany). (See
chapter 10 for more on fiscal policy issues as well as the definition and application of the
concept of a structural budget balance.)
International repercussions: how does the Euro crisis affect South Africa?
Due to limitations of space the knock-on effects of the Euro crisis on other countries, such
as South Africa, cannot be analysed here. It suffices to say that the main effects stem from a
decline in GDP in Europe, and hence in their imports from other countries, including South
Africa. At the same time, foreign investor nervousness may spill over into a wariness to invest
in emerging markets, which could have an impact on capital inflows into South Africa.
The analysis of the impact of these changes on GDP, interest rates and the exchange rate
in the IS-LM-BP diagram for South Africa is left to the reader as an exercise.
4.9
Analytical questions and exercises
1. Explain fully why international investors include a risk premium in their decision to
invest in South Africa. In your discussion you must clearly indicate what is meant by
the risk premium.
2. Use chain reactions and diagrams to explain and illustrate the internal and external
impact of an increase in economic growth in the European Union on the level of
national income, the interest rate and the exchange rate of South Africa. Assume that
the degree of international capital mobility is low for South Africa, that the European
and Chinese propensity to import is high and that the exchange rate is floating. Clearly
show the balance of payments adjustment process.
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3. In 2018–19, US President Trump initiated a ‘trade war’ with China, introducing high
tariffs on Chinese goods imported into the USA. This resulted in lower growth being
forecast for China. (a) How important is China as a trade partner for South Africa?
(b) Analyse and explain what would be the likely effect on the South African economy.
Assume that the degree of international capital mobility is low for South Africa, that
the Chinese propensity to import is high and that the exchange rate is floating. Clearly
show the balance of payments adjustment process.
4. Suppose the cash reserve requirement is increased. Use the Keynesian transmission
mechanism’s chain reactions to show the primary, secondary and net effects on
total expenditure, total income and the interest rate. Indicate clearly the balance of
payments adjustment process. Assume a floating exchange rate and the capital flows
are not interest rate sensitive.
5. The violence, shootings and deaths at the Marikana platinum mine in August 2012
triggered a sell-off of domestic bonds by foreign investors. (a) Use the Keynesian
transmission mechanism’s chain reactions to show the effect of this event on South
Africa’s income level, interest rate and exchange rate. Clearly indicate the balance of
payments adjustment process. Assume a floating exchange rate and capital flows that
are interest rate sensitive. (b) How would the outcomes have differed if capital flows
were not sensitive to interest rates?
6. In March 2019 the Minister of Finance’s budget speech indicated that the budget
deficit will increase markedly in 2019/20, partly due to bail-outs of Eskom. Use the
Keynesian transmission mechanism’s chain reactions to show the effect on South
Africa’s income level, interest rate and exchange rate. Indicate clearly the balance of
payments adjustment process. Assume a floating exchange rate and capital flows that
are interest rate sensitive.
7. Suppose the rating agency Moody’s reduces South Africa’s rating as a country, which
means that, compared to previous years, South Africa is considered a higher investment
risk. South Africa depends on the inflow of portfolio investments. Use the Keynesian
transmission mechanism’s chain reactions to show the likely effect on the inflow of
portfolio investments due to a lower rating by Moody’s. Then show how the changed
inflow of portfolio investments affects South Africa’s income level, interest rate and
exchange rate. Indicate clearly the balance of payments adjustment process. Assume
a floating exchange rate. (Hint: Assume that prior to the rating adjustment the slope
of the BP curve was flatter than the slope of the LM curve, while after the adjustment
the BP curve is the steeper of the two curves – i.e. the BP curve swivels anticlockwise
due to the ratings decrease. Thus, assume that the interest-rate sensitivity of capital
flows decreases.)
8. The Business Confidence Index decreased markedly in 2018–2019. Use the
Keynesian transmission mechanism’s chain reactions and appropriate diagrams
to explain and show the likely impact of lower levels of business confidence on
South Africa’s income level, interest rate and exchange rate. Indicate clearly the
balance of payments adjustment process. First, assume a fixed exchange rate and
that capital flows are not interest rate sensitive. Then assume a floating exchange
rate and capital flows that are interest-rate sensitive.
9. Growth has been sluggish since 2013, and especially bad in the first quarter of 2019.
In July 2019 the Reserve Bank reduced the repo rate by 0.25%. Describe the likely
impact on economic behaviour and macroeconomic outcomes in a chain reaction and
with the IS-LM-BP model, if capital inflows are sensitive to changes in the interest rate
and the exchange rate is allowed to float freely.
4.9 Analytical questions and exercises
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10. Use chain reactions and the IS-LM-BP model to explain and illustrate the internal
and external impact of a decrease in taxes on national income and the interest rate.
Assume the degree of international capital mobility is low and the exchange rate is
fixed. Assume further that both the real and monetary sectors are highly responsive
to interest rates.
11. Use chain reactions and the IS-LM-BP model to explain and illustrate the internal
and external impact of a major increase in the gold and platinum prices on national
income and the interest rate. Assume the degree of international capital mobility is
high and the exchange rate is floating.
12. Use chain reactions and the IS-LM-BP model to explain and illustrate the internal
and external impact a stimulating fiscal policy will have on national income and
the interest rate. Assume the degree of international capital mobility is low and the
exchange rate is floating.
13. Explain (by using a chain reaction) the relationship between a budget deficit in the
USA, a strengthening US dollar, a weaker rand and South Africa’s export and imports.
14. ‘Foreign investors are becoming risk-averse and selling their shares on the JSE, due to
uncertainty in the South African mining and political sectors.’ Explain the relationship
between the foreign investors selling their shares on the JSE, the effect on the financial
account and the implications for the balance of payments.
15. Explain the ‘twin deficit’ phenomenon by referring to the budget deficit and the
components of the balance of payments.
16. When a country develops an extraordinarily large current account or balance of
payments deficit, it may be forced ‘to get an IMF bail-out’. Consult internet sources
(including factsheets at https://www.imf.org/en/about) to answer the following questions:
a. What is the role and purpose of the IMF in assisting countries in such a case?
b.What kind of ‘assistance’ could it provide for a middle-income country such as
South Africa in the situation described above? (What specific instruments can the
IMF make available?)
c.What is typical IMF ‘conditionality’ in the case of such IMF assistance?
d.Analyse the likely impact on a country such as South Africa of implementing IMF
conditions (use suitable diagrams).
17. In the run-up to Brexit, the British pound lost a lot of value in international currency
markets. Discuss the likely effect of this on different sectors of the British economy
and on the economy as a whole.
18. In the United Kingdom, 2019 was the year of the prospect of leaving the European
Union (EU), of which it had been a member since 1973. At the time of writing (August
2019), it appeared that the ‘divorce’ could happen without an agreement on future
trade between the UK and the EU – i.e. a ‘no-deal Brexit’. The governor of the Bank
of England (the central bank) warned that such an exit would likely cause the UK
economy to shrink (have negative growth) in 2020.
a. Explain, with diagrams, why this could happen, taking domestic and international
aspects into account (and making appropriate assumptions about capital mobility
in the UK and EU).
b. What could be the effect on South Africa and why? Analyse and explain, given
that South Africa has a floating exchange rate and that capital flows are interest
rate sensitive.
c. What did eventually happen with Brexit and what was the impact on the UK
economy in the first couple of years? (Consult the internet.) Analyse and explain
how these outcomes differed, or not, from the prediction of the Bank of England.
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Understanding sectoral
coherence and constraints: how to
use macroeconomic identities
5
After reading this chapter, you should be able to:
■ analyse and interpret the different macroeconomic identities that are derived from the
national accounts;
■ use the identities as an analytical tool to understand the coherence between sectors and
evaluate the functioning of an economy;
■ integrate the constraints implied by these identities into macroeconomic analysis;
■ recognise the misuse of the national accounts relationships to derive invalid conclusions
regarding cause-and-effect relationships; and
■ explain the basic structure of the System of National Accounts (SNA) and the
relationships between the different subaccounts.
In chapters 2 to 4 most of the main macroeconomic variables were encountered. These
reflect different types of economic behaviour such as consumption, savings and investment,
by different economic actors such as households (consumers), domestic and foreign
business enterprises, and the government. These behaviours (and variables) influence
each other or are collectively influenced by domestic or international events. The assembly
and analysis of chain reactions have revealed how shocks or policy measures impact
behaviour throughout the economy, as reflected in changes in the magnitude of
macroeconomic variables. Various graphs have shown South African macroeconomic
data that reflect the course of these variables over time. The South African Reserve Bank
publishes much of these data regularly.
The theory in the previous chapters provides a framework for making sense of observed
patterns of economic behaviour – and understanding the likely linkages between variables.
It uses such linkages to explain channels through which disturbances or policy steps are
transmitted through the economy, moving the economy from one state to another. (The
theory explains these transitions as moves from one equilibrium point to another.)
A further dimension of all these interactions and transitions is that, in terms of the
measured values of the variables, they must, and will, at all times remain within an
encompassing set of constraints. These are rooted in an accounting-type coherence
between different sectors – the numbers must add up, must balance. For example, a change
in the measured balance (surplus or deficit) in one sector – for example, a current account
deficit in the external sector – must and will be reflected in the measured balance (surplus
or deficit) in another sector for that year or quarter – either the government-sector budget
balance or the country’s savings-investment balance, or both.
Such crosscutting coherence between sectors (or groups of economic activity) is valuable
to unravel interrelated changes in the data on key macroeconomic components. The
coherence is captured in several identities involving C, I, G, X and M and so forth. These
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identities are derived from the national accounts. The System of National Accounts (SNA)
has an important role in ‘keeping the books’ of a country.
❐ Fortunately, here we do not have to do accounting at all. But, we will see how these
national accounting identities constitute a powerful additional tool of analysis for the
economist.
The System of National Accounts (or SNA) is the primary data system in macroeconomics. It was
developed by the United Nations to promote and standardise systematic economic measurement.
The system prescribes the correct methods to collect, measure and process the data.
❐ It offers a complete set of definitions of macroeconomic variables such as consumption,
investment, imports and exports – the well-known variables of macroeconomic theory. The
definitions are crucial once one starts working with published data.
❐ It offers an accounting framework for all the numbers to ensure a consistent set of data. Section
5.6 offers a bird’s eye view. The SNA is illustrated using the classification of the numbers as in
the Quarterly Bulletin of the Reserve Bank. It is, therefore, a handy reference section. (You can
answer many of the questions in boxes in previous chapters using these data.) It also is an
introduction to the complexities of the data tables and the need to take utmost care when
working with such data. The Addendum offers a ‘student’s guide’ to the national accounts.
The analytical use of the identities is discussed in sections 5.1 to 5.5, while section 5.7
analyses how the sectoral balance identities can be used in decision making. Section 5.6
shows the interaction and links between different subaccounts, how the identities actually
operate, and the way economic changes are reflected in the real numbers.
5.1
From equilibrium conditions to identities
In all the chain reactions, the importance of unplanned changes in inventories were
highlighted. If planned expenditure is less than aggregate production, inventories will
increase. If planned expenditure exceeds aggregate production, inventories will be used up.
So what is the actual position in a non-equilibrium situation? While the economy is
moving towards the equilibrium level of income, there is an imbalance between aggregate
planned expenditure and production – which is reflected in either an increase or a decrease
in inventories (involuntary inventory investment).
Aggregate planned expenditure > production ⇒ Change in inventories is negative
(inventories decrease)
i.e.
C + IT + GC + (X – M) > Y ⇒ Inventory investment figure is negative
OR
C + IT + GC + (X – M) < Y ⇒ Inventory investment figure is positive
where IT is total fixed investment and GC is government consumption expenditure (see the
shaded box below on the definition of these symbols).
Both these inequalities can be changed into equalities by adding inventory investment II to
the left-hand side of the expression:
C + IT + GC + (X – M) + II = Y
OR
C + I* + GC + (X – M)  Y
OR
C + (IT + II ) + GC + (X – M) = Y
...... (5.1)
where I* denotes investment redefined to include unplanned inventory investment:
I* = IT + II. Thus I* constitutes gross domestic investment (fixed and non-fixed).
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Important: G and GC, I and IT
In chapter 2 (section 2.2.5) we defined G, total general government expenditure, as follows:
G = government consumption expenditure plus government investment = GC + IG. However, as
noted in section 2.2.5, published national accounts data do not do this, since IG is not a part of
‘G’ in the national accounts. That is why we have adopted the practice, throughout this book,
of using the symbol GC to denote government consumption.
In chapter 2 we adopted the practice of defining I as business real fixed investment:
I = IP + IPC, where the former is investment by private firms and the latter is investment by
public corporations. However, in the national accounts, government fixed investment IG is
included in the concept of total fixed investment:
❐ To avoid confusion, we introduce the symbol IT to denote total fixed investment in this allinclusive sense: IT = I + IG = IP + IPC + IG.
It should also be noted that the definition of GC as used in the sectoral balance identities in
section 5.4 (and in the ‘Production, distribution and accumulation accounts’ in the Reserve
Bank Quarterly Bulletin) is slightly broader and more comprehensive than general government
consumption in other contexts.
❐ The more comprehensive concept – called general government current expenditure – also
includes interest payments, subsidies and transfers to households and the rest of the
world. These items can be quite large (see table 10.1 in chapter 10).
❐ They are not included in the narrower definition of GC because interest on government debt,
though being current expenditure, does not represent consumption. It is a factor payment.
Subsidies represent a negative tax, while transfers represent a redistribution of income.
❐ Government current expenditure is relevant when calculating saving by general
government (see section 5.4).
The equality in equation 5.1 has the special attribute that it is always true, regardless of
whether the economy is in macroeconomic equilibrium or not. This follows from the fact
that the amount of any gap (excess or shortfall) between aggregate planned expenditure and
aggregate production (which then causes unplanned inventory investment) is automatically
included in the gross investment figure.1 This establishes and continuously maintains the
numerical equality between the left-hand and right-hand sides of the equation.
An expression such as equation 5.1, which is always true by definition, is called an identity. This
characteristic is indicated by using the ‘’ symbol rather than the normal ‘=’ symbol.
❐ This particular identity is called the national income identity.
!
The national income identity closely resembles the equilibrium condition for macroeconomic
equilibrium (see chapter 2, section 2.2.6). However, they are completely different kinds of
expression, as are their interpretations.
❐ The identity is always true, while the equilibrium condition is true only on the infrequent
occasion when the economy actually is in macroeconomic equilibrium.
❐ The major substantial difference lies in the way in which the investment term is put together to
include any excess or shortfall – which then actually creates the identity.
❐ When using either of these in macroeconomic analysis, these differences must be kept in mind
at all times.
1
In the case of equilibrium, planned expenditure and production will be equal, with unplanned inventory investment
being zero.
5.1 From equilibrium conditions to identities
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Figure 5.1 Nominal domestic expenditure and production
6 000
GDP
5 000
4 000
C
R billion
3 000
2 000
GC
1 000
I*
0
X-M
2018/01
2016/03
2015/01
2013/03
2012/01
2010/03
2009/01
2007/03
2006/01
2004/03
2003/01
2001/03
2000/01
1998/03
1997/01
1995/03
1994/01
1992/03
1991/01
1989/03
1988/01
1986/03
1985/01
–1 000
Source: South African Reserve Bank (www.resbank.co.za).
A more complete version of the national income identity, which corresponds to published
tables, also shows ‘net current transfers received from the rest of the world’ TR:
C + I* + GC + (X + TR – M)  Y + TR
...... (5.1a)
The graph in figure 5.1 shows the course of the variables in the national income identity
since 1985 (R million in nominal terms).2
At all times, despite all kinds of fluctuation, these variables conform to the national income
identity. How to interpret these changes is discussed next.
5.2
The interpretation of identities – uses and abuses
The national income identity can be interpreted in several important ways. With some
simple mathematical manipulation it can also be converted into different formats, which
provide yet more insights.
Broadly speaking, the meaning of these identities is that they indicate certain accounting
constraints on macroeconomic variables – as defined and measured in the system of national
accounts. All changes in variables that occur in the course of a macroeconomic chain
reaction must and always will ‘obey’ these identities.
This follows from the basic accounting coherence built into the system of national
accounts. As with the accounting practice of a private business, the numbers must add
up, must balance (with shortfalls or surpluses added in).
2
216
The data are taken from the table ‘National income and production account of South Africa’ in the Quarterly Bulletin
of the Reserve Bank. It would be worth your while to scrutinise this table.
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While the linkages between variables produce important insights, unfortunately it can say
absolutely nothing about causes, consequences or chain reactions.
❐ Hence it reveals nothing of the causality between economic variables and events. It
merely constitutes the accounting outlines within which economic chain reactions can
run their course. (Indeed, an incalculable number of permutations are possible within
these constraints.)
Example: the South African economy, 1985–2018
The graph in figure 5.2 shows the main variables from the national income identity from
1985. It differs from figure 5.1 in that all data are in real terms.
The components of aggregate expenditure show a number of important trends:
❐ Real GDP increased every year from 1993 to 2018 (following ‘negative growth’ between
1989 and 1992) with the exception of the steep recession of 2008–09.
❐ During 2008–09 gross capital formation by (private and public) businesses slumped
notably, whereafter it recovered before losing steam again since 2014.
❐ After being relatively stable for more than a decade, government consumption
expenditure increased markedly after 1999, before slowing down from 2010 onwards.
❐ Net exports (in real terms) grew gradually up to 2001, whereafter it declined steadily
and developed a persistent deficit since 2011.
❐ Household consumption expenditure increased steadily, but was stable as a ratio of
GDP (similarly showing a large dip during 2008–09).
The data patterns in figure 5.2 are open to various interpretations.
❐ For example, in the period of stagnation between 1988 and 1992, it could appear
that the increase in GC was the cause of the decline in investment I – i.e. excessive
government consumption expenditure GC was crowding out private economic activities
in general – and private investment in particular.
Figure 5.2 Real domestic expenditure and production (2010 prices)
3 500
GDP
3 000
2 500
R billion
2 000
C
1 500
1 000
GC
I*
500
X-M
0
2018/01
2016/03
2015/01
2013/03
2012/01
2010/03
2009/01
2007/03
2006/01
2004/03
2003/01
2001/03
2000/01
1998/03
1997/01
1995/03
1994/01
1992/03
1991/01
1989/03
1988/01
1986/03
1985/01
–500
Source: South African Reserve Bank (www.resbank.co.za).
5.2 The interpretation of identities – uses and abuses
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❐ To take another example, it might be argued that the sharp decline and eventual deficits
in net exports from 2001 are the result of increasing imports that, in turn, flow from
the sharp increase in private consumption.
Is it valid to derive such conclusions about cause and effect from the identity? It is not, since
an identity can give no indication of causality. Even if the explanation were correct, it would
still be scientifically invalid to deduce it from the identity. It is unwarranted because a number
of other explanations are possible for the same pattern. Consider the two examples again:
❐ The decline in investment between 1988 and 1992 could just as easily have been due
to political-economic uncertainty and a lack of investor confidence (as occurred since
2014). And the increase in GC after 1988 may have prevented the downswing from
being much more serious than it would have been, had GC not increased – rather than
being a cause of the recession.
❐ Regarding the decline in net exports, it is equally possible to argue that, due to promising returns on investment, foreign investors invested significantly in South Africa
in the high-growth period after 2003. This significant inflow of funds would have increased the external demand for rands, and the rand would have appreciated, which
would have discouraged exports
Two versions of the identities
and encouraged imports.
Is this view of the sequence of events
more correct? The answer remains
that one cannot deduce anything
about causes and consequences
merely by inspecting the identity.
Either of the two explanations – or
another one – may be correct. The
identity cannot help one in this
regard at all. The danger of the
identities lies in their simplicity, in
how ‘obvious’ apparently related
changes look. The actual relation­s­hips and cause-and-effect relations
in economic reality usually are
more complicated. To understand
the latter, one has to use logical
analysis, theoretical frameworks
and empirical research.
❐ The identities do not describe
behaviour. Rather, they record
a numerical balance in the
outcomes of several behavioural
variables in a specific, accounting
way. Economic theory, such as
the theory and chain reactions
contained in chapters 2 to 4,
describe behaviour and can be
used to explain how change in
one variable may lead to changes
in other variables.
218
The national accounting identities can be expressed
in terms of either GDP or GNDI (i.e. gross national
disposable income). The major difference between
GDP and GNDI is net ‘primary’ income from the rest
of the world (payments to migrant labour from other
countries, and so forth), as well as current transfers.
Each version is characterised by the way exports and
imports are defined and measured:
❐ If GDP is used, (X – M) is net exports, and only
includes foreign trade in goods and services.
❐ If GNDI is used, net primary income receipts and
current transfers are included in (X – M).
(Also see the data tip in chapter 4, section 4.2.1.)
It is immaterial which option is chosen. They are
equivalent, since the same element is added to both
sides of the definition.
One reason to work with GNDI is that it allows a
direct link-up with the current account data in the
balance of payments table (which always includes
international income flows). It also provides a direct
link-up with the important table called ‘The financing
of gross capital formation’ (see section 5.5).
❐ Hence the data and diagrams that follow are
shown in terms of gross national disposable
income. This means that the expression
(X + TR – M) encountered in the equations is
identical to the current account.
❐ Since balance of payments data are only
published in nominal terms (i.e. in current prices),
the rest of this chapter will mostly work in
nominal terms.
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Nevertheless, the identities provide important insights into the way components and sectors
of the macroeconomy cohere. In addition, they give some indication of the quantitative
range of possible macroeconomic changes as well as constraints on such changes. As
long as one is very careful not to use them incorrectly, identities can be valuable (see
section 5.7).
5.3
Expenditure, production and current account deficits
One can rewrite the complete, open economy national income identity as
(X + TR – M)  Y + TR – (C + I* + GC)...... (5.2)
This form of the identity has a very powerful interpretation. It shows that the extent to
which aggregate domestic expenditure3 (GDE = C + I* + GC) exceeds aggregate national
disposable income GNDI is directly and identically reflected in net exports, and therefore
in the current account (X + TR – M). Leaving aside the complication of net international
transfers TR, one can state the following:
❐ A current account surplus means that GDE is less than gross national disposable
income or GNDI.
❐ A current account deficit means that GDE exceeds gross national disposable income or
GNDI.
OR
❐ If GDE is less than gross national disposable income or GNDI, it implies a current
account surplus.
❐ If GDE exceeds gross national disposable income or GNDI, it implies a current account
deficit.
Therefore an external disequilibrium (current account deficit or surplus) always has an
internal macroeconomic counterpart (production is < or > expenditure). Therefore, the
removal of a current account disequilibrium must always include the restoration of
internal balance between expenditure and production (income). Likewise, restoring internal
equilibrium between expenditure and production (income) always will and must reflect in
the establishment of external (current account) equilibrium.
5.4
The sectoral balance identities
For these identities, we redefine some government sector variables slightly. Let T = current
revenue of government, i.e. taxes and other current revenue, and let GC = current expenditure
of government, i.e. government consumption expenditure and other current expenditure
(interest payments, subsidies and transfers to households and the rest of the world; see the
data tip in section 5.1).
If one adds and immediately subtracts T on the right-hand side of equation 5.2, it
produces:
(X + TR – M)  (Y + TR – T) – (C + I*+ GC – T) ...... (5.3)
3
Take note of the difference between gross domestic expenditure (GDE), expenditure on gross domestic product, and
aggregate demand. This is explained in the addendum to this chapter.
5.4 The sectoral balance identities
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Moving terms around produces:
(Y + TR – T)  C + I* + (GC – T) + (X + TR – M) ...... (5.4)
Since Y + TR – T is the disposable income (YD) of residents, the following can be derived
with some substitution of terms:
YD  C + I* + (GC – T) + (X + TR – M) ...... (5.5)
Furthermore, saving is that part of disposable income that is not spent on consumption:
S = YD – C, hence YD = S + C. Substituting this in equation 5.5, while collecting terms,
produces:
(S – I*) + (T – GC)  (X + TR – M)
...... (5.6)
This form of the identity is called the sectoral balance identity. It is extremely important, and
can be interpreted in various ways. It shows a fundamental linkage between key balances
in the private sector (households and business enterprises), the government sector and the
foreign sector. Each element (or balance) indicates the relationship between inflows and
outflows of a particular sector:
DATA TIP
S – I* = The excess of the total private saving (saving of households and businesses) over
capital formation by both the businesses and government.4 We will call this the
private saving balance.5
❐ Remember that government capital formation is included in I*. While this is not
entirely correct in terms of macroeconomic reasoning, convention is followed
here so that the form of the identities matches published South African data
tables.
❐ Should the consumption of fixed capital (also known as provision for depreciation) be included in both S and I*, the term S – I* will represent the gross private
saving balance. Otherwise it is net private saving.
❐ Keep in mind that unplanned inventory investment is included in the investment
term I* in all these identities. This element can be negative or positive.
4
5
220
Data for the components of total private saving S can be found in the following tables in
the Quarterly Bulletin:
❐ Production, distribution and accumulation accounts of South Africa
❐ Current income and saving.
The relevant data are also summarised in the table ‘Financing of gross capital formation’.
The latter table also shows the gross figure for I*, of which more details can be found in the
expenditure and capital formation tables.
This element shows the overall (gross and net) investment–saving balance. Investments and loans between firms or
between households and firms do not affect the (gross and net) balance, since these are internal to this component.
This terminology is not quite correct, given our comprehensive definition of I* to include government investment IG.
Most textbooks, indeed, show the identities with I as private sector investment, and government investment as a part
of G. Then (S – I) is the private sector balance proper, and (T – G) is the overall fiscal deficit (not only the current deficit,
as in South Africa). However, it does not change the analysis fundamentally – except that government saving or
dissaving is not highlighted so explicitly. The South African debate may have been distorted somewhat by the fact that
the data and the identities highlight government dissaving rather than the overall fiscal deficit.
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T – GC = The current government deficit or surplus (current income less current
expenditure, i.e. gross and net government saving). This term is often negative,
indicating general government ‘dissaving’.
❐ This is not the overall, conventional budget balance. Government capital
expenditure (and revenue) is not included. It only shows current expenditure
and revenue.
❐ Remember that in these sectoral identities GC is current government expenditure,
which comprises more than government consumption expenditure (previously
also indicated with the letter GC). The current expenditure of general government
comprises government consumption expenditure plus interest on public debt,
subsidies and transfers to households and the rest of the world.
❐ If one chooses to define current expenditure to include consumption of fixed
capital by government, T – GC represents gross saving by government. Otherwise
it is net saving by government.
❐ Remember that on the revenue side T includes, in addition to the tax revenue
of the general government, revenue from property, as well as transfers received
from households, business enterprises and the rest of the world.
❐ This element concerns the general government (national government plus
provincial governments plus local governments). The budget presented
annually by the Minister of Finance mostly concerns the national government.
DATA TIP
X + TR – M = The external surplus or deficit, i.e. the current account of the BoP. (Net
current transfers from the rest of the world, and net primary income from
the rest of the world, are included.)
Detailed data on (T – GC) can be found in the Quarterly Bulletin table ‘Production,
distribution and accumulation accounts for South Africa (General Government)’. It also is
summarised in the table ‘Financing of gross capital formation’.
The (X + TR – M) data can be found in the ‘Balance of payments’ table in the Quarterly
Bulletin.
Table 5.1 shows the sectoral balances for the South African economy for 2018 (in nominal
terms). Consider the first line of the table first. The observed values reflect the outcomes, in
a particular year, of numerous intertwined macroeconomic chain reactions, due inter alia
to external disturbances, inherent instability and policy steps. Amidst all the changes, the
figures remain within the constraints of the identity. The numbers always add up; always
balance (given the SNA definitions). While the identity allows an innumerable number of
combinations of values of economic variables such as C, I*, GC, X, M and T, there are limits
within which these values must stay (or add up).
Table 5.1 also demonstrates that the sectoral balances can be calculated either on a gross
saving (first line) or net saving (third line) basis, the latter being gross saving minus the
‘consumption of fixed capital’ (i.e. the provision for depreciation). (Recall that for gross
saving by government GC includes consumption of fixed capital, otherwise known as
provision for depreciation.)
❐ The first three columns show the gross and net private saving of businesses (financialand non-financial corporations) and households. This is denoted by S.
❐ Column four shows the gross and net saving by government, denoted by the current deficit
(T – GC).
5.4 The sectoral balance identities
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Table 5.1 The sectoral balances for 2018 (R million, current prices)
Households
Non–fin
corp
Financial
corp
(T – Gc)
S
Gross saving/
investment
Consumption of
fixed capital
Net saving/
investment
General
govt
Domestic economy
S + (T – Gc)
I*
(S – I*)
67 099
518 640
116 818
–1 124
701 433
874 396
–171 839
–70 138
–491 447
–21 141
–93 761
–676 487
–676 487
93 761
–3 039
27 193
95 677
–94 885
24 946
197 909
–78 078
Foreign sector
(S – I*) + (T – Gc)
= (X + TR – M)
–172 963
–172 963
–172 963
–172 963
Source: South African Reserve Bank (www.resbank.co.za).
❐ These add up to net or gross domestic saving (S + T – GC), with the difference between
gross and net saving again being the consumption of fixed capital.
❐ Subtracting I* from S yields (S – I*), the private saving balance, while subtracting I* from
[S + (T – GC)] yields excess domestic saving = (S – I*) + (T – GC), which equals the current
account (X + TR – M).
Figure 5.4 shows these basic elements for the South African economy since 1995 (in
nominal terms). Note the change with regard to the current account position after 2002,
and how it is linked to corresponding changes in the other variables.
The identity shows, at each point in time, a ‘snapshot’ of the limits, at a particular moment,
within which the values of variables must stay at all times.
By switching terms around, the sectoral balance identity (equation 5.6) can be written in
different forms, each of which provides different interpretations and insights.
5.4.1
Interpretation 1 – external imbalances
(X + TR – M)  (S – I*) + (T – GC)
 [S + (T – GC)] – I*
...... (5.6a)
Together, the two terms on the right-hand side amount to the overall domestic saving–
investment position:
❐ (T – GC) plus S is gross domestic saving (by government and businesses – i.e. private firms
and government corporations – and households).
❐ I* is gross capital formation (by government and businesses, with inventory investment
included).
The left-hand side is the current account of the BoP – the external (im)balance.
In this form of the identity one can deduce that, if there is an external, current account
surplus (net inflow of funds), the funds have to be, and are being, absorbed somewhere:
either the domestic private sector must save more than it invests, or the government sector
must collect taxes in excess of its current expenditure – or both. That is, any external
imbalance must be matched by corresponding internal sectoral imbalances.
❐ Still, there can and should be no explicit or implicit suggestion of causality in this
interpretation. That is the function of theory and ‘chain reasoning’.
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Conversely, if the government sector shows a current fiscal deficit (T < GC) and domestic
investment is in excess of domestic saving (S < I*) – in both cases more is spent than the
funds that are available – it will be matched by an external imbalance (current account
deficit) of corresponding size.
❐ This parallels the conclusion in section 5.3: a trade or current account deficit means
that domestic expenditure is in excess of available domestic production. And, once
again, these deficits or imbalances can have their origins/causes in any of the sectoral
balances, or in variables elsewhere in the economy.
In South Africa it was the case, until 1993, that T < GC (government dissaving) while
S > I* (private saving surplus). The positive (S – I*) figure exceeded the negative (T – GC)
figure in absolute terms, implying a net positive figure. Therefore it was matched by a
current account surplus in each year. (See section 5.5 for a further interpretation of this
situation.)
❐ After 1994 this situation reversed: (S – I*) was still positive, but in absolute terms it was
less than (T – GC). Hence the domestic saving–investment [(S + (T – GC)) – I*] situation was
matched by a parallel deficit on the current account.
The relationship over time between the different elements of the identity is shown in figure
5.3. The consumption of capital is included in saving and investment, so we are dealing
with gross saving concepts. The graph clearly shows how, when the gap between gross
domestic saving and gross domestic investment increased after 2002, the current account
deficit widened correspondingly.
Figure 5.3 Gross domestic saving and the current account
1 000
(S – I*) + (T – GC)
I*
800
600
R billion
S + (T – GC)
400
200
0
X + TR – M
–200
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
–400
Source: South African Reserve Bank (www.resbank.co.za).
5.4 The sectoral balance identities
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5.4.2
Interpretation 2 – saving and investment imbalances
(S  I*)  (GC  T)  (X  TR  M)
...... (5.6b)
A domestic imbalance between saving and investment (i.e. between inflows and outflows)
is mirrored in either the current government balance or the external balance.
If the private sector as a whole saves more than is being invested domestically, the resultant
surplus funds are being absorbed somewhere: either as loans to the government (to finance a
current government deficit (GC – T) or loans to the external sector (to foreign countries that
need the funds to finance their trade deficit with South Africa) or other forms of capital
outflow. Of course, both can occur simultaneously.
In South Africa, capital outflows absorbed the greater part of these surplus funds for many
years (in addition to those being absorbed by the fiscal deficit). Indeed, the capital outflows
were the major reason why a current account surplus had to be maintained – sufficient
foreign exchange reserves had to be generated from trade to finance the capital outflows.
(Capital flows cannot be seen explicitly in this identity. Section 5.5 shows a form of the
identity in which they are explicit.)
The relationship between the different elements of the identity is shown in figure 5.4
(again with consumption of capital included). It clearly shows how, when the gap between
gross domestic saving and gross domestic investment increased after 2002, the current
account deficit widened correspondingly.
❐ In 1994, and thereafter, the situation changed significantly, bringing about a positive inflow
of capital from other countries. For the first time in more than a decade, South Africa could
afford a current account deficit – the capital inflows brought sufficient foreign reserves to
finance the growing current account deficit (X + TR – M) (see figure 5.4 and table 5.2).
❐ This current account deficit was largely reflected in an increasing negative gross private
saving–investment gap (S – I*), while gr­oss saving by government (T – GC) turned
Figure 5.4 Gross private saving, government saving and the current account
1 200
1 000
I*
800
S
R billion
600
T
400
GC
200
0
X + TR – M
–200
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
–400
Source: South African Reserve Bank (www.resbank.co.za).
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positive in 2004. This means that government eliminated gross dissaving in 2004 (in
national accounting terms).
❐ However, what is not shown on this graph is that net saving by government (i.e. gross
saving minus the consumption of fixed capital) only turned positive for 2006 and 2007.
Since net saving is the relevant concept when analysing dissaving by government, this is
an important aspect to remember (see chapter 10, section 10.7.3 for data on net saving).
5.4.3
Interpretation 3 – current fiscal deficits
(T – GC)  (I* – S) + (X + TR – M)
...... (5.6c)
If government has a current fiscal deficit, it must borrow from a sector that has surplus
funds: either the domestic private sector (households and/or business enterprises) that
saves in excess of total domestic investment, or the foreign sector, which has earned net
surplus funds from trade with South Africa – or both.
❐ Should the current account happen to be in equilibrium, the current fiscal deficit can
be reflected in only one place: an internal imbalance between I* and S.
❐ Likewise, if government finances show a current balance, then the domestic S-I
imbalance must precisely match the external sector (current account) imbalance.
In South Africa, capital outflows occurred for a long period between the early 1980s and
1994; therefore a current account surplus had to be maintained. Domestic expenditure
had to be kept below total production. In other words, the domestic private saving–
investment balance had to generate sufficient surplus funds to finance both the current
fiscal deficit and the capital outflows.
❐ Increased political stability following the political change in 1994 put a stop to the
drainage of domestic saving to other countries. This left more room for gross fixed
capital formation, which could – for the first time in a decade – be allowed to exceed
domestic saving.
Despite the richness of the insights that can be derived from the different forms of the
sectoral balance identity, they still do not reveal any causal relationships. All three of
the balances are determined simultaneously by the entire complex of macroeconomic
relationships, processes and reactions.
5.5
The financing of gross capital formation
Table 5.2, reproduced from the Quarterly Bulletin of the Reserve Bank, provides very useful
additional insights in the constraints implied by the sectoral balance identities. It is closely
related to equation 5.6a, i.e. interpretation 1 of the identity.
The top four lines yield:
S + (T – GC) = gross domestic saving.
The last line is: I* = gross capital formation.
Lines 7 and 8 may be more difficult to understand. They derive from the following identity
for the external sector (BoP):
Change in gold and other foreign reserves
= BoP + change in liabilities related to reserves
= Current account + financial account + change in liabilities related to reserves
= Current account + ‘net capital inflow from the rest of the world’.
5.5 The financing of gross capital formation
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Table 5.2 Financing of gross capital formation (R millions, current prices)
2013
2014
2015
2016
–48 311
–45 553
–19 930
–23 214
5 595
–3 038
171 749
184 126
165 602
167 545
193 360
122 870
3. Saving by general governmenta
–62 083
–76 770
–45 941
–52 164
–80 809
–94 884
4. Consumption of fixed capital
482 989
525 308
560 416
617 969
638 782
676 486
5. Gross savingsc
544 344
587 111
660 147
710 136
756 928
701 434
6. Foreign investment
204 841
192 966
187 006
125 102
118 234
172 962
7. Net capital inflow from the rest of the world
209 468
208 100
172 991
164 624
143 759
184 299
8. Change in gold and other foreign reserves
–4 627
–15 134
14 015
–39 522
–25 525
–11 337
749 185
780 077
847 153
835 238
875 162
874 396
1. Saving by households
a
2. Corporate savingsa
9. Gross capital formation
b
d
2017
2018
a. After consumption of fixed capital and after inventory valuation adjustment.
b. At replacement value. (This term used to be called ‘provision for depreciation’.)
c. After inventory valuation adjustment.
d. Increase –; decrease +.
Source: SARB.
The change in liabilities related to reserves usually occurs due to short-term foreign loans
by the national government or the Reserve Bank from foreign banks and governments.
Thus it is a form of capital inflow, but for very specific reasons unrelated to international
trade and investment. It allows for changes in reserves for reasons other than normal BoP
transactions.
Moving terms around in this last equation produces:
Current account (CA) = Change in gold and other foreign reserves
+ net capital inflow from the rest of the world
This expression is particularly useful since it shows how changes in the current account
will be matched by changes in capital flows and especially foreign reserves:
❐ A current account deficit, for example, must be financed by either capital inflow or the
use of foreign reserves (or both). Hence a current account deficit will cause and require
an equivalent change in the sum of the latter two sources of financing.
❐ Conversely, a current account surplus must be reflected in an addition to reserves or an
outflow of capital (or both). The portion of the net current account inflow that does not
go into reserves must have flown out of the country.
Hence, the sum of lines 7 and 8 indicates the current account position. The current account
position is indicated in line 6, where it is called foreign investment. This may sound strange,
but it reflects the fact that a current account deficit needs to be financed, and matched, by
capital inflows. (Note that in this table a positive sign indicates a current account deficit.)
It can now be seen that the structure of the table simply reflects the sectoral balance
identity in a somewhat different form:
[S + (T – GC)] – CA  I*
Therefore, table 5.2 provides an extension of the set of identities above in that it makes explicit
the linkages between (a) the current account (CA) and (b) capital flows and changes in foreign
reserves.
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Interpretation 1 above therefore can be restated as follows: if gross domestic saving exceeds
gross domestic investment, it must be matched by a current account surplus – which
must, in turn, be matched by either a capital outflow or an increase in foreign reserves (or
both). This was the case in South Africa after 1986. Only in 1994 did things turn around,
showing current account deficits from 1995 onwards.
Another interpretation, which clearly illustrates the South African economic crisis of the
decade 1983–93, is as follows:
❐ If there is a continual capital outflow (net capital inflow is negative), and if reserves are
insufficient to finance this outflow fully, then the current account has to be kept in a
surplus.
❐ Given the sectoral links revealed by the identities, this can be achieved only by getting
gross capital formation (domestic investment) to a level lower than gross domestic
saving – and keeping it there.
❐ If the level of domestic saving is high, there is no problem. However, if total saving
already is relatively low, it implies a low ceiling below which investment must be
squeezed. Hence investment cannot be allowed to be ‘high’ (relative to domestic saving).
Such a ‘saving ceiling’ makes the problem of capital outflows much worse.
❐ If the contribution of the general government to domestic saving is negative (i.e.
government dissaving, a current fiscal deficit) – as had progressively been the case in
South Africa – it becomes increasingly difficult to generate enough net domestic saving
(from the only remaining source, private households and businesses). The pressure to
put a lid on investment (and expenditure in general) escalates.
❐ In other words, in such a situation a current fiscal deficit – which need not necessarily
be a problem in a general fiscal context6 – suddenly constitutes a major problem, placing
severe pressure on the fiscus.
This analysis reveals the severe ‘straitjacket’ that substantial capital outflows imply for
a country such as South Africa – given the intrinsic constraints, as revealed by the different
identities. In such a situation significant economic growth is not allowed, because:
❐ Private consumption C may not be stimulated, since that may depress personal saving.
❐ Government consumption expenditure GC may not be used for stimulation, since that
would increase government dissaving.
❐ Tax cuts may not be used to stimulate growth, since that also increases government
dissaving.
❐ Capital formation may not be stimulated, since it has to be kept far enough below total
saving to generate a large enough current account surplus (to finance the capital
outflow).
❐ GDP may not increase, since it will stimulate imports, aggravating the problem of sustaining a current account surplus.
The turnaround of this situation after 1994 signalled a great relief for South Africa from
the stranglehold, shown in the identities, which prevailed before that. With capital inflows
occurring again, government dissaving suddenly is less of a problem (and something that can
now be evaluated in fiscal terms rather than in the ‘financing of investment’ context; see
chapter 10).
Although the relief after 1994 has been quite significant (aided by capital inflows and government dissaving that decreased significantly), the low saving rate still creates problems
6
This is discussed in chapter 10.
5.5 The financing of gross capital formation
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for the economy. More specifically, I* exceeds S by a substantial margin because of the low
rate of domestic saving, particularly by households (see table 5.1).
5.6
The SNA at a glance – relationships between subaccounts7
The composite SNA table on the
If you have trouble understanding the concepts and
following pages shows the basic
variables in the tables, consult the addendum to this
structure and coherence of the
chapter, which provides a simple explanation of the
national accounts at a glance.
main definitions.
Study it carefully and thoroughly.
Nine different accounts are shown.
These correspond with the SNA tables in the Quarterly Bulletin of the Reserve Bank (which
also provide a more detailed breakdown of the tables.)
The SNA accounts organise macroeconomic data in terms of:
❐ the main domestic economic activities (production, income, expenditure and saving);
❐ the main domestic sectors (incorporated business enterprises, general government, and
the household or personal sector), and
❐ the external sector, which is represented in a separate account (no. 5), and indirectly in
the expenditure account (no. 3).
Account name
SARB table
BLOCK A
Account 1
Account 2
Account 3
Production
Income
Expenditure
Gross value added by kind of economic activity
National income and production accounts
Expenditure on gross domestic product
Account 4
Saving and investment
Account 5
External account
Financing of gross domestic capital formation; Gross and net capital formation by
type of organisation
Balance of payments
In this table X and M are defined to include income payments to, and receipts
from, the rest of the world (as is the practice in the balance of payments table)8
BLOCK B
BLOCK C
Accounts 6–9
Net sectoral saving
Production, distribution and accumulation
(One table for each sector, the sectors being financial corporations, non-financial
corporations, general government and households)
For all three sectors, capital expenditure – i.e. investment – is not shown here. All the investment components feature indirectly in account 4,
where together they constitute gross capital formation I* (= GCF or GDI).
7
8
228
This section can be omitted without loss of continuity.
Formally, the special capital flows are called Changes in liabilities related to reserves. These are short-term
foreign loans by the Reserve Bank and the government from foreign banks and governments. SDR allocations and
valuation adjustments are excluded from the Change in gross reserves item, since these fall outside the conventional
macroeconomic framework.
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Block A illustrates the three methods of calculating aggregate output noted above, and
the intrinsic equivalence of the three methods:
❐ Account 1 shows how total production is made up from production (value added)
in three sectors: the primary sector (agriculture, mining, etc.), the secondary sector
(manufacturing, electricity, construction) and the tertiary or services sector (wholesale
and retail trade, transport and communication services, financial services, and
community and social services).
❐ Account 2 calculates aggregate output from the income side of the circular flow, i.e.
from the income earned by different production factors.
❐ Account 3 works from the expenditure side, using the income-expenditure identity
Y = C + I* + GC + (X – M) (+ residual).
More detailed tables in the Quarterly Bulletin show the breakdown of expenditure within
each of the main categories, e.g. household consumption expenditure and capital
formation.
Block A also shows how indirect taxes and subsidies must be taken into account (compare
the market price vs. basic price vs. factor cost methods). The difference between GDP and
GNI is apparent, as is the equivalence of GDP and ‘Expenditure on GDP’.
Block B shows the relationship between domestic saving and investment (capital formation), as well as the external account (BoP).
❐ Account 5 shows the relationship between the current account, the capital account
and the BoP, as well as the foreign reserves. More specifically:
– Changes in either trade or capital flows are reflected in the BoP.
– Changes in the BoP are necessarily mirrored in changes in reserves.
– When observing the actual data for these variables (see Quarterly Bulletin), one can
see how the current account deficit in 2018 is financed by capital inflows. Since these
exceeded the CA deficit (outflow of payments), the reserves showed an increase. If
capital flows were less than the CA deficit, reserves would necessarily have been used
to finance the current account (the change in gross reserves figure would have been
negative).
❐ Account 4 is basically the ‘Financing of Gross Capital Formation’ (GCF) table discussed
in section 5.5. It is placed in Block B together with the external account to illustrate
the very important sectoral balance identity, discussed extensively above. In essence, any
gap between gross (or net) capital formation and gross (or net) domestic saving – a
saving deficiency – is reflected in a current account deficit. Excess domestic saving will
be matched by a current account surplus.
Block C shows the sectoral breakdown of production, distribution and accumulation. Note
that these sectoral tables are incomplete in the sense that investment (capital expenditure)
is not shown. Yet the tables are important in that they show how sectoral production,
income and expenditure behaviour, as reflected in saving, becomes an input in account 4,
where total saving is instrumental in financing total capital formation (which, in turn, is
composed of sectoral capital formation).
Of course, sectoral behaviour, in turn, is the endogenous result of changes occurring in
other accounts – as explained in the theory of chapters 2 to 4.
The SNA accounts constitute a complete and consistent system. As in business accounting,
identities and equalities govern the coherence between the different accounts and
subaccounts.
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Total capital flows (marked with *)
match the difference between saving and capital formation – and thus
also equals the current account.
C
Saving by households
Total corporate saving
S
Total private saving
(T – GC)1
Saving by genl government
(S + T – GC )1 Total savings
I*
– Total capital formation
(S – I* + T – G ) SAVING–INVESTMENT BALANCE
4. Saving and investment
Net
–3.0
122.9
119.9
–94.9
25.0
–197.9
5. External account
Merchandise exports
Net gold exports
Service receipts
Income receipts
– Merchandise imports
– Payment for services
– Income payments
Net current transfers
Capital transfer account*
FINANCIAL ACCOUNT
Direct investment
Portfolio investment
Financial derivatives
Other investment
[Reserve assest* (increase (–)]
FINANCIAL ACCOUNT*
(excluding change in reserves,
including unrecorded transactions)*
BALANCE OF PAYMENTS
(change in reserves excluded,
unrecorded transactions included)
–173.0  CURRENT ACCOUNT
Gross
67.1
635.5
702.6
–1.1
701.4
–874.4

4 873.49
4 857.1
1 457.6
1 440.9
2 921.0
1 037.3
886.4
–12.0
24.5
30.7
11.3
10.4
33.2
7.2
102.6
–11.3
153.4
0.2
–173.0
1 175.6
71.7
210.4
96.5
–1 222.9
–217.9
–250.6
–35.7
(‘Change in reserves’)
(X + TR – M)3
Difference between GDE and GNDI equals
the balance on the current account
–154.1
4 719.9
–35.7
4 684.2
Net primary income from the rest of the world
GNI @ market prices
Net current transfers from the rest of the world
GNDI @ market prices
Gross domestic expenditure (GDE)
+ Exports
– Imports
3. Expenditure
Final consumption expenditure by households
Final consumption expenditure by government
Gross fixed captital formation
Change in inventories
Residual
4 873.9  Expenditure on GDP 2 320.2
1 249.2
676.5
4 245.9
101.9
6.5
4 341.3
545.6
13.0
GDP at market prices 2. Income
Compensation of employees
Net operating surplus
Consumption of fixed captital
Gross value added at factor cost
+ Other taxes on production
– Other subsidies on production
Gross value added at basic prices
+ Taxes on products
– Subsidies on products
B) SECTORAL BALANCE IDENTITIES: (S – I*) + (T – GC) = X + TR – M
Total production equals total expenditure
(on the right-hand side of the table)
4 341.3 
Gross value added at basic prices
Y
456.9
909.2
2 975.2
1. Production
Primary sector
Secondary sector
Tertiary sector
A) NATIONAL PRODUCTION, INCOME AND EXPENDITURE: Y = C + I* + GC + (X – M )
(Please note that at the time of publication these figures were still subject to revision – so by e.g. 2022 some of the 2018 numbers will have changed after revision.)
THE NATIONAL INCOME AND PRODUCTION ACCOUNTS AT A GLANCE (2018, R billion, current prices)1
C + I* + GC + X – M
C + I* + GC
X
M
I*
C
GC2
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22.8
182.4
274.8
223.7
53.1
210.9
233.5
183.3
63.9
Net property income
Gross balance of primary income
Social contributions received
Other current transfers received
– Current taxes on income and wealth
– Social benefits paid
– Other current transfers paid
Gross disposable income
– Adj for change in net equity of households in pension reserves
– Residual
93.5
Net lending (+)/Net borrowing (–)
Net lending (+)/Net borrowing (–)
Gross saving
Capital transfers (net)
– Change in assets (net)
Net saving
– Consumption of fixed capital
Gross saving
– Residual
Other current transfers received
– Current taxes on income and wealth
– Social benefits paid
– Other current transfers paid
Gross disposable income
Net property income
Gross balance of primary income
7. Non-financial corporations
Gross value added
– Compensation of employees
– Other taxes on production
Other subsidies on production
Gross operating surplus
–86.5
518.6
2.2
607.3
65.1
491.5
518.6
16.2
40.4
196.3
19.0
45.6
534.8
–281.6
755.2
2 317.7
1 232.3
54.5
5.9
1 036.7
Net lending (+)/Net borrowing (–)
Gross saving
Capital transfers (net)
– Change in assets (net)
Net saving
– Consumption of fixed capital
Gross saving
–164.0
–1.1
–17.1
145.8
–136.6
93.8
–1.1
1 037.3
88.0
1 036.1
– Other current transfers paid
Gross disposable income
– Final consumption expenditure
836.7
719.0
9.6
0.4
108.6
545.6
101.9
13.0
6.5
–179.1
557.5
752.4
25.3
12.1
223.1
8. General government
Gross value added
– Compensation of employees
– Other taxes on production
Other subsidies on production
Gross operating surplus
Taxes on products
Other taxes on production
– Subsidies on products
– Other subsidies on production
Net property income
Gross balance of primary income
Current taxes on income and wealth
Social contributions received
Other current transfers received
– Social benefits paid
1) Due to rounding of numbers small discrepancies may appear in some totals.
2) GC in Block B4 is government current expenditure, where as in Block A3 it is government consumption expenditure – see section 5.4.
3) In this line X and M are defined to include income payments to, and receipts from, the rest of the world (as is the practice in the balance of payments table).
95.7
116.8
0.0
23.3
Gross saving
Capital transfers (net)
– Change in assets (net)
21.1
– Consumption of fixed capital
Net saving
116.8
Gross saving
2.6
373.7
208.8
5.3
0.0
159.6
6. Financial corporations
Gross value added
– Compensation of employees
– Other taxes on production
Other subsidies on production
Gross operating surplus
C) SECTORAL PRODUCTION, DISTRIBUTION AND ACCUMULATION ACCOUNTS
–15.9
67.1
15.1
98.0
–3.0
70.1
67.1
63.9
5.7
2 988.1
2 921.0
434.0
251.0
502.9
281.1
195.9
2 929.9
286.1
3 224.8
813.2
160.1
32.5
0.2
620.8
2 317.9
Sectoral saving produces total saving
Net lending (+)/Net borrowing (–)
Gross saving
Capital transfers (net)
– Change in assets (net)
Net saving
– Consumption of fixed capital
Gross saving
Social benefits received
Other current transfers received
– Current taxes on income and wealth
– Social benefits paid
– Other current transfers paid
Gross disposable income
+ Adj for change in net equity of households in pension reserves
– Residual
Total household resources
– Final consumption expenditure
Net property income
Gross balance of primary income
9. Households
Gross value added
– Compensation of employees
– Other taxes on production
Other subsidies on production
Gross operating surplus
Compensation of employees
Items that appear in more than one place must match. For example:
❐ Government consumption expenditure and household consumption in sector subaccounts 8 and 9 also appear in the expenditure account 3, in the familiar C + I +
GC + (X – M) context.
❐ Direct taxes of financial and non-financial corporations and households (accounts 6, 7
and 9) add up to the direct tax receipts of general government in account 8.
❐ Indirect taxes and subsidies, in account 2, match the indirect tax revenue received and
subsidies paid by general government in account 8.
❐ Gross capital formation in account 3 matches that in account 4.
❐ The different sectors’ saving, derived in accounts 6 to 9, reappear as components of
domestic saving in account 4.
❐ The X and M figures in account 5 match those in the C + I + GC + (X – M) table
(account 3).
Identities must always be true. A change in one place will and must be reflected in other
accounts (without saying anything about the direction of causality, as explained above). The
system must balance in an accounting sense.
❐ Any discrepancy between total domestic expenditure GDE and total production GNDI
(in account 3) will be reflected in a current account deficit (in account 5) – a sign of
domestic overspending. (This imbalance could have originated either internally or
externally, e.g. a drop in exports.)
❐ Because of the coherence between the accounts, this will necessarily have its mirror
image in a discrepancy between gross domestic saving GDS and gross capital formation
GCF (account 4).
❐ Any gap between GCF and gross domestic saving GDS – a domestic saving deficiency
– is reflected in the current account, but likewise requires financing by foreign capital
inflows or the use of reserves to finance that part of the investment not financed by
domestic saving. Or, equivalently, the current account deficit must be financed; thus
it will reflect in the financial account of the BoP and/or the reserves. (Excess domestic
saving is mirrored by capital outflows or reserves increasing, matched by a current
account surplus.)
Changes in the economy, as discussed in the various chain reactions in chapters 2 to 4,
will be reflected in the national accounts. For example:
❐ If the economy experiences a recession, production, income and expenditure on GDP
will all be at a lower level. The external account is likely to show changes, at least in
imports. In accounts 1 to 3 some or all components will have to be different (depending
on how, why and where exactly in the economy the recession started and spread through
the economy). Of necessity, some or all sectoral activities will also reflect this (without
revealing which of the changes were causes and which were effects in the various chain
reactions). All the elements in the sectoral balance identity are likely to have different
values – while the identity will remain true at all times (it will always balance).
5.7
Using the sectoral balance identities for decision making
It has been stated repeatedly that all the identities do not show any causal relationships
between sectors and variables. All the sectoral balances are simultaneously determined by
macroeconomic processes and reactions. So, what is the use of the identities for decision
making and analysis (over and above the insights already gained above)?
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Anticipating the possible causes of disturbances or policy steps
If one of the elements, e.g. in the sectoral balances, is disturbed by a policy step or some
other event, it will lead – via the normal economic channels and chain reactions – to a new
situation that will be reflected ex post in the identities and balances in an accounting sense.
If government is contemplating a change to (GC – T) with policy, the identity tells it
beforehand that changes in one or both of the other sectoral balances will result (via
the normal chain reactions indicated in chapters 2 to 4). However, since both sectoral
balances can be affected, and to different extents, this knowledge is of limited value only.
Also, GC and T may be affected by changes in the economy. On the basis of the identities
alone, one cannot even predict where the largest impact will be – unless one has other
information on the likely behaviour of sectoral variables (e.g. policy variables under the
control of policy authorities).
❐ Acceptable predictions require estimates of the different elasticities, sensitivities and
time lags involved in economic relationships. Empirical estimates of these can be made
using techniques such as regression analysis or econometric model building, based on
economic theory. These may then be used to generate quantitative estimates of changes
in economic variables following a disturbance.
Following such a disturbance or policy step, and with the prior knowledge of the origin
of a sequence of changes, one can follow the reflection of this sequence in the national
accounts, and interpret the accounting changes in that context. (One should bear in mind
that other events may also have impacted the sequence of events as they took their course.
An economy is continually subject to multiple influences.)
❐ Such an analysis of causes and effects does not flow from the identities themselves, but
from prior knowledge and theoretical insights in economic relationships and causality.
The identities can therefore be useful instruments, in conjunction with others, in better
anticipating and understanding the future course of events.
Diagnostic analysis or problem solving?
Where the cause of a sequence of events is not known, the identities are of less use. If one
were only to observe, ex post facto, changes in the sector balances, it would not be possible
to make a deduction regarding the sequence of events or the cause-and-effect relations
that might have been occurring. Observed changes in the balances cannot indicate where
changes originated; cannot indicate ‘guilty’ or ‘not guilty’ sectors or variables.
Where the identities can be an aid is in checking whether a possible explanation of an event
or problem or the use of economic theory is consistent with the identities. By checking whether
proposed explanations are consistent with the constraints revealed by the identities, invalid
explanations can be disqualified and the potential validity of others ascertained. However,
it would not be possible to designate a ‘winner’.
But is it not possible to identify likely problem areas, or a sector where one should start
to solve certain macroeconomic problems? To some extent this may be possible – first, the
identities do indicate sectors or balances where the economy is experiencing pressure or
tightness, and, second, one knows how the sectors are linked and has a good (theoretical) idea of
how chain reactions spread through the economy. It may therefore be possible to target certain
areas for remedial action.
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❐ This still does not mean that the targeted sector has been identified as ‘guilty’. An
undesirable balance in one or more sectors may have been caused by a disturbance or
policy step elsewhere in the economy.
❐ Without theoretical insights and reasoning, any identification of problem areas is a very
dangerous, mechanical exercise that bases decisions on a ‘black box’.
And so we come to a general and crucial insight regarding the national accounting identities: they
are very useful, but can easily be used improperly.
5.8
Analytical questions and exercises
1. Suppose that the government is running a budget surplus. Use the relevant sectoral
balance identity to indicate how this surplus could have originated.
2. Suppose that domestic investment exceeds domestic saving. Use the relevant sectoral
balance identity to indicate how this saving shortfall could have originated.
3. In 2019 several huge amounts (up to R70 billion) were given to Eskom by the National
Treasury as bail-outs to keep it running and to service its debt. At the same time, said
the Treasury, ‘growth is not coming through and tax revenues are not there: we are
in trouble’. Discuss the sectoral balance identity, the budget identity and fixed budgetary
commitments as constraints on the fiscal policy choices that the National Treasury faces.
4. Consider the current account position in South Africa at the moment and use the
relevant sectoral balance identity to indicate how this position can be absorbed in
the economy.
5. The current account recorded a deficit of R173 billion in 2018. Use the relevant
sectoral balance identity to show how this external imbalance could be absorbed in
the economy.
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Addendum 5.1: National accounting definitions and conventions –
a student’s guide
The intricacies of national accounting match those of accounting for a private business
enterprise. As the name indicates, the System of National Accounts is an accounting
framework for the national economy. It is a complete accounting system, organised in a
number of separate accounts that are linked together and which must balance. The most
important accounts and concepts, for macroeconomic purposes, concern expenditure,
saving, production and income. All these take both the domestic economy and external
linkages into account.9
An important element of the SNA, and of the linkages, is the definitions of variables.
These definitions, which can be quite complicated, are governed by a number of national
accounting conventions. For the purposes of basic macroeconomic analysis, the following
distinctions are most important.
1. Measurement at ‘market prices’, ‘basic prices’ and ‘factor cost’, as in GDP at market
prices, GDP at basic prices and GDP at factor cost
This distinction relates to the way in which GDP is actually calculated, and the different
sets of prices used. Three sets are used in the national accounts: market prices, basic prices
and factor cost.
The first refers to a calculation looking at the market value or prices of the goods and
services produced, the second considers the effective price received by a seller, and the
third considers the income earned by production factors in the process (i.e. the cost of the
factors of production such as labour, capital and land).
Conceptually, these three appear to be the same. However, in practice, the presence of
different types of indirect taxes and subsidies implies wedges between market price,
effective (or basic) price and factor income (or factor cost). Therefore the SNA distinguishes
between (a) taxes ‘on products’, e.g. VAT or import duties payable on products as such,
and (b) other taxes and subsidies ‘on production’; the latter relate to taxes payable in the
production process, e.g. payroll taxes or licence fees.
For example, the presence of VAT means that the market price of bread is higher than the
price effectively received by the seller of bread. The indirect tax VAT must be subtracted from
the market price figure to get the ‘basic price’ value of the bread. However, the presence of
a payroll tax, for example, means that this basic price still is higher than the income those
involved in producing the bread (production factors such as labour, capital and land) will
really receive as gross income (i.e. before paying income tax). When this type of indirect
tax is deducted, one gets the value of production ‘at factor cost’. Similar arguments apply
to subsidies on products or production.
Therefore the total value of the production of bread calculated on the basis of market
prices will not equal the total value of bread production calculated on the basis of basic
prices or the income earned by bread producers. The difference is made up by the net tax/
subsidy figure.
9 See the relevant section in Mohr (2019) Economic Indicators for a more complete explanation.
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The same principle applies to calculations of aggregate production in a country. Therefore:
GDP at market prices — taxes on products  subsidies on products  GDP (also known as
Gross value added) at basic prices
AND THEN
GDP at basic prices — taxes on production  subsidies on production  GDP (also known as
Gross value added) at factor cost
If GDP at market prices > GDP at factor cost, all the indirect taxes together (on products and
production) exceed total subsidies. In South Africa this is consistently the case, especially
with indirect taxes such as VAT and the fuel levy having become such important elements in
the national budget. In 2018, for example, GDP at market prices was R4 874 billion while
GDP at factor cost was R4 246 billion. GDP at basic prices was somewhere in the middle
of these two, at R4 341 billion.
What is ‘value added’?
Conceptually, value added simply is the total value of production. Gross value added
and gross domestic product (GDP) are therefore exactly the same concepts. In the national
accounts, whenever measurement of total value of production is made at either factor cost
or basic prices, the convention is to use the term gross value added rather than GDP. However,
this is only a terminological convention. It is perfectly proper to think of GDP at factor cost or
GDP at basic prices (compare the SNA table in section 5.6). Therefore:
GDP at market prices — taxes on products  subsidies on products  Gross value added (or
GDP) at basic prices
AND THEN
Gross value added (or GDP) at basic prices — taxes on production  subsidies on production
 Gross value added (or GDP) at factor cost
2. Domestic vs. national measures, e.g. as in gross domestic product (GDP) and gross
national income (GNI)
This relates to the geographic as against the citizenship basis of calculations:
❐ ‘Domestic’ refers to the gross production within the geographic borders of the country,
irrespective of whether South African citizens or foreigners (including migrant labour)
undertook the activity.
❐ ‘National’ refers to aggregate production by South African citizens, irrespective of
where in the world they do that. The production of foreigners within the country must
be subtracted, and the production of South African citizens working in other countries
added. The net figure is called ‘net primary income payments to the rest of the world’,
and constitutes the difference between GDP and GNI.
GDP at market prices — net income payments  GNI at market prices
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If GDP > GNI ⇒ Net primary income payments to the rest of the world are positive
⇒ Foreign workers and companies in South Africa produce and earn more here than
South African residents and companies earn in other countries.
In South Africa, GDP is consistently higher than GNI. This is mainly due to large numbers of
migrant labourers from neighbouring countries, and large numbers of foreign companies
doing business here. In 2018, GDP was R4 874 billion while GNI was R4 684 billion (both
at market prices).
What is gross national income (GNI)?
Gross national income (GNI) is exactly equivalent to gross national product (GNP). GNP is a
well-established term in macroeconomics. However, the new System of National Accounts
prefers GNI. Both are proper whenever GDP is being adjusted for net primary income flows
across national borders (compare the SNA table in section 5.6).
GDP at market prices — primary income from the rest of the world  primary income to the
rest of the world = GNI at market prices
The equivalence of production, income and expenditure
The equivalence of aggregate expenditure, aggregate production and aggregate income is
a most fundamental principle in the national accounts. There are also three corresponding
methods to calculate the total value of aggregate output in an economy.
1. Via production: calculate the aggregate value added, in the production of goods and services,
by private enterprises, government and households.
2. Via income: calculate the aggregate income, before taxes, of all the factors of production
(= remuneration of employees plus operating surpluses of producing units).
3. Via expenditure: calculate the aggregate final expenditure on goods and services, i.e.
C + l* + GC + (X – M), where investment includes unplanned inventory investment.
In principle these should be equivalent. In macroeconomic theory, notably in explaining
the circular flow of expenditure and income, one of the basic insights is that the value of
aggregate production must equal the value of income received by the factors of production.
Therefore the terms ‘product’ and ‘income’ are treated as synonyms. In national accounts data
there is one complication, introduced by indirect taxes and subsidies (see above). This affects
the distinction between product and income. Hence indirect taxes and subsidies must be
factored into the equation (see 1 above).
3. Gross domestic expenditure (GDE) or expenditure on gross domestic product?
It is crucial to understand the difference between these similar-sounding terms.
Gross domestic expenditure (GDE) at market prices is the value of aggregate spending on final
goods and services by households, business entities and the government in the country in
a particular year or quarter. Both fixed capital formation and inventory investment are
included. GDE includes spending on imported goods (but excludes exports, i.e. spending by
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foreigners on South African goods and services). Note that the residual term is included in
published estimates of GDE.10
GDE  C  I*  GC ( residual)
This is to be used when speaking of ‘total expenditure’ taking place in the country (despite
the fact that some of the expenditure will end up in the pockets of foreign producers). An
example is the relationship between the demand for money and total expenditure (total
transactions) in the country.
Expenditure on gross domestic product indicates the aggregate expenditure felt by domestic
producers. Expenditure leakages to other countries (imports) are subtracted from GDE,
and injections from other countries (exports) added.
By definition, expenditure on gross domestic product is identical to GDP (at market prices).
This reflects the expenditure method of calculating the value of gross output:
Expenditure on GDP  C  I*  GC  X  M ( residual)  GDP
Therefore this variable offers another way to read GDP from the SARB tables.
If one wishes to measure aggregate demand, in the sense of comparing it with aggregate
supply, only planned expenditure must be included. Inventory investment therefore must
be excluded in this case11 and the appropriate compilation is:
Aggregate demand  C  I  GC  X  M ( residual)
This is to be used when comparing ‘aggregate demand’ with present levels of domestic
production GDP.
10 See Mohr (2019) for an explanation of the residual term.
11 Of course, some inventory investment may be planned. Unfortunately there is no way of identifying the
planned portion.
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A model for an inflationary economy:
aggregate demand and supply
6
After reading this chapter, you should be able to:
■ use the aggregate demand (AD) and aggregate supply (AS) model to explain both
fluctuations in real GDP and changes in the average price level;
■ explain how the interaction between wage-setting and price-setting relationships
determines both a short-run and a long-run aggregate supply relationship;
■ analyse and assess the importance of the short-run supply adjustment process towards a
long-run, structural equilibrium and a long-run AS curve;
■ assess the importance of structural unemployment in determining the position and nature of
this long-run equilibrium, especially in a low- or middle-income country; and
■ compose complex chain reactions for an open economy which include effects on the price
level together with real GDP, and evaluate these chain reactions with appropriate graphical
aids.
As mentioned at the beginning of chapter 2, the original and relatively simple Keynesian
model paid scant attention to the average price level and inflation – the price level was
assumed to remain constant. The focus was on real income and unemployment.
The reason for this is that Keynesian theory (and macroeconomic theory as such) was
developed in response to high and sustained unemployment during the Great Depression.
While there were periods of inflation after that, they were never serious (at least until
the early 1970s). Therefore the basic Keynesian theory paid only limited attention to the
question of inflation, and only in a very circumscribed way. Below the full employment level
of Y the model shows unemployment, but no upward pressure on prices. If expenditure
is so high that the point of equilibrium is pushed beyond the full employment level of Y
– on the 45° diagram, the equilibrium is to the right of the full employment level of Y –
then there is no unemployment, but upward pressure on prices (inflation). Therefore, in
the simple Keynesian model there can be either unemployment or inflation – respectively
explained by deficient or excessive aggregate expenditure – but not both.
The stagflation experience of the 1970s, with high or rising inflation occurring simultan­
eously with high or rising unemployment, placed a serious question mark over the tradit­
ional Keynesian theory. As a result, it was adapted in order to try to find an explanation for
the phenomenon of stagflation.
Our objective in this chapter is to incorporate the average price level P into the various
interlinking relationships analysed so far. This is the purpose of the aggregate demand
(AD) and aggregate supply (AS) framework.
The derivation of the AD curve is the culmination of the expenditure theory of chapters
2 to 4, also utilising the IS-LM model. As a parallel to this, the aggregate supply (AS)
  Chapter 6: A model for an inflationary economy: aggregate demand and supply
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relationship will be developed in some depth by focusing on the labour market behaviour
of workers and businesses (firms) together with the aggregate production function. Both
a short-run and a long-run AS relationship will be identified. AD and AS through their
interaction determine the aggregate level of output and the average price level. (Inflation
will be discussed in depth in chapters 7 and 12.)
A complete circular flow (compare pp. 73; 76; 140)
The circular flow diagram has been progressively completed in the chapters so far. With
the concepts of aggregate supply and demand now introduced, as well as the average price
level as an explicit variable, a complete circular flow diagram can now be presented. Study
it carefully.
❐ The price level is indicated in the lower left-hand corner of the diagram. It is shown as
a leakage, in the sense that an increase in the price level implies a leakage (or dilution)
of real income: the larger a price increase, the less the quantity of real income left.
International
capital
flows
FOREIGN
COUNTRIES
Ex
po
rts
Ex
ch
a
rat nge
e
EXPENDITURE
Aggregate demand for goods and services
Government
expenditure
Investment
FINANCIAL
INSTITUTIONS
Supply of credit
Interest
rates
cre
rcial
Comme
C
or
po
ra
Changes in
average price level
te t
a
xes, VAT
dit
po
rts
s
Saving
Monetary
Demand for credit
FIRMS
(Producers)
Aggregate supply of
goods and services
Im
Consumption
policy
Disposable
income
RESERVE
BANK
HOUSEHOLDS
(Consumers)
Government C
on
sum
borrowing
er c
redit
(deficit)
GOVERNMENT
(Budget and fiscal
policy)
VA
T
+
G
I + M)
+
C (X –
et
Personal incom
,
ax
REAL INCOME
Remarks
1. In chapters 2 and 3 you were introduced to the distinction between nominal and real
values. This distinction becomes particularly important the moment the price level is
recognised and used as a variable. Expenditure and income aggregates (and data) can
240
Chapter 6: A model for an inflationary economy: aggregate demand and supply
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2.
3.
4.
5.
be expressed in terms of their present monetary value, i.e. at current prices. Then we
speak of nominal GDP, C, I, Y, etc. If these aggregates are adjusted to eliminate the
effect of inflation, then we are working with real GDP, C and so forth, i.e. at constant
prices.
One way to eliminate the effect of inflation is to divide nominal values by a suitable price
index (this is known as ‘deflating’). Another method is to express all amounts in terms
of a base year, for example 2010 rands.
As far as interest rates are concerned, the rate normally quoted by banks is the nominal
rate i. The real interest rate r can be calculated (approximately) by subtracting the rate
of inflation from the nominal rate of interest (see the introduction to chapter 2 on the
relationship between real and nominal values, as well as chapter 2, section 2.2.2 for
details on the calculation of the real interest rate).
The difference between real and nominal values is extremely important and must be
borne in mind at all times, otherwise incorrect conclusions and arguments may follow.
This distinction is especially important when working with published data.
Normally the symbols (Y, C, etc.) indicate real values. The only exception is the money
M
supply, where the real money supply is denoted by ​ 
P ​. The real money supply will be a
very important variable in this analysis.
S
DATA TIP
Real and nominal data and price indices
6.1
❐ The national accounts section in the Quarterly Bulletin shows all expenditure
components, income and product (GDP) in both real and nominal terms.
❐ Price indices (CPI, PPI) can be found in the section ‘General economic indicators’,
while inflation rates are shown in the section ‘Key information’.
❐ Real interest rates and real money supply data are not published by the Reserve Bank.
❐ Balance of payments data also are only available in nominal terms.
Essentials of the AD-AS model
You will recall that the traditional Keynesian model was a demand-determined model (see
chapter 2). It focused on explaining short-run fluctuations in real domestic income Y and
employment by considering fluctuations in aggregate expenditure (or aggregate demand).
❐ Recall that we defined the short-run as a period of usually up to three years. In section
6.3.3 we will encounter adjustments on the supply side of the economy that occur
in the so-called medium term. This can be thought of as lasting a further three to
seven years. The average for both processes, allowing for some overlap, typically is
approximately four to seven years. Short- and medium-term changes and adjustments
are frequently discussed in the context of business cycles with reference to ‘booms’ and
‘busts’, ‘upswings’ and ‘downswings’.
❐ Both the short- and medium-term periods can be distinguished from the very long
run, with a time horizon measured in decades, which is the topic of economic growth
(chapter 8).
Throughout the unfolding exposition of the Keynesian model – both for the closed and the
open economy – it was assumed that the supply side of the economy would respond effortlessly
to any change in demand. Also, the price level was assumed to be constant. We must now relax
these two assumptions.
6.1 Essentials of the AD-AS model
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The AD-AS model is a powerful analytical tool to focus on the price level, while retaining the
important focus on real income Y. The basic purpose of the aggregate demand-and-supply
model is to recast the analysis of the real and monetary sectors (encountered in chapters 2
to 4) in one diagram that explicitly isolates the average price level P as a variable on one axis.
Real income Y appears on the other axis (see figure 6.1).
The AD-AS model therefore summarises the traditional theory in one diagram. However,
it also expands that theory to incorporate the systematic explanation of the behaviour
of firms and workers on the production, or supply, side of the economy. The supply and
demand sides of the economy together then determine the average price level P. In this way,
the AD-AS model overcomes two of the major weaknesses of the traditional Keynesian
model in an inflationary context.
In essence, the entire analysis of the
traditional ‘demand-side’ model – the
45° diagram threesome as well as the
IS-LM and IS-LM-BP diagrams – is
collapsed into one curve, the aggregate
demand (AD) curve. The AD curve has
a negative slope, as shown in figure 6.1.
Figure 6.1 Simultaneous determination of real income
and the price level
P
ASLR
ASSR
Short-run
equilibrium
after
demand
stimulation
1
The aggregate supply (AS) curve is
P1
then added to represent the supply side
0
P0
(or producer side) of the economy and
allows for disturbances and chain re­
actions to originate on the supply side,
AD0
or for supply-side factors to modify the
anticipated consequences of demandY1
YS
side occurrences. To explain short-run
fluctuations we will use the short-run
AS or ASSR curve. It has a positive slope, as shown in the diagram in figure 6.1.
AD1
Y
Together the ASSR and AD curves simultaneously determine the short-run equilibrium levels
of real income Y and the average price level P. This equilibrium is at the intersection of the two
curves (see figure 6.1).
❐ Any disturbance will shift one or both of the curves, leading to a new intersection and
a new equilibrium level of Y and P.
❐ For instance, diagrammatically, an increase in government expenditure will be reflected
in a rightward shift of the AD curve. The diagram shows the result to be both an increase
in Y (i.e. real GDP) and an increase in the average price level P: the equilibrium moves
from point 0 to point 1.
In this way the model provides a diagrammatical explanation of short-run changes in the
price level together with short-run changes in the level of real GDP.
❐ However, the model also shows a new category of change: adjustments on the supply
side of the economy that occur over a somewhat longer time span, which we call the
medium term.
❐ To understand these supply adjustments, we will develop a second AS curve, i.e. the
so-called long-run AS curve, or ASLR. In the medium term the long-run AS relationship
has a strong influence: the short-run equilibrium will be pulled towards the ASLR curve
through adjustments of the ASSR curve.
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All this will become clear in this chapter. The derivation of the AD and both AS curves
is explained below. As always, we will stress that the economic chain reactions and reasoning
are more important than the diagrammatical analysis. However, given the complexity of
these curves, substantial energy will go into explaining the derivation and properties of
the curves. This is followed by an extensive demonstration of the use of these curves to
support reasoning about economic events and policy.
6.2
Aggregate demand (AD)
6.2.1
What is the aggregate demand relationship? How is it derived?
One definition of the aggregate
demand relationship is simply that
it shows, for each price level, the
aggregate quantity of goods and
services demanded in the economy.
While this is a useful interpretation,
it is not entirely correct. This is
apparent from the way the aggregate
demand relationship is derived
directly from the Keynesian expenditure model and the 45° diagram, as
described below (and in figure 6.2).
You will recall that a particular
45° diagram is drawn for a given,
constant price level, and shows a
particular equilibrium level of real
income. Suppose that initially the
economy is at equilibrium income
level Y0, with the associated price
level being P0. This can be depicted
as point 0 in the P-Y plane.
Figure 6.2 Deriving the AD curve from the 45° diagram
E
Equilibrium points
for different price
levels
(C + I + G + X – M)P0
(C + I + G + X – M)P1
Y
P
Points on the
aggregate
demand curve
Suppose the price is at a higher
level P1. For several reasons (ex­
1
plained in section 6.2.3) a higher P1
0
average price level implies a lower P
0
level of aggregate expendi­
ture
AD
(C + I + G + X – M). Allowing for the
secondary, money market effect of a
Y
Y1 Y0
change in expenditure and in­come
(see chapter 3, section 3.2.2), the
net ef­fect would be that the aggregate expenditure line now lies below the initial line, and
the equilibrium level of real income would also be lower at Y1 (showing the net effect on
Y). This produces point 1 in the P-Y plane.
❐ A similar analysis follows for a lower price level.
❐ Connecting these and other such points yields the AD curve.
6.2 Aggregate demand (AD)
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The aggregate demand curve there­
fore shows, for various average price levels, the
corresponding equilibrium level of expen­diture/income – under the assumption that supply
would re­spond automatically to meet changes in expenditure.
Formally, the AD curve can be defined as follows:
The AD curve shows all combinations of real income Y and the average price level P at which
there would be simultaneous equilibrium in the real and monetary sectors.
Another important way of under­
Essentially, each point on the AD curve is a little ‘black
standing the aggregate demand
box’ containing a 45° diagram with its own price level
curve is to see it as a collection of
and levels of expenditure and hence equilibrium real
points of potential equilibrium, each
income Y. A different level of Y implies a different 45°
at a different price level, under the
diagram with a different equilibrium Y – and therefore a
assumption that no supply-side
different point on the AD curve.
constraints are present.
❐ In the discussion that follows
we will show that supply considerations actually limit the choice between these po­
tential equilibrium points. (This interpretation will become clearer once the aggregate
supply curve has been discussed.)
6.2.2
What determines the slope of the aggregate demand curve?
As noted above, the expected slope of the AD curve is negative. Several reasons can be
given why an increase in P can be expected to lead to a decrease in aggregate expenditure,
i.e. why a negative relationship can be expected to exist between aggregate demand and
the average price level P.
1. The interest rate effect: An increase in the average price level P contracts the real money
supply 
​  MP ​; this forces interest rates upwards, which is likely to depress expenditure.1
2. The wealth effect: A higher average price level diminishes the real value of assets;
people become less affluent and expenditure is discouraged.
3. The foreign trade effect: A higher domestic price level discourages export expenditure
(and encourages imports), so that aggregate expenditure decreases.
4. The tax effect: When personal income increases in periods of increases in the average
price level (i.e. inflation), taxpayers are pushed into higher personal income tax
brackets (so-called bracket creep). This curbs disposable income and thus expenditure.2
S
The real income effect is often cited as an additional factor: a higher average price level
lowers the real value (real purchasing power) of people’s income and thus their capacity
to spend. There is no agreement on
the validity of this argument. It is
Recall the formal rule for shifting vs. moving along
applicable only if the ‘price level’
a curve. A curve shifts if a relevant variable not on
is understood not to include the
one of the axes of the diagram changes. If one of the
price of labour and other factors of
variables on the axes changes, there is a move along
production, i.e. only prices of final
the curve.
goods and services are included
1
2
244
Equivalently, one can consider the money market in nominal terms. In this case, an increase in the average price level
increases the nominal value of transactions. This increases the nominal demand for money. For a given nominal money
supply, an increase in the price level is likely to put upward pressure on interest rates. See chapter 3, section 3.2.
This is true only in countries where progressive income tax systems are used, which is the case in most Western
countries. See chapter 10.
Chapter 6: A model for an inflationary economy: aggregate demand and supply
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(as is done in the calculation of the
consumer price index). It may be safer not
to use this argument.
Figure 6.3 Deriving the AD curve from the IS-LM diagram
r
Graphically, any change in P, or any
change in expenditure that is exclusively
brought about by a change in P, leads to
a movement along the AD curve. Usually
such a change in P is the endogenous
result of a shift in the AD or AS curves.
6.2.3
LMP1
LMP0
1
0
Deriving the AD curve from the
IS-LM model
The derivation of the AD curve can also
be shown in the context of the IS-LM
model. This has the benefit that it clearly
shows the secondary, money market
effects associated with changes in the
IS-LM diagram.
Equilibrium points for
different price levels
IS
Y
P
Recall that the LM curve is always drawn
Points on the aggregate
for a particular (constant) price level.
demand curve
Either of two arguments can be used to
show the impact of a different price level
1
on the internal economic equilibrium
P1
0
shown by the intersection of the IS and
P0
LM curves. The first is couched in real
terms, the second in nominal terms:
AD
1. A higher price level implies a lower
Y0
Y1
M
, which shifts
real money supply ​ 
P​
the LM curve left; or
2. A higher price level implies a higher nominal value of transactions. This increases the
nominal (transactions) demand for money MD, for a given nominal money supply. This
shifts the LM curve to the left (see figure 6.3).
S
Suppose that initially the economy is at equilibrium income level Y0, with the associate
price level P0. This can be depicted as point 0 on the P-Y axes.
Suppose the price level is at a higher level P1. This implies a lower real money supply
M
​ 
P ​. Expressed diagram­matically, this is a leftward shift of the LM curve from the initial LM
curve. The result is a different equilibrium with a higher interest rate and a lower level of
real income Y1. This produces point 1 in the P-Y plane.
❐ Connecting these and other such points yields the AD curve.
S
1
This derivation can be supple­mented with an analysis of the wealth, foreign trade and tax
ef­fects of a higher price level. These reduce expenditure, and are reflected in a shift to the
left of the IS curve, in addition to the leftward shift of the LM curve already shown in the
dia­gram. The combined effect would be a (larger) decline in the equilibrium level of real in­
come Y. The addition of the IS curve to the analysis therefore confirms the diagrammatic
conclusion regarding the slope of the AD curve. (The IS effect is not shown in the diagram.)
6.2 Aggregate demand (AD)
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6.2.4
How steep is the AD curve?
The steepness of the AD curve can best be understood by considering the first reason for
its negative slope in section 6.2.2, i.e. the fact that an increase in the average price level P
decreases the real money supply 
​ MP ​. Since this is analytically equivalent to a contractionary
monetary policy step, the analysis in chapter 3 (section 3.2.1) relating to the factors
affecting the potency of monetary policy is relevant here. These were the interest sensitivity
of money demand, the interest sensitivity of investment (capital formation), and the size
of the expenditure multiplier.
S
The reasoning can be applied as follows:
❐ If the interest sensitivity of money demand is low, monetary contraction will have
a large impact on the real economy. In the derivation of the AD curve, for a given
M
increase in P (and thus a decrease in ​ 
P ​), Y will decline a lot. Hence the AD curve will
be relatively flat.
❐ If the interest sensitivity of investment is high, monetary contraction will have a large
impact on the real economy. Therefore, for a given change in P (and thus in 
​ MP ​), Y will
decline a lot. As a result, the AD curve will be relatively flat.
❐ If the expenditure multiplier is large, the drop in invest­ment (capital formation) caused
by monetary contrac­tion (via interest rate in­creases) will have a large impact on the
M
real economy. For a given change in P (and thus in ​ 
P ​) therefore, Y will decline a lot.
Conse­quently, the AD curve will be relatively flat.
S
S
S
Conversely, the AD curve will be steep if one or more of the following is true:
❐ the interest sensitivity of money demand is high;
❐ the interest sensitivity of investment is low; or
❐ the expenditure multiplier is small.
π
Deriving the AD relationship mathematically
Recall from chapter 3 that when we substituted the LM relationship into the IS relationship,
we found an equation for the level of real income Y at which both the goods and money
markets will be in equilibrium. Chapter 4 then added the foreign sector. More formally we
had:
(M
)
​  P ​+ l ​
Y  1(a  Ia  G  X – ma)  2​ __
S
where:
K
​ 1 + K Ehk/l ​
1  ________
E
...... (4.6)
......(4.6.1)
​  KEh ​
2  ______
l + KEhk
It now transpires that this equation for the equilibrium level of Y is nothing but the equation
for the AD curve, given the equations in our model as derived in the last several chapters –
where P now is a variable (having been treated as constant in the equations of chapters 3 and
4). It shows an inverse relationship between P and Y, hence the negatively sloping AD curve.
A higher price level P implies a smaller real money supply and therefore a smaller level
of Y.
❐ The slope parameter 2 contains several responsiveness parameters and multipliers
(k, l, h, KE).
❐ The position of AD depends on several autonomous expenditure components
(a, Ia, X and ma) and exogenously determined policy variables (G and MS).
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Chapter 6: A model for an inflationary economy: aggregate demand and supply
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In a more complete and more
complex analysis, it can also
be demonstrated that the
AD curve will be flatter if
the income sensitivity of the
demand for money is lower.
Another factor flows from
the open economy context. If
exports and imports are very
sensitive to domestic price
level changes, the AD curve
will be relatively flat. This
implies that the AD curve
will be flatter for an economy
that is relatively more open.
6.2.5
Which factors shift
the AD curve? How far
does AD shift?
Figure 6.4 Shifts of AD originate in IS-LM changes
r
r1
r3
r0
LM1
1
LM2
LM0
BP1
3
2
BP0
0
IS1
Y1 Y3 Y2
Y0
IS0
Y
P
Any factor other than P (or
Changes in Y (due
to shifts of IS and
Y) which affects aggregate
LM) translate into
expenditure will lead to a
equivalent horizontal
shift in the AD curve.
shifts of AD, at every
price level.
❐ Any stimulating factor
would increase aggregate
demand (and vice versa
for a contractionary
factor). In the diagram,
P0
any non-price stimulation
of expenditure would
cause the AD curve to
shift to the right. Factors
that contract expenditure
would shift the AD curve
Y
to the left.
❐ All the internal factors (real and monetary) and external factors that influ­ence ag­
gregate ex­penditure also influ­ence aggregate de­mand. These include monetary and
fiscal policy measures, ex­pectations, external shocks, interest rates, exchange rates,
etc. Changes in any of these factors would therefore shift the AD curve.
❐ The three illustrative examples analysed in chapter 4 (section 4.5) are all relevant here.
Both expansionary fiscal policy and ex­pansionary monetary policy would be re­flected
in the diagram as a rightward shift of the AD curve. Con­tractionary policy would shift
the AD curve left. A surge in exports would shift the AD curve right.
❐ More specifically, any change in the equilib­rium level of Y (due to real, monetary or
external disturbances or adjustments) – ex­cept due to a change in the average price
level P – will shift the AD curve by exactly the same amount.
The diagram in figure 6.4 copies the IS-LM-BP dynamics of an increase in the repo rate
from chapter 4, section 4.7.5.
6.2 Aggregate demand (AD)
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The fluctuating short-run equilibrium values of Y (on the
horizontal axis of the IS-LMBP diagram) show the different
phases and impacts of the repo
change (from point 0 to point 1,
which include the money market
secondary effect) plus the two
secondary BoP adjustment effects
(from point 1 to 2 and again to 3),
on the equilibrium value of Y –
all in an exclusively demand-side
model.
Note the typical pattern generated by the two BoP
effects following a BoP surplus: first the LM and AD
curves shift right (money supply effect), then the IS,
BP and AD curves shift left (exchange rate effect).
❐ The AD curve shifts right then left. The final, net
effect of the two BoP effects on the position of
the AD curve often appears to be relatively minor.
For a BoP deficit a contrasting typical pattern is
generated. First the LM and AD curves shift left
(money supply effect), then the IS, BP and AD curves
shift right (exchange rate effect).
❐ The AD curve shifts left then right.
When this result is transferred to
the P-Y axes, it reflects as corresponding horizontal shifts in the AD curve – still under the
assumption of a constant average price level P. The net shift in AD is indicated by the blue
curve.
When the aggregate supply curves are added to the AD curve in section 6.3, we will see
changes in Y resulting. These will impact on the final, net change in equilibrium real income
Y (together with Y).
Policy potency
The analysis of policy potency can also be transferred to explain the magnitude of any
shift in the AD curve:
❐ If fiscal policy is very potent, the AD curve will shift relatively far if an expansionary
fiscal step occurs.
❐ Likewise, if monetary policy is potent, the AD curve will shift relatively far when mon­
etary expansion occurs.
Again, the analysis in chapter 3 (section 3.3.7) can be applied. It identified underlying
characteristics of an economy that determine the potency of fiscal and monetary policy steps.
These were the interest sensitivity of money demand, the income sensitivity of money
demand, the interest sensitivity of investment, and the size of the expenditure multiplier.
Any of these that make fiscal or monetary policy potent would lead to the AD curve shifting
further (for a given real or monetary expansion).
For example, any of the following will cause the AD curve to shift relatively far if fiscal
expansion occurs:
❐ a high interest sensitivity of money demand;
❐ a low income sensitivity of money demand;
❐ a high interest sensitivity of investment, or
❐ a large expenditure multiplier.
Similar results can be derived for the magnitude of the shift in AD due to monetary
expansion.
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6.3
Aggregate supply (AS)
The explicit introduction of an aggregate supply relationship is aimed at correcting a
previous simplifying assumption, namely that supply (or production) automatically and
effortlessly reacts to all fluctuations in expenditure. Problems on the supply side often
prevent, hamper or modify the anticipated impact of changes in expenditure on Y. Also,
macroeconomic disturbances and problems can originate on the supply side.
❐ The supply side of the macroeconomy implies a constraint on the role of expenditure
(i.e. demand) in determining the equilibrium level of real income Y, and allows for
independent supply-side factors to impact on the economy.
❐ Therefore, before the expected consequences of changes in expenditure can be spelt
out, one must consider the quantity of aggregate production which producers in the
economy (a) are prepared to, and (b) are able to deliver, given supply-related circumstances
and behaviour.
These considerations are represented by the aggregate supply (AS) curve, which can be
defined formally as follows:
The AS curve shows, for each price level P, the aggregate level of real output Y that producers
are willing or able to supply.
As will be explained below, the AS curve can be interpreted as a set of attainable
combinations of P and Y, given supply-side conditions.
Which factors determine aggregate supply?
The main factors that determine, in the aggregate, the ability and/or willingness of firms to
produce output are the following:
❐ size of the labour force (and thus also population growth);
❐ productivity of labour;
❐ labour skills levels (and thus education and training);
❐ cost of labour (wages);
❐ availability of raw materials;
❐ cost of raw materials;
❐ availability of capital goods (and thus investment);
❐ cost of capital goods;
❐ technology (which increases the productivity of labour and capital goods);
❐ cost of financial capital, i.e. interest rates;
❐ exchange rates (which affect the cost of imported inputs), and
❐ actual and expected prices.
Some of these factors impact on supply in the short run (i.e. in the cyclical context), while
others only take effect in the medium to very long run (i.e. the economic growth context).
The long run and the short run
Although this general definition of aggregate supply is true in general, the discussion of
aggregate supply needs to distinguish between aggregate supply in the short run and in
the long run. The difference is defined by the introduction of expected prices (and expected
real wages). In particular (a) that there could be, at times, a difference between expected
prices and actual prices, but (b) over time such a difference should disappear – it will not be
sustained in the long run. In other words, expected prices will be assumed to equal actual
prices in the long run, but in the short run there can and often will be a deviation.
6.3 Aggregate supply (AS)
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In fact, this is how we will define long run and short run for purposes of the AS curve:
❐ The long run is when, following some disturbance, sufficient time has elapsed for any
mistaken price expectation to have corrected itself so that the expected average price level
P e is the same as the actual average price level: P = P e.
❐ The short run is when this has not yet happened: the expected average price level is not
equal to the actual average price level: P ≠ P e.
This distinction will be critical in un­derstanding aggregate sup­ply behaviour, as the
discussion below will show:
❐ Aggregate supply in the long run indicates combinations of P and Y where the actual
av­erage price and wage equal the expected average price and wage.
❐ When, due to some economic factor or disturbance, the actual average price and real
wage deviate from the expected average price and real wage, other combina­tions and
levels of P and Y can and will occur. This is aggregate supply in the short run.
(Note that, for ease of exposition,
we will from here on just talk of
‘prices’ and ‘wages’ to indicate
the ‘average price level’ and the
‘average wage level’.)
How long is the short run? And the long run?
It is risky to specify hard time frames for such
indications of time periods, since economic
behaviour and macroeconomic reactions vary across
time and countries. Nevertheless, it is helpful to
adopt some approximations, as follows:
1. The short run is normally assumed to cover a
period of up to three years.
2. The period necessary for price expectations
to adjust fully so that the ‘long-run’ position is
reached is normally assumed to be a further
period of between three and seven years.
Both the long-run and short-run
aggregate supply curves show
levels of output that producers are
willing to supply. The difference
between the relationships is that
in the short run producers can
and probably will supply more (or
less) than the long-run level of
The typical average for both processes, allowing for
output. They will do so if actual
some overlap, is approximately four to seven years.
prices and wages for a certain
period allow for higher (or lower)
profits, since such higher (or lower) profits create an incentive to supply more (or less).
However, as will also be shown below, these devia­tions are likely to persist only for a limited
period of time (which could be several years), since expectations will catch up – and aggre­gate supply will eventually return to the long-run level.
As will be seen in section 6.3.3, explanations of the reasons for actual prices to deviate
from expected prices – i.e. reasons why expectations turn out to be mistaken – are central
to understanding the short-run aggregate supply pattern in the economy. Imperfectly
anticipated economic events, disturbances and shocks can be seen to translate into
sometimes prolonged deviations between actual and expected prices. Aggregate supply will
accordingly deviate substantively
from the long-run level of output
The maths of aggregate supply
for considerable periods of time –
The derivation of the aggregate supply relationships
depending, as we will see, also on
and curves requires more mathematics than was the
the state of aggregate demand at
case with aggregate demand. In the exposition that
the time (see section 6.4).
follows, basic equations will be shown in the text,
❐ We will also see that even
but more advanced equations and derivations will be
the long-run level of output
shown in maths boxes.
as such can also vary due to
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economic factors, implying that the graphical posi­tion of the ‘long-run’ aggregate
supply curve is not stationary or permanent (even before we consider the impact of
economic growth, which is considered in chapter 8).
Preview
The core of the theory of aggregate supply can be summarised as follows:
❐ At the beginning of a period, firms decide/plan what amount they will supply at the price
level that they expect. Workers do the same in terms of the amount of labour services that
they are contracted to supply to the firm in exchange for the wage rate that they expect.
Should their price and wage expectations turn out to be correct, all parties will supply what
they wanted to supply, and hence no party desires to adjust its supply of goods or labour
services in that period.
❐ If, however, actual prices in the period exceed expected prices, real wages (and real wage
costs of the firm) will in effect fall short of expected real wages and costs. Because the
lower real wage costs increase profits, firms are willing and keen to supply more goods,
and will do so. However, once wage negotiations occur at the beginning of the next period,
real wages can and are likely to adjust, thereby eradicating some or all of the increase in
profit and hence causing the firm partially or fully to reverse the increase in the supply of
goods. (Analogous but reverse changes occur when actual prices fall short of expected
prices.)
❐ Thus, the changes in supply that result from actual prices falling short of, or exceeding,
expected prices are only short-run, temporary changes – arising from ‘temporary mistaken
expectations’ regarding prices (and thus real wages).
❐ In the longer run, after expected prices and wages have had time to catch up with actual
prices and wages, output will eventually return to the level where actual prices and wages
equal expected prices and wages. Expectations are assumed to be self-correcting in the
long run and thus there are no mistaken expectations in the end.
❐ This level of output to which supply tends to return in the long run – amidst short-run
fluctuations and deviations – will be called the long-run level of output, or long-run supply.
It is denoted graphically as the long-run aggregate supply curve (ASLR ).
❐ The pattern of output resulting when supply diverges from the long-run output level is the
short-run aggregate supply curve (ASSR ).
6.3.1 Deriving aggregate supply – the labour market
What determines the level of output that producers are willing to supply, either in the
‘short run’ or in the ‘long run’? The answer lies in the link between profit, output prices
and input prices. Producers of goods pursue profit, i.e. they want the difference between
the price per unit and the cost per unit that they produce to be sufficiently large, or even
as large as possible. Thus, how much producers supply will depend on the relationship
between the prices that they can charge and their cost of production, and how these vary
over time.
The price-setting (PS) relationship
A more formal way to state the link between prices and cost is to consider the price-setting
(PS) and wage-setting (WS) relationships. The PS relationship indicates how producers set
their prices, taking wages (labour cost) as the most important cost. The PS relationship
assumes that prices are set as a mark-up over wage cost, i.e. a producer determines her wage
cost and then adds a mark-up (margin) to set the price of the goods. The mark-up includes
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provision for profits but also for the cost of other (non-labour) inputs and also taxes.
Changes in non-labour costs and taxes would thus impact on the size of the mark-up.
❐ One could alternatively define the mark-up as a pure profit mark-up (i.e. to exclude taxes
and the cost of other inputs) over all costs (i.e. expenditure on all inputs as well as taxes).
However, this would complicate the discussion below without adding additional insight.
Labour cost (i.e. wage cost) is chosen as the base for the mark-up because it is usually the
largest running expenditure item of firms.
❐ Note that the PS relationship assumes that producers are price setters and not price
takers in goods markets. That is, goods markets are assumed to be not completely
competitive, so that sellers have market power to set prices.
Formally, the PS relationship can be stated as:
W
​ P = (1  μ)​ ____
Q(N)
...... (6.1)
where P is the price level, μ is the mark-up (denoted as a fraction) over labour cost, W is the
nominal wage level and Q is an indicator of labour productivity (which can be measured
W
as the volume of output that a worker produces on average). Thus, __
​ Q ​is a measure of
the labour cost per unit of output. Q is written as a function of N since the marginal
productivity of labour declines as employment N increases (see the discussion of the total
production function below).
❐ Equation 6.1 can represent the behaviour of a single business or that of all firms in
the economy together. It is in the latter, aggregate sense that we will use it in this book.
Thus the mark-up, for instance, will be interpreted as the average mark-up in the entire
economy.
Equation 6.1 can be interpreted as follows. (A graphical representation of the PS relation­
ship will be shown later.)
❐ A higher nominal wage W implies a higher cost per unit produced, and should lead to
a higher price P being set.
❐ Higher labour productivity Q implies a lower cost per unit produced – and should cause
the price P that a producer will charge to be lower. Because, in general, the marginal
productivity of labour decreases as a firm employs additional labour, Q (which can be
defined as the average product per worker) will be lower at higher levels of employment
N. (Labour productivity also depends on factors such as the managerial skills of the
producer and the skills and capacity of the workers, as well as the capital goods,
technology and enabling economic institutions available to workers.)
❐ The mark-up is likely to be higher if producers have more market power. If a producer
is a monopolist, or if a group of producers band together in a cartel, they have more
market power compared to producers in a competitive market.
❐ The mark-up is likely to be higher if non-labour input costs (including the cost of raw
material, energy, the depreciation of capital and so forth) are higher.
❐ The mark-up is also likely to be higher if taxes such as corporate taxes and VAT are
higher.
However, this leaves unanswered what determines the wage. For that, we need to consider
wage-setting behaviour in the economy in the aggregate.
The wage-setting (WS) relationship
The wage-setting (WS) relationship indicates how, on an aggregate level, nominal wages
are set – or contracted – by workers or worker organisations in their interaction with
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employers/firms. It is assumed that wages are not set in a competitive labour market, but
in a typical modern labour market characterised by collective bargaining, labour unions,
monopolistic and monopsonistic behaviour, minimum wage legislation and so forth.
Such contracts typically determine wages and other employment conditions for one to
three years.
❐ This is quite important, because it can cause fixed nominal wage contracts to be based
on an expected price level (and expected cost of living) that becomes outdated if and
when the actual price level changes unexpectedly due to an economic disturbance.
Unexpected price movements have major implications for the production decisions and
thus supply behaviour of firms, as will be shown in the discussion that follows.
Several factors are relevant to understanding wage-setting behaviour:
❐ The expected price level P e , which is an indicator of the expected cost of living in
the upcoming contract period, is a key determinant of wage-setting behaviour. If
increases in the cost of living are anticipated, workers will want a higher nominal wage
to compensate for the higher price level P (and in effect leave their future real wage
unchanged).
❐ General labour market conditions in terms of the rate of unemployment U are also
relevant. This is a reflection of the aggregate level of employment N relative to the labour
force LF. Lower levels of employment (which imply higher rates of unemployment U)
are likely to cause downward pressure on wages. Lower rates of unemployment are
likely to cause upward pressure on wages.
❐ A third causal factor comprises the various institutional aspects of labour markets,
mostly pertaining to the level and nature of unionisation, government labour institu­
tions and legislation, unemployment and other benefits, and so forth.
Formally, the WS relationship can be formulated as:
W = P e  f(N; Z)
...... (6.2)
where W is the nominal wage and P e is the expected price level, N is the employment level
and Z captures institutional factors in the labour market (to be discussed later).
❐ The employment level N and the unemployment rate U are inversely related, as follows.
The unemployment rate U is defined as the difference between the total labour force
LF and N, the number of the employed, expressed as a fraction of the labour force:
(LF – N)
U = ​ 
LF .​
Equation 6.2 indicates that, for a given expected price level, a higher employment level N
causes a higher nominal wage W:
❐ For a given labour force, a higher level of employment N will mean a lower rate of
unemployment. A higher level of employment will reduce rivalry among the unemployed
(i.e. workers become more scarce and their bargaining power is strengthened), and thus
put upward pressure on the wage level. Therefore, higher levels of employment are
associated with higher levels of the nominal wage W. There is a positive relationship
between N and W.
❐ Conversely, the higher the unemployment rate U, the lower is the employment level and
thus the number of people employed. More of the unemployed are competing for the
number of available job vacancies and their bargaining power is weaker. This will put
downward pressure on wages. Again, there is a positive relationship between N and W.
❐ If the labour force LF as such grows, this will also put downward pressure on wages.
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As far as the institutional factors in the labour market (indicated by Z) are concerned, one
can note the following:
1. Labour unions: In many labour markets there are labour unions that negotiate on
behalf of all or a substantial proportion of the workers. Such workers do not compete
with each other in their negotiations with employers. Rather, they band together
(like a cartel) to negotiate through their labour union. Such a labour union may then
exploit their market power and strong bargaining position to act as a monopolistic
seller of labour services. This is likely to cause the wage to be higher than it would be
in the absence of the unions (i.e. in a more competitive labour market).
❐ Of course, although employers may have to pay the higher wages, they may decide
to employ fewer workers.
2. Employer organisations: Employers in an industry can band together in an industry
association or employer’s organisation to be the sole buyer of labour services. (A sole
buyer is called a monopsonist.) The market power and strong bargaining position of
employers may result in workers being paid a lower wage than it would have been in a
more competitive market. If there are organised unions it implies bargaining between
two powerful organisations.
3. Efficiency wages: Efficiency wages are wages that are higher than the wages that
would otherwise be paid in a competitive labour market. Employers may choose to
pay such a premium in order to elicit higher levels of efficiency and productivity
from workers. Although this increases the unit cost of labour, the higher output
per worker implies that fewer workers are required.
4. Unemployment and other benefits: Many governments pay unemployment benefits and
other benefits such as disability grants. These could serve as a disincentive to seek
employment, since the unemployed will not accept employment at a wage below the
monthly unemployment benefit they could receive from government. Thus the benefit
implies a floor below which the wage cannot go. Higher unemployment benefits imply
a higher wage floor (and that more people may choose to remain unemployed or
outside the labour force).
❐ Social security and income grants may have similar disincentive effects. In addition,
both employees and employers may have to contribute to the fiscus or to social
security funds to finance these benefits, thereby increasing the effective cost per
worker.
5. Minimum wage legislation: Labour legislation may stipulate a minimum wage, some­
times for specific sectors. This wage may be higher than the wage rate would have
been in the absence of the labour legislation, thereby increasing the effective cost per
worker. It could also reduce the number of people employed by employers.
Generally, the nominal wage W will be set higher the larger the effect of unionisation, the
smaller the effect of employer organisations, the more prevalent the payment of efficiency
wages, the higher the level of unemployment benefits, and the higher the minimum wage.
While the combined effect of these institutional factors can be quite complex, they all
impact – together with the unemployment situation and the expected price level – on the
nominal wage that will be set for those employed.
Diagrammatical depictions of the price-setting and wage-setting relationships
To show these two relationships on one diagram requires some manipulation of the
equations (without changing their real meaning). Equation 6.2 can be rearranged as
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W
e
equation 6.3, which shows the expected real wage, ​ 
P ​ (because P is the ‘expected’ price
level) as a function of employment N and the institutional factors Z:
e
W
__
​  P ​= f(N; Z)
e
...... (6.3)
[Indirect WS relationship]
Figure 6.5 is a diagrammatical representa­ Figure 6.5 The wage-setting and labour supply curves
tion of equation 6.3, with the expected real
​
​  W

WS
wage on the y-axis and employment on
P
the x-axis. Given the positive relationship
between N and W discussed above, the WS
curve will have a positive slope.
❐ It must be understood that wage
negotiations and wage setting occur
LS once a
nominal wage
in terms of a nominal wage, not the
has been set
implied real wage. However, whether or
not workers explicitly factor in their cost
of living or expected changes in the cost
of living, in effect an expected real wage
is being set – and an actual real wage
N
will be determined as P is established by
price setting in the future.
❐ WS as written in equation 6.3 can be viewed as analogous to a labour supply
relationship, but one must remember that the context of the WS relationship is one of
wage setting through collective bargaining by workers and unions and not ‘competitive’
or ‘atomistic’ labour markets that clear, as usually assumed in labour supply theory.
❐ In addition, since wages are not determined by supply and demand continually and
recurrently, once the nominal wage has been contractually set, the WS relationship
becomes dormant until the next round of wage bargaining. The wage-setting
relationship thus is ‘active’ only at the time of bargaining and wage setting, since it
captures the underlying desired wage-and-work pattern of workers.
❐ The set nominal wage W becomes the price of employable labour for the duration of the
contract period, e.g. one to three years.
❐ This implies that the post-bargain­ing labour supply curve (LS) effectively is horizontal at the
level of the contracted implied real wage. (We will return to the LS curve when we analyse
the labour market and aggregate supply in the short run in section 6.3.3 below.)
Earlier we noted that the volume of output supplied by producers depends on the
relationship between the prices that they can charge and their cost of production,
especially labour costs. To see how price setting relates to wage setting, we need to relate
equations 6.1 and 6.3. We rewrite equation 6.1 so that its left-hand variable is similar
to the left-hand side of equation 6.3:
W
1
__
​ 1 + μ ​Q(N)
​  P ​= ____
...... (6.4)
[Indirect PS relationship]
Although equation 6.4 has the real wage on its left-hand side, it is just an indirect form of
the price-setting (PS) relationship – it still captures price-setting behaviour by firms. For
a specific nominal wage W there is a price P derived as a mark-up over the nominal wage
W
cost W (see equation 6.1). Every W implies a matching P and thus a real wage ​ 
P ​that firms
in effect are willing to pay as a function of labour productivity Q and the mark-up μ.
❐ Thus, PS as written in equation 6.4 can be viewed as analogous to a demand for
labour relationship, but always remembering that the PS relationship reflects pricesetting behaviour of firms in non-competitive market structures (rather than atomistic,
6.3 Aggregate supply (AS)
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competitive product markets where firms are price takers, as is usually assumed in
labour demand theory).3
W Figure 6.6 The price-setting curve
Equation 6.4 shows that the real wage ​ 
P​
that firms in effect are willing to pay (given
​
​  W

P
their chosen price-setting behaviour) will be
lower, the higher the mark-up and the lower
average labour productivity Q. Because the
marginal productivity of labour de­
creases
as a factory employs additional labour, Q is
inversely related to the levels of employment
N. Thus higher levels of employment N will
be associated with lower levels of the implied
W
real wage ​ 
P ​that firms are willing to pay (i.e.
as implied by the prices P set by firms).
PS
When depicting the price-set­ting relationship
diagrammatically as a set of combinations of
the real wage and employ­ment, as is done in
figure 6.6, the PS curve will have a negative slope.
N
Note that the faster the marginal product of labour de­clines, the faster Q (the average
product of labour) in equation 6.1 will decline and the steeper the PS curve will be. If the
mar­ginal productivity of labour does not decline as output grows, Q will remain constant
and the PS curve will be horizontal, its position (i.e. how high above the horizontal axis it
is drawn) depending on the nominal wage W and the mark-up.
Equilibrium and the determination of wage and employment levels
Having derived both the PS and WS curves, we can now put them on the same diagram,
which is done in figure 6.7. It then seems simple to say that, graphically, the equilibrium
W
levels of the real wage ​ 
P ​and employment N are determined by the intersection of the PS
and WS curves.
Equilibrium implies that the real wage
implicitly desired by workers during nominal
wage setting must be equal to the real wage
that firms are willing to pay (implied by the
price setting of firms). The equilibrium can be
derived by setting PS = WS using equations
6.3 and 6.4. This produces the following:
W
W __
​ __
P ​ = ​  P e ​
...... (6.5)
This equation is not very revealing, though.
At this stage it becomes necessary to dis­
tinguish between the labour market situation
and the resultant aggregate supply in the
long run and in the short run.
3
256
Figure 6.7 Equilibrium in the labour market
W
​  P ​

WS
W0
​  P ​

0
PS
N0
N
It can be shown that the WS curve lies above the competitive market labour supply curve, and the PS curve below the
competitive market labour demand curve. The PS-WS equilibrium level of N will be below that of a competitive market
model.
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6.3.2
The labour market and aggregate supply in the long run (ASLR)
Having defined the long run as a state when sufficient time has elapsed for any mistaken
price expectation to have corrected itself so that expected prices are the same as actual
prices, we assume now that P = P e. From equations 6.3 and 6.4:
W W
__
​  P ​ = ​ __
P e​
or
1
______
​ (1 + μ) ​Q(N) = f(N; Z)
The equilibrium can be under­
stood as follows. Recall that
A formula for the PS-WS equilibrium
equilibrium implies that the real
Instead of equation 6.5 one can insert
wage, implic­itly desired by work­
equation 6.2 into equation 6.1:
ers during wage setting, must be
P e · (1 + μ) · f(N; Z)
equal to the willingly-paid real
​
​
...... (6.6)
P = _____________
Q
wage im­plied by the price set­
This equation describes the equilibrium between PS
ting of firms. Because workers
and WS (for a given nominal wage W). We will return
in effect set their labour supply
to it below.
on the basis of their expect­ed
real wage, when the actual real
wage equals the expected real wage (as is as­sumed now), workers sup­ply the amount of
labour services that they want to supply in exchange for the real wage that they expected.
Likewise, firms supply their chosen output level at their preferred price level, given the
nominal wage previously contracted with workers.
❐ Therefore, excluding mistakes in price and wage expectations for the moment, no party
will desire to adjust its supply of goods or of labour services. Therefore, the actual real
wage will equal the expected real wage and both employers and workers will be satisfied
with their position. There can be said to be an equilibrium.
π
As long as the underlying fac­
tors that determine the position
A formula for the long-run equilibrium
of the price-setting and wageWith P = P e equation 6.6 becomes:
setting relationships remain
P  (1  μ)  f(N; Z)
unchanged (and as long as the
P = _____________
​
​
Q
actual price equals the expected
or
(1  μ)  f(N; Z)
price), labour supply and em­
​
​
...... (6.7)
1 = ___________
Q
ployment – and thus output
If a formula is specified for f(N,Z) the equation can be
– will remain at the levels de­
solved for N, the long-run equilibrium level of output,
fined by the equilibrium of the
as a function of Q, μ and Z.
price-setting and wage-setting
❐ An important insight is that the long-run equilibrium
relationships. Graphically, the
level of output is independent of the price level P. We
location of this equilibrium is
will return to equation 6.7.
where PS intersects WS.
❐ The concept and existence of
a long-run equilibrium in the
labour market does not imply that there is full employment, nor that there is no invol­
untary unemployment, at the long-run equilibrium. This is explained further in the
box on employment concepts below.
π
Note that many of the factors underlying the price-setting and wage-setting relationships,
and thus the positions of the PS and WS curves, are of a structural nature and, therefore,
usually change very slowly over time. Labour market institutional factors such as unions or
labour legislation or unemployment benefits do not frequently change materially. Product
market structure and the power of firms to set mark-ups and prices also change slowly.
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Thus, the equilibrium defined by the intersection of PS and WS can be defined as a longrun equilibrium whose location is largely determined by structural characteristics of the
economy. This equilibrium can also be denoted as a structural equilibrium (in contrast to a
cyclical equilibrium). The employment level of the structural equilibrium can be indicated
as NS and the corresponding output level as YS.
Nevertheless, the position of the long-run or structural equilibrium is not permanent or
invariable, and shifts in the PS and WS curves can occur should any of the factors that
determine the position of these curves change (also see section 6.4). Some of these shifts
can occur less frequently or slower than others (see below).
A shift of the PS curve: Equation 6.4 shows that an increase in the mark-up μ will cause the
W
price level to increase which, in turn, will cause the real wage ​ 
P ​that producers in effect
are willing to pay at any employ­ment level (i.e. at a given nomi­nal wage) to de­crease.
As figure 6.8 demonstrates, the PS curve will Figure 6.8 A shift in the PS curve
shift down­wards and a new ‘long-run’ or
​
​  W

struc­tural equilibrium will be estab­lished at a
P
WS
lower real wage and a lower level of employ­
ment NS1. (Similar reasoning applies to a
decrease in the mark-up.)
W
​  P ​

❐ An increase in taxes and non-labour input
costs may cause the mark-up to increase,
W
​  P ​
leading to a new ‘long-run’ equilibrium 
PS0
at a lower real wage and a lower level of
employment NS. Supply shocks such as an
oil price shock are important examples of
such negative impacts on the structural
PS1
equilib­rium level of employment (as seen
NS1 NS0
N
in a downward shift in the PS curve due to
a compensatory increase in the mark-up).
❐ An increase in economic concentration and the degree of product market power in the
economy may thus cause the mark-up to increase; hence real wages and the structural
equilibrium employment level NS will be at lower levels. While the mark-up in the first
instance needs to be large enough to cover the costs of non-labour inputs and taxes, the
extent to which a producer can pass on an increase in input costs to its clients depends
on its market power.
❐ An increase in import competition can also affect the structural equilibrium. If high
levels of economic concentration or monopolism characterise a relatively closed
economy, opening up the economy to foreign competition means that domestic
businesses may lose market power. The loss of market power may cause them to reduce
their mark-up and thus their prices, leading to the structural equilibrium being at a
higher real wage and employment level NS.
0
0
0
1
Likewise an increase, for example, in labour productivity implies a decrease in labour cost
per unit of output, enabling firms to reduce the price level P at every level of employment.
This amounts to an increase in the implied real wage at every level of employment. PS
shifts up. The structural equilibrium level of employment NS will be at a higher point.
In contrast, a drop in worker productivity will shift the PS curve down; the structural
equilibrium level of employment NS will be at a lower point.
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❐ Labour productivity, in turn, depends for example on the capital goods available to
workers, levels of technology and the skills levels of workers. An increase in capital
stock K (due to private sector or government real investment), or an improvement in
technology, or improved skill levels would all shift the PS curve up and yield a higher
structural equilibrium level of employment NS. (This is a longer-term effect, especially
relevant in the context of economic growth; see chapter 12.)
A shift of the WS curve: The WS curve will shift if any of the institutional factors that affect
its position change. The power of labour unions and employer organisations, the payment
of efficiency wages, and unemployment and other benefits may all influence the nominal
(and implied real) wage level that workers are willing to work for.
❐ When union power or the unemployment Figure 6.9 A shift in the WS curve
benefits that government pays increase,
WS1
there will be upward pressure on the real
​
​  W

P
expected wage that work­ers are willing
to work for. There will also be upward
WS0
pressure on the expected real wage if
businesses be­come willing to pay a higher
​( 
​  W ​  )​1
P
effi­ciency premium to workers, or if the
W ​  ​
​( ​ 
ability of employer organisa­tions to depress
P )0
wages diminishes. In the diagram this will
shift the WS curve vertically upwards, as
in figure 6.9. This change will cause the
equilibrium real wage to be at a higher
PS
level, while the long-run (or structural)
equilibrium level of employment NS will be
NS1 NS0
N
at a lower level than before.
❐ Note that structural market character­
istics that constrain competition either
Staggered contracts?
between firms in the goods market or
between workers in the labour market
In reality it is not the case that all contracts
tend to lower the long-run equilibrium
are si­multaneously revised every year
(or every three years). Such negotiations
level of employment NS.
It is important to note that the existence of
labour contracts that fix nominal wages for
a period of one to three years implies that
the WS curve can shift only at the time of
new wage bargaining. (Recall that the WS
curve is activated only at the time of wage
bargaining; once the nominal wage is set
the curve becomes dormant until the next
round of wage bargaining.)
❐ This means the WS curve is institution­
ally rigid. Thus changes in the location of
the long-run equilibrium due to changes
in the under­lying determinants of the
wage-setting rela­tionship will be slow.
occur in any month throughout the year,
for the next year or more. Cer­tain months
may see a higher frequency of contract
renegotiations than others, so the spread
of renego­tiations is not even.
❐ Nevertheless, staggered contracts
mean that instead of jumping every
year with a big amount, the LS (and
WS) moves every month with a
fraction of where it needs to go.
❐ In the analysis, however, we will
assume one move per period and
not, say, 12 small moves spread
across a period.
6.3 Aggregate supply (AS)
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❐ Recall that this also im­plies that the effective labour supply curve post-bargaining –
indi­cated as LS – is hori­z ontal. We will return to this when we consider the labour
market and aggregate supply in the short run (section 6.3.3).
If the labour force (LF) increases due to an increase in the labour force participation rate or
through normal population growth, the additional workers will put downward pressure
on wages, creating an incentive for producers to employ more workers. WS shifts down
and the equilibrium output level YS would be at a higher level.
Structural unemployment, the ‘natural’ unemployment rate and types of unemployment
Earlier in this chapter the long-run equilibrium was also denoted as a structural equilibrium with a
corresponding structural unemployment rate (SRU). It is important to realise that, at this ‘long run’ or
structural employment level, there may still be substantial involuntary unemployment. Employment may
still be below what would amount to genuine ‘full’ employment.
Types of unemployment
Four different types of unemployment can be distinguished:
1. Seasonal unemployment occurs due to seasonal patterns of increased or decreased activity in certain
sectors of the economy, for instance the building industry or the agricultural sector. This is not of great
importance and is often ignored from a macroeconomic perspective.
2. Frictional (or search) unemployment – which is always present – exists because there is always a certain
number of people who are in the process of searching for new jobs or busy changing jobs or careers. The
extent of this type of unemployment is relatively limited and it is not really a macroeconomic problem.
3. Cyclical unemployment exists because of short-run cyclical downswings in the level of macroeconomic
activity Y: as the level of Y fluctuates, so employment fluctuates. Usually this kind of unemployment
is the main focus of macroeconomic theory and policy. We will return to this below when combining
aggregate demand AD and aggregate supply AS.
4. Structural unemployment is especially important in the South African context. It refers to a form of
unemployment that occurs regardless of the cyclical state of the economy. This type of unemployment
can be of substantial proportions and is the most problematic, being very difficult to address with normal
macroeconomic policy instruments (see section 12.2.3 in chapter 12 for further analysis).
❐ Structural unemployment is involuntary unemployment and arises, first, from the nature, location and
pattern of employment opportunities (i.e. the demand side of the labour market). The types of product
that are selected for production and the production technology that is used to determine what kinds of,
and how much, labour can be employed. Technology largely determines the employment intensity of the
production process; most new production technologies are labour-saving. Another factor is mismatches
between the (increasing) skills requirements of jobs and the skills of workers.
❐ On the supply side of the labour market, many job seekers face a variety of constraints and entry barriers
with regard to entering labour markets. These include weak education backgrounds, low skill levels,
limited information on job opportunities, long distances from urban labour markets, being marginalised,
disempowered and trapped in poverty.
❐ Entry barriers are related to market segmentation. The South African labour market is not a single market
– in effect it comprises several submarkets. Labour mobility between these market segments is often
limited. An example is the informal and formal sectors – small numbers of workers succeed in entering
the formal sector from the informal sectors. Entry barriers also apply to (especially informal) small, labourintensive businesses wishing to enter markets that are dominated by large corporations.
❐ More generally, structural unemployment can be ascribed to structural rigidities, entry barriers,
distortions and imperfections in markets and in the manner in which the economy is organised.
Institutional factors and economic power relations play an important role.
❐ Given a certain pattern of production and employment, the labour market can absorb only a portion
of the labour force. The rest is excluded from the operation (and advantages) of the market.
260
⇒
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⇒
The existence of structural employment effectively implies an intrinsic ceiling on employment in the normal
labour market, given the structure of the economy at a certain stage. Despite being considerably below full
employment in South Africa, this level of employment is the maximum that the normal interaction of producers
and other decision-makers can deliver in input and labour markets, amidst short-run or cyclical fluctuations.
❐ The structurally unemployed thus remain without jobs ‘in the long run’, being more or less excluded
from the labour market proper.
❐ Cyclical fluctuations in production and employment occur around this level of employment and
production, denoted as YS . Upswings can push the economy above YS for considerable periods of
time, but not permanently. In downswings, real income Y will fall below YS.
The structural rate of unemployment (SRU) is the level of unemployment corresponding to YS. The
levels of genuinely full employment (FE) and structural equilibrium employment (at YS ) can be indicated
graphically in terms of real GDP or Y as in the following diagram – where FE only allows for those that are
frictionally unemployed.
At YS , which reflects the intersection of PS and WS, there is equilibrium employment in the labour
market. But the important point is that it is accompanied by structural unemployment – without any
downward (or upward) pressure on wages in the market. Labour markets are ‘saturated’ at YS.
❐ Below YS there is cyclical unemployment in the labour
P
ASLR
market, leading to downward pressure on wages.
❐ Above YS cyclical ‘over’-employment occurs, which is
Area of cyclical
Area of
likely to imply upward pressure on wages. The latter
unemployment
cyclical ‘over’may happen amidst and despite the existence of
employment
Downward
substantial structural unemploy­ment.
Such upward (or downward) pressure on wages and input
prices in short-run positions above or below YS is important
when the short-run supply curve ASSR is considered in
relation to YS (section 6.3.3).
❐ One must also remember that the position of ASLR and YS
can vary over time.
Full employment and the natural rate of
unemployment (NRU)
pressure on
wages
Structural
unemployment
ever present
Structural
equilibrium
Upward
pressure on
wages
Structural
unemployment
still present
YS
YFE Y
In much economic literature, the long-run unemployment rate is called the natural unemployment rate
(NRU). The use of the word ‘natural’ derives from the idea that NRU is a level of unemploy­ment created
by the natural forces of supply and demand in the labour market. It usually also im­plies the NRU
corresponds to a situation of ‘full’ employment in which there is no involuntary unem­ployment. Those
who are unemployed would be voluntarily so, choosing not to be part of the labour force at that moment.
The only unemployment would be frictional or seasonal.
Our analysis of the labour market, and the derivation of the PS and WS curves, explicitly incorpo­rated
non-competitive labour and product markets, characterised by market power, price and wage setting,
monopolies, monopsonies and so forth. This was done to recognise the reality of labour and product
markets in most countries, including South Africa.
The NRU approach usually assumes competitive market structures where the forces of supply and
demand can freely interact, clear the market, and produce competitive equilibria with, for labour markets,
no involuntary unemployment. This approach excludes recognition that structural factors in the economy
can preclude the ‘natural’ or automatic attainment of full employment and can cause workers to be
involuntarily unemployed for long periods, despite being willing and eager to work.
❐ Some theoreticians who adopt the NRU approach would argue that the economy returns to
long-run equilibrium so quickly and efficiently that even cyclical unemployment can be ignored
macroeconomically.
⇒
6.3 Aggregate supply (AS)
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⇒
To use the term ‘full employment’, as some textbooks do, to characterise equilibrium in the
labour market, is clearly misleading as well, since it suggest the absence of an unemployment
problem – which is not true at the long-run equilibrium at all. At the latter equilibrium the full
extent of structural unemployment is still present.
Thus it is more suitable to use the term structural rate of unemployment (SRU) to reflect the
true nature of the long-run (or structural) equilibrium in the labour market. In any case, in a
country such as South Africa where the official unemployment rate is close to 25% (and the
unemployment rate according to the expanded definition close to 35%), calling the long-term
unemployment rate natural is a bit misplaced.
Relating PS, WS and total production
The aggregate output produced by the number of workers employed in the ‘long-run’
equilibrium – graphically indicated by the intersection of the price-setting and wagesetting relationships – represents the total amount of goods that producers in the economy
can supply in the ‘long run’ (i.e. amidst short-run fluctuations and mistaken expectations).
This level of output represents the long-run aggregate supply of the economy (where longrun has the very specific meaning defined in the preceding discussion).
The relationship between the level of employment and the level of aggregate output can
be depicted by the total production function for the economy. Total production is a function
of the quantity of labour employed N, capital K and technology A. A basic production
function would look as follows:
Y = f(N; K; A)
A more sophisticated production function would also include human capital as well as
social and economic institutions. We will do this when we consider economic growth in
chapter 8.
The total production function – the TP curve in figure 6.10 – shows, for a given amount of
capital (i.e. keeping capital K constant), the relationship between the level of employment
N (on the x-axis) and the level of aggregate output Y (on the y-axis).
Since the employment of more workers will lead to an increase in output, the TP curve
has a positive slope. If capital usage increases, the TP curve rotates upwards: compared
to the original TP curve, the same number
of workers can now produce more output. Figure 6.10 The total production curve
Changes in the usage of new technology will
Y
TP
also rotate the TP curve correspondingly.
❐ In a very simple case the production function
can be assumed to be linear, e.g. Y = N
Y2
(meaning that if one additional unit of labour
Y1
is employed, one additional unit of output
will be produced). While ac­ceptable for some
Y0
simple mathematical manipulations (see box
below), this would be too unrealistic.
❐ Note in the diagram (figure 6.10) that,
although TP has a positive slope, the slope
becomes flatter at higher levels of employment:
creases
as employment increases, output in­
N
10 11 12
flects the
but at a decreasing rate. This re­
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decreasing marginal produc­tivity of labour (an economic phenome­non which also explained
the negative slope of the PS curve). As em­ployment increases, every extra worker added will
produce less additional output than the previous worker added.
❐ This is illustrated in figure 6.10 where the additional output (from Y1 to Y2) produced
by the 12th worker is less than the additional output (from Y0 to Y1) produced by the
11th worker.
❐ Because the effect of decreasing marginal productivity of labour becomes more
pronounced as output reaches higher levels, at some point the TP curve flattens out
and reaches a maximum. It means that even if more workers are employed, aggregate
output will not increase (for a given capital stock).
Deriving long-run aggregate supply ASLR
At the beginning of this section we stated that aggregate supply in the long run, as defined,
indicates combinations of P and Y in a situation where actual prices and wages equal
expected prices and wages.
To determine graphically what total level of output firms will supply in the long run, the
long-run equilibrium level of employment NS established by the PS and WS relationships
(bottom, left-hand panel of figure 6.11) is extended to the top left-hand panel of figure 6.11.
The level of output that corresponds, on the TP curve, to that long-run level of employment,
Figure 6.11 Deriving the ASLR curve
Y
Y
TP
45° line
YS
NS
N
YS
P
W
​  P ​

WS
W0
​  P ​

Y
ASLR
P0
0
PS
NS
N
YS
6.3 Aggregate supply (AS)
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Y
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is the level of output YS that
producers in the aggregate are
able and willing to supply ‘in the
long run’.
π
The formula for ASLR
The formula for the ASLR relationship can be derived
from equation 6.8, which describes the long-run
equilibrium intersection of PS and WS:
This output level YS can also be
shown on the P-Y plane, which
is the bottom right-hand panel
of figure 6.11. Note that in this
panel total output Y is measured
on the horizontal axis. (This
switch of axis is made possible
by the mirror graph with its 45°
line in the top right-hand panel of
figure 6.11.)
(1 + μ)  f(N; Z)
​
​
1 = ___________
Q
...... (6.8)
To translate this equilibrium level of employment N
into aggregate output (for a given capital stock), we
need the production function. To simplify matters,
assume for the moment that the production function
is a simple linear function Y = N. Then equation 6.8
becomes:
(1 + μ)  f(Y; Z)
​
​
1 = ___________
Q
..... (6.9)
The bottom, right-hand panel of
This equation describes the ASLR curve. If an equation
figure 6.11 finally shows ‘longis specified for f(N, Z) and for the production function
Y = f(N, K, A), the ASLR equation can be solved for Y
run’ aggregate supply ASLR.
so that Y is expressed as a function of Q, μ, Z factors,
❐ Note that graphically ASLR
N, K and A factors.
is a vertical line, indicating
❐ Since P does not appear in this equation, ASLR is a
that output in the ‘long run’
vertical line in the P-Y plane.
is inde­pendent of the price
level P.
❐ This might seem surpris­ing,
given the role that the price level plays in the PS and WS relation­ships. However, since
the long-run PS-WS equilib­rium is defined in real terms, changes in the price level do not
af­fect the equilibrium. (Also see the graphical inter­pretation of equa­tion 6.8 in the box.)
Shifts in the ASLR curve
As noted before, the position of the ASLR curve is not constant or permanent. Changes in
the ‘structural’ and other factors identified above that underlie the position of the PS and
WS curves will influence the position of the ASLR curve.
❐ The diagrammatical position of ASLR, like the ‘long-run’ or structural level of aggregate
output, is variable over time.
❐ Any factor that reduces the equilibrium level of output in the PS-WS diagram will be
reflected as a leftward shift of the ASLR curve, and conversely for a rightward shift. (Also
see the AD-AS discussion in section 6.4.1.)
❐ Changes from the price-setting side can change the position of the ASLR curve at any
time, while changes from the wage-setting side occur only at wage bargaining time (i.e.
the reason for the rigidity of the WS curve).
Example: changes from the price-setting side and PS
A change in labour productivity Q, e.g. an increase in labour productivity, firstly causes
the PS curve in figure 6.12 to shift upwards from PS0 to PS1. A new equilibrium is estab­
WS0. It is a characteristic of the new equilibrium
that
lished at the intersection of PS1 and
W
W
​ P ​). Likewise,
its real wage would be higher (at 
​ P ​) than that of the initial equilibrium (i.e. 
its long-run employment level would be at the higher level of NS1 compared to NS0 initially.
Secondly, the increased labour productivity rotates the TP curve upwards from TP0 to TP1.
1
0
264
0
0
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Figure 6.12 Shifts in the ASLR curve
TP1
Y
45° line
Y
TP0
YS1
YS0
NS0
NS1
N
YS0
YS1
Y
P
​  W
​

P
ASLR0
ASLR1
WS0
W1
​  P ​

P0
0
W
0
​ 
​
P
PS1
0
PS0
NS0
NS1
N
YS0
YS1
Y
Transferring this to the P-Y plane shows that ASLR shifts to the right from ASLR0 to ASLR1.
Thus the new structural equilibrium output level would be at YS1, which is higher than the
initial YS0.
❐ An increase in the capital stock K (due to private sector or government real investment),
or an improvement in technology (due to investment in research and development),
or improved skills levels (e.g. due to better education and training) would all improve
labour productivity over time. This yields a higher structural equilibrium level of
employment NS. Graphically, ASLR would shift to the right. (Bear in mind that some of
the changes can take some time to effect.)
Changes in the mark-up: As deduced earlier, an increase in the mark-up will shift the PS
W
curve downwards – the higher price level will decrease the real wage ​ 
P ​at every level of
employment – which results in a drop in the structural employment level. ASLR shifts to the
left, i.e. the structural equilibrium output YS would be at a lower level. (Note: In this case
TP does not rotate or shift.)
❐ This is an important case, since it is also the avenue through which changes in nonlabour input costs will impact on the structural equilibrium and on the position of
ASLR. A supply shock such as a large change in the oil price will push the structural
equilibrium point left, i.e. to a point with a lower output level YS than before the shock.
Graphically, ASLR will shift to the left.
❐ Increases in monopoly power that increase the mark-up will shift ASLR to the left.
6.3 Aggregate supply (AS)
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Example: changes from the wage-setting side and WS
Increases in union power or the unemployment benefits that government pays will put
upward pressure on the real expected wage that workers are willing to work for. Graphically,
the WS curve shifts vertically upwards, reducing the long-run or structural equilibrium
level of employment NS and thus output YS . This means ASLR shifts to the left.
A similar shift in ASLR will result if firms become willing to pay a higher efficiency wage
premium to workers, or if the ability of employer organisations to depress wages diminishes.
However, due to the rigidity of the WS curve for the duration of labour contract periods,
these shifts – or ‘jumps’, rather – can only occur infrequently.
If the labour force increases through normal population growth or due to an increase in
the labour force participation rate, the additional workers will put downward pressure
on wages (when wages are renegotiated), creating an incentive for producers to employ
more workers. WS will then shift down and the equilibrium output level YS will be at
progressively higher levels.
❐ A scourge such as HIV/Aids can dramatically reduce the life expectancy of the popula­
tion and decrease population growth or even shrink the labour force over time. This
would inhibit any rightward shift of YS to higher levels of equilibrium output.
Long-term economic growth and investment
In most countries the level of technology continuously improves in the long run, while the population and
thus the labour force also continually expand; capital stock also grows due to investment (capital formation).
Such continual improvements in productive capacity will be discussed in section 6.4.4, as well as in
chapter 8 on long-term economic growth. A continually growing labour force and capital stock, as well as
continually improving technology, implies that the ASLR curve will steadily shift to the right.
Such improvements in the factors of production depend to a large extent on real investment. One can
distinguish between (a) private sector real investment in, for example, factories and new machinery
and equipment, and (b) government real investment (capital formation) in infrastructure, education and
training facilities, health facilities, etc. (To the private sector in this context can also be added public
corporations and government enterprises; see chapter 2.) Another important form of investment is
investment in research and development (R&D), which produces new technology.
Government expenditure and shifts of ASLR
When analysing the macroeconomic impact of government spending G, one must distinguish between
government consumption expenditure GC and government capital formation IG.
GC impacts primarily on AD, while IG impacts on both AD (in the short run) and ASLR (in the medium to long
run). It can even be argued (see chapter 8, section 8.10), that a significant portion of GC goes towards the
provision of education and health services, which build human capacity and thus human capital – a key
element in generating economic growth and economic development. In an HIV- and Aids-affected society,
health spending can be particularly important. Thus GC partially could also impact on ASLR in the medium to
long run – an important point regarding the relationship between macroeconomic and development policy.
6.3.3
The labour market and aggregate supply in the short run (ASSR )
An important element of understanding the determination of the price and output
levels, and notably cyclical fluctuations and changes in these variables, is the behaviour
of aggregate supply in the short run. This section demonstrates that, in the short run,
producers can willingly deviate from the long-run output level.
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Deriving the short-run aggregate supply curve ASSR
Like the ASLR curve, the ASSR curve shows, for each price level P, the aggregate level
of real output that producers are willing or able to supply. The difference between the
relationships is that in the short run producers can and probably will supply more (or
less) than the long-run equilibrium level of output if actual prices and wages for a certain
period allow for higher (or lower) profits, since such higher (or lower) profits create an
incentive to supply more (or less). Such opportunities occur when the actual prices (and
thus actual real wages), set by producers, deviate from expected prices (and thus expected
real wages) due to some economic factor or disturbance.
❐ The corresponding deviations in output from YS yield aggregate supply in the short run.
Recall that, in the long-run equilibrium, the actual price P equals the expected price P e,
W
W
and the actual real wage 
​ P ​equals the expected real wage ​ 
P ​. But how will producers and
workers behave when the labour market is not in this long-run equilibrium, i.e. when P
W
W
​ P ​? Figure 6.13, and specifically the PS
does not equal Pe, and ​ 
P ​therefore does not equal 
curve, together with the LS curve, help to answer that question.
e
e
Figure 6.13 Deriving the ASSR curve
Y
45° line
Y
TP
Y1
YS
NS
N1
N
P
W
​  P ​

WS when
nominal
wage was
set at W0
W0
​  P ​

0
​  P ​

Y1
ASLR
Y
ASSR
P1
LS0
W0
YS
P0
LS1
1
PS
NS
N1
N
YS
Y1
6.3 Aggregate supply (AS)
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Y
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W0
In figure 6.13 the actual wage and expected real wage are initially equal at ​ 
P ​, with
W0 having been set contractually through the interaction of WS and PS behaviour.
Employment is at the long-run equilibrium level NS, long-run output is at YS, and actual
price P equals the expected price P e at P0.
0
W0
At a price that is higher than P e (= P0), say P1, the actual real wage will be lower at 
​ P .​
The ‘post-bargaining’ labour supply curve will in effect shift down from LS0 to LS1. At the
lower real wage, employers will, on the PS curve, be willing to employ more workers N1
and produce higher output Y1. On the price-output schedule (bottom right-hand panel of
figure 6.13), the combination of price P1 and output Y1 lies to the right and above the longrun equilibrium combination of P0 and YS. Firms will be willing to employ more workers
to produce more because, at the contracted wage of W0, a higher price implies a higher
mark-up, and thus higher profit.
1
Likewise (not shown in the dia­gram), at a price lower than P e (= P0), say P2, employment
will be N2. N2 workers will produce output Y2. The combination of price P2 and output Y2
can again be plotted on the price-output schedule, which indicates that this combination
lies to the left and below the equilibrium combination of P0 and YS.
This exercise can be re­peated for any price be­low or above the price that equals the expected
price. If the co­ordinates are then connected, the resulting curve is the short-run AS curve.
It is derived in the bottom right-hand panel of fig­ure 6.13. It shows, for each price level,
the level of output Y that produc­ers are willing to supply in the ‘short run’ – if, when and
as long as the price level deviates from the expected price level, i.e. as long as the price
expec­tation is incorrect or is lagging be­hind due to rigidity.
The ASSR curve shows the pattern of supply be­hav­iour that results when firms willingly
deviate from the long-run level of output as a result of profit opportu­nities due to unan­
ticipated increases in the price level coupled with wages being con­tractu­ally fixed for a
pe­riod – wages are rigid for a period of time. (A corresponding explanation applies to un­
anticipated declines of the price level.) Any ASSR curve is thus drawn for a given nominal
wage and expected price.
What is the probable slope and shape of the ASSR curve?
The slope of the ASSR curve is positive: an increase in output is caused by an opportunity
for producers, the price setters, to increase the price level above its ‘long-run’ position
(at which point it equalled the expected price Figure 6.14 The shape of the ASSR curve
level), and to increase output to realise new
P
profit opportunities. Likewise, a drop in the
price level leads to a drop in output.
The shape of the ASSR curve is explained
graphically by the shape of the TP curve in
figure 6.14. The shape of the ASSR curve is a
perfect mirror image of the curvature of the
total production (TP) curve. Both reflect the
decreasing marginal productivity of labour.
As production is increased, the average out­
put per worker decreases, while the nominal
wage remains the same (by contract). Thus
the labour cost per unit of output (i.e. the total
268
Bottleneck
area
ASSR
Y
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π
The formula for ASSR
The formula for the ASSR relationship can be derived by inserting equation 6.2
into equation 6.1, and inserting a production function. Assuming for simplicity,
as earlier, that Y = N, this produces the following illustrative equation for ASSR:
P e  (1 + μ)  f(Y; Z)
​
​ P = _____________
Q
...... (6.10)
Thus aggregate supply in the short run is positively related to the output level Y, the expected
price level P e and the mark-up μ; for Z it depends on each factor. Via the production function,
it is also related to capital stock K and the use of other inputs and technology A. Aggregate
supply in the short run is inversely related to labour productivity Q.
But P ≠ P e is a condition for its existence in the first place.
The intercept of the ASSR curve on the vertical ASLR curve is at the level of Pe. The ASSR curve
will shift up or down if there are changes in the expected price level Pe.
The ASSR curve will shift right or left (in lock-step with the ASLR curve) if there are changes
in the mark-up μ (which includes non-labour input costs and taxes), labour productivity
Q, a Z factor, or in capital stock K, the use of other inputs and technology A, or the labour
force LF.
Remember that the equation above is the same one that we used to derive the long-run AS
curve, except that now P ≠ P e and thus they are not eliminated from the equation. If it is
assumed that P = P e, i.e. that we are in the long run, this equation reduces to the equation for
the ASLR curve (see box in section 6.3.2).
wage bill divided by the units of output) increases as more workers are added. Producers
will be willing to produce more only if the price per unit of output, i.e. the price level P,
increases (and increases by an increasing amount – i.e. the rate at which it increases is itself
increasing). Graphically, ASSR curves become steeper at higher levels of output.
❐ If the production function is assumed to be linear, ASSR will also be linear.
The total production function will ulti­mately flatten out, as noted above, as mar­ginal
productivity converges towards zero. Correspondingly, ASSR ultimately becomes vertical.
Even if prices increase and more workers are employed, output can and will not increase
beyond this level.
❐ The area on the short-run supply curve when it becomes very steep, just before it
reaches its vertical point, is called the bottleneck area. It reflects the increasing dif­
ficulty and even futility of trying to increase output by adding additional labour to a
production process that operates with a fixed amount of capital (machinery, etc.) in
the short run. The economy is reaching short-run full capacity (i.e. unless additional
capital is added).
❐ This vertical portion of ASSR is not on the ASLR curve, nor is it on the YFE line indicated
in the box on page 261. It is somewhere in the middle, between them.
What shifts the ASSR curve?
Analysing shifts in the ASSR curve is relatively complicated. The ASSR curve can shift either
on its own or in lock-step (or in tandem) together with the vertical ASLR curve when the
latter shifts.
6.3 Aggregate supply (AS)
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❐ When the ASSR curve shifts on its
own, its intercept on the vertical
ASLR line changes: it shifts up or
down. In the diagram, for example,
the intercept on the vertical ASLR1
line changes from P0 to P1 (the blue
arrows in figure 6.15).
❐ When ASSR shifts in lock-step
with ASLR the intercept on the
vertical ASLR line does not change
– it remains at P0 in the diagram –
and it shifts right or left (the black
arrows in the diagram).
Figure 6.15 Two types of shift in the ASSR curve
P
ASLR1
ASLR0
Vertical shift
of ASSR alone:
intercept on
ASLR changes
ASSR2
ASSR1
ASSR0
P1
P0
Lock-step
horizontal shift
of both ASSR
and ASLR
An increase in the expected price
Y
P e will shift the ASSR curve up – it
changes the inter­
cept of the ASSR
curve on ASLR. In economic terms, this upward shift is a reflection of a higher nominal
wage being contracted (during a new round of negotiations) to match the increase in the
expected price level. (This is discussed again in the next section.)
❐ This shift thus only occurs if and when such negotia­tions occur.
❐ This is the only case when the ASSR curve shifts on its own.
The other shifts in the ASSR curve are
lock-step changes that occur when
Changes in the nominal wage
ASLR shifts due to its underlying
In the text it is stated that ‘any ASSR curve is
causal factors. Both of these curves
drawn for a given nominal wage’. What does this
thus shift left or right for the same
mean for shifts in the ASSR curve? The nominal
distance due to the same factors.
wage is the vehicle through which the expected
Thus the ASSR curve will shift right or
price manifests itself.
left – together (in lock-step) with the
❐ If it changes due to a change in P e it implies a
ASLR curve – if there are changes in
vertical shift of the ASSR curve.
the mark-up μ (which includes non❐ If it changes for a reason unrelated to
labour input costs and taxes), labour
expected price, e.g. the exercise of labour
union power, it is analysed as a change in
productivity Q, a Z factor, or in capital
that particular causal factor, which implies a
stock K, the use of other inputs and
lock-step shift of ASSR together with ASLR. In
technology A, or the la­bour force LF.
such
cases, an increase in the nominal wage
❐ For example, an in­crease in labour
has the same effect as an increase in the
pro­ductivity shifts ASSR and ASLR to
price of a non-labour input, e.g. oil.
the right in lock-step.
❐ Supply shocks, e.g. a large oil price
in­crease, will shift the ASSR curve to the left in lock-step with the ASLR curve.
As discussed earlier, except for changes in the average price (cost) of non-labour inputs,
most of these shifts in ASSR (and ASLR) are likely to occur relatively infrequently. They are
more of a medium- or long-run nature. This is especially true of those that originate in the
wage-setting context, whose WS curve is rigid.
Adapting expectations and the adaptive nature of the ASSR curve
Shifts in the ASSR curve due to a change in the expected price level Pe explain an important
pattern that usually follows a disturbance that places the economy at a point off the long270
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run or structural equilibrium, i.e. a point off the ASLR curve. (As noted in section 6.1, such
a point can occur due to a change/shift in the aggregate demand (AD) relationship; see
section 6.4.1 for further analysis.)
The key point of this section is that any equilibrium point on ASSR curve that is off the ASLR curve
is unlikely to be sustained for an indefinite period. An adjustment process will kick in that will
push the equilibrium back, over time, to the structural equilibrium output level YS (i.e. to the ASLR
curve). Adjustments in the expected price level P e are central to this process.
Recall that the short-run supply relationship – and the ASSR curve – was explained by
periods when the price level diverged from the expected price level. For example, firms will
willingly increase output beyond the structural equilibrium level of output YS – along the
ASSR curve – as a result of profit opportunities due to unanticipated increases in the price
level (coupled with wages being contractually rigid for a period of, for example, one to
three years).
However, after some time, people’s expectations will catch up with reality – a discrepancy
between the actual price level and the expected price level cannot be maintained in the
longer run. For example, if the actual price level has been higher than the expected price
level at the time of contracting, expectations will gradually adjust and the expected price
will move towards the actual price. Once wage renegotiations occur, real wages will
probably adjust to reflect this, causing an increase in labour costs and thereby eroding any
opportunistic profit opportunity and any incentive to produce more than the structural
output level YS. Output will decline.
❐ Theoretically the process should continue until P = P e and end when output has
returned to the long-run, structural equilibrium level YS. Exactly how, and in how
many phases, the economy moves back to the long-run level will become clear when
we combine aggregate demand and aggregate supply in the next section.
❐ Every output level above or below the long-run output level (and thus every point on
ASSR) is the result of mistaken price expectations or ‘price surprises’ (due to some kind
of economic disturbance). At every point on ASSR (except the price at ASLR) the actual
price either exceeds or falls short of the price expected at the time of contracting. Since
this is unlikely to be sustained over time, levels of output above or below the long-run
level of output cannot be sustained indefinitely.
❐ The only aggregate supply level that is sustainable in the long run – in the sense of
being free of expectations-driven pressure to change – is the level where P = P e, which is
also the output level YS corresponding to the ASLR curve. Only when P = P e will workers
have no reason to want to renegotiate their contracted wage to reflect a changed price
level and cost of living (assuming that the factors underlying the price-setting and
wage-setting relationships remain unchanged).
The fact that points along the ASSR curve are ‘temporary’ or ‘short-run’ in a specific
technical sense does not render them unimportant at all. The corresponding fluctuations
in aggregate output are the essence of the business cycle and one of the main ‘problems’
of macroeconomic analysis and policy. In reality, economic disturbances and related
dynamics (for instance, balance of payments or interest rate adjustments) push the
economy off the long-run ASLR curve most of the time.
❐ Moreover, because changes in price expectations have to be reflected in renegotiated
labour contracts before having an impact on labour costs and the position of the ASSR
curve, the shift in ASSR occurs relatively slowly. As we will see, it is also not completed in
one step, because the renegotiated wages usually do not catch up in one round.
6.3 Aggregate supply (AS)
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6.4
Aggregate supply (ASLR, ASSR) and aggregate demand (AD)
together
6.4.1
Macroeconomic equilibrium in the ‘short’ and ‘long’ run
As noted in the brief overview in section 6.1, and using the analogy of standard micro­
economic theory, the essence of the AD-AS model of explaining, graphically, the state of
the economy is twofold:
❐ First, the actual, ‘month-to-month’, Figure 6.16 AD-AS equilibrium
short-run equilibrium levels of out­
P
ASLR
put and real income Y and the price
level P are determined by the inter­
ASSR
section of the AD and ASSR curves.
❐ Second, the presence of a structural
Structural
equilibrium
equilibrium with its output level YS
(and price level PS) and a vertical PS
Short-run
‘long-run’ or structural ASLR curve P1
equilibrium
exerts a ‘gravita­tional pull’ so that,
if the actual, short-run equilibrium
output level of the econ­omy is not
AD
at YS, the intersection of the AD
and ASSR curves will over time move
YS Y1
YFE
towards ASLR through a dynamic
Y
justments in
process involving ad­
price expectations. Following this process, the intersec­tion of the AD and ASSR is likely
to end up exactly on the ASLR curve (see examples below). The long-run or structural
equilib­rium point – which can be thought of as exerting the gravitational pull – is thus
at the intersection of the AD and ASLR curves.
The economic interpretation of the longThe full-employment level of output YFE is
run point of equilibrium is somewhat
indicated on the horizontal axis throughout
different from how it is understood in
the rest of this chapter to serve as a
micro­
economics. We saw above that
reminder that the long-run, or structural,
the AD curve is a collection of potential
equilibrium level of output YS is not a fullequilibrium points – each for a different
employment level and still leaves structural
price level. However, all these points
unemployment untouched.
of equilibrium are not attainable at
all times, because producers are not
necessarily willing or able to produce the quantity of output that is demanded at certain
price levels. (Remember that the points on the AD curve are derived using the assumption
that production readily responds to expenditure.) The points that can be attained are
indicated by the ASSR curve.
❐ In this sense, the short-run aggregate supply curve is a kind of ‘production possibility
frontier’ – points on (and to the left of) the curve are attainable, but points to the right
are not.
❐ The point of intersection is the short-run equilibrium point with the highest attainable
level of income Y, given supply and demand conditions.
This leads to the conclusion that the actual, short-run level of real income Y and the price
level P are simultaneously determined by the interaction between aggregate demand and
short-run aggregate supply, graphically illustrated by their intersection, e.g. Y1 and P1 in
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figure 6.16. Shifts of the
The AD-AS equilibrium mathematically
short-run supply curve
would change the set
Having derived an equation for the AD curve in
of attainable points of
section 6.2 of this chapter:
equilibrium. In the same
S
Y = 1(a + Ia + G + X – ma) + 2​ __
​ MP ​+ lπ ​
…… (4.6)
way, shifts of the de­
mand curve change the
and an equation for the ASSR curve in section 6.3.3 above
point of equilibrium.
(based on equilibrium in the labour market):
P e  (1  )  f(Y; Z)
❐ Given the way AD
​ …… (6.10)
P = ​  ______________
Q
was constructed from
these two relations simultaneously determine the equilibrium
the goods and money
level
of Y and P ‘in the short run’. They can be solved to obtain
markets (i.e. the real
equilibrium values of Y and P.
and monetary sectors
❐ For the long-run equilibrium, one simply substitutes P for
and the IS and LM
P e in the equations.
curves), any point
on the AD represents
equilibrium in the goods and money markets.
❐ Likewise, given the way ASSR was constructed from the labour market (and the interaction of the PS and the post-bargaining LS curves), the labour market is in an interim,
between-bargaining equilibrium.
❐ Thus all three of these markets or sectors are simultaneously in equilibrium at the
intersection point of AD and ASSR. Both pairs LS-PS and IS-LM intersect at the same
equilibrium output level.
❐ Note that in a longer-term sense there is no labour market equilibrium, since we are
not at the intersection of WS and PS. Thus workers are not working for the real wage
at which they would have wanted to work at wage-setting and -bargaining time (which
is on the WS curve).
π
(
)
There is no reason why the AD-ASSR equilib­rium should be on the ASLR curve, i.e. why
equilibrium output should be at the long-run, structural level YS. De­pending on the position
of the AD curve (and thus values of investment, consumption, exports, imports, gov­ernment
expenditure, taxes and mone­tary aggregates) and the position of the ASSR curve (and thus
the expected price level Pe and other supply-side factors) the equil­ibrium of P and Y can be
anywhere on the P-Y plane. (At all but one of these, P will not equal P e.)
❐ Whether the economy can remain at such a point indefinitely is another matter, as ar­
gued above. It is analysed again below.
A number of typical patterns are often found in P and Y. One can distinguish patterns
originating in demand-side changes/disturbances, or in supply-side changes/disturbances.
Combinations can also occur. In each case, the initial effect of the disturbance is followed
by an adjustment back towards the long-run level of YS.
6.4.2
Demand-side disturbances leading to points off the ASLR curve
Demand expansion followed by supply adjustment
Suppose that aggregate demand increases (AD shifts to the right in figure 6.17), starting from
an equilibrium income level at YS with the price level at P0 and with P e = P0.
❐ Such a change can be caused by expenditure-stimulating events such as an increase in
government expenditure, a tax cut, an exogenous in­crease in exports, a drop in imports
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together
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due to a de­precia­tion of the rand or,
on the monetary side, a decrease in
the repo rate (see complete examples
and chain reac­tions below).
Figure 6.17 Initial impact of demand expansion
P
ASLR
ASSR0
The increased demand alerts firms to
Short-run
new possibilities to increase output, P2
equilibrium
after demand
which can be sold at a price premium P1
stimulation
– remembering that they are price
setters. Moreover, increased output P0
also requires a higher price because
AD1
AD0
of increased costs. As employment
increases to produce the higher output
demanded, the marginal product
of labour decreases; at the existing
YS
Y1
Y
YFE
nom-inal wage rate the unit cost of
production increases. Producers will
be willing to employ these additional workers only if there is a higher price level (which
will allow the real wage rate to fall and producers to recover the higher unit cost of
production). This places upward pressure on the price level: the price level increases from
P0 to P1 in the diagram. At the given nominal wage, the higher price level creates new
profit opportunities, which induce businesses to increase aggregate production.
Thus, the price increase leads to an increase in output and income Y along the ASSR curve.
Short-run equilibrium output and income increase from the long-run level YS to Y1. The
economy experiences a short-run or cyclical upswing.
❐ Graphically, this is a shift in the AD curve from an equilibrium point on the YS line to
the right, with the new intersection of AD with ASSR being to the right of YS.
❐ In the product and money markets, changes indicated by a rightward shift in IS and/
or LM would have occurred, depending on whether a real or a monetary change was
behind the shift in AD. (See section 6.2.5 and examples 1 and 2 further on.)
❐ In the labour market a downward shift of the LS curve occurs, as shown in figure 6.13 in
section 6.3.3. Equilibrium occurs at the intersection of the PS and LS curves. (Details of
changes in the PS and LS curves are shown in the graphical examples in addendum 6.1.)
W
❐ Workers experience a drop in living standards due to a drop in their real wage 
​ P ​ since P
has increased. However, there is nothing they can do about it until the next round of wage
negotiations. But at the initially contracted nominal wage W0 (based on P e = P0) there are
more employment opportunities available than before. So at least there is an increase in
employment along the horizontal labour supply curve LS1, as in figure 6.13.
❐ The structural equilibrium, meanwhile, has relocated to the intersection of AD1 with
the long-run supply curve ASLR at point (YS; P2).
❐ This kind of expansion typically takes one to three years to play out through changes in
interest rates, prices, expenditure decisions, production decisions, etc.
At the new short-run equilibrium, output is above the structural equilibrium employment
level YS and the actual price (at P1) is higher than the initial expected price (P e0 = P0). As
noted above, such a position cannot be sustained indefinitely, since adapting expectations
would start to impact on the labour market. Workers are likely to realise that the average
price level P has been increasing. Their price expectation P e would adjust towards the
actual price P1. In due course, labour contracts are likely to adjust to the higher average
price level P1. As a result, nominal wages start to increase.
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❐ Graphically, as shown in figure
6.18, this is indicated by the
ASSR curve starting to shift up,
say to position ASSR1, which
intercepts ASLR where the new
expected price level P e1 = P1.
Figure 6.18 Demand expansion followed by supply adjustment
P
ASLR
ASSR2
ASSR1
ASSR0
Equilibrium after
supply adjustments
P2
The increase in the nominal wage
P1
increases production costs, which
P0
constrains the ability of producers to produce. Aggregate output
contracts. The equilibrium moves
up and to the left. There is new
upward pressure on the average
price level, accompanied by a drop
in total production and income
Y – we have an increasing price
level combined with an economic contraction.
Equilibrium after
demand stimulation
AD0
YS
Y1
AD1
YFE
Y
The new output level is still above YS. And, the new price level is yet again above the
recently adjusted expected price level P e1, leading to further changes in the expected price
and resultant wage contract adjustments when the next round of negotiations comes
around. These processes where ASSR shifts up are likely to continue as long as Y is above
YS. The process pushes Y towards YS and ends when the equilibrium level of Y stabilises on
YS and the price level (as well as the expected price level P e) is at P2. In the diagram above
(figure 6.18), this is when ASSR
and AD intersect on the YS line.
The neutrality of money?
The economy has reached the
When the demand stimulation is due to an expansion
long-run, structural equilibrium
in the money supply, this example demonstrates
point (YS; P2).
what is meant by the term ‘neutrality of money’.
❐ We see here the ‘upward
Since the long-run effect of the monetary expansion
elbow’, the typical pattern of
on output is eventually zero, it has no long-term
the ASSR adjustment process
benefit regarding output or employment. The price
following stimulation of aggre­
level P will eventually increase exactly in proportion
to the increase in the money supply M – the only
gate demand AD that pushed Y
long-run change.
above YS.
❐ This does not mean that monetary policy cannot
❐ Remember that the move of the
be used to counter a recession. But output
equilibrium point up along the
cannot be sustained beyond YS indefinitely by
AD curve is founded in corresmoney supply growth.
ponding changes in the IS and
❐ The neutrality result depends on the ASLR curve
LM curves. Similarly, changes
being stationary. If the drop in interest rates due
on the supply side are founded
to the money supply expansion stimulates real
in changes in the WS, LS and
investment, it will shift ASLR to the right, producing
PS curves.
a long-term real positive impact on YS (see the
❐ Since the ASSR adjustment pro­
combination patterns below).
cess requires successive rounds
The neutrality of money was an important issue in the
of wage renegotiations, the
debate between Keynesians and Monetarists on the
adjustment process can take
use of monetary policy to stimulate economic growth
several years to complete. The
(see chapter 11).
entire process of stimulation
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together
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followed by supply adjustment can easily take five years or more, allowing for some
overlap and concurrency.
What if policymakers try to keep the economy at Y1, above the long-run, structural
equilibrium level of Y? They would again and again have to counter the supply
adjustment process and accompanying contraction by further expansionary policy
to push the economy towards Y1 again. Supply adjustment would occur yet again,
requiring yet further expansionary policy. And so on, and so on. The result would be
continual increases in the price level. As people start to expect these policy reactions,
price expectations would adjust much quicker and be incorporated into wage contracts
proactively. ASSR would start adjusting upwards much quicker, requiring stronger and
stronger expansionary policy. In the end, P would increase faster and faster – i.e. we
would get inflation (more specifically, increasing inflation). The output level Y1 simply
cannot be sustained indefinitely with a given capital stock, labour force and technology.
(We will examine this result better in the next chapter when the model is expanded to
deal with an inflationary environment.)
Demand contraction followed by supply adjustment
For a decrease in aggregate de­mand Figure 6.19 A demand contraction sequence
AD (figure 6.19), a similar pattern
P
ASLR ASSR0
emerges. In this case Y drops
ASSR1
below YS. The adjustment proc­ess
ASSR2
entails a down­ward adjust­ment in
the average price level P, this being
Equilibrium after
demand decrease
part of the process of moving back
P0
towards YS.
P1
Equilibrium after
❐ Such a change can be caused
supply adjustments
PS
by a decrease in government
penditure (e.g. to reduce a
ex­
large budget deficit), or a drop
in ex­ports due to a re­cession
AD1
AD0
in the economies of our major
trading partners.
YFE
Y1
YS
Y
❐ The details of the economic
analysis are similar to that
of the expansion example above, but in the opposite direction. Such an example is
presented below. Remember that the move of the equilibrium point down along the AD
curve is founded in corresponding changes in the IS and LM (and BP) curves. Similarly,
changes on the supply side are founded upon changes in the WS, LS and PS curves.
❐ As shown in figure 6.19 this is the ‘downward elbow’, the typical pattern of the ASSR
adjustment process after a decline in AD which decreases Y to a level below YS. The
adjustment returns the economy to YS.
❐ This adjustment can take many, many years, notably since actual prices and nominal
wages have to adjust downwards – not an easy thing in any economy.
Key perspectives on the complete chain reactions
Any of the open-economy chain reactions which in previous chapters led to changes in
aggregate expenditure, now lead to a change in Y as well as in P. The change in P can
also have a feedback effect on the components of expenditure (e.g. investment, imports
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and exports). Depending on the position of the equilibrium relative to YS, there could then
also be a supply adjustment process.
❐ Thus any chain reaction leading to an equilibrium income level above or below YS is
unlikely to stop there. The ASSR adjustment process will lead to further changes in Y
and P (and other variables).
❐ As mentioned in chapters 3 and 4, in practice the primary and secondary effects
are not neatly separated in time as distinct steps that follow one another – say, as if
an increase in Y is followed by a distinct increase in money demand. The secondary
effects concurrently become operational as the primary effect gathers speed. Different
secondary effects may, though, have different dynamics and time spans. The secondary
effects flowing from the balance of payments are likely to commence a while later than
the money market secondary effect, but will still unfold parallel and concurrent to
ongoing changes in main variables.
❐ We must now also distinguish between short-run and medium-run secondary effects.
The secondary effects in the money market, and thereafter the two BoP adjustment
effects, pertain to the short run, i.e. a period of up to three years following the initial
stimulus. (Note that these effects were all demand-side adjustments.) The supply-side
adjustment process, which we add now, takes place in the medium term, and can take
several years, typically from three to seven years.
❐ The supply adjustment (a medium-run secondary effect) similarly is not neatly separated
in time from the short-run primary and secondary effects of a change in demand, as the
above theory might suggest. There is likely to be overlap, with the supply adjustment
process starting and gathering speed already in the later stages of the short-term effects.
Such concurrency implies that, on average, an entire macroeconomic chain reaction
can take from four to seven years to complete. Time path diagrams will demonstrate
this in the discussion that follows.
❐ These only are indicative time frames. In reality, an economy never changes in neat,
mechanical fashion – as noted several times before. Moreover, long before this particular
complete chain reaction has played itself out, other shocks will occur on top of it and
start new stimulus-plus-adjustment processes.
❐ Like others, the supply adjustment process – the theoretically predicted move to the
long-run structural equilibrium – is unlikely to occur quite as quickly or smoothly as
the preceding discussion may suggest. Nevertheless, the existence of such adjustment
forces is clear.
❐ During the supply adjustment process, there will also be concurrent impacts on demandside elements such as the interest rate and balance of payments components. However,
in this phase their role becomes of minor importance. In the medium term, if any of the
other adjustments causes price or quantity changes contrary to the price and quantity
changes brought about by the supply-adjustment process, the latter will dominate –
the ‘gravitational pull’ of ASLR is persistent and will be as long as the economy is not at
ASLR. Thus expected price will continue to adjust to actual prices until they are equal.
The first two examples in chapter 4, section 4.7.5 will now be spelt out fully, while the third
is left to the reader as an activity. Additions are in italics. The IS-LM-BP dynamics in those
examples explain shifts of the AD curve. These shifts of the AD curve constitute the first
part of the complete chain reactions that follow. This will then be followed by a description
of the economic events that constitute the adjustment of the ASSR curve towards the longrun, structural equilibrium level of real income, i.e. a point of rest on ASLR.
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together
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Example 1: The short- and medium-run internal and external effects of an
increase in the repo rate
Primary effect (demand side)
(1) [The process starts at point 0 on the AD-AS diagram (figure 6.20).]
Higher repo rate ⇒ money supply contracts ⇒ increase in interest rates ⇒ aggregate
demand decreases ⇒ downward pressure on prices and production ⇒ Y decreases
(= downswing in the economy) and P starts to decline. As Y and P decline, imports
decrease ⇒ current account (CA) surplus develops; increase in r ⇒ capital inflows ⇒
financial account (FA) goes into surplus.
Short-run secondary effects (demand side):
(2) Money market effect: As Y decreases, it causes the demand for money to decrease
concurrently ⇒ downward pressure on interest rates ⇒ initial fall in Y arrested ⇒
drop in M arrested, initial strengthening of (X – M) starting to end.
The net effect of the primary and money Figure 6.20 AD-AS and an increase in the repo rate
market secondary effects is that aggregate
AD0
AD1 AD3 AD2
demand and output falls, but that this fall
P
ASLR
ASSR0
is restrained by (a) a concurrent drop
D
in M , which holds back (but does not
ASSR1
reverse) the repo-initiated rise in r and the
consequent drop in I and Y. Moreover, (b)
0
P
3 2
the simultaneous decline in the average price P0
3
level P implies upward pressure on 
​  MP ​. This
1
acts as a further restraining force on the P4
4
increase in r and the decline in I and Y
(and M).
❐ Note that, now that P is not assumed
to be constant any more, P changes
and has feedback effects on compo­
Y1 Y3 Y2 YS
Y
YFE
nents of expenditure (investment
and imports).
❐ If (a) didn’t happen, it would mean that the IS curve is flat. AD would shift left further.
If (b) didn’t happen, it would mean that the ASSR curve is flat. The decline in Y would
be larger.
S
The net effect of the primary and money market secondary effect can be depicted on the
P-Y plane, using the AD-AS framework. The demand/expenditure contraction causes the
AD curve to shift left. The first horizontal shift from AD0 to AD1 captures the combined
primary and money market secondary effects.
❐ The intersection of the shifting AD curve and the (stationary) ASSR curve determines the
short-run equilibrium of P and Y. The short-run equilibrium moves along ASSR0 from
point 0 to point 1.
❐ This move along the ASSR curve captures the restraining effect of the declining P on
aggregate expenditure.
[The economy is at point 1 on the diagram.]
The net effect of the primary and money market secondary effects leaves Y and P lower, r higher
and both the current and financial accounts in surplus. There is a BoP surplus (BoP > 0).
278
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Further secondary effects due to BoP > 0:
(3) Initial BoP effect (foreign reserves adjustment): BoP surplus ⇒ inflow of foreign exchange
⇒ MS increases and downward pressure on interest rates (which decreases the inflow
of foreign capital and the FA surplus) ⇒ aggregate demand increases, causing Y and
P to increase; as Y and P increase it stimulates imports ⇒ prevailing current account
surplus is reduced; the turnaround in the real interest rate starts to discourage or
reverse capital inflows. The BoP surplus is being reduced.
The increase in Y implies that the initial downswing has turned around (at least for
now …). The decline in P is also reversed slightly.
In the diagram, AD shifts a bit to the right to AD2 (or, the initial leftward shift is restrained
– depending on the speed of the MS effect, which is assumed to happen quicker than the
exchange rate effect).
[The economy is at point 2 on the diagram.]
(4) Concluding BoP effect (exchange
rate adjustment): The initial
BoP surplus (now already
slightly reduced) also leads
to appreciation of the rand
⇒ current account surplus
is reduced, and so is the
remaining BoP surplus. The
process will continue until BoP
= 0. This cumulative decrease
in (X – M) again reduces
aggregate expenditure, which
reverses the short recovery of
Y and P – a further economic
downswing occurs (Y and P
decline again).
Note the typical AD pattern generated by the two
BoP effects following a BoP surplus: first the AD
curve shifts right (money supply effect), then the AD
curve shifts left (exchange rate effect).
❐ The AD curve shifts right then left.
❐ The net effect of the two BoP effects on the
position of the AD curve and on equilibrium Y
appears to be relatively minor. Nevertheless,
Y went through a noticeable up-down cycle in
the process.
See chapter 4, section 4.7.4 for the initial analysis of
these BoP-related shifts. Addendum 6.3 provides a
complete illustration of the IS-LM-BP changes that
underlie the movements of and along the AD curve in
this example.
In the diagram, AD shifts a bit left
again to AD3. The short-run equilibrium moves to point (P3;Y3).
[The economy is at point 3 on the diagram.]
Depending on the timing of the BoP effects, there can be either a zig-zag in Y and P or one
will only notice the net effect, i.e. the net shift of AD from AD0 to AD3 and the net move of
the equilibrium along ASSR from point 0 to point 3 (blue arrow). Y declines from YS to Y3
and P from P0 to P3.
❐ Working with the net shift of AD simplifies AD-AS analysis. We will do so in the rest of
this and the next example.
The net effect of the primary and money market and BoP secondary effects leaves Y and P
lower, r higher and the BoP = 0. More specifically, and crucial for the supply adjustment that
will follow: real income Y is below YS, the structural equilibrium level of Y, and the actual
price level P is below the expected price level P e, since at this moment P e = P0. That is:
Y < YS and P < P e
These will lead to further economic adjustment processes.
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together
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Medium-run secondary effects (supply side):
(5) Supply adjustment: Y < YS and P < P e ⇒ downward pressure on expected prices. These
should lead to reduced wages in the next rounds of labour negotiations. As these come
into effect they reduce production costs and boost the ability of firms to produce ⇒
reduction in price level P and increase in sales and production Y. After several such
(annual) rounds of wage negotiation, the output level will gradually approach YS and
the price level P declines until a point on ASLR is reached and P = P e.
In figure 6.20 this is reflected as a downward move of the ASSR until it intersects AD3 at a
point that is on ASLR (which is where P = P e). The short-run equilibrium moves along the
AD3 curve from point 3 to point 4. Y increases from Y3 to YS and P declines from P3 to P4.
M
The decline in P also increases the real money supply ​ 
P ​, which puts downward pressure
on interest rates and increases aggregate demand (along the IS and AD curves). Thus the
FA should also go into deficit. The (cost- and interest-rate induced) increase in income Y
also leads to an increase in imports, so that the current account CA should go into deficit.
A BoP deficit develops.
S
The normal BoP adjust­ment processes will play out (during which r should increase some­
what and the rand should depreciate; the impact of a declining P on X and M will assist these
proc­esses). All these will then take the BoP back to a position of balance – perhaps caus­ing
minor fluctuations in Y on its path along AD3 towards its final resting point at YS.
These processes continue until the short- Figure 6.21 Illustrative time path of key variables –
run equilibrium is at YS and BoP = 0, i.e. increase in the repo rate
with both internal (real, monetary and
labour market) and external equilibrium.
[This is at point 4 in the diagram.]
Summary of final, net effects
1. The price level ends up significantly
lower than at its starting level. The
contractionary monetary policy step
followed by the AS adjustment has
unequivocally reduced the average
price level.
2. Real income is back where it started, af­
ter a deep cyclical down­swing, with the
recovery – punctuated by a dip on the
way – lasting several years.
3. Cyclical unemployment increases for
several years, but decreases during the
AS adjustment phase.
4. The balance of payments goes through
two cycles of surplus and deficit, but
ends up in balance.
5. The real interest rate goes through
a strong upward phase initially, but
declines during the BoP as well as AS
adjustment phases. It will probably end
up roughly where it started.
280
r
Time
Y
Time
P
Time
Rand
BoP
Demand contraction
phase
up to 3 years
Time
Supply adjustment
phase
3–7 years
Overall (with overlap): 4–7 years
Chapter 6: A model for an inflationary economy: aggregate demand and supply
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6. The external value of the rand increases during the second BoP effect of the demand
contraction phase, and will likewise decline again at the end of the supply adjustment
phase.
Example 2: the short- and medium-run internal and external consequences of an increase
in government expenditure
Primary effect and short-run, demand-side secondary effects:
The net impact of higher government expenditure, via its primary and money market secondary
effects, can be summarised as follows. (See chapter 4, section 4.7.5 for detailed steps.)
[The process starts at point 0 on the AD-AS diagram (figure 6.22).]
(1) & (2): Aggregate demand and output Y as well as P rises (as does M), but this increase
is restrained by (a) a concurrent rise in interest rates, which dampens expenditure, as
M
well as (b) the simultaneous increase in the average price level P, which contracts ​ 
P ​. This
acts as a further restraining force on the increase in Y (and M).
S
This phase leaves Y and P higher, r higher and the CA < 0. The increase in r leaves the
FA > 0. Assuming mobile international capital flows, the net effect will be a BoP > 0. As a
result, further secondary effects follow. These continue until BoP = 0.
(3) The initial, money supply effect of the BoP reduces interest rates, which stimulates
expenditure, Y and P to increase. This reduces the current account deficit, while the FA
surplus is also reduced by the drop in interest rates. The initial upswing in Y has been
followed by another upswing.
(4) The concluding, exchange rate effect of the BoP leads to an appreciation of the rand ⇒
current account deficit increases again. This helps to eliminate the remaining BoP surplus.
The appreciation of the rand is responsible for a contraction of aggregate expenditure and
Y towards the end.
In the diagram the entire set
of demand-side primary and
secondary effects is summarised in
the net rightward shift of AD from
AD0 to AD1. (If shown in detail, the
AD curve will display the typical
right-then-left
shift
pattern,
associated with phases 3 and 4 for
a BoP surplus, before reaching the
AD1 position.)
Figure 6.22 AD-AS and an increase in government expenditure
The short-run equilibrium has
moved from (P0; YS) to point (P1; Y1).
AD1
[The economy is at point 1 on the
diagram.]
P
ASSR2
ASSR1
ASLR
ASSR0
P2
P1
P0
Equilibrium after
supply adjustments
2
1
0
Equilibrium after
all demand-side
secondary effects
AD0
YS
Y1
YFE
Y
The net effect of the primary,
money market and BoP secondary
effects leaves Y and P higher, r higher and the BoP = 0. More specifically, and crucial for the
supply adjustment that will follow:
Y > YS and P > P e
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together
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since at this point in the process P e = P0. These will now lead to further economic adjustment
processes.
Medium-run secondary effect:
(5) Supply adjustment: Y > YS and P > P e ⇒ upward pressure on expected prices. These
should lead to increased wages in the next rounds of labour negotiations. As these come
into effect they increase production costs and restrict the ability of firms to produce ⇒
increase in price level P coupled with a decrease in sales and production Y.
This process will repeat itself. After several such (annual) rounds of wage negotiation,
the output level will continue to decline and gradually approach YS.
In the diagram, the short-run AS curve shifts upwards to, say, position ASSR1. It shows
a downswing in Y together with an increase in the average price level P – not a happy
combination for a country. Further such adjustments are portrayed as a continual upward
move of the ASSR until it intersects the AD and the ASLR, i.e. at point 2.
M
The increase in P also decreases the real money supply ​ 
P ​, which puts upward pressure on
interest rates and dampens demand (moving up along the AD curve). Thus the FA should
also go into surplus. The (cost- and interest-rate induced) decrease in income Y also leads
to a decrease in imports, so that the CA should go into surplus. A BoP surplus develops.
S
The normal BoP adjust­ment processes will play out (during which r should decrease some­
what and the rand should appreciate; the Figure 6.23 Illustrative time path of key variables –
impact of an increasing P on X and M will increase in government expenditure
assist these proc­esses). All these will then
take the BoP back to a position of balance –
perhaps caus­ing minor fluctuations in Y on
r
its path along AD3 towards its final resting
point at YS.
These processes continue until the shortrun equilibrium reaches YS and BoP = 0,
i.e. with both internal (real, monetary and
labour market) and external equilibrium.
[The economy ends up at point 2 on the AD-AS
diagram.]
Summary of final, net effects
1. The price level ends up significantly
higher than at its starting level, follow­
ing interrupted years of increase. The
expansionary fiscal policy step followed
by the AS adjustment has unequivo­
cally increased the average price level.
2. Real income goes through a substantial
cyclical up­swing, followed by a down­
swing lasting several years (the whole
process lasting perhaps four to seven
years on average). In the end, output and
income are back where they started, and
YS below YFE.
282
Time
Y
Time
P
Time
Rand
BoP
Time
Demand contraction
phase
up to 3 years
Supply adjustment
phase
3–7 years
Overall (with overlap): 4–7 years
Chapter 6: A model for an inflationary economy: aggregate demand and supply
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3. Unemployment decreases below long-run levels for several years, but increases again
during the downswing of the AS adjustment phase. It ends up at the same level as
when the process started – the structural rate of unemployment (and still below full
employment).
4. The balance of payments goes through two successive cycles of surplus, and ends up
in balance.
5. The real interest rate goes through two cycles of increase followed by a weaker decline
– one each in both the expansion and contraction phases. It should end up higher
compared to where it started.
6. The rand appreciates during the second BoP effect of the demand contraction phase,
and does so again at the end of the supply adjustment phase. At the end, the rand is
much stronger than it was initially.
✍
6.4.3
The two examples of the impact of monetary and fiscal policy changes built on the IS-LM-BP
analysis of chapter 4. Sections 4.5.3 and 4.7.5 in chapter 4 also presented a third demandside example, i.e. an increase in exports (an external disturbance). Complete that example by
incorporating price and supply behaviour. Draw an appropriate AD-AS diagram.
Supply-side disturbances leading to points off the ASLR curve
The analysis of a supply-side disturbance is complex since it affects both the long-run and
the short-run aggregate supply relationships (and curves). A decrease in aggregate supply
– a so-called supply shock – causes both ASSR and ASLR to shift to the left in tandem, and
results in a decrease in Y (a downswing), which is accompanied by an increase in P (see
figure 6.24).
❐ Such a change can be caused by output-restricting or cost-raising events such as a
drought, or increases in the cost of non-labour inputs, e.g. an increase in the oil
price, the price of electricity or an increase in the price of imported inputs due to a
depreciation of the rand, for instance.
❐ On the wage-setting side, such a change can result from an increase in union power
that is used to secure higher nominal wages during a wage bargain­ing round, or an
increase in the legislatively determined minimum wage.
The whole process plays out in two phases. Since the long-run supply curve also shifts to
the left, the structural equilibrium point relocates to the point (YS2; P2). Simulta­ne­ously,
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together
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the ASSR curve shifts left an Figure 6.24 Supply shock followed by supply adjustment
equal distance. The short-run
ASLR1
ASSR2
P
equilibrium point slides up and
ASSR1
to the left along the AD curve.
ASSR0
Because of the slide along the
Phase 1:
AD curve, this new short-run
Supply shock
P2
shifts both
equilibrium is not on ASLR –
ASSR and ASLR
P
1
output would be at Y1, which is
left
P0
to the right of YS2. Thus it is not
Phase 2:
a long-run or sustainable equi­
AD
Supply
librium because the expected
adjustment
process shifts
price level P e still is at P0, while
ASSR up
the actual price is already high­
e
er than that; thus P ≠ P . The
YS2 Y1 YS0
Y
YFE
normal ASSR supply adjustment
process in such a situation will
be activated – the second phase of the process. Thus ASSR starts shifting up through an
upwardly adjusting expected price P e and a renegotiated nominal wage W, as described
in the case of a demand-led expansion above. The short-run equilibrium moves further
up and to the left along AD through an upwardly shifting ASSR. This process depresses Y
further, combined with a further increase in the price level P. It should continue until the
short-run equilibrium reaches ASLR1 at actual price level P2 and income level YS2.
❐ Recall that the second phase in the diagram, where the ASSR curve shifts due to the
supply-adjustment process, will be relatively slow (i.e. not instantaneous – it may take
approximately three to seven years). This is because it requires the next round of wage
setting/bargaining to take place. Only then can the supply adjustment process start, to
be followed by yet further rounds of wage setting to complete the adjustment process.
❐ It could thus be several years before the new structural equilibrium point on ASLR1 is
reached. A prolonged economic contraction is likely.
❐ Remember that the move of the equilibrium point down along the AD curve is founded
in corresponding changes in the IS and LM curves. Similarly, changes on the supply
side are founded in changes in the WS, LS and PS curves. (Details of changes in the
PS and LS curves are shown in the graphical example in addendum 6.2; also compare
addendum 6.4.)
❐ Note that in this case the situation regarding both key variables, income and prices,
worsens (and does so in both phases). In the case of demand-side disturbances, the
position regarding one variable would worsen while the other would improve ‘in
exchange’ (see the preceding graphical examples). A negative supply shock is quite
disagreeable for society.
Example 3: the short- and medium-run internal and external impacts of an increase in the
price of imported inputs (e.g. oil)
Primary effect and short-run, demand-side secondary effects:
Two simultaneous impacts:
(1) Demand-side impact: Higher imported input prices ⇒ if price elasticity of the demand
for the product is low (as is the case with oil) ⇒ M increases ⇒ (X – M) decreases ⇒
total domestic expenditure decreases (and the CA into deficit) and output Y as well
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as P decreases. As Y decreases,
interest rates decline as a sec­
ondary money-market effect,
causing an outflow of foreign
capital (FA into deficit).
❐ The development of a large
initial current account
deficit is an important
characteristic of this case
(in contrast to a domestic
supply shock).
In the diagram (figure 6.25), AD
shifts leftward from AD0 to AD1. A
new (P; Y) short-run equilibrium
results.
Figure 6.25 AD, ASSR, ASLR and an increase in the oil price
P
ASSR2
AD0
AD1
ASSR1
3
P3
2
P2
P0
P1
0
1
ASLR1
YS1 Y2 Y1
ASLR0
YS0
ASSR0
Supply shock
shifts both
ASSR and ASLR
left. Then supply adjustment
process shifts
ASSR up
Rise in import
bill decreases
domestic
expenditure
YFE
Y
[The economy has moved from point 0 to point 1 on the AS-AD diagram.]
(2) Supply-side impact: Higher imported input prices (e.g. oil and petrol) ⇒ increase in costs
of production, constrains ability of firms to produce at current price levels ⇒ upward
pressure on the average price level P; this simultaneously decreases the real money
M
supply ​ 
P ​, which increases the interest rate and causes investment and thus aggregate
expenditure to decline ⇒ output Y starts declining. Thus P starts to increase while Y
declines (and thus also M).
S
Without an IS-LM-BP diagram, one cannot deduce the net effect on the interest rate.
It would have increased in phase 2 above, but may still be below the starting point.
(Addendum 6.4 contains a complete example that shows the IS-LM-BP curves as well.)
While the FA will have recovered, it is still likely to be in a deficit or a small surplus. The CA
should have improved somewhat due to the decline in Y (and thus M). Nevertheless, the
magnitude of the initial CA deterioration should still dominate, given the relative size of
the oil bill (and bearing in mind that the increase in P would curb any CA improvement).
Thus we can assume that the BoP is still in deficit when the economy reaches point 2.
Graphically, there is a leftward shift of (a) ASSR from ASSR0 to ASSR1 and (b) ASLR from ASLR0
to ASLR1 (see section 6.3.3 if this is not clear). This shows the following things:
(a) Through the interaction between ASSR1 and AD1 a temporary equilibrium (P2; Y2) is
reached on the AD-AS diagram.
(b) The structural equilibrium level of output YS has shifted to a lower level YS1.
(c) The average price level P is higher than at the starting point: P2 > P0.
[The economy is in the vicinity of point 2 in the diagram.]
The expected price level that is embodied in wage contracts is still at its initial level:
P e = P0. And Y is lower than before the supply shock occurred. Yet, because YS has shifted
to a lower level, we have:
Y > YS and P > P e
But first there is a BoP deficit that will have short-run effects:
(3) Initial BoP effect (foreign reserves adjustment): The BoP deficit and outflow of foreign ex­
change ⇒ money supply decreases ⇒ upward pressure on interest rates ⇒ aggregate
demand and expenditure decreases.
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together
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(4) Concluding BoP effect (exchange rate ad­justment): The initial BoP deficit also leads to a
depreciation of the rand ⇒ discourage­ment of imports and stimulation of exports ⇒
aggregate expen­diture stimulated.
These two effects will return the BoP to a position of balance. Within the AD-AS model it
suffices to note the typical AD patterns generated by the two BoP effects following a BoP
deficit. First the AD curve shifts left (due to the money supply effect), then the AD curve
shifts right (due to the exchange rate effect).
❐ The AD curve zig-zags left then right. Y would decline a bit, then rise again. P would
de­cline a bit, then rise again.
❐ The net effect of the two BoP effects on the position of the AD curve and on equilibrium
Y and P appears to be rela­tively minor. They are less relevant in the medium-term
context of this ex­ample.
❐ Whatever the magni­tude of the two BoP effects, we draw the curve AD1 to show the net
effect after both BoP adjustment processes.
[The internal equilibrium of the economy has moved to point 2 in the diagram.]
After the BoP adjustment effects, at short-run equilibrium point 2, we still have:
Y > YS1 and P > P e = P0
The economy still operates at an output level that exceeds the structural, long-run
equilibrium, and there is a discrepancy between the expected price level (in wage contracts)
and the actual price level. This is not a stable, sustainable equilibrium. A medium-run supply
adjustment process must follow.
Medium-run secondary effect:
(1) Supply adjustment: Because Y > YS and P > P e ⇒ upward pressure on expected prices.
These should lead to increased wages in the next rounds of labour negotiations. As
these come into effect they increase production costs ⇒ an increase in price level P
and a decrease in sales and production Y. Gradually the output level will approach YS.
Graphically this is portrayed by an upward shift of ASSR until it intersects the AD curve
and ASLR.
The increase in P also decreases the real money supply 
​ MP ​, which puts upward pressure
on interest rates and dampens demand.
S
The internal equilibrium moves along the IS and AD curves towards point 3. With
interest rates increasing again, now clearly above the starting levels, the FA should go
into surplus.
The further, cost- and interest-rate induced decrease in income Y (from point 2 to 3)
also leads to a decrease in imports, so that the current account should go into surplus.
A BoP surplus develops.
The normal BoP adjust­ment processes will play out (during which r should decrease
some­what and the rand should appreciate; the impact of an increasing P on X and
M will assist these proc­esses). All these will then take the BoP back to a position of
balance – perhaps caus­ing minor fluctuations in Y on its path towards its final resting
point at YS.
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Chapter 6: A model for an inflationary economy: aggregate demand and supply
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Graphically, AD is likely to shift right then
left, so we retain AD1 as the likely net
position of aggregate demand.
These processes continue until the
equilibrium is at YS and BoP = 0, i.e. with
both internal (real, monetary and labour
market) and external equilibrium. This is
point 3 on the AD-AS diagram.
[The final equilibrium of the economy is at
point 3.]
Summary of final, net effects:
1. The large initial in­crease in the import
bill implies a substitution of imported
goods for do­mestic goods. This re­duces
domestic expen­
diture, putting down­
ward pressure on prices initially. Yet
the price level soon starts to in­crease
due to the cost shock. The contraction­
ary effect of the outflow of reserves
temporarily brakes the upward mo­
mentum of P, before it resumes a
sustained in­crease.
2. Real income (and together with it employ­
ment) decreases significantly. Except for
a brief upturn due to the first exchange
rate effect of the BoP, it decreases to a new,
lower long-run equilibrium level.
✍
Figure 6.26 Illustrative time path of key variables –
increase in the oil price
r
Time
Y
Time
P
Time
Rand
BoP
Contraction due to
supply shock phase
up to 3 years
Time
Supply
adjustment phase
3–7 years
Overall (with overlap): 4–7 years
Example 3 above analyses the impact of a change in the oil price – a supply-side disturbance (or
shock) in the external sector. Supply-side disturbances can also originate within the domestic
economy. Examples include unexpected, large changes in labour cost or the price of important
other inputs such as electricity. Redo the analysis of example 3 for an internal cost disturbance
such as a sudden increase in the price of electricity. Illustrate this on an AD-AS diagram. (Also
see the case study in section 6.5.)
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together
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3. The balance of payments first deteriorates due to the increase in the oil import bill.
However, later, as part of the medium-run AS effect, it goes into a surplus before
adjusting to final equilibrium.
4. The real interest rate first decreases, before it increases significantly. Much later, as
part of the last BoP adjustments within the medium-run AS adjustment, it decreases
slightly – but still ends up higher than before the shock.
5. The rand first depreciates, before it appreciates later, as part of the BoP-adjustment
dimensions of the medium-run AS adjustment.
6.4.4
Combination patterns
A supply shock followed by policy stimulation
Combinations of patterns can also be found. A pattern that oc­curs frequently is a ‘left-hand
upward zig-zag’ due to a supply shock (ASSR and ASLR shift to the left) followed by expansion­ary
fiscal or monetary policy (AD shifts to the right) to counteract the contraction. This is shown in
figure 6.27.
As shown in figure 6.24, the initial shock, followed by a supply adjust­ment, takes the
economy to a new equilibrium at YS2 with the price level at P2. Note that the long-run
aggre­
gate supply curve has Figure 6.27 Supply shock followed by accommodation
moved left to ASLR1 due to the
P
initial shock. The expan­sionary
ASLR1 ASLR0 ASSR3
demand policy then pushes
ASSR2 ASSR1
the economy to a point to the
ASSR0
right which again is off ASLR1
(combined with an increase in P4
the price level to P3, say). A new
Adjustment
P3
round of supply adjustment –
process then
P2
shifts ASSR up
which increases the price level
again
yet again (eventually to P4) P
0
AD1 Policy
together with a reversal of the
AD0
stimulation
policy-led expansion to YS2 – is
shifts AD right
likely.
❐ The reason for the frequent
YS2
YS0
YFE
Y
occurrence of the latter zigzag pattern is that, as indi­
Understanding the structural equilibrium level
cated earlier, a supply shock
leaves the economy with twin
The level of structural employment, i.e. YS, can
problems: more unemploy­
now unambiguously be understood as the level
ment plus an increas­ing price
around which cyclical disturbances, fluctuations and
level. Political pressure and/or
adjustments in Y occur (see box on unemployment
socio-economic considerations
on page 260). It is the output level (together with its
price level PS ) from which the ‘gravitational pull’ that
often persuade a govern­ment
we have been speaking about is exerted. In other
to adopt unemploy­ment as the
words, YS is the cyclically neutral level of income (and
first priority of policy, and to
employment).
stimulate aggregate expendi­
ture.
Nevertheless, its own position is not permanent, since
❐ This is called the ‘accomit can also be shifted around due to economic factors
and forces.
modation’ of the supply shock.
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The problem with such accommo­da­tion is that, in exchange for what turns out to
be only temporary higher GDP and employ­ment, the country has to endure a further
increase in the price level – followed by yet another downswing-plus-price-increase
phase due to the fact that the long-run structural equilibrium has relocated to a lower
level. (This policy dilemma is discussed again in chapter 12, section 12.1.)
Government or business investment leading to supply expansion
It was noted above that real Figure 6.28 Supply expansion due to investment
investment expenditure, either
P
ASLR0
ASLR1
by government, public corpora­
Equilibrium
tions and government entities
after supply
or the private sector, has two
growth and
ASSR2
supply
creases aggregate
effects. It in­
adjustment
ASSR0
demand in the short run (and
ASSR1
P2
Equilibrium
thus shifts the AD curve to the
P1
after demand
right); and it boosts produc­
stimulation
P0
tive capacity in the medium
to long run. As shown in the
AD1
AD0
diagram (figure 6.28) it thus
gether
shifts the ASLR curve to­
with the ASSR curve to the right.
YS Y2 Y1
Y
YFE
Thus there is a com­
bination
of a positive supply shock and
a de­mand stimulation. Depending on the speed and magni­tude of the relative shifts of
the AD and AS curves, the new short-run equilibrium may be on, to the left of, or to the
right of the new ASLR1 curve (shown in figure 6.28). If it is off the ASLR curve, it may
be followed by supply-adjustment processes until the short-run equilibrium set­tles on the
new, augmented ASLR1 2 at point (P2; Y2).
❐ It is important to note that – compared to a standard non-investment aggregate demand
stimulation (see example 2 above) – the price level increases by less and that there is a
net increase in the long-run, structural equilibrium output to Y2.
❐ This will be important when discussing the determinants of economic growth, which
is graphically equivalent to a steadily outward shifting ASLR curve and a steadily
increasing structural equilibrium output YS.
❐ This example also relates to the discussion of the Phillips curve in chapter 7 and the
pros and cons of government expenditure to stimulate growth in chapter 10.
❐ Expenditure on new technology and human capital would have similar effects to those
shown above.
❐ This example also alerts one to the importance of supply-directed policies of a structural
nature – rather than anti-cyclical demand policy – to effect outward shifts in the longrun output level and thus achieve sustained reductions in structural unemployment.
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together
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YS and the rate of unemployment in a growing economy
The preceeding diagrams show how the long-run, structural equilibrium level of real income
YS shifts right or left over time due to different economic factors. A YS that continually shifts to
the right implies steady economic growth. It is important to understand how that relates to the
rate of unemployment.
An increase in the structural equilibrium level of output implies higher levels of employment N.
However, the rate of unemployment U will depend on what has been happening with the labour
force (LF) (as well as technology and labour intensity/productivity) over time. Recall that:
(LF – N)
LF
U = ​ _______​
A growing YS and growing employment N does not necessarily imply that the rate of
unemployment is declining over time. With a growing population and labour force, a growing
YS is necessary to absorb new entrants into the labour market to prevent the unemployment
rate from rising. However, the absorption of labour also depends on the extent to which the
growth in YS is due to productivity-enhancing technological progress.
❐ If YS grows steadily at the same rate as the labour force, but a major cause of this
growth is productivity-enhancing technological progress, the long-run or structural rate
of unemployment (SRU) could actually increase. A YS that grows at the same rate as the
labour force would produce an unchanging long-run or structural unemployment rate (SRU)
only if technology is not augmenting labour productivity.
❐ If YS grows at a rate higher than the growth in the labour force, but this relatively higher rate
is not primarily due to improved technology (i.e. higher labour productivity), it would mean
that the output growth is the result of increased employment or labour absorption. Thus
the long-run or structural rate of unemployment (SRU) would decline.
❐ The structural dimensions of unemployment imply that changes in YS on their own are not
sufficient.
For more on this, see section 12.2 in chapter 12.
✍
The world financial crisis of 2007–08: aggregate supply and price level effects
We introduced this case study at the end of chapter 3 and followed up in chapter 4.
Recall the context briefly. The world economy was shattered by the so-called subprime
credit crisis in the USA that came to a head in September–October 2008. It led to the failure
of several banks in the USA (and other countries), and a serious credit shortage ensued.
Economic confidence disappeared, durable consumer expenditure and residential (and
other) investment dropped. The US economy hit a recession, and many businesses, e.g. the
Big Three motor companies in the USA, faced serious financial ruin. (These recessionary
conditions spread to the UK, Europe and Japan, for example.)
In reaction to this, the US government increased government expenditure (including national
infrastructure investment) to restore confidence, create jobs and rebuild the economy,
and fend off the threat of deflation. The Federal Reserve also backed up the banking
sector, reduced the bank rate to stimulate credit creation and introduced several rounds of
quantitative easing.
Now analyse these fiscal and monetary policy steps with the additional analytical tools and
insights acquired in this chapter. Focus especially on the aggregate demand and aggregate
supply effects, and thus the joint impact on GDP as well as the average price level.
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⇒
✍
Hint: First consider the initial shock in the AD-AS model and then the policy response. Also
consider whether any supply adjustment processes take place or can be expected to take place.
Second, go back and try to analyse the underlying developments in the real and monetary sectors
(or use the IS-LM-BP diagram). Third, try to analyse events in the labour market (the WS-PS
framework).
What are probable or possible explanations for:
❐ increasing prices?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
❐ decreasing prices?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
❐ increasing prices combined with an upswing?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
❐ increasing prices combined with a downswing?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
❐ increasing prices with a constant level of Y?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
6.4.5
Can this theory explain the course of the South African economy?
The Keynesian framework developed in these chapters can be used to try to explain different
observed patterns in the macroeconomy. While this largely constitutes ‘enlightened
guesswork’ in hindsight, one can attempt to explain the course of the average price level P
and real GDP Y in the South African economy over the last decades.
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together
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Figure 6.29 Output fluctuations and the price level in South Africa
2018
2009
2008
2003
Average price level (log scale)
1997
1993
1989
1986
1981
1977
1974
–5
–4
–3
–2
–1
0
1
2
3
4
5
6
Real GDP (% deviation from long-run AS)
Source: South African Reserve Bank (www.resbank.co.za), and authors’ own calculations.
Consider the graph in figure 6.29 representing data on the South African economy since
1970. The graph plots the (log of the) CPI index against the deviation of output from its
long-run trend. Thus it is comparable to the AD-AS framework with P and Y on the axes.
The graph period includes the major recession that followed the substantial increase in oil
prices by the OPEC oil cartel in 1973. It also shows the recession after 1981 and 1989.
The economy reached a trough in 1993, whereafter output increased and exceeded trend
output. However, also note that, after the Asian crisis in 1998 and the rather severe
depreciation of the rand in 2001, output fell slightly below the trend. After the latter
deterioration it improved for several years, reaching a peak in 2007–08. However, in 2009
the economy experienced a deep recession following the fall-out from the global financial
crisis. At the time of writing (2019), the South African economy was stuck in a long period
of very low economic growth.
The question is: can shifts in AD and AS, and related adjustment processes that result
in changes in the equilibrium level of Y and P, map out a path that approximates the
behaviour of the real South African economy? Or, can the latter path be explained by
finding appropriate shifts in AD and AS that can be traced back to actual policy steps or
other disturbances?
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We will not provide such a comprehensive explanation now. It is left to the reader. What
one can and must do is to identify periods such as the following:
(1) demand pull;
(2) cost push;
(3) cost push followed by accommodation (stimulation);
(4) demand stimulation followed by supply adjustment towards long-run supply; and
(5) simultaneous demand pull and cost push.
Can you identify such periods in the graph? Once that is done, one can search – among the
determinants of AD and AS – for those potential determinants that were active at specific points
in time. Doing so would identify the likely causes of the changes in AD and AS, and thus of
Y and P. This would constitute a probable explanation of the course of the South African
economy during the past two decades.
6.4.6
A comprehensive explanation of the consequences of economic
disturbances
The entire modern Keynesian macroeconomic theoretical model is now almost complete.
This is apparent from the complete circular flow diagram earlier in this chapter. We have
considered the role of, and linkages between, all the major macroeconomic variables.
We have considered their behaviour and complex interrelationships in the short and
the medium term. The likely causes or consequences of changes in these variables can be
indicated with a reasonable degree of certainty. The model can be used to predict, albeit
only roughly, the expected consequences of any real or monetary, internal or external
disturbance, including adjustment towards the long-run supply curve.
Graphically, the model has been set out in a series of diagrams (see figure 6.30). It started
with the 45° model and its link to the monetary sector. This was then summarised in the
IS-LM model, or the IS-LM-BP model in the open-economy context. Finally, we derived the
AD-AS model, which summarised the initial three-diagram model and the IS-LM dynamics
in the AD curve, and added two AS curves.
Together, these diagrams enable one to trace the consequence of a real, monetary, internal
or external disturbance through the (open) economy. We can see how it impacts on interest
rates and exchange rates and several real and monetary economic variables along the way,
often initiating complex adjustment processes – until it ends with a final impact on the
price level and output/income.
Note that in many cases the
supply-adjustment process will
appear to be inoperative. This is
because of the length of time it
takes – from three to seven years
– and the frequent occurrence of
new disturbances or policy steps
that override the adjustment.
Truth or theory?
Remember that this is still only a theory of the way
the economy works. While it is sophisticated, and
the product of the work of highly regarded theorists
and economic scientists, including Nobel Prize
winners, it should never be regarded as the absolute
Truth (with a capital T). No theory or science can ever
be that. Human knowledge and insight are and always
will be limited, should be regarded as provisional, and
should be used unpretentiously and in full awareness
of their fallibility.
Therefore one often focuses on
the initial impact on the AD-AS
diagram, largely leaving the sup­
ply adjustment process out of consideration – especially in cases where the BoP adjustment
process is of greater importance. Nevertheless, one should always be aware of the underlying
forces of the AS adjustment process.
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together
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Figure 6.30 The whole model – monetary and real sectors, aggregate demand and aggregate supply
Monetary sector
Real sector
Transmission
mechanism
r
r
M
​
​ 
P
S
E
ASLR
P
ASSR
C+I+Gc+X–M
MD
​  P ​

Money
AD
I
I
Y
Y
Feedback
mechanism
NOTE
•Monetary changes are transmitted to the real sector via the interest-investment link (a left-to-right causality).
• Real sector changes include aggregate income (Y) as well as the average price level (P).
•Changes in the real sector (Y, P) have secondary, feedback effects on the monetary sector via the demand for
money (a right to left, indirect causality).
•The first impact of monetary policy is in the monetary sector, while the first impact of fiscal policy is in the real
sector.
This model enables one to consider and analyse specific problem areas of macroeconomics.
The first of these is macroeconomic policy; the second, the problems of inflation, un­em­
ploy­ment and low growth. These will be discussed in chapters 9 to 12.
However, the above model, though rather extensive, still needs one bit of upgrading to
represent a complete model for the modern era: it needs to be adapted for a world where
inflation is a permanent feature. Whereas this chapter introduced the aggregate price level
and changes in the price level, the next chapter extends the model to situate it in a world
where price increases are not one-off occurrences, but a permanent feature.
6.5
Real-world application – the Eskom crisis, GDP and prices
Section 6.4.4 describes how investment by government and the private sector expands
the long-run capacity of the economy. Graphically this expansion was represented by a
rightward shift of both the long-run and short-run AS curves. In the period after 2008,
South Africa had a striking experience of this kind – although it was in the reverse direction
and a bad experience!
The run-up: Eskom shocks the country with blackouts (or ‘load shedding’)
State-owned electricity producer Eskom, which declared its fourth power emergency of
the 2013/14 summer maintenance season on Thursday morning, began implementing load
shedding from 9:00, causing shops to shut, disrupting cellular networks and raising fresh
concerns about the constraint being placed on South Africa’s already poor growth outlook
by the country’s electricity shortages.
Mining Weekly, 6 March 2014
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In 2007 Eskom suddenly announced that, with electricity reserves running lower than 8%
in some areas, they would need to implement a blackout schedule – euphemistically called
‘load shedding’ – from 2008 onward to prevent crashing the entire national electricity
grid. They also announced that, following years of underfunding by the government, they
faced a huge longer-term generation capacity problem and would need to build several
new power stations – but that it could take several years (and cost billions of rands).
To ‘solve’ the problem in the interim, Eskom put pressure on mines, aluminium smelters
and large factories to cut back on their electricity usage. To achieve the desired 10%
reduction in electricity consumption, many had to cut back on production. Retail and
other businesses suffered losses and many had to buy diesel generators to carry them
through blackout periods. Planned – and often unplanned – maintenance on ageing
power stations and other equipment contributed to a bad period for the economy with
regard to a vital input. The disruptions had a very negative effect on business confidence
and appear to have discouraged foreign direct investment in South Africa. The year 2008
alone is estimated to have cost the economy R50 billion in lost production.
In 2012, Eskom once again warned that rolling blackouts may happen. This pattern
continued on and off until the time of writing (2019), despite the fact that Kusile and
Medupi, two coal power stations being built in Mpumalanga and Limpopo respectively, were
supposed to be on stream by 2017. (The fact that the construction of these power stations
had again fallen behind schedule and suffered from construction faults that prevented them
from operating at full capacity, further increased business and consumer anxiety.)
Moreover, to help fund its capital expenses, Eskom started to increase electricity tariffs
significantly. Having had average annual price increases of just above 5% since 2000,
from 2008 tariffs were increased by, on average, 27% per year for four years. After
that it was restricted by Nersa (the official regulator) to 16% and then 8% per year. By
2019 electricity tariffs had increased by more than 300% within ten years. By 2019
Eskom also accumulated debt of almost half a trillion rand, equal to almost 10% of
GDP, imposing a heavy interest burden on the company and necessitating continual
government bail-outs.
On a macroeconomic level, as shown in the diagrams in chapter 1, the period under
discussion is characterised by upward pressure on the average price level since 2010
(i.e. several increases in the inflation rate) plus a decline in the GDP growth rate since
2011. While many factors have probably contributed to this course of events – e.g.
increases in the dollar price of oil from 2009 to 2014, coupled with a decline in the real
effective exchange rate of the rand since early 2011 – the Eskom problems appear to have
had a noticeable impact on both the GDP rate of growth and the rate of inflation. At the
very least Eskom is a substantial part of the explanation of events.
Understanding the slowdown in GDP growth and upward pressure on the average price level
since 2008
The AD-AS model can be used to get a clear analytical grasp of how this could have
occurred.
There are two blows stemming from Eskom:
1. A bottleneck in electricity output (i.e. in the flow of electricity), which repeatedly
causes cost increases in production processes (lost production, damage to machinery,
workers and machines being unproductive during blackouts, switch-on costs of
factories after blackouts, having to install diesel generators and so forth), as well as
major increases in electricity tariffs.
6.5 Real-world application – the Eskom crisis, GDP and prices
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2. A backlog in Eskom’s long-term electricity generation capacity. This delays and
discourages private investment in productive capacity (factories, mines, infrastructure,
etc.), thereby constraining the growth in the country’s overall capital stock and
productive capacity in the medium to long run. (If Eskom’s construction of expensive
new power stations is delayed, that in itself would constitute an additional reduction
in real investment.)
Both of these are considered in the following discussion in the context of a situation with
a steadily growing GDP. This enables us to see the medium- to long-term effects of the two
Eskom-related problems. Figure 6.32 shows their combined impact on output Y and the
price level P over several years.
❐ The bottom diagram shows a base run with steadily growing output and income levels due
to steadily growing aggregate demand and aggregate supply – i.e. a steadily increasing
structural equilibrium output YS resulting from a steadily outward-shifting AD together
with ASLR (with ASST tagging along). The equilibrium price level P remains constant.
❐ The top diagram shows how the course of equilibrium Y and P is affected by Eskom’s
output and capacity constraints: Y expands less per year and the price level P increases.
The top path in figure 6.32 is a combination of the following:
❐ a supply, or cost, shock (see figure 6.24), and
❐ the supply (and demand) effects of a decline in investment (compare figure 6.28).
This path will be explained by first analysing changes in a single year and then inserting
that analysis into a longer-term, steady-growth situation.
Unpacking the Eskom effects for a single year
As a first step, figure 6.31 zooms in on an interval between two points in time, i.e. the
year 0 (when the Eskom problems start, approximately 2008) and year 1, when the
impact is felt. Nevertheless, we keep the context of a steadily outward-shifting AD and
ASLR in mind.
In figure 6.31 we start in year 0 at point 0 where AD0 and ASLR0 intersect. In the absence
of any Eskom problems, AD and ASLR would have shifted to AD1* and ASLR1* and generated
equilibrium point a with income at Y1* and the price level constant at P0.
However, the supply shock of load shedding (which causes cost increases and production
cutbacks) and higher tariffs implies that the expansion of aggregate supply is being
constrained. There is a negative supply shock on both long-term and short-term aggregate
supply: ASLR and ASSR shift left (in tandem) relative to where they would have been in the
absence of the shock.
Secondly, the discouragement of investment has two effects. First, it holds back aggregate
demand (AD) growth – AD only shifts to AD1 (indicated by the dotted blue arrow) and not
all the way to AD1*. Secondly, and importantly, it causes a negative impact on the growth of
the capital stock and the expansion of productive capacity. This causes a negative impact
on the expansion of aggregate supply (ASLR).
The combined negative supply-side effects imply that the long-term aggregate supply curve
actually shifts only from ASLR0 to ASLR1 (as indicated by the solid blue arrow). (In other
words, compared to where it would have been without the Eskom supply shock, ASLR ends up
in a more leftward position – it has ‘shifted’ left in relative terms, as has ASSR). Combined
with a constrained AD shifting rightwards only to AD1 it means that the economy would
converge on point b.
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Figure 6.31 The impact of Eskom bottlenecks on GDP growth and prices: decomposing the changes of a single year
ASLR0
ASLR1
ASLR1*
P
Equilibrium after supply
constriction, the drop in
investment (demand) and
the ASSR adjustment
ASSR1
ASSR0
ASSR1*
P1
P0
1
b
a
0
Equilibrium after supply
constriction and a drop in
investment – but before
ASSR adjustment
Equilibrium if no
Eskom problems
AD0
YS0
Y1
AD1
Y1*
AD1*
Y
However, since this point is not on the vertical ASLR1, it would not be an equilibrium point.
Price expectations will come into play and cause ASSR to adjust, shifting ASSR upwards to
ASSR1 and taking the economy to an equilibrium at point 1, with income at Y1 and the
price level having increased to P1.
The net effect is that the increase in equilibrium income (from YS0 to Y1) in that year ends
up being smaller than it would have been, were it not for the Eskom problems – and the
price level P ends up being higher. The economy has moved from point 0 to point 1 (see the
curved blue arrow) instead of point a.
Repeated Eskom problems leading to ongoing growth and inflation problems
Since these Eskom problems have recurred in the subsequent years, this pattern has
repeated itself several times. Figure 6.32 shows the cumulative effect of a series of years
such as that of figure 6.31 (without showing the smaller annual adjustments) compared
to a base run where no Eskom problems occur. Key to this sequence is that, following the
Eskom shocks in year 0, from year 1 onward the net annual rightward shifts of ASLR and
AD are smaller than before.
The result is a series of smaller annual steps in Y (i.e. a drop in the GDP growth rate) and
continued upward movements in the average price level P (i.e. a higher rate of inflation).
6.5 Real-world application – the Eskom crisis, GDP and prices
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Growth is being choked, coupled with upward pressure on prices, on a path indicated by
the curved row of equilibrium dots (upper half of figure 6.32).
If the cost shocks come to an end, the increases in P should level off within a few years, for
example by year 7 or 8 (i.e. the rate of inflation will decline again).
❐ Note that, for example by year 8 (i.e. 2016/7 in reality), Y would be much lower than
in the base run – i.e. much lower than it would have been, had the Eskom shocks and
backlogs not occurred. The Eskom problems would have had a large, permanent impact
on the level of GDP.
❐ If Eskom’s capacity problem remains, growth of GDP would continue steadily from
there on, but at the lower rate.
❐ If Eskom resolves the problem, the rate of growth could return to higher levels.
❐ If new problems recur, a pattern of still slower growth and a yet further increasing
price level would repeat itself.
While the diagram is only a stylised depiction of the post-2008 experience with Eskom,
it provides a powerful analysis and explanation of the performance of the South African
economy in this period – even though it is not the only explanation.
Figure 6.32 The impact of Eskom bottlenecks on GDP growth and prices (medium- to long-term effects)
P
AD-2 AD-1
ASLR-2 ASLR-1
ASLR1
ASLR0 ASLR2
AD0 AD1 AD2
ASSR-2 AS AS
SR0
SR-1
ASSR2
P8
P4
P0
?
Y-2
P
Y0 Y1 Y2 Y3
Y-1
ASLR-2 ASLR-1
Y8
Y
ASLR1 ASLR2
ASLR0
AD-2 AD-1 AD0 AD1 AD2
In years 1 and 2 the annual shift
of ASLR to the right gets smaller.
Thus the annual increase in
YS declines. Growth is being
choked, coupled with upward
pressure on costs and prices.
• By year 8, Y is much lower
than in the base run (below).
• Growth in Y will continue at
the lower rate until Eskom
solves the capacity problem.
ASSR-2 ASSR-1 AS ASSR1 AS
SR2
SR0
In this base run, the annual increase in
YS is constant. Growth is steady and
there is no upward pressure on costs
and prices.
• By year 8, Y is much higher than in
the Eskom-constrained run.
P1
Y-2
298
Y-1
Y0
Y1
Y2
Y3
Y8
Y
Chapter 6: A model for an inflationary economy: aggregate demand and supply
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6.6
Analytical questions and exercises
1. It is often argued that the introduction of the Labour Relations Act has restricted the
ability of businesses to lay off employees, making it more difficult for firms to reduce
their labour costs in order to stay profitable. Use the price-setting (PS) and wagesetting (WS) relations to explain and illustrate how such a restriction can impact the
long-run (or structural) rate of unemployment.
2. Suppose the productivity of South African workers increases due to better skills
development. Use the price-setting (PS) and wage-setting (WS) relations to explain and
illustrate the impact of higher productivity on the long-run rate of unemployment.
3. Use the AS-AD model to explain and illustrate the short-run and long-run impact, on
the aggregate price level and the level of national income, of the overall change in the
repo rate since 2007.
4. Turmoil in the Middle East, especially tension between the USA and Iran, has raised
the spectre of major increases in the price of oil again (following such a period in
2008–09). Use the AS-AD model to explain and illustrate the expected impact on the
economy of an oil-dependent country such as South Africa.
5. US President Trump signed large cuts in corporate tax into law in December 2017.
He has also put pressure on the US Federal Reserve to reduce interest rates further.
Use the AS-AD model to explain and illustrate the expected short-run and long-run
impact on the aggregate price level and the level of national income of South Africa
due to these policy steps in the USA.
6. ‘The flight from risk, by investors, has led to the depreciation of emerging countries’
currencies. South Africa’s rand depreciated due to the sale of shares and bonds by
foreigners – almost R70 billion in the first six months of 2019. The weak rand is likely
to result in an increase in the petrol price.’ Use the price-setting (PS) and wage-setting
(WS) relations to explain and also illustrate, in a diagram, the impact of an increase
in the petrol price. Clearly indicate the impact on the long-run rate of unemployment
and the aggregate price level. Also indicate diagrammatically how this will shift the
ASLR curve.
7. Suppose the annual rise in the consumer price index (CPI) increases to well outside the
3–6% official range targeted by the Reserve Bank, with direct implications for decisions
on the repo rate. There would be good reasons for the Bank to apply a restrictive policy.
Use the AS-AD model to explain and illustrate the short-run and long-run impact on the
aggregate price level and the level of national income if the Reserve Bank implemented
such a restrictive monetary policy.
8. Use the price-setting (PS) and wage-setting (WS) relations to explain and illustrate the
impact of more stringent labour laws on the South African economy. Clearly indicate
the expected impact on the unemployment rate. Also indicate diagrammatically how
this will shift the ASLR curve.
9. In 2014 the government introduced a youth wage subsidy, also known as the
Employment Tax Incentive Act (ETI), to encourage companies to employ more young
employees. Use the price-setting (PS) and wage-setting (WS) relations to explain and
illustrate the likely impact of the implementation of such a subsidy. Clearly indicate
the expected impact on employment and the unemployment rate. Also indicate
diagrammatically how this will shift the ASLR curve. What is the evidence regarding
the success of this subsidy in increasing youth employment? (Consult the internet as
necessary.)
6.6 Analytical questions and exercises
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Addendum 6.1: Labour market changes following demand stimulation
This is an extension of the example of demand stimulation followed by aggregate supply adjustment
in section 6.4.2. It should be read together with that text, plus the following to explain events in the
labour market.
❐ In the expansion phase, the LS curveWshifts down to LS1. WS remains stationary because P e has
not changed. The real wage drops to 
​  P ​because of the increase in actual price to P1; employment
increases to N1.
❐ As the ASSR adjustment starts, Pe and the renegotiated nominal wage increases (to W1) to match
W
up with price P1. However, the actual price has already risen above P1 to P2. The new real wage 
​  P ​
is still lower than the starting real wage. But the real wage has recovered some of the ground
lost due to the demand stimulus and unanticipated price level increase. Employment drops due
to the adjustment of ASSR, but not yet as far back as its starting value NS. LS would have shifted
back to LS2, reflecting effective labour supply at fixed nominal wage W1 for the duration of the
renegotiated labour contract.
❐ Since the equilibrium is not yet on ASLR the adjustment continues. In the end, when ASLR is
reached, the nominal wage will be at W3 to match up with the final price level P3. The final
expected price P e will equal the final actual price P3, but obviously
at a higher level than initially.
W
W
The real wage would have recovered all the way so that 
​  P ​= 
​  P ​. Employment drops yet further,
back to its starting level at NS, the structural equilibrium level of employment.
0
1
1
2
3
3
Y
0
0
Y
TP
45° line
Y1
YS
NS
N1
W
W
​  P 3 ​ = 
​  P 0​

3
N
P
​  W
​

P
YS
ASLR
WS
P3
0;2
LS0;3
0
LS2
W1
​  P ​

2
W0
​  P ​

1
1
LS1
2
ASSR2
ASSR1
1
0
AD1
PS
NS
300
N1
Y
ASSR0
P2
P1
P0
Y1
AD0
N
YS
Y1
Y
Chapter 6: A model for an inflationary economy: aggregate demand and supply
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Addendum 6.2: Labour market details following a domestic supply shock
This is an extension of the example of domestic supply shock followed by aggregate supply
adjustment in section 6.4.3. It should be read together with that text, plus the following to explain
what happens in the labour market.
❐ As the supply shock occurs, the PS curve shifts down due to an increase in the mark-up to
compensate for the increased non-labour input costs. Because the price level P increases (to
W
P1) to reflect the higher input costs, the LS curve shifts down to LS1. The real wage drops to 
​  P ​
because of the increase in actual price to P1 while the initially contracted nominal wage W0
is still in place. The new short-run equilibrium is at employment level N1, reflecting a drop in
employment due to the supply shock as such.
❐ As the ASSR adjustment starts, P e and the renegotiated nominal wage increases (to W1) to match
W
up with price P1. However, the actual price
has already risen above P1 to P2. The new real wage 
​  P ​
W
is still lower than the starting real wage 
​  P ​. But the real wage has recovered some of the ground
lost due to the supply shock and unanticipated price level increase. Employment drops further
below N1 due to the ASSR adjustment, but it is not yet at the long-run level NS. LS would have
shifted back to LS2, reflecting effective labour supply at fixed nominal wage W1 for the duration
of the renegotiated labour contract.
❐ Since the equilibrium is not yet on ASLR the adjustment continues. In the end, when ASLR is
reached, the nominal wage will be at W3 to match up with the final price level P3. The final
expected price P e will equal the final actual price P3, but obviously at a higher level than initially.
Through the Wincreases in the levels at
which W is set and P is set, the real wage would have
W
recovered to 
​  P ​ which is lower than 
​  P ​. Employment drops yet further, back to the new, postshock structural equilibrium level at N2.
0
1
1
2
0
0
3
0
3
0
TP
Y
N2
N1 N0
45° line
Y
N
YS2
Y
W
​  P ​

PS0
ASLR1
Y1 YS0
ASLR0
W0
LS0
​  P ​

0
W3
​  ​

P3
W1
LS3
​ 
​
P
P3
P2
P1
P0
Phase 1: Supply
shock shifts
both ASSR and
ASLR left
LS2
2
W0
​ 
​
P
AD
LS1
1
NS
N1 N0
N
ASSR2
ASSR1 AS
SR0
WS
PS1
Y
YS2
Y1 YS0
Phase 2:
Supply adjustment process
shifts ASSR up
Y
Addendum 6.2: Labour market details following a domestic supply shock
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Addendum 6.3: A complete example of IS-LM-BP and AD-AS for an
increase in the repo rate
The case of a repo rate increase
has been explained several times.
❐ In chapter 4 (section 4.7.5)
the IS-LM-BP analysis was
shown, still under the as­
sumption of a constant price
level P, to produce equilib­
rium values of r and Y.
❐ In section 6.2.5 the diagram
of section 4.7.5 was used
to show how the AD curve
would shift in line with the
change in the IS-LM equilib­
rium point.
❐ Section 6.4.2 finally showed
that same, shifting AD curve
together with AS curves,
generating changing equi­
librium values of P and Y.
The direct correspondence be­
tween changes in the IS-LM-BP
model and the AD-AS model are
shown alongside in one set of
diagrams.
❐ Note how the short-run
equilib­rium points 1 to 3 in
the IS-LM-BP diagram have
their exact counterparts in
the AD-AS dia­gram.
❐ Thus one can see, together
with the changes in Y and
P, what happens to the real
interest rate r as well as the
balance of payments (BoP).
r
LM1
LM2
LM3
LM0
LM4
1
r1
BP1
2
r3
r0
BP0
BP2
0
3
4
IS1
IS0
IS2
Y
P
AD1 AD3 AD2
AD0
ASLR
ASSR0
ASSR1
P0
P3
2
1
0
3
P4
4
Y1 Y3 Y2
One important thing to notice is
that the shifts of the LM curve
are NOT the same as the original shifts in section 4.7.5 or in 6.2.5.
Y0
YFE
Y
This is because the move of the equilibrium along the ASSR curve – from point 0 to 1 and back to 2
and 3 – implies changes in the price level P. This impacts correspond­ingly on the real money supply

​  MP ​, which affects the position of the LM curve.
❐ The leftward shift from LM0 to LM1 is re­strained by the decrease of P from P0 to P1. Thus LM1
shows the net shift in LM. Likewise, the shift from LM1 to LM2 is restrained by the increase of P
to P2. LM2 shows the net shift in LM.
❐ The LM shifts to position LM3 when P declines from P2 to P3. (Points 2 and 3 are not on the same
LM curve.)
S
MS
​  P ​, which shifts the LM curve right. Due to a
When P declines from point 3 to point 4, it increases 
BoP deficit that develops, the BP and IS curves will also shift to the right. This takes the economy to
point 4 on both diagrams.
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Addendum 6.4: A complete example of IS-LM-BP and AD-AS for an
increase in the price of imported inputs (e.g. oil)
The analysis of an oil price
increase was provided in
section 6.4.3. The purpose
here is to show the corres­
ponding changes in the ISLM-BP diagram, notably
its power in showing the
rather complex behaviour
of the BoP and its con­
stituent components, the
CA and FA. Thus we con­
centrate on the graphical
analysis – which is quite
complex and requires care­
ful scrutiny.
r
LM4 LM5
LM3 LM2 LM0
LM1
BP1&3
r5
r7
r0
r2
r1
5
7
BP2
6
4
3
BP0
0
2
1
IS0
IS2
IS1&3
From point 0 to point 1:
P
AD3&5
ASSR2
AD
The decrease in domestic
AD1&4 0
AD2
expenditure causes the IS
and BP curves to shift left
from IS0 to IS1 and BP0 to
7
BP1, while the LM curve P7
momentarily shifts right to
LM1 due to the decline in
2
M
P4
P (and increase in ​ 
P ​). The
P0
4
1
0
3
IS-LM intersection moves P1
left, and AD shifts the
same horizontal distance
left from AD0 to AD1. The
equilibrium moves from
ASLR1
ASLR0
point 0 to point 1 on both
the IS-LM-BP and ADYS1 Y3 Y4
Y1 YS0
AS diagrams. This point
is below the BP1 curve,
indicating that a BoP deficit has developed (CA and FA in deficit).
Y
ASSR1 ASSR0
S
YFE
Y
From point 1 to point 2:
As supply contracts, Y decreases while P increases; thus 
​ MP ​decreases. LM starts shifting
left. Given the slopes of IS and LM, the net effect on the interest rate from the starting
point is still negative: r2 < r0. While the FA should recover, it is still likely in a deficit. CA
should have improved due to the decline in Y, but the magnitude of the initial CA deficit
still dominates, given size of oil bill (and bearing in mind that the increase in P would curb
any CA improvement). The BoP is still in deficit.
S
There has been a leftward shift of (a) ASSR from ASSR0 to ASSR1 and (b) ASLR from ASLR0 to
ASLR1. This shows the following things:
Addendum 6.4: A complete example for an increase in the price of oil
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(a) Through the interaction between ASSR1 and AD1 a temporary equilibrium (P2; Y2) is
reached at point 2 on the AD-AS diagram.
(b) The structural equilibrium level of output YS has shifted to a lower level.
(c) The average price level P is higher than at the starting point: P2 > P0.
From point 2 to points 3 and 4:
Initial BoP effect (foreign reserves adjustment): Graphically, the net decrease in the money
supply will reflect as a shift in LM to the left from LM2 to LM3 (partly restrained by a decrease
in P from P2 to P3). Internal equilibrium moves to point 3. AD shifts left to AD2.
Concluding BoP effect (exchange rate adjustment): IS and BP move to the right from IS1 to IS2
and BP1 to BP2. An internal and external short-run equilibrium will be reached at point 4.
In the AS-AD diagram, AD will shift to the right from AD2 to AD3 with the equilibrium also
reaching point 4.
At short-run equilibrium point 4, we still have:
Y > YS and P > P e
A medium-run supply adjustment process follows.
From point 4 to point 5 (only shown on IS-LM-BP diagram):
Supply adjustment: Graphically, ASSR shifts upward until it intersects the AD curve and
ASLR.
M
The increase in P de­creases ​ 
P ​and LM shifts left to LM4. The equilibrium moves up along
IS and AD towards points 5 and 7 respec­tively. With r now above starting levels, FA moves
into a surplus. The cost- and interest-rate induced de­crease in income Y from point 4 to 5
also de­creases M, so CA moves into surplus. BoP surplus de­velops.
S
From point 5 to point 6 (only shown on IS-LM-BP diagram) and 7:
Normal BoP adjust­ment processes, during which r decreases and the rand appreciates;
(impact of in­creasing P on X and M will assist BoP proc­esses). BoP back to po­sition of
balance.
The money supply effect will see LM and AD shift right to LM5 and AD4 (al­most at the
position of AD1). After that IS, BP and AD will shift left to IS3 (almost at the posi­tion of IS1),
BP3 (almost at the position of BP1) and AD5 (almost back at the position of AD3). On the
IS-LM-BP dia­gram the equilibrium moves from 5 to 6 to 7. (For visual ease, we draw these
closely posi­tioned lines superimposed.)
On the AD-AS diagram only the net effect is shown. While all the shifts are not shown, the
typical right-then-left shift of AD will be present in the BoP adjustment phases of the final
stages of the ASSR adjustment. AD3 as shown must thus be understood as the final position
of AD. P and Y ends at (P7; YS1), following perhaps minor fluctuations in Y on its path
towards its final resting point on ASLR.
The process ends at point 7 where there is both internal (real, monetary and labour
market) and external (BoP) equilibrium.
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Extending the model: inflation
and policy reactions
7
After reading this chapter, you should be able to:
■ demonstrate how an adapted AD-AS framework can be used to show how the rate of
inflation is determined together with real GDP, i.e. to analyse economic fluctuations in an
inflationary environment;
■ use the Phillips (or PC) curve to assess and analyse possible short-run and long-run
relationships between inflation and GDP;
■ evaluate the relevance of the Phillips-curve debate for anti-inflation policy, and assess
arguments on whether policies can or cannot be used to manage inflation; and
■ analyse and compare typical central bank policy reactions to steer the inflation rate to a
target value, including the costs and benefits of a radical, as opposed to a gradualist,
approach to reducing inflation.
The previous chapter showed various cases of demand and supply disturbances
impacting on the average price level and output. Such disturbances tend to be followed
by supply adjustment processes that eventually return the economy to a long-run or
structural equilibrium level of output and a new, stable price level. In some of these
cases, the price level adjusts downwards before reaching the stability of the structural
equilibrium.
Both a stable price level and a downward-moving price level may seem strange, given that in
most economies inflation is a more
or less permanent phenomenon
Do you want to know more about inflation?
– the average price level is always
More information on and discussions of inflation
increasing, even in recessionary
in South Africa and other countries, including the
times or when the central bank or
probable causes of inflation, can be found in chapter
government is pursuing a contrac12, section 12.1.
tionary policy. Does this make the
model irrelevant? The answer is
no, but it requires a slight adjustment to the model to set it in an inAS by a different name? The Phillips curve
flationary context.
An inflationary context means an
economic envi­
ron­
ment where it
has be­come normal for prices and
wages to increase year by year and
where, indeed, prices and wages
are expected to increase continually.
An essential part of analysing the inflationary context,
and policy in that context, is a name that will crop up
in all textbooks: the Phillips curve. For reasons that
are explained below, the aggre­gate supply curves in
this context are frequently called Phillips curves, and
indicated as PCSR and PCLR in diagrams. We will also
do so in the discussion that follows.
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Defining inflation
Inflation is defined as a sustained increase in the average price level. One-off or intermittent
increases in the average price level do not constitute inflation.
The inflation rate, usually denoted by the symbol π, is the rate of increase of the average price
level during a specific period, normally one year. More specifically, the inflation rate is the
percentage increase in the price level during the chosen period:
Pt – Pt–1
π = 
​  P ​ 100
t–1
Statistically, it is measured using price indices such as the consumer price index (CPI). Various
ways of measuring the inflation rate exist in practice. This, and other aspects of inflation,
including historical data for South Africa, is discussed in chapter 12.
Improvements in quality
One complexity in measuring changes in the price level is that prices often increase due to
improvements in goods, i.e. higher quality. Or nominal prices remain roughly the same despite
significant increases in quality, e.g. cell phones or PCs since the 1990s. Separating quality
changes from pure price changes is very difficult.
Some economists have argued that, as a rule of thumb, a 2% inflation rate merely reflects the
increase in the price level that results from the general improvement in quality of all goods.
Thus an inflation rate of approximately 2% would be normal and, actually, negligible.
The rate of inflation may vary, but inflation is always there.
❐ Note that this regular increase in the price level may not be high, and might be as low
as 2% per annum in some countries. No central bank would be overly concerned with
an inflation rate of 2%. In some countries Figure 7.1 AD-AS and a continually increasing
a higher rate of inflation is considered price level
normal, and the central bank may be
ASLR
P
happy with a rate between 3% and 6%
(e.g. South Africa; see chapters 9 and 12).
7.1
7.1.1
Adjusting the model – inflationaugmented AD and AS curves
P4
A state of steady inflation
P3
Consider an economy with a steady rate of
inflation at x%, and assume that it is steady
at the structural equilibrium output level YS.
This means that the price level P increases by
x% every year, while the economy remains
on ASLR. If we illus­trate this ‘steady inflation
state’ graphi­cally on the P-Y plane, using the
AD-AS curves, it would show a repeatedly
up­ward-moving AD-AS cross, pushing the
equilibrium point up repeatedly along the
vertical ASLR line (see figure 7.1). The price
level in­creases from P0 to P1 to P2 and so forth
without end. This process would soon push
the AD-AS curves off the page!
306
ASSR2
ASSR1
P2
ASSR0
P1
AD2
P0
AD1
AD0
YS
Y
Chapter 7: Extending the model: inflation and policy reactions
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To prevent this, we can redefine the ver­tical axis: instead of the price level, we plot the
rate of change (%∆) in the price level (i.e. inflation, denoted as π) on the y-axis. Output Y
appears on the x-axis, as in the normal AD-AS framework. This is shown in the diagram
in figure 7.2.
❐ The thus redefined aggregate demand and aggregate supply relationships can be termed
inflation-augmented or quasi-AD and quasi-ASSR curves, in­dicated as AD and ASSR.
A quasi-ASLR curve can also be plotted (it will remain vertical).
❐ Alternatively, the supply curves can be indicated as PCSR or PCLR, as noted above.
The main characteristic of AD and
ASSR is that, in a state of steady inflation, they remain sta­tionary in the
new π-Y plane – while AD-AS would
soon drop off the top edge of the page
in the P-Y plane.
As we will see below, disturbances
would once again lead to short-run
equilibrium points off the ASLR curve,
followed by supply-side adjustments.
But we will see impacts on the inflation
rate π rather than on the price level P.
Figure 7.2 A state of steady inflation
π
ASLR (or PCLR )
ASSR (or PCSR )
π
Steady inflation
structural
equilibrium
AD
Note the following important points
regarding the steady inflation case:
Y
YS
❐ At every equilib­rium point in both
diagrams (figures 7.1 and 7.2), the
ex­pected price equals the actual price. Thus ∆P e = ∆P and thus also %∆P e = %∆P. The
latter means that the expected rate of inflation is equal to the actual rate of in­flation (in
the steady state described): πe = π. The short-run equilib­rium of AD and ASSR is on ASLR
all the time.
❐ In the labour market, the nominal wage would increase every year by exactly the same
rate as the price level P, i.e. its percentage rate of increase would equal the inflation rate
π. Thus the real wage remains constant. PS and WS would remain stationary. Producers
and workers expected inflation to be at π and inflation is at π. No one is surprised by
the normal price level increase. When wages are negotiated at the beginning of the
contract period, nominal wages are adjusted in anticipation of the expected normal
inflation in that period. The same is true for the prices set by firms.
❐ Likewise, the steady AD curve means that aggregate expenditure, comprising the
components of expenditure C, I, G and (X – M), remains constant in real terms (as does
The causes of inflation?
We are not analysing the causes of inflation now. That will be done in chapter 12, section 12.1.
We merely create the analytical tools to enable us to analyse economic fluctua­tions, shocks in
supply and demand, and policy steps in an environment where there always is inflation. Thus
we sim­ply work in terms of the inflation rate π rather than the price level P.
What will be required in due course is an economic explanation of how and why the AD and
ASSR curves started shifting up and how and why this shift came to be perpetuated as a
permanent phenomenon.
7.1 Adjusting the model – inflation-augmented AD and AS curves
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the real money supply 
​ MP ​). In other words, the nominal value of aggregate expenditure
increases by the same percentage π in every year (as does the nominal money
supply MS).
S
7.1.2
Disturbances in the π-Y plane
Disturbances due to demand or supply
shocks can now be analysed in parallel
fashion to the original analysis in the
AS-AD diagram. However, some results
are particularly forceful in the new diagram with π on the vertical axis.
Disturbances and shocks will register as
unexpected shifts in the ASSR and AD that
take place over and above the expected,
continual shifts shown in figure 7.1 or,
equivalently, in figure 7.2.
Figure 7.3 Higher expenditure growth in the P-Y plane
P
ASLR
ASSR2
ASSR1
P2
e
​P​2​​
AD2
ASSR0
P1
A demand expansion example
P0
Suppose expected inflation is steady at
AD1
π e = 4% and has been so for some time.
❐ In the P-Y plane (figure 7.3), both
ASSR and AD will have been shifting
AD0
upwards steadily by 4%. Suppose they
YS
Y1
Y
have now reached the point of shifting
from AD0 to AD1 and ASSR0 to ASSR1.
The price level increases the normal 4% from P0 to P1. Output is steady at YS.
❐ In the π-Y plane (figure 7.4), both AD and ASSR (i.e. PCSR – the short-run Phillips
curve) will be stationary and intersect at π0 = 4%. Expected inflation also is at π e = 4%.
Output is steady at YS.
However, suppose in the next period nominal government expenditure or investment
(due to an interest rate decrease, for instance) increases more than normal and causes
aggregate expenditure growth to go up to, for example, 6%.
❐ In the P-Y plane this will cause AD to Figure 7.4 Higher expenditure growth in the π-Y plane
shift upwards and to the right (to AD2)
π
ASLR (or PCLR )
faster than ASSR (since the expected
e
price P​​2​​  is now lagging behind).
This involves shifting in excess of its
ASSR0;1 (or PCSR )
‘normal’ (and expected) upward shift
Equilibrium
of 4%. Therefore, a larger increase
after demand
in the price level will occur (from P1 π
stimulation
1
to P2), in excess of the normal 4%, π
0
together with an increase in output
AD2
beyond long-run output (output will
AD0;1
climb to Y1).
❐ In the π-Y plane, the AD curve
shifts up and to the right, while PCSR
YS Y1
308
Y
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(i.e. ASSR) remains stationary since its intercept with PCLR (i.e. ASLR ) is at π0 (and the
expected inflation rate π e = π0). The short-run equilib­rium shifts along the ASSR curve
to the right of ASLR, registering an increase in the out­put level to Y1. The inflation rate
rises to π1.
Similar but opposite shifts in AD would occur for a decrease in the growth rate of
expenditure to below the expected inflation rate. It would cause a decrease in the out­put
level to below YS, and the inflation rate would drop to a value below π0.
❐ If AD shifts so far down that the short-run equilibrium inflation level is below zero, it
means that the economy is in negative inflation or deflation territory, i.e. prices decline
year after year.
7.1.3
The AS-adjustment process in the π-Y plane with AD and PCSR
As we know by now, points off the ASLR curve (i.e. PCLR) will not be sustained indefinitely
due to intrinsic economic dynamics. The expected aggregate supply adjustment process
also occurs in the inflationary context, and thus in the AD-AS model.
Demand expansion or contraction
Let us take up the example of demand Figure 7.5 Complete effect of higher growth in expenditure
stimulation shown above. Once
π
PCSR2
PCLR
inflation has increased from π0 to π1
(figure 7.5), inflation expectations
PCSR1
are sure to adjust upwards and there
PCSR0
Equilibrium
will be upward pressure on nominal π
2
after supply
wages. Once wages are renegotiated
adjustments
π
upwards, this will shift the ASSR,
1
Equilibrium
now renamed the short-run Phillips π
after demand
0
curve (PCSR), to shift upwards from
stimulation
PCSR0 to PCSR1. Prices, real wages
AD1
and employ­ment will adjust (as in
AD0
the AD-AS model), and inflation will
increase together with a decrease in
Y
YS Y1
output. The actual inflation rate will,
however, yet again be higher than
the expected inflation rate (which would now be at π e = π 1). Thus, during a next cycle of
wage negotiations, another upward adjustment of wages is sure to follow, shifting PCSR up
again. And so on and so on (just like the process in the AD-AS model).
❐ The process is likely to continue until the short-run equilibrium settles on PCLR, the
long-run supply curve, at the structural equi­librium level of output YS and with the
infla­tion rate at π2.
❐ As the economy is back at a structural equilib­rium point, π2 is now also the new
expected inflation rate πe. From now on, workers and firms will expect prices to increase
annually at rate π2 and not π0. There has been a lasting in­crease in the inflation rate
(and the expected inflation rate).
❐ Using the illustrative numbers of expenditure growth of the example above, the annual
inflation rate will have increased from 4% to 6%.
❐ As noted in the AD-AS con­text, the whole process of ex­pansion followed by supply
adjustment (in this case a con­
traction combined with an in­
crease in inflation,
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i.e. stagflation) could take
between four and seven years,
requiring suc­cessive rounds of
wage rene­gotiations.
What is stagflation?
The short-run Phillips curve associates higher output
and employment with higher inflation. This is typically
when inflation is what is called an ‘excess demand
phenomenon’, i.e. when the aggregate quantity
demanded exceeds long-run levels of output. This
corresponds to the expansion phase in the example
above.
Nevertheless, even though the
government or the central bank
was able to stimulate output (and
employment) in the short run for
a number of years, in the long run
In contrast, stagflation occurs when higher inflation
output is likely to return to YS (and
occurs together with economic stagnation. Typically,
employment will correspondingly
stagflation occurs after a supply shock or supply
decline again over time). The
adjustment that shifts the ASSR (or PCSR) upwards
short-run, and thus temporary,
and to the left. The adjustment phase in the example
gain in output and employment
above is an illustration, although a pure supply shock
came at the cost of a permanently
would be a better one.
higher inflation rate.
❐ The main implication for policy is that a sustained stimulation of aggregate demand growth will eventually only
translate, after all the short-term supply adjustments, into a higher rate of inflation
(even though this may take several years). The structural equilibrium level of output
will not change.
❐ This does not mean that monetary or fiscal policy cannot be used to counter a recession,
i.e. from a point below the structural equilibrium output level YS. But output cannot be
pushed beyond YS for a significant period of time without paying an inflation penalty
later.
❐ Of course, if the increased demand expenditure led to a permanent boost of the productive capacity of the economy (e.g. through infrastructure investment), the new YS
would indeed be higher than before, and any inflation rate increase would be moderated.
The more realistic policy lesson thus is less severe than the one stated in the previous
paragraph, as long as the focus of any increased expenditure is the creation of new
productive capacity (see section 7.1.6).
One-off vs. sustained demand changes
If the higher nominal growth rate (e.g. at 6%) of aggregate expenditure is sustained year
after year, the AD curve will remain in its higher position at AD1, followed by the supply
adjustment as shown.
However, if the increased growth rate of aggregate expenditure is one-off, so that it returns
to the normal 4% in the next year, the AD curve will shift down again to its original
position. The conclusion of the one-off demand stimulation will be back at the starting
point. Output will have declined back to YS after the brief upswing. Inflation will have
increased briefly, but it will be back at π0 (say 4%, as in the numerical example). There is
no permanent increase in the inflation rate.
Yet there may still be some social costs to this process. As long as inflation expectations
are slow to adjust and be reflected in wage contracts – which is not unlikely in practice
– the PCSR curve will remain stationary and the return to the original equilibrium will
be straightforward. The AD curve will simply shift down again to its original position
before any supply adjustment starts taking place. If, however, inflation expectations and
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renegotiated nominal wages go up rapidly, the PCSR curve will indeed shift up noticeably.
The drop in the AD curve will then generate a more roundabout route for the shortrun equilibrium point, involving a drop in output below YS before settling back, through
supply adjustment, at YS. (This phase shares elements of the case of a decrease in demand;
compare chapter 6, section 6.4.2. The details are left to the reader as an exercise.)
✍
Do the complete graphical analysis for a one-off increase in the growth rate of expenditure,
allowing for rapidly adjusting inflation expectations and wage contracts.
Supply shocks in the AD-PCSR model
A supply shock in the con­text of a steady inflation state will provide the fol­lowing, as
shown in figure 7.6. The sup­ply shock will shift both PCSR and PCLR an equal distance
to the left. The rate of inflation increases from π0 to π1, and output con­tracts from YS0 to
Y1. (Compare the supply shock analysis in the AD-AS model in chapter 6, sections 6.4.3
and 6.4.4.)
As higher inflation expectations are built into new rounds of wage negotiations, the PCSR
curve will start shifting up as part of the supply adjustment process. The inflation rate
increases further, eventually to π2, while output drops further to YS2, reaching the new
structural equilibrium output level. The equilibrium point ends up on the relocated PCLR
line, the long-run supply curve. The
net result of a contraction in output Figure 7.6 A supply shock in the π-Y plane
and employment combined with an
PCLR1 PCLR0
π
increase in the inflation rate is classic
PCSR2
π3
stagflation.
❐ The structural rate of unemployPCSR0
ment SRU would have increased –
Equilibrium
more involuntary unemployment
after supply
would be present. Involuntary
π2
shock
unemployment, whether cyclical
π1
π0
or structural, can be understood
AD2
as the difference between actual
AD0
unemployment and what it would
have been with market clearing in
labour and product markets.
Y
YS2 Y1 YS0
If policymakers come under political
pressure to counter the contraction
in output and employment, they may try to stimulate demand (to AD2) to reverse these
effects. They will be successful, but only for a while, and at the price of still higher inflation.
As we saw above, any short-run equilibrium point to the right of the PCLR line (which has
now been relocated) is not sustainable without higher inflation. The supply adjustment
process will eventually push output back to the relocated PCLR line, with yet another
increase in the inflation rate to π3. There appears to be no way to avoid the permanent
contractionary effect of a supply shock on output and employment, and neither can the
permanent upward effect of a supply shock on inflation be avoided.
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7.1.4
A permanent increase in output above YS? The augmented Phillips curve
policy lesson
The main implication for policy thus far has been that a sustained stimulation of aggregate
demand growth will eventually only translate, after all the short-term supply adjustments,
into a higher rate of inflation. Output will contract to the structural equilibrium level YS
after the initial upswing to Y1.
Our next conclusion is very important in the
context of the ‘augmented’ Phillips curve
debate (see below). It is the following: should
the government or the central bank wish
to increase output to Y1 and keep it there
permanently, it will only be possible through
repeated increases in the growth rate of
aggregate demand, which will translate into
a continually increasing inflation rate. Thus,
not only will the average price level increase
from period to period, it will increase at an
increasing rate.
Figure 7.7 Continually increasing inflation
π
PCLR
PCSR4
PCSR3
PCSR2
PCSR1
π3
PCSR0
π2
AD4
π1
π0
AD2
Consider the process following an increase
in the aggregate expenditure growth rate
from, for example, 4% to 6% with the aim of
increasing output to Y1.
AD3
AD1
YS Y1
AD0
Y
In year 1, the expansionary policy shifts the AD curve from AD0 to AD1, causing output
to increase from YS to Y1. The short-run equilibrium inflation rate in­creases to π1 (e.g. 5%).
In year 2, nominal wage increases will be renegotiated to match the new inflation rate of
π1 = 5%. This would shift the short-run Phillips curve upward from PCSR0 to PCSR1 (whose
intercept with PCLR is at π1).
Output would start to contract along AD1 – unless the sup­ply adjustment is countered by
pushing AD up fur­ther to AD2 by increasing the growth rate of expendi­ture further. This
would keep output at Y1, but the in­flation rate would increase to π2 = 6%, say. In year 3,
supply adjustment would again kick in via re­negotiated nominal wage increases to match
the new, higher inflation rate of π2 = 6%. If output is to be kept at Y1, government will
need to counter the effect of higher wage increases and the upward shift of PCSR1 to PCSR2
(whose intercept with PCLR is at π2). It will need to stimulate aggregate expenditure growth
again, this time shifting AD2 to AD3. Though output will then remain at Y1, inflation will
increase yet again to π3 = 7%, say. And so on and so on.
The picture of a ‘vicious cycle’ is clear. Keeping output at Y1 requires repeated increases in the
growth rate of aggregate demand. Inflation will increase continually year after year. In short,
output can only be kept at Y1 at the price of a continually increasing inflation rate. This is not
just a higher inflation rate – it is an increasing rate. This is clearly not a sustainable policy
as no country can live with an ever-increasing inflation rate. It would also not be possible to
increase expenditure growth indefinitely.
❐ In other words, the only output level where inflation is not increasing in the long run is
when the economy is at the structural equilibrium level of output YS.
❐ A contrasting result can be derived for keeping output levels below YS, in which case the
inflation rate would continually decline. The only output level where inflation would
not be declining in the long run is at the structural equilibrium level of output YS.
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The first bullet in the previous paragraph is the narrow augmented Phillips curve policy
result. As before, we must qualify this conclusion, since it assumes a permanently
stationary structural equilibrium output level YS (as in figure 7.7). Any positive impact of
the growing expenditure on productive capacity (i.e. on capital stock, technology, labour
skills and so forth) will shift the PCLR line to the right. This may significantly moderate the
harshness of the process previously described, since the inflation rate will increase less or
not at all, depending on the growth in YS.
❐ Thus one must rather say that the output level Y1 simply cannot be sustained indefinitely
with a given, unchanged capital stock, labour force, labour force skills and technology.
❐ More generally: even when YS is understood to be growing over time (inter alia due to
appropriate policies), output can only be sustained at a level above YS at the price of a
continually increasing inflation rate.
Alternatively, it can be expressed in terms of inflation and unemployment (rather than
output). Being at YS (be it stationary or growing) implies that the economy is at the
structural rate of unemployment (SRU). Thus the general augmented Phillips curve result
can be restated in terms of inflation and unemployment as follows: unemployment can
be sustained permanently below the SRU only at the price of a continually increasing inflation
rate.
❐ This also reminds us of a point made in chapter 6: structural unemployment cannot
be reduced through standard macroeconomic or demand-management policies. It
requires structural policies.
Therefore, over time (and amidst cyclical disturbances), actual output growth must match
the growth of the structural equilibrium level of output YS. The economy cannot be
pushed continually to grow beyond its long-term potential output growth (as determined
by the growth of its productive capacity). Such a strategy would only lead to increasing
inflation without the benefit of a sustained positive impact on output and employment.
Thus, a ‘tolerable’ amount of higher inflation cannot be exchanged for output growth
beyond YS (i.e. unemployment lower than the SRU). There would be increasing inflation,
not just higher inflation.
❐ Thus, in the long run there is no trade-off between inflation and unemployment (or
‘excess output’). The vertical PCLR line (whether stationary or growing) illustrates the
absence of a trade-off in the long run.
❐ In the short run, by contrast, there is a trade-off, but between unemployment (or ‘excess
output’) and rising inflation. The sloping PCSR curve provides the parameters for this
policy trade-off.
If policy stimulation beyond YS occurs only for a very limited period (i.e. a short enough time
before expectations and wages can adjust much) the inflation rate may not rise by much.
But there may always be a price to be paid. Using this trade-off to reduce unemployment
below the SRU for a few years, say, is likely to lead, at the very least, to higher inflation
and is likely to lead to increasing inflation. However, if in the same period PCLR is growing
concurrently due to expanding productive capacity, the inflation penalty may be small.
Such are the complex considerations that policymakers have to weigh in thinking about
policy options.
Reducing the inflation rate may also be a policy goal (from a high-inflation equilibrium
point on PCLR, say). Doing this through contractionary policy that reduces the growth
rate of aggregate expenditure will indeed lead to a lower rate of inflation. Graphically, AD
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would shift left/down, producing a new equilibrium point with a lower rate of inflation.
However, as demonstrated with the ‘downward elbow’ case in chapter 6 (section 6.4.2), it
will imply a relatively long period of higher unemployment. Graphically, this is when the
equilibrium point initially slides down along the PCSR curve – the short-term trade-off at
work again – followed by expansionary supply adjustment back to PCLR.
❐ As we will see in section 7.2, policy authorities such as a central bank (the monetary
policy authority) also have the option of fine-tuning or steering the process so that a
different, more preferable path is followed towards the final equilibrium, notably in the
supply adjustment phase.
7.1.5
The short-run and long-run Phillips curves (PCSR and PCLR) – history and
insight
As noted above, in economic literature the inflation-augmented AS or quasi-AS (denoted
ASSR) curve has come to be denoted as the short-run Phillips curve (denoted PCSR). This
was the final (and somewhat ironic) outcome of a long and roundabout theoretical and
policy discourse since the first proposition of the Phillips curve in 1958.
The curve was named thus after AWH Phillips, who plotted a curve in 1958 on the basis
of an observed pattern in empirical data of the UK economy. It suggested an inverse
correlation between the rate of unemployment and the rate of wage increases for the
period 1861 to 1957.
In its popular form, the Phillips curve refers
to an inverse correlation between the rate
of unemployment and the (price) inflation
rate. In many countries it was found that,
over long periods, observations of these
two variables tended to show the stable
pattern shown in the diagram (figure 7.8).
Figure 7.8 The original Phillips curve
Inflation
rate
(%)
The general proposition was that a stable
relationship exists between inflation and
unemployment. In the 1960s this was
interpreted as a menu of policy options
– combinations of unemployment and
inflation – from which policymakers
could choose at will. They could choose
Unemployment rate (%)
low unemployment, but paired with high
inflation. Or, they could choose to have low inflation as long as they were willing to accept
high unemployment in the country. At the time, it was understood that the choice to have
and keep an economy in such a position could be a lasting one.
This is the idea of a trade-off between inflation and unemployment. Given a particular
selection from the menu, the necessary policy stimulation or contraction could then be
used to push the economy to the desired equilibrium (point on the curve).
In contrast to the economists and policymakers who wanted to exploit the supposed tradeoff between inflation and unemployment, Friedman and Phelps argued already in the 1960s
that the trade-off between inflation and unemployment only exists in the short run. They
agreed that in the short run it is possible for government or the central bank to stimulate
the economy, an action that will result in higher inflation as well as higher output and
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How many Phillips curves?
One must be aware of possibly three forms of the short-run Phillips curve.
1. The original version depicted the Phillips curve as a relationship between nominal wage
inflation πW and unemployment U. This is the diagram on the left-hand side below.
2. The later, popular version depicts a relationship between price inflation π and
unemployment U. This is the centre diagram below.
3. The most recent version, in the form of the quasi-ASSR or PCSR curve, depicts a relationship
between price inflation π and aggregate output Y.
Graphically, the three versions capture the same relationship in almost equivalent ways:
π
πw
PCoriginal
U
employment. However, they also
argued that in the long run output
returns to its long-run level, leaving the economy only with higher
inflation. Changing inflation expectations was key to this process.
Thus, according to Friedman and
Phelps, in the long run the Phillips
curve is vertical: whatever the rate
of inflation, output will return to
its long-run level.
π
PCSR
PCpopular
U
Y
Figure 7.9 A disintegrating Phillips curve?
Inflation
rate
(%)
Observations
in the 1970s
Their warnings at first were left
un­heeded, inter alia because it was
part of the ideological struggle between Mone­tarists and Keynesians
Unemployment rate (%)
(see box below). However, during
the 1970s data points started to
appear on the diagram that suggested a positive correlation between unemployment and
inflation, or at least the absence of any correlation or pattern. This was the arrival of stagflation (a combination of high inflation and eco­nomic stagnation) on the world stage. This
experience seemed to suggest that the Phillips curve had broken down.
These experiences induced the development of the modern Keynesian AD-AS framework
with the average price level as an explicit variable. It transpired that the expanded Keynesian
theory of aggregate demand and supply could indeed provide a solid explanation for the
original Phillips relationship as well as the ‘aberrant’ observations of the 1970s.
Shifts in the aggregate demand curve produce an equilibrium that shifts up and down the
short-run aggregate supply curve – i.e. a series of equilibria on the ASSR curve. The price
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level and unemployment move
in opposite directions – an
inverse relationship between
inflation and unemployment.
This is precisely the original
Phillips pattern, which can
be seen to be a reflection of
the short-run equilibrium
sliding along the ASSR curve.
The Phillips curve simply is a
mirror-image of the short-run
supply curve ASSR.
Figure 7.10 A shifting Phillips curve
Inflation
rate
(%)
Second, the observations of the
1970s indicated not a disin­
te­grating curve but a shifting
Phillips curve. Theore­tically
Unemployment rate (%)
this is explained by shifts in
the short-run AS curve. For
example, shifts of ASSR due to supply shocks or inflationary expectations pro­duce episodes
of price in­creases coupled with a drop in real income (i.e. stagflation). For that particular
period it generates a positive correla­tion between inflation and un­employment. The data
points of the 1970s thus lie on dif­ferent, parallel Phillips curves.
This implies that the Phillips curve is not dead. When and if the short-run supply curve
shifts, the trade-off shifts to another plane. From a policy point of view, a usable trade-off
relationship still exists. However, this is in a more complex context of a shifting supply
relationship which implies that inflation will increase if output is above the long-run level,
even if for a limited period. The trade-off menu is very different from what it was before
(see illustrative Phillips curve data below).
Today the Phillips curve is an essential part of the analytical apparatus and vocabulary of
macroeconomic policy analysis. After a period of rather obscure existence, it has returned
to centre stage of the policy, and especially monetary policy, debate.
The empirical data pattern that Phillips observed generally is accepted as a manifestation
of economic relationships captured by the ASSR relationship relative to the ASLR curve.
❐ For many decades, the data reflected a more or less stationary ASSR relationship with
small variations around it. This was the era before inflation had become embedded in
price expectations. Whatever inflation existed was largely ignored in price and wage
setting.
❐ Since the 1970s, the data reflected a shifting ASSR due to various supply shocks, starting
with the oil price shock of 1973 and followed by the impact of increasingly ingrained
inflationary expectations. High inflation could not be ignored, and people wizened up
to the phenomenon of inflation. Inflation expectations came to be embedded in price
and wage setting.
❐ This means that the quasi-ASSR curve is identical to the original Phillips curve (in
its shifting form). This is why we adopted the practice of denoting it as PCSR in this
chapter.
Modern AD-AS theory also shows that in the long run – after the ASSR adjustment process
has run its course – output returns to the vertical ASLR curve. After any disturbances,
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shocks and cycles have played out, perhaps over several years, the only long-run impact is
on the inflation rate. In the long run there is no trade-off curve.
❐ This result is especially clear in the inflation-augmented AD-PC version of the
theory.
❐ This means that the ASLR curve is identical to the long-run Phillips curve of Friedman
and Phelps. This is why we adopted the practice of denoting it as PCLR in this chapter.
❐ The theory put forward by Friedman and Phelps is known as the expectations-augmented
Phillips curve theory. Their use of the theory of expectations injected an important
long-run dimension into the analysis of the original Phillips curve and the aggregate
supply relationship.
The fact that the modern expecta­
tions-augmented Phillips curve tradeoff means that inflation will increase
when output is above YS means that
higher output (i.e. lower unemployment, below SRU) will be associated
with an increase (posi­tive change) in
the inflation rate π. Likewise, higher
unemployment (above SRU) will be
associated with a decline (negative
change) in the inflation rate.
Figure 7.11 The expectations-augmented Phillips curve

6
4
Typical data points
generated by ‘new’
expectationsaugmented Phillips
relationship
2
0
Unemployment
–2
This implies an inverse, or negative,
correlation between unemployment
–4
SRU
and changes in the inflation rate (i.e.
∆π and not the inflation rate π, as was the case with the original Phillips relationship)
(figure 7.11). Thus it appears that the post-1970s era of (a) lively and energetic inflation expectations and thus (b) shifting the expectations-augmented Phillips curves has
generated a new inverse relationship that differs significantly from the original Phillips
relationship.
❐ The implied trade-off for an expansionary policy stance is thus between lower unemployment and rising inflation.
❐ If this theory is correct, it should also be displayed in real-world economic data. In the
case of the USA, this is indeed the case.
7.1.6
Summary: some Phillips curve lessons for policymakers
Starting from a position of long-run equilibrium on the PCLR line and with unemployment
at SRU:
1. A short and one-off demand stimulation, reversed after one period, is unlikely to cause
higher inflation. There will be a short upswing followed by a downswing back to the
starting level. Not much gain, not much pain.
2. An increase in the rate of expenditure growth that is sustained at the higher rate will
eventually lead to higher inflation. There will be an initial upswing in output, but
a downswing back to the original output level will follow (even though it may take
several years).
3. A continual, repeated increase in expenditure growth rates to keep output at a higher
level will lead to increasing inflation. The higher level of output is not sustainable
for long.
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4. A permanent reduction in the rate of unemployment below the structural rate
of unemployment (via expenditure growth) can be obtained only at the cost of a
continually increasing inflation rate (not just a higher level of inflation). A ‘tolerable’
amount of higher inflation cannot be exchanged for unemployment permanently
lower than the SRU.
5. Trying to counter the negative impact of a supply shock on output and employment
by stimulating demand will only lead eventually to further increases in inflation. The
pain of a supply shock cannot be avoided.
Is there a Phillips curve relationship in South Africa?
There is some debate on whether or not there is a Phillips curve relationship in South Africa.
Some of the evidence indicates that there is either no relationship between the output gap and
inflation or, if there is, the impact of the output gap on inflation is not that large. A small impact
is an indication of a rather flat PCSR.
As such, one might be under the impression that output can be stimulated beyond its long-run
equilibrium value without putting too much upward pressure on inflation. However, that would
be a mistake, because research also indicates that inflationary expectations in South Africa
adjust fairly quickly, wiping out any output gain in a rather short span of time and leaving the
economy with a permanent increase in inflation.
❐ This means that the South African Phillips curve may be relatively flat, but that it is quite
mobile and shifts up very quickly following inflationary stimulation.
The quick adjustment of expectations – and mobility of the PC curve – also provides benefits,
though. It means that if the economy is hit by a transitory external supply or demand shock
that causes a sudden, unexpected increase in the inflation rate, monetary policy can return
inflation to lower levels fairly quickly. (By fairly quickly is meant a period from 24 to 36 months
– around the lower end of the three-to-seven year interval mentioned earlier. This is the
minimum time it appears to take for interest rate changes to change the behaviour of private
economic agents via impacts on their balance sheets and income statements.)
❐ Examples include a sudden weakening of the rand as in 2001, or an unexpected increase in
the oil price as in 2007–08. In both cases, the inflation rate decreased fairly quickly after 2002
and 2008 following periods of significant inflationary pressure due to a supply shock.
6. If expenditure-raising policy is carefully designed so that it expands the productive
capacity of the economy effectively, the inflation penalty of expansionary policy will
be less severe or even negligible. Such policy can include government investment, or
expenditure on skills development, or incentivised taxes.
7. However, government should be very careful with more broad-range fiscal or monetary
policy steps such as general tax reductions or interest rate reductions. While such
broad-range steps may also stimulate investment and thus productive capacity, they
will in all likelihood lead to a significant expansion of consumption expenditure.
Unless the economy is below YS, this will put upward pressure on inflation. Hence, if
they are not to be inflationary, expenditure-raising policy steps must be very carefully
designed to focus on stimulating the supply side and not so much the demand side.
More generally:
8. If output falls below the structural equilibrium level due to a demand shock or cyclical
downturn, a countercyclical stimulation of expenditure (demand) to get the economy
back to the structural equilibrium output level (but not further) is appropriate.
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The mathematics of the Phillips curve
π
The augmented Phillips curve is typically written in one of two forms: either with reference
to output level Y and the structural equilibrium YS, or with reference to the unemployment
rate U and the SRU, or US:
e
 = ​​t​  ​+ (Yt – YS ) + x where  > 0...... (7.1)
or
e
 = ​​t​  ​+ (Ut – US) + x where  < 0...... (7.2)
Both equations state that inflation in period t, πt, will equal expected inflation π et plus the
unanticipated change in the inflation rate brought about by policy or an autonomous
shock that pushes output away from YS, or unemployment away from US. In addition, both
equations include x, which represents supply shocks such as increases in import prices,
wages, and other inputs such as oil.  and  are slope parameters when π is graphed relative
to (Y – YS), while  is a parameter measuring the response of π to a change in x.
❐ Graphically, this implies that the intercept of the augmented Phillips curve with the
vertical YS line (thus with PCLR) is at the level of πe. (This mirrors the intercept result that
we derived for the short-run supply curve in chapter 6, section 6.3.3.)
❐ These are linear curves for illustrative purposes. More complex mathematical functions
would provide the curvature associated with the short aggregate supply curve ASSR and
PCSR which reflect the curvature of the production function (compare chapter 6).
❐ (Yt – YS) is the so-called output gap, i.e. the gap between actual and long-run output.
Such a gap typically emerges from changes in either aggregate expenditure or aggregate
supply and, through that, actual output Y. One reason for such changes would be policy
steps.
❐ These equations do not actually model economic behaviour, as was done by the supply
relationships in chapter 6. They show a simple mathematical approximation of an
observed pattern in economic data using the concept of an output gap. (A behavioural
equation can be derived from appropriate aggregate supply equations.)
(For the link between the two versions of the Phillips curve, i.e. equations 7.1 and 7.2,
see the box on Okun’s Law in section 12.2.2.)
This can be either monetary or fiscal policy, although normally monetary policy may
be more appropriate as countercyclical medication (but see section 12.3.3). A weaker
exchange rate (weaker rand) will also help by stimulating net exports.
9. Do not try to push the economy faster than the expansion of its productive capacity.
Spend policy energy and resources on boosting human and physical capital,
technology and so forth. That is: pursue complementarity between macroeconomic
policy and development policy.
10. It is inappropriate, ineffective and, indeed, counterproductive to try to use macroeconomic demand stimulation (e.g. a weaker exchange rate, or a low interest rate
strategy to boost consumer demand) to address the underlying problems of long-run,
structural unemployment. Structural unemployment must be recognised for what
it is and addressed with appropriate structural policies. Rather use special targeted
policy measures in product and labour markets to reduce structural unemployment
(see chapter 12, section 12.2).
The Phillips curve discussion has taken us towards the analysis of policy options, trade-offs
and constraints. An interesting issue is whether this theory can help us understand the
behaviour of policymakers (or can guide policymakers in their decisions). An important
case study is the modelling of monetary policy, or central bank policy behaviour.
7.1 Adjusting the model – inflation-augmented AD and AS curves
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7.2
Managing inflation – policy options and the monetary reaction
(MR) function
We have seen that higher or increasing inflation can result from several sources, mainly
(a) excessive expenditure growth plus (b) the supply adjustment process following such
excessive growth, or (c) a supply shock (exacerbated by its supply adjustment process) or
(d) accommodating policy to counter the supply shock. These were depicted graphically in
section 7.1.3 above.
The question is what policymakers are set to do if, for any of these reasons, the inflation
rate is at an unacceptably high level. How can it be reduced? How can we analyse the
options using our model and diagrams?
7.2.1
Basic effects of anti-inflationary policy
The basic answer is simple. It was Figure 7.12 Demand contraction to reduce inflation
illustrated in our examples of the
π
PCSR0
PCLR
‘downward elbow’ in chapter 6
PCSR1
(section 6.4.2). Let us start from
a high inflation equilibrium point
PCSR2
on PCLR with inflation at π2 (figure
π2
Equilibrium
7.12). A reduction in the growth rate
π3
after demand
of nominal aggregate expenditure
decrease
below the current rate (which will
π4
AD1
equal the rate of inflation in the
AD2
Equilibrium
equilibrium) will cool the economy
after supply
down, reduce production and push
adjustment
output below the long-run, structural
level YS to point (π3; Y3). The inflation
Y
YS
Y3
rate will drop to π3. Since the latter
is below the expected inflation rate
(which still is equal to π2), expectations will adjust downwards and be reflected in the next
round of wage negotia­tions. Lower nominal wages will reduce costs and output will start
to expand. In this, the supply ad­justment phase, the short-run equilibrium will slide along
the new AD2 curve, through several rounds of wage renegotiations, until it reaches PCLR.
At this new equilibrium the final inflation rate will be still lower at π4, while output will be
back at YS. An inflation reduction would have been achieved, but at the cost of a fairly long
period of lower output and higher unemployment. (Output and income will experience a
cyclical downswing followed by a recovery.)
❐ By appropriately choosing the position of the new AD2 curve, the policymaker can
steer the economy towards a desired, target inflation rate such as π4 (assuming rather
precise demand control abilities; see below).
If the unacceptably high infla­tion rate was the result of pre­ceding excessive demand
growth (plus supply adjust­ment), the equilibrium would have followed an anticlockwise
diamond-shaped (or roughly cir­cular) route (figure 7.13). There would be four segments
as AD moved to the right (segment 1) and moved left again later (segment 3). The PCSR
curve would have shifted up (seg­ment 2) and down later (segment 4).
❐ The inflation rate and the output level would have fluctuated accordingly.
❐ The final, target inflation rate (indicated as π4 in the diagram) need not be the same
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as the initial inflation
rate π0, as was shown in
this illustration. It could
be either higher or lower.
That would dictate the
appropriate position of the
final AD curve.
7.2.2
Steering the process –
more activist
policy strategies
Figure 7.13 Demand contraction to counter demand inflation
π
PCSR1
PCLR
PCSR0;2
π2
π3
3
4
π0;4
2
1
Equilibrium after
demand increase
plus supply
adjustment
AD1 Initial equilibrium
AD0;2
AND equilibrium
after demand
decrease plus
supply
adjustment
Policy authorities may want
to intervene to change the
route of the short-run equilibY3
YS Y1
Y
rium. Remember that the only
thing that they can affect with
demand policy (fiscal or monetary), is to effect and affect the downward shift of the AD
curve. They can manage the timing, speed and magnitude of this shift.
❐ In reality, policy authorities do not have the information and mechanisms to control
aggregate demand as readily and accurately as may be suggested by these theoretical
manipulations. As noted several times in this book, the economy does not behave
mechanically. In addition, there are problems concerning policy control, including policy
lags. These are discussed in chapter 11.
Different paths, different options
Consider the second example above,
i.e. of excessive demand growth (figure
7.13). Let us regard its graphical depiction as a baseline path (represented
by the solid blue arrow curve in figure
7.14). If this path is not acceptable,
policymakers could act pre-emptively
and start contracting expenditure before
the first supply adjustment process gets
very far and before inflation reaches its
peak on PCLR.
Figure 7.14 Different policy paths to counter demand inflation
π
πT
PCLR
Baseline path to
eradicate excess
demand inflation
More graduated
anti-inflation policy
path
This would create a flatter circular route
YS
Y
back to the target inflation rate (represented by the dashed arrow curve).
Inflation would not rise as much, and output would have to dip less below YS. The preemptive and more moderated path seems to be less costly in terms of both inflation and
unemployment.
The first example above (figure 7.12) is particularly important for understanding typical
monetary policy management. It starts from a high-inflation point on the PCLR line, due to
ei­ther supply shocks or excess demand growth or both. Again, different paths are pos­sible.
Consider the basic graphical depiction in figure 7.12 as the baseline path. (In figure 7.15
it is shown as the bold blue arrow curve.)
7.2 Managing inflation – policy options and the monetary reaction (MR) function
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The contraction in aggregate expendi­ture Figure 7.15 Different policy paths to reduce inflation
can be managed so that the AD curve
π
gregate
shifts down slower, giving the ag­
PCSR
PCLR
supply and wage adjustment process more
time to kick in. This would produce a less
roundabout route to the target equilibrium
More gradualist
anti-inflation
point (and tar­get inflation rate) (represented
policy path
by the finely dashed arrow curve to the
More reactionist
right of the baseline arrow curve). The
anti-inflation
drop in output that is necessary to squeeze
policy path
πT
the unwanted inflation out of the system is
less in this case. However, the process will
take longer since the successive downward
adjustments in expectations and thus in
YS
Y
nominal wages will be in smaller steps. It is
a more gradualist process.
❐ This strategy implies that the minimisation of the contraction carries relatively more
weight than the speedy reduction of inflation.
If, by contrast, the reduction of inflation is top priority, demand can be pushed down more
quickly and further to force a quick drop in the inflation rate. The supply adjustment process
combined with some demand revitalisation can then be used to steer the equilibrium
point to the target inflation rate. This will produce the third path shown in the diagram
(represented by the dashed arrow curve to the left of the baseline arrow curve). Output and
employment will fall a great deal, but inflation will be squeezed out much more quickly.
This is a more severe, reactionist approach.
The strategy chosen by the policy authorities will depend on their preferences regarding
the urgency of lower inflation as against the unavoidable temporary drop in output and
employment (the core elements in the Phillips curve trade-off, essentially).
The monetary reaction function
One way to think about different strategies is in terms of a so-called policy reaction function.
This concept has been developed in recent years, primarily in the context of monetary
policy and central bank actions. So let us confine our attention to the monetary reaction
(MR) function. However, it can clearly be applied to other kinds of policy as well.
Chapter 3 introduced the basic analysis of monetary policy. It demonstrated how the
central bank can manage the money supply process to set the interest rate at a desired
level to pursue a chosen policy goal. What was not explained is how the desired interest
rate level will be determined. The MR function describes how a central bank decides what
should be its policy strategy, normally via interest rate setting, to steer the economy to a
target equilibrium point.
As chapter 9 will discuss in more detail, the SARB has had an official policy of inflation
targeting since 2000. For most of the time, the SARB wanted to contain the inflation rate
within a target range of 3% to 6%. Its main policy lever to achieve this was management of
the repo rate in reaction to the actual and anticipated inflation rate. An undesired increase
in the inflation rate is typically met by an increase in the repo rate to dampen demand.
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❐ The idea of a reaction function is not restricted to an inflation targeting regime. It can
apply to different monetary policy regimes (inflation targeting or others) and via either
interest rate setting or money supply manipulation (both most often via the repo rate).
The MR function is a way to describe the
likely reaction of the central bank should
the inflation rate increase above the target
value or target range. It can be interpreted
as the imposition of an enforced path for the
journey of the short-run equilibrium point
towards its target.
The reaction function, MR, of the central bank
can be plotted in the Phillips curve space, as
in figure 7.16. The MR curve intersects the
long-run Phillips curve at the target inflation
rate πT.
Figure 7.16 The MR curve
π
PCLR
πT
MR curve
The MR line shows the desired path of the
short-run equi­librium point (π; Y) on its way
YS
Y
towards the target equilib­
rium point (with
the target inflation rate πT) on the PCLR line.
Thus it is a series of desired levels of Y for inflation rates that still are above (or below) the
target inflation rate. Should the inflation rate exceed the target, the central bank would
try to push the economy to the MR line. Thereafter, the central bank will manage further
demand contractions (or expan­sions, as necessary) alongside the supply adjustment proc­ess to steer the equilibrium along the MR line towards the targeted level of inflation πT
(together with its matching output level YS).
❐ The MR curve has a negative slope, indicating the extent to which the central bank
needs to keep output below its long-run, structural equilibrium level to put downward
pressure on inflation.
As noted above, the central bank has a spectrum of options in terms of how gradually or
rapidly it wants to guide inflation back to its target level. It can adopt a gradualist approach
or a stronger, reactionist approach.
❐ Graphically, the differences in
approach are reflected in differ- Figure 7.17 A gradualist MR curve
ent MR slopes.
π
PCSR0
❐ The difference between these
PCLR
approaches will be evident in the
PCSR1
extent to which the central bank
PCSR2
chooses to increase interest rates
π0
Path forced by MR
via a repo rate increase.
The gradualist MR curve is
illustrated in the diagram in figure
7.17. It shows how the fall in
output is moderated by decreasing
aggregate demand gradually, in
stepwise fashion, until it reaches
AD2, allowing the supply adjust­
ment process to kick in and take the
function – stepwise
decrease in AD
curve
πT
AD2
Baseline path
AD0
MR curve
YS
Y1
7.2 Managing inflation – policy options and the monetary reaction (MR) function
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The Taylor ‘rule’
The most well-known monetary reaction function is known as the Taylor rule. In 1993 Taylor presented the
following equation as a simple model and description of monetary policy behaviour in the USA:
i = rLR + π + h(π – πT) + g(Y –YS )
where i is the nominal short-term interest rate, rLR is the long-term or ‘normal’ real interest rate, π is
the actual inflation rate, πT is the inflation target, and (Y – YS) is the output gap (i.e. the percentage gap
between actual output Y and long-term output YS ).
❐ The real interest rate is given by r = i – π. (It should not be confused with the long-term interest rate rLR.)
The rule means that two ‘gap-elements’ exert an influence on the central bank to change the real interest
rate. (They do so by changing the short-term nominal interest rate i as shown by the formula.)
❐ Inflation gap: If and while inflation is above the target value, there is pressure to increase the real
interest rate above the ‘normal’ value. [Consider the term h(π – πT).]
❐ Output gap: If and while output is above the long-run level YS , there is pressure to increase the real
interest rate above the ‘normal’ value. [Consider the term g(Y – YS).]
❐ If both inflation and output are below the target values, there is twofold pressure to reduce the real
(and nominal) interest rate.
❐ If inflation is above the target value, but output is below YS, there are opposing forces: the inflation
gap-related pressure to increase the real interest rate will be moderated by the output gap-related
pressure to reduce rates.
A central bank that behaves like this will in effect steer the economy along one of the reaction paths
shown in the diagrams above. Interest rate setting will change during the route to reflect the changing
influence of the two evolving gaps along the path.
As a description of interest rate policy, the Taylor rule highlights that a central bank fights inflation not so
much by increasing the nominal interest rate, but by increasing the real interest rate – it is when interest
cost in real terms increases that people cut back their expenditure and borrowing.
Note that the inflation target is not necessarily an officially announced target. It could also be the implicit,
unannounced target that the central bank pursues.
The parameters h and g indicate the importance that the central bank attaches to fighting inflation versus
keeping output and employment as close as possible to its long-run, structural value.
❐ For the USA, Taylor found that setting h = 0.5 and g = 0.5 provides a good description of monetary
policy behaviour.
A higher value of h implies that the central bank attaches more importance to fighting inflation.
❐ For instance, suppose rLR = 2% and that h = 0.2. If inflation is at 6% while its target value is 4%,
h(π – πT) will amount to 0.2(6% – 4%) = 0.4%. Assuming for a moment that (Y – YS) = 0, the short-term
nominal interest rate will be set at 8.4%. Thus the real interest rate r equals 2.4% = 8.4% minus 6%.
❐ However, if h = 0.5, h(π – πT) will amount to 1%, which translates into a short-term nominal interest rate
of 9%. The real interest rate r equals 3% = 9% minus 6%.
❐ A higher value of h thus implies a more stringent interest rate policy when inflation is above the target
value: the central bank attaches more weight to inflation than unemployment.
Similarly, the value of g shows how much emphasis the central bank places on getting output and
employment back to their long-run, structural values.
❐ A larger g will imply relatively greater output gap-related pressure to change the interest rate.
The parameters h and g should always exceed zero. A value below zero would imply that the central bank
perversely lowers interest rates when faced by higher inflation or an economic upswing, or vice versa.
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econ­omy towards the long-run equilibrium output level. The fall in output (which is less
than in the basic example in figure 7.12) is indicated as the ‘baseline path’. As noted,
this path will take longer than the baseline example to reach the tar­get level of inflation
πT. Unemployment will increase less, but those unemployed will remain un­employed for
longer.
❐ An MR curve that is relatively steep indicates a political or policy prefer­ence that favours
the protection of employment over infla­tion, even though the inflation reduction is the
agreed end goal.
❐ Interest rates will be pushed up less in this case.
The reactionist approach is illustrated in the next diagram (figure 7.18). The path from
π0 to πT is very different from that seen in the gradualist approach. Demand is con­tracted
further than AD2. The drop in short-run equilibrium output (and employ­ment) is severe,
so much so that demand has to be re­vitalised in the later stages, otherwise it would be
overkill and the infla­tion rate would end up below πT. However, the rate of inflation de­
clines much more quickly than in the baseline example, and obvi­ously also more quickly
than in the gradualist case. The recovery of output and employment may not be so quick,
though.
❐ An MR curve that is rela­tively flat indicates a politi­cal or policy preference that favours
low inflation over low unem­ployment, with a more or less single-minded focus on the
reduction of inflation.
Figure 7.18 A reactionist MR curve
❐ The necessary increase in interest
π
rates will be much larger in this case.
PCLR
PCSR0
An extreme example of the reactionist
PCSR1
approach is the so-called cold-turkey approach. It aims to eradicate excessive
inflation in one decisive move and in π0
Baseline path
one period by increasing the repo rate
drastically.
❐ Graphically, the cold-turkey approach πT
AD0
is indicated by a horizontal MR funcMR curve
Path forced by MR
AD2
tion, indicating an uncompromising
function – severe initial
anti-inflationary stance by the cendecrease in AD curve,
then gradual recovery
tral bank.
❐ The cold-turkey approach has the
YS
Y1
benefit that inflation returns to its low
level within one period. However, the drastic increase in unemployment that it entails
may render it politically difficult to implement. Few, if any, central banks follow a coldturkey approach (because the turkey may end up dead ...?).
How should the interest rate be set by the central bank? The appropriate interest rate path
in each case can be determined if one considers the IS-LM diagram corresponding to this
AD-PC diagram.
❐ In some textbooks, you will find a so-called IS-PC-MR three-equation model. This is like
figure 7.18, but it is trimmed to show only the essential curves from the point of view of
a central bank that sets/controls/pegs interest rates through open-market operations
and so forth. Typically, they will not show the AD curve, preferring to analyse demand
with the IS curve. The preferred equilibrium path is deduced from PC and MR only.
Then, on the accompanying IS-LM plane, they will not show the LM curve, and focus
7.2 Managing inflation – policy options and the monetary reaction (MR) function
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only on deriving, from the IS
Which policy objective?
curve, the target interest rate
to produce the desired fall in
At the moment most central banks consider price
output.
stability to be their main objective. This is a broad
❐ This ‘underplaying’ of the LM
current consensus in central bank and monetary
policy circles. The South African Reserve Bank
curve is not purely innocuous.
(SARB) is no exception.
It reflects a particular way of
❐ Usually, price stability does not mean zero
thinking about what central
inflation, but rather an inflation rate low and
banks should do, underpinned
stable enough so that people cease to take
by the growing influence of a
inflation into account in their economic decisions.
particular doctrine – in United
In other eras (and countries), objectives such as
States economic policy circles,
employment creation have had similar prominence.
for example – that monetary
In the USA the Federal Reserve has to consider both
policymakers should interfere
inflation and economic growth. In South Africa, an
as little as possible in markets,
influential labour federation such as Cosatu feels that
that markets clear efficiently,
the Reserve Bank should consider employment and
and so forth.
poverty alleviation as policy objectives, or at least
❐ A more generally useful model
that inflation should not be the only consideration
that can aid understanding of
of monetary policy. See chapter 12 for a fuller
different countries and eras
discussion of these issues.
keeps the LM intact, since it
can be used to analyse several
approaches to monetary policy.
❐ In any case, the world financial crisis of 2007–08, and the political reactions to it,
reminds one that different eras may also make different approaches appropriate. One’s
analytical apparatus should not be constrained by a single approach that is currently
in vogue.
✍
Analysing the world financial crisis of October 2007–08: inflation effects
We have considered this case study several times since chapter 3. You should have gained
many insights into a complex situation.
The analysis culminated in chapter 6, using the AD-AS model. The last step is to take your
analysis of chapter 6 and transfer it to the AD-PC model.
What additional insights does this model add, relative to the AD-AS model?
7.2.3
Conclusion
This concludes the exposition of the expanded AD-AS theory, in the form of the AD-PC
model, to be used to analyse macroeconomic behaviour, fluctuations, shocks and policy in
an inflationary context.
❐ Nevertheless, it appears that most of the analytical conclusions from the AD-AS chapter
regarding shocks and disturbances and their graphical reflection in diagrams, can
be transferred, with a few modifications, to the inflation context. Therefore, insights
from the standard AD-AS model remain relevant, in most respects, for the inflationary
context.
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In terms of the time frame concerned, we have now dealt, first, with short-term fluctuations
due to demand and supply shocks. These can be thought to occur over a time horizon of up
to approximately three years.
We have also considered medium-term adjustments of the supply side of the econ­omy towards the ‘long run’ (sic) or structural equilibrium level of output and employment. Such
adjustments can involve a period of a further three to seven years approximately (within
which short-term disturbances and fluctuations can recur, of course). The average for both
short- and medium-run processes, allowing for some overlap, is typically approximately four to
seven years.
Now is the time to consider the context of output and employment in the very long run,
with a time horizon measured in decades – the topic of economic growth.
7.3
Analytical questions and exercises
1. There was a steady reduction in the repo rate of the Reserve Bank between 2007
and 2013. Use the expectations-augmented Phillips curve to analyse (explain and
illustrate) the short-run and long-run impact of this reduction on the inflation rate,
as well as on the unemployment rate.
2. Use the expectations-augmented Phillips curve to analyse (explain and illustrate) the
short-run and long-run impact of negative supply shocks on the inflation rate, as well
as on the unemployment rate.
3. Following from the previous question, suppose the government wants to restore the
output level that existed prior to the occurrence of the shock, explain the effect such
steps will have on the inflation rate.
4. ‘Manufacturers will appeal to the National Energy Regulator of SA (NERSA) for relief
on Eskom's planned, steep electricity tariff increases, which they say will force many
companies out of business.’ Use the expectations-augmented Phillips curve to analyse
(explain and illustrate) the short-run and long-run impact of an increase in Eskom's
electricity tariffs on the inflation rate, as well as the unemployment rate.
5. During 2016 South Africa experienced the highest inflation rate in seven years. What
can policymakers do to reduce inflation? Which policy institution(s) is (are) best
geared to do that? Use the AS-AD model to illustrate and explain your answer.
6. Suppose the inflation rate is 12% and the Reserve Bank wants to reduce it to 6%,
explain the difference between the options that the Reserve Bank has in terms of the
speed by which it reduces the inflation rate and factors that may slow down such a
reduction.
7. In 2019 pressure increased to expand the mandate of the South African Reserve Bank
so that it does not only target inflation, but also economic growth. Use the AS-AD
model to discuss the merit of targeting growth and inflation. Can the South African
Reserve Bank ensure a higher economic growth rate in the longer term? Discuss. (You
can also consult chapter 9 in this regard.)
7.3 Analytical questions and exercises
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Macroeconomics in the very long run:
growth theory
8
After reading this chapter, you should be able to:
■ understand how the analysis of aggregate supply, and the production function in
particular, provides the key to explaining economic growth;
■ analyse and evaluate how the concept of balanced growth helps to explain the long-run
growth path of economies;
■ analyse the main sources of sustained growth in per capita GDP, and compare how
changes in economic behaviour and structure can impact on per capita growth;
■ evaluate the potent roles of technology, institutions and human capital in economic
growth;
■ evaluate how policy measures can and cannot be used to increase the long-term growth
prospects and performance of an economy; and
■ appreciate the importance of a wider social and human development context in understanding and promoting economic growth.
The foregoing chapters of this book have dealt with short-term fluctuations due to demand
and supply shocks (e.g. a time horizon of up to three years) and also medium-term
adjustments of the supply side of the econ­omy (a further three to seven years) towards
the ‘long-run’ or structural equilibrium level of output and employment. We have also ex­
panded our analysis of changes in the price level P to include the ‘con­tinually increasing’
context of P and thus inflation.
Now is the time to consider the context of continually growing output Y in the very long
run, with a time horizon measured in decades. That brings us to the topic of economic
growth and theories of economic growth.
8.1
The importance of growth
While short- and medium-term fluc­tuations of an economy are cru­cial for the inhabitants
of a country, the long-term economic health of an economy is a very important topic.
Within the broader context of devel­opment and poverty alleviation in a country such
as South Africa, increasing the standard of living of people in the long term is a major
political objective. The struggle in South Af­rica to reach a targeted 6% GDP growth rate
calls for a better understanding of the determinants of growth.
Table 1.1 in chapter 1 shows average economic growth rates for South Africa since the
1960s. Economic growth was strong up to the mid-1970s, with economic growth rates
peaking at 6% per annum in the 1960s. However, in the mid-1970s, eco­nomic growth in
South Africa weakened significantly, with per capita growth turning negative in the period
8.1 The importance of growth
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1981 to 1993. Since then the economic growth rate, both in aggre­gate and per capita
terms, has im­proved significantly.
Measuring economic growth
The simplest measure of economic growth is the annual growth rate of real GDP, i.e. the
percentage increase in real GDP from one year to the next.
GDP – GDP
t
t–1
Real GDP growth rate = ​ 
​× 100
GDP
t–1
or
Yt – Yt–1
​ 
​× 100
Y
t–1
It can also be measured in terms of per capita GDP (i.e. aver­age GDP per person). The formula
is the same except that aggregate GDP is replaced by real per capita GDP.
When studying long-term trends in economic growth, the focus of attention is per capita GDP.
Warning: economic growth theory is not about ‘economic growth’…
1. Popular discussions by economists, business people and politicians about economic
growth usually proceed in terms of the growth rate of GDP, not GDP per capita. Only rarely
will they relate the GDP growth rate to the popula­tion growth rate.
2. The annual change in GDP comprises both a short-run or cyclical component and a long-run
or trend (i.e. growth) component. However, this distinction is very often not made when either
cyclical or growth trend issues are discussed. Thus, when the business cycle is discussed
(for instance in the media), the growth rate is used indiscriminately by commentators who
forget that part of the growth rate represents trend or long-term growth. Strictly speaking,
the cyclical component should be removed from the actual growth rate to obtain the trend or
long-term growth rate. (Also see chapter 12, section 12.3.1.)
These averages, and particularly the dramatic drop in per capita GDP growth rates after
1981, clearly show the importance of long-term growth relative to the business cycle,
which involves short-run fluctuations.
❐ Graphs in chapter 12, section 12.3.2 show per capita GDP together with the long-term
trend in per capita GDP for South Africa and the USA. Deviations from the growth path
indicate the business cycle. It appears that, over the very long run, deviations from the
long-term growth path are dwarfed by the long-term trends of the macroeconomy.
8.2
Why growth theory?
While the harsh reality of recessions and depressions when people lose their jobs cannot
be denied, sustained economic growth can play a powerful role in lifting aggregate, as well
as per capita, production and income in a country.
In terms of the AD-AS framework, sustained growth in GDP implies that the structural
equilibrium output level continually shifts to the right at a sustained rate of growth. The
ASLR (or PCLR) curve obviously moves in tandem.
Note that in growth theory the focus is exclusively on the supply side of the economy. This
is a pattern: the theoretical analysis of short-run fluctuations focuses on expenditure and
demand, with some attention to the supply side; the analysis of me­dium-term adjustments
focuses largely on supply with some atten­tion to the demand side. Very long-term analysis
focuses exclusively on the supply side, since it is all about the expansion of productive
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potential in the very long term,
and the ad­justment of the economy towards that potential
growth path.
In our analysis of the aggregate
supply curve, we encountered
the aggregate production function (TP), which captures the way
aggregate output Y depends on
the quantities of labour N, capital K and technology A that are
employed in the multitude of production processes in an economy.
Does economic growth help everyone?
A major argument for economic growth is that the
economic pie must grow if the slices that people
get are to get bigger. Better living standards require
economic growth.
However, per capita GDP is an average. Despite an
increase in per capita GDP, some people may not be
better off. Or, the living standards of some people
may increase much faster than those of others.
It depends on how the growing income flows to
different households and individuals are apportioned.
❐ South Africa has one of the highest degrees of
income inequality in the world (see chapter 1,
section 1.3.5 and chapter 12, section 12.3.2).
For a more rounded analysis, we
expand this function somewhat in
this chapter. First, the A factor is
expanded to include the role of progress with regard to social and economic institutions
and practices that impact on the productive potential of an economy. These can be
legal (e.g. property rights, constitutional framework, company law frame­work, labour
law, competition law and policy, etc.), managerial (management techniques, style of
doing business, work ethic, motivational make-up, etc.) or organisational (new ways of
organisation and management) and so forth. These aspects do not change the analysis of
earlier chapters materially, but we embed a much richer analysis of social development
over time in that variable. This will
appear to be quite important (also
Why does demand not matter for growth?
see chapter 12, section 12.3.4.)
Second, we add another variable H. This represents so-called
human capital. In its narrowest sense, human capital can be
defined as the skills of individuals that allow them be more efficient. Such skills are accumulated over a lifetime, notably
through schooling and postschool training and education.
Expenditure in education that
increases the amount or years of
schooling of individuals can be
seen as an investment in human
capital, i.e. the ability of people
to be productive. Other forms of
knowledge, such as workplace
experience, on the job training,
life skills, etc., improve labour
efficiency as well. A broader interpretation would also allow
for the development of human
Short-run and medium-run fluctuations are largely
explained by shocks and disturbances that initially
cause output (supply) and expenditure (demand) to
diverge from each other. The adjustment in economic
behaviour that brings output and expenditure back
into bal­ance takes the economy to a new equilibrium
point. Moving equilibrium points are the substance
of the business cycle and medium-term patterns in
output and employment.
In the very long run, our interest is the long-run
trend in ag­gregate income. Thus we intentionally
ignore short-term and medium-term deviations
from the trend. To exclude that ele­ment, we regard
expenditure and output as being in equilibrium in
the long run. This means we can only focus on the
behaviour of output (and thus income) in the long
run, since expenditure will behave concurrently.
Obviously the economy will not be on the long-run
growth path at all times, as we will see, and will
regularly be busy, over time, adjusting back to the
long-run trend. Nevertheless, to see this we first
need the long-run trend.
8.2 Why growth theory?
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ability/capacity due to reasons other than education, e.g. improved health care. This
additional variable is included in our expanded production function, allowing one to
analyse the impact of changes in all these variables on aggregate supply. (See section
8.10 for a fuller discussion.)
It seems rather obvious that economic growth depends on things like labour, capital, skills,
technology and social and economic institutions. And it seems quite straightforward to
deduce how changes in the components of N, K, A or H will impact positively or negatively
on aggregate productive potential and actual output. For example, an increase in the skills
levels of the workforce will improve output and increase aggregate supply. If this happens
continually, aggregate output will grow continually. To be a bit sarcastic: what else is new
in growth theory?
Three aspects deserve attention:
❐ First, not all factors of production can necessarily contribute to economic growth in the
long term in the same way or with the same forcefulness. Some are more potent than
others (in a specific sense to be explained) and some are more constrained than others.
❐ Second, not all long-term growth paths are equally accessible for an economy. Some
growth paths can suffer from imbalances and run into constraints. But at least there
are some economic forces at work that help an economy to get to the balanced growth
path.
❐ Third, policymakers (and voters/citizens) can improve the conditions and prospects
for balanced growth if they are well informed and can implement a few appropriate
changes in economic behaviour and parameters in a country.
This chapter mainly presents the Solow growth model, named after Robert Solow, the
American economist who developed this theory (for which he received the Nobel Prize in
Economics in 1987). However, the chapter also highlights issues that the standard model
does not cover but that need to be considered when thinking about growth (and policies
to support growth) in a low- or middle income country. Thus, we try to fashion a bit of a
bridge between growth theory and development theory, without going into the detail of
the latter. (In chapter 12, section 12.3, we will see that this bridge may be very important.)
8.3
From intuition to formal analysis – from AD-AS to the Solow
growth model
Consider the production function and TP curve in chapter 6 (section 6.3.2), and let us add
the variable H on the right hand side:
Y = f(N; K; H; A)
...... (8.1)
where
N = Labour usage (employment) in production;
K = Physical capital stock in productive use;
H = Human capital stock (the skills levels of workers); and
A = An index of technological and institutional progress.
We will pay limited attention to H for a while, to simplify the initial analysis. However, it
is quite an important variable, particularly in a low- and middle-income countries, where
skills deficiencies often hamper productivity and economic growth. We will also see that the
role of human capital H in economic growth is thought to be very similar to that of physical
capital K, but that some kinds of human capital play a role similar to that of technology.
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So the analysis of both physical
capital K and labour efficiency
A can be largely replicated, with
some adjustments, for the analysis
of H (see section 8.10).
So, for the moment we proceed
with the simpler production
function:
What about natural resources as a source
of growth?
Countries rich in natural resources such as oil
reserves or mineral deposits (e.g. gold, platinum,
iron ore) clearly have a major economic advantage.
How would you accommodate that in the production
function and growth model?
❐ See the box in section 8.5.
Y = f(K; N; A) ...... (8.1a)
This is the form used originally by Solow. Constant returns to scale are assumed, as well as
diminishing marginal returns to both labour and capital.
(a) The former means that if each of the factors of production is increased by a given
percentage, e.g. 10%, total output will also increase by 10%.
(b) The latter means that if only one production factor, e.g. labour, is repeatedly increased
by a particular percentage, e.g. 10%, while the other factors remain constant, total
production Y will successively increase not by the same percentage (10%), but
by a shrinking percentage, e.g. 8%, and then 7%, and then 6%, and so forth. Each
successive increment in the production factor is met by a shrinking increment in
output. Eventually, if theoretically, this growth in output will approach zero.
❐ Graphically diminishing marginal returns are seen in a curved TP function that
gradually flattens out as the variable on the horizontal axis increases (given
that the other factors remain constant). Figure 8.1 shows diminishing marginal
returns to labour.
Factor A is very different in this
The maths of production functions – the
regard. Non-diminishing marginal
Cobb-Douglas function
returns are assumed with regard
This is one of the most popular production
to A. Technological and institufunctions in economics. Despite its simplicity, it
tional progress is thought to be
can be used to generate a variety of production
unconstrained by diminishing
relations that approximate real-world situations
marginal returns in the long run.
quite well. It looks as follows:
New technological or institutional
 1–
innovations and refinements that
Yt = At​K​t​  ​​N​t​  ​ where 0 <  < 1
add proportionally (or more) to
The parameters  and 1–  represent the share
output growth always appear to
of capital K and labour N in income Y. For more
be possible. This characteristic of
details, see addendum 8.1.
A, as against the others, will prove
to be very important in the analysis and conclusions that follow.
❐ The absence of diminishing marginal returns means that there are either constant
marginal returns for that factor, or increasing marginal returns.
❐ For illustrative purposes we will assume, in the rest of this chapter, that A is subject to
constant marginal returns (as against the other option, i.e. increasing marginal returns).
So we assume that an increase (i.e. growth) in A always leads to the same proportional
increase (i.e. growth) in Y: if A increases by 5% it will cause a 5% increase in Y.
π
Graphically, sustained increases in Y must come from either of two sources (or both): a
sustained move along TP due to increasing N, or a sustained upward shift/rotation of TP due
to increased K or improved technology and social and economic institutions A.
8.3 From intuition to formal analysis – from AD-AS to the Solow growth model
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Figure 8.1 TP and growth in long-run real income due to changing K or A
Y
TP1
TP0
Y
Y1
Y1
YS
YS
NS0
NS1
YS0
N
__
​ W​
P
45° line
P
YS1
Y
ASSR
WS
PS
NS0 NS1
N
YS
Y1
Y
1. Changes in K and A will increase labour productivity; thus TP rotates up and, in the
PS-WS diagram, PS shifts up – see figure 8.1.
❐ New technology lifts but also extends/elongates the TP curve to the right – there
is a new technical relationship, so that the flattening area (diminishing marginal
returns area) is shifted out to the right.
❐ Increasing K produces purely a proportional upward shift/rotation in TP, and the
hazard of diminishing marginal returns to labour setting in is not forestalled. There
is no change in the technical relationships inherent in TP.
2. Changes in the labour force (LF) will shift WS in the WS-PS diagram, but TP will not
rotate. That is, there is a move along a stationary TP, and no change in the technical
relationships inherent in TP.
3. For a similar change in the employment level N, the resultant change in YS (and ASLR)
will be larger when it is combined with changes in A and K (that shift/rotate TP).
What one sees here is that sustained increases in Y (i.e. GDP), and thus economic
growth in the very long run, will depend positively on investment (capital formation:
infrastructure, machinery and equipment, etc.), labour force growth, and progress in
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terms of new technology and the development of social and economic institutions and
processes. (Growth of human capital can be added to this list to be more complete; see
section 8.10.)
However, growth in Y is not without constraints and limitations.
❐ Regarding N (as a proxy for the labour force LF): First, it is constrained by natural limits on
the population growth rate. Moreover, increasing employment N is subject to diminishing
returns, so increasing N out of line with K is less productive in the long run.
❐ Regarding K: Capital expansion is subject to diminishing returns (if it is increased out
of line with N), which means that the rotation of TP will be stifled more and more.
Second, capital formation (investment) has to be financed from aggregate saving –
which depends, in turn, on Y (and the saving rate). Also, the capital stock does not
necessarily remain constant. A fraction of the capital stock is depleted annually – i.e.
there is depreciation – due to wear and tear, or machinery becoming obsolete and
having to be replaced regularly through investment.
❐ Regarding A: With growth due to improving technology and institutions not being subject
to diminishing returns, a given percentage growth in technology and institutions (as
measured by growth in A) leads to the same percentage growth in Y.
The amplifying impact of technology and institutions on labour efficiency means that by
improving technology and institutions one can overcome the ultimately choking effects,
on output growth, of diminishing re­turns to labour.
❐ This is seen in the way TP is rotated and elongated by improving technology and
institutions without the rotation being stifled by diminishing marginal returns: a given
improvement in A leads to an equi-proportional improvement in Y.
Note, with reference to figure 8.2, that in the
initial graphical depiction of the pro­duction
function shown in figure 8.1 we have chosen
to place employment N on the horizontal axis.
Thus, changes in K, which is not on either of
the axes, will shift the TP curve. The same
applies to changes in A. By contrast, changes
in N result in moves along the TP curve.
Figure 8.2 The impact of technology and institutions
on TP
Y
TP1
TP0
Y1
Y0
One can, alternatively, choose to show TP with
the capital stock K on the horizontal axis as in
figure 8.2. Changes in A would still shift/rotate
the TP curve, as from TP0 to TP1. A change in
K now is seen as a move along a particular
curve, e.g. TP0, as indicated. Changes in N
will shift the TP curve. Nevertheless, in terms
K0 K1
K
of analysis, the diagram will produce results
iden­tical to those for figure 8.1 and its version of TP. The resultant changes in Y will, as
before, re­flect as a shift of the vertical ASLR line.
❐ As before, the curvature shows diminishing marginal returns, in this case diminishing
marginal returns to capital.
From now on we will only work with the TP diagram and dispense with the ASLR diagram.
We know that any vertical change in Y in the TP diagram is equiva­lent, in the AD-AS
plane, to a right­ward shift of ASLR and an increase in YS.
❐ For reasons that will immediately become clear, our further development of the TP
relationship will build on figure 8.2, with K on the horizontal axis.
8.3 From intuition to formal analysis – from AD-AS to the Solow growth model
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8.4
Rearranging the model – towards income per capita
A major limitation of the analysis above is that it works in terms of the growth of aggregate
output and income Y (i.e. GDP). What is important for growth theory, but actually for the
population of a country, is GDP growth relative to population growth. This would determine
what is happening with GDP (or Y) per capita, which indicates what is happening with the
material living standards of individuals in the population.
Thus we have to evaluate and analyse growth in Y relative to the population growth rate
n. Changes in (if not levels of) the latter ratio can be approximated by changes in ​ NY ​, i.e.
output per worker or income per worker.
Although not precisely equivalent, for the purposes of this chapter we shall use the terms
Y

​  N ​, output per worker, income per worker, and income (or GDP) per capita interchangeably.
8.4.1
Recasting the production function
Thus it becomes convenient to recast our analysis with ​ NY ​as the key variable. This can
be done by rewriting the production function TP in so-called intense form with ​ NY ​as the
dependent variable, and thus the variable on the vertical axis of the TP diagram.
❐ This also has the benefit of avoiding a situation where a shifting and rotating TP will
rapidly disappear off the top of the page (similar to when we studied the AD-AS model
in an inflationary context).
Thus the standard production function
Y = f(K; N; A)
can be rewritten in the following form, which we will still indicate as TP:
Y
(K )
__
​ __
N ​ = f​ ​  N ​; A ​
where
...... (8.2)
​ NY ​ = output–labour ratio, i.e. output per worker (also: average labour productivity);
K
​ 
N ​ = capital­­­–labour ratio, i.e. capital stock per worker;
A = an index of labour efficiency. Since A in the first production function above is an
index of technological and institutional progress (and something that broadly
speaking is available to everybody), it need not be divided by N.
One could also simply think, in this form of the production function, of A as a measure, or
an index, of labour efficiency due to improved technology, social and economic institutions
and practices. This is the approach we adopt in this chapter.
❐ The growth rate of A (which is denoted as a) thus indicates the growth rate of labour
efficiency due to technological progress and social and economic institutional
development.
Note:
K
❐ Increasing ​ N ​is called capital deepening. Its opposite is capital widening.
❐ Another relevant ratio is ​ KY ​, the capital–output ratio, which is called the capital intensity
of an economy.
From this function we can derive a model that explains fairly robustly how sustained
increases in ​ NY ​– and thus economic growth that increases the standard of living over time
(in the very long run) – will depend on:
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(a) saving and investment (i.e. capital formation and accumulation, which improves
capital intensity);
(b) labour force growth;
(c) progress in terms of new technology and the development of social and economic
institutions and processes (which improves labour efficiency); and also
(d) improvements in human capital – which we will not analyse for the moment (see
section 8.10).
​ NK ​on the
This function enables us to generate a diagram with ​ NY ​on the vertical axis and 
horizontal axis (see figure 8.3).
❐ The benefit of this diagram is that any movement of the economy to a point on TP that
shows an increase in ​ NY ​implies that Y has not only grown, but has grown more than the
labour force or population growth in that period.
Economic growth in the sense of a
K
Working in terms of ratios such as 
​ NY ​ and ​ 
​is
sustained annual increase in GDP
N
Y
somewhat
confusing
at
first,
so
be
careful
when
per capita, as approximated by 
​ N​
thinking about changes in variables. We will
in the Solow model, implies (and
initially present the analysis in some detail to aid
requires) a sustained increase in
understanding. Addendum 8.2 provides a helpful
the ​ NY ​ ratio on the vertical axis.
illustrative numerical example. It is worth studying
A higher value of ​ NY ​is beneficial
it carefully.
for the population, but it does
not constitute growth (just as
an increase in the price level does not constitute inflation). Economic growth is about
​ NY ​ over time.
sustained, recurring annual increases in 
​ NY ​-​ NK ​plane has the same general shape as in the Y-K plane, for the same
The TP curve in the 
reason: diminishing marginal returns. It will thus also flatten out at higher levels of 
​ NK .​
8.4.2
Moving along TP, shifting TP
As noted above, increasing one factor of production while keeping the others constant will
increase out­put Y, but at a decreasing rate. This has complex implications for the change
in ​ NY ​, as follows:
K
❐ If K is increased (for constant N), ​ NK ​increases to ​ 
N ​. Graphically, there is a move to the
right along TP0. Output Y will increase due
to the
ad­ditional capital and ​ NY ​will increase Figure 8.3 Changes in TP
Y
). Since it involves diminishing re(to ​ 
N ​
TP2
Y/N
turns to capital (graphically, the move is
along the curvature of TP0), ​ NY ​ increases
Y2 /N0
proportionally less than the increase
TP0
Y1/N0
in ​ NK ​ (and K increases proportionally less
than Y).
Y0 /N0
❐ If only N is increased (for constant K),
there is a move to the left along TP0 (not
Y
shown). ​ 
N ​ will de­cline.
❐ Note that the variable N (or LF) has
Y

an unexpected effect on ​
N ​. Increasing
employment N increases output Y, yes,
but since the growth in Y is subject
K0 /N0
K1/N0
K/N
to diminishing marginal returns, the
1
0
1
0
8.4 Rearranging the model – towards income per capita
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higher value of N implies that output per worker (or per capita income) decreases. Put
differently, because the unchanging capital stock must be spread over more workers,
dimin­ishing marginal returns set in, and Y does not expand proportionally to match
the increase in N. Output per worker actually declines.
​ NY ​remains constant though, as
If both K and N are increased and in the same proportion, 
K
does ​ N ​(of course).
❐ Flowing from our assumption, for the production function, of constant returns to scale
for in-tandem increases in N and K, total output Y will increase in proportion to the
change in N and K. This means output per worker 
​  NY ​will remain constant. The economy
remains at the same point on the TP curve.
Once again, an improvement in technology or in social and economic institutions gives
strikingly different results. Improvements that improve labour efficiency A will increase
​ NK ​being required.
output Y as well as output per worker 
​ NY ​ without any change in K or N or 
Graphically, such an increase in A will rotate the TP curve and lengthen
it up and towards
Y
.
​
the right (from TP0 to TP2, say). Income per worker increases to ​ 
N
2
0
8.5
Y
Sources of sustained growth in ​ 
​​– first conclusions
N
Economic growth in the sense of a sustained increase in GDP per capita, or rather ​ NY ,​
graphically implies (and requires) a sustained increase in the 
​ NY ​ratio on the vertical axis.
An important question is the sources for such growth, and whether all apparent sources
of growth can deliver such an outcome – or whether they can deliver it in the same
way or with the same potency. We can examine this by repeating the analysis above in
a ‘continually growing’ context: deducing how and whether each factor can deliver the
required sustained increase in 
​ NY .​
Growing labour force and employment
Sustained growth in the labour force and employment can cause growth in aggregate
output and income Y, but income will grow slower than N and in such a way (being choked
increasingly by diminishing marginal returns) that it actually leads to a decline in ​ NY ​or per
capita income. The average material standard of living of people will decline.
​ NY .​
❐ So N alone cannot produce sustained growth in Y or 
Growing capital stock
Growth in the capital stock K (with constant N) will lead to growth in aggregate output
Y
(output per worker) will
and income Y. Since the labour force remains constant, ​ 
N ​
increase/grow, suggesting that income per capita grows correspondingly. Graphically, the
production point moves to the right along the TP curve. This demonstrates the unhappy
truth that the growth in ​ NY ​is constrained and ultimately capped by the slope of the TP
curve, which reflects diminishing marginal returns to capital for increasing capital–labour
ratios. ​ NY ​ can grow, but it cannot grow indefinitely. In fact, it will increase from one level to
a higher one, and will then remain there. (Its growth rate will be positive only during this
transition.)
Y
❐ Thus, sustained growth in K alone cannot produce sustained growth in ​ 
N ​.
❐ In addition, as we will see be­low, the move along TP is con­strained by being dependent
on capital formation (investment) that has to be financed from savings (which comes
out of GDP, i.e. Y). Forces will be at work to guide the ​ NK ​ratio to a stable rest point.
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Expanding human capital
Although we will only discuss
human capital H later, it is worth
noting here that the impact of
​ NY ​ and
growing human capital on 
per capita income is an important
part of our eventual analysis.
As we have noted, the impact of
human capital on ​ NY ​is thought to
be similar to that of either physical
capital K or labour efficiency A.
(See the analysis in section 8.10.)
What about natural resources as a source
of growth?
Countries rich in natural resources such as oil reserves or mineral deposits (e.g. gold, platinum, iron
ore) clearly have a major economic advantage. The
question is how to accommodate that in the production function and growth model.
The basic answer is that natural resources form the
resource base upon which K, N and A are applied
in order to produce output Y. They do not have a
separate effect on output, which depends on the
utilisation of K, N and A. Therefore:
❐ In a growth model, their main impact is on the
level of GDP (or the level of the GDP growth
path).
❐ Since the extraction of such resources involves
huge capital expenditure, there is also a capital
effect – but also only on the level of GDP.
❐ However, natural resources do not determine the
Y
growth rate of Y (or 
​ N
​).
❐ The infusion of new technology into mineral
extraction and mining will, however, affect the
growth rate of GDP.
Growing labour and capital together
Synchronised sustained growth in
the labour force and the cap-ital
stock will increase aggregate output
in the same proportion (in terms of
the assumption of constant return
K
to scale). 
​ N ​remains constant. This
means, however, that output per
worker, ​ NY ​, remains constant in the
long term. This is explained by the
fact that the benefit of the growth
in Y, caused by the growth in K, is
partly negated by the growth in N, which reduces the per capita benefit.
❐ Thus, sustained growth in N and K together can also not produce sustained growth
in ​ NY .​
Technological and social institutions/labour efficiency
Growth in labour efficiency due to progress in technology and/or social and economic
institutions will improve the productive performance of an economy and increase Y.
Moreover, since decreasing marginal returns to one of the main factors K and N are not
​ NY ​due to policy growth in A will always remain equal to the growth
involved, growth in 
rate of A, unlike the case with capital and labour growth. Graphically, TP can rotate and
be elongated upwards and to the right over time without constraint.
❐ This produces one of the most important results of the Solow growth model: sustained growth
​  NY ​, i.e. per capita GDP, can only be produced by sustained growth in labour efficiency resulting
in 
from sustained progress in technology and institutions. (But also see section 8.10.)
Historically, this factor, much more than capital accumulation, is understood to explain
the most important eras of sustained growth in living standard in the USA and other
countries, e.g. the post World War II period up to the middle 1970s.
Y
8.5 Sources of sustained growth in 
​  N​
​ – first conclusions
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8.6
Is any capital–labour ratio possible? The idea of balanced growth
A second set of results from the Solow growth model relates to the following key question
for society and government: can a society choose to be at any point on a given TP curve?
Can it move, or be pushed, as far right on the TP curve as it wishes?
Preview: key points of this section
1. The only economic growth path that can be maintained for a very long period is one where a
balance between output and the various factors of production is maintained.
2. Any other course will be subject to economic forces that gradually push the economy
towards the balanced growth path.
8.6.1
The concept of balanced growth
Assume for the moment that there is no growth in A, i.e. labour efficiency remains constant.
This will enable us to focus on 
​ NY ​ and ​ NK ​. We will relax this assumption in section 8.7.
The first question amounts to asking whether or not there is an optimal value of K relative
to N, i.e. an optimal value of the 
​ NK ​ratio (the capital–labour or capital per worker ratio).
Solow’s approach was the typical economist’s approach: he asked whether the course of
the economy (the growth path and growth rate of Y) is unconstrained and unbounded,
or whether there are either constraints or forces that push it towards rest values or, in
favoured economic parlance, equilibrium values. An important result of Solow’s model is
that there are indeed such rest points or balance points.
❐ In Solow’s model these are captured in the concept of balanced growth points, or steadystate growth points.
One can thus study economic growth by analysing the pattern and behaviour of ‘stable points’
over time and analysing how the economy moves towards such stable points over time if it is not
at such a point.
We can now give our first definition of the concept of balanced growth. This is in terms
of balanced growth in aggregate GDP (or Y). It will prepare the way for a more general
definition, in section 8.7 below, in terms of balanced growth in per capita GDP.
Balanced growth (in aggregate Y) is defined as a growing-economy situation in which the
K
Y
ratios ​ 
N ​ and ​ 
N ​remain constant. Y is growing in line with N, and K is growing in line with
N. No variable is getting out of line with regard to any of the others. But there is sustained
growth in aggregate output Y (equal to the growth rate in N and K). This means that both
output and capital stock expand precisely in line with population growth.
K
❐ In such a balanced growth situation, ​ 
Y ​(capital intensity) remains constant.
❐ The striking thing about a balanced growth situation is that, when the economy is
in such a state of growth, all these ratios remain constant while the many different
variables in the economy change, vary and grow over time.
❐ Note that this particular definition is for balanced growth in aggregate Y, i.e. it is only
for a situation where the aggregate growth (in Y) is such that there is no per capita
Y
growth (in ​ 
N ​). As we will see later, this is a situation where the factor A has no growth.
For the more or less normal situation where A has positive growth, the definition will
have to be broadened (section 8.7).
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Chapter 8: Macroeconomics in the very long run: growth theory
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Defining such a point of balanced aggregate growth is not very interesting in itself. But
Solow’s next conclusions are very interesting.
(a) For a given set of conditions and parameters, there is only one balanced growth
point.
(b) Any point on TP off the balanced growth point cannot be kept going in the very
long run. There are ‘gravitational’ forces at work, in the very long run, that pull the
economy towards the balanced growth point.
Let’s consider these in turn.
8.6.2
Conditions for a balanced growth point – a first version
To pin down the concept of balanced growth, the question is: ar